______________ (1) Book value per share is calculated as shareholders' equity at December 31, 2004 divided by the number of shares outstanding at December 31, 2004. Included in shareholders' equity are proceeds from the issuance of Class C Warrants to the Cypress Entities. The number of shares at December 31, 2004, does not include the 3,206,431 shares to be issued on conversion of the Class C Warrants. These will be issued once shareholder approval has been obtained. If these shares had been included, book value per share would have amounted to $20.00.
We are a holding company organized under the laws of the Cayman Islands with our principal executive office in Bermuda. We are a reinsurer of life insurance, annuities and annuity-type products. These products are written by life insurance companies and other financial institutions located principally in the United States, as well as around the world. We refer to this portion of our business as Life Reinsurance North America. Scottish Re Holdings Limited and its subsidiary, Scottish Re Limited, specialize in niche markets in developed countries and broader life insurance markets in the developing world. We refer to this portion of our business as Life Reinsurance International. Life Reinsurance North America and Life Reinsurance International are each a reporting operating segment. To a lesser extent, we directly issue variable life insurance and variable annuities and similar products to high net worth individuals and families for insurance, investment and estate planning purposes. In prior years, we referred to this portion of our business as Wealth Management, which was another reportable operating segment. As this business is no longer a material contributor to our results, we have combined it with the Other Segment for all
periods presented. Other revenues and expenses not related to Life Reinsurance are reported in the "Other" Segment.
In addition to the assets transferred by ING, we have raised an additional $230.0 million in new capital, which will be used to satisfy the capital requirements for the acquired business. This new capital includes equity of $180.0 million provided by The Cypress Group, a private equity firm, and an additional $50.0 million in capital raised through the issuance by one of our subsidiaries of trust preferred securities guaranteed by Scottish Annuity & Life Insurance Company (Cayman) Ltd. in a private transaction to institutional investors.
Our investment income includes interest earned on our fixed income investments and income from funds withheld at interest under modified coinsurance agreements. Under GAAP, because our fixed income investments are held as available for sale, these securities are carried at fair value, and unrealized appreciation and depreciation on these securities is not included in investment income on our statements of income, but is included in comprehensive income as a separate component of shareholders' equity. Realized gains and losses include gains and losses on investment securities that we sell during a period, write downs of securities deemed to be other than temporarily impaired and foreign currency exchange gains and losses.
We seek to generate profits from two principal sources. First, in our Life Reinsurance business, we seek to receive reinsurance premiums and financial reinsurance fees that, together with income from the assets in which those premiums are invested, exceed the amounts we ultimately pay as claims and policy benefits, acquisition costs and ceding commissions. Second, within our investment guidelines, we seek to maximize the return on our unallocated capital.
In addition, our profits can be affected by a number of factors that are not within our control. For example, movements in interest rates can affect the volume of business that we write, the income earned from our investments, the interest we credit on interest sensitive contracts, the level of surrender activity on contracts that we reinsure and the rate at which we amortize deferred acquisition costs. Other external factors that can affect profitability include mortality experience that varies from our assumed mortality, changes in regulation or tax laws which may affect the attractiveness of our products or the costs of doing business and changes in foreign currency exchange rates.
Statement of Financial Accounting Standard ("SFAS") No. 60 "Accounting and Reporting by Insurance Enterprises" applies to our traditional life policies with continuing premiums. For these policies, future benefits are estimated using a net level premium method on the basis of actuarial assumptions as to mortality, persistency and interest established at policy issue. Assumptions established at policy issue as to mortality and persistency are based on anticipated experience, which, together with interest and expense assumptions, provide a margin for adverse deviation. Acquisition costs are deferred and recognized as expense in a constant percentage of the gross premiums using these assumptions established at issue. Should the liabilities for future policy benefits plus the present value of expected future gross premiums for a product be insufficient to provide for expected future benefits and expenses for that product, deferred acquisition costs will be written off and thereafter, if required, a premium deficiency reserve will be established by a charge to income. Changes in the assumptions for mortality, persistency and interest could result in material changes to the financial statements.
Total benefits and expenses increased by 46% to $756.4 million in the year ended December 31, 2004 from $519.6 million in 2003. The increase was due to the acquisition of Scottish Re Life Corporation, continued growth in our Life Reinsurance North America Segment, additional operating costs required to meet the growth in our
During the year ended December 31, 2003, total revenues increased by 82% to $557.4 million. Total revenues include premiums earned in our Life Reinsurance operations, investment income on our invested assets, fee income, realized losses on our investment portfolio and the change in the value of embedded derivatives. The increase in premiums earned is primarily due to continued growth in our Life Reinsurance North America and Life Reinsurance International Segments. The increase in investment income is due to growth in our invested assets, which arises from business growth, our equity offering in July 2003 and our debt offerings in November and December 2002. The change in value of the embedded derivatives arises from the application of DIG B36.
During the year ended December 31, 2003, total benefits and expenses increased by 89% to $519.6 million from 2002 to 2003. The increase was due to continued growth in our Life Reinsurance North America and Life Reinsurance International Segments, a $12.5 million charge to account for revised reporting by a ceding company client in connection with two fixed annuity reinsurance contracts, additional operating costs required to meet the growth in our business and additional interest expense arising from the debt issuance in November and December 2002.
During the year ended December 31, 2003 we implemented the requirements of DIG B36 which addresses whether SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities" requires bifurcation of a debt instrument into a debt host contract and an embedded derivative if the debt instrument incorporates both interest rate risk and credit risk exposures that are unrelated or only partially related to the creditworthiness of the issuer of that instrument. Under DIG B36 modified coinsurance and coinsurance funds withheld reinsurance agreements where interest is determined by reference to a pool of fixed maturity assets, are arrangements containing embedded derivatives requiring bifurcation. In addition, reinsurance contacts with experience refunds are also considered to be arrangements containing embedded derivatives requiring bifurcation. DIG B36 was effective for fiscal quarters beginning October 1, 2003. We reviewed all contracts at October 1, 2003 and determined that the value of this derivative, net of related deferred acquisition costs, after taxation was a loss of $19.5 million. This is shown in the consolidated statements of income as a cumulative effect of change in accounting principle for the year ended December 31, 2003. The change in value of the derivative, net of related deferred amortization costs, during the year ended December 31, 2004 amounted to a gain of $4.6 million. In the quarter and year ended December 31, 2003, the change in value of this derivative amounted to a gain of $13.9 million. The change in value is primarily due to movements in risk free interest rates.
Diluted earnings per ordinary share amounted to $1.90 for the year ended December 31, 2004 and $0.85 in the same period in 2003, an increase of 124%. Diluted earnings per ordinary share increased as a result of the growth in net income discussed above. The weighted average number of ordinary shares outstanding, on a fully diluted basis, has increased from 32,228,001 for the year ended December 31, 2003 to 37,508,292 for the year ended December 31, 2004, principally as a result of the offering of 9,200,000 million ordinary shares in July 2003.
Income from continuing operations for the year ended December 31, 2003 increased by 47% to $48.8 million from $33.2 million in 2002. Diluted earnings per ordinary share from continuing operations amounted to
$1.51 for the year ended December 31, 2003 and $1.25 per ordinary share in 2002, an increase of 21%. The growth in both income from continuing operations and diluted earnings per share arises from the growth in both our Life Reinsurance North America and Life Reinsurance International Segments. The growth in diluted earnings per share from continuing operations was offset by the increase in the weighted average number of ordinary shares outstanding due to the public offering of 9,200,000 ordinary shares in July 2003.
During the year ended December 31, 2004 acquisition costs and other insurance expenses increased by 58% to $132.2 million from $83.6 million in 2003. The increase was a result of the acquisition of Scottish Re Life Corporation, including the amortization of the present value of in-force arising on this business, and the increased life and annuity business in our Life Reinsurance North America Segment as discussed above. The interest and costs of the collateral finance facility described, in "Liquidity and Capital Resources" are included in acquisition costs and other insurance expenses and amounted to $2.8 million in the year ended December 31, 2004.
Operating expenses increased by 110% to $18.4 million during the year ended December 31, 2004 from $8.6 million in 2003. The increase is primarily the result of the acquisition of Scottish Re Life Corporation, additional personnel costs incurred as we continue to grow our business and the costs necessary to meet the requirements of the Sarbanes Oxley Act of 2002. The costs of Scottish Re Life Corporation include the cost of the transition services agreement with GE ERC of $2.4 million. Total employees in this segment have grown from 64 at December 31, 2003 to 91 at December 31, 2004.
Interest expense in this segment arises on the trust preferred securities. The increase in interest expense to $4.6 million for the year ended December 31, 2004 from $1.1 million in 2003 results from the issuance of an additional $62.0 million of these securities in October 2003, November 2003, and May 2004. An additional $50.0 million were issued in December 2004.
During the year ended December 31, 2003, average book yields were lower than in 2002. On the $2.4 billion portfolio managed by our external investment managers the yields on fixed rate assets were 5.13% and 5.84% at December 31, 2003 and 2002, respectively. The reduction in yield was due primarily to the much lower market yields at which new cash flows were invested and proceeds of maturities and sales were reinvested. Yields on floating rate assets are indexed to LIBOR. The yield on our floating rate assets increased to 3.43% from 3.11%, and the yield on our cash and cash equivalents decreased to 1.01% from 1.48%. The market value of floating rate assets increased to $301.8 million in 2003 from $159.2 million in 2002 as a result of our increased floating rate funding agreements and our increased floating rate liabilities.
described. Death claims are reasonably predictable over a period of many years, but are less predictable over shorter periods and are subject to fluctuation from year to year.
Operating expenses increased by 18% to $8.6 million during the year ended December 31, 2003 from $7.3 million in 2002. The increase is primarily the result of additional personnel costs incurred as we continued to grow our business.
Our Life Reinsurance International Segment specializes in niche markets in developed countries and broader life insurance markets in the developing world and focuses on the reinsurance of short term group life policies and aircrew loss of license insurance.
Investment income during the year ended December 31, 2004 has increased to $10.0 million compared to $7.5 million in 2003. The agreements for the acquisition of a portfolio of business completed late in 2002 included conditions for recapture of certain business by the ceding company. This recapture has been completed and resulted in additional investment income of $1.1 million in the year ended December 31, 2004. The remainder of the increase is due to the increased level of invested assets arising principally from growth in business.
Claims and other policy benefits in our Life Reinsurance International Segment decreased by 22% to $81.6 million in the year ended December 31, 2004 from $104.2 million in 2003. Claims in comparison to the prior year have been impacted by the introduction of the estimates process as described above. During the current year we have recognized claims and other policy benefits of $1.8 million in respect of the recapture of business on the portfolio acquisition described above. In addition, during the year we incurred $1.0 million in respect of a claim from our stop loss business. We also released reserves of $3.1 million relating to revisions of estimated claims arising from the portfolio acquired in 2002. Claims and other policy benefits in 2004 also include $2.1 million of claims relating to our share of two Lloyd's of London life syndicates. Claims and other policy benefits in the prior year were favorably impacted by a $3.4 million release of reserves on the sale of our unit linked business in 2003. Our targeted maximum corporate retention per life in our Life Reinsurance International Segment is $250,000. In addition, we maintain catastrophe cover on our entire retained life reinsurance business, which effective January 1, 2005 provides reinsurance for losses of $57.5 million in excess of $2.5 million, and provides protection for terrorism, nuclear, biological and chemical risks.
Claims and other policy benefits increased by 107% to $104.2 million in 2003 compared to $50.4 million in 2002. The increase is a result of the increased volume of business, as previously described, the revisions of estimates of premiums earned together with the acquisition of an in-force block of business effective October 2002. The estimate process contributed a further $17.5 million to claims and other policy benefits. Claims on the in-force block amounted to $18.8 million and $3.5 million for the year ended December 31, 2003 and 2002, respectively. During 2003, we entered into an agreement to novate our unit-linked liabilities. The outstanding liabilities were settled by transferring an agreed number of unit-linked securities to the novation agreement counter-party. The settlement was less than the liability previously recorded of $15.5 million and therefore resulted in a release of liabilities of $3.4 million.
Acquisition costs and other insurance expenses for our Life Reinsurance International Segment increased to $30.1 million in 2003 from $8.3 million in 2002. This was a result of the growth in our business as described above, the revision of estimates of premiums earned discussed above and the acquisition of an in-force block of business effective October 2002. Acquisition costs on the in-force block amounted to $5.7 million in 2003 and $0.3 million in 2002. The revision of estimates of premiums earned contributed a further $6.0 million to acquisition costs and other insurance expenses.
raise capital and deploy it into our operating segments. Fee income and acquisition expenses arise from our Wealth Management operations. Operating expenses include the costs of running our principal office in Bermuda, compensation costs for our board of directors and legal and professional fees including those in respect of corporate governance legislation. Operating expenses have increased by 61% to $17.5 million the year ended December 31, 2004. These increases relate primarily to increased personnel costs and the costs of corporate governance initiatives, including implementation of the requirements of the Sarbanes Oxley Act of 2002. Due diligence costs of $4.6 million were incurred in respect of various proposed acquisitions. For the year December 31, 2004, interest expense has increased by 30% to $8.4 million from $6.4 million in 2003 as a result of the HyCU issuance in December 2003.
During the year ended December 31, 2004, realized losses amounted to $8.3 million in comparison with realized losses of $4.4 million in 2003. Included in realized losses is $2.2 million resulting from the mark to market of an interest rate swap. We entered into this contract in relation to certain of our investment assets not supporting reinsurance liabilities. This derivative has not been designated as a hedge and accordingly changes in the fair value are recorded in the determination of net income. During the year ended December 31, 2004, we recognized losses of $9.9 million in respect of impairments on the portfolio controlled by us. These losses were offset by net realized gains on the portfolio.
During the year ended December 31, 2003, realized losses amounted to $4.4 million in comparison with realized losses of $10.8 million in the same period in 2002. During the year ended December 31, 2003, we recognized $1.9 million in losses in respect of "other than temporary impairments" on investments, impairment losses of $4.4 million under EITF 99-20 and $2.9 million (net of related deferred acquisition costs) of "other than temporary impairment losses" notified by ceding companies on contracts written on a modified coinsurance basis. These losses were offset by realized exchange gains of $1.3 million and net gains and losses on disposals of investments amounting to $3.5 million.
The following tables provide details of the sales proceeds, realized loss, the length of time the security had been in an unrealized loss position and reason for sale for securities sold during 2004, 2003, and 2002.
The 2004 income tax benefit is in respect of certain of our U.S. taxable entities and our U.K. and Irish entities, offset by income tax expenses arising on our other U.S. entities. Included in the 2004 income tax benefit is $1.7 million in respect of U.S. state taxes and $10.0 million arising in our Irish entity relating to the acquisition of
The change in our effective tax rate is due primarily to the ratio of earnings on taxable jurisdictions to that in non-taxable jurisdictions.
At December 31, 2004, the portfolio controlled by us consisted of $4.3 billion of fixed income securities, preferred stock and cash. The majority of these assets are traded; however, $330.3 million represent investments in private securities. Of the total portfolio controlled by us, $3.5 billion represented the fixed income and preferred stock portfolios managed by external investment managers and $752.5 million represented other cash balances. At December 31, 2003, the portfolio controlled by us consisted of $2.4 billion of fixed income securities, preferred stock and cash. The majority of these assets are traded; however, $175.2 million represented investments in private securities. Of the total portfolio, $2.1 billion represented the fixed income and preferred stock portfolio managed by external investment managers and $262.7 million represented other cash balances.
At December 31, 2004, the average Standard & Poor's rating of that portfolio was "AA-", the average effective duration was 3.8 years and the average book yield was 4.2% as compared with an average rating of "AA-", an average effective duration 3.9 years and an average book yield of 4.5% at December 31, 2003. At December 31, 2004, the unrealized appreciation on investments, net of tax and deferred acquisition costs, was $13.7 million as compared with unrealized appreciation on investments, net of tax, of $16.8 million at December 31, 2003. The unrealized appreciation on investments is included in our consolidated balance sheet as part of shareholders' equity.
Year Ended December 31, 2004 ------------------ Portfolio performance.................................... 4.42% Customized index......................................... 3.87% Lehman Brothers Global Bond Index........................ 9.27% S&P 500.................................................. 10.87%
The data in the tables above excludes the assets held by ceding insurers under modified coinsurance and funds withheld coinsurance agreements.
Unrealized losses on securities that have been in an unrealized loss position for periods greater than 2 years amounted to $2.1 million at December 31, 2004 and $2.0 million at December 31, 2003. Unrealized losses on non-investment grade securities amounted to $2.1 million and $3.0 million at December 31, 2004 and December 31, 2003, respectively. Of these amounts, non-investment grade securities with unrealized losses of $1.0 million at December 31, 2004 and $1.8 million at December 31, 2003 had been in an unrealized loss position for a period greater than one year, of which $1.0 million at December 31, 2004 and $0.9 million at December 31, 2003 had been in an unrealized loss position for periods greater than 2 years.
The following tables illustrate the industry analysis of the unrealized losses at December 31, 2004 and 2003:
At December 31, 2004, there were two securities with fair values that traded continuously at less than 80% of amortized cost for at least six months or 90% of amortized cost for at least 12 months. The total unrealized loss on these securities amounted to $1.1 million and the largest unrealized loss position was $0.9 million. At December 31, 2003 there were 12 securities with fair values that traded continuously at less than 80% of amortized cost for at least six months or 90% of amortized cost for at least 12 months. The total unrealized loss on these securities amounted to $7.2 million and the largest unrealized loss position was $1.6 million.
At December 31, 2004, funds withheld at interest were in respect of seven contracts with four ceding companies. At December 31, 2003, funds withheld at interest were in respect of six contracts with three ceding companies. At December 31, 2004, we had three contracts with Lincoln National Insurance Company that accounted for $1.3 billion or 63% of the funds withheld balances. Additionally we had two contracts with Security Life of Denver International that accounted for $0.5 billion or 27% of the funds withheld balances. The remaining contracts were with Illinois Mutual Insurance Company and American Founders Life Insurance Company. Lincoln National Insurance Company has financial strength ratings of "A+" from A.M. Best, "AA-" from Standard & Poor's, "Aa3" from Moody's and "AA" from Fitch. In the event of insolvency of the ceding companies on these arrangements we would need to exert a claim on the assets supporting the contract liabilities. However, the risk of loss is mitigated by our ability to offset amounts owed to the ceding company with the amounts owed to us by the ceding company. Reserves for future policy benefits and interest sensitive contract liabilities relating to these contracts amounted to $2.0 billion and $1.7 billion at December 31, 2004 and December 31, 2003, respectively.
At December 31, 2004, the funds withheld at interest totaled $2.0 billion with an average rating of "A+", an average effective duration of 3.9 years and an average book yield of 5.2% as compared with an average rating of "A-", an average effective duration of 5.1 years and an average book yield of 6.3% at December 31, 2003. These are fixed income investments and include marketable securities, commercial mortgages, private placements and cash. The market value of the funds withheld amounted to $2.1 billion and $1.6 billion at December 31, 2004 and December 31, 2003, respectively.
Cash provided by operating activities amounted to $38.9 million in the year ended December 31, 2004 in comparison with $88.5 million in 2003. Operating cash flow includes cash inflows from premiums, fees and investment income, and cash outflows for benefits and expenses paid. In periods of growth of new business our operating cash flow may decrease due to first year commissions paid on new business generated. For income recognition purposes these commissions are deferred and amortized over the life of the business. The decrease in operating cash flow is partly attributable to settlement of a tax liability of approximately $23.0 million. This liability resulted from actions taken by the former owner of Scottish Re Life Corporation immediately prior to its acquisition in December 2003. When adjusted for this payment, cash inflows from operations in the year ended December 31, 2004 were $61.9 million compared to inflows $88.5 million in 2003. This decrease is due to the timing of receipt of reinsurance receivables and settlement of reinsurance payables. During the year ended December 31, 2004 we settled reinsurance payables outstanding at December 30, 2003.
Cash provided by operating activities amounted to $88.5 million in 2003 in comparison with cash flow of $9.2 million used in operating activities in 2002. The increase in operating cash flow from 2002 was $97.7 million. It related primarily to increases in premiums, fees, and investment income being greater than increases in benefits, reserve movements and expenses paid. Cash from premiums and fees increased by $116.3 million due to growth in our Life Reinsurance business. Cash from investment income increased by $68.7 million due to the growth in our invested asset base. The increase was offset by declining yields. Cash used to settle benefits increased by $66.9 million due to the growth in our Life Reinsurance business. This use of cash was offset by an increase in related reserves of $64.1 million. Cash used to pay acquisition and other expenses, including commissions and interest, increased by $84.5 million. This increase related principally to new business written in our Life Reinsurance North America Segment, increased operating expenses and increased debt. Acquisition costs include commissions on first year business that are deferred when paid and therefore do not impact net income until later years.
On April 4, 2002 we completed a public offering of 6,750,000 ordinary shares (which included an over-allotment option of 750,000 ordinary shares) in which we raised aggregate net proceeds of $114.3 million. We used the net proceeds of the offering to repay short-term borrowings of $40.0 million, which we had borrowed under a credit facility with a U.S. bank, and for general corporate purposes.
On August 20, 2003, the 200,000 Class B Warrants originally issued as part of our initial public offering with a strike price of $15.00 were repurchased at a price of $8.00 per warrant or $1.6 million in aggregate.
On October 29, 2003 and November 14, 2003 we privately placed $30.0 million of trust preferred securities which were issued by trust subsidiaries holding thirty year $30.9 million aggregate principal amount subordinated notes of Scottish Holdings, Inc. which is guaranteed by Scottish Annuity & Life Insurance Company (Cayman) Ltd. Net proceeds were $29.0 million. Scottish Holdings, Inc. provided a $21.0 million capital infusion to its direct subsidiary Scottish Re (U.S.), Inc. and used the remainder of the net proceeds for general corporate purposes.
In order to provide additional capital to support the individual life reinsurance business acquired from ING we signed a securities purchase agreement on October 17, 2004, with the Cypress Entities. Pursuant to this agreement, we issued to the Cypress Entities on December 31, 2004:
(i) 3,953,183 ordinary shares, par value $0.01 per share (equal to 9.9% of the aggregate number of ordinary shares issued and outstanding on December 31, 2004, taking into account such issuance);
(ii) Class C Warrants to purchase 3,206,431 ordinary shares (equal to the difference between (A) 19.9% of the ordinary shares issued and outstanding on December 31, 2004 (without taking into account the issuance of ordinary shares pursuant to (i) above) and (B) the number of ordinary shares issued to the Cypress Entities as provided in (i) above); and
If the shareholders do not approve the Shareholder Proposals by June 30, 2005 (a "Failed Condition"), we will make additional payments on the Class C Warrants by paying cash equal to, on a per annum basis, 5% of the product of (i) the number of ordinary shares underlying the Class C Warrants then held by the Cypress Entities and (ii) the Purchase Price, or, Scottish Re Group Limited's option in lieu of cash, by issuing additional 7.00% Convertible Junior Subordinated Notes with an equivalent aggregate principal amount, such payment or issuance to be made on the business day immediately following the date of occurrence of the Failed Condition, and on each six-month anniversary thereafter, until the Shareholder Proposals have been approved. In addition, until the Shareholder Proposals have been approved, we will make an additional payment on the Class C Warrants equal to the dividend then currently payable on ordinary shares, which will be assumed to be no less than $0.20 per share per annum.
Holders of the 7.00% Convertible Junior Subordinated Notes do not have voting rights. The 7.00% Convertible Junior Subordinated Notes are unsecured obligations, subordinated to all indebtedness that does not by its terms rank pari passu or junior to the 7.00% Convertible Junior Subordinated Notes, including any guarantees issued by us in respect of senior or senior subordinated indebtedness. The accrued but unpaid interest on the 7.00% Convertible Junior Subordinated Notes will be payable in kind on December 1 and June 1 of each year, beginning June 1, 2005, by the issuance of additional 7.00% Convertible Junior Subordinated Notes of the same series, having the same terms and conditions as the 7.00% Convertible Junior Subordinated Notes and having a principal amount equal to the amount of such accrued and unpaid interest. However, (i) during the period from December 31, 2007 to December 31, 2014, we may at our option pay any of such accrued but unpaid interest in cash in lieu of in kind, and (ii) subsequent to December 31, 2014, the Cypress Entities may at their option receive any of such accrued but unpaid interest in cash in lieu of in kind.
In the event of a Failed Condition, the 7.00% Convertible Junior Subordinated Notes will bear interest at the Penalty Rate applied retroactively from December 31, 2004 until the earliest to occur of a cure of such condition, early redemption of the 7.00% Convertible Junior Subordinated Notes or the maturity thereof. The "Penalty Rate" means a rate per annum equal to, (i) if a Failed Condition occurs in 2005, 15% applicable through December 31, 2005, (ii) if a Failed Condition occurs or continues in 2006, 17% through December 31, 2006 and (iii) 19% thereafter.
We must have sufficient assets available for use as collateral to support borrowings, letters of credit, and certain reinsurance transactions. With these reinsurance transactions, the need for collateral or letters of credit arises in five ways:
o when Scottish Re (U.S.), Inc. enters into a reinsurance transaction, it typically incurs a need for additional statutory capital This need can be met by its own capital surplus, an infusion of cash or assets from Scottish Re or an affiliate or by ceding a portion of the transaction to another company within the group or an unrelated reinsurance company, in which case that reinsurer must provide reserve credit by contributing assets in a reserve credit trust or a letter of credit;
o Scottish Re (U.S.), Inc. is licensed, accredited, approved or authorized to write reinsurance in 50 states and the District of Columbia. When Scottish Re (U.S.), Inc. enters into a reinsurance transaction with a customer domiciled in a state in which it is not a licensed, accredited, authorized or approved reinsurer, it likewise must provide a reserve credit trust or letter of credit;
o Scottish Re Life Corporation is licensed, accredited, approved or authorized to write reinsurance in 50 states, the District of Columbia, Guam and the Federated States of Micronesia. When Scottish Re Life Corporation enters into a reinsurance transaction with a customer domiciled in a state in which it is not a licensed, accredited, authorized or approved reinsurer, it likewise must provide a reserve credit trust or letter of credit; and
On June 25, 2004, we closed a collateral finance facility with HSBC Bank USA, N.A. This facility provides $200.0 million that can be used to collateralize reinsurance obligations under intercompany reinsurance agreements. Simultaneously, we entered into a total return swap with HSBC Bank USA, N.A. under which we are entitled to the total return of the investment portfolio of the trust established in respect of this facility. As a result, the balances and activities of the trust have been consolidated in these financial statements.
On December 29, 2004, Scottish Annuity & Life Insurance Company (Cayman) Ltd., Scottish Re (Dublin) Limited, Scottish Re (U.S.), Inc., and Scottish Re Limited closed a $175.0 million, 364-day revolving credit facility with a syndicate of banks led by Bank of America, N.A. The facility provides capacity for borrowing and for extending letters of credit. The proceeds from the facility will be used for working capital, capital expenditures and general corporate purposes. The facility is a direct financial obligation of each of the borrowers; however, Scottish Annuity & Life Insurance Company (Cayman) Ltd. has guaranteed the payment of obligations of Scottish Re (Dublin) Limited, Scottish Re (U.S.), Inc., and Scottish Re.
maintain minimum capital and surplus equal to the greater of (i) $20 million or (ii) the amount necessary to prevent a company action level event from occurring under the risk based capital laws of Delaware. Our failure to comply with the requirements of the credit facility would, subject to grace periods, result in an event of default, and we could be required to repay any outstanding borrowings. At December 31, 2004 we were in compliance with the requirements of the facility. At December 31, 2004, there were no borrowings under the facilities. Outstanding letters of credit under these facilities amounted to $35.8 million as at December 31, 2004.
We also have a reverse repurchase agreement with a major broker/dealer. Under this agreement, we have the ability to sell agency mortgage backed securities with the agreement to repurchase them at a fixed price, providing the dealer with a spread that equates to an effective borrowing cost linked to one-month LIBOR. This agreement is renewable monthly at the discretion of the broker/dealer. At December 31, 2004, there were no borrowings under this agreement.
On January 12, 2005, Stingray Pass-Through Trust ("Pass-Through Trust") issued $325.0 million in aggregate principal amount of 5.902% collateral facility securities (the "Pass-Through Certificates") in a private transaction. On the same date, Pass-Through Trust used the proceeds of this issuance to purchase an aggregate principal amount of $325 million of 5.902% investor certificates (the "Investor Certificates") from Stingray Investor Trust ("Investor Trust"). Investor Trust used the proceeds of this issuance to purchase a portfolio of high-grade commercial paper notes. Under a Put Agreement between Investor Trust and Scottish Annuity & Life Insurance Company (Cayman) Ltd., the Investor Trust agrees to purchase at a pre-determined price Funding Agreements issued by Scottish Annuity & Life Insurance Company (Cayman) Ltd., up to any amount such that the aggregate face amount of Funding Agreements outstanding at any time does not exceed $325.0, in exchange for a portfolio of highly rated 30-day commercial paper. In consideration for the Investor Trust's agreement to purchase Funding Agreements, Scottish Annuity & Life Insurance Company (Cayman) Ltd. will pay the Investor Trust a Put Premium on a monthly payment date. Although Scottish Annuity & Life Insurance Company (Cayman) Ltd. participated in the transactions leading to the establishment of the Pass-Through Trust and the Investor Trust, the trusts are independent entities and are not owned, controlled or managed by Scottish Annuity & Life Insurance Company (Cayman) Ltd. The Pass-Through Certificates are direct financial obligations of the Pass-Through Trust, the Investor Certificates are direct financial obligations of the Investor Trust, and the Funding Agreements are a direct financial obligation of Scottish Annuity & Life Insurance Company (Cayman) Ltd. when and if issued.
On February 11, 2005, Orkney Holdings, LLC, a Delaware limited liability company, and a direct wholly-owned subsidiary of Scottish Re (U.S.), Inc., issued $850.0 million in aggregate principal amount of Series A Floating Rate Insured Notes due February 11, 2035 (the "Orkney Notes") in a private placement. The payment of scheduled interest payments under the Orkney Notes and the ultimate repayment of principal on February 11, 2035 are insured by MBIA Insurance Corporation, a New York stock insurance company, through a financial guaranty insurance policy (the "Orkney Notes Policy"). MBIA Insurance Corporation will not guarantee the payment of any redemption premium, the early repayment of principal on the Orkney Notes, taxes or shortfalls for withholding taxes. The Orkney Notes are direct financial obligations of Orkney Holdings, LLC, and no affiliate of Orkney Holdings, LLC, including without limitation neither us nor Scottish Re (U.S.), Inc., is an obligor or guarantor on the Orkney Notes.
o payment by MBIA Insurance Corporation under the Orkney Notes Policy, or advancement of funds for payment to the holders of the Orkney Notes;
o nonpayment of all, or part, of the principal of the Orkney Notes;
o failure to make payments to MBIA Insurance Corporation under ancillary agreements;
o bankruptcy, insolvency, reorganization, liquidation conservation, rehabilitation or other similar proceeding of Orkney Holdings, LLC or Orkney Re, Inc.
The Orkney Notes are not redeemable prior to February 11, 2010, unless Scottish Re (U.S.), Inc. has recaptured all or part of the business reinsured to Orkney Re, Inc. Such redemption would be on an Orkney Scheduled Payment Date, in cash, at 105% of the principal amount to be redeemed. Orkney Holdings, LLC may redeem all or part of the Orkney Notes on any Orkney Scheduled Payment Date between February 11, 2010 and February 11, 2017 at a redemption price equal to 103%, 102% or 101% of the principal amount, as determined by the specified Orkney Scheduled Payment Date, payable in cash. The Orkney Notes are redeemable at a redemption price equal to 100% of the principal amount, payable in cash, after February 11, 2017. Pursuant to an insurance and indemnity agreement with MBIA Insurance Corporation, Orkney Holdings, LLC is obligated to pay a periodic premium to MBIA Insurance Corporation in respect of the Orkney Notes Policy.
Scottish Annuity & Life Insurance Company (Cayman) Ltd. has agreed with Scottish Re (U.S.), Inc. that it will (1) cause Scottish Re, (U.S.), Inc. to maintain capital and surplus equal to the greater of $20.0 million or such amount necessary to prevent the occurrence of a Company Action Level Event under the risk-based capital laws of the state of Delaware and (2) provide Scottish Re (U.S.), Inc. with enough liquidity to meet its obligations in a timely manner.
Our long-term debt is described in Note 18 to the Consolidated Financial Statements. Long term debt includes $115.0 million 4.5% senior convertible notes which are due December 1, 2022. The notes are subject to repurchase by us at a holder's option at various dates, the earliest of which is December 6, 2006. Long term debt also includes capital securities with various maturities from 2032 onwards. They are however, redeemable at earlier dates. They have been included in the above table at the earliest redemption date. We have not included in the table above 7.00% Convertible Junior Subordinated Notes payable to the Cypress Entities as described in Note 17 to the Consolidated Financial Statements as they are expected to convert into shares on shareholder approval in 2005.
Amounts due under funding agreements are reported in interest sensitive contract liabilities. These are agreements in which we earn a spread over LIBOR. The contractual repayment terms are detailed in the table above.
Amounts due under interest sensitive contract liabilities, (excluding funding agreements) and reserves for future policy benefits are estimated using the discounted projected net cash flow arising from premiums, fees, death benefits, surrender benefits, contractual expenses and commissions.
On December 31, 2004, we completed the acquisition of the individual in-force life reinsurance business of ING. ING has agreed to provide certain transition services to support the acquired business for up to 18 months from the date of acquisition at a cost of $6.6 million.
In July 2003, the Accounting Standards Executive Committee issued Statement of Position 03-01 ("SOP"), "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Insurance Contracts and for Separate Accounts". This SOP provides guidance on accounting and reporting by insurance enterprises for certain nontraditional long-duration contracts and for separate accounts and is effective for financial statements for fiscal years beginning after December 15, 2003. In implementing the SOP we have made various determinations, such as qualification for separate account treatment, classification of securities in separate account arrangements, significance of mortality and morbidity risk, adjustments to contract holder liabilities, and adjustments to estimated gross profits as defined in SFAS No. 97, "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments". Implementation of this SOP has not had a material effect on our financial statements.
In January 2003, the Financial Accounting Standards Board (FASB) issued FASB Interpretation 46, "Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51" ("FIN 46"). FIN 46 provides a framework for identifying variable interest entities and determining when a company should include its assets, liabilities, non-controlling interests and results of activities in the consolidated financial statements. A variable interest entity is a legal structure used to conduct activities or hold assets that either (1) has an insufficient amount of equity to carry out its principal activities without additional subordinated financial support, (2) has a group of equity owners that are unable to make significant decisions about its activities, or (3) has a group of equity owners that do not have the obligation to absorb losses or the right to receive returns generated by its operations. FIN 46 requires a variable interest entity to be consolidated if a party with an ownership, contractual or other financial interest in the variable interest entity is obligated to absorb a majority of the risk of loss from the variable interest entity's activities, is entitled to receive a majority of the variable interest entity's residual returns, or both. A variable interest holder that consolidates the variable interest entity is called the primary beneficiary. We are the primary beneficiary of the collateral finance facility discussed in note 16 and thus have consolidated the variable interest entity in accordance with FIN 46.
During the quarter ended September 30, 2004, EITF 04-8 "The Effect of Contingently Convertible Debt on Diluted Earnings Per Share" was issued. EITF 04-8 requires that certain instruments with embedded conversion features that are contingent upon market price triggers be included in diluted earnings per share calculations regardless of whether the contingency has been met. Our 4.5% senior convertible notes are convertible on the basis of a market price trigger. On October 26, 2004 we amended the terms of these notes so that we are required to settle the principal amount of $115.0 million in cash on conversion or repurchase. As a result we shall continue to apply the treasury stock method in calculating diluted earnings per share for amounts in excess of the principal of $115.0 million.
In December 2004, the FASB issued a revision to Statement of Financial Accounting Standard No. 123, "Accounting for Stock-Based Compensation" (SFAS 123R). This statement requires us to recognize in the determination of income , the grant date fair value of all stock options and other-equity based compensation issued to employees. It is effective for the interim period commencing after June 15, 2005. As described in note 2 to our financial statements, we have currently adopted SFAS 148 in relation to our stock options and are therefore expensing our equity based compensation issued after January 1, 2002. The adoption of SFAS 123R is expected to reduce net income in 2005 by less than $400,000.
with respect to our known and unknown risks, uncertainties and other factors, which may cause the actual results to differ materially from the forward-looking statements. Words such as "anticipates," "expects," "intends," "plans," "believes," "seeks," "estimates," "may," "will," "continue," "project" and similar expressions, as well as statements in the future tense, identify forward-looking statements.
These forward-looking statements are not guarantees of our future performance and are subject to risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements. These risks and uncertainties include:
o the risk that our risk analysis and underwriting may be inadequate;
o terrorist attacks on the United States and the impact of such attacks on the economy in general and on our business in particular;
The effects of these factors are difficult to predict. New factors emerge from time to time and we cannot assess the potential impact of any such factor on the business or the extent to which any factor, or combination of factors, may cause results to differ materially from those contained in any forward-looking statement. Any forward-looking statement speaks only as of the date of this report and we do not undertake any obligation, other than as may
be required under the Federal securities laws, to update any forward-looking statement to reflect events or circumstances after the date of such statement or to reflect the occurrence of unanticipated events.