Includes pre-tax net catastrophe costs of $544 million in 2005 and $215 million in 2004 and pre-tax net losses and loss adjustment expenses of $100 million related to the fourth quarter increase in net loss reserves in certain casualty lines in 2002. There were no significant catastrophe losses occurring in 2006, 2003 and 2002.
This Annual Report on Form 10-K and other publicly available documents may include, and Transatlantic Holdings, Inc. and its subsidiaries (collectively, “TRH”) officers and representatives may from time to time make, statements which may constitute “forward-looking statements” within the meaning of the U.S. federal securities laws. These forward-looking statements are identified, including without limitation, by their use of such terms and phrases as:
TRH’s major sources of revenues are net premiums earned for reinsurance risks undertaken and net investment income earned on investments made. The great majority of TRH’s investments are in
fixed maturity securities with an average duration of 5.9 years as of December 31, 2006. In general, premiums are received significantly in advance of related claims payments. The following table summarizes TRH’s revenues, income (loss) before income taxes and net income for the periods indicated:
Revenues in 2006 increased compared to 2005 due primarily to increases in Domestic and, to a lesser extent, International-Other net premiums earned and consolidated net investment income, offset, in part, by decreases in International-Europe net premiums earned and decreases in Domestic and International-Europe realized net capital gains (losses). The increase in International-Other net premiums earned occurred principally in the Miami branch (serving Latin America and the Caribbean) and, to a lesser extent, in the Toronto branch. The London and Paris branches reported the great majority of the decrease in International-Europe net premiums earned in 2006. The most significant increases in consolidated net premiums earned occurred in the other liability, accident & health (“A&H”) and property lines, partially offset by a significant decrease in the auto liability line. The changes in net premiums earned generally reflected prevailing market conditions over recent periods, as discussed below. Net investment income increased in 2006 due largely to an increase in fixed maturity investment income and, to a lesser extent, to an increase in investment income from limited parnerships. The increase in fixed maturity investment income was due, in part, to investment returns from continued positive operating cash flows and the investment of the net proceeds from the issuance of $750 million principal amount senior notes in December 2005.
Revenues in 2005 decreased compared to 2004 due primarily to significant decreases in domestic net premiums earned, partially offset by increases in international net premiums earned and consolidated net investment income. The decline in domestic net premiums earned in 2005 compared to 2004 resulted, in part, from higher ceding company retentions in recent periods and the softening of primary and reinsurance rates in most classes prior to the occurrence of significant catastrophe loss events in the latter half of 2005. The most significant declines in net premiums earned occurred in the auto liability and medical malpractice lines.
While there were no significant catastrophe losses occurring in 2006, the year 2006 includes pre-tax net catastrophe costs of $29 million related to events which occurred in prior years. (See Note 9 of Notes to Consolidated Financial Statements.)
Net pre-tax catastrophe costs of $215 million (gross $270 million; ceded $55 million), or $140 million after tax, dramatically affected 2004 results. These losses resulted from Hurricanes Charley, Frances, Ivan and Jeanne, that affected the Southeastern United States and the Caribbean, typhoons that affected Japan and the tsunami which principally affected South Asia.
Income (loss) before income taxes and net income increased in 2006 as compared to 2005 principally due to increased underwriting profit (loss) and net investment income, offset, in part, by interest expense on TRH’s senior notes and decreased realized net capital gains. The increased underwriting profit (loss) in 2006 reflect an improved combined ratio resulting largely from reduced significant net catastrophe costs and, to a lesser extent, lower net adverse loss reserve development. (See Note 16 of Notes to Consolidated Financial Statements for underwriting profit (loss) by segment.) Decreases in net catastrophe costs and lower net adverse loss reserve development in the aggregate increased underwriting profit (loss) by $618.4 million in 2006 compared to 2005. The reasons for the increase in net investment income are as discussed earlier. The significant tax expense in 2006 compared to the tax benefit recognized in 2005 tempered the impact of the above changes on net income.
Income (loss) before income taxes and net income decreased in 2005 as compared to 2004 due primarily to decreased underwriting profit (loss) resulting primarily from significantly higher net catastrophe costs. Significant tax savings were recognized in 2005 as a result of catastrophe costs, and considers the fact that TRH is able to carry back tax-basis net operating losses to prior years and carry forward minimum tax credits indefinitely. (See Note 4 of Notes to Consolidated Financial Statements.) These tax savings somewhat tempered the impact of catastrophe losses on net income in 2005 compared to 2004.
Much like the influx of capital after the event of September 11, 2001, a large amount of capital flowed into the market after the major catastrophe events of 2005. Unlike 2001, however, the hurricanes of 2005 had a disproportionate effect on reinsurers and much of the capital raised went to existing reinsurers. Some of the capital also went to new reinsurance companies that were started in Bermuda in the fourth quarter of 2005. The capital raised by existing reinsurers was not just to replace some of the capital lost in the catastrophe events of 2005, but also to meet the higher capital thresholds required by the rating agencies to support catastrophe exposure. Also, due to the severe impact on capital that the hurricanes had on property monoline carriers, the rating agencies imposed higher hurdles for ratings for this type of (re)insurer. Nevertheless, most of the start up companies achieved a rating of at least A- from Best by year end. While these new companies did write a fair amount of property catastrophe and energy excess-of-loss business in 2006, they did not slow the momentum of rate increases in these lines and, in fact, these companies have already begun to look to diversify their writings in order to fully apply their capital.
Hedge funds and other investment vehicles also formed or sponsored reinsurers or used other reinsurance companies as conduits to offer traditional reinsurance as well as industry loss warranties (ILWs) and other forms of index-based protections.
While rates for property catastrophe and other lines of business exposed to natural peril losses in U.S. peak zones (areas with concentrations of coastal exposures to hurricanes or general exposure to earthquakes) improved meaningfully at January 1, 2006, rates in these areas experienced more significant increases starting April 1, 2006 and this trend continued throughout the remainder of the year. These improvements were a confluence of capital depletion from the 2005 storms, model changes by the generally accepted catastrophe loss models and stricter rating agency requirements.
Due to the favorable trading conditions for most insurance companies since 2001, many potential buyers of reinsurance have more than replenished the capital lost since then. In many cases, companies’ capitalization is now higher than ever and they may choose to rely less on reinsurance as a form of capital and retain more business. In formulating a reinsurance purchasing strategy, the ceding company will also consider the perceived volatility of the business to be ceded.
This discussion and analysis of financial condition and results of operations are based upon TRH’s consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the use of estimates and judgments that affect the reported amounts and related disclosures. TRH relies on historical experience and on various other assumptions that it believes to be reasonable under the circumstances, to make judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ materially from these estimates.
TRH believes its most critical accounting estimates are those with respect to loss reserves, premium revenues and deferred acquisition costs, as they require management’s most significant exercise of judgment on both a quantitative and qualitative basis used in the preparation of TRH’s consolidated financial statements and footnotes. The accounting estimates that result require the use of assumptions about certain matters that are highly uncertain at the time of estimation. A discussion of these most critical accounting estimates follows:
Loss trend factors are used to establish expected loss and LAE ratios (“ELRs”) for subsequent accident years based on the projected loss and LAE ratios for prior accident years. Provisions for inflation and social inflation (e.g., awards by judges and juries which progressively increase in size at a rate exceeding that of general inflation) and trends in court interpretations of coverage are among the factors which must be considered.
During the loss settlement period, which can be many years in duration, additional facts regarding individual claims and trends usually become known. As these facts and trends emerge, it usually becomes necessary to refine and adjust the loss reserves upward or downward and even then the ultimate net liability may be materially different from the revised estimates.
The methodologies that TRH typically employs include paid loss development, incurred loss development, paid Bornhuetter-Ferguson (“B-F”) and incurred B-F methods. Triangles of written premium, paid losses and incurred losses are organized by underwriting year evaluated at six month intervals. The data triangles are split by branch, contract type (i.e., treaty versus facultative), line of business and often between excess-of-loss and pro rata business. The line of business groupings vary by branch and are reviewed annually to ensure proper balance between homogeneity and credibility of data. In the loss development methods, paid and incurred losses by underwriting year are projected to an ultimate basis by applying appropriate age to ultimate development factors to the inception to date paid and incurred losses. The development factors are selected based on curves fitted to the historical average which best represent the data. In the B-F methods, estimates of unpaid and unreported losses are arrived at by multiplying underwriting year earned premium by an ELR and an estimated percentage of unpaid or unreported losses. These percentages of unpaid or unreported losses are derived from the loss development factors described above. In the course of these detailed loss reserve reviews for each business grouping, a point estimate of the loss reserve need is determined. The sum of these point estimates for each of the individual groupings provides an overall actuarial estimate of the loss reserve for each underwriting office and ultimately an actuarial estimate of the loss reserve for TRH as a whole. This amount is then evaluated against actual carried loss reserves. Any changes to the carried loss reserve that are deemed appropriate are reflected in earnings in the period of change.
There is potential for significant variation in the development of loss reserves when actual costs differ from those costs implied by the assumptions used to test the loss reserves. This is particularly true for assumed reinsurance of long-tail casualty classes. Among the most critical assumptions are those made for ELRs and loss development factors, as described earlier.
While noting that there exists the potential for greater variations, TRH believes utilizing 5% changes to the assumptions made for both loss development factors and ELRs provides a reasonable benchmark for a sensitivity analysis of the loss reserve estimates. For example, changing the ELRs by 5 percentage points has an impact of about $135 million (either positively or negatively) on the loss reserve estimate. While considerably less likely for most classes of business, we note that changing the ELRs by 10 percentage points has an effect of about $270 million. As previously described, another key assumption is the selection of loss development patterns. The effect of a 5% deviation from the loss development factors utilized in the loss reserve review would be about $200 million. Because a downward deviation of 5% results in negative future development of reported losses for certain years, this scenario is not believed to be as likely as that of an upward deviation of this amount.
Due to the assumptions and methodologies utilized by TRH in its reviews of longer tailed classes of business, changes to the ELRs generally have a much greater impact on the assessment of loss
reserves for the most recent few underwriting years while deviations from the loss development factors utilized in the reviews generally are more critical to the loss reserve indications for older underwriting years (i.e., 2002 and prior). Management believes that it is reasonable to simultaneously vary both of the assumptions previously discussed by 5%. The effect of varying these assumptions together by 5% is about $340 million. We also note that the classes of business for which these assumptions are most critical are medical malpractice and D&O, particularly for excess-of-loss business, and excess casualty.
Management must make certain judgments in the determination of premiums written and earned by TRH. For pro rata treaty contracts, premiums written and earned are based on reports received from ceding companies. Generally for excess-of-loss treaty contracts, premiums are recorded as written based on contract terms and are earned ratably over the terms of the related coverages provided. In recent years, treaty contracts have generated approximately 95% of TRH’s premium revenues. Unearned premiums and prepaid reinsurance premiums represent the portion of gross premiums assumed and reinsurance ceded, respectively, relating to the unexpired terms of such coverages. The relationship between net premiums written and net premiums earned will, therefore, vary depending generally on the volume and inception dates of the business assumed and ceded and the mix of such business between pro rata and excess-of-loss reinsurance.
profitability, the impact of such differences are recorded, as appropriate, when actual results become known and may have a material effect on results of operations.
The following table summarizes the net effect of changes in foreign currency exchange rates compared to the U.S. dollar on the percentage change in net premiums written in 2006 and 2005 compared to its respective immediate prior year.
catastrophe losses affecting the region in 2005. International net premiums written decreased significantly in the auto liability ($53.4 million) and property ($48.9 million) lines. These decreases were partially offset by significant increases in the ocean marine ($41.9 million), credit ($25.1 million) and A&H ($24.0 million) lines. The overall change in international net premiums written includes the impact of changes in foreign currency exchange rates between the U.S. dollar and the currencies in which TRH does business as discussed earlier. International business represented 51.8% of 2006 net premiums written compared to 54.8% in 2005.
Domestic net premiums written decreased in 2005 by $271.7 million, or 14.8%, from the prior year to $1,568.3 million due to higher ceding company retentions in recent periods, significant net ceded reinstatement premiums related to catastrophe losses and the softening of primary and reinsurance rates in most classes prior to the occurrence of significant catastrophe loss events in the latter half of 2005. Significant decreases in domestic net premiums written were recorded in the auto liability ($127.6 million), medical malpractice ($94.2 million) and A&H ($26.3 million) lines.
Generally, reasons for changes in gross premiums written between years are similar to those for net premiums written, except as discussed earlier as regards reinstatement premiums and changes in premiums assumed from an affiliate that, by prearrangement, were ceded in an equal amount to other affiliates. The decrease in ceded premiums written and earned in 2006 compared to 2005 is due to a reduction in ceded reinstatement premiums related to 2005 and 2004 catastrophes, partially offset by increases in premiums assumed from an affiliate that, by prearrangement, were ceded in an equal amount to other affiliates.
Net investment income increased in 2006 compared to 2005 due generally to investment returns from continued positive operating cash flows, the investment of the net proceeds from issuance of $750 million principal amount senior notes in December 2005 and increases in investment income from limited partnerships. Net investment income increased in 2005 compared to 2004 due to the investment (principally in fixed maturities) of significant positive cash flows from operating activities generated in recent periods. (See Note 3(c) of Notes to Consolidated Financial Statements for a breakdown of the components of net investment income and the cash flow discussion under Financial Condition and Liquidity.)
Realized net capital gains totaled $10.9 million in 2006, $39.9 million in 2005 and $22.2 million in 2004. Realized net capital gains include investment dispositions, which reflect TRH’s investment and tax planning strategies to maximize after-tax income, and write-downs of securities that, in the opinion of management, had experienced a decline in fair value that was other-than-temporary. In 2006, realized net capital gains included charges for write-downs for other-than-temporary declines in fair value totaling $1.3 million related to fixed maturities available for sale and $0.1 million related to equities available for sale. In addition, realized net capital gains in 2006 were reduced by net foreign currency transaction losses, principally related to non-functional currencies, of $11.2 million. In 2005, realized net capital gains included charges for write-downs for other-than-temporary declines in fair value totaling $1.7 million related to equities available for sale. In 2004, realized net capital gains included charges for write-downs for other-than-temporary declines in fair value totaling $6.2 million related to other invested assets. Upon the ultimate disposition of securities which have recorded write-downs, a portion of the write-downs may be recoverable depending on market conditions at the time of disposition. (See Note 2(c) of Notes to Consolidated Financial Statements for criteria used in determination of such write- downs.)
The property and casualty insurance and reinsurance industries use the combined ratio as a measure of underwriting profitability. The combined ratio reflects only underwriting results, and does not include income from investments. Generally, a combined ratio under 100% indicates an underwriting profit and a combined ratio exceeding 100% indicates an underwriting loss. Underwriting profitability is subject to significant fluctuations due to competition, natural and man-made catastrophic events, economic and social conditions, foreign currency exchange rate fluctuations, interest rates and other factors. The loss and LAE ratio (“loss ratio”) represents net losses and LAE incurred divided by net premiums earned. The underwriting expense ratio represents the sum of net commissions and other underwriting expenses expressed as a percentage of net premiums written. The combined ratio represents the sum of the loss ratio and the underwriting expense ratio.
The following table presents loss ratios, underwriting expense ratios and combined ratios for consolidated TRH, and separately for its domestic and international components, for the years indicated:
Additionally, included in the above total net adverse development amounts are amounts related to the net adverse development of significant catastrophe losses occurring in prior years, a component of net catastrophe costs. Such net adverse development for 2006 totaled $29.7 million and related principally to catastrophe loss events occurring in 2005.
TRH writes a significant amount of non-proportional assumed casualty reinsurance as well as proportional assumed reinsurance of excess casualty business for such volatile classes as medical malpractice, D&O, E&O and general casualty. At the primary level, there are significant risk factors which contribute to the variability and unpredictability of the loss trend factor for this business such as jury awards, social inflation, medical inflation, tort reforms and court interpretations of coverage. In addition, as a reinsurer, TRH is also highly dependent upon the claims reserving and reporting practices of its cedants, which vary greatly by size, specialization and country of origin and whose practices are subject to change without notice.
The main reason for the decrease in gross and ceded losses and LAE incurred in 2006 compared to 2005 is the decrease in gross and ceded catastrophe losses (See Note 9 of Notes to Consolidated Financial Statements.) in 2006 partially offset by $199 million increase in gross and ceded losses and LAE incurred related to business assumed from an affiliate which, by prearrangement with TRH, was then ceded in an equal amount to other affiliates.
TRH’s 2005 results include net catastrophe costs of $543.9 million (domestic $385.8 million; international $158.1 million) principally related to Hurricanes Katrina, Rita and Wilma and, to a lesser extent, to Central European floods and European Windstorm Erwin. Such net catastrophe costs include net ceded reinstatement premiums of $61.1 million (domestic $56.2 million; international $4.9 million). Approximately $123.9 million of net catastrophe costs included in international operations relate to hurricanes occurring in the Americas. Net catastrophe costs in the aggregate added 16.0%, 26.3% and 8.2% to the combined ratios for consolidated TRH, domestic and international, respectively.
Amount of reestimation represents the amount of net losses and LAE incurred in 2005 related to losses occuring in 2004 and prior years.
As presented in the table above, the lines of business with the most significant net adverse development recorded in 2005 were the other liability line, arising principally from losses occurring in 1996 to 2002, and the medical malpractice line, arising principally from losses occurring between 1997 and 2001. The large majority of such net adverse development related to domestic operations. These increases to incurred losses were offset, in part, by net favorable development occurring most significantly in the fire line, which arose principally from losses occurring in 2004, and in the ocean marine and aviation line, which arose principally from losses occurring in 2001 through 2004.
A significant reason for the increase in gross and ceded losses and LAE incurred in 2005 compared to 2004 is the increase in gross and ceded catastrophe losses.
TRH’s 2004 results include pre-tax net catastrophe costs of $215.0 million (domestic $98.1 million; international $116.9 million) related to Hurricanes Charley, Frances, Ivan and Jeanne, that affected the Southeastern United States and the Caribbean, typhoons that affected Japan and the tsunami which principally affected South Asia. Such events in the aggregate added 5.9%, 5.4% and 6.3% to the combined ratios for consolidated TRH, domestic and international, respectively.
Amount of reestimation represents the amount of net losses and LAE incurred in 2004 related to losses occuring in 2003 and prior years.
The underwriting expense ratio for consolidated TRH increased in 2005 compared to 2004 due to an increase of 0.4% in each of the net commission and other underwriting expense components of the ratio.
In December 2005, the Company completed a public offering of $750 million principal amount of its 5.75% senior notes due in 2015 (the “Senior Notes”). 2006 includes interest expense incurred in connection with the Senior Notes of $43.4 million and interest paid of $43.1 million. 2005 includes interest expense incurred in connection with the Senior Notes of $2.1 million. No interest was paid in 2005.
Federal and foreign income tax expense (benefit) of $111.8 million, $(84.0) million and $21.6 million were recorded in 2006, 2005 and 2004, respectively. The 2005 tax benefit, which exceeds the amount of pre-tax loss in 2005, resulted from TRH carrying its current year tax net operating loss back to prior years ($61.2 million current tax benefit on the Consolidated Statement of Operations and a current tax recoverable in the same amount included in other assets on the Consolidated Balance Sheet) and recording a deferred tax benefit on the Consolidated Statement of Operations (also included on the Consolidated Balance Sheet as a deferred tax asset) of $20.9 million for a minimum tax credit
carryforward. In 2006, TRH generated an additional $6.6 million deferred tax benefit from a minimum tax credit carryforward.
The Company and its domestic subsidiaries, TRC (which includes foreign operations) and Putnam, filed consolidated federal income tax returns for the years under discussion, except those for 2006 which are not yet due. The tax burden among the companies is allocated in accordance with a tax sharing agreement. TRC also includes as part of its taxable income or loss those items of income of the non-U.S. subsidiary, TRZ, which are subject to U.S. income tax currently, pursuant to Subpart F income rules of the Internal Revenue Code, and included, as appropriate, in the consolidated federal income tax return.
The effective tax rates, which represent the sum of current and deferred income taxes (benefits) divided by income (loss) before income taxes, were 20.7% in 2006, 182.2% in 2005 and 7.8% in 2004. The major adjustments reconciling the expected tax expense to actual tax expense in each of the three years under discussion (as detailed in Note 4 of Notes to Consolidated Financial Statements) are similar in terms of their nature and relative size, except that the adjustment for tax-exempt interest has increased as the size of the tax-exempt fixed maturity portfolio has grown in 2006 and 2005 over the respective immediate prior year.
With respect to the unusual effective tax rate in 2005, it is important to note that while the actual tax benefit derived from tax-exempt interest income and the dividends received deduction in 2005 is not significantly different from 2006 and 2004, the percentage impact in the effective tax rate calculation from such items is significantly greater. The greater impact is caused by the fact that income (loss) before income taxes (i.e., denominator in the effective tax rate calculation) is a lower absolute value in 2005 compared to 2006 and 2004, due largely to the greater amount of catastrophe costs in 2005. The effective tax rate for 2006 reflects the fact that there were no significant net catastrophe costs during the year.
Net income and net income per common share on a diluted basis, respectively, were as follows: 2006-$428.2 million, $6.46; 2005-$37.9 million, $0.57; 2004-$254.6 million, $3.85. Reasons for the changes between years are as discussed earlier. (See Note 8 of Notes to Consolidated Financial Statements.)
2006 compared to 2005-Domestic revenues increased from the prior year due primarily to increases in net premiums earned, for reasons similar to those discussed earlier in MD&A for the increase in net premiums written, and, to a lesser extent, increased net investment income offset, in part, by a decrease in realized net capital gains. The increase in net premiums earned in 2006 occurred primarily in the other liability, property, A&H and auto liability lines offset, in part, by a significant decrease in the surety line. The increase in net investment income in 2006 is due, in part, to investment returns from the investment of the $745 million net proceeds from the issuance of the Senior Notes, continued positive operating cash flows and increases in investment income from limited partnerships. Income (loss) before income taxes for 2006 increased due primarily to an increase in underwriting profit (loss) and, to a lesser extent, by increased net investment income. The increase in underwriting profit (loss) is caused principally by decreased net catastrophe costs, which totaled $18.2 million in 2006 compared to $385.8 million in 2005. Both years included significant adverse development of losses occurring in prior years, though such development was lower in 2006 then 2005, in certain more volatile casualty classes, as discussed earlier under Results of Operations.
income taxes for 2005 decreased compared to the prior year due primarily to a decrease in underwriting profit (loss), slightly offset by increased net investment income and realized net capital gains, each in 2005. The decrease in underwriting profit (loss) is caused principally by increased net pre-tax catastrophe costs of $385.8 million in 2005, principally from Hurricanes Katrina, Rita and Wilma, compared to $98.1 million in 2004. 2005 catastrophe costs include net ceded reinstatement premiums of $56.2 million. Both years included significant adverse development of losses occurring in prior years in certain more volatile casualty classes, as discussed earlier under Results of Operations.
In addition, Domestic assets increased approximately $2.0 billion in 2005 compared to year end 2004, primarily due to increased investments and cash of $1.1 billion, increased reinsurance recoverable on paid and unpaid losses of $610 million (due, in part, to reinsurance recoverable related to 2005 catastrophe losses), and increased deferred and current income tax recoverables (current recoverable included in other assets) totaling $141 million. The increase in investments and cash resulted principally from $745 million of net proceeds from the issuance of senior notes and $297 million of positive operating cash flows.
2006 compared to 2005-Revenues decreased due principally to a decrease in net premiums earned in the London and Paris branches and, to a lesser extent, a decrease in realized net capital gains (losses), partially offset by increased net investment income. Net premiums earned decreased principally in the auto liability, other liability and property lines offset, in part, by increases in the ocean marine, A&H and credit lines. The decrease in net premiums earned is due, in part, to some weakness in market conditions and increased ceding company retentions. Income before income taxes for 2006 increased due primarily to an increase in underwriting profit (loss) in the London branch and TRZ and, to a lesser extent, to increased net investment income in each location. The increase in underwriting profit (loss) is caused principally by decreased net catastrophe costs, which totaled $16.9 million in 2006 compared to $119.6 million in 2005.
Assets decreased $236 million due largely to a reduction in the short-term investment of funds received under securities loan agreements and the impact of the strengthening U.S. dollar in 2005 against the currencies in which investments are denominated, partially offset by positive operating cash flows.
As a holding company, the Company’s assets consist primarily of the stock of TRC and the Company’s future cash flows depend on the availability of dividends or other statutorily permissible payments from TRC and its wholly-owned operating subsidiaries, TRZ and Putnam. (See Note 14 of Notes to Consolidated Financial Statements for a discussion of restrictions on dividend payment.) In 2006 and 2005, the Company received cash dividends from TRC of $88.0 million and $36.5 million, respectively. The increase in such dividends in 2006 was primarily to allow the Company to make interest payments on the Senior Notes. As of December 31, 2006, TRC could pay dividends to the Company of $305.9 million without regulatory approval. In 2005, TRC, the primary operating subsidiary, received a capital contribution of $745 million from the Company. These funds were obtained by the Company in connection with its public offering of the Senior Notes. (See Note 6 of Notes to Consolidated Financial Statements.) The Company uses cash primarily to pay interest to the holders of the Senior Notes and dividends to its common stockholders.
Sources of funds for the operating subsidiaries consist primarily of premiums, reinsurance recoverables, investment income, proceeds from sales, redemptions and the maturing of investments and funds received under securities loan agreements. Funds are applied by the operating subsidiaries primarily to payments of claims, ceded reinsurance premiums, insurance operating expenses, income taxes and investments in fixed income and equity securities. Premiums are generally received substantially in advance of related claims payments. Cash and cash equivalents, which are principally interest-bearing, are maintained for the payment of claims and expenses as they become due. TRH does not anticipate any material capital expenditures in the foreseeable future.
While the expected payout pattern of liabilities (see contractual obligations table later in this section) is considered in the investment management process, it is not the only factor considered as TRH has historically funded its claims payments from current operating cash flows. As a result of such funding history, TRH does not maintain a credit facility. TRH’s primary investment goal is to maximize after-tax income through a high quality diversified taxable fixed maturity and tax-exempt municipal fixed maturity portfolio, while maintaining an adequate level of liquidity. See discussion later in this section of the potential liquidity strain that could arise as a result of a significant acceleration of paid losses beyond TRH’s ability to fund such payments.
At December 31, 2006, total investments and cash were $11,336.1 million compared to $9,241.8 million at December 31, 2005. The increase was caused, in large part, by $845.4 million of cash provided by operating activities, $1,039.0 million of net funds received under securities loan agreements and by an increase of approximately $230 million due to the foreign exchange impact caused by the weakening U.S. dollar against the currencies in which the investments are denominated during 2006.
TRH’s fixed maturity investments, approximately 73.4% of total investments and cash as of December 31, 2006, are predominantly investment grade, liquid securities, approximately 97.4% of which will mature in less than 10 years. The duration of the fixed maturity portfolio was 5.9 years as of December 31, 2006. Also as of that date, approximately 7.9% of total investments and cash were in common and nonredeemable preferred stocks, approximately 1.6% of total investments and cash were in other invested assets, consisting of investments in limited partnerships, approximately 14.9% of total
At December 31, 2006, gross unrealized gains and losses on all fixed maturities (including those held to maturity and carried at amortized cost) amounted to $189.4 million and $34.0 million, respectively. At December 31, 2006, gross unrealized gains and losses on equities available for sale amounted to $59.9 million and $4.8 million, respectively.
Generally, reserve changes result from the setting of reserves on current accident year business, the adjustment of prior accident year reserves based on new information (i.e., reserve development) and payments of losses and loss adjustment expenses for which reserves were previously established.
The components of gross loss reserves as of December 31, 2006 and 2005 by major class of business, split between reported (“case”) amounts and IBNR amounts is presented below:
Gross loss reserves represent the accumulation of estimates for losses occurring on or prior to the balance sheet date. Gross loss reserves are principally based on reports and individual case estimates received from ceding companies. The IBNR portion of gross loss reserves is based on past experience and other factors. The methods used to determine such estimates and to establish the resulting reserves are continually reviewed and updated. Any adjustments are reflected in income currently.
At December 31, 2006, reinsurance recoverable on gross loss reserves totaled $1.25 billion (a component of reinsurance recoverable on paid and unpaid losses on the Consolidated Balance Sheet which is net of an allowance for uncollectible reinsurance recoverable of $12 million), a decrease of $161.1 million, or 11.4%, from the prior year end. The decrease in reinsurance recoverable on gross loss
Because the reserving process is inherently difficult and subjective, actual losses may materially differ from reserves and related reinsurance recoverables reflected in TRH’s consolidated financial statements, and accordingly, may have a material effect on future results of operations. And while there is also the possibility of changes in statutes, laws, regulations and other factors that could have a material effect on these liabilities and, accordingly, future earnings, TRH believes that its loss reserves carried at December 31, 2006 are adequate.
Of total consolidated operating cash flows, $400.1 million, $332.9 million and $583.7 million, were derived from international operations in 2006, 2005 and 2004, respectively. In each of such years, London was the most significant source of international operating cash flows.
The following table presents the year-end, average, high and low VaRs on a diversified basis and of each component of market risk for 2006 and 2005. The diversified VaR is usually smaller than the sum of its components due to correlation effects.
TRH’s stockholders’ equity totaled $2.96 billion at December 31, 2006, an increase of $414.3 million from year-end 2005. The net increase consisted primarily of net income of $428.2 million and an increase in accumulated other comprehensive income of $6.9 million, partially offset by cash dividends declared of $34.6 million.
The abovementioned increase in accumulated other comprehensive income consisted principally of net unrealized foreign currency translation gain from functional currencies, net of income taxes, of $16.1 million, partially offset by net unrealized depreciation of investments, net of income taxes, of $9.2 million. The net unrealized depreciation of investments, net of income taxes, is composed principally of a decrease of $23.9 million in unrealized appreciation of fixed maturities available for sale offset, in part, by an increase of $15.0 million in unrealized appreciation of equities available for sale.
Net unrealized appreciation (depreciation) of investments, net of income taxes, is subject to significant volatility resulting from changes in the fair value of fixed maturities and equities available for sale and other invested assets. Fair values may fluctuate due to changes in general economic and political conditions, market interest rates, prospects of investee companies and other factors.
In addition, in 2005, TRH recorded a reduction of retained earnings of $8.3 million (which is net of income tax savings that TRH expects to realize of $3.0 million) and an increase to additional paid-in capital of $11.3 million related to compensation to certain TRH employees from Starr International Company for all prior periods through December 31, 2004 as discussed in Note 12(c) of Notes to Consolidated Financial Statements.
The Company did not repurchase shares of its common stock in 2006 or 2004. In 2005, the Company repurchased 104,800 shares of its common stock, pursuant to a previously announced buyback program, at an aggregate cost of $6.3 million.
With respect to commitments and contingent liabilities, see Note 17 of Notes to Consolidated Financial Statements.
In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payments” (“SFAS 123R”). SFAS 123R and its related interpretive guidance replaced SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) and supercedes Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees.” SFAS 123 as originally issued in 1995, established as preferable a fair-value method of accounting for share-based payment transactions with employees. SFAS 123R requires share-based payment transactions with employees to be accounted for using a fair-value based method and broadens the recognition provisions to include share based payments awarded to an employee by related parties or other holders of an economic interest in the reporting entity.
On January 1, 2003, TRH adopted the recognition provisions of SFAS 123 using the prospective method of transition. For the period from January 1, 2003 through December 31, 2005, TRH accounted for share-based payment transactions with employees under SFAS 123. Effective January 1, 2006, TRH adopted SFAS 123R using the Modified Prospective Application method. The Modified Prospective Application method provides for the recognition of the fair value with respect to stock-based compensation for shares granted or modified on or after January 1, 2006 and for all previously granted but unvested awards as of January 1, 2006. Accordingly, financial statement amounts for 2005 and 2004 presented in this Form 10-K have not been restated. The impact of adopting SFAS 123R was not material to income before income taxes, net income (including basic and diluted net income per share amounts), financial condition or cash flows in 2006.
(v) In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”).
(vi) In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (“FIN 48”).
Consolidated Statements of Operations For the Years Ended December 31, 2006, 2005 and
Consolidated Statements of Stockholders’ Equity For the Years Ended December 31, 2006, 2005 and 2004
Consolidated Statements of Cash Flows For the Years Ended December 31, 2006, 2005 and
-Reinsurance For the Years Ended December 31, 2006, 2005 and 2004
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Transatlantic Holdings, Inc. and its subsidiaries (the “Company”) at December 31, 2006 and December 31, 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the accompanying index present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedules 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 the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements 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.
Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A., that the Company maintained effective internal control over financial reporting as of December 31, 2006 based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and
dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Transatlantic Holdings, Inc. (the “Company”) is a holding company, incorporated in the state of Delaware, which owns all of the common stock of Transatlantic Reinsurance Company (“TRC”). TRC owns all of the common stock of Trans Re Zurich (“TRZ”) and Putnam Reinsurance Company (“Putnam”). As of December 31, 2006, 2005 and 2004, American International Group, Inc. (“AIG”, and collectively with its subsidiaries, the “AIG Group”) beneficially owned approximately 59% of the Company’s outstanding shares.
Transatlantic Holdings, Inc. and its subsidiaries (collectively, “TRH”), through its operating subsidiaries TRC, TRZ and Putnam, offers reinsurance capacity for a full range of property and casualty products to insurers and reinsurers on a treaty and facultative basis, with an emphasis on specialty classes. Including domestic as well as international risks, TRH’s principal lines of business are other liability (including directors’ and officers’ liability (“D&O”) and errors and omissions coverages (“E&O”)), ocean marine and aviation, medical malpractice, auto liability (including non-standard risks), accident and health (“A&H”) and surety and credit in the casualty lines, and fire, allied lines, auto physical damage and homeowners multiple peril lines in the property lines (which include property catastrophe risks). Casualty lines represented 73.3%, 70.2% and 72.4% of net premiums written in 2006, 2005 and 2004, respectively. The balance represented property lines.
(c) Investments: Fixed maturities are classified as held-to-maturity and carried at amortized cost if TRH has the positive intent and ability to hold each of these securities to maturity. Where TRH may not have the positive intent to hold fixed maturities to maturity and such securities are not designated as trading, such fixed maturities are considered to be available for sale and carried at fair values. Premiums and discounts arising from the purchase of fixed maturities are treated as yield adjustments over their estimated lives, until maturity or call date, if applicable. Common and non-redeemable preferred stocks, including those held to meet short term investment objectives and classified as trading, are carried at fair values. Fair values for fixed maturity securities and equities are generally based upon quoted market prices. For certain fixed maturity securities, for which market prices were not readily available, fair values were principally estimated using values obtained from independent pricing services.
TRH periodically evaluates its securities for other-than-temporary impairments in valuation. As a matter of policy, the determination that a security has incurred an other-than-temporary decline in value and the amount of any loss recognition requires the judgment of TRH’s management and a continual review of its investments.
Trading at a significant (25% or more) discount to par, amortized cost (if lower) or cost for an extended period of time (nine months or longer);
The occurrence of a discrete credit event resulting in the debtor defaulting or seeking bankruptcy or insolvency protection or voluntary reorganization; or
Once a security has been identified as other-than-temporarily impaired, the amount of such impairment is determined by reference to that security’s contemporaneous fair value and recorded as a realized loss.
(f) Premium Revenues: In recent years, premiums from treaty contracts have approximated 95% of net premiums written, while facultative contracts have approximated 5%. For pro rata treaty contracts, premiums written and earned are based on reports received from ceding companies. Generally, for excess-of-loss treaty contracts, premiums are recorded as written based on contract terms. Premiums are earned ratably over the term of the related coverages. Unearned premiums and prepaid reinsurance premiums represent the portion of gross premiums assumed and reinsurance ceded, respectively, relating to the unexpired terms of such coverages. Premiums written and earned, along with related costs, for which data has not been reported by the ceding companies, are estimated based on historical patterns and other relevant information. These estimates are subject to change when actual data for such items estimated become available. In the Consolidated Statements of Operations, premiums written and earned and the change in unearned premiums are presented net of reinsurance ceded.
(h) Realized Net Capital Gains and Losses: Realized capital gains and losses are determined principally by specific identification and generally emanate from the following sources:
Losses and loss adjustment expenses net of related reinsurance recoverable (“net loss reserves”) include certain amounts for the reinsurance of risks related to environmental impairment and asbestos- related illnesses. The majority of TRH’s environmental and asbestos-related liabilities arise from contracts entered into after 1985. These obligations generally arose from contracts underwritten specifically as environmental or asbestos-related coverages rather than from standard general liability coverages where the environmental or asbestos-related liabilities were neither clearly defined nor specifically excluded. The reserves carried at December 31, 2006 for such claims, including IBNR, are based upon known facts and current law. However, significant uncertainty exists in determining the amount of ultimate liability for environment impairment and asbestos-related losses, particularly for those occurring in 1985 and prior. This uncertainty is due to inconsistent court resolutions and judicial interpretations with respect to underlying policy intent and coverage and uncertainties as to the allocation of responsibility for resultant damages, among other things. Further, there is always the possibility of changes in statutes, laws, regulations and other factors that could have a material effect on these liabilities and, accordingly, future earnings.
(b) In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. SAB 108 requires that registrants quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that when all relevant quantitative and qualitative factors are considered, is material. TRH adopted SAB 108 in the fourth quarter of 2006. The adoption of SAB 108 did not have a material effect on TRH’s consolidated financial statements.
(c) In November 2005, the FASB issued FASB Staff Position (“FSP”) No. FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“FSP FAS 115-1”). FSP FAS 115-1 replaces the measurement and recognition guidance set forth in FASB Emerging Issue Task Force (“EITF”) Issue No. 03-1 and codifies certain existing guidance on impairment. TRH adopted FSP FAS 115-1 in the first quarter of 2006. The adoption of FSP FAS 115-1 did not have a material effect on TRH’s results of operations, financial position or cash flows.
guidance, which directly depends on the nature and extent of eligible items elected to be measured at fair value, upon initial application of the standard on January 1, 2008.
(f) In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (“FIN 48”), which clarifies the accounting for uncertainty in tax positions. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of an income tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and additional disclosures. The effective date of this implementation guidance is January 1, 2007, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. TRH does not expect the implementation of FIN 48 to have a material effect on its results of operations, financial position or cash flows.
(a) Statutory Deposits: Investments, the substantial majority of which are fixed maturities and common stocks available for sale, were deposited with governmental authorities as required by law and amounted to approximately $351 million and $277 million at December 31, 2006 and 2005, respectively.
Includes write-downs for other-than-temporary declines in fair value of $0.1 million and $1.7 million for 2006 and 2005, respectively. There were no write-downs for other-than-temporary declines in fair value in 2004.
Includes write-downs for other-than-temporary declines in fair value of $6.2 million for 2004. There were no write-downs for other-than-temporary declines in fair value in 2006 or 2005. In addition, includes net foreign currency transaction losses of $11.2 million in 2006.
See Note 3(f) for additional information about gross unrealized losses as of December 31, 2006 and 2005.
Gross gains of $2.8 million, $4.1 million and $8.3 million and gross losses of $3.9 million, $5.0 million and $5.1 million were realized on sales of investments in fixed maturities available for sale in 2006, 2005 and 2004, respectively.
(f) Additional Information on Gross Unrealized Losses on All Fixed Maturities and on Equities Available for Sale: As of December 31, 2006 and 2005, TRH’s aggregate gross unrealized losses on all fixed maturities and on equities available for sale totaled $38.8 million and $55.8 million, respectively. As of December 31, 2006 and 2005, no single issuer accounted for more than 6% and 5%, respectively, of the aggregate gross unrealized losses.
At December 31, 2006 and 2005, the gross unrealized losses for all fixed maturities and equities available for sale included the following concentrations:
The Company files a U.S. consolidated federal income tax return with its domestic subsidiaries, TRC (which includes foreign operations) and Putnam. TRC will also include as part of its taxable income those items of income of the non-U.S. subsidiary, TRZ, which are subject to U.S. income tax currently, pursuant to Subpart F income rules of the Internal Revenue Code, and included, as appropriate, in the consolidated federal income tax return.
Deferred income taxes in 2004 include a benefit for tax refund claims from amended tax returns totaling $10.9 million. These claims primarily resulted from TRH’s ability to recover taxes through the utilization of foreign tax credit carrybacks. In 2006, $2.7 million of such refund claims was received.
There were no significant net catastrophe losses for events occurring in 2006. However, in 2006, TRH determined that its estimates of the ultimate amounts of net losses occurring in 2005 and prior years needed to be increased as a result of greater than expected loss activity in 2006. As a result of that determination, TRH increased net losses and LAE incurred by $181.1 million, representing significant net adverse development in 2006 of losses occurring in all prior years. This net adverse development was comprised of $339.7 million related to losses occurring in 2002 and prior, partially offset by favorable development of $158.6 million related primarily to 2005, and to a much lesser extent, 2004 and 2003. The line of business with the most significant net adverse development recorded in 2006 was the other liability line ($192 million), arising principally from losses occurring in 2000 to 2002. The other liability line includes certain specialty casualty classes, such as D&O and E&O, and general casualty classes. In addition, significant net adverse development was recorded in 2006 in the medical malpractice line ($35 million), arising principally from losses occurring between 1998 and 2002, the fidelity line ($28 million), arising principally from losses occurring between 1999 and 2005, and the ocean marine and aviation line ($22 million), arising principally from losses occurring in 2005. The large majority of such net adverse development related to domestic operations. These increases to incurred losses were offset, in part, by net favorable development occurring most significantly in the fire line ($129 million), arising principally from losses occurring in 2005, and the homeowners multiple peril line ($36 million), arising principally from losses occurring between 2004 and 2005.
The year 2004 included $215.0 million of catastrophe losses incurred related to Hurricanes Charley, Frances, Ivan and Jeanne, that affected the Southeastern United States and the Caribbean, typhoons that affected Japan and the tsunami which principally affected South Asia. In addition, as a result of net increases in estimates of losses occurring in prior years, net losses and LAE incurred was increased by $317.4 million in 2004. As a result of greater than expected reported loss activity in 2004, indicating that TRH’s estimates as of the end of 2003 of the ultimate amounts of losses occurring in 2003 and prior required a net increase, significant net adverse development was recorded in 2004. The vast majority of such adverse development relates to other liability and medical malpractice lines for losses occurring between 1998 and 2001, principally in domestic and, to a lesser extent, London operations. These increases to incurred losses were offset, in part, by favorable development across most lines on losses occurring in 2003 and, to a lesser extent, on losses occurring during 2002 in the other liability, aviation and fire lines.
Common stock activity for each of the three years in the period ended December 31, 2006 was as follows:
While there were no significant net catastrophe costs for events occurring during 2006, the year 2006 includes pre-tax net catastrophe costs of $28.7 million related to events which occurred in prior years. Such costs consist of net catastrophe losses incurred of $29.7 million (gross $84.5 million; ceded $54.8 million) and net ceded reinstatement premiums of ($1.0) million.
Prior to 2003, TRH had accounted for stock-based compensation based on the intrinsic-value method prescribed in APB 25 and related Interpretations, as permitted under SFAS 123. On January 1, 2003, TRH adopted the recognition provisions of SFAS 123, using the prospective method of transition and employed that method until the beginning of 2006. That method requires application of such recognition provisions under the fair value method to all stock-based compensation awards granted, modified, or settled on or after the date of adoption of the standard. Accordingly, net income for 2005 and 2004 reflects compensation expenses, primarily related to stock options, for stock-based compensation awards granted in 2003 and thereafter and, beginning in 2005, to TRH employees’ participation in Starr International Company (“SICO”) Deferred Compensation Profit Participation Plans (the “SICO Plans”).
Expenses related to stock-based compensation arrangements totaled $10.9 million, $9.6 million and $2.9 million in 2006, 2005 and 2004, respectively. Income tax benefits recognized related to stock- based compensation arrangements totaled $3.3 million, $2.8 million and $0.7 million in 2006, 2005 and 2004, respectively.
Total cash received from exercises of stock-based compensation was $3.3 million, $2.7 million and $5.3 million during 2006, 2005 and 2004, respectively. TRH has not paid out any cash to settle share- based payment awards during the 2006, 2005 or 2004. Cash savings resulting from excess tax benefits, as defined by SFAS 123R, totaled $1.9 million in 2006.
If TRH had adopted the provisions of SFAS 123R for recognizing compensation expense commencing at the date of grant for all awards, the effect would not have been material to net income or basic or diluted net income per share for 2005 or 2004.
(a) Stock Option Plans: In 2000, the Company’s Board of Directors (the “Board”) adopted, and the stockholders approved, the 2000 Plan. In 2006, the Board adopted, and the stockholders approved, amendments to the 2000 Plan increasing the maximum number of options which may be granted under the plan to 3,712,500 and increasing the maximum number of options which may be granted to any one person to 600,000. This plan provides that options to purchase the Company’s common stock (“TRH shares”) may be granted to certain key employees and non-employee directors at prices not less than their fair market value at the date of grant.
For options granted under the Stock Option Plans, in general, 25% of the options become exercisable on the anniversary date of the grant in each of the four years following the grant and expire 10 years from the date of grant. At December 31, 2006, 1,587,876 shares were available for future grants under the 2000 Plan. No further options can be granted under the 1995 Plan, although options outstanding continue in force until exercise, expiration or forfeiture.
An increasing dividend schedule was used in the binomial model based on historical information. The expected volatility was based on the historical volatility of TRH shares. The risk-free interest rate was based on the U.S. treasury yield curve in effect at the time of grant. The expected term was calculated based on historical data on employee exercise behavior.
A summary of the status of the Stock Option Plans as of December 31, 2006 and the changes since January 1, 2006 are presented below:
The aggregate intrinsic value of options exercised (the aggregate amount by which the market price of TRH shares at the time of exercise exceeds the exercise price of options exercised) was $4.4 million, $9.4 million and $11.7 million in 2006, 2005 and 2004, respectively. A total of approximately 368,000, 411,000 and 381,000 options vested in 2006, 2005 and 2004, respectively, with aggregate fair values of $5.8 million, $6.2 million and $5.6 million in 2006, 2005 and 2004, respectively.
the Senior Partners Plan will earn the maximum number of Performance RSUs until the actual amounts are determined, at which time, such shares available amount will be adjusted accordingly.
A summary of the status of the Service RSUs and Performance RSUs granted pursuant to the Stock Incentive Plan as of December 31, 2006 and the changes since January 1, 2006 are presented below:
The great majority of Service RSUs will vest on the fourth anniversary of the date of grant for those grantees with continued employment through such date. The Company reserves the right to make payment for the Service RSUs in TRH shares or the cash equivalent of the fair value of such shares on the date of vesting.
In August 2006, the Compensation Committee of the Board (the “Committee”) adopted the Partners Plan for purposes of incentivizing performance of certain of TRH’s senior executives. Under the Partners Plan, the Committee awards to senior executives Performance RSUs that pay out in TRH shares if performance goals for a specified period are satisfied. Each Performance RSU converts into one TRH share. The Partners Plan operates on the basis of successive overlapping two year performance periods, with a new period beginning each year. Awards were granted in 2006. The first award’s performance period runs from January 1, 2006 through December 31, 2007 and the second award’s performance period runs from January 1, 2007 through December 31, 2008.
131,525 for the performance period beginning in 2007. No Performance RSUs will be earned if BVPS Growth is less than 25% of target. Earned Performance RSUs will vest equally on the fourth and sixth anniversaries of the beginning of the performance period, generally so long as the participant is then employed by TRH.
As of December 31, 2006, there was $9.6 million of total unrecognized compensation costs related to Performance RSUs granted but not yet vested under the Senior Partners Plan and in the first and second awards under the Partners Plan. Compensation expense for Performance RSUs is recognized on a straight-line basis. These costs are expected to be recognized over a weighted average period of 5.5 years. Because the performance period for the second award under the Partners Plan does not begin until January 1, 2007, the second award is not included in TRH’s 2006 compensation expense.
SICO is a private holding company which has no direct ownership interest in TRH but which has a significant ownership interest in AIG (see Note 13(c)). SICO has provided a series of two-year SICO Plans to certain TRH employees through December 31, 2004. The SICO Plans came into being in 1975 when the voting shareholders and Board of Directors of SICO, a private holding company whose principal asset is AIG common stock, decided that a portion of the capital value of SICO should be used to provide an incentive plan for the current and succeeding managements of all American International companies, including TRH.
The SICO Plans provide that shares currently owned by SICO are set aside by SICO for the benefit of the participant and distributed upon retirement. The SICO Board of Directors currently may permit an early payout of units under certain circumstances. Prior to payout, the participant is not entitled to vote, dispose of or receive dividends with respect to such shares, and shares are subject to forfeiture under certain conditions, including but not limited to the participant’s voluntary termination of employment prior to normal retirement age. Under the SICO Plans, SICO’s Board of Directors may elect to pay a participant cash in lieu of shares of AIG common stock. Following notification in December 2005 from SICO to participants in the SICO Plans that it will settle specific future awards under the SICO Plans with shares rather than cash, the accounting for the SICO Plans changed from variable to fixed measurement accounting.
As of December 31, 2006, there was $9.4 million of total unrecognized compensation costs related to the SICO Plans. These costs are expected to be recognized over a weighted average period of 5.8 years.
As total SICO compensation expense for each year prior to 2005 would not have been material to any such prior year, TRH recorded in 2005 the total amount of compensation expense related to the SICO Plans that would have been recorded in all prior periods through December 31, 2004 as a reduction to retained earnings of $8.3 million, which is net of income tax savings that TRH expects to realize of $3.0 million. The entire amount of such prior year compensation cost, before tax effect, of $11.3 million, is considered a contribution to capital, and was recorded as an increase to additional paid-in capital.
TRH has service and expense agreements and certain other agreements with the AIG Group which provide for the reimbursement to the AIG Group of certain administrative and operating expenses which include, but are not limited to, investment advisory and cash management services, office space and human resource related activities. Under the guidance of TRH’s Finance Committee of the Board of Directors and senior management, certain subsidiaries of AIG act as financial advisors and managers of TRH’s investment portfolio. In 2006, 2005 and 2004, $13.1 million, $11.5 million and $11.0 million, respectively, of operating and investment expenses relate to services and expenses provided by the AIG Group under these agreements.
Approximately $593 million (15%), $575 million (15%) and $639 million (15%) of gross premiums written by TRH in 2006, 2005 and 2004, respectively, were attributable to reinsurance purchased by other subsidiaries of AIG, for the production of which TRH recorded ceding commissions totaling $140 million, $122 million and $122 million, respectively, in such years. (The amounts discussed in the preceding sentence include transactions with C.V. Starr & Co., Inc. (“Starr”) as described in Note 13(c).) In 2006, the great majority of such gross premiums written were recorded in the property, other liability, medical malpractice and ocean marine and aviation lines. In 2005, the great majority of such gross premiums written were recorded in the property, other liability, medical malpractice and ocean marine and aviation lines. In 2004, the great majority of such gross premiums written were recorded in the property, other liability, auto liability, medical malpractice and ocean marine and aviation lines. Of the premiums assumed from other subsidiaries of AIG, $227 million, $209 million and $306 million in 2006, 2005 and 2004, respectively, represent premiums resulting from certain insurance business written by AIG subsidiaries that is almost entirely reinsured by TRH by prearrangement, for the production of which TRH recorded ceding commissions to such AIG subsidiaries totaling approximately $40 million, $37 million and $40 million, respectively, in such years. (See Note 15 for information relating to reinsurance ceded to related parties.)
(c) Transactions with Starr: According to the Schedule 13D/A filed on November 20, 2006 by Starr, SICO, Edward E. Matthews, Maurice R. Greenberg, the Maurice R. and Corinne P. Greenberg Family Foundation, Inc., the Maurice R. and Corinne P. Greenberg Joint Tenancy Company, LLC and the Universal Foundation, Inc., these reporting persons may be deemed to beneficially own in the aggregate approximately 365.9 million shares of AIG common stock. Based on the shares of AIG common stock outstanding as of October 31, 2006, this beneficial ownership represents approximately 14% of the voting stock of AIG. Throughout 2005 and 2004 certain directors of TRH were also stockholders, executive officers or directors of Starr. On January 9, 2006, Starr released a press release
For 2004 and through April 3, 2005, Messrs. Greenberg, Matthews and Howard I. Smith were directors of TRH and also stockholders, executive officers or directors of Starr. On April 4, 2005, Messrs. Greenberg, Matthews and Smith resigned from the Board of Directors of TRH. For 2004 and 2005, Messrs. Orlich and Tizzio were also stockholders, executive officers or directors of Starr. From May 19, 2005, when Messrs. Bensinger and Sullivan were elected to the Board of TRH, through approximately December 31, 2005, Messrs. Bensinger and Sullivan were also stockholders, executive officers or directors of Starr.
(d) Other: TRH’s employees participate in certain benefit plans administered by the AIG Group and certain stock-based compensation plans which utilize AIG shares (see Notes 11 and 12, respectively).
The payment of dividends by the Company is dependent on the ability of its subsidiaries to pay dividends. The payment of dividends by TRC and its wholly-owned subsidiaries, TRZ and Putnam, is restricted by insurance regulations. Under New York insurance law, TRC and Putnam may pay dividends only out of their statutory earned surplus. Such dividends are limited by statutory formula unless otherwise approved by the New York State Insurance Department (the “NYS ID”). The statutory surplus of TRC includes the statutory surplus of Putnam since all the capital stock of Putnam is owned by TRC. At December 31, 2006, TRC had statutory earned surplus of $1.72 billion, and, in 2007, in accordance with the statutory formula, could pay dividends of approximately $305.9 million without regulatory approval.
TRC and Putnam each prepare statutory financial statements in accordance with accounting practices prescribed or permitted by New York-their state of domicile. Prescribed statutory accounting practices are discussed in a variety of publications of the National Association of Insurance Commissioners (“NAIC”), as well as in state laws, regulations and general administrative rules. Permitted statutory accounting practices encompass all accounting practices not so prescribed. All material statutory accounting practices of TRC and Putnam are prescribed in the authoritative literature described above. As required by the state of New York, TRC and Putnam use the Codification of Statutory Accounting Principles as primary guidance on statutory accounting.
Gross premiums assumed and earned includes $72 million of reinstatement premiums in 2005 related to catastrophe loss events. Reinstatement premiums were not significant in 2006 and 2004.
Gross incurred losses and LAE include gross catastrophe losses incurred of $85 million, $870 million and $270 million in 2006, 2005 and 2004, respectively.
Reinsured losses and LAE ceded include ceded catastrophe losses incurred of $55 million, $387 million and $55 million in 2006, 2005 and 2004, respectively.
Amounts recoverable from retrocessionnaires are recognized in a manner consistent with the claims liabilities associated with the retrocession and are presented on the balance sheet as reinsurance
recoverable on paid and unpaid losses and LAE. Such balances at December 31, 2006 and 2005 are comprised as follows:
TRH conducts its business and assesses performance through segments organized along geographic lines. The Domestic segment includes financial data from branches in the United States that underwrite primarily domestic business, as well as stock compensation expense and revenues and expenses of the Company. In addition, assets purchased with the proceeds of the Senior Notes, related net investment returns and interest expense on such Senior Notes are also reflected in the Domestic segment (see Note 6).
A significant portion of assets and liabilities of TRH’s international operations relate to the countries where ceding companies and reinsurers are located. Most investments are located in the country of domicile of these operations. In addition to licensing requirements, TRH’s international operations are regulated in various jurisdictions with respect to currency, amount and type of security deposits, amount and type of reserves and amount and type of local investment. Regulations governing constitution of technical reserves and remittance balances in some countries may hinder remittance of profits and repatriation of assets. International operations and assets held abroad may be adversely affected by political and other developments in foreign countries, including possibilities of tax changes, nationalization and changes in regulatory policy, as well as by consequences of hostilities and unrest. The risks of such occurrences and their overall effect upon TRH vary from country to country and cannot easily be predicted.
While the great majority of premium revenues and assets relate to the regions where particular offices are located, a portion of such amounts are derived from other regions of the world.
Includes revenues from the London, England office of $819.5 million, $862.0 million and $900.3 million in 2006, 2005 and 2004, respectively, and revenues from TRZ of $380.7 million, $388.4 million and $383.4 million in 2006, 2005 and 2004, respectively.
As part of these settlements, AIG has agreed to retain, for a period of three years, an Independent Consultant who will conduct a review that will include, among other things, the adequacy of AIG’s internal controls over financial reporting, the policies, procedures and effectiveness of AIG’s regulatory, compliance and legal functions and the remediation plan that AIG has implemented as a result of its own internal review. TRH, as a subsidiary of AIG, will cooperate with the terms of the settlements that are applicable to TRH.
TRH has responded to these subpoenas and continues to cooperate with these regulatory requests. There have been no further inquiries concerning the matters raised by the subpoenas received from the States of Florida and Georgia. While TRH does not believe that any of these inquiries will have a material impact on TRH’s business or financial results, it is not possible to predict with any certainty at this time what impact, if any, these inquiries may have on TRH’s business or financial results.
(c) Leases: As of December 31, 2006, the future minimum lease payments (principally for leased office space) under various long-term operating leases were as follows: