To manage reinsurance and insurance liability exposure, make investment decisions and assess overall enterprise risk, we model our underwriting and investing activities on an integrated basis. Our integrated risk management, as well as terms and conditions of our products, provides flexibility in making decisions regarding investments. Our investments are currently comprised of a high grade fixed maturities portfolio and an alternative investment portfolio that currently employs 11 strategies invested in approximately 40 underlying trading entities and one strategic reinsurance private equity investment. Our investment portfolio is designed to provide diversification and to generate positive returns while attempting to reduce the frequency and severity of loss outcomes. Based on fair value at December 31, 2006, the allocation of invested assets was approximately 76.5% in cash and fixed maturities and 23.5% in alternative investments.
Our principal operating subsidiary is Max Re. At December 31, 2006, Max Re had $1,327.8 million of shareholders’ equity. We conduct our European activities through Max Europe Holdings and its operating subsidiaries, Max Re Europe and Max Insurance Europe. We intend to conduct our United States operations through the operating subsidiary that Max USA intends to acquire. We also provide underwriting and administrative services on a fee basis through Max Re Managers. We hold all of our alternative investments in Max Re Diversified, other than the reinsurance private equity investment that is held by Max Re.
We believe our strong underwriting results demonstrate the balanced nature of the product lines we write as well as the discipline and expertise of our underwriting teams. Although our property underwriting, coupled with the mild hurricane season, positively affected our results for the year ended 2006, our casualty underwriting also contributed significantly to our underwriting profit. Our product lines are evenly weighted between property and casualty insurance and property and casualty reinsurance. Our current property and casualty reinsurance emphasis is on writing smaller accounts with a greater number of clients and varying the underlying exposures assumed. As a result, we have seen a significant reduction in the average premium volume per contract we write. We continue to emphasize long-tail casualty lines in our property and casualty reinsurance and insurance segments with excess liability and professional liability being our two largest exposures accounting for 26.5% and 24.5%, respectively of gross premium written for the year ended December 31, 2006.
We expect volatility in our underwriting results. The potential volatility has increased in comparison to prior years with the increase in property catastrophe reinsurance business we write. However, by carefully selecting line sizes of business assumed, diversifying our underlying exposures and purchasing reinsurance and retrocessional reinsurance protection, we believe we effectively manage, and will continue to manage, this volatility.
Net income for the year ended December 31, 2006 was $216.9 million compared to $9.5 million for the year ended December 31, 2005. The results for the year ended December 31, 2006 were principally attributable to underwriting income generated from our property and casualty business, which benefited from favorable loss development and low catastrophe loss activity in 2006 compared to the year ended December 31, 2005. Net income for the year ended December 31, 2005 was net of $123.4 million in underwriting losses and $34.0 million in reinsurance private equity investment losses associated with hurricanes.
Interest expense principally reflects interest on our bank loan at a rate based on LIBOR plus a spread. In addition, interest expense also includes the net interest charge on funds withheld from reinsurers under reinsurance and retrocessional contracts. Interest is recorded on the funds withheld balances based on various contractual and negotiated rates. The interest expense attributable to the funds withheld under a variable quota share retrocession agreement with Grand Central Re, our largest funds withheld balance, is based on the average of two total return fixed maturity indices. A charge or credit may be recorded in interest expense on this contract in any given period. As a result, interest expense is expected to vary from period to period with a corresponding entry to funds withheld. Interest expense on the remaining balance of funds withheld from other reinsurers under reinsurance and retrocessional contracts will vary principally due to changes in the balance of funds withheld. Finally, interest expense also includes interest on deposit contracts.
Our property and casualty insurance premiums are recorded at the inception of each contract, based upon contract terms. The amount of minimum and/or deposit premium is usually contractually documented at inception, and variances between deposit premium and final premium are generally small. An adjustment is posted to amend the minimum and/or deposit premium if there are changes in underlying exposures insured. Premiums are earned on a pro rata basis over the coverage period.
Certain contracts that we write are retrospectively rated and we are entitled to additional premium should losses exceed pre-determined, contractual thresholds. These required additional premiums are based upon contractual terms and the only element of
Additional premiums assumed and ceded, related additional acquisition costs, related net losses and the net impact on operating results for each of the three years to December 31, 2006 are as follows:
We accrue for reinstatement premiums resulting from losses recorded. Such accruals are based upon contractual terms and the only element of management judgment involved is with respect to the amount of losses recorded. Changes in estimates of losses recorded on contracts with reinstatement premium features will result in changes in reinstatement premiums based on contractual terms. Reinstatement premiums are recognized at the time we record losses and are earned on a pro rata basis over the coverage period. Reinstatement premiums assumed and ceded for each of the three years to December 31, 2006 are not material to our financial results.
For quota share or proportional contracts we are entitled to receive premium as the ceding client collects the premium under contractual reporting and payment terms, which are usually quarterly. Premiums are usually collected over a two year period on our quota share or proportional contracts. For excess of loss contracts, premium is generally paid in
In estimating reserves we, consistent with industry practice, utilize a variety of standard actuarial methods. The loss reserve selection from these various methods is based on the loss development characteristics of the specific line of business and specific contracts which take into consideration coverage terms, type of business, maturity of loss data, reported claims and paid claims. We do not necessarily utilize the same actuarial method or group of actuarial methods for all contracts within a line of business or segment, as variations between contracts result in a number of different methods or groups of methods being applied. These actuarial methods have been designed to address the lag in loss reporting in the insurance business. Reporting lag is more pronounced in our reinsurance contracts than in our insurance contracts and more pronounced in casualty business, which generally has a longer claims pay-out period (long claim-tail), than property business, which generally has a shorter claims pay-out period (short claim-tail). On casualty reinsurance transactions the reporting lag will generally be 60 days after the end of a reporting period, but can be longer than this in some cases. Based on the experience of our actuaries and management we select loss development factors and trending techniques to mitigate the problems caused by reporting lags and claims tails. We regularly evaluate and update our loss development and trending factor selections using client specific and industry data. We also subscribe to industry publications to enable us to keep current with the latest industry trends. The principal actuarial methods we use to perform our quarterly contract by contract loss reserve analysis may include:
Reported Loss Development Method. This method estimates ultimate losses by calculating past reported loss development factors and applying them to exposure periods
with further expected reported loss development. Since reported losses include payments and case reserves, changes in both of these amounts are incorporated in this method. This approach provides a larger volume of data to estimate ultimate losses than paid loss methods. Thus, reported loss patterns may be less varied than paid loss patterns, especially for coverages that have historically been paid out over a long period of time but for which claims are reported relatively early and case loss reserve estimates established.
case reserves, which are reserves established for individual claims (and as reported by our cedants in the case of reinsurance);
The table below breaks our reserves as of December 31, 2006 into these components by segment.
book, IBNR is calculated by taking our estimated ultimate reserves then reducing that amount by the cumulative paid claims and case reserves. Estimating IBNR in our reinsurance book is more difficult. Reinsureds provide loss data in various formats, with some reinsureds providing a detailed analysis of case reserves and IBNR, while other reinsureds provide less detailed information. Where reinsureds provide less detailed information, we estimate the split of IBNR and case reserves based on general industry patterns.
Development of our prior period incurred losses for each of the three years ended December 31, 2006 is reported in Note 4 - “Property and casualty losses and loss adjustment expenses” to our consolidated financial statements on page. Adjusting 2005 prior period incurred losses for contractual additional premiums received related to the recording of losses on two contracts, our development of prior period loss reserves has been less than 1.4% in each of the three years ending December 31, 2006 and an average of 5.8% over the past six years. Based on this experience, we currently believe it reasonably likely that loss reserves could change 3% from currently reported amounts. This change could be higher or lower depending on our client reported data and potential future commutation of reserves. As at December 31, 2006, we estimate that a 3% change in loss reserves would impact our net income and shareholders’ equity by $70.1 million. Depending on whether the reasonably likely adjustments to loss reserves are on contracts ceded to one of our various reinsurance arrangements, there may also be a partially offsetting change in the losses recoverable, net income and shareholders’ equity.
Our property and casualty reinsurance loss reserves include case reserves, amounts for IBNR reserves and loss adjustment expenses. The reserves are compiled on a contract-by-contract basis and are computed on an undiscounted basis. The majority of our reinsurance property and casualty business is casualty business. Historically, losses associated with casualty business have had a long claim-tail, the time period between the occurrence of a loss and the time it is settled by the insurer we reinsure. Casualty losses are also more susceptible to litigation and can be significantly affected by changing contract interpretations and a changing legal environment. Due to the long claim-tail nature of casualty business, a high degree of judgment is involved in establishing loss reserves.
include paid loss development, incurred loss development, paid and incurred Bornhuetter-Ferguson methods and frequency-severity methods. This actuarial data is analyzed by product, type of risk, coverage and accident or policy year, as appropriate. Industry loss experience is also used to supplement our own data in selecting development factors in areas where our own data or the clients’ data is limited.
As a reinsurer, we rely on loss data reported by our clients when calculating our reserves. The quality of the loss data varies from client to client. On a periodic basis, the clients’ loss data is analyzed by our actuarial and claims management teams to ascertain its quality and credibility. This process may involve comparisons with submission data and industry loss data, claim audits and inquiries about the methods of establishing case reserves or reserves associated with large industry events. There is often a time lag between our clients establishing case reserves and re-estimating their reserves, and notifying us of the new or revised case reserves. On casualty reinsurance transactions, the reporting lag will generally be 60 days after the end of a reporting period, but can be longer than this in some cases. Appropriate selection of loss development and trending techniques is used to mitigate these problems. We utilize the latest information received from our clients and work to ensure that the loss data is current. However, due to the varying quality of data from our reinsureds and the inherent reporting delays, our property and casualty reinsurance reserves will have more uncertainty than our property and casualty insurance reserves, where we receive loss information directly from our insureds.
When determining reserves, we also consider additional historical data, industry loss trends, legal developments, changes in social attitudes and economic conditions, including the effects of inflation. As additional data becomes available and is reviewed, we revise our property and casualty reserve estimates to reflect this additional data, which may result in increases or decreases to reserves for insured events of prior years. These adjustments are recorded in the period they are determined. The table below breaks our property and casualty reinsurance reserves as of December 31, 2006 and 2005 into casualty (long claim-tail) and property (short claim-tail) components.
our clients and for our estimate of losses resulting from catastrophe events, based on a detailed, location specific analysis of our clients’ properties impacted by the events.
In connection with our ongoing analysis of our property and casualty insurance and reinsurance loss reserves, we review loss notifications and reports received from our clients to confirm that submitted claims are covered under the contract terms. Disputes with clients arise in the ordinary course of business due to coverage issues such as classes of business covered and interpretation of contract wording. We typically resolve any disputes through negotiations that could vary from a simple exchange of email correspondence to arbitration with a panel of experts. Our contracts generally provide for dispute resolution through arbitration. We are not currently involved in any material coverage disputes.
The following table represents the development of balance sheet property and casualty loss reserves calculated in accordance with GAAP, as of December 31, 2000 through December 31, 2006. This table does not present accident or policy year development data. The top line of the table shows the gross reserves at the balance sheet date for each of the indicated years and is reconciled to the net reserve by adjusting for reinsurance recoverables. This represents the estimated amount of net claims and claim expenses arising in the current year and all prior years that are unpaid at the balance sheet date, including IBNR reserves. The table also shows the re-estimated amount of the previously recorded reserves as adjusted for new information received as of the end of each succeeding year. The estimate changes as more information becomes known about the frequency and severity of claims for individual years. The “net cumulative redundancy (deficiency)” represents the aggregate change to date from the original estimate on the third line of the table “reserve for property and casualty losses, originally stated, net of
reinsurance.” The “gross cumulative redundancy (deficiency)” represents the aggregate change to date from the original gross estimate on the top line of the table. The table also shows the cumulative net paid amounts as of successive years with respect to the net reserve liability.
For additional information on our reserves, including a reconciliation of losses and loss adjustment expense reserves for the years ended December 31, 2006, 2005 and 2004, please refer to Note 4 of our audited consolidated financial statements included herein.
There have been no material reserve adjustments to our life and annuity reinsurance benefit reserves during the years ended December 31, 2006, 2005 and 2004.
maintain a significant cash balance, which has consistently exceeded $200.0 million, and presently have a $150.0 million unsecured credit facility. We have also generated over $300.0 million of positive operating cash flow in each of the five years ended December 31, 2006.
Our investments are carried at fair value or amounts that approximate fair value. Fair value for our investments in fixed maturities is generally based on quoted market prices or pricing models. At December 31, 2006, the valuation of all of our fixed maturities investments was based on quoted market prices. Fair value for our alternative investments is generally based on the net asset value reported by the respective investment fund managers or, for our reinsurance equity investment, based on the carried amount under the equity method of accounting. The investment fund managers generally carry their trading positions and investments at fair value and the majority of the underlying holdings are securities with quoted market prices. We use the financial reports from these entities as part of our evaluation of fair value in order to record the net gains on alternative investments in our statement of income.
Our alternative investment portfolio contains approximately 40 underlying investments in 11 different strategy groupings. We focus on risk, as opposed to return, in the selection of each of our alternative investments. This causes us to select individual alternative investments that have exhibited attractive risk/reward characteristics and low correlation to other investments in the portfolio, as opposed to individual investments that have shown the highest return, but also higher volatility of return. We then combine the selected individual alternative investments into a portfolio of approximately 40 alternative investments. By combining investments with moderate volatility and low correlations, we are able to achieve a portfolio that has overall lower volatility relative to investing in a common stock portfolio or a typical fund of hedge funds portfolio. Over the five years ended December 31, 2006 the volatility of our overall alternative investment portfolio has been 3.91%, compared to the volatility of the S&P 500 of 12.37%.
Despite the lower volatility of the portfolio there is potential for loss events, as there is for any investment portfolio. During the quarter ended September 30, 2006, we recorded losses of $35.0 million stemming from energy trading losses in certain hedge fund investments included in our Diversified Arbitrage strategy. We approach our investment strategies based on long term performance and believe our alternative investment portfolios annualized five year return of 7.98% demonstrates a superior return profile compared to other alternative investment vehicles.
Investments in reinsurance private equity, where we have a meaningful ownership position and significant influence over operating and financial policies of the investee, are carried under the equity method of accounting. Under this method, we initially record the investments at cost and periodically adjust the carrying values to recognize our proportionate share of income or loss and dividends from these investments. Future adverse changes in general market, global and economic conditions, changes to the interest and currency rate environment or poor operating results by our investments carried under the equity method of accounting could result in losses.
We monitor the performance of our underwriting operations in three segments: property and casualty reinsurance, property and casualty insurance and life and annuity reinsurance. Within the property and casualty reinsurance segment, we offer quota share and excess of loss capacity providing coverage for a portfolio of underlying risks written by our clients. In the property and casualty insurance segment, we generally offer excess of loss capacity on specific risks related to one insured. Within the life and annuity reinsurance segment, we currently offer reinsurance products focusing on existing blocks of business, which take the form of co-insurance transactions. In co-insurance transactions, risks are reinsured on the same basis as the original policies. We also have a corporate function that includes our investment and financing activities.
Gross premiums written for the property and casualty reinsurance segment for the year ended December 31, 2005 were $615.7 million compared to $583.2 million for the year ended December 31, 2004, an increase of 5.6%. This increase included additional premiums of $182.0 million arising from the notification of additional losses on two excess of loss contracts written in prior years. This increase was largely offset by the non-renewal of four reinsurance contracts that accounted for approximately $174.5 million of premium in the year ended December 31, 2004. We chose not to renew these contracts as the renewal terms and conditions did not meet our underwriting criteria. There were no other significant changes to premium estimates on prior period contracts.
Net premiums earned for property and casualty reinsurance increased by 7.6% to $607.1 million for the year ended December 31, 2005 despite the non-renewal of four reinsurance contracts that accounted for approximately $173.2 million of net premiums earned in the year ended December 31, 2004. The non-renewals were largely offset by $154.6 million of additional net premiums earned on two contracts written in prior years.
Losses. Losses relating to property and casualty reinsurance were $296.0 million for the year ended December 31, 2006 compared to $552.8 million for the year ended December 31, 2005, a decrease of 46.5%. The losses for the year ended December 31, 2006 reflect expected loss activity on our casualty business combined with below average catastrophe losses on our recently expanded property reinsurance business. The losses for the year ended December 31, 2005 include $73.4 million of losses attributable to the hurricanes in the United States and $179.9 million of net losses pertaining to additional losses notified on two excess of loss contracts written in a prior year. The loss ratio for our property and casualty reinsurance segment for the year ended December 31, 2006 was 70.0% compared to 91.1% for the year ended December 31, 2005. Excluding hurricane losses and losses that triggered additional premiums in 2005, the adjusted loss ratio for our property and casualty reinsurance segment is 66.3%. The adjusted 2005 loss ratio is lower in part due to a large commutation that was made during the 2005 year.
Acquisition costs. Acquisition costs were $77.3 million for the year ended December 31, 2006 compared to $73.6 million for the year ended December 31, 2005, an increase of 5.0%. The increase in acquisition costs for the year ended December 31, 2006 is due to higher average acquisition costs on premiums earned. Acquisition costs vary from contract to contract depending on characteristics such as the type of business, the clients’ cost to administer the underlying contracts and the involvement of a broker. These factors may result in differences in the ratio of acquisition costs to net premiums earned from period to period.
Acquisition costs were $73.6 million for the year ended December 31, 2005 compared to $110.9 million for the year ended December 31, 2004, a decrease of 33.6%. The decrease in acquisition costs for the year ended December 31, 2005 is due to lower average acquisition costs on premiums earned and to the $141.3 million of additional net premiums written and earned on two contracts written in a prior year, which did not attract any further acquisition costs.
Statement of Financial Accounting Standards No. 113 and therefore are recorded as deposit liabilities on the balance sheet. These deposit liabilities are recorded on a net present value basis and an interest expense is accreted in order to grow the liability to the expected ultimate settlement amount. During 2006, we were notified by the cedant of one of the contracts that the ultimate loss is expected to be lower than our original estimate. As a result we recognized a reduction in interest expense of $12.0 million in order to reflect the current net present value of the revised loss estimate.
Net income attributable to property and casualty reinsurance for the year ended December 31, 2005 was $5.9 million compared to $54.8 million of income for the year ended December 31, 2004. The decrease in net income loss for the year ended December 31, 2005 was principally attributable to $73.4 million of losses recognized due to Hurricanes Katrina, Rita and Wilma compared to $6.0 million for hurricanes in 2004. This has been partially offset by a change in business mix to risk types that generally have lower average combined ratios as well as a large commutation that was made during the 2005 year. The net income for the year ended December 31, 2005 includes an additional $3.0 million of investment returns compared to the year ended December 31, 2004 as a result of an increase in invested assets partially offset by a lower return on the Max Re Diversified portfolio.
The loss ratio is calculated by dividing losses (shown as (b)) by net premium earned (shown as (a)). The combined ratio is calculated by dividing losses and expenses (shown as (c)) by net premiums earned (shown as (a)).
Gross premiums written. Gross premiums written for the property and casualty insurance segment for the year ended December 31, 2006 were $396.6 million compared to $355.3 million for the year ended December 31, 2005, an increase of 11.6%. The increase is the result of the expansion of our property insurance business from 9.6% of insurance premium volume in 2005 to 15.4% in 2006. In addition, 5.5% of the insurance premium volume relates to our aviation insurance business, which we began writing in October 2006. Typically, insurance business is written on an individual risk excess of loss basis with contractually defined premiums rather than estimates, which results in no material premium adjustments.
Reinsurance premiums ceded. Reinsurance premiums ceded for insurance for the year ended December 31, 2006 were $194.5 million compared to $145.7 million for the year ended December 31, 2005, an increase of 33.5%. Reinsurance premiums ceded were principally related to our quota share treaties that are utilized to manage our retained exposure and, therefore, will tend to increase when gross premiums written increase. In addition, because we increased the volume of short-tail property and aviation business that we write, we purchased excess of loss reinsurance in order to reduce our exposure large catastrophe events. The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2006 was 49.0% compared to 41.0% for the year ended December 31, 2005. Not all of the contracts we write qualify for inclusion in our quota share treaties and, accordingly, there may be differences in the ratio of gross premiums written to reinsurance premiums ceded from period to period.
Reinsurance premiums ceded for insurance for the year ended December 31, 2005 were $145.7 million compared to $114.3 million for the year ended December 31, 2004,
an increase of 27.5%. Reinsurance premiums ceded were principally related to our quota share treaties that are utilized to manage our retained exposure, which tend to increase when gross premiums written increase. The ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2005 was 41.0% compared to 46.1% for the year ended December 31, 2004.
Net premiums earned. Net premiums earned on insurance increased by 14.5% to $197.9 million for the year ended December 31, 2006 compared to the year ended December 31, 2005 and by 39.4% to $172.9 million for the year ended December 31, 2005 from $124.0 million for the year ended December 31, 2004. The increases are attributable to our expansion of the insurance segment over the past three years, including developing our property and aviation insurance products. The increase also reflects the earning pattern of a larger and increasingly mature portfolio of insurance contracts.
Losses. Losses relating to insurance were $124.2 million for the year ended December 31, 2006 compared to $175.5 million for the year ended December 31, 2005, a decrease of 29.2%. The decrease is principally due to a reduction of the expected ultimate losses on our 2003 excess liability insurance business and larger weighting of property business with lower average loss ratios. Our loss reserve analysis on this business, which has seasoned due to the passage of time, continued to show lower reported losses than originally estimated, which caused us to recognize positive development of $20.5 million during the year ended December 31, 2006. In addition, a low level of attritional property insurance losses during the year ended December 31, 2006 compared to $50.0 million of catastrophe losses due to hurricane activity during the year ended December 31, 2005 has affected the comparability between the two periods. The loss ratio for our insurance segment for the year ended December 31, 2006 was 62.8% compared to 101.5% for the same period in 2005. Excluding hurricane losses, the adjusted loss ratio for our property and casualty insurance segment was 72.6% in 2005.
Acquisition costs were $0.1 million for the year ended December 31, 2005 compared to $2.5 million for the year ended December 31, 2004. The decline in acquisition costs principally results from the settlement of all outstanding balances with insurance brokers in relation to PSAs, which we had terminated with effect from September 30, 2004, at $1.5 million less than our accrued liability.
General and administrative expenses were $9.9 million for the year ended December 31, 2005 compared to $6.8 million for the year ended December 31, 2004, an increase of 45.6%. The increase resulted principally from expenses associated with additional staff, including an expanded property underwriting team.
Net income. Net income attributable to the property and casualty insurance segment for the year ended December 31, 2006 was $78.2 million compared to $1.3 million for the year ended December 31, 2005. The variance between the year ended December 31, 2006 and the year ended December 31, 2005 is principally attributable to the low level of catastrophic events during the year ended December 31, 2006 compared to the $50.0 million of hurricane losses in the year ended December 31, 2005 and the release of $20.5 million of net reserves on prior year general liability insurance business during the year ended December 31, 2006. Further, additional invested assets combined with improved returns on both fixed maturities and the Max Re Diversified portfolio has increased net income for the year ended December 31, 2006.
Net income attributable to the property and casualty insurance segment for the year ended December 31, 2005 was $1.3 million compared to $29.8 million of income for the year ended December 31, 2004. The variance between the year ended December 31, 2005 and the year ended December 31, 2004 is principally attributable to the $50.0 million of hurricane losses in the year ended December 31, 2005. The net income for the year ended December 31, 2005 includes an additional $8.2 million of investment returns compared to the year ended December 31, 2004 as a result of an increase in invested assets partially offset by a lower return on the Max Re Diversified portfolio.
Gross premiums written for the life and annuity reinsurance segment for the year ended December 31, 2005 were $275.0 million compared to $212.3 million for the year ended December 31, 2004, an increase of 29.5%. We wrote two contracts with European based clients for premium of $235.0 million and one contract with a North American based client for premium of $32.5 million during the year ended December 31, 2005. We wrote one annuity contract for premium of $196.5 million as well as a health contract for premium of $12.3 million in 2004.
Reinsurance premiums ceded. Gross reinsurance premiums ceded for the life and annuity reinsurance segment were $0.7 million for the year ended December 31, 2006 and $1.5 million for the year ended December 31, 2005, a decrease of 53.3%. Gross reinsurance premiums ceded for the life and annuity reinsurance segment were $0.7 million for the year ended December 31, 2004. The life and annuity reinsurance premium ceded relates to our quota share agreement with Grand Central Re. Effective January 2004, Grand Central Re stopped accepting new business and, accordingly, there has been a decline in premium ceded in 2006 and 2005 with the $0.7 million and $1.5 million relating to additional premiums ceded on contracts written in prior years.
Interest expense. Interest expense was $5.2 million for the year ended December 31, 2006 compared to $3.3 million for the year ended December 31, 2005. Interest expense includes $2.4 million of interest expense pertaining to the funds withheld on the variable quota share retrocession agreement with Grand Central Re for the year ended December 31, 2006 compared to $1.4 million for the year ended December 31, 2005. The interest expense on the Grand Central Re funds withheld is based on the average of two total return fixed maturity indices, which had a higher total return for the year ended December 31, 2006 compared to the year ended December 31, 2005.
Interest expense also includes the accretion of interest expense on deposit liabilities, which comprise a number of annuities that are subject to discretionary withdrawal and a universal life reinsurance contract as prescribed under SFAS 97. These deposit liabilities are recorded on a net present value basis and an interest expense is accreted in order to grow the liability to the expected ultimate settlement amount.
Net investment income. Net investment income, excluding realized and unrealized gains and losses, for the year ended December 31, 2006 increased $43.2 million to $150.0 million compared to $106.8 million for the year ended December 31, 2005, an increase of 40.4%. The increase was principally attributable to the growth in the cash and fixed maturities portfolio from $2,996.9 million at December 31, 2005 to $3,470.0 million at December 31, 2006, resulting from cash flow from operations since December 31, 2005 and the additional capital we raised in the fourth quarter of 2005 in connection with a public offering of our common shares. The average annualized investment yield on the cash, fixed maturities investments and funds withheld by clients for the year ended December 31, 2006 was 4.7% compared to 4.2% for the year ended December 31, 2005 reflecting an increase in average interest rates in 2006 compared to 2005.
On December 28, 2006, as part of our plan to reduce the alternative investment allocation, Max Re consummated the sale of one of its private equity investments, an approximately 5% interest in DaVinci Re Holdings Ltd. and its operating subsidiary DaVinci Reinsurance Ltd., a Bermuda property catastrophe reinsurer, for a sale price equal to book value.
The return for the year ended December 31, 2006 is net of $35.0 million stemming from energy trading losses in certain hedge fund investments included in our Diversified Arbitrage strategy. For 2006, the return from our Max Re Diversified fund of funds portfolio was 6.30%. This return reflected the returns available in the capital markets as represented by the average money market fund returning 4.82%, the Lehman Brothers Intermediate Aggregate Bond Index returning 4.32% and the Standard & Poors 500 Index returning 11.85%.
Interest expense. Interest expense was $12.4 million for the year ended December 31, 2006 compared to $8.0 million for the year ended December 31, 2005, an increase of 55.0%. Interest expense relates to interest on the bank loan at a rate based on LIBOR plus a spread and increased as LIBOR increased.
Interest expense was $8.0 million for the year ended December 31, 2005 compared to $4.0 million for the year ended December 31, 2004, an increase of 100.0%. Interest expense relates to interest on the bank loan at a rate based on LIBOR plus a spread and increased as LIBOR increased.
General and administrative costs. The increase in general and administrative costs over the last three years resulted principally from expenses associated with the expansion of our corporate staff. In addition, the increase in general and administrative expenses for the year ended December 31, 2006 results principally from increased fees for professional services related to the ARMC’s internal review announced on March 24, 2006 and reopened in October 2006 and the ongoing SEC investigation. In addition, included in general and administrative expenses are costs associated with the resignation of our former Chief Executive Officer and expenses related to our planned U.S. operation.
Liabilities for property and casualty losses. Property and casualty losses totaled $2,335.1 million at December 31, 2006 compared to $2,006.0 million at December 31, 2005, an increase of 16.4%. The increase in property and casualty losses was principally attributable to estimated losses associated with premiums earned during the year ended December 31, 2006, partially offset by losses paid of approximately $200.0 million and net positive development due to the re-estimation of liabilities on prior year reserves of approximately $30.5 million.
Losses and benefits recoverable from reinsurers. Losses and benefits recoverable from reinsurers totaled $538.0 million at December 31, 2006 compared to $453.6 million at December 31, 2005, an increase of 18.6%, principally reflecting losses ceded under our reinsurance and retrocessional agreements, partially offset by a reduction of recoveries of $15.0 million as a result of the re-estimation of liabilities on prior year reserves that had been ceded under our reinsurance agreements. Grand Central Re, our largest retrocessionaire, accounted for 41.3% of our losses and benefits recoverable at December 31, 2006. In September 2004, Grand Central Re requested that A.M. Best Company withdraw its financial strength rating. Consequently, A.M. Best Company has assigned a financial strength rating of “NR-4” to Grand Central Re. We retain funds from Grand Central Re amounting to approximately 93.6% of its loss recoverable obligations.
The principal component of the remainder of losses recoverable relates to amounts due from reinsurers of our property and casualty insurance risks. The loss recoverable from these reinsurers represent 36.7% of losses recoverable at December 31, 2006 and all but one of these reinsurers are presently rated “A-” or above by A.M. Best Company. Losses recoverable from the single reinsurer of our property and casualty risks rated below “A-” are less than 3% of total losses recoverable.
Bank loans. In February 2003, Max Re completed a $150.0 million sale of shares of Max Re Diversified to a third party financial institution. Simultaneous with the sale, Max Re entered into a total return swap with the purchaser of these shares whereby Max Re receives the return earned on the Max Re Diversified shares in exchange for a variable rate of interest based on LIBOR plus a spread. Max Re Diversified shares owned by Max Re with a fair value of $106.7 million at December 31, 2006 were pledged as collateral to which we are exposed to credit risk. Under GAAP, these transactions are viewed on a combined basis and are accounted for as a financing transaction, which results in the recording of a $150.0 million bank loan. In February 2005, the parties amended the swap transaction principally to extend the swap termination date to February 2007, with provisions for earlier termination in the event that we fail to comply with certain covenants. We are currently in discussions to amend the swap transaction, principally to extend the swap termination date.
insurance segment. The casualty business we generally write has a long claim-tail and it is expected that we will generate significant operating cash flow as we build loss and benefit reserves on our balance sheet. As we continue to diversify into property and property catastrophe business, which generally has a short claim-tail, and as losses are incurred, we expect to see changes in our operating cash flow levels. We believe that our loss and benefit reserves currently have an average duration of approximately five years and we expect to see increases in the amount of expected loss payments in future periods. We do not expect loss payments to exceed premiums written and collected and net investment income, and therefore expect to have continued positive cash flow. However, actual premiums written and collected, net investment income, and losses and benefits paid in any period could vary from our expectations and could have a meaningful effect on operating cash flow.
While we tailor our fixed maturities portfolio to expected loss and benefit payments, increased loss amounts or settlement of losses and benefits earlier than anticipated can result in greater cash needs. We maintain a meaningful working cash balance (typically greater than $100.0 million), have generated positive cash flow from operations in each of our seven years of operating history and can access our credit facility described in Note 15 of our audited consolidated financial statements. We believe that we currently maintain sufficient liquidity to cover existing requirements and provide for contingent liquidity. Nonetheless, it is possible that significant deviations in expected loss and benefit payments can occur, potentially requiring us to liquidate a portion of our fixed maturities portfolio at a gain or loss.
As a holding company, Max Re Capital’s principal assets are its investments in the common shares of its principal operating subsidiary, Max Re, and its other subsidiaries. Max Re Capital’s principal source of funds is from interest income on cash balances and cash dividends from its subsidiaries, including Max Re. The payment of dividends is limited under Bermuda insurance laws. In particular, Max Re may not declare or pay any dividends if it is in breach of its minimum solvency or liquidity levels under Bermuda law or if the declaration or payment of the dividends would cause it to fail to meet the minimum solvency or liquidity levels under Bermuda law. At December 31, 2006, Max Re, which is required to have approximately $295.0 million in statutory capital and surplus in order to pay dividends, had approximately $1,265.0 million in statutory capital and surplus.
The amounts in this table represent our gross estimates of known liabilities as of December 31, 2006 and do not include any allowance for claims for future events within the time period specified. Accordingly, it is highly likely that the total amounts paid out in the time periods shown will be greater than that indicated in the table.
The Financial Accounting Standards Board (FASB) issued SFAS 157-Fair Value Measurements. SFAS 157 establishes a framework for measuring the fair value in generally accepted accounting principles and expands disclosures about fair value measurements. This statement applies under other accounting pronouncements that require or permit fair value measurements. Accordingly, this Statement does not require any new fair value measurements, but the application of this Statement to existing accounting pronouncements will change current practice. SFAS 157 was issued in order to remove inconsistencies in fair value measurements between various accounting pronouncements. The effective date for SFAS 157 is for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We are currently evaluating the effect of the Statement on our consolidated financial statements.