We have entered into a lease for office space in Bermuda that contains 8,445 square feet. The lease expires September 30, 2007. The annual lease payment for this office space is approximately $435,000. We rent an additional 750 square feet in Bermuda to house our IT systems. This lease expires in August 31, 2007. The annual lease payment for this space is approximately $22,500.
(2) Basic earnings per share is computed using the weighted average number of common shares outstanding during the period. All potentially dilutive securities including stock options and warrants are excluded from the basic earnings per share computation. In calculating diluted earnings per share, the weighted average number of shares outstanding for the period is increased to include all potentially dilutive securities using the treasury stock method. Any common stock equivalent shares are excluded from the computation if their effect is antidilutive. Basic and diluted earnings per share are calculated by dividing income available to ordinary shareholders by the applicable weighted average number of shares outstanding during the year.
(3) Includes the operations of ESC from September 3, 2003, the date of acquisition. We accounted for the acquisition of ESC as a purchase. Following the disposal of ESC during the third quarter of 2006, ESC is now presented in the discontinued operations in the Income Statement. See Note 3 to our consolidated financial statements.
The following discussion and analysis of our results of operations, financial condition and liquidity and capital resources should be read in conjunction with our audited consolidated financial statements and related notes for the year ended December 31, 2006 contained in this annual report on pages to and with the risk factors appearing under ‘‘Item 1A. Risk Factors’’ in this annual report.
Following our decision to place our remaining insurance and reinsurance business (other than our Lloyd’s business) in run-off, we have achieved the following, all of which are more fully described throughout this annual report:
• We returned approximately $97.8 million in premiums to our clients in the third and fourth quarters of 2006 in connection with cancellations and terminations of insurance and reinsurance policies.
• We commuted several assumed reinsurance contracts with our clients and reduced our gross loss and loss expense reserves by approximately $4.5 million.
• In the first quarter of 2007, we entered into a 100% quota share reinsurance transaction to replace the expired retrocession of substantially all the in-force business in our technical risk property lines of business and to provide protection from future natural peril or catastrophe events in that line.
• We reduced employee headcount (other than in Lloyd’s and ESC) from 183 employees on January 1, 2006 to 81 employees on December 31, 2006.
• We restructured our investment in our Lloyd’s business through the attraction of 10% of the committed capital to Syndicate 4000 from a third party and the establishment of Pembroke Managing Agency as a successor to the managing agent services of Chaucer.
• We sold ESC to WSP Environmental Holdings, Inc., or WSP, for total consideration of $12.5 million, and recognized a gain on sale of $0.7 million.
• In October 2006, we entered into a new letter of credit facility to support our obligations to policyholders. Cash, cash equivalents and investments posted as collateral to our new letter of credit facility was $196.8 million at March 5, 2007 compared to $273.6 million at December 31, 2006 and $217.2 million at December 31, 2005.
Our total gross loss reserves were $623.6 million at December 31, 2006 as compared to $534.0 million at December 31, 2005. This increase primarily reflects our estimates for incurred losses related to premiums earned during 2006 and the growth in our Lloyd’s business, offset by contract commutations, cancellations and expirations, and our claims paid during the year. The reserves represent obligations with short and long term duration. We believe that our shorter term obligations include reinsurance property, reinsurance marine, fidelity, technical risk property, surety and portions of our program business, including the property component of HBW. The total gross loss and loss expense reserves associated with these lines were approximately $165.5 million at December 31, 2006. We believe that our longer term obligations include reinsurance casualty, professional, environmental, the warranty and the contractors’ general liability portions of our HBW program and our Lloyd’s business. The total gross loss and loss expense reserves associated with these lines were approximately $458.1 million at December 31, 2006. The actual period over which we will pay losses for both of our short and long term business could significantly vary from our expectations given the immaturity of our business and our limited claims paying history and run-off status. We estimate that over 75% of our total gross loss and loss expense reserves are recorded as incurred but not reported reserves, or IBNR, and there can be no certainty as to when these IBNR amounts may become reported, and ultimately, paid losses. Furthermore, our loss and loss expense reserves may change significantly in future periods as we seek to commute, cancel or otherwise transfer our insurance and reinsurance contracts.
During the year ended December 31, 2006, we recognized adverse net loss and loss expense development of $5.0 million related to the 2005 hurricanes. Net of reinstatement premiums this adverse development was $2.6 million. Furthermore, we increased our estimate of loss and loss
expenses, net of reinsurance, relating to the rupture of an oil pipeline in California during a mudslide that occurred in the first quarter 2005 by $2.6 million during 2006, net of reinsurance, including approximately $2.4 million of additional loss expense that was recorded during the fourth quarter of 2006. In addition, we incurred net losses of $3.9 million related to the tornadoes that occurred in the first quarter of 2006. We may continue to incur losses from these as well as other historical events, including from policies that have been cancelled. Additionally, our remaining policies continue to be subject to risk of new losses from future catastrophes and other events. We will continue to seek and mitigate these exposures through policy cancellations, commutations and transfers along with the purchase of reinsurance protection for future catastrophes if it is available on terms that are acceptable to us. Based on our current estimate of losses related to Hurricane Katrina, we have exhausted our reinsurance and retrocessional protection with respect to that hurricane. If our Hurricane Katrina losses and our marine reinsurance losses with respect to Hurricane Rita prove to be greater than currently anticipated, we will have no further reinsurance and retrocessional coverage available for those windstorms. Offsetting these losses and loss developments during 2006 we recorded approximately $13.9 million of net favorable loss development on our loss and loss expense reserves recorded at December 31, 2005 in several of our product lines related to more mature accident periods in which actual loss experience was better than expected.
businesses. The restructuring of our investment in Syndicate 4000 and the commitment of third party capital to Syndicate 4000 is intended to address these issues and allow Syndicate 4000 to focus on implementing its business plan. The 2006 net loss ratio of Syndicate 4000 was higher than expected due to the impact of minimum premium requirements that we have on excess of loss reinsurance contracts for this business. We purchased this reinsurance for our Lloyd’s business before the A.M. Best downgrade when our expectations for the amount of gross premium the Lloyd’s segment would be able to write during 2006 were more robust. The excess of loss reinsurance contract requires us to cede minimum fixed amounts of our premium, regardless of the amount of gross premium written in Syndicate 4000. Consequently the proportion of written premium ceded to reinsurers was higher than planned and that had a direct impact on our net earned premium. As a result our net losses were higher than planned when expressed as a proportion of our earned premium, net of earned ceded reinsurance premiums.
Our net loss to common shareholders was $64.8 million for the year ended December 31, 2006 as compared to $106.0 million for the year ended December 31, 2005. Our 2006 results were impacted primarily by the A.M. Best downgrade and our decision to engage in a self-managed run-off in all our business lines other than our Lloyd’s business. As a result, we received significantly lower revenues from premiums earned and had significantly higher costs related to employee severance, professional, legal and advisory fees. Our 2006 results were also impacted to a lesser extent by adverse reserve developments on hurricanes Katrina, Rita and Wilma, the oil pipeline claim referred to above and other than temporary impairment charges on our invested assets.
Similarly, our net premiums earned were $225.3 million in 2006 as compared to $364.1 million in 2005. Our net premiums earned were impacted by significantly lower premium writings and, to a lesser extent, by premium returns associated with policy cancellations. We expect significant decreases in net premiums earned in future periods as we do not expect to underwrite new policies, other than in our Lloyd’s segment. Historically, net premiums earned have been our primary source of revenue. In 2005 net premiums earned contributed approximately 91% to our total revenues, and in 2006 this contribution reduced to 87%.
In 2006, net revenues from non-underwriting activities, such as net investment income and technical services revenues, were not sufficient to offset general and administrative expenses, interest expense and depreciation and amortization. We expect that this trend will continue and that we will incur net losses in future periods. We are seeking to mitigate these expected losses through continued overhead reduction strategies, particularly through headcount reductions. In the fourth quarter of 2006 our total general and administrative expenses were $16.0 million compared to $35.5 million in the same period in 2005, and our headcount, excluding Lloyd’s, has reduced to 81 as at December 31, 2006, compared to 183 on December 31, 2005.
We expect that our shareholders’ equity will decline as we incur net losses in future periods. However, we believe that our cash and investment asset portfolios totaling approximately $948.2 million at December 31, 2006 will provide sufficient liquidity to meet currently foreseen obligations.
During 2006 we incurred professional, legal and consulting costs of $22.5 million compared to $17.1 million in 2005. During 2006 we incurred significant professional, legal and consulting costs in connection with our Board’s review of strategic alternatives, the engagement of third party run-off advisors to assist in certain projects related to our transition to run-off, the restructuring of our Lloyd’s business, and the execution of and transition to our new letter of credit facility. We have reduced our audit and Sarbanes-Oxley Section 404 compliance costs from $6.3 million in 2005 to an estimated $4.1 million for 2006.
During the year ended December 31, 2006, following the decision of our Board of Directors to place most of our business in run-off, we changed the composition of our reportable segments and renamed our specialty insurance segment and specialty reinsurance segment as specialty insurance run-off segment and specialty reinsurance run-off segment. We continue to earn premiums in our insurance and reinsurance run-off segments related to business written in prior periods and related to extensions and renewals of policies which we are legally required to write in business lines we have exited. The specialty insurance run-off and specialty reinsurance run-off segments are more fully described as follows:
• Specialty reinsurance run-off. Our specialty reinsurance run-off segment includes the remaining contracts written in our traditional specialty reinsurance products line. Our specialty reinsurance products included property, casualty and marine and aviation products.
• Lloyd’s. Syndicate 4000 at Lloyd’s, our Lloyd’s segment, was created in December 2004 and currently writes traditional specialty insurance products including professional liability (professional indemnity and directors’ and officers’ coverage), fidelity and crime (financial institutions), specie and fine art and kidnap and ransom.
The geographic locations in which we have conducted our business are the United States, Europe and Bermuda. The location of the risks that are the subject of our insurance and reinsurance policies may be anywhere in the world.
We derive the majority of our revenues from three principal sources: premiums from policies currently written by Syndicate 4000 in our Lloyds operating segment, the continuation of premiums that are being earned on policies in our specialty insurance and reinsurance run-off segments that remain on our books and investment income from our investment portfolios.
Reinsurance premiums written on certain types of contracts, notably treaty quota share contracts, may not be known definitively on the inception date of the contract and therefore include estimates of premiums written. These estimates are based on data provided by the ceding companies or brokers, our underwriters’ judgment and underlying economic conditions. Our estimates of written premiums are re-evaluated over the term of the contract period as underwriting information becomes available and as actual premiums are reported by the ceding companies or brokers. For certain excess of loss reinsurance contracts we record the minimum premium, as defined in the contract, as our estimated premium written at inception of the contract. Subsequent changes to our premium estimates and also premiums returned through policy cancellations are recorded as adjustments to premiums written in the period in which they become known and could be material. As a result of potential premium estimate reductions and cancellations in future periods, we may not receive all of our premiums receivable. Adjustments may significantly impact net income in the period in which premiums are determined, particularly when the subject contract is fully or substantially expired resulting in the adjustment being fully or substantially earned.
Until the sale of ESC in September 2006, we also generated revenues to a much smaller extent, in our technical services segment from the remediation of environmental liability obligations that we have assumed.
Acquisition expenses, which are net of expenses recovered under our ceded reinsurance contracts, consist principally of commissions, fees, brokerage and tax expenses that are directly related to obtaining and writing insurance and reinsurance contracts. Typically, acquisition expenses are based on a certain percentage of the premiums written on contracts of insurance and reinsurance and may be adjustable based upon loss experience. These expenses are a function of the number and type of insurance and reinsurance contracts written. We may not be able to recover all or a portion of our acquisition costs on commuted or cancelled policies.
Premiums ceded were $78.2 million for the year ended December 31, 2006 a decrease of $140.7 million, or 64.3% compared to $218.9 million for the year ended December 31, 2005. The decrease in premiums ceded primarily reflects the reduction in gross premiums written
Technical services revenues. Technical services revenues were $3.3 million for the year ended December 31, 2006 a decrease of $15.7 million compared to $19.0 million for the year ended December 31, 2005. The decrease is due to a significant portion of remediation of one of our environmental liability assumption programs occurring during the second and third quarters of 2005. The remediation is now close to being completed and, as a result, has not generated technical services revenues in 2006 to the same extent as it did in 2005. We expect that our technical services revenues will continue to decrease in future periods as the remediation is closer to completion, and we do not plan to engage in any further environmental liability assumption programs.
Net foreign exchange losses. Net foreign exchange losses were $3.8 million for the year ended December 31, 2006 compared to net foreign exchange gains of $0.3 million in 2005. The increase in net foreign exchange losses was due to an increase in foreign currency assets, liabilities, particularly in Syndicate 4000 combined with a weakening US dollar during 2006 against those foreign currencies.
We incurred net losses and loss expenses of approximately $3.9 million related to the tornadoes that occurred in the first quarter of 2006. Our expected ultimate losses during the year ended December 31, 2006 also included adverse development of approximately $5.0 million excluding reinstatement premiums related to the 2005 hurricane storms and additional net losses of $2.6 million related to damage caused by an oil pipeline in California which ruptured during a mudslide in the first quarter of 2005, for which the damage is covered by an insurance contract written in our environmental liability product line. This development in 2006 was primarily related to extended remediation activities required by the relevant environmental agencies. There remains the possibility of further negative development on this loss in the future, particularly if the timing of the completion of the remediation plan for the spill is further delayed. Offsetting these adverse developments during 2006, we recorded approximately $13.9 million of net favorable loss development in several product lines related to maturing accident periods for which actual loss experience was better than expected. We continue to be exposed to potentially significant losses in lines of business where claims may not be reported for some period of time after those claims are incurred.
Our total net loss ratio (calculated by dividing net losses and loss expenses by net premiums earned) was 69.3% for the year ended December 31, 2006, a decrease of 19.8% compared to a total net loss ratio of 89.1% for the year ended December 31, 2005. The decrease in the total net loss and loss expense ratio is due primarily to the hurricanes and the oil pipeline loss that occurred in 2005 and, to a lesser extent, favorable development of expected losses in certain of our product lines.
Acquisition expenses. Acquisition expenses were $42.5 million for the year ended December 31, 2006, a decrease of $27.1 million, or 38.9%, compared to $69.6 million for the year ended December 31, 2005. The decrease in acquisition expenses is due to the decrease in the number of insurance and reinsurance contracts we entered into and the associated net premiums earned.
Our acquisition expense ratio for the year ended December 31, 2006 was 18.9%, which is comparable to our acquisition expense ratio of 19.1% for the year ended December 31, 2005. Deferred acquisition costs include, as of December 31, 2006, $12.1 million of acquisition expenses on written contracts of insurance and reinsurance that will be amortized in future periods as the premiums written to which they relate are earned.
$55.2 million of personnel related expenses (including $14.3 million of severance costs) and $44.8 million of other expenses during the year ended December 31, 2006 compared to $52.4 million of personnel related expenses (including $6.4 million of severance costs) and $57.2 million of other expenses during the year ended December 31, 2005. The decrease in general and administrative expenses is due to the cost saving measures taken in response to the decision to cease writing new business in 2006 but were offset by increased severance costs and to a lesser extent, the increased fees associated with ongoing efforts relating to Sarbanes-Oxley Section 404 compliance and costs relating to information technology development.
Interest expense. Interest expense was $5.5 million for the year ended December 31, 2006, an increase of $1.3 million compared to $4.2 million for the year ended December 31, 2005 and relates to the increase in interest rates during 2006 leading to a higher interest charge on the junior subordinated debentures.
(Loss) income from operations of discontinued operations. The loss from discontinued operations was $13.0 million for the period from January 1, 2006 to September 15, 2006, compared to income of $3.7 million for the year ended December 31, 2005 and consisted of revenues and expenses from ESC, which was sold on September 15, 2006.
ESC’s (loss) income from operations, previously included in the technical services segment, for the period from January 1, 2006 to September 15, 2006, and the years ended December 31, 2005 and 2004, now reported in discontinued operations, are as follows:
ESC’s technical services revenues include the inter-company revenues charged by ESC to the liability transfer programs and to our underwriting segment.
Direct technical services costs. Direct technical services costs were $14.0 million for the period ended December 31, 2006, compared to $37.0 million for the year ended December 31, 2005, and were comprised of subcontractor and direct labor expenses. Direct technical services costs, as a percentage of technical services revenues were approximately 63.6% for the year ended December 31, 2006 compared to 73.0% for the year ended December 31, 2005.
(2) Net assets of ESC at September 15, 2006, prior to the impact of the sale transaction.
As of December 31, 2005, the average duration of our investment portfolio was approximately 2.6 years with an average credit rating of approximately ‘‘AA+’’.
• the increase in loss occurrences, particularly those related to the 2005 hurricanes and the first quarter 2005 rupture of an oil pipeline in California during a mudslide; and
Our expected ultimate losses during the year ended December 31, 2005 also included estimated gross and net loss estimates of $21.6 million and $13.0 million related to damage caused by an oil pipeline in California which ruptured during a mudslide in the first quarter of 2005, for which the damage was covered by an insurance contract written in our environmental liability product line. In addition to the hurricanes and the oil pipeline loss, as of December 31, 2005, we have received a limited amount of significant reported losses. However, we participate in lines of business where claims may not be reported for some period of time after those claims are incurred.
Our acquisition expense ratio for the year ended December 31, 2005 was 19.1%, a decrease of 3.7% compared to our acquisition expense ratio of 22.8% for the year ended December 31, 2004. The decrease was due to four factors. First, during 2005, our earned premium was more heavily weighted towards specialty insurance, which carries lower acquisition costs than specialty reinsurance. Second, we were paying less fronting costs on our specialty insurance lines because we were licensed in more
General and administrative expenses. General and administrative expenses were $109.6 million for the year ended December 31, 2005, an increase of $51.9 million, or 90%, compared to $57.7 million for the year ended December 31, 2004. General and administrative expenses were comprised of $58.6 million of personnel related expenses (including $6.4 million of severance costs) and $51.0 million of other general and administrative expenses during the year ended December 31, 2005 compared to $40.7 million of personnel related expenses and $17.0 million of other expenses during the year ended December 31, 2004. The increase in general and administrative expenses was due primarily to an increase in the number of employees as we grew our lines of business, especially in Europe and our severance costs. To a lesser extent, the increase was attributed to increases in auditing fees, fees associated with ongoing efforts relating to Sarbanes-Oxley Section 404 compliance and costs relating to information technology development. General and administrative expenses related to our underwriting segment were $58.9 million for the year ended December 31, 2005, which included $3.1 million of expenses charged by our technical services segment for technical and information management services, and $10.7 million of expenses related to our technical services segment.
Depreciation and amortization of intangible assets. Depreciation and amortization of intangible assets was $3.0 million for the year ended December 31, 2005, an increase of $1.7 million compared to $1.3 million for the year ended December 31, 2004, and consisted of amortization of intangible assets related to the acquisition of ESC and depreciation of fixed assets. The increase in depreciation and amortization was due to the purchase of additional fixed assets throughout 2004 and 2005 as we grew our lines of business.
We did not record any net deferred income tax benefits or assets relating to tax operating losses generated by our subsidiaries since our results of operations included a 100% valuation allowance against net deferred tax assets. For the year ended December 31, 2005, the net valuation allowance increased by approximately $11.5 million, to $24.8 million.
In measuring the performance of our specialty insurance run-off, specialty reinsurance run-off and Lloyd’s segments, we consider each segment’s net underwriting income and a number of financial ratios. Net underwriting income is the sum of net premiums earned less net losses and loss expenses, acquisition expenses and direct and allocated general and administrative expenses.
• a substantial decline in the number of insurance contracts we entered into and the associated net premiums earned; and
Our acquisition expense ratio was 15.9% for the year ended December 31, 2006 compared to 13.6% for the year ended December 31, 2005. The increase in our acquisition expense ratio in the specialty insurance run-off segment is primarily due to the impact of purchased reinsurance protection in 2006 and 2005 which reduced net earned premium by a higher proportion in 2006 than 2005. The increase is also due, to a lesser extent, to the return of premiums following the cancellation of policies, including, in some instances, earned premium. Deferred acquisition costs include, as of December 31, 2006, $7.2 million of acquisition expenses on written contracts of insurance that will be amortized in future periods as the premiums written to which they relate are earned.
The table below shows gross and net premiums written by product line whether written on a traditional reinsurance, programs or structured basis:
Net premiums earned of $46.5 million for the year ended December 31, 2006 decreased by $120.5 million compared to $167.0 million for the year ended December 31, 2005. The decrease reflects the decrease in earning of premiums on contracts written during the years ended December 31, 2006, 2005 and 2004, the impact of the decision to discontinue writing of new and renewal business in our reinsurance and insurance lines of business and the purchase of additional retrocessional protection on our marine, technical risk and aviation product line. Gross premiums written in our specialty reinsurance run-off segment are being earned over the periods of reinsured or underlying insured risks which are typically one year.
Other income. Other income was $0.8 million for the year ended December 31, 2006 compared to $2.0 million for the year ended December 31, 2005, and related to income, including fees, recognized on non-traditional reinsurance contracts
Included in our estimated ultimate losses during the year ended December 31, 2006 are specific loss estimates on contracts of reinsurance insuring claims arising from Hurricanes Katrina, Rita and Wilma. Our estimate of our specialty reinsurance run-off segment’s exposure to ultimate claim costs associated with these hurricanes based on currently available information is $76.9 million (excluding the favorable impact of net reinstatement premiums of $0.3 million), of which $5.0 million is included in net losses and loss expenses for the year ended December 31, 2006 compared to $71.9 million for the year ended December 31, 2005 (excluding the negative impact of net reinstatement premiums of $1.6 million). Our estimate of ultimate losses from these events is primarily based on currently available information, claims notifications received to date, industry loss estimates, output from industry models, a review of affected contracts and discussions with cedents and brokers. The actual amount of losses from these hurricanes may vary significantly from the estimate.
Our specialty reinsurance run-off segment net loss ratio was 86.1% for the year ended December 31, 2006 compared to 107.2% for the year ended December 31, 2005. The decrease in the specialty reinsurance run-off segment net loss ratio is primarily due to the fact that we received a smaller amount of reported losses in 2006, than in 2005 which was impacted significantly by the Hurricanes Katrina, Rita and Wilma. This is offset by the impact of ceded earned premium relating to additional purchased reinsurance protection in our marine, technical risk and aviation product line.
Premiums. Gross and net premiums written were $91.8 million and $61.7 million for the year ended December 31, 2006 compared to $80.7 million and $61.6 million for the year ended December 31, 2005. The increase in our gross premiums written was largely due to the continued growth in this segment, which commenced operations in December 2004. This increase was partially offset by the adverse effects on Syndicate 4000 following A.M. Best’s ratings action which we believe created uncertainty about the future of Syndicate 4000 in the Lloyd’s market place.
December 31, 2005. Net losses and loss expenses are a function of our net premiums earned and our expected ultimate losses and loss expenses for reported and unreported claims on contracts of insurance underwritten. The increase in net losses and loss expenses is primarily due to the increase in our net premiums earned.
Our acquisition expense ratio was 18.4% for the year ended December 31, 2006, an increase of 4.5%, compared to 13.9% for the year ended December 31, 2005. The acceleration of minimum ceded earned premium contributed to the higher ratio.
Technical services revenues. Technical services revenues were $3.3 million for the year ended December 31, 2006, compared to $19.0 million for the year ended December 31, 2005. The decrease is due to a significant portion of remediation of one of our environmental liability assumption programs occurring during the second and third quarters of 2005. The remediation is now close to being completed and, as a result, has not generated technical services revenues to the same extent as it did in 2005. We expect that our technical services revenues will continue to decrease in future periods as the remediation is closer to completion.
General and administrative expenses. Direct general and administrative expenses were $4.3 million for the year ended December 31, 2006, compared to $18.5 million for the year ended December 31, 2005. The decrease is due to a significant portion of remediation of one of our environmental liability assumption programs occurring during the second and third quarters of 2005, and this program is now close to being fully remediated.
Our HBW gross premiums written during the year ended December 31, 2005 are summarized in the table below by specialty risk class.
were generated through a number of brokers, only one of which accounted for more than 10% of our total specialty insurance run-off segment gross premiums written.
Net premiums earned during the year ended December 31, 2005 were $160.6 million, an increase of $86.4 million, compared to $74.2 million for the year ended December 31, 2004 representing growth of premiums written and the earning and amortization of premiums written and ceded during the years ended December 31, 2004 and 2005. Gross premiums written and ceded premiums are earned over the period of each insured risk. The terms of our insurance contracts range from between one and ten years with the majority of our contracts being for a one year period.
Other income. Other income was $1.2 million for the year ended December 31, 2005 and related to income, including fees, recognized on non-traditional insurance contracts.
Our expected ultimate losses during the year ended December 31, 2005 also include estimated gross and net loss estimates of $21.6 million and $13.0 million related to damage caused by an oil
Our acquisition expense ratio was 13.6% for the year ended December 31, 2005 a decrease of 5.5% compared to 19.1% for the year ended December 31, 2004. The reduction in our acquisition expense ratio in the specialty insurance run-off segment is primarily due to three factors. First, we are paying less fronting costs because we are licensed in more states and no longer need to utilize fronting companies to the same extent in order to write our insurance business. Second, our ceding commission income that we are recovering on our specialty insurance run-off segment’s reinsurance treaties increased during 2005 as a result of the restructuring of those treaties during the second quarter of 2005. Third, we paid less commission in our HBW program during the year ended December 31, 2005 as a result of the contracts containing sliding scale commission provisions that vary with changes in the selected loss ratio. The selected loss ratio under the HBW contracts increased from 56.8% in 2004 to 64.8% in 2005. Deferred acquisition costs include, as of December 31, 2005, $17.5 million of acquisition expenses on written contracts of insurance that would be amortized in future periods as the premiums written to which they relate are earned.
General and administrative expenses. Direct general and administrative expenses totaled $21.8 million for the year ended December 31, 2005 an increase of $ 6.6 million, compared to $15.2 million for the year ended December 31, 2004. The increase in our general and administrative expense was due to the additional number of employees hired throughout 2004 and 2005. The increase is also attributed to severance costs, increases in auditing fees, fees associated with ongoing efforts relating to Sarbanes-Oxley Section 404 compliance and costs relating to information technology development, which were allocated to our specialty insurance run-off segment.
Ceded premiums were $83.4 million during the year ended December 31, 2005 compared to $2.6 million for the year ended December 31, 2004. The increase in our ceded premiums written reflects approximately $34.1 million of purchased retrocession protection, including reinstatement premiums, in our specialty reinsurance run-off property and marine, technical risk and aviation product lines. We obtained the retrocession protection to help limit our net loss exposures to natural catastrophe events. We also purchased additional retrocessional coverage for our marine, technical risk and aviation reinsurance product line to limit our future probable maximum losses during the fourth quarter of 2005. These retrocession treaties provide us with protection on an excess of loss, quota share treaty and facultative basis for policies written in our reinsurance product lines of business. Ceded premiums also includes $46.7 million of premium ceded to the third-party reinsurer under the
Other income. Other income was $2.0 million for the year ended December 31, 2005 compared to $1.6 million for the year ended December 31, 2004, and related to income, including fees, recognized on non-traditional reinsurance contracts. A more detailed description of these non-traditional contracts is provided under ‘‘-Non-Traditional Contracts’’ below.
Included in our expected ultimate losses during the year ended December 31, 2005 are specific loss estimates on contracts of reinsurance insuring claims arising from Hurricanes Katrina, Rita and Wilma. Our estimate of our specialty reinsurance run-off segment’s exposure to ultimate claim costs associated with these hurricanes totaled $71.9 million (excluding the negative impact and net reinstatement premiums of $1.6 million), which was included in net losses and loss expenses for the year ended December 31, 2005 compared to $60.7 million included in net losses and loss expenses for the year ended December 31, 2004 from Hurricanes Charley, Frances, Ivan and Jeanne. Our preliminary estimate of ultimate losses from these events was primarily based on currently available information, claims notifications received to date, industry loss estimates, output from industry models, a review of affected contracts and discussion with cedents and brokers. Other than the hurricane losses, as of December 31, 2005, we had received a limited amount of significant reported losses in our specialty reinsurance run-off segment.
Our acquisition expense ratio was 25.6% for the year ended December 31, 2005, compared to 24.5% for the year ended December 31, 2004. The increase reflects certain contracts with higher commission rates that were written during the second and third quarters of 2005 in our property, casualty and marine, technical risk and aviation reinsurance product lines and the impact of ceded premiums and ceded reinstatement premiums reducing our Specialty reinsurance run-off segment’s net earned premium.
General and administrative expenses. Direct general and administrative expenses totaled $9.8 million for the year ended December 31, 2005 an increase of $2.3 million, compared to $7.5 million for the year ended December 31, 2004, reflecting the additional number of employees hired throughout 2004 and 2005. The increase is also attributed to severance costs, increases in auditing fees, fees associated with ongoing efforts relating to Sarbanes-Oxley Section 404 compliance and costs relating to information technology development, which were allocated to our specialty reinsurance run-off segment.
Our Lloyd’s segment net loss ratio was 67.5% for the year ended December 31, 2005 an increase of 4.4% compared to a net loss ratio of 63.1% for the year ended December 31, 2004. The increase in the Lloyd’s segment net loss ratio is primarily due to the higher selected loss ratios during 2005 for the professional insurance written in our Lloyd’s syndicate.
Acquisition expenses. Acquisition expenses were $5.1 million for the year ended December 31, 2005 an increase of $5.0 million, compared to $0.1 million for the year ended December 31, 2004. The increase in acquisition expenses was due to the increase in the number of insurance contracts we entered into and the associated net premiums earned. These acquisition expenses primarily represented brokerage fees and commission fees and were net of ceding commissions earned on purchased reinsurance treaties.
General and administrative expenses. Direct general and administrative expenses totaled $8.7 million for the year ended December 31 2005 an increase of $7.7 million, compared to $1.0 million for the year ended December 31, 2004. The increase in our general and administrative expense was due to the additional number of employees hired throughout 2005 and increases in Lloyd’s central fund and managing agent expenses. The increase is also attributed to increases in auditing fees and fees associated with ongoing efforts relating to Sarbanes-Oxley Section 404 compliance allocated to our Lloyd’s segment.
Technical services revenues. Technical services revenues were $19.0 million for the year ended December 31, 2005, an increase of $18.6 million, compared to $0.4 million for the year ended December 31, 2004. The increase in technical services revenues is primarily attributable to increased remediation revenues associated with liability transfer project in Buffalo, New York.
development in several of our other product lines, including our fidelity, the property component of HBW, environmental and surety lines. Actual loss experience in these product lines was better than expected for maturing accident periods for 2004 and 2005.
Quanta Holdings is organized as a Bermuda holding company and as such, has no direct operations of its own. Quanta Holdings’ assets consist of investments in our subsidiaries through which we conduct substantially all of our business at Lloyd’s, our specialty insurance and reinsurance run-off and our technical services operations. As of December 31, 2006, we had operations in the U.S., Bermuda, Ireland and the United Kingdom.
We are also subject to constraints under the Bermuda Companies Act that affect our ability to pay dividends on our shares. We may not declare or pay a dividend or make a distribution if we have reasonable grounds for believing that we are, or will after the payment be, unable to pay our liabilities as they become due or if the realizable value of our assets will thereby be less than the aggregate of our liabilities and our issued share capital and share premium accounts. While we currently meet these requirements, there can be no assurance that we will continue to do so in the future.
As of December 31, 2006 we had cash and cash equivalents and investments of approximately $948.2 million. We estimate that our cash and cash equivalents and investment balances include approximately $273.6 million that is pledged as collateral for letters of credit, approximately $200.8 million held in trust funds for the benefit of ceding companies and to fund our obligations associated with the assumption of an environmental remediation liability, $189.6 million that is held by Lloyd’s to support our underwriting activities in Syndicate 4000, $39.3 million held in trust funds that are related to our deposit liabilities and $29.9 million that is on deposit with, or has been pledged to, U.S. state insurance departments. After giving effect to these assets pledged or placed in trust, we estimate that on December 31, 2006 we had net unrestricted investments of approximately $215.0 million, including net cash and cash equivalents of approximately $32.9 million. Of the $215.0 million,
As of December 31, 2006, we had net cash and cash equivalent balances and investments of approximately $215.0 million that are available to post as security or place in trust. We currently believe that we have sufficient assets to pay our foreseen liabilities as they become due and meet our foreseen collateral requirements within our subsidiaries. However, we cannot issue new letters of credit under our credit agreement if we have incurred a material adverse effect or if a default exists under the agreement.
During 2006 we determined that certain of our investment securities, with unrealized losses of approximately $16.9 million were other-than-temporarily impaired. The realization of these losses represented the maximum amount of potential losses in our investment securities if we were to sell all of these securities at the time of our determinations and were primarily due to changes in market interest rates and not changes in credit quality. As a result of our decision, the affected investments have been reduced to their estimated fair value, which becomes their new cost basis. The recognition of the losses did not affect our shareholders’ equity, the market value of our investments, our cash flows or our liquidity. The evaluation for other-than-temporary impairments require the application of significant judgment, including our intent to hold the investment for a period of time sufficient to allow for possible recovery. We believe we have sufficient assets to pay our currently foreseen
liabilities as they become due and we have no immediate intent to liquidate the investments securities affected, other than in the normal course of our investment management policies. However, we may be required to sell securities to satisfy return premium or loss obligations on contracts that are cancelled or commuted. Due to this and to the continuing general uncertainties surrounding our business resulting from our decision to cease underwriting or seeking new business and to place most of our remaining insurance and reinsurance businesses into orderly run-off, we concluded that there are no absolute assurances that we will have the ability to hold the affected investments for a sufficient period of time to permit unrealized losses to recover. It is possible that the impairment factors evaluated by management and fair values will change in subsequent periods, resulting in material impairment charges.
Our investment guidelines require compliance with applicable local regulations and laws. Without board approval, we will not purchase financial futures, forwards, options, swaps and other derivatives, except for instruments that are purchased as part of our business, for purposes of hedging capital market risks (including those within our structured products transactions), or as replication transactions, which are defined as a set of derivative, insurance and/or securities transactions that when combined produce the equivalent economic results of an investment meeting our investment guidelines. While we expect that the majority of our investment holdings will be denominated in U.S. dollars, we may make investments in other currency denominations depending upon the currencies in which loss reserves are maintained, or as may be required by regulation or law.
The market value of our total investment portfolio including cash and cash equivalents was $948.2 million, of which $720.0 million related to available-for-sale fixed maturity investments, $101.0 million related to cash and cash equivalents, $89.9 million related to available-for-sale short-term investments and $37.3 million to trading investments related to deposit liabilities. The majority of our investment portfolio consists of fixed maturity and cash investments which are currently managed by the following external investment advisors: Deutsche Asset Management and JP Morgan Investment Management Inc., our external investment advisors. Custodians of our externally managed investment portfolios are Comerica Incorporated, JP Morgan Chase Bank N.A. and Citibank N.A.
Our investment guidelines require that the average credit quality of the investment portfolio is typically Aa3/AA- and that no more than 5% of the investment portfolio’s market value shall be invested in securities rated below Baa3/BBB-. As of December 31, 2006, all of the fixed maturity investments were investment grade, with a weighted average credit rating of ‘‘AA+’’ based on ratings assigned by S&P.
Our total available-for-sale and cash and cash equivalents totaled $948.2 million as of December 31, 2006 compared to $998.4 million as of December 31, 2005. This included restricted cash at December 31, 2006 and 2005 of $68.1 million and $82.8 million. The decrease in these total invested assets was due to the payment of losses, general and administrative expenses and reinsurance payables offset by the receipt of premium receivable, net investment income and reinsurance recoverables.
Our deferred acquisition costs and unearned premiums, net of deferred reinsurance premiums, totaled $12.1 million and $83.9 million as of December 31, 2006 compared to $33.1 million and $224.5
Our reserves for losses and loss adjustment expenses, net of reinsurance recoverable, totaled $402.4 million as December 31, 2006 compared to $343.6 million as of December 31, 2005. The increase in our net loss and loss expense reserves reflects our net losses and loss expenses incurred during the year ended December 31, 2006, including adverse development of $5.0 million excluding reinstatement premiums resulting from the 2005 hurricanes and of $2.6 million related to the 2005 oil pipeline claim and losses of $3.9 million resulting from 2006 tornadoes. The increase was also driven by the number of historical insurance contracts we entered into and the associated net premiums earned, as well as greater reinsurance recoveries relative to our payment of losses during the period. The increase in our net loss and loss expense was mitigated, in part, by net favorable loss developments of approximately $13.9 million in several of our product lines in which actual loss experience in maturing accident periods was better than expected. Our reserves for losses and loss adjustment expenses as of December 31, 2006 includes our estimate of gross and net unpaid loss expenses, including incurred but not reported losses, totaling $89.9 million and $32.3 million relating to Hurricanes Katrina, Rita and Wilma and $8.1 million and $4.0 million relating to the claim related to the oil pipeline claim that occured in 2005. Our estimate of our unpaid exposure to ultimate claim costs associated with these losses is based on currently available information, claim notifications received to date, industry loss estimates, output from industry models, a review of affected contracts and discussions with clients and others. The actual amount of future loss payments relating to these loss events may vary significantly from this estimate. In 2006 we commuted several assumed reinsurance contracts and reduced our gross loss and loss expense reserves by $4.5 million. Of our total gross losses and expense reserves of $623.6 million as of December 31, 2006 approximately $487.1 million or 77.1% is represented by our estimate of incurred but not reported reserves. However, we have participated in lines of business where claims may not be reported for some period of time after those claims are incurred.
Our reinsurance recoverables as of December 31, 2006 totaled $221.2 million, of which $28.0 million had been submitted to our reinsurers for payment, which included $17.9 million that was due on December 31, 2006, compared to reinsurance recoverables as of December 31, 2005 of $190.4 million. The increase in our reinsurance recoverable balance reflects our losses and loss expenses recoverable from reinsurers during the year ended December 31, 2006. As of December 31, 2006, our reinsurance recoverable balances also include our estimate of unpaid loss expenses recoverable totaling $57.6 million relating to Hurricanes Katrina, Rita and Wilma and $2.8 million relating to the oil pipeline claim that we incurred during the year ended December 31, 2005. Our estimate of our reinsurance recoverable balance associated with these losses is based on currently available information, claim notifications received to date, industry loss estimates, output from industry models, a detailed review of affected ceded reinsurance contracts and an assessment of the credit risk to which we are subject. The actual amount of future loss receipts relating to these loss events may vary significantly from this estimate. The average credit rating of our reinsurers as of December 31, 2006 is ‘‘A’’ (excellent) by A.M. Best.
The following table lists our largest reinsurers measured by the amount of losses and loss adjustment expenses recoverable at December 31, 2006 and the reinsurers’ financial strength rating from A.M. Best:
Our shareholders’ equity was $328.3 million as of December 31, 2006 compared to $384.2 million as of December 31, 2005, reflecting a decrease of $55.9 million that was primarily the result of a net loss to common shareholders of $64.8 million for the year ended December 31, 2006 partially offset by the net change in unrealized gains on our investment portfolios of $8.3 million. As of December 31, 2006, we have provided a 100% cumulative valuation allowance against our net deferred tax assets in the amount of $49.1 million. These deferred tax assets were generated primarily from net operating losses. As a company in which most of its business is in orderly run-off, the realization of these deferred tax assets is neither assured nor accurately determinable.
The following table shows our capitalization as of December 31, 2006 and December 31, 2005 (in thousands):
(1) Consisted of secured letter of credit facilities. As of December 31, 2006, the total amount of letters of credit outstanding under these facilities was $235.4 million. See ‘‘Liquidity’’ below for a discussion of our new credit facility.
(3) The debt to total capital ratio is calculated as the sum of the revolving credit facility, junior subordinated debentures and redeemable preferred shares, or Total Debt, divided by the sum of Total Debt and Total Shareholders’ Equity, or Total Capitalization.
On and after December 15, 2010, we may redeem our series A preferred shares, in whole or in part, at any time, at the redemption price set forth in the Certificate of Designation relating to preferred shares, plus declared but unpaid dividends and additional amounts, if any, to the date of redemption. We may not redeem our series A preferred shares before December 15, 2010 except that we may redeem our series A preferred shares before that date pursuant to certain tax redemption provisions described in the Certificate of Designation. If we experience a change of control, we may be required to make offers to redeem our series A preferred shares at a price of $25.25 per share, plus declared but unpaid dividends and additional amounts, if any, to the date of redemption and on the terms described in the Certificate of Designation. Our series A preferred shares have no stated maturity and are not subject to any sinking fund and are not convertible into any of our other securities or property.
We used net operating cash flow of approximately $43.2 million during the year ended December 31, 2006, primarily related to premiums and investment income received offset by losses and loss expenses as well as general and administrative expenses paid. In addition, we also generated net proceeds from the issuance of our preferred shares of $3.2 million. During the same period, we used net cash of $103.3 million in our investment activities. This amount includes $9.3 million of cash received from the sale of ESC. Our cash flows from operations for the year ended December 31, 2006 provided us with sufficient liquidity to meet operating cash requirements during that period.
As of December 31, 2006, we had cash and cash equivalents and investments of approximately $948.2 million. We estimate that our cash and cash equivalents and investment balances include approximately $273.6 million that is pledged as collateral for letters of credit, approximately $200.8 million held in trust funds for the benefit of ceding companies and to fund our obligations associated with the assumption of an environmental remediation liability, $189.6 million that is held by Lloyd’s to support our underwriting activities, $39.3 million held in trust funds that are related to our deposit liabilities and $29.9 million that is on deposit with, or has been pledged to, U.S. state insurance departments. After giving effect to these assets pledged or placed in trust, we estimate that we presently have unrestricted net investments of $215.0 million, including net cash and cash
equivalents of approximately $32.9 million. Of the $215.0 million, approximately $204.9 million represents net unrestricted investments held by our operating subsidiaries of which approximately $21.4 million is held by Quanta Bermuda. Additionally, Quanta Indemnity Company, Quanta Specialty Lines Insurance Company and Quanta Reinsurance U.S. Ltd., which are subsidiaries of Quanta Bermuda, hold approximately $161.5 million of net unrestricted investments. The remaining amount of the net unrestricted investments balance is held by Quanta Europe. Any distributions from these subsidiaries are subject to significant legal, regulatory and compliance requirements. We believe our operating subsidiaries currently have sufficient assets to pay their respective foreseen liabilities as they become due. We are working and will, over time, continue to work with applicable regulatory authorities to facilitate dividends or capital return from our insurance subsidiaries to Quanta Holdings. Working with these regulators takes time and will require us to meet many conditions.
Our sources of cash consist primarily of existing cash and cash equivalents, premiums written, proceeds from sales and redemptions of investment assets, capital or debt issuances, investment income, reinsurance recoveries, and, to a lesser extent, our secured bank credit facility and collections of receivables for technical services rendered to third parties. As a result of the A.M. Best rating actions in 2006, the resulting loss of business and business opportunities, our decision to cease writing new business in all our product lines, excluding business written at Lloyd’s, cash flows associated with the receipt of premiums written in our run-off segments will continue to decrease substantially.
On October 27, 2006, we entered into a Credit Agreement with a syndicate of lenders and ING Bank N.V., London Branch, as the mandated lead arranger, providing for a secured bank letter of credit facility (the ‘‘ING credit facility’’). The ING credit facility provides for an aggregate commitment of $240 million for a period of three years terminating on October 27, 2009. We have elected to reduce the aggregate commitment under the ING facility to $210.0 million as of February 9, 2007.
Under the ING credit facility, the lenders will issue from time to time, for the account of the designated subsidiary borrowers, one or more back-to-back letters of credit naming JPMorgan Chase Bank, N.A. as beneficiary in the face amount equal to the face amount of the outstanding letters of credit under the JPMorgan credit facility, and other letters of credit in an aggregate face amount up to the aggregate commitment. The facility is secured by specified investments of the borrowers. Availability for issuances of letters of credit on account of any borrower is based on the amount of eligible investments pledged by the applicable borrower(s) and no material adverse change provisions. Regulatory restrictions will also limit the amount of investments that may be pledged by certain U.S. insurance borrowers and, consequently, the amount available for letters of credit under the facility on account of those borrowers. Quanta Holdings unconditionally and irrevocably guaranteed all of the obligations of our subsidiaries to the lenders under the ING credit facility.
On October 27, 2006, we also entered into a Fourth Consent and Amendment to Credit Agreement (the Fourth Amendment’’) to the JPMorgan credit facility. The Fourth Amendment, among other things, permanently terminates the lenders’ obligations to extend any loan, issue any letter of credit, modify the terms of any existing letter of credit, or otherwise extend any additional credit under the JPMorgan credit facility, releases the liens granted by us and our designated subsidiary borrowers and transfers the collateral to the collateral agent under the ING credit facility in exchange for a letter of credit issued pursuant to the ING credit facility in a stated principal amount equal to 102% of the letters of credit outstanding under the JPMorgan credit facility. Furthermore, the Fourth Amendment reduces certain fees payable under the JPMorgan credit facility and permanently removes most of the covenants contained in the JPMorgan credit facility, including the covenants mandating a maximum leverage ratio, a minimum consolidated net worth, restrictions against the incurrence of additional indebtedness, liens, dividends and other restricted payments, and the requirement that we maintain certain insurance ratings.
After giving effect to assets pledged or placed in trust, we estimate that we have net unrestricted investments of $215.0 million, including net cash of approximately $32.9 million. Of the $215.0 million, approximately $204.9 million represents net unrestricted investments held by our operating subsidiaries of which approximately $21.4 million is held by Quanta Bermuda. Additionally, Quanta Indemnity Company, Quanta Specialty Lines Insurance Company and Quanta Reinsurance U.S. Ltd., which are subsidiaries of Quanta Bermuda, hold approximately $161.5 million of net unrestricted investments. The remaining amount of the net unrestricted investments balance is held by Quanta Europe. Any distributions from these subsidiaries are subject to significant legal, regulatory and compliance requirements and may require the settlements of any applicable intercompany debts. We believe our operating subsidiaries currently have sufficient assets to pay their respective foreseen liabilities as they become due. Substantially all of our capital has been distributed among our rated operating subsidiaries based on our assessment of the levels of capital that we believe are prudent to support our business, the applicable regulatory requirements, and the recommendations of the insurance regulatory authorities and rating agencies.
In the near term, our other principal cash requirements are expected to be losses and loss adjustment expenses and other policy holder benefits, including those related to policy cancellations and commutations, brokerage and commissions in our Lloyd’s business, expenses to implement our run-off plans, including legal, professional, severance and incentive payments, other operating expenses, premiums ceded, capital expenditures, the servicing of borrowing arrangements and taxes. We may also be required or choose to place capital in our operating subsidiaries. Following our restructured investment in Syndicate 4000 we are committed to provide up to 90% of the syndicate’s
capital requirements for the 2007, 2008 and 2009 underwriting years of account. Although this capital requirement is capped at the amount of our actual funds at Lloyd’s in place on the date Lloyd’s finalizes the capital requirements of Syndicate 4000 for each underwriting year, we may in certain circumstances be required to place additional funds at Lloyd’s prior to these dates.
While insurance regulation differs by location, each jurisdiction requires that minimum levels of capital be maintained in order to write new insurance business. Factors that affect capital requirements generally include premium volume, the extent and nature of loss and loss expense reserves, the type and form of insurance and reinsurance business underwritten and the availability of reinsurance protection from adequately rated retrocessionaires on terms that are acceptable to us. These regulatory requirements restrict the amount of capital we are able to distribute to Quanta Holdings and other insurance subsidiaries. For further discussion, see ‘‘-Adequacy of Regulatory and Rating Capital.’’ Substantially all of our capital has been distributed among our subsidiaries based on our assessment of the levels of capital that we believed were prudent to support the levels of expected business we had at the time, the applicable regulatory requirements, and the recommendations of the insurance regulatory authorities and rating agencies.
We are also subject to Bermuda regulatory constraints that affect our ability to pay dividends on our shares, redeem our series A preferred shares and make other payments. Under the Companies Act, even though we are solvent and able to pay our liabilities as they become due, we may not declare or pay a dividend or make a distribution if we have reasonable grounds for believing that we are, or will after the payment be, unable to pay our liabilities as they become due or if the realizable value of our assets will thereby be less than the aggregate of our liabilities and our issued share capital and share premium accounts.
For additional discussion concerning risks relating to our dividend policy and our holding company structure and its effect on our ability to receive and pay dividends, see ‘‘Item 1A.-Risk Factors-Risks Related to the Runoff and to Syndicate 4000-Our holding company structure and certain regulatory and other constraints, including our credit facility, affect our ability to pay dividends on our shares, return capital make payments on our indebtedness and other liabilities and our ability to redeem our series A preferred shares.’’ See also note 20 to our consolidated financial statements. For a discussion of certain additional limitations on our ability to pay dividends on our common shares relating to certain preferential rights associated with the Company’s series A preferred shares, see ‘‘Item 1A.-Risk Factors-Risks Related to our Securities-Our series A preferred shares have rights, preferences and privileges senior to those of holders of our common shares and the holders of our series A preferred shares might exercise their right to appoint two directors to our board of directors which might result in decisions that prejudice the economic interests of the holders of our common shares in favor of the holders of our series A preferred shares.’’
We have contractual obligations relating to our reserves for losses and loss expenses and commitments under the trust preferred securities, preferred shares and non-cancelable operating leases for property and office equipment described above under ‘‘Liquidity’’ as of December 31, 2006 as follows:
(1) The interest on the long-term debt obligation is based on a spread above LIBOR. We have reflected the interest due based upon the current interest rate at December 31, 2006 on the facility.
Similarly, we have limited loss payout pattern information specific to our experience, therefore we have used industry data, on a line by line basis, to estimate our expected payments. Consequently, despite management’s care in selecting them, the actual payment of our reserve for losses and loss expenses will differ from estimated payouts.
As described under ‘‘Liquidity’’ above we entered into the ING credit facility providing for the issuance of letters of credit for a period of three years terminating on October 27, 2009. Regulatory restrictions also limit the amount of investments that may be pledged by our U.S. insurance borrowers and, consequently, the amount available for letters of credit and borrowings under the facility to those borrowers. As of December 31, 2006, we had approximately $235.4 million of secured letters of credit issued and outstanding. If we fail to maintain or enter into adequate letter of credit facilities on a timely basis, we may be unable to provide necessary security to cedent companies that have the right to require the posting of additional security by reason of the downgrade of our A.M. Best rating.
Some of our insurance and many of our reinsurance contracts contain termination rights that were triggered by the A.M. Best rating downgrade. Some of these insurance and reinsurance contracts also require us to post additional security. As a result, we may be required to post additional security either through the issuance of letters of credit or the placement of securities in trust under the terms of those insurance or reinsurance contracts. We may also elect to post security under other insurance
contracts. We currently have net cash and cash equivalent balances of approximately $32.9 million that are available to post as security or place in trust. However, the distribution of these funds from each of our operating subsidiaries is subject to significant legal, regulatory and compliance requirements.
The method by which we record and recognize premiums written differs based upon the nature of the underlying insurance or reinsurance contract.
Some of our written and ceded contracts include retrospective rating provisions, including profit commissions, no claims bonuses and reinstatement premiums that adjust estimated premiums or acquisition expenses based upon experience and underwriting results. Profit commissions are expenses that vary with and are directly related to acquiring new and renewal insurance and reinsurance business. Profit commission accruals are recorded in acquisition costs and are adjusted at the end of each reporting period based on the experience of the underlying contract. No claims bonuses are accrued as a reduction of earned premiums and are adjusted at the end of each reporting period based on the experience of the underlying contract. We also write certain structured insurance and reinsurance contracts as risk management solutions that cannot otherwise be provided by traditional contracts. Typically, we assume a measured amount of risk in exchange for a premium, a specified portion of which may be returnable to the insured based on the level of loss experience or underwriting profitability. Adjustments related to retrospective rating provisions that adjust estimated premiums or acquisition expenses are recognized over the remaining contract periods in accordance with the underlying contract terms based on current experience under the contracts.
Certain of our written and ceded reinsurance contracts contain provisions that require us to receive or pay additional premiums in the event that losses of a certain magnitude are incurred or ceded under such contracts. These additional premiums are known as reinstatement premiums that typically reinstate coverage limits under pre-defined contract terms. Terms principally include a pro-rata amount of the original contract premium relative to the proportion of the contractual limit exhausted by the associated loss, without respect to time remaining in the term of the original limit, that is, the amount due is 100% as to time and pro-rata as to amount. Since these reinstatement premiums are triggered and are mandatorily due upon the occurrence of incurred or ceded losses, they are written or ceded and earned or expensed at the time the associated loss event occurs. The original contract premium is earned over the remaining exposure period of the contract. During the year ended December 31, 2005, we wrote and earned $9.8 million of reinstatement premiums written and expensed $13.9 million of reinstatement premiums ceded associated with the occurrence of the 2005 hurricanes. During 2006, these estimates were adjusted to $11.4 million and $13.1 million as losses developed under those contracts that contained reinstatement provisions.
For those contracts that transfer neither significant underwriting risk nor significant timing risk and for contracts that transfer significant timing risk only, the deposit asset or liability is adjusted, and corresponding interest income or expense recognized within our results of operations, by using the interest method to calculate the effective yield on the deposit based on the estimated amount and timing of cash flows. If a change in the actual or estimated timing or amount of cash flows occurs, the effective yield is recalculated and the deposit is adjusted to the amount that would have existed had the new effective yield been applied since the inception of the insurance or reinsurance contract. The adjustment is recorded as interest income or interest expense.
result, we could be deemed to have retained life reinsurance risk and, as a result, may be required to account for some or all of the underlying insurance contracts as life insurance, recognizing life premiums written and life benefit reserves in the consolidated statement of operations. If deposit accounting had not been used with respect to this particular arrangement, we would have recognized gross life reinsurance premiums written of approximately $62.6 million and $16.8 million for the years ended December 31, 2006 and 2005. At this time, we believe that the recognition of these premiums written would not have had a material effect on our financial position and results of operations. However, as the underlying life insurance contracts mature the effect on our financial condition and results of operations may become material.
Of the $3.5 million and $2.5 million, $0.6 million and $0.2 million of other income recognized during the years ended December 31, 2006 and 2005 relate to explicitly defined margins on one short duration contract written by our specialty reinsurance segment that does not meet the risk transfer provisions of SFAS 113. This contract was written on a funds withheld basis, such that the deposit liability of $21.3 million and $21.7 million recorded is equal to a funds withheld asset according to the contract terms. In accordance with FIN 39, the funds withheld asset and the deposit liability have been offset in the consolidated balance sheet.
The remaining $2.3 million and $1.6 million of other income derived from non-traditional contracts recognized during the years ended December 31, 2006 and 2005 relates to revenues earned from five and five reinsurance contracts accounted for as deposits. Although these contracts did possess some underwriting and timing risks as prescribed by SFAS No. 113, we do not believe we are exposed to a reasonable possibility of significant loss. Included in the remaining $2.3 million and $1.6 million of other income are $1.7 million and $1.1 million related to one surplus relief life reinsurance agreement. Underlying treaties attach to this contract on a coinsurance basis. As of December 31, 2006 and 2005, we have provided approximately $30.1 million (unaudited) and $33.2 million (unaudited) of statutory surplus relief to a U.S. insurance company under this contract.
As an insurance and reinsurance company we are required, under U.S. GAAP and applicable insurance regulations, to establish reserves for losses and loss expenses for estimates of future amounts to be paid in settlement of our ultimate liabilities for claims arising under the terms of written insurance and reinsurance policies that have occurred at or before the balance sheet date. Under U.S. GAAP, we are only permitted to establish loss and loss expense reserves for actual losses that have occurred before the balance sheet date. We do not record contingency reserves for expected future loss occurrences, nor do we discount our reserves for losses and loss expenses to be paid in the future.
• the proximity of loss occurrences to the period end limiting the amount of available loss information from our clients,
• the availability of complete historical data on which to base loss expectations,
A significant uncertainty in our estimation of loss and loss expense reserves involves our estimates of catastrophe losses. In reserving for catastrophe losses, our estimates are influenced by underwriting information provided by our clients, industry catastrophe models, industry loss estimates and our internal analyses of this information. Reliance on this information can cause significant development from initial loss estimates in the immediate wake of a catastrophe event due to the limited information available and the volatility in that information. This process can cause our ultimate estimates to differ significantly from initial projections. The hurricanes that occurred during the third quarter of 2005 present an example of the uncertainty and potential variability associated with reserving for catastrophe losses. As of September 30, 2005, we initially based our reserves to a significant degree on our knowledge about the industry loss estimates of the total loss and we also considered what we believed to be similar historical events such as the 2004 hurricanes. We used this information and data in conjunction with a review of the majority of the underlying affected contracts in assessing initial loss and loss expense reserves. At September 30, 2005, our initial estimated ultimate net loss and loss expense was approximately $68.5 million, net of reinstatement premiums. As of December 31, 2006 our updated estimate of ultimate net loss and loss expenses is approximately $90.0 million, which represents a 31% increase over the fifteen month period following September 30, 2005. We believe that industry loss estimates published during October and November 2005 totaled approximately $45.0 billion, excluding costs associated with marine offshore energy claims. By December 31, 2006 we believe that these estimates had increased by 26% to $56.7 billion. Given that our catastrophe exposed business has been a very small proportion of the total market, we do not expect that changes in our loss estimates will be closely correlated to changes in industry loss estimates.
claims experience tends to be frequency driven. As a result, historical loss development data may be available and traditional actuarial methods of loss estimation may be used. Conversely, the available amount of relevant loss experience that we can use to quantify the emergence, severity and payout characteristics of the loss liabilities is limited for policies that are written with the expectation that potential losses will be characterized by lower frequency but higher severity claims, such as contracts written that are exposed to natural catastrophes or other significant sudden and accidental events. As a result, incurred losses are inherently more volatile in our product lines exposed to these types of losses, such as property and marine reinsurance.
The estimation of unpaid loss liabilities will also vary in subjectivity depending on the tail of incurred losses which we typically analyze between short-tail and long-tail businesses. Short-tail business describes lines of business for which losses become known and paid in a relatively short period time after the loss actually occurs. Typically, there will be less variability caused by the tail in the ultimate amount of losses from claims incurred in the short-tail lines that we have written such as technical risk property, property, marine and aviation. Long-tail business describes lines of business for which actual losses may not be known for some time or for which the actual amount of loss may take a significantly longer period of time to emerge or develop. Our casualty, professional and environmental lines of business are generally considered longer tail in nature. Because loss emergence and settlement periods can be many years in duration, these lines of business are more likely to have significant variability in the estimates of their loss and loss expense reserves.
In general, the industry-accepted IBNR reserving techniques involve the extrapolation of historical or reported loss data to estimate ultimate loss and loss expense reserves. We generally apply several reserving methodologies in estimating loss and loss expense reserves in each of our product lines. We typically select the highest reserve estimate generated by each of the methodologies used for each accident year (or period of loss occurrence) and in making that selection we also consider the ‘‘maturity’’ of the accident period. The maturity of the accident period depends upon the nature and tail of the product line being considered. If the accident period is considered mature we are more likely to select the actuarial method that places reliance on our own historical reported loss experience compared to an immature accident period where we are more likely to select a method based on initial expected losses with limited consideration to actual historical loss development. We believe that accident periods in our short-tail product lines become mature after six to twelve months. We believe our long-tail product line accident periods mature, for reserving selection purposes, between eighteen months and three years.
technical risk property specialty insurance run-off business lines was the Bornhuetter-Ferguson actuarial method for mature accident periods. The Bornhuetter-Ferguson actuarial method utilizes the expected loss (initial expected loss and loss expense ratio multiplied by earned premium) multiplied by loss development factors derived by our internal actuaries from our own actual loss and loss expense experience in each product line and also from industry statistics. As accident periods mature we place more reliance on the Bornhuetter-Ferguson method for which we use both historical paid and historical reported data.
At December, 31, 2006 approximately 83.2%, or $ 334.9 million of our loss and loss expense reserves, net of reinsurance are based on estimates of incurred but not yet reported losses and as such we believe remain subject to significant volatility.
As of December 31, 2006, a 10% change in our reserves for loss and loss expenses, net of losses and loss adjustment expenses recoverable, of $402.4 million would equate to a $40.2 million change in our reserves for loss and loss expenses, which would represent 64.0% of our net loss for the year ended December 31, 2006 and 12.3% of our shareholders’ equity as of December 31, 2006.
In our technical services segment we assume environmental liabilities in exchange for remediation fees and contracts to perform the required remediation in accordance with the underlying remediation agreements. We estimate our initial and ongoing ultimate liabilities for such environmental remediation obligations using actual experience, past experience with similar remediation projects, technical engineering examinations of the contaminated sites and state, local and federal guidelines. However, we cannot assure you that actual remediation costs will not significantly differ from our estimated amounts. We continually review our estimates for ultimate remediation costs taking into account all currently known information and updated assumptions related to unknown information. Any adjustments to previously established liabilities, resulting from a change in our estimates, may significantly impact our current period operating results. As of December 31, 2006, we had assumed two environmental remediation projects for which we have recorded an estimated liability of $3.3 million.
In December 2004, the FASB issued SFAS No. 123 (revised 2004) ‘‘Share-based payment’’ (‘‘SFAS 123(R)’’). SFAS 123(R) replaces SFAS No. 123, ‘‘Accounting for Stock-Based Compensation’’ (‘‘SFAS 123’’) and supersedes Accounting Principles Board Opinion No. 25, ‘‘Accounting for Stock Issued to Employees’’ and related interpretations (‘‘APB 25’’). Generally, the approach in SFAS 123(R) is similar to SFAS 123, however, SFAS 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the consolidated financial statements based on their fair values and, accordingly, SFAS 123(R) does not allow pro forma disclosure as an alternative to financial statement recognition. SFAS 123(R) is effective for the beginning of the first annual period beginning after September 15, 2005.
Prior to January 1, 2006, we accounted for the Incentive Plan under the recognition and measurement provisions of APB 25 and related Interpretations, as permitted by SFAS 123. No stock-based employee compensation cost was recognized in the Statement of Operations for the years ended December 31, 2005 or 2004, as all options granted under the Incentive Plan had an exercise
We engage in certain derivative related activities and have adopted SFAS No. 133, ‘‘Accounting for Derivative Instruments and Hedging Activities’’ (‘‘SFAS 133’’) and SFAS 149, ‘‘Amendment of Statement No. 133 on Derivative Instruments and Hedging Activities.’’
During the year ended December 31, 2004, we adopted an Annual Variable Cash Compensation Plan (the ‘‘Annual Variable Cash Incentive Plan’’) which was generally available to employees in 2004 and 2005. Awards paid under this plan were dependent on performance measured at an individual and line of business level for the years ended December 31, 2004 and 2005. In general, the Annual Variable Cash Incentive Plan provided for an annual bonus award to employees that was based on a sharing of profit in excess of a minimum return on capital to shareholders (as calculated under the Annual Variable Cash Incentive Plan). Profit for each calendar year was measured by estimating the ultimate net present value of after-tax profit generated from business during that calendar year and, up until December 31, 2006, was re-estimated on an annual basis through the vesting period. Annual Incentive Plan awards for 2004 and 2005 have now fully vested and any remaining unpaid amounts are scheduled to be paid no later than March 31, 2007.
Following our determination to engage in a self-managed run-off, employees will generally receive a bonus for the year ended December 31, 2006 based on individual performance that is comprised of a guaranteed and variable element. Awards are expected to be paid out in one installment to employees who remain employed on the date of the payment.
Reference is made to Item 15(a) of this annual report for the Consolidated Financial Statements of Quanta Capital Holdings Ltd. and the Notes thereto, as well as the Schedules to the Consolidated Financial Statements.