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 the following states for our 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) On July 30, 2003, the holders of Max Bermuda non-voting common shares and warrants to acquire Max Bermuda non-voting common shares exchanged such shares and warrants for Max Capital common shares and warrants to acquire Max 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.
We are a global provider of specialty property and casualty insurance and reinsurance products, with underwriting operations based in Bermuda, Ireland and the United States. We underwrite a diversified portfolio of risks that encompass long-tail business, including but not limited to excess liability, professional liability and workers compensation risks, as well as short-tail property, property catastrophe and aviation risks. We also provide life and annuity reinsurance when opportunities arise.
Favorable underwriting results in our mature segments, continued diversification into new markets and new underwriting channels, as well as strong investment returns in the midst of unpredictable and volatile financial markets were the key components of our net income of $303.2 million for the year ended December 31, 2007. We believe that continuing to build on our complimentary underwriting platforms and capitalizing on our diversified investment strategy allowed us to realize the most successful financial performance in our history.
Our underwriting results for the year ended December 31, 2007 reflect a mixture of the results of adherence to our underwriting standards, favorable loss development and expansion into new product lines where we foresee growth opportunities. Losses, and large loss events, in particular, have for the most part been lower than expected for the second consecutive year.
Gross premiums written in our property and casualty segments for the year ended December 31, 2007 decreased 5.3% to $776.3 million compared to the same period in 2006. We expect the softening property and casualty market to continue in many of our product lines and we intend to continue to focus on adherence to our underwriting standards and diversification. As of December 31, 2007, our mix of gross premiums written between property and casualty reinsurance and insurance remained fairly evenly balanced, with insurance and U.S. excess and surplus lines insurance representing 55.5% of our total property and casualty gross premiums written as of December 31, 2007, up slightly from 48.3% for the same period in 2006. We continue to emphasize long-tail casualty lines in our property and casualty reinsurance and insurance segments, with professional liability and excess liability being our first and third largest exposures accounting for 24.6% and 19.1%, respectively, of gross premiums written for the year ended December 31, 2007. Our U.S. excess and surplus lines insurance platform, which commenced in April 2007, continued to grow with gross premiums written of $48.2 million for the year ended December 31, 2007, with 55.0% of this premium being written in the fourth quarter of 2007. We expect this platform will provide opportunities for growth in 2008 in the niche markets we are currently targeting.
Our life and annuity reinsurance segment produced gross premiums written of $302.0 million for the year ended December 31, 2007 compared to $45.0 million for the same period in 2006. The nature of life and annuity reinsurance transactions that we consider results in a limited number of transactions actually bound with potentially large variations in annual premium volume. Of the gross premiums written during 2007, $91.4 million was the result of underwriting additional closed blocks of annuities for existing clients. We believe our strong relationships with our existing clients provided the opportunity to underwrite these additional transactions.
For the year ended December 31, 2007, our cash, fixed maturities and alternative investments collectively increased by $586.7 million, or 12.9%, due to positive operating cashflow and a 10.38% total investment return. We believe our 3.2 to 1 ratio of invested assets to shareholders’ equity and our overall investment strategy enhances the return potential for our shareholders.
We are pleased with the performance of our alternative investments, which provided an investment rate of return of 16.97% and net gains of $186.7 million for the year ended December 31, 2007. Our rolling 60-month annualized rate of return at December 31, 2007 was 10.28%. The alternative investment strategies that principally contributed to the gains for the year ended December 31, 2007 were the long/short equity and event driven arbitrage strategies, which are the two largest allocations of our alternative investments at 25.4% and 16.1%, respectively. Certain of our underlying funds in the alternative investment portfolio have traded sub-prime securities, both long and short positions. This activity was a meaningful contributor to the returns made in 2007. Our alternative investment strategies are selected because of their low correlation with the stock market, the bond market and each other. Our alternative investment portfolio continued to achieve consistently positive returns with volatility similar to an investment-grade quality fixed maturities portfolio.
Our investment allocation to alternative investments was 20.7% at December 31, 2007 compared to 23.5% at December 31, 2006. We made net redemptions of $195.0 million from our alternative investments during the year ended December 31, 2007 as part of our investment objective to reduce our target allocation to alternative investments to approximately 20% of our total invested assets.
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 principal expenses are losses and benefits, acquisition costs, interest expense and general and administrative expenses. Losses and benefits are based on the amount and type of reinsurance and insurance contracts written by us during the current reporting period and information received during the current reporting period from clients pertaining to contracts written in prior years. We record losses and benefits based on actuarial estimates of the expected losses and benefits to be incurred on each contract written. The ultimate losses and benefits depend on the actual costs to settle these liabilities. We increase or decrease losses and benefits estimates as actual claim reports are received. Our ability to make reasonable estimates of losses and benefits at the time of pricing our contracts is a critical factor in determining profitability.
Interest expense principally reflects interest on our bank loans at a rate based on LIBOR plus a spread and interest on our senior notes. In addition, interest expense also includes the net interest charge on funds withheld from reinsurers under reinsurance and retrocessional contracts. Interest expense on funds withheld from other reinsurers under reinsurance and retrocessional contracts will vary principally due to changes in the balance of funds withheld. Finally, interest expense also includes interest on deposit contracts.
We follow SFAS No. 60, “Accounting and Reporting by Insurance Enterprises,” SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and Realized Gains and Losses from the Sale of Investments,” and SFAS No. 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts,” in determining the accounting for our reinsurance and insurance products. Assessing whether or not the contracts we write meet the conditions for risk transfer requires judgment. The determination of risk transfer is based, in part, on the use of actuarial and pricing models and assumptions.
Property and casualty insurance and U.S. excess and surplus lines insurance revenue recognition
Our property and casualty insurance and U.S. excess and surplus lines insurance premiums are recorded at the inception of each contract, based upon contract terms. For property and casualty insurance and U.S. excess and surplus lines insurance, the amount of minimum and/or deposit premium is usually contractually documented at inception, and variances between deposit premium and final premium are generally small. An adjustment is posted to amend the minimum and/or deposit premium if there are changes in underlying exposures insured. Premiums are earned on a pro rata basis over the coverage period.
Our property and casualty reinsurance premiums are recorded at the inception of each contract, based upon contract terms and information received from ceding clients and their brokers. For excess of loss contracts, the amount of minimum and/or deposit premium is usually contractually documented at inception, and variances between deposit premium and final premium are generally small. An adjustment is posted to amend the minimum and/or deposit premium when notified if there are changes in underlying exposures insured. For quota share or proportional property and casualty reinsurance contracts, gross premiums written are normally estimated at inception based on information provided by cedants and/or brokers. We generally account for such premiums using the client’s initial estimates, and then adjust them as more current information becomes available, with such adjustments recorded as premiums written in the period they are determined. We believe that the ceding clients’ estimate of the volume of business they expect to cede to us represents the best estimate of gross premium written at the beginning of the contract. As the contract progresses, we monitor actual premium received in conjunction with correspondence from the ceding client in order to refine our estimate. Variances from original premium estimates are normally greater for quota share contracts than excess of loss contracts. Premiums are earned on a pro rata basis over the coverage period. The net adjustments to gross premiums written as a result of changes in premium estimates for the years ended December 31, 2007 and 2006 were not material.
Certain of the contracts we write, particularly the property and property catastrophe reinsurance risks, provide for reinstatements of coverage. Reinstatement premiums are the premiums for the restoration of the insurance or reinsurance limit of a contract to its full amount after a loss occurrence by the insured or reinsured and principally relate to our property catastrophe reinsurance contracts. The purpose of optional and required reinstatements is to permit the insured / reinsured to reinstate the insurance coverage at a pre-determined price level once a loss event has penetrated the insured layer. In addition, required reinstatement premiums permit the insurer / reinsurer to obtain additional premiums to cover the additional loss limits provided.
We accrue for reinstatement premiums resulting from losses recorded. Such accruals are based upon contractual terms and the only element of management judgment involved is with respect to the amount of losses recorded. Changes in estimates of losses recorded on contracts with reinstatement premium features will result in changes in reinstatement premiums based on contractual terms. Reinstatement premiums are recognized at the time we record losses and are earned on a pro rata basis over the coverage period. Reinstatement premiums assumed and ceded for each of the three years to December 31, 2007 are not material to our financial results.
Under GAAP, we are not permitted to establish loss reserves until the occurrence of an event that may give rise to a loss. Once such an event occurs, we establish reserves based upon loss reports from insureds and estimates of total losses incurred by the ceding client as a result of the event and our estimate of the portion of such loss we cover. As a result, only loss reserves applicable to losses incurred up to the reporting date and an allowance for the future emergence of losses that have already occurred may be recorded, with no allowance for the provision of a contingency reserve to account for expected future losses.
In estimating reserves we, consistent with industry practice, utilize a variety of standard actuarial methods together with management judgment. The loss reserve selection from these various methods is based on the loss development characteristics of the specific line of business and specific contracts which take into consideration coverage terms, type of business, maturity of loss data, reported claims and paid claims. We do not necessarily utilize the same actuarial method or group of actuarial methods for all contracts within a line of business or segment, as variations between contracts result in a number of different methods or groups of methods being appropriate. These actuarial methods have been designed to address the lag in loss reporting in the insurance business as well as the delay in obtaining information that would allow us to more accurately estimate future payments. Reporting lag is more pronounced in our reinsurance contracts than in our insurance contracts and more pronounced in casualty business, which generally has a longer claims pay-out period (long claim-tail), than property business, which generally has a shorter claims pay-out period (short claim-tail). On casualty reinsurance transactions the reporting lag will generally be 60-90 days after the end of a reporting period,
but can be longer than this in some cases. Based on the experience of our actuaries and management, we select loss development factors and trending techniques to mitigate the problems caused by reporting lags and claims tails. We regularly evaluate and update our loss development and trending factor selections using client specific and industry data. The principal actuarial methods we use to perform our quarterly loss reserve analysis may include:
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, frequency-severity and rate level forecasts 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.
Reported Loss Development Method. This method estimates ultimate losses by calculating past reported loss development factors and applying them to exposure periods with further expected reported loss development. Since reported losses include payments and case reserves, changes in both of these amounts are incorporated in this method. This approach provides a larger volume of data to estimate ultimate losses than paid loss methods. Thus, reported loss patterns may be less varied than paid loss patterns, especially for coverages that have historically been paid out over a long period of time but for which claims are reported relatively early and case loss reserve estimates established.
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 paid loss experience develops differently than historical paid 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.
During 2007, several large reinsurance contracts were commuted that resulted in a significant reduction to case reserves. In addition, many of the losses associated with the 2005 hurricanes were paid in 2007, which also decreased case reserves. As a result, our property and casualty reserves are approximately $300 million lower as of December 31, 2007 when compared to December 31, 2006 reserves.
Development of our prior period incurred losses for each of the three years ended December 31, 2007 is reported in Note 6 - “Property and casualty losses and loss adjustment expenses” to our consolidated financial statements on page. After adjusting 2005 prior period incurred losses for contractual additional premiums received related to the recording of losses on two contracts, our development of prior period loss reserves has been less than 3.5% in each of the three years ending December 31, 2007 and an average of 3.3% over the past six years. Based on this experience, we currently believe it reasonably likely that loss reserves could change 3.5% from currently reported amounts. This change could be higher or lower depending on our client reported data and potential future commutation of reserves. As at December 31, 2007, we estimate that a 3.5% change in loss reserves would impact our net income and shareholders’ equity by $81.7 million. Depending on whether the reasonably likely adjustments to loss reserves are on contracts ceded to one of our various reinsurance arrangements, there may also be a partially offsetting change in the losses recoverable, net income and shareholders’ equity.
Our property and casualty reinsurance loss reserves include case reserves, amounts for IBNR reserves and loss adjustment expenses. The reserves are compiled on a contract-by-contract basis and are computed on an undiscounted basis. The majority of our reinsurance property and casualty reserves are related to casualty business. Historically, losses associated with casualty business have had a long claim-tail, the time period between the occurrence of a loss and the time it is settled by the insurer we reinsure. Casualty losses are also more susceptible to litigation and can be significantly affected by changing contract interpretations and a changing legal environment. Due to the long claim-tail nature of casualty business, a high degree of judgment is involved in establishing loss reserves.
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, together with management judgment. 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, as appropriate. Industry loss experience is also used to supplement our own data in selecting development factors in areas where our own data or the clients’ data is limited.
When determining reserves, we also consider additional historical data, industry loss trends, legal developments, changes in social attitudes and economic conditions, including the effects of inflation. As additional data becomes available and is reviewed, we revise our property and casualty reinsurance 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. The table below breaks our property and casualty reinsurance reserves as of December 31, 2007 and 2006 into casualty (long claim-tail) and property (short claim-tail) components.
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 our clients and for our estimate of losses resulting from catastrophe events, based on a detailed, location specific analysis of our clients’ properties impacted by the events.
We determine our IBNR reserves by first projecting the ultimate expected losses by product within each line of business. We then subtract paid losses and reported loss reserves from the ultimate loss reserves. The remainder is our incurred but not reported reserves. The level of IBNR reserves in relation to total reserves depends upon the characteristics of the particular line of business, particularly with respect to the speed by which losses are reported and outstanding loss reserves are adjusted. Lines for which losses are reported quickly will have a lower percentage of IBNR reserves than lines for which losses are reported more slowly, and lines for which reserve volatility is low will have a lower percentage of IBNR reserves than higher volatility lines.
The reserves for reported losses related to our U.S. excess and surplus lines insurance business are initially set by our claims personnel or independent claims adjusters we retain. The loss reserves are subject to our review, with a goal of setting them at the ultimate expected loss amount as soon as possible when the information becomes available.
We establish and review our property and casualty U.S. excess and surplus lines insurance IBNR loss and loss expense reserves on a quarterly basis. We use a variety of actuarial techniques and methods in estimating our ultimate liability for excess and surplus lines insurance losses and loss expenses, together with management judgment. As noted above, these methods include paid loss development, incurred loss development, paid and incurred Bornhuetter-Ferguson methods. Industry loss experience is also used to supplement our own data in selecting loss reporting and payment patterns and expected loss ratios. The table below breaks our U.S. excess and surplus lines insurance reserves as of December 31, 2007 into casualty (long claim-tail) and property (short claim-tail) components.
In connection with our ongoing analysis of our property and casualty insurance and reinsurance and U.S. excess and surplus lines insurance loss reserves, we review loss notifications and reports received from our clients to confirm that submitted claims are covered under the contract terms. Disputes with clients arise in the ordinary course of business due to coverage issues such as classes of business covered and interpretation of contract wording. We typically resolve any disputes through negotiations that could vary from a simple exchange of email correspondence to arbitration with a panel of experts. Our contracts generally provide for dispute resolution through arbitration. We are not currently involved in any coverage disputes that would, individually or in the aggregate, be material to us.
(1) Adjusted for reclassification of a contract to a deposit liability.
During 2007 our re-estimated balance sheet reserves for 2001 and each subsequent balance sheet decreased as a result of net favorable development on a large number of contracts with varied underwriting years and lines of business. The more significant development included:
The settlement of a large block of prior period reinsurance reserves resulting in a net favorable development of $15.2 million and net paid losses related to prior years of $131.9 million. The favorable development and paid losses impacted the reserves for 2001, 2002 and 2003.
Favorable development of $13.0 million on one alternative risk reinsurance contract where reserves were released based on updated information received from one client. Due to contractual features requiring additional premiums and interest thereon in the event of additional losses in excess of pre-determined thresholds, an offsetting decrease in additional premium was recorded and earned in the amount of $15.2 million which is 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 our insurance and reinsurance and U.S. excess and surplus lines insurance 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 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, fixed maturities’ amortized cost will equal their 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.
Fair value for our alternative investments is generally based on the net asset value reported by the respective investment fund managers or, for our reinsurance equity investment, based on the carried amount under the equity method of accounting. The investment fund managers generally carry their trading positions and investments at fair value and greater than 90% of the underlying holdings are securities with quoted market prices. For underlying securities that do not have quoted market prices, fair value is estimated by the fund manager. We use the financial reports from the fund managers as part of our evaluation of fair value in order to record the net gains on alternative investments in our statement of income. In addition, audited financial statements are obtained annually for each of the funds held in our alternative investment portfolio and we have never had a material difference between the reported net asset value of a fund and the audited net asset value.
As at December 31, 2007, our Max Diversified alternative investment portfolio contained 35 underlying investments in 9 different strategies. We focus on risk, as opposed to return, in the selection of each of our alternative investments. This causes us to select individual alternative investments that have exhibited attractive risk/reward characteristics and low correlation to other investments in the portfolio, as opposed to individual investments that have shown the highest return, but also higher volatility of return. We then combine the selected individual alternative investments into a portfolio of alternative investments. By combining investments with moderate volatility and low correlations, we are able to achieve an alternative investment portfolio within Max Diversified that has overall lower volatility relative to investing in a common stock portfolio or a typical fund of hedge funds portfolio.
We monitor the performance of our underwriting operations in four segments:
We also have a corporate function that manages our investment and financing activities.
Invested assets relating to the three non-U.S. segments are managed on a consolidated basis. Consequently, investment income on this consolidated portfolio and gains on the alternative investment portfolio (collectively referred to as the “non-U.S. portfolio”) are not directly captured in the non-U.S. segments. However, because of the longer duration of liabilities on casualty insurance and reinsurance business and life and annuity reinsurance business, investment returns are important in evaluating the profitability of these segments. Accordingly, we allocate investment returns from the non-U.S. portfolio to each non-U.S. segment. This is based on a notional allocation of invested assets from the total portfolio using durations that are determined based on estimated cash flows into and out of each segment. The balance of investment returns are allocated to our corporate function. The investment returns for our strategic private equity reinsurance investment are allocated entirely to the corporate function.
We continue to monitor pricing and market trends closely and changes to our premium mix reflect the risk types where we believe our price requirements, terms and conditions are being met. As a result, our gross reinsurance premium volume and mix may vary from period to period. In addition, changes in client appetite for risk retentions will vary with market conditions and may also cause fluctuations in our premium volume and mix. For the foreseeable future, we expect to see softening premium rates and increased competition for business. As a result, we expect downward pressure on our property and casualty reinsurance premium volume.
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.
Losses. Losses relating to property and casualty reinsurance were $173.3 million for the year ended December 31, 2007 compared to $296.0 million for the year ended December 31, 2006, a decrease of 41.5%. The decrease in losses for the year ended December 31, 2007 is principally attributable to the following:
Net favorable development of $13.0 million stemming from one contract where updated information received from the client indicated reported losses lower than previously expected;
Adverse development of $20.0 million on a marine reinsurance quota share contract that had losses in relation to the 2005 hurricanes. As a result of this development the contract has reached the aggregate limit;
Acquisition costs were $77.3 million for the year ended December 31, 2006 compared to $73.6 million for the year ended December 31, 2005, an increase of 5.0%. The increase in acquisition costs for the year ended December 31, 2006 is due to higher average acquisition costs on premiums earned.
Interest expense. Interest expense was $11.9 million for the year ended December 31, 2007 compared to $(3.8) million for the year ended December 31, 2006. Interest expense includes $9.3 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, 2007 compared to $7.0 million for the year ended December 31, 2006. 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, 2007 compared to the year ended December 31, 2006.
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 Statement of Financial Accounting Standards No. 113 and therefore are recorded as deposit liabilities on the balance sheet. These deposit liabilities are recorded on a net present value basis and an interest expense is recorded and added to the liability over the life of the contract so as to equal the expected ultimate settlement amount. During 2006, we were notified by the cedant of one of the contracts that the ultimate loss is expected to be lower than our original estimate. As a result we recognized a reduction in interest expense of $12.0 million during the year ended December 31, 2006 in order to reflect the current net present value of the revised loss estimate.
Net income attributable to property and casualty reinsurance for the year ended December 31, 2006 was $88.6 million compared to $5.9 million for the year ended December 31, 2005. The primary difference in net income for the year ended December 31, 2006 compared with the year ended December 31, 2005 is the $73.4 million of losses stemming from hurricane activity impacting the year ended December 31, 2005. Further, additional invested assets combined with improved returns on both fixed maturities and the Max Diversified portfolio increased net income for the year ended December 31, 2006.
Reinsurance premiums ceded for insurance for the year ended December 31, 2006 were $194.5 million compared to $145.7 million for the year ended December 31, 2005, an increase of 33.5%. Reinsurance premiums ceded were principally related to our quota share treaties that are utilized to manage our retained exposure and, therefore, will tend to increase when gross premiums written increase. In addition, because we increased the volume of short-tail property and aviation business that we write, we purchased excess of loss reinsurance in order to reduce our exposure to large catastrophe events. This resulted in the ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2006 increasing to 49.0% compared to 41.0% for the year ended December 31, 2005.
Losses. Losses relating to insurance were $153.8 million for the year ended December 31, 2007 compared to $124.2 million for the year ended December 31, 2006, an increase of 23.8%. During the year ended December 31, 2007, we recorded $1.7 million net favorable development on our excess liability reserves and $5.7 million net favorable development on our property reserves compared to net favorable development of $20.5 million on reserves for the year ended December 31, 2006. The favorable development in 2007 was partially offset by a net loss of $5.6 million stemming from aviation losses in 2007. The loss ratio for our insurance segment for the year ended December 31, 2007 was 77.1% compared to 62.8% for the same period in 2006. The addition of aviation to our premium mix has contributed to in an increase in our average loss ratio for this segment.
Acquisition costs. Acquisition costs were $(1.2) million for the year ended December 31, 2007 compared to $(0.1) million for the year ended December 31, 2006 and $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, and have increased as our premiums ceded have increased.
General and administrative expenses. General and administrative expenses were $19.4 million for the year ended December 31, 2007 compared to $15.6 million for the year ended December 31, 2006, an increase of 24.4%. The increase principally relates to additional claims and underwriting staff hired since December 31, 2006, in order to service a larger client base.
Net income attributable to the property and casualty insurance segment for the year ended December 31, 2006 was $78.2 million compared to $1.3 million for the year ended December 31, 2005. The variance between the year ended December 31, 2006 and the year ended December 31, 2005 is principally attributable to the low level of catastrophic events during the year ended December 31, 2006 compared to the $50.0 million of hurricane losses in the year ended December 31, 2005 and the release of $20.5 million of net reserves on prior year general liability insurance business during the year ended December 31, 2006. Further, additional invested assets combined with improved returns on both the fixed maturities and alternative investment portfolios has increased net income for the year ended December 31, 2006.
Net premiums earned of $4.0 million for the year ended December 31, 2007 reflect the short period of time since Max Specialty began writing business. We expect this figure to increase as gross premium written volume increases.
General and administrative expenses. General and administrative expenses were $17.4 million for the year ended December 31, 2007. General and administrative expenses principally comprise personnel and infrastructure costs reflecting the start-up period of the Max Specialty operations. Compared to our other segments, we expect this segment to have the highest volume of transactions and the lowest average dollar value per transaction. This will require a greater number of personnel to generate and process the high volume of transactions customary for this operation and, accordingly, we expect a higher general and administrative expense ratio for this segment compared to our other segments.
We write life and annuity reinsurance transactions when opportunities arise. The nature of life and annuity reinsurance transactions that we consider results in a limited number of transactions actually bound with potentially large variations in quarterly and annual premium volume. Consequently, components of our underwriting results, such as premiums written, premiums earned and benefits can be volatile and, accordingly, period to period comparisons are not necessarily representative of future trends.
Gross premiums written. Gross premiums written for the life and annuity reinsurance segment for the year ended December 31, 2007 were $301.9 million compared to $45.0 million for the year ended December 31, 2006 and compared to $275.0 million for the year ended December 31, 2005. During the year ended December 31, 2007, we wrote six reinsurance contracts, each covering closed blocks of pension annuities, compared to one contract written in 2006. Of the gross premium written in 2007, $207.9 million was from new clients and $91.4 million was from the reinsurance of additional closed blocks of annuities for existing clients. These additional closed blocks of annuities have similar characteristics to reinsurance contracts written in previous years. We believe our strong relationships with our existing clients provided the opportunity to underwrite these additional transactions.
Gross premiums written during the year ended December 31, 2006, primarily relate to one new reinsurance contract written. We wrote three reinsurance contracts during the year ended December 31, 2005. Apart from the components related to the new contracts incepting during the years ended December 31, 2007, 2006 and 2005, gross premiums written, reinsurance premiums ceded, net premiums earned, acquisition costs and general and administrative expenses represent ongoing premium receipts or adjustments and related administration expenses on existing contracts. Interest expense relates to interest on funds withheld on the variable quota share retrocession agreement with Grand Central Re. The interest expense is based on the average of two total return fixed maturity indices, which varies from period to period.
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. 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.
Net income (loss). Net income attributable to the life and annuity reinsurance segment for the year ended December 31, 2007 was $39.5 million compared to $8.5 million for the year ended December 31, 2006 and $(2.2) million for the year ended December 31, 2005. The results are driven by the increasing spread between our actual rate of return on investments and the rate of return assumption used when pricing the business that we write, together with the lack of material unexpected changes in our estimates of life and annuity benefit reserves.
Net investment income. Net investment income from our cash and fixed maturities portfolio, which excludes realized and unrealized gains and losses, for the year ended December 31, 2007 increased $38.2 million to $188.2 million compared to $150.0 million for the year ended December 31, 2006, an increase of 25.5%. The increase was principally attributable to the growth in the cash and fixed maturities portfolio from $3,470.0 million at December 31, 2006 to $4,060.9 million at December 31, 2007, together with an increase in yield on the fixed maturities portfolio. The average annualized investment yield on the cash, fixed maturities investments and funds withheld by clients for the year ended December 31, 2007 was 4.96% compared to 4.73% for the year ended December 31, 2006. We expect a lower yield in 2008 due to the lower interest rates stemming from the downward movement in the U.S. Federal Open Market Committee’s discount rate between August 2007 and January 2008.
Each alternative investment strategy we employed was profitable during the year ended December 31, 2007. Alternative investment strategies principally contributing to the gains in the current period were the event driven arbitrage and long/short equity strategies, which returned 36.14% and 26.94%, respectively. Contributing to the returns were meaningful gains from a variety of long and short sub-prime mortgage positions taken by several of the underlying funds in our Max Diversified portfolio. The event driven arbitrage strategy typically entails the purchase of securities of a company involved in a significant corporate event. The long/short equity strategy comprises funds that typically purchase common
stock (go long) of companies in a particular sector with perceived strong fundamentals and sell common stock (go short) of companies in the same sector that are perceived to have deteriorating fundamentals. While this strategy can profit from either positive or negative price trends in the overall stock market, investment managers of long/short equity funds generally have a net long position and returns tend to benefit from upward movement in the stock market and be negatively affected by declines in the stock market. As at December 31, 2007, 16.1% and 25.4% of our alternative investments were allocated to the event driven arbitrage and long/short equity strategies, respectively.
Our portfolio of investment grade fixed maturities includes mortgage-backed and asset-backed securities and collateralized mortgage obligations. These types of securities have cash flows that are backed by the principal and interest payments of a group of underlying mortgages or other receivables. During 2007, delinquency and default rates have increased on these types of securities, and particularly on securities backed by sub-prime mortgages. Generally, sub-prime mortgages are considered to be those made to borrowers who do not qualify for market interest rates for one or more possible reasons, such as a low credit score, a limited or lack of credit history or a lack of earnings documentation. As a result of the increasing default rates of sub-prime borrowers, there is a greater risk of defaults on mortgage-backed and asset-backed securities and collateralized mortgage obligations, especially those that are non-investment grade. Therefore, fixed maturities securities backed by sub-prime mortgages have exhibited significant declines in fair value and liquidity. These factors combined with the contraction in liquidity in the principal markets for these securities makes the estimate of fair value increasingly uncertain. The fair values of our holdings in securities exposed to sub-prime borrowers are generally not based on quoted prices for identical securities, but are based on model-derived valuations from independent pricing sources in which all significant inputs and significant value drivers are observable in active markets. We obtain fair value estimates from multiple independent pricing sources in an effort to mitigate some of the uncertainty surrounding the fair value estimates. Should we need to liquidate these securities within a short period of time, the actual realized proceeds may be significantly different from the fair values estimated at December 31, 2007. We believe our exposure to sub-prime credit risk is limited although there can be no assurance that events in the sub-prime mortgage sector will not adversely affect the value of our investments. At December 31, 2007, securities with significant exposure to sub-prime borrowers totaled $54.2 million in fair value, $58.0 million in amortized cost, and $58.3 million in par value, for a net unrealized loss of $3.8 million. By fair value, 90% of these securities are AAA-rated with the remainder AA-rated. The weighted average life of these securities is 3.0 years. We have determined that a write-down for impairment of these securities is not necessary based on a consideration of relevant factors including prepayment rates, subordination levels, default rates, credit ratings, weighted average life, credit default insurance and cash flow testing. Together with our investment managers, we continue to monitor our potential exposure to sub-prime borrowers and we will make adjustments to the investment portfolio as necessary.
The following table summarizes the amortized cost and fair value of our fixed maturities securities with exposure to sub-prime or Alt-A mortgages as at December 31, 2007. Generally, Alt-A mortgages are considered to be those made to borrowers who do not qualify for market interest rates but who are considered to have less credit risk than sub-prime borrowers.
Interest expense. Interest expense was $23.9 million for the year ended December 31, 2007 compared to $12.4 million for the year ended December 31, 2006. Interest expense principally reflects interest on our bank loans and senior notes outstanding. Our swap loan, described below under “Financial Condition - Bank Loans,” attracts interest at a rate based on LIBOR plus a spread. The notional amount of this loan increased from $210.0 million to $280.0 million between December 31, 2006 and December 31, 2007. Our $50.0 million revolver loan, also described below, attracts interest at a rate based on LIBOR plus a spread, and was drawn on April 3, 2007. As at December 31, 2007, we had $100.0 million in senior notes outstanding that were issued by Max USA on April 16, 2007, which mature in April 2017, and bear interest at 7.20%. Interest expense for the year ended December 31, 2007 has increased primarily due to the increase in outstanding debt compared to the same period in 2006.
Interest expense was $12.4 million for the year ended December 31, 2006 compared to $8.0 million for the year ended December 31, 2005, an increase of 55.0%. Interest expense in both 2006 and 2005 was based on LIBOR plus a spread applied to the swap loan. The increase principally reflects the increase in LIBOR from 2005 to 2006.
General and administrative costs. General and administrative expenses were $38.7 million for the year ended December 31, 2007 compared to $44.1 million for the year ended December 31, 2006, and $26.8 million for the year ended December 31, 2005. The decrease in general and administrative expenses during the year ended December 31, 2007 compared to 2006 is principally from a decrease in professional service fees.
Cash and invested assets. Aggregate invested assets, comprising cash and cash equivalents, fixed maturities and alternative investments, were $5,122.6 at December 31, 2007 compared to $4,535.9 million at December 31, 2006, an increase of 12.9%. The increase in cash and invested assets resulted principally from $443.3 million in cash flows from operations and $100.6 million in cash flows from financing in the year ended December 31, 2007.
Liabilities for property and casualty losses. Property and casualty losses totaled $2,333.9 million at December 31, 2007 compared to $2,335.1 million at December 31, 2006. The decrease in property and casualty losses was principally attributable to the settlement of a block of prior period reserves in the amount of $203.6 million, resulting in a release of $23.3 million in reserves, favorable reserve development of $15.3 million from one contract written where reported losses have been lower than originally recorded based on updated information received from the client and $30.9 million of positive development resulting from our internal review of reserves. During the year ended December 31, 2007, we also paid $280.6 million in property and casualty losses in addition to the settlement previously described. Largely offsetting the payment of property and casualty losses and the favorable development were losses incurred of $394.1 million pertaining to earned premium for the year ended December 31, 2007.
The principal component of the remainder of losses recoverable relates to amounts due from reinsurers of our property and casualty insurance risks. The loss recoverable from these reinsurers represent 67.8% of losses recoverable at December 31, 2007 and all are presently rated “A-” or above by A.M. Best Company.
Bank loans. In February 2003, Max Bermuda completed a sale of 127,549 shares of its subsidiary, Max Diversified to a third party financial institution, or the Bank, for a fair value of $150.0 million, or the notional amount. Simultaneous with the sale, Max Bermuda entered into a total return swap with the Bank whereby Max Bermuda receives the return earned on the Max Diversified shares in exchange for the payment of a variable rate of interest based on LIBOR plus a spread. The terms of the share sale obligate the Bank to sell the shares to Max Bermuda and give Max Bermuda the right to repurchase the shares at fair value at termination of the total return swap. On February 28, 2007 Max Bermuda amended the swap transaction. The notional amount under the swap was increased to $235.0 million and the number of shares sold to the Bank was increased to 143,952. In addition, the amendment, among other things: (i) extended the termination date under the swap to February 28, 2010; (ii) increased the maximum notional amount under the swap to $300.0 million; (iii) decreased the monthly excess collateral requirement under the swap from 50% to 33% of the notional amount; and (iv) permits Max Bermuda to accelerate the swap termination date to a business day no earlier than February 28, 2009. Max Diversified shares with a fair value of $93.4 million at December 31, 2007 were pledged to the Bank as collateral and to which Max Bermuda is thus exposed to credit risk. The swap transaction contains provisions for earlier termination at Max Bermuda’s option or in the event that Max Bermuda fails to comply with certain covenants, including maintaining a minimum financial strength rating and a minimum Max Diversified net asset value.
Under GAAP, the non-controlling interest in Max Diversified and the total return swap are recorded on a combined basis and accounted for as a financing transaction. The effect of combining the transactions results in the notional amount being presented as a bank loan, with changes in the fair value of the Max Diversified shares increasing or decreasing this notional amount. At December 31, 2007, the notional amount of the loan was approximately $280.0 million.
On April 2, 2007, Max USA completed the acquisition of Max Specialty. On April 3, 2007, Max Capital borrowed $50.0 million and Max USA borrowed $100.0 million under their revolving credit facility, in connection with the acquisition and capitalization of Max Specialty. Max USA repaid the $100.0 million borrowed under their revolving credit facility with the proceeds of the issuance of $100.0 million of senior notes. As of December 31, 2007, the $50.0 million revolver loan to Max Capital remains outstanding. This loan renews at intervals of 1-6 months at Max Capital’s option, at which time the interest rate is reset to LIBOR plus a premium based on Max Capital’s current debt rating. As of December 31, 2007 the interest rate is at 5.63%.
Shareholders’ equity. Our shareholders’ equity increased to $1,583.9 million at December 31, 2007 from $1,390.1 million at December 31, 2006, an increase of 13.9%, principally reflecting net income of $303.2 million, partially offset by the repurchase of common shares of $114.4 million, and payments of dividends of $19.2 million during the year ended December 31, 2007.
Liquidity. We generated $443.3 million of cash from operations during the year ended December 31, 2007 compared to $518.6 million for the year ended December 31, 2006, a decrease of 14.5%. The two principal factors that impact our operating cash flow are premium collections and timing of loss and benefit payments. For the year ended December 31, 2007, two of the largest events impacting operating cash flows were the $252.6 million increase in life and annuity reinsurance premiums written compared to the year ended December 31, 2006, partially offset by the agreement to settle a block of prior period loss reserves for $203.6 million.
While we tailor our fixed maturities portfolio to match the duration of expected loss and benefit payments, increased loss amounts or settlement of losses and benefits earlier than anticipated can result in greater cash needs. We maintain a meaningful working cash balance (typically greater than $250.0 million), have generated positive cash flow from operations in each of our seven years of operating history and can access our credit facilities described in Note 17 of our audited consolidated financial statements. We believe that we currently maintain sufficient liquidity to cover existing requirements and provide for contingent liquidity. Nonetheless, it is possible that significant deviations in expected loss and benefit payments can occur, potentially requiring us to liquidate a portion of our fixed maturities portfolio. If it became necessary to liquidate these securities within a short period of time, the actual realized proceeds may be significantly different from the fair values estimated at December 31, 2007, resulting in realized losses.
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, 2007 providing an aggregate of $720.0 million of letter of credit capacity, and subject to certain conditions, up to an additional $200.0 million in 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, 2007.
Capital resources. At December 31, 2007, our capital structure consisted of common equity. Total capitalization amounted to $1,583.9 million as compared to $1,390.1 million at December 31, 2006, an increase of 13.9%. On August 20, 2007, we filed a shelf registration statement with the SEC indicating that we may periodically issue up to $500.0 million in debt securities, common, preferred and depository shares and warrants. Subject to market conditions, we believe we have flexibility with respect to capitalization as a result of our access to the debt and equity markets.
In April 2007, Max USA sold $100.0 million aggregate principal amount of 7.20% senior notes due April 14, 2017. The senior notes are guaranteed by Max Capital. The senior notes were assigned a senior unsecured debt rating of “Baa2” by Moody’s, “bbb-” by A.M. Best, “BBB+” by Fitch, and “BBB-” by S&P, all with a stable outlook. The ratings assigned by rating agencies to reinsurance and insurance companies are based upon factors and criteria established independently by each rating agency. They are not an evaluation directed to investors in our senior notes, and are not a recommendation to buy, sell or hold our senior notes. These ratings are subject to periodic review by the rating agencies or may be revised downward or revoked at the sole discretion of the rating agencies.
Max Capital’s board of directors declared dividends of $0.07 per share on each of February 9, 2007 and May 4, 2007, and $0.09 per share on each of July 27, 2007 and November 1, 2007, payable to shareholders of record on February 23, 2007, May 18, 2007, August 10, 2007 and November 15, 2007, respectively. Continuation of cash dividends in the future will be at the discretion of the board of directors and will be dependent upon our results of operations and cash flows, and our financial position and capital requirements, general business conditions, legal, tax, regulatory and any contractual restrictions on the payment of dividends and other factors the board of directors deems relevant. On February 12, 2008, Max Capital’s board of directors declared a dividend of $0.09 per share to be paid on March 11, 2008 to shareholders of record on February 26, 2008.
No off-balance sheet arrangements. We do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or variable interest entities that would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
In September 2006, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standard No. 157, “Fair Value Measurements”, or FAS 157. FAS 157 defines fair value, establishes a framework for measuring fair value, establishes a fair value hierarchy based on the quality of inputs used to measure fair value and enhances disclosure about fair value measurements. FAS 157 nullifies the guidance included in Emerging Issues Task Force Issue No. 02-3, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities,” or EITF 02-3, that prohibited recognition of day one gains or losses on derivative transactions where model inputs that significantly impact valuation are not observable. In addition, FAS 157 prohibits the use of block discounts for large positions of unrestricted financial instruments that trade in an active market and requires an issuer to incorporate changes in its own credit spreads when determining the fair value of its liabilities. FAS 157 is effective for fiscal years beginning after November 15, 2007. The provisions of FAS 157 are to be applied prospectively, except that the provisions related to block discounts and existing derivative financial instruments measured under EITF 02-3 are to be applied as a one-time cumulative effect adjustment to opening retained earnings in the year of adoption. The adoption of FAS 157 on January 1, 2008 is not expected to have a material impact on our consolidated financial statements.
In February 2007, the FASB issued Financial Accounting Standard No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities”, or FAS 159. FAS 159 permits an entity to choose, at specified election dates, to measure eligible financial instruments and certain other items at fair value that are not currently required to be measured at fair value. An entity shall report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date. Upfront costs and fees related to items for which the fair value option is elected shall be recognized in earnings as incurred and not deferred. FAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. FAS 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. At the effective date, an entity may elect the fair value option for eligible items that exist at that date. The entity shall report the effect of the first re-measurement to fair value as a cumulative-effect adjustment to the opening balance of retained earnings. We have elected not to apply the fair value option to any eligible assets or liabilities held as at December 31, 2007.
In December 2007, the FASB issued Financial Accounting Standard No. 160, “Noncontrolling Interests in Consolidated Financial Statements-an amendment of Accounting Research Bulletin No. 51”, or FAS 160. FAS 160 requires reporting entities to present noncontrolling (minority) interests as equity (as opposed to as a liability or mezzanine equity) and provides guidance on the accounting for transactions between an entity and noncontrolling interests. FAS 160 is effective for fiscal years beginning on or after December 15, 2008, except for the presentation and disclosure requirements which will be applied retrospectively for all periods presented. We are currently evaluating the effect of FAS 160 on our consolidated financial statements.
In December 2007, the FASB issued Financial Accounting Standard No. 141(R), “Business Combinations”, or FAS 141(R). FAS 141(R) requires the acquiring entity in a business combination to recognize the full fair value of assets acquired and liabilities assumed in the transaction (whether a full or partial acquisition); establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; requires expensing of most transaction and restructuring costs; and requires the acquirer to disclose to investors and other users all of the information needed to evaluate and understand the nature and financial effect of the business combination. FAS 141(R) applies to all transactions or other events in which the reporting entity obtains control of one or more businesses, including those sometimes referred to as “true
mergers” or “mergers of equals” and combinations achieved without the transfer of consideration, for example, by contract alone or through the lapse of minority veto rights. FAS 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. We are currently evaluating the effect of FAS 141(R) on our consolidated financial statements.