We lease office space in Hamilton, Bermuda and Dublin, Ireland, the locations in which we operate. We lease office space on a long-term basis, which we believe will be adequate for anticipated future operations. The property and casualty and life and annuity segments use both locations, although the life and annuity segment primarily works from our Bermuda office.
The following is a discussion and analysis of our results of operations for the year ended December 31, 2005 compared to the year ended December 31, 2004 and for the year ended December 31, 2004 compared to the year ended December 31, 2003, and also a discussion of our financial condition as of December 31, 2005. This discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes that are included in this annual report.
We are a Bermuda-based provider of reinsurance and insurance products for both the property and casualty and the life and annuity markets. Since 2001, the property and casualty market has presented more opportunities to us than the life and annuity market due to a shortage of reinsurance capacity in the property and casualty market, resulting in improvement in premium rates, terms and conditions. However, prior to the severe hurricane activity in 2005, we observed a decrease in attractive property and casualty opportunities as competition increased in most property and casualty lines of business that we write. We anticipate that hurricanes Katrina, Rita and Wilma will result in improved premium rates, terms and conditions in the property and property catastrophe reinsurance and insurance markets. As a result we are growing our short-tail property and property catastrophe reinsurance and insurance premium volume, including through an expansion of the underwriting of property and property catastrophe reinsurance. With respect to the types of life and annuity reinsurance contracts we offer, we have seen more opportunities in the market and increased production in 2005 compared to 2004. We remain cautious about whether these opportunities will continue to result in additional business for us in the near term.
Gross premiums written for the property and casualty reinsurance segment increased by 5.6% to $615.7 million for the year ended December 31, 2005 compared to $583.2 million for the year ended December 31, 2004. The increase in gross premiums written in this segment includes additional premium of $182.0 million stemming from additional losses on two contracts written in prior periods, which was largely offset by the non-renewal of four reinsurance contracts with an aggregate premium of approximately $174.5 million in 2004.
We expanded our customer base and renewed the contracts we desired to renew in the property and casualty insurance segment, resulting in a 43.2% increase in gross premiums written to $355.3 million, for the year ended December 31, 2005 compared to $248.1 million for the year ended December 31, 2004.
In 2005, we continued to emphasize casualty lines in our property and casualty reinsurance and insurance segments, with the largest portion of gross premiums written coming from professional liability and general liability. We intend to continue to diversify our property and casualty reinsurance and insurance underwriting by writing business with a greater number of clients and by varying the underlying exposures assumed. We are continually reviewing our business strategy in relation to the underwriting environment and we expect that the recent hurricanes in the United States will result in a more attractive market environment for short-tail property and property catastrophe reinsurance and insurance. In order to position ourselves to take advantage of these anticipated opportunities, we sold 11.0 million common shares and 1.65 million common shares on October 17, 2005 and November 4, 2005, respectively, at a price of $23.50 per share in an underwritten public offering, resulting in aggregate net proceeds of approximately $284.1 million.
We operate in a business where we expect volatility in our underwriting results arising from our reinsurance and insurance businesses. However, by carefully selecting line sizes of business assumed, diversifying our underlying exposures, establishing contractual liability caps on our contracts and purchasing reinsurance and retrocessional reinsurance protection, we believe we manage, and will continue to manage, this volatility effectively. During the year ended December 31, 2005, Hurricane Katrina, likely to be the most costly natural disaster ever seen in the property and casualty industry, Hurricane Rita and Hurricane Wilma, collectively resulted in an industry estimated $45 billion to $80 billion in insured losses. We believe that events such as these demonstrate that our risk management and diversification strategy is operating effectively, as we recorded $6.7 million in net income for the year ended December 31, 2005, despite an aggregate $157.4 million negative impact to net income from natural catastrophes. The $157.4 million negative impact is composed of $73.4 million in property and casualty reinsurance losses, $50.0 million of property and casualty insurance losses and $34.0 million in investment losses recorded under the equity method of accounting from our investment in DaVinci Re Holdings Ltd. and its operating subsidiary DaVinci Reinsurance Ltd. (“DaVinci”).
In 2004, the New York State Attorney General and other regulatory authorities launched investigations into broker conduct and the accounting of certain types of finite risk reinsurance transactions. We are not a party to any related litigation and have not received any subpoena or information requests. Moreover, we conducted an internal review of our business arrangements and we have discovered no evidence that we were involved in the type of conduct that is the subject of the investigations. It is not possible to predict the ultimate effect of the investigations or their impact on the reinsurance industry or our business. During the year ended December 31, 2005 we settled all outstanding balances in relation to Placement Service Agreements (PSAs) with insurance brokers, which we had terminated with effect from September 30, 2004.
We derive operating revenues from premiums from our reinsurance and insurance businesses. Additionally, we recognize returns from our investment portfolio.
Our net investment income is a function of the average invested assets and the average yield that we earn on those invested assets. The investment yield on our fixed maturities investments is a function of market interest rates as well as the credit quality and maturity of our fixed maturities portfolio. We recognize realized capital gains or losses on our fixed maturities investments at the time of sale. The realized capital gains or losses reflect the results of changing market conditions, including changes in market interest rates and changes in the market’s perception of the credit quality of our fixed maturities holdings. Our net gains on alternative investments are a function of the success of the funds in which we are invested, which depends on, among other things, the underlying strategies of the funds, the ability of the fund managers to execute the fund strategies, general economic and investment market conditions and the underlying operating results of our private equity reinsurance investments.
Our property and casualty insurance premiums are recorded at the inception of each contract, based upon contract terms. The amount of minimum and/or deposit premium is usually contractually documented at inception, and variances between deposit premium and final premium are generally small. An adjustment is posted to amend the minimum and/or deposit premium as data regarding the underlying exposure is provided to us by our insureds. Premiums are earned on a pro rata basis over the coverage period.
Our property and casualty reinsurance premiums are recorded at the inception of each contract, based upon contract terms and information received from ceding clients and their brokers. For excess of loss contracts, the amount of minimum and/or deposit
premium is usually contractually documented at inception, and variances between deposit premium and final premium are generally small. An adjustment is posted to amend the minimum and/or deposit premium as data regarding the underlying exposure is provided to us by our ceding clients. For quota share or proportional property and casualty reinsurance contracts, gross premiums written are normally estimated at inception by the ceding client. We generally account for such premiums using the client’s initial estimates, and then adjust them as advised by our ceding clients. We believe that the ceding clients’ estimate of the volume of business they expect to cede to us represents the best estimate of gross premium written at the beginning of the contract. As the contract progresses, we monitor actual premium received in conjunction with correspondence from the ceding client in order to refine our estimate. Variances from original premium estimates can be greater for quota share contracts than excess of loss contracts. Premiums are earned on a pro rata basis over the coverage period.
Under GAAP, we are not permitted to establish loss reserves until the occurrence of an event that may give rise to a loss. Once such an event occurs, we establish reserves based upon loss reports from insureds and estimates of total losses incurred by the ceding client as a result of the event and our estimate of the portion of such loss we cover. As a result, only loss reserves applicable to losses incurred up to the reporting date may be recorded, with no allowance for the provision of a contingency reserve to account for expected future losses.
Setting appropriate reserves for losses and benefits is an inherently uncertain process. Losses and benefit reserves represent estimates, at a given point in time, of the ultimate settlement costs of losses incurred (including IBNR losses, which are losses that have been
Our reinsurance and insurance reserves are actuarial projections as of the balance sheet date of the ultimate unpaid losses and benefits associated with our reinsurance and insurance contracts. Considerable judgment is required in the evaluation of losses and benefits and the establishment of liabilities for losses and benefits. We employ a variety of actuarial loss reserving techniques and several models to assist in the setting and reviewing of reserves. The actuarial loss reserves techniques and models employed include paid loss development, incurred loss development, paid and incurred Bornhuetter-Ferguson methods and frequency and severity methods. Further, we retain an independent actuarial firm to review annually the adequacy of the reserves as determined by management. Additional information regarding losses and benefit amounts incurred will become available over time and the estimates of such amounts may need to be revised, resulting in gains and losses in the periods determined.
premium estimate changes resulted principally from changes in two ceding clients’ operations due to a rating agency downgrade in one instance and the loss of key members of the client’s underwriting team in the second instance, with both items leading to lower premium production for the ceding clients.
year, which did not attract any further acquisition costs. Acquisition costs vary from contract to contract depending on characteristics such as the type of business, the clients’ cost to administer the underlying contracts and the involvement of a broker. These factors may result in differences in the ratio of acquisition costs to net premiums earned from period to period.
Gross premiums written. Gross premiums written for the property and casualty insurance segment for the year ended December 31, 2005 were $355.3 million compared to $248.1 million for the year ended December 31, 2004, an increase of 43.2%. The increase is the result of the continued expansion of this segment, including new business coming from the addition of our property underwriting team in 2004. Typically, insurance business is written on an individual risk excess of loss basis with contractually defined premiums rather than estimates, which results in no material premium adjustments.
Gross premiums written for the property and casualty insurance segment for the year ended December 31, 2004 were $248.1 million compared to $163.2 million for the year ended December 31, 2003, an increase of 52.0%. Our first full year of production for our insurance team was 2004.
Reinsurance premiums ceded for insurance for the year ended December 31, 2004 were $114.2 million compared to $57.0 million for the year ended December 31, 2003, an increase of 100.4%. Reinsurance premiums ceded were principally related to our quota share treaties, utilized to manage our retained exposure, and line sizes on our insurance products, which were put in place in the latter half of 2003. The ratio of reinsurance premiums ceded to gross premium written for the year ended December 31, 2003 was 34.9%.
Net premiums earned. Net premiums earned on insurance increased by 39.4% to $172.9 million for the year ended December 31, 2005 compared to the year ended December 31, 2004 and by 170.2% to $124.0 million for the year ended December 31, 2004 from $45.9 million for the year ended December 31, 2003. The increases are attributable to our expansion of the insurance product line over the past three years, including developing our property insurance product. The increase also reflects the earning pattern of a larger and increasingly mature portfolio of insurance contracts.
Acquisition costs. Acquisition costs were $0.1 million for the year ended December 31, 2005 compared to $2.5 million for the year ended December 31, 2004. The decline in acquisition costs principally results from the current year settlement of our 2004 PSA
obligations to brokers at $1.5 million less than our accrued liability. The acquisition costs are net of ceding commissions associated with premiums ceded to our quota share partners. These ceding commissions are designed to compensate us for the costs of producing the portfolio of risks ceded to our reinsurers.
General and administrative expenses. General and administrative expenses were $9.9 million for the year ended December 31, 2005 compared to $6.8 million for the year ended December 31, 2004, an increase of 45.6%. The increase resulted principally from expenses associated with additional staff, including an expanded property underwriting team. The general and administrative expense to net premiums earned ratio was 5.7% for the year ended December 31, 2005 compared to 5.5% for the year ended December 31, 2004.
Net income (loss). Net loss attributable to the property and casualty insurance segment for the year ended December 31, 2005 was $12.6 million compared to $24.1 million of income for the year ended December 31, 2004. The net loss for the year ended December 31, 2005 relates principally to the $50.0 million in losses from Hurricanes Katrina, Rita and Wilma.
Net income attributable to the property and casualty insurance segment was $3.3 million for the year ended December 31, 2003.
Gross premiums written. Gross premiums written for the life and annuity reinsurance segment for the year ended December 31, 2005 were $275.0 million compared to $212.3 million for the year ended December 31, 2004, an increase of 29.5%. We wrote two contracts with European based clients for premium of $235.0 million and one contract with a North American based client for premium of $32.5 million during the year ended December 31, 2005. In addition we received additional premium on contracts that were written in prior years, during the year ended December 31, 2005. We wrote one large annuity contract as well as a small life transaction in 2004.
Acquisition costs. Acquisition costs were $2.5 million for the year ended December 31, 2005 compared to $3.5 million for the year ended December 31, 2004 and $1.9 million for the year ended December 31, 2003. The acquisition costs on the life and annuity reinsurance transactions that we bind will vary from period to period depending on brokerage rates.
Net loss. Although we expect to incur underwriting losses in connection with our life and annuity reinsurance contracts, we seek to achieve sufficient investment income from premiums received to fund benefit payments as they occur and provide for a profit margin. Net loss attributable to the life and annuity reinsurance segment for the year ended December 31, 2005 was $43.7 million compared to $34.7 million for the year ended December 31, 2004, reflecting the additional business we have written and earned. The results are driven by the accretion of life and annuity reinsurance benefits over time.
Net investment income. Net investment income, excluding realized and unrealized gains and losses, for the year ended December 31, 2005 increased $24.0 million to $106.8 million compared to $82.8 million for the year ended December 31, 2004, an increase of 29.0%. The increase was principally attributable to the growth in the fixed maturities portfolio from $2,156.0 million at December 31, 2004 to $2,682.9 million at December 31, 2005, resulting from cash flow from operations since December 31, 2004 and the additional capital we raised in October and November 2005 in connection with a public offering of our common shares. The average annualized investment yield on the cash, fixed maturities investments and funds withheld by clients for the year ended December 31, 2005 was 4.2% compared to 4.2% for the year ended December 31, 2004.
Net gains on alternative investments. Net gains on the alternative investment portfolio were $39.9 million, or 3.34%, including a loss of $26.2 million from our private equity reinsurance investments, for the year ended December 31, 2005 compared to $81.6 million, or 8.23%, including a loss of $8.1 million from our private equity reinsurance investments, for the year ended December 31, 2004. Our investment in DaVinci has been impacted by losses from hurricanes Katrina, Rita and Wilma in the year ended December 31, 2005 and by losses from hurricanes Charley, Frances, Ivan and Jeanne in the year ended December 31, 2004. DaVinci is a property catastrophe reinsurer and therefore, it is expected that losses will be incurred during periods where there are severe or frequent catastrophes. For 2005, the return from our Max Re Diversified fund of funds portfolio was 5.88%. This return reflected the mediocre returns available in the capital markets as represented by the average money market fund returning 3.0%, the Lehman Brothers Intermediate Aggregate Bond Index returning 2.0% and the Standard & Poors 500 Index returning 3.0%.
Net realized gains on sale of fixed maturities. Our fixed maturities investment strategy is not intended to generate realized gains and losses as more fully discussed below. The realized gains(losses) for the year ended December 31, 2005 and December 31, 2004 of $(0.7) million and $10.4 million, respectively, are the result of the sale of fixed maturities in connection with normal portfolio rebalancing transactions. The realized gains in the year ended December 31, 2003 of $19.3 million are the result of hiring two additional fixed maturities managers and the resulting changes to the portfolio based on individual manager recommendations.
We own a portfolio of investment grade fixed maturities that are available for sale and, as a result, we record the investments at fair value on our balance sheet. The unrealized gain or loss associated with the difference between the fair value and the amortized cost of the investments is recorded in other comprehensive income in the equity section of our balance sheet. Fixed maturities are subject to fluctuations in fair value due to changes in the interest rates, changes in issuer specific circumstances such as credit rating and changes in industry specific circumstances such as movements in credit spreads based on the markets perception of industry risks. As a result of these potential fluctuations, it is possible to have significant unrealized gains or losses on a security. Our strategy for our fixed maturities portfolio is to tailor the maturities of the portfolio to the timing of expected loss and benefit payments. At maturity, a fixed maturity’s amortized cost will equal its fair value and no realized gain or loss will be recognized in income. If, due to an unforeseen change in loss payment patterns, we need to sell investments before maturity, we could realize significant gains or losses in any period, which could result in a meaningful effect on reported net income for such period.
Interest expense for the year ended December 31, 2004 increased 16.7% over the interest expense for the year ended December 31, 2003. The increase resulted principally from interest expense on additional funds withheld from our reinsurers for the year ended December 31, 2004 compared to the same period in 2003.
General and administrative costs. The increase in general and administrative costs over the last three years resulted principally from expenses associated with the expansion of our corporate staff. Our total general and administrative expenses to net premiums earned ratio was 5.4% for the year ended December 31, 2005 compared to 5.3% for the year ended December 31, 2004 and 5.5% for the year ended December 31, 2003.
Liabilities for property and casualty losses. Property and casualty losses totaled $2,006.0 million at December 31, 2005 compared to $1,455.1 million at December 31, 2004, an increase of 37.9%. The increase in property and casualty losses was principally attributable to estimated losses associated with premiums earned during the year ended December 31, 2005, an increase of $159.3 million in loss reserves on two prior period contracts and $133.7 million in losses related to hurricanes Katrina, Rita and Wilma, partially offset by losses paid and changes in reserve estimates on carried property and casualty losses.
Liabilities for life and annuity benefits. Life and annuity benefits totaled $854.2 million at December 31, 2005 compared to $666.1 million at December 31, 2004. The increase in the year ended December 31, 2005 was principally attributable to reinsurance transactions written and earned during the year ended December 31, 2005, partially offset by benefit payments on existing contracts in force.
In addition, at December 31, 2005, one other retrocessionaire accounted for 20.0% of our losses recoverable from reinsurers. This retrocessionaire has a financial strength rating of “A” by A.M. Best Company. We retain funds amounting to approximately 72.1% of its loss recoverable obligations. The principal component of the remainder of losses recoverable relates to amounts due from reinsurers of our property and casualty insurance risks. The loss recoverable from these reinsurers represent 34.6% of losses recoverable at December 31, 2005 and all of these reinsurers are presently rated “A-”or above by A.M. Best Company.
As a holding company, Max Re Capital’s principal assets are its investments in the common shares of its principal subsidiary, Max Re, and its other subsidiaries. Max Re Capital’s principal source of funds is from interest income on cash balances and cash dividends from its subsidiaries, including Max Re. The payment of dividends is limited under Bermuda insurance laws. In particular, Max Re may not declare or pay any dividends if it is in breach of its minimum solvency or liquidity levels under Bermuda law or if the declaration or payment of the dividends would cause it to fail to meet the minimum solvency or liquidity levels under Bermuda law. At December 31, 2005, Max Re, which is required to have approximately $380.0 million in statutory capital and surplus in order to pay dividends, had approximately $1,085.0 million in statutory capital and surplus.
Capital resources. At December 31, 2005, our capital structure consisted of common equity. Total capitalization amounted to $1,217.2 million as compared to $937.0 million at December 31, 2004, an increase of 29.9%. We have flexibility with respect to capitalization as a result of our access to the debt and equity markets.
On October 11, 2005 we sold 11.0 million common shares at $23.50 per share in an underwritten public common share offering which resulted in net proceeds to Max Re Capital of approximately $246.0 million. As part of the offering, Max Re Capital granted the underwriters a 30 day option to purchase up to 1.65 million additional common shares. On November 4, 2005, the underwriters exercised their option in full, resulting in additional net proceeds to Max Re Capital of approximately $38.1 million. Substantially all of the net proceeds were contributed to our reinsurance operating subsidiaries to support expanded underwriting capacity, particularly in property insurance and property catastrophe reinsurance lines, in 2006 and for general corporate purposes.
Max Re Capital’s Board of Directors declared a dividend of $0.03 per share on February 4, 2005 and $0.05 per share on each of April 28, 2005, July 29, 2005 and October 27, 2005, payable to shareholders of record on February 14, 2005, May 13, 2005, August 12, 2005 and November 11, 2005, respectively. Continuation of cash dividends in the future will be at the discretion of the board of directors and will be dependent upon our results of operations and cash flows, and our financial position and capital requirements, general business conditions, legal, tax, regulatory and any contractual restrictions on the payment of dividends and other factors the board of directors deems relevant. On February 10, 2006, Max Re Capital’s Board of Directors declared a dividend of $0.05 per share to be paid on March 10, 2006 to shareholders of record on February 24, 2006.
We have been assigned an insurer financial strength rating of “A- (Excellent)” by A.M. Best Company, Inc. and an insurer financial strength rating of “A (Strong)” by Fitch, Inc. These ratings reflect each rating agency’s opinion of our financial strength, operating performance and ability to meet obligations. If an independent rating agency downgrades or withdraws any of our ratings, we could be severely limited or prevented from writing any new insurance or reinsurance contracts, which would significantly and negatively affect our business. To date, our ratings have been affirmed by A.M. Best and Fitch on each rating review. Insurer financial strength ratings are based upon factors relevant to policyholders and are not directed toward the protection of investors.
No off-balance sheet arrangements. We do not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
awards expire without being exercised and the adjustment of future expense based on revisions to fair value due to award modifications after grant date. The effective date for SFAS 123(R) has been deferred from periods beginning after June 15, 2005 to the first interim reporting period of the first fiscal year beginning after June 15, 2005. We believe that the amount of additional share-based compensation expense to be recognized by us under the provisions of SFAS 123(R) is not material.
In November 2005, FASB finalized FSP FAS 115-1-The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments. The FSP provides guidance on the recognition of impairments deemed other-than-temporary. FSP 115-1 is effective for other-than-temporary impairment analysis conducted in periods beginning after December 15, 2005. We believe that our current policy on other-than-temporary impairments complies with FSP 115-1. Accordingly, the adoption of this standard will not have a material effect on the consolidated financial statements.