The principal offices of Seneca are located in space leased by Seneca in New York, New York. The lease covers approximately 21,500 square feet at 160 Water Street. The term of the lease ends June 30, 2010.
The table shown below presents selected financial data for each of the five years ended December 31, 2006. This financial information was prepared in accordance with GAAP. The GAAP statement of income data for the years ended December 31, 2006, 2005, 2004, 2003 and 2002 and the GAAP balance sheet data at December 31, 2006, 2005, 2004, 2003 and 2002 were derived from Crum & Forster Holdings Corp.’s consolidated financial statements, which have been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm. The consolidated balance sheets at December 31, 2006 and 2005, and the related consolidated statements of income, of shareholder’s equity, of comprehensive income and of cash flows for each of the three years ended December 31, 2006, and accompanying notes, appear in “Item 8. Financial Statements and Supplementary Data”. The combined statutory data has been derived from annual statutory financial statements, which have been filed with the domiciliary states of the Company’s insurance subsidiaries, and prepared in accordance with SAP, which differs from GAAP.
Commercial Automobile. For third party claims, the methodology for establishing case reserves is virtually identical to that of general liability. First party automobile reserves are established based upon the cost of repair or actual cash value as appropriate under the circumstances, generally confirmed by an appraisal, and consistent with applicable state claims handling regulations.
The Company’s actuaries also conduct an internal ground-up study of asbestos and environmental reserves at least annually. Such ground-up studies involve a policyholder-by-policyholder evaluation considering the following factors: available insurance coverage based upon the type of loss being presented (premises/operations or products), including the role of any umbrella or excess insurance purchased by the policyholder and court decisions concerning specific coverage provisions; other policy specific provisions, including whether defense is included in or in addition to loss; limits, deductibles and self-insured retentions; an analysis of each policyholder’s ultimate potential liability; the jurisdictions involved; past and anticipated future asbestos claim filings against the policyholder; past settlement values of similar claims against the policyholder and their associated defense costs; dismissal rates of claims by jurisdiction; distribution of claims by disease type (cancers, asbestosis and no impairment) where known; the potential role of other insurance (estimating the Company’s ultimate participation of loss settlements percentage); and applicable coverage defenses. The evaluations are based on current trends without any assumption of potentially favorable or unfavorable legislation in the future. In 2004, the Company engaged an independent actuarial firm to perform a ground-up study in addition to the Company’s own internal review.
Consideration may also be given to the results of actuarial reserve reviews conducted by the Company’s independent actuaries. Management considers a “best estimate” to be one where the total reserves have an equal likelihood of developing a redundancy or deficiency as the loss experience matures. Following the completion of each semi-annual internal actuarial reserve review, management reviews the actuarial reserve valuation with the Company’s actuaries and compares the indicated reserve levels by line of business to the corresponding recorded reserves. In general, management’s best estimate will approximate the internal actuaries’ point estimates. There may, however, be circumstances in which management chooses not to adjust its best estimate for assumptions made by its actuaries regarding emerging trends - positive or negative - until the passage of further time or additional information has confirmed the credibility of the trend. At December 31, 2006 and 2005, management’s best estimate exceeded the actuaries’ point estimate in the aggregate by amounts that the Company considers immaterial.
Of the $97.6 million development for calendar year 2004, $90.5 million was due to an increase in asbestos reserves, driven mainly by an increase in the average severity of claims for known policyholders. For a more detailed description of the asbestos strengthening, see “Asbestos reserves” below.
The following table presents an analysis of the estimated distribution of all policies, listed by attachment point, against which asbestos claims have been presented:
The Company did not issue insurance to 55 of the 75 companies. It did issue insurance coverage to the remaining 20 companies; however, it has resolved the asbestos claims of 18 of these policyholders. With respect to the other two policyholders, Crum & Forster has $20 million of policy limits remaining.
Reserves for asbestos cannot be estimated with traditional loss reserving techniques that rely on historical accident year loss development factors. Since each policyholder presents different liability and coverage issues, the Company evaluates its asbestos exposure on a policyholder-by-policyholder basis. Crum & Forster utilizes sophisticated methodologies, which draw upon Company experience and supplemental databases, to assess asbestos liabilities on reported claims. These methodologies utilize comprehensive ground-up, exposure-based analyses. In 2004, Crum & Forster also retained an outside actuarial consultant to perform an independent ground-up evaluation of its asbestos reserves.
In addition to estimating liabilities for reported asbestos claims, reserves for IBNR claims are estimated using information as to the reporting patterns of known policyholders, historical settlement costs per policyholder and characteristics of policyholders such as the number of coverage years.
Once the gross ultimate exposure for indemnity and ALAE is determined for each policyholder and policy year, the amount ceded to reinsurers is estimated by reviewing the applicable reinsurance treaty.
As part of the overall review of the Company’s asbestos exposure, management compares the level of reserves to various industry benchmarks. The most widely reported benchmark is the survival ratio, which equals the outstanding loss and ALAE reserves (including IBNR) at December 31 divided by the average paid losses and ALAE for the past three years. The resulting ratio is a simple measure of the estimated number of years before the year-end loss and ALAE reserves would be exhausted using recent payment run rates. The higher the ratio, the more years the loss and ALAE reserves would be expected to cover. Because there is a high degree of certainty regarding the ultimate liabilities for those claims subject to settlement agreements, the Company also presents its survival ratio excluding those outstanding loss reserves and historical loss payments.
As discussed in more detail in the following paragraphs, the Company increased its reserves for asbestos liabilities in each of 2006, 2005 and 2004. Asbestos liabilities are uniquely difficult to estimate due to both industry-wide issues and Company-specific factors. Industry-wide trends and factors have generally been adverse to insurance companies and include complex coverage issues, expansive judicial interpretation, lack of historical data, long reporting delays, substantial defense costs, increases in claims by unimpaired plaintiffs, venue shopping, bankruptcies of traditional defendants and targeting of peripheral defendants whose exposures may not be subject to aggregate policy limits. In developing its asbestos reserve estimates, the Company gives consideration to the current state of industry trends and factors, particularly those that most directly affect its policyholder universe such as the targeting of smaller, peripheral defendants. However, changes in these trends or the emergence of new trends or factors may not be reasonably foreseeable or their effects may not be reliably quantifiable as of the date of the Company’s estimate. Further, while industry trends have an effect on the Company, increases in the Company’s asbestos reserve estimates are most directly and significantly affected by changes in the state of asbestos claims against Crum & Forster’s specific policyholders. A comparatively small number of policyholders account for a substantial share of the Company’s asbestos claim payout activity in any given period and of the asbestos net unpaid losses and ALAE reserves at each balance sheet date. Changes in the conditions of specific policyholders, such as being targeted by plaintiffs in a state or states from which claims had not been previously filed or expected, adverse court decisions regarding coverage or defense obligations, the discovery (or allegation) of the existence of additional policies issued by the Company, the inability of another of the policyholder’s insurers to discharge its policy obligations, thereby increasing the obligations of the remaining insurers, can have a material impact on the previous estimate of the potential liability associated with that policyholder. These changes may not have been foreseeable or lacked sufficient credibility, even if foreseeable, as of the date of the Company’s previous estimate.
In 2006, the trends noted previously have continued, including stable numbers of claimants filing asbestos claims against the Company’s policyholders, increased value of claims against viable asbestos defendants as co-defendants seek bankruptcy protection and an increased number of policyholders asserting that their asbestos claims are not subject to aggregate limits and that each individual bodily injury claim should be treated as a separate occurrence. In general, a small percentage of policyholders account for the majority of paid losses. In 2006, 90% of gross payments for loss and allocated loss adjustment expenses were made on behalf of approximately 4% of policyholders.
In 2006 and 2005, the Company increased asbestos reserves by $22.7 million and $31.6 million, respectively, (approximately 6% and 8%, respectively, of the preceding year-end reserves balances). The increases were largely attributable to developments related to one policyholder.
As with asbestos reserves, exposure for environmental pollution cannot be estimated with traditional loss reserving techniques that rely on historical accident year loss development factors. Since each policyholder presents different liability and coverage issues, the methodology used to establish environmental reserves is similar to that used for asbestos liabilities. In the course of performing these individual policyholder assessments, the following factors are considered: the policyholder’s probable liability and available coverage; relevant judicial interpretations; the nature of the alleged pollution activities of the policyholder at each site; the number of sites; the total number of PRPs at each site; the nature of environmental harm and the corresponding remedy at each site; the ownership and general use of each site; the involvement of other insurers and the potential for other available coverage; and the applicable law in each jurisdiction. A provision for IBNR is developed, using methodology similar to that for asbestos liabilities, and an estimate of ceded reinsurance recoveries is calculated.
New reports for environmental claims are trending downward while the cost of the remedy in certain jurisdictions has increased. Claims against Fortune 500 companies are declining, and, while policyholders with single-site exposures are still active, the Company has resolved the majority of disputes with respect to policyholders with a large number of sites. In many cases, claims are being settled more expeditiously due to improved site remediation technology and effective policy buybacks. However, due to the high level of uncertainty, revisions to these reserve estimates could have a material impact on the Company’s results of operations in the period recognized and the ultimate actual payments for claims and LAE could turn out to be significantly different from estimates.
In addition to asbestos and environmental pollution, the Company faces exposure to other types of latent mass tort claims. These other latent claims include those associated with silica, gas and vapors, lead, mold, chemical, welding fumes and pesticides. Similar to asbestos and pollution, traditional actuarial techniques cannot be used to estimate ultimate liability for these exposures. Management sets reserves for other latent exposures at a selected gross survival ratio (currently 5 years) and selects a gross to net ratio based on the gross to net ratio of historical payments.
An analysis of gross and net reserves from other latent exposures is presented in Note 5 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
Management believes that the asbestos, environmental and other latent reserves reported at December 31, 2006 are reasonable estimates of the ultimate remaining liability for these claims based on facts currently known, the present state of the law and coverage litigation, current assumptions and the reserving methodologies employed. These latent reserves are continually monitored by management and reviewed by independent consulting actuaries. New developments will continue to be evaluated as they arise in order to supplement the ongoing analyses and reviews of the latent exposures. Due to the inherent uncertainties in estimating reserves for unpaid losses and LAE described above, and to the potential impact of recent trends, the ultimate liability for the Company’s loss and LAE reserves, and, in particular, its asbestos, environmental and other latent claims reserves, may vary substantially from the amounts currently reserved.
Management’s evaluation of other than temporary losses is particularly sensitive to assumptions it makes relative to forecasts of an issuer’s financial performance and near term prospects such as earnings trends, dividends, analysts forecasts and cash flows supporting fixed income securities. Although management is unable to quantify the likelihood of changes to these assumptions that may occur in the future, any change in assumptions could result in recognition of impairments in the future in an amount potentially greater than the unrealized losses on the securities at December 31, 2006.
At December 31, 2006 and 2005, reinsurance recoverable was $1,733.9 and $2,110.1 million, net of reserves for uncollectible reinsurance of $42.8 million and $34.4 million, respectively. Bad debt expense for the years ended December 31, 2006, 2005 and 2004 related to uncollectible reinsurance was $9.5 million, $7.2 million and $5 million, respectively. While management believes the allowance for uncollectible reinsurance recoverable is adequate based on information currently available, failure of reinsurers to meet their obligations could have a material adverse impact on the Company’s financial position and results of operations. At December 31, 2006, the five largest gross reinsurance recoverable balances aggregated $1,054.1 million, or approximately 61% of the total reinsurance recoverable balance. Application of collateral reduces the unsecured exposure to these five reinsurers to $389.1 million. The largest unsecured balance at December 31, 2006 was $166.2 million, due from an unaffiliated company rated A+ by A.M. Best.
Realization of the deferred tax asset under SFAS No. 109 ultimately depends on the existence of sufficient taxable income available under tax law, including future reversals of existing temporary differences, future taxable income exclusive of reversing differences, taxable income in prior carryback years and tax planning strategies. Future profitability, as it relates to taxable income expectations discussed above, can be negatively affected by substantial changes in premium volume, persistent underwriting losses resulting from significant events such as severe natural disasters, large settlements for asbestos or environmental claims or materially lower investment results.
The Company is a national commercial property and casualty insurance company with a focused underwriting strategy, targeting specialty classes of business and underserved market opportunities. Operating through its home office and regional branch network, the Company writes a broad range of commercial coverage, including workers’ compensation, property, general liability, commercial automobile, commercial multi-peril and other lines of business. The Company generally conducts business on a brokerage basis through more than 1,200 producers located throughout the United States.
The profitability of property and casualty insurance companies is primarily determined by their underwriting results and investment performance. Underwriting results are the net result of a company’s premiums earned and amounts paid, or expected to be paid, to settle insured claims and policy acquisition costs and other underwriting expenses. The insurance business is unique in that premiums charged for insurance coverage are set without certainty of the ultimate claim costs to be incurred on a given policy. This requires that liabilities be estimated and recorded in recognition of future loss and settlement obligations. Due to the inherent uncertainty in estimating these liabilities, there can be no assurance that actual liabilities will not exceed recorded amounts or premiums received. The ultimate adequacy of premium rates is affected mainly by the severity and frequency of claims, which are influenced by many factors, including natural and man-made disasters, regulatory measures and court decisions that define and expand the extent of coverage. Insurance premium rates are also influenced by available insurance capacity or the industry’s willingness to deploy capital to cover each insurable risk.
With respect to the Company’s underwriting operations, management monitors key indicators of growth and profitability. Growth is generally measured in terms of gross premiums written. Management further monitors growth in its gross premiums written in terms of its rate of retention of existing policyholders, increases or decreases in the pricing of renewed policies and the growth in new business premiums. Underwriting profitability is measured both in dollars and by the combined ratio, a standard industry measure. Underwriting profit or loss equals premiums earned, less losses and LAE, policy acquisition costs and other underwriting expenses. The combined ratio expresses underwriting results as a percentage of premiums earned and generally comprises two components: the loss ratio, which is the percentage of losses and LAE to premiums earned, and the expense ratio, which is the percentage of the sum of policy acquisition costs and other underwriting expenses to premiums earned. A combined ratio less than 100% indicates an underwriting profit; a combined ratio greater than 100% indicates an underwriting loss.
The property and casualty insurance business is cyclical and influenced by many factors, including price competition, economic conditions, natural and man-made disasters (for example, hurricanes, earthquakes and terrorism), availability and cost of reinsurance, interest rates, state regulations, court decisions and changes in the law. Commencing in mid-2000 through mid-2003, insurers generally achieved significant rate increases and improved terms and conditions. In 2003, however, market capacity expanded, particularly for property risks. In the fourth quarter of 2003 and through 2004 and 2005, property risks were generally written at or below expiring prices. Price increases in casualty lines slowed considerably in 2004 while casualty risks were generally written at or below expiring prices in 2005. The casualty market has continued to see an acceleration of softening market conditions in 2006, particularly in respect of workers’ compensation policies in California, while property market conditions improved significantly in the aftermath of severe 2005 hurricane activity. The improvement in the property market was primarily attributable to more limited availability of catastrophe reinsurance and at higher rates, which in turn drove price increases on property risks. However, commencing late in the third quarter of 2006, the property market has begun to experience increased competition as a result of the mild 2006 hurricane activity, with several major competitors offering more capacity in the coastal wind areas as well as greater capacity and more competitive pricing on non-catastrophe exposed business.
Renewal pricing in the Company’s casualty lines declined by approximately 7% in 2006 and renewal pricing in the Company’s property lines increased by approximately 11% in 2006, with such increases varying largely based on potential exposures to catastrophes. The Company’s overall renewal retention rate held steady in 2006. The casualty renewal retention rate increased by approximately four percentage points and the property renewal retention rate declined by approximately six percentage points in 2006. New business was up approximately 20% in 2006 (15% excluding Fairmont), largely attributable to increases in property lines.
Net income was $312.3 million in 2006 as compared to $155.9 million in 2005. The increase in net income in 2006 was primarily due to lower catastrophe losses and higher investment earnings. Specifically, investment results were positively affected by a $106.6 million gain on the sale of Zenith National Insurance Corp. (“Zenith”) as well as higher investment income from HWIC Asia Fund (“HWIC”). The Company also experienced continued favorable development of prior years’ losses and LAE in 2006 which amounted to $96.2 million compared to favorable development of $68.6 million in 2005. The combined ratio improved 6.8 percentage points in 2006 as compared to 2005, primarily attributable to the favorable impact of lower catastrophe losses.
During 2006, the Company identified and recorded certain adjustments associated with its accounting for investments. The adjustments relate principally to four areas: (i) equity method accounting - the Company did not properly reflect adjustments to realized investment gains and losses reported by equity method investees arising from basis differences associated with initial purchases or changes in ownership percentages. These adjustments relate principally to the Company’s investments in Northbridge Financial Corporation (“Northbridge”) and HWIC; (ii) partnership accounting - several of the Company’s partnership interests were recorded on the equity method of accounting pursuant to Statement of Position 78-9, Accounting for Investments in Real Estate Ventures, even though the Company did not have the ability to exercise significant influence over the investees. In such circumstances, the Company should have retained the investment company accounting of the investees; (iii) embedded derivatives mark-to-market - the Company did not properly reflect the mark to market through earnings of derivative features embedded in convertible securities pursuant to SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. Several of the Company’s equity investees also held the same or similar securities with embedded derivatives. The Company determined that the investees also did not properly bifurcate their investments, which required adjustments to the Company’s financial statements; and (iv) valuation of an affiliated equity method investee - the Company did not correctly reflect the carrying value of its 1.4% ownership interest in TRG Holding Corp. (“TRG”) in 2002, pursuant to guidance in SFAS No. 141, Business Combinations.
For year ended December 31, 2006, the Company reported gross premiums written of $1,351.6 million, representing an increase of $253.8 million, or 23.1%, over the year ended December 31, 2005. The increase includes $187.0 million of Fairmont’s premiums, of which $15.0 million, $3.8 million, $18.0 million, $30.4 million, $29.7 million and $90.1 million relate to the workers’ compensation, property, general liability, commercial automobile, commercial multi-peril and other lines of business, respectively. Excluding Fairmont, gross premiums written increased by $66.8 million, or 6.1%, in the year ended December 31, 2006. This increase was primarily due to an increase in new business of approximately 15%, attributable to greater property writings resulting from an overall improved property market in the wake of the 2005 hurricanes. Renewal retention rates held steady at 62 %, despite the soft market, while pricing across all lines of business declined slightly.
For the year ended December 31, 2005, the Company reported gross premiums written of $1,097.8 million, representing a decrease of $41.2 million, or 3.6%, over the year ended December 31, 2004. This decline was primarily due to a reduction in renewal retention rates from approximately 65% in 2004 to 61% in 2005, modest price decreases on renewal policies of approximately 5% and a reduction in new business of approximately 9%. The reduction in new business was largely attributable to a significant decrease in the casualty lines of business, with a more modest decrease for property lines.
For the year ended December 31, 2005, gross premiums written in casualty lines decreased by $23.5 million, or 3.1%, as compared to the year ended December 31, 2004. The decrease was due to a reduction in renewal retention rates, price decreases on renewal polices and a reduction in new business.
For the year ended December 31, 2006, net premiums written increased by $297.5 million, or 34.2%, as compared to the year ended December 31, 2005, which was generally in line with the growth in gross premiums written after giving effect to increased retention on various lines of business and corresponding reduced premium cessions as well as reinsurance reinstatement premiums of $39.3 million associated with catastrophe losses in 2005. Offsetting the increase in part were higher property catastrophe reinsurance costs in 2006. Excluding Fairmont, net premiums written increased by $133.1 million or 15.3%. For the year ended December 31, 2005, net premiums written decreased by $49.3 million, or 5.4%, as compared to the year ended December 31, 2004. The decrease was generally in line with gross premiums written after giving effect to reinsurance reinstatement premiums associated with catastrophe losses in both years and aggregate reinsurance premiums in 2004.
In 2005, the Company recognized net favorable prior year loss development of $60.5 million (6.8 loss ratio points) prior to amortization of deferred gains on corporate aggregate retroactive reinsurance. The net favorable development was comprised of three principal components: (i) adverse development of asbestos, environmental and other latent liabilities of $44.6 million, primarily due to developments related to one asbestos policyholder, largely offset by favorable emergence of non-latent umbrella and other casualty reserves in accident years 1998 and prior, (ii) $24.7 million of strengthening of prior year reserves for the surety line of business, a line the Company exited in 2005, and (iii) net favorable development of the Company’s remaining property and casualty reserves of $97.5 million, arising from accident years 1999 through 2004.
The decrease in the other lines loss ratio from 2004 to 2005 and continuing to 2006 reflects the runoff of the Company’s surety line of business, which began in 2005.
The Company’s other underwriting expense ratio increased to 14.7% in 2006 from 14.4% in 2005. In 2006, the underwriting ratio was affected by the addition of the Fairmont business, which added to the Company’s fixed expenses but only modestly to its net premiums earned. Additionally, the Company incurred higher legal and technology expenses related to systems development costs. The Company’s other underwriting expense ratio increased slightly in 2005 to 14.4% from 14.3% in 2004. In 2005, excluding reinsurance reinstatement premiums associated with catastrophe losses, the other underwriting expense ratio would have decreased to 13.8%.
Includes book value of assets pledged for short-sale obligations of $540.9 million, $497.9 million and $279.8 million at December 31, 2006, 2005 and 2004, respectively.
The Company manages its investment portfolio with an emphasis on total return. Total return for the period is the sum of investment income (including pre-tax equity in earnings of investees), realized investment gains and losses and changes in the market value of the portfolio expressed as a percentage of the average book value of the portfolio during the period. Total rate of return on investments was 7.2%, 6.6% and 6.3% for the years ended December 31, 2006, 2005 and 2004, respectively. The increase in the Company’s total return on investments in 2006 as compared to 2005 was principally the result of the combined effects of higher investment income and realized gains, partially offset by a decrease in the unrealized investment gains and losses on the Company’s investment portfolio. The following paragraphs discuss each component of the total return on investments.
Investment income was $220.0 million, $131.1 million and $85.1 million in 2006, 2005 and 2004, respectively. The increase in investment income of $88.9 million, or 67.8%, in 2006 as compared to 2005 was primarily attributable to higher earnings from HWIC of $48.5 million and higher partnership earnings of approximately $20.2 million. HWIC realized significant capital gains during 2006. For further details on certain accounting adjustments in respect of investments, see Note 14 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”. Additionally, the Company also benefited from increased interest income earned on cash and cash equivalents due to higher short term interest rates and greater invested portfolio assets as well as lower funds held interest expense associated with a retroactive reinsurance contract. For further discussion of corporate aggregate reinsurance activity, see Note 6 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
Realized investment gains were $172.8 million in 2006, $84.2 million in 2005 and $79.5 million in 2004. The increase in realized investment gains of $88.6 million in 2006 over 2005 was due to the combined impact of a $106.6 million gain on the sale of Zenith common stock, a gain of $45 million on the sale of a corporate fixed income security and higher realized gains from the sale of other equity securities, partially offset by lower realized investment gains on the sale of U.S. Treasury securities, higher realized losses on the change in fair value of the short-sale obligations and other derivatives and other than temporary impairment charges. For further details on certain accounting adjustments in respect of investments, see Note 14 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”. The increase in realized investment gains of $4.7 million in 2005 was principally the result of gains in U.S. Treasury securities, as well as a gain arising on the sale of Zenith common stock, partially offset by net realized investment losses arising from changes in the fair value of the Company’s derivatives and equity securities. Included in realized investment gains in 2006 and 2005 were $15.9 million and $3.9 million, respectively, of losses related to other than temporary impairments. No other than temporary impairments were recorded in 2004.
Pre-tax equity in earnings of investees was $20.2 million, $26.5 million and $19.2 million in 2006, 2005 and 2004, respectively. The decrease in pre-tax equity in earnings of investees in 2006 as compared to 2005 and 2004 was primarily attributable to lower earnings from Northbridge, an affiliated equity method investee. Northbridge contributed $17.9 million, $26.3 million and $18.1 million to the Company’s pre-tax equity in earnings of investees in 2006, 2005 and 2004, respectively. Northbridge’s earnings in the year ended December 31, 2006 were affected by equity adjustments and mark to market adjustments in respect of the derivative features embedded in convertible securities. For further details on certain accounting adjustments in respect of investments, see Note 14 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
In 2006, the net decrease in unrealized investment gains and losses and foreign currency translation of $139.0 million was largely due to a reduction in unrealized gains on equity securities attributable to the sale of certain equity securities, including approximately $92.3 million on the aforementioned sale of Zenith common stock and greater unrealized losses on the Company’s fixed income portfolio due to higher interest rates. In 2005, the net decrease in unrealized investment gains and losses and foreign currency translation of $3.7 million was due to unrealized gains from fixed income securities offset by unrealized losses on equity securities and other invested assets.
Interest and other expense was $41.0 million, $35.5 million and $41.6 million 2006, 2005 and 2004, respectively. The increase in interest and other expenses in 2006 as compared to 2005 was primarily due to an increase in other expense, attributable to higher charitable contributions. The decrease in interest and other expense in 2005 as compared to 2004 was primarily due to a 2004 corporate expense of approximately $3.5 million related to a retirement and consulting agreement with the former chairman of the Company’s insurance subsidiaries and general fluctuations in corporate expenses.
In 2003, Crum & Forster issued $300 million aggregate principal amount of senior notes. These notes, which bear interest payable semi-annually at 10-3/8%, mature on June 15, 2013. The net proceeds from the offering of approximately $291 million were used to fund an interest escrow account of approximately $63.1 million to make the first four semi-annual interest payments on the notes and to pay a dividend to Fairfax in the amount of $217.9 million, with the remainder used to pay certain financing costs. Under the terms of the Company’s senior notes, the Company has significant restrictions on the amount of new debt that may be issued. After June 15, 2008, the Company may redeem the notes at its option, in whole or in part, upon not less than 30 nor more than 60 days’ notice, at varying redemption prices. Should the Company choose to redeem the notes, in whole or in part, prior to their maturity in 2013, potential sources of funds include the issuance of new notes and dividends from insurance subsidiaries, subject to regulatory restrictions.
Gross premiums written in 2006 increased by 23.1% from 2005 following a decrease of 3.6% from 2004. Excluding Fairmont, gross premiums written increased by 6.1% in 2006 from 2005, largely attributable to an increase in new business in property lines in the wake of severe 2005 hurricane activity. However, as the market continues to soften and competitors are focused on production, new business growth and the retention of existing accounts has become very challenging. These factors, coupled with any deterioration in the pricing environment, may affect cash flows from operations.
Cash provided by operating activities amounted to $89.4 million in 2006, $25.5 million in 2005 and $125.3 million in 2004. The increase in 2006 reflected general business expansion driven by the assumption of Fairmont’s business, partially offset by higher income taxes paid as a result of higher realized investment gains. The decline in cash flows from operations in 2005 from 2004 was the result of several factors including higher net paid hurricane and latent payments, lower proceeds from reinsurance commutations of $49.6 million and lower premium collections of $35 million, partially offset by lower non-latent claim payments.
The aggregate carrying value of the Company’s investment portfolio, including cash and cash equivalents, including assets pledged for short-sale obligations, was approximately $3.9 billion, $3.7 billion and $3.5 billion at December 31, 2006, 2005 and 2004, respectively. For detailed information on the Company’s investment portfolio, see Note 3 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
The Company’s investment portfolio has exposure to credit risk primarily related to fixed income securities. Management attempts to control this exposure by emphasizing investment grade credit quality in the fixed income securities purchased. Management believes that this concentration in investment grade securities reduces the Company’s exposure to credit risk to an acceptable level.
Estimates of future payments pursuant to the Company’s contractual obligations at December 31, 2006 are summarized as follows:
Included in other long-term liabilities are expected contributions to postretirement health care and life insurance benefit plans sponsored by the Company and an estimated payment under the Crum & Forster Holdings Corp. Long Term Incentive Plan.
The postretirement health care and life insurance benefit obligations are estimated ultimate payments required to provide such benefits. Actual payments may differ significantly from these estimates. Although the Company provides various benefit plans, programs and arrangements to its employees, the Company has reserved the right to amend, modify or terminate these plans, programs or arrangements at any time, subject to the terms and conditions of such plans, programs or arrangements and applicable law. For more information on the Company’s postretirement benefit plans, see Note 10 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
The Crum & Forster Holdings Corp. Long Term Incentive Plan is a compensation arrangement for certain of the Company’s executives. Included in the amounts above is an estimated payment of $14.2 million in 2009 based upon the December 31, 2006 valuation of the plan. This is management’s best estimate of the plan liability. The actual payment could be materially different from this estimate.
Consolidated Statements of Income for the Years Ended December 31, 2006, 2005 and 2004
Crum & Forster Holdings Corp. (the “Company” or “Crum & Forster”) is a Delaware holding company, which is 100% owned by Fairfax Inc., a Wyoming holding company. Fairfax Inc. is ultimately owned by Fairfax Financial Holdings Limited (“Fairfax”), a Canadian financial services holding company, which is publicly traded on the Toronto Stock Exchange and the New York Stock Exchange under the symbol “FFH”. The Company, through its subsidiaries, offers a full range of commercial property and casualty insurance distributed through an independent producer force located across the United States.
Effective January 1, 2006, Fairfax announced that certain of the business of the insurance companies of Fairmont Specialty Group, affiliates of Fairfax, would be carried on as Fairmont Specialty, a division of Crum & Forster (“Fairmont”), thereby giving Fairmont access to the “A-” A.M. Best rating of Crum & Forster. The Fairmont business is comprised of standard commercial and personal lines, bail bonds and accident and health coverages. In return for the opportunity to quote Fairmont Specialty Group’s renewals effective January 1, 2006 and thereafter, the Company hired substantially all Fairmont Specialty Group employees and assumed certain operating obligations. Pending regulatory approval of Crum & Forster company rate and form filings for the Fairmont business, substantially all of the policies underwritten by Fairmont through September 2006, were being issued by the insurance companies of Fairmont Specialty Group and assumed by the Company through a 100% quota share reinsurance agreement. Commencing in the fourth quarter of 2006, the majority of the Fairmont business is now being written directly by Crum & Forster companies.
Investments in entities that are consolidated subsidiaries of Fairfax, but are less than 50% owned by the Company as well as investments in certain partnerships, are carried under the equity method of accounting. For all other investments, the Company determines if it exercises significant influence based upon its ownership of shares without consideration of the ownership interest of other Fairfax affiliates. The Company’s pro-rata share of earnings of equity method investees is recorded in the consolidated statements of income. Earnings of investment companies and similar equity method investees are reported in investment income and earnings of other equity method investees are reported as equity in earnings of investees, net of tax. Dividends received from equity method investees reduce the carrying value of the investment. Realized investment gains or losses are determined on the basis of average cost. Investment income is recorded as earned.
Certain costs that vary with and are primarily related to the acquisition of new and renewal policies, consisting of commissions and premium taxes incurred, are deferred and amortized over the period in which the related premiums are earned. Deferred policy acquisition costs are limited to their estimated realizable value, which considers anticipated losses and loss adjustment expenses on the related policies and estimated remaining costs of servicing the contracts. Realizability is determined without considering investment income.
Goodwill is subject to an assessment of impairment on an annual basis or more frequently under certain circumstances. The assessment of impairment involves a two-step process whereby an initial assessment for potential impairment is performed followed by a measurement of the impairment, if any. Impairments are charged to operations in the period in which the impairment occurs. The Company’s annual impairment tests in 2006 and 2005 resulted in a conclusion that no goodwill impairment has occurred. Goodwill in the amount of $7,311 is included in other assets on the consolidated balance sheets at December 31, 2006 and 2005.
Deferred income taxes are provided for temporary differences between the financial statement and tax bases of assets and liabilities. Such differences relate principally to unrealized net appreciation of investments, certain realized gains and losses, income related to foreign investments, deferred income on retroactive reinsurance, net operating loss carryforwards, unpaid losses and LAE, unearned premiums, deferred policy acquisition costs and employee benefit plans. A valuation allowance against deferred tax assets is recorded if it is more likely than not that all, or some portion of, the benefits related to deferred tax assets will not be realized.
Insurance premiums are earned ratably over the terms of the related policies after deductions for premiums ceded to reinsurers. Unearned premium reserves are established for the unexpired portion of policy premiums. Premiums are accrued for retrospectively rated policies and on policies subject to audit based on estimates throughout the contract or policy term. The reserve for uncollectible premiums includes both specific allowances for probable uncollectible amounts and a non-specific reserve determined principally on the basis of past collection experience. At December 31, 2006 and 2005, the reserve for uncollectible premiums was $25,331 and $24,437, respectively.
The Company periodically purchases certain derivative contracts for its investment portfolio consistent with its overall investment strategy. In addition, the Company owns convertible securities with embedded derivatives within its fixed income portfolio, which allow the Company to convert the fixed income securities to equity securities. In accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”), the Company bifurcates all derivatives that are embedded in its convertible securities. The original host instruments are recorded at fair value in fixed income investments and the embedded derivatives are recorded at fair value in other invested assets. All derivative instruments are recognized as either assets or liabilities on the consolidated balance sheet and are measured at fair value. Gains or losses arising from changes in the fair value of derivatives are recorded in realized investment gains and losses on the consolidated statements of income.
In June 2006, the FASB issued FASB Interpretation 48, Accounting for Uncertainty in Income Taxes. The interpretation clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with SFAS 109, Accounting for Income Taxes. Specifically, the pronouncement prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The interpretation also provides guidance on the related derecognition, classification, interest and penalties, accounting for interim periods, disclosure and transition of uncertain tax positions. The interpretation is effective for fiscal years beginning after December 15, 2006. Based on an analysis of its tax positions taken or expected to be taken, the Company does not expect this interpretation to have an impact on its results of operations or financial position.
Investments in available-for-sale fixed income and equity securities, including assets pledged for short-sale obligations, are summarized as follows:
Certain individual available-for-sale securities had gross unrealized losses at December 31, 2006 totaling $140,815, which represented 6.2% of the cost or amortized cost of such securities in the aggregate, of which $129,719 was attributed to fixed income securities and $11,096 was attributed to equity securities.
Includes U.S. Treasury securities pledged for short-sale obligations at a fair value of $130,122 (amortized cost of $135,447).
Substantially all of the gross unrealized losses of $129,719 in the fixed income portfolio at December 31, 2006, are attributable to U.S. Treasury securities. These securities are backed by the full faith and credit of the United States government and the Company has the ability and intent to hold such securities for a period of time sufficient to allow a market recovery, or to maturity if necessary. The unrealized losses attributable to equity securities in the amount of $11,096 at December 31, 2006, are in respect of four securities, none of which has been in a loss position for greater than twelve consecutive months, nor did the unrealized loss in any case exceed 10% of cost at December 31, 2006. The Company has the ability and intent to hold such securities for a period of time sufficient to allow a market recovery.
The number of continuous months in which securities in an unrealized loss position at December 31, 2005 were in such a position is summarized as follows:
In September 2006, the Company acquired an additional 196,538 units of Dalton from various Fairfax companies at fair value, for consideration of $5,281.
In June 2006, the Company redeemed approximately 1.7 million, or 78%, of its interest in HWIC for proceeds of $118,675 and a realized investment gain of $5,053. The Company reinvested $25,000 in HWIC in December 2006.
In June 2005, Advent completed a public offering of its common stock. The Company purchased its pro-rata share equal to $8,321 in the offering and, accordingly, suffered no dilution of its 11.4% ownership interest. Concurrent with the offering, Advent’s common stock was listed for trading on the Alternative Investment Market of the London Stock Exchange.
The Company’s investment portfolio includes investments accounted for using the equity method. These investments consist of equity interests of between 1.1% and 37.2% at December 31, 2006 with a total carrying value of $307,818 and $350,603 at December 31, 2006 and 2005, respectively, and are included in other invested assets on the consolidated balance sheets. For the years ended December 31, 2006, 2005 and 2004, earnings of equity method investees were $108,011, $45,477 and $24,402 respectively. Earnings of investment companies and similar equity method investees of $87,762, $19,026 and $5,205 in 2006, 2005 and 2004, respectively, are included in investment income on the consolidated statements of income. Pre-tax earnings of other equity method investees of $20,249, $26,451 and $19,197 in 2006, 2005 and 2004, respectively, are included in equity in earnings of investees, net of tax, on the consolidated statements of income. Dividends received from other equity method investees were $5,113, $4,766 and $4,173 in 2006, 2005 and 2004, respectively.
The Company purchased its investment in Northbridge in May 2003 and holds a 15.2% interest at December 31, 2006. For the years ended December 31, 2006, 2005 and 2004, pre-tax equity in earnings of Northbridge were $17,907, $26,319 and $18,118, respectively, and were included in equity in earnings of investees, net of tax, on the consolidated statements of income. Dividends received from Northbridge were $4,545, $4,205 and $3,591 in 2006, 2005 and 2004, respectively.
Other invested assets include investments in partnerships in which the Company has an ownership interest of less than 20% and does not have the ability to exercise significant influence. These investments are accounted for using the cost method. At December 31, 2006, the cost of the Company’s cost method investments was $6,388 and their fair value was $7,657.
In July 2004 and January 2005, as an economic hedge against a decline in the U.S. equity markets, the Company executed short-sales of Standard & Poor’s Depositary Receipts (“SPDRs”) totaling approximately $300,000. Simultaneously, the Company purchased S&P Index call options (“Options”) limiting the potential loss on the future purchase of the SPDRs. The cost of the Options was $8,217. Certain of these options expired in July 2006 and replacement options were purchased at a cost of $1,900, bringing the total cost of the Options purchased through December 31, 2006, to $10,117. At December 31, 2006, the Options limit the potential loss to the Company on the future purchase of the SPDRs to approximately $70,000. Both the obligations to purchase the SPDRs and the Options are carried at fair value on the consolidated financial statements. The fair value of the obligations to purchase the SPDRs is included in short-sale obligations and the fair value of the Options is included in other invested assets on the consolidated balance sheets. The fair values of the SPDRs obligation and the Options at December 31, 2006 amounted to a liability of $375,558 and an asset of $9,925, as compared to a liability of $329,740 and an asset of $6,358 at December 31, 2005.
Changes in the fair value of the short-sale obligations and derivative transactions described above have been included in realized investment gains and losses in the consolidated statements of income as follows:
Fixed income securities and cash and cash equivalents of $382,603 and $323,699 were on deposit with various state regulatory authorities at December 31, 2006 and 2005, respectively, as required by insurance laws.
In 2006, the Company recognized net favorable prior year loss development of $96,162 (8.8 loss ratio points), including $12,889 of amortization of deferred gains on retroactive reinsurance. The net favorable development was comprised of favorable development across all major casualty lines, with the largest redundancy being recognized in workers’ compensation, principally attributable to the favorable results in California in accident years 2005 and 2004, consistent with industry-wide experience. Additionally, favorable development was also experienced in umbrella and other general liability exposures, due in part to favorable settlements of claims in accident years 2000 and prior and in commercial automobile liability for accident years 2005 and prior. The favorable development was partially offset by $33,897 of adverse development of asbestos, environmental and other latent liabilities.
In 2004, the Company recognized net adverse prior year loss development of $69,254 (7.6 loss ratio points), net of $18,324 of amortization of deferred gains on retroactive reinsurance. The net adverse development was principally attributable to $100,522 of strengthening of reserves for asbestos and environmental liabilities, driven mainly by an increase in the average severity of claims for known policyholders. These reserve increases were offset, in part, by $20,000 of reserve decreases primarily in the general liability line for accident years 1997 and prior.
The components of the Company’s total reinsurance recoverable are summarized as follows:
The Company actively monitors and evaluates the financial condition of its reinsurers and develops estimates of the uncollectible amounts due from reinsurers. Such estimates are made based on periodic evaluation of balances due from reinsurers, judgments regarding reinsurers’ solvency, known disputes, reporting characteristics of the underlying reinsured business, historical experience, current economic conditions and the state of reinsurer relations in general and with the Crum & Forster companies in particular. Management attempts to mitigate collection risk from reinsurers by obtaining collateral and by entering into reinsurance arrangements only with reinsurers that have credit ratings and statutory surplus above certain levels. Reinsurance recoverable on the consolidated balance sheets is stated net of reserves for uncollectible reinsurance of $42,777 and $34,441 at December 31, 2006 and 2005, respectively.
Crum & Forster’s underwriting results are significantly affected by reinsurance. The Company currently purchases, or has in the past purchased, reinsurance to limit its exposure to loss from any one claim or occurrence (“per risk or per occurrence reinsurance”), from aggregate loss experience for an accident year that exceeds an amount the Company is willing to accept and from adverse development of prior years’ loss and LAE reserves (the latter two types of reinsurance are referred to herein as “corporate aggregate reinsurance”, as distinct from the aforementioned “per risk or per occurrence reinsurance”). The Company’s corporate aggregate reinsurance contracts are of the type commonly referred to as “finite” reinsurance and cover or covered, in varying amounts and on varying terms, accident years 2002 and prior. Per risk or per occurrence reinsurance designed to limit exposure to loss from any one claim or occurrence generally responds at the individual claim or occurrence level and is priced based on underlying loss costs and exposures. As a result, loss experience, net of the effect of this reinsurance, is generally consistent with the underlying gross loss experience. Reinsurance designed to limit accident year losses in the aggregate or adverse development of prior years’ loss and LAE reserves may significantly affect the reported loss experience for a given period in amounts or directions that are not consistent with the loss experience of the underlying policies. The prices paid for corporate aggregate reinsurance may also affect the underwriting expense ratios by reducing the net premiums earned, upon which the ratio is calculated. Therefore, management believes that presenting the Company’s results net of per risk or per occurrence reinsurance but before benefit of corporate aggregate reinsurance generally provides a more accurate portrayal of the actual loss experience of the underlying policies. The Company last entered into a corporate aggregate reinsurance contract in 2001.
An analysis of activity in prospective corporate aggregate reinsurance contracts follows:
At December 31, 2006, one prospective contract, covering accident years 2000 through 2002, has an unused limit available of $96,272 in the event the net loss and LAE ratio for accident year 2002, before the effect of this contract, exceeds 70%. The subject loss and LAE ratio as valued at December 31, 2006 is 62.4%. No additional premium or funds held interest would be due under this contract upon usage of the remaining limit. Coverage of accident years 2000 and 2001 under this contract has been exhausted and recovered. The reinsurer under this contract is nSpire, a Fairfax affiliate.
An analysis of activity in retroactive corporate aggregate reinsurance contracts follows:
The second contract, covering substantially all lines of business, provides $100,000 of limit in excess of a retention for accident periods prior to August 13, 1998, the date of acquisition of the Company by Fairfax. The contract contains sub-limits relating to asbestos, environmental and latent, construction defect and other losses and is subject to a maximum economic loss provision. Premium for this contract was $32,597. The contract is on a funds held basis with interest credited at 7%. The Company may commute the contract any time the funds held balance is positive. In the fourth quarter of 2006, cessions under this contract were reversed due to favorable loss development of the underlying policies covered by this contract. As a result, the Company reduced the funds held balance to offset amounts due the Company at December 31, 2006, pursuant to the aforementioned commutation provision. At December 31, 2006, the Company had no cumulative ceded losses under this contract and had a return of premium of ($1,539) in 2004 and paid premiums of $34,136 prior to 2004. None of the $100,000 coverage under this treaty is available for asbestos development.
The reinsurance contracts discussed above were put in place to protect the Company’s surplus while the Company took the steps necessary to improve underwriting results following its acquisition by Fairfax in 1998. The Company has not purchased corporate aggregate reinsurance since 2001 and does not currently have plans to purchase corporate aggregate reinsurance in the future.
After June 15, 2008, the Company may redeem the Notes at its option, in whole or in part, upon not less than 30 nor more than 60 days’ notice, at the following redemption prices (expressed as percentages of the principal amount thereof) if redeemed during the twelve-month period commencing on June 15 of the year set forth below:
In addition, the Company must pay accrued and unpaid interest to the date of redemption on the Notes redeemed.
In the normal course of business, nSpire, a Fairfax affiliate, participates in reinsurance agreements covering substantially all reinsured lines of business. For the years ended December 31, 2006, 2005 and 2004, the Company ceded to nSpire premiums of $35,515, $44,301 and $43,750, respectively. The Company had reinsurance recoverable of $71,905 and $110,987 at December 31, 2006 and 2005, respectively, related to these reinsurance agreements. In 2006, the decrease in reinsurance recoverable balances due from nSpire is primarily due to collections made on the 2005 and 2004 hurricanes as well as mild hurricane activity in 2006. Pursuant to the terms of the reinsurance agreements between nSpire and the Company, nSpire, as a foreign reinsurer, is required to collateralize in full reinsurance balances due to the Company. The recoverable from nSpire is collateralized by irrevocable trusts in compliance with NAIC regulations. There are no regulatory or other restrictions on payments to the Company from nSpire. In 2006, upon renewal of the Company’s fidelity and umbrella treaties, Wentworth Insurance Company Ltd. (“Wentworth”), a Fairfax affiliate, participated in these reinsurance agreements in lieu of nSpire. During the year ended December 31, 2006, the Company ceded premiums of $1,574 to Wentworth and had a reinsurance recoverable balance of $112 at December 31, 2006.
The Company entered into an aggregate stop loss agreement covering accident years 2000 through 2002. For accident years 2002 and 2001, nSpire is the direct reinsurer. Accident year 2000 was fronted by a third party reinsurer that retroceded the liability in full to nSpire on the same terms and conditions as if nSpire were the direct reinsurer. The 2000 accident year was exhausted in 2000 and recovered in full in 2004. The Company retains an ultimate net loss of up to 70% of net premiums earned in 2002 and 73% in 2001. Accident years 2002 and 2001 are subject to a per-term maximum recovery of $96,272 and $94,195 respectively. Pursuant to the agreement, the Company ceded premiums of $32,091 and $31,398 for accident years 2002 and 2001, respectively. At December 31, 2006 and 2005, no losses were ceded to nSpire under this contract for accident year 2002.
A former parent of the Company required the transfer of a number of policies and related assets and liabilities among insurance companies controlled by the former parent, effective through assumption and indemnity reinsurance agreements. The assuming parties were required to seek novation of certain policies. At December 31, 2006 and 2005, amounts recoverable from TIG included $119,935 and $122,321, respectively, related to these policies, which were not novated.
Effective January 1, 2001, the Company entered into a reinsurance agreement with Lombard General Insurance Company of Canada (“Lombard”), an affiliate of Fairfax, under which the Company has agreed to reinsure 100% of the surety business of Lombard underwritten by the Company. For the years ended December 31, 2006, 2005 and 2004, the Company assumed $98, $340 and $788, respectively, in premiums from Lombard. At December 31, 2006 and 2005, the Company had $1,002 in reserves for this assumed business.
The Company and its subsidiaries have entered into agreements with Hamblin Watsa Investment Counsel Ltd. (“Hamblin Watsa”), a wholly-owned subsidiary of Fairfax, for investment management services, and with Fairfax for investment administration services. Pursuant to the agreements, fees, based upon assets under management, totaled $17,528, $13,924 and $7,606 for the years ended December 31, 2006, 2005 and 2004, respectively, and were included as investment expenses in the consolidated statements of income.
Under an agreement effective January 1, 2006, US Fire provides underwriting, administration, financial and claims services for the business of Fairmont Premier Insurance Company, Fairmont Specialty Insurance Company and Fairmont Insurance Company, affiliates of Fairfax. The fees billed for such services were $13,043 in 2006.
Fairfax purchases insurance coverage on behalf of its affiliates, including comprehensive crime, insurance companies’ professional liability, directors’ and officers’ liability and company reimbursement, employment practices liability, fiduciary liability and special accident insurance. The Company’s share of the expense incurred for this coverage was $1,534, $1,417, and $1,396 for the years ended December 31, 2006, 2005 and 2004, respectively.
In addition, FITS entered into an agreement with the Company effective January 1, 2001 pursuant to which FITS is provided certain management and general services by the Company. Under this agreement, the Company billed $139, $145 and $49 for the years ended December 31, 2006, 2005 and 2004, respectively.
The Company receives income from subleases of office space to Fairfax affiliates. Sublease income received from affiliates in 2006, 2005 and 2004 amounted to $235, $477 and $399, respectively.
Included in accounts payable and other liabilities at December 31, 2006 and 2005 are amounts payable to Fairfax and affiliates of $13,841 and $8,564, respectively, principally related to Hamblin Watsa investment management fees and FITS fees. Included in assets at December 31, 2006 and 2005 are amounts receivable from Fairfax and affiliates of $839 and $306, respectively.
The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 5.5% at December 31, 2006 and 2005. For purposes of measuring the accumulated postretirement benefit obligation at December 31, 2006, the health care cost trend rates are assumed to decline gradually from 10.0% in 2006 to 5.0% in 2012 and thereafter for all participants. Increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation at December 31, 2006 by $1,414, and the aggregate of the service and interest cost components of net periodic postretirement benefit expense for 2006 by $74.
At December 31, 2006, the future benefit payments through 2016, net of estimated participant contributions, are expected to be as follows:
The amounts above are reduced by space subleased to other companies in the aggregate amount of $258.
Rental expense, before sublease income, under these operating leases was $14,318, $14,470 and $12,325 in 2006, 2005 and 2004, respectively. The Company recognized $601, $1,160 and $1,821 in 2006, 2005 and 2004, respectively, from subleases.
The Company’s insurance subsidiaries are domiciled in the states of Delaware, New Jersey, New York and Arizona. In December 2003, US Fire and CF Indemnity changed their state of domicile from New York to Delaware. The maximum dividend that could be paid by the insurance companies to the Company in 2007, without prior regulatory approval, is $138.4 million.
The principal differences between statutory policyholders’ surplus and shareholder’s equity determined in accordance with GAAP relate to accounting for deferred gains on retroactive insurance, unrealized gains and losses on fixed income securities, deferred policy acquisition costs and deferred federal income taxes. Under the Codification of Statutory Accounting Principles adopted by the NAIC in 1998, US Fire’s state of domicile had granted a permitted accounting practice to treat Zenith, a former affiliate of the Company, as a non-affiliated investment based on the absence of control by US Fire. During 2006, the Company disposed of its investment in Zenith, which resulted in the same impact to statutory surplus for this permitted accounting practice as if prescribed accounting practice had been applied. This permitted practice had no effect on statutory surplus at December 31, 2005 and increased statutory surplus by $11,305 at December 31, 2004 over what it would have been had prescribed accounting practice been followed.
During the second and third quarters of 2006, the Company identified and recorded certain adjustments associated with its accounting for investments. The adjustments relate principally to four areas: (i) equity method accounting - the Company did not properly reflect adjustments to realized investment gains and losses reported by equity method investees arising from basis differences associated with initial purchases or changes in ownership percentages. These adjustments relate principally to the Company’s investments in Northbridge and HWIC; (ii) partnership accounting - several of the Company’s partnership interests were recorded on the equity method of accounting pursuant to Statement of Position 78-9, Accounting for Investments in Real Estate Ventures, even though the Company did not have the ability to exercise significant influence over the investees. In such circumstances, the Company should have retained the investment company accounting of the investees; (iii) embedded derivatives mark-to-market - the Company did not properly reflect the mark to market through earnings of derivative features embedded in convertible securities pursuant to SFAS 133. Several of the Company’s equity investees also held the same or similar securities with embedded derivatives. The Company determined that the investees also did not properly bifurcate their investments, which required adjustments to the Company’s financial statements; and (iv) valuation of an affiliated equity method investee - the Company did not correctly reflect the carrying value of its 1.4% ownership interest in TRG in 2002, pursuant to guidance in SFAS No. 141, Business Combinations.
The cumulative charge to net income in the year ended December 31, 2006 was $3,089 pre-tax ($2,008 after- tax) for these adjustments. Of the $3,089 pre-tax charge, $4,255 was recorded as a charge to realized investment gains, $3,534 was recorded as a charge to equity in earnings of investees (including $456 of previously waived immaterial adjustments) and $4,700 was recorded as an increase to investment income on the consolidated statements of income. Additionally, the Company recorded a $7,369 increase to accumulated other comprehensive income, net of tax, that together with the aforementioned $2,008 charge to net income, resulted in a $5,361 increase in shareholder’s equity.
Based on its loss reserves review as of September 30, 2006, the Company recognized approximately $71.5 million ($46.5 million after-tax) of favorable loss and LAE development in the fourth quarter of 2006.