The headquarters of Quanta U.S. Holdings and our other U.S. subsidiaries is located in New York, New York and contains approximately 13,650 square feet. The term of the lease expires in February 2012 with an option to extend the lease term by an additional five years. The annual lease payment for this office starts at approximately $464,100 and increases in annual increments to approximately $555,220 at the end of the lease term. Our other offices in the U.S. are located in Hartford, Connecticut with a lease cost of approximately $230,000 per year.
We believe that these facilities are sufficient for our current purposes and that alternative space will be available, if needed, on commercially reasonable terms.
(2) Basic earnings per share are computed using the weighted average number of common shares outstanding during the period. All potentially dilutive securities including stock options, restricted stock and warrants are excluded from the basic earnings per share computation. In calculating diluted earnings per share, the weighted average number of shares outstanding for the period is increased to include all potentially dilutive securities using the treasury stock method. Any common stock equivalent shares are excluded from the computation if their effect is anti-dilutive. Basic and diluted earnings per share are calculated by dividing income available to ordinary shareholders by the applicable weighted average number of shares outstanding during the year.
(3) Includes the operations of ESC from September 3, 2003, the date of acquisition. We accounted for the acquisition of ESC as a purchase. Following the disposal of ESC during the third quarter of 2006, ESC was presented in the discontinued operations in the Income Statement. See Note 3 to our consolidated financial statements.
The following discussion and analysis of our results of operations, financial condition and liquidity and capital resources should be read in conjunction with our audited consolidated financial statements and related notes for the year ended December 31, 2007 contained in this annual report on pages to and with the risk factors appearing under ‘‘Item 1A. Risk Factors’’ in this annual report.
• We recorded total net favorable loss development (including $9.0 million from commutations) related to prior year accident periods of $39.1 million.
• We further reduced our net loss reserves by $5.1 million through cancellation of insurance contracts with our clients, primarily as a result of policy cancellations in our HBW program.
• We returned approximately $23.5 million in premiums to our clients during 2007 in connection with cancellations and terminations of insurance policies.
and other income of $1.9 million. This amount was partially offset by returned earned premium of approximately $1.3 million. The net commutation payments resulted in a reduction in net loss and loss expenses reserves of approximately $47.1 million and a reduction in premium receivables of approximately $15.6 million.
• During the third quarter of 2007, we repurchased all of the outstanding Series A preferred shares at a price of $22.50 per share. The aggregate purchase price for the Series A preferred shares was $70.4 million which resulted in a gain of $2.4 million, net of repurchase costs and write off of original deferred issuance costs, which is reported as an increase in net income available to common shareholders.
• In the third quarter of 2007, we purchased all of the outstanding junior subordinated debentures for an aggregate purchase price of $54.5 million. We originally issued and sold an aggregate $60.0 million of the junior subordinated debentures in private placements. We recognized a gain on repurchase of $4.4 million, net of repurchase costs and write off of original deferred issuance costs.
• We have reduced the amount of assets placed in trust as collateral for our clients in our run-off segments to $153.8 million at December 31, 2007.
• $14.9 million in several product lines related to mature accident periods in which actual loss experience was better than expected;
• $6.7 million related to the 2005 and 2004 hurricanes; and
On February 13, 2008, we sold all of our interests in Syndicate 4000 through the sale of Quanta 4000 Ltd. (‘‘Quanta 4000’’) and our interest in Pembroke JV. We expect that, in the first quarter of 2008, we will recognize a gain on the sale of our interest in Quanta 4000, with the amount of such gain being determined based on recorded balances as of the date of sale. If the sale had occurred on December 31, 2007, based on balances recorded at that date, the pro forma amount of the gain would have been approximately $17.9 million. This gain is net of transaction costs, the payment of bonuses to the management and employees of Syndicate 4000 and writing off the cost of our investment in Pembroke JV. There can be no assurances that the gain we record in the first quarter of 2008 will be substantially similar to the amount stated above or that there will be a gain at all. If we record a loss, it could have a material adverse impact on our financial results and statement of operations.
• contributed net earned premium of $80.8 million for the year ended December 31, 2007 as compared to $65.5 million in net earned premium for the year ended December 31, 2006.
• $3.9 million of net reserves for reported claims. These claims were reported in Syndicate 4000’s professional directors and officers (‘‘D&O’’) and errors and omissions (‘‘E&O’’) product lines.
• A premium deficiency reserve amounting to approximately $8.0 million. This reserve relates to the write-off of deferred acquisition costs that are deemed irrecoverable from the future earning of unearned premium reserves because we expect that potential future subprime reported losses may exceed those unearned premium reserves.
earned contributed approximately 87% to our total revenues, and in 2007 this contribution reduced to 61%, and we expect further significant reductions in future periods.
In 2007, net revenues from non-underwriting activities, for example net investment income and technical services revenues, were not sufficient to offset general and administrative expenses, interest expense and depreciation and amortization. We expect that this trend may continue and that we may incur net losses in future periods. We seek to mitigate any losses through continued overhead reduction strategies.
During the year ended December 31, 2004, we wrote a non-traditional statutory surplus relief life reinsurance contract that was deemed not to meet the risk transfer criteria set out in the accounting literature and was therefore accounted for as a deposit under the accounting rules. For additional information regarding accounting policies relating to non-traditional contracts, see ‘‘Critical Accounting Policies-Non-traditional contracts’’. Under this contract, we provided reinsurance on certain underlying life insurance contracts written by our client, a U.S. life insurance company. The client is subject to insurance regulation in the United States and, therefore, is required to maintain a certain amount of statutory capital. The client was entitled to reduce its statutory capital requirements as a result of entering into a reinsurance contract with us. The reinsurance transaction was done partially on a funds withheld basis under which some funds are held by the life insurance company. We received fees for this transaction. Other than receipt of our fees, there were no net cash flows at inception of this contract, nor were there expected to be net cash flows other than fees through the life of the contract. We monitor this transaction on a quarterly basis to, among other things, ensure that the performance of the underlying life insurance
Our analysis of consolidated losses and loss expense development shown below presents the subsequent development of our estimated year end liability for net loss and loss expenses (net of loss and loss adjustment expenses recoverable) at the end of each balance sheet date for the years ended December 31, 2003 through 2007. The top line of the table shows our estimated net liability for unpaid losses and loss expense reserves recorded at the balance sheet date for each of the indicated periods. The net liability for loss and loss expenses represents the estimated aggregate amount of losses and loss expenses for claims arising from all prior years’ accident periods that were unpaid at the balance sheet date.
The lower portion of the table presents the amounts paid as of subsequent periods on those claims for which we recorded reserves as of each balance sheet date. Conditions and trends that have affected development of the liabilities in the past are not indicative of events or development that may occur in the future. Accordingly, it is inappropriate to extrapolate future redundancies or deficiencies based on the tables below.
Overall, we have experienced net favorable loss developments as our estimates of ultimate loss liabilities have been adjusted to lower amounts than we had estimated when we were first required to record reserves. This is particularly noticeable in our shorter tail policies we underwrote or in lines of business where policies and periods of exposure have expired with either a fewer number of claims than expected or with lower than expected claim amounts. Prior to 2004 we did not have significant development in our estimation of loss and loss expense reserves since we started our operations in 2003 and only wrote a small number of contracts during that year.
During the year ended December 31, 2004 we recorded approximately $61.3 million in net loss and loss expenses in our property and marine reinsurance product lines associated with hurricanes Charley, Frances, Ivan and Jeanne (the ‘‘2004 hurricanes’’).
• approximately $83.3 million in net loss and loss expenses in our property and marine reinsurance and technical property and fidelity insurance product lines associated with the hurricanes Katrina, Rita and Wilma (the ‘‘2005 hurricanes’’);
• $1.9 million of net favorable loss development in certain of our other short-tail policies and product lines.
During the year ended December 31, 2007, we recorded a decrease in our loss reserves of $44.2 million. The decreases from the 2004, 2005 and 2006 accident years were $2.6 million, $30.4 million and $11.2 million and were primarily driven by the following:
capital for the 2007 underwriting year was provided by Chaucer Holdings PLC. We included all of the results of insurance business written by Syndicate 4000 since its inception in 2004 through the 2006 underwriting year and 90% of the results of Syndicate 4000 for the 2007 underwriting year. Due to the sale of our interest in Syndicate 4000, this segment will be reclassified as discontinued operations in 2008.
• Technical services. Prior to the sale of ESC in the third quarter of 2006, our technical services segment provided diversified environmental investigation, remediation and engineering services, assessment services, other technical and information management services primarily in the environmental area in the U.S. Our technical services segment also provided technical and information management services to our specialty insurance run-off and reinsurance run-off segments. Following the sale of ESC, the technical services segment now consists of our two environmental liability assumption programs, QLT of Buffalo LLC and QLT of Alabama LLC. The results for the prior years have been reclassified to conform with the presentation of ESC in discontinued operations.
During the fourth quarter of 2006 we ceased allocating our indirect corporate, general and administrative expenses to our operating segments. Prior to the fourth quarter of 2006, we allocated corporate general and administrative expenses to each segment based upon each product line’s allocated capital for the relevant reporting period. We allocated capital to each of our product lines through the estimated value-at-risk method, which used statistical analyses of historical market trends and volatility to estimate the probable amounts of capital at risk for each reporting period. Since our decision to conduct a self-managed run-off of most of our businesses we no longer allocate capital to our segments and corporate expenses are no longer evaluated at the segment level. We also do not evaluate net investment income, and depreciation and amortization at the segment level.
contract periods and the type of purchased reinsurance protection. Because of all these factors, the amount of premiums written and ceded may not result in a correlative level of profitability.
Our investment income depends on the average invested assets in our investment portfolios and the yield that we earn on those invested assets. Our investment yield is a function of market interest rates and the credit quality and maturity period of our invested assets. Our investment portfolio consists principally of fixed income securities, short-term investments, cash, and cash equivalents. In addition, we realize capital gains or losses on sales of investments as a result of changing market conditions, including changes in market interest rates and changes in the credit quality of our invested assets. We also recognize capital gains and losses on investments as a result of fluctuations in the fair market values of the investments. The objective of our current investment strategy is to preserve investment principal, maintain liquidity and manage duration risk between investment assets and insurance liabilities (when they become due, at the time of either loss settlement, cancellations or commutations), while maximizing investment returns through a diversified portfolio.
Our expenses primarily consist of general and administrative expenses, net loss and loss expenses and acquisition expenses.
General and administrative expenses consist primarily of personnel related expenses (including severance costs), professional fees and other operating overheads. From time to time we engage administrative service providers and legal, accounting, tax and financial advisors. These general and administrative expenses may be incurred directly by a segment or indirectly at the corporate level.
Acquisition expenses, which are net of expenses recovered under our ceded reinsurance contracts, consist principally of commissions, fees, brokerage and tax expenses that are directly related to obtaining and writing insurance and reinsurance contracts. Typically, acquisition expenses are based on a certain percentage of the premiums written on contracts of insurance and reinsurance and may be adjustable based upon loss experience. These expenses are a function of the number and type of insurance and reinsurance contracts written. We may not be able to recover all or a portion of our acquisition costs on commuted or cancelled policies. A premium deficiency reserve is recognized if the sum of expected losses and loss expenses and unamortized acquisition costs exceeds related unearned premiums. A premium deficiency reserve is recognized by charging unamortized acquisition costs to acquisition expenses in the consolidated statement of operations to the extent required in order to eliminate the deficiency. If the premium deficiency reserve exceeds unamortized acquisition costs then a liability is accrued for the excess deficiency.
The financial ratios we use in our Lloyd’s segment include the net loss and loss expense ratio, the acquisition expense ratio and the general and administrative expense ratio. Our net loss and loss expense ratio is calculated as net losses and loss expenses incurred divided by net premiums earned. Our acquisition expense ratio is calculated by dividing acquisition expenses by net premiums earned. Our general and administrative expense ratio is calculated by dividing general and administrative expenses by net premiums earned. Our financial ratios provide a measure of the current profitability of the earned portions of insurance contracts that were written in our Lloyd’s
Substantially all of our revenues were generated by our underwriting subsidiaries in the U.S., Bermuda and Europe.
Net premiums earned were $87.2 million for the year ended December 31, 2007, a decrease of $138.1 million, compared to $225.3 million for the year ended December 31, 2006. The decrease in net premiums earned reflects the decision to discontinue writing new business in our insurance and reinsurance lines of business, other than in our Lloyd’s segment, and the continued return of premiums to our clients following policy commutations or cancellations. Our net premiums written are typically earned over the risk periods of the underlying insurance policies which are generally twelve months. Net premiums written that are not yet earned and are deferred as unearned premium reserves, net of deferred reinsurance premiums, totaled $75.6 million at December 31, 2007 and will be earned and recognized in our results of operations in future periods to the extent these premiums are not returned following future commutations or cancellations. The contribution to net premiums earned from our Lloyd’s segment is detailed under ‘‘Results by Segments’’ below.
Technical services revenues. Technical services revenues were $1.7 million for the year ended December 31, 2007, a decrease of $1.6 million, compared to $3.3 million for the year ended December 31, 2006. We expect that our technical services revenues will decrease in future periods as the remediation activities near completion. Technical services revenues prior to the quarter ended September 30, 2006 were derived from the operations of ESC which was sold on September 16, 2006 and from the operations of our environmental liability assumption programs. This revenue is included in the results of our discontinued operations.
Net investment income and net gains (losses) on investments. Net investment income and net gains (losses) on investments consisted of the following for the years ended December 31, 2007 and 2006:
Net investment income was $41.9 million for the year ended December 31, 2007 a decrease of $4.0 million, compared to $45.9 million for the year ended December 31, 2006. This decrease was primarily due to a decrease in interest earned on fixed maturity and short term investments plus amortization of discounts on fixed maturity investments. Net investment income decreased in the year ended December 31, 2007 as compared to 2006 due to a lower level of invested assets at December 31, 2007 compared to December 31, 2006. The lower level of invested assets is a result of our insurance and reinsurance businesses being in run-off as well as the repurchase of our Series A preferred shares and junior subordinated debentures. Our average annualized effective yield (calculated by dividing net investment income by the average amortized cost of invested assets, net
of amounts payable or receivable for investments purchased or sold) was approximately 4.7% for the year ended December 31, 2007 compared to 5.0% for the year ended December 31, 2006. This decrease is due to shortening of the duration of some of our invested assets during 2007 as compared to 2006 and the resulting lowering of the yield on those invested assets.
Net realized losses for the year ended December 31, 2006 of $15.9 million were generated primarily from an other than temporary impairment charge of $16.9 million.
On January 1, 2007 we converted our available-for-sale portfolio to trading as permitted under the early adoption rules of SFAS 159. This resulted in all changes in the fair market value of investments during the year ended December 31, 2007 being recorded as net gains or losses within our statement of operations. During the year ended December 31, 2006 any change in the fair market value of investments were reflected within other comprehensive income within the equity section of the balance sheet unless any securities were deemed to be other than temporarily impaired in which case unrealized losses were recognized as a realized loss in the statement of operations. Other comprehensive income for the year ended December 31, 2006 included $9.7 million of net change in unrealized losses.
Net losses and loss expenses. Net losses and loss expenses were $31.1 million for the year ended December 31, 2007, a decrease of $125.0 million, compared to $156.1 million for the year ended December 31, 2006. Net losses and loss expenses are a function of our net premiums earned and changes in our expected ultimate losses and loss expenses for reported and unreported claims on contracts of insurance and reinsurance underwritten. The decrease in net losses and loss expenses is due to:
• the reduced number of insurance contracts we entered into in 2007 as compared to the number of insurance and reinsurance contracts we entered into in 2006 and the associated net premiums earned as our insurance and reinsurance portfolios continue to run-off;
Our expected ultimate losses and loss expenses during the year ended December 31, 2007, included total net favorable loss development (including those arising from commutations) related
to prior year accident periods of $39.1 million. This was comprised of $14.9 million in several product lines related to mature accident periods in which actual loss experience was better than expected, $9.0 million relating to the commutations of a number of our reinsurance policies, $8.0 million in our Lloyd’s segment particularly in relation to the 2005 underwriting year, $6.7 million related to the 2005 and 2004 hurricanes and $0.5 million related to the tornadoes that occurred in the first quarter of 2006. We expect future developments in the loss and loss expenses of our product lines as we continue to receive information related to our loss and loss expense reserves and as those reserves develop over time. We continue to be exposed to potentially significant losses in lines of business where claims may not be reported for some period of time after those claims are incurred. We also recorded a reduction in our losses and loss expense reserves of $5.1 million as a result of cancellations on policies primarily in our HBW program and the related reduction in reserves associated with those cancellations.
In estimating reserves we may utilize a variety of standard actuarial methods in line with industry practice, including the expected loss ratio method, the Bornhuetter-Ferguson method, paid loss development method and reported loss development method. The loss reserves are based on the loss development characteristics of the specific line of business and specific contracts within that line of business, and consider coverage, type of business, maturity of loss data and claims.
Within acquisition costs for the year ended December 31, 2007 we have recorded a premium deficiency reserve of approximately $8.0 million. This premium deficiency reserve relates to the write-off of deferred acquisition costs in our Lloyd’s segment that are deemed irrecoverable from the future earning of unearned premium reserves because we expect that potential future subprime reported losses may exceed those unearned premium reserves.
to $5.0 million for the year ended December 31, 2006. The majority of the decrease relates to the following three items. Firstly, an impairment charge of $1.7 million with respect to our intangible assets associated with our U.S. insurance licenses was made in 2006 to record these licenses at their estimated net realizable value and secondly, amortized $0.4 million in the year ended December 31, 2007 related to software costs compared to $1.2 million for the year ended December 31, 2006. Finally, we also amortized approximately $0.8 million of leasehold improvements during the fourth quarter of 2006 associated with our anticipated relocation of our New York operations. The remaining decrease is due to the decreasing value of our fixed assets.
The realization of deferred tax assets is dependent on future taxable income and future reversals of existing taxable temporary differences. Based upon our assessment of historical data and future earnings, it is our belief that it is more likely than not that the $5.3 million net deferred tax asset established for the U.K. NOL carryforwards will be realized in future periods by Quanta 4000. We will continue to periodically assess the realizability of the net deferred tax asset and adjust the valuation allowance accordingly.
In relation to the U.S. NOL and Irish NOL, due to prior and existing operating losses, we believe that it is more likely than not that the deferred tax asset will not be realized. Accordingly, we have recorded a full valuation allowance against these net deferred tax assets as of December 31, 2007 and 2006.
(Loss) from operations of discontinued operations. We had no income from discontinued operations for the year ended December 31, 2007. For the period from January 1, 2006 to September 15, 2006, the loss from discontinued operations represented the revenues and expenses from ESC, which was sold on September 15, 2006.
During the period from January 1, 2006 to September 15, 2006, our loss from operations of discontinued operations generated by ESC, previously included in the technical services segment, now reported in discontinued operations was as follows:
Dividends on preferred shares. During the year ended December 31, 2007, we paid no dividend on our Series A preferred shares. During the year ended December 31, 2006, we paid a dividend of $1.9 million to our Series A preferred shareholders.
Our Lloyd’s segment contributed $91.8 million of total gross written premiums in 2006, or 59.4%, compared to $80.7 million, or 13.2% in 2005. This increase in Lloyd’s contribution reflects the run-off status of other segments in 2006 and modest growth in our Lloyd’s operations in 2006.
Premiums ceded were $78.2 million for the year ended December 31, 2006 a decrease of $140.8 million, or 64.3% compared to $218.9 million for the year ended December 31, 2005. The decrease in premiums ceded primarily reflects the reduction in gross premiums written.
Net premiums earned were $225.3 million for the year ended December 31, 2006, a decrease of $138.8 million, or 38.9%, compared to $364.1 million for the year ended December 31, 2005. The decrease in net premiums earned reflects the decision to discontinue writing new business in our insurance and reinsurance lines of business, other than in our Lloyd’s segment. Our net premiums written are typically earned over the risk periods of the underlying insurance policies. Net premiums written that are not yet earned and are deferred as unearned premium reserves, net of deferred reinsurance premiums, totaled $119.2 million at December 31, 2006 and will be earned and recognized in our results of operations in future periods. The contribution to net premiums earned from our Lloyd’s segment is detailed under ‘‘Results by Segments’’ below.
Technical services revenues. Technical services revenues were $3.3 million for the year ended December 31, 2006 a decrease of $15.7 million compared to $19.0 million for the year ended December 31, 2005. The decrease is due to a significant portion of remediation of our QLT Buffalo LLC environmental liability assumption program occurring during the second and third quarters of 2005. The remediation was close to being completed and, as a result, did not generate technical services revenues in 2006 to the same extent as it did in 2005.
Net investment income and net losses on investments. Net investment income and net realized losses totaled $30.0 million for the year ended December 31, 2006, an increase of $15.8 million compared to $14.2 million for the year ended December 31, 2005. The amounts consisted of the following:
The increase is primarily due to an increase in net investment income of $18.7 million because of our larger amount of invested assets and rises in market interest rates, which is partially offset by an increase in net realized losses of $2.9 million, of which $16.9 million is attributable to other than temporary impairment losses recognized during the year ended December 31, 2006, compared to other than temporary losses of $10.2 million in 2005.
As of December 31, 2006, the average duration of our investment portfolio was approximately 2.5 years with an average credit rating of approximately ’’AA+’’, compared to 2.6 years with an average credit rating of approximately ’’AA+’’ as at December 31, 2005.
• the lack of natural catastrophe events reported during 2006 to which our in-force contracts may be exposed;
Our total net loss ratio (calculated by dividing net losses and loss expenses by net premiums earned) was 69.3% for the year ended December 31, 2006, a decrease of 19.8% compared to a total net loss ratio of 89.1% for the year ended December 31, 2005. The decrease in the total net loss and loss expense ratio is due primarily to the hurricanes and the oil pipeline loss that occurred in 2005.
We have not recorded any net deferred income tax benefits or assets relating to tax operating losses generated by our subsidiaries since our results of operations include a 100% valuation allowance against net deferred tax assets. For the year ended December 31, 2006, the net valuation allowance increased by approximately $24.4 million, to $49.1 million.
ESC’s (Loss) income from operations, previously included in the technical services segment, for the period from January 1, 2006 to September 15, 2006, and the year ended December 31, 2005, now reported in discontinued operations, are as follows:
Income on disposal of discontinued operations. Income on disposal of discontinued operations was $0.7 million. This income is presented in the Consolidated Statement of Operations as Income on disposal of discontinued operations, a component of discontinued operations. The components of this income are summarized below.
(3) Transaction costs include advisory fees directly associated with the sale, of which $0.6 million were paid to Friedman Billings Ramsey & Co, Inc. (‘‘FBR’’).
For the 2007 underwriting year, we provided 90% of the capital requirements of Syndicate 4000. From its inception in 2004 through the 2006 underwriting year, we provided all of the capital requirements of Syndicate 4000. In our financial statements, we included all of the results of business written by Syndicate 4000 since its inception in 2004 through the 2006 underwriting year and 90% of the results of business written by Syndicate 4000 in the 2007 underwriting year.
Our participation in Syndicate 4000 is represented by and recorded as our proportionate share of the underlying assets and liabilities and results of operations of Syndicate 4000 for each underwriting year because we hold an undivided interest in each asset and we are proportionately liable for each liability of Syndicate 4000. The results reported for the year ended December 31, 2007 comprise our 90% share of the results of the 2007 underwriting year activities of
Syndicate 4000 plus all of the results of prior underwriting year activities. The results reported for the year ended December 31, 2006 comprise all of the activities of Syndicate 4000 during that period.
Premiums. Gross and net premiums written were negative $20.9 million and $17.4 million for the year ended December 31, 2007 compared to $60.1 million and $26.0 million for the year ended December 31, 2006. The significant decrease in our specialty insurance run-off segment’s gross and net premiums written was due to the decision to cease writing new business in 2006, our decision to run-off the majority of our businesses and the effect of premium returns to our clients on policy cancellations and the transfer of policies to third parties.
For the year ended December 31, 2007 we returned or transferred approximately $23.3 million of gross written premiums, compared to $58.7 million for the year ended December 31, 2006.
Premiums ceded. Premiums ceded were negative $3.5 million during the year ended December 31, 2007, a decrease of $37.6 million, compared to $34.1 million for the year ended December 31, 2006, reflecting the impact of policy cancellations and transfers and the associated premium returns collected from our reinsurers.
Net premiums earned. Net premiums earned during the year ended December 31, 2007 were $6.1 million, a decrease of $107.2 million, compared to $113.3 million for the year ended December 31, 2006, representing the reductions of premiums written and the return of premiums to our clients. Gross premiums written and ceded premiums are earned over the period of each insured risk. The terms of our insurance contracts range from between one and ten years with the majority of our contracts being for a one year period.
Other income (expense). Other expense was $2.2 million for the year ended December 31, 2007, compared to other income of $2.9 million for the year ended December 31, 2006 and relates to income, including fees, recognized on non-traditional insurance contracts. The decrease in other income is due to the recording of the return of all fee income earned to date as a result of our decision to cancel one of our non-traditional statutory surplus relief life reinsurance contracts as discussed in more detail in ‘‘Our results’’ above. At December 31, 2007 we have recorded the return of all fee income, net of commissions, in the amount of $3.7 million reflecting net fee income earned since inception of the contract, which will become payable upon the effectiveness of the rescission, if at all.
Net losses and loss expenses. Net losses and loss expenses had a favorable impact of $16.6 million for the year ended December 31, 2007 compared to an expense of $65.7 million for the year ended December 31, 2006. Net losses and loss expenses are a function of our net premiums earned and our expected ultimate losses and loss expenses for reported and unreported claims on contracts of insurance and reinsurance underwritten. The decrease in net losses and loss expenses is due largely to the net favorable loss development in maturing accident periods in several of our product lines, the reduction of losses as a result of the cancellation of policies, particularly in our HBW program, and the substantial decline in the number of insurance contracts we entered into and the associated net premiums earned. We continue to participate in lines of business where claims may not be reported for some period of time after those claims are incurred.
segment’s gross premiums written reflects the decrease in our reinsurance business lines as a result of our decision to discontinue the writing of new and renewal business in our reinsurance business line, combined with changes in estimates in written premiums, return premiums and contract commutations. Ceded written premiums in 2006 were greater than gross premiums written because of the purchase of additional reinsurance protection for exposures in our marine, technical risk and aviation product line.
Premiums ceded Premiums ceded were $4.5 million during the year ended December 31, 2007 compared to $14.0 million for the year ended December 31, 2006. The decrease in our ceded premiums written largely reflects the decrease in gross premiums written. We also purchased additional retrocessional coverage for our marine, technical risk and aviation reinsurance product line to limit our future probable maximum losses during 2007. These retrocession treaties provide us with protection on an excess of loss, quota share treaty and facultative basis for policies written in our reinsurance product lines of business. Ceded premiums are earned over the period of each insured risk.
Net premiums earned. Net premiums earned of $0.3 million for the year ended December 31, 2007 decreased by $46.2 million compared to $46.5 million for the year ended December 31, 2006. The decrease reflects the decrease in earning of premiums on contracts written in prior periods, the impact of the decision to discontinue writing of new and renewal business in our reinsurance and insurance lines of business and the impact of changes in premium estimates and premiums written. Gross premiums written in our specialty reinsurance run-off segment are being earned over the periods of reinsured or underlying insured risks which are typically one year.
Acquisition expenses. Acquisition expenses were favorable $1.1 million for the year ended December 31, 2007 compared to an expense of $12.5 million for the year ended December 31, 2006. The decrease in acquisition expenses was due to the decrease in the number of reinsurance contracts we entered into and the associated net premiums earned. These acquisition expenses primarily represented brokerage and ceding commissions.
Net losses and loss expenses. Net losses and loss expenses were $53.8 million for the year ended December 31, 2007, an increase of $3.4 million, compared to $50.4 million for the year ended December 31, 2006. Net losses and loss expenses are a function of our net premiums earned and our expected ultimate losses and loss expenses for reported and unreported claims on contracts of insurance underwritten.
Syndicate 4000 has exposure to the subprime mortgage developments in the United States through D&O and E&O policies it has written primarily in its financial institutions and professional lines of business. We expect claims activity within the D&O and E&O insurance markets to rise as a result of an increase in class action lawsuits filed against public companies due to market losses and related stock price depreciation associated with the subprime mortgage and credit crisis in the United States. As a result, the increase in net losses and loss expenses is primarily due to $9.8 million of new losses and loss expenses recorded in relation to our estimates associated with this exposure. We have recorded specific reserves for reported claims of $11.3 million in the results for the year ended December 31, 2007. In addition we have recorded $12.0 million of IBNR reserves, following an actuarial review of the Syndicate’s portfolio and its exposure to further claims from these subprime mortgage developments, based to a significant degree, on industry loss estimates of the total expected losses. We have also recorded a reinsurance recoverable of $13.5 million on purchased contracts of reinsurance. Due to these loss and loss expense notifications, a premium deficiency reserve amounting to approximately $8.0 million has been recorded. This adjustment has been reflected in the statement of operations through acquisition costs, as more fully described below.
Technical services revenues. Technical services revenues were $1.7 million for the year ended December 31, 2007, compared to $3.3 million for the year ended December 31, 2006. Technical
services revenues are mainly derived from our environmental liability assumption programs. We expect that our technical services revenues will continue to decrease in future periods as the remediation is closer to completion.
General and administrative expenses. General and administrative expenses were $2.3 million for the year ended December 31, 2007, compared to $4.3 million for the year ended December 31, 2006. The decrease is due to the fact that most of the remediation work on one of our environmental liability assumption programs occurred during the first quarter of 2006. The remediation is now close to being completed and, as a result, has not generated expenses to the same extent as it did in 2006. We expect that our technical services expenses will continue to decrease in future periods as the remediation is closer to completion.
Premiums. Gross and net premiums written were $60.1 million and $26.0 million for the year ended December 31, 2006 compared to $311.3 million and $194.9 million for the year ended December 31, 2005. The significant decrease in our specialty insurance run-off segment’s gross and net premiums written was due to the decision to cease writing new business in 2006, our decision to run-off the majority of our businesses and the effect of premium returns to our clients and the transfer of policies to third parties.
The table below shows gross and net premiums written by product line for the years ended December 31, 2006 and 2005, whether written on a traditional insurance, program or structured basis.
During the year ended December 31, 2006, we continued to write the HBW program in our technical risk property product line under the terms of the managing agency agreement which expired on December 2, 2006. This program accounted for the substantial majority of total specialty insurance run-off segment gross and net premiums written in the year ended December 31, 2006. The policies in our HBW program have been underwritten by a third-party agent which is instructed to follow our underwriting guidelines. Our HBW gross premiums written during the year ended December 31, 2006 are summarized in the table below by specialty risk class.
Premiums ceded were $34.1 million during the year ended December 31, 2006, a decrease of $82.3 million compared to $116.4 million for the year ended December 31, 2005. The decrease in premiums ceded is a result of the decrease in our gross premiums written.
Other income. Other income was $2.9 million for the year ended December 31, 2006 and related to income, including fees, recognized on non-traditional insurance contracts.
Acquisition expenses. Acquisition expenses were $18.0 million for the year ended December 31, 2006 compared to $21.8 million for the year ended December 31, 2005. The decrease in acquisition expenses was due to the substantial decline in the number of insurance contracts we entered into and the associated net premiums earned. These acquisition expenses primarily represented brokerage fees, commission fees and premium tax expenses and were net of ceding commissions earned on purchased reinsurance treaties.
Premiums. Gross and net premiums written were $6.8 million and $(7.2) million for the year ended December 31, 2006 compared to $216.9 million and $133.5 million of gross and net premiums written for the year ended December 31, 2005. The decrease in our specialty reinsurance run-off segment’s net premiums written reflects the decrease in our reinsurance business lines as a result of our decision to discontinue the writing of new and renewal business in our reinsurance business line. Ceded written premiums in 2006 were greater than gross premiums written because of the purchase of additional reinsurance protection for exposures in our marine, technical risk and aviation product line.
Included in our expected ultimate losses during the year ended December 31, 2006 are specific loss estimates on contracts of reinsurance insuring claims arising from Hurricanes Katrina, Rita and Wilma. Our estimate of our specialty reinsurance run-off segment’s exposure to ultimate claim costs associated with these hurricanes based on currently available information is $76.6 million (including net reinstatement premiums), of which $5.0 million is included in net losses and loss expenses for the year ended December 31, 2006 compared to $71.9 million for the year ended December 31, 2005. Our estimate of ultimate losses from these events was primarily based, at the time of the estimate, on then available information, claims notifications, industry loss estimates, output from industry models, a review of affected contracts and discussion with cedants and brokers.
Net premiums earned during the year ended December 31, 2006 were $65.5 million, an increase of $29.0 million, compared to $36.5 million for the year ended December 31, 2005, representing amortization of premiums written and ceded during the years ended December 31, 2004, 2005 and 2006. The increase in our net premiums earned was largely due to the growth of our net premiums written from our Lloyds syndicate. This increase was partially offset by the effect of the A.M. Best’s ratings downgrade and subsequent uncertainties around the business and achievements of gross premium estimates resulting in the acceleration of the minimum ceded earned premium as described above. Gross premiums written and ceded premiums are being earned over the period of each insured risk which is typically one year.
Our Lloyd’s segment net loss ratio was 76.9% for the year ended December 31, 2006, an increase of 9.4% compared to a net loss ratio of 67.5% for the year ended December 31, 2005. The increase in the Lloyd’s segment net loss ratio is primarily due to the effect of the excess of loss reinsurance contract we entered into that requires us to cede minimum fixed amounts of our premium, regardless of the amount of gross premium written in Syndicate 4000 in the year ended December 31, 2006.
agent expenses. General and administrative expenses includes a number of fixed costs including the Lloyd’s Central Fund contributions which are based on a percentage of underwriting capacity set at the start of the underwriting year, and employee and related expenses.
General and administrative expenses. Direct general and administrative expenses were $4.3 million for the year ended December 31, 2006, compared to $18.5 million for the year ended December 31, 2005. The decrease is due to a significant portion of remediation of our QLT Buffalo LLC environmental liability assumption program occurring during the second and third quarters of 2005.
Quanta Holdings is organized as a Bermuda holding company and as such, has no direct operations of its own. Quanta Holdings’ assets currently consist of investments in our subsidiaries through which we conducted our specialty insurance and reinsurance run-off and our technical services operations. We have operations in the U.S., Bermuda and Ireland.
As a holding company, Quanta Holdings has and will continue to have funding needs for general corporate expenses, taxes and the payment of other obligations. Funds to meet these obligations are expected to come primarily from dividends, interest and other statutorily permissible payments from its operating subsidiaries. We believe that the operating subsidiaries have sufficient assets to pay their respective currently foreseen insurance liabilities as they become due. However, the ability of our operating subsidiaries to make payments to Quanta Holdings is limited by the applicable laws and regulations of the domiciles in which the subsidiaries operate. These laws and regulations subject our subsidiaries to significant restrictions and require, among other things, the maintenance of minimum solvency requirements and limitations regarding the amount of dividends, or the approval of certain regulators in the event of a return of capital, that these subsidiaries can ultimately pay to Quanta Holdings. In addition, following the withdrawal of our A.M. Best rating, the Bermuda Monetary Authority, the regulator of our most significant subsidiary, Quanta Bermuda, amended Quanta Bermuda’s license to, among other things, restrict it from making any dividend payments to Quanta Holdings without the approval of the BMA or to enter into new transactions. We are working with applicable regulatory authorities to facilitate our ability, as the business we wrote expires over time, to pay dividends or return capital from our insurance operating subsidiaries to the holding company. The payment of dividends or return of capital to the holding company requires regulatory approval. In addition, because we have regulated subsidiaries which are owned by other regulated subsidiaries, which we refer to as ‘‘stacked subsidiaries,’’ in certain instances obtaining approval to dividend funds or return capital requires the approval of a number of regulators before the funds can be made available to Quanta Holdings. Following approval from the Bermuda Monetary Authority we declared a dividend of $1.75 per share or approximately $122.7 million which is payable on March 28, 2008 to shareholders of record on March 25, 2008.
We are also subject to constraints under the Bermuda Companies Act that affect our ability to pay dividends on our shares. We may not declare or pay a dividend or make a distribution if we have
reasonable grounds for believing that we are, or will after the payment be, unable to pay our liabilities as they become due or if the realizable value of our assets will thereby be less than the aggregate of our liabilities and our issued share capital and share premium accounts. While we currently meet these requirements, there can be no assurance that we will continue to do so in the future.
As of March 3, 2008, prior to the payment of the March dividend our cash and cash equivalents and investments of approximately $667.4 million following the sale of our interest at Lloyd’s. Our cash and cash equivalents and investment balances include approximately $96.8 million that is pledged as collateral for letters of credit, approximately $152.5 million held in trust funds for the benefit of ceding companies and to fund our obligations associated with the assumption of an environmental remediation liability, $37.3 million held in trust funds that are related to our deposit liabilities and $27.9 million that is on deposit with, or has been pledged to, U.S. state insurance departments. After giving effect to these assets pledged or placed in trust, we estimate that we have unrestricted net investments of $352.9 million, including net cash and cash equivalents of approximately $19.0 million. This amount is held mainly by our operating subsidiaries in Bermuda, the U.S. and Europe.
Some of our insurance and many of our reinsurance contracts contain termination rights that were triggered by the A.M. Best rating downgrades. Some of these insurance and reinsurance contracts also require us to post additional security. Further, the downgrade in our rating from ‘‘B++’’ (very good) to ‘‘B’’ (Fair) triggered additional termination provisions and required the posting of additional security in certain of our other insurance and reinsurance contracts. We were required to post additional security either through the issuance of letters of credit or the placement of securities in trust under the terms of those insurance or reinsurance contracts. In addition, many of our insurance contracts and certain of our reinsurance contracts provide for cancellation at the option of the policyholder regardless of our financial strength rating. Accordingly, we may also elect to post security under these other contracts.
As of December 31, 2007, we had net cash and cash equivalent balances and other investments of approximately $228.8 million that are available to post as security or place in trust. We currently believe that we have sufficient assets to pay our foreseen liabilities as they become due and meet our foreseen collateral requirements within our subsidiaries.
As at December 31, 2007, the market value of our total investment portfolio including cash and cash equivalents was $801.7 million, of which $559.5 million related to trading fixed maturity
Our investment guidelines require that the average credit quality of the investment portfolio is typically Aa3/AA− and that no more than 5% of the investment portfolio’s market value shall be invested in securities rated below Baa3/BBB−. As of December 31, 2007, all of the fixed maturity investments were investment grade, with a weighted average credit rating of ‘‘AA+’’ based on ratings assigned by S&P.
The following table shows the amortized cost and fair value of our fixed maturities with exposure to subprime or Alt-A mortgages as at December 31, 2007.
Our reserves for losses and loss adjustment expenses, net of reinsurance recoverable, totaled $376.6 million as December 31, 2007 compared to $402.4 million as of December 31, 2006. This includes $134.5 million and $71.6 million as of December 31, 2007 and 2006 relating to our Lloyd’s segment.
Of our total reserves for losses and expenses of $525.1 million as of December 31, 2007 approximately $400.9 million or 76% is represented by our estimate of incurred but not reported reserves (IBNR). Excluding Lloyd’s, approximately 74% is represented by IBNR. However, we have participated in lines of business where claims may not be reported for some period of time after those claims are incurred.
Our reinsurance recoverables as of December 31, 2007 totaled $148.4 million, of which $1.5 million was currently due, compared to reinsurance recoverables as of December 31, 2006 of $221.2 million. This includes $25.8 million and $28.8 million as of December 31, 2007 and 2006 relating to our Lloyd’s segment. The decrease in our reinsurance recoverable balance reflects cash received from reinsurers during the year and, to a lesser extent, favorable developments in our estimates of gross loss and loss expenses and our commutation activity. As of December 31, 2007, our reinsurance recoverable balances also include our estimate of unpaid loss expenses recoverable totaling $16.4 million relating to Hurricanes Katrina, Rita and Wilma and $10.9 million in relation to subprime mortgage developments. Our estimate of our reinsurance recoverable balance associated with these losses is based on currently available information, claim notifications received to date, industry loss estimates, output from industry models, a detailed review of affected ceded reinsurance contracts and an assessment of the credit risk to which the Company is subject. The actual amount of future loss receipts relating to these loss events may vary significantly from this estimate.
The average credit rating of the Company’s reinsurers as of December 31, 2007 is ‘‘A’’ (excellent) by A.M. Best. As of December 31, 2007, the losses and loss adjustment expenses recoverable from reinsurers balance in the consolidated balance sheet included approximately 34.6% due from Everest Reinsurance Ltd., a reinsurer rated ‘‘A+’’ (superior) by A.M. Best.
Our shareholders’ equity was $350.7 million as of December 31, 2007 compared to $328.3 million as of December 31, 2006, reflecting an increase of $22.4 million that was primarily the result of a net income to common shareholders of $22.4 million for the year ended December 31, 2007.
We have recorded a net deferred income tax benefit of $5.3 million related to tax operating losses generated in our Lloyd’s segment for the year ended December 31, 2007. For the year ended December 31, 2007, our net valuation allowance increased by approximately $1.8 million, to $50.9 million. These deferred tax assets were generated primarily from net operating losses. The realization of deferred tax assets is dependent on future taxable income and future reversals of existing taxable temporary differences. Based upon our assessment of historical data and future earnings, it is our belief that it is more likely than not that the $5.3 million net deferred tax asset established for the U.K. NOL carryforwards will be realized in future periods by Quanta 4000. We will continue to periodically assess the realizability of our net deferred tax asset and adjust the valuation allowance accordingly.
(1) Consisted of a secured letter of credit dated October 27, 2006. The total commitment under our letter of credit facility was $110 million as of December 31, 2007 and was $240 million as of December 31, 2006. As of December 31, 2007, $91.6 million of letters of credit were outstanding under this facility. See ‘‘Liquidity’’ below for a discussion of our new credit facility.
(3) During the year ended December 31, 2007, we repurchased all of our Series A preferred shares at a price of $22.50 per share. The aggregate purchase price for the Series A preferred shares was $70.4 million which resulted in a gain of $2.4 million, net of repurchase costs of $2.2 million and write off of original deferred issuance costs of $3.3 million.
We used net operating cash flow of approximately $92.8 million during the year ended December 31, 2007, primarily due to the payments during the year of claims and claim expenses, general and administrative expenses partially offset by reinsurance recoverable received. During the same period, net cash of $209.4 million was provided by receipts from sales of investments, net of purchases, and net cash of $127.1 million was used in the repurchase of the Series A preferred shares and junior subordinated debentures. Our cash flows from investing activities for the year ended December 31, 2007 provided us with sufficient liquidity to meet operating cash requirements during that period. A description of our cash, cash equivalents, investments and restricted assets is provided in ‘‘Financial Condition and Liquidity’’ above.
income, reinsurance recoveries, and, to a lesser extent, our secured bank credit facility and collections of receivables for technical services rendered to third parties. As a result of the A.M. Best rating actions in 2006, the resulting loss of business and business opportunities, our decision to cease writing new business in all our product lines, excluding business written at Lloyd’s, cash flows associated with the receipt of premiums written in our run-off segments will continue to decrease substantially. Due to the sale of our interest in Syndicate 4000, the receipt of premiums written by Syndicate 4000 will cease during the first quarter of 2008. A description of our cash, cash equivalents, investments and restricted assets is provided in ‘‘Financial Condition and Liquidity’’ above.
The A.M. Best rating action discussed above caused a default under our credit facility led by JPMorgan (the ‘‘JPMorgan credit facility’’) during 2006. The lenders waived the default under the JPMorgan credit facility until October 27, 2006 and on that date we entered into a new credit facility described below.
Under the ING credit facility, the lenders issue from time to time, for the account of the designated subsidiary borrowers, one or more back-to-back letters of credit naming JPMorgan Chase Bank, N.A. as beneficiary in the face amount equal to the face amount of the outstanding letters of credit under the JPMorgan Credit Agreement, and other letters of credit in an aggregate face amount up to the aggregate commitment. The facility is secured by specified investments of the borrowers. Availability for issuances of letters of credit on account of any borrower is based on the amount of eligible investments pledged by the applicable borrower(s) and no material adverse change provisions. Regulatory restrictions will also limit the amount of investments that may be pledged by certain U.S. insurance borrowers and, consequently, the amount available for letters of credit under the facility on account of those borrowers. Quanta Holdings unconditionally and irrevocably guaranteed all of the obligations of our subsidiaries to the lenders under the ING credit facility.
Some of our insurance and many of our reinsurance contracts contained termination rights that were triggered by the A.M. Best rating action. Some of these insurance and reinsurance contracts also required us to post additional security either through the issuance of letters of credit or the placement of securities in trust under the terms of those insurance or reinsurance contracts. We may also elect to post security under other insurance contracts in order to maintain that business. As of December 31, 2007, we had cash and cash equivalent and investment balances of approximately $228.8 million that were available to post as security or place in trust.
and incentive payments, other operating expenses, premiums ceded, capital expenditures and taxes. We may also be required or choose to place capital in our operating subsidiaries. Following the sale of Syndicate 4000 we are no longer committed to provide any of the Syndicate’s capital requirements for any underwriting years of account.
Quanta Holdings is dependent on dividends and other payments from its operating subsidiaries to satisfy its obligations. The potential for a large claim under one of our insurance or reinsurance contracts means that we may need to make substantial and unpredictable payments within relatively short periods of time. As a result of our decision to cease underwriting or seeking new business and to place most of our remaining specialty insurance and reinsurance lines into orderly run-off, we have incurred substantial costs, including severance payments, in connection with the implementation of changes based on such decision. This decision also involves significant risks that may result in restructuring charges and unforeseen expenses and costs associated with exiting lines of business and complications or delays, including, among others things, the risk of failure. Additionally, we have entered into agreements with Peter D. Johnson and Jonathan J.R. Dodd, and a number of other key employees that provide for specified severance payments in the event of termination without cause or following a change of control. In the event of payout to all employees covered by these agreements, our cash requirements would include payments in an aggregate amount of up to approximately $5.9 million. Of this amount, $0.7 million is included within our accounts payable and accrued expenses at December 31, 2007. During the year ended December 31, 2007, we have incurred severance charges of $0.3 million.
We expect that our cash requirements for the payment of claims will be significant in future periods as we receive and settle claims, including those relating to the claims for the hurricanes that occurred in 2005.
Quanta Holdings depends on future dividends and other permitted payments from its subsidiaries to pay any dividends. Approval from regulatory authorities is required and we will continue to work with applicable regulatory authorities to facilitate dividends or capital return from our subsidiaries to Quanta Holdings. Further, our ability to pay dividends is subject to regulatory and contractual constraints, including the terms of the ING credit facility. Working with these regulators will take a long period of time and require the Company to meet many conditions. Following approval from the Bermuda Monetary Authority we declared a dividend of $1.75 per share or approximately $122.7 million which is payable on March 28, 2008 to shareholders of record on March 25, 2008.
For additional discussion concerning risks relating to our dividend policy and our holding company structure and its effect on our ability to receive and pay dividends, see ‘‘Item 1A.-Risk Factors-Risks Related to the Runoff-Our holding company structure and certain regulatory and other constraints, including our credit facility, affect our ability to pay dividends on our shares and return capital’’.
As of December 31, 2007, we do not have any off-balance sheet arrangements with special purpose entities or variable interest entities.
Our Bermuda and Irish operating subsidiaries are not licensed, accredited or otherwise approved as reinsurers anywhere in the United States. Many U.S. jurisdictions do not permit insurance companies to take credit on their U.S. statutory financial statements for reinsurance to cover unpaid liabilities, such as loss and loss adjustment expense and unearned premium reserves, obtained from unlicensed or non-admitted insurers without appropriate security acceptable to U.S. insurance commissioners. Typically, this type of security will take the form of a letter of credit issued by an acceptable bank, the establishment of a trust, funds withheld or a combination of these elements.
Our consolidated financial statements contain certain amounts that are inherently subjective in nature and require management to make certain judgments, estimates and assumptions in the application of accounting policies used to determine inherently subjective amounts reported in the consolidated financial statements. The use of different assumptions and estimates could produce materially different estimates of the reported amounts. In addition, if actual events differ materially from management’s assumptions used in applying the relevant accounting policy, there could be a material adverse effect on our results of operations and financial condition and liquidity.
Premiums written and ceded on certain types of contracts include estimates based on information received from the ceding companies, brokers or insureds. Estimates of written premiums are re-evaluated over the term of the associated contracts as underwriting information becomes available and as actual premiums are reported by the ceding companies, brokers or insureds. Subsequent changes to the premium estimates and cancellations are recorded as adjustments to premiums written in the period in which they become known. Such adjustments to estimated premium may be significant.
Adjustments related to retrospective rating provisions that adjust estimated premiums or acquisition expenses are recognized over contract periods in accordance with the underlying contract terms based on current experience under the contracts. Reinstatement premiums that reinstate coverage limits under pre-defined contract terms are written and earned at the time the associated loss event occurs. The original premium is earned over the remaining exposure period of the contract. Profit commissions are expenses that vary with and are directly related to acquiring new and renewal insurance and reinsurance business. Profit commission accruals are recorded as acquisition costs and are adjusted at the end of each reporting period based on the experience of the underlying contract. No claims bonuses are accrued as a reduction of earned premium and are adjusted at the end of each reporting period based on the experience of the underlying contract. Such adjustments related to retrospective rating provisions, reinstatement premiums, profit commissions and no claims bonuses may be significant.
Ceded reinsurance or retrocessional coverage is used to increase our underwriting capacity and to limit individual and aggregate exposures to risks of losses arising from contracts of insurance or reinsurance that it underwrites. Reinsurance premiums ceded to reinsurers are recorded and earned in a manner consistent with that of the original contracts or policies written and the terms of the reinsurance agreements.
Premiums written and ceded relating to the unexpired periods of coverage or policy terms are recorded on the consolidated balance sheet as unearned premiums and deferred reinsurance premiums.
For those contracts that transfer significant underwriting risk only and for reinsurance contracts where it is not reasonably possible that we can realize a significant loss even though it assumes significant insurance risk, the deposit asset or liability is measured based on the unexpired portion of the coverage provided. The deposit asset or liability is adjusted for any losses incurred or recoverable based on the present value of the expected future cash flows arising from the loss event with the adjustment being recorded in net losses and loss expenses within our results of operations.
We report commutations in accordance with SFAS No. 113, ‘‘Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts’’ (‘‘SFAS 113’’).
A commutation generally results in a single net payment to, or receipt from, a policyholder or ceding company. This payment or receipt settles all applicable outstanding balances with the policyholder or ceding company, including reserves for loss and loss expenses, unearned premiums, reinsurance balances payable, premiums receivable, deferred acquisition costs and funds withheld. Typically, the settlement of existing loss and loss expenses reserves is recorded as a paid claim, and settlement of unearned premiums is recorded as an adjustment to gross written and earned premiums, and acquisition expenses. Net gains or losses arising on commutation arrangements are primarily recorded within either net losses incurred, premiums earned, or a combination of both.
We believe the arrangement, including the client’s option to recapture, and the assumption of the life insurance contracts constitute one contract with minimal mortality, credit or other insurance or economic risk which results in deposit accounting. If our client does not recapture the underlying
In respect of life reinsurance arrangements written on a coinsurance basis, where investment assets have been transferred to us, such assets have been recorded within our trading investment portfolio. A deposit liability has been recorded in the consolidated balance sheet in accordance with SFAS 97 ‘‘Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments’’ for non-risk investment contracts as an interest bearing instrument using the effective yield method. The investments related to the deposit liability are held in trust funds and are pledged to the ceding companies.
Also included in other income is an amount of $3.7 million (net of commission of $0.8 million), which has been recorded as the return of all fee income received to date as a result of our decision to rescind a surplus life relief insurance contract. As of December 31, 2007, 2006 and 2005, we have provided approximately $29.3 million, $30.1 million and $33.2 million (unaudited) of statutory surplus relief to a U.S. insurance company under this contract. This contract is further discussed in Note 13(h) to the financial statements.
The remaining other income is derived from a limited number of non-traditional contracts relating to revenues earned on reinsurance contracts accounted for as deposits. Although these contracts did possess some underwriting and timing risks as prescribed by SFAS No. 113, we do not believe we are exposed to a reasonable possibility of significant loss.
Acquisition expenses are policy issuance related costs that vary with and are directly related to the acquisition of insurance and reinsurance business, and primarily consist of commissions, third party brokerage and insurance premium taxes. Ceding commission income consists of commissions we receive on business that we cede to our reinsurers. Acquisition expenses also include the sliding scale net contingent commissions relating to one program which generate either additional net commission expense or net commission returns based on loss ratio development. Acquisition expenses and commission income are recorded and deferred at the time the associated premium is written or ceded and are subsequently amortized in earnings as the premiums to which they relate are earned or expensed. Acquisition expenses are reflected in the consolidated statement of operations net of ceding commission income from reinsurers. Acquisition costs relating to unearned premiums are deferred in the consolidated balance sheet as deferred acquisition costs and reported net of commission income relating to deferred reinsurance premiums ceded.
In February 2007, the Financial Accounting Standards Board (‘‘FASB’’) issued Statement of Financial Accounting Standards No. 159 ‘‘The Fair Value Option for Financial Assets and Financial Liabilities’’ (‘‘SFAS 159’’). This Statement permits entities to choose to measure many financial instruments and certain other items at fair value, with changes in fair value recorded in net income. The statement is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. Early adoption was permitted as of the beginning of a fiscal year that begins on or after November 15, 2006, provided the entity also elects to apply the provisions of FASB Statement No. 157, ‘‘Fair Value Measurements’’ (‘‘SFAS 157’’). SFAS 157 established a hierarchy for inputs in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the observable inputs are used when available.
Following the adoption of SFAS 159, all investments are now classified as ‘‘Trading’’ and all subsequent changes to the fair value of the investment portfolio are recorded as net gains (losses) on investments in the consolidated statements of operations. Prior to January 1, 2007, unrealized gains and losses were included within accumulated other comprehensive income as a separate component of shareholders’ equity.
Realized gains and losses on sales of investments continue to be determined on a first-in, first-out basis. Net investment income includes interest income on fixed maturity investments, recorded when earned, and the amortization of premiums and discounts on investments, net of investment management and custody expenses.
Beginning January 1, 2007, assets and liabilities recorded at fair value in the consolidated balance sheet are categorized based upon the level of judgment associated with the inputs used to measure their fair value. An asset or a liability’s categorization within the fair value hierarchy is based on the lowest level of significant input to its valuation. Hierarchical levels-defined by SFAS 157 and directly related to the amount of subjectivity associated with the inputs to fair valuation of these assets and liabilities-are as follows:
• Level III - Valuations based on inputs that are significant to the overall fair value measurement but are not observable. These are generally company generated inputs and are not market based inputs.
Short-term investments include highly liquid debt instruments and commercial paper that are generally due within one year of the date of purchase and are held as part of the investment portfolios that are managed by independent investment managers.
Capitalization of costs ceases as soon as the project is substantially complete and ready for its intended purpose. The carrying value of software costs is reviewed by us whenever events or changes in circumstances indicate that its carrying amount may not be recoverable, and a loss is recognized when the value of estimated undiscounted cash flow benefit related to the asset falls below the unamortized cost.
and are reviewed by independent actuaries. In applying these techniques, management uses estimates as to ultimate loss emergence, severity, frequency, settlement periods and settlement costs. In making these estimates, we rely on the most recent information available, including pricing information, industry information and on our historical loss and loss expense experience.
The estimation of unpaid loss liabilities will be affected by the type or structure of the policies that we have written. For specialty insurance run-off business, we often assumed risks for which claims experience will tend to be frequency driven. As a result, historical loss development data may be available and traditional actuarial methods of loss estimation may be used. Conversely, the available amount of relevant loss experience used to quantify the emergence, severity and payout characteristics of loss liabilities is limited for policies written where we expect that potential losses will be characterized by lower frequency but higher severity claims.
lines that we wrote such as property, marine, and aviation. Long-tail business describes lines of business for which actual losses may not be known for some time or for which the actual amount of loss may take a significantly longer period of time to emerge or develop. We wrote casualty, professional and environmental lines of business that are generally considered longer tail in nature. Due to the fact that loss emergence and settlement periods can be many years in duration, these lines of business will have more variability in the estimates of their loss and loss expense reserves.
We continually review and adjust our reserve estimates and reserving methodologies taking into account all currently known information and updated assumptions related to unknown information. Loss and loss expense reserves established in prior periods are adjusted in current operations as claim experience develops and new information becomes available. Any adjustments to previously established reserves may significantly impact current period underwriting results and net income by reducing net income.
We have assumed environmental liabilities in exchange for remediation fees and contracts to perform the required remediation in accordance with the underlying remediation agreements.
We estimate our initial and ongoing ultimate liabilities for environmental remediation obligations based upon actual experience, past experience with similar remediation projects, technical engineering examinations of the contaminated sites and state, local and federal guidelines. However, there can be no assurance that actual remediation costs will not significantly differ from the estimated amounts.
$0.7 million higher than if it had continued to account for share-based compensation under APB 25. Basic and diluted income (loss) per share for the years ended December 31, 2007 and December 31, 2006, would have been $0.33 and $(0.92), if we had not adopted SFAS 123(R), compared to reported basic and diluted loss per share of $0.32 and $(0.93).
In September 2006, the FASB issued FASB Statement No. 155, ‘‘Accounting for certain hybrid financial instruments’’ (‘‘SFAS 155’’). SFAS 155 amends FASB Statements No. 133, (‘‘Accounting for Derivative Instruments and Hedging Activities,’’ and No. 140, (‘‘Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities’’. SFAS 155 was effective for financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The adoption of SFAS 155 on January 1, 2007 has not affected our financial position or results of operations.
See Note 2(y) to the consolidated financial statements which are included in ‘‘Item 8. Financial Statements and Supplementary Data’’ for a discussion of recent accounting pronouncements.