The following selected financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and notes thereto that are included in this Annual Report on Form 10-K. Financial information in the table reflects the results of operations and financial position of OdysseyRe.
The Emerging Issues Task Force (“EITF”) Issue 4-08 “The Effect of Contingently Convertible Instruments on Diluted Earnings Per Share,” which is effective for periods ending after December 15, 2004, requires that the dilutive effect of contingently convertible debt securities, with a market price threshold, should be included in diluted earnings per share. The terms of our convertible senior debentures, which were issued in June 2002, (see Note 11 to our consolidated financial statements) meet the criteria defined in EITF Issue 4-08, and accordingly, the effect of conversion of our convertible senior debentures to common shares has been assumed when calculating our diluted earnings per share for all years. See Notes 2(l) and 4 to our consolidated financial statements included in this Annual Report on Form 10-K.
Book value per common share, a financial measure often used by investors, is calculated using common shareholders’ equity, a non-GAAP financial measure, which represents total shareholders’ equity, a GAAP financial measure, reduced by the equity attributable to our preferred stock, which was issued during 2005. The common shareholders’ equity is divided by our common shares outstanding at each respective year end to derive book value per common share as reflected in the following table (in millions, except per share and share amounts).
Odyssey Re Holdings Corp. is a holding company, incorporated in the state of Delaware, which owns all of the common shares of Odyssey America Reinsurance Corporation, its principal operating subsidiary. Odyssey America directly or indirectly owns all of the capital stock of the following companies: Clearwater Insurance Company; Clearwater Select Insurance Company; Odyssey UK Holdings Corporation; Newline Underwriting Management Ltd., which owns and manages Newline Syndicate 1218, a member of Lloyd’s of London; Newline Insurance Company Limited (“NICL”); Hudson Insurance Company; Hudson Specialty Insurance Company; and Napa River Insurance Services, Inc.
Our gross premiums written for the year ended December 31, 2007 were $2,282.7 million, a decrease of $53.0 million, or 2.3%, compared to gross premiums written for the year ended December 31, 2006 of $2,335.7 million. Our business outside of the United States accounted for 48.2% of our gross premiums written for the year ended December 31, 2007, compared to 45.8% for the year ended December 31, 2006. For the years ended December 31, 2007 and 2006, our net premiums written were $2,089.4 million and $2,160.9 million, respectively. For the years ended December 31, 2007 and 2006, we had net income available to common shareholders of $587.2 million and $499.6 million, respectively. As of December 31, 2007, we had total assets of $9.5 billion and total shareholders’ equity of $2.7 billion.
We are exposed to losses arising from a variety of catastrophic events, such as hurricanes, windstorms and floods. The loss estimates for these events represent our best estimates based on the most recent information available. We use various approaches in estimating our losses, including a detailed review of exposed contracts and information from ceding companies. As additional information becomes available, including information from ceding companies, actual losses may exceed our estimated losses, potentially resulting in adverse effects to our financial results. The extraordinary nature of these losses, including potential legal and regulatory implications, creates substantial uncertainty and complexity in estimating these losses. Considerable time may elapse before the adequacy of our estimates can be determined. For the years ended December 31, 2007, 2006 and 2005, current year catastrophe events were $105.9 million, $34.9 million and $537.9 million, respectively.
For the year ended December 31, 2005, the total current year catastrophe losses of $537.9 million included net losses and LAE of $445.9 million, which is after reinsurance of $241.1 million, related to Hurricanes Katrina, Rita and Wilma, which occurred during the third and fourth quarters of 2005. In addition to the net losses and LAE, we assumed $9.9 million in net reinstatement premiums received, resulting in an underwriting loss of $436.0 million related to these three hurricanes. In addition, for the year ended December 31, 2005, we incurred losses of $25.6 million related to Windstorm Erwin. As a result of the uncertainty and complexity in estimating losses for Hurricanes Katrina, Rita and Wilma, we incurred additional underwriting losses of $9.4 million and $46.4 million, net of applicable reinstatement premiums for the years ended December 31, 2007 and 2006, respectively.
The EuroAsia division consists of our international reinsurance business, which is geographically dispersed, mainly throughout the European Union, and includes business in the Pacific Rim, Eastern Europe, the Middle East and Japan.
The U.S. Insurance division writes specialty insurance lines and classes of business, such as medical malpractice, professional liability, non-standard personal and commercial automobile, specialty liability and property and package.
The following table displays, by division, the estimates included in our consolidated financial statements as of and for the years ended December 31, 2007, 2006 and 2005 related to gross premiums written, acquisition costs, premiums receivable and unearned premium reserves (in millions):
Our losses and LAE reserves, for both reported and unreported claims obligations, are maintained to cover the estimated ultimate liability for all of our insurance and reinsurance obligations. Losses and LAE reserves are categorized in one of three ways: (i) case reserves, which represent unpaid losses and LAE as reported by cedants to us, (ii) additional case reserves (“ACRs”), which are reserves we establish in excess of the case reserves reported by the cedant on individual claim events, and (iii) incurred but not reported reserves (“IBNR”), which are reserves for losses and LAE that have been incurred, but have not yet been reported to us, as well as additional amounts relating to losses already reported, that are in excess of case and ACR reserves. Incurred but not reported reserves are estimates based on all information currently available to us and are reevaluated quarterly utilizing the most recent information supplied from our cedants.
We rely on initial and subsequent claims reports received from ceding companies for reinsurance business, and the estimates advised by our claims adjusters for insurance business, to establish our estimates of losses and LAE. The types of information that we receive from ceding companies generally vary by the type of contract. Proportional, or quota share, contracts are typically reported on a quarterly basis, providing premium and loss activity as estimated by the ceding company. Reporting for excess of loss and facultative contracts includes detailed individual claim information, including a description of the loss, confirmation of liability by the cedant and the
We complete comprehensive reserve reviews, which include a reassessment of loss development and expected loss ratio assumptions, on an annual basis. The results of these reviews are reflected in the period they are completed. Quarterly, we compare actual loss emergence to expectations established by the comprehensive loss reserve review process. In the event that loss trends diverge from expected trends, we may have to adjust our reserves for losses and LAE accordingly. Any adjustments will be reflected in the periods in which they become known, potentially resulting in adverse or favorable effects to our financial results. We believe that the recorded estimates represent the best estimate of unpaid losses and LAE based on the information available at December 31, 2007.
Our most significant assumptions underlying our estimate of losses and LAE reserves are as follows: (i) that historical loss emergence trends are indicative of future loss development trends; (ii) that internally developed pricing trends provide a reasonable basis for determining loss ratio expectations for recent underwriting years; and (iii) that no provision is made for extraordinary future emergence of new classes of loss or types of loss that are not sufficiently represented in our historical database or that are not yet quantifiable if not in our database.
If a change were to occur in the frequency and severity of claims underlying our December 31, 2007 unpaid losses and LAE, the approximate change in pre-tax income would be as follows (in millions):
Historically, our actual results have varied considerably in certain instances from our estimates of losses and LAE because historical loss emergence trends have not been indicative of future emergence for certain segments of our business. In recent years, we experienced loss emergence, resulting from a combination of higher claim frequency and severity of losses, greater than expectations that were established based on a review of prior years’ loss emergence trends, particularly for business written in the late 1990s and early 2000s. General liability and
The Americas division reported net adverse loss development for prior years of $143.1 million, $212.7 million, and $213.2 million for the years ended December 31, 2007, 2006, and 2005, respectively. For the year ended December 31, 2007, the increase in prior year loss estimates included an increase of $11.7 million related to prior period catastrophe activity, principally due to increased loss estimates on Hurricanes Katrina and Wilma. In addition, asbestos and environmental loss estimates were increased by $77.4 million, principally attributable to the annual review of these exposures. The remaining net adverse loss development on prior years of $54.0 million included $21.2 million related to settlement of litigation during the third quarter, with the remainder principally attributable to increased loss estimates due to loss emergence greater than expectations during the year on U.S. casualty business. For the year ended December 31, 2006, the increase in prior year loss estimates included an increase of $43.0 million related to prior period catastrophe activity, principally due to an increase in loss estimates on marine business for Hurricane Rita and the triggering of industry loss warranty contracts written by us for Hurricane Wilma due to unexpected deterioration in industry-wide Wilma loss estimates as well as unexpected loss emergence on Florida proportional property accounts in the period. In addition, asbestos loss estimates were increased by $27.1 million, principally attributable to the annual review of this exposure. The remaining net adverse loss development on prior years of $142.6 million was principally attributable to increased loss estimates due to loss emergence greater than expectations during the period on U.S. casualty business. For the year ended December 31, 2005, the increase in prior year loss estimates included an increase of $5.9 million related to prior period catastrophe activity, principally due to greater than expected loss emergence on the 2004 Florida Hurricanes, and $41.2 million for increased asbestos loss estimates, principally attributable to the annual review of this exposure. The remaining net adverse loss development on prior years of $166.1 million was principally attributable to loss emergence greater than expectations during the period on U.S. casualty business. Competitive market conditions and an increase in corporate improprieties and bankruptcies during the late 1990s and early 2000s have adversely impacted our ability to estimate losses and LAE in recent calendar years attributable to U.S. casualty business written in the period. In particular, U.S. casualty business written in the late 1990s and early 2000s has generated unexpectedly prolonged emergence patterns as a result of an increasing level of deductibles, expanded coverage and expanded policy terms.
The London Market division reported net favorable loss development for prior years of $57.0 million, $24.8 million, and $22.8 million for the years ended December 31, 2007, 2006, and 2005, respectively. For the year ended December 31, 2007, the reduction in prior year loss estimates was principally attributable to favorable loss emergence on liability, property catastrophe, and other miscellaneous property lines of business in the period. For the year ended December 31, 2006, the reduction in prior year loss estimates was principally related to favorable loss emergence on satellite, accident and health, non-catastrophe property, and aviation exposures, partially offset by $3.6 million of net adverse loss development on prior period catastrophe losses in the period. For the year ended December 31, 2005, the reduction in prior year loss estimates was principally due to favorable loss emergence on aviation, satellite and non-catastrophe property exposures, partially offset by $1.7 million of net adverse loss development on prior period catastrophe losses in the period.
The U.S. Insurance division reported net favorable loss development for prior years of $38.7 million, $39.0 million, and $9.0 million for the years ended December 31, 2007, 2006, and 2005, respectively. For the years ended December 31, 2007 and 2006, the reduction in prior year loss estimates was principally due to favorable loss emergence on medical malpractice business in each period. For the year ended December 31, 2005, the reduction in prior year loss estimates was principally related to loss emergence less than expectations for medical malpractice and general liability business in the period.
We have exposure to asbestos, environmental pollution and other latent injury damage claims resulting from contracts written by Clearwater prior to 1986. Exposure arises from reinsurance contracts under which we assumed liabilities, on an indemnity or assumption basis, from ceding companies, primarily in connection with general liability insurance policies issued by such ceding companies. Our estimate of our ultimate liability for such exposures includes case basis reserves and a provision for IBNR claims. The provision for asbestos loss liabilities is established based on an annual review of Company and external trends in reported loss and claim payments, with monitoring of emerging experience on a quarterly basis.
The number of asbestos claims, with case reserves, as of December 31, 2007 was 1,554, amounting to $216.8 million in gross case losses and LAE reserves. The largest 10 reported claims accounted for 14.9% of the gross case reserves, with an average reserve of $3.2 million. The number of asbestos claims, with case reserves, as of December 31, 2006 was 1,553, amounting to $228.5 million in gross case losses and LAE reserves. The largest 10 reported claims accounted for 15.2% of the gross case reserves, with an average reserve of $3.5 million. Gross case reserves decreased in 2007, as newly reported claims and additional reported reserves on existing claims were less than claim payments in the year. Based on an aggregation of claims by insured, our 10 largest insured involvements accounted for 42.3% of our gross case reserves as of December 31, 2007, compared to 42.7% as of December 31, 2006. Net losses and LAE for the year ended December 31, 2007 for asbestos claims were increased by $63.0 million, principally attributable to the annual review of this exposure.
In the event that loss trends diverge from expected trends, we may have to adjust our reserves for asbestos and environmental exposures accordingly. Any adjustments will be reflected in the periods in which they become known, potentially resulting in adverse effects on our financial results. Due to the uncertainty involving estimates of ultimate asbestos and environmental exposures, management does not attempt to produce a range around its best estimate of loss.
We purchase reinsurance to increase our aggregate premium capacity, to reduce and spread the risk of loss on our insurance and reinsurance business and to limit our exposure to multiple claims arising from a single occurrence. We are subject to accumulation risk with respect to catastrophic events involving multiple contracts. To protect against this risk, we purchase catastrophe excess of loss reinsurance protection. The retention, the level of capacity purchased, the geographical scope of the coverage and the costs vary from year to year. Specific reinsurance protections are also placed to protect selected portions of our business outside of the United States. Our catastrophe excess of loss reinsurance protection available for losses in the United States for 2005 was exhausted by Hurricanes Katrina, Rita and Wilma during the year ended December 31, 2005.
We seek to limit the probable maximum loss to a specific level for severe catastrophic events. Currently, we generally seek to limit the probable maximum loss, after tax, including the effect of reinsurance protection and applicable reinstatement premiums, to a maximum of approximately 15% of statutory surplus for a severe catastrophic event in any geographic zone that could be expected to occur once in every 250 years, although
this can change based on market opportunities. There can be no assurances that we will not incur losses greater than 15% of our statutory surplus from one or more catastrophic events due to the inherent uncertainties in estimating the frequency and severity of such events, the margin of error in making such determinations resulting from potential inaccuracies and inadequacies in the data provided by clients and brokers, and the modeling techniques and the application of such techniques.
Our reinsurance protection, which covered certain amounts of our 1995 and prior unpaid losses and loss adjustment expenses (the “1995 Stop Loss Agreement”), provided by nSpire Re Limited (“nSpire Re”), a wholly-owned subsidiary of Fairfax, was commuted effective September 29, 2006, for consideration of $63.2 million. In accordance with the terms of the commutation agreement, we commuted ceded loss reserves of $71.8 million, resulting in a pre-tax commutation loss of $5.5 million for the year ended December 31, 2006. The 1995 Stop Loss Agreement was originally entered into with Skandia Insurance Company Ltd. (“Skandia”) in conjunction with the purchase of Clearwater in 1996. Pursuant to the agreement, we paid a premium of $60.5 million in 1995 for protection of $175.0 million in excess of Clearwater’s December 31, 1995 reserves for net unpaid losses and loss adjustment expenses and reserves for uncollectible reinsurance. In January 1999, the liabilities under the contract were assigned by Skandia to nSpire Re for $97.0 million in consideration. Following the assignment to nSpire Re, we accounted for the 1995 Stop Loss Agreement as retroactive reinsurance. Accordingly, losses ceded under the contract in excess of $97.0 million in the aggregate had been recorded as a deferred gain rather than as a benefit in the applicable periods. The deferred gain had been amortized into income over the estimated remaining settlement period of the underlying claims. As of December 31, 2005, we have utilized the full limit of $175.0 million under the 1995 Stop Loss Agreement. We ceded losses of $17.5 million to the 1995 Stop Loss Agreement for the year
For years ending December 31, 2001 and prior, we utilized whole account aggregate excess of loss retrocessional coverage (“Whole Account Excess of Loss Agreements”) to manage our exposures, including catastrophic occurrences and the potential accumulation of exposures. As further discussed below, during the second quarter of 2006, we commuted certain Whole Account Excess of Loss Agreements. In addition, Whole Account Excess of Loss Agreements were purchased covering underwriting years 2002 through 2004 though no losses were ceded to these coverages. The Whole Account Excess of Loss Agreements are broad in coverage, and include property and casualty insurance and reinsurance business written on a worldwide basis, as applicable. Classes of business excluded from coverage primarily include non-traditional business. In each calendar year, we have the ability to cede losses attributable to certain prior periods to the Whole Account Excess of Loss Agreements to the extent there are limits remaining for the period. These agreements cover business written or incepting during a defined period of time (underwriting year), which is typically twelve months, or in other cases, business earned during a defined period of time (accident year). The Whole Account Excess of Loss Agreements were purchased on an underwriting year basis for 1996 through 2004 and on an accident year basis for 1994 and 1995. Accident year agreements were also purchased to supplement the 1996 and 1997 underwriting year agreements. All of these Whole Account Excess of Loss Agreements covering prior underwriting and accident years have been commuted except for two agreements covering underwriting years 2000 and 2001. Loss cession limits on these two covers still outstanding have been fully utilized. Each agreement provides for recoveries from the retrocessionaires, subject to a limit, in the event that the net subject business results in a composite ratio (the sum of the commission and loss ratios), in excess of a specified attachment point. The attachment point is net of other inuring third party reinsurance. The premium paid, net of commission, by us is calculated based on a contractual fixed rate that is applied to the total premiums covered by the retrocession agreements. Each agreement includes a provision for additional premium, subject to a maximum, based on the amount of loss activity under the agreement. Reinsurance recoverables on paid and unpaid losses are fully secured by letters of credit or funds held by us.
attributable to business written during a particular period in excess of the attachment point, subject to a maximum limit, are ceded to the reinsurer. The following table provides a summary of the significant terms of the Whole Account Excess of Loss Agreements that were in effect as of December 31, 2007 (in millions):
In addition to the Whole Account Excess of Loss Agreements, we entered into a three-year aggregate excess of loss reinsurance contract protecting our United States facultative casualty business for underwriting years 1998 through 2000 (“Facultative Excess of Loss Agreement”) which indemnified us for losses in excess of an annual retention, subject to an annual limit of liability. During December 2006, we entered into a commutation and release agreement related to this contract, pursuant to which all rights, obligations and liabilities were fully and finally settled. As a result of the commutation, a pre-tax loss of $1.4 million was recognized. Additionally, reinsurance recoverables were reduced by $16.1 million for the year ended December 31, 2006. The aggregate limit for underwriting years 1998, 1999 and 2000 was equal to 40% of our total facultative net premiums written, subject to a minimum annual dollar limit of $7.4 million, and a maximum annual dollar limit of $18.5 million. The aggregate limit of liability is $41.6 million across all years, which has been fully utilized. The retention in each year was equal to the greater of $9.3 million or 51.0% of the subject written premium income, together with amounts contributed to a loss payment account under the agreement. We maintained a loss payment account for the benefit of the reinsurer, equal to 18.5% of the subject written premium income for underwriting year 1998, and 18.9% for 1999 and 2000. A minimum interest credit is applied to the loss payment account, equal to the one year U.S. Treasury Bill yield plus 75 basis points. As of December 31, 2006, the loss payment account had a zero balance. The principal reinsurer under these agreements is Hannover Reinsurance - Ireland Ltd.
The income (loss) before income taxes reflected in our consolidated statements of operations related to our Whole Account and Facultative Excess of Loss Agreements for the years ended December 31, 2007, 2006, and 2005 is as follows (in millions):
As indicated by the table above, for the years ended December 31, 2007, 2006 and 2005, we ceded $(0.1) million, $8.3 million and $18.7 million, respectively, of losses and LAE, primarily to the 2001 aggregate excess of loss treaty. The increases in losses ceded to our Whole Account and Facultative Excess of Loss Agreements, for the years ended December 31, 2006 and 2005, were primarily attributable to adverse loss development on casualty business written in 2001. Losses ceded to our Whole Account and Facultative Excess of Loss Agreements were minimal in 2007 and represented 1.1% of our pre-tax income in 2006 and 10.3% of our pre-tax loss in 2005.
We record deferred income taxes as net assets or liabilities on our consolidated balance sheets to reflect the net tax effect of the temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and their respective tax bases. As of December 31, 2007 and 2006, a net deferred tax asset of $32.3 million and $185.0 million, respectively, was recorded. In recording this deferred tax asset, we have made estimates and judgments that future taxable income will be sufficient to realize the value of the net deferred tax asset. Accordingly, deferred tax assets have not been reduced by a valuation allowance, as management believes it is more likely than not that the deferred tax assets will be realized.
London Branch - Gross premiums written of $145.3 million for the year ended December 31, 2007 increased $7.1 million, or 5.1%, compared to $138.2 million for the year ended December 31, 2006. Property business increased $19.9 million, or 41.9%, due to increased writings on both a new and renewal basis. Casualty business decreased by $5.6 million, or 19.7%, and marine and aerospace business decreased $7.2 million, or 11.6% in 2007 compared to 2006, due to share reduction and non-renewal of business not meeting our underwriting criteria.
Our personal auto business, which primarily includes non-standard auto business written in California and Florida, decreased $26.1 million, or 33.6%, to $51.6 million for the year ended December 31, 2007, from $77.7 million for the year ended December 31, 2006. This decrease is primarily due to market conditions, which has resulted in the non-renewal of several programs.
Ceded Premiums Written. Ceded premiums written for the year ended December 31, 2007 increased by $18.5 million, or 10.6%, to $193.3 million (8.5% of gross premiums written) from $174.8 million (7.5% of gross premiums written) for the year ended December 31, 2006. Ceded premiums written in the EuroAsia division increased by $4.8 million, reflecting an increase in property catastrophe premiums and motor business specific retrocessions; the London Market division increased by $16.2 million, reflecting the purchase of additional primary layer reinsurance; the U.S. Insurance division increased by $6.8 million, reflecting an increase in specific retrocessions on its program business. These increases were offset by a decrease of $9.3 million in the Americas division.
Americas Division - Losses and LAE decreased $104.3 million, or 13.6%, to $661.5 million for the year ended December 31, 2007, from $765.8 million for the year ended December 31, 2006. This resulted in a loss and LAE ratio of 78.6% for the year ended December 31, 2007, compared to 78.5% for the year ended December 31, 2006. The decrease in losses and LAE was principally due to a decrease in prior period losses of $69.6 million and a decline in net earned premium of $133.2 million, or 13.7%. Losses and LAE for the year ended December 31, 2007 included prior period losses of $143.1 million, which included $11.7 million for increased loss estimates on prior period catastrophe events, principally attributable to Hurricanes Katrina and Wilma, $77.4 million for increased asbestos and environmental loss estimates, principally attributable to the annual review of these exposures, and $21.2 million related to settlement of litigation in the third quarter, with the remainder principally due to loss emergence greater than expectations in the period on U.S. casualty business. Losses and LAE for the year ended December 31, 2006 included prior period losses of $212.7 million, which included $43.0 million for increased loss estimates on prior period catastrophe events, principally attributable to Hurricanes Rita and Wilma. In addition, asbestos loss estimates were increased by $27.1 million, principally attributable to the annual review of this exposure. The remaining prior period losses of $142.6 million were principally attributable to loss emergence greater than expectations in the period on U.S. casualty business.
ended December 31, 2007, compared to 94.4% for the year ended December 31, 2006. The following table reflects the combined ratio for the years ended December 31, 2007 and 2006 for each of our divisions:
Our investment in HWIC Asia Fund (“HWIC Asia”), an investment vehicle, was fully redeemed during 2006; accordingly, we did not recognize any investment income related to HWIC Asia for the year ended December 31, 2007. For the year ended December 31, 2006, HWIC Asia, which was accounted for in accordance with the equity method of accounting, contributed $168.7 million of investment income. Net investment income, in accordance with the equity method of accounting, includes realized investment gains attributable to our equity investment in HWIC Asia. Our equity in the net income of HWIC Asia included in investment income for the year ended December 31, 2006, is comprised of the following items (in millions):
Our total effective annualized yield on average invested assets, net of expense but before the impact of interest expense from funds held balances and the positive impact of realized gains included in investment income attributable to HWIC Asia, was 4.5% and 5.0% for the year ended December 31, 2007 and 2006, respectively.
Net Realized Investment Gains. Net realized investment gains of $539.1 million for the year ended December 31, 2007 increased by $350.0 million from $189.1 million for the year ended December 31, 2006. The increase in net realized investment gains, including the effect of other-than-temporary impairment losses discussed below, for the year ended December 31, 2007 compared to 2006 is principally due to the following:
Federal and Foreign Income Tax Provision. As a result of our higher pre-tax income for the year ended December 31, 2007, compared to 2006, our federal and foreign income tax provision for the year ended December 31, 2007 increased by $86.4 million, to a provision of $317.7 million, compared to a provision of $231.3 million for the year ended December 31, 2006. Included in the income tax provision for the year ended December 31, 2006 is a one-time tax benefit of $16.5 million, which is attributable to the settlement of tax issues related to the acquisition of Clearwater in 1996. Our effective tax rates were 34.8% and 31.3% for the years ended December 31, 2007 and 2006, respectively.
Gross premiums written include reinstatement premiums of $5.4 million and $70.4 million for the years ended December 31, 2006 and 2005, respectively. Reinstatement premiums in 2005 were primarily related to reinstating the coverage under property catastrophe excess of loss reinsurance contracts following Hurricanes Katrina, Rita and Wilma. The higher level of reinstatement premiums in 2005 was attributable to the significant number of full limit losses resulting from Hurricanes Katrina, Rita and Wilma in 2005. Excluding reinstatement premiums in each period, gross premiums written would be $2,330.3 million and $2,556.5 million for the years ended December 31, 2006 and 2005, respectively, representing a decrease of $226.2 million, or 8.8%.
United States - Gross premiums written of $756.4 million for the year ended December 31, 2006 decreased $173.5 million, or 18.7%, compared to $929.9 million for the year ended December 31, 2005. The decrease
in the United States is in all classes of business. Property business decreased by $59.8 million, or 23.7%, to $192.3 million in 2006 from $252.1 million in 2005 as we reduced our proportional catastrophe exposed business in certain peak zones combined with a reduction in reinstatement premiums. Alternative risk and specialty business decreased by $58.7 million as we exited or reduced our writings in these classes of business. Treaty and facultative casualty business decreased by $43.5 million, or 7.9%, to $504.0 million in 2006 from $547.5 million in 2005 due to an increase in competitive market conditions and the cancellation of certain business that did not meet our underwriting criteria. All other classes of business accounted for the remaining decrease of $11.5 million.
Latin America - Gross premiums written of $134.9 million for the year ended December 31, 2006 decreased $13.7 million, or 9.2%, compared to $148.6 million for the year ended December 31, 2005. The decrease is principally due to a $6.3 million decrease in property proportional business and a $2.8 million decrease in property excess business. We continue to see increased competition across our Latin America operations.
London Branch - Gross premiums written of $138.2 million for the year ended December 31, 2006 decreased $51.1 million, or 27.0%, compared to $189.3 million for the year ended December 31, 2005. Excluding reinstatement premiums of $0.9 million in 2006 and $33.2 million in 2005, gross premiums written for the year ended December 31, 2006 were $137.3 million, a decrease of $18.8 million, or 12.0%, compared to $156.1 million for the year ended December 31, 2005. Excluding the effects of the reinstatement premium in both periods, property business decreased $12.8 million, or 21.1%, due to the non-renewal of certain proportional business. Casualty business decreased by $12.1 million, or 29.9%, in 2006 compared to 2005, primarily due to the non renewal of a large proportional directors and officers contract and a large motor quota share contract. These decreases were offset by an increase in marine and aerospace business of $6.1 million, or 11.0%, due to new business written in 2006.
Medical malpractice gross premiums written were $152.8 million for the year ended December 31, 2006, an increase of $2.2 million, or 1.5%, from $150.6 million for the year ended December 31, 2005. Medical malpractice, our largest line of business in the U.S. Insurance division, represented 30.0% of gross premiums written in U.S. Insurance for the year ended December 31, 2006.
Included in net premiums earned are premiums ceded to our Whole Account and Facultative Excess of Loss Agreements. For the year ended December 31, 2006, this represented $1.7 million, a reduction of $12.2 million, or 87.8%, compared to $13.9 million for the year ended December 31, 2005.
Americas Division - Losses and LAE decreased $420.4 million, or 35.4%, to $765.8 million for the year ended December 31, 2006, from $1,186.2 million for the year ended December 31, 2005. This resulted in a loss and LAE ratio of 78.5% for the year ended December 31, 2006, compared to 112.8% for the year ended December 31, 2005. The decrease in losses and LAE was principally due to a decrease in current year catastrophes of $335.6 million and a decline in net earned premium of $76.1 million, or 7.2%. Losses and LAE for the year ended December 31, 2006 included an increase in prior period losses of $212.7 million, which reflected $43.0 million from prior period catastrophe losses, principally Hurricanes Rita and Wilma. In addition, asbestos loss estimates were increased by $27.1 million, principally attributable to the annual review of this exposure. The remaining net increase in prior period losses of $142.6 million was principally attributable to loss emergence greater than expectations in the period on U.S. casualty business. Losses and LAE for the year ended December 31, 2005 included an increase in prior period losses of $213.2 million, which reflected $5.9 million on prior period catastrophes, principally due to loss emergence greater than expected in the period on the 2004 Florida Hurricanes, and $41.2 million for increased asbestos loss estimates, principally attributable to the annual review of this exposure. The remaining increase in prior period losses of $166.1 million is principally attributable to loss emergence greater than expectations in the period on U.S. casualty business.
EuroAsia Division - Losses and LAE decreased $5.6 million, or 1.7%, to $320.4 million for the year ended December 31, 2006, from $326.0 million for the year ended December 31, 2005. This resulted in a loss and LAE ratio of 60.3% for the year ended December 31, 2006, compared to 63.2% for the year ended December 31, 2005. This decrease was principally due to a reduction in current year catastrophe losses of $29.9 million, partially offset by an increase in net premiums earned of $15.2 million, or 2.9%. Losses and LAE for the year ended December 31, 2006 included a benefit of $9.0 million attributable to prior years, principally due to favorable emergence on property catastrophe, marine and credit lines of business in the period. Losses and LAE for the year ended December 31, 2005 included a decrease in prior period losses of $8.7 million, principally related to favorable emergence on liability and bond exposures in the period, partially offset by an increase in prior period catastrophes of $7.4 million predominantly attributable to Typhoon Songda and the Indonesian earthquake and resulting tsunami.
U.S. Insurance Division - Losses and LAE increased $14.9 million, or 7.4%, to $215.5 million for the year ended December 31, 2006, from $200.6 million for the year ended December 31, 2005. This resulted in a loss and LAE ratio of 55.8% for the year ended December 31, 2006, compared to 62.0% for the year ended December 31, 2005. The increase in losses and LAE was related to a 19.3% increase in net premiums earned and was partially offset by a decrease of $39.0 million on losses and LAE attributable to prior years, principally due to favorable loss emergence on medical malpractice business in the period. For the year ended December 31, 2005, losses and LAE related to prior years decreased by $9.0 million, principally due to loss emergence less than expectations in the period on medical malpractice and general liability business.
Acquisition Costs. Acquisition costs for the year ended December 31, 2006 were $464.1 million, a decrease of $6.1 million or 1.3%, compared to $470.2 million for the year ended December 31, 2005. The resulting acquisition expense ratio, expressed as a percentage of net premiums earned, was 20.9% for the year ended December 31, 2006, compared to 20.6% for the year ended December 31, 2005, an increase of 0.3 points. The London Market and U.S. Insurance divisions’ acquisition ratio increased by 2.1 points and 1.5 points, respectively,
due to the change in composition of the mix of business written and increased retentions, while the Americas and EuroAsia divisions had a slight decrease of 0.6 points and 0.1 points, respectively.
The following table reflects the acquisition and other underwriting expenses, expressed as a percentage of net premiums earned, for the years ended December 31, 2006 and 2005 for each of our divisions:
Net Investment Income. Net investment income for the year ended December 31, 2006 increased by $267.0 million, or 121.3%, to $487.1 million, from $220.1 million for the year ended December 31, 2005. Net investment income is comprised of gross investment income of $517.4 million less investment expenses of $30.3 million for the year ended December 31, 2006, compared to gross investment income of $247.8 million less
investment expenses of $27.7 million for the year ended December 31, 2005. Higher net investment income for the year ended December 31, 2006 is primarily attributable to the following:
an increase of $28.7 million for the year ended December 31, 2006 over 2005 in net investment income on other invested assets, which primarily reflects interest income attributable to our total return swaps on equity indexes and includes income from hedge funds and private equity investments of $29.3 million and $15.6 million for the years ended December 31, 2006 and December 31, 2005, respectively.
Our total effective annualized yield on average invested assets, net of expense but before the impact of interest expense from funds held balances and the positive impact of realized gains attributable to HWIC Asia, was 5.0% and 3.8% for the years ended December 31, 2006 and 2005, respectively. Also excluding the negative impact of the 2005 losses attributable to Advent, our total effective annualized yield, net of expenses but before the impact of interest expense from funds held balances, was 5.0% and 4.1% for the years ended December 31, 2006 and 2005, respectively.
Interest expense on funds held, which is included in investment expenses, and primarily relates to our Whole Account and Facultative Excess of Loss Agreements, was $8.7 million for the year ended December 31, 2006, representing a decrease of $10.0 million, or 53.5%, from $18.7 million for the year ended December 31, 2005. The lower amount of interest expense was due to reduced amounts ceded to the treaties in 2006 and 2005 and the commutation of several of these agreements during 2006, which resulted in lower interest expense associated with ceded amounts during the period.
Other Expenses, Net. Other expenses, net, for the year ended December 31, 2006, were $21.1 million, compared to $27.0 million for the year ended December 31, 2005. Other expenses are primarily comprised of operating expenses of our holding company and includes audit related fees, Sarbanes-Oxley compliance consulting fees, corporate-related legal fees, consulting fees, and compensation expense, including the amortization of restricted share grants. The decrease of $5.9 million for the year ended December 31, 2006 over 2005 is primarily comprised of: (i) a decrease of $5.7 million related to consulting fees in implementing procedures and documentation for Sarbanes-Oxley, (ii) a decrease of $1.0 million related to the renewal of the employment contract of our Chief Executive Officer, which is reflected in 2005, offset by, (iii) an increase of $1.4 million as a result of higher amortization expense of restricted stock.
Federal and Foreign Income Tax Benefit/Provision. As a result of our pre-tax income for the year ended December 31, 2006, compared to a pre-tax loss for 2005, our federal and foreign income tax provision for the year ended December 31, 2006 increased by $297.4 million, to a provision of $231.3 million, compared to a benefit of $66.1 million for the year ended December 31, 2005. Included in the income tax provision for the year ended December 31, 2006 is a one-time tax benefit of $16.5 million, which is attributable to the settlement of tax issues related to the acquisition of Clearwater in 1996. Our effective tax rates were 31.3% and 36.4% for the years ended December 31, 2006 and 2005, respectively.
representing an increase of $8.86 from the book value per common share of $27.92 as of December 31, 2006 and an increase of $3.87 from the book value per common share of $32.91 as of September 30, 2007.
Holding company cash and cash equivalents equaled $44.3 million as of December 31, 2007, as compared to $58.8 million as of December 31, 2006, with the lower amount primarily due to increased tax payments and the implementation of our share repurchase program. As a holding company, our assets are principally comprised of the shares of Odyssey America, and our principal sources of funds are cash dividends and other permitted payments from our operating subsidiaries, primarily Odyssey America. If our subsidiaries are unable to make payments to us, or are able to pay only limited amounts, we may be unable to pay dividends on our common or preferred shares or make payments on our indebtedness. The payment of dividends by our operating subsidiaries is subject to restrictions set forth in the insurance laws and regulations of Connecticut, Delaware, New York and the United Kingdom. During 2008, Odyssey America can pay dividends to the holding company of $292.3 million without prior regulatory approval. Odyssey America paid dividends of $155.0 million to the holding company during 2007.
Cash provided by operations was $188.7 million for the year ended December 31, 2007, compared to $752.3 million for the year ended December 31, 2006. The decrease in cash flow from operations is primarily attributable to lower premium volume, a decline in reinsurance recoveries and an increase in taxes paid.
Total investments and cash exclude amounts receivable for securities sold and amounts payable for securities purchased, representing the timing between the trade date and settlement date of securities sold and purchased. As of December 31, 2007 and 2006, we had a receivable for securities sold of $23.6 million and $21.3 million, respectively, which is included in other assets, and a payable for securities purchased of $27.1 million and $13.0 million, respectively, which is included in other liabilities.
During the second quarter of 2005, we issued $125.0 million aggregate principal amount of senior notes due May 1, 2015. The issue was sold at a discount of $0.8 million, which is being amortized over the life of the notes. Interest accrues on the senior notes at a fixed rate of 6.875% per annum which is due semi-annually on May 1 and November 1.
During the fourth quarter of 2003, we issued $225.0 million aggregate principal amount of senior notes due November 1, 2013. The issue was sold at a discount of $0.4 million, which is being amortized over the life of the notes. Interest accrues on the senior notes at a fixed rate of 7.65% per annum, which is due semi-annually on May 1 and November 1.
In June 2002, we issued $110.0 million aggregate principal amount of convertible senior debentures due 2022 (the “Convertible Notes”). In accordance with the indenture under which the Convertible Notes were issued, the Convertible Notes became convertible, at the option of the holders, on August 14, 2006. As of March 31, 2007, 1.9 million shares of our common stock were issued to the Convertible Notes holders who elected to convert their Convertible Notes, resulting in a decrease to Convertible Notes and a corresponding increase to shareholders’ equity of $40.1 million. In March 2007, we announced that we had called for the redemption of the remaining $22.5 million principal value of our outstanding Convertible Notes. At the close of business on April 30, 2007, all holders of the Convertible Notes had exercised their rights of conversion with respect to the Convertible Notes. Accordingly, on May 1, 2007, we issued 1,056,107 shares of our common stock related to the final conversion of $22.5 million principal value of the Convertible Notes, and no Convertible Notes remained outstanding as of such date.
On July 13, 2007, we entered into a $200.0 million credit facility (the “Credit Agreement”) with Wachovia Bank National Association (“Wachovia”), KeyBank National Association and a syndicate of lenders. The Credit Agreement provides for a five-year credit facility of $200.0 million, $100.0 million of which is available for direct, unsecured borrowings by us, and all of which is available for the issuance of secured letters of credit. The Credit Agreement contains an option that permits us to request an increase in the aggregate amount of the facility by an amount up to $100.0 million, to a maximum facility size of $300.0 million. Following such a request, each lender has the right, but not the obligation, to commit to all or a portion of the proposed increase. The Credit Agreement is for working capital and other corporate purposes, including the issuance of letters of credit to support our insurance and reinsurance business. The Credit Agreement replaced our three-year, $150.0 million credit facility entered into as of September 23, 2005, which has been terminated, and the obligations thereunder have been satisfied.
On November 27, 2007, our Board of Directors declared a quarterly cash dividend of $0.0625 per common share to be paid on December 28, 2007 to all common shareholders of record as of December 14, 2007. During each of the four quarters of 2007, our Board of Directors declared quarterly cash dividends of $0.0625 per common share, resulting in an aggregate dividend of $17.8 million.
On November 27, 2007, the Board of Directors declared quarterly dividends of $0.5078125 per share on our 8.125% Series A preferred shares and $0.526875 per share on our floating rate Series B preferred shares. The total dividends of $2.1 million were paid on January 20, 2008 to Series A and Series B preferred shareholders of record on December 31, 2007.
The Company and its subsidiaries are assigned financial strength (insurance) and credit ratings from internationally recognized rating agencies, which include A.M. Best Company, Inc., Standard & Poor’s Insurance Rating Services and Moody’s Investors Service. Financial strength ratings represent the opinions of the rating agencies of the financial strength of a company and its capacity to meet the obligations of insurance and reinsurance contracts. The rating agencies consider many factors in determining the financial strength rating of an insurance or reinsurance company, including the relative level of statutory surplus necessary to support the business operations of the company.
In September 2006, the FASB issued SFAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of SFAS 87, 88, 106, and 132(R).” SFAS 158 requires us, as of December 31, 2006, to recognize the overfunded or underfunded status of a defined benefit postretirement plan, including pension plans, as an asset or liability in our balance sheet, and to recognize changes in that funded status, in the year in which the changes occur, through comprehensive income. We adopted the recognition provisions of SFAS 158. As a result of the adoption, as of December 31, 2006, we recorded a one-time charge of $15.7 million to increase other liabilities, a $5.5 million deferred tax asset and a $10.2 million decrease to accumulated other comprehensive income on our balance sheet. In addition, SFAS 158 requires that, as of December 31, 2008,
employers measure plan assets and liabilities as of the date of their financial statements. SFAS 158 does not require retrospective application.
In February 2007, the FASB issued SFAS 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115,” which provides a fair value option (“FVO”) to measure many financial instruments and certain other assets and liabilities at fair value on an instrument-by-instrument basis. SFAS 159 will be effective for us beginning in the first quarter of 2008. We will elect the FVO for an investment, currently recorded under the equity method of accounting. On January 1, 2008, we will discontinue applying the equity method of accounting for this investment and in accordance with SFAS 159, will carry the investment at fair value with changes in fair value recognized as realized gains or losses in the consolidated statement of operations. Upon electing the FVO for this investment, we will record a cumulative adjustment of $1.5 million to reclassify foreign currency unrealized gains, net of tax, to retained earnings as of January 1, 2008.
In June 2007, the American Institute of Certified Public Accountants (“AICPA”) issued Statement of Position 07-1 (“SOP 07-1”), “Clarification of the Scope of the Audit and Accounting Guide Investment Companies and Accounting by Parent Companies and Equity Method Investors for Investments in Investments Companies,” to assist entities in determining if the guidance of the AICPA Audit and Accounting Guide for Investment Companies should be followed and whether the industry accounting should be utilized by parent companies and other investees that exercise significant influence over the investment company. SOP 07-1 requires extensive disclosures, if the entity falls under the definition of an investment company, or the entity is a parent or equity method investor that owns an investment that falls within the scope of investment company accounting. We anticipate that the adoption of SOP 07-1 will not have a material effect on our consolidated financial position or results of operations. SOP 07-1 will require us to make additional disclosures regarding certain investments. On October 17, 2007, the effective date of SOP 07-1 was indefinitely deferred, as it will be further reviewed by the FASB.
In December 2007, the FASB issued SFAS 160, “Non-controlling Interests in Consolidated Financial Statements,” which amends Accounting Research Bulletin 51, “Consolidated Financial Statements,” to establish accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 clarifies the definition of a non-controlling interest and the proper accounting for that entity. SFAS 160 is effective for fiscal years beginning on or after December 15, 2008. Earlier adoption is prohibited. We are evaluating the impact of the adoption of SFAS 160, if any, on our consolidated financial statements.
We have certain business arrangements with affiliated companies that have financial implications. A description of these arrangements is provided in Note 14 to our consolidated financial statements included in this Annual Report on Form 10-K.
The term “market risk” refers to the risk of loss arising from adverse changes in prices. We believe that we are principally exposed to four types of market risk related to our investment operations. These risks are interest rate risk, credit risk, equity price risk and foreign currency risk. Market sensitive instruments discussed in this section principally relate to our fixed income securities and common stocks carried at fair value which are classified as
available for sale. As of December 31, 2007, our total investments and cash of $7.8 billion includes $4.6 billion of fixed income securities that are subject to interest rate risk, foreign currency risk and credit risk.
The table below displays the potential impact (in millions) of fair value fluctuations on our fixed income securities portfolio as of December 31, 2007 and December 31, 2006, based on parallel 200 basis point shifts in interest rates up and down in 100 basis point increments. This analysis was performed on each security individually.
As of December 31, 2007, we had net unrealized gains of $135.9 million, before taxes, related to our total investments and cash. This net amount was comprised of gross unrealized appreciation of $206.6 million, offset by gross unrealized depreciation of $70.7 million, which includes gross unrealized appreciation of $180.9 million and gross unrealized depreciation of $69.6 million related to fixed income securities and common stocks carried at fair value.
risk associated with the collection of current and future amounts owing from our reinsurers. We control this exposure by emphasizing reinsurers with financial strength.
As of December 31, 2007 and December 31, 2006, 96.1% and 89.5%, respectively, of the aggregate fair value of our fixed income securities consisted of securities rated investment grade, with 3.9% and 10.5%, respectively, rated below investment grade.
We have purchased credit default swaps, referenced to various issuers in the banking, mortgage and insurance sectors of the financial services industry, that provide a hedge against adverse movements in the fair value of investments and other corporate assets resulting from systemic financial and credit risk. These credit default swaps are acquired by Fairfax and assigned to us to facilitate administration of counterparty credit risk and collateral maintenance. Under a credit default swap, we agree to pay at specified periods fixed premium amounts based on an agreed notional principal amount in exchange for the credit default protection on a specified asset. Credit default swaps are recorded at fair value in other invested assets, with the related changes in fair value recognized as a realized gain or loss in the period in which they occur. The total cost of the credit default swaps was $94.2 million and $75.6 million as of December 31, 2007 and 2006, respectively, and the fair value was $307.6 million and $13.5 million, as of December 31, 2007 and 2006, respectively. The notional amount of the credit default swaps was $5.0 billion and $3.5 billion as of December 31, 2007 and 2006, respectively. The credit default swaps had net realized gains of $298.3 million and net realized losses of $22.6 million and $36.2 million for the years ended December 31, 2007, 2006 and 2005, respectively. We obtain market-derived fair values for our credit default swaps form third-party providers, principally broker-dealers. We assess the reasonableness of the fair values obtained from these providers by comparison to models validated by qualified personnel, by reference to movements in credit spreads and by comparing the fair values to recent transaction prices for similar credit default swaps where available. The fair values of credit default swaps are subject to significant volatility given potential differences in the perceived risk of default of the underlying issuers, movements in credit spreads and the length of time to the contracts’ maturities. The fair value of the credit default swaps may vary dramatically either up or down in short periods, and their ultimate value may therefore only be known upon their disposition. As a result of the appreciation in the fair value of the credit default swaps, counterparties to these transactions are required to place government securities as collateral, pursuant to the swap agreements. The fair value of this collateral at December 31, 2007 was $227.8 million. We do not have the right to sell or repledge this collateral, as it continues to be the property of the counterparties.
In the third quarter of 2004, we sold short Standard & Poor’s 500 depository receipts (“SPDRs”) and the Financial Select SPDR Fund (“XLF”) as an economic hedge against a general decline in our equity portfolio. In order to reduce the margin maintenance requirements for these short positions, we replaced the short positions with total return swaps, which had aggregate notional amounts of $691.0 million and $581.4 million as of December 31, 2007 and December 31, 2006, respectively. The margin maintenance requirement related to the total return swaps was $205.7 million and $10.5 million as of December 31, 2007 and December 31, 2006, respectively. The swap transactions terminate during the first half of 2008. As of December 31, 2007 and December 31, 2006, we have
As of December 31, 2007 and December 31, 2006, 13.4% and 12.5%, respectively, of our total investments and cash was in common stocks (unaffiliated and affiliated). Marketable equity securities, which represented 11.6% and 10.6% as of December 31, 2007 and December 31, 2006, respectively, of our total investments and cash, are exposed to equity price risk, defined as the potential for loss in fair value owing to a decline in equity prices. A 10% decline in the price of each of these marketable equity securities would result in a decline of $90.3 million and $75.3 million as of December 30, 2007 and December 31, 2006, respectively, in the fair value of our total investments and cash.
Through investment in securities denominated in foreign currencies, we are exposed to foreign (i.e., non-U.S.) currency risk. Foreign currency exchange rate risk creates the potential for loss in fair value owing to a decline in the U.S. dollar value of these investments resulting from a decline in the exchange rate of the foreign currency in which these assets are denominated. As of December 31, 2007 and December 31, 2006, our total exposure to foreign denominated securities in U.S. dollar terms was approximately $2.1 billion and $1.6 billion, respectively, or 26.8% and 22.8%, respectively, of our total investments and cash. The primary foreign currency exposures were from securities denominated in the British pound, which represented 9.2% and 7.7% of our total investments and cash as of December 31, 2007 and December 31, 2006, respectively, from German securities denominated in the Euro, which represented 8.3% and 7.0%, respectively, and from securities denominated in the Canadian dollar, which represented 4.2% and 4.7% of our total investments and cash as of December 31, 2007 and December 31, 2006, respectively. As of December 31, 2007, the potential impact of a 10% decline in each of the foreign exchange rates
Through our international operations, we conduct our business in a variety of foreign (non-U.S.) currencies, with the primary exposures being the Euro, the British pound, and Canadian dollar. Assets and liabilities denominated in foreign currencies are exposed to changes in currency exchange rates to the extent that they do not offset each other resulting in a natural hedge. Our reporting currency is the U.S. dollar, and exchange rate fluctuations relative to the U.S. dollar may materially impact our results and financial condition. We manage this risk on a macro basis by entering into forward currency contracts. As of December 31, 2007, we own forward currency contracts with a notional amount of $149.2 million. The fair value of these contracts is reported in other liabilities at $2.8 million. Forward currency contracts had net realized losses of $2.8 million for the year ended December 31, 2007.
Based on our review, we recognized other-than-temporary impairment losses in the amount of $54.5 million and $5.3 million, before taxes, which were recognized in our consolidated statement of operations as a reduction to our net realized gains and net investment income, respectively, for the year ended December 31, 2007.
The following tables reflect the fair value and gross unrealized depreciation of our fixed income securities and common stock investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, as of December 31, 2007 and December 31, 2006 (in millions):
For further detail on our losses and LAE, see Note 7 to our consolidated financial statements included in this Annual Report on Form 10-K. Our reserves for losses and LAE do not have contractual maturity dates. However, based on historical payment patterns, we have included an estimate of when we expect our losses and LAE to be paid in the table above. The exact timing of the payment of claims cannot be predicted with certainty. We maintain a portfolio of investments with varying maturities and a substantial amount of short-term investments to provide adequate cash flows for the payment of claims. The reserves for unpaid losses and LAE reflected in the table above have not been reduced for reinsurance recoverables on unpaid losses which are reflected in our consolidated balance sheet as an asset of $643.5 million as of December 31, 2007. Based on historical patterns, we estimate that we will collect the recoveries as follows: $139.5 million in less than one year; $182.4 million in one to three years; $103.0 million between three and five years and $218.6 million in more than five years.
Consolidated Statements of Cash Flows for the years ended December 31, 2007, 2006 and 2005.
II. Condensed Financial Information of Registrant as of December 31, 2007 and 2006 and for the years ended December 31, 2007, 2006 and 2005
III. Supplementary Insurance Information as of December 31, 2007 and 2006 and for the years ended December 31, 2007, 2006 and 2005
In our opinion, the accompanying consolidated financial statements listed in the index appearing under Item 8 present fairly, in all material respects, the financial position of Odyssey Re Holdings Corp. and its subsidiaries at December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Controls over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
(b) Investments. The majority of the Company’s investments in fixed income securities and common stocks not accounted for under the equity method, are categorized as “available for sale,” and are recorded at their estimated fair value based on quoted market prices. Effective January 1, 2007, the Company has categorized its investment in fixed income securities that contain embedded derivatives as trading securities (see Note 3). Short-term investments, which have a maturity of one year or less from the date of purchase, are carried at fair value. The Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. Investment transactions are recorded on their trade date, with balances pending settlement reflected in the consolidated balance sheet as a component of other assets or other liabilities.
The Company records its proportionate share of income or loss from common stocks of affiliates, limited partnerships and investment funds in investment income in accordance with the equity method of accounting and includes these investments in other invested assets in the consolidated balance sheet. The Company routinely evaluates the carrying value of these investments. In the case of limited partnerships and investment funds, the carrying value is generally established on the basis of the net valuation criteria as determined by the managers of the investments. Such valuations could differ significantly from the values that would have been available had markets existed for the securities. Income from equity investees, including realized gains or losses, is recorded in net investment income. Unrealized appreciation and depreciation related to available for sale securities are recorded through accumulated other comprehensive income, a component of shareholders’ equity. Unrealized appreciation and depreciation relating to trading securities are recorded as realized investment gains or losses in the consolidated statements of operations. The unrealized appreciation and depreciation related to hedge funds and private equity investments, is recorded in net investment income. Other invested assets also include trust accounts relating to the Company’s benefit plans and derivative securities which are each carried at fair value. Due to the timing of when financial information is reported by equity investees, including limited partnerships and investment funds, results attributable to these investments are generally reported by OdysseyRe on a one month or one quarter lag. If the
Company becomes aware of a significant event that would impact the value of these investments, it will assess the impact, if any, on the carrying value of the investment.
(g) Deposit Assets and Liabilities. The Company may enter into assumed and ceded reinsurance contracts that contain certain loss limiting provisions and, as a result, do not meet the risk transfer provisions of SFAS 113, “Accounting for Reinsurance of Short-Duration and Long-Duration Contracts.” These contracts are accounted for using the deposit accounting method in accordance with Statement of Position 98-7, “Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Risk” (“SOP 98-7”). Under the deposit method of accounting, revenues and expenses from reinsurance contracts are not recognized as written premium and incurred losses. Instead, the profits or losses from these contracts are recognized net, as other income or expense over the contract or contractual settlement periods. In accordance with SOP 98-7, these contracts are deemed as either transferring only significant timing risk or transferring neither significant timing nor underwriting risk.
For such contracts, the Company initially records the amount of consideration paid as a deposit asset or received as a deposit liability. Revenue or expense is recognized over the term of the contract, with any deferred amount recorded as a component of assets or liabilities until such time it is earned. The ultimate asset or liability under these contracts is estimated, and the asset or liability is initially established, which represents consideration received, is increased or decreased over the term of the contract. The change during the period is recorded in the Company’s consolidated statements of operations, where increases and decreases in the ultimate asset or liability are shown in other expense, net. As of December 31, 2007 and 2006, the Company had reflected in other assets
$8.5 million and $8.5 million, respectively, and in other liabilities $1.0 million and $0.7 million, respectively, related to deposit contracts. In cases where cedants retain the consideration on a funds held basis, the Company records those assets in other assets, and records the related investment income on the assets in the Company’s consolidated statements of operations as investment income.
Company’s convertible debt to equity securities. Restricted shares, stock options or the effect of the conversion of the convertible debt and the related interest expense would not be included in the calculation of diluted earnings per common share, if the effect would be antidilutive. (see Note 4).
Depreciation and amortization expense for the years ended December 31, 2007, 2006 and 2005 was $9.5 million, $5.0 million and $7.3 million, respectively.
On January 1, 2007, the Company adopted SFAS 155, “Accounting for Certain Hybrid Financial Instruments - an amendment of SFAS 133 and 140.” SFAS 155 applies to certain “hybrid financial instruments,” which are instruments that contain embedded derivatives. The standard established a requirement to evaluate beneficial interests in securitized financial assets to determine if the interests represent freestanding derivatives, or are hybrid financial instruments containing embedded derivatives requiring bifurcation. SFAS 155 permits an election for fair value measurement of any hybrid financial instrument containing an embedded derivative that otherwise would have required bifurcation under SFAS 133, including financial instruments previously recorded by the Company under SFAS 133. As a result of the adoption of SFAS 155 on January 1, 2007, the Company no longer bifurcates the embedded derivatives included in certain fixed income securities, and, beginning on January 1, 2007, changes in the fair value of the hybrid financial instruments, which have been categorized as trading securities, are recorded as realized investment gains and losses in the Company’s consolidated statements of operations. Prior to the adoption of SFAS 155, changes in the fair value of the host instrument were recorded as unrealized investment gains and losses, a component of shareholders’ equity, while changes in the fair value of the embedded derivative were recorded as realized investment gains and losses. Upon adoption, the Company recorded a cumulative adjustment of $16.5 million to reclassify unrealized investment gains, net of tax, including foreign currency effects, to retained earnings as of January 1, 2007.
The Company elected to recognize accrued interest and penalties, if any, associated with uncertain tax positions as part of the income tax provision. As of December 31, 2007, the Company has not recorded any interest or penalties. The Company files income tax returns with various federal, state, and foreign jurisdictions. The Company’s U.S. federal income tax returns for 1999 through 2006 remain open for examination. The Internal Revenue Service expects to complete their audit of the Company’s 2003 and 2004 tax returns and commence their audit of the Company’s 2005 and 2006 tax returns during 2008. Income tax returns filed with various state and foreign jurisdictions remain open to examination in accordance with individual statutes.
In September 2006, the FASB issued SFAS 157, “Fair Value Measurements,” to define existing fair value measurements, create a framework for measuring fair value, and expand disclosures about fair value measurements. SFAS 157 will be effective for the Company beginning in the first quarter of 2008. The impact of the adoption of SFAS 157 is not expected to have a material effect on the Company’s consolidated financial statements.
In June 2007, the American Institute of Certified Public Accountants (“AICPA”) issued Statement of Position 07-1 (“SOP 07-1”), “Clarification of the Scope of the Audit and Accounting Guide for Investment Companies and Accounting by Parent Companies and Equity Method Investors for Investments in Investments Companies,” to assist entities in determining if the guidance of the AICPA Audit and Accounting Guide for Investment Companies should be followed and whether the industry accounting should be utilized by parent companies and other investees that exercise significant influence over the investment company. SOP 07-1 requires extensive disclosures, if the entity falls under the definition of an investment company, or the entity is a parent or equity method investor that owns an investment that falls within the scope of investment company accounting. The Company anticipates that the adoption of SOP 07-1 will not have a material effect on its consolidated financial position or results of operations. SOP 07-1 will require the Company to make additional disclosures regarding certain investments. On October 17, 2007, the effective date for SOP 07-1 was indefinitely deferred, as it will be further reviewed by the FASB.
In December 2007, the FASB issued SFAS 160, “Non-controlling Interests in Consolidated Financial Statements,” which amends Accounting Research Bulletin 51, “Consolidated Financial Statements,” to establish accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 clarifies the definition of a non-controlling interest and the proper accounting for that entity. SFAS 160 is effective for fiscal years beginning on or after December 15, 2008. Earlier adoption is prohibited. The Company is evaluating the impact of the adoption of SFAS 160, if any, on its consolidated financial statements.
Basic earnings per common share is calculated by dividing net income (loss) available to common shareholders for the period by the weighted-average number of common shares outstanding during the period, excluding those non-vested shares granted under the Odyssey Re Holdings Corp. Restricted Share Plan (“Restricted Share Plan”). Diluted earnings (loss) per common share is calculated by dividing net income (loss) available to common shareholders for the period, adjusted for interest expense on the Company’s 4.375% convertible senior debentures (the “Convertible Notes”), by the weighted-average number of common shares outstanding during the period, inclusive of: vested and non-vested shares granted under the Restricted Share Plan, as determined using the treasury stock method; stock options that would be assumed to be exercised on the balance sheet date, as determined using the treasury stock method; and the effect of the conversion of the Convertible Notes to equity securities. Restricted shares, stock options or the effect of the conversion of the Convertible Notes and the related interest expense are not included in the calculation of dilutive earnings per common share, if the effect would be antidilutive.
Net income (loss) per common share for the years ended December 31, 2007, 2006 and 2005 has been computed in the following table based upon weighted average common shares outstanding (in thousands, except share and per share amounts):
On May 1, 2007, the remainder of the Convertible Notes then outstanding were fully converted and 1.1 million shares of the Company’s common stock were issued related to the conversion (see Note 11) and weighted for inclusion in the calculation of basic earnings per share. As the Convertible Notes were outstanding for a portion of the year ended December 31, 2007, the effect of the conversion of the Convertible Notes has been included in the diluted weighted average common shares outstanding used in the calculation of diluted earnings per share.
Common stocks accounted for under the equity method of accounting were carried at $157.5 million as of December 31, 2007, reflecting gross unrealized appreciation of $25.7 million and gross unrealized depreciation of $0.1 million. Other invested assets, including amounts that were accounted for under the equity method of accounting, were carried at $412.7 million as of December 31, 2007, reflecting no gross unrealized appreciation and gross unrealized depreciation of $0.2 million. Fixed income securities held as trading securities were carried at fair value of $243.2 million as of December 31, 2007, with changes in fair value reflected as realized gains or losses in the consolidated statements of operations. Fixed income securities held as trading securities include corporate and foreign government securities, at fair value of $138.2 million and $105.0 million, respectively, as of December 31, 2007.
During the first quarter of 2007, the Company determined that certain short-term investments were more appropriately classified as cash and cash equivalents held as collateral due to the nature of those investments. The Company has reclassified the corresponding 2006 amounts.
A summary of the Company’s investment portfolio as of December 31, 2006, excluding common stocks at equity and other invested assets, is as follows (in thousands):
The amortized cost and fair value of fixed income securities as of December 31, 2007, by contractual maturity, are shown below (in thousands).
Actual maturities may differ from the contractual maturities shown in the table above due to the existence of call or put options. In the case of securities containing call options, the actual maturity will be the same as the contractual maturity if the issuer elects not to exercise its call option. Total securities subject to the call option represent approximately 1% of the total fair value. In the case of securities containing put options, the actual maturity will be the same as the contractual maturity if the Company elects not to exercise its put option. Total securities containing the put option represent approximately 4% of the total fair value.
The following table sets forth the components of net realized investment gains and losses for the years ended December 31, 2007, 2006, and 2005 (in thousands):
Included in net realized gains for the years ended December 31, 2007, 2006 and 2005, respectively, are net increases in fair value of $259.0 million and $36.8 million, and a decrease in fair value of $75.9 million, principally related to derivatives and investments designated as trading securities.
Included in net realized investment gains for the years ended December 31, 2007, 2006 and 2005 are $54.5 million, $28.1 million and $54.9 million, respectively, related to realized investment losses on the other-than-temporary impairment of investments, as follows (in thousands):
The Company reviews, on a quarterly basis, its investment portfolio for declines in value, and specifically considers securities with fair values that have declined to less than 80% of their cost or amortized cost at the time of review. Generally, a change in the market or interest rate environment does not constitute an impairment of an investment, but rather a temporary decline in value. Temporary declines in investments will be recorded as unrealized depreciation, net of tax, in accumulated other comprehensive income. If the Company determines that a decline is “other-than-temporary,” the cost or amortized cost of the investment will be written down to the fair value and a realized loss will be recorded in the Company’s consolidated statements of operations. An other-than-temporary decline in the carrying value of investments accounted for in accordance with the equity method of accounting is recorded in net investment income in the consolidated statements of operations.
In assessing the value of the Company’s debt and equity securities held as investments and possible impairments of such securities, the Company reviews (i) the issuer’s current financial position and disclosures related thereto, (ii) general and specific market and industry developments, (iii) the timely payment by the issuer of its principal, interest and other obligations, (iv) the outlook and expected financial performance of the issuer,
(v) current and historical valuation parameters for the issuer and similar companies, (vi) relevant forecasts, analyses and recommendations by research analysts, rating agencies and investment advisors, and (vii) other information the Company may consider relevant. In addition, the Company considers its ability and intent to hold the security to recovery when evaluating possible impairments.
The facts and circumstances involved in making a decision regarding an other-than-temporary-impairment are those that exist at that time. Should the facts and circumstances change such that an other-than-temporary impairment is considered appropriate, the Company will recognize the impairment, by reducing the cost, amortized cost or carrying value of the investment to its fair value, recording the loss in its consolidated statement of operations. Upon the disposition of a security where an other-than-temporary impairment has been taken, the Company will record a gain or loss based on the adjusted cost or carrying value of the investment.
The following tables reflect the fair value and gross unrealized depreciation of the Company’s fixed income securities, preferred stocks and common stocks, at fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized depreciation position, as of December 31, 2007 and December 31, 2006 (in thousands):
Common stocks, at equity, totaled $157.5 million as of December 31, 2007, compared to $245.4 million as of December 31, 2006. The following table shows the components of common stocks, at equity, as of December 31, 2007 and 2006 (in thousands):
During 2006, the Company redeemed its interest in HWIC Asia, an investment vehicle that primarily invests in public foreign equities, resulting in a pre-tax realized gain of $75.1 million. HWIC Asia had been reflected in the Company’s consolidated financial statements in accordance with the equity method of accounting since the second quarter of 2005. The carrying value of investments reflected in the value of HWIC Asia is established at their fair value based on quoted market prices. In accordance with the equity method of accounting, interest and dividend income, and realized gains and losses of HWIC Asia are included in net investment income.
The following table reflects the effect of the Company’s redemption of HWIC Asia shares during the year ended December 31, 2006 (in thousands):
A summary of HWIC Asia’s financial information, and the Company’s proportionate share of HWIC Asia as of August 16, 2006, the date of the Company’s redemption of HWIC Asia, for the period January 1, 2006 through August 16, 2006 and the year ended December 31, 2005 follows (in thousands):
foreign currency effects, to retained earnings as of January 1, 2007. The following sets forth the components of the cumulative adjustment as of January 1, 2007 (in thousands):
The net realized gains or losses on disposal in the table below, represent the total gain or loss from the purchase date of the investment. The following table sets forth the total net realized investment gains and losses on derivatives and short sales for the years ended December 31, 2007, 2006 and 2005 (in thousands):
The Company is required to maintain assets on deposit with various regulatory authorities to support its insurance and reinsurance operations. These requirements are generally promulgated in the statutes and regulations of the individual jurisdictions. The assets on deposit are available to settle insurance and reinsurance liabilities. The Company utilizes trust funds in certain transactions where the trust funds are set up for the benefit of the ceding companies and generally take the place of letter of credit requirements. As of December 31, 2007, restricted assets totaled $1.4 billion, with $1.0 billion included in fixed income securities and the remaining balance of $396.6 million included in short-term investments, cash and cash equivalents. Of the $1.4 billion of assets on deposit, $354.9 million was held for foreign regulatory requirements, which included $271.2 million in fixed income securities and the remaining balance of $83.7 million held in short-term investments, cash and cash equivalents.
The following table sets forth the activity in the liability for unpaid losses and loss adjustment expenses for the years ended December 31, 2007, 2006 and 2005 (in thousands):
Losses and loss adjustment expenses incurred related to the current year, as reflected in the table above, were $1,367.9 million, $1,344.3 million and $1,888.9 million for the years ended December 31, 2007, 2006 and 2005, respectively. The increase in losses and loss adjustment expenses incurred for the year ended December 31, 2007 was primarily attributable to increased catastrophe losses, partially offset by reduced loss exposure associated with a decline in earned premium. The decrease in losses and loss adjustment expenses incurred for the year ended December 31, 2006 was primarily attributable to decreased catastrophe losses. For the years ended December 31, 2007, 2006 and 2005, current year catastrophe events were $105.9 million, $34.9 million and $537.9 million, respectively. For the year ended December 31, 2007, the total catastrophe losses included $38.5 million for
Net losses and loss adjustment expenses incurred related to prior years were $40.5 million, $139.9 million and $172.7 million for the years ended December 31, 2007, 2006 and 2005, respectively. Prior period losses and loss adjustment expenses for the year ended December 31, 2007 included $0.9 million related to prior period catastrophe activity. The remaining amount of prior period losses and loss adjustment expenses for the year ended December 31, 2007 was predominantly attributable to increased non-catastrophe loss estimates in the Americas division of $131.4 million, which included $77.4 million for increased asbestos and environmental loss estimates, principally attributable to the annual review of these exposures, and $21.2 million related to settlement of litigation during the third quarter, with the remainder predominantly attributable to increased loss estimates due to loss emergence greater than expectations during the year on U.S. casualty business. This increase was partially offset by reduced loss estimates due to loss emergence lower than expectations in the period on non-catastrophe business written in the London Market, EuroAsia and U.S. Insurance divisions. Prior period losses and loss adjustment expenses for the year ended December 31, 2006 included $42.6 million related to prior period catastrophe activity, principally related to an increase in loss estimates on marine business for Hurricane Rita and the triggering of industry loss warranty contracts written by the Company for Hurricane Wilma due to unexpected deterioration in industry-wide Wilma loss estimates as well as unexpected loss emergence on Florida proportional property accounts in the period. In addition, prior period losses and loss adjustment expenses for the year ended December 31, 2006 for asbestos were increased $27.1 million, principally attributable to the annual review of this exposure. The remaining amount of prior period losses of $70.2 million in 2006 was predominantly attributable to increased loss estimates due to loss emergence greater than expectations during the year on U.S. casualty business. This increase was partially offset by reduced loss estimates due to loss emergence lower than expectations during the year on non-catastrophe business written in the London Market, EuroAsia and U.S. Insurance divisions. Prior period losses and loss adjustment expenses for the year ended December 31, 2005 included $15.0 million related to 2004 and prior catastrophe activity, principally related to greater than expected emergence in 2005 on the 2004 Florida Hurricanes, the Indonesian earthquake and resulting tsunami, and Typhoon Songda. In addition, prior period losses and loss adjustment expenses for the year ended December 31, 2005 for asbestos were increased $41.2 million, principally attributable to the annual review of this exposure. The remaining amount of prior period losses of $116.5 million in 2005 was predominantly attributable to increased loss estimates due to loss emergence greater than expectations during the year on U.S. casualty business. This increase was partially offset by reduced loss estimates due to loss emergence lower than expectations during the year on non-catastrophe business written in the London Market, EuroAsia and U.S. Insurance divisions. Competitive market conditions and an increase in corporate improprieties and bankruptcies during the late 1990s and early 2000s have adversely impacted the Company’s ability to estimate losses and loss adjustment expenses in recent calendar years attributable to U.S. casualty business written during this period. In particular, U.S. business written in the late 1990s and early 2000s has generated unexpectedly prolonged emergence patterns due to an increasing level of deductibles, expanded coverage and expanded policy terms.
The Company uses tabular reserving for workers’ compensation indemnity reserves, which are considered to be fixed and determinable, and discounts such reserves using an interest rate of 3.5%. Losses have been discounted using the Life Table for Total Population: United States, 2004. Reserves reported at the discounted value were $128.7 million and $134.2 million as of December 31, 2007 and 2006, respectively. The amount of case reserve discount was $62.4 million and $64.9 million as of December 31, 2007 and 2006, respectively. The amount of incurred but not reported reserve discount was $27.0 million and $30.2 million as of December 31, 2007 and 2006, respectively.
The Company has exposure to losses from asbestos, environmental pollution and other latent injury damage claims. Gross unpaid asbestos and environmental losses and loss adjustment expenses as of December 31, 2007 were $381.3 million, representing 7.4% of total gross unpaid losses and loss adjustment expenses. Exposure arises from reinsurance contracts written by Clearwater under which the Company has assumed liabilities, on an indemnity or assumption basis, from ceding companies, primarily in connection with general liability insurance policies issued by such ceding companies. The Company’s estimate of its ultimate liability for such exposures includes “case basis” reserves and a provision for liabilities incurred but not reported. Case basis reserves are a combination of reserves reported to the Company by ceding companies and additional case reserves determined by the Company. The provision for liabilities incurred but not reported is established based on an annual review of the Company’s experience and external trends in reported loss and claim payments, with monitoring of emerging experience on a quarterly basis.
The Company’s reserves for asbestos and environmental related liabilities displayed below are from business written prior to 1986. The Company’s asbestos and environmental reserve development, gross and net of reinsurance, for the years ended December 31, 2007, 2006 and 2005, is set forth in the table below (in thousands):
Net losses and loss adjustment expenses incurred for environmental claims increased $14.5 million for the year ended December 31, 2007 and decreased $2.2 million and $0.8 million for the years ended December 31, 2006 and 2005, respectively. The increase in 2007 net losses and loss adjustment expenses incurred was attributable to the annual review of this exposure. The decrease in 2006 net losses and loss adjustment expenses incurred included a net reserve decrease of $0.3 million, a $3.1 million benefit resulting from the amortization of the deferred gain related to the 1995 Stop Loss Agreement and a loss of $1.2 million related to the commutation of this agreement. As a result of this commutation, net reserves were increased by $17.3 million and net paid losses were decreased by $19.2 million.
uncollectible reinsurance recoverables based upon an evaluation of each retrocessionaire and the Company’s assessment as to the collectability of individual balances. The reserve for uncollectible recoverables as of December 31, 2007 and 2006 was $44.4 million and $42.5 million, respectively, and has been netted against reinsurance recoverables on loss payments in the consolidated balance sheets. The Company has also established a reserve for potentially uncollectible assumed reinsurance balances of $1.5 million and $1.9 million as of December 31, 2007 and 2006, respectively, which has been netted against premiums receivable.
For the years ending December 31, 2001 and prior, the Company utilized whole account aggregate excess of loss retrocessional coverage (“Whole Account Excess of Loss Agreements”) to manage its exposures, including catastrophic occurrences and the potential accumulation of exposures. As further discussed below, during the second quarter of 2006, the Company commuted certain whole account excess of loss agreements. In addition, Whole Account Excess of Loss Agreements were purchased covering underwriting years 2002 through 2004 though no losses were ceded to these coverages. In each calendar year, the Company has the ability to cede losses attributable to certain prior periods to the Whole Account Excess of Loss Agreements to the extent there are limits remaining for the period. These agreements cover business written or incepting during a defined period of time (underwriting year), which is typically twelve months, or in other cases, business earned during a defined period of time (accident year). The Whole Account Excess of Loss Agreements were purchased on an underwriting year basis for 1996 through 2004 and on an accident year basis for 1994 and 1995. Accident year agreements were also purchased to supplement the 1996 and 1997 underwriting year agreements. All of these Whole Account Excess of Loss Agreements covering underwriting and accident years have been commuted except for two agreements covering underwriting years 2000 and 2001. Loss cession limits on these two covers still outstanding have been fully utilized. Each agreement provides for recoveries from the retrocessionaires, subject to a limit, in the event that the net subject business results in a composite ratio (the sum of the commission and loss ratios), in excess of a specified attachment point. The attachment point is net of other inuring third party reinsurance. The premium paid, net of commission, by the Company is calculated based on a contractual fixed rate that is applied to the total premiums covered by the retrocession agreements. Each agreement includes a provision for additional premium,
subject to a maximum, based on the amount of loss activity under the agreement. Reinsurance recoverables on paid and unpaid losses are fully secured by letters of credit or funds held by the Company.
During the second quarter of 2006, the Company commuted certain Whole Account Excess of Loss Agreements for total consideration of $80.6 million through the settlement of funds held under reinsurance contracts and the receipt of cash from the reinsurer, net of the settlement of outstanding commissions receivable. During the second quarter of 2006, the commutation of these contracts decreased the Company’s paid and unpaid reinsurance recoverables by $71.0 million, resulting in a commutation gain of $9.5 million. This commutation covered all outstanding Whole Account Excess of Loss Agreements applicable to underwriting and accident years 1999 and prior, as well as the reinsurer’s participation on underwriting years 2000 and 2001.
In addition to the Whole Account Excess of Loss Agreements, the Company entered into a three-year aggregate excess of loss reinsurance contracts protecting its United States facultative casualty business for underwriting years 1998 through 2000 (“Facultative Excess of Loss Agreement”) which indemnified the Company for losses in excess of an annual retention, subject to an annual limit of liability. The aggregate limit for underwriting years 1998, 1999 and 2000 was equal to 40% of the Company’s total facultative net premiums written, subject to a minimum annual dollar limit of $7.4 million, and a maximum annual dollar limit of $18.5 million. The aggregate limit of liability is $41.6 million across all years, which has been fully utilized. The retention in each year was equal to the greater of $9.3 million or 51.0% of the subject written premium income, together with amounts contributed to a loss payment account under the agreement. The Company maintained a loss payment account for the benefit of the reinsurer, equal to 18.5% of the subject written premium income for underwriting year 1998, and 18.9% for each of 1999 and 2000. A minimum interest credit was applied to the loss payment account, equal to the one year U.S. Treasury Bill yield plus 75 basis points. During December 2006, the Company entered into a commutation and release agreement related to this contract, pursuant to which all rights, obligations and liabilities were fully and finally settled. As a result of the commutation, a pre-tax loss of $1.4 million was recognized. Recoverables were reduced by $16.1 million for the year ended December 31, 2006.
The Company has recorded interest expense associated with other ceded reinsurance agreements, and not reflected in the table above, of $975 thousand, $571 thousand and $485 thousand for the years ended December 31, 2007, 2006 and 2005, respectively.
the Company’s ten largest reinsurers for paid and unpaid losses as of December 31, 2007, the amount of collateral held, and each reinsurer’s A.M. Best rating (in thousands):
Several individual reinsurers are part of the same corporate group. The following table shows the five largest aggregate amounts that are recoverable from all individual entities that form part of the same corporate group as of December 31, 2007 and the amount of collateral held from each group (in thousands):
The Company is the beneficiary of letters of credit, cash, and other forms of collateral to secure certain amounts due from its reinsurers. The total amount of collateral held by the Company as of December 31, 2007 is
$184.1 million, which represents 25.3% of the total amount of reinsurance recoverables, comprised of the following forms of collateral (in thousands):
Each reinsurance contract between the Company and the reinsurer describes the losses which are covered under the contract and terms upon which payments are to be made. The Company generally has the ability to utilize collateral to settle unpaid balances due under its reinsurance contracts when it determines that the reinsurer has not met its contractual obligations. Letters of credit are for the sole benefit of the Company to support the obligations of the reinsurer, providing the Company with the unconditional ability, in its sole discretion, to draw upon the letters of credit in support of any unpaid amounts due under the relevant contracts. Cash and investments supporting funds withheld from reinsurers are included in the Company’s invested assets. Funds withheld from reinsurers are typically used to automatically offset payments due to the Company in accordance with the terms of the relevant reinsurance contracts. Amounts held under trust agreements are typically comprised of cash and investment grade fixed income securities and are not included in the Company’s invested assets. The ability of the Company to draw upon funds held under trust agreements to satisfy any unpaid amounts due under the relevant reinsurance contracts is typically unconditional and at the sole discretion of the Company.
On November 28, 2006, the Company completed the private sale of $40.0 million aggregate principal amount of floating rate senior debentures, Series C (the “Series C Notes”), due on December 15, 2021. Interest on the Series C Notes accrues at a rate per annum equal to the three-month London Interbank Offer Rate (“LIBOR”), reset quarterly, plus 2.50%, and is payable quarterly in arrears on March 15, June 15, September 15 and December 15 of each year with the first interest payment having been made on March 15, 2007. The Company has the option to redeem the Series C Notes at par, plus accrued and unpaid interest, in whole or in part on any interest payment date on or after December 15, 2011. For the years ended December 31, 2007 and 2006, the average annual interest rate on the Series C Notes was 7.93% and 7.87%, respectively.
On February 22, 2006, the Company issued $100.0 million aggregate principal amount of floating rate senior debentures, pursuant to a private placement. The net proceeds from the offering, after fees and expenses, were
During the years ended December 31, 2006 and 2005, the Company repurchased portions of its Convertible Notes, as reflected in the following table (in thousands):
As of December 31, 2007 and 2006, the amortized cost of the Company’s debt obligations was $489.2 million and $512.5 million, respectively, as reflected in the consolidated balance sheets. As of December 31, 2007 and 2006, the estimated fair value of the Company’s debt obligations was $506.2 million and $507.9 million, respectively. The estimated fair value is based on quoted market prices for debt similar to the Company’s, and discounted cash flow calculations.
As a result of the conversion of the Convertible Notes, through December 31, 2006 the Company issued 1,838,151 shares of the Company’s common stock. During the year ended December 31, 2007, the Company converted the remaining Convertible Notes into 1,103,099 shares of the Company’s common stock, resulting in a decrease to Convertible Notes, and a corresponding increase to shareholders’ equity, of $23.5 million.
On October 12, 2005, the Company completed the sale of 4.1 million of its common shares at a price of $24.96 per share, resulting in total common shares outstanding as of December 31, 2005 of 69.1 million shares. Fairfax purchased 3.1 million shares in the offering. Net proceeds to the Company, net of underwriting discounts and commissions, were $102.1 million.
The Company’s operations are managed through four operating segments: Americas, EuroAsia, London Market and U.S. Insurance. The Americas division is comprised of the Company’s reinsurance operations in the United States, Canada and Latin America, and writes property and casualty business on a treaty and facultative basis. The EuroAsia division writes primarily treaty and facultative property business. The London Market division operates through three distribution channels, Newline at Lloyd’s and NICL, which focus on casualty insurance, and the London branch, which focuses on worldwide property and casualty reinsurance. The U.S. Insurance division writes specialty insurance lines and classes of business, such as medical malpractice, professional liability and non-standard automobile.
The components of the federal and foreign income tax provision (benefit) included in the consolidated statements of operations for the years ended December 31, 2007, 2006 and 2005 follow (in thousands):
The decrease in the Company’s net deferred tax assets as of December 31, 2007 as compared to December 31, 2006 is primarily attributable to an increase in the fair value of the Company’s derivative instruments, resulting in an increase in the Company’s deferred tax liabilities as of December 31, 2007. Management believes that it is more likely than not that the Company will realize the benefits of its net deferred tax assets and, accordingly, no valuation allowance has been recorded as of December 31, 2007 and 2006.
The following table reconciles federal and foreign income taxes at the statutory federal income tax rate to the Company’s tax provision (benefit) for the years ended December 31, 2007, 2006 and 2005 (in thousands):
During the second quarter of 2004, Odyssey America pledged U.S. Treasury Notes with a par value of $162.0 million (“the pledged assets”), or approximately £110.0 million equivalent, to the Society and Council of Lloyd’s on behalf of Advent Capital (Holdings) PLC (“Advent”) to support Advent’s underwriting activities for the 2001 to 2005 underwriting years of account. Advent is 44.5% owned by Fairfax and its affiliates, which includes 8.1% held by OdysseyRe. nSpire Re had previously pledged assets at Lloyd’s on behalf of Advent pursuant to a November 2000 agreement with Advent. Advent is responsible for the payment of any losses to support its underwriting activities and the capital resources of Advent, including its funds deposited at Lloyd’s, are first available to support any losses prior to a draw down of Odyssey America’s pledged assets. In consideration of Odyssey America pledging the assets, nSpire Re agreed to pay Odyssey America a fee equal to 2.0% per annum of the pledged assets, which the Company considered to be representative of commercial market terms. The pledged assets continue to be owned by Odyssey America, and Odyssey America receives any investment income thereon. The securities are carried at fair value and are included in investments and cash in OdysseyRe’s consolidated balance sheets. Interest earned on the securities is included in investment income. As additional consideration for, and further protection of, the pledged assets, nSpire Re has provided Odyssey America with indemnification in the event of a draw down on the pledged assets. Odyssey America retains the right to withdraw the pledged assets at any time upon 180 days advance written notice to nSpire Re. nSpire Re retains the obligation to pledge assets on behalf of Advent. In any event, the placement of funds at Lloyd’s will automatically terminate effective no later than December 31, 2008 and any remaining pledged assets will revert to Odyssey America at that time. The pledge of assets is not considered material to OdysseyRe’s consolidated financial position. In January 2006, September 2006 and June 2007, Odyssey America received assets with par values of $48.6 million, $10.7 million and $14.6 million, respectively, in each case representing a permanent reduction and unconditional release of such amount, prior to the
Clearwater agreed to allow Ranger Insurance Company, a subsidiary of Fairfax that is now known as Fairmont Specialty Insurance Company (“Fairmont”), to attach an assumption of liability endorsement of Clearwater to certain Fairmont policies issued from July 1, 1999 to April 30, 2004, the effective termination date of the agreement. Should Fairmont fail to meet its obligations, Clearwater is ultimately liable for any unpaid losses, pursuant to the terms of the endorsements. This arrangement enabled Fairmont to provide additional security to its customers as a result of Clearwater’s financial strength ratings and capital resources. The agreement to provide the endorsements was provided by Clearwater while each company was 100% owned by Fairfax. The potential exposure in connection with these endorsements is currently estimated at $0.9 million, based on the subject policies’ outstanding case loss reserves as of December 31, 2007. Fairmont has met and continues to meet all of its obligations, including those subject to this agreement, in the normal course of business, and Clearwater does not anticipate making any payments under this guarantee. The Company believes that the financial resources of Fairmont provide adequate protection to support its liabilities in the ordinary course of business. In addition, Fairfax has indemnified Clearwater for any obligations under this guarantee. The Company does not consider its potential exposure under this guarantee to be material to its consolidated financial position.
Odyssey America agreed, as of April 1, 2002, to guarantee the payment of all of the insurance contract obligations (the “Subject Contracts”), whether incurred before or after the agreement, of Falcon Insurance Company (Hong Kong) Limited (“Falcon”), a subsidiary of Fairfax Asia Limited (“Fairfax Asia”), in the event Falcon becomes insolvent. Fairfax Asia is 100% owned by Fairfax, which includes a 25.9% economic interest owned by the Company. The guarantee by Odyssey America was made to assist Falcon in writing business through access to Odyssey America’s financial strength ratings and capital resources. Odyssey America is paid a fee for this guarantee of one percent of all gross premiums earned associated with the Subject Contracts on a quarterly basis. For the years ended December 31, 2007, 2006 and 2005, Falcon paid $0.5 million, $0.5 million and $0.6 million, respectively, to Odyssey America in connection with this guarantee. Odyssey America’s potential exposure in connection with this agreement is estimated to be $50.0 million, based on Falcon’s loss reserves at December 31, 2007. Falcon’s shareholders’ equity on a U.S. GAAP basis is estimated to be $59.0 million as of December 31, 2007. Fairfax has agreed to indemnify Odyssey America for any obligation under this guarantee. The Company believes that the financial resources of Falcon provide adequate protection to support its liabilities in the ordinary course of business. The Company anticipates that Falcon will meet all of its obligations in the normal course of business and does not expect to make any payments under this guarantee. The Company does not consider its exposure under this guarantee to be material to its consolidated financial position.
The Company organized O.R.E. Holdings Limited (“ORE”), a corporation domiciled in Mauritius, on December 30, 2003 to act as a holding company for various investments in India. On January 29, 2004, ORE was capitalized by the Company in the amount of $16.7 million. ORE is consolidated in the Company’s consolidated financial statements. During 2004, ORE entered into a joint venture agreement relating to the purchase by ORE of 45% of Cheran Enterprises Private Limited (“CEPL”). CEPL is a corporation domiciled in India, engaged in the purchase, development and sale of commercial real estate properties. The joint venture agreement governing CEPL contains a provision whereby Odyssey America could be called upon to provide a guarantee of a credit facility, if such facility were established by CEPL, in an amount up to $65.0 million for the funding of proposed developments. The credit facility was never established, and the requisite conditions for any future provision of the guarantee no longer exist. ORE’s Indian joint venture partner is claiming that the guarantee should be available and is pursuing legal actions against the Company. The Company finds this claim without merit and is vigorously defending the legal actions. The carrying value of the Company’s investment in ORE as of December 31, 2007 and 2006 was $6.7 million, which includes a $9.9 million other-than-temporary write-down recognized in prior years.
The Company and its subsidiaries lease office space and furniture and equipment under long-term leases expiring through the year 2022. Minimum annual rentals follow (in thousands):
The amounts above are reduced by an aggregate minimum rental recovery of $2.5 million resulting from the sublease of space to other companies.
Odyssey America, the Company’s principal operating subsidiary, is subject to state regulatory restrictions that limit the maximum amount of dividends payable. In any 12-month period, Odyssey America may pay dividends equal to the greater of (i) 10% of statutory capital and surplus as of the prior year end or (ii) net income for such prior year without prior approval of the Insurance Commissioner of the State of Connecticut (the “Connecticut Commissioner”). The maximum amount of dividends which Odyssey America may pay in 2008, without such prior approval is $292.3 million, based on Odyssey America’s separate financial statements. Connecticut law further provides that (i) Odyssey America must report to the Connecticut Commissioner, for informational purposes, all dividends and other distributions within five business days after the declaration thereof and at least ten days prior to payment and (ii) Odyssey America may not pay any dividend or distribution in excess of its earned surplus, as reflected in its most recent statutory annual statement on file with the Connecticut Commissioner, without the Connecticut Commissioner’s approval.
Written premiums assumed from Fairfax’s affiliates in 2007 represent 1.2% of OdysseyRe’s total gross premiums written for the year ended December 31, 2007. Ceded premiums written represent 0.3% of OdysseyRe’s total ceded premiums written for the year ended December 31, 2007. The largest amounts of related party assumed business in 2007 were received from Commonwealth Insurance Company and Lombard Canada Ltd. The largest amounts of business ceded to related parties in 2005 involved nSpire Re and Commonwealth Insurance Company, each relating to a proportional catastrophe treaty covering various classes of worldwide catastrophe business written by OdysseyRe.
The Company’s subsidiaries have entered into investment management agreements with Fairfax and its wholly-owned subsidiary, Hamblin Watsa Investment Counsel Ltd. These agreements provide for an annual base fee of 0.20% (20 basis points), calculated and paid quarterly based upon the subsidiary’s average invested assets for the preceding three months. The agreements also include incentive fees of 0.10% (10 basis points), which are payable if realized gains exceed 1% of the average investment portfolio in any given year, subject to cumulative realized gains on investments exceeding 1% of the average investment portfolio. Additional incentive fees are paid based upon the performance of the subsidiary’s equity portfolio equal to 10% of the return on equities (subject to an
annual maximum) in excess of the Standard & Poor’s 500 index plus 200 basis points, provided that the equity portfolio has achieved such excess on a cumulative basis. If the performance of the equity portfolio does not equal or exceed this benchmark in a given year, the annual base fee is reduced to 0.18% (18 basis points). The aggregate annual investment management fee payable by each subsidiary, including incentive fees, is capped at 0.40% (40 basis points) of its investment portfolio, with any excess amounts carried into the following year. These agreements may be terminated by either party on 30 days’ notice. For the years ended December 31, 2007, 2006 and 2005, total fees, including incentive fees, of $17.3 million, $17.6 million and $16.2 million, respectively, are included in the consolidated statements of operations.
The OdysseyRe Foundation, a not-for-profit entity through which the Company provides funding to charitable organizations active in the communities in which the Company operates, was formed in February 2007. Prior to the formation of the OdysseyRe Foundation, the Company provided funding to charitable organizations through the Sixty-Four Foundation, a not-for-profit affiliate of Fairfax and the Company. Included in other expense, net for the years ended December 31, 2007, 2006 and 2005, are incurred charitable contributions of $2.5 million, $1.7 million and $0.7 million, respectively, related to these entities.
In connection with the acquisition of Opus Re (now known as Clearwater Select Insurance Company), the Company incurred a $2.5 million pre-tax expense for the year ended December 31, 2005, which is included in other expense, net, to RiverStone Group LLC, an affiliate, for services provided to the Company in connection with the acquisition.
Employer contributions to the Plan are in accordance with the minimum funding requirements of the Employee Retirement Income Security Act of 1974, as amended.
The following tables set forth the Plan’s funded status, which uses a measurement date of October 1, and amounts recognized in the Company’s consolidated financial statements as of December 31, 2007 and 2006 (in thousands):
The Company established a trust fund, which invests in U.S. government securities, related to the Excess Plans. The trust fund, which is included in other invested assets, had a fair value of $6.8 million and $6.5 million as of December 31, 2007 and 2006, respectively. Plan benefits are paid by the Company as they are incurred by the participants, accordingly, there are no assets held directly by the Excess Plans.
The Company expects to contribute $1.1 million to the Excess Plans during the year ended December 31, 2008, which represents the amount necessary to fund the 2008 expected benefit payments.
The Company estimates that it will record a $2.0 million net loss related to the net periodic benefit cost during the year ended December 31, 2008.
The net amount recognized in the consolidated balance sheets related to the accrued benefit cost of $14.2 million and $13.0 million, as of December 31, 2007 and 2006, respectively, is included in other liabilities. The net amount of pre-tax accumulated other comprehensive loss is $0.1 million and $0.9 million as of December 31, 2007 and 2006, respectively.
The weighted average assumptions used to calculate the benefit obligation as of December 31, 2007 and 2006 are as follows:
As a result of the adoption of SFAS 158, the Company recognized a $0.5 million, after-tax, reduction in accumulated other comprehensive income related to the postretirement plan, as of December 31, 2006, of which, on an after tax basis, $0.8 million related to net losses, while $0.3 million related to prior service credit.
The Company estimates that it will record $2.6 million in benefit costs during the year ended December 31, 2008.
The Company maintains a qualified deferred compensation plan pursuant to Section 401(k) of the Internal Revenue Code of 1986, as amended. Employees may contribute up to 50% of base salary on a pre-tax basis, subject to annual maximum contributions set by law ($15,500 in 2007). The Company contributes an amount equal to 100% of each employee’s pre-tax contribution up to certain limits. The maximum matching contribution is 4% of annual base salary, with certain government mandated restrictions on contributions to highly compensated employees. The Company also maintains a non-qualified deferred compensation plan to allow for contributions in excess of qualified plan limitations. The Company contributed $1.8 million, $1.6 million and $1.6 million to these plans in 2007, 2006 and 2005, respectively, which is included in other underwriting expenses in the consolidated statements of operations.
Effective January 1, 2006, the Company adopted, on a prospective basis, SFAS 123(R) “Share-Based Payments,” which is a revision of SFAS 123 “Accounting for Stock Based Compensation” and supersedes
Accounting Principles Board Opinion (“APB”) 25. The prospective method requires the application of the fair value based method to compensation awards granted, modified or settled on or after the date of adoption. The approach to account for share-based payments in SFAS 123(R) is similar to the approach described in SFAS 123, however, SFAS 123(R) requires the expense related to all share-based payments to employees, including grants of employee stock options, to be recognized in the consolidated financial statements. Pro forma disclosure of the impact of fair value share-based payments is no longer an alternative to financial statement recognition. The Company had previously adopted the expense recognition provisions of SFAS 123, on a prospective basis, effective January 1, 2003, and since that date has included the expense related to stock options granted subsequent to January 1, 2003 in its statements of operations. In addition, the Company has historically expensed the compensation cost associated with its restricted shares plan beginning with the initial grant in 2001. Accordingly, the effect of adopting SFAS 123(R) did not have a material effect on the Company’s results of operations or financial position. Subsequent to January 1, 2006, deferred compensation related to restricted stock grants will be recognized in additional paid-in capital. In accordance with SFAS 123(R), compensation cost associated with stock options recognized during 2006 includes: 1) quarterly amortization related to the remaining unvested portion of all stock option awards granted prior to January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123; and 2) quarterly amortization related to all stock option awards granted on or after December 31, 2005, based on the grant-date fair value estimated.
In 2002, the Company adopted the 2002 Option Plan, which provides for the grant of non-qualified stock options to officers, key employees and directors who are employed by, or provide services to the Company. Options for an aggregate of 1,500,000 of the Company’s common shares may be granted under the 2002 Option Plan. Pursuant to the 2002 Option Plan, 25% of the options granted become exercisable on each anniversary of the grant in each of the four years following the date of grant and all options expire 10 years from the date of grant. Stock options are exercisable at the grant price.
The following table summarizes stock option activity for the 2002 Option Plan for the year ended December 31, 2007:
There were no options granted during the year ended December 31, 2007. The fair value of options granted during the years ended December 31, 2006 and 2005, estimated as of the grant date using the Black-Scholes option pricing model, was $9.21 and $6.89 per share, respectively. The weighted-average remaining contractual term for options outstanding as of December 31, 2007, 2006 and 2005 was 4.9 years, 5.9 years and 6.8 years, respectively. The weighted-average remaining contractual term for options vested and exercisable as of December 31, 2007 was 4.8 years. As of December 31, 2007, the aggregate intrinsic value was $6.5 million for options outstanding and $6.4 million for options vested and exercisable.
The following table summarizes stock option activity for the 2001 Option Plan for the year ended December 31, 2007:
The weighted-average remaining contractual term for options outstanding as of December 31, 2007, 2006 and 2005 was 7.2 years, 7.4 years and 7.1 years, respectively. The weighted-average remaining contractual term for options vested and exercisable as of December 31, 2007 was 6.3 years. As of December 31, 2007, the aggregate fair value was $6.1 million for options outstanding and $1.5 million for options vested and exercisable.
In 2001, the Company adopted the Restricted Share Plan, which provides for the grant of restricted shares of the Company’s common stock to directors, officers and key employees of the Company. Shares granted under the Restricted Share Plan generally vest and become exercisable in equal installments over three years or five years from the grant dates. Amounts granted in 2001 vest and become exercisable in two equal installments on the fifth and tenth anniversary of the grant dates. Awards under each of the Restricted Share Plan and the 2001 Option Plan (described above) may not exceed an aggregate of 10% of the Company’s issued and outstanding shares of common stock as of the last business day of the previous calendar year. The Company had 71,140,948 issued and outstanding shares of common stock as of December 31, 2006.
In accordance with SFAS 123(R), the fair value of restricted share awards is estimated on the date of grant based on the market price of the Company’s stock and is amortized to compensation expense on a straight-line basis over the related vesting periods. As of December 31, 2007, there was $12.2 million of unrecognized compensation cost related to unvested restricted share awards, which is expected to be recognized over a remaining weighted-average vesting period of 2.5 years. SFAS 123(R) requires that the deferred stock-based compensation on the consolidated balance sheet on the date of adoption be netted against additional paid-in capital. As of December 31, 2005, there was approximately $1.8 million of deferred stock-based compensation that was netted against additional paid-in capital on January 1, 2006. The total fair value of the restricted share awards vested during the year ended December 31, 2007, 2006 and 2005 was $7.4 million, $5.8 million and $1.8 million, respectively. As of December 31, 2007, the aggregate fair value of restricted share awards outstanding was $24.8 million.
In 2001, the Company established the Employee Share Purchase Plan (the “ESPP”). Under the terms of the ESPP, eligible employees may elect to purchase Company common shares in an amount up to 10% of their annual base salary. The Company issues or purchases, on the employee’s behalf, the Company’s common shares equal to 30% of the employee’s contribution. In the event that the Company achieves a return on equity of at least 15% in any calendar year, as computed in accordance with GAAP, additional shares are purchased by the Company for the employee’s benefit in an amount equal to 20% of the employee’s contribution during that year. During the years ended December 31, 2007, 2006 and 2005, the Company purchased 68,542 shares, 83,046 shares and 74,764 shares, respectively, on behalf of employees pursuant to the ESPP, at average purchase prices of $38.67, $27.58 and $24.93, respectively. The compensation expense recognized by the Company for purchases of the Company’s common shares under the ESPP was $0.9 million, $0.5 million and $0.4 million for the years ended December 31, 2007, 2006 and 2005, respectively.
For the years ended December 31 2007, 2006 and 2005, the Company received $2.5 million, $2.7 million and $1.5 million, respectively, in cash from employees for the exercise of stock options. For the years ended December 31, 2007, 2006 and 2005, the Company recognized an expense related to all stock based compensation of $6.7 million, $5.6 million and $4.2 million, respectively. Of the $6.7 million expense for the year ended December 31, 2007, $0.2 million relates to the adoption of SFAS 123(R). The total tax benefit recognized for the year ended December 31, 2007, 2006 and 2005 was $2.3 million, $2.0 million and $1.5 million, respectively. For the year ended December 31, 2007, the additional stock based compensation expense as a result of the adoption of SFAS 123(R) caused income before income taxes to decrease by $0.2 million, net income to decrease by $0.1 million, and basic and diluted earnings per share to decrease by less than $0.01.
As of December 31, 2007, financial guaranty reinsurance in force had a remaining maturity term of one (1) to 20 years. The approximate distribution of the estimated debt service (principal and interest) of bonds, by type and unearned premiums, for the years ended December 31, 2007 and 2006 is as follows (in millions):
(2) Certain amounts from prior periods have been reclassified to conform with the current year’s presentations.