Scottish Re Life Corporation was acquired on December 22, 2003 and is included in balance sheet data and income statement data for years 2003-2006. Consolidated statement of income data for the year ended December 31, 2003 includes net income of $1.2 million in respect of Scottish Re Life Corporation.
(2) Reflects reduction for dividends declared on non-cumulative perpetual preferred shares.
(3) Book value per share is calculated as shareholders' equity divided by the number of ordinary shares outstanding.
The most important factors we monitor to evaluate our financial condition and performance includes:
Premiums from reinsurance assumed on life business are included in revenues over the premium paying period of the underlying policies. When we acquire blocks of in-force business, we account for these transactions as purchases, and our results of operations include the net income from these blocks as of their respective dates of acquisition. Reinsurance assumed on annuity business does not generate premium income but generates investment income over time on the assets we receive from the ceding company. We also earn revenues on funding agreements. A deposit received on a funding agreement also does not generate premium income but does create income to the extent we earn an investment return in excess of our interest payment obligations thereon.
In connection with reinsurance of annuity and annuity-type products, we record a liability for interest sensitive contract liabilities, which represents the amount ultimately due to the policyholder. We credit interest to these contracts each period at the rates determined in the underlying contract, and the amount is reported as interest credited to interest sensitive contract liabilities on our consolidated statements of income (loss).
A portion of the costs of acquiring new business, such as commissions, certain internal expenses related to our policy issuance and underwriting departments and other variable selling expenses are capitalized. The resulting deferred acquisition costs asset is amortized over future periods based on our expectations as to the emergence of future gross profits from the underlying contracts. These costs are dependent on the structure, size and type of business written. For certain products, we may retrospectively adjust our amortization when we revise our estimate of current or future gross profits to be realized. The effects of this adjustment are reflected in earnings in the period in which we revise our estimate. Acquisition costs also include letter of credit costs although this amount has decreased significantly in the past two years due to the collateral finance transactions we have completed for which the cost is included in collateral finance facility expense.
Collateral finance facilities expense includes costs incurred on our Regulation XXX funding arrangements and other collateral finance facilities. See Note 7 to the Consolidated Financial Statements for additional information.
o volume and amount of death claims incurred and lapse experience;
o our ability to assess and price adequately for the risks we assume;
o changes in our assessment of the realizability of deferred tax assets;
o the mix of different types of business that we reinsure, because profits on some lines of business emerge later than on other lines;
Given the nature of our business, our accounting policies require the use of judgments relating to a variety of assumptions and estimates. Because of the inherent uncertainty in the assumptions and estimates underlying these accounting policies under different conditions or assumptions, the amounts reported in our financial statements could be materially different. Our accounting policies are described in Note 2 to the Consolidated Financial Statements. We believe our most critical accounting policies include the establishment of reserves for future policy benefits, the capitalization and amortization of deferred acquisition costs, the valuation of present value of in-force business, the valuation of investment impairments, estimates of premiums, the valuation of tax balances and the determination of whether we are the primary beneficiary of a variable interest entity.
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, reserves for future policy benefits are computed based upon expected mortality rates, lapse rates, investment yields, expenses and other assumptions established at policy issue, including a margin for adverse deviation. Once these assumptions are made for a given treaty or group of treaties, they will not be changed over the life of the treaty. We periodically review actual historical experience and relative anticipated experience compared to the assumptions used to establish reserves for future policy benefits. Further, we determine whether actual and anticipated experience indicates that existing policy reserves together with the present value of future gross premiums are sufficient to cover the present value of future benefits, settlement and maintenance costs and to recover unamortized acquisition costs. Significant changes in experience or assumptions may require us to provide for expected losses on a group of treaties by establishing additional net reserves. Because of the many assumptions and estimates used in establishing reserves and the long-term nature of the reinsurance contracts, the reserving process, while based on actuarial science, is inherently uncertain.
We primarily rely on our own valuation and administration systems to establish reserves for future policy benefits. The reserves for future policy benefits may differ from those established by ceding companies due to the use of different assumptions, based principally on actual and anticipated experience, including industry experience and standards. We rely on our ceding companies, however, to provide accurate policy level data, including face amount, age, duration and other characteristics as well as underlying premiums and claims. This data constitutes the primary information used to establish reserves for essentially all of our future policy benefits. The use of reinsurance intermediaries in our transactions with ceding companies has been infrequent. In the few instances in which intermediaries are involved, we receive data from the intermediary in a similar timeframe and fashion as if received directly from the ceding company.
analysis of incurred but not reported losses, including lag studies, on a quarterly basis and adjust our claim liabilities accordingly. The adjustments in a given period have generally not been significant relative to the overall reserves for future policy benefits or our results of operations.
Our primary investments are in fixed maturity securities, including corporate and government bonds, asset and mortgage-backed securities. All of our fixed maturity and preferred stock are classified as available-for-sale as defined in SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities". Available-for-sale securities are carried at fair value with the difference from amortized cost included in shareholders' equity as a component of accumulated other comprehensive income. The difference is net of related deferred acquisition costs and taxes. Fair values for fixed maturity securities are based on quoted market prices, where available. For fixed maturity securities that are not actively traded, fair values are estimated using values obtained from independent pricing services.
Management reviews securities with material unrealized losses and tests for other than temporary impairments on a quarterly basis. Factors involved in the determination of potential impairment include fair value as compared to cost, length of time the value has been below cost, credit worthiness of the issuer, forecasted financial performance of the issuer, position of the security in the issuer's capital structure, the presence and estimated value of collateral or other credit enhancement, length of time to maturity, interest rates and our intent and ability to hold the security until the market value recovers. When a decline is considered to be "other-than-temporary" the cost basis of the impaired asset is adjusted to its fair value and a corresponding realized investment loss is recognized in the consolidated statements of income (loss). The actual value at which such financial instruments could actually be sold or settled with a willing buyer may differ from such estimated fair values.
Our results of operations for the year ended December 31, 2004 do not include the results of the acquisition of the ING individual life reinsurance business, which was completed on December 31, 2004. All amounts are reported in thousands of United States dollars, except per share amounts.
Total revenues increased by 7% in 2006 to $2,451.5 million compared to $2,297.3 million in 2005. Net premiums earned decreased by 5% in 2006 to $1,842.0 million compared to $1,933.9 million in 2005. Net premiums for the year were adversely affected by our ratings downgrades, which negatively affected new business volume, increased retrocession costs and the adverse effect of certain adjustments in 2006 to revise previous estimates related to premium accrual estimates, estimates for external retrocession premiums due, experience refunds and cedant balance true-ups.
The net realized loss in 2006 was $27.4 million compared to a net gain of $3.7 million in 2005. The majority of the realized losses related to the selling of investments in preparation of funding the Ballantyne Re transaction along with losses incurred from the rebalancing of an investment portfolio related to a specific annuity agreement.
The change in value of the embedded derivatives arises from the application 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
Total benefits and expenses increased by 19% in 2006 to $2,599.0 million compared to $2,183.7 million in 2005. The increase was principally due to $167.6 million higher collateral finance facilities expense as a result of our Regulation XXX transactions completed in December 2005 and May 2006, reduced slightly by $11.7 million due to lower letter of credit costs, higher than expected mortality, adverse lapse experience and additional operating expenses due to increased headcount, severance, legal fees, directors' fees and other costs related to the sale of the company that could not be capitalized. In addition, based on a reassessment of the in-force and new business profits of the Life Reinsurance International Segment, goodwill of approximately $34.0 million was written-off and approximately $12.0 million of deferred acquisition costs were deemed unrecoverable.
Income tax expense in 2006 was $220.6 million compared to an income tax benefit of $16.4 million in 2005. The change in our effective tax rate in 2006 compared to 2005 is primarily related to a valuation allowance established on deferred tax assets during the year. The valuation allowances primarily resulted from the actual results of legal entity statutory income and movements in statutory reserves for the period combined with a reassessment of certain tax planning strategies.
We generate deferred tax assets principally due to net operating losses, reserves and unrealized losses on investment securities. In accordance with SFAS No. 109, we must conclude whether the future realization of our deferred tax asset is "more likely than not". The evaluation regarding realizability of deferred tax assets is made on a gross as opposed to a net basis. Sources of support for the gross deferred tax asset are the reversal of deferred tax liabilities within the carry forward period (which in the United States for life insurance companies is 15 years), projected future taxable income and tax planning strategies. Pursuant to the guidance under SFAS No. 109, we are currently unable to rely on projections of future taxable income. Therefore, we must rely on tax planning strategies for support of the gross deferred tax asset.
During the second half of 2006, we formally requested the South Carolina Department of Insurance to approve such a change in our accounting basis. However, in February the South Carolina Department of Insurance indicated that our request for a change in accounting basis would not be granted. Accordingly, our tax planning strategy was determined to no longer be prudent and feasible and we established a valuation allowance of approximately $91.0 million in the fourth quarter of 2006.
Net income increased by 82%, or $58.8 million, in 2005 compared to 2004 due to the reasons outlined above.
Premiums earned during 2006 decreased 5% to $1,719.2 million compared to $1,814.9 million in 2005. A portion of this decrease was due to a curtailment of a number of large treaties immediately following the ING acquisition that did not meet our risk management criteria and a shift in business mix from coinsurance to yearly renewable term life reinsurance. Also impacting premiums were adjustments in the second quarter of 2006 related to revisions of certain estimates. We recorded an adjustment to reduce premiums by approximately $4.0 million as a result of a revision of estimates relating to 2005. This adjustment related principally to the ING block and resulted from the unusual activity in premium levels post acquisition which made the use of historical trends less effective in estimating current period accruals. In addition, as a result of an initiative to improve the quality of our external retrocession data and related administration systems, we made a number of revisions to the estimates and underlying assumptions used in calculating our retrocession premiums. As a result, during the second quarter of 2006, we recorded an additional retrocession adjustment of approximately $13.0 million. In connection with our periodic internal review of the underlying performance of our treaties, we recorded a $16.5 million experience refund adjustment that reduced our third quarter of 2006 premiums. These experience refunds related to underlying profitability of specific assumed treaties, most notably within our ING block. Treaty provisions for these contracts permit our clients to participate in the overall profitability of the business, assuming certain financial measurement thresholds are met. In the fourth quarter of 2006, we recorded a $5.3 million collectability allowance pertaining to accruals for recoveries of retroceded premiums. Experience refunds on retroceded business were approximately $9.0 million favorable in 2006. These experience refunds are directly related to our underlying mortality experience. The above favorable amount partially offsets the adverse mortality experienced in 2006, as discussed below.
Our pricing and actuarial projection models include various lapse assumptions by treaty and by product type which are based on historical experience and industry expectations. While our actual lapse experience during the third and fourth quarters of 2006 was only slightly lower in the aggregate than expected, we noted that the lapse distribution pattern was such that certain policies had higher than average lapses while others had lower than average lapses. However, the policies with higher lapses had the higher margins and the policies with lower lapses had the lower margins, thereby reducing our earnings against expectations by approximately $13 million and $14 million in the third and fourth quarters of 2006, respectively.
Related to the improvement in retrocession data and related administration systems, we revised our estimates based on refinements of certain of our calculations and processes for the net cost of reinsurance. The impact of these changes resulted in an adjustment which increased our claims and other policy benefits by approximately $8 million in the second quarter of 2006. During the third quarter of 2006, and in connection with ongoing initiatives to improve the quality of our cedant information, we received updated claims totaling $9.2 million relating to the 2004 and 2005 years. Although the increased claims from cedant reporting were largely mitigated by offsetting premium adjustments, they had the impact of artificially increasing the claims and benefits ratio for the year. Finally, as noted above, there was a reserve fluctuation on the equity-indexed annuity contract of approximately $19.8 million which impacted 2006 claims.
Interest credited to interest sensitive contract liabilities increased 30% to $173.0 million in 2006 compared to $133.0 million in 2005. The increase was principally due to the previously described equity-indexed annuity contract written in late 2005, along with increases in interest credited on existing treaties due to increasing average liability balances. During the third quarter of 2006, we terminated four funding agreements, resulting in a decrease to our interest sensitive contract liabilities of approximately $650.0 million.
Acquisition costs and other insurance expenses decreased 10% to $360.7 million in 2006 compared to $401.0 million in 2005. Acquisition costs and other insurance expenses as a percentage of net earned premiums for 2006 and 2005 were 21% and 22%, respectively. During the second quarter of 2006, we recorded adjustments of $13.0 million to increase deferred acquisition cost amortization related to several deferred fixed annuity treaties in which emerging lapse experience was significantly higher than expected. This adjustment was partially offset as we received a $6.2 million rebate from ING as a result of the Ballantyne Re securitization (a similar rebate of $6.7 million was received in 2005 resulting from our 2005 collateral finance facility transactions). Excluding the ING rebate, letter of credit fees have declined in 2006 by $18.8 million as a result of the Regulation XXX transactions completed in December 2005 and May 2006. During the fourth quarter of 2006, a client review revealed usage of an incorrect allowance percentage by the client resulting in a $6.6 million favorable adjustment. The 2005 acquisition costs were impacted by a $17.7 million adjustment which increased acquisition costs with a corresponding decrease to the change in reserves related to the purchase accounting adjustments for the ING block.
Operating expenses for 2006 increased 19% to $58.1 million compared to $48.8 million in 2005. Operating expenses as a percentage of operating revenues (total revenues excluding realized gains and losses and changes in the value of embedded derivatives) were 2.5% and 2.3% for 2006 and 2005, respectively. The overall increase in operating expenses related primarily to an overall increase in headcount in 2006 compared to 2005, executive severance costs of $3.1 million and increases in compensation costs, legal fees and depreciation expenses. Partially offsetting these amounts was a $1.2 million reduction in restricted share expense in 2006 compared to 2005 related to the reversal of previously recognized expense in accordance with SFAS No. 123(R), combined with lower consulting fees and technical service fees paid to ING.
Net investment income increased by $135.5 million, or 66% in 2005 compared to 2004. The increase was due to the growth in our average invested assets base because of the ING acquisition, Regulation XXX financing transactions, increased operating cash flows and additional trust preferred securities issued in December 2004.
On the portfolio managed by our external investment managers, the yields on fixed rate assets (5.2%) did not change in 2005 compared to 2004. Yields on floating rate assets, which are indexed to LIBOR, increased to 4.9% in 2005 from 3.4% in 2004, and the yield on our cash and cash equivalents increased to 3.9% in 2005 from 1.8% in 2004.
Operating expenses for 2005 compared to 2004 increased by $30.4 million, or 165%. The increase was primarily the result of the ING acquisition and additional personnel and consulting costs incurred as we expanded our infrastructure in response to our recent and anticipated growth. We increased our head count principally because of hiring additional employees in respect of the acquisition of the ING business and adding management bench strength in key functional areas across the segment. Total employees in this segment have grown from 91 at December 31, 2004 to 226 at December 31, 2005. Operating expenses as a percentage of operating revenues decreased from 2.7% in 2004 to 2.3% in 2005 reflecting the benefits of scale and a portion of the benefits of the integration of ING into our existing operations.
Investment income in 2005 increased by $1.5 million, or 15%, compared to 2004 due to the investment income earned on the proceeds of additional capital contributed to this segment in December 2004 and June 2005.
Claims and other policy benefits decreased to $76.9 million, or 6%, in 2005 compared to 2004. During 2005, additional information was received from ceding companies that resulted in a review of policy benefits on certain lines of business and a decrease of $7.9 million in claims and other policy benefits. This was partially offset by an increase of $5.3 million due to revised reporting received on our share of two Lloyd's of London life syndicates. In addition, claims and other policy benefits in 2005 were impacted by the lower levels of premiums written during 2005 and revisions to premium accruals described above.
Operating expenses increased by 34% to $25.3 million in 2005 as compared to 2004. The primary drivers of the increase were $3.0 million relating to consulting fees for the review, design and implementation of processes and controls required to assist us in the remediation of the material weakness in internal controls noted in 2004. The remaining increase was principally related to personnel costs from increased headcount as we continue to grow our business and include costs for recruitment expenses and professional expenses incurred in addressing implementation of the requirements of the Sarbanes Oxley Act of 2002 and United Kingdom regulatory changes. The number of employees in this segment has grown as we continue to strive to grow our business in existing and prospective markets.
Acquisition costs and other insurance expenses increased by 439% in 2006 to $11.1 million compared to $2.1 million in 2005. The increase is partially due to a $4.3 million write-off of a portion of our deferred acquisition costs and present value of in-force business related to our wealth management business resulting from the impact of our ratings downgrades. In addition, we incurred $3.1 million of costs in 2006 for the Tartan Capital Limited catastrophe bond issued in May 2006 and $1.0 million for federal excise taxes, which had previously been charged to the Life Reinsurance North America segment prior to 2006.
Operating expenses include the costs of running our principal office in Bermuda, our senior executive officers, legal and capital markets departments, compensation and other costs for our Board of Directors and legal
and professional fees, including those in respect of corporate governance legislation and regulations. Operating expenses increased by 52% in 2006 to $62.9 million compared to $41.4 million in 2005. Salaries were $9.3 million higher due to $6.5 million of severance paid to certain executives with the balance of the increase related to a higher headcount in 2006 as compared to 2005. Directors' costs were approximately $3.0 million higher as a result of the formation of the Office of the Chairman to assist in the sale of the Company and higher D&O insurance costs. Also related to the sale of the Company were various uncapitalizable costs of approximately $5.0 million. Finally, legal costs were higher in 2006 related to the class action suit, the SEC and Senate Subcommittee subpoenas and other various matters. These higher costs were partially offset by $1.5 million of lower benefit costs, mainly relating to a reversal of accruals for performance based restricted stock awards. It was determined that the performance thresholds related to these awards were unlikely to be met and in accordance with FAS 123(R), previously recognized costs were reversed in the third quarter of 2006.
Operating expenses include the costs of running our principal office in Bermuda, our senior executive officers, legal and capital markets departments, compensation and other costs for our Board of Directors and legal and professional fees, including those in respect of corporate governance legislation and regulations. Operating expenses increased by 137% to $41.4 million in 2005 from $17.5 million in 2004. The increases were principally due to increased personnel costs, including recruitment and relocation costs, as we continue to grow our business, the costs of option and restricted stock unit awards granted under our equity incentive compensation plans and professional fees of approximately $7.0 million incurred in respect of the implementation of the requirements of the Sarbanes-Oxley Act of 2002.
The collateral finance facilities expense consisted of a portion of the put premium and amortization of facility costs on the Stingray facility described in Note 7 to the Consolidated Financial Statements. Expenses related to the proportion of the Stingray facility utilized in 2005 have been allocated to the Life Reinsurance North America segment.
In the table below are the total returns earned by our portfolio in 2006, compared to the returns earned by three indices: the Lehman Brothers Global Bond Index, the S&P 500 and a customized index that we developed to take into account our investment guidelines and the risk characteristics of the underlying liabilities. We believe that this customized index is the most relevant benchmark for our portfolio's performance.
Year Ended December 31, 2006 --------------------------- Portfolio performance............................ 4.58% Customized index................................. 4.21% Lehman Brothers Global Bond Index................ 3.64% S&P 500.......................................... 15.78%
December 31, 2006 December 31, 2005 ------------------------ -------------------------- Ratings $ in millions % $ in millions % - ------- ------------------------ -------------------------- AAA............... $ 3,350.5 38.5% $ 3,017.4 44.8% AA................ 2,353.1 27.0 1,069.1 15.9 A................. 2,050.9 23.6 1,646.9 24.4 BBB............... 918.5 10.6 977.7 14.5 BB or below....... 24.9 0.3 28.0 0.4 --------- ----- -------------- ----- Total............. $ 8,697.9 100.0% $ 6,739.1 100.0% ========= ===== ============== =====
The following table illustrates the fixed income investment portfolio sector exposure.
At December 31, 2006, our fixed income portfolio had 2,967 securities and $79.9 million of gross unrealized losses. No single position had an unrealized loss greater than $1.3 million. There were $41.6 million of unrealized gains on the remainder of the portfolio. There were 128 private securities in an unrealized loss position totaling $5.1 million. At December 31, 2005, our fixed income portfolio had 2,493 positions and $59.2 million of gross unrealized losses. No single position had an unrealized loss greater than $0.5 million. There were $25.5 million of unrealized gains on the remainder of the portfolio. There were 127 private securities in an unrealized loss position totaling $4.3 million in our fixed income portfolio.
Unrealized losses on securities that have been in an unrealized loss position for periods greater than two years amounted to $7.8 million at December 31, 2006 and $1.1 million at December 31, 2005. Unrealized losses on non-investment grade securities amounted to $1.7 million and $1.3 million at December 31, 2006 and December 31, 2005, respectively. Of these amounts, non-investment grade securities with unrealized losses of $1.3 million at December 31, 2006 and $0.1 million at December 31, 2005 had been in an unrealized loss position for a period greater than one year.
The expected maturity dates of our fixed maturity investments that have an unrealized loss at December 31, 2006 and 2005 are presented in the table below.
At December 31, 2006, there were 1,796 securities with unrealized loss positions, with two securities having an unrealized loss greater than $1.0 million. At December 31, 2005, there were 1,698 securities with unrealized losses: no securities had an unrealized loss greater than $0.5 million. The increase in the number of securities with unrealized losses is primarily attributable to increases in interest rates.
At December 31, 2006, there were three securities with a fair value 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 this security amounted to $0.8 million. At December 31, 2005 there was one security 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 this security amounted to $0.5 million.
The following tables provide details of the sales proceeds, realized loss, length of time the security had been in an unrealized loss position and reason for sale for securities sold with a realized loss during 2006, 2005 and 2004.
We use various asset/liability management processes to provide adequate liquidity over the lives of the liabilities and to limit exposure to changes in interest rates, adverse credit default experience and currency risk.
Liquidity expectations and requirements vary with the type of liability. For liabilities with potentially greater liquidity demands, we select more liquid assets and run more frequent simulations reflecting updated experience.
December 31, 2006 December 31, 2005 -------------------------- ------------------------- Ratings $ Millions % $ Millions % - ------- ------------- ---------- ------------- --------- AAA............... $ 427.5 22.1% $ 705.9 27.4% AA................ 166.6 8.6 146.0 5.7 A................. 561.1 29.0 741.6 28.9 BBB............... 605.6 31.3 785.8 30.6 BB or below....... 75.1 3.9 78.0 3.0 ------------- ---------- ------------- --------- 1,835.9 94.9 2,457.3 95.6 Commercial mortgage loans.... 98.8 5.1 112.6 4.4 ------------- ---------- ------------- --------- Total............. $ 1,934.7 100.0% $ 2,569.9 100.0% ============= ========== ============= =========
December 31, 2006 December 31, 2005 ---------------------- ------------------ Sector $ Millions % $ Millions % - ---- ------------ ------- ---------- ----- U.S. Treasury securities and U.S. government agency obligations .... $ 58.8 3.0% $ 62.3 2.4% Corporate securities ............... 1,323.7 68.4 1,634.4 63.6 Municipal bonds .................... 29.9 1.6 33.0 1.3 Mortgage and asset backed securities ....................... 463.4 24.0 595.1 23.1 Commercial mortgage loans .......... 98.9 5.1 112.5 4.4 Cash ............................... (40.0) (2.1) 132.6 5.2 ------------ ------- ---------- ------ Total .............................. $ 1,934.7 100.0% $ 2,569.9 100.0% ============ ======= ========== ======
Net cash provided by operating activities amounted to $462.9 million in 2006 compared to net cash provided by operating activities of $365.7 million in 2005. 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. During 2006, $442.3 million of funds withheld were released as a result of the Ballantyne Re transaction.
We believe cash flows from operations will be positive over time. However, they may be positive or negative in any one period depending on the amount of new life reinsurance business written, the level of ceding commissions paid in connection with writing that business, the level of renewal premiums earned in the period and the timing of receipt of reinsurance receivables and settlement of reinsurance payables.
See Notes 8, 9, 10 and 11 of the Consolidated Financial Statements for additional details on the items noted in the table.
In connection with the December 23, 2005 ordinary share offering, we entered into forward sales agreements with affiliates of Bear, Stearns & Co. Inc. and Lehman Brothers, Inc. (the "forward purchasers") and the forward purchasers borrowed and sold an aggregate of approximately 3,150,000 ordinary shares as their initial hedge of the forward sale agreements. Pursuant to the forward sale agreements, the forward purchasers agreed to pay us an aggregate of approximately $75.0 million on September 29, 2006 and an aggregate of approximately $75.0 million on December 29, 2006, subject to our right to receive a portion of such payment prior to the settlement dates. In exchange, on each of such dates we would deliver to the forward purchasers a variable number of ordinary shares based on the average market price of the ordinary shares, subject to a floor price of $22.80 and a cap price of $28.80. We also had the right to net share settle or cash settle the forward sale agreements. The fair value of the forward sales agreements at inception was reflected in shareholders' equity (as a reduction in additional paid-in capital). In addition, the underwriting costs of the forward sales agreements were reflected in shareholders' equity (as a reduction in additional paid-in capital).
On June 26, 2006, we exercised our right of prepayment under the forward sale agreements and received 75% of the $150.0 million proceeds totaling $110.0 million, net of prepayment discounts of $2.5 million. This prepayment was recorded as a separate component of consolidated shareholders' equity. The total amount of the discount related to the prepayment transaction was recorded as an imputed dividend charge over the applicable contract settlement period.
On August 9, 2006, the forward purchasers notified us of the occurrence of "Increased Cost of Stock Borrow" under the forward sale agreements and proposed price adjustments thereto. Pursuant to the forward sales agreements, upon receipt of such notification, we were entitled to elect to (a) agree to amend the transactions to take into account the price adjustments; (b) pay the forward purchasers an amount corresponding to the price adjustments; or (c) terminate the transactions. On August 11, 2006, the forward purchasers proposed an amendment to the forward sales agreements which provided us an additional alternative, the acceleration of the scheduled maturity date to August 14, 2006 under each of the forward sales agreements. We agreed to this amendment on August 14, 2006. On August 17, 2006, we received cash proceeds of $36.5 million and issued 6,578,948 ordinary shares, which satisfied in full our obligation to deliver shares pursuant to the forward sales agreements and the forward purchasers' obligations to pay us under such agreements. An imputed dividend was charged to earnings based on the pro-rated amount of time that elapsed from the original prepayment date until settlement date. The balance of the discount reduced the net proceeds on issuance of shares.
Upon the settlement of the forward sales agreements, we have received $147.3 million in the aggregate and issued an aggregate 6,578,948 ordinary shares.
In accordance with the forbearance agreement with HSBC, we are prohibited from declaring any cash dividend, exclusive of the non-cumulative perpetual preferred shares during the forbearance period from November 26, 2006 until December 31, 2008, unless at the time of declaration and payment of cash dividend, Scottish Annuity & Life Insurance Company (Cayman) Ltd. has an insurer financial strength rating of at least A- for Standard & Poor's and A3 for Moody's Investors Service.
o When Scottish Annuity & Life Insurance Company (Cayman) Ltd., Scottish Re (Dublin) Limited or Scottish Re Limited enter into a reinsurance treaty with a U.S. customer, they must contribute assets into a qualifying reserve credit trust and/or provide a letter of credit to enable the U.S. ceding company to obtain a reserve credit for the reinsurance transaction since these companies are not licensed or accredited U.S. reinsurers.
o When Scottish Re (U.S.), Inc. enters into a reinsurance transaction, it typically incurs a need for additional statutory capital to cover strain from acquisition costs and increases in required risk-based capital. To the degree its own surplus is not sufficient to meet this need, we can make an additional capital contribution into Scotitsh Re (U.S.), Inc. or Scottish Re (U.S.), Inc. can cede a portion of the transaction to another company within the group or an unrelated reinsurance company. If that reinsurer is not a licensed or accredited U.S. reinsurer, it must contribute assets to a qualifying reserve credit trust and/or provide a letter of credit in order for Scottish Re (U.S.), Inc. to obtain reserve credit. Scottish Re (U.S.), Inc. has ceded significant amounts of business to Scottish Re (Dublin) Limited, relieving Scottish Annuity & Life Insurance Company (Cayman) Ltd. of the need to contribute substantial amounts of capital to Scottish Re (U.S.), Inc. in connection with such cessions by Scottish Re (U.S.), Inc. to Scottish Re (Dublin) Limited, Scottish Re (Dublin) Limited must contribute eligible assets to qualifying reserve credit trusts and/or provide letters of credit to provide Scottish Re (U.S.), Inc. with reserve credit.
The first transaction is a 20 year collateral finance facility with HSBC that provides up to $1.0 billion of collateral to satisfy Regulation XXX statutory reserve requirements ("HSBC II") and is in addition to the facility with HSBC that was originally completed in 2004 ("HSBC I"). The second arrangement is a long-term reinsurance facility ("Reinsurance Facility") with a third-party Bermuda reinsurer which provides collateral to secure Regulation XXX statutory reserve requirements in an amount up to $1.0 billion. The Bermuda reinsurer provides security in the form of letters of credit in trust equal to the statutory reserves. Finally, in 2006 we completed the Ballantyne Re securitization in a private offering of $1.74 billion of debt to external investors and $178.0 million of debt to Scottish Annuity & Life Insurance Company (Cayman) Ltd. These transactions have allowed us to secure within eighteen months of the ING acquisition financing for almost all of the Regulation XXX reserves business acquired from ING. These transactions replaced ING collateral and resulted in a refund from ING for fees incurred of $6.7 million in 2005 and $6.2 million in 2006.
In 2004, we entered into a collateral finance facility with HSBC ("HSBC I"). This facility provides up to $200.0 million that can be used to collateralize reinsurance obligations under inter-company reinsurance agreements. Simultaneously, we entered into a total return swap with HSBC under which we are entitled to the total return of the investment portfolio of the trust established for this facility. In accordance with FIN 46R, the trust is considered to be a variable interest entity and we are deemed to hold the primary beneficial interest in the trust. As a result, the trust has been consolidated in our financial statements. The assets of the trust have been recorded as fixed maturity investments. Our consolidated statements of income (loss) show the investment return of the trust as investment income and the cost of the facility is reflected in collateral finance facilities expense. The creditors of the trust have no recourse against our general assets. As at December 31, 2006, approximately $188.5 million of this facility was being utilized.
Due to the rating agency downgrades after our announcement of earnings for the second quarter of 2006, HSBC requested additional collateral under the total return swap agreements related to both HSBC I and HSBC II (see below). In exchange for us agreeing to provide HSBC with additional collateral of up to $65.0 million, HSBC agreed to forbear from demanding any amounts of additional collateral through December 6, 2006. To date, we have provided HSBC with $65.0 million of additional collateral.
The holders of the Orkney Notes cannot require repayment from us or any of our subsidiaries, other than Orkney I. The timely payment of interest and ultimate payment of principal for the Orkney Notes are guaranteed by MBIA Insurance Corporation.
The holders of the Orkney II Notes cannot require repayment from us or any of our subsidiaries, only from Orkney II. Assured Guaranty (UK) Ltd. has guaranteed the timely payment of the scheduled interest payments and the principal on the maturity date, December 21, 2035, of the Series A-1 Notes.
In accordance with FIN 46R, Orkney II is considered to be a variable interest entity and we are considered to hold the primary beneficial interest. As a result, Orkney II has been consolidated in our financial statements. The assets of Orkney II have been recorded as fixed maturity investments and cash and cash equivalents. Our consolidated statements of income (loss) show the investment return of Orkney II as investment income and the cost of the facility is reflected in collateral finance facilities expense.
On May 2, 2006, Ballantyne Re plc, an orphan special purpose vehicle incorporated under the laws of Ireland issued in a private offering $1.74 billion of debt to external investors and $178.0 million of debt to Scottish Annuity & Life Insurance Company (Cayman) Ltd. The total debt issued to external investors (collectively, the "Notes") consisted of:
o $500.0 million of Class A-2 Floating Rate Guaranteed Notes Series A,
o $100.0 million of Class A-3 Floating Rate Guaranteed Notes Series C,
o $40.0 million of Class B-2 Subordinated Floating Rate Notes, and
Proceeds from this offering were used to fund the Regulation XXX reserve requirements for the business acquired from ING $1.65 billion of the proceeds from the Ballantyne Notes have been deposited into a series of accounts that collateralize the reserve obligations of Scottish Re (U.S.), Inc.
The holders of the Ballantyne Notes cannot require repayment from us or any of our subsidiaries. The timely payment of the scheduled interest payments and the principal on the maturity date of Series A of the Class A-2 Notes and Series A, Series B, Series C, Series D and, if issued, Series E of the Class A-3 Notes has been guaranteed by Ambac Assurance UK Limited. The timely payment of the scheduled interest payments and the principal on the maturity date of Series B of the Class A-2 Notes and, if issued, Series F of the Class A-3 Notes has been guaranteed by Assured Guaranty (UK) Ltd.
In accordance with FIN 46R, Ballantyne Re is considered to be a variable interest entity and we are considered to hold the primary beneficial interest. As a result, Ballantyne Re is consolidated in our financial statements beginning in the second quarter of 2006. The assets of Ballantyne Re are recorded as fixed maturity investments and cash and cash equivalents. Our consolidated statements of income (loss) include the investment return of Ballantyne Re as investment income and the cost of the facility is reflected in collateral finance facilities expense.
As described above, we have a number of facilities in place to provide collateral for our reinsurance business, including HSBC I and Stingray. However, the HSBC I facility has been fully utilized and it is uncertain if a similar facility can be completed or if the current facility will remain available for future use following a permanent Regulation XXX transaction which would reduce the current usage of the HSBC I facility. Finally, the Stingray facility has been fully utilized. Other existing sources of collateral include cash and other assets which are available, although extremely limited in their amount.
Based on our known sources and uses of liquidity, our collateral and liquidity position is very tight over the near term. During the third quarter of 2006, we successfully completed a reinsurance transaction that provided approximately $120.0 million of additional liquidity. To further enhance our liquidity position, we are negotiating a $100 million term loan facility with Cerberus to provide a source of liquidity until the closing of the Transaction. To the extent that we are not able to close this term loan facility or obtain additional sources of liquidity in the second quarter of 2007. We face the possibility of running out of collateral and liquidity. Over the longer term, we will need significant amounts of new capital to support existing and new business. These capital requirements will largely be satisfied by the consummation of the Transaction.
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.
Scottish Annuity & Life Insurance Company (Cayman) Ltd. and Scottish Re Group Limited have agreed with Scottish Re Limited that in the event Scottish Re Limited is unable to meet its obligations under its insurance or reinsurance agreements, Scottish Annuity & Life Insurance Company (Cayman) Ltd. or if Scottish Annuity & Life Insurance Company (Cayman) Ltd. cannot fulfill such obligations, then Scottish Re Group Limited will assume all of Scottish Re Limited's obligations under such agreements.
We lease office space in the countries in which we operate. These leases expire at various dates through 2023.
Collateral finance facilities include HSBC I and HSBC II, and securitization obligations with Orkney Re, Orkney Re II plc and Ballantyne Re plc. These transactions are described in the previous section. These obligations are fully secured by fixed maturity investments and cash and cash equivalents included in our Consolidated Balance Sheet. The liabilities have been included in the table above at the earliest redemption date.
We have no obligations, assets or liabilities other than those disclosed in the financial statements forming part of this Form 10-K, no trading activities involving non-exchange traded contracts accounted for at fair value, and no relationships and transactions with persons or entities that derive benefits from their non-independent relationship with us or our related parties.
FIN 48 is effective for fiscal years beginning after December 15, 2006 and the provisions of FIN 48 will be applied to all tax positions upon initial adoption. The cumulative effect of applying the provisions of FIN 48 will be reported as an adjustment to the opening balance of retained earnings for that fiscal year. We have not completed our evaluation of the effect of adoption of FIN 48. However, due to the fact that we have established tax positions in previously filed tax returns and are expected to take tax positions in future tax returns that will affect the financial statements, the adoption of FIN 48 may have a significant impact on our consolidated financial statements.
FASB Statement No. 156, Accounting for Servicing of Financial Assets -- an amendment of FASB Statement No. 140
o Fair value measurement method -- measure servicing assets or servicing liabilities at fair value at each reporting date and report changes in fair value in earnings in the period in which the change occurs.
In September 2006, the FASB issued Statement No. 157 ("SFAS No. 157"), "Fair Value Measurements," which defines fair value, establishes a framework for measuring fair value under GAAP and expands disclosures about fair value measurements. We are required to adopt SFAS No. 157 on January 1, 2008 and are evaluating the implications of SFAS No. 157 on our results of operations and financial position.
Statement of Position 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts
In September 2005, the American Institute of Certified Public Accountants issued Statement of Position ("SOP") 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts ("SOP 05-1"). SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. Under SOP 05-1, modifications that result in a substantially unchanged contract will be accounted for as a continuation of the replaced contract. A replacement contract that is substantially changed will be accounted for as an extinguishment of the replaced contract resulting in a release of unamortized deferred acquisition costs, unearned revenue and deferred sales inducements associated with the replaced contract. The SOP will be adopted in fiscal years beginning after December 15, 2006. We are currently evaluating the impact of SOP 05-1 and do not expect that the adoption of SOP 05-1 will have a material impact on our consolidated financial statements.
Some of the statements contained in this report are not historical facts and are forward-looking statements within the meaning of the Private Securities Litigation Reform Act. Forward-looking statements involve 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.
o the impact on our financial condition of the failure to consummate the Transaction;
o the validity of assumptions and methodologies used by management in analyzing potential run-off scenarios and in predicting our further capital and liquidity needs and the inability to predict with certainty any future scenarios;
o uncertainties relating to future actions that may be taken by creditors, regulators and ceding insurers relating to our ratings and financial condition;
o the impact of acquisitions, including our ability to successfully integrate acquired businesses, the competing demands for our capital and the risk of undisclosed liabilities;
o loss of the services of any of our key employees;
The effects of these factors are difficult to predict. New factors emerge from time to time and we cannot assess the financial impact of any such factor on our 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 statements to reflect events or circumstances after the date of such statement or to reflect the occurrence of unanticipated events.