Our principal and executive offices are located in Houston, Texas, in buildings owned by Houston Casualty Company. We also maintain offices in 50 locations elsewhere in the United States, the United Kingdom, Spain, Bermuda and Ireland. The majority of these additional locations are in leased facilities. We are not dependent on our facilities to conduct business and such office space is suitable for the conduct of our business.
We are a specialty insurance group with offices in the United States, the United Kingdom, Spain, Bermuda and Ireland transacting business in more than 100 countries. Our group consists of insurance companies, underwriting agencies and intermediaries. Our shares are traded on the New York Stock Exchange and had a market capitalization of $3.5 billion at January 31, 2007. We earned $342.3 million or $2.93 per diluted share in 2006, compared to $191.2 million or $1.75 per diluted share earned in 2005. The increase in earnings in 2006 was due to increased revenue and the impact of hurricane losses on our 2005 results. We grew shareholders’ equity by 21% in 2006 to $2.0 billion at December 31, 2006, principally due to net earnings.
In 2005 and 2004, the property and casualty insurance industry suffered record losses from nine major hurricanes that affected the Atlantic and Gulf Coasts of the United States. We recorded gross losses of $394.6 million from the 2005 hurricanes and $89.8 million from the 2004 hurricanes in the year they occurred. Recoveries expected from our reinsurance programs reduced these gross losses to net losses of $89.7 million in 2005 and $33.1 million in 2004. There were no hurricane losses in 2006. In 2006 and 2005, we also opportunistically commuted two large reinsurance contracts related to run-off assumed accident and health reinsurance business included in our discontinued lines, for which we had $120.2 million in 2006 and
$145.7 million in 2005 of reinsurance recoverables as of the date of commutation. As a result of these commutations, we recognized losses of $20.2 million in 2006 and $26.0 million in 2005, which principally represent the discount for the time value of money on the reinsurance recoverables. We expect to recoup these losses over future years as we earn interest on the cash proceeds from the commutations prior to the related claims being paid.
Our major insurance companies are rated “AA (Very strong)” by Standard & Poor’s Corporation, “AA- (Very Strong)” by Fitch Ratings and “A+ (Superior),” by A.M. Best Company, Inc.
related to our stock option investigation. Net earnings in 2005 included after-tax losses of $58.2 million ($0.53 per diluted share) due to the combined effects of five hurricanes and $16.9 million ($0.15 per diluted share) due to a reinsurance commutation. Growth in underwriting profits, net investment income, other operating income and the lack of hurricane losses contributed to the increase in 2006 earnings. Net earnings increased 18% to $191.2 million ($1.75 per diluted share) in 2005 from $162.7 million ($1.65 per diluted share) in 2004. Net earnings in 2004 included an after-tax loss of $21.5 million ($0.22 per diluted share) due to the combined effects of four hurricanes.
During 2006 and 2005, we reached agreements with various reinsurers to commute two large reinsurance contracts related to run-off assumed accident and health reinsurance business included in our discontinued lines, for which we had $120.2 million in 2006 and $145.7 million in 2005 of reinsurance recoverables at the date of commutation. In consideration for discounting the recoverables and reassuming the associated loss reserves, we agreed to accept cash payments that were less than the related recoverables. We recorded a pre-tax loss of $20.2 million in 2006 and $26.0 million in 2005 related to these commutations, which were included in loss and loss adjustment expense in our insurance company segment.
The following table shows the reported amounts, as well as the effect on those amounts of the two commutations and the hurricanes in the year they occurred. The table does not include reserve reductions related to prior year hurricanes as follows: $17.7 million in 2006 ($15.2 million for the 2005 hurricanes and $2.5 million for the 2004 hurricanes) and $7.2 million in 2005 for the 2004 hurricanes. The impact on ceded earned premium relates to the effect of premiums to reinstate our excess of loss reinsurance, which reduced net earned premium.
The following table shows our net loss, expense and combined ratios and the effect that the losses related to the hurricanes in the year they occurred and of the two commutations had on these ratios. To determine the effect of the hurricanes and commutations, we calculated the 2006, 2005 and 2004 net loss ratios by excluding $20.2 million, $99.2 million and $23.3 million, respectively, of losses from the numerator of the net loss ratio and zero, $16.5 million and $9.8 million, respectively, of reinstatement premium from the denominator of both the net loss ratio and the expense ratio.
Total revenue increased 26% to $2.1 billion in 2006 and 28% to $1.6 billion in 2005, driven by significant growth in net earned premium and investment income, offset by the expected decrease in fee and commission income in 2005. Approximately 28% of the increase in revenue in 2006 and 6% in 2005 was due to the acquisition of businesses. We expect total revenue to continue to grow in 2007.
Fee and commission income increased $4.5 million in 2006 as a result of profit commissions from reinsurers, which were triggered by reserve releases. Fee and commission income decreased to $132.6 million in 2005, as expected, resulting from a decrease in the level of ceded reinsurance by our insurance company subsidiaries, which resulted in reduced revenue from our reinsurance brokers and reduced ceding commissions earned by our insurance companies and underwriting agencies. Also, effective January 1, 2005, we consolidated the operations of our largest underwriting agency into one of our life insurance company subsidiaries. This higher retention of our premium and the consolidation of operations resulted in increased underwriting revenue and profitability in our insurance company subsidiaries.
Net investment income increased 55% in 2006 and 52% in 2005. These increases were primarily due to higher investment assets, which increased to $3.9 billion at December 31, 2006 compared to $3.3 billion at December 31, 2005 and $2.5 billion at December 31, 2004, and higher interest rates. The growth in investment assets resulted from: 1) cash flow from operations, 2) higher retentions, 3) commutations of reinsurance recoverables, 4) our public offerings of common stock in 2005 and 2004 and 5) the increase in net loss reserves particularly from our diversified financial products line of business, which generally has a longer time period between reporting and payment of claims. Average yields on our short-term investments increased from 2.7% in 2005 to 4.5% in 2006 and our long-term tax equivalent yield increased from 4.9% in 2005 to 5.2% in 2006. We continue to invest our funds primarily in fixed income securities, with a weighted average duration of 4.6 years at December 31, 2006. We expect investment assets to continue to increase in 2007, consistent with our anticipated growth in revenue and earnings.
At December 31, 2006, our unrealized loss on fixed income securities was $1.6 million, down from an unrealized loss of $8.5 million at December 31, 2005, due to fluctuations in market interest rates. The change in the unrealized gain or loss, net of the related income tax effect, is recorded in other comprehensive income and fluctuates with changes in market interest rates. Our general policy has been to hold our fixed income securities, which are classified as available for sale, through periods of fluctuating interest rates and to not realize significant gains or losses from their sale. The unrealized loss on our fixed income securities increased to $14.9 million at January 31, 2007 due to an increase in interest rates.
from strategic investments or dispositions of such investments. The following table details the components of other operating income.
Other operating expense, which includes compensation expense, increased 23% in 2006 and 8% in 2005. The 2006 amount increased for stock option expense under Statement of Financial Accounting Standards (SFAS) No. 123(R); higher professional fees, legal costs and other expenses related to the stock option investigation; and operating expenses of subsidiaries acquired in 2006 and the second half of 2005. The 2005 increase primarily related to higher incentive compensation based on increased profitability, operating expenses of subsidiaries acquired or formed, and the expensing of $8.9 million for an indemnification claim. We had 1,660 employees at December 31, 2006, compared to 1,448 a year earlier. The increase in employees was primarily due to acquisitions.
In 2006, we expensed $13.1 million ($9.4 million after tax or $0.08 per diluted share) of stock-based compensation, after the effect of the deferral and amortization of related policy acquisition costs. Effective January 1, 2006, we adopted SFAS No. 123(R), Share-Based Payment, using the modified prospective method. We are recognizing compensation expense in 2006 and thereafter for all previously granted but unvested stock options as of January 1, 2006, and all options granted after that date. Prior to adoption, we accounted for our stock options in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and recognized compensation expense of $3.0 million in 2005 and $2.6 million in 2004. We made no modifications to our stock option plans in conjunction with our implementation of SFAS 123(R). The 2005 and 2004 consolidated financial statements were not restated to reflect our adoption of SFAS 123(R). During adoption, we reviewed our Black-Scholes assumptions and established a policy to align our assumptions with the individual grant terms for all future grants. This resulted in lower assumptions for expected volatility and expected option life for our 2006 grants. At December 31, 2006, there was approximately $32.4 million of total unrecognized compensation expense related to unvested options that is expected to be recognized over a weighted-average period of 2.8 years. In 2007, we expect to recognize $10.9 million of expense, including the amortization of deferred policy acquisition costs, related to stock-based compensation for options currently outstanding.
Our effective income tax rate on earnings from continuing operations was 32.9% for 2006, compared to 30.9% for 2005 and 34.1% for 2004. The effective tax rate was lower in 2005 because our tax exempt interest income increased as a percentage of our pre-tax income and we recorded a special $2.8 million repatriation tax benefit. The 2006 rate is a more normalized rate.
In December 2003, we sold the business of our retail brokerage subsidiary, HCC Employee Benefits, Inc., for $62.5 million in cash. We recognized gains of $6.3 million ($4.0 million after-tax) in 2004 and $4.4 million ($2.8 million after-tax) in 2005 from a contractual earnout, which is now completed. The after-tax gains on earnout are reported as earnings from discontinued operations in the consolidated statements of earnings. Cash flows from earnout are included in investing activities.
Net earnings of our insurance company segment increased 116% to $272.0 million in 2006 compared to $126.1 million in 2005, which in turn increased 15% from $109.3 million in 2004. The 2006 net earnings included $13.1 million of after-tax losses related to a commutation. The 2005 net earnings included $75.2 million of after-tax losses related to hurricanes and a commutation, while 2004 net earnings included $21.5 million of after-tax hurricane losses. The growth in segment net earnings was driven by: 1) improved underwriting results, 2) increased retentions, which resulted in higher earned premium, 3) increased investment income and 4) the operations of acquired subsidiaries. Effective April 1, 2006 and January 1, 2005, we consolidated two underwriting agencies into two insurance companies; all operations after those dates have been reported in our insurance company segment. Even though there is some pricing competition in certain of our markets, our margins remain at an acceptable level of profitability due to our underwriting expertise and discipline. We expect net earnings from our insurance companies to continue to grow in 2007.
Gross written premium increased 10% to $2.2 billion in 2006 and 3% in 2005. We expect gross written premium to continue to grow in 2007. Net written premium increased 21% to $1.8 billion and net earned premium increased 25% to $1.7 billion in 2006 compared to increases of 36% and 36%, respectively, in 2005 and 2004. These increases were primarily due to higher retention levels on most non-catastrophe business, acquisitions and the mix of business due to increased premium in lines where we had greater retentions. The overall percentage of retained premium increased to 81% in 2006 from 74% in 2005 and 56% in 2004. Net written and net earned premium are expected to continue to grow in 2007.
Diversified financial products - The growth in our gross written premium in 2006 resulted principally from organic growth in our surety, credit and special financial products businesses, where pricing is good and competition is reasonable. Premium volume in the other major products was stable and the pricing for these products is down slightly. In response to some increased competition and a reduction in available reinsurance at an acceptable cost, we scaled back our writing of directors’ and officers’ liability business in 2005. Our professional indemnity and surety business increased in 2005 due to organic growth and acquisitions. The growth in net written and net earned premium in both years was due to increased retentions resulting from a reduction in proportional reinsurance, some of which has been replaced by excess of loss reinsurance.
Group life, accident and health - Gross written, net written and net earned premium of our medical stop-loss product increased $75.3 million in 2006 as a result of our acquisition of the Health Products Division on October 2, 2006. The increase in gross written premium was partially offset by a decrease in premium due to our non-renewing a book of business which was 100% reinsured and, thus, did not impact net written premium. Our retention of our medical stop-loss business increased in 2006 and 2005 as we chose to reinsure less of this non-volatile business, which has very little catastrophe
London market account - Gross written premium increased in 2006 due to the substantial increase in rates in the energy sector as a result of the 2005 hurricane losses. Net written premium increased for the same reason and will be reflected in increases in our net earned premium into 2007. In 2006, to increase our capacity and spread our risk in the energy sector, we entered into a new quota share reinsurance agreement which was renewed in 2007. Although the cost of our 2006 excess of loss reinsurance increased, our potential profitability is greater on the increased gross written premium. Our aggregate exposure in Florida and the Gulf of Mexico was lower in 2006 than in 2005, and we are maintaining the reduced exposure in 2007. The decrease in premium writings in 2005 was due to more selective underwriting in response to reduced premium rates from increased competition. Retention percentages can vary due to the effect of reinstatement premiums and the amount of earned premium in relation to substantial, relatively fixed excess of loss premiums. Premium rates in this line are stable.
Annually, we analyze our overall threshold for risk in each line of business based upon a number of factors including market conditions, pricing, competition and the inherent risks associated with the business type, then structure a specific reinsurance program for each of our lines of business. Based on our analysis of these factors, we may determine not to purchase reinsurance for some lines of business. We generally purchase reinsurance to reduce our net liability on individual risks and to protect against catastrophe losses and volatility. We purchase reinsurance on a proportional basis to cover loss frequency, individual risk severity and catastrophe exposure. Some of the proportional reinsurance agreements may have maximum loss limits, the lowest of which is a 200% loss ratio. We also purchase reinsurance on an excess of loss basis to cover individual risk severity and catastrophe exposure. Additionally, we may obtain facultative reinsurance protection on a single risk. The type and amount of reinsurance we purchase varies year to year based on our risk assessment, our desired retention levels based on profitability and other considerations, and the market availability of quality reinsurance at prices we consider acceptable. Our reinsurance programs renew throughout the year and, during 2006, some of those renewals contained price increases, which were not material to our net underwriting results. Our reinsurance generally does not cover war or terrorism risks, which are excluded from most of our policies.
The following table provides comparative net loss ratios by line of business.
Aviation - The 2005 hurricanes increased the net loss ratio by 5.0 percentage points in 2005 and the 2004 hurricanes increased the net loss ratio by 6.5 percentage points. The 2005 net loss ratio also includes the positive impact from the release of redundant reserves related to the 2004 hurricanes. Excluding the impact of the hurricanes, 2005 had worse than expected underwriting experience due to some unusually large international losses while 2006 underwriting results were better than expected, due in part to the release of redundant reserves on the 2004 and 2005 accident years.
Other specialty lines - The release of redundant hurricane reserves reduced the 2006 net loss ratio by 3.9 percentage points. The 2005 hurricanes increased the net loss ratio by 14.0 percentage points and the 2004 hurricanes increased the net loss ratio by 6.5 percentage points.
Discontinued lines - The commutation losses in 2006 and 2005 affected the net losses for those years. In addition, the 2006, 2005 and 2004 net losses were impacted by loss reserve strengthening of $4.9 million, $8.9 million and $27.3 million, respectively, on certain run-off assumed accident and health reinsurance business.
Our net paid loss ratios were 34.1%, 33.4% and 30.0% in 2006, 2005 and 2004, respectively. The paid loss ratio is the percentage of losses paid, net of reinsurance, divided by net earned premium for that year.
The GAAP expense ratio of 25.0% in 2006 decreased in comparison to 26.1% in 2005 due to the higher level of net earned premiums in 2006 and the effect of reinstatement premiums in 2005. The decrease between 2005 and 2004 results from the same factors as the decrease in the policy acquisition percentage.
Regulatory guidelines suggest that a property and casualty insurer’s annual statutory gross written premium should not exceed 900% of its statutory policyholders’ surplus and net written premium should not exceed 300% of its statutory policyholders’ surplus. However, industry standards and rating agency criteria place these ratios at 300% and 200%, respectively. Our property and casualty insurance companies have maintained premium to surplus ratios lower than such guidelines. For 2006, our statutory gross written premium to policyholders’ surplus was 167.2% and our statutory net written premium to policyholders’ surplus was 135.1%. At December 31, 2006, each of our domestic insurance companies’ total adjusted capital was significantly in excess of the authorized control level risk-based capital level prescribed by the National Association of Insurance Commissioners.
Cash provided by operating activities increased $29.4 million in 2006 and decreased $44.7 million in 2005. Cash received from commutations, included in cash provided by operating activities, totaled $12.8 million, $180.8 million and $79.5 million in 2006, 2005 and 2004, respectively. Excluding the commutations, cash provided by operating activities increased $197.4 million in 2006 and decreased $146.0 million in 2005. The increase in 2006 was primarily due to the increase in net earnings and activity in our trading portfolio. The decrease in 2005 was principally due to an increase in paid claims in 2005 as a result of payments of 2004 hurricane losses and claims related to business commuted in 2004, the timing of receipt of premiums and payment of payables, and the effect of our trading portfolio activity. Cash flows are expected to be strong again in 2007.
Our investment policy is determined by our Board of Directors and our Investment and Finance Committee and is reviewed on a regular basis. Our policy for each of our insurance company subsidiaries must comply with applicable State and Federal regulations which prescribe the type, quality and concentration of investments. These regulations permit investments, within specified limits and subject to certain qualifications, in federal, state and municipal obligations, obligations of foreign countries, corporate bonds and preferred and common equity securities. The regulations generally allow certain other types of investments subject to maximum limitations.
We engage independent investment advisors to oversee our fixed income investments and to make investment recommendations. We invest our funds principally in highly rated fixed income securities. Our historical investment strategy is to maximize interest income and yield, rather than to maximize total return. In accordance with our strategy, realized gains and losses from sales of investment securities are usually minimal, unless we decide to capture gains to enhance statutory capital and surplus of our insurance company subsidiaries. Although we generally intend to hold fixed income securities to maturity, we regularly re-evaluate
At December 31, 2006, we had cash and short-term investments of $763.0 million, of which $492.9 million is held by our insurance companies. We maintain cash and liquid short-term instruments in our insurance companies in order to be able to fund losses of our insureds. Cash and short-term investments were higher than normal at December 31, 2006 due to proceeds from the liquidation of our trading portfolio and, at December 31, 2005, due to proceeds from a common stock offering and commutations that were consummated close to year end. Those proceeds had not yet been invested on a longer term basis.
The market value of our fixed income securities is sensitive to changing interest rates. As interest rates increase, the market value will generally decrease and as rates decrease, the market value will generally increase. The fluctuations in market value are somewhat muted by the relatively short duration of our portfolio and our relatively high level of investments in state and municipal obligations. During 2006, the net pre-tax unrealized loss on our fixed income securities decreased $6.9 million due to market value changes. We estimate that a 1% increase in interest rates would decrease the market value of our fixed income securities by approximately $138.3 million and a 1% decrease would increase the market value by a like amount. Fluctuations in interest rates have a minimal effect on the value of our short-term investments due to their very short maturities. In our current position, higher interest rates would have a positive effect on net earnings.
Some of our fixed income securities have call or prepayment options. This could subject us to reinvestment risk should interest rates fall or issuers call their securities and we reinvest the proceeds at lower interest rates. In addition, for asset-backed and mortgage-backed securities, prepayment risk could reduce the yield we realize on the remaining principal of these securities. We mitigate this risk by investing in securities with varied maturity dates, so that only a portion of our portfolio will mature at any point in time.
The following table compares our insurance company subsidiaries’ cash and investment maturities with their estimated future claims payments at December 31, 2006.
As demonstrated in the above table, we maintain sufficient liquidity to pay anticipated policyholder claims on their expected payment dates. In addition, we can use current operating cash flow to pay claims as they become due. We manage the liquidity of our insurance company subsidiaries such that each subsidiary’s
In preparing the previous table, we made the following estimates and assumptions.
The 1.30% Convertible Notes mature in 2023 and the 2.00% Convertible Exchange Notes mature in 2021, but are shown in the 2007 column since they may be surrendered for cash at the option of the holders in the first quarter of 2007 because our stock traded at specified price levels in the fourth quarter of 2006. Both convertible notes have various put and redemption dates as disclosed in Note 6 to the Consolidated Financial Statements.
Our acquisitions of HCC Global Financial Products, LLC (HCC Global) and Covenant Underwriters, Ltd. and Continental Underwriters Ltd. (collectively, CUL) include a contingency for earnout payments based on earnings after the acquisition date, as defined in the purchase agreement. When the conditions for accrual have
The payment of dividends by our insurance companies is subject to regulatory restrictions and will depend on the surplus and future earnings of these subsidiaries. HCC’s direct domestic insurance company subsidiaries can pay an aggregate of $172.1 million in dividends in 2007 without obtaining special permission from state regulatory authorities. In 2006, 2005 and 2004, our insurance company subsidiaries paid HCC dividends of $44.0 million, $50.0 million and $20.0 million, respectively. The 2005 and 2004 dividends were then contributed to another insurance company subsidiary.
Our debt to total capital ratio was 13.1% at December 31, 2006 and 15.5% at December 31, 2005.
In the second quarter of 2006, we filed a “Universal Shelf” registration statement with the SEC, which replaced our previously filed registration statements and provides for the issuance of an aggregate of $1.0 billion of our securities. These securities may be debt securities, equity securities, trust preferred securities, or a combination thereof. We sold 4.7 million and 4.5 million shares of our common stock at prices of $32.05 and $22.17 per share in 2005 and 2004, respectively, under our shelf registrations. Net proceeds of $150.0 million in 2005 were used to make $108.0 million of capital contributions to our insurance company subsidiaries and to fund acquisitions. We used the net proceeds of $96.7 million in 2004 to make a $75.0 million capital contribution to an insurance company subsidiary and $17.0 million to pay down bank debt.
In connection with a voluntary independent investigation by a Special Committee of the Board of Directors of our past practices related to granting stock options, the SEC commenced an informal inquiry into our option pricing practices. We have provided the results of our internal review and independent investigation to the SEC and we have responded to informal requests for documents and additional information. We intend to fully cooperate with the SEC. We are unable to predict the outcome of or the future costs related to the informal inquiry, but it may result in additional professional fees including our advancement of attorneys’ fees incurred by our Directors, certain officers and certain former executives and directors; may continue to occupy the time and attention of our management team; and could negatively impact our business and our ability to raise and borrow additional funds in the future. Furthermore, if we are subject to adverse findings in this or
We believe that our operating cash flows, investments, Revolving Loan Facility and other sources of liquidity are sufficient to meet our operating needs for the foreseeable future.
Inflation can also affect interest rates. Any significant increase in interest rates could have a material adverse effect on the market value of our investments. In addition, the interest rate payable under our Revolving Loan Facility fluctuates with market interest rates. Any significant increase in interest rates could have a material adverse effect on our net earnings, depending on the amount borrowed on that facility.
We underwrite risks that are denominated in a number of foreign currencies. As a result, we have receivables and payables in foreign currencies and we establish and maintain loss reserves with respect to our insurance policies in their respective currencies. Our net earnings could be impacted by exchange rate fluctuations affecting these balances. Our principal area of exposure is related to fluctuations in the exchange rates between the British pound sterling, the Euro and the U.S. dollar. We constantly monitor the balance between our receivables and payables and loss reserves to mitigate the potential exposure should an imbalance be expected to exist for other than a short period of time. Our gain (loss) from currency conversion was zero in 2006 compared to $(1.0) million in 2005 and $1.2 million in 2004.
Each quarter-end, management compares recorded reserves to the most recent actuarial point estimate and range for each line of business. If the recorded reserves vary significantly from the actuarial point estimate, management determines the reasons for the variances and may adjust the reserves up or down to an amount that, in management’s judgment, is adequate based on all of the facts and circumstances considered, including the actuarial point estimates. We consistently maintain total consolidated net reserves above the total actuarial point estimate but within the actuarial range.
The excess of the total recorded net reserves over the actuarial point estimate was 2.2% of recorded net reserves at December 31, 2006 compared to 1.6% at December 31, 2005. The percentage will vary in total and by line depending on the potential volatility of the line, the severity of claims reported and of claims incurred but not reported, management’s judgment with respect to the risk of development, the nature of business acquired in acquisitions and historical development patterns.
Assumed reinsurance represented 20% of our gross written premium in 2006 and 35% of our gross reserves at December 31, 2006. Approximately 41% of the assumed reinsurance reserves related to run-off assumed accident and health reinsurance business in our discontinued lines, 17% related to assumed reinsurance in our London market account, 14% related to the assumed business in our group life, accident and health line of business, and 11% related to assumed reinsurance in our aviation and diversified financial products lines of business. The remaining assumed reinsurance reserves covered various minor reinsurance programs. The table above recaps the underwriting, claims characteristics and major actuarial assumptions for our assumed reinsurance business.
The run-off assumed accident and health reinsurance business is primarily reinsurance that provides excess coverage for large losses related to workers’ compensation policies. As discussed previously, we recorded $4.9 million of adverse development, net of reinsurance, in 2006, $8.9 million in 2005 and
The following tables show the composition of our gross, ceded and net reserves at the respective balance sheet dates.
We determine our incurred but not reported reserves by first projecting the ultimate expected losses by product within each line of business. We then subtract paid losses and reported loss reserves from the ultimate loss reserves. The remainder is our incurred but not reported reserves. The level of incurred but not reported reserves in relation to total reserves depends upon the characteristics of the particular line of business, particularly with respect to the speed by which losses are reported and outstanding claims reserves are adjusted. Lines for which losses are reported fast will have a lower percentage incurred but not reported reserve than slower reporting lines, and lines for which reserve volatility is low will have a lower percentage incurred but not reported loss reserve than high volatility lines.
The percentage of net incurred but not reported reserves to net total reserves increased slightly from 50% at December 31, 2005 to 51% at December 31, 2006. The reasons, by line of business, for significant changes in net reserves and the percentage of incurred but not reported to total net reserves, other than changes related to normal maturing of claims, follow:
Diversified financial products - Total net reserves in our diversified financial products line of business increased $297.3 million from 2005 to 2006 as this relatively new line of business continues to grow. The incurred but not reported portion of the total reserves for this line of business is higher than in most of our other lines, since these losses report slower and have a longer duration. The percentage will decrease as the claims start to mature.
Group life, accident and health - Net reserves and the percentage of incurred but not reported reserves increased due to the acquisition of the Health Products Division in 2006. The reserves associated with the acquired business did not include a large case basis factor as do our other medical stop-loss reserves. We expect the percentage will decrease as we integrate those reserves into our normal reserving practices.
London market account - The percentage decreased in 2006 due to the maturity and settlement of 2005 hurricane claims.
Discontinued lines - Total net reserves for our discontinued lines increased $68.2 million in 2006 primarily as a result of a large commutation, partially offset by claim payments.
With the exception of 2004 when we had negative development principally in the reserves related to our discontinued line of business, our net reserves historically have shown positive development except for the effects of losses on commutations, which we have completed in the past and may negotiate in the future. Commutations can produce negative prior year development since, under generally accepted accounting principles, any excess of undiscounted reserves assumed over assets received must be recorded as a loss at the time the commutation is completed. Economically, the loss generally represents the discount for the time value of money that will be earned over the payout of the reserves; thus, the loss may be recouped as investment income is earned on the assets received. Based on our reserving techniques and our past results, we believe that our net reserves are adequate.
clauses which limit pollution coverage to “sudden and accidental” losses only, thus excluding intentional dumping and seepage claims. Policies issued by our other insurance company subsidiaries do not have significant environmental exposures because of the types of risks covered.
We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. We regularly review our deferred tax assets for recoverability and establish a valuation allowance based on our history of earnings, expectations for future earnings, taxable income in carry back years and the expected timing of the reversals of existing temporary differences. Although realization is not assured, we believe that, as of December 31, 2006, it is more- likely-than-not that we will be able to realize the benefit of recorded deferred tax assets, with the exception of certain pre-acquisition tax loss carryforwards for which valuation allowances have been provided. We expect to take an immaterial charge to retained earnings on January 1, 2007 to increase our reserves for and recognize interest on uncertain tax positions. If there is a material change in the tax laws such that the actual effective tax rate changes or the time periods within which the underlying temporary differences become taxable or deductible change, we will need to reevaluate our assumptions, which could result in a change in the valuation allowance required.
investment and are recognized when appropriate. For fixed income securities with unrealized losses due to market conditions or industry-related events where we have the positive intent and ability to hold the investment for a period of time sufficient to allow a market recovery or to maturity, declines in value below cost are not assumed to be other-than-temporary. At December 31, 2006, we had gross unrealized losses on fixed income securities of $24.3 million (0.8% of aggregate market value) compared to $22.1 million (1.0% of aggregate market value) at December 31, 2005.
The FASB has issued SFAS No. 157, Fair Value Measurements, which clarifies the definition of fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurement. SFAS 157 does not require any new fair value measurements and eliminates inconsistencies in guidance found in various prior accounting pronouncements. The FASB has also issued SFAS No. 159, The Fair Value Option for Financial Assets and Liabilities. SFAS 159 allows a company to measure fair value of eligible financial assets and liabilities that are not otherwise measured at fair value. Unrealized gains and losses for those items are reported in current earnings at each subsequent reporting date. Both SFAS 157 and SFAS 159 will be effective on January 1, 2008. We are currently assessing whether their adoption will have an impact on our consolidated financial statements.