Includes amounts payable to affiliates and others as follows: 2007-Affiliates $448,158; Others $298,772; 2006-Affiliates $447,980; Others $298,653; 2005-Affiliates $447,812; Others $298,541.
TRH conducts its business and assesses performance through segments organized along geographic lines. The Domestic segment principally includes financial data from branches in the United States except Miami, as well as revenues and expenses of the Company (including interest expense on the Company’s senior notes) and stock-based compensation expense. Data from the London and Paris branches and from TRZ are reported in the aggregate as International-Europe and considered as one segment due to operational and regional similarities. Data from the Miami (which serves Latin America and the Caribbean), Toronto, Hong Kong and Tokyo branches are grouped as International-Other and represent the aggregation of non-material segments.
TRH’s operating strategy emphasizes product and geographic diversification as key elements in managing its level of risk concentration. TRH also adjusts its mix of business to take advantage of market opportunities. Over time, TRH has most often capitalized on market opportunities when they arise by strategically expanding operations in an existing location or opening a branch or representative office in new locations. TRH’s operations that serve international markets leverage TRH’s product knowledge, worldwide resources and financial strength, typically utilizing indigenous management and staff with a thorough knowledge of local markets and product characteristics.
In 2007, casualty lines comprised 71% of TRH’s net premiums written, while property lines totaled 29%. In addition, treaty reinsurance totaled 96% of net premiums written, with the balance representing facultative accounts. Moreover, business written by international operations represented 51% of net premiums written in 2007.
TRH’s major sources of revenues are net premiums earned for reinsurance risks undertaken and net investment income earned on investments made. The great majority of TRH’s investments are in fixed maturity securities held to maturity and available for sale with an average duration of 5.8 years as of December 31, 2007. In general, premiums are received significantly in advance of related claims payments.
The following table summarizes TRH’s revenues, income (loss) before income taxes and net income for the periods indicated:
Revenues in 2006 increased compared to 2005 due primarily to increases in Domestic and, to a lesser extent, International-Other net premiums earned and consolidated net investment income, offset in part by decreases in International-Europe net premiums earned and decreases in Domestic and International-Europe realized net capital gains (losses). The increase in International-Other net premiums earned occurred principally in the Miami branch and, to a lesser extent, in the Toronto branch. The London and Paris branches reported the great majority of the decrease in International-Europe net premiums earned in 2006. The most significant increases in consolidated net premiums earned occurred in the other liability, accident & health (“A&H”) and property lines, partially offset by a significant decrease in the auto liability line. The changes in net premiums earned generally reflected prevailing market conditions over recent periods, as discussed below. Net investment income increased in 2006 due largely to an increase in fixed maturity investment income and, to a lesser extent, to an increase in investment income from limited partnerships. The increase in fixed maturity investment income was due in part to investment returns from continued positive operating cash flows and the investment of the net proceeds from the issuance of $750 million principal amount senior notes in December 2005.
Income (loss) before income taxes and net income increased in 2006 as compared to 2005 principally due to increased underwriting profit (loss) and net investment income, offset in part by interest expense on TRH’s senior notes and decreased realized net capital gains. The increased underwriting profit (loss) in 2006 reflects an improved combined ratio resulting largely from reduced significant net catastrophe costs and, to a lesser extent, lower net adverse loss reserve development. Decreases in net catastrophe costs and lower net adverse loss reserve development in the aggregate increased underwriting profit (loss) by $618.4 million in 2006 compared to 2005. The reasons for the increase in net investment income are as discussed earlier. The significant tax expense in 2006 compared to the tax benefit recognized in 2005 tempered the impact of the above changes on net income.
In addition to new company formations, capital markets, including hedge funds, have become more active in assuming reinsurance risk other than from investing in various companies. Numerous hedge funds have provided both pro rata and excess-of-loss reinsurance and retrocessional protections through captive companies or other alternative transactions on a fully collateralized basis for property and energy catastrophe business. One type of an alternative transaction is a vehicle known as a “sidecar”. Sidecars are essentially reinsurance companies set up as a special purpose reinsurer to reinsure a discrete group of risks. The sidecar may have an equity investment from its sponsor as well as additional capital provided by hedge funds and other institutional investors and may also have a debt portion that is provided by a bank or other financial institution.
Hedge funds and other investment vehicles also formed or sponsored reinsurers or used other reinsurance companies as conduits to offer traditional reinsurance as well as industry loss warranties (“ILWs”) and other forms of index-based protections.
One major factor keeping overall casualty rates from sliding too much is the actuarial, claims and underwriting barriers to entry for certain specialty casualty lines of business (such as directors’ and officers’ liability (“D&O”), errors and omissions liability (“E&O”) and medical malpractice classes). TRH has been underwriting casualty business for over 20 years and has developed a favorable reputation for knowledge and commitment to the casualty marketplace. This expertise is difficult to duplicate and has kept some newer competitors from entering these lines. Furthermore, many buyers of casualty reinsurance have been far more cautious about the ability and willingness of reinsurers to pay claims that may not come due for many years. TRH’s capital base, financial strength ratings from major
Further information relating to items discussed in this Executive Overview may be found throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”).
TRH believes its most critical accounting estimates are those with respect to loss reserves, fair value measurements of financial instruments, other-than-temporary impairments, premium revenues and deferred acquisition costs, as they require management’s most significant exercise of judgment on both a quantitative and qualitative basis used in the preparation of TRH’s consolidated financial statements and footnotes. The accounting estimates that result require the use of assumptions about certain matters that are highly uncertain at the time of estimation. To the extent actual experience differs from the assumptions used, TRH’s results of operations and financial condition would be affected. A discussion of these most critical accounting estimates follows:
The reserving process is inherently difficult and subjective, especially in view of changes in the legal and tort environment which impact the development of loss reserves, and therefore quantitative
Standard actuarial methodologies employed to estimate ultimate losses incorporate the inherent “lag” from the time claims are reported to the cedant to when the cedant reports the claims to the reinsurer. Certain actuarial methodologies may be more appropriate than others in instances where this “lag” may not be consistent from period to period. Consequently, additional actuarial judgment is employed in the selection of methodologies to best incorporate the potential impact of this situation.
Generally, for each line of business, significant actuarial judgments are made with respect to the following factors used in the loss reserve setting process:
ELRs for the latest accident years generally reflect the ELRs from prior accident years adjusted for the loss trend (see loss trend factors discussion immediately above), as well as the impact of rate level changes and other quantifiable factors. For certain longer tail lines of business that are typically lower frequency, higher severity classes, such as excess medical malpractice and D&O, ELRs are often utilized for the last several accident years.
Therefore, these assumptions tend to be less critical and the reserves calculated pursuant to these assumptions are subject to less variability for the shorter tailed lines of business.
Healthcare Professional: This business, which is the most significant component of TRH’s medical malpractice line of business, is reviewed separately for treaty and facultative contracts. Pro rata contracts are reviewed separately from excess-of-loss contracts. There is significant volume in all categories. This class is also quite long tailed due to the excess-of-loss nature of most of the contracts. Due to the lack of mature reported experience, B-F methods are generally utilized for the most recent five underwriting years with some weight given to the loss development methods for earlier years. Because almost all of these accounts are actuarially priced, the indications from these reviews are critical to the selection of the ELRs.
In the course of these detailed loss reserve reviews, which are performed by year and by line of business, a point estimate of the loss reserve need is determined. Differences between the indications arising from the various methods are analyzed to understand the drivers of these differences, so that TRH can make a selection based on the methods that are believed to be most appropriate for that line of business. Frequently, the selection is based on an average of the various indications, giving the most weight to the indications deemed most appropriate. Generally speaking, TRH is often able to give more weight to loss development indications for more mature years where credible reported losses exist, as opposed to the more current years, where the B-F method is often highly relied upon due to the lack of credible and mature reported experience. When the actuarial point estimate is compared to the carried reserve, it is recognized that there is an implicit range around the indicated point estimate whereby a carried reserve within that range may be considered reasonable. TRH reviews the appropriateness of the held reserves relative to the indicated point estimate considering many factors. These factors may include, but are not limited to, the amount and direction of any difference between the point estimate and the held reserve, any operational issues which may be difficult to actuarially quantify, various actuarial assumptions on which management may want additional input or any observations regarding optimism or conservatism which management may believe need to be considered. Thus, the carried reserves, as determined by management, may be more or less than the actuarially determined point estimate. As of December 31, 2007, TRH’s carried loss and LAE reserves, net of related reinsurance recoverable, were $6.90 billion and were equal to the actuarial point estimate. As of December 31, 2006, the indicated point estimate was within 0.5% of the carried reserve.
An analysis of the sensitivity of the loss reserve indications to these key assumptions can be performed by measuring the effect of various changes to the assumptions utilized in the reviews. The assumptions made regarding factors considered in the sensitivity analysis, such as loss trends, ELRs and loss development factors, are generally consistent with TRH’s historical experience. Loss development factors, for example, which are used to project reported paid and incurred losses to an ultimate incurred loss, are selected based on the curves fitted to the historical averages which best represent the data. ELRs are based on the ultimate loss ratios for the more mature years adjusted for changes in the rate levels and other quantifiable factors to enable the ELRs to remain consistent with historical experience. In general, it is believed that the vast majority of potential volatility in the loss reserves results from the longer tailed lines of business. For the purpose of these sensitivity analyses, only loss reserves from these longer tailed lines, which represent approximately 65% of total loss reserves, were included in the calculations. Additionally, only those underwriting years where it is believed reasonable for deviations
from the original assumptions to occur were utilized. Generally, the last 12 years were included in the analysis. This sensitivity analysis was performed on unpaid losses and loss adjustment expenses (“gross loss reserves”) and net loss reserves. The results derived from these analyses were roughly equivalent.
While noting that there exists the potential for greater variations, TRH believes utilizing 5% to 10% changes to the assumptions made for both loss development factors and ELRs provide reasonable benchmarks for a sensitivity analysis of the loss reserve estimates. For example, changing the ELRs by 5 percentage points has an impact of about $155 million (either positively or negatively) on the loss reserve estimate. While less likely for most classes of business, we note that changing the ELRs by 10 percentage points has an effect of about $310 million. As previously described, another key assumption is the selection of loss development patterns. The effect of a 5% deviation from the loss development factors utilized in the loss reserve review would be about $285 million. Similarly, a 10% deviation would impact the reserve estimate by about $565 million. Because a downward deviation of 5% or 10% results in negative future development of reported losses for certain years, this scenario is not believed to be as likely as that of an upward deviation of this amount.
Due to the assumptions and methodologies utilized by TRH in its reviews of longer tailed classes of business, changes to the ELRs generally have a much greater impact on the assessment of loss reserves for the most recent few underwriting years while deviations from the loss development factors utilized in the reviews generally are more critical to the loss reserve indications for older underwriting years (i.e., 2002 and prior). Management believes that it is reasonable to simultaneously vary both of the assumptions previously discussed by 5%. The effect of varying these assumptions together by 5% is about $450 million. Increasing these assumptions by 10% simultaneously adds approximately $900 million to the reserve estimates, although management considers this scenario to be significantly less likely than the 5% scenario previously discussed. We also note that the classes of business for which these assumptions are most critical are medical malpractice and D&O, particularly for excess-of-loss business, and excess casualty.
Subsidiaries of AIG manage the investments and perform investment recordkeeping services for TRH. In a recently filed Form 8-K, AIG reported that their independent auditors had concluded and advised AIG that as of December 31, 2007, AIG had a material weakness in its internal control over financial reporting and oversight relating to the fair value valuation of the super senior credit default swap portfolio of AIG Financial Products and AIG Trading Group Inc., including their respective subsidiaries (collectively, “AIGFP”). TRH’s portfolio does not contain any of these instruments, and TRH has determined that the control weakness identified by AIG’s independent auditors did not affect any class of TRH’s investments.
TRH may not realize a full recovery on its investment, regardless of the occurrence of one or more of the foregoing events.
The above criteria also consider circumstances of a rapid and severe market valuation decline, such as that experienced in current credit markets, in which TRH could not reasonably assert that the recovery period would be temporary.
from a sale subsequent to a balance sheet date pursuant to changes in circumstances, the loss is recognized in the period in which the intent to hold the securities to recovery no longer exists.
Management must make certain judgments in the determination of premiums written and earned by TRH. For pro rata treaty contracts, premiums written and earned are based on reports received from ceding companies. Generally for excess-of-loss treaty contracts, premiums are recorded as written based on contract terms and are earned ratably over the terms of the related coverages provided. In recent years, treaty contracts have generated approximately 96% of TRH’s premium revenues. Unearned premiums and prepaid reinsurance premiums represent the portion of gross premiums written and ceded premiums written, respectively, relating to the unexpired terms of such coverages. The relationship between net premiums written and net premiums earned will, therefore, vary depending generally on the volume and inception dates of the business assumed and ceded and the mix of such business between pro rata and excess-of-loss reinsurance.
Acquisition costs, consisting primarily of net commissions incurred on business conducted through reinsurance contracts or certificates, are deferred and then amortized over the period in which the related premiums are earned, generally one year. The evaluation of recoverability of acquisition costs to be deferred considers the expected profitability of the underlying treaties and facultative certificates, which may vary materially from actual results. If the actual profitability varies from the expected profitability, the impact of such differences is recorded, as appropriate, when actual results become known and may have a material effect on results of operations.
Net premiums written increased in 2007 compared to 2006. The sources of the most significant growth were premiums generated by domestic regional offices which were opened during 2006 but generated minimal premium volume in that year, increased international other liability business and A&H premiums generated by TRZ. In addition, the impact of changes in foreign currency exchange
rates contributed significantly to premium growth as shown in the table below. Excluding the impact of the change in foreign currency exchange rates, net premiums written would have increased by approximately 6.4% in 2007 compared to 2006. In general, premium fluctuations reflect prevailing market conditions in recent periods as discussed earlier in MD&A. Premium growth continues to be mitigated by increased ceding company retentions in certain lines.
The following table summarizes the net effect of changes in foreign currency exchange rates compared to the U.S. dollar on the percentage change in net premiums written in 2007 and 2006 compared to its respective immediately prior year.
Generally, reasons for changes in gross premiums written between years are similar to those for net premiums written, except as discussed earlier as regards reinstatement premiums and changes in premiums assumed from an affiliate that, by prearrangement, were ceded in an equal amount to other affiliates (see Note 15 of Notes to Consolidated Financial Statements (“Note 15”)). The decrease in ceded premiums written and earned in 2006 compared to 2005 is due to a reduction in ceded reinstatement premiums relating to 2005 and 2004 catastrophes, partially offset by increases in premiums assumed from an affiliate that, by prearrangement, were ceded in an equal amount to other affiliates.
Net investment income increased in 2007 compared to 2006 principally due to an increase in fixed maturity income, resulting mostly from investment returns from continued positive operating cash flows. The strengthening of foreign currencies against the U.S. dollar increased net investment income by approximately $9 million in 2007 compared to 2006. Net investment income increased in 2006 compared to 2005 due generally to investment returns from continued positive operating cash flows, the investment of the net proceeds from issuance of $750 million principal amount senior notes in December 2005 and increases in investment income from limited partnerships. (See Note 3(b) of Notes to Consolidated Financial Statements for a breakdown of the components of net investment income and the cash flow discussion under Financial Condition and Liquidity.)
For 2007, 2006 and 2005, the pre-tax effective yields on investments were 3.9%, 4.2% and 3.9%, respectively. The pre-tax effective yield on investments represents net investment income divided by the average balance sheet carrying value of investments and interest-bearing cash. The reduction in investment yield in 2007 compared to 2006 resulted in part from the growth in securities lending collateral, which generates minimal net investment income because investment income earned from invested collateral is reduced by interest payable to the collateral provider. The reduction in pre-tax effective yields also resulted in part from a decline in investment return from the equities trading portfolio and a slight reduction of investment income from limited partnerships. Generally, market interest rates on fixed maturities increased during the first half of 2006, losing much of that increase in the second half of the year. The increase in the pre-tax effective yield on investments in 2006 compared to 2005 was due in part to increased investment income from limited partnerships offset in part by a significant increase in 2006 in securities lending collateral, which produces minimal net investment income. In addition, a portion of the increase in investment yield in 2006 compared to 2005 relates to the investment in December 2005 of significant net proceeds from the issuance of senior notes. Such investments generated limited investment income in 2005, due to the minimal amount of time that they were owned. (See Note 2(c) of Notes to Consolidated Financial Statements (“Note 2(c)”).)
values of certain equities, TRH could not assert that certain of these equities would be held to recovery. Therefore, TRH determined that such equities were other than temporarily impaired and recorded write-downs to fair value. Write-downs in 2006 totaled $1.3 million relating to fixed maturities available for sale and $0.1 million relating to equities available for sale. Such write-downs in 2005 totaled $1.7 million relating to equities available for sale. Upon the ultimate disposition of securities for which write-downs have been recorded, a portion of the write-downs may be recovered depending on market conditions at the time of disposition. (See Note 2(c) for criteria used in determination of such write-downs.) In addition, realized net capital gains in 2007 and 2006 were reduced by net foreign currency transaction losses, principally relating to non-functional currencies, of $24.6 million and $11.2 million, respectively.
2007 includes net catastrophe costs of $55.2 million principally relating to European Windstorm Kyrill and floods in the U.K. Net catastrophe costs in the aggregate added 1.4%, 0.4% and 2.4% to the 2007 combined ratios for consolidated, domestic and international, respectively. (See Note 9 for the amounts of net catastrophe costs by segment and the amounts of consolidated gross and ceded catastrophe losses incurred and reinstatement premiums. See discussion in Catastrophe Exposure of the magnitude of TRH’s catastrophe exposures.)
The net adverse development arising from losses occurring in years 1998 through 2002, which represent the great majority of the 2002 and prior development, generally relates to the fact that for many classes within these years, ceding companies continue to experience increased loss costs relative to expectations coupled with an unexpected lengthening of the loss emergence patterns. Generally, loss activity was greater than expected from losses occurring in the D&O and E&O classes, which continued to be impacted by claims relating to corporate bankruptcies and IPO allocation/laddering claims. Also, classes such as Excess Umbrella and Architects & Engineers were impacted by construction defect and other late reported high layer excess claims to a greater extent than expected. Contributing to this increase is the fact that many policies during this period covered underlying contracts that extended over multiple years, which contributed to recent reported loss activity exceeding previous expectations. This has led to an increase in both the frequency and severity of claims entering the reinsured excess-of-loss coverage layers at later points in time than had previously been experienced. The favorable development in accident years 2004 through 2006 results from favorable loss trends.
For 2007 compared to 2006, the changes in gross and ceded losses and LAE incurred each include the effect of a $151 million decrease in losses and LAE incurred relating to business assumed from an affiliate which, by prearrangement with TRH, was then ceded in an equal amount to other affiliates (see Note 15). In addition, the change in gross and ceded losses and LAE incurred includes the changes in gross and ceded catastrophe losses as discussed in Note 9.
TRH’s 2005 results include net catastrophe costs of $543.9 million (domestic $385.8 million; international $158.1 million) principally relating to Hurricanes Katrina, Rita and Wilma and, to a lesser
extent, to Central European floods and European Windstorm Erwin. Such net catastrophe costs include net ceded reinstatement premiums of $61.1 million (domestic $56.2 million; international $4.9 million). Approximately $123.9 million of net catastrophe costs included in international operations relate to hurricanes occurring in the Americas. Net catastrophe costs in the aggregate added 16.0%, 26.3% and 8.2% to the combined ratios for consolidated TRH, domestic and international, respectively.
The underwriting expense ratio for consolidated TRH increased in 2006 compared to 2005 due to an increase of 0.5% in the other underwriting expense component of the ratio and 0.2% in the net commission component of the ratio. The increase in the other underwriting expense component is due largely to increased employee compensation and benefits expenses.
In December 2005, the Company completed a public offering of $750 million principal amount of its 5.75% senior notes due in 2015 (the “Senior Notes”). The Senior Notes remained outstanding at December 31, 2007 and 2006. Interest expense incurred in connection with the Senior Notes totaled $43.4 million, $43.4 million and $2.1 million in 2007, 2006 and 2005, respectively. Interest paid on the Senior Notes totaled $43.1million, $43.1 million and nil in 2007, 2006 and 2005, respectively.
With respect to the unusual effective tax rate in 2005, it is important to note that while the actual tax benefit derived from tax-exempt interest income and the dividends received deduction in 2005 is not significantly different from 2006, the percentage impact in the effective tax rate calculation from such items is significantly greater. The greater impact is caused by the fact that income (loss) before income
taxes (i.e., denominator in the effective tax rate calculation) is a lower absolute value in 2005 compared to 2007 and 2006, due largely to the greater amount of catastrophe costs in 2005. The effective tax rates for 2007 and 2006 reflect the fact that there were no significant net catastrophe costs during those years.
malpractice lines offset in part by a significant decrease in the auto liability line. Income before income taxes for 2007 increased due primarily to increases in underwriting profit, despite a significant increase in catastrophe loss activity (as further discussed below) and increased net investment income offset in part by an increase in realized net capital losses. The increase in underwriting profit reflects a lower combined ratio from the London branch, reflecting improved loss experience, partially offset by a higher combined ratio from the Paris branch due to increased loss activity relating to catastrophe losses occuring in 2007.
Assets increased $799 million in 2007 due largely to a $742 million increase in investments and cash. The increase in investments and cash was due in part to significant net operating cash inflows in recent periods.
Assets increased $1.37 billion in 2006 due largely to an increase of $1.1 billion in securities lending collateral, due to increased demand to borrow securities denominated in certain European currencies, and an increase of $400 million in fixed maturities available for sale reflecting significant positive operating cash flows in recent periods.
2006 compared to 2005-Revenues increased in 2006 due primarily to increases in net premiums earned in all branches, with the largest increases in the Miami and Toronto branches. These increases generally occurred in the property line along with relatively minor increases spread among several other lines. The increased net premiums earned in the Miami branch benefited from favorable market conditions in Latin America following significant catastrophe losses affecting the region in 2005. Income before income taxes increased in 2006 due to increases in underwriting profit (loss) and net investment income. The increase in underwriting profit (loss) is caused in part by decreased net catastrophe costs, which totaled ($6.4) million in 2006 compared to $38.5 million in 2005, and generally improved loss experience in 2006.
Assets increased by $284 million in 2006 due principally to increases in reinsurance recoverable from affiliates on paid and unpaid losses and LAE and increases in investments and cash.
As a holding company, the Company’s assets consist primarily of the stock of TRC. The Company’s liabilities consist primarily of the Senior Notes and related interest payable. The Company’s future cash flows depend on the availability of dividends or other statutorily permissible payments from TRC and its wholly-owned operating subsidiaries, TRZ and Putnam. (See Note 14 of Notes to Consolidated Financial Statements for a discussion of restrictions on dividend payment.) In 2007 and 2006, the Company received cash dividends from TRC of $81.0 million and $88.0 million, respectively. As of December 31, 2007, TRC could pay dividends to the Company of $336.9 million without regulatory approval. In 2005, TRC, the primary operating subsidiary, received a capital contribution of $745 million from the Company. These funds were obtained by the Company in connection with its public offering of the Senior Notes. (See Note 6 of Notes to Consolidated Financial Statements.) The Company uses cash primarily to pay interest to the holders of the Senior Notes, dividends to its common stockholders and, to a lesser extent, operating expenses.
While the expected payout pattern of liabilities (see contractual obligations table later in this section) is considered in the investment management process, it is not the only factor considered as TRH has historically funded its claims payments from current operating cash flows. As a result of such funding history, TRH has not historically maintained a credit facility. TRH’s primary investment goal is to maximize after-tax income through a high quality diversified taxable fixed maturity and tax-exempt municipal fixed maturity portfolio, while maintaining an adequate level of liquidity. See discussion later in this section of the potential liquidity strain that could arise as a result of a significant acceleration of paid losses beyond TRH’s ability to fund such payments.
The following table summarizes the investments and cash of TRH (on the basis of carrying value) as of December 31, 2007 and 2006:
Based on the composition of its investments and cash, TRH considers its liquidity to be adequate through the end of 2008 and thereafter for a period the length of which is difficult to predict, but which TRH believes will be at least one year.
The following table summarizes the ratings of fixed maturities held to maturity and available for sale as of December 31, 2007:
Of the non-asset-backed and collateralized fixed maturities rated Aaa, approximately $3.3 billion represent insured municipal bonds. The underlying ratings of such bonds (i.e., without the rating benefit of insurance) as of December 31, 2007 were as follows: Aaa-7%; Aa-68%; A-23%, Baa-2%; Not rated-less than 1%.
The following table summarizes the ratings of the underlying securities included in the Consolidated Balance Sheet as securities lending collateral as of December 31, 2007:
The ratings of three securities included above as Aaa benefit from insurance. The underlying rating of a domestic HELOC with a fair value of $22.4 million is Ba. The underlying rating of one domestic other asset-backed and collateralized security with a fair value of $18.5 million and one foreign other asset-backed and collateralized security with a fair value of $6.0 million is Aa.
At December 31, 2007, gross loss reserves totaled $7.93 billion, an increase of $458.3 million, or 6.1% over 2006. The increase in gross loss reserves includes the impact of net changes in foreign currency exchange rates of $183 million and gross loss reserve development.
The components of gross loss reserves as of December 31, 2007 and 2006 by major class of business, split between reported (“case”) amounts and IBNR amounts is presented below:
Net loss reserves include amounts for risks relating to environmental impairment and asbestos-related illnesses totaling $124 million at each of December 31, 2007 and 2006, respectively, including $25 million and $30 million at the aforementioned dates, respectively, relating to such losses occurring in 1985 and prior. As TRC, the major operating subsidiary of the Company, commenced operations in 1978, the great majority of TRH’s environmental and asbestos-related liabilities arose from contracts entered into after 1985 that were underwritten specifically as environmental or asbestos-related
If paid losses accelerated significantly beyond TRH’s ability to fund such paid losses from current operating cash flows, TRH would be compelled to liquidate a portion of its investment portfolio and/or arrange for financing. Such events that may cause such a liquidity strain could be the result of several catastrophic events occurring in a relatively short period of time. Additional strain on liquidity could occur if the investments sold to fund such paid losses were sold in a depressed marketplace and/or reinsurance recoverable on such paid losses became uncollectible.
TRH’s operations are exposed to market risk. Market risk is the risk of loss of fair value resulting from adverse fluctuations in interest rates, equity prices and foreign currency exchange rates. TRH’s market risk exposures arise from the following:
The abovementioned decrease in accumulated other comprehensive income consisted principally of net unrealized depreciation of investments, net of income taxes, of $101.2 million, partially offset by net unrealized foreign currency translation gain from functional currencies, net of income taxes, of $23.8 million. The net unrealized depreciation of investments, net of income taxes, is composed principally of decreases of $34.6 million in unrealized appreciation of fixed maturities available for sale, $41.3 million in unrealized appreciation of equities available for sale and $26.8 million in net unrealized depreciation on the investment of securities lending collateral.
Net unrealized appreciation (depreciation) of investments, net of income taxes, is subject to significant volatility resulting from changes in the fair value of fixed maturities and equities available for sale, securities lending collateral and other invested assets. Fair values may fluctuate due to changes in general economic and political conditions, market interest rates, prospects of investee companies and other factors.
In addition, in 2005, TRH recorded a reduction of retained earnings of $8.3 million (which is net of income tax savings that TRH expected to realize of $3.0 million) and an increase to additional paid-in capital of $11.3 million related to compensation to certain TRH employees from Starr International Company for all prior periods through December 31, 2004 as discussed in Note 12(c) of Notes to Consolidated Financial Statements.
As of December 31, 2007, the amounts due and the estimated period between year-end 2007 and the dates of payment, under specified contractual obligations of TRH are as follows:
The nature of TRH’s business exposes it to losses from various catastrophe events. In a catastrophe event, losses from many insureds across multiple lines of business may result directly or indirectly from such single occurrence. In order to control such exposures, TRH employs a combination of measures, including setting targets for the amount of its exposure in key geographic zones and product lines that
purchased by TRH. In addition, these estimates take into account what TRH believes to be the most likely accumulation of territories and/or lines of business in a catastrophic natural peril event, but there can be no assurance that we have captured every possible scenario in our analysis. As a result of these factors, among others, there can be no assurance that TRH will not experience after-tax net catastrophe costs from individual events that will exceed these estimates by a material amount. There also can be no assurance that TRH will not experience catastrophe events more frequently than the modeled probabilities would suggest. In any given year, catastrophe events could have a material adverse effect on TRH’s financial condition, results of operations, cash flows and liquidity.
In mid-2007, the U.S. residential mortgage market began to experience serious disruption due to credit quality deterioration in a significant portion of loans originated, particularly to non-prime and sub-prime borrowers; evolving changes in the regulatory environment; a slower residential housing market; increased cost of borrowings for mortgage participants; and illiquid credit markets. In addition, the financial strength of certain bond insurers has been compromised to varying degrees by losses these entities are presently experiencing due in part to the coverage they provide for domestic residential mortgage-backed securities.
These issues carry risk relating to certain lines of business TRH underwrites because disruption in the U.S. residential mortgage market may increase claim activity in lines such as D&O, E&O, credit and mortgage guaranty business, where TRH has provided reinsurance on two programs. TRH also participates in the U.S. residential mortgage market through investments in mortgage-backed securities, in which the underlying collateral is composed in whole or in part of residential mortgage loans, a significant majority of which have Aaa underlying or subordinate layers.
To a limited extent, TRH also wrote financial guaranty business, which was last underwritten in 1998. The underlying exposures for the vast majority of such business related to municipal bonds and state agencies. TRH still has limited exposure to liabilities which may arise from such financial guaranty business.
The operating results and financial condition of TRH have been and are likely to continue to be adversely affected by the factors referred to above. The downward cycle in the U.S. housing market is not expected to improve until residential inventories return to a more normal level and the mortgage credit market stabilizes. TRH expects that this downward cycle may have an adverse affect on TRH’s operating results in the future. TRH also incurred unrealized market valuation losses in 2007 on its available for sale securities. The result on TRH’s operations with exposure to the U.S. residential mortgage market will be somewhat dependent on future market conditions.
The ongoing effect of the downward cycle in the U.S. housing market on TRH’s operating results, investment portfolio and overall consolidated financial condition could be adversely affected if the market disruption continues and expands beyond the U.S. residential mortgage markets, although TRH attempts to mitigate these, as well as other financial and operational risks, by disciplined underwriting of a diversified book of business, generally conservative investment strategies and risk management. While TRH cannot predict with any certainty the ultimate impact the recent market disruption will have on TRH, these events may have a material adverse effect on TRH’s results of operations, financial condition and cash flows.
(a) Adoption of Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement No. 109” (“FIN 48”)
(b) Adoption of Statement of Financial Accounting Standards (“SFAS”) No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans-an amendment of FASB Statements No. 87, 88, 106 and 132(R)” (“SFAS 158”)
(c) Adoption of Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”)
In September 2006, the Securities and Exchange Commission issued SAB 108. TRH adopted SAB 108 in the fourth quarter of 2006.
(d) Adoption of SFAS No. 123 (revised 2004), “Share-Based Payments” (“SFAS 123R”)
In December 2004, the FASB issued SFAS 123R. TRH adopted SFAS 123R on January 1, 2006.
In November 2005, the FASB issued FSP FAS 115-1. TRH Adopted FSP FAS 115-1 in the first quarter of 2006.
(iv) In December 2007, the FASB issued SFAS No. 141R, “Business Combinations” (“SFAS 141R”).
Consolidated Statements of Operations For the Years Ended December 31, 2007, 2006 and
Consolidated Statements of Stockholders’ Equity For the Years Ended December 31, 2007, 2006 and 2005
Consolidated Statements of Cash Flows For the Years Ended December 31, 2007, 2006 and
IV-Reinsurance For the Years Ended December 31, 2007, 2006 and 2005
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Transatlantic Holdings, Inc. and its subsidiaries (the “Company”) at December 31, 2007 and December 31, 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. In addition, in our opinion, the financial statement schedules listed in the accompanying index present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. 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 and financial statement schedules, 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 Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, 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.
The Company and its subsidiaries (collectively, “TRH”), through its operating subsidiaries TRC, TRZ and Putnam, offers reinsurance capacity for a full range of property and casualty products to insurers and reinsurers on a treaty and facultative basis, with an emphasis on specialty classes. Including domestic as well as international risks, TRH’s principal lines of business are other liability (including directors’ and officers’ liability (“D&O”), errors and omissions liability (“E&O”) and general casualty), medical malpractice, ocean marine and aviation, auto liability (including non-standard risks), accident and health and surety and credit in the casualty lines, and fire, allied lines, auto physical damage and homeowners multiple peril lines in the property lines (which include property catastrophe risks). Casualty lines represented 71.0%, 73.3% and 70.2% of net premiums written in 2007, 2006 and 2005, respectively. The balance represented property lines.
(a) Basis of Presentation: The consolidated financial statements include the accounts of the Company and its majority owned subsidiaries. The Company consolidates subsidiaries in which it holds a controlling financial interest. Entities where the Company holds 20% to 50% of the voting rights or has the ability to exercise significant influence are accounted for under the equity method.
The accompanying consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). All material intercompany accounts and transactions have been eliminated. Certain reclassifications have been made to conform prior years’ presentations with 2007.
(b) Use of Estimates: The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting periods. Actual results could materially differ from those estimates.
(c) Investments: Fixed maturities are classified as held to maturity and carried at amortized cost if TRH has the positive intent and ability to hold each of these securities to maturity. Where TRH may not have the positive intent to hold fixed maturities to maturity and such securities are not designated as trading, such fixed maturities are considered to be available for sale and carried at fair values. Premiums and discounts arising from the purchase of fixed maturities are treated as yield adjustments over their estimated lives, until maturity or call date, if applicable. Common stocks and non- redeemable preferred stocks, including those held to meet short term investment objectives and classified as trading, are carried at fair values.
including asset-backed and collateralized securities, and interest bearing cash equivalents. During the latter half of 2007, TRH’s interest in such pooled accounts was exchanged for separate portfolios containing floating rate bonds (i.e., fixed maturities), including asset-backed and collateralized securities, and interest-bearing cash equivalents. Such securities are maintained in segregated accounts for TRH by the program manager. The investment of securities lending collateral is shown on the balance sheet at fair value. A liability is recorded in an amount equal to the collateral received to recognize TRH’s obligation to return such funds when the related loaned securities are returned. The fair value of the loaned securities, which is reflected parenthetically as pledged on the balance sheet, is monitored on a daily basis with additional collateral obtained or refunded as the value fluctuates. Income earned on invested collateral, net of interest payable to the collateral provider, is included in net investment income. At December 31, 2007, TRH’s securities lending payables totaled $2.05 billion, $294 million of which were one-day tenor. These loans do not have a contractual end date but are terminable by either party on demand. In addition to the invested collateral, all of the assets of TRH are generally available to satisfy the liability for collateral received.
Unrealized gains and losses from fixed maturities available for sale, equities available for sale, securities lending collateral and other invested assets, are reflected as a separate component of accumulated other comprehensive income, net of deferred income taxes, in stockholders’ equity. Unrealized gains and losses from investments in trading securities are reflected in income currently. Investments in fixed maturities and equity securities are recorded on a trade date basis.
(d) Cash and Cash Equivalents: Cash and cash equivalents, which are principally interest-bearing, generally include cash deposited in demand deposits at banks and highly liquid investments with original maturities of 90 days or less.
(f) Premium Revenues: In recent years, premiums from treaty contracts have approximated 96% of net premiums written, while facultative contracts have approximated 4%. For pro rata treaty contracts, premiums written and earned are based on reports received from ceding companies. For excess-of-loss treaty contracts, premiums are generally recorded as written based on contract terms. Premiums are earned ratably over the term of the related coverages. Unearned premiums and prepaid reinsurance premiums represent the portion of gross premiums written and ceded premiums written, respectively, relating to the unexpired terms of such coverages. Premiums written and earned, along with related costs, for which data has not been reported by the ceding companies, are estimated based on historical patterns and other relevant information. These estimates are subject to change when actual data for such items estimated becomes available. In the Consolidated Statements of Operations, premiums written and earned and the change in unearned premiums are presented net of reinsurance ceded.
Realized and unrealized gains and losses from investments in trading securities.
(h) Realized Net Capital Gains and Losses: Realized capital gains and losses emanate from the following sources:
Sales of fixed maturities, equities (except trading securities) and limited partnership interests, principally on the basis of specific identification.
Estimation of loss reserves is a difficult and subjective process, especially in view of changes in the legal and tort environment, which impact the development of loss reserves, and therefore, quantitative techniques frequently have to be supplemented by subjective considerations and managerial judgment. In addition, trends that have affected development of liabilities in the past may not necessarily occur or affect liability development to the same degree in the future.
While the reserving process is difficult and subjective for the ceding companies, the inherent uncertainties of estimating such reserves are even greater for the reinsurer, due primarily to the longer-term nature of most reinsurance business, the diversity of development patterns among different types of reinsurance treaties or facultative contracts, the necessary reliance on the ceding companies for information regarding reported claims and differing reserving practices among ceding companies, which are subject to change without notice. TRH writes a significant amount of non-proportional assumed casualty reinsurance as well as proportional assumed reinsurance of excess liability business for classes such as medical malpractice, D&O, E&O and general casualty. Claims from such classes can exhibit greater volatility over time than most other classes due to their low frequency, high severity nature and loss cost trends that are more difficult to predict.
Losses and loss adjustment expenses net of related reinsurance recoverable (“net loss reserves”) include certain amounts for the reinsurance of risks relating to environmental impairment and asbestos-related illnesses. The majority of TRH’s environmental and asbestos-related net loss reserves arise from contracts entered into after 1985. These obligations generally arose from contracts underwritten specifically as environmental or asbestos-related coverages rather than from standard general liability coverages where the environmental or asbestos-related liabilities were neither clearly defined nor specifically excluded. The reserves carried at December 31, 2007 and 2006 for such claims, including IBNR, are based upon known facts and current law at the respective balance sheet dates. However, significant uncertainty exists in determining the amount of ultimate liability for environment impairment and asbestos-related losses, particularly for those occurring in 1985 and prior. This uncertainty is due to inconsistent court resolutions and judicial interpretations with respect to underlying policy intent and coverage and uncertainties as to the allocation of responsibility for resultant damages, among other things. Further, there is always the possibility of changes in statutes, laws, regulations and other factors that could have a material effect on these liabilities and, accordingly, future earnings.
(j) Deferred Income Taxes: Deferred tax assets and liabilities are recorded for the effects of temporary differences between the tax basis of an asset or liability and its reported amount in the consolidated financial statements. TRH assesses its ability to realize deferred tax assets primarily based on earnings history, future earnings potential, the reversal of taxable temporary differences and the tax planning strategies available to legal entities recognizing deferred tax assets, in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes.” See Note 4 for further discussion of income taxes.
In July 2006, the FASB issued FIN 48, which clarified the accounting for uncertain income tax positions. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of an income tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and additional disclosures. TRH adopted the provisions of FIN 48 on January 1, 2007. The adoption of FIN 48 did not have a material effect on TRH’s financial position as of January 1, 2007 or TRH’s results of operations and cash flows in 2007.
plan as of the date of its year-end statement of financial position, with limited exceptions. SFAS 158 does not change the accounting for a multiemployer plan.
TRH adopted SFAS 158 in the fourth quarter of 2006. The adoption of SFAS 158 did not have a material effect on TRH’s results of operations, financial position or cash flows in the year of adoption.
(3) Adoption of Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”)
(4) Adoption of SFAS No. 123 (revised 2004), “Share-Based Payments” (“SFAS 123R”)
In December 2004, the FASB issued SFAS 123R. SFAS 123R and its related interpretive guidance replaced SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) and supercedes Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). SFAS 123R requires share-based payment transactions with employees to be accounted for using a fair-value based method and broadens the recognition provisions to include share-based payments awarded to an employee by related parties or other holders of an economic interest in the reporting entity.
In 2005, TRH accounted for share-based payment transactions with employees under SFAS 123. Effective January 1, 2006, TRH adopted SFAS 123R using the Modified Prospective Application method. The Modified Prospective Application method provides for the recognition of the fair value with respect to stock-based compensation for shares granted or modified on or after January 1, 2006 and for all previously granted but unvested awards as of January 1, 2006. Accordingly, financial statement amounts for 2005 presented in this Form 10-K have not been restated. The impact of adopting SFAS 123R was not material to income before income taxes, net income (including basic and diluted net income per share amounts), financial condition or cash flows in the year of adoption. (See Note 12 for a discussion of stock-based compensation plans.)
(c) In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS 157 is effective for TRH on January 1, 2008. In February 2008, the FASB issued FSP No. FAS 157-2, “Effective Date of FASB Statement No. 157” (“FSP FAS 157-2”). FSP FAS 157-2 defers the effective date of FAS 157 for one year for nonfinancial assets and nonfinancial liabilities that are recognized or disclosed at fair value in the consolidated financial statements on a non-recurring basis. TRH adopted SFAS 157 on January 1, 2008, its required effective date. With certain specific exceptions which call for a cumulative-effect adjustment to opening retained earnings on January 1, 2008, SFAS 157 must be applied prospectively. Based on TRH’s review to date which is based on its balance sheet components at December 31, 2007, management does not expect the adoption of SFAS 157 to have a material effect on opening retained earnings nor on its prospective fair value measurements when compared to fair values determined based on authoritative accounting literature in effect at December 31, 2007.
(c) Investment Gains and Losses: Realized net capital gains (losses) and the change in net unrealized appreciation (depreciation) of investments are summarized as follows:
Includes write-downs for other-than-temporary declines in fair value of $2.5 million and $1.3 million for 2007 and 2006, respectively. There were no write-downs for other-than-temporary declines in fair value in 2005.
Includes write-downs for other-than-temporary declines in fair value of $24.7 million, $0.1 million and $1.7 million for 2007, 2006 and 2005, respectively.
(d) Fixed Maturities: The amortized cost and fair value of investments classified as fixed maturities on the balance sheet at December 31, 2007 and 2006 are summarized as follows:
See Note 3(g) for additional information about gross unrealized losses as of December 31, 2007 and 2006.
Asset-backed and collateralized fixed maturities by their nature do not generally have single maturity dates.
For fixed maturities and securities lending collateral, which is comprised principally of fixed maturities, represents amortized cost.
At December 31, 2007 and 2006, the gross unrealized losses for all fixed maturities, equities available for sale and securities lending collateral included the following concentrations:
The fair value of fixed maturities and securities lending collateral, which is comprised principally of fixed maturities, in an unrealized loss position at December 31, 2007 and 2006, by contractual maturity, is shown below:
Income (loss) before income taxes from Domestic operations was $268.1 million, $199.3 million and $(189.7) million in 2007, 2006 and 2005, respectively. Income before income taxes from foreign operations was $327.6 million, $340.6 million and $143.6 million in 2007, 2006 and 2005, respectively.
The domestic deferred tax benefit for 2007 and 2006 includes $32.9 million and $6.6 million, respectively, resulting from a minimum tax credit carryforward which, by law, may be carried forward indefinitely.
The components of the net deferred income tax asset at December 31, 2007 and 2006 were as follows:
Interest and penalties relating to unrecognized tax benefits/expenses are recognized in income tax expense, when applicable. As of December 31, 2007, there was $4.3 million of net interest receivable on income taxes. There was no interest or penalties accrued as of January 1, 2007. Current income tax expense was reduced by $4.3 million of interest on net tax refunds in 2007.
The table below reconciles the total amounts of unrecognized tax positions from December 31, 2006 to December 31, 2007, including interest and penalities, if any:
There were no significant net catastrophe losses for events occurring in 2006. However, in 2006, TRH determined that its estimates of the ultimate amounts of net losses occurring in 2005 and prior years needed to be increased as a result of greater than expected loss activity in 2006. As a result of that determination, TRH increased net losses and LAE incurred by $181.1 million, representing significant net adverse development in 2006 of losses occurring in all prior years. This net adverse development was comprised of $339.7 million relating to losses occurring in 2002 and prior, partially offset by favorable development of $158.6 million relating primarily to 2005, and to a much lesser extent, 2004 and 2003. The line of business with the most significant net adverse development recorded in 2006 was the other liability line ($192 million), arising principally from losses occurring in 2000 to 2002 for reasons similar to those discussed earlier for the other liability line development in 2007. In addition, significant net adverse development was recorded in 2006 in the medical malpractice line ($35 million), arising principally from losses occurring between 1998 and 2002, the fidelity line ($28 million), arising principally from losses occurring between 1999 and 2005, and the ocean marine and aviation line ($22 million), arising principally from losses occurring in 2005. The large majority of such net adverse development related to domestic operations. These increases to incurred losses were offset in part by net favorable development occurring most significantly in the fire line ($129 million), arising principally from losses occurring in 2005, and the homeowners multiple peril line ($36 million), arising principally from losses occurring between 2004 and 2005.
The year 2005 included $482.8 million of catastrophe losses incurred principally relating to Hurricanes Katrina, Rita and Wilma, and, to a lesser extent, to Central European floods and European Windstorm Erwin. In addition, in 2005, TRH determined that its estimates of the ultimate amounts of net losses occurring in 2004 and prior years needed to be increased as a result of greater than expected loss activity in 2005. As a result of that determination, TRH increased net losses and LAE incurred by $268.8 million, representing significant net adverse development in 2005 of losses occurring in all prior years. This net adverse development was comprised of $524.9 million relating to losses occurring in 2002 and prior, partially offset by favorable development of $256.1 million relating primarily to 2004 and, to a lesser extent, to 2003. The lines of business with the most significant net adverse development recorded in 2005 were the other liability line ($366 million), arising principally from losses occurring in 1996 to 2002 for reasons similar to those discussed earlier for the other liability line development in 2007, and the medical malpractice line ($64 million), arising primarily from losses occurring between 1997 and 2001. The large majority of such net adverse development related to domestic operations. These increases to incurred losses were offset in part by net favorable development occurring most significantly in the fire line ($99 million), which arose principally from losses occurring in 2004, and in the ocean marine and aviation lines ($42 million, mostly related to aviation), which arose principally from losses occurring in 2001 through 2004.
In December 2005, the Company completed a public offering of $750 million principal amount of its 5.75% senior notes due on December 14, 2015 (the “Senior Notes”). At December 31, 2007 and 2006, the Senior Notes remained outstanding. Of the $750 million aggregate principal amount of the Senior Notes offered, $450 million principal amount was purchased by certain subsidiaries of AIG. In addition, the unamortized original issue discount, which totaled $3.1 million and $3.4 million at December 31, 2007 and 2006, respectively, has been deducted from the carrying value of the Senior Notes and is being amortized over the term of the Senior Notes on the effective interest rate method. The proceeds from the offering were used to increase the capital and surplus of TRC and for other general corporate purposes. Interest expense incurred in connection with the Senior Notes was $43.4 million, $43.4 million and $2.1 million in 2007, 2006 and 2005, respectively. Interest payments on the Senior Notes totaled $43.1 million in each of 2007 and 2006. There were no interest payments on the Senior Notes in 2005.
Net income for 2005 includes estimated pre-tax net catastrophe costs of $543.9 million, or $353.5 million after tax, arising principally from Hurricanes Katrina ($304 million pre-tax), Rita ($44 million pre-tax) and Wilma ($111 million pre-tax) and, to a lesser extent, from Central European floods and European Windstorm Erwin. Such costs consist of net catastrophe losses incurred of $482.8 million (gross $870.0 million; ceded $387.2 million) and net ceded reinstatement premiums of $61.1 million (gross $72.3 million; ceded $133.4 million).
A summary of the components of pre-tax net catastrophe costs for 2007, 2006 and 2005 is presented below:
A summary of pre-tax net catastrophe costs by segment for 2007, 2006 and 2005 is presented below:
The components of accumulated other comprehensive income and changes in such amounts between years are as follows:
TRH’s employees participate in benefit plans administered by the AIG Group, including noncontributory defined benefit pension plans, other postretirement benefit plans and incentive savings plans (such as a 401(k) plan) which provides for certain matching contributions. A substantial majority of TRH’s employees are eligible to participate in these plans. Certain of the pension plans are multiemployer plans in that they do not separately identify plan benefits and plan assets attributable to employees of participating companies. For such plans, only contributions paid or accrued are charged to expense.
At December 31, 2007, TRH had four stock-based compensation plans, the Transatlantic Holdings, Inc. 1995 Stock Option Plan (the “1995 Plan”), the Transatlantic Holdings, Inc. 2000 Stock Option Plan, as amended, (the “2000 Plan” and collectively with the 1995 Plan, the “Stock Option Plans”), the Transatlantic Holdings, Inc. 2003 Stock Incentive Plan, as amended, (the “Stock Incentive Plan”) and the Transatlantic Holdings, Inc. 1990 Employee Stock Purchase Plan, as amended (the “Stock Purchase Plan”). The Stock Incentive Plan includes two sub-plans, the Transatlantic Holdings, Inc. Partners Plan (the “Partners Plan”) and the Transatlantic Holdings, Inc. Senior Partners Plan (the “Senior Partners Plan”). In addition, certain TRH employees participate in the SICO Plans and certain AIG stock-based compensation plans.
If TRH had adopted the provisions of SFAS 123R for recognizing compensation expense commencing at the date of grant for all awards, the effect would not have been material to net income or basic or diluted net income per share for 2005.
The impact on the financial statements of the Stock Purchase Plan and TRH employees’ participation in certain AIG stock-based compensation plans was not material to TRH in 2007, 2006 and 2005. A discussion of the more significant stock-based compensation plans follows.
210,000 and 291,000 options were granted in 2007 and 2005, respectively. No options were granted in 2006. The fair value of each option grant is estimated on the date of grant using a binomial option pricing model. The following table presents the weighted average grant date fair value and the weighted average assumptions which were used in the calculation for options granted in 2007 and 2005:
In 2007, a weighted average dividend yield of 0.82% was used in valuing options granted and was based on the dividend yield over the twelve month period prior to the grant date. In 2005, an increasing dividend schedule was used based on historical information. The expected volatility was based on the historical volatility of TRH shares. The risk-free interest rate was based on the U.S. treasury yield curve in effect at the time of grant. The expected term was calculated based on historical data on employee exercise behavior.
The aggregate intrinsic value of options exercised (the aggregate amount by which the market price of TRH shares at the time of exercise exceeded the exercise price of options exercised) was $7.1 million, $4.4 million and $9.4 million in 2007, 2006 and 2005, respectively. A total of approximately 301,000, 368,000 and 411,000 options vested in 2007, 2006 and 2005, respectively, with aggregate fair values of $5.0 million, $5.8 million and $6.2 million in 2007, 2006 and 2005, respectively.
(b) Stock Incentive Plan, Partners Plan and Senior Partners Plan: In 2003, the Board adopted, and the stockholders approved, the Stock Incentive Plan. In 2006, the Board adopted, and the stockholders approved, certain amendments which increased the maximum number of shares available for grant under the Stock Incentive Plan to 925,000, increased the maximum number of awards a grantee may receive in any one year to 60,000, allowed for flexibility in determining the vesting terms of grants and allowed for grants of performance-based restricted stock or restricted stock units. This plan provides that equity-based or equity-related awards can be granted to officers, directors, employees and other individuals as determined by the Board. No award may be made to directors who are not employees of the Company without stockholder approval.
Pursuant to the Stock Incentive Plan, service-based restricted stock units (“Service RSU”) have been granted and, as part of the Partners Plan and Senior Partners Plan, performance-based restricted stock units (“Performance RSU”) have been granted. As of December 31, 2007, there were 376,211 shares of common stock available for issuance in connection with future grants of awards under the Stock Incentive Plan. Shares available for future issuance assume participants in the Partners Plan and
7,597 and 150 Service RSUs vested in 2007 and 2005, respectively. No Service RSUs vested in 2006.
In August 2006, the Compensation Committee of the Board (the “Compensation Committee”) adopted the Partners Plan for purposes of incentivizing performance of certain of TRH’s senior executives. Under the Partners Plan, the Compensation Committee awards to senior executives Performance RSUs that pay out in TRH shares if performance goals for a specified period are satisfied. Each Performance RSU converts into one TRH share. The Partners Plan operates on the basis of successive overlapping two year performance periods, with a new period beginning each year. No awards were granted in 2007. Awards were granted in 2006. The first award’s performance period runs from January 1, 2006 through December 31, 2007 and the second award’s performance period runs from January 1, 2007 through December 31, 2008.
from 25% to 150% of the awarded number of Performance RSUs. The maximum number of Performance RSUs that can be earned for the performance period beginning in 2006 and 2007 is 64,387 and 131,525, respectively. No Performance RSUs will be earned if BVPS Growth is less than 25% of target. Earned Performance RSUs will vest equally on the fourth and sixth anniversaries of the beginning of the performance period, generally so long as the participant is then employed by TRH. The two-year performance period beginning in 2006 ended on December 31, 2007. The maximum performance target was reached for the 2006-2007 period.
In August 2006, the Committee also adopted the Senior Partners Plan designed for TRH’s senior-most executives. The Senior Partners Plan generally operates in the same manner as the Partners Plan, except that the performance period is three years, participants can earn from 25% to 200% of the awarded number of Performance RSUs and no Performance RSUs will be earned if BVPS growth is less than 50% of target. In 2007, 27,000 Performance RSUs were awarded under the Senior Partners Plan with respect to the performance period beginning in 2007. In 2006, 12,000 Performance RSUs were awarded under the Senior Partners Plan with respect to the performance period beginning in 2006. The maximum number of Performance RSUs that can be earned is 54,000 for the performance period beginning in 2007 and 24,000 for the performance period beginning in 2006.
As of December 31, 2007, there was $12.1 million of total unrecognized compensation costs relating to Performance RSUs granted but not yet vested under the Senior Partners Plan and the Partners Plan. Compensation expense for Performance RSUs is recognized on a straight-line basis. These costs are expected to be recognized over a weighted average period of 3.8 years. Because the performance period for the second award under the Partners Plan did not begin until January 1, 2007, the second award was not included in TRH’s 2006 expenses.
SICO is a private holding company which has no direct ownership interest in TRH but which has a significant ownership interest in AIG (see Note 13(c)). SICO had provided a series of two-year SICO Plans to certain TRH employees through December 31, 2004. The SICO Plans came into being in 1975 when the voting shareholders and Board of Directors of SICO, a private holding company whose principal asset is AIG common stock, decided that a portion of the capital value of SICO should be used to provide an incentive plan for the current and succeeding managements of all American International companies, including TRH.
None of the costs of the various benefits provided under the SICO Plans has been paid by TRH. Following AIG’s determination in 2005 to record a charge for the deferred compensation amounts paid to TRH employees by SICO, TRH determined that, as a subsidiary of AIG, it was appropriate to record the compensation expense relating to its employees’ participation in such plans, with an offsetting amount credited to additional paid-in capital reflecting amounts deemed contributed by AIG to TRH.
As total SICO compensation expense for each year prior to 2005 would not have been material to any such prior year, TRH recorded in 2005 the total amount of compensation expense relating to the SICO Plans that would have been recorded in all prior periods through December 31, 2004 as a reduction of retained earnings of $8.3 million, which was net of income tax savings that TRH expected to realize of $3.0 million. The entire amount of such prior year compensation cost, before tax effect, of $11.3 million, is considered a contribution to capital, and was recorded as an increase to additional paid-in capital.
(a) Transactions with the AIG Group: As of December 31, 2007, 2006 and 2005, AIG beneficially owned approximately 59% of the Company’s outstanding shares.
Approximately $555 million (13%), $593 million (15%) and $575 million (15%) of gross premiums written by TRH in 2007, 2006 and 2005, respectively, were attributable to reinsurance purchased by other subsidiaries of AIG, for the production of which TRH recorded ceding commissions totaling $114 million, $140 million and $122 million, respectively, in such years. (The amounts discussed in the preceding sentence include transactions with C.V. Starr & Co., Inc. (“Starr”) as described in Note 13(c).) In 2007, 2006 and 2005, the great majority of such gross premiums written were recorded in the property, other liability, medical malpractice and ocean marine and aviation lines. Of the premiums assumed from other subsidiaries of AIG, $248 million, $227 million and $209 million in 2007, 2006 and 2005, respectively, represent premiums resulting from certain insurance business written by AIG subsidiaries that is almost entirely reinsured by TRH by prearrangement, for the production of which TRH recorded ceding commissions to such AIG subsidiaries totaling approximately $41 million, $40 million and $37 million, respectively, in such years. (See Note 15 for information relating to reinsurance ceded to related parties.)
(b) Senior Notes Purchased by AIG Subsidiaries: In December 2005, certain subsidiaries of AIG purchased, and at December 31, 2007 still hold, $450 million aggregate principal amount of the Senior Notes. Such amount comprised 60% of the total amount of the Senior Notes. (See Note 6.)
(c) Transactions with Starr: According to the Schedule 13D filed on March 20, 2007 by Starr, SICO, Edward E. Matthews, Maurice R. Greenberg, the Maurice R. and Corinne P. Greenberg Family Foundation, Inc., the Universal Foundation, Inc., the Maurice R. and Corinne P. Greenberg Joint Tenancy Company, LLC and the C.V. Starr & Co., Inc. Trust, these reporting persons could be deemed to beneficially own 355.0 million shares of AIG’s common stock at that date. Based on the shares of
Throughout 2007, 2006 and 2005, certain of Starr’s subsidiaries operated as insurance agencies or brokers for insurance subsidiaries of AIG and, in such capacity, had produced reinsurance business for TRH. Net commissions relating to Starr subsidiaries were insignificant in 2007 and 2006. Net commissions relating to Starr subsidiaries totaled $11 million in 2005 for such reinsurance purchased by subsidiaries of AIG totaling $59 million.
In the normal course of business, TRH generally purchases reinsurance from its retrocessionnaires to reduce the effect of individual or aggregate losses and to allow increased gross premium writings and afford greater risk capacity without necessarily requiring additional capital.
Reinsured losses and LAE ceded include ceded catastrophe losses incurred of $4 million, $55 million and $387 million in 2007, 2006 and 2005, respectively.
Amounts recoverable from retrocessionnaires are recognized in a manner consistent with the claims liabilities associated with the retrocession and are presented on the balance sheet as reinsurance recoverable on paid and unpaid losses and LAE. Such balances at December 31, 2007 and 2006 are comprised as follows:
TRH conducts its business and assesses performance through segments organized along geographic lines. The Domestic segment includes financial data from branches in the United States except Miami, as well as revenues and expenses of the Company (including interest expense on the Senior Notes) and stock-based compensation expense. (See Note 6.)
In addition, two large international brokers, respectively, accounted for non-affiliated business equal to 16% and 14% in 2007, 15% and 14% in 2006 and 15% and 15% in 2005, of consolidated revenues, with a significant portion in each segment.
Rent expense approximated $11.3 million, $9.7 million and $8.8 million in 2007, 2006 and 2005, respectively.