We lease office space in Bermuda, which houses our executive offices and operations for both our Reinsurance and Individual Risk segments. In addition, our Individual Risk segment leases a number of offices in the U.S.; Stonington leases office space in Addison, Texas, and our other U.S. based subsidiaries currently lease office space in Richmond, Virginia; Raleigh, North Carolina; Houston, Texas; Stamford, Connecticut; and Chicago, Illinois. Our Reinsurance segment also leases office space in Dublin, Ireland. While we believe that for the foreseeable future our current office space is sufficient for us to conduct our operations, as we anticipate additional growth in our businesses, it is likely that we will need to expand into additional facilities to accommodate this growth. To date, the cost of acquiring and maintaining our office space has not been material.
(1) Earnings (loss) per common share - diluted was calculated by dividing net income (loss) available (attributable) to common shareholders by the number of weighted average common shares and common share equivalents outstanding. Common share equivalents are calculated on the basis of the treasury stock method. In accordance with FAS 128, diluted earnings per share calculations use weighted average common shares outstanding - basic, when in a net loss position.
(1) Includes $66.9 million, $45.3 million, $18.8 million, $20.8 million and $22.2 million of premium assumed from our Individual Risk segment in the years ended December 31, 2006, 2005, 2004, 2003 and 2002, respectively.
The operating results, also known as the underwriting results, of an insurance or reinsurance company are discussed frequently by reference to its net claims and claim expense ratio, underwriting expense ratio, and combined ratio. The net claims and claim expense ratio is calculated by dividing net claims and claim expenses incurred by net premiums earned. The underwriting expense ratio is calculated by dividing underwriting expenses (acquisition expenses and operational expenses) by net premiums earned. The combined ratio is the sum of the net claims and claim expense ratio and the underwriting expense ratio. A combined ratio below 100% generally indicates profitable underwriting prior to the consideration of investment income. A combined ratio over 100% generally indicates unprofitable underwriting prior to the consideration of investment income. We also discuss our net claims and claim expense ratio on an accident year basis. This ratio is calculated by taking net claims and claim expenses, excluding development on net claims and claim expenses from events that took place in prior fiscal years, divided by net premiums earned.
We conduct our business through two reportable segments, Reinsurance and Individual Risk. Those segments are more fully described as follows:
1) Property catastrophe reinsurance, written for our own account and for DaVinci, our traditional core business. We believe we are one of the world’s leading providers of this coverage, based on managed catastrophe gross premiums written. This coverage protects against large natural catastrophes, such as earthquakes, hurricanes and tsunamis, as well as claims arising from other natural and man-made catastrophes such as winter storms, freezes, floods, fires, wind storms, tornadoes, explosions and acts of terrorism. We offer this coverage to insurance companies and other reinsurers primarily on an excess of loss basis. This means that we begin paying when our customers’ claims from a catastrophe exceed a certain retained amount.
In addition to our existing reinsurance and insurance businesses, from time to time, we consider opportunistic diversification into new ventures, either through organic growth, the formation of new joint ventures, or the acquisition of other companies or books of business of other companies. This potential diversification includes opportunities to write targeted classes of non-catastrophe business, both directly for our own account and through possible new joint venture opportunities.
The following table summarizes our claims and claim expense reserves by line of business and split between case reserves, additional case reserves and IBNR at December 31, 2006 and 2005:
During 2005, we incurred significant losses from hurricanes Katrina, Rita and Wilma. Our estimates of these losses are based on factors including currently available information derived from claims information from our clients and brokers, industry assessments of losses from the events, proprietary models and the terms and conditions of our contracts. In particular, due to the size and unusual complexity of the issues relating to hurricane Katrina, meaningful uncertainty remains regarding total covered losses for the insurance industry and, accordingly, our loss estimates. Our actual losses from these events will likely vary, perhaps materially, from our current estimates due to the inherent uncertainties in reserving for such losses, the potential inaccuracies and inadequacies in the data provided by clients and brokers, the inherent uncertainty of modeling techniques and the application of such techniques, and complex coverage and other legal issues.
Within our property catastrophe reinsurance unit, we principally write property catastrophe excess of loss reinsurance contracts to insure insurance and reinsurance companies against natural and man-made catastrophes. Under these contracts, we indemnify an insurer or reinsurer when its aggregate paid claims and claim expenses from a single occurrence of a covered peril exceed the attachment point specified in the contract, up to an amount per loss specified in the contract. Our most significant exposure is to losses from earthquakes and hurricanes and other windstorms, although we are also exposed to claims arising from other catastrophes, such as tsunamis, freezes, floods, fires,
tornadoes, explosions and acts of terrorism. Our predominant exposure under such coverage is to property damage. However, other risks, including business interruption and other non-property losses, may also be covered under our property catastrophe reinsurance contracts when arising from a covered peril. Our coverages are offered on either a worldwide basis or are limited to selected geographic areas.
Coverage can also vary from ‘‘all property’’ perils to limited coverage on selected perils, such as ‘‘earthquake only’’ coverage. We also enter into retrocessional contracts that provide property catastrophe coverage to other reinsurers or retrocedants. This coverage is generally in the form of excess of loss retrocessional contracts and may cover all perils and exposures on a worldwide basis or be limited in scope to selected geographic areas, perils and/or exposures. The exposures we assume from retrocessional business can change within a contract term as the underwriters of a retrocedant may alter their book of business after the retrocessional coverage has been bound. We also offer dual trigger reinsurance contracts which require us to pay claims based on claims incurred by insurers and reinsurers in addition to the estimate of insured industry losses as reported by referenced statistical reporting agencies.
Our property catastrophe reinsurance business is generally characterized by loss events of low frequency and high severity. Initial reporting of paid and incurred claims in general, tends to be relatively prompt. We consider this business ‘‘short-tail’’ as compared to the reporting of claims for ‘‘long-tail’’ products, which tends to be slower. However, the timing of claims payment and reporting also varies depending on various factors, including: whether the claims arise under reinsurance of primary insurance companies or reinsurance of other reinsurance companies; the nature of the events (e.g., hurricanes, earthquakes or terrorism); the geographic area involved; post-event inflation which may cause the cost to repair damaged property to increase significantly from current estimates, or for property claims to remain open for a longer period of time, due to limitations on the supply of building materials, labor and other resources; and the quality of each client’s claims management and reserving practices. Management’s judgments regarding these factors are reflected in our claims reserve estimates.
policyholders affected by the same loss event. Although the REMS© modeling system assists with the analysis of the underlying loss and provides us with the information and ability to perform increased analysis, the estimation of claims resulting from catastrophic events is inherently difficult because of the variability and uncertainty associated with property catastrophe claims and the unique characteristics of each loss.
The percentage of claims unpaid at December 31, 2006 for each accident year reflects both the speed to which claims and claim expenses for each accident year have been paid and our estimate of claims and claim expenses for that accident year. As seen above, claims and claim expenses for the 2004 accident year have been paid quickly compared to prior accident years. This is due to the fact that hurricanes Charley, Frances, Ivan and Jeanne which occurred in 2004 have been rapid claims paying events. This is driven in part by the mix of our business in Florida, which primarily includes property catastrophe excess of loss reinsurance for personal lines property coverage rather than commercial property coverage or retrocessional coverage, and the speed of the settlement and payment of claims by our underlying cedants. In contrast, our 2001 accident year, which includes losses from the events of September 11, 2001, and our 2005 accident year, which includes significant losses from hurricane Katrina, includes a higher mix of commercial business where the underlying claims of our cedants tend to be settled and paid more slowly. In addition, claims from our underlying cedants for the 2001
and 2005 accident years are subject to more complex coverage and legal matters due to the complexity of the catastrophic events taking place in those years.
Our specialty reinsurance business can generally be characterized as providing coverage for low frequency and high severity losses, similar to our property catastrophe reinsurance business. As with our property catastrophe reinsurance business, our specialty reinsurance contracts frequently provide coverage for relatively large limits or exposures. As a result of the foregoing, our specialty reinsurance business is subject to significant claims volatility. In periods of low claims frequency or severity our results will generally be favorably impacted while in periods of high claims frequency or severity our results will generally be negatively impacted.
The utilization of the Bornhuetter-Ferguson technique requires us to estimate an expected ultimate claims and claim expense ratio and select an expected loss reporting pattern. We select our estimates of the expected ultimate claims and claim expense ratios and expected loss reporting patterns by reviewing industry standards and adjusting these standards based upon the terms of the coverages we offer. The estimated expected claims and claim expense ratio may be modified to the extent that reported losses at a given point in time differ from what would be expected based on the selected loss reporting pattern. Our estimate of IBNR is the product of the premium we have earned, the initial expected ultimate claims and claim expense ratio and the percentage of estimated unreported losses. In addition, certain of our specialty reinsurance coverages may be impacted by natural and man-made
Within our specialty reinsurance business, we seek to review substantially all of our claims and claim expense reserves quarterly. Typically, our quarterly review procedures include reviewing paid and reported claims in the most recent reporting period, reviewing the development of paid and reported claims from prior periods, and reviewing our overall experience by underwriting year and in the aggregate. We monitor our expected ultimate claims and claim expenses ratios and expected loss reporting assumptions on a quarterly basis and compare them to our actual experience. These actuarial assumptions are generally reviewed annually, based on input from our actuaries, underwriters, claims personnel and finance professionals, although adjustments may be made more frequently if needed. Assumption changes are made to adjust for changes in the pricing and terms of coverage we provide, changes in industry standards, as well as our actual experience, to the extent we have enough data to rely on our own experience. If we determine that adjustments to an earlier estimate are appropriate, such adjustments are recorded in the period in which they are identified. During the twelve months ended December 31, 2006, 2005 and 2004, changes to our prior year estimated claims reserves in our specialty reinsurance unit increased our net income by $139.2 million, reduced our net loss by $169.6 million and increased our net income by $46.6 million, respectively.
The Actual vs. Initial Expected Ultimate Claims and Claim Expenses Ratio table below summarizes our key actuarial assumptions in reserving for our specialty reinsurance business. As noted above, the key actuarial assumptions include the estimated ultimate claims and claim expense ratios and the estimated loss reporting patterns. The table shows our initial estimates of the ultimate claims and claim expenses ratio by underwriting year. The table shows how our initial estimates of these ratios have developed over time; with the re-estimated ratios reflecting a combination of the amount and timing of paid and reported losses compared to our initial estimates. The initial estimate is based on the actuarial assumptions that were in place at the end of that year. A decrease in the ultimate claims and claim expense ratio implies that our current estimates are lower than our initial estimates while an increase in the ultimate claims and claim expense ratio implies that our current estimates are higher than our initial estimates. The result would be a corresponding favorable impact on shareholders’ equity and net income or a corresponding unfavorable impact on shareholders’ equity and net income, respectively. The table also shows how our initial estimated ultimate claims and claim expense ratios have changed from one underwriting year to the next. The table below reflects a summary of the weighted average assumptions for all classes of business written within our specialty reinsurance unit. The table is presented on a gross loss basis and therefore does not include the benefit of reinsurance recoveries.
Actual vs. Initial Expected Specialty Reinsurance Claims and Claim Expenses Reserve Analysis - Estimated Ultimate Claims and Claim Expenses Ratio
The table above shows that our initial estimated expected ultimate claims and claim expense ratios for attritional losses for each new underwriting year within our specialty reinsurance unit have stayed relatively constant between 76.6% and 78.8% over the last five years. This reflects the fact that
As noted above, some of our specialty reinsurance contracts are exposed to net claims and claim expenses from large natural and man-made catastrophes. Net claims and claim expenses from these large catastrophes are reserved for after the event which gave rise to the claims in a manner which is consistent with our property catastrophe reinsurance reserving practices as discussed above. The large catastrophes occurring during the period from 2002 to 2006, principally include hurricanes Katrina, Rita and Wilma which occurred in 2005. Our estimate of ultimate net claims and claim expenses from hurricanes Katrina, Rita and Wilma within our specialty reinsurance unit, net of reinsurance recoveries and assumed and ceded loss related premium, totaled $98.8 million and $77.1 million as of December 31, 2005 and 2006, respectively.
During the twelve months ended December 31, 2006, 2005 and 2004, changes to our prior year estimated claims reserves in our Individual Risk unit increased our net income by $11.3 million, reduced our net loss by $10.1 million and increased our net income by $26.4 million, respectively.
The Actual vs. Initial Expected Ultimate Claims and Claim Expense Ratio table below summarizes our key actuarial assumptions in reserving for our Individual Risk unit. As noted above, the key actuarial assumptions include the estimated ultimate claims and claim expense ratios and the estimated loss reporting patterns. The table shows our initial estimates of the ultimate claims and claim expenses ratio by accident year. The table shows how our initial estimates of these ratios have developed over time; with the re-estimated ratios reflecting a combination of the amount and timing of paid and reported losses compared to our initial estimates. The initial estimate is based on the actuarial assumptions that were in place at the end of each fiscal year. A decrease in the ultimate claims and claim expense ratio implies that our current estimates are lower than our initial estimates while an increase in the ultimate claims and claim expense ratio implies that our current estimates are higher than our initial estimates. The result would be a corresponding favorable impact on shareholders’ equity and net income or a corresponding unfavorable impact on shareholders’ equity and net income, respectively. The table also shows how our initial estimated ultimate claims and claim expense ratios have changed from one accident year to the next. The table below reflects a summary of the weighted average assumptions for all classes of business written within our Individual Risk unit. The table is presented on a gross loss basis and therefore does not include the benefit of reinsurance recoveries.
As noted above, some of our Individual Risk contracts are exposed to net claims and claim expenses from large natural and man-made catastrophes. Net claims and claim expenses from these large catastrophes are reserved for after the event which gave rise to the claims in a manner which is consistent with our property catastrophe reinsurance reserving practices as discussed above. The large catastrophes occurring during the period from 2002 to 2006, principally include hurricanes Charley,
Within our Reinsurance segment, we experienced a decrease in our property catastrophe reinsurance reserves for claims and claim expenses principally due to re-estimating the ultimate expected cost for both small and large catastrophes. This was due to a reassessment of our reserves for claims and claim expenses in light of historical paid loss trends and reported loss activity for these catastrophes. In coming to this conclusion, we reviewed claims files, requested updated claims information from brokers, and developed some new tools to help us assess trends in paid and reported losses. As a result of this review, we determined that there were trends of paid and reported claims for these catastrophes that were coming in less than originally expected and therefore the ultimate expected losses for these catastrophes were decreased.
patterns based on a combination of new industry information and actual experience accumulated over the three preceding years. The assumptions for the new loss reporting patterns were applied to all prior underwriting years. In addition, we made explicit allowances for commuted contracts whereas previously these were considered in the overall reserving assumptions. We also reviewed substantially all of our case reserves and additional case reserves. The result of the foregoing was a decrease in our specialty reinsurance reserves for claims and claim expenses.
The estimate of losses recoverable can be more subjective than estimating the underlying claims and claim expense reserves as discussed under the heading ‘‘Claims and Claim Expense Reserves’’ above. In particular, losses recoverable may be affected by deemed inuring reinsurance, industry losses reported by various statistical reporting services, and other factors. Losses recoverable on dual trigger reinsurance contracts require us to estimate our ultimate losses applicable to these contracts as well as estimate the ultimate amount of insured losses for the industry as a whole that will be reported by the applicable statistical reporting agency, as per the contract terms. In addition, the level of our additional case reserves and IBNR reserves has a significant impact on losses recoverable. These factors can impact the amount and timing of the losses recoverable to be recorded.
The three most significant items impacting our 2006 financial performance compared to 2005 and 2004 include: 1) an increase in our net premiums earned, principally due to growth in our catastrophe reinsurance unit where we found pricing and terms more favorable in 2006 compared with 2005 and 2004 and we chose to write more business in that unit in 2006; 2) a significant decrease in net claims and claim expenses as a result of light insured catastrophe loss activity for 2006; our net claims and claims expenses were significantly impacted by hurricanes Katrina, Rita and Wilma in 2005 and hurricanes Charley, Frances, Ivan and Jeanne in 2004, and losses of that magnitude did not occur in 2006; and 3) a significant increase in net investment income due to higher average invested assets due to the generation of cash flow from operations during the last three years that has been invested in our investment portfolio, combined with higher average yields on our portfolio of fixed maturity investments available for sale and short term investments.
Our 2004 financial performance was impacted by a $570.2 million net negative impact from hurricanes Charley, Frances, Ivan and Jeanne.
Our Reinsurance operations are comprised of three units: 1) property catastrophe reinsurance, primarily written through Renaissance Reinsurance and DaVinci; 2) specialty reinsurance, primarily written through Renaissance Reinsurance and DaVinci; and 3) certain activities of Ventures.
(1) Includes gross premiums ceded from the Individual Risk segment to the Reinsurance segment of $66.9 million, $45.3 million and $18.8 million for the years ended December 31, 2006, 2005 and 2004, respectively.
(1) The category ‘‘Worldwide (excluding U.S.)’’ consists of contracts that cover more than one geographic region (other than the U.S.). The exposure in this category for gross written premiums written to date is predominantly from Europe and Japan.
Ceded premiums written increased by $103.1 million in 2006 primarily as a result of the utilization in the 2006 U.S. hurricane season of two new fully-collateralized joint ventures, Starbound Re and Tim Re, pursuant to which $114.0 million of assumed catastrophe reinsurance premium was fully ceded to those entities.
To the extent that appropriately priced coverage is available, we anticipate continued use of reinsurance to reduce the impact of large losses on our financial results and to manage our portfolio of risk; however, the buying of ceded reinsurance in our Reinsurance segment is opportunistic and is not based on a placing a specific reinsurance program each year.
Reinsurance Segment Underwriting Results - In 2006, we generated underwriting income of $636.2 million and recorded a net claims and claim expense ratio of 15.2%, an expense ratio of 19.3%, and a combined ratio of 34.5%, compared to an underwriting loss of $461.5 million, a net claims and claim expense ratio of 132.2%, expense ratio of 16.5% and combined ratio of 148.7%, in 2005. The significant improvement in our underwriting performance is directly attributable to the light insured catastrophe loss activity experienced during 2006, compared to 2005. As noted above, hurricanes Katrina, Rita and Wilma resulted in $1,076.1 million of net claims and claim expenses in 2005 and added 113.6 percentage points to our net claims and claim expense ratio in 2005. In 2004, hurricanes Charley, Frances, Ivan and Jeanne resulted in net claims and claim expenses of $581.8 million and increased our net claims and claim expense ratio by 61.6 percentage points in that year. There was an absence of large, land falling hurricanes and other catastrophes impacting the insurance industry in 2006, which substantially contributed to the significant improvement in our underwriting profit.
Our underwriting results over the last three years have been, and may well continue to be, impacted by prior year reserve development. Our prior year reserves experienced $125.2 million, $231.3 million and $113.8 million of net favorable development in 2006, 2005 and 2004, respectively. The favorable prior year reserve development in 2006 was principally driven by our specialty reinsurance unit. The reductions in reserves within our specialty reinsurance unit were principally driven by the application of our formulaic reserving methodology for this book of business with the reductions being due to actual paid and reported loss activity being better than what we anticipated when setting the initial IBNR reserves. In addition, within our specialty reinsurance unit $46.0 million of the favorable development was driven by a reduction in carried reserves due to commutations. The favorable prior year reserve development in 2005 was principally the result of our 2005 reserve reviews. With the
growth in our reserves for claims and claim expenses, we announced in early 2005 that we would review the processes and assumptions for establishing and evaluating our reserves during 2005. We completed reviews of our property catastrophe reinsurance and specialty reinsurance reserves in the second and third quarters of 2005, respectively. As a result of these reviews, we reduced prior year reserves within our Reinsurance segment by $248.1 million, which reduced our 2005 net claims and claim expense ratio by 26.2 percentage points. After adjusting for the impact of minority interest, our 2005 net loss was reduced by $225.8 million as a result of the Reinsurance segment reserve reviews. The reserve changes for our property catastrophe portfolio reflects a reassessment of our reserves for claims and claim expenses in light of historical paid loss trends and reported loss activity for the 1994 to 2004 accident years. For our specialty reinsurance business, the changes were principally due to a reassessment of our estimated loss reporting patterns. Since establishing the specialty reinsurance business unit in 2002, reported claim activity has been less than expected and therefore we have adjusted our estimated loss reporting patterns to reflect this experience. The 2004 reduction in prior years’ estimated ultimate net claims reserves of $113.8 million was primarily due to a re-estimation of our ultimate losses associated with six large catastrophe events, a reduction in reserves from numerous smaller catastrophe events, and reductions from our specialty book of business.
The following financial data shows the net financial statement impact on our Reinsurance segment as a result of the 2005 large hurricanes and reserve reviews and the 2004 large hurricanes:
Losses from our property catastrophe reinsurance and specialty reinsurance policies can be infrequent, but severe, as demonstrated by our 2005 and 2004 results compared to 2006. During periods with low levels of property catastrophe loss activity, such as 2006, we have the potential to produce a low level of losses and a related increase in underwriting income. As described above, we believe there has been an increase in the frequency and severity of hurricanes that have the potential to make landfall in the U.S., potentially as a result of decadal ocean water temperature cyclical trends, a longer-term trend towards global warming, or both or other factors.
Our underwriting expenses consist of acquisition expenses and operational expenses. Acquisition expenses consist of the costs to acquire premiums and are principally comprised of broker commissions and excise taxes. Acquisition expenses are driven by contract terms and are normally a set percentage of premiums and, accordingly, these costs will normally move in line with the fluctuation in gross premiums earned. In 2006, the acquisition expense ratio of 11.9% was higher than the 9.8% recorded in 2005, driven mainly by the significant amount of loss related premium generated in 2005 which typically has lower brokerage expenses associated with it. In 2004, the acquisition expense ratio was 12.4%. Operating expenses consist of salaries and other general and administrative expenses. Operating expenses increased by $8.8 million to $72.4 million in 2006 when compared to 2005, principally due to expenses related to the growth in our business which has resulted in an increase in the number of employees and associated compensation, general and administrative expenses. Our consolidated operating expense ratio may increase over time, as a result of factors including the absolute and comparative growth of our Individual Risk business, which generally produces higher operating expenses than reinsurance, and market trends and dynamics.
We have entered into joint ventures and specialized quota share cessions of our book of business. In accordance with the joint venture and quota share agreements, we are entitled to certain fee income and profit commissions. We record these fees and profit commissions as a reduction in acquisition and operating expenses and, accordingly, these fees have reduced our underwriting expense ratios. These fees totaled $10.5 million, $21.1 million and $12.6 million in 2006, 2005 and 2004, respectively and resulted in a corresponding decrease to the underwriting expense ratio of 1.1%, 2.2% and 1.3% for the years ended December 31, 2006, 2005 and 2004, respectively. In addition, we are entitled to certain fee income and profit commissions from DaVinci. Because the results of DaVinci, and its parent DaVinciRe, are consolidated in our results of operations, these fees and profit commissions are eliminated in our consolidated financial statements and are principally reflected in minority interest. The net impact of all fees and profit commissions related to these joint ventures and specialized quota share cessions within our Reinsurance segment were $55.4 million, $35.8 million and $38.4 million for the years ending December 31, 2006, 2005 and 2004, respectively.
(1) Includes gross premiums written ceded from the Individual Risk segment to the Catastrophe unit of $64.6 million, $43.6 million and $18.8 million for the years ended December 31, 2006, 2005 and 2004, respectively.
Below is a summary of the underwriting results and ratios for the years ended December 31, 2006, 2005 and 2004 for our Individual Risk segment:
Individual Risk Gross Premiums Written - The following table shows our Individual Risk gross premiums written by major type of business for the years ended December 31, 2006, 2005 and 2004:
Our Individual Risk gross premiums written increased by $38.0 million to $689.4 million in 2006, compared to 2005. This increase was principally a result of an increase in our commercial property and commercial multi-line business of $103.0 million and $42.4 million, respectively, offset by a decrease in our personal lines property business of $107.4 million. We elected during 2006 to reduce our Individual Risk quota share personal lines property capacity and redeployed this capacity to property catastrophe excess of loss reinsurance within our Reinsurance segment, where we found the pricing and terms more attractive. Our Individual Risk gross premiums written increased by
We purchase reinsurance to reduce our exposure to large losses and to help manage our portfolio of risks. The increase in ceded premiums written in 2006 compared with 2005 is principally due to higher pricing for property catastrophe excess of loss reinsurance for the Individual Risk segment’s ceded reinsurance program and the purchase of reinsurance for a U.S. program relationship that terminated in 2006. Included in ceded premiums written in 2005 and 2004 is $34.4 million and $8.3 million of ceded reinstatement premiums written attributable to the 2005 and 2004 hurricanes, respectively.
Our Individual Risk segment purchases catastrophe excess of loss reinsurance from our Reinsurance segment operating subsidiaries, namely Renaissance Reinsurance and DaVinci. Included in our Individual Risk underwriting result is $64.6 million, $44.3 million and $18.8 million of ceded premiums to the Reinsurance segment in 2006, 2005 and 2004, respectively. Also included in our Individual Risk underwriting result are ceded losses to our Reinsurance segment of $8.6 million, $104.9 million and $80.0 million in 2006, 2005 and 2004, respectively. Our Individual Risk segment underwriting result incurred an expense of $56.0 million in 2006 and generated a benefit of $60.6 million and $61.2 million in 2005 and 2004, respectively, as a result of this reinsurance. There was a corresponding opposite effect on our Reinsurance segment underwriting results as a result of this reinsurance. We believe the terms of such cessions are on an arm’s length basis.
Also impacting the underwriting result in 2006, 2005 and 2004, were reductions of prior years’ estimated ultimate net claims reserves of $11.3 million, $10.1 million and $26.4 million, respectively.
The reduction in prior years’ estimated ultimate net claims reserves was principally driven by the application of our formulaic reserving methodology used for the Individual Risk book of business and is primarily due to actual paid and reported loss activity being better than what we had anticipated when estimating the initial ultimate claims and claims expense ratios and the initial loss reporting patterns. The favorable development in 2005 includes a $1.1 million reduction of prior years’ reserves as a result of the 2005 reserve review. We can not provide assurance that favorable reserve releases will continue, or that we will not experience unfavorable reserve development in the future.
The following financial data shows the net financial statement impact on our Individual Risk segment as a result of the 2005 large hurricanes and reserve review and the 2004 large hurricanes.
The increase in net investment income in 2005 compared to 2004 was a result of both higher investment returns and an increased level of invested assets in 2005 compared to 2004. The increase in average invested assets is due to the positive cash flow from our operating and financing activities which we generated in 2005 and which we deployed into our invested assets, principally short term investments. Other investments generated $59.3 million of net investment income in 2005, compared to $46.9 million in 2004.
Equity in earnings of other ventures represents our pro-rata share of the net income from our investments in Channel Re, Top Layer Re, Starbound and Tower Hill for 2006. The $6.3 million increase in equity in earning of other ventures in 2006 is primarily due to the inclusion of Starbound, which added $2.1 million of equity in earnings of other ventures, and improved profitability of Channel Re which added an additional $3.7 million of equity in earnings of other ventures in 2006.
The decrease in equity in earnings of other ventures in 2005 was due to a decline in the earnings attributable to our equity investment in Top Layer Re compared to 2004, offset by an increase in
earnings from our investment in Channel Re, due to 2004 reflecting only a partial year of earnings as this investment was made in February of 2004 and earnings attributable to Channel Re are recorded by the Company one quarter in arrears. In addition, during the first quarter of 2005 we made a $10.0 million equity investment in Tower Hill. We recorded earnings of $0.3 million from the Tower Hill investment in 2005 compared to $nil in 2004. As with Channel Re, we record our pro-rata share of the net income of Tower Hill one quarter in arrears.
In 2006, fee income increased by $1.9 million to $8.1 million from $6.2 million in 2005. In 2005, fee income decreased $0.6 million from $6.8 million in 2004. Fee income primarily consists of management fees related to services we provide to Platinum. Our current management fee arrangement with Platinum is scheduled to expire in September 2007.
Other items, which principally include income or losses on assumed and ceded reinsurance contracts accounted for as derivatives or deposits under GAAP, the mark-to-market on our warrant to purchase shares of Platinum stock, and the mark-to-market on credit, energy and weather-related derivatives trading, generated a loss of $12.0 million, income of $3.3 million and income of $12.1 million in 2006, 2005 and 2004, respectively. Included in other items in 2006 was a loss of $7.0 million (2005 - a gain of $0.2 million) related to assumed and ceded reinsurance contracts that are classified as derivatives and deposit contracts under GAAP and $4.7 million (2005 - losses of $2.1 million) and $2.2 million (2005 - $0.4 million) in losses related to our business unit that focuses on weather-related consulting and weather and energy related trading activities, respectively. Other items in 2004 was driven by the recording of $27.4 million of cumulative unrealized gains on the Platinum warrant in our consolidated statement of operations in the fourth quarter of 2004 for the first time as the result of the expiration of a lockup provision, in accordance with GAAP. This was partially offset by $2.7 million in 2005 and $12.5 million in 2004 of losses recognized by us from short positions in credit derivatives generally used to hedge potential credit-related exposures of the Company.
During 2006, our $34.5 million of net realized losses on investments includes $46.4 million of other than temporary impairment charges. The increase in other than temporary impairment charges in 2006
Corporate expenses include certain executive, legal and consulting expenses, costs for research and development, and other miscellaneous costs associated with operating as a publicly traded company. The $47.4 million decrease in corporate expenses to $24.4 million in 2006 is primarily due to a reduction in certain professional fees and costs related to the internal review and ongoing investigations into the Company and certain of its present and former officers by governmental authorities. These costs totaled $5.3 million in 2006 compared to $39.7 million in 2005. Also included in the 2005 corporate expense line is $13.3 million of compensation expense due to the accelerated vesting of our former Chairman and Chief Executive Officer’s equity grants upon his departure from the Company in the fourth quarter of 2005.
We are subject to income taxes in certain jurisdictions in which we operate; however, since the majority of our income is currently earned in Bermuda, a non-taxable jurisdiction, the tax impact to our operations has historically been minimal. In 2006, we generated taxable income in our U.S. tax-paying subsidiaries which was offset by utilization of a net operating loss carryforward. Due to a history of losses in our U.S. subsidiaries we continue to maintain a valuation allowance equal to 100% of our net deferred tax asset. The income tax expense in 2006 primarily relates to alternative minimum taxes incurred by our U.S. subsidiaries. During 2004, our U.S. tax-paying subsidiaries did not generate taxable income and, accordingly, we recorded a valuation allowance against the remaining net deferred tax asset of $4.0 million.
We currently plan to continue to increase the amount of business written by our U.S. tax-paying insurance subsidiaries. If, as a result, our U.S. operations begin to generate taxable income over a sustained period of time, the appropriateness of the valuation allowance will continue to be reassessed, and, at such time that we believe it is more likely than not that we will generate taxable
The payment of dividends by our Bermuda subsidiaries is, under certain circumstances, limited under U.S. statutory regulations and Bermuda insurance law, which require our Bermuda insurance subsidiaries to maintain certain measures of solvency and liquidity. At December 31, 2006, the statutory capital and surplus of our Bermuda insurance subsidiaries was $3.1 billion (2005 - $2.4 billion), and the amount of capital and surplus required to be maintained was $597.9 million (2005 - $573.0 million). During 2006, Renaissance Reinsurance, DaVinci and Glencoe declared aggregate cash dividends of $349.1 million, $nil and $nil, respectively, compared with $337.8 million, $5.0 million and $nil, respectively, in 2005. Because of an accumulated deficit in earned surplus from prior operations, Glencoe is not currently permitted to pay ordinary dividends without BMA approval.
Our principal U.S. insurance subsidiary Stonington is also required to maintain certain measures of solvency and liquidity. Restrictions with respect to dividends are based on state statutes. In addition, there are restrictions based on risk based capital tests which is the threshold that constitutes the authorized control level. If Stonington’s statutory capital and surplus falls below the authorized control level, the commissioner is authorized to take whatever regulatory actions considered necessary to protect policyholders and creditors. At December 31, 2006, the statutory capital and surplus of Stonington was $93.8 million (2005 - $56.5 million). Because of an accumulated deficit in earned surplus from prior operations, Stonington cannot currently pay an ordinary dividend without commissioner approval.
In the aggregate, our operating subsidiaries have historically produced sufficient cash flows to meet their expected claims payments and operational expenses and to provide dividend payments to us. Our subsidiaries also maintain a concentration of investments in high quality liquid securities, which management believes will provide additional liquidity for extraordinary claims payments should the need arise. Additionally, we maintain a $500.0 million revolving credit facility to meet additional liquidity and capital requirements. At December 31, 2006, we have not drawn against this revolving credit facility.
Our reserving techniques, assumptions and processes differ between our Reinsurance and Individual Risk segments, as well as between our property catastrophe reinsurance and specialty reinsurance businesses within our Reinsurance segment. Refer to our ‘‘Claims and Claim Expense Reserves Critical Accounting Estimates’’ discussion in ‘‘Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations’’ for more information on the risks we insure and reinsure, the reserving techniques, assumptions and processes we follow to estimate our claims and claim expense reserves, and our current estimates versus our initial estimates of our claims reserves, for each of these units.
During 2006, our capital resources increased by $1,126.7 million primarily as a result of our net income of $761.6 million, the issuance of $300.0 million in Series D Preference Shares, and by a $100.0 million increase in our DaVinciRe revolving credit facility, offset by dividends paid to our common and preferred shareholders of $60.4 million and $35.5 million, respectively.
In December 2006, we raised $300.0 million through the issuance of 12 million Series D Preference Shares; in March 2004, we raised $250.0 million through the issuance of 10 million Series C Preference Shares; in February 2003, we raised $100.0 million through the issuance of 4 million Series B Preference Shares; and in November 2001, we raised $150.0 million through the issuance of 6 million Series A Preference Shares. The Series D, Series C and Series B Preference Shares may be redeemed at $25 per share at our option on or after December 1, 2011, March 23, 2009 and February 4, 2008, respectively. Dividends on the Series D, Series C and Series B Preference Shares are cumulative from the date of original issuance and are payable quarterly in arrears at 6.60%, 6.08% and 7.30%, respectively, when, if, and as declared by the Board of Directors. If RenaissanceRe submits a proposal to our shareholders concerning an amalgamation or submits any proposal that, as a result of any changes to Bermuda law, requires approval of the holders of RenaissanceRe preference shares to vote as a single class, RenaissanceRe may redeem the Series D, Series C and Series B Preference Shares prior to December 11, 2011, March 23, 2009 and February 4, 2008, respectively, at $26 per share. On December 15, 2006, we gave redemption notices to the holders of the Series A Preference Shares to redeem such shares for $25 per share. Subsequent to December 31, 2006, we redeemed all of the Series A Preference Shares for $150.0 million plus accrued and unpaid dividends thereon. The preference shares have no stated maturity and are not convertible into any other of our securities.
In January 2003, we issued $100.0 million of 5.875% Senior Notes due February 15, 2013, with interest on the notes payable on February 15 and August 15 of each year. In July 2001, we issued $150.0 million of 7.0% Senior Notes due July 15, 2008 with interest on the notes payable on January 15 and July 15 of each year. The notes can be redeemed by us prior to maturity subject to payment of a ‘‘make-whole’’ premium; however, we have no current intention to call the notes. The notes, which are senior obligations, contain various covenants, including limitations on mergers and consolidations, restrictions as to the disposition of stock of designated subsidiaries and limitations on liens on the stock of designated subsidiaries. RenaissanceRe was in compliance with the related covenants at December 31, 2006 and 2005.
During April 2006, DaVinciRe amended and restated its credit agreement to, among other things, (i) extend the termination date of the revolving credit facility established thereunder from May 25, 2010 to April 5, 2011; (ii) increase the borrowing capacity to $200.0 million; and (iii) increase the minimum net worth requirement with respect to DaVinciRe and DaVinci by $100.0 million to $350.0 million and $450.0 million, respectively. All other material terms and conditions in the credit agreement remained the same, including the requirement that DaVinciRe maintain a debt to capital ratio of 30% or below. Neither RenaissanceRe nor Renaissance Reinsurance is a guarantor of this facility and the lenders have no recourse against us or our subsidiaries other than DaVinciRe and its subsidiary under the DaVinciRe facility. Pursuant to the terms of the $500.0 million revolving credit facility maintained by RenaissanceRe, a default by DaVinciRe on its obligations will not result in a default under the RenaissanceRe facility. At December 31, 2006, the initial $100.0 million drawn in 2002 remained outstanding. An additional borrowing of $60.0 million was made on April 5, 2006 and the remaining $40.0 million was drawn on December 28, 2006. Interest rates on the facility are based on a spread above LIBOR, and averaged approximately 5.8% during 2006 (2005 - 4.1%). The term of the credit facility may be further extended and the size of the facility may be increased to $250.0 million if certain conditions are met. At December 31, 2006 and 2005, DaVinciRe was in compliance with the covenants under this agreement.
During August 2004, we amended and restated our committed revolving credit agreement to increase the facility from $400.0 million to $500.0 million, to extend the term to August 6, 2009 and to make certain other changes. On December 2, 2005, $150.0 million was drawn under this facility, of which $nil remained outstanding at December 31, 2006. Interest rates on the facility are based on a spread above LIBOR, and averaged approximately 5.4% during the period from the initial draw down in December 2005 through September 2006 when the outstanding balance was repaid. As amended, the agreement contains certain financial covenants. These covenants generally provide that consolidated debt to capital shall not exceed the ratio (the ‘‘Debt to Capital Ratio’’) of 0.35:1 and that the consolidated net worth (the ‘‘Net Worth Requirements’’) of RenaissanceRe and Renaissance Reinsurance shall equal or exceed $1.0 billion and $500.0 million, respectively, subject to certain adjustments under certain circumstances in the case of the Debt to Capital Ratio and certain grace periods in the case of the Net Worth Requirements, all as more fully set forth in the agreement. We have the right, subject to certain conditions, to increase the size of this facility to $600.0 million.
Effective January 1, 2006, the Company purchased the shares of one of DaVinciRe’s original shareholders for $15.4 million, subject to a true-up for development on outstanding loss reserves after the settlement of all claims relating to the applicable years; thereby increasing our economic ownership to 22.3%. In addition, on February 1, 2006, DaVinciRe raised an additional $53.9 million of equity capital. We continue to maintain majority voting control of DaVinciRe and, accordingly, will continue consolidating the results of DaVinciRe into the Company’s consolidated results of operations and financial position. Our economic ownership interest in DaVinciRe was 20.5% at December 31, 2006 compared to 19.7% at December 31, 2005.
Shareholders’ equity increased by $1.0 billion to $3.3 billion at December 31, 2006, from $2.3 billion at December 31, 2005. The significant components of the change in shareholders’ equity included our net income available to common shareholders of $761.6 million, an increase in accumulated other comprehensive income of $20.5 million, and partially offset by dividends to our common shareholders of $60.4 million. In addition, as discussed above in ‘‘Capital Resources’’ we raised an additional $300.0 million in capital through the issuance of Series D Preference Shares. Subsequent to December 31, 2006, we redeemed all of our Series A Preference Shares for $150.0 million plus accrued and unpaid dividends, and as a result our shareholders’ equity has decreased by $150.0 million.
We also hold a significant amount of short term investments. Short term investments are managed as part of our investment portfolio and have a maturity of one year or less when purchased. Short term investments are carried at cost which approximates fair value. As of December 31, 2006, we had $2,411.0 million of short term investments compared to $1,653.6 million as of December 31, 2005.
Our target benchmark portfolio for our fixed maturities and short term investments currently has a 3 year duration. Our duration at December 31, 2006 was 1.3 years (2005 - 1.4 years), reflecting our view that the current level of rates affords inadequate compensation for the assumption of additional interest rate risk associated with longer duration. From time to time, we may reevaluate the duration of our portfolio in light of the duration of our liabilities and market conditions.
prepayments on their mortgages and, as a result, our investments in mortgage-backed securities will be repaid to us more quickly than we might have originally anticipated. When we receive these prepayments, our opportunities to reinvest these proceeds back into the investment markets will likely be at reduced interest rates. Conversely, when interest rates increase, consumers will generally make fewer prepayments on their mortgages and, as a result, our investments in mortgage-backed securities will be repaid to us less quickly than we might have originally anticipated. This will increase the duration of our portfolio, which is disadvantageous to us in a rising interest rate environment.
• Our investments in mortgage-backed securities are also subject to default risk. This risk is due in part to defaults on the underlying securitized mortgages, which would decrease the market value of the investment and be disadvantageous to us.
During the year ended December 31, 2006, the Company recorded $46.4 million (2005 - $33.2 million, 2004 - $1.2 million) in other than temporary impairment charges. The significant increase in other than temporary impairment charges in 2006 and 2005 was due to rising interests and our decision to recognize impairment charges for all of our fixed maturity investments available for sale that were in an unrealized loss position as of December 31, 2006 and 2005 as we do not currently have the intent to hold them until they fully recover in value. Credit related impairment charges were $0.1 million, $0.5 million and $0.1 million in 2006, 2005 and 2004, respectively. The Company had no fixed maturity investments which were carried at an unrealized loss as of December 31, 2006 and 2005.
management of large investment portfolios of different subsidiaries in the same group. In addition, the administrative efficiency afforded by the use of RIHL facilitates the establishment of our collateralized letter of credit facility on advantageous terms that we believe would otherwise not be available. Through RIHL, certain of our operating subsidiaries invest in a diversified portfolio of highly liquid debt securities which are recorded at fair value. RIHL has been assigned a rating of AAAf/S2 by S&P and 100% of the securities held through RIHL have been assigned a rating of AA or higher by S&P.
Net investment income in respect of RIHL includes interest with the amortization of market premiums and discounts and is net of investment management and custody fees. Also included in the investments held through RIHL are short term investments which have a maturity of one year or less when purchased and are carried at cost which approximates fair value. We may redeem our interests in RIHL at the current net asset value no more frequently than monthly. Mellon Bank, NA, provides custodial functions in respect of RIHL, including valuation of the investment assets held through RIHL. Currently, an external investment manager manages the assets held through RIHL, pursuant to written investment guidelines.
The potential exists, after a catastrophe loss, for the development of inflationary pressures in a local economy. The anticipated effects on us are considered in our catastrophe loss models. The effects of inflation are also considered in pricing and in estimating reserves for unpaid claims and claim expenses. The actual effects of this post-event inflation on our results cannot be accurately known until claims are ultimately settled.
Effective January 1, 2006, we adopted FASB Statement No. 123 (revised 2004), Share-Based Payment (‘‘FAS 123(R)’’), using the modified prospective transition method. Under the modified prospective transition method, compensation cost recognized for the twelve months ending December 31, 2006 includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested, as of January 1, 2006 based on the grant date fair value estimated in accordance with the original provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation (‘‘FAS 123’’) and (b) compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of FAS 123(R). The adoption of FAS 123(R) did not have a material impact on the Company.
Disclosure (‘‘FAS 148’’). Prior to January 1, 2003, we accounted for stock-based employee compensation under the recognition and measurement provisions of APB Opinion Number 25, Accounting for Stock Issued to Employees, and related interpretations.
In accordance with the transitional disclosure provisions of FAS 148, the following table sets out the effect on the Company’s net income (loss) and earnings (loss) per share for all reported periods had compensation cost been calculated based upon the fair value method recommended in FAS 123:
In June 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (‘‘FIN 48’’). FIN 48 prescribes guidance for the financial statement recognition, measurement and disclosure of uncertain tax positions recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. Tax positions must meet a more-likely-than-not recognition threshold at the effective date to be recognized upon the adoption of FIN 48 and in subsequent periods. FIN 48 became effective for us on January 1, 2007 and the provisions of FIN 48 will be applied to all tax positions upon initial adoption of the Interpretation. The cumulative effect of applying the provisions of this Interpretation will be reported as an adjustment to the opening balance of retained earnings for our 2007 fiscal year. The adoption of FIN 48 is not expected to have a material impact on our consolidated statements of operations or financial condition.
In January 2007, the State of Florida enacted the Bill, which is new legislation that increases the access of primary Florida insurers to the FHCF. Through the FHCF, the State of Florida now provides below market rate reinsurance of up to $28.0 billion per season, an increase from the previous cap of $16.0 billion, with the State able to further increase the limits up to an additional $4.0 billion per season. In addition, the legislation allows Florida insurers to choose a lower retention level for FHCF reinsurance coverage, at specified rates for specified layers of coverage. Further, the legislation expanded the ability of Citizens, a state-sponsored entity, to compete with private insurance companies, such as ours. While we intend to seek to utilize our strong relationships, record of superior service and financial strength to mitigate the impact of the Bill, because of our position as one of the largest providers of catastrophe-exposed coverage, both on a global basis and in respect of the Florida market, the Bill may have a disproportionate adverse impact on us compared to other market participants.
(5) Private equity commitments do not have a defined contractual commitment date and we have therefore included them in the less than one year category.