Scottish Re Holdings Limited was acquired on December 31, 2001 and is included in balance sheet data for 2002-2006 and income statement data for years 2002-2006. SRLC was acquired on December 22, 2003 and is included in balance sheet data and income statement data for years 2003-2006. Consolidated statement of income data for the year ended December 31, 2003 includes net income of $1.2 million in respect of SRLC. The ING individual life reinsurance business was acquired on December 31, 2004 and is included in balance sheet data for years 2004-2006 and income statement data for years 2005 and 2006.
This discussion should be read in conjunction with the summary of selected financial data, consolidated financial statements and related notes found under Part II, Item 6 and Part IV, Item 15 contained herein. In addition, you should read our discussion of “Critical Accounting Policies” beginning on page 51 for an explanation of those accounting estimates that we believe are most important to the portrayal of our financial condition and results of operations and that require our most difficult, subjective and complex judgments.
the risk that available liquidity will be insufficient beyond the short term;
uncertainties in our statutory capital position and ability to continue to take reserve credit for our securitization facilities;
uncertainties in our ability to comply with the terms of our forbearance or renew the forbearance agreements prior to December 15, 2008;
risks relating to the sale of our Life Reinsurance International Segment or Wealth Management business;
uncertainties arising from control of our invested assets by third parties;
catastrophes and their impact on the economy in general and on our business in particular;
the risk that our retrocessionaires may not honor their obligations to us;
uncertainties relating to the ratings accorded to us and our insurance subsidiaries;
Scottish Re Group Limited is a holding company incorporated under the laws of the Cayman Islands with our principal executive office in Bermuda. Through our operating subsidiaries, we are principally engaged in the reinsurance of life insurance, annuities and annuity-type products. We have three reportable segments: Life Reinsurance North America, Life Reinsurance International and Corporate and Other. The life reinsurance operating segments have written reinsurance business that is wholly or partially retained in one or more of our reinsurance subsidiaries. As discussed above, we have changed our strategic focus and have executed agreements to sell our Life Reinsurance International Segment and our Wealth Management business. We have also stopped writing new business and have initiated a process to sell our Life Reinsurance North America Segment.
In June 2007, Hugh T. McCormick, Executive Vice President of Corporate Development, left the Company to return to the New York law office of Dewey & LeBoeuf LLP.
In August 2007, George Zippel, former President and CEO of Genworth Financial’s Protection segment, joined us to serve as our President and Chief Executive Officer.
In August 2007, Paul Goldean, who had been serving as our President and Chief Executive Officer for the past year, assumed the role of Chief Administrative Officer and interim President and Chief Executive Officer-North America.
In August 2007, Cliff Wagner resigned from his position as President and Chief Executive Officer-North America
In August 2007, Meredith Ratajczak assumed the role of interim Chief Financial Officer, North America. She continues to also serve as our Chief Actuary, North America.
We derive revenue primarily from premiums from reinsurance assumed on life treaties, investment income, realized gains and losses from our investment portfolio and fees from our financial solutions business.
Our primary business is life reinsurance, which involves reinsuring life insurance policies, with premiums earned over the associated policy period. Each year, however, a portion of the business under existing treaties terminates, principally due to lapses or surrenders of underlying policies, deaths of policyholders and the exercise of recapture options by ceding companies.
Premiums from reinsurance assumed on life reinsurance business are included in revenues over the premium paying period of the underlying policies. When we acquire blocks of in-force business, we account for these transactions as purchases, and our results of operations include the net income from these blocks as of their respective dates of acquisition. Premium from reinsurance assumed on annuity business generates investment income over time on the assets we receive from the ceding company. We also earn revenues on funding agreements. A deposit received on a funding agreement creates income to the extent we earn an investment return in excess of our interest payment obligations thereon.
Our investment income includes interest earned on our fixed income investments and income from funds withheld at interest under modified coinsurance agreements or coinsurance funds withheld agreements. Realized gains and losses include gains and losses on investment securities that we sell during a period, write downs of securities deemed to be other than temporarily impaired and foreign currency exchange gains and losses.
We have six principal types of expenses: claims and policy benefits under our reinsurance contracts, interest credited to interest sensitive contract liabilities, acquisition costs and other insurance expenses, operating expenses, collateral finance facilities expense and interest expense.
For our annuity-type reinsurance products, we record a liability for interest sensitive contract liabilities, which represents the amount ultimately due to the policyholder. We credit interest to these contracts each period at the rates determined in the underlying contract, and the amount is reported as interest credited to interest sensitive contract liabilities on our consolidated statements of income (loss).
Acquisition costs consist principally of commissions, certain internal expenses related to our policy issuance and underwriting departments and other variable selling expenses. These costs are dependent on the structure, size and type of business written. These costs are deferred and amortized over future periods based on our expectations as to the emergence of premiums or future gross profits from the underlying contracts.
We seek to generate profits from two principal sources. First, in our Life Reinsurance business, we seek to receive reinsurance premiums and financial reinsurance fees that, together with income from the assets in which those premiums are invested, exceed the amounts we ultimately pay as claims and policy benefits, acquisition costs and ceding commissions. Second, within our investment guidelines, we seek to maximize the return on our unallocated capital. The following factors affect our profitability:
our ability to manage our assets and liabilities and to control investment and liquidity risk;
changes in our assessment of the ability to realize deferred tax assets;
our ability to assess and price adequately for the risks we assumed;
In addition, our profits can be affected by a number of other factors that are not within our control. Other external factors that can affect profitability include mortality experience that varies from our assumed mortality. In addition, while death claims are reasonably predictable over a period of many years, claims become less predictable over shorter periods and are subject to potential significant fluctuation from quarter-to-quarter and year-to-year. Other factors include changes in regulation or tax laws which may affect the attractiveness of our products or the costs of doing business and changes in foreign currency exchange rates.
Investments: credit quality/experience, concentration risk, stability of long-term returns, cash flows and asset and liability duration.
This amount represents liquidity in excess of liquidity held by our insurance operating subsidiaries and includes cash and marketable securities as well as $275.0 million available under the Stingray facility as at December 31, 2007 (2006 - $2.0 million and 2005 - $275.0 million). See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Analysis-Liquidity.”
Highly-Leveraged Business. Regulation XXX requires life insurers and reinsurers to establish additional statutory reserves for term life insurance policies with long-term premium guarantees, which increases the capital required to write these products. We have established a number of Regulation XXX facilities to fund our Regulation XXX collateral requirements. A substantial portion of the assets held by Orkney Re II and Ballantyne Re are invested in sub-prime and Alt-A mortgage-backed securities, which have significantly declined, and continue to decline, in value, thereby reducing the funds available to such entities to support their reinsurance obligations to our United States domiciled insurance subsidiaries. Such subsidiaries’ statutory capital may be significantly reduced if Orkney Re II and Ballantyne Re are unable to provide the required collateral to support our statutory reserve credit and we could not find an alternative source for collateral. As a result of our current ratings and financial condition, it would be difficult to obtain such alternative sources of capital. In addition, emerging lapse and mortality experience within the HSBC II block of business and the resulting strain on our liquidity from increased collateral requirements may result in additional negative impact on our capital in 2008. The HSBC II facility requires us to provide assets in trust based upon certain assumptions including assumed future mortality and lapse rates. Mortality and lapse rates are periodically reviewed in light of emerging experience. During 2007, we contributed additional assets in trust based upon emerging mortality and lapse experience for the block of business. It is possible that future experience could require us to further increase assets in trust which would result in a strain on our liquidity position.
Life Reinsurance. We bear four principal classes of risk in our life reinsurance products (i) mortality risk, (ii) investment risk, (iii) persistency risk, and (iv) counter-party risk.
Investment Risk - Our asset portfolio consists predominantly of investments in fixed and floating-rate debt securities with stated maturity dates, the fair value of which are sensitive to changes in both the general level of interest rates and credit spreads representing perceived risk of default. In general, we manage our investment portfolio so as to minimize the duration gap between our assets and liabilities, in order to reduce our exposure to changes in interest rates. If the duration of our assets does not properly match that of our liabilities, we risk earning less interest on our assets than expected, thereby preventing us from satisfying our guaranteed fixed benefit obligations, or having to sell assets at an unfavorable time to meet policyholder surrenders or withdrawals. Our investment portfolio includes mortgage-backed securities, known as MBS’s, and collateralized mortgage obligations, known as CMO’s. As of December 31, 2007, MBS’s and CMO’s constituted approximately 19.3% of our invested assets (at December 31, 2006 - 21.4%). As with other fixed income investments, the fair value of these securities will fluctuate depending on market and other general economic conditions and the interest rate environment; however, changes in interest rates can also expose us to prepayment risks on these investments, as during periods of declining interest rates, mortgage prepayments generally increase and MBS’s and CMO’s are prepaid more rapidly, requiring us to reinvest the proceeds at the then-current market rates, which may not be favorable. Recently, the residential mortgage market in the United States has experienced a variety of difficulties and changed economic conditions. We have exposure to the sub-prime market as a result of securities held in our investment portfolio, as described in more detail under “Financial Condition-Structured Securities Backed by Sub-prime and Alt-A Residential Mortgage Loans.” Due to these recent developments, especially in the sub-prime sector, we have suffered significant realized and unrealized investment losses; as the market for these securities continues to be highly volatile and illiquid, there is a risk that these investment values may further decline, which may adversely affect our financial condition. Also, declines in the value of our investments that provide collateral for reinsurance contracts would require us to post additional collateral.
Persistency Risk - Persistency risk relates to variation in financial results associated with more or less policyholders choosing to lapse their policies than planned. The impact of lapse rates varies significantly by a number of factors including plan of insurance, treaty, and policy year. As such, one can not generalize that higher lapse rates represent a positive or negative event. During 2006 and 2007 persistency has generally been stronger than previously assumed. Much of this relates to the flattening of direct life insurance rates which has reduced the incentive for replacement activity in the direct market. The stronger persistency is favorable to our long term value, but does also result in higher capital and collateral requirements to back the larger amount of in-force that persists. During the past two years we have also observed differences in the distribution of lapse rates in the acquired ING block of business relative to the assumptions contemplated in the Purchase Generally Accepted Accounting Principles (“PGAAP”) reserves. Effectively business with relatively higher margins is lapsing somewhat faster than planned while lower margin business is exhibiting higher persistency. This results in an erosion in margin on the block of business for which the impact is accelerated by the mechanics of the PGAAP reserve mechanisms. It should be noted that this impact is driven by differences in early policy year lapse rates on level term business by underlying policyholders and does not relate to our ratings or perceived creditworthiness.
Counter-party Risk - We take on counterparty risk from external parties with whom we retrocede business to. During 2006 and 2007 we had no losses associated with retrocession counter-party
There are risks and uncertainties associated with determining whether declines in the fair value of investments are other-than-temporary. These include subsequent changes in general economic conditions, as well as specific business conditions affecting particular issuers, future financial market effects such as interest rate spreads, future rating agency actions and significant accounting, fraud or corporate governance issues that may adversely affect certain investments. Other significant estimates and assumptions that we use to estimate the fair values of securities include projections of expected future cash flows and pricing of private securities. We continually monitor developments and update underlying assumptions and financial models based upon new information.
In determining whether an other-than-temporary decline in value has occurred, U.S. GAAP requires that we evaluate, for each impaired security where the estimated fair value is less than its amortized cost, whether we have the intent and ability to hold the security for a reasonable time for a forecasted recovery of the fair value up to the amortized cost of the investment. This requires us to consider our capital and liquidity requirements, any contractual or regulatory obligations, and the implications of our strategic initiatives that might indicate that impaired securities may need to be sold before the forecasted recovery of fair value occurs. The following matters were considered in evaluating our intent and ability to hold impaired securities as of December 31, 2007:
(i) Intent to Sell Our Businesses and Related Investment Portfolios - On February 22, 2008, we announced our intent to sell the Life Reinsurance International Segment and Wealth Management business and recently entered into definitive agreements for each of these transactions. Additionally, on April 4, 2008, we announced our intent to sell the Life Reinsurance North America Segment. For accounting purposes, these business sales change our intent to hold the impaired securities within the related investment portfolios.
As a result of the foregoing conditions, our intent and ability to hold securities with unrealized losses for a period of time sufficient to allow for a recovery in their value has changed as of December 31, 2007. In accordance with SFAS No. 115, we recorded $780.3 million as part of net realized investment losses in the Consolidated Statements of Income (Loss) during the fourth quarter of 2007 to recognize other-than-temporary impairments in securities that we no longer can positively assert our intent and ability to hold to recovery of fair value.
All derivative instruments are recognized as either assets or liabilities in the consolidated balance sheets at fair value as required by SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”). The accounting for changes in the fair value of standalone derivatives that have not been designated as a hedge are included in realized gains and losses in the consolidated statements of income (loss). The gains or losses on derivatives designated as a hedge of our interest expense on floating rate securities is included in interest expense. The gain or loss on embedded derivatives are included as a separate line item in the consolidated statements of income (loss).
Our funds withheld at interest arise on modified coinsurance and fund withheld coinsurance agreements. Derivatives Implementation Group Issue No. B36 “Embedded Derivatives: Bifurcation of a Debt Instrument that Incorporates Both Interest Rate and Credit Rate Risk Exposures that are Unrelated or Only Partially Related to the Creditworthiness of the Issuer of that Instrument” indicates that these transactions contain embedded derivatives. The embedded derivative feature in our funds withheld treaties is similar to a fixed-rate total return swap on the assets held by the ceding companies.
For each of our reinsurance contracts, we must determine if the contract provides indemnification against loss or liability relating to insurance risk, in accordance with applicable accounting standards. We must review all contractual features, particularly those that may limit the amount of insurance risk to which we are subject to or features that delay the timely reimbursement of claims. If we determine that a contract does not expose us to a reasonable possibility of a significant loss from insurance risk, we record the contract on a deposit method of accounting with the net amount payable/receivable reflected in other reinsurance assets or liabilities on our consolidated balance sheets. Fees earned on the contracts are reflected as other revenues, as opposed to premiums, on the consolidated statements of income.
Present value of in-force business (PVIF) is established upon the acquisition of a block of business and is amortized over the expected life of the business at the time of acquisition. The amortization each year will be a function of the ratio of annual gross profits or revenues to total anticipated gross profits or revenues expected over the life of the business, discounted at the assumed net credited rate (4.9% for 2007 and 2006). The determination of the initial value and the subsequent amortization require management to make estimates and assumptions regarding the future business results and such estimates could differ materially from actual results. Estimates and assumptions involved in the PVIF and subsequent amortization are similar to those used in the establishment and amortization of DAC. Currently, all PVIF relates to our traditional life reinsurance business, or SFAS No. 60 traditional life business. As a result, these assumptions are not revised after acquisition unless the PVIF balance is deemed unrecoverable by the loss recognition testing process. Absent a premium deficiency, which could be caused by unfavorable mortality experience, variability in amortization after policy issuance or acquisition is caused only by variability in premium volumes. Loss recognition testing over the last several years has indicated that no unlocking of assumptions on the PVIF was necessary nor is it currently expected to be necessary in the near future.
The determination of the initial value and the subsequent amortization require management to make estimates and assumptions regarding the future business results that could differ materially from actual results.
Liabilities for future policy benefits for long term insurance products are computed based on expected investment yields, mortality and lapse rates, and other assumptions, including provisions for adverse deviation in claims and investment yields in accordance with the provisions of SFAS No. 60 “Accounting and Reporting by Insurance Enterprises”. These assumptions are primarily based on historical experience and information provided by ceding companies and are locked in at issue with periodic review against experience. During the periodic review process, using loss recognition testing, we determine whether actual and anticipated experience indicate that the existing policy reserve together with the present value of future gross premiums are sufficient to cover the present value of future benefits, maintenance expenses and to recover unamortized acquisition costs. Loss recognition testing conducted in the last several years has indicated that no unlocking of assumptions on the SFAS No. 60 liabilities is necessary. Because of the many assumptions and the long term nature of the business, the reserving process is inherently uncertain and actual results could differ materially from expected.
The estimate of claims payable for incurred but not reported losses varies by major block of policies assumed. Those estimates are determined using some or all of the following: studies of actual claim lag experience, best estimates of expected incurred claims in a period, actual reported claims, and best estimates of incurred but not reported losses as a percentage of current in-force. We update our analysis of incurred but not reported losses, including lag studies, on a quarterly basis and adjust our claim liabilities accordingly. The time lag from the date of claim to when the ceding company reports the claim to us can vary significantly by both ceding company and individual claim, but generally averages 2 months.
In the underwriting process, we perform procedures to evaluate the ceding company’s process for compiling and reporting data. After entering into a reinsurance contract, we work closely with our ceding companies to help ensure information submitted by them is in accordance with the underlying reinsurance contracts. Additionally, we have a dedicated compliance team that performs extensive audits, including on-site audits and desk reviews, of the information provided by ceding companies. In addition to ceding company audits, we routinely perform analysis, at a treaty level, to compare the actual results of ceding companies against initial pricing and expected results. Generally, there have been few disputes or disagreements with ceding companies and most are resolved through normal administration procedures.
DAC related to interest-sensitive life and investment-type contracts is amortized over the lives of the contracts, in relation to the present value of estimated gross profits (“EGP”) from mortality, investment income, and expense margins. The EGP for asset-intensive products includes the following components: (1) estimates of fees charged to policyholders to cover mortality, surrenders and maintenance costs; (2) expected interest rate spreads between income earned and amounts credited to policyholder accounts; and (3) estimated costs of administration. EGP is reduced by our estimate of future losses due to defaults in fixed maturity securities. DAC is sensitive to changes in assumptions regarding these EGP components and any change in such an assumption could have an effect on our profitability. We periodically review the EGP valuation model and assumptions so that the assumptions reflect management’s best estimate. Consequently, the level of DAC reported by us reflects the current best estimate regarding the projection of future EGPs.
As a reinsurer of interest-sensitive life and investment-type contracts, we assume treaties with a unique set of product characteristics. These unique product characteristics, combined with the age of the treaty, either increase or decrease the impact changes in spreads, lapses or mortality have on the projected EGP. Since each treaty has different characteristics and is in a different stage in its treaty life cycle, it is difficult to make general statements as to the level and likelihood of changes in amortization due to changes in assumptions.
For the block as a whole, management considers two assumptions to be most significant for the interest sensitive business on our balance sheet: (1) estimated interest spread, and (2) estimated future policy lapses. In the event that spread increases, we would amortize our DAC at a faster rate as actual gross profits would exceed EGP. In the event spread decreases, we would amortize our DAC at a slower rate. Lapse assumption changes would impact DAC by increasing or decreasing the fund value upon which our spread is earned. If we believe that either spread or lapse assumption variations are other-than-temporary, we will make an assumption change that will result in unlocking of the DAC balance.
The amortization of deferred acquisition costs for our products requires management to make estimates and assumptions regarding mortality, lapse, expenses and investment experience. Such estimates are primarily based on historical experience and information provided by ceding companies. Actual results could differ materially from those estimates. Management monitors actual experience, and should circumstances warrant, will revise its assumptions and the related reserve estimates.
We generally report retrocession activity on a gross basis. Amounts paid or deemed to have been paid for reinsurance are reflected in reinsurance ceded receivables. The cost of reinsurance related to long-duration contracts is recognized over the terms of the reinsured policies on a basis consistent with the reporting of those policies.
In the normal course of business, we seek to limit our exposure to loss on any single insured and to recover a portion of benefits paid by ceding reinsurance to other insurance enterprises or reinsurers under excess coverage and coinsurance contracts. In the Life Reinsurance North America Segment, we retain a maximum of $5.0 million of coverage per individual life. In certain limited situations, due to the acquisition of in force blocks of business, we have retained more than $5.0 million per individual policy. In total, there are three such cases of over-retained policies, for amounts averaging $0.7 million over our normal retention limit. The largest amount over-retained on any one life is $5.9 million. In the Life Reinsurance International Segment, we retain a maximum of $1.2 million of coverage per individual life. In certain limited situations, due to historical administrative deficiencies, we have retained more than $1.2 million per individual policy. In total, there are 565 such cases of over-retained policies, for amounts averaging $0.8 million over our normal retention limit. The largest amount over-retained on any one life is $5.1 million. We have a number of retrocession arrangements whereby certain business in force is retroceded on an automatic or facultative basis. We also retrocede most of our financial reinsurance business to other insurance companies to alleviate statutory capital requirements created by this business.
Retrocessions are arranged through our retrocession pools for amounts in excess of our retention limit. As of December 31, 2007, all rated retrocession pool participants followed by the A.M. Best Company were rated “A-” or better.
We have never experienced a material default in connection with retrocession arrangements, nor have we experienced any difficulty in collecting claims recoverable from retrocessionaires; however, no assurance can be given as to the future performance of such retrocessionaires or as to recoverability of any such claims.
The consolidated income tax expense or benefit is determined by applying the income tax rate for each subsidiary to its pre-tax income or loss in any reporting period, as well as by the valuation allowance recorded during the period. Management assesses and determines quarterly the need for the amount of the valuation allowance in subsequent periods in accordance with the requirements of SFAS No. 109 “Accounting for Income Taxes”, or in accordance with FASB issued Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). The tax rates for our subsidiaries vary from jurisdiction to jurisdiction and range from 0% to approximately 39%. Our effective tax rate in each reporting period is determined by dividing the net tax benefit (expense) by our pre-tax income or loss. The change in our effective tax rate is due primarily to the amount in any reporting period of pre-tax earnings attributable to different subsidiaries (which changes from time to time), each of which is subject to different statutory tax rates, as well as to the valuation allowance recorded during the period. Pre-tax earnings of certain subsidiaries in any period may be impacted by the amount of various inter-company charges, including but not limited to net worth maintenance fees and other management fees paid to SALIC and to the parent holding company. These fees are charged in accordance with our inter-company charging policy and may be adjusted periodically within limits prescribed by applicable transfer pricing regulations.
There is presently no taxation imposed on income or capital gains by the Governments of the Cayman Islands (“domestic”) and Bermuda. Our Bermuda companies have been granted an exemption from income, withholding or capital gains taxation in Bermuda until 2016. If any taxation on income or capital gains were enacted in the Cayman Islands, SRGL and SALIC have been granted an exemption until 2028; and The Scottish Annuity Company (Cayman) Ltd. has been granted an exemption until 2024. These companies operate in a manner such that they will owe no U.S. tax other than premium excise taxes and withholding taxes on certain investment income. Additionally, we have operations in various jurisdictions around the world including, but not limited to, the United States, the United Kingdom, Ireland, Singapore and Luxembourg that are subject to relevant taxes in those jurisdictions.
Effective January 1, 2006, we adopted SFAS No. 123(R) “Share Based Payment”. In accordance with SFAS No. 123(R), compensation cost is determined on the option grant date using the Black-Scholes model to estimate the fair value of the option. Under SFAS No. 123(R), the grant date for all Time-Based Options is the date the options are issued, while the grant date for all Performance-Based Options is the date the performance criteria are communicated to the option holders, which may occur substantially after the issuance date. Compensation cost, net of estimated pre-vesting forfeitures, is then recognized on a straight-line basis over the requisite service period (vesting period). However, per SFAS No. 123(R), compensation cost for the Performance-Based Options is only recognized when it is probable that the performance criteria will be met. Compensation cost is recognized as a component of operating expenses with a corresponding increase in additional paid in capital.
The following table presents an analysis of our net (loss) income (attributable) available to ordinary shareholders and other financial measure (described below) for the years ended December 31, 2007, 2006, and 2005.
The net loss attributable to ordinary shareholders increased by 172% to $1,025.6 million, or $15.24 per ordinary share, for the year ended December 31, 2007 compared to a net loss of $376.7 million, or $6.70 per ordinary share, in the same period in 2006. The net loss attributable to ordinary shareholders for year ended December 31, 2007 is primarily the result of realized investment losses arising principally on our sub-prime and Alt-A securities and the change in embedded value of derivatives.
Our net income (loss) and other financial measures as shown above for the years ended December 31, 2007, 2006 and 2005 have been affected by among other things, the following significant items:
Investment Results and Impairment Charges for Sub-prime and Alt-A Residential Mortgage Securities
The net realized loss in 2007 was $979.3 million compared to $27.4 million in 2006. In the fourth quarter of 2007, $780.3 million was recognized in connection with other-than-temporary impairment charges as a result of us no longer having the intent and ability to hold impaired securities for a period of time sufficient to allow for a recovery in their fair value. In determining whether an other-than-temporary decline in value has occurred, U.S. GAAP requires that we evaluate, for each impaired security where the estimated fair value is less than the amortized cost, whether we have the intent and ability to hold the security over a reasonable time for a forecasted recovery of fair value up to the amortized cost of the security. This requires us to consider our capital and liquidity requirements, any contractual or regulatory obligations, and the implications of our strategic initiatives that might indicate that impaired securities may need to be sold before the forecasted recovery of the fair value occurs. As discussed in more detail in Part I, “Overview” above, we have changed our strategic focus and have entered into definitive agreements to sell our Life Reinsurance International Segment and our Wealth Management business and we are currently in the process of selling our Life Reinsurance North America Segment. Additionally, as a result of declines in the fair value of our invested assets, which contain a significant concentration of sub-prime and Alt-A residential mortgage-backed securities, we have experienced deteriorating financial performance and a worsening liquidity and collateral position that raise substantial doubt about our ability to continue as a going concern beyond the short term. Furthermore, as part of our efforts to alleviate the collateral requirements of our reinsurance operating subsidiaries, we executed an Assignment Letter of Intent for the reinsurance agreements between SRUS and Ballantyne Re to ING which will adversely impact our ability to restrict the sale of impaired securities within this securitization structure. Given these conditions, we can no longer assert as of December 31, 2007 that we have the positive intent and ability to hold impaired securities to the forecasted recovery of fair value and as a result have recorded a $780.3 million other-than-temporary impairment charge for the fourth quarter of 2007. We expect to have an additional impairment charge of approximately $751.7 million for the first quarter of 2008.
Our current ratings, the ratings of our subsidiaries, along with the ratings on the notes issued by Ballantyne Re and Orkney Re II are negatively impacting our operating expenses and liquidity. Ballantyne Re, Orkney Re II and Orkney I have fees payable to bond insurers that increase as our ratings decrease. At the current time, we are paying the maximum rate, based on these ratings, to the bond insurers. This serves to increase annual expenses by $18.1 million per year over the fee that was in effect at the beginning of each transaction. For Ballantyne Re the payment of this additional fee is deferred, but for Orkney Re and Orkney Re II the additional fee is paid in cash on a quarterly basis, thereby reducing the funds available to make reinsurance payments, fund reserve trusts and make interest payments on the bonds. There is no recourse to us or any of our affiliates for these payments.
For both 2006 and 2007 we have experienced moderately adverse lapse experience on the acquired ING block of business. This relates to the mix of lapse rates actually experienced relative to the assumptions locked into our GAAP reserve basis for the block. We have experienced higher rates of lapse on certain segments of the block with low margins and higher rates of lapse on other segments with more favorable margins. The accounting methodology associated with benefit reserves for this block recognizes the small reduction in overall future margins in the current period. It is worth noting that this lapse emergence is not related to our ratings or other company specific factors. Rather it is simply a function of underlying policyholder behavior relative to the assumptions built into the benefit reserve methodology.
On September 7, 2007, we terminated HSBC I in connection with the establishment of Clearwater Re. The HSBC I facility originally provided $200.0 million, and as of July 1, 2007, provided $188.5 million, for the purpose of collateralizing reinsurance obligations under inter-company reinsurance agreements. In addition to repaying the $188.5 million notional amount due to HSBC under a total return swap, we paid $2.2 million in fees associated with the early termination of this facility. The total collateral held at December 31, 2006 was $65.0 million, of which $40.0 million was released upon the change in control in 2007. No additional collateral amounts (out of the remaining $25.0 million) were released upon the wind up of HSBC I.
Pursuant to the terms of the Indenture of the Ballantyne Re transaction, $232.5 million of the Ballantyne Re Class C Notes held by both the Company and external investors, including principal and accrued interest, were written off on November 30, 2007. On a consolidated basis, this resulted in a reduction in collateral finance facilities liabilities and a realized non-cash gain of $27.1 million, comprising $20.0 million of principal, net of the write-off of the premium and discount values, and $7.1 million of accrued interest, on the extinguishment of third party debt in accordance with SFAS No. 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities”. This was not deemed a reconsideration event under FIN No. 46R “Consolidation of Variable Interest Entities-An Interpretation of ARB No. 51” (“FIN 46R”), as there was no change to the governing agreements nor the contractual arrangements of the securitization.
In both 2007 and 2006, a higher level of operating cost was incurred. In 2007, higher costs were primarily due to expenses related to the 2007 New Capital Transaction, in particular, costs triggered by the change-in-control employee bonuses relating to completion of the 2007 New Capital Transaction, severance payments and recognition of all previously unrecognized compensation expense for stock options and restricted share awards. In 2006, additional operating cost resulted from an increased headcount as corporate positions were added due to growth in the segment, along with severance, legal fees, directors’ fees and other costs related to due diligence and the potential sale of the Company that could not be capitalized.
On July 18, 2007, our shareholders approved and adopted the Scottish Re Group Limited 2007 Stock Option Plan (“2007 Plan”). The 2007 Plan provides for the granting of stock options to eligible employees, directors and consultants. The total number of our shares reserved and available for issuance under the 2007 Plan is 18,000,000. On July 18, 2007, we issued 10,620,000 options - 2,250,000 options to directors and 8,370,000 options to eligible employees. Of the 10,620,000 options issued on July 18, 2007, 6,535,000 are Time-Based Options and 4,085,000 are Performance Based options. The terms and conditions for the Performance-Based Options that were due to vest on December 31, 2007 were approved by the Compensation Committee on December 13, 2007 and subsequently communicated to eligible employees on December 14, 2007. At that time, in accordance with SFAS No. 123(R) “Share Based Payment” (“SFAS No. 123 (R)”), we were able to determine a grant date, calculate the fair value and recognize the expense of the Performance-Based Options. Based on this, of the 4,085,000 Performance Based Options issued on July 18, 2007, none were considered granted on July 18, 2007 as the terms and conditions had not yet been communicated to eligible employees. Upon approval of the Compensation Committee, 801,000 of the 4,085,000 Performance Based Options approved on July 18, 2007 were deemed granted on December 14, 2007.
Premium revenue increased $54.0 million as strong persistency and premium increases on yearly renewable term business offset declines from new business volumes. Traditional Solutions new volumes decreased to $22.8 billion in 2007 from $56.5 billion in 2006. Prior year premium levels were negatively impacted by $8.0 million due to revisions on the ING block which are more fully explained in the comparison of 2006 to 2005 results below.
Investment income was $7.1 million lower in 2007 compared to 2006 primarily due to a combination of lower floating rates over the last quarter of 2007 along with a decline in our modified coinsurance asset base. In particular, the modified-coinsurance asset base was impacted by continued lapsation in 2007 which resulted in lower income of $23.1 million and the unwinding of certain funding agreements in the third quarter of 2006, which resulted in a further lowering of income by $23.0 million. In addition, movements in an implied hedge on the option component of an equity-indexed annuity treaty negatively impacted investment income in the current year by $21.1 million. This movement was effectively offset by reserve decreases related to the option liability on this treaty. These declines were partially offset by the closing of the Ballantyne Re Regulation XXX transaction in May 2006 which increased income by $53.0 million and Clearwater Re in September 2007 which increased income by $7.8 million.
Also negatively impacting revenues was a net loss of $43.6 million arising from the change in value of embedded derivatives for 2007 compared to $16.2 million in 2006. The movement resulted from a combination of a shift in the yield curve in 2007 and realized losses in 2006 on securities held under a modified coinsurance agreement that were sold to provide collateral for the Ballantyne Re collateral finance facility.
Claims and other policy benefits in 2007 were comparable to prior year levels as an $86.3 million increase in Traditional Solutions claims incurred was offset by lower required reserve levels on our Traditional Solutions and
annuity blocks of $42.2 million and $39.3 million, respectively. Our claims experience was consistent with expectations of a growing block of early duration mortality risk business for which the increase in year over year mortality rates exceeds the underlying rate of lapsation. Total net mortality for 2007 was favorable at 96% of modeled expectations. Changes in reserve levels are based on pricing and actuarial projection models which include lapse assumptions by treaty and product type based on historical experience and industry expectations. While our actual lapse experience during the third and fourth quarters of 2006 was marginally lower in aggregate than expected, the lapse distribution pattern was not as anticipated, thereby increasing our reserve levels by approximately $13.0 million and $14.0 million in the third and fourth quarters of 2006, respectively. The balance of the reserve change related to lower new Traditional Solutions business volumes in 2007, timing of earnings emergence on the existing block, and implementation of certain treaty-specific reserving models during the year. The lower reserve level for annuities was primarily driven by a $40.9 million reserve decline on the aforementioned equity-indexed annuity contract related to the option liability component of the treaty.
Acquisition costs and other insurance expenses for 2007 increased slightly as compared to 2006. As a percentage of net premiums earned, acquisition and other insurance expenses was 20% and 21% for 2007 and 2006 respectively.
Operating expenses decreased $4.8 million year-over-year. Contributing to this decrease was a first quarter 2007 receipt of a $2.6 million indemnification settlement related to a provision in the ERC purchase agreement regarding the level of statutory unauthorized reinsurance liabilities required for certain reinsurers. This was not related to the ERC mediation described in Note 19 “Commitments and Contingencies” in the Notes to Consolidated Financial Statements. Also contributing to lower expenses was an absence of executive severance in 2007 as compared to $3.1 million executive severance incurred in the second and third quarters of 2006.
A portion of the premium earned decrease was due to a curtailment of a number of large treaties immediately following the ING acquisition that did not meet our risk management criteria and a shift in business mix from coinsurance to yearly renewable term life reinsurance. Also impacting premiums were adjustments in the second quarter of 2006 related to revisions of certain estimates. In respect of the newly acquired ING block in December 2004, we made an adjustment to revise our premium accrual estimates by $8.0 million in the second quarter of 2006.
The adjustment of $8.0 million was comprised of two adjustments of $4.0 million each and related primarily to the newly acquired ING block in December 2004. In respect of the first $4.0 million adjustment, we conducted a review of the policy administration data provided to us by ING in the first year post acquisition of the block, which exhibited unusual premium levels as a result of two policy years of data being received together. This data had been used for trend purposes for the accrual estimate as of December 31, 2005. Based on actual cash received and the analysis of the data, we determined a different trend on which to base our premium accrual and, consequently, reduced our premium accrual estimate by $4.0 million.
In respect of the second $4.0 million adjustment, we made a revision to our previous estimation process for a certain group of new issuances from late 2004, for which our administrative system did not have sufficient
historical information to provide a best estimate at December 31, 2005. During 2006, we determined the premium estimates for these new issuances based on actual cash received. We then revised the premium accrual because our updated data from the administrative system showed clearer historical trends of actual cash received for our automatic premium estimation process.
In total, a net impact of $4.0 million on premium accrual adjustments for the Life Reinsurance North America Segment for the year ended December 31, 2006 was recorded in the context of a total premium accrual of $242.0 million as of December 31, 2005. This represented revisions to all premium accrual estimates recorded in that year, inclusive of the aforementioned $8.0 million recorded in respect of the ING block. The impact on net income of these adjustments was immaterial given that we had offsetting reserves and allowances against the premium accrual. We consider this revision of premium accrual to have been within management’s expectation of the normal variability of such an estimate.
Finally, premiums earned in 2006 were lower than in 2005 due to the termination of new business on certain treaties, an overall reduction in new business volume and a decrease in renewal premiums as a result of the rating downgrades in mid 2006. Traditional life reinsurance new business face amounts assumed was $56.5 billion in 2006 compared to $131.0 billion in 2005.
As a percentage of net earned premiums, claims and other policy benefits were 85% and 75% for 2006 and 2005, respectively. In the first quarter of 2006, although gross claims were within expectations in the aggregate, a higher number of smaller claims within our retention limit resulted in retrocession recoveries below our expectations, which resulted in approximately $16.0 million of adverse mortality, principally within our ING block. We experienced a similar situation in the fourth quarter of 2006, although at a much lower level. Mortality was within expectations for the second and third quarters of 2006 but again adverse in the fourth quarter of 2006 by approximately $14.0 million. In addition to lower than expected retrocession recoveries, fourth quarter of 2006 mortality experience was due to a combination of higher claim volume and higher average claim size. Offsetting our adverse mortality in the first and fourth quarters were favorable experience refunds of $5.8 million and $3.4 million, respectively. Total net mortality for 2006 (excluding experience refunds) was approximately 103% of our internal expectations.
Related to the improvement in retrocession data and related administration systems, we revised our estimates based on refinements of certain of our calculations and processes for the net cost of reinsurance. The impact of these changes resulted in an adjustment which increased our claims and other policy benefits by approximately $8.0 million in the second quarter of 2006. During the third quarter of 2006, and in connection with ongoing initiatives to improve the quality of our cedant information, we received updated claims totaling $9.2 million relating to the 2004 and 2005 years. Although the increased claims from cedant reporting were largely mitigated by offsetting premium adjustments, they had the impact of artificially increasing the claims and benefits ratio for the year. Finally, as noted above, there was a reserve fluctuation on the equity-indexed annuity contract of approximately $19.8 million which impacted 2006 claims.
Acquisition costs and other insurance expenses as a percentage of net earned premiums for 2006 and 2005 were 21% and 22%, respectively. During the second quarter of 2006, we recorded adjustments of $13.0 million to increase deferred acquisition cost amortization related to several deferred fixed annuity treaties in which emerging lapse experience was significantly higher than expected. This adjustment was partially offset as we received a $6.2 million rebate from ING as a result of the Ballantyne Re collateral finance facility (a similar rebate of $6.7 million was received in 2005 resulting from our 2005 collateral finance facility transactions). Excluding the ING rebate, letter of credit fees have declined in 2006 by $18.8 million as a result of the Regulation XXX transactions completed in December 2005 and May 2006. During the fourth quarter of 2006, a client review revealed usage of an incorrect allowance percentage by the client resulting in a $6.6 million favorable adjustment. The 2005 acquisition costs were impacted by a $17.7 million adjustment which increased acquisition costs with a corresponding decrease to the change in reserves related to the purchase accounting adjustments for the ING block.
Investment income decreased from $24.1 million to $12.5 million primarily as a result of an annuity contract recaptured in 2006. This contract provided $11.0 million of investment income before recapture and was also responsible for $10.5 million of realized losses in the prior year.
Acquisition costs and other insurance expenses were $10.7 million lower than in the prior year. This was primarily due to the recoverability assessment of deferred acquisition costs for U.K. protection business in 2006 following rating downgrades and other market developments. Margin estimates were revised and $11.8 million of deferred acquisition costs written-off as non-recoverable in the prior year. In addition to this write-off, $3.5 million was expensed in 2006 relating to secondary collateral obligations following recapture of the aforementioned annuity
contract. Partially offsetting these adjustments was a higher average commission rate in 2007 on our U.K. protection business, totalling $4.6 million on these treaties.
There was an increase of premiums earned from a number of new U.K. protection treaties over the course of 2006 amounting to $14.5 million. In addition, a number of clean up activities within the portfolio took place in 2006 both positive and negative, with an overall impact of reducing premium by $2.0 million reflecting updated data received from cedants but also a business initiative to reduce historic backlogs in processing. In addition, in 2005 premiums were grossed up as a result of updated information from two Lloyd’s syndicates which accounted for increased premium of $9.0 million, related to prior periods.
The net realized loss for the year to date includes a $7.2 million loss related to the rebalancing of the investment portfolio in respect of the aforementioned annuity agreement in the second quarter of 2006 and a further loss of $3.3 million arising from a previously unrealized loss position becoming realized upon the recapture of this annuity agreement in the third quarter of 2006. These losses were caused by rising GBP interest rates and were offset by reductions in the liability value that we had to pay the ceding company upon termination of the transaction.
Claims cost and other policy benefits increased significantly in 2006 due to the new U.K. protection treaties, amounting to $9.3 million. There was a significant increase in claims cost recorded in the first quarter of 2006 arising from adverse mortality and morbidity experience, adjustments on retrocession recoverables and updated cedant data of approximately $12.0 million in total. Additionally, during the fourth quarter of 2006, claims related to our North American lives business increased $3.0 million as a result of the accelerated processing of backlog. Prior year claims were also higher than average due to $5.3 million of claims in relation to information received from two of our syndicates in Lloyd’s of London. Other effects in 2005 amounted to reduced claims cost of $6.0 million.
deferred. A provision for shortfall in future rental income of $2.0 million and accelerated write-down of fixed assets of $1.8 million related to the Windsor property lease was made in the fourth quarter of December 31, 2006.
Realized gains and losses are primarily incurred on the Corporate and Other Segment invested asset base and certain interest rate swap agreements. The year-over-year change from a realized gain position in 2006 to a realized loss position in 2007 is primarily due to gains realized on termination of the interest rate swap agreements in the prior year, offset by other-than-temporary impairment charges in 2007, primarily on our sub-prime and Alt-A investment portfolio.
The decrease in acquisition costs and other insurance expenses primarily relates to a prior year write-off of acquisition costs and present value of in-force business on our Wealth Management block. This was partially offset by increased costs on the Tartan catastrophe bond as this instrument, incepted in May 2006, was in force for all of 2007.
Operating expenses include the costs of running our principal office in Bermuda, our senior executive officers, legal, investments and capital markets departments, compensation and other costs for our Board and legal and professional fees, including those in respect of corporate governance legislation and regulations. The increase from 2006 to 2007 is a result of the change in control of the Company as a result of the 2007 New Capital Transaction. As part of this process, the Corporate and Other Segment incurred costs totaling $28.4 million for employee bonuses relating to completion of the 2007 New Capital Transaction, severance payments, recognition of all previously unrecognized compensation expense for stock options and restricted share awards and post change in control restructuring related expenses.
Current year interest expense was primarily incurred on an interim term loan facility put in place for the period between shareholder approval of the 2007 New Capital Transaction and the closing of the 2007 New Capital Transaction. In comparison, costs incurred in the prior year related to facilities no longer in use or available, including the unsecured credit facility, interest on the 4.5% Convertible Note, the reverse repurchase security agreement, and the dividends payable on the Hybrid Capital Units (“HyCUs”).
Investment income increased by 190% in 2006 compared to 2005. The increase is principally due to an increase in investment assets arising from the borrowing under the Stingray facility, a portion of the proceeds received from the equity issuance in December 2005 and settlement of the forward share sale agreement during the third quarter of 2006.
The increase in acquisition costs is partially due to a $4.3 million write-off of a portion of our deferred acquisition costs and present value of in-force business related to our Wealth Management business resulting from the impact of our ratings downgrades. In addition, we incurred $3.1 million of costs in 2006 for the Tartan catastrophe bond issued in May 2006 and $1.0 million for federal excise taxes, which had previously been charged to the Life Reinsurance North America Segment prior to 2006.
The increase in operating costs was primarily due to our ratings downgrades and the resulting class action lawsuit and change in control sales process. Salaries were $9.3 million higher due to $6.5 million of severance paid to certain executives with the balance of the increase related to a higher headcount in 2006 as compared to 2005. Directors’ costs were approximately $3.0 million higher as a result of the formation of the Office of the Chairman to assist in the sale of the Company and higher D&O insurance costs. Also related to the sale of the Company were various uncapitalizable costs of approximately $5.0 million. Finally, legal costs were higher in 2006 related to the class action suit, the Securities and Exchange Commission and Senate Subcommittee subpoenas and other various matters. These higher costs were partially offset by $1.5 million of lower benefit costs, mainly relating to a reversal of accruals for performance based restricted stock awards. It was determined that the performance thresholds related to these awards were unlikely to be met and in accordance with FAS 123(R), previously recognized costs were reversed in the third quarter of 2006.
Interest expense increased as a result of our utilization of our credit facilities and reverse repurchase agreements during the current year. Other interest expense included interest on the 4.5% Senior Convertible Notes and the 1.0% dividend payable on the convertible preferred shares of our HyCU’s. Nearly all of the 4.5% Senior
Convertible Notes were repurchased and retired in December 2006 with a small remaining balance retired in January 2007.
As of December 31, 2007, we had total cash, cash equivalents and invested assets of $10.2 billion. We manage our assets in an asset-liability framework with the aim of limiting interest rate risk while meeting the potential liquidity requirements of our reinsurance liabilities. We invest primarily in fixed maturities, including government, corporate, mortgage-backed and other asset-backed securities and mortgage loans on commercial real estate. We also invest in short-term securities and other investments.
Our general account investment portfolio consists of three categories: (1) investments and cash and cash equivalents which we control, (2) assets held within our collateral finance facilities, which we control subject to certain restrictions detailed below, and (3) funds withheld at interest, which are associated with modified coinsurance agreements with the assets retained by the cedant company or its asset manager, who manage them for our account, subject to the terms of the agreement.
Investments within our collateral finance facilities are governed by investment guidelines designed to comply with applicable restrictions imposed by insurance regulatory authorities and to provide adequate credit quality desired by counterparties. These investment guidelines cannot be changed or amended without the consent of the directing party of the transaction. The directing party may be either the financial guarantor or our banking counterparty.
In most modified coinsurance transactions, the ceding insurance company retains control of the assets supporting the ceded business and manages them for our account. Although the ceding company must adhere to investment guidelines agreed to by us, we do not control the selection of the specific investments or the timing of the purchase or sale of investments made by the ceding company.
Our investment department, under the direction of the Group Investment Committee and the Board Investment Committee, is responsible for establishing investment policies and strategies, reviewing asset liability management, performing asset allocation and managing the activities of third party asset management firms, with whom we have entered into investment management agreements detailing the objectives and constraints of each portfolio. We currently employ seven such third-party investment managers.
Under the direction of the Board Investment Committee, we instituted the Group Investment Committee during 2007. The Group Investment Committee is comprised of our Chief Executive Officer, our Chief Financial Officer, our Chief Investment Officer, our Chief Risk Officer and other members of senior management. The Group Investment Committee acts as an executive body focused on providing comprehensive governance oversight and timely decision-making related to all aspects of our investment management activities. It also serves as a forum for facilitating cross-functional communication of information critical to the success of the investment program and of processes important to other major departments. The Group Investment Committee meets on a regular basis and also reports regularly to the Board Investment Committee.
The Board Investment Committee reviews reports from the investment officers on the investment activities, the performance of the investment portfolio and the performance of our investment managers on a quarterly basis. In addition, our Board Investment Committee approves changes in the investment policy proposed by management and oversees compliance with the investment policy.
Our primary investment objective is to meet our reinsurance obligations while increasing value to our shareholders. We seek to meet this objective by investing in a diversified high quality portfolio of income producing securities and other assets. Our current investment policy includes limits requiring diversification by asset class, fixed income sector and single issuer families and limits exposure to securities rated below investment grade. It also requires effective asset-liability management processes including the maintenance of adequate liquidity to meet potential cash outflows and management of exposures to interest rate and other market risks. We review our investment policies periodically for effectiveness and adequacy with regard to achieving our investment objectives, while managing the market, credit, operational and other risks inherent in our investment program. Revisions of the investment policy are proposed by management and approved by the Board Investment Committee.
mitigating interest rate risk through management of asset duration and convexity, and the pattern of asset cash flows relative to those of the respective reinsurance obligations;
regularly evaluating our asset class mix and pursuing additional investment classes; and
We execute our investment strategy through third party asset management firms, with whom we have entered into investment management agreements detailing the objectives and constraints of each portfolio. These firms were selected through a process of due diligence covering their past performance on similar mandates, investment decision-making process, risk management discipline, and operational capabilities. We monitor all transactions made by these managers to ensure compliance with all Company, regulatory and contractual guidelines and constraints, and review their performance on a regular basis.
The funds held by each of our three securitizations, Orkney I, Orkney Re II and Ballantyne Re are managed by third-party investment managers pursuant to investment guidelines established at the formation of each entity. We are not able to revise such investment guidelines without the consent of the financial guarantors involved in each transaction. The investment guidelines for Orkney Re II and Ballantyne Re have been amended to provide flexibility to address the needs of the current portfolio and to reduce the forced sale of securities. We have also received waivers from the appropriate financial guarantors to hold certain securities that are no longer compliant with the initial investment guidelines.
We generally match the currency of invested assets to that of the supported liabilities as our primary tool for managing currency risk. We may enter into interest rate swaps, futures, forwards and other hedging transactions to manage our market and credit risks. We currently use derivatives only to hedge interest rate risk rather than as a speculative investment or to provide leverage.
The following table illustrates the fixed income, preferred stock and cash and cash equivalents investment portfolio sector exposure.
We review securities with material unrealized losses and test for other-than-temporary impairments on a quarterly basis. Factors involved in the determination of potential impairment include fair value as compared to cost, length of time the value has been below cost, credit worthiness of the issuer, forecasted financial performance of the issuer, position of the security in the issuer’s capital structure, the presence and estimated value of collateral or other credit enhancement, length of time to maturity, interest rates and our intent and ability to hold the security until the estimated fair value recovers. When a decline is considered to be “other-than-temporary” the cost basis of the impaired asset is reduced to its fair value and a corresponding realized investment loss is recognized in the consolidated statements of income (loss). The actual value at which such financial instruments could actually be sold or settled with a willing buyer may differ from such estimated fair values.
Other industries each represent less than 3% of estimated fair value
The expected maturity dates of our fixed maturity investments that have an unrealized loss at December 31, 2006 are presented in the tables below.
The modified coinsurance and funds withheld coinsurance agreements that comprise the funds withheld balance also contain an embedded derivate as determined under Derivatives Implementation Group Issue No. B36 “Embedded Derivatives: Bifurcation of a Debt Instrument that Incorporates Both Interest Rate and Credit Rate Risk Exposures that are Unrelated or Only Partially Related to the Creditworthiness of the Issuer of that Instrument”. The embedded derivative feature in our funds withheld treaties is similar to a fixed-rate total return swap on the assets held by the ceding companies. The fair value of this embedded derivative was a liability of $38.5 million and $7.9 million at December 31, 2007 and 2006, respectively, and is included in other liabilities.
Related to this, we also carry equity-indexed life reinsurance contracts, with account values credited with a return indexed to an equity index rather than established interest rates. Under Derivatives Implementation Group Issue No. B10 “Embedded Derivatives: Equity-Indexed Life Insurance Contracts”, these transactions contain embedded derivatives.
The fair value of these embedded derivatives at December 31, 2007 was a liability of $131.5 million (2006 - $87.9 million) and is included in other liabilities. The change in fair value of embedded derivatives is reported in the income statement under the caption “Change in value of embedded derivatives, net”.
According to data provided by our ceding companies, the amortized cost, gross unrealized appreciation and depreciation and estimated fair values of invested assets backing our funds withheld at interest at December 31, 2007 and 2006 are as follows:
The investment objectives for these arrangements are included in the modified coinsurance and funds withheld coinsurance agreements. The primary objective is to maximize current income, consistent with the long-term preservation of capital. The overall investment strategy is executed within the context of prudent asset/liability management. The investment guidelines permit investments in fixed maturity securities, and include marketable securities, commercial mortgages, private placements and cash. The guidelines limit exposure to credit risks, including the maximum percentage of securities rated below investment grade, ensure issuer and industry diversification and maintain liquidity and overall portfolio credit quality.
According to data provided by our ceding companies, the following table reflects the estimated fair value of assets including cash backing the funds withheld at interest portfolio using the lowest rating assigned by the three major rating agencies.
According to data provided by our ceding companies, the following table reflects the estimated fair value of assets backing the funds withheld at interest portfolio by sector.
As part of our quarterly tests for other-than-temporary impairments of investments, we have reviewed our investment holdings in accordance with SFAS No. 115, and related accounting guidance including FASB Staff Position FAS115-1/124-1 “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” and EITF 99-20.
For all other investment securities, we utilize systematic procedures to review all investments that are in a loss position to determine if the decline is other-than-temporary, including the length of the time and the extent to which the fair value has been below cost, credit worthiness of the issuer, position of the security in the issuer’s capital structure, the presence and estimated value of collateral or other credit enhancement, length of time to maturity, interest rates, and our intent and ability to hold the security until the estimated fair value recovers. We perform best estimate cash flow simulations of projected principal losses for structured securities outside the scope of EITF 99-20.
At December 31, 2007, our total investment portfolio, including controlled assets and funds withheld at interest and excluding operating cash, had an amortized cost of $10.1 billion, and an estimated fair value of $10.1 billion. Of the amortized cost, $1.3 billion, or 13.2%, were ABS backed by sub-prime residential mortgage loans and $0.9 billion, or 8.9%, were RMBS backed by Alt-A mortgage loans. These include bonds held in portfolios in our collateral finance facilities, in portfolios of our subsidiaries and by ceding companies in funds withheld at interest. Our exposure to collateralized debt obligations backed by similar ABS and RMBS was approximately $12,500.
The slowing U.S. housing market, greater use of affordable mortgage products, and relaxed underwriting standards for some originators of sub-prime loans has recently led to higher delinquency and loss rates, especially for those issued during 2006 and 2007. These factors have caused a decrease in market liquidity and repricing of risk, which has led to estimated fair value declines from December 31, 2006 to December 31, 2007. We expect delinquency and loss rates in the sub-prime mortgage sector to continue to increase in the future. Tranches of securities will experience losses according to the seniority of the claim on the collateral, with the least senior (or most junior), typically the unrated residual tranche, taking the initial loss. The credit ratings of the securities reflect the seniority of the securities that we own.
As sub-prime and Alt-A loan performance has deteriorated, the market has become increasingly illiquid and unbalanced, with an absence of buyers, causing market prices to decrease and a decline in the estimated fair value of our bonds below their amortized cost. As a result of subsequent fair value declines of these securities in the
period from December 31, 2007 to March 31, 2008 we estimate that an approximately further $751.7 million of impairment charges will be recognized in the first quarter of 2008.
The credit rating, amortized cost, estimated fair value and related unrealized and realized losses related to our sub-prime and Alt-A securities are set out below:
Our consolidated Alt-A portfolio includes securities that are collateralized by residential mortgage loans issued to borrowers with stronger credit profiles than sub-prime borrowers, but who cannot qualify for prime financing terms due to high loan-to-value ratios and/or limited supporting documentation. Of our $848.7 million of Alt-A holdings,
$185.6 million (3.0% of total investments at amortized cost) were rated AAA/Aaa;
$758.8 million (12.1% of total investments at amortized cost) were rated AA-/Aa3 or above;
$825.7 million (13.1% of total investments at amortized cost) were rated A-/A3 or above; and
$652.3 million (10.4% of total investments at amortized cost) reside in our collateral finance facilities.
As part of our fourth quarter impairment process, we marked down Alt-A bonds with an amortized cost of $1,030.4 million, realizing losses of $181.7 million bringing the unrealized loss position at December 31, 2007 to zero. As a result of estimated fair value reductions from December 31, 2007 to March 31, 2008, we estimate that we incurred further other-than-temporary impairments of approximately $322.2 million or 38.0% of amortized cost of our Alt-A holdings and is 4.2% of our investment portfolio.
The following table shows the amortized costs of our Alt-A RMBS exposure by rating and vintage:
The following table details the amount of amortized costs of our sub-prime and Alt-A holdings by rating and vintage held in our three securitization structures:
We are a holding company whose primary uses of liquidity include, but are not limited to, operating expenses, the immediate capital and collateral needs of our operating companies, dividends paid to our shareholders and interest payments on our indebtedness. See Note 8 “Debt Obligations and Other Funding Arrangements” in the Notes to Consolidated Financial Statements. The primary sources of our liquidity include proceeds from our capital raising efforts and interest income on undeployed corporate investments. We also receive funding from our subsidiaries through transfer pricing arrangements reflecting services performed by us on behalf of our subsidiaries. We will continue to be dependent upon these sources of liquidity.
As of December 31, 2007, we estimate that we had $399.6 million of available liquidity among us and our subsidiary, SALIC. This amount represents liquidity in excess of liquidity held by our insurance operating subsidiaries and includes cash and marketable securities. It also includes $275.0 million that was available under the Stingray Investor Trust (“Stingray”) facility as of December 31, 2007.
In the first quarter of 2008, the following events significantly impacted our available liquidity:
On March 12, 2008, a $211.0 million capital contribution was made to SRUS due to an increase in its statutory reserve requirements as a result of asset adequacy testing. This is previously described in “Business Overview” of Part I, Item 1 above.
As of March 31, 2008, we estimate that we had $201.3 million of available liquidity among us and our subsidiary, SALIC. This represents an estimated reduction of $198.3 million from December 31, 2007.
Estimated fair values in the HSBC II collateral finance facility declined by a further $57.2 million between March 2008 and April 2008 resulting in a corresponding reduction to available liquidity in the second quarter of 2008.
Our statutory capital position and our ability to continue to take reserve credit have been further reduced as a result of declines in the fair values of sub-prime and Alt-A securities within Orkney Re II. In order to maintain reserve credit in SRUS, we expect approximately $15.0 million in available liquidity will be used to supplement assets inside Orkney Re II.
Prior to the completion of the sale of our Wealth Management business, cash dividends totaling $14.2 million were received from the three associated regulated entities (The Scottish Annuity Company (Cayman) Ltd, Scottish Annuity & Life Insurance Company (Bermuda) Ltd and Scottish Annuity & Life International Insurance Company (Bermuda) Ltd.). This resulted in a corresponding increase to available liquidity.
As a result of the events highlighted above, as well as financing costs and anticipated operating expenses, we estimate that our liquidity has decreased in excess of $135 million in the second quarter of 2008 and available liquidity is below $65 million as of June 30, 2008. This figure represents available liquidity prior to receiving the proceeds from the sale of our Life Reinsurance International Segment and Wealth Management business. We currently expect to complete the sale of these businesses in the third quarter of 2008 and, subject to various closing conditions, we anticipate the net proceeds to contribute over $70 million to available liquidity in the third quarter of 2008.
As highlighted in the “Risks Related to Our Business”, the implications of a breach of certain financial reporting obligations and the potential breach of net worth covenants in two of our existing Regulation XXX collateral finance facilities, would have materially lowered and potentially exhausted our available liquidity in 2008 had we not reached forbearance agreements with the relevant counterparties. In particular:
As described in Part I “Business Overview” above, we are currently in breach of two covenants under the Clearwater Re facility for failure to deliver our financial statements for the period ended March 31, 2008 within the prescribed deadline. An event of default gives the counterparty banks the ability to accelerate the transaction and request repayment of any amounts currently being used under the facility. As of May 31, 2008, the amount we would have to pay the Clearwater Re banks is $365.9 million.
outstanding certificates from HSBC equal to the outstanding notional amount less collateral totaling $523.3 million, as of May 31, 2008 or (b) request additional collateral.
Set forth below are additional considerations related to our near to mid-term liquidity:
statutory reserves. As at December 31, 2007, $904.6 million (2006 - $884.9 million) of collateral support was being provided. To the extent that statutory reserve requirements for this business exceed $1.0 billion, the excess will have to be funded through corporate liquidity. Currently we anticipate reserve requirements exceeding the Reinsurance Facility capacity in the fourth quarter of 2009.
We have also undertaken the following activities to increase and/or maintain liquidity:
As highlighted in Part I “Business Overview” above, we recently entered into definitive agreements for the sale of our Life Reinsurance International Segment and Wealth Management business for cash, the proceeds of which will benefit our short term liquidity position. We currently expect to complete the sale of these businesses in the third quarter of 2008 and, subject to various closing conditions, we anticipate the net proceeds to increase available liquidity by over $70 million in the third quarter of 2008.
As highlighted in Part 1 “Business Overview”, we have ceased writing new reinsurance treaties and have notified our existing clients that we will not be accepting any new reinsurance risks under existing treaties.
Even with these positive liquidity actions in 2008, to the extent we are not successful in selling the Life Reinsurance North America Segment by December 15, 2008, we will be required to rely on our run-off strategy to continue to administer the business in our Life Reinsurance North America Segment without taking on additional risk and will be required to record appropriate statutory reserves for the duration of these reinsurance obligations. Execution of our run-off strategy relies on the following: (1) obtaining additional forbearance from the relevant counterparties to Clearwater Re and HSBC II; (2) potentially finding alternative collateral support for Clearwater Re and HSBC II; and (3) raising additional capital to support corporate financial obligations. Our inability to implement one or more of these actions could result in our exhausting liquidity by the first quarter of 2009, and potentially sooner. As a result, our insurance operating subsidiaries may become insolvent and we may need to seek bankruptcy protection.
On, June 30, 2008, we entered into a forbearance agreement with the relevant counterparties under the Clearwater Re facility in order to avoid the repayment events highlighted above. The forbearance period will remain in effect, subject to certain conditions being met, until December 15, 2008. In order to achieve forbearance, we agreed to both economic and non-economic terms related to the Clearwater Re facility. The economic terms for forbearance have led to additional constraints on our available liquidity.
Subject to terms agreed upon with the relevant counterparties, such counterparties will forbear during the forbearance period from accelerating the Clearwater Re financing due to the default by us in our obligation to deliver certain financial statements and filings by their respective due dates, as required to be delivered in accordance with the Clearwater Re transaction documents. Similarly, the relevant counterparties have agreed during the forbearance period to forbear from accelerating the Clearwater Re financing in the event we default in the performance of certain existing minimum net worth covenants. We have agreed that as a result of the existing defaults, the counterparties have no further obligation to fund any future advances under the facility. If we fail to deliver any required financial statements by December 15, 2008, fail to achieve the specified financial covenants during the applicable measurement periods, or fail to achieve certain milestones with respect to, among other things,
We have also agreed to contribute additional capital to Clearwater Re’s surplus account, including (i) $22 million on July 1, 2008, (ii) $6 million on or prior to August 15, 2008, (iii) additional future contributions based on our liquidity position, (iv) specified percentages of any sales proceeds that we receive on the disposition of our assets or lines of business, and (v) any collateral released by HSBC.
In addition to the financial covenants and reporting requirements, the relevant counterparties required amendments to certain of the transaction documents relating to, among other things, pricing, restrictions on dividends and experience refunds out of Clearwater Re, recapture from Clearwater Re of the related insurance business, minimum balance requirements in Clearwater Re’s accounts, restrictions on the disposition of assets and certain uses of liquidity, minimum net worth tests, certain amendments to Clearwater Re’s investment guidelines, additional rights to appoint a majority of Clearwater Re’s directors, the right to request prior to July 31, 2008 that SALIC and SRGL pledge their respective equity interests in Clearwater Re, and the right to more frequent inspections and audits of Clearwater Re and SRUS. We have also agreed to make available to the relevant counterparties the same terms and conditions that we provide to any party in any other restructuring, refinance or forbearance arrangement in the future.
Pursuant to the terms of the amended and restated forbearance agreement, HSBC has agreed during the forbearance period to forbear from demanding additional collateral under the transaction documents as a result of our anticipated failure to meet certain existing minimum net worth requirements. The forbearance period is subject to early termination upon the occurrence of certain events, including events of default under the underlying transaction documents, failure to maintain specified liquidity requirements, the institution of certain litigation proceedings, the early termination of the Clearwater Re forbearance period, failure to achieve certain milestones with respect to the progress of our revised business strategy (including the sale of our assets or lines of business), defaults under other agreements and borrowing facilities, and the breach of certain restrictive covenants relating to dividends and capital contributions.
We will be required to pay certain fees to HSBC upon the redemption of the facility. We posted $22 million in additional collateral to HSBC and agreed to post additional collateral to HSBC over time if our liquidity position reaches certain specified thresholds. We have also agreed to apply specified percentages of any sales proceeds that we receive on the disposition of our non-core assets or lines of business to the reinsurance trust account related to the facility or as additional collateral to HSBC. SRGL agreed to guaranty the obligations of SALIC under the HSBC facility.
In addition, HSBC has requested amendments to the transaction documents relating to, among others, an increase in the interest spread payable to HSBC, timing of recapture of the related insurance business, certain amendments to the investment guidelines (including an agreement to remove and replace certain assets currently in the reinsurance trust account), and additional reporting requirements. We have also agreed to make available to HSBC the same terms and conditions that we provide to any party in any other restructuring, refinance or forbearance arrangement in the future.
Under the forbearance agreement, HSBC’s obligation to provide additional funding during the forbearance period has been capped and future funding to the facility would terminate upon the occurrence of certain events, including events of default under the transaction documents, the termination of the Clearwater Re forbearance period, and failure to enter into definitive agreements with respect to the sale of our Life Reinsurance North America Segment.
Immediately following the consummation of the Recapture, SLD will recapture the Recaptured Business from SRUS in exchange for consideration from SRUS to SLD. SLD will then cede the Recaptured Business to SLDI, which will cede the Recaptured Business to SRLB. SRLB may cede the Recaptured Business to either of SALIC or SRD. SLDI has agreed to provide, or cause the provision of, one or more LOCs in order to provide SLD with statutory financial statement credit for the excess of the U.S. statutory reserves associated with the Recaptured Business over the economic reserves held in an account related thereto. We will bear the costs of the LOC by paying to SLD a facility fee based on the face amount of such LOCs outstanding as of the end of the preceding calendar quarter.
SRUS will remain obligated to administer the Ballantyne Business following the consummation of the Assignment consistent with its obligation to administer the business acquired from ING at the end of 2004, of which the Ballantyne Business is a part.
The Assignment will not relieve SRUS of liability for breaches of its representations, warranties, covenants or other obligations that relate to periods before the effective date of the Assignment, and the Company and SRUS will remain responsible for certain ongoing covenants made for the benefit of Ballantyne Re, Ambac and Assured. In addition, SRUS has agreed to indemnify and hold harmless SLD and its affiliates for losses and damages incurred arising from the exercise by Ballantyne Re of any right, or from any limitation on the ability of SLD to exercise any right or recover any amount, under the Post-Assignment Reinsurance Agreement as a result of (a) any breach of any representation, warranty or covenant of SRUS under the Pre-Assignment Reinsurance Agreement or any related transaction document, (b) any action or omission by any director, officer, employee, agent, representative, appointee, successor, or permitted assign of SRUS or any of its affiliates that causes a Tax Event (as defined in the Pre-Assignment Reinsurance Agreement) for Ballantyne Re or otherwise causes Ballantyne Re to be in breach of any representation, warranty or covenant under the Pre-Assignment Reinsurance Agreement or any related transaction document or (c) any arbitration award against SRUS that SLD pays on its behalf to avoid termination of the Post-Assignment Reinsurance Agreement.
The Assignment will be effective as of June 30, 2008 or effective as of July 1, 2008 if the closing does not occur in time to permit SLD to take statutory financial statement credit for the reinsurance provided by Ballantyne Re as of June 30, 2008. The parties to the Assignment Letter of Intent have agreed to use their reasonable best efforts to close the Assignment by August 11, 2008, and if the Assignment has not closed by September 30, 2008 any party is entitled to terminate the Assignment Letter of Intent and not consummate the Assignment.
We must have sufficient assets available for use as collateral to support our borrowings, letters of credit and certain reinsurance transactions. With reinsurance transactions, the need for collateral or letters of credit arises in the following ways:
When SRUS enters into a reinsurance transaction, it typically incurs a need for additional statutory capital to cover strain from acquisition costs and increases in required risk-based capital. To the degree its own surplus is not sufficient to meet this need, we can make an additional capital contribution into SRUS, or SRUS can cede a portion of the transaction to another company within the group or an unrelated reinsurance company. If that reinsurer is not a licensed or accredited U.S. reinsurer, it must contribute assets to a qualifying reserve credit trust and/or provide a letter of credit in order for SRUS to obtain reserve credit. SRUS has ceded significant amounts of business to SRD, relieving SALIC of the need to contribute substantial amounts of capital to SRUS. In connection with such cessions by SRUS to SRD, SRD must contribute eligible assets to qualifying reserve credit trusts and/or provide letters of credit in order for SRUS to obtain reserve credit.
U.S. customers of SRUS and SRLC are able to receive reserve credit from SRUS and SRLC by virtue of their licenses and authorizations to write reinsurance throughout the United States and, as a result, they generally are not required to provide collateral to such U.S. customers. However, SRUS may agree reserving certain circumstances to provide a reserve credit trust, security trust, or letter of credit to mitigate the counter-party risk from the customer’s perspective, thereby enabling transactions that otherwise would be unavailable or would be available only on significantly less attractive terms.
On July 14, 2005, SALIC, SRD, SRUS and Scottish Re Limited entered into a $200.0 million, three-year revolving unsecured senior credit facility with a syndicate of banks to provide capacity for borrowing and extending letters of credit. All outstanding letters of credit under this facility were cancelled and the facility was terminated effective January 19, 2007.
On August 18, 2005, SRD entered into a $30.0 million three-year revolving, unsecured letter of credit facility with a syndicate of banks. Effective September 22, 2006, SALIC and SRD terminated the $30 Million Credit Agreement. All letters of credit outstanding under the agreement, in an aggregate of $10.0 million, were cancelled on September 22, 2006.
We had total shareholders’ equity, as calculated in accordance with U.S. GAAP, of approximately $346.7 million as of December 31, 2007. Total capitalization at December 31, 2007 and 2006 is as follows:
Our three securitization structures provide reserve credit to our operating subsidiaries for business reinsured. Therefore, an important metric is whether the value of the assets in the securitization portfolios is greater than the statutory reserves of the underlying blocks of business. At December 31, 2007, all of the securitization structures were currently providing full reserve credit. If any deficiency were to develop, then our operating subsidiaries may be required to pledge additional assets to secure reserve credit outside of the securitization structure. As such, the amount of invested assets that exceeds statutory reserves within the securitization portfolios potentially represents additional protection from unexpected estimated fair value declines in invested assets.
As summarized in the following table, the fair value of invested assets within Orkney I, Orkney Re II and Ballantyne Re, exceeded the statutory reserves covered by the structures by approximately $652.6 million and $1,409.1 million as of December 31, 2007 and 2006, respectively. The aggregate excess of the fair value of invested assets over the statutory reserves had declined to $556.7 million as of March 31, 2008. For further details, refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources-Liquidity.”
Over time, we expect to receive distributions from the securitization structures through our debt and equity investments in the securitization structures. Temporary and permanent changes in the estimated fair value of assets in these structures, and the ratings of SRUS, could impact the size and timing of these distributions.
In connection with the December 23, 2005 ordinary share offering, we entered into forward sales agreements with affiliates of Bear, Stearns & Co. Inc. and Lehman Brothers, Inc. (the “forward purchasers”) and the forward purchasers borrowed and sold an aggregate of approximately 3,150,000 ordinary shares as their initial hedge of the forward sale agreements. Pursuant to the forward sale agreements, the forward purchasers agreed to pay us an aggregate of approximately $75.0 million on September 29, 2006 and an aggregate of approximately $75.0 million on December 29, 2006, subject to our right to receive a portion of such payment prior to the settlement dates. In exchange, on each of such dates, we would deliver to the forward purchasers a variable number of ordinary shares based on the average market price of the ordinary shares, subject to a floor price of $22.80 and a cap price of $28.80. We also had the right to net share settle or cash settle the forward sale agreements. The fair value of the forward sales agreements at inception together with the underwriting costs of the forward sales agreements was reflected in shareholders’ equity (as a reduction in additional paid-in capital).
On June 26, 2006, we exercised our right of prepayment under the forward sale agreements and received 75% of the $150.0 million proceeds totaling $110.0 million, net of prepayment discounts of $2.5 million. This prepayment was recorded as a separate component of consolidated shareholders’ equity. The total amount of the discount related to the prepayment transaction was recorded as an imputed dividend charge over the applicable contract settlement period.
On July 28, 2006, the Board suspended the dividend on our ordinary shares. All future payments of dividends are at the discretion of our Board and will depend on our income, capital requirements, insurance regulatory conditions, operating conditions and such other factors as the Board may deem relevant.
The declaration of any cash dividend or similar capital distribution, exclusive of the Non-Cumulative Perpetual Preferred Shares during the forbearance period from November 26, 2006 until December 31, 2008, unless at the time of declaration and payment of cash dividend, SALIC has an insurer financial strength rating of at least “A-” for Standard & Poor’s and A3 for Moody’s Investors Service, would terminate the Forbearance Agreement with HSBC.
Dividends on the perpetual preferred shares are payable on a non-cumulative basis at a rate per annum of 7.25% until the dividend payment date in July 2010. Thereafter, the dividend rate may be at a fixed rate determined through remarketing of the perpetual preferred shares for specific periods of varying length not less than six months or may be at a floating rate reset quarterly based on a predefined set of interest rate benchmarks. During any dividend period, unless the full dividends for the current dividend period on all outstanding perpetual preferred shares have been declared or paid, no dividend shall be paid or declared on our ordinary shares and no ordinary shares or other junior shares shall be purchased, redeemed or otherwise acquired for consideration. Declaration of dividends on the perpetual preferred shares is prohibited if we fail to meet specified capital adequacy, net income or shareholders’ equity levels. See Note 11 “Shareholders’ Equity” in the Notes to Consolidated Financial Statements for further details.
SALIC has agreed with SRUS that it will (1) cause SRUS to maintain capital and surplus equal to the greater of $20.0 million or such amount necessary to prevent the occurrence of a Company Action Level Event under the risk-based capital laws of the State of Delaware and (2) provide SRUS with enough liquidity to meet its obligations in a timely manner.
SALIC and the Company have agreed with Scottish Re Limited that in the event Scottish Re Limited is unable to meet its obligations under its insurance or reinsurance agreements, SALIC, or if SALIC cannot fulfill such obligations, then we will assume all of Scottish Re Limited’s obligations under such agreements.
All of our regulated insurance entities are in excess of their minimum regulatory capital requirements as of December 31, 2007. See Note 20 “Statutory Requirements and Dividend Restrictions” in the Notes to Consolidated Financial Statements for further details.
Our long-term debt is described in Note 8 “Debt Obligations and Other Funding Arrangements” in the Notes to Consolidated Financial Statements. Long-term debt includes capital securities with various maturities from
Interest sensitive contract liabilities (excluding amounts due under funding agreements) include amounts primarily related to deferred annuities. These are generally comprised of policies or contracts that do not have contractual maturity dates and may not result in any future payment obligation. For these policies and contracts (i) we are not currently making payments and will not make payments in the future until the occurrence of an insurable event, such as death or disability or (ii) the occurrence of a payment triggering event, such as a surrender of a policy or contract, which is outside of our control. We have made significant assumptions to determine the estimated undiscounted cash flows of these policies and contracts which include mortality, morbidity, persistency, future lapse rates and interest crediting rates. Due to the significance of the assumptions used, the amounts presented could materially differ from actual results. The sum of the obligations shown for all years in the table of $3.1 billion exceeds the liability amount of $2.5 billion included on the consolidated balance sheet (which excludes amounts due from funding agreements) principally due to the fact that amounts presented above are on an undiscounted basis.
We have no obligations, assets or liabilities other than those disclosed in the consolidated financial statements forming part of this Annual Report on Form 10-K, no trading activities involving non-exchange traded contracts accounted for at fair value, and no relationships and transactions with persons or entities that derive benefits from their non-independent relationship with us or our related parties.
In September 2006, the FASB issued Statement No. 157 “Fair Value Measurements” (“SFAS No. 157”), which defines fair value, establishes a framework for measuring fair value under U.S. GAAP and expands the disclosures about fair value measurements. The standard clarifies that fair value is represented by an exchange price in an orderly transaction between market participants to sell the asset or transfer the liability in the principal or most advantageous market for that asset or liability as of the measurement date. Fair value is measured based on
assumptions used by market participants in pricing the asset or liability, which should also include assumptions about inherent risk, restrictions on sale or use and non-performance risk. The standard also establishes a three-level fair value hierarchy, which reflects the nature of inputs into the valuation techniques used to measure fair value. The highest level in the hierarchy is given to quoted prices in active markets for identical assets or liabilities and the lowest level is given to unobservable inputs in situations where there is little or no market activity for the asset or liability. In addition, disclosure requirements for annual and interim reporting have been expanded to focus on the inputs used to measure fair value, including those measurements using significant unobservable inputs, and the effects of those measurements on earnings. SFAS No. 157 is generally applied prospectively and is effective January 1, 2008 for calendar-year companies. Retrospective application is required for certain financial instruments as a cumulative effect adjustment to the opening balance of retained earnings. We have reviewed the requirements of SFAS No. 157 and, while we are still assessing the impact, we do not believe SFAS No. 157 will have a material effect on our consolidated financial condition and results of operations. We note that there will be increased disclosure regarding certain investments deemed to be the lowest level in the fair value hierarchy.