The Company also leases office space for its branch offices. Crum & Forster does not own any of the real estate used for its operations.
General Liability. An individual investigation of each loss reported is undertaken and the claims personnel, using their experience and judgment, establish a case reserve in an amount estimated to be the most likely ultimate loss amount to be paid considering the assumed jurisdiction where the claim is pending and the applicable law of allowable direct and consequential damages and defenses; the effect, if any, of the particular venue, including settlement and verdict values; and, where applicable, the advice of counsel retained to represent the defendant in the individual case.
The Company’s actuaries conduct a full actuarial reserve study of each line of business every six months. For all lines of business other than asbestos, environmental and other latent, ultimate losses and LAE are projected by line of business by accident year using several standard actuarial methodologies, including paid and incurred loss development, the Bornheutter-Ferguson incurred and paid loss methods, the Berquist-Sherman loss methods and frequency and severity approaches. The Company’s actuaries utilize assumptions in determining their estimates, including loss development factors, expected loss ratios, frequency and severity trends, year-on-year price changes and inflation. These assumptions are affected by items such as past loss experience, changes in legislative conditions, changes in judicial interpretation of legal liability and policy coverage, and changes in claims handling practices. In addition, prevailing economic, social and legal factors, such as inflation in medical services, costs to repair damaged property or changes in statutory benefits, influence these assumptions. After projecting ultimate losses for each of the various actuarial methodologies, the actuaries select a point estimate ultimate for each accident year within a line of business based on many factors, such as the age of the accident year and the risk characteristics of the individual line of business. For example, for older years where more credibility can be placed upon actual observed loss emergence, paid or incurred loss development methods are generally the basis of the ultimate loss selection. For more recent years where the actual emergence of losses is less credible, methods that place more emphasis on expected loss development (e.g., the Bornheutter-Ferguson method) may be selected as the loss ultimate. A point estimate unpaid loss and LAE reserve is determined by subtracting actual paid losses and LAE from the projected ultimate losses and LAE for each line of business by accident year. These reserves are aggregated by line of business and the IBNR component is derived therefrom by deducting the recorded case reserves. The IBNR reserve includes anticipated additional development of case reserves (either positive or negative), provision for claims that have not been reported and estimated settlement expenses.
The majority of IBNR loss reserves relate to the Company’s casualty business, which generally has a longer tail (meaning a longer period of time between the occurrence of the covered event and the ultimate settlement of the claim) than the Company’s other lines of business. Line of business specific factors that are considered in the aforementioned actuarial methodologies that affect the IBNR reserves are as follows:
The shorter tailed lines, such as property, in which claims are paid shortly after the loss occurrence, have less variability in IBNR reserve estimates and are less dependent on the above assumptions. The key assumptions for the property line of business are catastrophe reserve estimates and cost to repair damaged property.
For liabilities other than asbestos, environmental and other latent, a range is developed around the point estimate loss and LAE reserves using statistical techniques to create an aggregate loss distribution. The methodology attempts to quantify the variability in the historical loss development data for each line of business separately. The variability depends on the line of business specific factors described above. From the aggregate loss distribution, an 80% confidence interval is constructed which represents a reasonable range of possible outcomes.
At each balance sheet date, Company management establishes its “best estimate” based on the actuarial point estimates by line of business from the most recent internal actuarial reserve review, together with the actual loss emergence since such most recent review. Consideration may also be given to the results of actuarial reserve reviews conducted by the Company’s independent actuaries. Management considers a “best estimate” to be one where the total reserves have an equal likelihood of developing a redundancy or deficiency as the loss experience matures. Following the completion of each semi-annual internal actuarial reserve review, management reviews the actuarial reserve valuation with the Company’s actuaries and compares the indicated reserve levels by line of business to the corresponding recorded reserves. In general, management’s best estimate will approximate the internal actuaries’ point estimates and recorded reserves will be adjusted to reflect approximately the actuarial indications by line of business and in the aggregate. While it has not been the case in recent years, there may, however, be circumstances in which management chooses not to adjust its best estimate for assumptions made by its actuaries regarding emerging trends - positive or negative - until the passage of further time or additional information has confirmed the credibility of the trend. At December 31, 2005 and 2004, management’s best estimate exceeded the actuaries’ point estimate in the aggregate by approximately $41 million and $18 million, respectively, before corporate aggregate reinsurance. In light of the inherent uncertainty associated with loss and LAE reserve estimates and the imprecise nature of the estimates, the Company considered such differences to be immaterial.
The Company has written general liability, commercial multi-peril and umbrella policies under which its policyholders continue to present asbestos, environmental and other latent claims. The vast majority of these claims are presented under policies written many years ago. There are significant uncertainties in estimating the amount of reserves required for asbestos, environmental and other latent claims. Reserves for these exposures cannot be estimated solely with the traditional loss reserving techniques described above, which rely on historical accident year development factors and take into consideration the previously mentioned variables. Among the uncertainties relating to asbestos, environmental and other latent reserves are a lack of historical data, long reporting delays and complex unresolved legal issues regarding policy coverage and the extent and timing of any such contractual liability. Courts have reached different, and frequently inconsistent, conclusions as to when losses occurred, what claims are covered, under what circumstances the insurer has an obligation to defend, how policy limits are determined and how policy exclusions are applied and interpreted.
Early asbestos claims focused on manufacturers and distributors of asbestos-containing products. Thus, the claims at issue largely arose out of the products hazard and typically fell within the policies’ aggregate limits of liability. Increasingly, policyholders have been asserting that their asbestos claims are not subject to these aggregate limits and that each individual bodily injury claim should be treated as a separate occurrence, potentially creating even greater exposure for primary insurers. Generally, policyholders who assert these positions are installers of asbestos products or property owners who allegedly had asbestos on their property. In addition, in an effort to seek additional insurance coverage, some policyholders that have eroded their aggregate limits are submitting new asbestos claims as “non-product” claims or attempting to reclassify previously resolved claims as non-product claims. Unlike product exposures, these non-product exposures are argued not to be subject to aggregate limits, creating potentially greater exposure. The extent to which policyholders will be successful in obtaining coverage on this basis is uncertain and court decisions have been inconsistent to date. Accordingly, it is difficult to predict the ultimate size of the claims for coverage not subject to aggregate policy limits.
The Company’s asbestos exposure is related mostly to policyholders that are peripheral defendants, including a mix of manufacturers, distributors and installers of asbestos-containing products, as well as premises owners. For the most part, these policyholders are defendants on a regional, rather than a nationwide, basis. As the financial assets and insurance recoveries of traditional asbestos defendants have been depleted, plaintiffs are increasingly focusing on these peripheral defendants.
Uncertainties also remain as to the Superfund law itself. The excise tax imposed to fund Superfund lapsed at the end of 1995 and has not been renewed. While a number of proposals to reform Superfund have been put forward by various parties, no reforms have been enacted by Congress since then. It is unclear what legislation, if any, will be enacted in the future and what potential effect it will have on the insurance industry. In the absence of federal movement on Superfund, the enforcement of Superfund liability is shifting to the states, which are reconsidering state-level cleanup statutes and regulations. As individual states move forward, the potential for conflicts among states becomes greater, increasing the uncertainty of the cost to remediate state sites.
There are risks and uncertainties associated with determining whether declines in the fair value of investments are other than temporary such as significant subsequent changes in general economic conditions, as well as specific business conditions affecting particular issuers; subjective assessment of issuer-specific factors (seniority of claims, collateral value, etc.); future financial market effects; stability of foreign governments and economies; future rating agency actions; and significant disclosures relating to accounting, fraud or corporate governance issues that may adversely affect certain investments. In addition, significant assumptions and management judgment regarding these risks and uncertainties are involved in determining if a decline is other than temporary.
For the years ended December 31, 2005 and 2003, charges for other than temporary impairments amounted to $3.9 million and $13.8 million, respectively, relating to one security for each year. There were no other than temporary impairments recorded for the year ended December 31, 2004. There have been no revisions to the amount of impairments recorded on these securities and the securities are carried at amounts that approximate post-impairment cost.
At December 31, 2005 and 2004, reinsurance recoverable was $2,110.1 million and $1,804.8 million, net of reserves for uncollectible reinsurance of $34.4 million and $40.9 million, respectively. Bad debt expense for the years ended December 31, 2005, 2004 and 2003 related to uncollectible reinsurance was $7.2 million, $5 million and $5.3 million, respectively. While management believes the allowance for uncollectible reinsurance recoverable is adequate based on information currently available, failure of reinsurers to meet their obligations could have a material adverse impact on the Company’s financial position and results of operations. At December 31, 2005, the five largest gross reinsurance recoverable balances aggregated $1,170.9 million, or 55.5% of the total reinsurance recoverable balance. Application of collateral reduces the unsecured exposure to these five reinsurers to $451.2 million. The largest unsecured balance at December 31, 2005 was $183.1 million, due from an unaffiliated company rated A+ by A.M. Best.
Although realization is not assured, management believes the recorded deferred tax assets are fully recoverable based on estimates of the future profitability of Crum & Forster’s taxable subsidiaries and current forecasts for the periods through which losses may be carried back and/or forward. The Company has several material deferred tax assets, including deferred gain on retroactive reinsurance, loss reserve discounting, net operating losses and unearned premium adjustment. The realizability of these reversing deferred tax assets is considered in conjunction with similar originating deferred tax assets and other taxable income. The Company’s current projections of future taxable income are based on assumptions of modest business growth and relatively stable combined ratios, with portfolio yields approximating current levels. Since 2002, the Company’s operating subsidiaries have recorded positive taxable income of $736.2 million that included capital gains and other investment income during that period of approximately $1 billion. This taxable income was sufficient to absorb the Company’s operating company net operating loss carryovers of $228.9 million arising prior to 2002. The current net operating losses of $128.4 million relate primarily to the Company’s debt. Under tax planning strategies allowed pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 109 the Company may elect to file a consolidated tax return for tax sharing purposes. Should such an election be made, the Company projects that these net operating losses can be fully utilized against the operating companies’ income, based on the assumptions discussed above.
At December 31, 2005, there are no valuation allowances against the Company’s deferred tax assets of $235.3 million. Should the assumptions of future profitability change significantly, however, or the taxable income of these entities fall far below expectations, a valuation allowance, which could be significant, may have to be established if management believes any portion of the deferred tax asset will not be realized. A valuation allowance may also be required if there is a material change in the tax laws such that the actual effective tax rate or the time periods within which the underlying temporary differences become taxable or deductible change. Realization of the deferred tax asset under SFAS No. 109 ultimately depends on the existence of sufficient taxable income available under tax law, including future reversals of existing temporary differences, future taxable income exclusive of reversing differences, taxable income in prior carryback years and tax planning strategies. Future profitability, as it relates to taxable income expectations discussed above, can be negatively affected by substantial changes in premium volume, persistent underwriting losses resulting from significant events such as severe natural disasters, large settlements for asbestos or environmental claims or materially lower investment results. While underwriting losses reduced taxable income in years 2002 through 2005, sufficient taxable income was generated during this period through capital gains and other investment income to enable the Company to realize deferred tax benefits of $118.7 million, thereby reducing net deferred tax assets from $293.9 million at December 31, 2001 to $175.2 million at December 31, 2005.
Investment results are generally measured in terms of total return on assets under management. Growth in the Company’s cash and invested assets is also a key measure of investment performance.
Net income was $155.9 million in 2005 as compared to $24.2 million in 2004. The increase in net income in 2005 is primarily due to better underwriting results and higher investment income. Favorable development of prior years’ losses and LAE in 2005 amounted to $68.6 million compared to adverse development of $69.3 million in 2004 and included adverse development of latent reserves of $44.6 million and $100.5 million in 2005 and 2004, respectively.
For the year ended December 31, 2005, the Company reported gross premiums written of $1,097.8 million, representing a decrease of $41.2 million, or 3.6%, over the year ended December 31, 2004. This decline was primarily due to a reduction in renewal retention rates from approximately 65% in 2004 to 61% in 2005, modest price decreases on renewal policies of approximately 5% and a reduction in new business of approximately 9%. The reduction in new business is largely attributable to a significant decrease in the casualty lines of business, with a more modest decrease for property lines. As the market continues to soften and competitors are focused on production growth, new business growth and the retention of existing accounts has become very challenging.
For the year ended December 31, 2004, the Company reported gross premiums written of $1,139 million, representing an increase of $34.8 million, or 3.2%, over the year ended December 31, 2003. The growth in gross premiums written was primarily due to an increase in the renewal retention rate from approximately 60% in 2003 to approximately 65% in 2004, partially offset by a decrease in new business of approximately 22%. Renewal retention rates increased despite the softening market, particularly in the property lines, as a result of the maturing of the Company’s book of business. New business declined as the market softened and competition for new business, particularly from higher rated companies, intensified. Overall, pricing remained relatively stable in 2004.
For the year ended December 31, 2004, gross premiums written in casualty lines increased by $42.7 million, or 6%, as compared to the year ended December 31, 2003. This increase was primarily due to modest increases in pricing on renewal policies and in the renewal retention rate, partially offset by a reduction in new business. The renewal retention rate was negatively affected by increased competition and the discontinuance of certain business programs accounting for approximately $17.7 million of gross premiums written in 2003.
California workers’ compensation gross premiums written totaled $136.6 million, $156.1 million and $147 million in 2005, 2004 and 2003, respectively.
For the year ended December 31, 2005, net premiums written decreased by $49.3 million, or 5.4%, as compared to the year ended December 31, 2004. The decrease was generally in line with gross premiums written after giving effect to reinsurance reinstatement premiums associated with catastrophe losses in both years and aggregate reinsurance premiums in 2004.
For the year ended December 31, 2004, net premiums written increased by $27.5 million, or 3.1%, as compared to the year ended December 31, 2003, which was in line with the growth in gross premiums written.
Premiums earned reflect the amount of net premiums written applicable to the portion of the policy term that expires in a given period. The Company generally earns premiums on a pro-rata basis over the period in which the coverage is provided. For the year ended December 31, 2005, premiums earned decreased by $13.5 million, or 1.5%, as compared to the year ended December 31, 2004.
The adverse development before corporate aggregate reinsurance in calendar year 2004 of $97.6 million (10.7 loss ratio points) was primarily due to deficiencies in asbestos reserves of $90.5 million, principally recorded in the fourth quarter following the Company’s internal actuarial review and an independent actuarial firm’s ground-up study of such reserves. The asbestos reserve increase was driven mainly by an increase in the average severity of claims for known policyholders and allegations of reclassification of products claims (that are subject to an aggregate limit) as premises/operations claims (that are not subject to an aggregate limit). Additionally, environmental reserves were strengthened by $10 million in the fourth quarter of 2004. The Company also recognized favorable development of $37.5 million for accident years 2003, primarily in property and workers’ compensation and $30.7 million in 1998 and prior, principally in non-latent general liability. This was largely offset by unfavorable non-latent development of $68.8 million for accident years 1999 and 2000, principally in the workers’ compensation and general liability lines.
Loss cessions to prospective corporate aggregate reinsurance in 2003 of $1.1 million includes the benefit of cessions to the accident year 2001 portion of the accident year 2000 through 2002 treaty with nSpire, a Fairfax affiliate, of $55.1 million, partially offset by charges of $54 million associated with the commutation of two prospective corporate aggregate reinsurance contracts. The commutation charge of $54 million included $27.2 million arising from the commutation of the accident year 2001 portion of the accident year 2000 through 2002 treaty with nSpire and $26.8 million related to commutation of a contract with an unrelated party covering accident years 1992 and prior.
Accident year loss and LAE ratios, as estimated at December 31, 2005 by line of business, net of per risk reinsurance but before the benefit of corporate aggregate reinsurance, are summarized as follows:
In 2005, the Company began to significantly restrict the writing of contract surety business. New contract bonds for existing contractors are written only in very rare circumstances and new contractors are no longer accepted.
Underwriting expenses are comprised of policy acquisition costs and other underwriting expenses. Policy acquisition costs are those costs that vary with and are primarily related to the acquisition of new and renewal policies and are comprised of commissions paid to producers and premium taxes. Other underwriting expenses consist of all other operating expenses associated with the Company’s underwriting activities, including salaries and benefits, information technology and rent. The Company’s underwriting expense ratio was 28.5%, 27.9% and 29.3% for the years ended December 31, 2005, 2004 and 2003, respectively. The policy acquisition ratio and the other underwriting expense ratio components of the underwriting expense ratio follow:
The Company’s policy acquisition expense ratio increased to 14.1% in 2005 from 13.6% in 2004, primarily due to higher reinsurance reinstatement premiums associated with catastrophe losses. The policy acquisition expense ratio increased to 13.6% in 2004 from 12.8% in 2003, primarily due to reinstatement premiums associated with catastrophe losses and lower amounts of ceding commissions paid by reinsurers in 2004.
Investment income was $131.1 million, $85.1 million and $69.9 million in 2005, 2004 and 2003, respectively. In 2005, the increase in investment income of $46 million, or 54.1%, was the result of higher earnings from HWIC Asia Fund, an affiliated investment, of $9.8 million, an increase in interest income from fixed income securities of $9.6 million due primarily to higher amounts of fixed income securities, an increase in dividend income of $9.1 million, including a special dividend on one of the Company’s equity securities and an increase in interest income on cash collateral pledged for short-sale obligations of $8.6 million. In 2004, the increase in investment income of $15.2 million, or 21.7%, was primarily due to the reinvestment of cash balances into longer-duration fixed income securities in mid-first quarter 2004 as well as higher earnings from equity method investees, partially offset by interest charges relating to higher funds held under reinsurance contracts. The proceeds from realized investment gains of $268.2 million in 2003 were held in low-yielding short-term investments, pending long-term reinvestment, which occurred in 2004. The net investment yield over the three-year period was also affected by interest charged on funds held from reinsurers under reinsurance contracts. Funds held from reinsurers on reinsurance contracts increased as the result of additional losses ceded under such contracts during 2004. For further discussion of investment income, see Note 3 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
Pre-tax equity in earnings of investees was $26.5 million, $19.2 million and $2.4 million in 2005, 2004 and 2003, respectively. The increase in pre-tax equity in earnings of investees in 2005 as compared to 2004 and 2003 was primarily attributable to higher earnings from Northbridge Financial Corporation (“Northbridge”), a Fairfax affiliate, which was purchased in the second quarter of 2003. Northbridge contributed $26.3 million, $18.1 million and $3.2 million to the Company’s pre-tax equity in earnings of investees in 2005, 2004 and 2003, respectively.
In 2005, the net decrease in unrealized investment gains and losses and foreign currency translation of $3.7 million was due to unrealized losses from fixed income securities offset by unrealized gains from equity securities and other invested assets. The net increase in unrealized investment gains and losses and foreign currency translation of $19.0 million in 2004 was due to unrealized gains from equity securities and other invested assets, partially offset by unrealized losses from fixed income securities.
Interest and other expense was $35.5 million, $41.6 million and $24.6 million in 2005, 2004 and 2003, respectively. The decrease in interest and other expenses in 2005 compared to 2004 was primarily due to a 2004 corporate expense of approximately $3.5 million related to a retirement and consulting agreement with the former chairman of the Company’s insurance subsidiaries and general fluctuations in corporate expenses. The increase in interest and other expense in 2004 as compared to 2003 was primarily due to increased interest expense of $33.2 million in 2004 as compared $18.7 million in 2003 on the Company’s 10-3/8% senior notes, which were issued in June 2003.
The effective income tax rate (including income taxes on equity in earnings of investees) was 32.4%, 31.7% and 34.5% for the years ended December 31, 2005, 2004 and 2003, respectively. The difference between the Company’s effective income tax rate and the statutory rate of 35% was primarily due to the benefit of dividends received deductions in both 2005 and 2004 and, in 2005, to the benefit of additional tax credits allocated to the Company as a result of a federal tax audit of the Company’s former parent company, Xerox Corporation. For further discussion of income taxes, see Note 8 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
As a holding company with no direct operations, Crum & Forster Holdings Corp.’s assets consist primarily of its investments in the capital stock of its insurance subsidiaries and deferred tax assets associated with holding company net operating losses. The Company requires cash to meet its annual debt service obligations (approximately $31.1 million per year), to pay corporate expenses and, ultimately, to repay the $300 million aggregate principal amount of senior notes due 2013. Crum & Forster’s ability to satisfy its corporate obligations is primarily dependent on the dividend paying capacity of its subsidiaries. State insurance laws restrict the amount of shareholder dividends that insurance companies may pay without prior approval of regulatory authorities. For a detailed discussion of shareholder dividend regulations, see “Item 1. Business-Insurance Regulatory Matters”.
On June 5, 2003, Crum & Forster Funding Corp. issued $300 million aggregate principal amount of 10-3/8% senior notes due 2013. Crum & Forster Funding Corp. was a Delaware corporation formed by Policy Inc., an unaffiliated third party, as a special purpose entity, solely for the purpose of issuing 10-3/8% senior notes due 2013. On June 30, 2003, Crum & Forster assumed all of Crum & Forster Funding Corp.’s outstanding obligations under such notes and the indenture governing such notes. These notes, which bear interest payable semi-annually at 10-3/8%, mature on June 15, 2013. The net proceeds from the offering of approximately $291 million were used to fund an interest escrow account of approximately $63.1 million to make the first four semi-annual interest payments on the notes and to pay a dividend to Fairfax in the amount of $217.9 million, with the remainder used to pay certain financing costs. Under the terms of the Company’s senior notes, the Company has significant restrictions on the amount of new debt that may be issued.
The agreements governing the bank credit facility of Fairfax contain restrictive covenants prohibiting Fairfax, with certain exceptions, from allowing Crum & Forster to borrow money, encumber its property or assets, acquire or attempt to acquire direct or indirect control of another person or asset where the acquisition is being contested or resisted, effect a reorganization, consolidation, merger, amalgamation or other business combination with any person other than a wholly-owned subsidiary of either Crum & Forster or Fairfax, dispose of property or assets other than in a bona fide disposition for fair value to an arm’s length third party or to Fairfax or one of its wholly-owned subsidiaries or enter into any agreements that limit the amount of dividends or management fees payable by the Company to Fairfax. Although Crum & Forster is not a party to the Fairfax credit facility, it is expected, and should be assumed, that Fairfax will not permit Crum & Forster to borrow additional funds unless it is permitted to do so pursuant to the Fairfax credit facility. This affects the Company’s ability to incur debt pursuant to bank loans or raise funds in the capital markets.
Gross premiums written declined by 3.6% in 2005 from 2004 following an increase of 3.2% from 2003. As the market continues to soften and competitors are focused on production, new business growth and the retention of existing accounts has become very challenging. These factors, coupled with any deterioration in the pricing environment, will affect cash flows from operations. While the Company’s accident year combined ratio (excluding hurricanes) has improved considerably in the last three years, there is no assurance that the Company will have the same experience in the future. Should the Company’s combined ratio deteriorate, cash flow from operations will be directly affected.
The particularly harsh hurricane seasons of 2005 and 2004 and latent claim payments also directly affected cash flows. In 2005, the Company reported gross and net incurred hurricane losses of $389.7 million and $96.3 million, respectively, associated with hurricanes Katrina, Rita, and Wilma. Gross and net incurred hurricane losses associated with the 2004 third quarter hurricanes were $182.5 million and $72.7 million, respectively. When these hurricanes occur, the Company is required to pay the direct losses and recover from its reinsurers any amounts covered by reinsurance contracts. The lapse of time between payments to claimants and recovery from reinsurers directly affects reported cash flows. In 2005, the Company paid $133.5 million related to the 2005 and 2004 hurricanes and recovered $40.5 million from reinsurers, while in 2004 the Company paid $40.7 million related to hurricanes and recovered $1.4 million from reinsurers. Ultimate payments and recoveries from reinsurers associated with the 2005 and 2004 hurricanes will take place over several years. There were no significant hurricane payments made in 2003. It is difficult to predict the impact of future catastrophes on the Company’s cash flows, but it is expected that they will occur in the future with similar effects on cash flows. Other claims settlements with significant reinsurance also have similar effects on the Company’s cash flows as payment of the direct loss to the claimant is generally made before any recovery from reinsurers can be made. In 2005 and 2004, the Company paid latent claims of $143.9 million and $98.6 million, respectively. Reinsurance recoverables for 2005 of $26.2 million, net of a $32.2 million claim payment which was recovered in 2005, and recoverables for 2004 of $22.2 million associated with these payments are expected to be collected over an extended period due to the complexity of the underlying claims. The Company also may periodically commute certain of its reinsurance treaties as it did in 2003. Upon commutation, the reinsurer makes a payment to the Company for the agreed upon settlement of all future contractual amounts. While these commutations improve cash flow in the year of commutation, the Company will have cash payments on the related claims as they come due in the future.
Cash provided by operating activities amounted to $25.5 million in 2005, $125.3 million in 2004 and $387.5 million in 2003. The decline in cash flows from operations in 2005 was the result of several factors including higher net paid hurricane and latent payments as discussed above, lower proceeds from reinsurance commutations of $49.6 million and lower premium collections of $35 million, partially offset by lower non-latent claim payments. The primary reasons for the decline in cash flows from operations in 2004 as compared to 2003 were $234.5 million in proceeds received in 2003 as a result of the commutation of two reinsurance treaties (an additional $39.5 million in proceeds from one such commutation was received in 2004) and, in 2004, higher net paid losses (attributable to higher net paid losses of $39.3 million on hurricanes and $15.8 million on latent claims in 2004), partially offset by growth in premium collections.
In 2005 and 2004, the Company pledged cash and U.S. Treasury securities as collateral for the Company’s obligation to purchase SPDRs (see “-Results of Operations -Investment results”). The fair value of such collateral was $496.9 million and $277.9 million at December 31, 2005 and 2004, respectively.
Estimates of future payments pursuant to the Company’s contractual obligations at December 31, 2005 are summarized as follows:
The postretirement health care and life insurance benefit obligations represent management’s best estimate of the ultimate payments required to provide such benefits, and such payments differ from the obligation recognized on the balance sheet by approximately $.6 million. The amounts included above for such obligations represents management’s best estimate of the timing of future payments. Actual payments may differ significantly from these estimates. Although the Company provides various benefit plans, programs and arrangements to its employees, the Company has reserved the right to amend, modify or terminate these plans, programs or arrangements at any time, subject to the terms and conditions of such plans, programs or arrangements and applicable law. For more information on the Company’s post-retirement benefit plans, see Note 10 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
At December 31, 2005 and 2004, the Company did not have any transactions, agreements or other contractual arrangements with an unconsolidated entity that would be considered an off-balance sheet arrangement required to be disclosed pursuant to Item 303(a)(4)of Regulation S-K.
Consolidated Statements of Shareholder’s Equity for the Years Ended December 31, 2005, 2004 and 2003
Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2005, 2004 and 2003
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, of shareholder’s equity, of comprehensive income and of cash flows present fairly, in all material respects, the financial position of Crum & Forster Holdings Corp., an indirect wholly-owned subsidiary of Fairfax Financial Holdings Limited, and its subsidiaries at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform our audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes 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. We believe that our audits provide a reasonable basis for our opinion.
Crum & Forster Holdings Corp. (the “Company” or “Crum & Forster”) is a Delaware holding company, which is 100% owned by Fairfax Inc., a Wyoming holding company. Fairfax Inc. is ultimately owned by Fairfax Financial Holdings Limited (“Fairfax”), a Canadian financial services holding company, which is publicly traded on the Toronto Stock Exchange and the New York Stock Exchange under the symbols “FFH.SV” and “FFH”, respectively. The Company, through its subsidiaries, offers a full range of commercial property and casualty insurance distributed through an independent producer force located across the United States.
These consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of the Company, Holding and their wholly-owned subsidiaries, including United States Fire Insurance Company (“US Fire”), The North River Insurance Company (“North River”), Crum & Forster Indemnity Company (“CF Indemnity”) and Crum and Forster Insurance Company (“CF Insurance”). US Fire owns 100% of the stock of Crum & Forster Specialty Insurance Company. North River owns 100% of the stock of Seneca Insurance Company, Inc. and its subsidiaries. All material intercompany accounts and transactions have been eliminated in consolidation.
The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and disclosure of contingent assets and liabilities. Such estimates and assumptions may differ from actual results. Certain amounts in the Company’s prior year consolidated financial statements have been reclassified to conform to the 2005 presentation.
The Company’s fixed income and equity securities are categorized as “available-for-sale” and are carried at their fair value based primarily on quoted market prices. Unrealized gains or losses on the Company’s investments, net of applicable income taxes, are included in other comprehensive income.
Unrealized losses that are deemed other than temporary are charged to operations. The Company considers an impairment as “other than temporary” if evidence indicating that an investment’s carrying amount is recoverable within a reasonable period of time, which in the case of fixed income securities, may mean until maturity, is outweighed by evidence to the contrary. The Company also considers its ability and intent to hold an investment until such recovery of the security’s fair value. Notwithstanding the foregoing, with respect to fixed income securities, an impairment may be considered other than temporary if it is probable that the Company will be unable to collect all amounts due under the terms of the securities. Recognition of impairment losses for declines in the value of fixed income investments and equity securities attributable to issuer-specific events are based upon all relevant facts and circumstances for each investment. Factors considered by management include, but are not limited to, the impact of issuer-specific events, current and expected future market and economic conditions, the nature of the investment, the number of investment positions with losses, the severity and duration of the impairment and the volatility of the security’s market price.
The estimated liability for unpaid losses and loss adjustment expenses (“LAE”) includes estimates of the ultimate settlement value of reported claims, incurred but not reported claims, future expenses to be incurred in the settlement of claims and claim recoveries. These estimates are determined based on the Company’s loss experience, as well as consideration of industry experience and current trends and conditions. The estimated liability for unpaid losses and LAE is an estimate and future loss payments could differ significantly from initial estimates. The methods of determining such estimates and the resulting estimated liability are regularly reviewed and updated. Changes in the estimated liability for unpaid losses and LAE are reflected in income in the period in which such changes are required.
The Company maintains a reserve for uncollectible loss deductibles. This reserve includes both specific allowances for probable uncollectible amounts and a non-specific reserve determined principally on the basis of past collection experience. At December 31, 2005 and 2004, the amount of the reserve was $8,680 and $5,738, respectively.
The Company participates in tax sharing agreements that provide for the inclusion of the Company in the consolidated federal income tax returns of Fairfax Inc. (the “Fairfax Group”), as well as the consolidated or combined state income or franchise tax returns of Fairfax Inc. Subject to the tax sharing agreements discussed in this paragraph, every member of the Fairfax Group is severally liable for the federal income tax liabilities of the Fairfax Group and may be liable under similar rules for state income or franchise taxes of the entire group. Under the tax sharing agreements, Crum & Forster and its insurance subsidiaries make payments to Fairfax Inc. equal to the amounts of federal income taxes that each company would pay, subject to some adjustments, if they each had filed their own separate federal income tax returns, and their shares of any state income or franchise taxes. Although the Company does not currently offset its losses (including amounts arising from interest expense on its senior notes) or losses of one of its subsidiaries against income of another in computing the federal income tax payments to Fairfax Inc. under the tax sharing agreements, during 2005, Fairfax Inc. and the Company reaffirmed, in writing, the Company’s interpretation of the agreements that all tax elections, including the election to file a consolidated tax return, are available to the Company. Furthermore, Fairfax Inc. confirmed its commitment to stand in the place of the tax authority for purposes of determining federal income tax payments, including the requirement to honor all valid tax elections.
Insurance premiums are earned ratably over the terms of the related policies after deductions for premiums ceded to reinsurers. Unearned premium reserves are established for the unexpired portion of policy premiums. Premiums are accrued for retrospectively rated policies and on policies subject to audit based on estimates throughout the contract or policy term. The reserve for uncollectible premiums includes both specific allowances for probable uncollectible amounts and a non-specific reserve determined principally on the basis of past collection experience. At December 31, 2005 and 2004, the reserve for uncollectible premiums was $24,437 and $23,859, respectively.
Financial statements of foreign investees accounted for using the equity method are translated into U.S. dollars in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 52, “Foreign Currency Translation”. Under SFAS No. 52, investments in entities accounted for under the equity method are translated into U.S. dollars at the rate of exchange in effect at the date of the transaction and related equity earnings are translated at the average rate in effect during the period. At each balance sheet date, the carrying amounts are translated into U.S. dollars at the rate in effect at the balance sheet date and any translation gains or losses are recorded in other comprehensive income.
The Company periodically purchases certain derivative contracts for its investment portfolio consistent with its overall investment strategy. Such derivative contracts are accounted for in accordance with SFAS No. 133, “Derivatives and Hedging”, as amended, which requires derivatives to be recorded at fair value on the balance sheet. Changes in fair value are recognized in the statement of income.
The aggregate carrying value of the Company’s investment portfolio was $3,223,635 and $3,217,610 at December 31, 2005 and 2004, respectively, and is comprised of available-for-sale securities, other invested assets and cash and cash equivalents.
The amortized cost and fair value of fixed income securities by contractual maturity are shown below. Actual maturities may differ from maturities shown below due to the existence of call features. At December 31, 2005, securities containing call features represented 3% of the total fair value of the fixed income portfolio.
Certain individual available-for-sale securities had gross unrealized losses at December 31, 2004 totaling $67,518 of which $48,060 was attributed to fixed income securities and $19,458 was attributed to equity securities. U.S. Treasury securities, the majority of which mature in 2020 or beyond, accounted for $43,712 of the gross unrealized losses in the fixed income portfolio. The total gross unrealized losses of $67,518 represented 3.5% of the cost of such securities in the aggregate.
At December 31, 2004, approximately $592, or 1.2%, of the fixed income portfolio gross unrealized losses were attributable to two securities in an unrealized loss position for greater than 12 consecutive months. One fixed income security had a gross unrealized loss totaling $1,094, which exceeded 10% of its amortized cost at December 31, 2004. No fixed income securities had unrealized losses that were both greater than 12 consecutive months and exceeded 10% of amortized cost.
At December 31, 2004, no securities in the Company’s equity portfolio had gross unrealized losses attributable to securities in an unrealized loss position for greater than 12 consecutive months. Four equity securities had gross unrealized losses totaling $19,454, which exceeded 10% of their cost at December 31, 2004. The majority of the $19,454 unrealized loss was attributable to one equity security in the pharmaceutical industry. The remaining unrealized loss of $4 was attributable to one equity security and was less than 10% of its cost at December 31, 2004.
Securities that are in a loss position are reviewed by management at least quarterly for potential impairment. Management’s review involves detailed credit analyses in the case of non-U.S. Treasury securities. While a loss position for 12 consecutive months or a 10% price decline is considered significant, upon review of securities in this category, management has concluded that such price declines are temporary market price fluctuations. Management has the ability to hold these securities until maturity or until the anticipated recovery in market value occurs.
The components of investment income for the years ended December 31, 2005, 2004 and 2003 are summarized as follows:
The components of realized investment gains for the years ended December 31, 2005, 2004 and 2003 are summarized below:
Included in realized investment gains of equity securities for the year ended December 31, 2003 is $40,725 from the exchange of Hub International Limited common stock and debentures held by the Company for approximately 7.8 million shares of the common stock of Northbridge Financial Corporation (TO:NB), a subsidiary of Fairfax, that completed an initial public offering of its common stock in 2003.
In December 2005, the Company acquired 398,837 units of Dalton, an affiliate, for consideration of $7,985.
In August 2005, the Company completed the sale of one million shares of Zenith common stock at a price of $66 per share. The Company received net proceeds of $65,997 from the transaction, resulting in a pre-tax realized gain of $37,997. Following completion of this sale, the Company continued to hold approximately 3,360,670 shares of Zenith common stock, which represented a 9% interest in Zenith. On February 7, 2006, the Company sold its remaining Zenith shares for proceeds of $169,311 and a realized gain of $106,578.
In November 2004, the Company invested $10,000 in Pacific, a fund owned 100% by Fairfax affiliates, which invests primarily in Japanese equity securities. In January 2005, the Company invested an additional $10,000, bringing the total investment in Pacific to $20,000. Since its initial purchase, the Company increased its investment by $9 under the equity method for its share of Pacific’s income. In December 2005, the Company redeemed all of its investment in Pacific for consideration of $22,304, resulting in a realized investment gain of $2,295.
In July 2004, the Company sold 66,775 shares of Zenith common stock for total proceeds of $2,748, resulting in a realized investment gain of $1,030.
The Company purchased its investment in Northbridge in May 2003 and holds a 15.2% interest at December 31, 2005. For the years ended December 31, 2005, 2004 and 2003, pre-tax equity in earnings of Northbridge were $26,319, $18,118 and $3,180, respectively, and were included in equity in earnings of investees, net of tax, on the consolidated statements of income. Dividends received from Northbridge were $4,205, $3,591 and $1,722 in 2005, 2004 and 2003, respectively.
As an economic hedge against a decline in the U.S. equity markets, the Company executed short-sales of Standard & Poor’s Depositary Receipts (“SPDRs”) in July 2004 and January 2005 totaling approximately $300,000. Simultaneously, the Company purchased two-year S&P Index call options (“Options”) limiting the potential loss on the future purchase of the SPDRs to $60,000. The total cost of the Options was $8,217. Both the obligations to purchase the SPDRs and the Options are carried at fair value on the consolidated financial statements. The fair value of the obligations to purchase the SPDRs is included in short-sale obligations and the fair value of the Options is included in other invested assets on the consolidated balance sheets. For the years ended December 31, 2005 and 2004, the change in the fair value of the SPDRs obligation amounted to a loss of $12,349 and $17,632, respectively. For the years ended December 31, 2005 and 2004, the change in the fair value of the Options amounted to a loss of $4,254 and a gain of $2,395, respectively. The net change in the fair value of the SPDRs obligation and the Options is included in realized investment gains on the consolidated statements of operations. The fair values of the SPDRs obligation and the Options at December 31, 2005 amounted to a liability of $329,740 and an asset of $6,358, as compared to a liability of $217,378 and an asset of $8,395 at December 31, 2004. The Company also incurs additional expense in an amount equal to the dividend earnings on the SPDRs sold. Dividend earnings on the SPDRs amounted to $5,692 and $2,495, for the years ended December 31, 2005 and 2004, respectively, and are included as an investment expense on the consolidated statements of income.
At December 31, 2005 and 2004, the fair value of the Company’s derivative contracts was $40,528 and $13,069, respectively, including the Options discussed above. For the years ended December 31, 2005 and 2004, the Company recorded net realized investment losses of $34,305 and $1,373, respectively, as a result of changes in the fair value of derivative contracts. The majority of the Company’s derivative contracts consist of credit default swaps on securities issued by various U.S. companies in the banking, mortgage and insurance industries and serve as economic hedges against declines in the fair value of the Company’s financial assets. At December 31, 2005 and 2004, the fair value of the Company’s credit default swaps was $33,559 and $4,224, respectively.
Fixed income securities and cash and cash equivalents of $323,699 and $292,408 were on deposit with various state regulatory authorities at December 31, 2005 and 2004, respectively, as required by insurance laws.
In conjunction with the issuance of the Company’s $300,000 aggregate principal amount of 10-3/8% senior notes due 2013, Crum & Forster funded an interest escrow account in the amount of $63,115. Following the June 2005 semi-annual interest payment, the Company was no longer required to maintain the escrow account, in accordance with the terms of the indenture.
Changes in the Company’s liability for unpaid losses and LAE are summarized as follows:
Losses and LAE paid in 2003 for prior accident years are reduced by $273,977 in proceeds from the commutation of two reinsurance contracts in December 2003.
The Company has exposure to asbestos and environmental pollution claims arising from the sale of general liability, commercial multi-peril and umbrella insurance policies, the predominance of which were written for accident years 1985 and prior. Estimation of ultimate liabilities for these exposures is unusually difficult due to issues such as whether coverage exists, the definition of an occurrence, the determination of ultimate damages and allocation of such damages to financially responsible parties.
Current accident year losses and LAE in both 2005 and 2004 were significantly affected by severe hurricane activity. In 2005, hurricanes Katrina, Rita and Wilma accounted for approximately $389,700 and approximately $57,000 of gross and net losses and LAE, respectively. In 2004, hurricanes Charley, Frances, Ivan and Jeanne accounted for approximately $149,300 and approximately $83,000 of gross and net losses and LAE, respectively. Ceded premiums written and earned were increased, and net premiums written and earned were accordingly decreased, by related property catastrophe treaty reinstatement premiums of approximately $39,300 and approximately $13,000 in 2005 and 2004, respectively.
In 2003, the Company strengthened its asbestos reserves by $149,835 based on its latest actuarial estimates. The asbestos increase was largely due to a significant increase in the number of new policyholders presenting claims for asbestos exposures. In addition, commutations of two reinsurance contracts resulted in a $53,968 charge to incurred losses and LAE related to prior years. These reserve increases were partially offset by favorable development of $34,919 for accident year 2002 and $47,592 for accident years 2000 and prior.
Changes in the Company’s liability for asbestos and environmental exposures are summarized as follows:
At December 31, 2005, the Company had reinsurance recoverable of $2,110,115, due from approximately 300 reinsurers. At such date, the five largest gross reinsurance recoverable balances aggregated $1,170,942, or 55.5% of the total reinsurance recoverable balance. Application of collateral reduces the unsecured exposure to these five reinsurers to $451,207. The collateral received with respect to these top five reinsurers is in the form of clean, unconditional, irrevocable and evergreen letters of credit in the amount of $130,168, irrevocable trusts in the amount of $394,113 and funds held in the amount of $231,806, with one reinsurer’s collateral exceeding its reinsurance recoverable balance. The letters of credit are in compliance with NAIC regulations and are issued or confirmed by Bank of Montreal and Lloyds TSB Bank which are both NAIC approved banks that are not related to Fairfax or any Fairfax affiliates. The irrevocable trusts are in compliance with NAIC regulations and are principally composed of cash and fixed income securities of various issuers, virtually all of which are investment grade rated securities. None of the issuers of the fixed income securities is related to Fairfax or any Fairfax affiliates. The funds withheld balances are held in the Company’s general account and equal premiums plus interest thereon credited at the rates stipulated in the related reinsurance contracts. There is no limitation on the ability of the Company to access these funds in accordance with the reinsurance agreements. The largest unsecured balance at December 31, 2005 was $183,076 with an unaffiliated company rated A+ by A.M. Best Company.
Includes $389,010 which has been recognized as a reduction of losses and LAE less $21,510 for additional premiums due on retrospectively rated insurance policies that inure to the benefit of the reinsurer. Total amounts recognized as a reduction of losses and LAE include the $389,010 above, $53,145 on the 2000 accident year prospective aggregate stop loss contract and $49,686 of amortization of deferred gains on the retroactive reinsurance contracts.
The subject loss and LAE ratio as valued at December 31, 2005 is 64.2%. No additional premium or funds held interest will be due under this contract upon usage of the remaining limit. Coverage of accident years 2000 and 2001 under this contract has been exhausted and recovered. The reinsurer under this contract is nSpire, a Fairfax affiliate.
The reinsurance contracts discussed above were put in place to protect the Company’s surplus while the Company took the steps necessary to improve underwriting results following its acquisition by Fairfax in 1998. The Company has not purchased corporate aggregate reinsurance since 2002 and does not currently have plans to purchase corporate aggregate reinsurance in the future.
For additional information on reinsurance transactions with related parties, see Note 9. Related Party Transactions.
The current agreements governing the bank credit facility of Fairfax contain restrictive covenants, which prohibit Fairfax from allowing any of its subsidiaries to borrow money. These agreements are not legally binding on Crum & Forster; however, given the potential negative financial impact on Fairfax of violations of these covenants, it is expected, and should be assumed, that Fairfax, as the sole shareholder, will not permit Crum & Forster to borrow unless a modification or waiver of these covenants can be obtained.
Deferred income taxes reflect the income tax impact of temporary differences between the amount of assets and liabilities for financial reporting purposes and such amounts as measured by income tax laws and regulations. The deferred income tax expense above does not include $9,258, $6,719 and $844 in 2005, 2004 and 2003, respectively, of income taxes, which are included in equity in earnings of investees, net of tax, on the consolidated statements of income. Total deferred income tax expense (benefit) in 2005, 2004 and 2003 was $60, ($17,244) and $24,888, respectively.
At December 31, 2005, the Company had net operating and other loss carryforwards of approximately $128,429. These will expire between 2009 and 2025. Based on projections of estimated future operations, management expects the deferred income tax asset to be recovered from taxable income in future years.
The Company entered into an aggregate stop loss agreement covering accident years 2000 through 2002. For accident years 2002 and 2001, nSpire is the direct reinsurer. Accident year 2000 was fronted by a third party reinsurer that retroceded the liability in full to nSpire on the same terms and conditions as if nSpire were the direct reinsurer. The 2000 accident year was exhausted in 2000 and recovered in full in 2004. The Company retains an ultimate net loss of up to 70% of net premiums earned in 2002 and 73% in 2001. Accident years 2002 and 2001 are subject to a per-term maximum recovery of $96,272 and $94,195 respectively. Pursuant to the agreement, the Company ceded premiums of $32,091 and $31,398 for accident years 2002 and 2001, respectively. At December 31, 2005 and 2004, no losses were ceded to nSpire under this contract for accident year 2002. During 2003, the Company ceded losses of $55,098 for accident year 2001, which exhausted the limit. In December 2003, the Company and nSpire commuted the 2001 accident year liabilities of $94,195. In connection with the commutation, Crum & Forster received the estimated present value of the ceded liability of approximately $67,002 from nSpire. The excess of the nominal ceded liabilities over the present value received of approximately $27,193 was recorded as a component of incurred losses and LAE on the consolidated statement of operations. At December 31, 2003, $39,514 of the settlement amount was recorded as a receivable in other assets on the consolidated balance sheet and was received by the Company in January 2004.
In the normal course of business, the Company has several reinsurance agreements in effect with Odyssey America Reinsurance Corporation (“Odyssey America”) and its subsidiaries, affiliates of Fairfax. Under these agreements, Odyssey America participates on contracts covering substantially all reinsured lines of business. For the years ended December 31, 2005, 2004 and 2003, the Company ceded $8,879, $7,247 and $7,434, respectively, in premiums to Odyssey America and had reinsurance recoverable of $35,626 and $20,118 at December 31, 2005 and 2004, respectively, under these reinsurance agreements.
A former parent of the Company required the transfer of a number of policies and related assets and liabilities among insurance companies controlled by the former parent, effective through assumption and indemnity reinsurance agreements. The assuming parties were required to seek novation of certain policies. At December 31, 2005 and 2004, amounts recoverable from TIG included $122,321 and $122,222, respectively, related to these policies.
Effective January 1, 2001, the Company entered into a reinsurance agreement with Lombard General Insurance Company of Canada (“Lombard”), an affiliate of Fairfax, under which the Company has agreed to reinsure 100% of the surety business of Lombard underwritten by the Company. For the years ended December 31, 2005, 2004 and 2003, the Company assumed $340, $788 and $1,103, respectively, in premiums from Lombard. At December 31, 2005 and 2004, the Company had $1,002 and $1,002 in reserves for this assumed business.
The Company has various reinsurance agreements in the normal course of business in effect with RiverStone Insurance (UK) Ltd., an affiliate of Fairfax. No premiums were ceded to RiverStone Insurance (UK) Ltd. in 2005, 2004 and 2003. At December 31, 2005 and 2004, the Company had reinsurance recoverable of $7 and $26, respectively, on these policies.
The Company and its subsidiaries have entered into agreements with Hamblin Watsa Investment Counsel Ltd. (“Hamblin Watsa”), a wholly-owned subsidiary of Fairfax, for investment management services, and with Fairfax for investment administration services. Pursuant to the agreements, fees, based upon assets under management, totaled $13,924, $7,606 and $7,506 for the years ended December 31, 2005, 2004 and 2003, respectively, and were included as investment expenses in the consolidated statements of income.
On September 28, 2005, the Company completed the sale of 271,000 shares of common stock of a publicly traded pharmaceutical company to Fairfax affiliates at the prevailing market price of $27.50 per share. The Company received net proceeds of $7,439 from the transaction, resulting in a pre-tax realized loss of $2,561.
Under an agreement effective July 1, 2000, the Company appointed RiverStone Claims Management LLC (“RiverStone”), a wholly-owned subsidiary of Fairfax, as its claims manager to handle its asbestos, environmental, other latent and construction defects claims. The expense incurred for these services was $3,600, $3,600 and $2,100 for the years ended December 31, 2005, 2004 and 2003, respectively. The Company also engages RiverStone on a contingent basis to assist in reinsurance commutation negotiations. Fees for such services were $58, $5 and $338 in 2005, 2004 and 2003, respectively.
Fairfax purchases insurance coverage on behalf of its affiliates, including comprehensive crime, insurance companies’ professional liability, directors’ and officers’ liability and company reimbursement, employment practices liability, fiduciary liability and special accident insurance. The Company’s share of the expense incurred for this coverage was $1,417, $1,396 and $1,141 per year for the years ended December 31, 2005, 2004 and 2003, respectively.
Under an agreement effective October 1, 2001 through January 1, 2004, the Company provided certain claims services to TIG. Fees billed for these services were $84 in 2003.
The Company receives loss adjustment services from Cunningham Lindsey U.S., Inc., an affiliate of Fairfax. Expenses incurred for these services were $33, $64 and $132 for the years ended December 31, 2005, 2004 and 2003, respectively.
Included in accounts payable and other liabilities at December 31, 2005 and 2004 are amounts payable to Fairfax and affiliates of $8,564 and $4,173, respectively.
A reconciliation of the changes in the postretirement plans’ benefit obligation, fair value of assets, accrued benefit cost and a statement of the funded status is presented below. The Company uses a December 31 measurement date for its postretirement health care and life insurance plans.
The Medicare Prescription Drug, Improvement and Modernization Act of 2003, which was enacted in December 2003, introduced a prescription drug benefit under Medicare (Medicare Part D) as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. The Company’s plan was not deemed actuarially equivalent last year but, due to provisions in the final regulations, the plan was deemed actuarially equivalent for 2005. As a result, the accumulated postretirement benefit obligation at December 31, 2005 and net periodic postretirement benefit cost for the year ended December 31, 2005 were reduced by $1,691 and $238, respectively.
Rental expense, before sublease income, under these operating leases was $14,470, $12,325 and $18,558 in 2005, 2004 and 2003, respectively. Rental expense for 2003 includes a $4,312 charge for future rent payments on facilities that are currently vacant. The Company recognized $1,160, $1,821 and $2,064 in 2005, 2004 and 2003, respectively, from subleases.
The Company has purchased structured settlement annuities from various insurance companies in order to settle certain claim liabilities. Should these other companies become unable to make the annuity payments, the Company would be liable. The value of these annuities included in reinsurance recoverable in the consolidated balance sheets at December 31, 2005 and 2004 was approximately $152,521 and $152,022, respectively. Approximately 81% of this balance is due from insurance companies rated A- or better by A.M. Best Company.
On September 7, 2005, Fairfax announced that it received a subpoena from the SEC requesting documents regarding any non-traditional insurance or reinsurance transactions entered into or offered by Fairfax and the entities in its consolidated group. The U.S. Attorney’s Office for the Southern District of New York is reviewing documents produced by Fairfax and the entities in its consolidated group to the SEC and is participating in the investigation of these matters. Fairfax and entities in its consolidated group are cooperating fully with these requests. Fairfax has prepared presentations and provided documents to the SEC and the U.S. Attorney’s Office, and its employees, including senior officers, have attended or have been requested to attend interviews conducted by the SEC and the U.S. Attorney’s Office.
Fairfax and its Chief Executive Officer, V. Prem Watsa, who is also the chairman of the board of directors of the Company, received subpoenas from the SEC in connection with the answer to a question on Fairfax’s February 10, 2006 investor conference call concerning the review of finite insurance contracts of Fairfax and entities in its consolidated group. In the fall of 2005, Fairfax and entities in its consolidated group, including the Company, prepared and provided to the SEC a list intended to identify certain finite contracts and contracts with other non-traditional features of all Fairfax consolidated group companies. As part of the 2005 reporting and closing process, Fairfax and entities in its consolidated group, including the Company, internally reviewed all of the contracts on the list provided to the SEC and some additional contracts as deemed appropriate. For those reinsurance contracts that the Company identified as finite or non-traditional reinsurance contracts, the Company consolidated relevant contract documentation into a single compendium, prepared memoranda regarding the rationale and economic intent of each contract and prepared analyses of reinsurer experience where contemporaneous documentation of risk transfer was not available.
The Company and US Fire, among numerous other insurance company and insurance broker defendants, have been named as defendants in a class action suit filed by policyholders alleging, among other things, that the defendants used the contingent commission structure to deprive policyholders of free competition in the market for insurance. The action is pending in the U.S. District Court for the District of New Jersey. Plaintiffs seek certification of a nationwide class consisting of all persons who between August 26, 1994 and the date of class certification engaged the services of any one of the broker defendants and who entered into or renewed a contract of insurance with one of the insurer defendants. The Company intends to defend vigorously the action.
The Company’s subsidiaries are involved in various lawsuits and arbitration proceedings arising in the ordinary course of business. While the outcome of such matters cannot be predicted with certainty, in the opinion of management, no such matter is likely to have a material adverse effect on the Company’s consolidated net income, financial position or liquidity. However, it should be noted that the frequency of large damage awards, including punitive damage awards that bear little or no relation to actual economic damages incurred by plaintiffs in some jurisdictions, continues to create the potential for an unpredictable judgment in any given matter.
The calendar year losses and LAE and losses and LAE ratios of the Company’s lines of business are summarized as follows:
Investment income includes realized investment gains and losses and pre-tax equity in earnings of investees.
Effective January 1, 2006, Fairfax announced that certain of the business of the insurance companies of Fairmont Specialty Group, affiliates of Fairfax, would be carried on as Fairmont Specialty, a division of Crum & Forster (“Fairmont Specialty”), thereby giving Fairmont Specialty access to the “A-” A.M. Best rating of Crum & Forster. In return for the opportunity to quote Fairmont Specialty Group’s renewals effective January 1, 2006 and thereafter, the Company has hired substantially all Fairmont Specialty Group employees and assumed certain operating obligations. Among these obligations are the office leases, which have future minimum payments totaling $3,706. Pending licensing and filing approvals for US Fire, North River and CF Indemnity, the policies underwritten by Fairmont Specialty will be issued by the insurance companies of Fairmont Specialty Group and assumed by the Company through a 100% quota share reinsurance agreement.
For the year ended December 31, 2005, Fairmont Specialty Group reported gross premiums written and net premiums written of approximately $205,800 and $159,100, respectively, which included energy and agricultural, standard personal and commercial lines, accident and health and bail bond premiums.