The reinsurance markets have historically been highly cyclical in nature. The cycle is driven by competition, the amount of capital and capacity in the industry, loss events, and investment returns. The Company’s long-term strategy to generate shareholder value focuses on broad product and geographic diversification of risks, assuming a moderately greater degree of risk than the market average, actively managing its capital across its portfolio and over the duration of the cycle, adding value through underwriting and transactional excellence, and achieving superior returns on invested assets in the context of a disciplined risk framework.
During 2005, pricing was generally flat to down, except for those lines specifically affected by the 2004 hurricanes, and led to a reduction in premiums written by the Company in 2005. However, 2005 eventually developed into the worst year in the history of the industry in terms of catastrophe losses, with Hurricane Katrina, which devastated the Gulf Coast in late August, being the largest insured event ever. The catastrophic events of 2005, which included two other significant Atlantic hurricanes, Rita and Wilma, as well as a significant winterstorm and a flood in Europe, followed an unusually active Atlantic hurricane season in 2004. Consequently, the Company observed in 2006 strong pricing increases in the lines and geographies that were affected by the large 2005 catastrophic loss events, including catastrophe covers in the southeastern U.S. and in the U.S. property and energy lines. Pricing in other lines was generally stable.
During the January 1, 2007 renewals, the Company observed strong pricing in U.S. wind-exposed lines, while all other lines saw pricing declines. There was a significant increase in risk retention by cedants, as well as
a trend to restructure proportional business to a non-proportional basis, which reduced the overall amount of premiums in the reinsurance marketplace. Nevertheless, the Company wrote a considerable amount of new business during the January 1, 2007 renewals and believes it has maintained profitability on business renewed. While facing the changes in market conditions, the Company has not changed its strategy or approach to business and continues to be opportunistic in writing business in its property, casualty and specialty lines. The Company also continues to maintain balance and diversification in its overall portfolio and to maintain its focus on growth in its Life and ART business segments.
The prevailing competitive environment in which most of the ART products are written is currently characterized by high liquidity, high asset valuations, and low credit spreads. This environment has been in place for the last few years and has limited organic growth opportunities. The Company’s response has been to continue to apply underwriting discipline, opportunistically grow in existing classes, and selectively expand its scope to new niche asset classes. In addition to providing more opportunities for profitable growth, this expansion strategy has increased the diversification with the ART segment, and positioned the Company to participate in the next cyclical correction in the nontraditional credit markets.
The Company also generates revenue from its substantial and high quality investment portfolio. The Company follows prudent investment guidelines through a strategy that seeks to maximize returns while managing investment risk in line with the Company’s overall objectives of earnings stability and long-term book value growth. Liability funds are used to support the Company’s net reinsurance liabilities, defined as the Company’s operating and reinsurance liabilities, net of reinsurance assets, and are invested in a way that generally matches them to the corresponding liabilities in terms of both duration and currency composition to protect the Company against changes in interest and foreign exchange rates. The Company invests the liability funds in high-quality fixed income securities with the primary objective of preserving liquidity and protecting capital. Capital funds are invested to achieve total returns that enhance growth in shareholders’ equity and are invested in investment-grade and below investment-grade fixed income securities and equity instruments. A key challenge for the Company is achieving the right balance between current investment income and total returns (that include price appreciation or depreciation) in changing market conditions. The Company regularly reviews the allocation of investments to asset classes within its investment portfolio and reallocates investments to those asset classes the Company anticipates will outperform in the near future, subject to limits and guidelines. The Company may also lengthen or shorten the duration of its fixed income portfolio in anticipation of changes in interest rates, or increase or decrease the amount of credit risk it assumes, depending on credit spreads and anticipated economic conditions.
In addition to revenues generated from its underwriting operations and investment activities, the Company’s profitability is significantly affected by the level of its losses and loss expenses incurred. The Company recognizes losses and loss expenses on the basis of actual and expected claims on business written. The
Company’s non-life net reserve position at December 31, 2006 was $6.7 billion. Management believes that it follows prudent reserving policies in pursuit of a strong financial position. A key challenge for the Company is the accurate estimation of loss reserves for each line of business, which is critical in order to accurately determine the profitability of each line and allocate the optimal amount of capital to each line. The risk for the Company is that it will allocate too much of its capital to one or more lines of business that are less profitable than anticipated, and not enough capital to those lines of business that eventually prove to be more profitable.
Diluted Book Value per Share: Management uses diluted book value per share growth as a prime measure of the value the Company is generating for its common shareholders, as Management believes that growth in the Company’s diluted book value per share ultimately translates into growth in the Company’s stock price. Diluted book value per share is calculated using common shareholders’ equity (shareholders’ equity less the liquidation value of preferred shares) divided by the number of fully diluted shares outstanding. Diluted book value per share is impacted by the Company’s net income and external factors such as interest rates, which can drive changes in unrealized gains or losses on its investment portfolio. Since December 31, 2001, the Company has generated a compound annual growth rate in diluted book value per share in excess of 14%.
ROE: Management uses operating return on beginning shareholders’ equity (ROE) as a measure of profitability that focuses on the return to common shareholders. It is calculated using net operating earnings (loss) available to common shareholders (net income excluding after-tax net realized gains or losses on investments and preferred share dividends) divided by beginning common shareholders’ equity. Management has set a minimum 13% ROE target over the reinsurance cycle, which Management believes provides an attractive return to shareholders for the risk assumed. Each business unit and support department throughout the Company is focused on seeking to ensure that the Company meets the 13% return objective. This means that most economic decisions, including capital allocation and underwriting pricing decisions, incorporate an ROE impact analysis. For the purpose of that analysis, an appropriate amount of capital (equity) is allocated to each transaction for determining the transaction’s ROE. Subject to an adequate return for the risk level as well as other factors, such as the contribution of each risk to the overall risk level and risk diversification, capital is allocated to the transactions generating the highest ROE. Management’s challenge consists of (i) allocating an appropriate amount of capital to each transaction based on the incremental risk created by the transaction, (ii) properly estimating the Company’s overall risk level and the impact of each transaction to the overall risk level, and (iii) assessing the diversification benefit, if any, of each transaction. The risk for the Company lies in mis-estimating any one of these factors, which are critical in calculating a meaningful ROE, and entering into transactions that do not contribute to the Company’s 13% ROE objective.
Combined Ratio: The combined ratio is used industry-wide as a measure of underwriting profitability for Non-life business. The combined ratio is the sum of the technical ratio (losses and loss expenses and acquisition costs divided by net premiums earned) and the other operating expense ratio (other operating expenses divided by net premiums earned). A combined ratio under 100% indicates underwriting profitability, as the total losses and loss expenses, acquisition costs and other operating expenses are less than the premiums earned on that business. While an important metric of success, the combined ratio does not reflect all components of profitability, as it does not recognize the impact of interest income earned on premiums between the time premiums are received and the time losses payments are ultimately made to clients. Since 2001, the Company has had four years of underwriting profitability reflected in combined ratios of less than 100% for its Non-life segment. In 2005, when the industry recorded its worst year in history in terms of catastrophe losses, with Hurricane Katrina, which devastated the Gulf Coast, being the largest insured event ever, the Company recorded a net underwriting loss as a result of the significant catastrophic loss events that year and that was reflected in the
The Company’s risk management framework encompasses all the risks faced by the Company: the strategic risks that it shares with the rest of the reinsurance industry, assumed risks (the reinsurance and capital market risks that it is paid to assume) and the operational risks that are a part of running any business. Management identifies and categorizes risks in terms of their source, their impact on the Company and the preferred strategies for dealing with them. It takes an integrated approach, because it is impossible to manage any of these risks in isolation. There are interrelationships and dependencies between the various categories of risk. Each must be viewed in the context of the whole if their potential impact on the organization is to be fully understood and effectively managed.
The Company maintains a risk appetite moderately above the average of the reinsurance market because Management believes that this position offers the best potential for creating shareholder value at an acceptable risk level. The most profitable products generally present the most volatility and potential downside risk. The Company manages that risk through diversification and absolute limits on any one risk. The Company accepts that results on a quarterly basis may be volatile; however, it seeks to protect itself from downside risk that can materially impair its balance sheet. The limits imposed represent the boundaries of risk tolerance and are based on the amount of capital that may be lost.
PartnerRe Ltd. (the Company) provides reinsurance on a worldwide basis through its principal wholly owned subsidiaries, Partner Reinsurance Company Ltd. (Partner Reinsurance), PartnerRe SA and Partner Reinsurance Company of the U.S. (PartnerRe U.S.). Risks reinsured include, but are not limited to property, casualty, motor, agriculture, aviation/space, catastrophe, credit/surety, engineering, energy, marine, specialty property, specialty casualty, other lines, life/annuity and health and alternative risk products. The Company’s alternative risk products include weather and credit protection to financial, industrial and service companies on a worldwide basis.
The Company was incorporated in August 1993 under the laws of Bermuda. The Company commenced operations in November 1993 upon completion of the sale of common shares and warrants pursuant to subscription agreements and an initial public offering. In July 1997, the Company completed the acquisition of SAFR (subsequently renamed PartnerRe SA), and in December 1998, the Company completed the acquisition of the reinsurance operations of Winterthur Group (Winterthur Re).
Gross premiums written and earned are based upon reports received from ceding companies, supplemented by the Company’s own estimates of premiums written and earned for which ceding company reports have not been received. Differences between such estimates and actual amounts are recorded in the period in which the estimates are changed or the actual amounts are determined. Net premiums written and earned are presented net of ceded premiums, which represent the cost of retrocessional protection purchased by the Company. Premiums are earned on a basis that is consistent with the risks covered under the terms of the reinsurance contracts, which is generally one to two years. Specifically, for U.S. and European wind risks, premiums are earned commensurate with the seasonality of the underlying exposure. Unearned premiums represent the portion of premiums written which is applicable to the unexpired risks under contracts in force. Premiums related to individual life and annuity business are recorded over the premium-paying period on the underlying policies. Premiums on annuity and universal life policies for which there is no significant mortality or critical illness risk are accounted for in a manner consistent with accounting for interest-bearing financial instruments and are not reported as revenues, but rather as direct deposits to the contract. Amounts assessed against annuity and universal life policyholders are recognized as revenue in the period assessed.
The Company’s non-life operations are composed of its Non-life and Alternative Risk Transfer (ART) segments. The liability for unpaid losses and loss expenses for non-life operations includes amounts determined from loss reports on individual treaties (case reserves), additional case reserves when the Company’s loss estimate is higher than reported by the cedants (ACRs) and amounts for losses incurred but not yet reported to the Company (IBNR). Such reserves are estimated by Management based upon reports received from ceding companies, supplemented by the Company’s own actuarial estimates of reserves for which ceding company reports have not been received, and based on the Company’s own historical experience. To the extent that the Company’s own historical experience is inadequate for estimating reserves, such estimates may be determined based upon industry experience and Management’s judgment. The estimates are continually reviewed and the ultimate liability may be in excess of, or less than, the amounts provided. Any adjustments are reflected in the periods in which they become known.
The Company writes certain business on a funds held basis. Under such contractual arrangements, the cedant retains the premiums that would have otherwise been paid to the Company and the Company earns interest on these funds. With the exception of those arrangements discussed below, the Company generally earns investment income on the funds held balances based upon a predetermined interest rate, either fixed contractually at the inception of the contract or based upon a recognized index (e.g., LIBOR). Interest rates at December 31, 2006 and 2005, ranged from 1.0% to 6.8% in 2006 and 1.5% to 6.4% in 2005, with the exception of one treaty in 2005, which earned 9.3%.
In certain circumstances, the Company may receive an investment return based upon either the result of a pool of assets held by the cedant, generally used to collateralize the funds held balance, or the investment return earned by the cedant on its entire investment portfolio. This is most common in the Company’s life reinsurance business. In these arrangements, gross investment returns are typically reflected in net investment income with a corresponding increase or decrease (net of a spread) being recorded as life policy benefits in the Company’s Consolidated Statements of Operations. In these arrangements, the Company is exposed, to a limited extent, to the underlying credit risk of the pool of assets inasmuch as the underlying life policies may have guaranteed minimum returns. In such cases, an embedded derivative exists under Statement of Financial Accounting Standards (SFAS) 133 Derivatives Implementation Group (DIG) Issue No. B36 “Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposures That Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor under Those Instruments” (Issue B36). The fair value of these derivatives is recorded by the Company as an increase or decrease to the funds held balance, which is substantially offset by a comparable but opposite adjustment to deferred acquisition costs.
Fixed maturities, short-term and equity investments that are classified as available for sale are carried at fair value, based on quoted market prices, with the difference between cost or amortized cost and fair value, net of
the effect of taxes, included as a separate component of accumulated other comprehensive income in the Consolidated Balance Sheets. Short-term investments comprise securities with a maturity greater than three months but less than one year from the date of purchase. Investment purchases and sales are recorded on a trade-date basis.
Fixed maturities, short-term and equity investments that are bought and held principally for the purpose of selling in the near term are classified as trading securities and are carried at fair value, based on quoted market prices, with the changes in fair value included in net realized investment gains and losses in the Consolidated Statements of Operations.
The reporting currency of the Company is the U.S. dollar. The national currencies of the Company’s subsidiaries are generally their functional currencies, except for the Bermuda subsidiaries or branches, whose functional currency is the U.S. dollar. In translating the financial statements of those subsidiaries whose functional currency is other than the U.S. dollar, assets and liabilities are converted into U.S. dollars using the rates of exchange in effect at the balance sheet dates, and revenues and expenses are converted using the weighted average foreign exchange rates for the period. The effect of translation adjustments are reported in the Consolidated Balance Sheets as currency translation adjustment, a separate component of accumulated other comprehensive income.
In recording foreign currency transactions, revenue and expense items are converted into the functional currency at the weighted average rates of exchange for the period. Assets and liabilities originating in currencies other than the functional currency are translated into the functional currency at the rates of exchange in effect at the balance sheet dates. The resulting foreign exchange gains or losses are included in net foreign exchange gains and losses in the Consolidated Statements of Operations. The Company records realized and unrealized foreign exchange gains and losses that are covered by designated hedges in net realized investment gains and losses in the Consolidated Statements of Operations (see Note 2(k)).
As a part of the Company’s ART operations, the Company has entered into weather related transactions that are structured as insurance, reinsurance or derivatives. When those transactions are determined to be derivatives,
they are recorded at fair value with the changes in fair value reported in other income in the Consolidated Statements of Operations. The Company uses internal valuation models to estimate the fair value of these derivatives.
FIN 46(R) requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or is entitled to receive a majority of the entity’s residual returns or both. A variable interest entity is a corporation, partnership, trust or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. The Company has determined that PartnerRe Finance II, which issued the capital efficient notes (CENts), PartnerRe Capital Trust I (the Trust), which issued the Company’s trust preferred securities and PartnerRe Finance I, which owns the Trust, do not meet the consolidation requirements of FIN 46(R). As a result, the Company has not consolidated the Trust and PartnerRe Finance I or II and has reflected the debt related to the trust preferred securities and capital efficient notes issued by the Company to PartnerRe Finance I and II, respectively, as liabilities in the Consolidated Balance Sheets (see Note 12). The interest on the debt related to the trust preferred securities and CENts is reported as interest expense in the Consolidated Statements of Operations.
The Company monitors the performance of its underwriting operations in three segments, Non-life, ART and Life. The Non-life segment is further divided into three sub-segments, U.S. Property and Casualty (U.S. P&C), Global (Non-U.S.) Property and Casualty (Global (Non-U.S.) P&C) and Worldwide Specialty. Segments and sub-segments represent markets that are reasonably homogeneous in terms of geography, client types, buying patterns, underlying risk patterns and approach to risk management. These segments and sub-segments were determined in accordance with SFAS No. 131 “Disclosures about Segments of an Enterprise and Related Information”. See Note 19.
In February 2006, the FASB issued Statement No. 155 “Accounting for Certain Hybrid Financial Instruments-an amendment of FASB Statements No. 133 and 140” (SFAS 155). This Statement amends SFAS
133 and SFAS No. 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (SFAS 140). This Statement resolves issues addressed in SFAS 133 DIG Issue No. D1 “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets”. It permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS 133; establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and amends SFAS 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument.
In January 2007, the FASB finalized SFAS 133 DIG Issue No. B40 “Embedded Derivatives: Application of Paragraph 13(b) to Securitized Interests in Prepayable Financial Assets” (Issue B40). Issue B40 determined criteria to evaluate whether a securitized interest in prepayable financial assets would not be subject to the bifurcation conditions in paragraph 13(b) of SFAS 133, thereby modifying the way beneficial interests in securitized financial assets are evaluated under SFAS 155.
SFAS 155 is effective for fiscal years that begin after September 15, 2006. The Company will adopt SFAS 155 as of January 1, 2007. Issue B40 is effective for all securitized interests in prepayable financial assets acquired by the Company after the adoption of SFAS 155. The adoption of SFAS 155 and Issue B40 are not expected to have a significant impact on the consolidated shareholders’ equity or net income of the Company.
The cost, fair value, gross unrealized gains and gross unrealized losses on investments classified as available for sale at December 31, 2006 and 2005, were as follows (in thousands of U.S. dollars):
The following tables present the continuous periods during which the Company has held investment positions classified as available for sale that were carried at an unrealized loss at December 31, 2006 and 2005 (in millions of U.S. dollars):
The Company’s investment security with the largest unrealized loss position at December 31, 2006 and 2005, for which an other-than-temporary impairment charge has not been taken, had a gross unrealized loss of $5.4 million and $3.0 million, representing 6.4% and 1.9%, respectively, of the amortized cost of the security, which is rated AAA. This unrealized loss and the majority of the total unrealized losses related to fixed maturity securities for which an other-than-temporary impairment charge has not been taken, are due to changes in interest rates. Typically, as interest rates rise, market values of fixed maturity portfolios fall, and vice versa. The majority of the fixed maturity securities with unrealized losses at December 31, 2006 were rated AAA. As of December 31, 2006 and 2005, the Company had no significant unrealized losses caused by other factors or circumstances, including an issuer’s specific corporate risk or due to industry or geographic risk, for which an other-than-temporary impairment charge has not been taken.
The following table is a reconciliation of the net realized investment gains on available for sale securities to the net realized investment gains for the years ended December 31, 2006, 2005 and 2004 in the Consolidated Statements of Operations (in thousands of U.S. dollars):
At December 31, 2006 and 2005, approximately $46.8 million and $50.2 million, respectively, of cash and cash equivalents and approximately $1,206.1 million and $1,135.7 million, respectively, of available for sale securities were deposited, pledged or held in escrow accounts to support long-term debt, or in favor of ceding companies and other counterparties or government authorities to comply with reinsurance contract provisions and insurance laws.
4. Unpaid Losses and Loss Expenses and Policy Benefits for Life and Annuity Contracts
Unpaid losses and loss expenses are categorized into three types of reserves: reported outstanding loss reserves (case reserves), additional case reserves (ACRs) and incurred but not reported (IBNR) reserves. Case reserves represent unpaid losses reported by the Company’s cedants and recorded by the Company. ACRs are established for particular circumstances where, on the basis of individual loss reports, the Company estimates that the particular loss or collection of losses covered by a treaty may be greater than those advised by the cedant. IBNR reserves represent a provision for claims that have been incurred but not yet reported to the Company, as well as future loss development on losses already reported, in excess of the case reserves and ACRs. The following table shows unpaid losses and loss expenses reported by cedants (case reserves) and those estimated by the Company (ACRs and IBNR reserves) at December 31, 2006 and 2005 (in thousands of U.S. dollars):
The table below is a reconciliation of the beginning and ending liability for unpaid losses and loss expenses, excluding policy benefits for life and annuity contracts, for the years ended December 31, 2006, 2005 and 2004 (in thousands of U.S. dollars):
The following table summarizes the net prior year (favorable) adverse development of loss reserves for the Company’s non-life operations for the years ended December 31, 2006, 2005 and 2004 (in millions of U.S. dollars):
For the Worldwide Specialty sub-segment, losses reported by cedants during 2006, 2005 and 2004 for prior accident years were lower than the Company expected in most lines of business. This led the Company to decrease its expected ultimate loss ratios and loss estimates for prior year losses in each of these years. Losses reported by cedants during each of these years regarding prior accident years included no significant loss reductions but a series of attritional loss reductions.
The table below is a reconciliation of losses and loss expenses including life policy benefits for the years ended December 31, 2006, 2005 and 2004 (in thousands of U.S. dollars):
Net premiums written, net premiums earned and losses and loss expenses and life policy benefits are reported net of reinsurance in the Company’s Consolidated Statements of Operations. Assumed, ceded and net amounts for the years ended December 31, 2006, 2005 and 2004 were as follows (in thousands of U.S. dollars):
In connection with the acquisition of the reinsurance operations of Winterthur Re in 1998, the Company’s subsidiary, PartnerRe U.S. Corporation (PartnerRe U.S. Holdings) obtained a $220.0 million, 5.81% fixed rate bank loan. The loan, which is fully collateralized, is repayable in December 2008, with interest payments due semiannually. PartnerRe U.S. Holdings incurred interest expense of $13.0 million in each of the years ended December 31, 2006, 2005 and 2004 and paid interest of $13.0 million, $13.0 million and $13.1 million for the years ended December 31, 2006, 2005 and 2004, respectively, in relation to this loan.
In October 2005, the Company entered into a loan agreement with Citibank, N.A. under which the Company borrowed $400.0 million. The loan, which matures in April 2009, bears interest quarterly at a floating rate of 3-month LIBOR plus 0.50%. The Company is not permitted to prepay the loan prior to its maturity, and the loan is not callable or puttable by the lender other than upon an event of default. Citibank, N.A. has pledged its rights under the loan agreement, including the proceeds of any repayment or syndication of the loan, to the Company to secure its obligations to the Company under a forward sale agreement (see Note 14), subject to Citibank, N.A.’s right to substitute cash collateral. The Company incurred interest expense of $22.7 million and $3.2 million for the years ended December 31, 2006 and 2005, respectively, in relation to this loan. The Company paid interest of $21.8 million for the year ended December 31, 2006 and did not pay any interest in 2005.
Income tax expense for the years ended December 31, 2006, 2005 and 2004 was as follows (in thousands of U.S. dollars):
The following table is a reconciliation of the actual income tax rate for the years ended December 31, 2006, 2005 and 2004 to the amount computed by applying the effective rate of 0% under Bermuda law to income or loss before income taxes (in thousands of U.S. dollars):
The components of net tax assets at December 31, 2006 and 2005 were as follows (in thousands of U.S. dollars):
In the normal course of its underwriting activities, the Company and certain subsidiaries entered into reinsurance contracts (assumed and ceded) with Atradius N.V. Included in the 2006 Consolidated Statement of Operations were net premiums written of $48.5 million, net premiums earned of $44.8 million, losses and loss expenses and life policy benefits of $19.2 million and acquisition costs of $17.0 million. Included in the Consolidated Balance Sheet at December 31, 2006 were reinsurance balances receivable of $19.7 million, unpaid losses and loss expenses of $56.6 million and unearned premiums of $27.4 million. Included in the 2005 Consolidated Statement of Operations were net premiums written of $43.8 million, net premiums earned of $45.2 million, losses and loss expenses and life policy benefits of $31.1 million and acquisition costs of $15.3 million. Included in the Consolidated Balance Sheet at December 31, 2005 were reinsurance balances receivable of $18.1 million, unpaid losses and loss expenses of $52.2 million and unearned premiums of $21.0 million. Included in the 2004 Consolidated Statement of Operations were net premiums written of $43.3 million, net premiums earned of $37.2 million, losses and loss expenses and life policy benefits of $20.9 million and acquisition costs of $12.6 million.
In the normal course of its operations, the Company has entered into certain agreements with Barclays Bank PLC and its subsidiaries (Barclays) on market terms. The Company held convertible bond securities issued by Barclays and invested in an index fund and a money market fund managed by Barclays. In addition, Barclays provided the Company with brokerage and cash management services. As part of its overall currency risk management, the Company utilized the services of Barclays when entering into certain foreign exchange contracts. The Company also entered into weather related transactions with Barclays in 2005 and 2004 as part of its ART operations. Barclays is also a lending financial institution on the Company’s unsecured credit facility (see Note 17).
In the normal course of its operations, the Company subleases office space to Novelis, and leased office space from Atis Real on market terms. Pursuant to the agreements, rent (income) expense for the years ended December 31, 2006, 2005 and 2004, aggregated $(0.7) million, $4.9 million (through June 2005) and $8.6 million, respectively.
For employee retirement benefits, the Company maintains active defined-contribution plans, a defined benefit plan and a frozen non-contributory defined benefit plan.
Contributions are made by the Company, and in some locations, these contributions are supplemented by the local plan participants. Contributions are based on a percentage of the participant’s base salary depending upon competitive local market practice. Vesting provisions meet legal compliance standards and market trends; the accumulated benefits for the majority of these plans vest immediately or over a two-year period. As required by law, certain retirement plans also provide for death and disability benefits and lump sum indemnities to employees upon retirement.
The Company incurred expenses for these defined contribution arrangements of $10.0 million, $12.3 million and $12.0 million for the years ended December 31, 2006, 2005 and 2004, respectively.
At December 31, 2006 the pension obligation was $66.1 million, the accumulated pension obligation was $63.7 million, and the fair value of plan assets was $58.5 million. At December 31, 2006, the Zurich Plan’s asset allocation was as follows:
The assumptions used to determine the pension obligation and net periodic benefit cost for the year ended December 31, 2006 were as follows:
The Company does not believe that any plan assets will be returned to the Company during 2007.
In May 2005, the shareholders approved the PartnerRe Ltd. 2005 Employee Equity Plan (the EEP) and replaced the existing employee plan, the Employee Incentive Plan (the EIP). The EEP permits the grant of stock options, restricted shares (RS), restricted share units (RSU) stock appreciation rights (SAR) or other share-based awards to employees of the Company. The EEP is administered by the Compensation Committee of the Board (the Committee).
Total unrecognized stock-based compensation expense related to unvested stock options was approximately $3.4 million at December 31, 2006, which is expected to be recognized over a weighted-average period of 1.0 years.
The following table summarizes information about stock options outstanding at December 31, 2006:
The Company valued stock-options issued with a Black-Scholes valuation model and used the following assumptions:
Prior to the adoption of SFAS 123(R) on January 1, 2006, the Company used historical experience to determine the expected life of stock options; expected volatility equivalent to the historical volatility of the Company’s common shares since inception of the Company; a risk-free interest rate based on the market yield of U.S. securities with maturities equivalent to the expected life of the Company’s stock options; and a dividend yield reflecting the inception-to-date average dividend yield of the Company. Since January 1, 2006, the Company has used the simplified method for vanilla options under Staff Accounting Bulletin No. 107, “Share-Based Payment” (SAB 107) to determine the expected life of options. Expected volatility is based on the historical volatility of the Company’s common shares over a period equivalent to the expected life of the Company’s options. The risk-free interest rate is based on the market yield of U.S treasury securities with maturities equivalent to the expected life of the Company’s options. The dividend yield is based on the average dividend yield of the Company’s shares over the expected life of the Company’s options.
The Company’s ability to pay common and preferred shareholders’ dividends and its expenses are dependent on cash dividends from Partner Reinsurance, PartnerRe SA and PartnerRe U.S. (collectively the reinsurance subsidiaries). The payment of such dividends by the reinsurance subsidiaries to the Company is limited under Bermuda and French laws and certain statutes of various U.S. states in which PartnerRe U.S. is licensed to transact business. The restrictions are generally based on net income and/or certain levels of policyholders’ earned surplus as determined in accordance with the relevant statutory accounting practices. As of December 31, 2006, there were no significant restrictions on the payment of dividends by the reinsurance subsidiaries, except for PartnerRe U.S. that has a statutory negative earned surplus and may not pay cash dividends without prior regulatory approval.
The following table summarizes the statutory stockholders’ equity of the Company’s reinsurance subsidiaries as of December 31, 2006 and 2005 (in thousands of U.S. dollars):
The Company’s Swiss operations are a branch of Partner Reinsurance. Foreign insurance entities that are effecting or carrying on exclusively reinsurance business in Switzerland are exempt from insurance and reinsurance supervision, provided such entities are not acting for that purpose through a Swiss subsidiary.
Contemporaneously, PartnerRe Finance II issued a 6.440% Fixed-to-Floating Rate promissory note, with a principal amount of $257.6 million to PartnerRe U.S. Holdings. Under the term of the promissory note, PartnerRe U.S. Holdings promises to pay to PartnerRe Finance II the principal amount on December 1, 2066 unless previously paid. Interest on the promissory note will be payable semi-annually commencing on June 1, 2007 to December 1, 2016 at an annual fixed rate of 6.440% and will be payable quarterly thereafter until maturity at an annual rate of 3-month LIBOR plus a margin equal to 2.325%.
The Company did not consolidate the Trust, which issued the trust preferred securities, or PartnerRe Finance I, which owned the Trust, as they did not meet the consolidation requirements under FIN 46(R). The Company reflected the debt related to the trust preferred securities on its December 31, 2005 Consolidated Balance Sheet.
In November 2001, the Company issued 4 million Premium Equity Participating Security Units (PEPS Units). Each PEPS Unit consisted of (i) one of the Company’s 5.61% Series B cumulative redeemable preferred shares, $1 par value, liquidation preference $50 per share (Series B preferred shares), and (ii) a purchase contract (purchase contract) issued by the Company pursuant to which the holder was obligated to purchase from the Company, no later than December 31, 2004, a number of common shares for a price of $50 per share. The Company was required to redeem the Series B preferred shares on June 30, 2005, at a redemption price of $50 per Series B preferred share, plus all accrued and unpaid dividends. Each Series B preferred share was pledged to the Company’s benefit to secure the holder’s obligations under the purchase contract. Holders of Series B preferred shares were permitted to withdraw the pledged Series B preferred shares from the pledge arrangement only upon early settlement, settlement for cash or termination of the related purchase contract.
On December 31, 2004, the Company issued 3.5 million of its common shares following the settlement of the purchase contract associated with the PEPS Units. The Company participated in the remarketing of the Series B preferred shares and as a result purchased 100% of the outstanding Series B preferred shares. There was no net cash flows to the Company as the cash received from the sale of the common shares was equal to the cash required to acquire the Series B preferred shares in the remarketing process. The Series B preferred shares were subsequently cancelled and are no longer outstanding. In addition, following the settlement of the purchase contract on the PEPS Units, the PEPS Units were retired and are no longer outstanding.
At December 31, 2006 and 2005, the total authorized shares of the Company were 200 million shares, par value $1.00 per share, as follows (in millions of shares):
During 2006, the Company did not repurchase any common shares and has approximately 4.3 million common shares remaining under its current share repurchase authorization of 5 million common shares.
During 2004, the Company repurchased in the open market 0.9 million of its common shares pursuant to the share repurchase program at a total cost of $48.5 million, or an average cost of $53.06. The repurchased shares were cancelled and are no longer outstanding.
In May 2003, the Company issued 11.6 million of 6.75% Series C cumulative redeemable preferred shares (Series C preferred shares) for a total consideration of $280.9 million after underwriting discounts and commissions totaling $9.1 million. The Series C preferred shares cannot be redeemed before May 8, 2008. Beginning May 8, 2008, the Company may redeem the Series C preferred shares at $25.00 per share plus accrued
In November 2004, the Company issued 9.2 million of 6.5% Series D cumulative redeemable preferred shares (Series D preferred shares) for a total consideration of $222.3 million after underwriting discounts and commissions totaling $7.7 million. The Series D preferred shares cannot be redeemed before November 15, 2009. Beginning November 15, 2009, the Company may redeem the Series D preferred shares at $25.00 per share plus accrued and unpaid dividends without interest. Dividends on the Series D preferred shares are cumulative from the date of issuance and are payable quarterly in arrears. A portion of the net proceeds from the sale ($124.8 million) was used to repurchase common shares under the accelerated share repurchase agreement. The remaining net proceeds were used for general corporate purposes. In the event of liquidation of the Company, the holders of outstanding preferred shares would have preference over the common shareholders and would receive a distribution of $25.00 per share, or an aggregate value of $230 million, plus accrued and unpaid dividends.
Contract fees of approximately $29 million related to the forward sale agreement were recorded against additional paid-in capital and will be paid over the three year contract period. Prior to the issuance of shares under the forward sale agreement, this transaction has no other impact on the Company’s common shareholders’ equity and the Company calculates the dilutive impact related to the forward sale agreement using the treasury method prescribed under SFAS 128, “Earnings per Share”. The Company expects this instrument to be dilutive only if the Company’s share price exceeds the maximum price per share prior to the sale of shares.
The Company is also exposed to credit risk in its underwriting operations, most notably in the credit/surety line and in the business written by the Company’s ART segment. Loss experience in these lines of business is cyclical and is affected by the state of the general economic environment. The Company provides its clients in these lines of business with reinsurance protection against credit deterioration, defaults or other types of financial non-performance of or by the underlying credits that are the subject of the reinsurance provided and, accordingly, the Company is exposed to the credit risk of those credits. The Company mitigates the risks associated with these credit-sensitive lines of business through the use of risk management techniques such as risk diversification,
The Company has exposure to credit risk as it relates to its business written through brokers if any of the Company’s brokers is unable to fulfill their contractual obligations with respect to payments to the Company. In addition, in some jurisdictions, if the broker fails to make payments to the insured under the Company’s policy, the Company might remain liable to the insured for the deficiency.
The Company has entered into service agreements and lease contracts that provide for business and information technology support and computer equipment. Future payments under these contracts amount to $38.4 million through 2011.
As of December 31 2006, the Company was not a party to any litigation or arbitration that it believes could have a material adverse effect on the financial condition or business of the Company.
For certain financial instruments where quoted market prices are not available, Management’s best estimate of fair value may be based on quoted market prices of similar instruments or on other valuation techniques. SFAS No. 107 “Disclosures about Fair Value of Financial Instruments” (SFAS 107) excludes insurance contracts, other than financial guarantees, investment contracts, investments accounted for under the equity method and certain other financial instruments.
The carrying values and fair values of the financial instruments recorded in the Consolidated Balance Sheets as of December 31, 2006 and 2005 were as follows (in thousands of U.S. dollars):
The Company also utilizes foreign currency options contracts to mitigate foreign currency risk. For the years ended December 31, 2006 and 2005, the balances related to contracts maturing on December 31 were a receivable of $2.2 million and $1.3 million, respectively. At December 31, 2006 and 2005, there were no outstanding contracts.
As a part of the Company’s ART operations, the Company has entered into various weather derivatives. The fair value of weather derivatives (the Company’s net liabilities or assets) was a net unrealized loss of $2.0 million and a net unrealized gain of $4.7 million, respectively, at December 31, 2006 and 2005. The notional value of the Company’s weather derivatives was $23 million and $8 million, respectively, at December 31, 2006 and 2005.
Included in the total credit facilities available to the Company at December 31, 2006 is a $700 million five-year syndicated, unsecured credit facility. This unsecured credit facility has the following terms: (i) a maturity date of September 30, 2010, (ii) a $300 million accordion feature, which enables the Company to potentially increase its available credit from $700 million to $1 billion, and (iii) a minimum consolidated tangible net worth requirement as defined below. This facility is predominantly used for the issuance of letters of credit, although the Company does have access to a $350 million revolving line of credit under this facility. At December 31, 2006 and 2005, there were no borrowings under this revolving line of credit.
greater flexibility and simultaneously provides participants under the facility some price protection. As long as the Company maintains a minimum senior unsecured debt rating of BBB+ by Standard & Poor’s and Baa1 by Moody’s, the pricing on the facility will not change significantly.
The U.S. P&C sub-segment includes property, casualty and motor risks generally originating in the United States and written by PartnerRe U.S. The Global (Non-U.S.) P&C sub-segment includes property, casualty and motor risks generally originating outside of the United States, written by Partner Reinsurance and PartnerRe SA. The Worldwide Specialty sub-segment is comprised of business that is generally considered to be specialized due to the sophisticated technical underwriting required to analyze risks, and is global in nature, inasmuch as appropriate risk management for these lines requires a globally diversified portfolio of risks. This sub-segment consists of several lines of business for which the Company believes it has developed specialized knowledge and underwriting capabilities. These lines of business include agriculture, aviation/space, catastrophe, credit/surety, engineering, energy, marine, specialty property, specialty casualty and other lines. The ART segment includes structured risk transfer reinsurance, principal finance, weather-related products, and strategic investments, including the Company’s share of Channel Re Holdings’ net income. The Life segment includes life, health and annuity lines of business.
Because the Company does not manage its assets by segment, net investment income is not allocated to the Non-life segment. However, because of the interest-sensitive nature of some of the Company’s Life and ART products, net investment income is considered in Management’s assessment of the profitability of the Life and ART segments. The following items are not considered in evaluating the results of each segment: net realized investment gains and losses, interest expense, net foreign exchange gains and losses, income tax expense or benefit and preferred share dividends. Segment results are shown net of intercompany transactions.
The following table provides the distribution of net premiums written by line of business for the years ended December 31, 2006, 2005 and 2004:
The following table summarizes the percentage of gross premiums written through these two brokers by segment and sub-segment for the years ended December 31, 2006, 2005 and 2004:
The following tables provide summarized financial information for Channel Re Holdings, which is accounted for using the equity method, for 2006, 2005 and 2004. As the Company calculates its share of Channel Re Holdings’ results on a one-quarter lag, 2006 and 2005 include summarized financial information for the period from October 1, 2005 to September 30, 2006, and the period from October 1, 2004 to September 30, 2005 respectively. The 2004 period includes summarized financial information for the period from February 12, 2004 (date of Channel Re Holdings’ incorporation) to September 30, 2004. As Channel Re Holdings has a financial year-end of December 31, this information is not presented in the annual financial statements of Channel Re Holdings.
There is diversity in practice among financial guaranty insurers and reinsurers with respect to their accounting policies for loss reserves. Current accounting literature does not specifically address the unique characteristics of financial guaranty insurance contracts. The FASB indicated, in the fourth quarter of 2006, that a proposed interpretation is expected to be issued in the first quarter of 2007. The FASB interpretation may require Channel Re Holdings and its financial guaranty peers to change some aspects of their respective loss reserving policies, timing of premium recognition and the related amortization of deferred acquisition costs. The Company cannot currently assess how the FASB interpretation will impact Channel Re Holdings.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 1, 2007 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.