These statements should not be regarded as a representation by us or any other person that any anticipated event, future plan or other expectation described or discussed in this Report will be achieved. We undertake no obligation to update publicly or review for any reason any forward-looking statement after the date of this Report or to conform these statements to actual results or changes in our expectations. All subsequent written and oral forward-looking statements attributable to us or individuals acting on our behalf are expressly qualified in their entirety by this paragraph.
Darwin Professional Underwriters Incorporated (DPUI) was originally formed by Stephen Sills, our President and Chief Executive Officer, and Alleghany in March 2003 as an underwriting manager to underwrite professional liability coverages in the D&O, E&O and medical malpractice liability lines for three insurance companies that are wholly-owned subsidiaries of Alleghany Corporation (“Alleghany”): Capitol Indemnity Corporation, Capitol Specialty Insurance Corporation and Platte River Insurance Company (which we refer to, collectively, as the “Capitol Companies”). DPUI also writes the same professional liability coverages on its two wholly-owned carriers Darwin National Assurance Company (DNA) and Darwin Select Insurance Company (Darwin Select). Since inception, we have had full responsibility for managing the business produced by DPUI and issued on policies of the Capitol Companies, including responsibility for obtaining reinsurance on such business and responsibility for administering claims. Whenever we refer to business generated, written or produced by any of the aforementioned
Darwin legal entities (Darwin), we include business produced by DPUI and written on policies of the Capitol Companies (whether before or after the acquisitions of DNA and Darwin Select), all of which policies are now fully reinsured by DNA.
Effective January 1, 2006, DPUI became the parent of Darwin Group and its subsidiaries, DNA and Darwin Select and, in connection therewith, DPUI issued to Alleghany Insurance Holdings, LLC (“AIHL”) shares of Series B Convertible Preferred Stock with an aggregate liquidation preference of $197,178, equal to the book value of Darwin Group on December 31, 2005, in exchange for all of the outstanding common stock of Darwin Group held by AIHL. In addition, AIHL exchanged its 6,600,000 shares of common stock of DPUI, representing 80% of the issued and outstanding shares of DPUI, for 9,560 additional shares of Series A Preferred Stock of DPUI having an additional aggregate liquidation preference of $20 per share, representing 80% of the book value of DPUI on December 31, 2005. We refer to these transactions, collectively, as the “Reorganization.” As a result of the Reorganization, the only shares of common stock outstanding as of January 1, 2006 were unvested restricted shares.
The financial statements for 2005, 2004 and 2003 give retroactive effect to both the transfer of the in-force business to Darwin Group from the Capitol Companies and the contribution of Darwin Group to DPUI as transactions between entities under common control, accounted for as a pooling of interests. This results in a presentation that reflects the actual business produced and managed by DPUI, regardless of the originating insurance carrier, with all periods presented as if DPUI and Darwin Group, including the transferred in-force business, had always been combined.
On May 3, 2006, the DPUI Board of Directors approved a 33-for-two stock split of the DPUI’s shares of common stock, to be effected on the effective date of DPUI’s registration statement on Form S-1 in connection with its initial public offering, which occurred on May 19, 2006. In addition, the par value of the common stock has been adjusted to $0.01 per common share from $0.10 per common share. The resulting increase in common stock was offset by a decrease in additional paid-in capital.
After giving effect to the Reorganization and the IPO, Alleghany owned approximately 55% of Darwin’s common stock and our management owned approximately 10% (with management’s equity interest held through a restricted stock plan).
The accompanying historical consolidated financial statements are presented on a basis that reflects the actual business written by DPUI, regardless of the originating insurance carrier and include the stand-alone operations of DPUI, Darwin Group and its subsidiaries, DNA, Darwin Select and Vantapro, and certain assets, liabilities and results of operations of the Capitol Companies resulting from the business produced by DPUI and issued on policies of the Capitol Companies. All of the business produced by DPUI and issued on policies of the Capitol Companies was assumed through reinsurance by DNA for all periods presented in these financial statements.
These consolidated financial statements are presented in accordance with U.S. generally accepted accounting principles (GAAP). The preparation of financial statements requires management to make estimates and assumptions that affect amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates.
The major components of our loss and LAE reserves are (1) case reserves and (2) reserves for losses and LAE incurred but not reported (IBNR). Both include a provision for LAE. We divide LAE into two types: (1) “allocated” expenses (ALAE) are those that arise from defending and settling specific claims, such as the cost of outside defense counsel, and (2) “unallocated” expenses (ULAE) are those that do not arise from and cannot be assigned to specific claims, such as the general expense of maintaining an internal claims department.
Case reserves are liabilities for unpaid losses and ALAE on reported cases. Case reserves are established by claims adjustors as soon as sufficient information has been reported for a reasonable estimate of the expected cost of the claim. The amount of time required for the information to be reported may vary depending on the circumstances of the event that produced the loss. Claims adjusters seek to establish case reserves that are equal to the ultimate payments. The amount of each reserve is based upon an evaluation of the type of claim involved, the circumstances surrounding each claim, the policy provisions relating to the loss, the level of insured deductibles, retentions or co-insurance provisions within the contract and other factors relevant to the specific claim. For claims involving litigation, Darwin utilizes outside attorneys with expertise in the area of litigation as monitoring counsel or defense counsel. In addition to relying on his or her own experience and judgment, a claims adjuster will consider monitoring or defense counsel’s estimate of ultimate liability on a claim in the establishment of case reserves. Expenses incurred by the monitoring or defense counsel are included as ALAE reserves. During the loss adjustment
period, these estimates are revised as deemed necessary by our claims department based upon developments and periodic reviews of cases. Individual case reserves on all claims are reviewed regularly by claims management. Individual case reserves on severe claims are reviewed for adequacy at least quarterly by senior management.
IBNR is the estimated liability for (1) changes in the values of claims that have been reported to the Company but are not yet settled, as well as (2) claims that have occurred but have not yet been reported. Each claim is settled individually based upon its merits, and it is not unusual for a claim to take years after being reported to settle, especially if legal action is involved. As a result, reserves for unpaid losses and ALAE include significant estimates for IBNR reserves.
Darwin relies on two actuarial methods that employ significant judgments and assumptions to establish loss and ALAE reserves recorded on the balance sheet. Darwin’s choice of actuarial methodologies is limited by the fact that, due to Darwin’s relatively short history, its loss and ALAE emergence since inception lacks sufficient data to be statistically credible for many methodologies.
The B-F method blends actual reported losses with expected losses based on insurance industry experience.
Darwin believes that both of the methodologies used are well-suited to Darwin’s relatively short history and low level of reported losses and ALAE, and we utilize an actuarial weighting of the two methodologies. The weighting relies predominantly on the Expected Loss Ratio methodology, which has generally produced higher reserve estimates, but allows the B-F methodology to have a modest impact on our ultimate loss estimates initially. The weighting of the B-F methodology for each individual accident year increases over time as Darwin’s actual loss and ALAE history becomes more mature and as the volume of business Darwin writes reaches levels where actuarial projections relying on this data are statistically credible.
Thus, as of fourth quarter 2007, gross and net loss ratios for 2003 and 2004 are moderately below the loss ratios indicated by our standard weighting methodology. For accident years 2005, 2006 and 2007 gross and net, we have adopted the weighted loss ratios with one exception - 2005 Public Company D&O, which is moderately higher than the indication. We selected our 2005 Public Company D&O gross and net ratios based on a detailed assessment of several Public Company D&O claims for this accident year. Based on the detailed assessment, the limits outstanding on the underlying policies and the potential volatility in the loss ratio given the potential severity of these claims, we determined that a slightly higher loss ratio was appropriate.
actuarial methodologies and reasonable assumptions are more actuarially reasonable. The point estimates are recorded in Darwin’s financial statements. Also, we do not discount (recognize the time value of money) in establishing our reserve for losses and LAE.
The liabilities for loss and LAE reserves include significant judgments, assumptions and estimates made by management relating to the ultimate losses that will arise from the claims. Due to the inherent uncertainties in the process of establishing these liabilities, the actual ultimate loss from a claim is likely to differ, perhaps materially, from the liability initially recorded and could be material to the results of Darwin’s operations. The accounting policies used in connection with the establishment of these liabilities are considered to be critical accounting policies.
Darwin establishes its best estimate for liabilities for loss and LAE reserves. Because of the high level of uncertainty regarding the setting of liabilities for loss and LAE reserves, it is the practice of Darwin to engage, at least annually, an independent actuary to evaluate and opine on the reasonableness of these gross and net liabilities. Based on the Company’s analyses and the independent actuarial opinions as of December 31, 2007, management believes that the reserves for loss and LAE established as of December 31, 2007 are adequate and represent the best estimate of Darwin’s liabilities. For December 31, 2007, our independent actuaries issued unqualified statements of actuarial opinion as to the reasonableness of net reserves on a statutory basis for each of DNA, Darwin Select, and Vantapro. These unqualified statements were filed with the insurance departments of the respective states of domicile of DNA, Darwin Select, and Vantapro (Delaware, Arkansas, and Illinois). The statements of actuarial opinion issued by our independent actuaries indicate that the opinions may be relied upon only by DNA, Darwin Select, and Vantapro and the insurance departments of the various states with which the companies file annual statutory statements.
Private passenger auto liability reserves are gross outstanding reserves from the acquisition of Vantapro. These reserves are 100% ceded to Fireman’s Fund, the former parent of Vantapro.
These scenarios are well within historical variation for Darwin’s lines of business in the industry and we believe they create a reasonable sensitivity test of Darwin’s reserves. Neither of these adjustments is believed to be more likely than the other in the assumptions underlying Darwin’s reserves.
part of the insurance with respect to a single risk, exposure, or policy) to provide reinsurance protection on individual risks. Accounting for reinsurance contracts is complex and requires a number of significant judgments and estimates to be made regarding the calculation of amounts payable to reinsurers, amounts recoverable from reinsurers and the ultimate collectibility of those reinsurance recoverables from reinsurers. In addition, significant judgments are required in the determination of the compliance with overall risk transfer provisions that guide the accounting for reinsurance. These judgments and estimates are critical accounting estimates for Darwin.
In general we retain the first $1 million of loss per claim across most classes of business including many of the E&O classes, private and non-profit D&O and most medical malpractice classes. However for Commercial, Healthcare and FI D&O, Managed Care and FI E&O and Shortline Railroad Liability we retain the first $2 million of loss per claim. On other specific classes we retain lower limits that currently range from $0.3 million to $0.5 million of loss per claim. In addition we retain various additional amounts known as co-insurances that vary between 10% and 25% of the limits above these retentions.
Equity and fixed maturities deemed to have declines in value that are other-than-temporary are written down to carrying values equal to their estimated fair values in the consolidated statement of operations. On a quarterly basis, all securities with an unrealized loss are reviewed to determine whether the decline in the fair value of any investment below cost is other-than-temporary. Considerations relevant to this determination include the persistence and magnitude of the decline of the issuer, issuer-specific financial conditions rather than general market or industry conditions and extraordinary events including negative news releases and rating agency downgrades. Risks and uncertainties are inherent in our assessment methodology for determining whether a decline in value is other-than-temporary. Risks and uncertainties could include, but are not limited to, incorrect or overly optimistic assumptions about financial condition or liquidity, incorrect or overly optimistic assumptions about future prospects, inadequacy of any underlying collateral, unfavorable changes in economic or social conditions and unfavorable changes in interest rates or credit ratings.
Impairment losses result in a reduction of the underlying investment’s cost basis. Significant changes in these factors could result in a considerable charge for impairment losses as reported in the consolidated financial statements.
The following table sets forth our consolidated results of operations and underwriting results. . The consolidated results of operations give retroactive effect to our reorganization for 2005. All significant inter-company accounts and transactions have been eliminated.
Our D&O gross premiums written decreased by $1.9 million or 4.6% to $38.7 million for the year ended December 31, 2007, compared to $40.6 million for the year ended December 31, 2006. This decrease resulted from competitive pricing pressures. We wrote new policies for D&O gross premiums written of approximately $12.7 million for the year ended December 31, 2007 and we renewed policies for $26.0 million of gross premiums written for the year ended December 31, 2007. Our average premium rate for D&O business renewed in 2007 decreased by 11.9% when compared to 2006.
We began writing GL insurance in July 2007 through our program administrator agreement with Empire Insurance Services, LLC. This program administrator writes GL business for short-line railroads. For the year ended December 31, 2007, we wrote GL written premiums of approximately $0.7 million.
Ceded premiums written. Ceded premiums written were $80.6 million for the year ended December 31, 2007, compared to $89.2 million for the year ended December 31, 2006, a decrease of $8.6 million or 9.7%. The ratio of ceded premiums written to gross premiums written was 28.7% for the year ended December 31, 2007 compared to 36.2% for the year ended December 31, 2006. Ceded premiums written were reduced in 2007 by $7.6 million due to the favorable adjustments for 2003 through 2006 accident year loss results. The decrease in our estimate of expected ultimate losses incurred for the 2003 through 2006 accident years reduced our estimated ultimate ceded premium cost on certain of our variable rated reinsurance contracts in-force during the 2003 through 2006 accident years. The decrease in ceded premiums written as a percentage of gross premiums written was attributable to the adjustment to ceded premiums described above, the growth in classes of business for which Darwin ceded lesser amounts under our reinsurance contracts and to the restructuring of our reinsurance program for policies written beginning on April 1, 2007. This new reinsurance program utilized less variable rated reinsurance, was at better pricing terms than our expiring programs and will generally reduce the overall cost of reinsurance on each policy.
Net premiums earned. Net premiums earned were $180.9 million for the year ended December 31, 2007 compared to $132.4 million for the year ended December 31, 2006, an increase of $48.5 million or 36.7%. The increase in net premiums earned is attributable to the growth in net premiums written across all lines of business as described above. The ratio of net premiums earned to net premiums written was 90.6% for the year ended December 31, 2007 and 84.3% for the year ended December 31, 2006.
Net investment income and realized investment gains (losses). Net investment income increased to $22.6 million for the year ended December 31, 2007 compared to $16.4 million for the year ended December 31, 2006, an increase of $6.2 million, or 37.3%. This increase in net investment income was the result of an increase of $131.6 million or 38.0% in average invested assets as of December 31, 2007 of $478.2 million compared to average invested assets of $346.6 million at December 31, 2006 primarily due to the growth in our business. The book investment yield, which is the weighted average earnings to maturity on all investments in the portfolio determined at the time of purchase, was 4.59% on investments held at December 31, 2007 as compared to 4.92% on investments held at December 31, 2006. The decrease in book investment yield was primarily attributable to the investment of
operating cash flows in mostly lower yielding tax-exempt municipal fixed maturity securities. The tax-equivalent yield, which is the weighted average expected earnings adjusted for any estimated tax savings on investments with such savings for all investments in the portfolio yield determined at the time of purchase, was 5.32% on investments held at December 31, 2007 as compared to 5.53% on investments held at December 31, 2006. Darwin recognized net realized losses of $28 thousand in 2007 compared to $12 thousand of realized gains in 2006.
Losses and LAE incurred. Losses and LAE incurred was $101.3 million for the year ended December 31, 2007 compared to $88.6 million for the year ended December 31, 2006, an increase of $12.7 million or 14.3%. Losses and LAE incurred increased over the prior year due to the estimated losses on the increased premium volume, offset by actual and anticipated reinsurance recoveries for the losses (including a provision for recoveries on IBNR losses and LAE). The increase in losses and LAE primarily reflects increased net premiums earned. During 2007, Darwin recognized favorable loss development of $13.8 million net of anticipated reinsurance recoveries on the 2003 through 2006 accident years. Darwin’s loss ratio for the year ended December 31, 2007 decreased to 56.0% compared to 66.9% for the year ended December 31, 2006. The decrease in loss ratio for 2007 compared to 2006 was primarily due to adjustments totaling $21.4 million ($13.8 million to net losses incurred and $7.6 million to ceded premiums earned) due to Darwin’s revision of its ultimate loss ratio on its 2003 through 2006 accident years.
Commissions and brokerage expenses. Commissions and brokerage expenses were $22.6 million for the year ended December 31, 2007 compared to $14.6 million for the year ended December 31, 2006, an increase of $8.0 million or 54.8%. The ratio of commissions and brokerage expenses to net premiums earned increased to 12.5% for the year ended December 31, 2007 from 11.1% for the year ended December 31, 2006. The increase in commissions and brokerage expenses is attributable to growth in net premiums earned as well as the increase in the overall commissions paid as a percentage of net premiums earned. The increase in the commission and brokerage expense ratio for 2007 compared to 2006 is due to changes in mix of business as well as profit sharing expenses associated with certain program administrators whose arrangements allow for participation in the favorable loss development recognized during 2007 and the higher rate for the Capitol Companies policy issuance fee in 2007. For certain of our classes of business, particularly business written for insureds with smaller average premiums and risk profiles, the commission rate was higher. In addition, Darwin raised its commission rates an average of approximately 2.0% on new business during 2007, resulting in higher average commission rates being paid on our overall business. These increases in gross commission and brokerage expense were partially offset by increased ceded commission expense. The ceded commission expense increased to $21.2 million or 15.1% of net premiums earned for 2007 from $14.0 million or 12.2% of net premiums earned for 2006, an increase of $7.2 million or 51.4%. The increase in ceded commission expenses was due to increased earned ceded premiums and restructuring certain reinsurance agreements to increase the premiums subject to ceding commissions and higher ceding commission rates.
Income tax expense. Income tax expense incurred was $13.2 million for the year ended December 31, 2007 compared to $7.3 million for the year ended December 31, 2006, an increase of $5.9 million. The increase was due to the increased profitability for the year ended December 31, 2007 compared to the year ended December 31, 2006, partially offset by a decrease in the effective tax rate. The effective tax rate decreased to 29.0% for the year ended December 31, 2007 from 31.3% for the year ended December 31, 2006. The decrease in the effective tax rates was attributable primarily to an increase in the portion of net investment income received on tax-exempt municipal securities.
Gross premiums written. Gross premiums written were $246.3 million for the year ended December 31, 2006 compared to $165.8 million for the year ended December 31, 2005, an increase of $80.5 million, or 48.5%. The increase in gross premiums written during 2006 compared to 2005 reflects significant growth across all of Darwin’s lines of business. Of the $246.3 million of gross premiums written in 2006, $111.1 million was attributable to E&O business, $94.6 million was attributable to medical malpractice liability business and $40.6 million was attributable to D&O business.
Our E&O gross premiums written increased by $52.2 million to $111.1 million for the year ended December 31, 2006, compared to $58.9 million for the year ended December 31, 2005. This increase resulted from the writing of new E&O policies for approximately $65.2 million and the renewal of policies for $45.9 million of gross premiums written for the year ended December 31, 2006. New business writings were primarily in our managed care, public officials, lawyers and insurance agents E&O classes of business. Darwin experienced a weighted average rate decrease for our E&O business in 2006 of approximately 8.4% when compared to 2005. These decreases in rate were primarily the result of competitive pricing pressures in our managed care, lawyers and insurance agents E&O classes of business.
Our medical malpractice liability premiums increased by $20.6 million to $94.6 million for the year ended December 31, 2006, compared to $74.0 million for the year ended December 31, 2005. This increase resulted from the writing of new medical malpractice liability policies for gross premiums of approximately $53.1 million, primarily in our hospital professional liability and miscellaneous medical facility classes of business, and the renewal of existing policies for $41.5 million of medical malpractice liability premiums. Darwin experienced a weighted average decrease in rate for our medical malpractice liability renewal business in 2006 of approximately 3.2% when compared to 2005.
premiums earned. The ratio of commissions and brokerage expenses to net premiums earned increased slightly to 11.1% for the year ended December 31, 2006 from 10.9% for the year ended December 31, 2005, resulting from business written at a higher commission rate.
Other expenses. Other expenses incurred were $0.8 million for the year ended December 31, 2006 compared to $1.1 million for the year ended December 31, 2005, a decrease of $0.3 million or 31.9%. These expenses were primarily attributable to Darwin’s Long-Term Incentive Plan (“LTIP”). The decrease for the year ended December 31, 2006 compared the year ended December 31, 2005 is due to a change in the formula for the calculation of the long-term incentive compensation payable to certain key employees. Effective January 1, 2006, the long-term incentive plan was changed to introduce a net underwriting profitability hurdle rate and imputed investment income was no longer credited to participants.
Income tax expense. Income tax expense incurred was $7.3 million for the year ended December 31, 2006 compared to $2.3 million for the year ended December 31, 2005, an increase of $5.0 million. These increases were due to the increased profitability for the year ended December 31, 2006 compared to the year ended December 31, 2005, partially offset by a decrease in the effective tax rate. The effective tax rate decreased to 31.3% year ended December 31, 2006 from 38.0% for the year ended December 31, 2005. The decrease in effective tax rate was attributable primarily to an increase in net investment income received on tax-exempt municipal securities.
General. DPUI is the ultimate parent of Darwin Group, DNA, Darwin Select, Vantapro, Evolution and AMS. Until December 31, 2007, DPUI provided underwriting, claims, management, and administrative services to DNA and Darwin Select under a Service Agreement in exchange for management fees. The management fees were determined based upon agreements between DPUI and each of DNA and Darwin Select, which have been filed with and approved by the insurance departments responsible for regulatory oversight of each of such insurance companies. These agreements provided for payments to DPUI at a rate equal to 32.0% of gross premiums written on business produced by DPUI and written on the policy of the relevant insurance company or, if lower, in an allocable amount based upon the total operating expense actually incurred by DPUI. Additional payment to DPUI was due upon the achievement of profitability levels that would trigger a payout under our LTIP. On December 31, 2007, the agreement was terminated and the underwriting, claims, management, administrative services, and related staff were transferred to DNA. DPUI continues to bear the direct expenses incurred in connection with being a holding company and to be an agent for the insurance companies. These include expenses associated with owning the fixed assets and leasing real property that are used by the insurance companies. DPUI and DNA have agreed in principle to the execution of a Cost Sharing Agreement under which DPUI will charge back to DNA and to its other direct subsidiary, Evolution, each subsidiary’s allocable share of the corporate expenses, rent and the tangible assets and software.
Dividends. State insurance laws restrict the ability of our insurance company subsidiaries to declare dividends. State insurance regulators require insurance companies to maintain specified levels of statutory capital and surplus. Generally, dividends may only be paid out of earned surplus, and the amount of an insurer’s surplus following payment of any dividends must be reasonable in relation to the insurer’s outstanding liabilities and adequate to meet its financial needs. Further, prior approval of the insurance department of its state of domicile is required before either of our insurance company subsidiaries can declare and pay an “extraordinary dividend” to us.
DNA is domiciled in Delaware. Under Delaware law, DNA may not pay an “extraordinary” dividend, which is defined as any dividend or distribution, the fair market value of which, together with that of other dividends or distributions made within the preceding 12 months, exceeds the greater of (i) 10% of statutory surplus as of the prior year-end or (ii) statutory net income less realized capital gains for such prior year, until thirty days after the Insurance Commissioner of the State of Delaware (“Delaware Commissioner”) has received notice of such dividend and has either (i) not disapproved such dividend within such thirty day period or (ii) approved such dividends within such thirty day period. In addition, DNA must provide notice to the Delaware Commissioner of all dividends and other distributions to stockholders within five business days after declaration and at least ten days prior to payment. As of December 31, 2007, DNA could pay approximately $32.2 million in dividends to DPUI without prior approval of the Commissioner. Since DNA operated at a statutory loss in 2005 and had no earned surplus, no ordinary dividend distribution could be paid by DNA to DPUI in 2006. DNA received approval on February 28, 2007 from the Delaware Insurance Department to pay DPUI a dividend of $3.5 million, which was paid to DPUI in March 2007.
Vantapro is domiciled in Illinois. Vantapro has filed an application to redomesticate to Arkansas. Since Vantapro has minimum capital and earned surplus at December 31, 2007 of $7 thousand, no ordinary dividend distribution may be paid by Vantapro to DNA in 2008 without prior approval from the Insurance Commissioner.
On April 1, 2006, the Company declared a dividend of $2.5 million in the form of Series C Preferred Stock to the holders of Series B Convertible Preferred Stock.
The Company’s Registration Statement filed with the Securities and Exchange Commission for the purpose of making an initial public offering of Common Stock was declared effective on May 18, 2006 for the issuance of 5,217,391 shares of common stock at an initial offering price of $16.00 per share. Subsequently, the underwriters of the initial public offering exercised their over-allotment option in which an additional 782,609 shares of Common Stock were issued at the $16.00 per share initial public offering price. Gross proceeds from the sale of the 6,000,000 shares of Common Stock were $96.0 million. Total costs associated with the initial public offering included $9.7 million of underwriting costs and offering expenses. Net proceeds from the offering, after deducting underwriting costs and offering expenses, were $86.3 million.
Cash Flows. We have three primary types of cash flows: (1) cash flows from operating activities, which consist mainly of cash generated by our underwriting operations and income earned on our investment portfolio, (2) cash flows from investing activities related to the purchase, sale and maturity of investments, and (3) cash flows from financing activities that impact our capital structure, such as capital contributions, borrowing under the Credit Agreement and changes in paid-in capital and shares outstanding.
The following table summarizes these cash flows for the years ended December 31, 2007 and 2006:
Contractual Obligations. We have certain obligations to make future payments under contracts and commitments. At December 31, 2007, certain long-term aggregate contractual obligations and commitments were as follows:
Investments. We utilize a third-party investment manager, General Re-New England Asset Management, to manage our investments. We have provided our investment manager with investment guidelines and the Finance and Investment Committee of our Board of Directors reviews our investment performance and the investment manager’s compliance with our investment guidelines on a quarterly basis. We believe that we have a conservative approach to our investment and capital management strategy with an objective of providing a stable source of income and preserving capital to offset underwriting risk. We maintain an investment portfolio representing funds that have not yet been paid out as claims, as well as the capital we hold for our stockholders. As of December 31, 2007, our investment portfolio had a fair value of $556.9 million, an increase of $157.5 million over the December 31, 2006 investment portfolio fair value of $399.4 million. The increase in invested assets at December 31, 2007 when compared to December 31, 2006 was primarily due to cash flows from operations, investing excess cash balances, invested income, and unrealized gains. Our investment portfolio consists of preferred stocks, long-term fixed income and short-term investment securities. We are currently moving forward with plans for diversifying our portfolio to include some classes of common equity for a small percentage of the Company’s total portfolio holdings.
The following table presents the dollar and percentage distributions of investments as of December 31, 2007 and December 31, 2006:
The following table presents the book and tax-equivalent yield on all investments as of December 31, 2007 and December 31, 2006:
Our fixed-income portfolio is invested in investment grade bonds. The National Association of Insurance Commissioners (NAIC) assigns ratings that range from Class 1 (highest quality) to Class 6 (lowest quality). The following table shows our fixed income portfolio by independent rating agency and comparable NAIC designations as of December 31, 2007 and December 31, 2006:
As of December 31, 2007, the average option adjusted duration of our fixed-income portfolio was 3.90 years compared to 3.99 years as of December 31, 2006. The concept of average option adjusted duration takes into consideration the probability of having the various option features associated with many of the fixed-income investments we hold exercised. Fixed maturity securities are frequently issued with call provisions which provide the option of adjusting the maturity of the security at the option of the issuer. In 2007, the duration decreased slightly due to declining interest rates leading to a slight reduction in the mortgage-back securities’ average life.
The unrealized losses on preferred stock and fixed maturity securities are primarily interest rate related. The Company’s unrealized loss increased $0.2 million to $1.0 million from December 31, 2006 to December 31, 2007. Each of the securities with an unrealized loss at December 31, 2007 has a fair value that is greater than 92.0% of its amortized cost, with the exception of one security which was valued at 87.7% of cost due largely to concerns over a bond insurer’s rating. With the exception of this one security, the remaining 16 securities have been in an unrealized loss position for longer than 12 month and have a fair value that is greater than 97.7% of its amortized cost. None of the preferred stock or fixed maturity securities with unrealized losses has ever missed, or been delinquent on, a scheduled dividend, principal or interest payment, and none is rated below investment grade. As of January 31, 2008, 8 of these securities have recovered their unrealized losses and are trading in excess of their cost basis. Of the remaining securities, all but two of the securities have shown improvement in the fair market value since December 31, 2007 and are paying interest currently and we remain comfortable with the credit quality of the issuer. Based on management’s review of the factors above, no securities are considered to be other-than-temporarily impaired.
Given recent rating agency actions on sub-prime securities, we performed additional procedures to review for any impairment on our mortgage/asset-backed securities that are classified as sub-prime mortgage obligations. As of December 31, 2007, we held sub-prime fixed income securities totaling $1.3 million. All of these securities (4 in total) are currently rated AAA and none is currently under watch by a major rating agency. The remaining average life of each of these securities is less than 3 months and all are currently paying down their balances. The total unrealized loss on these securities as of December 31, 2007 was approximately $8 thousand. In addition to the sub-prime mortgage obligations, we hold $8.5 million of Alt-A mortgage obligations, commonly known as low documentation mortgages, which have historically had lower default rates than sub-prime mortgages. Similar to the sub-prime mortgage obligations, all of these securities (7 in total) are currently rated AAA, have a remaining average life of less than 1.8 years (except one with a remaining average life of 5.1 years) and have total unrealized losses as of December 31, 2007 of less than $22 thousand. As such, we do not believe we have any other-than-temporarily impaired fixed income securities classified as “sub-prime” or Alt-A mortgage obligations.
Certain asset-backed and municipal securities held by Darwin are backed by a financial guarantee insurance policy from a mono-line insurance guarantor (“mono-lines”) to strengthen the overall credit quality of the security. These mono-lines have historically been rated at the highest credit quality ratings from the major rating agencies (Standard & Poors’, Moody’s and Fitch). Recent volatility in the credit market, particularly related to the sub-prime credit market, has caused large losses for these mono-lines, reduced their capital and put their credit ratings at risk. Several have been downgraded and/or are on a negative credit watch by the major rating agencies. When a security
In March 2006, the Financial Accounting Standards Board (FASB) issued Statement No. 155 (SFAS No. 155), Accounting for Certain Hybrid Instruments, an amendment to FASB Statement No. 133 and 140. This Statement permits fair value re-measurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, and establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. This Statement is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. Darwin adopted the
In July 2006, FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes. The Interpretation clarifies the accounting for income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. The Interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. Darwin adopted the provisions of this Interpretation as of January 1, 2007, and the implementation did not have a material impact on the Company’s results of operations or financial condition.
In September 2006, FASB issued Statement No. 157, Fair Value Measurements. This Statement provides guidance for using fair value to measure assets and liabilities. The Statement does not expand the use of fair value in any new circumstances. The Statement is effective for financial statements prepared for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Darwin does not anticipate that this Statement will have a material impact on the Company’s results of operations or financial condition.
In December 2007, FASB Statement No. 141 (revised 2007), Business Combinations was issued. The Statement requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction, establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed, and requires the acquirer to disclose additional information regarding the nature and financial effect of the business combination. This Statement is effective for the first annual reporting period beginning after December 15, 2008. Darwin will adopt the statement for all business combinations initiated after December 31, 2008.
In December 2007, FASB Statement 160, Non-controlling Interests in Consolidated Financial Statements (“SFAS 160”) was issued. SFAS 160 requires all entities to report non-controlling (minority) interests in subsidiaries as equity in the consolidated financial statements. SFAS 160 also requires disclosure, on the face of the consolidated statement of income, of the amounts of consolidated net income attributable to the parent and to the non-controlling interest. We will adopt SFAS 160 for all business combinations initiated after December 31, 2008.
The Company does not have any off-balance sheet arrangements, as defined for purposes of the SEC rules, which are not accounted for or disclosed in the consolidated financial statements as of December 31, 2007.
The financial statements and financial statement schedules listed in the accompanying Index to Consolidated Financial Statements and Schedules are filed as part of this Annual Report on Form 10-K.