We lease office space in Hamilton, Bermuda and Dublin, Ireland for use by our existing property and casualty and life and annuity segments, although the life and annuity segment primarily works from our Bermuda office. Max USA has leased office space in four U.S. cities, Richmond, Virginia, Atlanta, Georgia, San Francisco, California and Philadelphia, Pennsylvania, for our planned U.S.-based excess and surplus lines activities. We lease office space on a long-term basis, which we believe will be adequate for anticipated future operations.
(1) Formerly shown as combined shareholders’ equity (shareholders’ equity and minority interest) and combined book value per share. On July 30, 2003, the holders of Max Re non-voting common shares and warrants to acquire Max Re non-voting common shares exchanged such shares and warrants for Max Re Capital common shares and warrants to acquire Max Re Capital common shares. The result of this exchange was the elimination of minority interest and an increase in shareholders’ equity of equal amounts as of the date of the exchange.
The following is a discussion and analysis of our results of operations for the year ended December 31, 2006 compared to the year ended December 31, 2005 and for the year ended December 31, 2005 compared to the year ended December 31, 2004, and also a discussion of our financial condition as of December 31, 2006. This discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes that are included in this Annual Report.
We are a Bermuda headquartered provider of reinsurance and insurance products for the property and casualty market and a provider of reinsurance for the life and annuity market. The property and casualty market continues to present more opportunities to us than the life and annuity market due to a shortage of reinsurance capacity in the property and casualty market. Prior to the severe hurricane activity in 2005, we observed a decrease in attractive property and casualty opportunities as competition increased in most property and casualty lines of business that we write. We increased our short-tail property and property catastrophe reinsurance and insurance premium volume during 2006 as market pricing, terms and conditions were favorable following hurricanes Katrina, Rita and Wilma in 2005. During 2006, there was an unusually low level of catastrophe activity and property and property catastrophe rates have begun to soften from rates observed in mid 2006 as reinsurance capacity returns to that market. While we continue to see attractive opportunities in all of the risk types we underwrite, the number of submissions that meet our pricing requirements is declining. In anticipation of this trend, we intend to expand into the excess and surplus lines business in the United States in 2007 by acquiring all of the outstanding shares of capital stock of a run-off stage property and casualty insurance company that is domiciled in Delaware and an eligible surplus lines carrier in approximately 40 U.S. States.
On October 29, 2006, subsequent to the filing on June 7, 2006 of our Amendment to our Annual Report on Form 10-K/A and the filing on February 15, 2006 of our Annual Report on Form 10-K for the year ended December 31, 2005, we announced that the ARMC had reopened its previously announced internal investigation that centered on a review of three finite property and casualty retrocessional contracts purchased in 2001 and 2003. The review was initiated to consider whether these three contracts were properly accounted for by us, principally with respect to whether they contained sufficient risk
In October 2006, the ARMC received from the counter-party to two of these contracts additional information that was unknown and unavailable to us at the May 2006 conclusion of the initial internal investigation. The ARMC immediately reopened its internal investigation to determine whether, in light of this additional information, these two contracts, which were entered into in 2001, still satisfied the risk transfer requirements of SFAS 113. The additional information raised the possibility of the existence of an oral agreement that would negate risk transfer. The available evidence did not allow for a definitive conclusion as to the existence of such an oral agreement. However, because some of the evidence suggested such an agreement, we did not believe that there was sufficient basis to conclude that there was risk transfer with respect to these two contracts and, accordingly, we determined that it was appropriate to restate our financial statements for the years ending December 31, 2001 through 2005 and for each of the periods ended March 31, 2006 and June 30, 2006 to reflect no risk transfer for these two contracts. The additional information does not relate to the third contract reviewed in the initial internal investigation, which is with a different counter-party, and the accounting for that contract remained unchanged from that reported on our Form 10-K/A (Amendment No. 1) filed on June 7, 2006. With this decision to restate, the ARMC concluded its internal investigation. The restated financial statements for the years ended December 31, 2005, 2004 and 2003 were reported on our Annual Report on Form 10-K/A (Amendment No. 2) filed on November 13, 2006. A description of the SEC inquiry into our decision to restate our financial statements is set forth under Item 3 - Legal Proceedings.
We achieved favorable underwriting results in 2006 and have progressed in building a diversified reinsurance and insurance company with a highly skilled and specialized team of underwriting professionals. Our property and casualty reinsurance and insurance segments produced an 86.4% combined ratio (the sum of total losses, acquisition costs and general and administrative expenses as a percentage of net premiums earned) for the year ended December 31, 2006 compared to 106.0% for the year ended December 31, 2005. This significant improvement stems principally from positive development on our excess liability insurance business written in 2003 and low catastrophe activity in 2006. We continually re-evaluate our estimates of ultimate liabilities for loss reserves. During 2006, our analysis of our 2003 excess liability business, which has seasoned due to the passage of time and has incurred lower reported losses than originally estimated, caused us to revise our estimate of ultimate losses and recognize positive development of $20.5 million during the year ended December 31, 2006. We also benefited from a below average number of catastrophe events in 2006, which led to strong results from our property catastrophe reinsurance and property insurance product lines compared to the unfavorable loss results due to Hurricanes Katrina, Rita and Wilma that we recorded in the year ended December 31, 2005.
Our investments during the year ended December 31, 2006 produced a total return of 4.73% compared to 3.66% for the year ended December 31, 2005. The cash and fixed maturities portfolio produced a total return of 3.78% during the year ended December 31, 2006 compared to 3.83% for the year ended December 31, 2005. The total return of the fixed maturities portfolio for the years ended December 31, 2006 and 2005 has been affected by a period of increasing interest rates, which has resulted in a combination of higher yields on the fixed maturities and is reflected in net investment income, partially offset by unrealized losses on the market value of the fixed maturities, which is reflected in shareholders’ equity in the consolidated balance sheet.
We expect to see increased opportunities to grow our existing underwriting activities through the expansion of our product range, and in order to allocate the necessary capital to these opportunities, we decided to change our allocation of invested assets. Our plan is to reduce our investment allocation to alternative investments to represent less than 20% of our total invested assets, down from the current allocation of 23.5%. We intend to meet our lowered allocation during 2007 in an orderly manner by reducing our alternative investment portfolio through redemptions and investing our excess cash from operations in fixed maturities. As part of our reduction of alternative assets, on December 28, 2006, we sold our equity interest in DaVinci Re Holdings Ltd. and its operating subsidiary DaVinci Reinsurance Ltd., a Bermuda property catastrophe reinsurer, for a price equal to book value. The decision to change our allocation of invested assets is consistent with our approach of deploying capital to attractive underwriting opportunities as they arise and results from our integrated risk management process and the flexibility we have regarding our investment decisions.
We continually assess our liquidity needs by monitoring and evaluating new business prospects and opportunities and the development of our existing operations. During the year ended December 31, 2006, we generated $528.6 million of cash from operations and invested $387.7 million in fixed maturities. We expect to continue to generate positive operating cash flow through premium receipts and investment returns, which will be partially offset by paid losses on reinsurance and insurance obligations, as well as operating expenses.
We derive operating revenues from premiums from our reinsurance and insurance businesses. Additionally, we recognize returns from our investment portfolios.
Reinsurance and insurance premiums are a function of the amount and type of contracts written as well as prevailing market prices. Property and casualty premiums are earned over the terms of the underlying coverage. Life and annuity reinsurance premiums
are generally earned when the premium is due from policyholders. Each of our reinsurance and insurance contracts contain different pricing, terms and conditions and expected profit margins. Therefore, the amount of premiums is not necessarily an accurate indicator of our anticipated profitability. Premium estimates are based upon information in underlying contracts, data received from clients and from premium audits. Changes in premium estimates are expected and may result in significant adjustments in any period. These estimates change over time as additional information regarding the underlying business volume of our clients is obtained. There is often a delay in the receipt of updated premium information from clients due to the time lag in preparing and reporting the data to us. After review by our underwriters and finance staff, we increase or decrease premium estimates as updated information from our clients is received.
Our consolidated financial statements are prepared in accordance with GAAP, which require management to make estimates and assumptions. We believe that the following accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements.
management judgment involved is with respect to the estimate of the amount of losses that we expect to be ceded to us. Additional premiums are recognized at the time loss thresholds specified in the contract are exceeded and are earned over the policy period. Changes in estimates of losses recorded on contracts with additional premium features will result in changes in additional premiums based on contractual terms.
contractually stipulated installments with payment terms ranging from payment at the inception of the contract to four quarterly payments. As a result of recognizing the estimated gross premium written at the inception of the policy and collecting that premium over an extended period, we include a premium receivable asset on our balance sheet. We actively monitor our premium receivable asset to consider whether we need an allowance for doubtful accounts. As part of this process we consider the credit quality of our cedants and monitor premium receipts versus expectations. We also seek to include a right of offset in the contract terms. Since commencing our operations, we have not written off any premiums receivable and, currently, no premiums receivables are significantly beyond their due dates or in dispute.
Expected Loss Ratio Method. To estimate ultimate losses under the expected loss ratio method, we multiply earned premiums by an expected loss ratio. The expected loss ratio is selected utilizing industry data, historical client data and professional judgment. We use this method for lines of business and contracts where there are no historical losses or where past loss experience is not sufficient.
Bornheutter-Ferguson Paid Loss Method. The Bornheutter-Ferguson paid loss method is a combination of the paid loss development method and the expected loss ratio method. The amount of losses yet to be paid is based upon the expected loss ratios. These expected loss ratios are modified to the extent paid losses to date differ from what would have been expected to have been paid based upon the selected paid loss development pattern. This method avoids some of the distortions that could result from a large development factor being applied to a small base of paid losses to calculate ultimate losses. This method will react slowly if actual loss experience develops differently than historical loss experience because of major changes in rate levels, retentions or deductibles, the forms and conditions of coverage, the types of risks covered or a variety of other factors.
Frequency-Severity Method. This method is based on assumptions about the number of claims that will impact a transaction and the average ultimate size of those claims. On excess of loss contracts, reported claims in lower layers provide insight to the expected number of claims that will likely impact the upper layers.
Although these actuarial methods for establishing reserves have been developed over time, assumptions about anticipated size of loss and loss emergence patterns are subject to fluctuation. Newly reported loss information from our clients is the principal contributor to changes in our loss reserve estimates. The selection of appropriate actuarial methods to establish reserves may change over time as the underlying loss information becomes more seasoned. Additional discussion of the reserving practices by business segment is included below.
Our reserving methodology, as discussed above, uses a loss reserving model that calculates a point estimate for our ultimate losses, as opposed to a methodology that develops a range of estimates. Although we believe that our assumptions and methodologies are reasonable, we cannot be certain that our ultimate payments will not vary, perhaps materially, from the estimates we have made. If we determine that adjustments to an earlier estimate are appropriate, those adjustments are reflected in our net income during the period in which we determine these adjustments. The establishment of new reserves, or the adjustment of reserves for reported claims, could result in significant upward or downward changes to our financial condition or results of operations in any particular period. We regularly review and update these estimates using the most current information available to us.
Our property reinsurance loss reserves are established on a contract-by-contract basis, based on losses reported by clients and our assessment of potential losses from catastrophe events, which are initially based on catastrophe model aggregate assessments and location specific assessments when available. Loss estimates are subsequently refined based on broker advices and client notifications.
We establish and review our property and casualty reinsurance loss reserves on a quarterly basis. The process for establishing our property and casualty reinsurance loss reserves is based upon internally generated actuarial analysis of loss data provided by clients. We use a variety of actuarial techniques and methods in estimating our ultimate liability for property and casualty reinsurance losses and loss expenses. These methods
Mitigating the uncertainty inherent in the reserves of our reinsurance portfolio is the fact that a large portion of our recorded reinsurance reserves are attributable to contracts that are booked at contractual aggregate limits. As of December 31, 2006 and December 31, 2005 more than 42% and 50% respectively, of the total reinsurance reserves are on contracts that are recorded at contractual aggregate limits.
Our property insurance loss reserves, which include case reserves, amounts for IBNR reserves and loss adjustment expenses, are compiled on a portfolio basis and are computed on an undiscounted basis. These reserves are adjusted for losses reported by
In connection with our ongoing analysis of our property and casualty insurance loss reserves, we review loss reports received from our clients to confirm that submitted claims are covered under the contract terms and take into account industry loss activity and industry loss trends. We also consider historical data, legal developments, changes in social attitudes and economic conditions, including the effects of inflation. As additional data becomes available and is reviewed, we may revise our property and casualty insurance reserve estimates to reflect this additional data, which may result in increases or decreases to reserves for insured events of prior years. These adjustments are recorded in the period they are determined.
We establish and review our property and casualty insurance loss reserves on a quarterly basis. The process for adjusting our property and casualty insurance loss reserves is based upon loss reports received from clients, which are input into actuarial models. We use a variety of actuarial techniques and methods in estimating our ultimate liability for property and casualty insurance losses and loss expenses. As noted above, these methods include paid loss development, incurred loss development, paid and incurred Bornhuetter-Ferguson methods and frequency-severity methods. This actuarial data is analyzed by product, type of risk, coverage and accident or policy year. Industry loss experience is also used to supplement our own data in selecting long term trend and development factors and in areas where our own data or the clients’ data is limited. The table below breaks our insurance reserves as of December 31, 2006 and 2005 into casualty (long claim-tail) and property (short claim-tail) components.
(3) The difference between the reinsurance recoverable included above and that reflected in the reconciliation of losses and loss adjustment expenses in Note 4 to the consolidated financial statements of $626 (2005-$166; 2004-$4,574) relates to the remaining net deferred gain or charge on retroactive reinsurance.
Our balance sheet reserves for 2005 have decreased principally as the result of redundancy in our 2003 excess liability insurance business which is developing more favorably than originally estimated. Accordingly, we reduced gross reserves by $35.5 million and losses recoverable from reinsurers by $15.0 million, to reflect the change in estimates. In addition, there has been partially offsetting adverse development on the property and casualty reinsurance business, including $8.6 million in relation to our 2005 hurricane losses.
Our balance sheet date reserves for 2001 and each subsequent balance sheet date through 2004 shown in the above tables were increased in 2005 by the development on two specific contracts. The first contract increased 2001 reserves by $50.2 million with the recording of such increased losses, triggering additional premiums and interest on additional premiums of $49.3 million, which are not reflected in the table above. The second contract increased 2002 reserves by $49.6 million, 2003 reserves by $64.8 million and 2004 reserves by $15.3 million, for a total increase of $129.7 million. The adverse development triggered additional premiums and interest on such additional premiums of $105.3 million, which are not reflected in the table above.
Changes in loss estimates principally arise from changes in underlying reported, incurred and paid claims data on contracts. Other assumptions used in our process, such as inflation, change infrequently in the reserving process and we do not perform a sensitivity analysis of changes in these assumptions. Given the variety of assumptions and judgments involved in establishing reserves for losses and benefits on both our insurance and reinsurance portfolios, we have not designed and maintained a system to capture and quantify the financial impact of changes in each of our underlying individual assumptions and judgments.
We own a portfolio of exchange traded investment grade fixed maturities that are available for sale and, as a result, we record the investments at fair value on our balance sheet. The unrealized gain or loss associated with the difference between the fair value and the amortized cost of the investments is recorded in other comprehensive income in the equity section of our balance sheet. Fixed maturities are subject to fluctuations in fair value due to changes in the interest rates, changes in issuer specific circumstances such as credit rating and changes in industry specific circumstances such as movements in credit spreads based on the markets perception of industry risks. As a result of these potential fluctuations, it is possible to have significant unrealized gains or losses on a security. Our strategy for our fixed maturities portfolio is to tailor the maturities of the portfolio to the timing of expected loss and benefit payments. At maturity, a fixed maturity’s amortized cost will equal its fair value and no realized gain or loss will be recognized in income. If, due to an unforeseen change in loss payment patterns, we need to sell investments before maturity, we could realize significant gains or losses in any period, which could result in a meaningful effect on reported net income for such period.
We utilize dynamic financial analysis to determine our overall asset and liability risk and the potential for adverse scenarios producing projected losses and potential adverse cash flow. This analysis is accomplished through a stochastic simulation of future periods with each asset and liability cash flow individually modeled. This 5000 path stochastic simulation utilizes the expected volatility of each of our individual asset and liability cash flows. We construct our asset portfolio based on the expected cash flows from our liability portfolio. Fixed income securities are purchased to meet cash flows along the entire maturity spectrum of the liabilities. In our dynamic financial analysis modeling we assume that alternative investments will liquidate in years five through ten, so fixed income securities are purchased to meet liability cash flows in years one through five and for liability cash flows beyond ten years. Our liability cash flows are highly variable. Because of this risk, we
We have constructed our alternative investment portfolio to have significantly less risk, as measured by standard deviation of return, than a common stock portfolio, which is the equity investment choice of many insurance organizations. For the five years ended December 31, 2006, our Max Re Diversified investment has produced an annual standard deviation of return of 4.05% compared to the annual standard deviation of return of 12.37% for the S&P 500. The worst annual result for our Max Re Diversified investment over the five year period ended December 31, 2006 was a gain of 4.15% in 2002, compared to the S&P’s loss of 22.09% in 2002, its worst year. Similarly, our best annual result over the five year period ended December 31, 2006 was a return of 16.67% in 2003, compared to the best annual result for the S&P 500 of 28.67% in 2003. There is significant risk in all investment activities, and the results of our alternative investment portfolio will vary over time with the investment markets. Our alternative investments have never produced a loss for an annual period and have shown one third the risk of the S&P 500.
We do not manage invested assets within our segments, rather we manage the portfolio in its entirety. Consequently, investment returns which comprise investment income and gains on our Max Re Diversified portfolio are not directly captured in segment results. However, because of the long duration of liabilities on casualty business and life and annuity business, investment returns are important in evaluating each segment’s profitability. Accordingly, we allocate investment returns to each of our segments based on an approximation of the timing of cash flows into and out of each segment, resulting invested assets within each segment and the estimated investment duration for the invested assets within each segment. The balance of investment returns are allocated to our corporate function. The investment returns for our strategic private equity reinsurance investments are allocated entirely to our corporate function.
Gross premiums written. Gross premiums written for the property and casualty reinsurance segment for the year ended December 31, 2006 were $423.6 million compared to $615.7 million for the year ended December 31, 2005, a decrease of 31.2%. Additional premiums of $182.0 million arising from the notification of additional losses on two excess of loss contracts written in prior years are included in the gross premiums written for the year ended December 31, 2005 compared with additional premiums of $16.7 million in the year ended December 31, 2006. This decrease in additional premiums is the primary reason for the 31.2% decrease in gross premiums written. There were no other significant changes to premium estimates on prior period contracts. Gross premiums written for the property and casualty reinsurance segment for the year ended December 31, 2006 reflect our current emphasis on writing a greater number of smaller transactions. As a result there are fewer significant premium adjustments or additional premiums than in prior years. We expect to continue to write a large number of smaller transactions.
Reinsurance premiums ceded. Reinsurance premiums ceded for property and casualty reinsurance for the year ended December 31, 2006 were $35.3 million compared to $51.8 million for the year ended December 31, 2005, a decrease of 31.9%. The decrease was largely due to $27.3 million of reinsurance premiums ceded during the year ended December 31, 2005, which were directly related to the $182.0 million of additional premiums written on two contracts written in a prior year, as described above. This compares to $2.5 million of reinsurance premiums ceded during the year ended December 31, 2006 in relation to additional premiums written. The decline in premiums ceded in relation to additional premiums was partially offset by an increase in purchased excess of loss reinsurance to manage our exposure to significant catastrophe events.
Reinsurance premiums ceded for property and casualty reinsurance for the year ended December 31, 2005 were $51.8 million compared to $47.6 million for the year ended December 31, 2004, an increase of 8.8%. The increase included $27.3 million of reinsurance premiums ceded which were directly related to the $182.0 million of additional premiums written on two contracts written in a prior year, as described above, partially offset by a decline in premium ceded to Grand Central Re, which stopped writing new business in 2004. Reinsurance premiums ceded were principally related to our purchase of specific reinsurance to manage the risks associated with our reinsurance underwriting and to manage the exposure retained by us on certain transactions, therefore the ratio of gross premiums written to reinsurance premiums ceded may fluctuate based on our assessment of exposure and the availability of reinsurance capacity at attractive prices.
Net premiums earned. Net premiums earned for property and casualty reinsurance decreased by 30.4% to $422.8 million for the year ended December 31, 2006 from $607.1 million in 2005. The decrease was primarily the result of the decrease in additional premiums described above.
Losses relating to property and casualty reinsurance were $552.8 million for the year ended December 31, 2005 compared to $422.6 million for the year ended December 31, 2004, an increase of 30.8%. The losses for the year ended December 31, 2005 include $73.4 million of losses attributable to the hurricanes in the United States and $179.9 million of net losses pertaining to additional losses notified on two contracts written in a prior year. The loss ratio for our property and casualty reinsurance segment for the year ended December 31, 2005 was 91.1% compared to 74.9% for the year ended December 31, 2004. Excluding hurricane losses and losses that triggered additional premiums in 2005, the adjusted loss ratio for our property and casualty reinsurance segment is 66.3%. The adjusted 2005 loss ratio is lower as a result of a change in business mix to risk types that generally have a lower average loss ratio as well as a large commutation that was made during the 2005 year.
Interest expense. Interest expense was $(3.8) million for the year ended December 31, 2006 compared to $11.5 million for the year ended December 31, 2005. Interest expense includes $7.0 million of interest expense pertaining to the funds withheld on the variable quota share retrocession agreement with Grand Central Re for the year ended December 31, 2006 compared to $6.0 million for the year ended December 31, 2005. The interest expense on the Grand Central Re funds withheld is based on the average of two total return fixed maturity indices, which had a higher total return for the year ended December 31, 2006 compared to the year ended December 31, 2005.
Interest expense also includes the accretion of interest expense on a number of reinsurance contracts that are not deemed to transfer risk under the requirements of
Interest expense was $11.5 million for the year ended December 31, 2005 compared to $12.7 million for the year ended December 31, 2004. Interest expense includes $6.0 million of interest expense pertaining to the funds withheld on the variable quota share retrocession agreement with Grand Central Re for the year ended December 31, 2005 compared to $6.5 million for the year ended December 31, 2004
General and administrative expenses. General and administrative expenses were $23.5 million for the year ended December 31, 2006 compared to $15.0 million for the year ended December 31, 2005, an increase of 56.7%. The increase resulted principally from personnel costs associated with an increased headcount within our reinsurance staff. In addition there has been an increase in incentive-based compensation as a result of the improved net income for the year ended December 31, 2006.
General and administrative expenses were $15.0 million for the year ended December 31, 2005 compared to $12.1 million for the year ended December 31, 2004, an increase of 24.0%. The increase resulted principally from ongoing personnel costs associated with our reinsurance staff, including hiring additional property underwriters.
Losses relating to insurance were $175.5 million for the year ended December 31, 2005 compared to $90.6 million for the year ended December 31, 2004, an increase of 93.7%, and includes $50.0 million in losses recorded related to the hurricanes in the United States. The loss ratio for our insurance segment for the year ended December 31, 2005 was 101.5% compared to 73.0% for 2004. Excluding hurricane losses in 2005, the adjusted loss ratio for our property and casualty insurance segment is 72.6%. During the year ended December 31, 2005, there were no adjustments to loss reserves relating to prior year contracts.
Acquisition costs. Acquisition costs were $(0.1) million for the year ended December 31, 2006 compared to $0.1 million for the year ended December 31, 2005. The acquisition costs are net of ceding commissions associated with premiums ceded to our quota share partners. These ceding commissions are designed to compensate us for the costs of producing the portfolio of risks ceded to our reinsurers.
General and administrative expenses. General and administrative expenses were $15.6 million for the year ended December 31, 2006 compared to $9.9 million for the year ended December 31, 2005, an increase of 57.6%. The increase resulted principally from expenses associated with an increased headcount within our insurance staff. In addition there has been an increase in incentive-based compensation as a result of the improved net income for the year ended December 31, 2006.
Gross premiums written. Gross premiums written for the life and annuity reinsurance segment for the year ended December 31, 2006 were $45.0 million compared to $275.0 million for the year ended December 31, 2005. Gross premiums written primarily relate to one reinsurance contract written during the year ended December 31, 2006. We wrote three reinsurance contracts during the year ended December 31, 2005.
Net premiums earned. Life and annuity reinsurance business written in each respective year was fully earned in that year.
Benefits. Benefits relating to the life and annuity reinsurance segment were $77.8 million for the year ended December 31, 2006 compared to $311.2 million for the year ended December 31, 2005. Benefits include regular changes in existing policy and claim liabilities together with benefits incurred on transactions written during the period. The decrease was principally due to the decline in premiums written and earned during the year ended December 31, 2006 compared to the year ended December 31, 2005.
Benefits relating to the life and annuity reinsurance segment were $311.2 million for the year ended December 31, 2005 compared to $238.3 million for the year ended December 31, 2004, an increase of 30.6%. The increase was principally due to the recognition of losses associated with the premiums written and earned in the current year.
Acquisition costs. Acquisition costs were $1.7 million for the year ended December 31, 2006 compared to $2.5 million for the year ended December 31, 2005 and $3.5 million for the year ended December 31, 2004. The acquisition costs on the life and annuity reinsurance transactions that we bind will vary from period to period depending on brokerage rates.
Interest expense was $3.3 million for the year ended December 31, 2005 compared to $3.9 million for the year ended December 31, 2004. Interest expense includes $1.4 million of interest expense pertaining to the funds withheld on the variable quota share retrocession agreement with Grand Central Re for the year ended December 31, 2005 compared to $1.6 million for the year ended December 31, 2004.
General and administrative expenses. General and administrative expenses were $3.0 million for the year ended December 31, 2006 compared to $3.5 million for the year ended December 31, 2005 and $4.5 million for the year ended December 31, 2004. General and administrative expenses have varied in proportion to staffing levels in each of the years.
Net income (loss). Net income attributable to the life and annuity reinsurance segment for the year ended December 31, 2006 was $8.5 million compared to a loss of $2.2 million for the year ended December 31, 2005. The results are driven by the changes in existing policy and claim liabilities offset by the investment income on the assets generated by the segment. The increase in invested assets combined with improved returns on both fixed maturities and the Max Re Diversified portfolio has increased net income for the year ended December 31, 2006.
Net loss attributable to the life and annuity reinsurance segment was $2.2 million for the year ended December 31, 2005 compared to net income of $7.1 million for the year ended December 31, 2004. The results are driven by the changes in existing policy and claim liabilities offset by the investment income on the assets generated by the segment. The net income for the year ended December 31, 2005 includes a reduction of $0.9 million in investment returns compared to the year ended December 31, 2004 as a result of a lower return on the Max Re Diversified portfolio partially offset by an increase in invested assets.
Net gains on alternative investments. Net gains on the alternative investment portfolio were $84.8 million, or 6.96%, including a gain of $10.0 million from our private equity reinsurance investments, for the year ended December 31, 2006 compared to $39.9 million, or 3.34%, including a loss of $26.2 million from our private equity reinsurance investments, for the year ended December 31, 2005.
Net realized gains on sale of fixed maturities. Our fixed maturities investment strategy is not intended to generate realized gains and losses as more fully discussed below. The realized gains (losses) for the years ended December 31, 2006, December 31, 2005 and December 31, 2004 of $(5.8) million, $(0.7) million and $10.4 million, respectively, are the result of the sale of fixed maturities in connection with normal portfolio rebalancing transactions.
We own a portfolio of investment grade fixed maturities that are available for sale and, as a result, we record the investments at fair value on our balance sheet. The unrealized gain or loss associated with the difference between the fair value and the amortized cost of the investments is recorded in other comprehensive income in the equity section of our balance sheet. Fixed maturities are subject to fluctuations in fair value due to changes in the interest rates, changes in issuer specific circumstances such as credit rating and changes in industry specific circumstances such as movements in credit spreads based on the markets perception of industry risks. As a result of these potential fluctuations, it is possible to have significant unrealized gains or losses on a security. Our strategy for our fixed maturities portfolio is to tailor the maturities of the portfolio to the timing of expected loss and benefit payments. At maturity, a fixed maturity’s amortized cost will equal its fair value and no realized gain or loss will be recognized in income. If, due to an unforeseen change in loss payment patterns, we need to sell investments before maturity, we could realize significant gains or losses in any period, which could result in a meaningful effect on reported net income for such period. In order to reduce the likelihood of needing to sell investments before maturity, especially given the unpredictable and potentially significant cash flow requirements of our property catastrophe business, we have increased our cash and cash equivalent balances.
Cash and invested assets. Aggregate invested assets, comprising cash and cash equivalents, fixed maturities and alternative investments, were $4,535.9 million at December 31, 2006 compared to $4,223.2 million at December 31, 2005, an increase of 7.4%. The increase in cash and invested assets resulted principally from $528.6 million in cash flows from operations generated in the year ended December 31, 2006, offset by a decrease of $30.4 million in unrealized appreciation on our fixed maturities portfolio. The decline in unrealized appreciation on our fixed maturities portfolio principally relates to increases in interest rates. Our fixed maturities portfolio did not suffer any credit events during the year ended December 31, 2006.
Liabilities for life and annuity benefits. Life and annuity benefits totaled $895.6 million at December 31, 2006 compared to $854.2 million at December 31, 2005. The increase was principally attributable to one new contract written in the year ended December 31, 2006, in addition to changes in policy and claim liabilities, and foreign exchange movements on, liabilities.
Shareholders’ equity. Our shareholders’ equity increased to $1,390.1 million at December 31, 2006 from $1,185.7 million at December 31, 2005, an increase of 17.2%, principally reflecting net income of $216.9 million partially offset by a decrease in accumulated other comprehensive income of $26.7 million and the payment of dividends of $14.3 million during the year ended December 31, 2006.
Liquidity. We generated $528.6 million of cash from operations during the year ended December 31, 2006 compared to $394.5 million for the year ended December 31, 2005, an increase of 34.0%. The two principal factors impacting our operating cash flow are premium collections and timing of loss and benefit payments. We write principally casualty business in the property and casualty reinsurance segment and the property and casualty
In the ordinary course of business, we are required to provide letters of credit or other regulatory approved security to certain of our clients to meet contractual and regulatory requirements. We have three credit facilities as of December 31, 2006 providing an aggregate of $720.0 million of letter of credit capacity. Each of our credit facilities requires that we comply with certain substantially similar covenants, including a minimum consolidated tangible net worth, a minimum insurer financial strength rating and restrictions on the payment of dividends. We were in compliance with all the covenants of each of our credit facilities at December 31, 2006.
Capital resources. At December 31, 2006, our capital structure consisted of common equity. Total capitalization amounted to $1,390.1 million as compared to $1,185.7 million at December 31, 2005, an increase of 17.2%. We believe we have flexibility with respect to capitalization as a result of our access to the debt and equity markets. We may attempt to access the capital markets within the next twelve months.
relevant. On February 9, 2007, Max Re Capital’s board of directors declared a dividend of $0.07 per share to be paid on March 9, 2007 to shareholders of record on February 23, 2007.
We have been assigned an insurer financial strength rating of “A- (Excellent)” by A.M. Best Company, Inc. and an insurer financial strength rating of “A (Strong)” by Fitch, Inc. These ratings reflect each rating agency’s opinion of our financial strength, operating performance and ability to meet obligations. If an independent rating agency downgrades or withdraws any of our ratings, we could be severely limited or prevented from writing any new insurance or reinsurance contracts, which would significantly and negatively affect our business. Insurer financial strength ratings are based upon factors relevant to policyholders and are not directed toward the protection of investors.
Furthermore, life and annuity benefits and deposit liabilities recorded in the financial statements at December 31, 2006 are computed on a discounted basis, whereas the expected payments by period in the table above are the estimated payments at a future time and do not reflect a discount of the amount payable.
Financial Accounting Standard No. 48-Accounting for Uncertainty in Income Taxes. FIN 48
In July 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”), which clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes . FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. The provisions of FIN 48 must be applied beginning January 1, 2007. The Company is currently evaluating the impact of this guidance on the Company’s financial condition and results of operations.