Crum & Forster’s principal offices are located in space leased by the Company in Morristown, New Jersey. The lease covers approximately 201,887 square feet of office space at 305 Madison Avenue. The term of the lease ends December 31, 2022, and provides for up to four consecutive additional terms totaling twenty-five years. 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 Company also leases office space for its field offices. Crum & Forster does not own any of the real estate used for its operations.
The table shown below presents selected financial data for each of the five years ended December 31, 2007. This financial information was prepared in accordance with GAAP. The GAAP statement of income data for the years ended December 31, 2007, 2006, 2005, 2004 and 2003 and the GAAP balance sheet data at December 31, 2007, 2006, 2005, 2004 and 2003 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, 2007 and 2006, 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, 2007, 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.
The following discussion and analysis should be read in conjunction with Crum & Forster’s consolidated financial statements and accompanying notes included in “Item 8. Financial Statements and Supplementary Data”. Certain information constitutes forward-looking statements that involve risks and uncertainties. For further discussion of forward-looking statements, see “Statements Regarding Forward-Looking Information”. Actual results may differ materially from the results discussed in these forward-looking statements as a result of certain factors including, but not limited to, those set forth under “Item 1A. Risk Factors”.
The Company’s internal actuaries conduct full reserve studies using generally accepted actuarial methods for each line of business except asbestos, environmental and other latent, every six months, and for asbestos, environmental and other latent, annually. For all lines of business other than asbestos, environmental and other latent, ultimate losses and ALAE are projected by line of business by accident year using several standard actuarial methodologies, including paid and incurred loss development, the Bornhuetter-Ferguson incurred and paid loss methods, case reserve adequacy methods and frequency and severity approaches. For ULAE, the Company utilizes paid ULAE to paid loss analysis and the Wendy Johnson method. The Company’s actuaries utilize assumptions in determining their estimates, including loss development factors, expected loss ratios, frequency and severity trends, year-on-year price changes and inflation. These assumptions are affected by items such as past loss experience, changes in legislative conditions, changes in judicial interpretation of legal liability and policy coverage, and changes in claims handling practices. In addition, prevailing economic, social and legal factors, such as inflation in medical services, costs to repair damaged property or changes in statutory benefits, influence these assumptions. After projecting ultimate losses for each of the various actuarial methodologies, the actuaries select a point estimate ultimate for each accident year within a line of business based on many factors, such as the age of the accident year and the risk characteristics of the individual line of business.
For example, for older years where more credibility can be placed upon actual observed loss emergence, paid or incurred loss development methods are generally the basis of the ultimate loss selection. For more recent years where the actual emergence of losses is less credible, methods that place more emphasis on expected loss development (e.g., the Bornhuetter-Ferguson method) may be selected as the loss ultimate. A point estimate unpaid loss and ALAE reserve is determined by subtracting actual paid losses and ALAE from the projected ultimate losses and ALAE for each line of business by accident year. These reserves are aggregated by line of business and the IBNR component is derived therefrom by deducting the recorded case reserves. The ULAE IBNR reserve is calculated directly by the methods described above. The IBNR reserve includes anticipated additional development of case reserves (either positive or negative), provision for claims that have not been reported and estimated settlement expenses.
The Company’s actuaries also conduct an internal ground-up study of asbestos and environmental reserves on an annual basis. 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.
At each balance sheet date, Company management establishes its “best estimate” based on the actuarial point estimates by line of business from the most recent internal actuarial reserve review, together with the actual loss emergence since such most recent review.
Early asbestos claims focused on manufacturers and distributors of asbestos-containing products. Thus, the claims at issue largely arose out of the products hazard and typically fell within the policies’ aggregate limits of liability. Increasingly, policyholders have been asserting that their asbestos claims are not subject to these aggregate limits and that each individual bodily injury claim should be treated as a separate occurrence, potentially creating even greater exposure for primary insurers.
In 1994, Congress enacted a new section of the bankruptcy code aimed at facilitating the reorganization of businesses with large asbestos liabilities. Under this law, an asbestos defendant can receive a discharge from present and future asbestos claims by following the provisions of the bankruptcy code. Insurers of the defendant have typically been excluded from the pre-petition negotiations between the asbestos defendant and the asbestos plaintiffs’ lawyers, although the typical plan presumes the insurers will pay for claims under negotiation. These “pre-packaged bankruptcies” can inflate claim costs and accelerate the timing of claims payments, and it is likely that additional defendants will seek protection under this provision in the future. Although the pace of new filings has slowed considerably, bankruptcy filings by various defendants in the asbestos arena continue to result in larger claim values to be paid by the remaining solvent defendants, including certain Crum & Forster policyholders. To date, this continued flow of claims has forced at least 78 manufacturers and users of asbestos products into bankruptcy. These bankruptcies have, in turn, aggravated both the volume and the value of claims against viable asbestos defendants. Accordingly, there is a high degree of uncertainty with respect to future exposure from asbestos claims, both in identifying which additional policyholders may become targets in the future and in predicting the total number of asbestos claimants.
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 discussed in more detail in the following paragraphs, the Company increased its reserves for asbestos liabilities in each of 2007, 2006 and 2005. 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 or 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 2007, 2006 and 2005, the Company increased asbestos reserves by $24.3 million, $22.7 million and $31.6 million, respectively, (approximately 7%, 6% and 8%, respectively, of the preceding year-end reserves balances). The increases were largely attributable to developments related to one policyholder.
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, chemicals, 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. In 2007, the Company increased other latent reserves by approximately $8.0 million, due in part to a policyholder with both asbestos and silica claims. In 2007, the exposures for silica were identified as the predominant exposure for this policyholder and the reserves were established in other latent. 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, 2007 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.
At December 31, 2007, the Company had unrealized losses of $81.4 million in investments in available-for-sale fixed income and equity securities (including $4.0 million of unrealized losses in respect of fixed income securities held for short-sale obligations) of which $46.4 million was associated with fixed income securities and $35.0 million related to equity securities. Substantially all of the gross unrealized losses of $46.4 million 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. Of the gross unrealized losses of $35.0 million in the equity portfolio, $27.7 million, or 79.1%, is in respect of one security in the pharmaceutical industry whose loss exceeded 10% of its cost at December 31, 2007 but had not been in an unrealized loss position for greater than 12 consecutive months. The Company has the ability and intent to hold this security and others in an unrealized loss position for a period of time sufficient to allow a market recovery. For the years ended December 31, 2007, 2006 and 2005, charges for other than temporary impairments amounted to $25.4 million, $15.9 million and $3.9 million, respectively.
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, 2007.
In the third quarter of 2007, the Company entered into a new tax sharing agreement with Fairfax that permits the Company and its subsidiaries to elect to file federal income tax returns on a consolidated basis for tax sharing purposes. The Company has made this election effective January 1, 2007. The election resulted in the utilization of the holding company net operating losses (“NOLs”) in the amount of $79.7 million and 2.7 million in the third and fourth quarters of 2007, respectively, and will avoid the generation of holding company NOLs going forward, provided the subsidiaries earn sufficient taxable income to offset holding company losses arising principally from interest on the Company’s senior notes. For further details see Note 2 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data” and “- Results of Operations - Income Taxes”.
At December 31, 2007, there are no valuation allowances against the Company’s gross deferred tax assets of $175.0 million. The Company’s current projections of future taxable income are based on assumptions of level to modestly declining business growth and relatively stable combined ratios, with portfolio yields approximating current levels. Should the assumptions of future profitability change significantly, however, or the taxable income of these entities fall far below expectations, a valuation allowance, which could be significant, may have to be established if management believes any portion of the deferred tax asset will not be realized. A valuation allowance may also be required if there is a material change in the tax laws such that the actual effective tax rate or the time periods within which the underlying temporary differences become taxable or deductible change.
Management monitors the contribution to earnings of underwriting operations and investment results separately. The ability to achieve underwriting profitability on a consistent basis is the core competency of a property and casualty insurance company, demonstrating discipline, individual risk selection and pricing skills, and effective risk management on a portfolio basis. The underwriting functions of the Company are managed separately from the investment operations. Accordingly, in assessing the Company’s results of operations, management evaluates underwriting results separately from investment performance.
Overall, in 2007, renewal retention rates increased by two percentage points over the prior year to approximately 65% whereas renewal pricing in the Company’s casualty and property lines declined by approximately 8% and 9% respectively. New business declined by approximately 28%, largely attributable to decreases in property and general liability writings. The Company expects that the market will continue to soften through 2008; however, it continues to maintain a disciplined approach to underwriting and write new business only at acceptable rates.
The increase in net income in the year ended December 31, 2006 as compared to 2005 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”) common stock as well as higher investment income from HWIC, an affiliated equity method investee. 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.
The casualty market softened throughout 2006, particularly with respect to the California workers’ compensation business, which has been affected by declining market prices as a consequence of system reforms and very favorable industry accident year results in recent years. California workers’ compensation gross premiums written totaled $77.5 million, $97.4 million and $136.6 million in 2007, 2006 and 2005, respectively. Throughout 2007, rates for all lines continued to be under competitive pressure, particularly for larger accounts, with competitors focused on retaining their renewals, making it very challenging for the Company to write new business at acceptable prices.
For the year ended December 31, 2006, gross premiums written in casualty lines increased by $64.9 million, or 8.9%, as compared to the year ended December 31, 2005. This increase included $63.4 million of Fairmont’s premiums. Excluding Fairmont, gross premiums written in casualty lines remained level during the year ended December 31, 2006 compared to the prior year, primarily due to modest increases in renewal retention rates and new business partially offset by price decreases on renewal policies.
For the year ended December 31, 2006, the increase in other gross premiums written as compared to the year ended December 31, 2005, included $90.1 million of Fairmont premiums. Excluding Fairmont, other gross premiums written decreased by $12.7 million, or 66.1%, principally attributable to a reduction in the surety line of business as a result of a decision by management to restrict writings of contract surety business, in response to a greater than expected emergence of surety claims in 2005.
Premiums earned reflect the amount of net premiums written applicable to the portion of the policy term that expires in a given period. The Company generally earns premiums on a pro-rata basis over the period in which the coverage is provided. For the year ended December 31, 2007, premiums earned increased by $102.1 million, or 9.4%, as compared to the year ended December 31, 2006. The increase in premiums earned relative to the decline in net premiums written is primarily attributable to the Fairmont business which the Company assumed at the start of 2006 and which therefore contributed a lower portion to premiums earned in 2006 as compared to 2007. Further, accident and health premiums, which grew significantly in 2007, are earned as written.
In 2006, the Company recognized net favorable prior year loss development of $85.9 million (7.9 loss ratio points) prior to corporate aggregate reinsurance activity. The net favorable development was comprised principally 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 2004 and 2005, 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 offset by adverse development of asbestos, environmental and other latent liabilities of $33.9 million.
In 2005, the Company recognized net favorable prior year loss development of $60.5 million (6.8 loss ratio points) prior to corporate aggregate reinsurance activity. 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 workers’ compensation loss ratio increase from accident year 2005 to 2007 reflects the effects of price softening beginning in 2005 and continuing throughout 2006 and 2007, particularly as respects the California business. Management monitors the price adequacy of each line of business and believes that this business remains profitable.
The commercial multi-peril loss ratio increase from 2006 to 2007 is primarily attributable to the effects of price softening and the severe rainstorms which struck in April 2007. Such rainstorms are reflected in the catastrophe impact cited above (1.3 points) but had a comparatively larger impact on the commercial multi-peril line.
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.
Includes book value of assets pledged for short-sale obligations of $1,047.4 million, $540.9 million and $497.9 million at December 31, 2007, 2006 and 2005, respectively.
The decrease in investment income of $76.6 million, or 34.8%, in 2007 as compared to 2006, was primarily due to lower earnings from HWIC, which realized significant capital gains in 2006, as well as lower earnings from other partnerships in 2007 compared to 2006. Earnings from HWIC and other partnerships were $7.7 million and $5.3 million, respectively, in the year ended December 31, 2007 and $60.5 million and $27.3 million, respectively, in the year ended December 31, 2006. Partially offsetting these effects were lower investment fees in 2007 compared to 2006.
As of December 31, 2007, the Company held $5.2 billion notional amount of credit default swaps with an average term to maturity of 3.7 years, with a cost of $84.5 million and a market value of $234.1 million. As of December 31, 2006, the company held $4.2 billion notional amount of credit default swaps with a cost of $77.6 million and a market value of $16.7 million. From January 1, 2008 to February 15, 2008, the Company sold an additional $555 million notional amount of credit default swaps (including virtually all of its credit default swaps referenced to U.S. financial guarantee insurance companies) for gross proceeds of $127.9 million and gains on sale in excess of the mark-to-market value as at December 31, 2007 of $27.1 million. The net mark-to-market gain for the January 1 to February 15, 2008 period on the $4.8 billion notional amount of credit default swaps remaining at February 15, 2008 (including 2008 purchases of $132 million notional amount of credit default swaps for $3.8 million) was $141.4 million (representing total net gains related to credit default swaps for this period of $168.5 million). These credit default swaps continue to be very volatile, with the result that their market value (and their liquidity) may vary dramatically either up or down in short periods, and their ultimate value will therefore only be known upon their disposition.
In 2007, the change in unrealized investment gains and losses and foreign currency translation was primarily attributable to the combined effects of a rally in the U.S. Treasury market, attributable to the sub-prime mortgage market crisis, an increase in unrealized gains on the equity portfolio and other invested assets and a weakening U.S. dollar, which resulted in an increase in foreign currency translation gains. 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 sale of Zenith common stock and greater unrealized losses on the Company’s fixed income portfolio due to higher interest rates.
In July 2007 and November 2007, the Company executed additional short-sales of SPDRs of approximately $200 million and $120 million, respectively, bringing the total short positions held in SPDRs to approximately $620 million at December 31, 2007. These short positions serve as an economic hedge against a decline in the U.S. equity markets. In connection with the SPDRs transactions, the Company has purchased S&P Index call options (the “Options”) limiting the potential loss on the future purchase of the SPDRs to approximately $220 million at December 31, 2007. 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 obligation 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, 2007 amounted to a liability of $706.5 million and an asset of approximately $0.1 million, respectively, as compared to a liability of $375.6 million and an asset of $9.9 million, respectively, at December 31, 2006.
As an economic hedge against deteriorating conditions in the credit markets, the Company holds short positions on securities of certain U.S. financial guarantee insurance companies, mortgage insurance companies and financial institutions totaling approximately $12.5 million and $24.9 million at December 31, 2007 and December 31, 2006, respectively. The obligation to purchase these securities is included, at fair value, in short-sale obligations on the consolidated balance sheets and amounted to $12.2 million and $24.6 million, at December 31, 2007 and December 31, 2006, respectively.
The obligations to purchase the short-sale securities discussed above and the Options are carried at fair value on the consolidated financial statements and related changes in fair value are recorded in realized investment gains and losses. Changes in the fair value of the short-sale transactions and related Options amounted to realized gains of $20.7 million in 2007 and realized losses of $43.8 million and $16.6 million in 2006 and 2005, respectively. The Company also incurs investment expense in an amount equal to the dividend earnings on the SPDRs sold. Investment expense of $10.0 million, $6.5 million and $5.7 million relating to this transaction was recorded for the years ended December 31, 2007, 2006 and 2005, respectively.
Interest and other expense, excluding costs related to early retirement of debt of $21.2 million in 2007, was $39.4 million, $41.0 million and $35.5 million in 2007, 2006 and 2005, respectively. The lower expense in 2007 was attributable to lower interest expense as a result of the restructuring of the Company’s long-term debt, described more fully in Note 7 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data” and lower compensation costs, partially offset by a retirement expense in respect of the Company’s President and Chief Executive Officer.
The increase in interest and other expense in 2006 as compared to 2005 was primarily due to an increase in other expense, attributable to higher charitable contributions.
The effective income tax rate (including income taxes on equity in earnings of investees) was 34.2%, 34.3% and 32.4% for the years ended December 31, 2007, 2006 and 2005, respectively. The difference between the Company’s effective income tax rate and the statutory rate of 35% was primarily due to the benefit of dividends received deductions in all three years and, in 2005, to the benefit of additional tax credits allocated to the Company as a result of a federal tax audit of the Company’s former parent company, Xerox Corporation. For further discussion of income taxes, see Note 8 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
In the third quarter of 2007, the Company entered into a new tax sharing agreement with Fairfax that permits the Company and its subsidiaries to elect to file federal income tax returns on a consolidated basis for tax sharing purposes. The Company has made this election effective January 1, 2007. Accordingly, tax sharing for the third and fourth quarters of 2007 reflected the utilization of holding company NOLs in the amount of $79.7 million and $2.6 million, respectively. The third quarter refund from NOL utilization was paid by Fairfax in the form of cash of $37.8 million and a note for $41.9 million. This cash and note at the holding company permitted the payment of a dividend of $79.7 million to Fairfax (discussed further below in Liquidity and Capital Resources) on September 11, 2007. The election going forward will avoid the generation of holding company NOLs, provided the subsidiaries earn sufficient taxable income to offset holding company losses.
In May 2007, the Company issued pursuant to a private offering (the “Offering”) $330.0 million aggregate principal amount of 73/4% senior notes due May 1, 2017 at an issue price of 100%. Net proceeds of the Offering to the Company, after commissions and expenses, of approximately $325.1 million were used to repurchase $295.7 million of the Company’s outstanding $300 million aggregate principal amount of 103/8% senior notes due June 15, 2013 (the “2013 Notes”), through a tender offer which the Company completed in May 2007. The Company paid approximately $325.7 million to purchase the 2013 Notes tendered.
For further information on the Company’s long-term debt see Note 7 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
Shareholder’s equity was $1,293.5 million at December 31, 2007, as compared to $1,093.1 million at December 31, 2006. The increase was primarily the result of current year earnings and net unrealized investment gains partially offset by cash and non-cash dividends paid to Fairfax.
The insurance subsidiaries are currently operating in a soft market and as a result have been experiencing declining premiums. Specifically, over 50% of the insurance subsidiaries’ business is in the casualty insurance sector, which has been experiencing accelerating softening conditions since 2004. The casualty business in general has a longer tail, meaning the period of time from the occurrence of a claim through the settlement of a liability may extend several years into the future. Additionally, the lapse of time between payments to claimants and recoveries from reinsurers, if collections from reinsurers are not received on a timely basis, will directly affect cash flows. Due to this uncertainty regarding the amount and timing of settlement of unpaid claims and ultimate recoveries from reinsurers, the insurance subsidiaries’ cash flow from operations and liquidity needs may vary from year to year.
The insurance subsidiaries maintain a substantial position in highly liquid, short term and other marketable securities in order to provide available cash in the event of unanticipated large claim payments. Management believes that, for the foreseeable future, the insurance subsidiaries have sufficient cash, short-term investments and available credit facilities, that together with cash generated from future investing operations, will meet their operating liquidity needs.
The aggregate carrying value of the Company’s investment portfolio, including cash and cash equivalents and assets pledged for short-sale obligations, was approximately $4.5 billion and $3.9 billion December 31, 2007 and 2006, respectively, of which $343.6 million and $380.9 million was held in cash, cash equivalents and short-tem investments at December 31, 2007 and 2006, 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. At December 31, 2007, the Company held three securities within its fixed income portfolio, with a fair value of $1.1 million, that are guaranteed by financial guarantee companies. Any downgrade in the ratings of these financial guarantee companies is likely to have an adverse effect on the fair value of these securities. The Company does not hold any mortgage-backed securities in its investment portfolio, has generally avoided taking long positions in equity securities where there may be indirect exposure to mortgages and currently has substantial defensive positions in the mortgage, financial guarantee and other financial services industries through credit default swaps, short-sales of individual securities and short-sales of the SPDRs.
At December 31, 2007 and 2006, 94.0% and 92.0% of the Company’s fixed income securities, including hybrid financial instruments, were rated investment grade, respectively. Fixed income securities and cash and cash equivalents of $431.9 million and $382.6 million were on deposit with various state regulatory authorities at December 31, 2007 and 2006, respectively, as required by insurance laws.
For discussion of regulatory issues, see “Item 1. Business - Insurance Regulatory Matters”.
Consolidated Statements of Shareholder’s Equity for the Years Ended December 31, 2007, 2006 and 2005
The Company’s fixed income and equity securities are carried at fair value. Fair value is the amount that would be received for an asset in an orderly transaction between market participants at the measurement date. The degree of judgment used in measuring the fair value of financial instruments is related to the level of observed pricing. Financial instruments with quoted prices in active markets generally have more observed pricing and less judgment is used in measuring fair value. Conversely, financial instruments traded in non-active markets or that do not have quoted prices are measured at fair value using valuation models or other pricing techniques that require more judgment. Observed pricing is affected by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and general market conditions. The Company obtains market price data to value financial instruments for substantially all of its securities. Market price data is principally obtained from market exchanges or broker-dealer quotations. Equity security prices are obtained from market exchanges and U.S. Treasury and corporate fixed income security prices are obtained from broker-dealer quotations.
The Company periodically purchases derivative contracts for its investment portfolio consistent with its overall investment strategy. Derivatives currently held by the Company include credit default swaps, warrants, and options purchased to limit the potential loss on the Company’s short-sales of Standard & Poor’s Depositary Receipts (“SPDRs”). In addition, the Company owns convertible securities with embedded derivatives within its fixed income portfolio.
The Company maintains a reserve for uncollectible loss deductibles. This reserve 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, 2007 and 2006, the amount of the reserve was $12,780 and $8,811, respectively.
Prior to 2007, the Company did not offset its losses (including amounts arising from interest expense on its senior notes) or losses of one of its subsidiaries against income of another in computing the federal income tax payments to Fairfax Inc. In the third quarter of 2007, the Company entered into a new tax sharing agreement with Fairfax Inc. The new agreement, between Crum & Forster Holdings Corp. and Fairfax Inc., permits the Company and its subsidiaries to elect to file federal income tax returns on a consolidated basis for tax sharing purposes. The agreement also provides that all tax sharing payments otherwise payable directly to Fairfax from the Company’s subsidiaries be paid instead to Crum & Forster Holdings Corp., where they are netted against holding company losses before being remitted as net tax sharing to Fairfax. The Company made this election effective January 1, 2007. The election resulted in the utilization of the holding company net operating losses (“NOLs”) in the amount of $79,697 and $2,672 in the third quarter and fourth quarters of 2007, respectively, and will avoid the generation of holding company NOLs going forward, provided the subsidiaries earn sufficient taxable income to offset holding company losses.
Deferred income taxes are provided for temporary differences between the financial statement and tax bases of assets and liabilities. Such differences relate principally to deferred income on retroactive reinsurance, unpaid losses and LAE, unearned premiums, certain realized gains and losses, deferred policy acquisition costs, unrealized net appreciation of investments 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.
In June 2006, the FASB issued FASB Interpretation 48, Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 (“FIN 48”). 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. The Company adopted FIN 48 on January 1, 2007 and although its adoption did not have a direct impact on the Company’s results of operations or financial position, adoption of FIN 48 by one of the Company’s equity method investees resulted in the Company recording a cumulative adjustment of $681, net of tax, to opening retained earnings.
Financial statements of foreign investees accounted for using the equity method are translated into U.S. dollars in accordance with SFAS No. 52, Foreign Currency Translation (“SFAS 52”). Under SFAS 52, investments in entities accounted for under the equity method are translated into U.S. dollars at the rate of exchange in effect at the date of the transaction and related equity earnings are translated at the average rate in effect during the period. At each balance sheet date, the carrying amounts are translated into U.S. dollars at the rate in effect at the balance sheet date and any translation gains or losses are recorded in other comprehensive income.
Accumulated other comprehensive income includes unrealized investment gains and losses on the Company’s available-for-sale fixed income and equity securities, foreign currency translation gains and losses arising from the translation of financial statements of equity method investees denominated in foreign currencies and adjustments to recognize the overfunded or underfunded status of the Company’s defined benefit postretirement plans arising from the adoption of SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statements No. 87, 88, 106, and 132(R) (“SFAS 158”). At December 31, 2007 and 2006, included in accumulated other comprehensive income (loss) were unrealized investment gains of $11,640 and unrealized investment losses of $(49,499), net of tax, respectively, foreign currency translation gains of $31,812 and $12,576, net of tax, respectively, and defined benefit postretirement obligations of $1,027 and $(55), net of tax, respectively. See Note 10 to the consolidated financial statements for further details of the impact of SFAS 158 on the Company’s consolidated financial statements.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115 (“SFAS 159”), which provides the option to measure many financial instruments and certain other items at fair value primarily on an instrument-by-instrument basis. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company plans to elect to apply the fair value option, effective January 1, 2008, to its investment in Northbridge Financial Corporation (“Northbridge”), an affiliated company traded on the Toronto Stock Exchange. Northbridge is currently accounted for under the equity method of accounting pursuant to Accounting Principals Board No. 18, The Equity Method of Accounting for Investments in Common Stock. The Company believes that recording Northbridge at fair value will provide more relevant information to users of the financial statements than the equity method of accounting. At December 31, 2007, the carrying value of the Company’s investment in Northbridge was $200,484 and the fair value was $289,812. Upon adoption of SFAS 159, the Company will record a cumulative adjustment of $89,328 to other invested assets to recognize the difference between the fair value and carrying value of Northbridge, a deferred tax liability of $31,265 and a $58,063 adjustment to opening shareholder’s equity.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. SFAS 157 also establishes a fair value hierarchy that prioritizes the inputs used in valuation techniques. The fair value hierarchy is designed to indicate the relative reliability of fair value measurement. The highest priority is given to quoted prices in active markets and the lowest to unobservable data. The Company currently determines fair value using inputs that are published exchange prices, third party broker quotes or quoted prices for similar securities. The Company has determined that where the measurement of fair value is based on bid and ask prices, the price that is most representative of fair value is the bid price for long positions and the ask price for short positions. The Company currently uses a market price within the bid-ask spread. This change will be effective January 1, 2008 and will result in a cumulative adjustment that is not material to the financial statements.
At December 31, 2007, the Company held three securities within its fixed income portfolio, with a fair value of $1,071, that are guaranteed by financial guarantee companies. Any downgrade in the ratings of these financial guarantee companies is likely to have an adverse effect on the fair value of these securities.
Includes interest of $25,609, $16,893 and $8,923 in 2007, 2006 and 2005, respectively, on cash collateral pledged for short-sale obligations, as well as interest on short-term investments.
Income from other invested assets in 2006 includes $60,555 of realized investment gains reported in the earnings of an affiliated equity method investee.
The components of realized investment gains for the years ended December 31, 2007, 2006 and 2005 are summarized below:
Included in realized investment losses for the years ended December 31, 2007, 2006 and 2005 are $25,443, $15,857 and $3,889, respectively, related to losses on other than temporary impairments of fixed income and equity securities. The amount for 2007 reflects a write-down of $2,982 attributable to fixed income securities and $22,461 attributable to equity securities. The amounts for 2006 and 2005 are attributable to write-downs of equity securities only. For further details of realized gains or losses attributable to the Company’s derivatives, short-sale obligations and hybrid financial instruments, refer to the section below “Derivative Transactions, Short-Sale Obligations and Hybrid Financial Instruments”.
The amounts are net of transfers to realized investment gains and losses, of $21,904, $108,045 and $12,383 in 2007, 2006 and 2005, respectively.
At December 31, 2007 and 2006, cost has been reduced by an other than temporary impairment charge of $7,253 and $5,379, respectively.
On December 11, 2007, the Company sold 116,000 shares of HWIC stock to Fairfax in exchange for a note of $12,993 and a realized investment gain of $2,658.
In December 2006, the Company sold 76,401 Odyssey preferred shares for cash consideration of $2,120 and a realized gain of $210.
In September 2006, the Company acquired an additional 196,538 units of Dalton from various Fairfax companies, for consideration of $5,281.
The Company’s aggregate share of its equity investees’ statements of income is summarized as follows:
The Company holds a 29.5% interest in HWIC at December 31, 2007. For the years ended December 31, 2007, 2006 and 2005, pre-tax equity in earnings of HWIC were $7,711, $60,457 and $11,996, respectively, and were included in investment income on the consolidated statements of income. No dividends have been received from HWIC. During 2007, the Company sold 116,000 shares of HWIC stock to Fairfax, at fair value, in exchange for a note of $12,993 and a realized investment gain of $2,658.
During the year, the Company purchased $10,012 of credit default swaps and sold credit default swaps with a cost $3,104, bringing the total cost of the credit default swaps to $84,529 at December 31, 2007 as compared to a cost of $77,621 at December 31, 2006. The fair value of the credit default swaps was $234,053 and $16,702 at December 31, 2007 and 2006, respectively. The notional value of the credit default swaps was approximately $5,200,000 and $4,200,000 at December 31, 2007 and 2006, respectively, with an average term to expiration of 3.7 years as of December 31, 2007. The swap agreements require the counterparties to pledge U.S. Treasury securities as collateral, in the event that appreciation in the fair value of the credit default swaps meets certain thresholds. The fair value of this collateral, which is held by an independent custodian in the name of Fairfax on behalf of the Company, was approximately $157,000 at December 31, 2007.
In July 2007 and November 2007, the Company executed additional short-sales of SPDRs of approximately $200,000 and $120,000, respectively, bringing the total short positions held in SPDRs to approximately $620,000 at December 31, 2007, as compared to approximately $300,000 held at December 31, 2006. The SPDRs serve as an economic hedge against a decline in the U.S. equity markets. In connection with the SPDRs transactions, the Company owns S&P Index call options (the “Options”) with a cost of $1,615 and $10,117 at December 31, 2007 and 2006, respectively. The Options limit the potential loss on the future purchase of the SPDRs to approximately $220,000 at December 31, 2007 ($70,000 at December 31, 2006). 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 obligations and the Options at December 31, 2007 amounted to a liability of $706,504 and an asset of $60 as compared to a liability of $375,558 and an asset of $9,925 at December 31, 2006.
In December 2004, the Company entered into a four-month swap transaction whereby the Company received the total equity return on a publicly traded security in exchange for payment of a stated return tied to LIBOR. In March 2005, the Company terminated this swap transaction and recorded a net loss of $2,614, which is included in realized investment gains on the consolidated statement of income for the year ended December 31, 2005.
Fixed income securities and cash and cash equivalents of $431,934 and $382,603 were on deposit with various state regulatory authorities at December 31, 2007 and 2006, respectively, as required by insurance laws.
In 2007, 2006 and 2005, the Company recognized net favorable prior year loss development of $63,854 (5.4 loss ratio points) including $13,673 of amortization of deferred gains on retroactive reinsurance, $96,162 (8.8 loss ratio points) including $12,889 of amortization of deferred gains on retroactive reinsurance and $68,564 (7.7 loss ratio points) including $8,058 of amortization of deferred gains on retroactive reinsurance, respectively.
In 2007, the net favorable development was comprised of favorable development across all major casualty lines as well as commercial multi-peril, with the largest redundancy being recognized in workers’ compensation. Specifically, favorable development in the workers’ compensation line was principally attributable to favorable results in non-California for older accident years due to favorable claims settlements and continued recognition of favorable development for California in accident years 2004 and 2005 due to the impact of industry reforms. Favorable development for general liability and commercial multi-peril exposures in accident years 2003 through 2006 was due to the selection of faster loss development factors, recognizing decreased loss activity in those years. The favorable development in these lines was partially offset by $54,547 of adverse development of asbestos, environmental and other latent liabilities.
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 $50,021 and $42,777 at December 31, 2007 and 2006, 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. The Company last entered into a corporate aggregate reinsurance contract in 2001.
In general, contracts covering future insurable events are referred to as “prospective reinsurance” contracts, as opposed to contracts covering past insurable events, such as adverse loss development covers, which are categorized as “retroactive reinsurance” contracts. Amounts ceded under prospective contracts are recognized, as to premiums, as a reduction of premiums written and earned in the period in which premiums are ceded and, as to losses, as a reduction of incurred losses as the losses are ceded to the reinsurer. Under retroactive contracts, the excess of reinsurance recoverable due from reinsurers pursuant to the contract over premiums paid for coverage is deferred and amortized as a reduction to incurred losses over the expected period of recovery, generally many years, using the interest method. Under both prospective and retroactive contracts, funds held interest, if applicable, is recognized as a reduction of investment income in the period in which the interest is credited to the funds held account.
The effect of prospective and retroactive corporate aggregate reinsurance on components of the Company’s consolidated statements of income is summarized as follows ((decrease) increase in indicated components):
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. For additional information on reinsurance transactions with related parties, see Note 9 to the consolidated financial statements.
The Company intends to redeem the 2013 notes as soon after June 15, 2008 as administratively possible. In addition, the Company must pay accrued and unpaid interest to the date of redemption on the notes redeemed.
Concurrent with the issuance of the 2013 Notes, the Company entered into a non-interest bearing standby credit agreement, subordinate to the notes, whereby Fairfax agreed, under certain conditions, to lend up to $40,000 to Crum & Forster in order to meet certain corporate obligations. Borrowings under this agreement, if any, are due in June 2018. Through December 31, 2007, there have been no borrowings under this agreement.
Income tax expense shown on the consolidated statements of income excludes $12,546, $7,087 and $9,258 of deferred income taxes on equity in earnings of investees in 2007, 2006 and 2005, respectively. Total income tax expense in 2007, 2006 and 2005, inclusive of these amounts, was $152,533, $163,243 and $74,578, respectively.
Deferred income taxes reflect the income tax impact of temporary differences between the amount of assets and liabilities for financial reporting purposes and such amounts as measured by income tax laws and regulations. The deferred income tax expense above does not include $12,546, $7,087 and $9,258 in 2007, 2006 and 2005, respectively, of income taxes, which are included in equity in earnings of investees, net of tax, on the consolidated statements of income. Total deferred income tax expense/(benefit) in 2007, 2006 and 2005 was $143,812, $(62,007) and $60, respectively.
Included in accounts payable and other liabilities on the consolidated balance sheets at December 31, 2007 and 2006, respectively, is $13,656 and $41,230 in respect of current income taxes payable.
In June 2006, the FASB issued FIN 48, which 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. The Company adopted FIN 48 on January 1, 2007 and although its adoption did not have a direct impact on the Company’s results of operations or financial position, adoption of FIN 48 by one of the Company’s equity method investees resulted in the Company recording a cumulative adjustment of $681, net of tax, to opening retained earnings.
The Company elects to recognize accrued interest and penalties associated with uncertain tax positions as part of the income tax provision. The Company did not record any uncertain tax positions, interest or penalties in 2007.
In the normal course of business, a Fairfax offshore reinsurance affiliate, Wentworth Insurance Company Ltd. (“Wentworth”), participates in reinsurance agreements covering substantially all reinsured lines of business. In 2006 and prior, nSpire, also a Fairfax affiliate, participated in these agreements. For the years ended December 31, 2007 and 2006, the Company ceded premiums of $18,623 and $1,574, respectively, to Wentworth and had reinsurance recoverable balances of $6,036 and $112, respectively, at December 31, 2007 and 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. Accident year 2001 was commuted in 2003. Accident year 2002 is subject to a per-term maximum recovery of $96,272 and the Company retains an ultimate net loss of up to 70% of net premiums earned in 2002. Pursuant to the agreement, the Company ceded premiums of $32,091 and $31,398 for accident years 2002 and 2001, respectively. At December 31, 2007 and 2006, no losses were ceded to nSpire under this contract for accident year 2002.
In the normal course of business, Odyssey, an affiliate of Fairfax, may participate on the Company’s reinsurance agreements. Currently, Odyssey participates on the umbrella per risk contract. For the years ended December 31, 2007, 2006 and 2005, the Company ceded $2,088, $2,911 and $8,879, respectively, in premiums to Odyssey and had reinsurance recoverable of $10,990 and $16,499 at December 31, 2007 and 2006, respectively, under these reinsurance agreements.
Reinsurance recoverable from TIG, a subsidiary of Fairfax, totaled $133,093 and $137,514 at December 31, 2007 and 2006, respectively. TIG is domiciled in California and cessions to domestic insurance companies do not require collateral to be recognized for statutory reporting purposes. The Company has considered several factors in assessing the collectibility of reinsurance recoverable balances from TIG. TIG is a runoff company with a B+ (stable) financial strength rating from A.M. Best, a financial strength rating of BB (negative) from Standard and Poor’s and BB+ (stable) from Fitch, all nationally recognized rating agencies. TIG is a sizable regulated entity with policyholders’ surplus of $738,419 at December 31, 2007 and is subject to periodic independent examination by the California Insurance Department. TIG also had short-term liquidity represented by cash and short-term investments of $167,593 at December 31, 2007. The Company has fourteen years of experience with TIG, during which the balances due from TIG have declined from approximately $267,000 to $133,093 at December 31, 2007, principally through settlement of underlying claims. There are no regulatory or other restrictions on payments to the Company from TIG. 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, 2007 and 2006, amounts recoverable from TIG included $111,201 and $119,935, respectively, related to these policies, which were not novated.
Effective March 1, 1999, the Company entered into a reinsurance agreement with Fairmont Specialty Insurance Company (“Fairmont”, formerly Ranger Insurance Company), an affiliate of Fairfax, covering 100% of policies that are classified as excess liability for public entities and that incept, renew, have an anniversary date or come into effect on or after March 1, 1999. This business was produced by an agency affiliate of Fairmont. Effective June 30, 2002, this agreement was terminated and a new agreement was signed with TIG covering the same business, at substantially the same terms. The new agreement covers policies written on or after July 1, 2002. The agreement was terminated effective September 1, 2003. At December 31, 2007 and 2006, the Company had reinsurance recoverable of $34,675 and $27,388, respectively, from Fairmont, and $19,881 and $14,307, respectively, from TIG, related to these agreements.
Effective February 1, 2002, the Company entered into an arrangement with TIG whereby the Company issued policies on behalf of TIG totaling $22,923 in gross premiums written. The Company entered into reinsurance agreements under which approximately 30% of the total risk under these policies was ceded to TIG with the remaining 70% ceded to third party reinsurers. This arrangement with TIG was terminated as of June 30, 2002. At December 31, 2007 and 2006, the Company had reinsurance recoverable of $2,011 and $3,272, respectively, from TIG related to this agreement.
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, 2007, 2006 and 2005, the Company assumed $(7), $98 and $340, respectively, in premiums from Lombard. At December 31, 2007 and 2006, the Company had $1,002 in reserves for this assumed business.
Advent Syndicate 780 (“Syndicate 780”), which is managed by Advent, a Fairfax affiliate, is a participant on the Company’s property per risk, property catastrophe and workers’ compensation catastrophe treaties with shares ranging from 2% to 6% up to certain limits. For the years ended December 31, 2007 and 2006, the Company ceded premiums of $1,190 and $769, respectively, to Syndicate 780 and had reinsurance recoverable balances of $430 and $890, respectively, at December 31, 2007 and 2006, respectively.
In December 2006, the Company acquired from TIG approximately 42 million additional units of a special purpose trust which contains U.S. Treasury strips and corporate fixed income securities for cash consideration of $63,587. The Company owned approximately 46.5% of this special purpose trust at December 31, 2006.
In September 2005, the Company completed the sale of 271,000 shares of common stock of a publicly traded pharmaceutical company to Fairfax affiliates at the prevailing market price of $27.50 per share. The Company received net proceeds of $7,439 from the transaction, resulting in a pre-tax realized loss of $2,561.
Under an agreement effective January 1, 2003, the Company receives royalty payments from FITS for the use of software by other clients of FITS that was developed for and funded by the Company. Under this agreement, the Company received $265 in the year ended December 31, 2007. No royalty payments were received in 2006 or 2005.
Under an agreement effective January 1, 2006, the Company 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 $3,855 and $13,043 in 2007 and 2006, respectively. The decrease in fees billed in 2007, as compared to 2006, reflects the transition of the Fairmont business to the Company.
Fairfax purchases insurance coverage for itself and on behalf of its subsidiaries, including comprehensive crime, insurance companies’ professional liability, directors’ and officers’ liability, employment practices liability, fiduciary liability and special accident insurance. The Company’s share of the expense incurred for this coverage was $1,151, $1,534, and $1,417 for the years ended December 31, 2007, 2006 and 2005, respectively.
Included in accounts payable and other liabilities at December 31, 2007 and 2006 are amounts payable to Fairfax and affiliates of $692 and $13,841, respectively. The 2007 amount is principally related to FITS fees, whereas the 2006 amount includes Hamblin Watsa investment management fees and FITS fees. The Company did not have any Hamblin Watsa investment management fees payable at December 31, 2007. Included in assets at December 31, 2007 and 2006 are amounts receivable from Fairfax and affiliates of $295 and $839, respectively.
The Company receives income from subleases of office space to Fairfax affiliates. Sublease income received from affiliates in 2007, 2006 and 2005 amounted to $3, $235 and $477, respectively.
A reconciliation of the changes in the postretirement plans’ benefit obligation, fair value of assets, a statement of the funded status and accrued benefit cost is presented below. The Company uses a December 31 measurement date for the funded status of its postretirement health care and life insurance plans.
The estimated net actuarial gain and transition obligation expense that will be amortized from accumulated other comprehensive income into net benefit costs during 2008 is $473.
The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 5.75% and 5.5% at December 31, 2007 and 2006, respectively. For purposes of measuring the accumulated postretirement benefit obligation at December 31, 2007, the health care cost trend rates are assumed to decline gradually from 9.0% in 2008 to 5.0% in 2013 and thereafter for all participants.
The amounts above are reduced by space subleased to other companies in the aggregate amount of $94.
Rental expense, before sublease income, under these operating leases was $13,178, $14,318 and $14,470 in 2007, 2006 and 2005, respectively. The Company recognized $163, $601 and $1,160 in 2007, 2006 and 2005, respectively, from subleases.
The Company has purchased structured settlement annuities from various insurance companies in order to settle certain claim liabilities. Should these other companies become unable to make the annuity payments, the Company would be liable. The value of these annuities included in reinsurance recoverable in the consolidated balance sheets at December 31, 2007 and 2006 was approximately $141,056 and $147,190, respectively. Approximately 83.0% of this balance is due from insurance companies rated A- or better by A.M. Best Company.
The Company’s insurance subsidiaries are subject to state regulatory restrictions that limit the maximum amount of dividends they can pay to the Company. These regulations vary by state. The restrictions are generally based on the net income, investment income and policyholders’ surplus of each insurance company, and further provide that the payment of dividends must be from the earned policyholders’ surplus of the insurance company. Any payment of dividends above the regulatory limits is subject to the approval of the Insurance Commissioner in the state of domicile.
Investment income includes realized investment gains and losses and pre-tax equity in earnings of investees. The increase in investment income in the third and fourth quarters of 2007 as compared to the first two quarters was primarily attributable to significant gains on the credit default swaps.
2006 data includes adjustments described in Note 14 to the consolidated financial statements.
Based on its loss reserves reviews as of September 30, 2007 and 2006, the Company recognized approximately $24.5 ($15.9 million after-tax) and $71.5 million ($46.5 million after-tax), respectively, of favorable loss and LAE development in the fourth quarters of each year.