We operate in the United States, Bermuda, Europe and Singapore. We own the property in which our offices are located in Dublin, Ireland, and we lease office space in the other countries. We renew and enter into new leases in the ordinary course of business as required. During 2006, we leased new offices at 92 Pitts Bay Road, Bermuda, which have become our worldwide headquarters. See Item 8, Note 11 to the Consolidated Financial Statements for a discussion of our lease commitments for real property. We believe that our office space is sufficient for us to conduct our operations for the foreseeable future.
The following is a discussion and analysis of our financial condition and results of operations. This discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes included in Item 8 of this report. For an overview of our business including information on segments and individual lines of business refer to Item 1 of this report.
Results of Operations: Years ended December 31, 2006, 2005 and 2004
Our underwriting results have significantly impacted the level of net income in the last three years following losses incurred from Hurricanes Katrina, Rita and Wilma in 2005, and Hurricanes Charley, Frances, Ivan and Jeanne in 2004. In 2006, there was an absence of significant catastrophes and therefore our underwriting income was substantially higher. Investment income has grown over the last three years due to a combination of a larger investment base and higher yields and increased income from our allocation to other investments.
Although major losses are an inevitable part of our business, the hurricane losses in 2004 and 2005 had such a significant impact that we have highlighted them separately above.
The prior period reserve development was the net result of several underlying favorable and adverse developments, primarily on our short tail lines of business. In 2006 it included 3.9 percentage points of reserve strengthening in relation to Hurricane Katrina, Rita and Wilma. While we believe that our loss reserves at December 31, 2006 are adequate, new information may lead to future developments in ultimate loss and loss expenses significantly greater or less than the reserves currently provided. In addition, conditions and trends that affected the development of liabilities in the past may not necessarily occur in the future. Accordingly, it is inappropriate to anticipate future redundancies and deficiencies based on historical experience.
Our loss ratio also fluctuates from year to year depending on a number of other variables that include the level of estimated attritional losses, changes in our mix of business and changes in pricing and other assumptions used to establish our loss ratios. In 2005, the Company began to incorporate its own specific loss information in establishing initial loss ratios on certain short-tail lines of business.
where acquisition costs are higher than our insurance segment. The share of reinsurance business stabilized during 2006 and the increase in the ratio in 2006 as compared to 2005 was largely due to business mix changes in our U.S insurance sub-segment.
Net investment income: Net investment income increased 58.6% in 2006 over 2005 and 68.8% in 2005 over 2004. The growth from period to period is a result of a combination of a larger investment base, higher investment yields and increased income from our allocation to other investments. Our average investment base increased substantially to $8.4 billion in 2006 from $6.4 billion in 2005 and from $4.9 billion in 2004 due to positive operating cash flow and capital raising activity in 2005. The growth in the annualized effective yield was primarily due to higher U.S. interest rates at the short end of the yield curve. As an example, the yield on the 3 year U.S. Treasury increased from a 3.22% yield at December 31, 2004 to 4.36% at December 31, 2005 and 4.73% at December 31, 2006. The yield on our portfolio may vary significantly from period to period due primarily to the timing of cash flows, changes in interest rates and changes in asset allocation. Increased income from our other investment portfolio is a result of larger allocations combined with better total returns in 2006 from those investments.
Total return: Our portfolio is managed to maximize total return within certain guidelines. In assessing returns under this approach, we include net investment income, net realized investment gains and losses and the change in unrealized gains and losses generated by our investment portfolio. The increase in our total return between 2004 and 2006 was due to a growing allocation to the higher returning other investments and more significantly an increase in short and intermediate U.S. interest rates which stemmed from the increases in the Federal Funds rate which began in the mid part of 2004 and continued in 2005 and 2006. Despite the steady increase in yield over this period, the magnitude of the rate increases in 2005 had such a negative impact on the fair value of the fixed income portfolio that the realized losses and unrealized losses more than offset the increase in yield in that year.
Corporate expenses: Our corporate expenses include holding company costs necessary to support our worldwide insurance and reinsurance operations and costs associated with operating as a publicly-traded company. As a percentage of net premiums earned, corporate expenses were 2.2%, 1.8% and 1.9% for 2006, 2005 and 2004 respectively. The movement largely reflects changes in our incentive compensation costs which are tied to our operating results.
Income tax expense: Income tax expense is generated primarily through our foreign operations in the United States and Europe. Income tax expense increased over the three year period as the foreign operations contribution to income before tax increased. Our effective tax rate on net income, which we calculate as income tax expense divided by income before income tax, was 3.4% for 2006 compared with 6.0% in 2005 and 1.1% in 2004. The Company’s effective tax rate was higher in 2005 than 2006 or 2004 due to the substantial reduction in the Company’s income before tax due to hurricane losses. Changes in our geographic mix of earnings also impact income tax expense and effective tax rate.
Generally, we are satisfied that the broad property and casualty insurance marketplace, provides us ample opportunity to target attractively priced risks. Current rate levels for some lines of business, like catastrophe-exposed property and energy business, continue to produce returns above historic levels. In areas where the competition has been much more aggressive, such as terrorism and aviation, we are maintaining a conservative posture. Other lines, such as primary casualty, umbrella, and professional lines, still contain good profit potential, but bear closer scrutiny. Smaller accounts are experiencing less pricing pressure and we continue to develop our capabilities for efficiently accessing and underwriting these accounts.
The following is a discussion of the underwriting results within our global and U.S. insurance sub-segments:
exposed property and offshore energy risks in the U.S. and Gulf of Mexico where significant rate increases were implemented following the 2005 hurricane losses. Growth in these lines would have been greater had it not been for initiatives to reduce our natural peril catastrophe exposure. In 2006, we grew our political risk business through a combination of an additional underwriting resource and new market opportunities.
Although major losses are an inevitable part of our business, the hurricane losses in 2004 and 2005 had such a significant impact that we have highlighted them separately above. The prior period reserve development was the net result of several underlying favorable and adverse developments, primarily on our short tail lines of business. In 2006 it included 7.9 percentage points of reserve strengthening in relation to Hurricanes Katrina, Rita and Wilma.
Our loss ratio also fluctuates year on year depending on a number of variables that include the volume of estimated attritional losses, changes in mix of business and changes in pricing and other assumptions used to establish our loss ratios. In 2005, the Company began to incorporate its own specific loss information in establishing initial net loss ratios on certain short tail lines of business.
Gross premiums written: The following table provides gross premiums written by line of business:
In 2006 we were able to consolidate, build and strengthen the market position we had established by the end of 2005. The majority of growth in 2006 was driven by significant rate increases in our natural peril exposed property catastrophe business following the 2005 hurricane losses. This was achieved while substantially reducing our natural peril aggregate exposures. The premium trends that characterized 2005 continued into 2006. These included: growth of custom accounts in our property line of business, writing additional errors and omissions insurance in our professional lines book (having appointed a managing general underwriter effective January 1, 2005), expanding our umbrella and excess liability business, and growing our employer stop-loss business in our other specialty account. Despite the aforementioned
Net premiums earned: The following table provides net premiums earned by line of business:
Acquisition Costs: Incentive commission costs accounted for 3.9 percentage points of our 2004 acquisition cost ratio, however, we discontinued such arrangements at the end of that year. Our ratio has otherwise increased in each of the last two years reflecting the growing share of business generated by managing general underwriters within our professional lines book. This business generally has higher gross acquisition costs than the rest of the book and a significant portion of it does not have an override commission associated with reinsurance coverage.
Gross Premiums Written: The following table provides gross premiums written by line of business:
Ceded premiums written: Premiums ceded as a percentage of gross premiums written was 0.6%, 1.8% and 3.0% in 2006, 2005 and 2004 respectively. We primarily purchase reinsurance as and when market opportunities arise to mitigate the impact of catastrophe loss events. Consequently, the level of premiums ceded can fluctuate period to period. The percentage of premiums ceded was lower in 2006 due to a reduction in the availability of appropriately priced coverage.
Although major losses are an inevitable part of our business, the hurricane losses in 2004 and 2005 had such a significant impact that we have highlighted them separately above. The net favorable development in 2006 includes 3.9 percentage points, of strengthening to net reserves relating to Hurricanes Katrina, Rita and Wilma. The favorable development in all three years was primarily due to better than expected claims experience on our property catastrophe and other short tail lines of business.
Our loss ratio also fluctuates year on year depending on a number of other variables that include the volume of attritional losses, changes in mix of business and changes in pricing and other assumptions used to establish our loss ratios.
Rates continue to be up substantially for U.S. catastrophe-exposed reinsurance business relative to the 1st of January 2006 as an element of catch-up to mid-year 2006 levels took place. However, the market dislocation evident at mid-year 2006 renewals has further corrected. Reinsurance renewals in Continental Europe, where the primary renewal date is January 1st, were characterized by an abundance of capacity. We expect that Windstorm Kyrill, which caused damage across a number of European countries in January of 2007, will stabilize this marketplace. Finally, we expect the impact of recent Florida legislation bypassing the private reinsurance marketplace to directly impact less than 2% of reinsurance premiums.
Financing activities: Cash flows relating to financing activities include the payment of dividends, share related transactions and the issue or repayment of debt. During 2006, we generated $289.5 million from financing activities compared to $260.8 million and $426.8 million in 2005 and 2004, respectively. These cash inflows primarily related to the following: during 2006 we received $400.0 million from a repurchase agreement used to fund an investment in an asset-backed note (refer to “commitments and contingencies” below). In 2005 we raised $693.6 million of additional capital in the form of common and
preferred shares offset by a $350.0 million repurchase of common shares from initial investors at the formation of the Company. In 2004, we raised $495.7 million from a senior notes offering.
Shareholders’ equity: At December 31, 2006, our shareholders’ equity was $4,412.6 million compared to $3,512.3 million at December 31, 2005. The increase of $900.3 million was primarily due to 2006 net income of $963.1 million. During 2006, we declared dividends of $101.7 million to common shareholders and $37.3 million to preferred shareholders. For further information on our shareholders’ equity refer to Item 8, Note 13 of the Consolidated Financial Statements.
Shelf registrations: On August 6, 2004, we filed an unallocated universal shelf registration statement with the Securities and Exchange Commission that was declared effective on August 27, 2004. Under the shelf registration statement, we may issue up to $750.0 million of equity, debt, trust preferred securities or a combination of these securities. On November 15, 2004, we completed a public offering of $500 million of senior notes. In addition the shelf registration statement also registered for possible future sales up to 68,216,017 common shares held by certain of the Company’s founding shareholders. The registration of the founding shareholders’ common shares did not obligate these shareholders to offer or sell any of the securities held by them. As at December 31, 2006, there were 36,501,410 remaining common shares available for sale by founding shareholders.
We believe our financial strength provides us with the flexibility and capacity to continue to obtain external funding within the foreseeable future.
Estimated life insurance premiums: To avoid life policies from lapsing, we are required to make monthly life premium payments on 222 life policies in connection with our investment in life settlement contracts. We will fund these payments through the use of the $65.0 million premium reserve account set aside for this purpose and with future life insurance proceeds and investment income earned on the cash flows relating to the life settlement contracts portfolio. Any shortfall from these funding sources will be met by the Company’s cash flows from operations.
For most insurance and reinsurance companies, the most significant judgment made by management is the estimation of the reserve for losses and loss expenses, which we also refer to as loss reserves. Our loss reserves are established based upon our estimate of the total cost of claims that were reported to us but not yet paid, or case reserves, the costs of additional case reserves on claims reported to us but not considered to be adequately reserved, or ACR, and the anticipated cost of claims incurred but not reported, or IBNR.
In order to reflect this increased level of uncertainty in establishing our loss reserves, some of our underwriting, claims and reserving practices have been modified for our reinsurance business. In deciding whether to provide treaty reinsurance, we carefully review and analyze the cedant’s underwriting and risk management practices to ensure appropriate underwriting, data capture and reporting procedures. We also utilize an outsourced claims audit program that allows us to review a cedant’s claims administration to ensure that its claim reserves are consistent with reinsured exposures, are adequately established and are properly reported in a timely manner, and to verify that claims are being handled appropriately. For those losses where we receive contract-specific loss notifications, our claims department evaluates each notification and may record ACRs if claims are not considered to be adequately reserved. This requires considerable judgment. Where claims information is received in an aggregated form, our reinsurance contracts typically require that pre-defined large losses must be separately notified so that these losses can
be adequately evaluated. As, Ernst & Young, our independent actuaries, estimate reserves on a line of business basis, their actuarial methodology allows for reporting time lags when establishing ultimate loss and loss expenses for reinsurance business. In addition, because we have limited loss experience and insufficient claims development data to calculate credible trends, our independent actuaries use industry data when establishing ultimate loss and loss expenses for our reinsurance business.
For our insurance segment, the assumed ultimate loss and loss expense ratios developed by the independent actuaries are based on benchmarks derived from the independent actuaries wider market experience together with our limited historical data. These benchmarks are then adjusted for rating increases and changes in terms and conditions that have been observed by the market and by us. For our reinsurance segment, the assumed ultimate loss and loss expense ratios are based on contract-by-contract initial expected loss ratios derived during pricing and benchmarks derived from the independent actuaries
wider market experience together with our limited historical data. Under U.S. GAAP, we are not permitted to establish loss reserves until an event that gives rise to a loss occurs. On contracts that respond to highly visible, major loss events, we establish IBNR where potential exposure has been identified.
To reduce some of this uncertainty, our independent actuary performs, in conjunction with management, an analysis of additional factors to be considered when establishing our IBNR. These uncertainties are intended to compensate for our limited operating history and claims loss development patterns, which require the use of industry information that may not be indicative of our actual loss experience. At December 31, 2006, we recorded additional IBNR for uncertainties relating to the timing of the emergence of claims. We anticipate that these uncertainties may vary over time. A combination of the baseline estimate of IBNR and the reserves for the additional uncertainties produces a single point estimate that constitutes management’s and the actuaries’ best estimate of IBNR.
The following table provides a breakdown of reserves for losses and loss expenses by segment by type of exposure:
Our ceded unpaid losses and loss expenses consist of two elements, those for reported losses and those for IBNR. Ceded amounts for IBNR are developed as part of our loss reserving process. Consequently, the estimation of ceded unpaid losses and loss expenses is subject to similar risks and uncertainties as the estimation of gross IBNR (see “Reserve for losses and loss expenses”). At December 31, 2006 and 2005, ceded IBNR recoverable balances were $666.5 million and $555.0 million, respectively.
unlikely to collect in full. Lastly, we evaluate the overall adequacy of the valuation allowance for the total reinsurance recoverable balances based on qualitative and judgmental factors. Based on this process, we recorded a valuation provision against reinsurance recoverable balances of $34.0 million and $15.6 million as at December 31, 2006 and 2005, respectively.
We also write business on a line slip basis, under which we assume a fixed percentage of the premiums and losses on a particular risk or group of risks along with numerous other unrelated insurers. Statement of Financial Accounting Standard No. 60 “Accounting and Reporting By Insurance Enterprises” requires that if the ultimate premium is reasonably estimable, the estimated ultimate premium should be recognized as revenue over the period of the contract. Although a premium estimate is not contractually stated for business written on a line slip basis, we believe that the premium is reasonably estimable because we receive an initial estimate of the expected premium written from the client via the broker. This estimate has been derived by reference to one or more of the following: the historical premium volume experienced by the line slip; historical premium volume of similar line slips; and industry information on the underlying business. We may, if we believe appropriate, adjust the initial estimates provided by the broker to reflect management’s best judgments and expectations. This is most likely where the underwriter believes that the estimate is not prudent. Under these circumstances, we will generally recognize as revenue a lower than advised premium written estimate. We actively monitor the development of actual reported premium to the estimates made. Where actual reported premium deviates from the estimate, we carry out an analysis to determine the cause and may, if necessary, adjust the estimated premium in the period in which the determination was made. During 2006, 2005 and 2004, line slip premiums accounted for 10%, 8% and 5%, respectively, of total gross premiums written.
For our reinsurance business, we write contracts on both an excess of loss basis and a proportional basis. For excess of loss contracts, the amount of premium is usually contractually documented at inception and no management judgment is necessary. For most such contracts, a deposit premium is generally contractually specified and is payable during the contract period. After the contract has expired, a premium adjustment is calculated, which is based on the underlying exposure of the ceded business. We record the deposit premium at the inception of the contract and record adjustments in the periods in which they are reasonably determinable.
Other investments consist of collateralized loan obligations (“CLOs”), investment funds (such as short duration high yield fund, credit funds, and fund of hedge funds) and life settlement contracts. We record our other investments at fair value.
We have elected to use the fair value method to account for all the life settlement contracts in accordance with FASB Staff Position FTB 85-4-1, Accounting for Life Settlement Contracts by Third-Party Investors. As there are no active markets for these contracts, we are required to estimate fair value, which is based on discounting the future cash flows of the life insurance policies including life insurance proceeds and premium payments.
There is significant judgment involved in the fair value estimation process. The timing of life insurance receipts is dependent on the longevity of the insured individuals underlying the life insurance policy. The estimation of life expectancy of an individual is a complex process which may include, but not limited to, subjective interpretation of the following: sex; age; height; weight; race; lifestyle; medical history and ancestry; marital status; educational background; improvements in mortality rates; wealth; and access to and impact of changes in medical techniques. The subjectivity of these input variables can lead to vast complexities. Further, experts in the field of estimating life expectancy can arrive at materially different quotes for life expectancy for the same individual based on the same input information. The discount factor used in discounting future cash flows adds to the measurement uncertainty. It is calculated by deriving a risk yield curve which incorporates the USD LIBOR swap rates, credit spreads for the life insurance companies and a spread for longevity risk as observed in the secondary market. A third key assumption in discounting future cash flows is life premiums. We assume fairly stable life premium rates over the life of the respective policies.
The terms “FAS” and “FASB” used in these notes refer to Statements of Financial Accounting Standards issued by the Financial Accounting Standards Board, a United States based accounting standard setter.
The preparation of these consolidated financial statements requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. The significant estimates reflected in the Company’s consolidated financial statements are:
· the estimate of reinsurance recoverable balances, including the provision for unrecoverable reinsurance;
· the impairments to the carrying value of the investment portfolio.
Certain reclassifications have been made to prior year amounts to conform to the current year’s presentation.
The Company accounts for its collateralized loan obligations (“CLOs”), investment funds and life settlement contracts at fair value. Interest, dividend income, income distributions, changes in net asset values, and realized gains and losses are included in net investment income.
The Company elected to use the fair value method to account for all of the life settlement contracts under FASB Staff Position No. FTB 85-4-1, Accounting for Life Settlement Contracts by Third Party Investors. The fair value of the life settlement contracts is based on discounting the estimated cash flows of the life insurance policies, as calculated by a financial institution and reviewed by management. The discount factor is calculated by deriving a risk yield curve which incorporates the USD LIBOR swap rates, credit spreads for the life insurance companies and a spread for longevity risk as observed in the secondary market. Changes in the fair value of life settlement contracts, life insurance proceeds and life premium
payments are included in net investment income. The cash flows relating to the life settlement contracts are included in investing activities in the Consolidated Statements of Cash Flows.
The Company has no significant influence and does not participate in the management of CLOs, investment funds and the life settlement contracts.
Cash equivalents include money-market funds and fixed interest deposits placed with a maturity of under 90 days when purchased. At December 31, 2006, cash and cash equivalents included restricted cash of $105.7 million primarily for funding future life insurance premiums (see Notes 6 (c) and 11(h)) and collateralizing certain reinsurance agreements.
Reserves for losses and loss expenses are established by management with assistance from the Company’s independent actuaries. They represent an estimate of the total cost of claims that are reported but not yet paid, the cost of additional case reserves on claims reported to the Company but not considered to be adequately reserved and the anticipated cost of claims incurred but not reported (“IBNR”).
The IELR method estimates ultimate loss and loss expenses based on pricing information and industry data. Both methods are typically used by companies with limited loss experience.
On January 1, 2003, the Company adopted the fair value recognition provisions of FAS No. 123, Accounting for Stock-Based Compensation (“FAS 123”), as amended under FAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure (“FAS 148”), under the prospective method permitted for stock-based awards granted subsequent to January 1, 2003.
determination of share-based compensation expense. For awards that have a graded vesting schedule, the Company recognizes compensation expense on a straight-line basis over the vesting period for each separate vesting portion of the award as if the award was, in-substance, multiple awards. The Company has not issued awards subject to performance and market conditions. The adoption of FAS 123 (R) did not have a significant impact on net income and basic and diluted earnings per share for 2006.
The Company accounts for its derivative instruments using FAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“FAS 133”). For non-hedging transactions, FAS 133 generally requires an entity to recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value with movements in fair value reflected in earnings. The Company may enter into derivative instruments such as futures, options, interest rate swaps and foreign currency forward contracts in order to manage duration and foreign currency exposure, obtain exposure to a particular financial market or for yield enhancement. The Company manages the exposure to these instruments based on guidelines established by management and these derivative instruments are carried at fair value with the corresponding changes in fair value recognized in the Consolidated Statements of Operations in the period that they occur.
From time to time the Company enters into insurance and reinsurance contracts that meet the definition of a derivative contract under FAS 133. The Company has recorded these contracts at fair value with any changes in the value reflected in other insurance related income in the Consolidated Statements of Operations. Generally, the contracts are modeled on prevailing market conditions and certain other factors relating to the structure of the contracts. The Company’s model takes into account movements on
credit spreads and credit qualities and when data is not readily available from the market, the Company uses data from independent counterparties.
The Company accounts for intangible assets in accordance with FAS No. 142, Goodwill and Other Intangible Assets. The Company does not amortize goodwill or identifiable intangible assets with indefinite lives, but rather re-evaluates on a yearly basis, or whenever changes in circumstances warrant, the recoverability of the assets. If it is determined that an impairment exists, the Company adjusts the carrying value of the assets to fair value. In respect of intangible assets with finite lives, the Company amortizes the value of the assets over their useful lives.
Certain subsidiaries of the Company operate in jurisdictions where they are subject to taxation. Current and deferred income taxes are provided based upon enacted tax laws and rates applicable in the relevant jurisdictions. Deferred income taxes are provided on all temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.
In September 2006, the FASB issued FAS No. 157, Fair Value Measurement (“FAS 157”). This Statement provides guidance for using fair value to measure assets and liabilities. Under this standard, the definition of fair value focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price). FAS 157 clarifies that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy with the highest priority being quoted prices in active markets and the lowest priority to unobservable data. Further, FAS 157 requires tabular disclosures of the fair value measurements by evel within the fair value hierarchy. FAS 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Early adoption is permitted as of the beginning of a fiscal year. The Company is currently evaluating the potential adoption impact of FAS 157 on the Company’s financial condition, results of operations and cash flows.
In February 2007, the FASB issued FAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“FAS 159”). Under this standard, an entity is required to provide additional information that will assist investors and other users of financial information to more easily understand the effect of the company’s choice to use fair value on its earnings. Further, the entity is required to display the fair value of those assets and liabilities for which the company has chosen to use fair value on the face of the balance sheet. This standard does not eliminate the disclosure requirements about fair value measurements included in FAS 157 and FAS No. 107, Disclosures about Fair Value of Financial Instruments. FAS 159 is effective for fiscal years beginning after November 15, 2007, and early adoption is permitted as of January 1, 2007, provided that the entity makes that choice in the first quarter of 2007 and also elects to apply the provisions of FAS 157. The Company is currently evaluating the potential adoption impact of FAS 159 on the Company’s financial condition, results of operations and cash flows.
The Company’s insurance segment provides insurance coverage on a worldwide basis and is divided into two sub-segments: global insurance and U.S. insurance.
On August 1, 2005, the Company completed the purchase of Fireman’s Fund Insurance Company of Wisconsin, which is licensed in 48 states of the United States and the District of Columbia. Fireman’s Fund
In 2006, the Company adopted FASB Statement 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans (“FAS 158”), an amendment of FASB Statements No 87, 88, 106 and 132 (R). Accordingly, at December 31, 2006, the Company reclassified the remaining unrecognized prior service costs from intangible assets to accumulated other comprehensive income and recorded a negligible unfunded pension liability in other liabilities.
As of December 31, 2006, there were approximately 1,945 securities (2005: 2,113) in an unrealized loss position with a fair value of $4,418.2 million (2005: $4,852.7 million). Of these securities, there are 1,497 securities (2005: 517) that have been in an unrealized loss position for 12 months or greater with a fair value of $2,639.0 million (2005: $1,259.2 million). At December 31, 2006 and 2005 none of these securities were considered to be other than temporarily impaired. The unrealized losses from these securities were not a result of credit, collateral or structural issues. In 2006, the Company recorded an impairment charge of $4.6 million (2005 and 2004: nil) relating to 36 securities that the Company determined to be other than temporarily impaired, included in net realized (losses) gains in the Consolidated Statements of Operations.
The following table sets forth certain information regarding the credit ratings of the Company’s fixed maturity portfolio:
The following represents an analysis of gross realized gains (losses) and the change in unrealized gains (losses) on investments included within accumulated other comprehensive loss:
Beginning in 2004 the Company expanded its investment strategy to other asset sectors. At December 31, 2006, the Company had $1,130.7 million of other investments at fair value (2005: $409.5 million), representing 11.8% (2005: 5.3%) of total cash and investments. Many of the investments are subject to restrictions on redemptions and sales which are determined by the governing documents and limit the Company’s ability to liquidate these investments in the short term. Due to a lag in the valuations reported by some managers, the majority of our credit fund valuations are reported on a one month lag. Other investments consist of the following:
December 31, 2006 Consolidated Balance Sheets and eliminated all inter-company balances including the Note. The consolidated assets and liabilities of the SPEs consist primarily of restricted cash of $65.0 million, life settlement contracts portfolio of $377.8 million and an other liability of $42.8 million. To estimate the fair value of the life settlement contracts portfolio the Company used the following three key assumptions: an average life expectancy of 9.96 years, discount yield of USD LIBOR + 3.7%, and stable life premium rates over the life of the respective policies. The following table is based on the estimated remaining life expectancy as at December 31, 2006.
The purchase of the Note was financed by a $400.0 million three-month repurchase agreement at an interest rate of 3-month USD LIBOR plus 0.9% per annum and is reported as a liability under repurchase agreement in the Consolidated Balance Sheets. The Note serves as collateral for this funding facility; however, the Company is required to meet cash margin calls in the event the Note depreciates in value and to pay capital calls, if any called, in accordance with the terms of the Note.
The Company has invested in various CLOs with the investments ranging from equity to senior debt tranches. At December 31, 2006, the Company had invested in 26 (2005: 21) different CLOs with underlying assets totaling $13.6 billion (2005: $8.6 billion).
securities on loan at December 31, 2006. The Company considers its securities lending activities to be non-cash investing and financing activities.
The following table represents an analysis of paid and unpaid losses and loss expenses and a reconciliation of the beginning and ending unpaid losses and loss expenses:
has been reached. This excess point can be based on the size of an industry loss or a fixed monetary amount. These covers can be purchased on a package policy basis, which provide cover for a number of lines of business within one contract. Quota share covers provide a proportional amount of coverage from the first dollar of loss. All of these reinsurance covers provide for recovery of a portion of losses and loss expenses from reinsurers. Under its reinsurance security policy, the Company predominantly cedes its business to reinsurers rated A- or better by Standard & Poor’s Company (“S&P”) and/or A.M. Best Company (“A.M. Best”). The Company remains liable to the extent that reinsurers do not meet their obligations under these agreements either due to solvency issues, contractual disputes or some other reason.
At December 31, 2006, the total reinsurance recoverable balance was 13.8% collateralized.
During 2006, the Company recorded realized and unrealized losses on foreign currency forward contracts in its investment portfolio of $1.1 million (2005: $7.3 million gain; 2004: $3.0 million loss). As at December 31, 2006, the net contractual amount of these foreign currency forward contracts was $2.5 million (2005: $27.1 million; 2004: $30.0 million) with a negligible unrealized loss in each of the three years. During 2006, the Company recorded realized and unrealized losses on mortgage-backed securities that were accounted for as derivatives of $2.8 million (2005: $0.4 million; 2004: $0.3 million gain). At December 31, 2006 and 2005, the Company did not hold any mortgage-backed securities in its investment portfolio that are accounted for as derivatives.
During 2006, the Company entered into a $100.0 million Total Return Swap Facility (the “Facility”) with a financial institution for the purpose of accessing and isolating natural peril exposures embedded in capital market instruments. The Company utilized half of the Facility to enter into a $50.0 million catastrophe-related total return swap transaction, which was collateralized by a lien over a portfolio of the Company’s investment grade securities. The Company received contract payments in exchange for assuming losses from qualifying earthquake loss events. The total return swap was marked-to-market with the change in estimated fair value reported as other insurance related income (loss) in the Consolidated
Statements of Operations. At December 31, 2006, the fair value of the swap was $0.2 million. The quarterly net contract payments, including the Facility fee, are included in other insurance related income (loss). The Facility will terminate on September 15, 2009.
On November 15, 2004, the Company issued $500.0 million of senior unsecured debt (“Senior Notes”) at an issue price of 99.785%, generating net proceeds of $495.7 million. The Senior Notes bear interest at a rate of 5.75%, payable semi-annually in arrears on June 1 and December 1 of each year, beginning on June 1, 2005. Unless previously redeemed, the Senior Notes will mature on December 1, 2014. The Company may redeem the Senior Notes at any time and from time to time, in whole or in part, at a “make-whole” redemption price, however, the Company has no current intentions of calling the Senior Notes. The Senior
Notes indenture contains various covenants, including limitations on liens on the stock of restricted subsidiaries, restrictions as to the disposition of the stock of restricted subsidiaries and limitations on mergers and consolidations. The Company was in compliance with all the covenants contained in the Senior Notes indenture at December 31, 2006 and 2005. The fair value of the Senior Notes at December 31, 2006 was $496.2 million (2005: $498.5 million).
Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of investments and reinsurance recoverable balances. The investment portfolio is managed by external advisors in accordance with prudent standards of diversification. Specific provisions limit the allowable holdings of a single issue and issuers. The Company did not have an aggregate exposure in a single entity, other than in U.S. Government and U.S. Government agency securities, of more than 10.0% of shareholders’ equity at December 31, 2006 and 2005. Concentration of credit risk with respect to reinsurance recoverable balances is limited due to the number of reinsurers used on the Company’s reinsurance programs. At December 31, 2006, the top ten reinsurers accounted for 58.2% of reinsurance balances recoverable, one of which accounted for 12.8% of reinsurance balances recoverable. Of the 58.2%, 30.2 percentage points are with reinsurers rated A+ by A.M. Best, 16.5 percentage points are with reinsurers rated A by A.M. Best and 11.5 percentage points are with reinsurers rated A- by A.M. Best.
On December 7, 2006 the Board of Directors declared a dividend of $0.165 per common share to shareholders of record at December 31, 2006 and payable on January 16, 2007. Additionally, the Board of Directors declared a dividend of $0.45 per Series A 7.25% Preferred share and a dividend of $1.88 per Series B 7.5% Preferred share. The Series A Preferred share is payable on January 16, 2007, to shareholders of record at December 31, 2006 and the Series B Preferred share is payable on March 1, 2007 to shareholders of record at February 15, 2007.
The following securities, that would result in the issuance of common shares, were not included in the computation of diluted earnings per common share because the effect would be antidilutive: 2006: 881,980, 2005: 1,106,499 and 2004: 1,664,500.
On December 7, 2006, the Company announced that its Board had authorized a renewal of the Company’s share repurchase plan with authorization to repurchase up to $400 million of its common shares. This repurchase plan will expire on December 31, 2008.
In connection with its formation, the Company issued warrants to founding shareholders which entitle them to purchase up to 12% of the aggregate number of outstanding shares at the date of issuance, calculated on a fully diluted basis, on the exercise date at a price of $12.50 per share. The warrants are subject to anti-dilution provisions that adjust in the event of dividends, distributions or stock adjustments. In the event of a dividend, a warrant holder may elect to take either an adjustment to both the exercise price and the number of shares issuable upon exercise of the warrants or to take a cash dividend that is paid upon exercise of the warrant. The anti-dilution provisions ensure that the holder is in the same position as if the warrant had been exercised immediately before the dividend, distribution or stock adjustment.
The following table shows the components of pension expense and the amounts included in the Company’s Consolidated Balance Sheets for the SERPs.
The weighted-average assumptions used to determine net periodic pension cost and benefit obligations were:
During 2006, the Company expensed $4.3 million (2005: $5.2 million; 2004: $3.0 million) related to the grant of options and realized a tax benefit of $1.3 million (2005: $1.7 million; 2004: $0.5 million). At December 31, 2006, there was $0.9 million of unrecognized compensation cost related to options which is expected to be recognized over the weighted average period of one year. The total intrinsic value of options exercised during 2006 was $11.0 million (2005: $10.3 million; 2004: $0.6 million) and the Company received proceeds of $17.1 million (2005: $8.6 million; 2004: $0.7 million). The total intrinsic value of options vested at December 31, 2006, was $70.2 million (2005: $69.9 million; 2004: $55.2 million). The fair value of options granted during 2006 was $0.1 million (2005: $6.7million; 2004: $7.3 million).
The Company has elected to use the simplified method of calculating the expected life of the options, which is the average of the vesting period and the expiry period.
The fair value of restricted share grants is determined using the closing price of the Company’s shares on the New York Stock Exchange on the day of the grant, with grants generally vesting three years after the date of grant or upon the employee’s earlier retirement, death, permanent disability or a change in control of the Company. Restricted shares are entitled to vote and to receive dividends but may not be transferred during the period of restriction and are forfeited if the employee’s employment terminates prior to vesting. Compensation cost equivalent to the estimated fair value at the date of grant for the number of shares expected to fully vest is amortized over a three-year vesting period. At December 31, 2006, there was $29.4 million of unrecognized compensation cost related to these awards which is expected to be recognized over the weighted average period of 1.4 years. The total fair value of shares vested during 2006 was $3.1 million (2005: $25.7 million; 2004: $4.2 million). During 2006, the Company expensed $20.9 million (2005: $20.0 million; 2004: $14.1 million) in respect of restricted stock, and recorded tax benefits thereon of $3.3 million (2005: $4.7 million; 2004: $1.9 million).
The following is a summary of restricted stock granted under the LTEC and related activity:
The grants in 2006 include modifications to grants made in prior years in relation to an employee pursuant to a severance agreement. The earlier grants were deemed forfeited and new grants issued at the new terms.
The Company receives a tax deduction for certain vested restricted stocks and exercised stock options. The Consolidated Statements of Cash Flows in 2006 include excess tax benefits of $0.4 million (2005: 2.9 million; 2004: nil) on exercise of stock options and restricted stock vests as a financing cash flow.
The Company has adopted a Directors Long-Term Equity Compensation Plan (“DLTECP”) that provides for the grant of non-qualified stock options and stock awards (restricted and unrestricted) to non-employee directors of the Company. The maximum number of common shares with respect to which awards may be granted under the plan is 1,200,000. The plan is administered by the Compensation Committee of the Board of Directors.
During 2006, the Company expensed $0.2 million (2005: $0.2 million; 2004: $0.1million) related to the grant of options. At December 31, 2006, there was a negligible amount of unrecognized compensation cost related to options which is expected to be recognized over the weighted average period of 1 year. The total intrinsic value of options exercised during 2006 was $0.09 million (2005: $nil; 2004: $nil) and the Company received proceeds of $0.3 million (2005: $nil; 2004: $nil) and realized no tax benefit. The total intrinsic value of options vested at December 31, 2006, was $0.5 million (2005: $0.3 million; 2004: $0.1 million). There were no option grants during 2006, and the fair value of options granted during 2005 and 2004 was $0.3 million. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants in 2005 and 2004, respectively: risk free interest rates of 4.2% and 4.4%, respectively, expected life of 7 years, a dividend yield of 2.5% and 1.9%, respectively, and an expected volatility of 22% and 23%, respectively. The Company has elected to use the simplified method of calculating the expected life of the options, which is the average of the vesting period and the expiry period.
The fair value of restricted share grants is determined using the closing price of the Company’s shares on the New York Stock Exchange on the day of the grant, with grants generally vesting six months after the date of grant or upon the director’s earlier retirement, death, permanent disability or a change in control of the Company. Restricted shares are entitled to vote and to receive dividends but may not be transferred during the period of restriction and are forfeited if the director resigns prior to vesting. Compensation cost equivalent to the estimated fair value at the date of grant for the number of shares expected to fully vest is amortized over a six-month vesting period. As of December 31, 2006, there was no unrecognized compensation cost related to these awards. The Company recorded expenses of $0.1 million or less in each of the years under 2006, 2005 and 2004, representing the total fair value of shares vesting during the period.
The Company has an unfunded nonqualified deferred compensation plan that allows participating directors to elect (i) the amount, if any, of cash or stock as fees for services to be deferred and (ii) the form in which payment is to be made. Directors who choose to defer fees otherwise payable in shares are credited a number of phantom stock units equal in amount to the number of shares of stock deferred. In the event a cash dividend is declared on the stock, the portion of the participant’s deferral account denominated in phantom share units is credited with additional phantom share units (or portions thereof). Directors who choose to defer fees otherwise payable in cash are credited with interest on their cash deferral at a rate for the year of deferral that is 100 basis points above the 12-month LIBOR rate for deposits of U.S. dollars. Generally, benefits are paid upon termination of service as a director. At December 31, 2006, 35,656 (2005: 30,267; 2004: 23,235) phantom share units had been issued under the plan in lieu of fees, 1,997 (2005: 1,144; 2004: nil) had been issued in lieu of dividends, and 10,739 (2005: 6,657; 2004: 4,473) had been issued in lieu of restricted shares.
In 2005, the Company began investing in various CLOs. The collateral manager of four of these investments was Blackstone Debt Advisors L.P., who is entitled to management fees payable by the collateralized obligations in the ordinary course of business. The Company invested in a fund of hedge funds and in a distressed debt fund that is managed by Blackstone Alternative Asset Management, LP, who is entitled to management fees in the ordinary course of business. During 2006, total management fees to the Blackstone Group was $2.8 million (2005: $1.2 million).
The Company pay Marsh & McLennan Companies, Inc (“Marsh”) brokerage and commissions, which vary based on the amount of business produced. In addition, the Company pays fees to Marsh relating to accounting and human resources consulting services and the placement of insurance. Effective May 2005, Marsh ceased to be a related party. The Company incurred brokerage fees and commissions during 2005 and 2004 of $92.1 million and $109.0 million, respectively.
The Company has received an undertaking from the Minister of Finance in Bermuda that, in the event of any taxes being imposed, the Company will be exempt from taxation in Bermuda until March 2016.
The Company’s U.S. subsidiaries are subject to federal, state and local corporate income taxes and other taxes applicable to U.S. corporations. The provision for federal income taxes has been determined under the principles of the consolidated tax provisions of the U.S. Internal Revenue Code and Regulation. Should the U.S. subsidiaries pay a dividend to the Company, withholding taxes will apply. The Company also has operating subsidiaries and branch operations in Ireland, the United Kingdom, Singapore, and Switzerland and is subject to the relevant taxes in those jurisdictions.
Income tax expense and net income tax assets were as follows:
There are no other statutory restrictions on the payment of dividends from retained earnings of the Company’s Bermudian or Irish subsidiaries as applicable minimum levels of statutory capital and surplus requirements have been met and all regulatory requirements and licensing rules complied with.
The Company uses various financial instruments in the normal course of its business. Fair values of these financial instruments are based on quoted market prices, if available, estimates of fair values of similar instruments or estimates of fair values determined by the Company. See Notes 2 (b) and (h) for further information on the methods and assumptions used by the Company in estimating its fair value disclosures for financial instruments.
The carrying amounts and fair values of the Company’s financial instruments at December 31, 2006 and 2005: