We encourage you to read the consolidated financial statements included in this Form 10-K because they contain our complete consolidated financial statements for the years ended December 31, 2006, 2005, and 2004. The results of operations for the year ended December 31, 2006 are not necessarily indicative of future results.
The Emerging Issues Task Force (“EITF”) Issue 4-08 “The Effect of Contingently Convertible Instruments on Diluted Earnings Per Share,” which is effective for periods ending after December 15, 2004, requires that the dilutive effect of contingently convertible debt securities, with a market price threshold, should be included in diluted earnings per share. The terms of our convertible senior debentures, which were issued in June 2002, (see Note 13 to our consolidated financial statements) meet the criteria defined in EITF Issue 4-08, and accordingly, the effect of conversion of our convertible senior debentures to common shares has been assumed when calculating our diluted earnings per share for all years. See Notes 3(l) and 6 to our consolidated financial statements included in this Form 10-K.
Inclusion of restricted common shares, stock options and the effect of the conversion of our convertible debt to common shares would have an antidilutive effect on the 2005 diluted earnings per common share (i.e., the diluted earnings per common share would be greater than the basic earnings per common share). Accordingly, such common shares were excluded from the calculations of the 2005 diluted earnings per common share. See Notes 3(l) and 6 to our consolidated financial statements included in this Form 10-K.
Odyssey Re Holdings Corp. is a holding company, incorporated in the state of Delaware, which owns all of the common shares of Odyssey America Reinsurance Corporation, its principal operating subsidiary. Odyssey America directly or indirectly owns all of the capital stock of the following companies: Clearwater Insurance Company; Clearwater Select Insurance Company; Odyssey UK Holdings Corporation; Newline Underwriting Management Ltd., which owns and manages Newline Syndicate 1218, a member of Lloyd’s of London; Newline Insurance Company Limited; Hudson Insurance Company; Hudson Specialty Insurance Company; and Napa River Insurance Services, Inc.
We are a leading United States based underwriter of reinsurance, providing a full range of property and casualty products on a worldwide basis. We offer a broad range of both treaty and facultative reinsurance to property and casualty insurers and reinsurers. We also write insurance in the United States and through the Lloyd’s marketplace.
The property and casualty reinsurance and insurance industries use the combined ratio as a measure of underwriting profitability. The GAAP combined ratio is the sum of losses and loss adjustment expenses (“LAE”) incurred as a percentage of net premiums earned, plus underwriting expenses, which include acquisition costs and other underwriting expenses, as a percentage of net premiums earned. The combined ratio reflects only underwriting results, and does not include investment results. Underwriting profitability is subject to significant fluctuations due to catastrophic events, competition, economic and social conditions, foreign currency fluctuations and other factors. Our combined ratio was 94.4% for the year ended December 31, 2006, compared to 117.6% for the year ended December 31, 2005.
We are exposed to losses arising from a variety of catastrophic events, such as hurricanes, windstorms and floods. The loss estimates for these events represent our best estimates based on the most recent information available. We use various approaches in estimating our losses, including a detailed review of exposed contracts and information from ceding companies. As additional information becomes available, including information from ceding companies, actual losses may exceed our estimated losses, potentially resulting in adverse effects to our financial results. The extraordinary nature of these losses, including potential legal and regulatory implications, creates substantial uncertainty and complexity in estimating these losses. Considerable time may elapse before the adequacy of our estimates can be determined. For the years ended December 31, 2006, 2005 and 2004, current year catastrophe events were $34.9 million, $537.9 million and $138.8 million, respectively.
offset by reduced loss estimates on other prior period property catastrophes due to favorable emergence during the year.
For the year ended December 31, 2004, the total current year catastrophe losses of $138.8 million include net losses and LAE of $93.4 million, which is after reinsurance of $77.8 million, related to Hurricanes Charley, Frances, Ivan and Jeanne (the “2004 Florida Hurricanes”). In addition to the net losses and LAE, we ceded $4.0 million in net reinstatement premiums paid, resulting in an underwriting loss of $97.4 million from these storms. As a result of the uncertainty and complexity in estimating losses from the 2004 Florida Hurricanes, we incurred additional underwriting losses of $3.1 million and $12.6 million, net of applicable reinstatement premiums, for the years ended December 31, 2006 and 2005, respectively.
On March 31, 2006, we restated our consolidated financial statements as of and for the years ended December 31, 2000 through 2004, as well as our unaudited financial information as of and for the nine months ended September 30, 2005, to correct for accounting errors associated with certain reinsurance contracts entered into by us between 1998 and 2004. On August 28, 2006, we restated our unaudited financial information as of March 31, 2006 and December 31, 2005 and for the three months ended March 31, 2006 and 2005, to correct for accounting errors associated with certain investments held by us, and on October 16, 2006 we filed an Annual Report on Form 10-K/ A to reflect the impact of this restatement on our consolidated financial statements as of and for the years ended December 31, 2001 through 2005. The total cumulative impact of these restatements through December 31, 2005 was to decrease shareholders’ equity by $19.6 million, after tax. The aggregate net effect of the restatements for the year ended December 31, 2005 was to increase net loss available to common shareholders by $17.3 million, and for the year ended December 31, 2004 was to increase net income available to common shareholders by $18.3 million. The effects of the restatements are reflected in this Management’s Discussion and Analysis and our consolidated financial statements and accompanying notes included in this Form 10-K.
Critical accounting estimates are defined as those that are both important to the portrayal of our financial condition and results of operations and require us to exercise significant judgment. The preparation of consolidated financial statements in accordance with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of material contingent
assets and liabilities, including litigation contingencies. These estimates, by necessity, are based on assumptions about numerous factors.
Our estimates are based on contract and policy terms. Estimates are based on information typically received in the form of a bordereau, broker notifications and/or discussions with ceding companies. These estimates, by necessity, are based on assumptions regarding numerous factors. These can include premium or loss trends, which can be influenced by local conditions in a particular region, or other economic factors and legal or legislative developments which can develop over time. The risk associated with estimating the performance under our contracts with our ceding companies is the impact of events or trends that could not have been reasonably anticipated at the time the estimates were performed. Our business is diversified across ceding companies and there is no individual ceding company which represents more than 2.4% of our gross premiums written in 2006. As a result, we believe the risks of material changes over time are mitigated.
We rely on initial and subsequent claims reports received from ceding companies to establish our estimates of losses and LAE. The types of information that we receive from ceding companies generally vary by the type of contract. Proportional, or quota share, contracts are typically reported on a quarterly basis, providing premium and loss activity as estimated by the ceding company. Reporting for excess of loss and facultative contracts includes detailed individual claim information, including a description of the loss, confirmation of liability by the cedant and the cedant’s current estimate of the ultimate liability under the claim. Upon receipt of claim notices from cedants, we review the nature of the claim against the scope of coverage provided under the contract. Questions arise from time to time regarding the interpretation of the characteristics of a particular claim measured against the scope of contract terms and conditions. Reinsurance contracts under which we assume business generally contain specific dispute resolution provisions in the event that there is a coverage dispute with the ceding company. The resolution of any individual dispute may impact estimates of ultimate claims liabilities. Reported claims are in various stages of the settlement process. Each claim is settled individually based on its merits, and certain claims may take several years to ultimately settle, particularly where legal action is involved. Based on an assessment of the circumstances supporting the claim, we may choose to establish additional case reserves over the amount reported by the ceding company. Aggregate case reserves established in addition to reserves reported by ceding companies were $17.2 million and $17.3 million as of December 31, 2006 and December 31, 2005, respectively. Due to potential differences in ceding company reserving and reporting practices, we perform periodic audits of our ceding companies to ensure the underwriting and claims procedures of the cedant are consistent with representations made by the cedant during the underwriting process and meet the terms of the reinsurance contract. Our estimates of ultimate loss liabilities make appropriate adjustment for inconsistencies uncovered in this audit process. We also monitor our internal processes to ensure that information received from ceding companies is processed in a timely manner.
The reserve methodologies employed by us are dependent on the nature and quality of the data that we collect from ceding companies. This data primarily consists of loss amounts reported by the ceding companies, loss payments made by ceding companies, and premiums written and earned reported by the ceding companies or estimated by us. Underwriting and claim information provided by our ceding companies is aggregated by the year in which each treaty is written into groups of business by geographic region and type of business to facilitate analysis, generally referred to as “reserve cells.” These reserve cells are reviewed annually and change over time as our business mix changes. We supplement this information with claims and underwriting audits of specific contracts, internally developed pricing trends, as well as loss trend data developed from industry sources. This information is used to develop point estimates of carried reserves for each business segment. These individual point estimates, when aggregated, represent the total carried losses and LAE reserves carried in our consolidated financial statements. Due to the uncertainty involving estimates of ultimate loss exposures, we do not attempt to produce a range around our point estimate of loss. The actuarial techniques for projecting losses and LAE reserves by reserve cell rely on historical paid and case reserve loss emergence patterns and insurance and reinsurance pricing trends to establish the claims emergence of future periods with respect to all reported and unreported insured events that have occurred on or before the balance sheet date.
We reported net adverse development for prior years of $139.9 million, $172.7 million, and $190.0 million for the years ended December 31, 2006, 2005, and 2004, respectively. The increases in prior year loss estimates for these periods were due to a reevaluation of loss reserve assumptions principally related to United States casualty business written in 2001 and prior. Our actual loss emergence reported in 2006, 2005, and 2004 for United States casualty business written prior to 2002 was considerably greater than expectations, which were based on historical loss emergence information available prior to 2006, 2005, and 2004, respectively. Upon consideration of this new loss emergence information received during 2006, 2005, and 2004, we revised the loss development assumptions used in our Untied States casualty business loss reserving analyses and increased ultimate loss, which had the effect of increasing our loss reserves for this business.
If a change were to occur in the frequency and severity of claims underlying our December 31, 2006 unpaid losses and loss adjustment expenses, the approximate change in pre-tax income would be as follows (in millions):
Historically, our actual results have varied considerably in certain instances from our estimates of losses and LAE because historical loss emergence trends have not been indicative of future emergence for certain segments of our business. In recent years, we experienced loss emergence, resulting from a combination of higher claim frequency and severity as reported by our cedants, greater than expectations that were established based on a review of prior years’ loss emergence trends, particularly for business written in the period 1997 through 2001. General liability and excess workers’ compensation classes of business during these years were adversely impacted by the highly competitive conditions in the industry at that time. These competitive conditions resulted in price pressure and relatively broader coverage terms, thereby affecting the ability of standard actuarial techniques to generate reliable estimates of ultimate loss. Similarly, directors’ and officers’ professional liability lines were impacted by the increase in frequency and severity of claims resulting from an increase in shareholder lawsuits against corporations and their officers and directors, corporate bankruptcies and other financial and management improprieties in the 1990s through early 2000s.
The following table provides detail on net adverse (favorable) loss and LAE development for prior years, by division, for the years ended December 31, 2006, 2005, and 2004 (in millions):
Estimates of reserves for unpaid losses and LAE are contingent upon legislative, regulatory, social, economic and legal events and trends that may or may not occur or develop in the future, thereby affecting assumptions of claim frequency and severity. Examples of emerging claim and coverage issues and trends in recent years that could affect reserve estimates include: (i) developments in tort liability law; (ii) legislative attempts at asbestos liability reform; (iii) uncertainties regarding the future scope of the Terrorism Risk Insurance Act of 2002; (iv) an increase in shareholder derivative suits against corporations and their officers and directors; and (v) increasing governmental focus on, and involvement in, the insurance and reinsurance industry generally. The eventual outcome of these events and trends may be different from the assumptions underlying our loss reserve estimates. In the event that loss trends diverge from expected trends during the period, we adjust our reserves to reflect the change in losses indicated by revised expected loss trends. On a quarterly basis, we compare actual emergence of the total value of newly reported losses to the total value of losses expected to be
The following table summarizes, by type of reserve, the unpaid losses and LAE reserve as of December 31, 2006 and 2005. Case reserves represent unpaid claim reports provided by cedants to us plus additional reserves determined by us. IBNR is the estimate of unreported loss liabilities established by us.
The following tables provide the historical gross and net asbestos and environmental losses and LAE incurred for the years ending December 31, 2006, 2005 and 2004 (in millions).
The asbestos open claim count as of December 31, 2006 was 1,553, amounting to $228.5 million in gross case losses and LAE reserves. The largest 10 reported claims account for 15.2% of the gross case reserves, with an average reserve of $3.5 million. The asbestos open claim count as of December 31, 2005 was 1,532, amounting to $206.0 million in gross case losses and LAE reserves. The largest 10 reported claims account for 15.7% of the gross case reserves, with an average reserve of $3.2 million. Gross case reserves increased in 2006, as newly reported claims and additional reported reserves on existing claims more than offset case reserve reductions associated with claim payments in the year. Based on an aggregation of claims by insured, our 10 largest insured involvements account for 42.7% of our gross case reserves at December 31, 2006, compared to 47.8% at year end 2005. Based on our annual reserve study, we increased net asbestos loss reserves by $27.1 million based on the observed trends in our internal loss data as well as external loss trends.
The environmental open claim count as of December 31, 2006 was 738, amounting to $28.9 million in gross case losses and LAE reserves. The largest 10 reported claims account for 28.0% of the gross case reserves, with an average case reserve of $0.8 million. The environmental open claim count as of December 31, 2005 was 1,373, amounting to $32.2 million in gross case losses and LAE reserves. The largest 10 reported claims account for 24.2% of the gross case reserves, with an average case reserve of $0.8 million. Overall gross case reserves decreased in 2006, as newly reported claims and additional reported reserves on existing claims were less than claim payments in the year. The environmental open claim count decreased by 635, or 46%, during calendar year 2006 due to the closing of many small case reserved claims not expected to generate a payment based on the most recent information available to us. Based on an aggregation of claims by insured, our 10 largest insured involvements account for 45.7% of our gross case reserve as of December 31, 2006, compared to 45.1% as of
We seek to limit the probable maximum loss to a specific level for severe catastrophic events. Currently, we generally seek to limit the probable maximum loss, after tax, including the effect of reinsurance protection and applicable reinstatement premiums, to a maximum of approximately 15% of statutory surplus for a severe
catastrophic event in any geographic zone that could be expected to occur once in every 250 years, although this can change based on market opportunities. There can be no assurances that we will not incur losses greater than 15% of our statutory surplus from one or more catastrophic events due to the inherent uncertainties in estimating the frequency and severity of such events, the margin of error in making such determinations resulting from potential inaccuracies and inadequacies in the data provided by clients and brokers, and the modeling techniques and the application of such techniques.
The total amount of reinsurance recoverables on paid and unpaid losses as of December 31, 2006 and 2005 was $798.8 million and $1,347.7 million, respectively. We have established a reserve for potentially uncollectible reinsurance recoverables based upon an evaluation of each retrocessionaire and our assessment as to the collectibility of individual balances. The reserve for uncollectible recoverables as of December 31, 2006 and 2005 was $42.5 million and $30.9 million, respectively, and has been netted against reinsurance recoverables on loss payments. We have also established a reserve for potentially uncollectible assumed reinsurance balances of $1.9 million and $6.3 million as of December 31, 2006 and 2005, respectively, which has been netted against premiums receivable.
Our reinsurance protection, which covered certain amounts of our 1995 and prior unpaid losses and loss adjustment expenses (the “1995 Stop Loss Agreement”), provided by nSpire Re Limited (“nSpire Re”), a wholly-owned subsidiary of Fairfax, was commuted effective September 29, 2006, for consideration of $63.2 million. In accordance with the terms of the commutation agreement, we commuted ceded loss reserves of $71.8 million, resulting in a pre-tax commutation loss of $5.5 million, recorded in the third quarter of 2006. The 1995 Stop Loss Agreement was originally entered into with Skandia Insurance Company Ltd. (“Skandia”) in conjunction with the purchase of Clearwater in 1996. Pursuant to the agreement, we paid a premium of $60.5 million in 1995 for protection of $175.0 million in excess of Clearwater’s December 31, 1995 reserves for net unpaid losses and loss adjustment expenses and reserves for uncollectible reinsurance. In January 1999, the liabilities under the contract were assigned by Skandia to nSpire Re for $97.0 million in consideration. Following the assignment to nSpire Re, we accounted for the 1995 Stop Loss Agreement as retroactive reinsurance. Accordingly, losses ceded under the contract in excess of $97.0 million in the aggregate had been recorded as a deferred gain rather than as a benefit in the applicable periods. The deferred gain had been amortized into income
For years ending December 31, 2001 and prior, we utilized whole account aggregate excess of loss retrocessional coverage (“Whole Account Excess of Loss Agreements”) to manage our exposures, including catastrophic occurrences and the potential accumulation of exposures. As further discussed below, during the second quarter of 2006, we commuted certain Whole Account Excess of Loss Agreements. In addition, Whole Account Excess of Loss Agreements were purchased covering underwriting years 2002 through 2004 though no losses were ceded to these coverages. The Whole Account Excess of Loss Agreements are broad in coverage, and include property and casualty insurance and reinsurance business written on a worldwide basis, as applicable. Classes of business excluded from coverage primarily include non-traditional business. In each calendar year, we have the ability to cede losses attributable to certain prior periods to the Whole Account Excess of Loss Agreements to the extent there are limits remaining for the period. These agreements cover business written or incepting during a defined period of time (underwriting year), which is typically twelve months, or in other cases, business earned during a defined period of time (accident year). The Whole Account Excess of Loss Agreements were purchased on an underwriting year basis for 1996 through 2004 and on an accident year basis for 1994 and 1995. Accident year agreements were also purchased to supplement the 1996 and 1997 underwriting year agreements. All of these Whole Account Excess of Loss Agreements covering prior underwriting and accident years have been commuted except for two agreements covering underwriting years 2000 and 2001. Loss cession limits on these two covers still outstanding have been fully utilized as of December 31, 2005. Each agreement provides for recoveries from the retrocessionaires, subject to a limit, in the event that the net subject business results in a composite ratio (the sum of the commission and loss ratios), or in some agreements a loss ratio, in excess of a specified attachment point. The attachment point is net of other inuring third party reinsurance. The premium paid, net of commission, by us is calculated based on a contractual fixed rate that is applied to the total premiums covered by the retrocession agreements. Each agreement includes a provision for additional premium, subject to a maximum, based on the amount of loss activity under the agreement. Reinsurance recoverables on paid and unpaid losses are fully secured by letters of credit or funds held by us.
During the second quarter of 2006, we commuted certain Whole Account Excess of Loss Agreements for total consideration of $80.6 million through the settlement of funds held under reinsurance contracts (included as a liability on our consolidated balance sheet) and the receipt of cash from the reinsurer, net of the settlement of
In addition to the Whole Account Excess of Loss Agreements, we entered into a three-year aggregate excess of loss reinsurance contract protecting our United States facultative casualty business for underwriting years 1998 through 2000 (“Facultative Excess of Loss Agreement”) which indemnified us for losses in excess of an annual retention, subject to an annual limit of liability. During December 2006, we entered into a commutation and release agreement related to this contract, pursuant to which all rights, obligations and liabilities were fully and finally settled. As a result of the commutation, a pre-tax loss of $1.4 million was recognized. Additionally, reinsurance recoverables have been reduced by $16.1 million for the year ended December 31, 2006. The aggregate limit for underwriting years 1998, 1999 and 2000 was equal to 40% of our total facultative net premiums written, subject to a minimum annual dollar limit of $7.4 million, and a maximum annual dollar limit of $18.5 million. The aggregate limit of liability is $41.6 million across all years, which has been fully utilized. The retention in each year was equal to the greater of $9.3 million or 51.0% of the subject written premium income, together with amounts contributed to a loss payment account under the agreement. We maintained a loss payment account for the benefit of the reinsurer, equal to 18.5% of the subject written premium income for underwriting year 1998, and 18.9% for 1999 and 2000. A minimum interest credit is applied to the loss payment account, equal to the one year U.S. Treasury Bill yield plus 75 basis points. As of December 31, 2006, the loss payment account had a zero balance. The principal reinsurer under these agreements is Underwriters Reinsurance Company (Barbados) Inc.
The income (loss) before income taxes reflected in our consolidated statements of operations related to our Whole Account and Facultative Excess of Loss Agreements for the years ended December 31, 2006, 2005, and 2004 is as follows (in millions):
We have recorded interest expense associated with other ceded reinsurance agreements, and not reflected in the table above, of $571 thousand, $372 thousand and $18 thousand for the years ended December 31, 2006, 2005 and 2004, respectively.
As indicated by the table above, for the years ended December 31, 2006, 2005 and 2004, we ceded $8.3 million, $18.7 million and $5.6 million, respectively, of losses and LAE, primarily to the 2001 aggregate excess of loss treaty. The increase in losses ceded to our Whole Account and Facultative Excess of Loss Agreements, for the years ended December 31, 2006, 2005 and 2004, were primarily attributable to adverse loss development on casualty business written in 2001. Losses ceded to our Whole Account and Facultative Excess of Loss Agreements represented 1.1% of our pre-tax income in 2006, 10.3% of our pre-tax loss in 2005 and 1.8% in pre-tax income in 2004.
The reinsurance recoverables on paid and unpaid losses related to the Whole Account and Facultative Excess of Loss Agreements are $122.2 million and $251.9 million as of December 31, 2006 and 2005, respectively. Funds held under reinsurance contracts, related to these agreements, shown as a liability on our consolidated balance sheets, reflect $83.4 million and $150.7 million as of December 31, 2006 and 2005, respectively. Other collateral related to these agreements is $43.2 million and $124.8 million as of December 31, 2006 and 2005, respectively.
Total reinsurance gross premiums written for the year ended December 31, 2006 were $1,623.6 million compared to $1,863.6 million for 2005, a decrease of 12.9%. Total insurance gross premiums written for the year
ended December 31, 2006, which includes our U.S. Insurance division and our Lloyd’s syndicate (which is part of London Market), were $712.1 million, compared to $763.3 million for 2005, a decrease of 6.7%. For the year ended December 31, 2006, total reinsurance gross premiums written represented 69.5% (71.0% in 2005) of our business and insurance represented the remaining 30.5% (29.0% in 2005) of our business.
United States - Gross premiums written of $756.4 million for the year ended December 31, 2006 decreased $173.5 million, or 18.7%, compared to $929.9 million for the year ended December 31, 2005. The decrease in the United States is in all classes of business. Property business decreased by $59.8 million, or 23.7%, to $192.3 million in 2006 from $252.1 million in 2005 as we reduced our proportional catastrophe exposed business in certain peak zones combined with a reduction in reinstatement premiums. Alternative risk and specialty business decreased by $58.7 million as we exited or reduced our writings in these classes of business. Treaty and facultative casualty business decreased by $43.5 million, or 7.9%, to $504.0 million in 2006 from $547.5 million in 2005 due to an increase in competitive market conditions and the cancellation of certain business that did not meet our underwriting criteria. All other classes of business accounted for the remaining decrease of $11.5 million.
Canada - Gross premiums written of $32.0 million for the year ended December 31, 2006 decreased $18.4 million, or 36.5%, compared to $50.4 million for the year ended December 31, 2005. The reduction in gross premiums written was primarily due to the cancellation of certain automobile business by ceding companies, based on their decision to retain more business. In certain cases, this included the return of unearned premiums to the ceding company.
EuroAsia. Gross premiums written in the EuroAsia division for the year ended December 31, 2006 were $561.2 million, an increase of $17.4 million, or 3.2%, as compared to $543.8 million for the year ended December 31, 2005. These amounts represent 24.0% of our gross premiums written for the year ended December 31, 2006 and 20.7% in 2005. These amounts include $5.2 million of reinstatement premiums for the year ended December 31, 2005 compared to $0.5 million in 2006. The overall increase is primarily attributable to increases in property, marine, credit and bonds, and liability, offset by a decrease in motor business, accident and health and aviation. Gross premiums written from property business, which represents 60.8% of EuroAsia in 2006, increased by $15.0 million, or 4.6%, for the year ended December 31, 2006 driven by increases in the European and Middle East markets. The increase in marine business of $4.8 million, or 16.8%, and all other classes of business of $4.0 million, or 5.3%, is related to increases in new and renewal business throughout
Europe. Offsetting these increases is a decrease in motor business of $3.4 million, or 3.8%, primarily related to European and Asia business and accident and health and aerospace business of $1.2 million and $1.8 million, respectively.
Our personal auto business, which primarily includes non-standard auto business written in California and Florida, decreased $25.9 million, or 25.0%, to $77.7 million for the year ended December 31, 2006 from $103.6 million for the year ended December 31, 2005.
The loss and LAE ratio for the years ended December 31, 2006 and 2005 and the percentage point change for each of our divisions and in total are as follows:
in the 2006 period include a benefit of $24.8 million attributable to 2005 and prior years, principally due to favorable emergence on satellite, accident and health, non-catastrophe property, and aviation exposures in the period, and includes $3.6 million of unfavorable development on prior period catastrophe losses, principally Hurricane Rita, due to loss emergence greater than expectations in 2006. For the year ended December 31, 2005, losses and LAE in the 2005 period include a benefit of $22.8 million attributable to 2004 and prior years, principally due to favorable emergence on aviation, satellite and non-catastrophe property exposures in the period, and includes $1.7 million of loss development from prior period catastrophe losses due to loss emergence greater than expectations.
Acquisition costs are reduced by ceding commissions related to our Whole Account and Facultative Excess of Loss Agreements, of $1.5 million and $5.3 million for the years ended December 31, 2006 and 2005, respectively. The decrease of $3.8 million in 2006 over 2005 was attributable to reduced premiums ceded to these agreements during 2006. Ceding commissions due under certain of our Whole Account Excess of Loss Agreements are deferred and will be received by us in future periods. Ceding commissions have therefore been recorded at their present value, with the discount amortized over the expected collection period. For years ended December 31, 2006 and 2005, the discount recorded on ceding commissions is $1.8 million and $0.8 million, respectively, which is net of the amortization of the discount recorded in prior periods.
The GAAP combined ratio is the sum of losses and LAE as a percentage of net premiums earned, plus underwriting expenses, which include acquisition costs and other underwriting expenses, as a percentage of net premiums earned. The combined ratio reflects only underwriting results, and does not include investment results. Underwriting profitability is subject to significant fluctuations due to catastrophic events, competition, economic and social conditions, foreign currency fluctuations and other factors. Our combined ratio was 94.4% for the year ended December 31, 2006, compared to 117.6% for the year ended December 31, 2005. The following table reflects the combined ratio for the years ended December 31, 2006 and 2005 for each of our divisions:
Excluding the positive impact of realized capital gains attributable to our equity investment in HWIC Asia and the negative impact of the 2005 loss attributable to Advent, net investment income for the year ended December 31, 2006 was $319.5 million, an increase of $111.9 million or 53.9%, from $207.6 million for the year ended December 31, 2005. We believe this figure is more representative of investment income from our ongoing investment activities.
Our total effective annualized yield on average invested assets, net of expense but before the impact of interest expense from funds held balances and the positive impact of realized gains attributable to HWIC Asia, was 5.0% and 3.8% for the years ended December 31, 2006 and 2005, respectively. Also excluding the negative impact of the 2005 losses attributable to Advent, our total effective annualized yield, net of expenses but before the impact of interest expense from funds held balances, was 5.0% and 4.1% for each of the years ended December 31, 2006 and 2005, respectively.
Net Realized Investment Gains. Net realized investment gains of $189.1 million for the year ended December 31, 2006 increased by $129.2 million from $59.9 million for the year ended December 31, 2005. The increase in net realized investment gains is principally due to higher gains from equity securities and other investments, which were offset by lower gains from fixed income securities and higher losses from derivative securities. The total net realized investment gains for the year ended December 31, 2006 of $175.4 million on equity securities, primarily reflect a net gain of $75.1 million related to the redemption of shares of HWIC Asia and the sale of unrelated equity securities. Net realized investment gains from equity securities also include realized losses of $17.1 million related to the other-than-temporary impairment of a security. Net realized investment gains from other investments were $86.5 million for the year ended December 31, 2006, representing a positive change of $134.5 million over 2005, primarily reflecting realized foreign exchange rate gains on short term securities. Net realized investment gains from fixed income securities of $30.4 million for the year ended December 31, 2006 decreased by $51.6 million over 2005. Realized investment gains include mark-to-market movements on derivative securities, including credit default swaps and total return swaps on equity indexes. The net investment loss on derivative securities of $103.1 million for the year ended December 31, 2006 increased by $64.3 million over 2005.
During the year ended December 31, 2006, net realized investment gains were reduced by other-than-temporary impairment losses in the amount of $28.1 million, with $11.0 million relating to fixed income securities and other invested assets and $17.1 million relating to equity securities. Other-than-temporary impairments reflect situations where the market value was below the cost of the securities and the ability of the security to recover its value could not be reasonably determined. Other-than-temporary impairments related to fixed income securities include $7.5 million for security which has no quoted price, to reflect the deterioration in the underlying financial position of the security. During the year ended December 31, 2005, net realized investment gains were reduced by other-than-temporary impairment losses in the amount of $54.9 million, with $37.3 million relating to fixed income securities and other invested assets and $17.6 million relating to equity securities. Other-than-temporary impairments related to fixed income securities include $19.4 million for securities which have no quoted prices, to reflect a deterioration in the underlying financial position of the securities.
Other Expenses, Net. Other expenses, net, for the year ended December 31, 2006, were $21.1 million, compared to $27.0 million for the year ended December 31, 2005. Other expenses are primarily comprised of operating expenses of our holding company and includes audit related fees, Sarbanes-Oxley compliance consulting fees, corporate-related legal fees, consulting fees, and compensation expense, including the amortiza-
Interest Expense. We incurred interest expense, related to our debt obligations, of $37.5 million and $30.0 million for the years ended December 31, 2006 and 2005, respectively. The higher amount of interest expense primarily reflects our $100.0 million senior notes offering completed in February 2006.
Federal and Foreign Income Tax Benefit/ Provision. As a result of our pre-tax income for the year ended December 31, 2006, compared to a pre-tax loss for 2005, our federal and foreign income tax provision for the year ended December 31, 2006 increased by $297.4 million, to a provision of $231.3 million, compared to a benefit of $66.1 million for the year ended December 31, 2005. Included in the income tax provision for the year ended December 31, 2006 is a one-time tax benefit of $16.5 million, which is attributable to the settlement of tax issues related to the acquisition of Clearwater in 1996. Our effective tax rates were 31.3% and 36.4% for the years ended December 31, 2006 and 2005, respectively.
Total reinsurance gross premiums written for the year ended December 31, 2005 were $1,863.6 million compared to $1,968.8 million for 2004, a decrease of 5.3%. Total insurance gross premiums written for the year ended December 31, 2005, which includes our U.S. Insurance division and our Lloyd’s syndicate (which is part of our London Market division), were $763.3 million, compared to $682.0 million for 2004, an increase of 11.9%. For the year ended December 31, 2005, total reinsurance gross premiums written represented 71.0% (74.3% in 2004) of our business and insurance represented the remaining 29.0% (25.7% in 2004) of our business.
Americas. Gross premiums written in the Americas division for the year ended December 31, 2005 were $1,130.5 million, a decrease of $127.0 million, or 10.1%, as compared to $1,257.5 million for the year ended December 31, 2004. These amounts represented 43.1% of our gross premiums written for the year ended December 31, 2005 and 47.4% in 2004. These amounts include reinstatement premiums of $32.0 million and $5.0 million for the years ended December 31, 2005 and 2004, respectively, which principally relate to Hurricanes Katrina, Rita and Wilma in 2005, and the 2004 Florida Hurricanes. Excluding reinstatement premiums in each period, gross premiums written would be $1,098.5 million and $1,252.5 million for the years ended December 31, 2005 and 2004, respectively, representing a decrease of $154.0 million, or 12.3% over the period. Gross premiums written across each geographic region of the Americas are as follows:
Canada - Gross premiums written of $50.4 million for the year ended December 31, 2005 increased $4.4 million, or 9.6%, compared to $46.0 million for the year ended December 31, 2004. The increase primarily relates to exchange rate movements between December 31, 2005 and 2004 as the Canadian dollar strengthened.
EuroAsia. Gross premiums written in the EuroAsia division for the year ended December 31, 2005 were $543.8 million, a decrease of $9.9 million, or 1.8%, as compared to $553.7 million for the year ended December 31, 2004. These amounts represented 20.7% of our gross premiums written for the year ended December 31, 2005 and 20.9% in 2004. These amounts include $5.2 million of reinstatement premiums for the year ended December 31, 2005, as compared to none in 2004. Gross premiums written for the year ended December 31, 2004 included $24.9 million related to the consolidation of a wholly owned subsidiary, First Capital Insurance Limited (“First Capital”), which writes business in Singapore. Starting in the fourth quarter of 2004, our economic interest in First Capital declined below 50% and it is no longer consolidated in our consolidated financial statements. Excluding this amount, gross premiums written for the year ended December 31, 2005 increased $15.0 million, or 2.8%, as compared to the year ended December 31, 2004. This increase is primarily attributable to higher volume of property and motor business, offset by lower volume in accident and health and credit and bonds. Gross premiums written from property business, which represents 60.0% of EuroAsia in 2005, increased by $21.8 million, or 7.2%, for the year ended December 31, 2005 compared to 2004, driven by greater penetration in the French market. Motor business, which represents 16.3% of EuroAsia in 2005, increased $8.8 million, or 11.1%, in 2005 and was primarily attributable to a $17.3 million increase in France, offset by a decline in other parts of Europe and the Middle East. Accident and health business, which represents 2.1% of EuroAsia in 2005, decreased $12.3 million, or 51.7%, in 2005 over 2004 primarily due to the non renewal of selected proportional accounts.
London Branch - Gross premiums written of $189.3 million for the year ended December 31, 2005 increased $6.8 million, or 3.8%, compared to $182.5 million for the year ended December 31, 2004. Excluding reinstatement premiums in each period, gross premiums written for the year ended December 31, 2005 were $156.2 million, a decrease of $14.5 million or 8.5%, compared to $170.7 million for the year ended December 31, 2004. Gross premiums written from property business, which represents 46.3% of London branch in 2005, increased by $14.6 million, or 20.0%, in 2005 over 2004, entirely driven by higher reinstatement premiums in 2005 as ceding companies are choosing to retain more business. Casualty business showed little change in 2005 but reflects more business written on an excess of loss basis than on a proportional basis.
Medical malpractice gross premiums written were $150.6 million for the year ended December 31, 2005, an increase of $12.9 million, or 9.4%, from $137.7 million for the year ended December 31, 2004. Medical malpractice, our largest line of business in the U.S. Insurance division, represented 28.9% of gross premiums written in the U.S. Insurance division for the year ended December 31, 2005. Growth was driven by increases in our select markets and hospital coverages and partially offset by reductions in physician groups business, which reflects more competitive market conditions.
development of $116.5 million is principally attributable to loss emergence greater than expectations in 2005 on U.S. casualty classes of business written in 2001 and prior. For the year ended December 31, 2004, losses and LAE reflect $138.8 million for property catastrophe events occurring in calendar year 2004, including $93.4 million related to the 2004 Florida Hurricanes. Losses and LAE in the 2004 period include net adverse loss development of $190.0 million attributable to 2003 and prior years, of which $30.0 million is related to increased asbestos estimates resulting from the annual review of these liabilities, and $7.6 million is related to prior year catastrophe events due to loss emergence greater than expectations in the period. The remaining net adverse development of $152.4 is principally attributable to loss emergence greater than expectations in 2004 on U.S. casualty classes of business written in 2001 and prior, partially offset by a $21.1 million reduction in environmental pollution estimates due to better than expected loss emergence in the period.
The loss and LAE ratio for the years ended December 31, 2005 and 2004 and the percentage point change for each of our divisions and in total are as follows:
December 31, 2004. The increase in losses and LAE was related to losses of $141.6 million from catastrophe events, of which $131.9 million is attributable to Hurricanes Katrina, Rita and Wilma. Losses and LAE in the 2005 period include favorable loss development of $22.8 million attributable to 2004 and prior years, principally related to favorable emergence on aviation, satellite and non-catastrophe property exposures in the period, and include $1.7 million of net adverse development on prior period catastrophe losses due to loss emergence greater than expectations. For the year ended December 31, 2004, losses and LAE reflect $21.4 million for property catastrophe events including the 2004 Florida Hurricanes. Losses and LAE in the 2004 period include favorable loss development of $0.2 million attributable to 2003 and prior years and include a benefit of $0.3 million from prior period catastrophe losses.
Acquisition costs are reduced by ceding commissions related to our Whole Account and Facultative Excess of Loss Agreements, of $5.3 million and $2.7 million for the years ended December 31, 2005 and 2004, respectively. The increase of $2.6 million in 2005 over 2004 was attributable to ceding commissions on higher premiums ceded to these agreements during 2005. Ceding commissions due under certain of our Whole Account Excess of Loss Agreements are deferred and will be received by us in future periods. Ceding commissions have therefore been recorded at their present value, with the discount amortized over the expected collection period. For years ended December 31, 2005 and 2004, the discount recorded on ceding commissions is $0.8 million and $2.1 million, respectively, which is net of the amortization of the discount recorded in prior periods.
Other Underwriting Expenses. Other underwriting expenses for the year ended December 31, 2005 were $146.0 million, compared to $120.8 million for the year ended December 31, 2004. The other underwriting expense ratio, expressed as a percentage of net premiums earned, was 6.4% for the year ended December 31, 2005, compared to 5.2% for the year ended December 31, 2004. Other underwriting expenses increased while net premiums earned decreased, resulting in a higher other underwriting expense ratio in 2005 as compared to 2004. In addition, legal expenses of $8.4 million for the year ending December 31, 2005, primarily attributable to outstanding litigation matters, increased by $4.5 million over 2004. This increase in other underwriting expenses is also attributable to an increase in personnel related costs and related benefits, particularly in our U.S. Insurance division.
an increase of $26.7 million for the year ended December 31, 2005 over 2004 in net income due to equity accounting of HWIC Asia, an investment vehicle which is included in common stock, at equity. Net investment income on equity securities includes, in accordance with the equity method of accounting,
a decrease of $18.6 million for the year ended December 31, 2005 over 2004 in net income due to equity accounting of Advent Capital (Holdings) PLC, a Lloyd’s syndicate, which is included in common stock, at equity. This resulted in a net loss of $15.4 million for the year ended December 31, 2005 from net income of $3.2 million in 2004, primarily reflecting catastrophe losses from Hurricanes Katrina, Rita and Wilma during 2005.
an increase of $6.0 million for the year ended December 31, 2005 over 2004 in net investment income on other invested assets, which primarily reflects interest income attributable to our total return swaps on equity indexes and includes income from hedge funds and private equity investments of $15.6 million and $15.9 million for the years ended December 31, 2005 and December 31, 2004, respectively.
Net Realized Investment Gains. Net realized investment gains of $59.9 million for the year ended December 31, 2005 decreased by $62.1 million from $122.0 million for the year ended December 31, 2004. The decrease in net realized investment gains is principally due to higher gains from fixed income securities, which were offset by lower gains from equity securities and higher losses from derivative securities and other investments. The total net realized investment gains for the year ended December 31, 2005 of $64.7 million on equity securities, primarily reflect a gain of $47.0 million related to the sale of Zenith National Insurance Corp. (“Zenith”) securities and also includes realized losses of $17.6 million related to other-than-temporary impairments on selected securities. Net realized investment gains from fixed income securities of $82.0 million for the year ended December 31, 2005 increased by $28.5 million over 2004, primarily reflecting gains on U.S. Treasury securities sold through the year. Realized investment gains include mark-to-market movements on derivative securities, including credit default swaps and total return swaps on equity indexes. The net investment loss on derivative securities of $38.8 million for the year ended December 31, 2005 increased by $11.7 million over 2004. Net realized investment losses from other securities were $48.0 million for the year ended December 31, 2005, representing an adverse change of $51.2 million over 2004, primarily reflecting unrealized
foreign exchange rate losses on short term securities and impairment of certain investments included in other invested assets.
Preferred Dividends. We recorded preferred dividends related to our Series A and Series B non-cumulative perpetual preferred shares of $1.9 million after-tax for the year ended December 31, 2005. There were no amounts in 2004, as the preferred shares were first issued in October 2005.
Our shareholders’ equity increased by $444.1 million, or 27.1%, to $2,083.6 million as of December 31, 2006, from $1,639.5 million as of December 31, 2005. The net increase as of December 31, 2006 compared to December 31, 2005 was primarily attributable to net income of $507.9 million and an increase to additional paid in capital of $43.7 million principally resulting from the conversion of a portion of our convertible debt into our common stock. These increases were offset by a decrease in accumulated other comprehensive income of $93.7 million, after-tax, of which $82.8 million relates to a decrease in unrealized appreciation and $10.2 million relates to the adoption of SFAS 158 (see Note 19 to our consolidated financial statements included in this Form 10-K). Our book value per common share was $27.92 as of December 31, 2006, representing an increase of $5.61 from the book value per common share of $22.31 as of December 31, 2005 and an increase of $0.88 from the book value per common share of $27.04 as of September 30, 2006.
The following table reconciles total shareholders’ equity, a GAAP financial measure, to common shareholders’ equity, a non-GAAP financial measure, as used in the book value per common share calculation. We believe
this presentation may be useful to investors who utilize common shareholders’ equity in their return on equity calculation.
On November 28, 2006, we completed the private sale of $40.0 million aggregate principal amount of floating rate senior debentures, Series C (the “Notes”), maturing on December 15, 2021. Interest on the Notes accrues at a rate per annum equal to three-month London Interbank Offer Rate (“LIBOR”), reset quarterly, plus 2.50%, and is payable quarterly in arrears on March 15, June 15, September 15 and December 15 of each year starting on March 15, 2007. We have the option to redeem the Notes at par, plus accrued and unpaid interest, in whole or in part on any interest payment date on or after December 15, 2011. The proceeds were used to retire, in November 2006, our 7.49% Senior Notes.
In June 2002, we issued $110.0 million aggregate principal amount of 4.375% convertible senior debentures due 2022 (“Convertible Notes”). On August 14, 2006, in accordance with the terms of the indenture under which the Convertible Notes were issued, the Convertible Notes became convertible, at the option of the holders, into shares of our common stock at a fixed rate of 46.9925 shares per $1,000 principal amount of Convertible Notes, which represents a conversion price of $21.28 per share. The convertibility trigger was met as a result of our common shares trading at or above $25.54 per share for a specified period of time. Pursuant to the terms of the indenture, we are permitted to satisfy our conversion obligations in stock or in cash, or in a combination thereof. To date, we have elected to satisfy all conversion obligations with common shares, and therefore, as of December 31, 2006, we had issued a total of 1,838,151 common shares to satisfy conversions up to that date. During February 2007, we issued 46,992 common shares related to $1.0 million principal amount of Convertible Notes subject to a notice of conversion received in December 2006. Subsequent to December 31, 2006, we have
not received conversion notices related to the remaining $22.5 million principal value of Convertible Notes, which could be converted into cash or 1.1 million shares of our common stock, or a combination of cash and stock, at our election. In February 2007, we announced that the Convertible Notes will continue to be convertible during the period from February 14, 2007 through May 13, 2007. For more information regarding the Convertible Notes, see Note 13 to the consolidated financial statements included in this Form 10-K.
During 2005, we contributed $185.0 million to Odyssey America. Effective December 31, 2005, we received approval from the Connecticut Insurance Commissioner to make a $200.0 million capital contribution to Odyssey America, to be completed prior to February 28, 2006. In February 2006, we completed the $200.0 million capital contribution to Odyssey America, funded with holding company cash resources, including the proceeds from our financing transactions completed in October 2005 and February 2006.
Holding company cash and cash equivalents equaled $58.8 million as of December 31, 2006, as compared to $102.4 million as of December 31, 2005, with the lower amount primarily due to capital contributions made to Odyssey America. As a holding company, our assets are principally comprised of the shares of Odyssey America, and our principal sources of funds are cash dividends and other permitted payments from our operating subsidiaries, primarily Odyssey America. If our subsidiaries are unable to make payments to us, or are able to pay only limited amounts, we may be unable to pay dividends on our common or preferred shares or make payments on our indebtedness. The payment of dividends by our operating subsidiaries is subject to restrictions set forth in the insurance laws and regulations of Connecticut, Delaware, New York and the United Kingdom. During 2007, Odyssey America can pay dividends to the holding company of $561.7 million without prior regulatory approval. Odyssey America paid a dividend of $60.0 million to the holding company during 2006.
Although the obligations of our reinsurers to make payments to us are based on specific contract provisions, these amounts only become recoverable when we make a payment of the associated loss amount, which may be several years, or in some cases decades, after the actual loss occurred. Reinsurance recoverables on unpaid losses, which represent 92.5% of our total reinsurance recoverables as of December 31, 2006, will not be due for
collection until some time in the future, and over this period of time, economic conditions and the operational performance of a particular reinsurer may negatively impact its ability to meet its future obligations to us. We manage our exposure by entering into reinsurance transactions with companies that have a strong capital position and a favorable long term financial profile.
Our total reinsurance recoverable on paid losses as of December 31, 2006, net of the reserve for uncollectible paid and unpaid reinsurance, which is established based on an evaluation of each reinsurer or retrocessionaire and historical experience, is $59.8 million. The top ten reinsurers measured on total reinsurance recoverables represent $35.6 million, or 59.5% of the total paid loss recoverable, of which $12.1 million is collateralized and the remaining $23.5 million is with highly rated companies. The remaining $24.2 million recoverable on paid losses is with numerous companies, and no single company has a balance greater than $4.4 million net of the reserve on uncollectible reinsurance.
Total investments and cash exclude amounts receivable for securities sold and amounts payable for securities purchased, representing the timing between the trade date and settlement date of securities sold and purchased. As of December 31, 2006 and 2005, we had a receivable for securities sold of $21.3 million and $2.9 million, respectively, which is included in other assets, and a payable for securities purchased of $13.0 million and $9.5 million, respectively, which is included in other liabilities.
We participate in Lloyd’s through our 100% ownership of Newline Syndicate 1218 (“Syndicate 1218”), where we provide 100% of the capacity for Newline. The results of Syndicate 1218 are consolidated in our consolidated financial statements. In support of its capacity at Lloyd’s, Odyssey America has pledged U.S. Treasury Notes and cash, with a fair value of $247.7 million as of December 31, 2006, in a deposit trust account in favor of the Society and Council of Lloyd’s. These securities may be substituted with other securities at our discretion, subject to approval by Lloyd’s. The securities are carried at fair value and are included in investments and cash in our consolidated balance sheets. Interest earned on the securities is included in investment income. The pledge of assets in support of Syndicate 1218 provides us with the ability to participate in writing business through Lloyd’s, which remains an important part of our business. The pledged assets effectively secure the contingent obligations of Syndicate 1218 should it not meet its obligations. Odyssey America’s contingent liability to the Society and Council of Lloyd’s is limited to the aggregate amount of the pledged assets. We have the ability to remove funds at Lloyd’s annually, subject to certain minimum amounts required to support its outstanding liabilities as determined under risk based capital models and approved by Lloyd’s. The funds used to support outstanding liabilities are adjusted annually and our obligation to support these liabilities will continue until they are settled or the liabilities are reinsured by a third party approved by Lloyd’s. We expect to continue to actively operate Syndicate 1218 and support its requirements at Lloyd’s. We believe that Syndicate 1218 maintains sufficient liquidity and financial resources to support its ultimate liabilities and we do not anticipate that the pledged assets will be utilized.
On November 29, 2006, our Board of Directors declared a quarterly cash dividend of $0.03125 per common share to be paid on December 29, 2006 to all common shareholders of record as of December 15, 2006. During each of the four quarters of 2006, our Board of Directors declared quarterly cash dividends of $0.03125 per common share, resulting in an aggregate dividend of $2.2 million paid in each quarter. On February 22, 2007, our Board of Directors announced that it had increased our quarterly dividend to $0.0625 per common share, double its previous level, and declared a dividend payable on March 30, 2007 to shareholders of record at the close of business on March 16, 2007.
On November 29, 2006, the Board of Directors declared quarterly dividends of $0.5078125 per share on our 8.125% Series A preferred shares and $0.5389844 per share on our floating rate Series B preferred shares. The total dividends of $2.1 million were paid on January 22, 2007 to Series A and Series B preferred shareholders of record on December 31, 2006.
On September 23, 2005, we entered into a credit agreement that provides for a three-year revolving credit facility of $150.0 million, which is available for direct, unsecured borrowings. The credit facility is available for working capital and other corporate purposes, and for the issuance of secured or unsecured letters of credit. Wachovia Bank, N.A. is the administrative agent for the credit facility and is one of a group of lenders thereunder. As of December 31, 2006, there was $55.0 million outstanding under the credit agreement, all of which was in support of letters of credit. Loans under the credit facility will bear interest at a fluctuating rate per annum equal to the higher of (a) the federal funds rate plus 0.5% and (b) Wachovia Bank, N.A.’s publicly announced prime rate. Alternatively, at our option, loans will bear interest at the LIBOR, which is the offered rate that appears on the page of the Telerate screen that displays an average British Bankers Association Interest Settlement Rate for deposits in dollars, plus 0.85%. This credit facility replaced our $90.0 million facility, which terminated on September 23, 2005.
These ratings are used by insurers, reinsurers and intermediaries as an important means of assessing the financial strength and quality of reinsurers. A reduction in our financial strength ratings could limit or prevent us from writing new reinsurance or insurance business. The financial strength ratings of our principal operating subsidiaries are: A.M. Best: “A” (Excellent); Standard & Poor’s: “A-” (Strong); and Moody’s: “A3” (Good Financial Security). These ratings are based upon factors relevant to policyholders, agents and intermediaries and are not directed toward the protection of investors, nor are they recommendations to buy, sell or hold securities.
In September 2006, the FASB issued SFAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of SFAS 87, 88, 106, and 132(R)”. SFAS 158 required, as of December 31, 2006, us to recognize the overfunded or underfunded status of a defined benefit postretirement plan, including pension plans, as an asset or liability in its balance sheet and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. We adopted the recognition provisions of SFAS 158. As a result of the adoption, we recorded a one-time charge of $15.7 million to increase other liabilities, a $5.5 million deferred tax asset and a $10.2 million decrease to accumulated other comprehensive income on our balance sheet. In addition, SFAS 158 requires that, as of December 31, 2008, employers measure plan assets and liabilities as of the date of their financial statements. SFAS 158 does not require retrospective application.
The term “market risk” refers to the risk of loss arising from adverse changes in prices. We believe that we are principally exposed to four types of market risk related to our investment operations. These risks are interest rate risk, credit risk, equity price risk and foreign currency risk. Market sensitive instruments discussed in this section principally relate to our fixed income securities and common stocks carried at fair value which are classified as available for sale. As of December 31, 2006, our total investments and cash of $7.1 billion includes $3.5 billion of fixed income securities that are subject primarily to interest rate risk and credit risk.
The table below displays the potential impact (in millions) of market value fluctuations on our fixed income securities portfolio as of December 31, 2006 and December 31, 2005, based on parallel 200 basis point shifts in interest rates up and down in 100 basis point increments. This analysis was performed on each security individually.
In addition, as of December 31, 2006 and December 31, 2005, we had short positions of $115.3 million and $83.5 million, respectively, of primarily equity securities, for which we recorded a liability equal to the underlying fair value of the securities of $119.8 million and $82.5 million, respectively. A net realized gain of $3.0 million and $4.3 million for the twelve months ended December 31, 2006, 2005, respectively, and a net realized loss of $13.3 million for 2004 were recognized in our consolidated statements of operations. As of December 31, 2006 and December 31, 2005, we provided cash and fixed income securities of $208.6 million and $161.7 million, respectively, as collateral for the borrowed securities. Our net investment income for the years ended December 31, 2006, 2005 and 2004 was reduced by $7.2 million, $5.0 million and $2.7 million, respectively, related to dividend and interest payments associated with the borrowed securities.
As of December 31, 2006 and December 31, 2005, 12.0% and 19.6%, respectively, of our total investments and cash was in common stocks (unaffiliated and affiliated). Marketable equity securities, which represented 10.2% and 17.5% as of December 31, 2006 and December 31, 2005, respectively, of our total investments and cash, are exposed to equity price risk, defined as the potential for loss in market value owing to a decline in equity prices. A 10% decline in the price of each of these marketable equity securities would result in a decline of $72.3 million and $104.4 million as of December 30, 2006 and December 31, 2005, respectively, in the fair market value of our total investments and cash.
Through investment in securities denominated in foreign currencies, we are exposed to foreign (i.e., non-U.S.) currency risk. Foreign currency exchange rate risk creates the potential for loss in market value owing to a decline in the U.S. dollar value of these investments resulting from a decline in the exchange rate of the foreign currency in which these assets are denominated. As of December 31, 2006 and December 31, 2005, our total exposure to foreign denominated securities in U.S. dollar terms was approximately $1.6 billion and $1.3 billion, respectively, or 22.8% and 21.2%, respectively, of our total investments and cash. The primary foreign currency exposures were from securities denominated in the British pound, which represented 7.7% and 8.5% of our total investments and cash as of December 31, 2006 and December 31, 2005, respectively, from
We review our investment portfolio on a quarterly basis for declines in value, and specifically consider securities, the market value of which have declined to less than 80% of their amortized cost at the time of review. Temporary declines in investments will be recorded as unrealized depreciation in accumulated other comprehensive income. If we determine that a decline is “other-than-temporary,” the carrying value of the investment will be written down to the fair value and a realized loss will be recorded in our consolidated statements of operations.
The following tables reflect the fair value and gross unrealized depreciation of our fixed income securities and common stock investments, aggregated by investment category and length of time that individual securities
For further detail on our long term debt principal and interest payments, see Note 13 to our consolidated financial statements included in this Form 10-K. For further detail on our operating lease payments, see Note 16 to our consolidated financial statements included in this Form 10-K.
investments with varying maturities and a substantial amount of short-term investments to provide adequate cash flows for the payment of claims. The reserves for unpaid losses and LAE reflected in the table above have not been reduced for reinsurance recoverables on unpaid losses which are reflected in our consolidated balance sheet as an asset of $739.0 million as of December 31, 2006. Based on historical patterns, we estimate that we will collect the recoveries as follows: $210.2 million in less than one year; $222.8 million in one to three years; $118.4 million between three and five years and $187.6 million in more than five years.
I. Summary of Investments - Other than Investments in Related Parties as of December 31, 2006
IV. Reinsurance for the years ended December 31, 2006, 2005 and 2004
We have completed integrated audits of Odyssey Re Holdings Corp.’s consolidated financial statements and of its internal control over financial reporting as of December 31, 2006, in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
(b) Investments. The Company’s investments in fixed income securities and common stocks not accounted for under the equity method, are categorized as “available for sale,” and are recorded at their estimated fair value based on quoted market prices. Investment transactions are recorded on their trade date with balances pending settlement reflected in the consolidated balance sheet as a component of other assets or other liabilities. Short-term investments, which have a maturity of one year or less from the date of purchase, are carried at cost, which
Common stocks of affiliates are accounted for under the equity method of accounting, under which OdysseyRe records its proportionate share of income or loss from such investments. Other invested assets include limited partnerships and investment funds, which are accounted for under the equity method of accounting. The Company routinely evaluates the carrying value of these investments. In the case of limited partnerships and investment funds, the carrying value is generally established on the basis of the net valuation criteria as determined by the managers of the investments. Such valuations could differ significantly from the values that would have been available had markets existed for the securities. Income from equity investees, including realized gains or losses, is recorded in net investment income in the period in which it is known. Unrealized appreciation and depreciation are recorded through accumulated other comprehensive income. In the case of hedge funds and private equity investments, unrealized appreciation and depreciation is recorded in net investment income in the period in which it is known. Other invested assets also include trust accounts relating to the Company’s benefit plans and derivative securities which are each carried at fair value. Due to the timing of when financial information is reported by equity investees, including limited partnerships and investment funds, results attributable to these investments are generally reported by OdysseyRe on a one month or one quarter lag. If the Company becomes aware of a significant event, it will assess the impact, if any, on the carrying value of the investment.
The cost of reinsurance purchased by the Company (reinsurance premiums ceded) is reported as prepaid reinsurance premiums and amortized over the contract period in proportion to the amount of insurance protection provided. The ultimate amount of premiums, including adjustments, is recognized as premiums ceded, and amortized over the applicable contract period to which they apply. Reserves are established for the unexpired portion of premiums ceded and recorded as an asset in prepaid reinsurance premiums. Premiums earned are reported net of reinsurance ceded premiums earned in the consolidated statements of operations. Amounts paid by the Company for retroactive reinsurance that meets the conditions for reinsurance accounting are reported as reinsurance receivables to the extent those amounts do not exceed the associated recorded liabilities. If the
(f) Unpaid losses and loss adjustment expenses. The reserves for losses and loss adjustment expenses are estimates of amounts needed to pay reported and unreported claims and related loss adjustment expenses. The estimates are based on assumptions related to the ultimate cost to settle such claims. The inherent uncertainties of estimating reserves are greater for reinsurers than for primary insurers, due to the diversity of development patterns among different types of reinsurance contracts and the necessary reliance on ceding companies for information regarding reported claims. As a result, there can be no assurance that the ultimate liability will not exceed amounts reserved, with a resulting adverse effect on the Company.
The reserve for unpaid losses and loss adjustment expenses is based on the Company’s evaluations of reported claims and individual case estimates received from ceding companies for reinsurance business or the estimates advised by the Company’s outside claims adjusters for insurance business. The Company utilizes generally accepted actuarial methodologies to determine reserves for losses and loss adjustment expenses on the basis of historical experience and other estimates. The reserves are reviewed continually during the year and changes in estimates in losses and loss adjustment expenses are reflected as an expense in the consolidated statements of operations in the period the adjustment is made. Reinsurance recoverables on unpaid losses and loss adjustment expenses are reported as assets. A reserve for uncollectible reinsurance recoverables is established based on an evaluation of each reinsurer or retrocessionaire and historical experience. The Company uses tabular reserving for workers’ compensation indemnity reserves, which are considered to be fixed and determinable, and
discounts such reserves using an interest rate of 3.5%. Losses have been discounted using the Life Table for Total Population, United States, 2003.
(h) Income Taxes. The Company records deferred income taxes to provide for the net tax effect of temporary differences between the carrying values of assets and liabilities in the Company’s consolidated financial statements and their tax bases. Such differences relate principally to deferred acquisition costs, unearned premiums, unpaid losses and loss adjustment expenses, investments and tax credits. Deferred tax assets are reduced by a valuation allowance when the Company believes it is more likely than not that all or a portion of deferred taxes will not be realized. As of December 31, 2006 and 2005, a valuation allowance was not required. During the third quarter of 2006, Fairfax reduced its ownership of the Company to below 80%, and as a result, the Company has been deconsolidated from the United States tax group of Fairfax. Accordingly, the Company will file a separate consolidated tax return for the period August 29, 2006 to December 31, 2006 and for each subsequent tax year. The deconsolidation has no effect on the Company’s tax position.
(k) Foreign Currency. The Company translates the financial statements of its foreign subsidiaries to United States dollars by translating balance sheet accounts at the balance sheet date exchange rate and income statement accounts at the average exchange rate for the year. Translation gains or losses are recorded, net of deferred income taxes, as a component of accumulated other comprehensive income. Foreign currency transaction gains or losses are reflected in the consolidated statement of operations in the period in which they are realized.
(l) Earnings Per Share. Basic earnings per common share are calculated by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding, excluding those non-vested shares granted under the OdysseyRe Restricted Share Plan. Diluted earnings (loss) per common share are calculated by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding, inclusive of: vested and non-vested shares, granted under the OdysseyRe Restricted Share Plan, as determined using the treasury stock method; stock options that would be assumed to be exercised on the balance sheet date, as determined using the treasury stock method; and the effect of the conversion of the Company’s convertible debt to equity securities. Restricted shares, stock options or the effect of the conversion of the convertible debt and the related interest expense would not be included in the calculation of diluted earnings per common share, if the effect would be antidilutive. (See Note 6).
(m) Stock Compensation Plans. In April 2002, the Company’s shareholders approved the Odyssey Re Holdings Corp. 2002 Stock Incentive Plan (the “2002 Plan”). Effective January 1, 2003, the Company adopted the expense recognition provisions of SFAS 123, “Accounting for Stock-Based Compensation,” on a prospective basis, in accordance with SFAS 148, “Accounting for Stock-Based Compensation - Transaction and Disclosure” with respect to the 2002 Plan. The prospective method requires the application of the fair value based method to compensation awards granted, modified, or settled on or after the date of adoption. Accordingly, net income (loss) for the years ended December 31, 2005 and 2004 reflects stock-based compensation expense related to stock options granted in 2003 and subsequent. For stock options granted during 2002, the Company accounted for stock-based compensation based on the intrinsic-value method prescribed in Accounting Principles Board Opinion (“APB”) 25, “Accounting for Stock Issued to Employees” and related interpretations, as permitted under SFAS 123. In December 2004, the Financial Accounting Standards Board issued SFAS 123R (revised 2004), “Share-Based Payment,” which is a revision of SFAS 123 and supersedes APB 25. The approach to account for share-based payments in SFAS 123R is similar to the approach described in SFAS 123. SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the consolidated financial statements based on their fair values. Pro forma disclosure of the impact of fair value of share-based payments is no longer an alternative to financial statement recognition. The Company adopted SFAS 123R, on a prospective basis, effective January 1, 2006. SFAS 123(R) requires that the deferred stock-based compensation on the consolidated balance sheet on the date of adoption be netted against additional paid-in capital. As of December 31, 2005, there was approximately $1.8 million of deferred stock-based compensation that was netted against additional paid-in capital on January 1, 2006.
obligations. Interest generally accrues on withheld funds in accordance with contract terms. Funds held by reinsureds is an account used to record an asset resulting from the ceding company, in accordance with the contractual terms, withholding a portion of the premium due the Company as a guarantee that the Company will meet its loss and other obligations.
(p) Fixed Assets. Fixed assets, with a net book value of $10.3 million and $12.2 million as of December 31, 2006 and 2005, respectively, are included in other assets. Property and equipment are recorded at cost. Depreciation and amortization are computed on a straight-line basis over the following estimated useful lives:
In February 2006, the FASB issued SFAS 155, “Accounting for Certain Hybrid Financial Instruments - an amendment of SFAS 133 and 140.” SFAS 155 amends SFAS 133, “Accounting for Derivative Instruments and Hedging Activities,” and SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” and clarifies SFAS 133 Implementation Issue D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” SFAS 155 applies to certain “hybrid financial instruments,” which are instruments that contain embedded derivatives. The standard establishes a requirement to evaluate beneficial interests in securitized financial assets to determine if the interests represent freestanding derivatives, or are hybrid financial instruments containing embedded derivatives requiring bifurcation. SFAS 155 also permits an election for fair value measurement of any hybrid financial instrument containing an embedded derivative that otherwise would have required bifurcation under SFAS 133, including financial instruments previously recorded by the Company under SFAS 133. The fair value election to existing instruments on an instrument-by-instrument basis at the date of adoption and can be applied to new instruments on a prospective basis. SFAS 155 will be effective in fiscal years that begin after September 15, 2006. The Company expects to elect fair value measurement of hybrid financial instruments under SFAS 155 effective with its adoption on January 1, 2007. As of January 1, 2007, the Company will no longer bifurcate the embedded derivatives in its investments in convertible securities, changes in the fair value of the host instrument will be recorded as unrealized investment gains and losses, and changes in the fair value of the embedded derivative will be recorded as realized investment gains and losses. As of December 31, 2006, the fair value of the host instruments included in fixed income securities was $268.1 million and the fair value of embedded derivatives included in other invested assets was $15.1 million. Upon adopting SFAS 155, the Company will record a cumulative adjustment of $16.5 million to reclassify unrealized investment gains, net of tax, to retained earnings as of January 1, 2007. Subsequent to January 1, 2007, changes in the fair value of securities accounted for in accordance with SFAS 155 will be recorded in realized investment gains or losses.
December 15, 2006. The Company has completed an analysis of FIN 48 and does not expect any material effect on its consolidated financial statements.
In September 2006, the FASB issued SFAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of SFAS 87, 88, 106, and 132(R)”. SFAS 158 requires, as of December 31, 2006, the Company to recognize the overfunded or underfunded status of a defined benefit postretirement plan, including pension plans, as an asset or liability in its balance sheet, and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. The Company adopted the recognition provisions of SFAS 158. As a result of the adoption, the Company has recorded a one-time charge of $15.7 million to increase other liabilities, a $5.5 million deferred tax asset and a $10.2 million decrease to accumulated other comprehensive income on its balance sheet. In addition, SFAS 158 requires that, as of December 31, 2008, employers measure plan assets and liabilities as of the date of their financial statements. SFAS 158 does not require retrospective application.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115,” which provides a fair value option to measure many financial instruments and certain other assets and liabilities at fair value on an instrument-by-instrument basis. SFAS No. 159 is effective for the Company beginning in the 2008 first quarter. The Company is evaluating the impact of the adoption of SFAS 159 on its consolidated financial statements.
On October 1, 2004, the Company exchanged all of its common shares of First Capital Insurance Ltd. (“First Capital”), which represented 97.7% of the total common shares of First Capital, for Class B non-voting common shares of Fairfax Asia Limited (“Fairfax Asia”), representing a 44.0% economic interest in Fairfax Asia. Following the transaction, Fairfax Asia owns 97.7% of the common shares of First Capital. The transaction valued the Company’s interest in First Capital at $38.6 million, which was based on First Capital’s GAAP shareholders’ equity as of September 30, 2004, subject to certain adjustments, in exchange for Class B shares of Fairfax Asia based on its fair value as of September 30, 2004. In recording the exchange, there was no gain or loss recorded by the Company. Fairfax owns the remaining Class A and Class B common shares of Fairfax Asia.
Prior to the exchange, the Company’s interest in First Capital was consolidated in the Company’s financial statements. Following the exchange, the Company records its investment in Fairfax Asia in accordance with the equity method of accounting. Subsequent to the exchange, the results of First Capital, including its underwriting activity, are reflected in the Company’s investment income through its proportionate share of the net income of Fairfax Asia.
Basic earnings per common share is calculated by dividing net income (loss) available to common shareholders for the period by the weighted-average number of common shares outstanding during the period, excluding those non-vested shares granted under the OdysseyRe Restricted Share Plan. Diluted earnings (loss) per common share is calculated by dividing net income (loss) available to common shareholders for the period, adjusted for interest expense on the 4.375% convertible senior debentures, by the weighted-average number of common shares outstanding during the period, inclusive of: vested and non-vested shares granted under the OdysseyRe Restricted Share Plan, as determined using the treasury stock method; stock options that would be assumed to be exercised on the balance sheet date, as determined using the treasury stock method; and the effect of the conversion of the Company’s convertible debt to equity securities. Restricted shares, stock options or the effect of the conversion of the convertible debt and the related interest expense are not included in the calculation of dilutive earnings per common share, if the effect would be antidilutive.
Common stocks accounted for under the equity method of accounting were carried at $245.4 million as of December 31, 2006, reflecting gross unrealized appreciation of $25.7 million and gross unrealized depreciation of $4.1 million. Other invested assets, including amounts that were accounted for under the equity method of accounting, were carried at $165.2 million as of December 31, 2006, reflecting gross unrealized appreciation of $1.1 million and gross unrealized depreciation of $0.1 million.
The amortized cost and fair value of fixed income securities as of December 31, 2006, by contractual maturity, are shown below (in thousands).
Actual maturities may differ from the contractual maturities shown in the table above due to the existence of call or put options. In the case of securities containing call options, the actual maturity will be the same as the contractual maturity if the issuer elects not to exercise its call option. Total securities subject to the call option represent approximately 3% of the total fair value. In the case of securities containing put options, the actual maturity will be the same as the contractual maturity if the Company elects not to exercise its put option. Total securities containing the put option represent approximately 4% of the total fair value.
The following table sets forth the components of net realized investment gains and losses for the years ended December 31, 2006, 2005, and 2004 (in thousands):
The following table sets forth the changes in unrealized net appreciation (depreciation) of investments, and the related tax effect, reflected in accumulated other comprehensive income for the years ended December 31, 2006, 2005, and 2004 (in thousands):
The Company reviews, on a quarterly basis, its investment portfolio for declines in value, and specifically considers securities with market values that have declined to less than 80% of their cost or amortized cost at the time of review. Generally, a change in the market or interest rate environment does not constitute an impairment of an investment, but rather a temporary decline in value. Temporary declines in investments will be recorded as unrealized depreciation, net of tax, in accumulated other comprehensive income. If the Company determines that a decline is “other-than-temporary,” the cost or amortized cost of the investment will be written down to the fair value and a realized loss will be recorded in the Company’s consolidated statements of operations.
In assessing the value of the Company’s debt and equity securities held as investments and possible impairments of such securities, the Company reviews (i) the issuer’s current financial position and disclosures related thereto, (ii) general and specific market and industry developments, (iii) the timely payment by the issuer of its principal, interest and other obligations, (iv) the outlook and expected financial performance of the issuer, (v) current and historical valuation parameters for the issuer and similar companies, (vi) relevant forecasts, analyses and recommendations by research analysts, rating agencies and investment advisors, and (vii) other information the Company may consider relevant. In addition, the Company considers its ability and intent to hold the security to recovery when evaluating possible impairments.
The facts and circumstances involved in making a decision regarding an other-than-temporary-impairment are those that exist at that time. Should the facts and circumstances change such that an other-than-temporary impairment is considered appropriate, the Company will recognize the impairment, by reducing the cost or amortized cost of the investment to its fair value, recording a realized investment loss in its consolidated statement of operations. Upon the disposition of a security where an other-than-temporary impairment has been taken, the Company will record a gain or loss based on the adjusted cost or amortized cost of the investment.
The following tables reflect the fair value and gross unrealized depreciation of the Company’s fixed income securities and common stocks, at fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized depreciation position, as of December 31, 2006 and December 31, 2005 (in thousands):
Common stocks, at equity, totaled $245.4 million as of December 31, 2006, compared to $567.0 million as of December 31, 2005. The following table shows the components of common stocks, at equity, as of December 31, 2006 and 2005 (in thousands):
MFXchange Holdings Inc. (“MFX”) (100% owned by Fairfax, which includes 7.4% owned by the Company). Common stocks, at equity, and certain other invested assets, are recorded under the equity method of accounting based on the Company’s proportionate share of income or loss and changes in shareholders’ equity of the investee. Due to the timing of when financial information is reported by investees, results attributable to the investments are generally reported by the Company on a one month or one quarter lag. Dividends received by the Company from these entities were $6.0 million, $6.0 million, and $6.1 million for the years ended December 31, 2006, 2005, and 2004, respectively. The Company routinely evaluates the carrying value of these investments by reviewing, among other things, each investee’s current and expected operating performance and current and historical trading values of the issuer’s securities, where applicable.
The Company’s equity in the net income of HWIC Asia is included in pre-tax net investment income and is comprised of the following items for the years ended December 31, 2006, 2005 and 2004 (in thousands):
Including realized investment gains of $75.1 million for the year ended December 31, 2006, related to the redemption of HWIC Asia shares, total realized investment gains from the Company’s interest in HWIC Asia were $242.8 million, $27.9 million and $1.4 million, pre-tax for the years ended December 31, 2006, 2005 and 2004, respectively.
period January 1, 2006 through August 16, 2006 and the years ended December 31, 2005 and 2004, follows (in thousands):
Other invested assets totaled $165.2 million as of December 31, 2006, compared to $238.1 million as of December 31, 2005. The following table shows the components of other invested assets as of December 31, 2006 and 2005 (in thousands):
Many of the Company’s hedge fund and private equity investments are subject to restrictions on redemptions or sales, which are determined by the governing documents thereof, and limit the Company’s ability to liquidate these investments in the short term. Due to a time lag in reporting by a majority of hedge fund and private equity fund managers, valuations for these investments are reported by OdysseyRe on a one month or one quarter lag. Income from hedge funds and private equity investments included in net investment income totaled $29.3 million, $15.6 million and $15.9 million for the years ended December 31, 2006, 2005 and 2004, respectively. With respect to the Company’s $22.8 million in private equity partnerships included in other invested assets as of December 31, 2006, the Company has commitments that may require additional funding of up to $23.1 million over the next four years. Interest and dividend income, and realized and unrealized gains and losses of hedge funds and private equity partnerships are generally included in net investment income. Other invested assets include $6.7 million related to the Company’s investment in O.R.E Holdings Limited, which is net of a other-than-temporary write-down of $9.9 million, of which $7.5 million and $2.4 million was recognized during the years ended December 31, 2006 and 2005, respectively.
In connection with the short sales described above, the Company purchased a SPDR call option as protection against a decline in the value of the short positions, at a cost of $0.4 million. The call option is recorded at fair value in other invested assets in the consolidated balance sheet and changes in the fair value are recorded as a realized gain or loss in the consolidated statements of operations in the period in which they occur. For the years ended December 31, 2006 and 2005, the net change in the fair value of the call option resulted in a net realized loss of $0.1 million and $1.2 million respectively, and a net realized gain of $0.4 million for the year ended December 31, 2004.
resulted in a net realized loss of $22.6 million, $36.2 million and $4.5 million for the years ended December 31, 2006, 2005 and 2004, respectively.
The Company has investments in warrants, which are contracts that grant the holder the right to purchase an underlying financial instrument at a given price and time or at a series of prices and times. The total cost of the warrants was $6.2 million and $7.0 million, and the fair value was $7.5 million and $11.9 million as of December 31, 2006 and 2005, respectively. The notional amount of the warrants was $189.7 million and $219.2 million as of December 31, 2006 and 2005, respectively. Warrants, which are included in other invested assets, are recorded at fair value with the related changes in fair value recognized as a realized gain or loss in the period in which they occur. As of December 31, 2006, 2005 and 2004, the net change in the fair value of the warrants resulted in a net realized loss of $4.4 million and a net realized gain of $6.9 million and $6.1 million, respectively.
The components of comprehensive income (loss) for the years ending December 31, 2006, 2005 and 2004 are shown in the following table (in thousands):
The following table sets forth the activity in the liability for unpaid losses and loss adjustment expenses for the years ended December 31, 2006, 2005 and 2004 (in thousands):
Estimates of reserves for unpaid losses and loss adjustment expenses are contingent on many events that may or may not occur in the future. The eventual outcome of these events may be different from the assumptions underlying the Company’s reserve estimates. In the event that the business environment and loss trends diverge from expected trends, the Company may have to adjust its reserves accordingly. The Company believes that the recorded estimate represents the best estimate of unpaid losses and loss adjustment expenses based on the information available as of December 31, 2006. The estimate is reviewed on a quarterly basis and the ultimate
Losses and loss adjustment expenses incurred related to the current year were $1,344.3 million, $1,888.9 million and $1,441.1 million for the years ended December 31, 2006, 2005 and 2004, respectively. The higher current year losses and loss adjustment expenses in 2005 were principally related to catastrophe events. For the years ended December 31, 2006, 2005 and 2004, current year catastrophe events were $34.9 million, $537.9 million and $138.8 million, respectively.
For the year ended December 31, 2005, the total catastrophe losses of $537.9 million include net losses and loss adjustment expenses of $445.9 million, net of reinsurance of $241.1 million, related to Hurricanes Katrina, Rita and Wilma, which occurred during the third and fourth quarters of 2005. In addition, for the year ended December 31, 2005, the Company incurred losses of $25.6 million related to Windstorm Erwin. For the year ended December 31, 2006, the loss estimates for Hurricanes Katrina, Rita and Wilma were increased by $49.4 million (11.1% of 2005 estimate) principally attributable to unexpected loss emergence in 2006 on marine and Florida proportional property accounts and due to the triggering of industry loss warranty contracts written by the Company resulting from deterioration in industry-wide Wilma loss estimates.
loss emergence lower than expectations during the year on environmental pollution and business written in more recent years.
The Company has exposure to losses from asbestos, environmental pollution and other latent injury damage claims. Gross unpaid asbestos and environmental losses and loss adjustment expenses as of December 31, 2006 were $344.7 million, representing 6.7% of total gross unpaid losses and loss adjustment expenses. Exposure arises from reinsurance contracts under which the Company has assumed liabilities, on an indemnity or assumption basis, from ceding companies, primarily in connection with general liability insurance policies issued by such ceding companies. The Company’s estimate of its ultimate liability for such exposures includes “case basis” reserves and a provision for liabilities incurred but not reported. Case basis reserves are a combination of reserves reported to the Company by ceding companies and additional case reserves determined by the Company. The provision for liabilities incurred but not reported is established based on an annual review of Company and external trends in reported loss and claim payments.
Estimation of ultimate asbestos and environmental liabilities is unusually difficult due to several significant issues surrounding these exposures. Among the issues are: (i) the long period between exposure and manifestation of an injury; (ii) difficulty in identifying the sources of asbestos or environmental contamination; (iii) difficulty in allocating responsibility or liability for asbestos or environmental damage; (iv) difficulty determining whether coverage exists; (v) changes in underlying laws and judicial interpretation of those laws; and (vi) uncertainty regarding the identity and number of insureds with potential asbestos or environmental exposure.
Several additional factors have emerged in recent years regarding asbestos exposure that further compound the difficulty in estimating ultimate losses for this exposure. These factors include: (i) continued growth in the number of claims filed due to an increasingly aggressive plaintiffs’ bar; (ii) an increase in claims involving defendants formerly regarded as peripheral; (iii) growth in the use of bankruptcy filings by companies as a result of asbestos liabilities, which companies in some cases attempt to resolve asbestos liabilities in a manner that is prejudicial to insurers; (iv) the concentration of claims in states with laws or jury pools particularly favorable to plaintiffs; and (v) the potential that states or the federal government may enact legislation on asbestos litigation reform.
The Company’s reserves for asbestos and environmental related liabilities displayed below are from business written in years 1985 and prior. The Company’s asbestos and environmental reserve development, gross and net
Net losses and loss adjustment expenses incurred for asbestos claims increased $27.1 million for the year ended December 31, 2006. Included in this increase is a net reserve increase of $40.6 million, a $17.3 million benefit resulting from the amortization of the deferred gain related to the 1995 Stop Loss Agreement and a loss of $3.8 million related to the commutation of this agreement. Also as a result of this commutation, net reserves were increased by $49.9 million and net paid losses were decreased by $63.4 million.
Net losses and loss adjustment expenses incurred for environmental claims decreased $2.2 million for the year ended December 31, 2006. Included in this reduction is a net reserve decrease of $0.3 million, a $3.1 million benefit resulting from the amortization of the deferred gain related to the 1995 Stop Loss Agreement and a loss of $1.2 million related to the commutation of this agreement. Also as a result of this commutation, net reserves were increased by $17.3 million and net paid losses were decreased by $19.2 million.
The Company’s survival ratio for asbestos and environmental related liabilities as of December 31, 2006 is 11 years. The Company’s underlying survival ratio for asbestos related liabilities is 11 years and for environmental related liabilities is 18 years. The survival ratio represents the asbestos and environmental reserves,
The Company’s reinsurance protection, which covered certain amounts of its 1995 and prior unpaid losses and loss adjustment expenses (the “1995 Stop Loss Agreement”), provided by nSpire Re Limited (“nSpire Re”), a wholly-owned subsidiary of Fairfax, was commuted effective September 29, 2006, for consideration of $63.2 million. In accordance with the terms of the commutation agreement, the Company commuted ceded loss reserves of $71.8 million, resulting in a commutation loss of $5.5 million, pre-tax, for the year ended December 31, 2006. The 1995 Stop Loss Agreement was originally entered into with Skandia Insurance Company Ltd. (“Skandia”) in conjunction with the purchase of Clearwater in 1996. Pursuant to the agreement, the Company paid a premium of $60.5 million in 1995 for protection of $175.0 million in excess of Clearwater’s December 31, 1995 reserves for net unpaid losses and loss adjustment expenses and reserves for uncollectible reinsurance. In January 1999, the liabilities under the contract were assigned by Skandia to nSpire Re for $97.0 million in consideration. Following the assignment to nSpire Re, the Company accounted for the 1995 Stop
For the years ending December 31, 2001 and prior, the Company utilized whole account aggregate excess of loss retrocessional coverage (“Whole Account Excess of Loss Agreements”) to manage its exposures, including catastrophic occurrences and the potential accumulation of exposures. As further discussed below, during the second quarter of 2006, the Company commuted certain whole account excess of loss agreements. In addition, Whole Account Excess of Loss Agreements were purchased covering underwriting years 2002 through 2004 though no losses were ceded to these coverages. In each calendar year, the Company has the ability to cede losses attributable to certain prior periods to the Whole Account Excess of Loss Agreements to the extent there are limits remaining for the period. These agreements cover business written or incepting during a defined period of time (underwriting year), which is typically twelve months, or in other cases, business earned during a defined period of time (accident year). The Whole Account Excess of Loss Agreements were purchased on an underwriting year basis for 1996 through 2004 and on an accident year basis for 1994 and 1995. Accident year agreements were also purchased to supplement the 1996 and 1997 underwriting year agreements. All of these Whole Account Excess of Loss Agreements covering underwriting and accident years have been commuted except for two agreements covering underwriting years 2000 and 2001. Loss cession limits on these two covers still outstanding have been fully utilized as of December 31, 2005. Each agreement provides for recoveries from the retrocessionaires, subject to a limit, in the event that the net subject business results in a composite ratio (the sum of the commission and loss ratios), or in some agreements a loss ratio, in excess of a specified attachment point. The attachment point is net of other inuring third party reinsurance. The premium paid, net of commission, by the Company is calculated based on a contractual fixed rate that is applied to the total premiums covered by the retrocession agreements. Each agreement includes a provision for additional premium, subject to a maximum, based on the amount of loss activity under the agreement. Reinsurance recoverables on paid and unpaid losses are fully secured by letters of credit or funds held by the Company.
In addition to the Whole Account Excess of Loss Agreements, the Company entered into a three-year aggregate excess of loss reinsurance contracts protecting its United States facultative casualty business for underwriting years 1998 through 2000 (“Facultative Excess of Loss Agreement”) which indemnified the Company for losses in excess of an annual retention, subject to an annual limit of liability. The aggregate limit for underwriting years 1998, 1999 and 2000 was equal to 40% of the Company’s total facultative net premiums written, subject to a minimum annual dollar limit of $7.4 million, and a maximum annual dollar limit of $18.5 million. The aggregate limit of liability is $41.6 million across all years, which has been fully utilized. The retention in each year was equal to the greater of $9.3 million or 51.0% of the subject written premium income, together with amounts contributed to a loss payment account under the agreement. The Company maintained a loss payment account for the benefit of the reinsurer, equal to 18.5% of the subject written premium income for underwriting year 1998, and 18.9% for each of 1999 and 2000. A minimum interest credit was applied to the loss payment account, equal to the one year U.S. Treasury Bill yield plus 75 basis points. During December 2006, the Company entered into a commutation and release agreement related to this contract, pursuant to which all rights, obligations and liabilities were fully and finally settled. As a result of the commutation, a pre-tax loss of $1.4 million was recognized. Additionally, reinsurance recoverables have been reduced by $16.1 million for the year ended December 31, 2006.
The reinsurance recoverables on paid and unpaid losses related to the Whole Account Excess of Loss Agreements and Facultative Excess of Loss Agreement are $122.2 million and $251.9 million as of December 31, 2006 and 2005, respectively. Funds held under reinsurance contracts related to these agreements, shown as a liability on the Company’s consolidated balance sheets, reflect $83.4 million and $150.7 million as of December 31, 2006 and 2005, respectively. Other collateral related to these agreements is $43.2 million and $124.8 million as of December 31, 2006 and 2005, respectively.
The Company’s ten largest reinsurers represent 49.6% of its total reinsurance recoverables as of December 31, 2006. Amounts due from all other reinsurers are diversified, with no other individual reinsurer representing more than $15.4 million, or 1.9%, of reinsurance recoverables as of December 31, 2006, and the average balance is less than $3.0 million. The Company held total collateral of $238.2 million as of December 31, 2006, representing 29.8% of total reinsurance recoverables. The following table shows the total amount that is recoverable from each of the Company’s ten largest reinsurers for paid and unpaid losses as of December 31, 2006, the amount of collateral held, and each reinsurer’s A.M. Best rating (in thousands):
The Company is the beneficiary of letters of credit, cash, and other forms of collateral to secure certain amounts due from its reinsurers. The total amount of collateral held by the Company as of December 31, 2006 is $238.2 million, which represents 29.8% of the total amount of reinsurance recoverables, comprised of the following forms of collateral (in thousands):
On November 28, 2006, the Company completed the private sale of $40.0 million aggregate principal amount of floating rate senior debentures, Series C (the “Series C Notes”), maturing on December 15, 2021. Interest on the Series C Notes accrues at a rate per annum equal to the three-month London Interbank Offer Rate (“LIBOR”), reset quarterly, plus 2.50%, and is payable quarterly in arrears on March 15, June 15, September 15 and December 15 of each year starting on March 15, 2007. The Company has the option to redeem the Series C Notes at par, plus accrued and unpaid interest, in whole or in part on any interest payment date on or after December 15, 2011. As of December 31, 2006, the current annual interest rate on the Series C Notes is 7.87%. The proceeds from the Series C Notes were used to retire, in November 2006, the Company’s 7.49% senior notes.
In June 2002, the Company issued $110.0 million aggregate principal amount of convertible senior debentures due 2022 (the “Convertible Notes”). Interest accrues on the Convertible Notes at a fixed rate of 4.375% per annum, which is due semi-annually on June 15 and December 15. The Convertible Notes have been redeemable at the Company’s option since June 22, 2005. Each holder of Convertible Notes may, at its option, require the Company to repurchase all or a portion of its Convertible Notes on June 22, 2007, 2009, 2012 and 2017. Under certain conditions specified in the indenture under which the Convertible Notes were issued (the “Indenture”), each Convertible Notes holder has the right to request conversion of its Convertible Notes into 46.9925 of the Company’s common shares for every $1,000 principal amount of the Convertible Notes held by such holder, which represents a conversion price of $21.28 per share. These conditions include the common stock of the Company trading at or above $25.54 per share for a specified period of time. Pursuant to the terms of the Indenture, the Company is permitted to satisfy the conversion obligations in stock or in cash, or in a combination thereof. The conversion conditions were first satisfied on August 9, 2006, and in accordance with the Indenture, the Convertible Notes have continued to be convertible, at the option of the holders, since August 14, 2006. As of December 31, 2006, 1.8 million shares of the Company’s common stock were issued to the Convertible Notes holders who elected to convert their Convertible Notes, resulting in a decrease to Convertible Notes and a corresponding increase to shareholders’ equity of $39.1 million. During February 2007, 46,992 common shares were issued related to $1.0 million principal amount of Convertible Notes subject to a notice of conversion received in December 2006.
In December 2001, the Company issued $100.0 million aggregate principal amount of 7.49% senior notes due November 30, 2006, pursuant to a private placement. In November 2003 and June 2002, the Company prepaid $50.0 million and $10.0 million, respectively, aggregate principal amount of the 7.49% senior notes. Immediately following the issuance of the 7.49% senior notes, the Company entered into an interest rate swap agreement that effectively converted the fixed 7.49% interest rate into a variable rate of interest. In May 2003, the Company settled the interest rate swap for a pre-tax gain of $6.4 million. In accordance with hedge accounting, a basis adjustment equivalent to the $6.4 million pre-tax gain was made, increasing the carrying value of the 7.49% senior notes. The basis adjustment was recognized into income over the remaining life of the 7.49% senior notes. On November 30, 2006, the 7.49% senior notes matured and the Company settled the remaining $40.0 million of outstanding notes.
On September 23, 2005, the Company entered into a credit agreement that provides for a three-year revolving credit facility of $150.0 million, which is available for direct, unsecured borrowings. The credit facility is available for working capital and other corporate purposes, and for the issuance of secured or unsecured letters of credit. Wachovia Bank, N.A. is the administrative agent for the credit facility, and is one of a group of lenders thereunder. As of December 31, 2006, there was $55.0 million outstanding under the credit agreement, all of which was in support of letters of credit. Loans under the credit facility will bear interest at a fluctuating rate per annum equal to the higher of (a) the federal funds rate plus 0.5% and (b) Wachovia Bank, N.A.’s publicly announced prime rate. Alternatively, at the Company’s option, loans will bear interest at the LIBOR, which is the offered rate that appears on the page of the Telerate screen that displays an average British Bankers Association Interest Settlement Rate for deposits in dollars, plus 0.85%. This credit facility replaced the Company’s $90.0 million facility, which was terminated on September 23, 2005.
During the fourth quarter of 2006, Fairfax sold or exchanged an aggregate of 13.1 million shares of the Company’s common shares to third parties. As a result, Fairfax’s ownership in the Company was reduced from 78.5% as of September 30, 2006 to 59.6% as of December 31, 2006. The Company did not receive any proceeds related to these transactions.
On October 20, 2005, the Company completed the sale of $100.0 million of non-cumulative perpetual preferred shares. The Company sold 2.0 million shares of 8.125% Series A perpetual preferred stock and 2.0 million shares of floating rate Series B perpetual preferred stock, for total net proceeds of $97.5 million. The Series A preferred shares have a liquidation preference of $25.00 per share and are redeemable at $25.00 per share at the Company’s option, in whole, or in part from time to time, starting on or after October 20, 2010. Dividends on the Series B preferred shares are payable at an annual rate equal to 3.25% above the three-month LIBOR on the applicable determination date. The Series B preferred shares have a liquidation preference of $25.00 per share and are redeemable at the redemption prices below (in thousands, except per share amounts):
The Company’s operations are managed through four operating segments: Americas, EuroAsia, London Market and U.S. Insurance. The Americas division is comprised of the Company’s reinsurance operations in the United States, Canada and Latin America, and writes property and casualty business on a treaty and facultative basis. The EuroAsia division writes primarily treaty and facultative property business. The London Market division operates through three distribution channels, Newline at Lloyd’s, which focuses on casualty insurance, Newline Insurance Company Limited, the Company’s recently formed London-based casualty insurer, and the London branch, which focuses on worldwide property and casualty reinsurance. The U.S. Insurance division writes specialty insurance lines and classes of business, such as medical malpractice, professional liability and non-standard automobile.
The following table reconciles federal and foreign income taxes at the statutory federal income tax rate to the Company’s tax provision (benefit) for the years ended December 31, 2006, 2005 and 2004 (in thousands):
Included in the income tax provision for the year ended December 31, 2006 is a one-time tax benefit of $16.5 million, which is attributable to the settlement of tax issues related to the acquisition of Clearwater in 1996.
On September 7, 2005, the Company announced that it had been advised by Fairfax, the Company’s majority shareholder, that Fairfax had received a subpoena from the Securities and Exchange Commission (“SEC”) requesting documents regarding any non-traditional insurance and reinsurance transactions entered into or offered by Fairfax and any of its affiliates, which included OdysseyRe. The United States Attorney’s Office for the Southern District of New York is reviewing documents provided to the SEC in response to the subpoena, and is participating in the investigation into these matters. In addition, the Company provided information and made a presentation to the SEC and the U.S. Attorney’s office relating to the restatement of the Company’s financial results announced by it on February 9, 2006 and responded to questions with respect to transactions that were
part of the restatement. The Company is cooperating fully in addressing its obligations under this subpoena. This inquiry is ongoing, and the Company continues to comply with requests from the SEC and the U.S. Attorney’s office. At the present time, the Company cannot predict the outcome of these matters, or the ultimate effect on the Company’s consolidated financial statements, which effect could be material and adverse. No assurance can be made that the Company will not be subject to further requests or other regulatory proceedings of a similar kind.
In January 2004, two retrocessionaires of Odyssey America under the common control of London Reinsurance Group Inc. (together, “London Life”) filed for arbitration under a series of aggregate stop loss agreements covering the years 1994 and 1996-2001 (the “Agreements”). On March 9, 2006, the arbitration panel issued its decision, confirming the enforceability of the Agreements and resolving in Odyssey America’s favor substantially all issues in dispute regarding Odyssey America’s administration of the Agreements. Effective May 12, 2006, Odyssey America and London Life entered into a commutation and release agreement pursuant to which all rights, obligations and liabilities for the Agreements were fully and finally settled without material effect to the results of operations or financial position of the Company.
material to the OdysseyRe’s liquidity and capital resources. In January 2006, Odyssey America received assets with a par value of $48.6 million, representing a permanent reduction and unconditional release of such amount, prior to the stated termination date, following the deposit by Advent of £38.0 million equivalent, in new funds at Lloyd’s. In September 2006, Odyssey America received assets with a par value of $10.7 million, representing a permanent reduction and unconditional release of such amount, prior to the stated termination date, following the deposit by Advent of such amount in new funds at Lloyd’s. Following these returns of assets, and as of December 31, 2006, Odyssey America continues to have a par value of $102.7 million, or approximately £52.5 million equivalent, pledged to Lloyd’s in support of Advent and will continue to receive a fee for these pledged assets. The fair market value of the pledged assets as of December 31, 2006 is $128.2 million, or approximately £65.5 million equivalent. OdysseyRe believes that the financial resources of Advent provide adequate protection to support its liabilities in the ordinary course of business.
Clearwater agreed to allow Ranger Insurance Company (“Ranger”), a subsidiary of Fairfax that is now known as Fairmont Specialty Insurance Company, to attach an assumption of liability endorsement of Clearwater to certain Ranger policies issued from July 1, 1999 to April 30, 2004, the effective termination date of the agreement. Should Ranger fail to meet its obligations, Clearwater is ultimately liable for any unpaid losses, pursuant to the terms of the endorsements. This arrangement enabled Ranger to provide additional security to its customers as a result of Clearwater’s financial strength ratings and capital resources. The agreement to provide the endorsements was provided by Clearwater while each company was 100% owned by Fairfax. The potential exposure in connection with these endorsements is currently estimated at $4.7 million, based on the subject policies’ outstanding case loss reserves as of December 31, 2006. Ranger has met and continues to meet all of its obligations, including those subject to this agreement, in the normal course of business, and Clearwater does not anticipate making any payments under this guarantee. The Company believes that the financial resources of Ranger provide adequate protection to support its liabilities in the ordinary course of business. In addition, Fairfax has indemnified Clearwater for any obligations under this agreement. The Company does not consider its potential exposure under this guarantee to be material to its liquidity and capital resources.
As of July 14, 2000, Odyssey America agreed to guarantee the performance of all the insurance and reinsurance contract obligations, whether incurred before or after the agreement, of Compagnie Transcontinentale de Réassurance (“CTR”), a subsidiary of Fairfax, in the event CTR became insolvent and CTR was not otherwise indemnified under its guarantee agreement with a Fairfax affiliate. The guarantee, which was entered into while
Odyssey America agreed, as of April 1, 2002, to guarantee the payment of all of the insurance contract obligations (the “Subject Contracts”), whether incurred before or after the agreement, of Falcon Insurance Company (Hong Kong) Limited (“Falcon”), a subsidiary of Fairfax Asia Limited (“Fairfax Asia”), in the event Falcon becomes insolvent. Fairfax Asia is 100% owned by Fairfax, which includes a 29.5% economic interest owned by the Company. The guarantee by Odyssey America was made to assist Falcon in writing business through access to Odyssey America’s financial strength ratings and capital resources. Odyssey America is paid a fee for this guarantee of one percent of all gross premiums earned associated with the Subject Contracts on a quarterly basis. Odyssey America was given the option to reinsure a portion of the business written by Falcon. The option was not exercised and terminated on December 31, 2005. For the years ended December 31, 2006 and 2005, Falcon paid $0.5 million and $0.6 million, respectively, to Odyssey America in connection with this agreement. Odyssey America’s potential exposure in connection with this agreement is estimated to be $56.1 million, based on Falcon’s loss reserves at December 31, 2006. Falcon’s shareholders’ equity on a U.S. GAAP basis is estimated to be $49.8 million as of December 31, 2006. Fairfax has agreed to indemnify Odyssey America for any obligation under this agreement. The Company believes that the financial resources of Falcon provide adequate protection to support its liabilities in the ordinary course of business. The Company anticipates that Falcon will meet all of its obligations in the normal course of business and does not expect to make any payments under this guarantee. The Company does not consider its exposure under this guarantee to be material to its liquidity and capital resources.
Rental expense, before sublease income under these operating leases, was $9.8 million, $11.1 million and $9.9 million in 2006, 2005 and 2004, respectively. The Company recovered pre-tax amounts of $0.1 million, $0.2 million and $0.4 million in 2006, 2005 and 2004, respectively, from subleases.
Odyssey America paid dividends to the Company of $60.0 million, $22.5 million and $55.0 million during 2006, 2005 and 2004, respectively. During 2005, the Company contributed $185.0 million to Odyssey America and there were no contributions made in 2006. Effective December 31, 2005, the Company received approval from the Connecticut Insurance Commissioner to make a $200.0 million capital contribution to Odyssey America, to be completed prior to February 28, 2006. In February 2006, the Company completed the $200.0 million capital contribution to Odyssey America.
The use of such collateral provided by the Company is a permitted accounting practice approved by the Insurance Department of the State of Delaware, the domiciliary state of Clearwater and Hudson. The Company has provided a $20.5 million letter of credit to Clearwater and a $0.5 million letter of credit to Hudson as of December 31, 2006, which have been used as collateral in regard to the indemnification agreements. The indemnification agreements do not affect the accompanying consolidated financial statements.
All amounts are assumed and ceded from Fairfax’s affiliates at commercial market terms, the prices and terms of which are often established by other third party reinsurers that participate in the contracts. Written premiums assumed from Fairfax’s affiliates in 2006 represent 1.4% of OdysseyRe’s total gross premiums written for the year ended December 31, 2006. Ceded premiums written represent 5.8% of OdysseyRe’s total ceded premiums written for the year ended December 31, 2006. The largest amounts of related party assumed business in 2006 were received from Commonwealth Insurance Company and ICICI Lombard General Insurance Co. Ltd. Odyssey previously assumed business from Zenith National Insurance Corp (“Zenith”) through December 31, 2004. Assumed premiums written reflect $91.6 million from Zenith for the year ended December 31, 2004. The largest amounts of business ceded to related parties in 2005 involved nSpire Re and Commonwealth Insurance Company, each relating to a proportional catastrophe treaty covering various classes of worldwide catastrophe business written by OdysseyRe.
fee of 0.20% (20 basis points), calculated and paid quarterly based upon the subsidiary’s average invested assets for the preceding three months. The agreements also include incentive fees of 0.10% (10 basis points), which are payable if realized gains exceed 1% of the average investment portfolio in any given year, subject to cumulative realized gains on investments exceeding 1% of the average investment portfolio. Additional incentive fees are paid based upon the performance of the subsidiary’s equity portfolio equal to 10% of the return on equities (subject to an annual maximum) in excess of the Standard & Poor’s 500 index plus 200 basis points, provided that the equity portfolio has achieved such excess on a cumulative basis. If the performance of the equity portfolio does not equal or exceed this benchmark in a given year, the annual base fee is reduced to 0.18% (18 basis points). The aggregate annual investment management fee payable by each subsidiary, including incentive fees, is capped at 0.40% (40 basis points) of its investment portfolio, with any excess amounts carried into the following year. These agreements may be terminated by either party on 30 days’ notice. For the years ended December 31, 2006, 2005 and 2004, total fees, including incentive fees, of $17.6 million, $16.2 million and $7.5 million, respectively, are included in the consolidated statements of operations.
For each of the years ended December 31, 2005 and 2004, the Company paid $0.3 million of intranet fees, to MFXchange, an affiliate. For the year ended December 31, 2006, the Company did not pay intranet fees to MFXchange.
Included in other expense, net, for the years ended December 31, 2006, 2005 and 2004, respectively, are incurred charitable contributions of $1.7 million, $0.7 million and $2.8 million related to the Sixty Four Foundation, a not-for-profit entity affiliated with Fairfax.
In connection with the acquisition of Opus Re (now known as Clearwater Select Insurance Company), the Company incurred a $2.5 million pre-tax expense for each of the years ended December 31, 2005 and 2004, which is included in other expense, net, to RiverStone Group LLC, an affiliate, for services provided to the Company in connection with the acquisition.
In connection with the 2004 sale of Old Lyme Insurance Company, Ltd. (“OLIC”) by an affiliate of the Company to an unrelated entity, OdysseyRe provided a loan to the unrelated entity in the amount of $9.0 million to finance this transaction. This loan had a term of five years, bearing interest at a rate of prime plus 3% and was collateralized by the shares of OLIC’s common stock. The balance of the loan as of March 2006 was $4.1 million following a February 2006 principal payment of $3.2 million. In the fourth quarter, the Company received a principal payment of $4.1 million and the loan was retired.
OdysseyRe believes that the revenues and expenses related to the transactions with affiliated entities would not be materially different if such transactions were with unaffiliated entities.
In September 2006, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (“SFAS”) 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of SFAS 87, 88, 106, and 132(R)”. SFAS 158 requires, as of December 31, 2006, the Company to recognize the overfunded or underfunded status of a defined benefit postretirement plan, including pension plans, as an asset or liability in its balance sheet and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. The Company adopted the recognition provisions of SFAS 158 and has recognized the results of adoption within its financial statements as of December 31, 2006, as reflected in the table below. In addition, SFAS 158 requires that, as of December 31, 2008, employers measure plan assets and liabilities as of the date of their financial statements. SFAS 158 does not require retrospective application.
The Company maintains a qualified, non-contributory, defined benefit pension plan (“Plan”) covering substantially all employees who have reached age twenty-one and who have completed one year of service. Employer contributions to the Plan are in accordance with the minimum funding requirements of the Employee Retirement Income Security Act of 1974, as amended.
The net amount recognized in the consolidated balance sheets related to the accrued pension cost of $10.8 million and prepaid pension cost of $3.5 million, as of December 31, 2006 and 2005, respectively, is included in other liabilities. The net amount of pre-tax accumulated other comprehensive loss is $12.7 million as of December 31, 2006.
As a result of the adoption of SFAS 158, the Company recognized an $8.3 million, after tax, reduction in accumulated other comprehensive income related to the Plan, as of December 31, 2006, of which, on an after tax basis, $8.0 million related to net losses, while $0.3 million related to prior service cost. The Company estimates that it will record $0.7 million in net loss and $0.1 million in prior service cost to net periodic benefit cost during the year ended December 31, 2007. The Company does not expect any refunds of Plan assets during the year ended December 31, 2007.
The net amount recognized in the consolidated balance sheets related to the accrued pension cost of $16.3 million and $10.9 million, as of December 31, 2006 and 2005, respectively, is included in other liabilities. The net amount of pre-tax accumulated other comprehensive loss is $4.1 million as of December 31, 2006.
The accumulated benefit obligation for the Excess Plans is $11.7 million and $11.4 million as of December 31, 2006 and 2005, respectively.
The Company established a trust fund, which invests in U.S. government securities, related to the Excess Plans. The trust fund, which is included in other invested assets, had a fair value of $6.5 million and $6.3 million as of December 31, 2006 and 2005, respectively. Plan benefits are paid by the Company as they are incurred by the participants, accordingly, there are no assets held directly by the Excess Plans.
The Company expects to contribute $0.9 million to the Excess Plans during the year ended December 31, 2007, which represents the amount necessary to fund the 2007 expected benefit payments.
As a result of the adoption of SFAS 158, the Company recognized a $1.4 million, after-tax, reduction in accumulated other comprehensive income related to the Excess Plans as of December 31, 2006, of which, on an after tax basis, $1.7 million related to net losses, while $0.3 million related to net prior service credit.
The Company also maintains a defined contribution profit sharing plan for all eligible employees. Each year, the Board of Directors may authorize payment of an amount equal to a percentage of each participant’s basic annual earnings based on the experience of the Company for that year. These amounts are credited to the employee’s account maintained by a third party, which has contracted to provide benefits under the plan. No contributions were authorized in 2006, 2005, or 2004.
The Company maintains a qualified deferred compensation plan pursuant to Section 401(k) of the Internal Revenue Code of 1986, as amended. Employees may contribute up to 50% of base salary on a pre-tax basis, subject to annual maximum contributions set by law ($15,000 in 2006). The Company contributes an amount equal to 100% of each employee’s pre-tax contribution up to certain limits. The maximum matching contribution is 4% of annual base salary, with certain government mandated restrictions on contributions to highly compensated employees. The Company also maintains a non-qualified deferred compensation plan to allow for
contributions in excess of qualified plan limitations. The Company contributed $1.6 million, $1.6 million and $1.3 million to these plans in 2006, 2005 and 2004, respectively, which is included in other underwriting expenses in the consolidated statements of operations.
As of December 31, 2006, there was $0.3 million of unrecognized compensation cost related to unvested options from the 2002 Option Plan, which is expected to be recognized over a remaining weighted-average vesting period of 0.9 years. The total intrinsic value of options exercised during the year ended December 31, 2006 was approximately $1.7 million, as compared to $0.5 million and $0.1 million of total intrinsic value of options exercised during the year ended December 31, 2005 and 2004, respectively.
In 2001, the Company adopted the 2001 Option Plan, which provides for the grant of stock options with a grant price of zero to officers and key employees of the Company employed outside of the United States. Options granted under the 2001 Option Plan generally vest and become exercisable in equal installments over three or five years from the date of grant. Amounts granted in 2001 vest and become exercisable in two equal installments on the fifth and tenth anniversary of the grant dates. Awards under each of the 2001 Option Plan and the Restricted Share Plan (described below) may not exceed an aggregate of 10% of the Company’s issued and outstanding shares of common stock as of the last business day of the previous calendar year. The Company had 69,127,532 issued and outstanding shares of common stock as of December 31, 2005.
The following table summarizes stock option activity for the 2001 Option Plan for the year ended December 31, 2006:
A summary of selected quarterly financial information follows for each of the quarters in the years ended December 31, 2006 and 2005 (in thousands, except share amounts).
Due to changes in the number of weighted average common shares outstanding during 2006 and 2005, the sum of quarterly earnings per common share amounts will not equal the total for the year.
Our audits of the consolidated financial statements, of management’s assessment of the effectiveness of internal control over financial reporting and of the effectiveness of internal control over financial reporting referred to in our report dated March 9, 2007 appearing in the 2006 Annual Report to Shareholders of Odyssey Re Holdings Corp. (which report, consolidated financial statements and assessment are incorporated by reference in this Annual Report on Form 10-K) also included an audit of the financial statement schedules listed in Item 8 of this Form 10-K. In our opinion, these financial statement schedules present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements.