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, 2005, 2004, and 2003. The results of operations for the year ended December 31, 2005 are not necessarily indicative of future results.
Assumes retroactive implementation of Statement of Financial Accounting Standards (“SFAS”) Numbers 141 and 142, which relate to goodwill and negative goodwill. These statements were adopted by us on January 1, 2002.
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 12 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. The diluted earnings per share for the years ended December 31, 2003, 2002 and 2001 have been restated to conform to the requirements of EITF Issue 4-08. See Notes 3(l) and 5 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 anti-dilutive 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). Inclusion of restricted shares would have an anti-dilutive effect on the 2001 diluted earnings per share. Accordingly, such common shares were excluded from the calculations of the 2005 and 2001 diluted earnings per common share. See Notes 3(l) and 5 to our consolidated financial statements included in this Form 10-K.
The effect of the restatement of our consolidated financial statements, as of and for the nine months ended September 30, 2005 and as of and for the years ended December 31, 2004 and 2003, is included in Note 2 to our consolidated financial statements. The effect of the restatement on our quarterly consolidated financial statements is included in Note 21 to our consolidated financial statements. The previously reported restatement adjustment and restated amounts for those accounts in our consolidated financial statements as of and for the years ended December 31, 2002, 2001 and 2000 affected by this restatement is as follows:
Our consolidated statement of operations for the year ended December 31, 2005 includes a pre-tax underwriting loss of $436.0 million from Hurricanes Katrina, Rita and Wilma, which occurred during the third and fourth quarters of 2005. The underwriting loss from Hurricanes Katrina, Rita and Wilma is comprised of losses and LAE of $445.9 million, which is after reinsurance recoverables of $241.1 million, reduced by $9.9 million in net reinstatement premiums received. The loss estimate represents our best estimate based on the most recent information available. We used various approaches in estimating the loss, including a detailed review of exposed contracts and information from ceding companies. As additional information becomes available, these estimates may be revised, potentially resulting in adverse effects to our financial results. The extraordinary nature of these catastrophes, including potential legal and regulatory implications, creates substantial complexity and uncertainty in estimating these losses. Considerable time may elapse before the adequacy of our estimates can be determined.
Our consolidated statement of operations for the year ended December 31, 2004 includes a pre-tax underwriting loss of $97.4 million from Hurricanes Charley, Frances, Ivan and Jeanne, which occurred in the third quarter of 2004 (the “2004 Florida Hurricanes”). The underwriting loss from the 2004 Florida Hurricanes is comprised of losses and LAE of $93.4 million, which is after reinsurance recoverables of $77.8 million, increased by $4.0 million in net reinstatement premiums paid. As a result of the complexity and uncertainty in estimating losses from the 2004 Florida Hurricanes, we incurred an additional pre-tax underwriting loss of $12.6 million, net of applicable reinstatement premiums, for the year ended December 31, 2005.
Our consolidated statement of operations for the year ended December 31, 2003 includes net losses and LAE of $73.3 million from catastrophe losses recognized during the period. The largest of the 2003 catastrophe losses relate to $12.7 million for Typhoon Maemi, which occurred in South Korea in September 2003, and $10.0 million for floods which occurred in France in December 2003.
We have restated our consolidated financial statements as of and for the years ended December 31, 2000 through 2004, as well as our unaudited statements as of and for the nine months ended September 30, 2005, to correct for accounting errors associated with reinsurance contracts entered into by us between 1998 and 2004. Our decision to restate our financial results follows a re-evaluation by us of the accounting considerations previously applied to these transactions. The effects of the restatement are reflected in our consolidated financial statements and accompanying notes included herein. Amounts for the nine months ended September 30, 2005 are unaudited.
(ii) The accounting treatment of a ceded reinsurance contract entered into with Skandia Insurance Company Ltd. (“Skandia”) in 1995 in conjunction with the acquisition of Clearwater, a wholly owned subsidiary of ours. The contract provides $175.0 million of protection 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 Limited (“nSpire Re”), a subsidiary of our majority shareholder, Fairfax, for $97.0 million in consideration. Following a re-evaluation of the accounting treatment for the contract by our independent registered public accountants and us, we have restated the accounting of the contract for 2002 and subsequent periods. We had accounted for the contract similar to prospective reinsurance for 2002 and subsequent periods, where a benefit had been recorded in each period equal to the loss cessions made under the contract. It has been determined that, in accordance with retroactive reinsurance accounting, losses ceded under the contract in 2002 and subsequent periods which were in excess of $97.0 million should have been recorded as a deferred
(iii) The treatment of deferred ceding commissions to be received by us under three aggregate excess of loss reinsurance contracts purchased by us. Due to the deferred nature of the ceding commissions, amounts were reflected at their present value rather than the nominal value previously recorded by us. All of these contracts satisfied risk transfer requirements and remain active as of December 31, 2005. These contracts involve two unaffiliated counterparties. The corrections under these contracts resulted in an $8.4 million after-tax cumulative decrease to shareholders’ equity as of September 30, 2005, with the net effect of decreasing the net loss for the nine months ended September 30, 2005 by $0.8 million, increasing 2004 net income by $1.4 million, decreasing 2003 net income by $6.1 million, decreasing 2002 net income by $1.3 million, increasing 2001 net loss by $1.6 million and decreasing 2000 net income by $1.6 million. The cumulative effect of $8.4 million, after-tax, will be amortized into income in future periods.
(v) Other unrelated adjustments of an immaterial nature that were previously recorded by us in the first quarter of 2005. As part of the restatement, these adjustments were applied to the periods in which they occurred. There is no cumulative effect to shareholders’ equity as of September 30, 2005, with the net effect of increasing the net loss for the nine months ended September 30, 2005 by $5.3 million and increasing 2004 net income by $5.3 million.
Odyssey Re Holdings Corp. and its subsidiaries. For a discussion of our significant accounting policies, see Note 3 to the notes to our consolidated financial statements.
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 U.S. 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.
We derive our revenues from two principal sources: premiums from insurance placed and reinsurance assumed, net of premiums ceded (net premiums written), and income from investments. Net premiums written are earned (net premiums earned) as revenue over the terms of the underlying contracts or certificates in force. The relationship between net premiums written and net premiums earned will, therefore, vary depending on the volume and inception dates of the business assumed and ceded and the mix of such business between proportional and excess of loss reinsurance.
Premium estimates, the corresponding acquisition costs, premiums receivable and unearned premium reserves are established on a contract level for significant accounts due but not reported by the ceding company at the end of each accounting period. The estimated ultimate premium for the contract, actual accounts reported by the ceding company, and our own experience on the contract are considered in establishing the estimate at the end of each accounting period. Subsequent adjustments based on actual results are recorded in the period in which they become known. The estimated premiums receivable balances are considered fully collectible. The estimates primarily represent the most current two underwriting years of account for which all corresponding reported accounts have been settled within contract terms. The estimates are considered “critical accounting estimates” because changes in these estimates can materially affect net income.
The most significant assumptions underlying our December 31, 2005 estimate of losses and LAE reserves are as follows: (i) that the information developed from internal and external sources can be used to develop reasonable estimates of loss experience for business written by us; (ii) that historical loss emergence trends are indicative of future loss development trends; and (iii) that no provision is made for extraordinary future
If an unfavorable change were to occur for the following assumptions, the approximate decrease in pre-tax income would be as follows (in millions):
The London Market division reported net favorable loss development for prior years of $23.6 million and $0.2 million for calendar years 2005 and 2004, respectively, and net adverse loss development of $22.6 million for calendar year 2003. The reduction in prior year loss estimates during calendar year 2005 results from favorable loss emergence trends for satellite, non-catastrophe property and auto liability business written during 2002 through 2004. The increase in prior year loss estimates during calendar year 2003 is due to greater than expected loss emergence on U.S. casualty business written in the late 1990s through early 2000s. The London Market division discontinued the underwriting units that concentrated on writing U.S. casualty business by 2002.
The following table sets forth our liabilities for unpaid losses and LAE for the years ended December 31, 2005, 2004 and 2003 (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 claims 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 reported during the period and the cumulative value since the date of our last reserve review. Variation in actual loss emergence from expectations may result in a change in our estimate of losses and LAE reserves. Any adjustments will be reflected in the periods in which they become known, potentially resulting in adverse effects to our financial results. Changes in expected claim payment rates, which represent one component of losses and LAE emergence, may impact our liquidity and capital resources, as discussed in “- Liquidity and Capital Resources.”
The following table summarizes, by type of reserve, the unpaid losses and LAE reserve as of December 31, 2005 and 2004. 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.
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 a more 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) concentration of claims in states with laws or jury pools particularly favorable to plaintiffs; and (v) the potential that states or the U.S. Congress may enact legislation on asbestos litigation reform.
We purchase reinsurance to increase our aggregate premium capacity, to reduce and spread the risk of loss on our insurance and reinsurance business and to limit our exposure to multiple claims arising from a single occurrence. We are subject to accumulation risk with respect to catastrophic events involving multiple contracts. To protect against this risk, we purchase catastrophe excess of loss reinsurance protection. The retention, the level of capacity purchased, the geographical scope of the coverage and the costs vary from year to year. The maximum recovery from a major United States catastrophic event in 2005 was $75.0 million, increased by proportional protection covering targeted portions of our property business. Specific reinsurance protections are also placed to protect selected portions of our business outside of the United States. As of December 31, 2005, our catastrophe excess of loss reinsurance protection available for losses in the United States was exhausted by losses incurred by Hurricanes Katrina, Rita and Wilma. Depending on the cost and availability, we may elect not to purchase new or renewal coverage for catastrophe risks across our reinsurance portfolio in 2006. The ultimate amount of coverage we purchase will be considered in establishing the maximum amount of catastrophe exposure assumed by us during 2006.
When we purchase reinsurance protection, we cede to reinsurers a portion of our risks and pay premiums based upon the risk and exposure of the policies subject to the reinsurance. Although the reinsurer is liable to us
for the reinsurance ceded, we retain the ultimate liability in the event the reinsurer is unable to meet its obligation at some later date.
We are the beneficiary of a 1995 stop loss reinsurance agreement with nSpire Re (the “1995 Stop Loss Agreement”). The 1995 Stop Loss Agreement was originally entered into with Skandia Insurance Company Ltd. in conjunction with the purchase of Clearwater in 1996. In January 1999, the liabilities under the contract were assigned by Skandia to nSpire Re. Pursuant to the agreement, we ceded 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. We account for the 1995 Stop Loss Agreement as retroactive reinsurance. We ceded losses of $17.5 million to the agreement in each of the years ended December 31, 2005, 2004 and 2003, which are deferred over the estimated remaining settlement period. The income before income taxes reflected in our statements of operations related to the amortization of the cumulative deferred gain under the 1995 Stop Loss Agreement for the years ended December 31, 2005, 2004 and 2003 is $11.3 million, $8.7 million and $6.5 million respectively. The remaining deferred amortization included in our consolidated balance sheet for the years ended December 31, 2005, 2004 and 2003 is $45.6 million, $39.3 million, and $30.5 million, respectively. Reinsurance recoverables on paid and unpaid losses related to this agreement were $175.0 million and $157.5 million as of December 31, 2005 and 2004, respectively, and are reflected in our consolidated balance sheets, fully secured by letters of credit and cash. As of December 31, 2005, we have utilized the full limit of this cover.
terms of the Whole Account Excess of Loss Agreements that were in effect as of December 31, 2005 (in millions).
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. 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
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, 2005, 2004, and 2003 is as follows (in millions):
We record deferred income taxes as assets or liabilities on our consolidated balance sheets to reflect the net tax effect of the temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and their respective tax bases. Deferred tax assets have not been reduced by a valuation allowance, as management believes it is more likely than not that the deferred tax assets will be realized. As of December 31, 2005 and 2004, respectively, a net deferred tax asset of $153.6 million and $97.8 million was recorded. In recording this deferred tax asset, we have made estimates and judgments that future taxable income will be sufficient to realize the value of the net deferred tax asset and accordingly, no valuation allowance has been recorded.
Gross Premiums Written. Gross premiums written for the year ended December 31, 2005 decreased by $23.9 million, or 0.9%, to $2,626.9 million compared to $2,650.8 million for the year ended December 31, 2004, as reflected in the following table (in millions):
Gross premiums written include reinstatement premiums of $70.4 million and $16.8 million for the years ended December 31, 2005 and 2004, respectively. Reinstatement premiums were primarily related to reinstating the coverage under property catastrophe excess of loss reinsurance contracts following Hurricanes Katrina, Rita and Wilma in 2005 and the 2004 Florida Hurricanes. The higher level of reinstatement premiums in 2005 as compared to 2004 was attributable to the significant number of full limit losses resulting from Hurricanes
Latin America - Gross premiums written of $148.6 million for the year ended December 31, 2005 decreased $12.8 million, or 7.9%, compared to $161.4 million for the year ended December 31, 2004. The decrease was due to a $25.0 million reduction from the non-renewal of a large facultative property contract, offset by a general increase in proportional treaty business, led by automobile business. We continue to see increased competition across our Latin America operations.
U.S. Insurance. Gross premiums written in the U.S. Insurance division for the year ended December 31, 2005 were $521.0 million, an increase of $129.1 million, or 32.9%, as compared to $391.9 million for the year ended December 31, 2004. These amounts represented 19.8% of our gross premiums written for the year ended December 31, 2005 and 14.8% in 2004. Growth in specialty insurance which is distributed through program administrators, was primarily due to new program administrators which were added during 2004 and early 2005. Gross premiums written by our U.S. Insurance division are reduced by amounts which are ceded to the Americas division of $20.2 million and $20.1 million for the years ended December 31, 2005 and 2004, respectively. Excluding the impact of amounts ceded to the Americas division, gross premiums written for the year ended December 31, 2005 increased by $129.2 million, or 31.4%, over 2004. Gross premiums written across each line of business is as follows:
Ceded Premiums Written. Ceded premiums written for the year ended December 31, 2005 increased by $36.3 million, or 12.6%, to $325.3 million (12.4% of gross premiums written) from $289.0 million (10.9% of
gross premiums written) for the year ended December 31, 2004. These amounts include reinstatement premiums paid of $65.7 million and $20.8 million for the years ended December 31, 2005 and 2004, respectively. Ceded premiums written for the year ended December 31, 2004 included $12.0 million related to First Capital. Excluding First Capital and reinstatement premiums in each period, ceded premiums written were $259.6 million for the year ended December 31, 2005 an increase of $3.4 million, or 1.3%, as compared to $256.2 million for the year ended December 31, 2004.
Ceded premiums written relating to our Whole Account and Facultative Excess of Loss Agreements were $11.9 million and $5.9 million for the years ended December 31, 2005 and 2004, respectively. Premiums are payable by us based on the amount of losses ceded under each of the agreements. The increase of $6.0 million for the year ended December 31, 2005 was primarily attributable to premiums paid on a higher level of losses ceded during 2005 to the 2001 whole account excess of loss agreement. This was offset by reduced cessions of Newline of $3.9 million in 2005 over 2004, primarily due to larger deductibles. In addition, there were reduced cessions of our U.S. Insurance business of $5.2 million in 2005 over 2004, primarily due to increased retentions across the business.
Net Premiums Written. Net premiums written for the year ended December 31, 2005 decreased by $60.1 million, or 2.5%, to $2,301.7 million from $2,361.8 million for the year ended December 31, 2004. Net premiums written represent gross premiums written less ceded premiums written. Net premiums written decreased over 2004 at a higher rate than gross premiums written, reflecting the increase in ceded premiums written in the period. Included in net premiums written are $4.7 million of net reinstatement premiums received for the year ended December 31, 2005 and $4.0 million in net reinstatement premiums paid in 2004, related to catastrophes. Excluding reinstatement premiums, net premiums written decreased by $68.8 million, or 2.9%, for the year ended December 31, 2005 over 2004, which is consistent with the 2.9% decrease in gross premiums written, excluding reinstatement premiums.
Net Premiums Earned. Net premiums earned for the year ended December 31, 2005 decreased by $56.7 million, or 2.4%, to $2,276.8 million, from $2,333.5 million for the year ended December 31, 2004. Net premiums earned decreased in the Americas division by $178.9 million, or 14.5%, and in the London Market division $36.7 million, or 8.7%, offset by increases in the EuroAsia division of $33.8 million, or 7.0%, and in the U.S. Insurance division of $125.0 million, or 63.0%. Included in net premiums earned are $4.7 million of net reinstatement premiums received for the year ended December 31, 2005 and $4.0 million in net reinstatement premiums paid in 2004, related to catastrophes. Excluding reinstatement premiums, net premiums earned decreased by $65.4 million, or 2.8%, for the year ended December 31, 2005 over 2004, which is consistent with the decrease in gross and net premiums written.
2004 and prior years, of which $40.3 million is related to asbestos and environmental losses, with the remainder principally related to U.S. casualty classes of business written in 2001 and prior, which includes $15.0 million for prior year catastrophe events, principally 2004 Florida Hurricanes, Typhoon Songda and the Indonesian earthquake and resulting tsunami. 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 $190.0 million attributable to 2003 and prior years, principally related to U.S. casualty classes of business written in 2001 and prior. Prior year development also includes $7.6 million for catastrophe events occurring prior to 2004 as well as an increase of $8.9 million for asbestos and environmental liabilities. The following table reflects the losses and LAE, as reported and includes the impact of catastrophe losses and prior period reserve development, expressed as a percentage of net premiums earned, for the years ended December 31, 2005 and 2004:
Losses and LAE for the years ended December 31, 2005 and 2004 were reduced by $18.7 million and $5.6 million, respectively, due to cessions to our Whole Account and Facultative Excess of Loss Agreements. Predominantly, these amounts were ceded to our 2001 whole account stop loss treaties, and were attributable to adverse loss development on U.S. casualty business written in 2001.
The following table reflects losses and LAE for the Americas division as reported, and includes the impact of catastrophe losses and prior period reserve development, expressed as a percentage of net premiums earned for the years ended December 31, 2005 and 2004 (in millions):
is also attributable to an increase in personnel related costs and related benefits, particularly in our U.S. Insurance division.
an increase of $845.1 million or 18.2% in average invested assets for the year ended December 31, 2005 over 2004, and higher short term rates over the period
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, realized investment gains attributable to our equity investment in HWIC Asia. Our equity in the net income of HWIC Asia Fund is comprised of the following items (in millions):
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 $15.3 million and $15.4 million for the years ended December 31, 2005 and December 31, 2004, respectively.
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, 2005 was $204.8 million, an increase of $43.9 million or 27.3%, from $160.9 million for the year ended December 31, 2004. We believe this figure is more representative of investment income from our ongoing investment activities.
Net Realized Investment Gains. Net realized investment gains of $81.5 million for the year ended December 31, 2005 decreased by $29.6 million from $111.1 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 more than 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 $65.7 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 $123.6 million for the year ended December 31, 2005 increased by $70.0 million over 2004, primarily reflecting gains on U.S. Treasury securities sold through the year and $46.4 million in gains related to the sale of Zenith convertible securities. 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 $59.8 million for the year ended December 31, 2005 increased by $23.6 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.
Latin America - Gross premiums written of $161.4 million for the year ended December 31, 2004 increased $17.5 million, or 12.2%, compared to $143.9 million for the year ended December 31, 2003. The increase is attributable to new property business written through our Latin American offices.
Canada - Gross premiums written of $46.0 million for the year ended December 31, 2004 decreased $33.5 million, or 42.1%, compared to $79.5 million for the year ended December 31, 2003. The decrease is primarily due to the cancellation of certain affiliated Canadian company business during 2004.
London Market. Gross premiums written in the London Market division for the year ended December 31, 2004 were $447.7 million, an increase of $9.8 million or 2.2% as compared to $437.9 million for the year ended December 31, 2003. These amounts represented 16.9% of our gross premiums written for the year ended December 31, 2004 and 17.1% in 2003. Gross premiums written for 2004 include $11.8 million of reinstatement premiums (all related to the London Branch), which principally relate to the 2004 Florida Hurricanes. Excluding reinstatement premiums in 2004, gross premiums written would be $435.9 million for the year ended December 31, 2004, representing a decrease of $2.0 million or 0.5%. Gross premiums written across each unit of the London Market division are as follows:
Newline - Gross premiums written of $265.2 million for the year ended December 31, 2004 decreased $18.3 million, or 6.5%, compared to $283.4 million for the year ended December 31, 2003. The decline in premiums generally reflects more competitive conditions in the market, where we were experiencing lower prices in certain classes or choosing to non-renew business that does not meet our underwriting criteria.
Medical Malpractice - Gross premiums written of $137.7 million for the year ended December 31, 2004, increased $27.1 million, or 24.5%, from $110.6 million for the year ended December 31, 2003. Expansion of our select markets business was the primary driver of the increase.
Ceded Premiums Written. Ceded premiums written for the year ended December 31, 2004 decreased by $107.3 million, or 27.1%, to $289.0 million (10.9% of gross premiums written) from $396.3 million (15.5% of gross premiums written) for the year ended December 31, 2003. These amounts include reinstatement premiums of $20.8 million for the year ended December 31, 2004. Excluding reinstatement premiums, ceded premiums decreased by $128.1 million to $268.2 million for the year ended December 31, 2004 from $396.3 million for year end December 31, 2003. The decrease in ceded premiums written relates to decreases in cessions to our Whole Account and Facultative Excess of Loss Agreements of $71.6 million, the cancellation of certain affiliated business of $36.7 million, decreases in the Latin America facultative cessions of $14.3 million, as well as reductions in the cessions of our Newline of $15.8 million. These reductions were offset by increased cessions in our catastrophe program for reinstatement premiums of $20.8 million, primarily associated with the 2004 Florida Hurricanes, and an increase in the U.S. Insurance division’s cessions due to increases in the gross premium volume.
Of the $361.6 million increase in net premium earned for the year 2004, $70.1 million is attributable to a decrease in premium ceded to our Whole Account and Facultative Excess of Loss Agreements. We ceded premium of $6.6 million to the Whole Account and Facultative Excess of Loss Agreements for the year ended December 31, 2004, compared to $76.7 million in 2003, a decrease of 91.4%.
Losses and Loss Adjustment Expenses. Losses and LAE increased 22.1% to $1,631.1 million for the year ended December 31, 2004 from $1,336.0 million for the year ended December 31, 2003, as follows (in millions):
For the Americas division, losses and LAE increased 11.8% to $907.6 million for the year ended December 31, 2004, from $811.6 million for the year ended December 31, 2003. This resulted in a loss and LAE ratio of 73.8% for the year ended December 31, 2004, compared to 69.1% for the year ended December 31, 2003. The increase in losses and LAE was principally related to a $55.7 million increase in net premiums earned and $68.0 million of property catastrophe losses related to the 2004 Florida Hurricanes. In the Americas division, losses and LAE reserves adjustments for the year ended December 31, 2004 relating to 2003 and prior years were $184.8 million, principally related to casualty classes of business. Casualty lines net reserve adjustments for 2000 and prior years increased $251.2 million, partially offset by net reserve reductions of $66.4 million on years 2001 through 2003. For the year ended December 31, 2003, reserve adjustments of $92.9 million, principally related to casualty exposures, were recorded.
For the EuroAsia division, losses and LAE increased 20.5% to $299.8 million for the year ended December 31, 2004, from $248.7 million for the year ended December 31, 2003. This resulted in a loss and LAE ratio of 62.2% for the year ended December 31, 2004, compared to 68.1% for the year ended December 31, 2003. The increase in losses and LAE is primarily due to the net premiums earned growth of 32.2%, as the loss ratios on the underlying business improved. In the EuroAsia division, losses and LAE reserves adjustments for the year ended December 31, 2004 relating to 2003 and prior years were $6.6 million, principally related to bond exposures underwritten in 2002. For the year ended December 31, 2003, there were $11.0 million of reserve adjustments related to prior years.
For the U.S. Insurance division, losses and LAE increased 84.8% to $130.1 million for the year ended December 31, 2004, from $70.4 million for the year ended December 31, 2003. This resulted in a loss and LAE expense ratio of 65.6% for the year ended December 31, 2004, compared to 73.6% for the year ended December 31, 2003. The increase in losses and LAE was principally related to the increase in net premiums earned. In the U.S. Insurance division, losses and LAE reserves adjustments for the year ended December 31, 2004 related to 2003 and prior years decreased by $1.2 million. There were $1.4 million of reserve adjustments related to prior years in the U.S. Insurance division for the year ended December 31, 2003.
Ceded losses and LAE for the year ended December 31, 2004 decreased by $93.3 million, or 22.4%, to $322.9 million, from $416.2 million for the year ended December 31, 2003. The decrease in ceded incurred losses and LAE primarily relates to a decrease in cessions to the Whole Account Excess of Loss Agreements for the year ended December 31, 2004. Losses and LAE for the years ended December 31, 2004 and 2003 were reduced by $5.6 million and $104.7 million, respectively, ceded to our Whole Account and Facultative Excess of Loss Agreement. Amounts recorded in 2004 were ceded to our 2001 whole account excess of loss treaty, and were attributable to adverse loss development on U.S. casualty business written in 2001. Losses and LAE of $104.7 million recognized in 2003 were ceded to our Whole Account and Facultative Excess of Loss Agreements relating to prior period losses which emerged in 2003, as follows: (i) $65.9 million ceded to the 2001 aggregate excess of loss treaty, principally due to the 2001 World Trade Center disaster, (ii) $39.0 million ceded to the 2000 aggregate excess of loss treaty, principally due to adverse loss development on U.S. casualty business written in 2000, (iii) a reduction in ceded losses of $4.5 million related to business written in prior years that was previously ceded and (iv) $4.3 million ceded related to facultative casualty business.
Other Underwriting Expenses. Other underwriting expenses for the year ended December 31, 2004 were $120.8 million, compared to $101.3 million for the year ended December 31, 2003. The other underwriting expense ratio, expressed as a percentage of net premiums earned, was 5.2% for the year ended December 31, 2004, compared to 5.1% for the year ended December 31, 2003. This increase in other underwriting expenses is attributable to an increase in headcount, personnel-related costs and other expenses generated by our substantial growth and global and product line diversification over the last three years.
The following table reflects the acquisition and other underwriting expenses, expressed as a percentage of net premiums earned, for the years ended December 31, 2004 and 2003 for each of our divisions:
an increase of $995.9 million or 27.2% in average invested assets for the year ended December 31, 2004 over 2003 and the reinvestment of cash balances in 2004 into asset classes with investment yields substantially greater than the amount earned on the cash balances;
an increase of $10.8 million for the year ended December 31, 2004 over 2003 in net investment income on other invested assets, which includes income from hedge funds and private equity investments of $15.4 million and $6.6 million for the years ended December 31, 2004 and December 31, 2003, respectively.
Excluding the positive impact of realized gains attributable to our equity investment in HWIC Asia, net investment income for the year ended December 31, 2004 was $160.9 million, an increase of $57.4 million or 55.4%, from $103.5 million for the year ended December 31, 2003. We believe this figure is more representative of investment income from our ongoing investment activities.
Interest expense on funds held primarily relates to our Whole Account and Facultative Excess of Loss Agreements, which is included in investment expenses, was $20.1 million for the year ended December 31, 2004, representing a decrease of $5.8 million, or 22.4%, from $25.9 million for the year ended December 31, 2003. The lower amount of interest expense was due to reduced amounts ceded to the treaties in 2004, which resulted in lower interest expense associated with ceded amounts during the period.
Interest Expense. We incurred interest expense, related to our debt obligations, of $25.6 million for the year ended December 31, 2004, compared to $12.7 million for the year ended December 31, 2003. The increase is due primarily to our issuance in the fourth quarter of 2003 of $225.0 million aggregate principal amount of 7.65% senior notes due 2013, offset by the prepayment of $50.0 million aggregate principal amount of our 7.49% senior notes due 2006.
Federal and Foreign Income Tax Provision. Our federal and foreign income tax provision for the year ended December 31, 2004 decreased by $29.8 million to $98.0 million, compared to $127.8 million for the year ended December 31, 2003, as a result of the decrease in pre-tax income. Our effective tax rates were 33.1% and 34.1% for the years ended December 31, 2004 and 2003, respectively.
Our shareholders’ equity increased by $68.4 million, or 4.4%, to $1,623.4 million as of December 31, 2005, from $1,555.0 million as of December 31, 2004. The net increase as of December 31, 2005 compared to December 31, 2004 was primarily attributable to the proceeds of our equity and preferred share offerings in
Holding company cash and cash equivalents equaled $102.4 million as of December 31, 2005, as compared to $1.7 million as of December 31, 2004, with the higher amount primarily due to the proceeds from our May 2005 senior notes offering. 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 2006, Odyssey America can pay dividends to the holding company of $207.1 million without prior regulatory approval. During the year ended December 31, 2005, we received $22.5 million in dividends from Odyssey America, all of which were received during the first half of the year.
Odyssey America’s liquidity requirements are principally met by cash flows from operating activities, which principally result from collections of premiums, reinsurance recoverables and investment income, net of paid losses, acquisition costs and underwriting and investment expenses. We seek to maintain sufficient liquidity to satisfy the timing of projected claim payments and operating expenses. The estimate of claim payments is inherently uncertain and the timing and ultimate amount of actual claim payments will vary based on the frequency and severity of losses across various lines of business. Claim payments can accelerate due to a variety of factors, including losses stemming from catastrophic events, which are typically paid out in a short period of time, legal settlements or emerging claim issues. We estimate claim payments, net of associated reinsurance recoveries, of approximately $1.2 billion during 2006. The timing and certainty of associated reinsurance collections which may be due to us can add uncertainty to our liquidity position to the extent amounts are not received on a timely basis. As of December 31, 2005, our operating subsidiaries maintained cash and cash equivalents of $1.4 billion, which is readily available for expected claim payments. In addition, our liquidity is enhanced through the collection of premiums on new business written through the year. We believe our cash resources, together with readily marketable securities, are sufficient to satisfy expected payment obligations, including any unexpected acceleration in claim payments or timing differences in collecting reinsurance recoverables.
several years, or in some cases decades, after the actual loss occurred. Reinsurance recoverables on unpaid losses, which represent 89.5% of our total reinsurance recoverables as of December 31, 2005, 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.
Cash provided by operations was $397.2 million for the year ended December 31, 2005, compared to $594.5 million for the year ended December 31, 2004. This reflects cash used in operations of $23.8 million for the three months ended December 31, 2005, compared to cash provided of $142.5 million for the three months ended December 31, 2004.
Total investments and cash amounted to $5.9 billion as of December 31, 2005, an increase of $853.1 million compared to December 31, 2004. Our average invested assets were $5,500.9 million for the year ended December 31, 2005, as compared to $4,655.8 million for the year ended December 31, 2004. It is anticipated that our cash and cash equivalents will continue to be reinvested on a basis consistent with our long-term, value oriented investment philosophy. Cash and short-term investments represented 29.2% and 26.9%, respectively, of our total investments and cash as of December 31, 2005 and December 31, 2004. Total fixed income securities were $2.6 billion as of December 31, 2005. The fixed income securities portfolio has a weighted average security rating of “AA” as measured by Standard and Poor’s. The duration of our investment portfolio, including cash and cash equivalents, was 6.0 years, which exceeds the duration of our liabilities. We believe this difference is mitigated by the significant amount of cash and cash equivalents maintained and our cash provided by operations.
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, 2005, we had a receivable for securities sold of $2.9 million, which is included in other assets, and a payable for securities purchased of $9.5 million, which is included in other liabilities.
In December 2001, we issued $100.0 million aggregate principal amount of senior notes due November 30, 2006, pursuant to a private placement. Interest accrues on the senior notes at a fixed rate of 7.49% per annum, which is due semi-annually on May 31 and November 30. In November 2003 and June 2002, we prepaid $50.0 million and $10.0 million, respectively, aggregate principal amount of the 7.49% senior notes. Immediately following the issuance of the senior notes, we 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, we settled the variable 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 is baing recognized into income over the remaining life of the 7.49% senior notes. In conjunction with the prepayment of the 7.49% senior notes, a portion of the capitalized gain was immediately realized. As of December 31, 2005, the aggregate principal amount of the 7.49% senior notes outstanding was $40.0 million and the remaining capitalized gain was $0.7 million. Pursuant to the terms of our 7.49% senior notes, we are subject to certain covenants, none of which significantly restricts our operating activities or dividend paying ability. We are in compliance with all covenants.
We participate in Lloyd’s through our 100% ownership of Newline, 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 $282.5 million as of December 31, 2005, 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 under total investments and cash in our consolidated financial statements and are classified as available for sale. 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 the obligations of OdysseyRe to support these liabilities will continue until they are settled or the liabilities are reinsured by a third party approved by Lloyd’s. OdysseyRe expects 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.
The Company and its subsidiaries are assigned financial strength (insurance) and credit ratings from internationally recognized rating agencies, which include A.M. Best Company, Inc., Standard & Poor’s Insurance Rating Services and Moody’s Investors Service. Financial strength ratings represent the opinions of the rating agencies of the financial strength of a company and its capacity to meet the obligations of insurance and reinsurance contracts. The rating agencies consider many factors in determining the financial strength rating of an
insurance or reinsurance company, including the relative level of statutory surplus necessary to support the business operations of the company.
Following our announcement on March 16, 2006 that the filing of our annual report on Form 10-K would be delayed in connection with the restatement of our consolidated financial results, Standard & Poor’s placed on CreditWatch with negative implications our counterparty credit, senior unsecured debt and preferred stock ratings and the financial strength ratings of our principal operating subsidiaries. In addition, Moody’s revised from “stable” to “negative” the outlook for our senior debt and preferred stock and the insurance financial strength ratings of our principal operating subsidiaries. Further, A.M. Best placed under review with negative implications our debt ratings and the financial strength ratings of our principal operating subsidiaries.
In December 2004, the Financial Accounting Standards Board issued SFAS 123R (revised 2004) “Share-Based Payment” which is a revision of SFAS 123, “Accounting for Stock-Based Compensation,” and supersedes Accounting Principles Board Opinion 25, “Accounting for Stock Issued to Employees,” and related interpretations. The approach to account for share-based payments in SFAS 123R is similar to the approach described in SFAS 123. Nevertheless, SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the 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 table below displays the potential impact (in millions) of market value fluctuations on our fixed income securities portfolio as of December 31, 2005 and December 31, 2004, 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.
We have exposure to credit risk, primarily as a holder of fixed income securities. We control this exposure by emphasizing investment grade ratings in the fixed income securities we purchase. We also have exposure to credit risk associated with the collection of current and future amounts owing from our reinsurers. We control this exposure by emphasizing reinsurers with financial strength.
We have purchased credit default swaps, which are included in other invested assets, that provide a hedge against adverse movements in the fair value of investments and other corporate assets resulting from systemic financial and credit risk. Under a credit default swap, we agree to pay at specified periods fixed premium amounts based on an agreed notional principal amount in exchange for the credit default protection on a specified asset. Credit default swaps 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. The total cost of the credit default swaps was $75.6 million and $11.5 million, and the fair value was $36.2 million and $4.1 million, as of December 31, 2005 and 2004, respectively. The notional amount of credit default swaps was $3.3 billion and $420.3 million as of December 31, 2005 and 2004, respectively. The net change in the fair value of the credit default swaps resulted in a net realized loss of $36.2 million and $4.5 million for the years ended December 31, 2005 and 2004, respectively.
In the third quarter of 2004, we sold short Standard & Poor’s 500 depository receipts (“SPDRs”) and the Financial Select SPDR Fund (“XLF”) as an economic hedge against a decline in our equity portfolio. The aggregate notional amount of the transactions was $451.8 million. In order to reduce the margin maintenance requirements for these short positions, we replaced the short positions with total return swaps. The margin maintenance requirement related to the total return swaps was $96.4 million and $99.2 million as of December 31, 2005 and 2004, respectively. The swap transactions terminate during 2006. As of December 31, 2005 and 2004, we have provided $104.3 million and $99.2 million, respectively, of U.S. Treasury bills as collateral for the swap transactions. The swap transactions are recorded at fair value in other liabilities and changes in the fair value are recorded as realized gains or losses in the consolidated statement of operations in the period in which they occur. For the years ended December 31, 2005 and 2004, the net change in the fair value of the swap transactions resulted in a net realized loss of $11.8 million and $44.9 million, respectively.
In connection with the short sales described above, we purchased a SPDR call option as protection at a cost of $1.5 million. The call option is recorded at fair value in other liabilities 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. As of December 31, 2005 and 2004, the net change in the fair market value of the call option resulted in a net realized loss of $1.2 million and a net realized gain of $0.4 million, respectively.
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, 2005 and December 31, 2004, our total exposure to foreign denominated securities in U.S. dollar terms was approximately $1.3 billion and $1.1 billion, respectively, or 21.4% and 22.0%, respectively, of our total investments and cash. The primary foreign currency exposures were from securities denominated in the British pound, which represented 8.5% and 8.1% of our total investments and cash as of December 31, 2005 and December 31, 2004, respectively, from German securities denominated in the Euro, which represented 5.5% and 4.1%, respectively, and from securities denominated in the Canadian dollar, which represented 4.9% and 4.9% of our total investments and cash as of December 31, 2005 and December 31, 2004, respectively. As of December 31, 2005, the potential impact of a 10% decline in each of the foreign exchange rates on the valuation of investment assets denominated in those respective foreign currencies would result in a $126.8 million decline in the fair value of our total investments and cash, before taxes.
sive 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.
Consolidated Statements of Operations and Comprehensive Income for the years ended December 31, 2005, 2004 and 2003
IV. Reinsurance for the years ended December 31, 2005, 2004 and 2003
VI. Supplementary Information (for Property-Casualty Insurance Underwriters) as of December 31, 2005, 2004, 2003 and for the years ended December 31, 2005, 2004 and 2003
We have completed integrated audits of Odyssey Re Holdings Corp. 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005 and an audit of its 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
As discussed in Note 2 to the consolidated financial statements, Odyssey Re restated its 2004 and 2003 consolidated financial statements and financial statement schedules.
Also, we have audited management’s assessment, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A, that the Company did not maintain effective internal control over financial reporting as of December 31, 2005 because the Company did not maintain effective controls over the accurate accounting for complex reinsurance transactions, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit.
with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
The Company has restated its consolidated financial statements as of and for the years ended December 31, 2000 through 2004, as well as its unaudited statements as of and for the nine months ended September 30, 2005, to correct for accounting errors associated with reinsurance contracts entered into by the Company between 1998 and 2004. The Company’s decision to restate its financial results follows a re-evaluation by the Company of the accounting considerations previously applied to these transactions. The effects of the restatement are reflected in the Company’s consolidated financial statements and accompanying notes included herein. Results for the nine months ended September 30, 2005 are unaudited.
The total cumulative impact of the restatement through September 30, 2005 is to decrease shareholders’ equity by $35.6 million, after-tax. The aggregate net effect of the restatement for each period is to increase the net loss for the nine months ended September 30, 2005 by $5.1 million, increase 2004 net income by $11.4 million, decrease 2003 net income by $2.3 million, decrease 2002 net income by $5.6 million, increase 2001 net loss by $30.7 million and decrease 2000 net income by $3.3 million. The $35.6 million after-tax cumulative decrease to shareholders’ equity as of September 30, 2005 will be offset by net income of $12.5 million to be recognized for the three months ended March 31, 2006 in connection with one of the restated contracts as discussed below.
(iii) The treatment of deferred ceding commissions to be received by the Company under three aggregate excess of loss reinsurance contracts purchased by the Company. Due to the deferred nature of the ceding commissions, amounts were reflected at their present value rather than the nominal value previously recorded by the Company. All of these contracts satisfied risk transfer requirements and remain active as of December 31, 2005. These contracts involve two unaffiliated counterparties. The corrections under these contracts resulted in an $8.4 million after-tax cumulative decrease to shareholders’ equity as of September 30, 2005, with the net effect of decreasing the net loss for the nine months ended September 30, 2005 by $0.8 million, increasing 2004 net income by $1.4 million, decreasing 2003 net income by $6.1 million, decreasing 2002 net income by $1.3 million, increasing 2001 net loss by $1.6 million and decreasing 2000 net income by $1.6 million. The cumulative effect of $8.4 million, after-tax, will be amortized into income in future periods.
(iv) The treatment of a proportional automobile reinsurance contract written by the Company in Latin America in 2003 and subsequently renewed in 2004 and 2005, relating to the potential existence of an oral side agreement that could limit the risk transfer under the contract. Following an internal review and
investigation by the Company’s outside counsel, the Company was unable to conclude as to whether there was an oral side agreement that would limit the risk transfer under the contract. After consideration of information from the investigation, the Company was unable to conclude that there is a reasonable possibility of a significant loss under the contracts and has therefore restated the contract to apply the deposit method of accounting in accordance with Statement of Position 98-7, “Deposit Accounting: Accounting for Insurance and Reinsurance Contracts that Do Not Transfer Risk” rather than reinsurance accounting. The corrections under this contract resulted in a $144 thousand after-tax cumulative increase to shareholders’ equity as of September 30, 2005, with the net effect of decreasing the net loss for the nine months ended September 30, 2005 by $220 thousand, decreasing 2004 net income by $18 thousand and decreasing 2003 net income by $58 thousand.
The previously reported restatement adjustment and restated amounts for those accounts affected by this restatement in the consolidated statements of operations for the nine months ended September 30, 2005 and for the years ended December 31, 2004 and 2003 and on the consolidated balance sheets as of September 30, 2005, December 31, 2004 and 2003 is as follows:
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 derivative securities and trust accounts relating to the Company’s benefit plans, 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 is aware of a significant event, it will estimate the impact of the event in the period in which it occurred.
(e) Goodwill and Intangible Assets. The Company accounts for goodwill and intangible assets in accordance with Statement of Financial Accounting Standard No. 141, “Business Combinations.” A purchase price paid that is in excess of net assets (“goodwill”) arising from a business combination is recorded as an asset, and is not amortized. Intangible assets with a finite life are amortized over the estimated useful life of the asset. Intangible assets with an indefinite useful life are not amortized. Goodwill and intangible assets are tested for impairment on an annual basis or more frequently if events or changes in circumstances indicate that the carrying amount may not be recoverable. If the goodwill or intangible asset is impaired, it is written down to its realizable value with a corresponding expense reflected in the consolidated statements of operations. Goodwill and intangible assets of $36.4 million and $37.1 million, reflected in other assets as of December 31, 2005 and 2004, respectively, are not impaired. Unamortized deferred credits (“negative goodwill”) related to net assets acquired in excess of purchase price arising from a business combination are recognized as an extraordinary gain in the consolidated statement of operations at the time of the acquisition.
For such contracts, the Company initially records the amount of consideration received as a deposit liability. Revenue earned by the Company is recognized over the term of the contract, with any unearned portion recorded as a component of deposit liabilities until such time it is earned. The ultimate liability under these contracts is estimated, and the liability is initially established, which represents consideration received, is increased or decreased over the term of the contracts. The change during the period is recorded in other income (expense) in the Company’s consolidated statements of operations, where decreases in the ultimate liability are shown as other income, and increases in the ultimate liability are shown as other expense. Consideration received is included in invested assets and the related investment income on the assets is included in investment income. In cases where cedants retain the consideration on a funds held basis, the Company records those assets in other assets, and records the related investment income on the assets in the Company’s consolidated statements of operations as investment income. As of December 31, 2005, the Company had reflected a liability of $2.5 million in other liabilities related to deposit contracts that transfer only significant timing risk, while there were no amounts for funds held balances included in other assets.
(j) Operating Segments. The Company has four operating segments to reflect the manner in which management monitors and evaluates the Company’s financial performance. The Company’s four segments include: Americas, EuroAsia, London Market and U.S. Insurance.
(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 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) 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) 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 would not be included in the calculation of diluted earnings per common share, if the effect would be anti-dilutive. (See Note 5).
(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, 2004 and 2003 reflects stock-based compensation expense related to stock options granted in 2003 and subsequently. 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. Had compensation cost been charged to earnings in accordance with the fair value
On April 21, 2005, the Securities and Exchange Commission (“SEC”) amended Rule 210.4-01(a) of Regulation S-X regarding the implementation date for SFAS 123R. This amendment modified the effective dates of SFAS 123R, requiring adoption of this standard on the first interim or annual reporting period of the first fiscal year beginning on or after June 15, 2005. Accordingly, the Company will adopt SFAS 123R effective January 1, 2006. The Company believes that the implementation of SFAS 123R will not have a significant impact on the Company’s results of operations or shareholders’ equity.
(o) Funds Held Balances. Funds held under reinsurance contracts is an account used to record a liability, in accordance with the contractual terms, arising from the Company’s receipt of a deposit from a reinsurer or the withholding of a portion of the premiums due as a guarantee that a reinsurer will meet its loss and other 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.
On November 15, 2004, the Company acquired Overseas Partners US Reinsurance Company (“Opus Re”), a reinsurance company domiciled in the state of Delaware, the name of which has been changed to Clearwater Select Insurance Company. The purchase price of $43.0 million, which was based on the fair value of the net assets of Opus Re at the date of acquisition, was comprised of $237.8 million of assets, principally investments, and $194.8 million of liabilities, principally unpaid losses and loss adjustment expense reserves. The Company recorded an intangible asset of $5.8 million, which as of December 31, 2005 and 2004 was not impaired and had an indefinite life. There was no goodwill recognized related to the acquisition of Opus Re. Following the acquisition, Clearwater Select was contributed to Clearwater.
In October 2003, the Company purchased the renewal rights to medical malpractice business underwritten by TIG Insurance Company, a subsidiary of Fairfax. The Company paid consideration of $7.5 million, which was recorded as an intangible asset and is being amortized over a ten year life. For the years ended December 31, 2005 and 2004, $0.7 million and $0.9 million, respectively, has been amortized and the unamortized value, which is included in other assets, was $5.9 million and $6.6 million as of December 31, 2005 and 2004, respectively.
Common stocks under equity accounting were carried at $402.6 million as of December 31, 2004, reflecting gross unrealized appreciation of $82.5 million and no gross unrealized depreciation. Other invested assets, including amounts that are accounted for under the equity method of accounting, were carried at $171.8 million as of December 31, 2004, reflecting gross unrealized appreciation of $2.1 million and gross unrealized depreciation of $0.1 million.
Actual maturities may differ from the contractual maturities shown in the table above due to the existence of call features or put features. In the case of securities containing call features, the actual maturity will be the same as the contractual maturity if the issuer elects not to exercise its call feature. Total securities subject to the call feature represent approximately 4% of the total fair value. In the case of securities containing put features, 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 feature represent approximately 5% 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, 2005, 2004, and 2003 (in thousands):
Included in gross realized investment losses for the years ended December 31, 2005 and 2003 are $54.9 million and $58.8 million, respectively, related to realized investment losses on the other-than-temporary write-down of certain fixed income and equity securities. The amount for 2005 reflects $35.0 million attributable to fixed income oriented investments and $19.9 million related to equity securities. The amount for 2003 reflects $51.8 million attributable to fixed income oriented investments and $7.0 million related to equity securities. The Company did not recognize any other-than-temporary write-down of investments for the year ended December 31, 2004.
The Company reviews, on a quarterly basis, its investment portfolio for declines in value, and specifically considers 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 the Company determines 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 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 intent and ability to hold the security to recovery when evaluating possible impairments.
The Company believes the gross unrealized depreciation is temporary in nature and has not recorded a realized investment loss in its statement of operations related to these securities. Given the size of its investment portfolio and capital position, the Company has the ability and intent to hold these securities until the fair value recovers the gross unrealized depreciation.
Common stocks, at equity, totaled $534.4 million as of December 31, 2005, compared to $402.6 million as of December 31, 2004. The following table shows the components of common stocks, at equity, as of December 31, 2005 and 2004 (in thousands):
The Company’s interest in HWIC Asia, an investment vehicle that primarily invests in public foreign equities, has been reflected in the Company’s consolidated financial statements in accordance with the equity method of accounting since the second quarter of 2005. The carrying value of investments reflected in the value of HWIC Asia is established at their fair value based on quoted market prices. In accordance with the equity method of accounting, interest and dividend income, and realized gains and losses of HWIC Asia are included in net investment income. The net amount of unrealized appreciation or depreciation of the Company’s proportional interest in investments held by HWIC Asia, net of applicable deferred income taxes, is reflected in the Company’s shareholders’ equity in accumulated other comprehensive income. The Company recorded unrealized appreciation, net of deferred income taxes, of $111.3 million and $45.0 million as of December 31, 2005 and 2004, respectively, related to its interest in HWIC Asia. The Company’s interest in HWIC Asia was previously consolidated beginning in the third quarter of 2004. The Company has a 39.2% voting interest in HWIC Asia, and a 56.2% economic interest in a portfolio of invested assets of HWIC Asia that share similar investment criteria as those of the Company. During the second quarter of 2005, it was determined that the equity method is appropriate, based on a review of the overall structure of HWIC Asia and the Company’s ownership interests and rights. This reclassification during the second quarter of 2005 has no effect on the Company’s consolidated shareholders’ equity or net income. Certain prior period amounts have been presented on a basis consistent with the current presentation under the equity method of accounting.
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, 2005, 2004 and 2003 (in thousands):
Other invested assets totaled $188.8 million as of December 31, 2005, compared to $171.8 million as of December 31, 2004. The following table shows the components of other invested assets as of December 31, 2005 and 2004 (in thousands):
During the second quarter of 2005, the Company purchased a 10-year swaption contract, which provides an economic hedge against a decline in the Company’s fixed income portfolio as a result of an increase in interest rates. The swaption gives the Company the option, but not the obligation, to enter into an interest rate swap contract under which the Company would receive a floating interest rate and pay a fixed interest rate based on the notional amount of the contract of $1.0 billion. The option expires during the second quarter of 2006, and if exercised, the interest rate swap would mature during the second quarter of 2015. The cost of the swaption was $12.9 million. The swaption is recorded at fair value of $5.8 million as of December 31, 2005 in other invested assets and the change in fair value is recorded as a realized gain or loss in the consolidated statement of operations. For the year ended December 31, 2005, the change in the fair value of the swaption resulted in a
realized loss of $7.1 million. The swaption was extended in February 2006 to the third quarter of 2006 at an additional net cost of $5.5 million.
The components of comprehensive income (loss) for the years ending December 31, 2005, 2004 and 2003 are shown in the following table (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 at December 31, 2005. The estimate is reviewed on a quarterly basis and the ultimate liability may be more or less than the amounts provided, for which any adjustments will be reflected in the periods in which they become known.
The Company’s consolidated statements of operations for the year ended December 31, 2004 include an underwriting loss of $97.4 million from the 2004 Florida Hurricanes. The underwriting loss from the 2004 Florida Hurricanes is comprised of net losses and loss adjustment expenses of $93.4 million, which is after reinsurance of $77.8 million, increased by $4.0 million in net reinstatement premiums paid. As a result of the uncertainty and complexity in estimating losses from the 2004 Florida Hurricanes, the Company incurred an additional underwriting loss of $12.6 million (12.9% of 2004 estimate) on the 2004 Florida Hurricanes, net of applicable reinstatement premiums, for the year ended December 31, 2005.
The Company’s consolidated statements of operations for the year ended December 31, 2003 includes net losses and loss adjustment expenses of $73.3 million from catastrophe losses recognized during the period. The largest of the 2003 catastrophe losses relate to $12.7 million for Typhoon Maemi, which occurred in South Korea in September 2003, and $10.0 million for floods which occurred in France in December 2003.
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 of reinsurance, for the years ended December 31, 2005, 2004 and 2003, is set forth in the table below (in thousands):
The Company’s survival ratio for asbestos and environmental related liabilities as of December 31, 2005 is 11 years. The Company’s underlying survival ratio for environmental related liabilities is seven years and for asbestos related liabilities is 12 years. The survival ratio represents the asbestos and environmental reserves, net of reinsurance, on December 31, 2005, divided by the average paid asbestos and environmental claims for the last three years of $18.3 million, which are net of reinsurance but prior to amounts subject to cession to the 1995 Stop Loss Agreement.
The Company utilizes retrocessional agreements principally to reduce and spread the risk of loss on its insurance and reinsurance business and to limit its exposure to multiple claims arising from a single occurrence. There is a credit risk with respect to reinsurance, which would become an ultimate liability of the Company in the event that such reinsuring companies are unable, at some later date, to meet their obligations under the reinsurance agreements in force. Reinsurance recoverables are recorded as assets, based on the Company’s evaluation of the retrocessionaires’ ability to meet their obligations under the agreements. Premiums written and earned are stated net of reinsurance ceded in the consolidated statements of operations. Direct, reinsurance assumed, reinsurance ceded and net amounts for the years ended December 31, 2005, 2004 and 2003 follow (in thousands):
The total amount of reinsurance recoverable on paid and unpaid losses as of December 31, 2005 and 2004 was $1,347.7 million and $1,142.6 million, respectively. The Company has established a reserve for potentially uncollectible reinsurance recoverables based upon an evaluation of each retrocessionaire and the Company’s assessment as to the collectibility of individual balances. The reserve for uncollectible recoverables as of December 31, 2005 and 2004 was $30.9 million and $33.0 million, respectively, and has been netted against reinsurance recoverables on loss payments. The Company has also established a reserve for potentially uncollectible assumed reinsurance balances of $6.3 million and $5.9 million as of December 31, 2005 and 2004, respectively, which has been netted against premiums receivable.
The Company previously purchased 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. 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. 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 OdysseyRe. The principal reinsurers under these agreements are London Life and Casualty Reinsurance Corporation and Underwriters Reinsurance Company (Barbados) Inc.
As of December 31, 2005, the 1994, 1998, 2000 and 2001 agreements have remaining aggregate limits of $62.7 million, $9.6 million, $0.9 million and $85.4 million, respectively. The limits for the other retrocessional agreements have been fully utilized or commuted.
The income (loss) before income taxes reflected in the Company’s statements of operations related to the Company’s Whole Account Excess of Loss Agreements and Facultative Excess of Loss Agreement for the years ended December 31, 2005, 2004, and 2003 is as follows (in thousands):
The Company has recorded interest expense associated with other ceded reinsurance agreements, and not reflected in the table above, of $44 thousand, $18 thousand and $775 thousand for the years ended December 31, 2005, 2004 and 2003, respectively.
The reinsurance recoverables on paid and unpaid losses related to the Whole Account Excess of Loss Agreements and Facultative Excess of Loss Agreement are $251.9 million and $262.0 million as of December 31,
Reinsurance recoverables were $1,142.6 million and collateral was $619.5 million, or 54.0% of the reinsurance recoverable balance, as of December 31, 2004.
Aggregate maturities of the Company’s debt obligations, at face value, are as follows (in thousands):
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. As of December 31, 2005, there was $49.5 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 “London Interbank Offer Rate” (“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 and had a maturity date of September 27, 2005.
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 two distribution channels, Newline at Lloyd’s, which focuses on casualty insurance, 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 components of the federal and foreign income tax (benefit) provision follow (in thousands):
The Company is a member of the United States tax group of Fairfax and makes payments to Fairfax in accordance with its tax sharing agreements. The Company paid federal and foreign income taxes of $63.4 million, $116.6 million and $142.2 million for the years ended December 31, 2005, 2004 and 2003, respectively. The Company, as of December 31, 2005, has a current tax recoverable of $96.1 million, which reflects $111.7 million receivable from Fairfax, principally offset by foreign tax payables. The Company’s tax recoverable was $19.4 million as of December 31, 2004.
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”). London Life had alleged that Odyssey America improperly administered the Agreements and sought a determination of its liability under the Agreements. Odyssey America sought enforcement of the Agreements. The arbitration hearing commenced in November 2005 and concluded in January 2006. On March 9, 2006, the arbitration panel issued its decision (Interim Final Award and 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. The arbitration panel directed the parties to resolve two remaining items representing, in the aggregate, less than $1 million, pretax. The resolution of this arbitration will have no material impact on the Company’s consolidated financial statements.
Odyssey America participated in providing quota share reinsurance to Gulf Insurance Company (“Gulf”) from January 1, 1996 to December 31, 2002, under which Gulf issued policies that guaranteed the residual value of automobile leases incepting during this period (“Treaties”). In March 2003, Gulf requested a payment of approximately $30.0 million, which included a “special payment” of $26.0 million, due on April 28, 2003, representing Odyssey America’s purported share of a settlement (“Settlement”) between Gulf and one of the insureds whose policies, Gulf contends, were reinsured under the Treaties (the “Disputed Policies”). In July 2003, Gulf initiated litigation against Odyssey America, demanding payment relating to the Settlement and other amounts under the Treaties. Odyssey America answered the complaint. Discovery has commenced and is expected to be completed in the second quarter of 2006. Among other things, Odyssey America contends that (i) Gulf breached its duty to Odyssey America of utmost good faith when it placed the Treaties by failing to disclose material information concerning the policy it issued to the insured; and (ii) the Disputed Policies are not covered under the terms of the Treaties. Among the remedies Odyssey America seeks is rescission of the Treaties. The Company is vigorously asserting its claims and defending itself against any claims asserted by Gulf. The Company estimates that the amount in dispute under the Treaties that has not been recorded by the Company as of December 31, 2005 could range between $35 million to $40 million, after taxes. If Odyssey America is ultimately found to be liable for all or a portion of this amount, any such amount will be recorded in the period in which it is judicially determined. It is presently anticipated that the case will not go to trial prior to the third quarter of 2006. It is not possible to make any determination regarding the likely outcome of this matter at this time.
During the second quarter of 2004, Odyssey America pledged to the Society and Council of Lloyd’s the equivalent of £110 million of U.S. Treasury Notes (“the pledged assets”) on behalf of Advent Capital (Holdings) PLC (“Advent”) to support Advent’s underwriting activities for the 2001 to 2005 underwriting years of account. Advent is 46.8% owned by Fairfax and its affiliates, which includes 15.0% held by OdysseyRe. nSpire Re Limited (“nSpire Re”), a subsidiary of Fairfax, had previously pledged assets at Lloyd’s on behalf of Advent pursuant to a November 2000 agreement with Advent. Advent is responsible for the payment of any losses to support its underwriting activities and the capital resources of Advent are first available to support any losses prior to a draw down of Odyssey America’s pledged assets. In consideration of Odyssey America pledging the assets, nSpire Re agreed to pay Odyssey America a fee equal to 2.0% per annum of the pledged assets, which the Company considers to be representative of commercial market terms. The pledged assets continue to be owned by Odyssey America, and Odyssey America receives any investment income thereon. The securities are carried at fair value under total investments and cash in OdysseyRe’s consolidated financial statements and are classified as available for sale. Interest earned on the securities is included in investment income. As additional consideration for, and further protection of, the pledged assets, nSpire Re has provided Odyssey America with indemnification in the event of a draw down on the pledged assets. Odyssey America retains the right to withdraw the pledged assets at any time upon 180 days advance written notice to nSpire Re. nSpire Re retains the obligation to pledge
The Company participates in Lloyd’s through its 100% ownership of Newline where the Company provides 100% of the capacity for Newline Syndicate 1218. The results of Syndicate 1218 are consolidated in the financial statements of the Company. In support of its capacity at Lloyd’s, Odyssey America has pledged U.S. Treasury Notes and cash with a fair value of $282.5 million as of December 31, 2005, in a deposit trust account in favor of the Society and Council of Lloyd’s. These securities may be substituted with other securities at the discretion of the Company, subject to approval by Lloyd’s. The securities are carried at fair value under total investments and cash in the Company’s consolidated financial statements and are classified as available for sale. Interest earned on the securities is included in investment income. The pledge of assets in support of Syndicate 1218 provides the Company with the ability to participate in writing business through Lloyd’s, which remains an important part of the Company’s 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. The Company has 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 the obligations of the Company to support these liabilities will continue until they are settled or the liabilities are reinsured by a third party approved by Lloyd’s. The Company expects to continue to actively operate Syndicate 1218 and support its requirements at Lloyd’s. The Company believes that Syndicate 1218 maintains sufficient liquidity and financial resources to support its ultimate liabilities and the Company does not anticipate that the pledged assets will be utilized.
Clearwater agreed to allow Ranger Insurance Company (“Ranger”), a subsidiary of Fairfax, 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, and at the inception of the agreement, no consideration was received by Clearwater. Ranger paid Clearwater $0.1 million in 2004 in connection with this agreement. There were no amounts received from Ranger prior to 2004. 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, 2005. 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.
indemnified under its guarantee agreement with a Fairfax affiliate. The guarantee, which was entered into while Odyssey America and CTR were each 100% owned by Fairfax, was provided by Odyssey America to facilitate the transfer of renewal rights to CTR’s business, together with certain CTR employees, to Odyssey America in 2000 in order to further expand the Company’s international reinsurance business. The guarantee was terminated effective December 31, 2001. There were no amounts received from CTR under the guarantee, and the Company did not provide any direct consideration for the renewal rights to the business of CTR. CTR was dissolved and its assets and liabilities were assumed by subsidiaries of Fairfax that have the responsibility for the run-off of its liabilities. Although CTR’s liabilities were assumed by Fairfax subsidiaries, the guarantee only pertains to those liabilities attaching to the policies written by CTR. Fairfax has indemnified Odyssey America for all its obligations under its guarantee. The Company believes that the financial resources of the Fairfax subsidiaries that have assumed CTR’s liabilities provide adequate protection to satisfy the obligations that are subject to this guarantee. The Company does not expect to make payments under this guarantee and does not consider its potential exposure under this guarantee to be material to its liquidity and capital resources.
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, in the event Falcon becomes insolvent. OdysseyRe holds a 44.0% economic interest in Fairfax Asia. 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, 2005 and 2004, Falcon paid $0.6 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 $47.5 million, based on Falcon’s loss reserves at December 31, 2005. Falcon’s shareholders’ equity on a U.S. GAAP basis is estimated to be $35.4 million as of December 31, 2005. 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.
The Company organized O.R.E Holdings Limited (“ORE”), a corporation domiciled in Mauritius, on December 30, 2003 to act as a holding company for various investments in India. On January 29, 2004, ORE was capitalized by the Company in the amount of $16.7 million. ORE is consolidated in the Company’s consolidated financial statements. During 2004, ORE entered into a joint venture agreement relating to the purchase by ORE of 45% of Cheran Enterprises Private Limited (“CEPL”). CEPL is a corporation domiciled in India, engaged in the purchase, development and sale of commercial real estate properties. The joint venture agreement governing CEPL contains a provision whereby Odyssey America could be called upon to provide a guarantee of a credit facility, if such facility were established by CEPL, in an amount up to $65.0 million for the funding of proposed developments. The credit facility has not been established as of December 31, 2005, and the requisite conditions for any future provision of the guarantee no longer exist. ORE’s Indian joint venture partner is claiming that the guarantee should be available and is pursuing legal actions against the Company. The Company finds this claim without merit and is vigorously defending the legal actions. The Company recognized an other-than-temporary write-down of $2.4 million in the carrying value of ORE for the year ended December 31, 2005.
The amounts above are reduced by an aggregate minimum rental recovery of $2.4 million resulting from the sublease of space to other companies.
Rental expense, before sublease income under these operating leases, was $11.1 million, $9.9 million and $8.4 million in 2005, 2004 and 2003, respectively. The Company recovered pre-tax amounts of $0.2 million, $0.4 million and $0.7 million in 2005, 2004 and 2003, respectively, from subleases.
The following is the consolidated statutory basis net income (loss) and policyholders’ surplus of Odyssey America and its subsidiaries, for each of the years ended and as of December 31, 2005, 2004 and 2003 (in thousands):
All amounts are assumed and ceded from Fairfax and its 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 and its affiliates in 2005 represent 2.0% of OdysseyRe’s total gross premiums written for the year ended December 31, 2005. Ceded premiums written represent 9.3% of OdysseyRe’s total ceded premiums written for the year ended December 31, 2005. The largest amounts of related party assumed business in 2005 were received from Commonwealth Insurance Company and Crum & Forster Insurance Company. Odyssey previously assumed business from Zenith National Insurance Corp (“Zenith”) through December 31, 2004. Assumed premiums written reflect $91.6 million and $76.9 million from Zenith for the years ended December 31, 2004 and 2003, respectively. 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.
Included in the consolidated balance sheets are amounts receivable from affiliates of $1.1 million and $13.1 million as of December 31, 2005 and 2004, respectively, and amounts payable to affiliates of $4.5 million and $1.1 million as of December 31, 2005 and 2004, respectively.
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 has a term of five years, bears interest at a rate of prime plus 3% and is collateralized by the shares of OLIC’s common stock. The balance of the loan was $7.3 million as of December 31, 2005 and has been reduced to $4.1 million as of March 2006 following a $3.2 million principal payment in February 2006.
As of December 31, 2005, the Company has invested $36.0 million in a Canadian investment fund managed by an officer of Fairfax (representing approximately 12% of the funds total assets). Fairfax and certain of its subsidiaries have also invested in the fund. The officer receives no remuneration or benefits associated with his position as an officer of Fairfax, and derives all of his compensation from his management of the investment fund. In the ordinary course of the Company’s investment activities, the Company makes investments in investment funds, limited partnerships and other investment vehicles in which Fairfax or its affiliates may also be investors.
The Company is a member of the United States tax group of Fairfax and makes tax payments to Fairfax in accordance with its tax sharing agreement. As a result of a net loss for the year ended December 31, 2005, OdysseyRe is due $97.5 million from Fairfax, which is included in federal income taxes in the Company’s consolidated balance sheets.
The amortization period for unrecognized pension costs and credits, including prior service costs, if any, and actuarial gains and losses, is based on the remaining service period for those employees expected to receive pension benefits. Actuarial gains and losses result when actual experience differs from that assumed or when actuarial assumptions are changed.
The weighted average assumptions used to calculate the net periodic benefit cost are as follows:
The accumulated benefit obligation for the Plan is $41,138 and $33,725 as of December 31, 2005 and 2004, respectively. As the fair value of the Plan assets exceeds the accumulated benefit obligation, the Company did not recognize an additional minimum pension liability as of December 31, 2005 and 2004.
The investment policy for the Plan is to invest in highly rated, lower risk securities that preserve the investment asset value of the Plan while seeking to maximize the return on those invested assets. The Plan assets as of December 31, 2005 and 2004 are invested principally in highly rated fixed income securities. The long term rate of return assumption is based on the fixed income securities portfolio. The actual return on assets has historically been in line with the Company’s assumptions of expected returns. During 2005, the Company contributed $3.2 million to the Plan. Based on the Company’s current expectations, the 2006 contribution should approximate $2.0 million.
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 $6.3 million and $6.2 million as of December 31, 2005 and 2004, 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 $1.0 million to the Excess Plans during the year ended December 31, 2006, which represents the amount necessary to fund the 2006 expected benefit payments.
The Company provides certain health care and life insurance (“postretirement”) benefits for retired employees. Substantially all employees may become eligible for these benefits if they reach retirement age while working for the Company. The Company’s cost for providing postretirement benefits other than pensions is accounted for in accordance with SFAS 106 “Employers’ Accounting for Postretirement Benefits Other Than Pensions.” The following tables set forth the amounts recognized for the postretirement benefit plan, which has a measurement date of January 1, in the Company’s consolidated financial statements as of December 31, 2005 and 2004 (in thousands):
The accrued benefit cost of $10.3 million and $8.8 million, as of December 31, 2005 and 2004, respectively, is included in other liabilities in the Company’s consolidated balance sheets.
The weighted average assumptions used to calculate the benefit obligation are as follows:
The accumulated benefit obligation for the postretirement benefit plan was $11.1 million and $8.5 million as of December 31, 2005 and 2004, respectively.
The plan change of $1.3 million and the unrecognized prior service cost of $0.7 million as of December 31, 2004 result from a change in eligibility for postretirement medical benefits, which previously had no age limitation, to age 45 and 10 years of service and the adoption of the Medicare Reform Act. The curtailment credit of $0.6 million in 2004 is the result of the eligibility change.
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 10% of base salary on a pre-tax basis, subject to annual maximum contributions set by law ($14,000 in 2005). 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, $1.3 million, and $1.1 million to these plans in 2005, 2004 and 2003, respectively, which is included in other underwriting expenses in the consolidated statements of operations.
A summary of the status of the 2002 Plan and changes during the years ended December 31, 2005 and 2004 is presented below:
During 2001, the Company adopted the Odyssey Re Holdings Corp. Stock Option Plan (the “Option Plan”), which provides for the grant of stock options to key employees of the Company outside of the United States. Options granted under the Option Plan generally vest and become exercisable in equal installments over three years or five years from the grant dates. Amounts granted in 2001 vest and become exercisable in two equal installments on the fifth and tenth anniversary of the grant dates. As of December 31, 2005 and 2004, respectively, 142,295 and 97,685 options were issued with an exercise price of zero. For the year ended December 31, 2005, 54,237 and 48,472 options were granted, 5,425 and 741 options were exercised and 4,202 and 2,700 options were forfeited, respectively, pursuant to the Option Plan. The Company has reflected, in other expense, net, $0.8 million, $0.5 million, and $0.2 million of expense for the years ended December 31, 2005, 2004 and 2003 respectively, which represents the vested portion of the stock options.
The Company provides a compensatory employee share purchase plan through which all employees who meet the eligibility requirements of the plan have the option to purchase OdysseyRe common shares in an amount up to 10% of their annual base salary. The Company purchases, on the employee’s behalf, OdysseyRe common shares equal to 30% of each employee’s contribution. In the event that the Company meets certain financial objectives, additional shares are purchased for the employee’s benefit. The expense related to this plan for the years ended December 31, 2005, 2004 and 2003 was $0.4 million, $0.5 million, and $0.3 million, respectively.
Prior to the initial public offering of the Company in June 2001, certain employees of the Company were granted shares of Fairfax restricted common stock in connection with their employment with OdysseyRe. The Fairfax restricted shares, which were granted from 1996 to 2000, vest over a three to ten year period. The Company assumed the expense for the Fairfax restricted common shares and has reflected $0.3 million, $0.4 million and $0.3 million of expense, before taxes, for the years ended December 31, 2005, 2004 and 2003, respectively, which represents the vested portion of the restricted shares. As of December 31, 2005, there was $1.6 million in unvested amounts of Fairfax restricted shares that will be recorded as an expense by OdysseyRe in future periods. Following its initial public offering, the Company did not participate in this plan.
The following table sets forth the effects of the restatement of the Company’s consolidated financial statements for each of the quarters in the years ended December 31, 2005 and 2004 (in thousands, except share amounts). (See Note 2).
Certain amounts reflected in the “As Previously Reported” column have been reclassified to conform with the December 31, 2005 presentation.
Fixed income securities, at amortized cost are $2,611,460, $2,576,346 and $2,642,126 as of March 31, June 30 and September 30, respectively, on an as previously reported and restated basis and $2,674,999 as of December 31, 2005. Fixed income securities, at amortized cost are $2,403,475, $2,571,422, $2,433,881 and $2,478,614 as of March 31, June 30, September 30 and December 31, 2004, respectively, on an as previously reported and restated basis.
On March 29, 2006, the Company received $78.0 million in cash from nSpire Re in partial settlement of amounts recoverable under the Company’s 1995 Stop Loss Agreement with nSpire Re. In connection with the receipt of the cash, the Company will recognize a deferred gain of $12.5 million after-tax in income for the three months ended March 31, 2006.
On February 22, 2006, the Company completed the private sale of $100.0 million of floating rate senior notes. The notes were sold in two tranches, $50.0 million of series A due February 2021 and $50.0 million of series B due February 2016. The interest rate on each series of notes is equal to 3-month LIBOR, which will be recalculated on a quarterly basis, plus 2.20%. The interest rate from February 22 through March 16, 2006 on each series of notes was 6.97% per annum. Pursuant to the terms of the indentures, as a result of our delay in completing the restatement of our financial results and in completing this annual report on Form 10-K, the annual interest rate on each series of notes has been increased to 3-month LIBOR (calculated as of March 15, 2006) plus 3.20%, which equals 8.12%. This interest rate remained in effect until March 31, 2006, after which it will revert to 3-month LIBOR plus 2.20%, recalculated quarterly. The series A notes are callable by the Company in 2011 at their par value, plus accrued and unpaid interest, and the series B notes are callable by the Company in 2009 at their par value, plus accrued and unpaid interest.