We currently lease office space in Hamilton, Bermuda where our executive and principal offices are located, and in Dublin, Ireland; Singapore; Japan; Denver, Colorado; Charlotte, and North Carolina, United States; London and Windsor, United Kingdom. Our life reinsurance business operates out of the Charlotte, Denver, Dublin, Singapore, Japan, and London offices, while our Wealth Management business operates out of the Bermuda office. Following the completion of the sale of our Life Reinsurance International Segment, the London, Windsor, Singapore and Japan leases will be transferred to the purchaser.
The Dublin and Singapore leases expire in 2008, the Denver lease expires in 2009 with an option to lease office space for an additional five years, the Japan lease expires in 2010, the Bermuda lease expires in 2011 and the London and Charlotte leases expire in 2016. The Windsor lease expires in 2023 but there is an option to break the lease in 2013 which we will activate. A certain number of the offices have lease renewal options for terms ranging from 1 to 5 years.
The following selected financial data should be read in conjunction with the Consolidated Financial Statements, including the related Notes, and “Management’s Discussion and Analysis of Financial Condition and Results of Operations”.
Book value per ordinary share is calculated as shareholders’ equity less preferred shares divided by the number of ordinary shares outstanding.
Some of the statements contained in this report are not historical facts and are forward-looking statements within the meaning of the Private Securities Litigation Reform Act. Forward-looking statements involve known and unknown risks, uncertainties and other factors, which may cause the actual results to differ materially from the forward-looking statements. Words such as “anticipates”, “expects”, “intends”, “plans”, “believes”, “seeks”, “estimates”, “may”, “will”, “continue”, “project”, and similar expressions, as well as statements in the future tense, identify forward-looking statements.
uncertainties in our ability to raise new sources of equity or debt capital to support ongoing capital, liquidity and collateral needs;
uncertainties relating to future actions that may be taken by creditors, regulators and ceding insurers relating to our ratings and financial condition;
uncertainties in our ability to successfully dispose of our Life Reinsurance North America Segment in a timely manner;
changes in expectations regarding future realization of gross deferred tax assets;
risks related to recent negative developments in the residential mortgage market, especially in the sub-prime sector, and our exposure to such market;
risks arising from our investment strategy, including risks related to the estimated fair value of our investments, fluctuations in interest rates and our need for liquidity;
the risk that our risk analysis and underwriting may be inadequate;
conflicts of interest with the Investors, who are our majority shareholders;
uncertainties relating to government and regulatory policies (such as subjecting us to insurance regulation or taxation in additional jurisdictions);
restrictions in our articles of association to effect a change in control;
insurance regulatory restrictions that impact our ability to effect a change in control;
risks that one or more of our non - U.S. subsidiaries may be considered a passive foreign investment company for U.S. federal income tax purposes; and
risk that one or more of our non - U.S. subsidiaries may be characterized as engaged in a U.S. trade or business.
In our Life Reinsurance North America Segment, we have assumed risks associated with primary life insurance, annuities and annuity-type policies. We reinsure mortality, investment, persistency and expense risks of United States life insurance and reinsurance companies. Most of the reinsurance assumed is through automatic treaties, but in 2006 we also began assuming risks on a facultative basis. The Life Reinsurance North America Segment suspended bidding for new treaties on March 3, 2008. While there currently remains a number of open treaties, the flow of new business from these treaties is small, and we expect to close them off for new business over the remainder of 2008.
Prior to 2005, our Life Reinsurance International Segment specialized in niche markets in developed countries and broader life insurance markets in the developing world and focused on the reinsurance of short-term insurance. In 2005, the Life Reinsurance International Segment became involved in the reinsurance of United Kingdom and Ireland protection and annuity business. The U.K. represents 65% of the current Life Reinsurance International Segment in-force premium. We also maintain a branch office in Singapore and a representative office in Japan. Treaties with clients outside of the U.K., Ireland, and Asia are mostly in run-off, including our loss of license business. On June 9, 2008, we entered into a definitive agreement with Pacific Life Insurance Company, to purchase our Life Reinsurance International Segment. The sale price is $71.2 million, subject to certain downward adjustments. The transaction is subject to regulatory approvals and other customary closing conditions, both of which are expected to be achieved during the third quarter of 2008.
Income in our Corporate and Other Segment comprises investment income, including realized investment gains or losses, from invested assets not allocated to support reinsurance segment operations and undeployed proceeds from our capital raising efforts. General corporate expenses consist of unallocated overhead and executive costs and collateral finance facility expense. Additionally, the Corporate and Other Segment includes the results from our Wealth Management business. On May 30, 2008, we entered into a definitive agreement with Northstar Financial Services Ltd. to sell our Wealth Management business. The sale includes the sale of three legal entities, The Scottish Annuity Company (Cayman) Ltd., Scottish Annuity & Life Insurance Company (Bermuda) Ltd. and Scottish Annuity & Life International Insurance Company (Bermuda) Ltd. The combined sale price for all three entities is $6.75 million, subject to certain sale price adjustments. The closing is subject to regulatory approval from the Bermuda Monetary Authority and the Cayman Islands Monetary Authority and other customary closing conditions. We expect to close this transaction in the third quarter of 2008.
During 2007, there have been a number of changes in our management structure, described as follows in chronological order:
In May 2007, Dean E. Miller resigned from his position as Executive Vice President and Chief Financial Officer.
In May 2007, Dan Roth, a former executive officer of Cerberus, was appointed as Chief Restructuring Officer.
In October 2007, Terry Eleftheriou, a former executive with XL Capital, joined the Company and assumed responsibility as Chief Financial Officer in November 2007.
In December 2007, Chris Shanahan was appointed interim President and Chief Executive Officer - North America.
In December 2007, Thomas A. McAvity, Jr. retired from the Company and, as a result, left his position as Chief Investment Strategist.
In December 2007, Samir Shah was appointed to the position of Chief Risk Officer.
Reserves for claims and future policy benefits are our estimates of what we expect to pay in claims and policy benefits and related expenses under the contract or policy. From time to time, we may change the reserves if our experience leads us to believe that benefit claims and expenses will ultimately be greater than the existing reserve. We report the change in these reserves as an expense during the period when the reserve or additional reserve is established.
Operating expenses consist of salary and salary related expenses, legal and professional fees, rent and office expenses, directors’ expenses, insurance and other similar expenses.
Collateral finance facilities expense includes costs incurred on our Regulation XXX funding arrangements and other collateral finance facilities.
The primary factor affecting profitability in fiscal year 2007 has been other-than-temporary impairment charges relating to our sub-prime and Alt-A securities. These securities are primarily held by two bankruptcy remote special purpose reinsurers, Ballantyne Re and Orkney Re II, which have financed a large portion of our Regulation XXX statutory reserves. We consolidate these entities for U.S. GAAP reporting purposes. As sub-prime and Alt-A loan performance deteriorated, the market became increasingly illiquid and unbalanced, with an absence of buyers, causing market prices to decrease which created a decline in the estimated fair value of our bonds below their amortized cost. We expect delinquency and loss rates in the sub-prime mortgage sector to continue to increase in the future. Tranches of securities will experience losses according to the seniority of the claim on the collateral, with the least senior (or most junior), typically the unrated residual tranche, taking the initial loss.
Financial condition: liquidity to ensure adequate resources are available to meet our normal operating cash flow needs and book value per share to maximize returns to shareholders;
Operations: premiums, changes in the number of treaties and life insurance in-force, investment results, claim frequency and severity trends, claims and benefit ratio and acquisition and expense ratios and operating earnings per share; and
In recent years, our business has been, and we expect will continue to be, influenced by a number of industry-wide trends and conditions.
Interest Rate Fluctuations. Our principal interest sensitive products are deferred annuities, which are interest rate sensitive instruments. In an interest rate environment of falling or stable rates, our annuity holders are less likely to seek to surrender their annuities prior to maturity to seek alternative, higher-yielding investments. However, in an environment of moderately or significantly increasing rates, such surrenders should be expected to increase. As of December 31, 2007, the existence of surrender fees and the lower interest rate environment acts as a deterrent against surrenders. However, if interest rates climb sufficiently, such fees may not have a significant deterrent effect. In the event of a substantial increase in surrenders during a short period of time, we may have to sell off longer-term assets to pay current surrender liabilities. We continually develop strategies to address the match between the timing of its assets and liabilities. The deferred annuities also provided guaranteed minimum interest rates. In an interest environment of falling rates, as was the case for 2007, interest spreads realized on the business may be compressed by the required guaranteed interest rates as positive cash flow is invested in lower yielding assets.
Mortality Risk - Mortality risk is the primary risk transferred in most of our life reinsurance agreements. While we maintain a significant amount of expertise related to mortality expectations, actual claim results will exhibit a moderate amount of volatility on a period by period basis related to the number and average size of reported deaths during a given accounting period. During 2007, actual claims in our Life Reinsurance North America Segment were approximately 96% of our current best estimate of mortality. The favorable experience during 2007 was driven by consistently favorable results throughout the year on the acquired ING block of business as well as favorable results on the organic block. The favorable mortality in 2007 was a turnaround from 2006 when overall North America claims results ran at about 104% of expectation. Both years results fall within the expected reasonable range of variation for the North America business.
risk on any of our excess retrocession programs. Within the acquired ERC block of business there are several first-dollar retrocession pools which cede a quota share of the business to a pool of external parties. During 2007 we negotiated an extra contractual recapture of the quota share retrocession to one of those external parties. As a result of that recapture we wrote off approximately $4.5 million of outstanding reinsurance recoverables from that external party. The entire amount of that write off was covered by a previously established valuation allowance.
Given the nature of our business, our accounting policies require the use of judgments relating to a variety of assumptions and estimates. Because of the inherent uncertainty in the estimates underlying these accounting policies under different conditions or assumptions, the amounts reported in our financial statements could be materially different. Our accounting policies are described in Note 2 “Summary of Significant Accounting Policies” in the Notes to Consolidated Financial Statements. For all of these policies, we caution that future events rarely develop exactly as forecast, and management’s best estimate may require adjustment.
These consolidated financial statements do not give effect to any adjustments to recorded amounts and their classification, which would be necessary if we were unable to continue as a going concern and, therefore, be required to realize its assets and discharge its liabilities in other than the normal course of business and at amounts different from those reflected in the consolidated financial statements.
In accordance with FASB Interpretation No. 46R, “Consolidation of Variable Interest Entities - An Interpretation of ARB No. 51 (“FIN 46R”), various collateral financing facilities structures maintained by us (including both Ballantyne Re and Orkney Re II which are non-recourse and bankruptcy remote special purpose reinsurance vehicles domiciled in Ireland) are considered to be variable interest entities and we are deemed to hold the primary beneficial interest. As a result, these vehicles have been consolidated in our financial statements as more fully described in Note 7 “Collateral Finance Facilities and Securitization Structures” in the Notes to Consolidated Financial Statements. Our consolidated balance sheets include the assets of Ballantyne Re, Orkney Re II and the other collateral facilities structures, recorded as fixed maturity investments, other invested assets, and restricted cash and cash equivalents, with the liability for the notes recorded as collateral finance facilities. Our consolidated statements of income (loss) include the revenues and expenses of these structures including other-than-temporary impairments of sub-prime assets which is reflected in net realized investment losses and the cost of the facility is reflected in collateral finance facility expense. Our consolidated net loss for the year ended December 31, 2007, included net losses of $543 million and $115 million for Ballantyne Re and Orkney Re II, respectively. Our consolidated net loss for the year ended December 31, 2006 included net losses of $187.5 million for Ballantyne Re and net income of $2.3 million for Orkney Re II.
For certain investments in beneficial interests in securitized financial assets of less than high quality with contractual cash flows, including asset-backed securities, EITF 99-20 requires a periodic update of our best estimate of cash flows over the life of the security. If the fair value of an investment in beneficial interests in a securitized financial asset is less than its cost or amortized cost and there has been a decrease in the present value of estimated cash flows since the last revised estimate, considering both their timing and amount, an other-than-temporary impairment charge is recognized.
(ii) Going Concern Uncertainties - As a result of declines in the fair value of our invested assets, which contain a significant concentration of sub-prime and Alt-A residential mortgage-backed securities, we have experienced deteriorating financial performance and a worsening liquidity and collateral position. Our liquidity is insufficient to fund our future needs and, without additional sources of capital or the successful completion of the actions resulting from our change in strategic focus, is currently projected to be exhausted by the first quarter of 2009. These conditions raise substantial doubt about our ability to continue as a going concern and adversely impact our ability to retain impaired securities to their expected recovery of fair value.
(iii) ING Assignment - As part of our efforts to alleviate the collateral requirements of our reinsurance operating subsidiaries, we have executed an Assignment Letter of Intent with ING to assign and novate the reinsurance and trust agreements between SRUS and Ballantyne Re to ING. This assignment will adversely impact our ability to restrict the sale of impaired securities within this securitization structure as the investment management agreements and associated consent rights are expected to be amended as part of the transaction.
The fair value of these embedded derivatives at December 31, 2007 was a liability of $131.5 million (2006- $87.9 million) and is included in other liabilities. The change in fair value of embedded derivatives is reported in the income statement under the caption “Change in value of embedded derivatives, net.”
In respect of premium accrual estimates for the year ended December 31, 2006 we recorded subsequent adjustments totaling $7.1 million which resulted in higher premiums in the year ended December 31, 2007. The impact on net income of these adjustments was immaterial given that we had offsetting reserves and allowances against the premium accrual. We consider these adjustments to our premium accruals to have been within management’s expectation of the normal variability of such an estimate and the impact on net income from these adjustments was immaterial.
During the three and six months ended June 30, 2006 we made an adjustment to revise our premium accrual estimates by $8.0 million in the context of a total premium accrual of $221.0 million as of December 31, 2005. The impact on net income of this adjustment was immaterial given that we had offsetting reserves and allowances against the premium accrual. We consider this revision of premium accrual to have been within management’s expectation of the normal variability of such an estimate.
We primarily rely on our own valuation and administration systems to establish reserves for future policy benefits. The reserves for future policy benefits may differ from those established by ceding companies due to the use of different assumptions, based principally on actual and anticipated experience, including industry experience and standards. We rely on our ceding companies, however, to provide accurate policy level data, including face amount, age, duration and other characteristics as well as underlying premiums and claims. This data constitutes the primary information used to establish reserves for essentially all of our future policy benefits. The use of reinsurance intermediaries in our transactions with ceding companies has been infrequent. In the few instances in which intermediaries are involved, we receive data from the intermediary in a similar timeframe as if received directly from the ceding company.
The development of policy reserves for our products requires management to make estimates and assumptions regarding mortality, lapse, expense and investment experience. Interest rate assumptions for individual life reinsurance reserves range from 2.5% to 7.0% during 2007 (2.5% to 7.0% during 2006). The credited interest assumptions for deferred annuities ranged from 2.7% to 5.6% during 2007 (2.7% to 6.1% during 2006).
treaties significantly deteriorates to the point where a premium deficiency exists, the cumulative amortization is re-estimated and adjusted by a cumulative charge or credit to current operations.
DAC related to SFAS No. 60 traditional life reinsurance contracts is amortized over the entire premium paying period in proportion to the present value of expected future gross premiums. The present value of expected future gross premiums is based upon the premium requirement of each policy and assumptions for mortality, persistency and investment return at treaty issuance. The assumptions are not revised after treaty issuance unless the DAC balance is deemed unrecoverable by the loss recognition testing process. Absent a premium deficiency, variability in amortization after policy issuance or acquisition is caused only by variability in premium volumes. Loss recognition testing conducted over the last several years has indicated that no unlocking of assumptions on the SFAS No. 60 related DAC balance was necessary nor is it currently expected to be necessary in the near future.
In general, a change in assumption that improves our expectations regarding EGPs will increase expected earnings and the current DAC balance (favorable locking). Conversely, a change in assumption that decreases EGP will have the effect of reducing expected earnings and lowering the DAC balance (unfavorable locking). The likelihood of the favorable or unfavorable unlocking for all policies for all treaties in the same direction on a permanent basis is not likely. Each interest sensitive treaty is analyzed separately every quarter for changes in assumptions. The impact on DAC from unlocking for the last six quarters has ranged from 5.4% favorable unlocking to a 1.3% unfavorable unlocking. The current DAC balance for the interest sensitive business is $154.0 million.
SFAS No. 97 “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments” (“SFAS No. 97”), applies to investment contracts, limited premium contracts, and universal life-type contracts. For investment and universal life-type contracts, future benefit liabilities are held using the retrospective deposit method, increased for amounts representing unearned revenue or refundable policy charges. Acquisition costs are deferred and recognized as expense as a constant percentage of gross margins using assumptions as to mortality, persistency, and expense established at policy issue without provision for adverse deviation and are revised periodically to reflect emerging actual experience and any material changes in expected future experience. Liabilities and the deferral of acquisition costs are established for limited premium policies under the same practices as used for traditional life policies with the exception that any gross premium in excess of the net premium is deferred and recognized into income as a constant percentage of insurance in-force. Should the liabilities for future policy benefits plus the present value of expected future gross premiums for a product be insufficient to provide for expected future benefits and expenses for that product, deferred acquisition costs will be written off and thereafter, if required, a premium deficiency reserve will be established by a charge to income. Changes in the assumptions for mortality, persistency, maintenance expense and interest could result in material changes to the financial statements.
The Black-Scholes model incorporates six key factors: (i) the price of our stock on the grant date, (ii) the exercise price of the option, (iii) the expected term of the option, (iv) the expected volatility of our stock, (v) the expected dividend rate and (vi) the risk-free interest rate as of the grant date. Several of these factors (the expected term of the option, the expected volatility of our stock, and the expected dividend rate) incorporate management’s judgment, which could materially impact the fair value of the option. Management has used historical data to estimate the expected term or amount of time between the option grant date and the exercise/cancellation date. The expected term of the option is also used to select the risk-free interest rate as of the grant date. The expected volatility of our stock is based on historical volatility. As we are currently prohibited from declaring any cash dividends, management has used an expected dividend rate of zero in calculating the fair value of the option.
Operating income (loss) is a non-GAAP measure. We define operating income (loss) as income (loss) before income taxes and minority interest before realized gains and losses and the net change in value of embedded derivatives. While these
items may be significant components in understanding and assessing our consolidated financial performance, we believe that the presentation of operating income (loss) enhances the understanding of our results of operations by highlighting earnings attributable to the normal, recurring operation of our reinsurance business. However, operating income (loss) is not a substitute for net income determined in accordance with U.S. GAAP.
Book value per share is calculated as shareholders’ equity less preferred shares divided by the number of ordinary shares outstanding.
The operating loss for the year ended December 31, 2007 was $49.8 million, an improvement of $54.1 million compared to the prior year. The reduction in operating loss, excluding the impact of non-recurring items, was driven by improved operating results in the Life Reinsurance North America Segment, the Life Reinsurance International Segment and lower overall Corporate and Other Segment expenses.
Refer to “Management’s Discussion and Analysis-Financial Condition -Impairment Methodology and Realized Losses” for further details on our impairment methodology.
For Ballantyne Re, the Class A-3 Notes ($400.0 million) are auctioned on a weekly basis. Since August 24, 2007 the auction has failed. The Class A-3 Notes provide that, in the event of a failed auction, the rate payable on these notes will be a maximum amount based upon the current LIBOR plus a spread. The spread varies from 1.25-2.00% based upon Ambac’s rating of the Notes. As of year end the spread was 1.25%. Subsequent to year end the bonds were downgraded by Fitch and placed on negative watch, thus increasing the spread to 2.00%. As of June 5, 2008 Standard & Poors downgraded Ambac’s rating, with a negative outlook, and the spread for auctions after that date increased to 2.00%. The increased costs associated with the failed auction and our ratings will negatively impact liquidity of Ballantyne Re by reducing the funds available to make reinsurance payments, fund reserve trusts and make interest payments on the bonds.
For Clearwater Re, the interest payable on the Notes is tied to the ratings of SALIC and ranges from LIBOR plus 0.85% per annum to LIBOR plus 1.75% per annum. As of December 31, 2007 the ratings of SALIC were such that the rate due on the Notes was LIBOR plus 1.75%. The increased costs associated with these Notes will negatively impact liquidity of Clearwater Re by reducing the funds available to make reinsurance payments, fund reserve trusts and make interest payments on the bonds. We have the responsibility to make any payments that cannot be funded by Clearwater Re, which may negatively impact our liquidity.
Net premiums for 2007 continue to be adversely affected by ratings downgrades. New business volumes were significantly decreased in 2007 relative to 2006. This equates to lower income growth in 2008 attributable to new business written in 2007, as compared to 2006 new business. Net premiums for 2006 were adversely affected by our ratings downgrades (which negatively affected new business volume), increased retrocession costs, the adverse effect of certain adjustments in 2006 to revise previous estimates related to premium accrual estimates, estimates for external retrocession premiums due, experience refunds and cedant balance true-ups.
Mortality claims experience for the North America business was favorable compared to our internal planning models for 2007. For 2007, net claims for the Life Reinsurance North America Segment were favorable. This was primarily driven by favorable experience on the acquired ING block of business and organically produced business, partially offset by adverse net mortality on the acquired ERC block. The 2007 basis for expected mortality is consistent with the prior years’ planning models. During 2006, we reported adverse mortality to plan. Both 2006 and 2007 results were within the internal range of normal fluctuation for the block of business.
During the period July 19, 2007 to December 31, 2007, we granted an additional 850,000 Time Based Options and an additional 170,000 Performance Based Options to eligible employees. As at December 31, 2007, 3,666,000 Performance Based Options were approved but are not included in the tables as granted in Note 13 “Employee Benefit Plans” in the Notes to Consolidated Financial Statements as we do not have a grant date to calculate the fair value in accordance with SFAS No. 123 (R).
We incurred a non-cash expense of $10.0 million in stock option expense related to the 2007 Stock Option Plan for the year ended December 31, 2007. The weighted average exercise price for outstanding options in the 2007 Plan at December 31, 2007 is $4.51.
Income tax benefit for the year ended December 31, 2007 was $157.6 million compared to a $220.6 million expense in 2006. The benefit is primarily related to the release of a $136.8 million valuation allowance on deferred tax assets associated with net operating loss carryforwards and $34.8 million of other current year movements in the deferred taxes associated with the U.S. consolidated tax life group. The release of the valuation allowance principally relates to significant current year taxable income generated from the redomestication of Orkney I from South Carolina to Delaware, which occurred in May 2007. The net operating losses carryforwards utilized to offset the taxable income generated from the redomestication were previously written down via a valuation allowance, thus the utilization of these losses resulted in an offsetting valuation allowance release.
In May 2007, we redomesticated Orkney I to Delaware to, among other considerations, take advantage of the synergies created by having both Orkney I and our principle U.S. operating subsidiary, SRUS, subject to a single regulator with a more comprehensive understanding of the overall combined business and statutory considerations. The valuation allowance previously assessed on the net operating loss carryforwards was released.
Our estimation processes may lead to subsequent modifications as actual results may differ from original estimates. In respect of premium accrual estimates for the year ended December 31, 2006, we recorded adjustments in the current year totaling $7.1 million in the year ended December 31, 2007. We consider these premium accrual adjustments within management’s expectation of normal variability of such estimates.
Experience refunds related to the underlying mortality experience on retroceded business were $18.4 million lower in 2007 compared to 2006. Largely offsetting this current year reduction was a $14.3 million increase to retrocession premiums driven by increased rates and new business volume. In 2006 an initiative to improve the quality of retrocession data and related administration systems resulted in a number of revisions to estimates and underlying assumptions used in calculating retrocession premiums. As a result, we recorded an additional retrocession expense of $13.0 million and a $16.5 million experience refund reducing 2006 premiums. These experience refunds related to underlying profitability of specific assumed treaties, most notable within our ING block. Provisions in these treaties permit our clients to participate in the overall profitability of the business as long as certain financial measurement thresholds are met. Additionally, in 2006 we increased our allowance for recoveries of retroceded premiums by $6.1 million. This was followed by a further increase of $0.6 million in 2007.
At the request of a client, we reviewed and repriced certain excess retrocession treaties. As a result of this repricing process, inception to date fee income increased $2.7 million on one specific treaty in 2007.
Net realized losses in 2007 were $969.5 million and were driven by $971.7 million of other-than-temporary impairment charges, primarily on our sub-prime and Alt-A investment portfolio. This was partially offset by a $20.0 million gain on extinguishment of third-party debt representing a write-off of Ballantyne Re Class C Notes held by external parties in the fourth quarter 2007, which were written down in accordance with the securitization’s indenture.
Interest credited to interest sensitive contract liabilities decreased from $173.0 million in 2006 to $135.4 million in 2007. A combination of higher lapse experience on our annuity business and terminated funding agreements contributed $27.3 million and $19.9 million, respectively, to the decline. Partially offsetting these reductions was $11.5 million of interest credited for the aforementioned equity-indexed annuity contract due to increasing account values on this treaty. The higher interest credited is effectively offset by higher net investment income as the asset base on this treaty increased during the year.
Collateral finance facilities expense for 2007 increased by $69.5 million as a result of a full year’s impact of Ballantyne Re which closed in May 2006 and higher financial guarantor costs resulting from our credit rating downgrades. The increase was partially mitigated by the write off of $7.1 million of accrued interest on the Ballantyne Re C Notes as referred to above.
Our estimation processes may lead to subsequent adjustments as actual results differ from these estimates. In respect of premium accrual estimates for the year ended December 31, 2006 we recorded adjustments totaling $7.1 million which were recorded in the year ended December 31, 2007. We consider these adjustments to our premium accruals to have been within management’s expectation of the normal variability of such an estimate and the impact on net income from these adjustments was immaterial.
In addition, as a result of an initiative to improve the quality of our external retrocession data and related administration systems, we made a number of revisions to the estimates and underlying assumptions used in calculating our retrocession premiums. As a result, during the second quarter of 2006, we recorded an additional retrocession adjustment of approximately $13.0 million. In connection with our periodic internal review of the underlying performance of our treaties, we recorded a $16.5 million experience refund adjustment that reduced our third quarter of 2006 premiums. These experience refunds related to underlying profitability of specific assumed treaties, most notably within our ING block. Treaty provisions for these contracts permit our clients to participate in the overall profitability of the business, assuming certain financial measurement thresholds are met. In the fourth quarter of 2006, we recorded a $5.3 million collectability allowance pertaining to accruals for recoveries of retroceded premiums. Experience refunds on retroceded business were approximately $9.0 million favorable in 2006. These experience refunds are directly related to our underlying mortality experience. The above favorable amount partially offsets the adverse mortality experienced in 2006, as discussed below.
The net realized loss for the year includes losses related to selling investments in the first quarter of 2006 in preparation of funding the Ballantyne Re transaction and is effectively offset by gains in the change in value of embedded derivatives. The change in value of embedded derivatives for 2006 resulted in a $16.2 million loss compared to $8.5 million in 2005. This movement in embedded derivative value is related to the realization of losses on certain securities held under a modified coinsurance arrangement that were sold in the first quarter of 2006 in order to provide collateral for the Ballantyne Re securitization.
Our pricing and actuarial projection models include various lapse assumptions by treaty and by product type which are based on historical experience and industry expectations. While our actual lapse experience during the third and fourth quarters of 2006 was only slightly lower in aggregate than expected, we noted that the lapse distribution pattern was such that certain policies had higher than average lapses while others had lower than average lapses. However, the policies with higher lapses had the higher margins and the policies with lower lapses had the lower margins, thereby reducing our earnings against expectations by approximately $13 million and $14 million in the third and fourth quarters of 2006, respectively.
The increase to interest credited to interest sensitive contract liabilities was principally due to the previously described equity-indexed annuity contract written in late 2005, along with increases in interest credited on existing treaties due to increasing average liability balances. During the third quarter of 2006, we terminated four funding agreements, resulting in a decrease to our interest sensitive contract liabilities of approximately $650.0 million.
Operating expenses as a percentage of operating revenues (total revenues excluding realized gains and losses and changes in the value of embedded derivatives) were 2.5% and 2.3% for 2006 and 2005, respectively. The overall increase in operating expenses related primarily to an overall increase in headcount in 2006 compared to 2005, executive severance costs of $3.1 million and increases in compensation costs, legal fees and depreciation expenses. Partially offsetting these amounts was a $1.2 million reduction in restricted share expense in 2006 compared to 2005 related to the reversal of previously recognized expense in accordance with SFAS No. 123(R), combined with lower consulting fees and technical service fees paid to ING.
The increase to collateral finance facilities expense is due to interest costs relating to the Regulation XXX transactions. In addition, beginning in the second half of 2005, a portion of the cost of the Stingray facility was charged to the Life Reinsurance North America Segment. Due to rating agency downgrades, our 2006 collateral finance facilities expenses increased by $5.8 million relating to additional fees to be paid to the financial guarantors of our collateral finance facility transactions.
Our premium mix changed significantly from 2006 to 2007 as UK protection treaties generated $42.9 million of new premium. This was more than offset by the $41.3 million impact of retroceded and exited Middle East and other treaties combined with changes in estimated premiums following receipt of updated client reported data.
The increase in operating expense was driven by change in control related costs including employee bonuses, stock option and equity based compensation costs, and further employee costs related to investment in our operating platforms to support previously anticipated growth in the Segment. Included in 2007 is also an additional provision of $3.3 million for anticipated shortfalls in future rental income and building retirement obligations on our Windsor property leases.
Acquisition costs and other insurance expenses have increased due to a shift in business mix towards long term protection business which carries a higher average commission rate. In addition, collateral costs of $3.5 million in relation to the recapture of the annuity agreement increased other insurance expenses in the year, but were offset by $4.0 million of reduced costs previously described in 2005 due to one-off cost adjustments in respect of our Lloyd’s of London syndicates. Our deferred acquisition costs are principally related to our U.K. protection business written in late 2005 and 2006. Given the relatively small amount of in-force business in the Life Reinsurance International Segment, the assessment of the recoverability of deferred acquisition costs is very dependent upon projections of new business margins. Based on the impact of the rating downgrades and other market developments within the U.K., we revised our estimate of the future margins on this business and determined that a substantial portion of our deferred acquisition costs were unrecoverable and, accordingly, a write-off of $11.8 million deferred acquisition costs was made in the fourth quarter of 2006.
Operating expenses increased due to increase in personnel costs in response to the anticipated growth in the Life Reinsurance International Segment in addition to severance costs, including those related to the Life Reinsurance International Segment head office relocation from Windsor to London, were offset by reductions primarily in various professional services costs and adjustments related to non-commission acquisition costs
Investment income in the Corporate and Other Segment arises on capital not specifically allocated to the Life Reinsurance North America or Life Reinsurance International Segments. Investment income increases or decreases as capital is raised and deployed to operating segments. The increase in investment income from $8.2 million in 2006 to $9.9 million in 2007 was primarily a result of the $555.9 million net proceeds received on issue of the Convertible Cumulative Participating Preferred Shares in May 2007. From the net proceeds, $275.0 million was used to repay the outstanding balance on the Stingray credit facility and a further $127.0 million was utilized to capitalize Clearwater Re. The remaining proceeds formed part of the Corporate invested asset base and are available to fund general operating or subsidiary capital requirements as needed.
Collateral finance facilities expense consisted of the put premium under the Stingray credit facility and $3.0 million of forbearance fees paid to HSBC relating to the HSBC I and HSBC II collateral finance facility structures. Costs increased from 2006 to 2007 due to the fully drawn tenure of the Stingray credit facility, coupled with the aforementioned forbearance fees.
During 2006, a gain was realized upon wind-up of certain interest rate swap agreements, which were terminated as a result of our rating downgrades during the year. In 2005, realized gains were driven by fair value adjustments on these interest rate swap agreements.
The collateral finance facilities expense consisted entirely of the put premium and interest costs under the Stingray facility. Costs increased during the current year due to borrowing under the Stingray facility in August 2006.
In all cases, investments for our particular insurance operating subsidiaries are required to comply with restrictions imposed by applicable laws and insurance regulatory authorities.
seeking opportunities to diversify and diminish the overall credit risk of the portfolio;
deploying available cash primarily into low-volatility liquid fixed income assets while selectively pursuing strategies to enhance yield;
Over the past year, the residential mortgage market in the United States has experienced a severe setback resulting from the reversal of excessive residential property price appreciation, which had been reinforced by imprudent mortgage underwriting and lending practices. These problems, as well as overall market illiquidity due to
a sharp credit contraction, have caused significant volatility in the prices of securities collateralized by residential mortgage loans, including those securities rated AAA by the major rating agencies. Our portfolio has significant exposure to the sub-prime Asset Backed Securities (“ABS”) and Alt-A Residential Mortgage Backed Securities (“RMBS”) sectors of the mortgage-backed securities market, as described in more detail under “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Condition - Structured Securities Backed by Sub-prime and Alt-A Residential Mortgage Loans.” Due to the uncertain outcome of current and predicted trends in these markets and the severity of any recession that may ensue, there is a risk that the value of these investments may further decline, which may adversely affect our financial condition.
The portfolio controlled by us consisting of fixed income securities, preferred stock, and cash and cash equivalents was $8.4 billion and $8.7 billion, respectively, at December 31, 2007 and 2006 as expressed at estimated fair value. The portfolio controlled by us excludes the assets held by ceding insurers under funds withheld coinsurance arrangements. The majority of these assets are publicly traded securities; however, at December 31, 2007 and 2006, $787.0 million and $532.9 million, respectively, represent investments in private securities. Of the total portfolio controlled by us at December 31, 2007 and 2006, $7.7 billion and $8.2 billion, respectively, represented the fixed income and preferred stock portfolios managed by external investment managers and $0.7 billion and $0.5 billion, respectively, represented other cash balances. The data in the tables below exclude assets held by ceding insurers under funds withheld coinsurance agreements.
At December 31, 2007, the average Standard & Poor’s rating of our portfolio was “AA” the average effective duration was 4.2 years and the average book yield was 4.9% as compared to an average rating of “AA” an average effective duration of 2.9 years and an average book yield of 5.5% at December 31, 2006. At December 31, 2007, the net unrealized appreciation on investments, before deferred tax and deferred acquisition costs, was $38.5 million as compared to unrealized depreciation on investments, before deferred tax and deferred acquisition costs, of $39.6 million at December 31, 2006. The unrealized appreciation (depreciation) on investments is included in our consolidated balance sheet as part of shareholders’ equity.
The following table presents the fixed income, preferred stock and cash and cash equivalents investment portfolio credit exposure by Standard & Poor’s ratings, where available, and otherwise by ratings provided by other agencies.
At December 31, 2007 and 2006, our fixed income portfolio had 11,191 and 9,406 positions, respectively. Of these positions, there were no individual securities trading at an unrealized loss at December 31, 2007 due to the write down of the carrying value of these securities as a result of other-than-temporary impairment charges in the fourth quarter of 2007. As of December 31, 2006 there were 5,400 individual securities trading at an unrealized loss totaling $78.5 million.
The following table presents the estimated fair values and gross unrealized losses for the fixed maturity investments and preferred stock that have estimated fair values below amortized cost or cost as of December 31, 2006. These investments are presented by class and grade of security, as well as the length of time the related estimated fair value has remained below amortized cost or cost. There are no fixed maturity investments or preferred stock that have estimated fair values below amortized cost or cost as of December 31, 2007.
Funds withheld at interest arise on modified coinsurance agreements and funds withheld coinsurance agreements. In substance, these agreements are identical to coinsurance treaties except that the ceding company retains the assets supporting the ceded business and manages them for our account. The deposits paid to the ceding company by the underlying policyholders are held in a segregated portfolio and managed by the ceding company or
by investment managers appointed by the ceding company. These treaties transfer a quota share of the risks. The funds withheld at interest represent our share of the ceding companies’ statutory reserves. The cash flows exchanged with each monthly settlement are netted and include, among other items, our quota share of investment income on our proportionate share of the portfolio, realized losses, realized gains (amortized to reflect the statutory rules relating to interest maintenance reserve), interest credited and expense allowances.
At December 31, 2007, funds withheld at interest totaled $1.7 billion with an average rating of “A-” an average effective duration of 3.1 years and an average book yield of 6.0% as compared to $2.0 billion with an average rating of “A” an average effective duration of 5.0 years and an average book yield of 5.9% at December 31, 2006. These are fixed income investments and include marketable securities, commercial mortgages, private placements and cash. The estimated fair value of the funds withheld amounted to $1.7 billion and $2.0 billion at December 31, 2007 and December 31, 2006, respectively.
At December 31, 2007 and 2006, funds withheld at interest were in respect of seven contracts with five ceding companies. At December 31, 2007, we had three contracts with Lincoln Financial Group that accounted for $0.6 billion, or 35%, of the funds withheld balances. Additionally, we had one contract with SLDI that accounted for $0.4 billion, or 24%, of the funds withheld balances, and one contract with Fidelity & Guaranty Life that accounted for $0.6 billion, or 38%, of the funds withheld balances. The remaining contracts were with Illinois Mutual Insurance Company and American Founders Life Insurance Company. Lincoln National Life Insurance Company has financial strength ratings of “A+” from AM. Best, “AA” from Standard & Poor’s, “Aa3” from Moody’s and “AA” from Fitch. Fidelity & Guaranty Life has financial strength ratings of “A3” from Moody’s and “A-” from Fitch. In the event of insolvency of the ceding companies on these arrangements, we would need to exert a claim on the assets supporting the contract liabilities. However, the risk of loss is mitigated by our ability to offset amounts owed to the ceding company with the amounts owed to us by the ceding company. Reserves for future policy benefits and interest sensitive contract liabilities relating to these contracts amounted to $1.6 billion and $1.9 billion at December 31, 2007 and 2006, respectively.
According to data provided by our ceding companies, the contractual maturities (excluding cash) of the assets backing our funds withheld fixed maturities are as follows (actual maturities may differ as a result of calls and prepayments):
For certain investments in beneficial interests in securitized financial assets of less than high quality with contractual cash flows, including asset backed securities, we are required to apply EITF 99-20. EITF 99-20
provides that a security is other-than-temporarily impaired if, based on our best estimate cash flows over the life of the security, utilizing assumptions and estimates that a market participant would use, there has been an adverse change in expected cash flows. Other-than-temporary impairments are recognized for those securities whose fair value is less than carrying value and for which we project an adverse change in cash flows (considering principal loss, adverse timing, illiquidity factors, and credit spreads).
In determining whether an other-than-temporary decline in value has occurred, U.S. GAAP requires that we evaluate, for each impaired security where the estimated fair value is less than the amortized cost, whether we have the intent and ability to hold the security over a reasonable time for a forecasted recovery of fair value up to the amortized cost of the security. This requires us to consider our capital and liquidity requirements, any contractual or regulatory obligations, and the implications of our strategic initiatives that might indicate that impaired securities may need to be sold before the forecasted recovery of the fair value occurs. As discussed in more detail in Part I-Overview above, we have changed our strategic focus and have entered into definitive agreements to sell our Life Reinsurance International Segment and our Wealth Management business and we are currently in the process of selling our Life Reinsurance North America Segment. Additionally, as a result of declines in the fair value of our invested assets, which contain a significant concentration of sub-prime and Alt-A residential mortgage-backed securities, we have experienced deteriorating financial performance and a worsening liquidity and collateral position that raise substantial doubt about our ability to continue as a going concern beyond the short term. Furthermore, as part of our efforts to alleviate the collateral requirements of our reinsurance operating subsidiaries, we executed an Assignment Letter of Intent for the reinsurance agreements between SRUS and Ballantyne Re to ING which will adversely impact our ability to restrict the sale of impaired securities within this securitization structure. Given these conditions, we can no longer assert as of December 31, 2007 that we have the positive intent and ability to hold impaired securities to the forecasted recovery of fair value and as a result have recorded a $780.3 million other-than-temporary impairment charge for the fourth quarter of 2007. We expect to have an additional impairment charge of approximately $751.7 million for the first quarter of 2008.
The consolidated sub-prime portfolio includes securities that are collateralized by mortgage loans issued in the United States to borrowers that cannot qualify for prime financing terms due in part to an impaired or limited credit history. The sub-prime portfolio also includes securities that are collateralized by certain second lien mortgages regardless of the borrower’s credit profile. Of our $1,281.8 million in sub-prime residential ABS holdings,
$363.2 million (5.8% of total investments at amortized cost) were rated AAA/Aaa;
$994.8 million (15.8% of total investments at amortized cost) were rated AA-/Aa3 or above;
$1,204.2 million (19.2% of total investments at amortized cost) were rated A-/A3 or above; and
$975.6 million (15.5% of total investments at amortized cost) reside in our collateral finance facilities.
The following table shows the amortized costs of our consolidated sub-prime portfolio by rating and vintage:
Consolidated Sub-prime and Alt-A Portfolios Excluding Those Held in Securitization Structures
The following table details the amount of amortized costs of our sub-prime ABS and Alt-A holdings by rating and vintage for its consolidated portfolios excluding invested assets held in our three securitization structures: Orkney I, Orkney Re II and Ballantyne Re.
The HSBC II collateral finance facility requires us to fund any estimated fair value decline in the assets supporting the Regulation XXX reserves for the underlying business. Estimated fair values
in the facility declined by $33.0 million between December 2007 and March 2008 resulting in a corresponding reduction to available liquidity in the first quarter of 2008.
Subsequent to March 31, 2008, the following events significantly impacted our available liquidity:
We utilized approximately $28.5 million in available liquidity resources to facilitate the ING and Ballantyne Re Reinsurance Transaction effective March 31, 2008 described in Part I “Business Overview.”
On June 30, 2008, we agreed to post $22 million in additional collateral to each of our Clearwater Re and HSBC II collateral finance facilities resulting in an aggregate $44 million reduction to our available liquidity as part of the Forbearance Agreements executed with the counterparties to these facilities which are described in more detail in “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources-Forbearance Agreements with Counterparties.”
We also believe that after taking into account the impairments on our investment portfolio, we would have been in breach of a minimum net worth covenant under HSBC II. In the event of a breach, HSBC may either (a) accelerate the transaction and require SALIC to purchase
On June 30, 2008, we executed forbearance agreements with the relevant counterparties to each facility, whereby the relevant counterparties have agreed to forbear taking action related to covenant breaches until December 15, 2008. In order to achieve forbearance, we agreed to certain economic and non-economic terms which further constrained our available liquidity. The economic terms were in the form of (1) additional collateral posted to the respective facilities and (2) restrictions on additional usage of the facility. For the Clearwater Re facility, additional funding stops immediately, requiring us to fund future reserve strain incremental to the current $365.9 million facility. We estimate funding approximately $17 million in the second half of 2008. For the HSBC II facility, additional funding stops on December 15, 2008 unless terminated earlier under the terms of the forbearance agreement. We estimate funding approximately $7 million in the fourth quarter of 2008. Further details, including more specific information on the additional collateral required for the respective facilities are provided below in “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources-Forbearance Agreements with Counterparties.”
On March 12, 2009, we have an obligation to repay $100.0 million as part of an unsecured funding agreement with the Premium Asset Trust that matures on that date. SALIC entered into this agreement (Premium Asset Trust Series 2004-4) on March 12, 2004 and has been paying interest at a rate of three-month LIBOR plus 0.922% payable on a quarterly basis. The amount due under this funding agreement is included under interest sensitive contract liabilities on the consolidated balance sheet.
Our three securitizations (Orkney I, Orkney Re II and Ballantyne Re - See Note 7, “Collateral Finance Facilities and Securitization Structures” in the Notes to Consolidated Financial Statements) provide reserve credit to our operating subsidiaries for reinsured Regulation XXX business. Due to declines in the fair value of assets, particularly those investments classified as sub-prime and Alt-A residential mortgage-backed securities, the structures may not be able to provide full reserve credit equal to the statutory reserves associated with each underlying block of business. If the value of assets in the reinsurance trust falls below the statutory reserve requirements, either due to estimated fair value decreases or unfunded reserve increases, then we may have to provide liquidity to the operating subsidiaries or pledge additional assets to the extent of the deficiency in order to secure full reserve credit. Statutory reserves associated with level term life insurance (subject to Regulation XXX) tend to increase during the initial years of the policies, until the peak reserve requirement is met, and then decrease gradually over many years, although the specific composition of the underlying policies and the lapse rates, among other things, will greatly impact the future reserve requirement. The following tables illustrate for each securitization the extent to which the fair value of assets is sufficient to meet current statutory reserve requirements.
On May 9, 2008, we executed amendments to certain transaction documents for Orkney Re II to provide greater flexibility in dealing with additional near and long term estimated fair value declines in the sub-prime and Alt-A securities held by Orkney Re II. The amendments eliminate certain priority of payment limitations and provide us with the ability to efficiently and economically recapture business from Orkney Re II. Without these amendments, it was expected that a default would have occurred under the Indenture on May 12, 2008. The table above as at March 31, 2008 includes the impact of the amendments. Notwithstanding these efforts, there continues to be significant exposure to further declines in the fair value of asset, which may have a negative impact on liquidity.
For Ballantyne Re, on March 31, 2008, we entered into an LOI with ING which allows us to recapture up to $375.0 million of excess statutory reserves from Ballantyne Re and requires ING to post letters of credit to support the related statutory reserve strain. On May 6, 2008, we completed this transaction and recaptured approximately 30% of the business in Ballantyne Re, effective as of March 31, 2008. This business was in turn recaptured by ING and ultimately ceded to SRD, utilizing the entire amount of the $375.0 million of letters of credit made available by ING. The LOI also required the parties to effect an assignment of the entire Ballantyne Re structure from SRUS to ING. The assignment to ING of SRUS’s interest in the Ballantyne Re structure would permanently remove SRUS’s exposure to the uncertainty of continued asset value fluctuations within Ballantyne Re. Accordingly, on June 30, 2008, we executed a binding letter of intent with ING to effect this novation and assignment transaction. In addition, on June 30, 2008, we and ING executed a binding letter of intent whereby we have the ability to recapture a portion of the Ballantyne Re business if, prior to completion of the assignment agreement, we deemed it necessary to conduct another recapture in order to allow SRUS to obtain full statutory reserve credit. We expect to execute this recapture and complete the assignment agreement during the third quarter of 2008. If certain conditions related to the ING Ballantyne Re Reinsurance Transaction effective March 31, 2008 are not satisfied by December 31, 2008, the LOC Fee will be stepped up and we will pay a $10 million commitment fee for use of the facility. These transactions are described in more detail in “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources-Recapture and Assignment Agreements with Counterparties.”
As highlighted in Part 1 “Business Overview”, given our financial condition and the forbearance agreements reached with the relevant counterparties to the Clearwater Re and HSBC II collateral finance facilities, we suspended the payment of dividends on our perpetual preferred shares effective for the April 15, July 15, and October 15, 2008 declaration dates.
We are reducing our cost structure consistent with our change in strategy. In March of 2008, we executed a reduction in force including 26 employees, covering both Corporate and Life Reinsurance North America Segment employees. We expect this reduction in force to lower our annual personnel expenses by approximately $5.0 million.
the sale of our assets or lines of business, the forbearance will automatically terminate and give the relevant counterparties the right, without further notice or action, to accelerate the financing transaction as of such date.
On June 30, 2008, we entered into a binding letter of intent with ING (the “June 30 LOI”) and we entered into a separate binding letter of intent with Ballantyne Re, ING, Ambac Assurance UK Limited and Assured Assurance UK Limited (the “Assignment Letter of Intent”). The June 30 LOI and the Assignment Letter of Intent relate to the business that SRUS ceded to Ballantyne Re for the purpose of collateralizing the statutory reserve requirements of the Valuation of Life Insurance Policies Model Regulation XXX for a portion of the business that the Company acquired from ING at the end of 2004. We refer to this business as the “Ballantyne Business.”
The closing of the transactions contemplated by the June 30 LOI and the Assignment Letter Agreement, respectively, are subject to receipt of required regulatory approvals, completion of transaction documentation reasonably acceptable to the respective parties and customary closing conditions.
Pursuant to the June 30 LOI, SLD consented to the recapture by SRUS of a pro-rata portion of the Ballantyne Business effective as of June 30, 2008 (the “Recapture”). The Recapture would extend up to $200 million of excess statutory reserves on the subject business (the business recaptured, the “Recaptured Business”) and would involve, among other things, amendments to the reinsurance agreement between SRUS and SLD.
The Recapture will be effective as of June 30, 2008 and will be consummated before the Assignment is consummated.
Pursuant to the Assignment Letter of Intent, the parties have agreed to assign and novate to SLD the reinsurance agreement and trust agreement between SRUS and Ballantyne Re (the “Assignment”) as follows: (a) SLD and SRUS would terminate the portion of their existing reinsurance agreement that covers the Ballantyne Business, (b) SRUS and Ballantyne Re would terminate their existing reinsurance agreement (pursuant to which SRUS retroceded to Ballantyne Re the Ballantyne Business) (the “Pre-Assignment Reinsurance Agreement”) and would terminate the related reinsurance trust agreement between those parties, and (c) SLD and Ballantyne Re would enter into a new reinsurance agreement (the “Post-Assignment Reinsurance Agreement”), pursuant to which SLD would cede directly to Ballantyne Re the Ballantyne Business, and a new reinsurance trust agreement, pursuant to which SLD would become the sole beneficiary of the reinsurance trust account maintained by Ballantyne Re.
Net cash provided by operating activities amounted to $410.8 million in 2007 compared to net cash provided by operating activities of $483.4 million in 2006. Operating cash flow includes cash inflows from premiums, fees and investment income, and cash outflows for benefits and expenses paid. In periods of growth of new business, our operating cash flow may decrease due to first year commissions paid on new business generated. For income recognition purposes, these commissions are deferred and amortized over the life of the business. The decrease in net cash provided by operating activities principally relates to activity in the prior year period where $442.3 million of funds withheld were released as a result of the Ballantyne Re collateral finance facility. The remaining cash provided by operating activities in the prior year was mainly due to the increase in reserves for future policy benefits related to a new annuity contract written by the Life Reinsurance International Segment, which was subsequently recaptured.
Net cash used in investing activities was $447.9 million in 2007 compared to net cash used in investing activities of $2,820.4 million in 2006. The decrease in net cash used in investing activities principally relates to the purchases of fixed maturity securities in the first quarter of 2006.
Pursuant to the terms of our acquisition of the individual life reinsurance business of ING, ING is obligated to maintain collateral for the Regulation XXX and AXXX reserve requirements of the acquired business (excluding the business supported by other arrangements) for the duration of such requirements. We pay ING a fee based on the face amount of the collateral provided.
In 2005 and 2006, we completed three transactions that collectively provided approximately $3.7 billion in collateral to fund Regulation XXX reserve requirements associated with specific blocks of business originally assumed as part of the acquisition of ING’s individual life reinsurance business. These transactions extinguished ING’s obligation to provide collateral for Regulation XXX statutory reserve requirements on the business covered. These transactions replaced ING collateral and resulted in a refund from ING for fees incurred of $6.2 million in 2006 and $6.7 million in 2005. At December 31, 2007, $1.73 billion of collateral support is being provided by ING.
Effective December 1, 2006, we executed an amendment to our bank credit facility agreement that permitted the payment of up to $115.0 million from SALIC to us. The payment was transferred on December 4, 2006. These actions enabled us to repurchase nearly all of the $115.0 million 4.5% Senior Convertible Notes which note holders had the right to put to us on December 6, 2006. We subsequently repurchased the remaining $8,000 in Senior Convertible Notes that were not put in order to retire the full issue. The notes were purchased at a repurchase price of 100% of their principal amount plus accrued and unpaid interest and additional amounts, if any, in cash.
On January 12, 2005, we entered into a put agreement with Stingray for an aggregate value of $325.0 million. Under the terms of the put agreement, we acquired an irrevocable put option to issue funding agreements to Stingray in return for the assets in a portfolio of 30 day commercial paper. This put option may be exercised at any time.
In addition, we may be required to issue funding agreements to Stingray under certain circumstances, including, but not limited to, the non-payment of the put option premium and a non-payment of interest under any outstanding funding agreements under the put agreement. The facility matures on January 12, 2015. This transaction may also provide collateral for SRUS for reinsurance obligations under inter-company reinsurance agreements. At December 31, 2007, $50.0 million was in use for this purpose. The put premium and interest costs incurred during the years ended December 31, 2007 and 2006 amounted to $11.1 million and $10.2 million, respectively, and is included in collateral finance facilities expense in the consolidated statements of income (loss). In accordance with FIN 46R, we are not considered to be the primary beneficiary of Stingray and, as a result, we do not consolidate Stingray. We are not responsible for any losses incurred by the Stingray Pass Through Trust. Any funds drawn down on the facility are included in interest sensitive contract liabilities on our balance sheet. As at December 31, 2007 and 2006, $275.0 million and $2.0 million, respectively, were available and unutilized for use under this facility. As at December 31, 2007 $275.0 million of the facility was unutilized.
On March 11, 2008, the $50.0 million used to provide collateral for SRUS was no longer needed for that purpose and was returned to the facility. As a result, on March 11, 2008, $325.0 million of the facility was un-utilized. On March 12, 2008, a $275.0 million funding agreement was put to the facility. On April 14, 2008, an
On March 12, 2004, SALIC entered into an unsecured funding agreement with the Premium Asset Trust for an aggregate of $100 million. The funding agreement has a stated maturity of March 12, 2009 and accrues interest at a rate of three month LIBOR plus 0.922%, payable on a quarterly basis. The amount due under this funding agreement is included under interest sensitive contract liabilities on the consolidated balance sheet.
On November 30, 2006, SALIC and Scottish Re Limited entered into a one year, $5.0 million letter of credit facility with a single bank on a fully secured basis. This facility was amended on October 31, 2007 to a term of two years and to a limit of $15.0 million. Outstanding letters of credit for SALIC at December 31, 2007 were $75,000. Outstanding letters of credit for Scottish Re Limited at December 31, 2007 were $3.3 million.
On March 9, 2007, SALIC entered into a $100 million unsecured term loan facility with Ableco Finance LLC and Massachusetts Mutual Life Insurance Company, both of which are related parties to Cerberus and MassMutual Financial Group respectively. This facility was terminated on May 7, 2007 in conjunction with the $600.0 million equity investment by SRGL LDC and MassMutual Capital. The facility was not drawn down or utilized over the period it was in place.
On May 4, 2006, we entered into an agreement that provides two classes totaling $155.0 million of collateralized catastrophe protection with Tartan, a special purpose Cayman Islands company which was funded through a catastrophe bond transaction. This coverage is for the period January 1, 2006 to December 31, 2008 and provides SALIC with protection from losses arising from higher than normal mortality levels within the United States, as reported by the U.S. Centers for Disease Control and Prevention or other designated reporting agency. This coverage is based on a mortality index, which is based on age and gender weighted mortality rates for the United States constructed from publicly available data sources, as defined at inception, and which compares the mortality rates over consecutive 2 year periods to a reference index value. Expenses related to this transaction are included in “Acquisition costs and other insurance expenses” in the Corporate and Other Segment.
In accordance with SFAS No. 133, this contract is considered to be a derivative. The fair value of the contract has been determined to be $0 as at both December 31, 2007 and 2006.
The change in total capitalization at December 31, 2007 as compared to December 31, 2006 was primarily due to the issuance of the convertible cumulative participating preferred shares (mezzanine equity) resulting in aggregate net proceeds of $555.9 million and the issuance of ordinary shares to holders of HyCUs on the conversion of purchase contracts of $143.7 million. This is offset by the net loss attributable to ordinary shareholders of $1,025.6 million for the year ended December 31, 2007 which was predominantly the result of net realized losses on investments of $979.3 million. Realized losses of $780.3 million were incurred in the fourth quarter of 2007 for other-than-temporary impairments of securities with unrealized losses where we lacked the positive intent and ability to hold the impaired securities for a reasonable time necessary for a forecasted recovery in value. We estimate that we will recognize a further $751.7 million of other-than-temporary impairment charges relating to the investment portfolio for the quarter ended March 31, 2008 which will further erode our consolidated shareholders’ equity.
See Note 7 “Collateral Finance Facilities and Securitization Structures” and Note 20 “Statutory Requirements and Dividend Restrictions” in the Notes to Consolidated Financial Statements for additional details on the items noted in the table.
On August 9, 2006, the forward purchasers notified us of the occurrence of “Increased Cost of Stock Borrow” under the forward sale agreements and proposed price adjustments thereto. Pursuant to the forward sales agreements, upon receipt of such notification, we were entitled to elect to: (a) agree to amend the transactions to take into account the price adjustments; (b) pay the forward purchasers an amount corresponding to the price adjustments; or (c) terminate the transactions. On August 11, 2006, the forward purchasers proposed an amendment to the forward sales agreements which provided us an additional alternative, the acceleration of the scheduled maturity date to August 14, 2006 under each of the forward sales agreements. We agreed to this amendment on August 14, 2006. On August 17, 2006, we received cash proceeds of $36.5 million and issued 6,578,948 ordinary shares, which satisfied in full our obligation to deliver shares pursuant to the forward sales agreements and the forward purchasers’ obligations to pay us under such agreements. An imputed dividend was charged to earnings based on the pro-rated amount of time that elapsed from the original prepayment date until settlement date. The balance of the discount reduced the net proceeds on issuance of shares.
SALIC has agreed with SRLC that it will (1) cause SRLC to maintain capital and surplus equal to at least 175% of Company Action Level risk-based capital, as defined under the laws of the State of Delaware and (2) provide SRLC with enough liquidity to meet its obligations in a timely manner.
The following table shows our contractual obligations and commitments as of December 31, 2007, including obligations arising from our reinsurance business and payments due by period:
December 4, 2032 through December 15, 2034. They are however, redeemable at various dates from September 30, 2008 through December 15, 2009. They have been included in the above table based on their maturity date.
Collateral finance facilities include HSBC II, and securitization obligations with Orkney I, Orkney Re II, Ballantyne Re and Clearwater Re. These obligations are secured by fixed maturity investments and cash and cash equivalents included in our Consolidated Balance Sheet. The liabilities have been included in the table above at their earliest possible redemption date at our option and not their scheduled maturity date. These transactions and their contractual maturity dates are described in Note 7 “Collateral Finance Facilities and Securitization Structures” in the Notes to Consolidated Financial Statements.
Reserves for future policy benefits include liabilities related primarily to our reinsurance of traditional life insurance and related policies. These are generally comprised of policies or contracts that do not have contractual maturity dates and may not result in any future payment obligation. For these policies and contracts (i) we are not currently making payments and will not make payments in the future until the occurrence of an insurable event, such as death or disability or (ii) the occurrence of a payment triggering event, such as a surrender of a policy or contract, which is outside of our control. We have made significant assumptions to determine the estimated undiscounted cash flows of these policies and contracts which include mortality, morbidity, persistency, future lapse rates and interest crediting rates. Due to the significance of the assumptions used, the amounts presented could materially differ from actual results. The sum of the obligations shown for all years in the table of $4.4 billion exceeds the liability amount of $4.1 billion included on the consolidated balance sheet principally due to the fact that amounts presented above are on an undiscounted basis.
FASB Statement No. 159, Fair Value Option for Financial Assets and Financial Liabilities
In February 2007, the FASB issued Statement No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS No. 159”), which permits entities to choose to measure eligible financial instruments and certain other items at fair value at specified election dates. A company must report unrealized gains and losses on items for which the fair value option has been elected in earnings at each subsequent reporting date, and any upfront costs and fees related to the item will be recognized in earnings as incurred. The fair value option may be applied on an instrument by instrument basis with a few exceptions. The fair value option is irrevocable (unless a new election date occurs) and the fair value option may be applied only to entire instruments and not to portions of instruments. SFAS 159 will be effective for interim and annual financial statements issued after January 1, 2008 for calendar-year companies. At the effective date, the fair value option may be elected for eligible items that exist on that date, with the effect of the first re-measurement to fair value reported as a cumulative-effect adjustment to the opening balance of retained earnings. W have completed our review of all applicable financial assets and financial liabilities on the consolidated balance sheet and have decided not to elect the fair value option for eligible instruments at the effective date.
In June 2006, the FASB issued Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income tax recognized in a company’s financial statements. FIN 48 requires companies to determine whether it is “more likely than not” that a tax position will be sustained upon examination by the appropriate taxing authorities before any part of the benefit can be recorded in the financial statements. It also provides guidance on the recognition, measurement and classification of income tax uncertainties, along with any related interest and penalties. Previously recorded income tax benefits that no longer meet this standard are required to be charged to earnings in the period that such determination is made. On January 1, 2007, we adopted FIN 48. As a result of the implementation of FIN 48, we recorded a net decrease to our beginning retained earnings of $18.0 million representing a total FIN 48 liability of $75.3 million (excluding previously recognized liabilities of $6.5 million and including interest and penalties of $8.9 million) offset by a $57.3 million reduction of our existing valuation allowance. We had total unrecognized tax benefits (excluding interest and penalties) of $72.7 million at January 1, 2007, the recognition of which would result in a $15.4 million benefit to the effective tax rate.
The information called for by this item is set forth in “Item 15: Exhibits, Financial Statement Schedules and Reports on Form 8-K.”