We have entered into a lease for office space in London that contains approximately 2,000 square feet. The initial term of the lease expires in August 2007. The annual lease payments for this office is approximately £185,000, which is currently approximately $357,087.
During 2006, we assigned the lease on our office space in Dublin to another lessor with the consent of our landlord and moved to offices containing approximately 400 square feet. This lease expires on July 31, 2007, may be extended and may be cancelled prior to that date following three months notice. The annual lease payments for this office space is approximately $170,000.
The headquarters of Quanta U.S. Holdings and our other U.S. subsidiaries is located in New York, New York and, as of February 28, 2007, contains approximately 13,650 square feet. The term of the lease expires in February 2012 with an option to extend the lease term by an additional five years. The annual lease payment for this office starts at approximately $464,100 and increases in annual increments to approximately $555,220 at the end of the lease term. Our other offices in the U.S. are located in Hartford, Connecticut with a lease cost of approximately $293,350 per year.
Quanta Holdings was incorporated on May 23, 2003 as a Bermuda holding company formed to provide specialty lines insurance, reinsurance, risk assessment and risk technical services on a global basis through its affiliated companies. Since the beginning of 2005, we have participated in the Lloyd’s market, which is rated ‘‘A’’ by A.M. Best, through Syndicate 4000.
From the beginning of 2004 until the second half of 2006 we mainly provided specialty lines insurance and reinsurance services on a global basis and to a lesser extent risk assessment and risk technical services. Following A.M. Best’s rating action in the first quarter of 2006 in the wake of losses from the 2005 hurricanes and subsequent decisions by our Board of Directors after a review of strategic alternatives, we substantially ceased writing new business and began conducting a self-managed run-off of our remaining insurance and reinsurance businesses with the exception of our business at Lloyd’s which is more fully described below.
• We reduced the lease costs related to the New York offices of our U.S. subsidiaries from $2.5 million per year to approximately $0.5 million per year.
• We reduced our total general and administrative costs from $29.5 million (including $2.4 million in our Lloyd’s segment) in the first quarter of 2006 to $16.0 million (including $3.9 million in our Lloyd’s segment) in the fourth quarter of 2006.
The specialty insurance and reinsurance business that is subject to our self-managed run-off is still exposed to new losses on unexpired policies and adverse development on recorded loss and loss expense reserves. During the run-off we will continue to pay losses as they fall due and collect outstanding loss and loss expenses recoverable from our reinsurers. As we continue to run-off and wind-up our businesses we will be seeking, over time and subject to the approval of our regulators, to extract capital from our subsidiaries and dividend it or return it as capital to our holding company where it may be available to our stakeholders.
We believe that important factors that have a direct impact on the amount of capital that may ultimately be available to our stakeholders and the timing of when it will be available include our ability to (1) determine which portion of our business to maintain, commute, cancel, transfer, or otherwise mitigate, as the case may be, (2) mitigate exposures to our capital by purchasing additional reinsurance, (3) make available sufficient assets to facilitate distributions from our subsidiaries, (4) invest our assets in a way that balances risk with return and that is adequately matched with the expected payment periods of our obligations, (5) reduce our expenses, (6) manage our claims and collect premiums receivable and losses recoverable, (7) achieve the release of cash and investment encumbrances relating to reinsurance deposits and other security requirements, (8) manage our capital structure and (9) obtain the approval of our regulators to extract capital from our subsidiaries and distribute it to Quanta Holdings. This process will take a long period of time and require us to meet many conditions. We have engaged our regulators and have begun this process. To the extent any capital is released from our subsidiaries in the future, our Board of Directors will determine when and how much of those funds will be made available to our stakeholders.
With respect to our remaining policies with current and future exposure periods, our gross unearned premium reserves were approximately $119.2 million at December 31, 2006. Some of these policies have exposure periods that extend beyond one year. We believe that approximately 61.6% of our gross unearned premium reserves will be earned within one year. The balance will be earned after one year over the remaining term of the underlying exposure periods which can be up to 14 years. In the first quarter of 2007 we purchased 100% quota share reinsurance for future losses that may occur in our technical risk property product line from natural peril or catastrophe or accidental events. This reinsurance purchase resulted in approximately $4.8 million in ceded premium in the first quarter of 2007, and we believe that this significantly reduces our future net loss exposure from these events. We continue to seek to reduce these exposure periods through policy commutation, cancellation and loss portfolio transfers and, where appropriate, through the purchase of reinsurance protection.
As of December 31, 2006, our total capital was approximately $465.2 million, including our junior subordinate debentures and our redeemable preferred shares. This capital is subject to regulation in the following jurisdictions: approximately $272.5 million in Bermuda; approximately $104.7 million in the UK (Lloyd’s and the Financial Services Authority); approximately $65.7 million in the United States (mainly in Colorado and in Indiana); and approximately $22.1 million in the European Union unrelated to Lloyd’s and subject to the jurisdiction of the Irish Financial Services Regulatory Authority. The balance of our capital of approximately $0.2 million is held in our other non-insurance regulated subsidiaries.
During 2006, our business in Syndicate 4000 continued to operate in the ‘‘A’’ rated Lloyd’s market. On March 2, 2007, we restructured our investment in Syndicate 4000 by committing to support 90% of the syndicate’s 2007 capital requirements and by attracting the remaining commitment of 10% of that capital requirement from Chaucer Plc., a third party. We also established Pembroke Managing Agency to act as the managing agent for Syndicate 4000. While we own 15% of Pembroke Managing Agency, the majority is owned by Chaucer and the senior management of Syndicate 4000. We believe that this structure aligns management with the interest of the capital providers of Syndicate 4000. We intend to continue to seek third party capital for Syndicate 4000.
Our Lloyd’s segment recorded $91.8 million and $61.7 million in gross and net written premiums in the year ended December 31, 2006 as compared to $80.7 million and $61.6 million in gross and net written premiums in the year ended December 31, 2005. The syndicate generated net earned premium of $65.5 million and $36.5 million in the years ended December 31, 2006 and 2005. Its net loss ratio was 76.9% and 67.5% in 2006 and 2005. We believe that the levels of gross premium written and earned in Syndicate 4000 were lower than expected in 2006 as a result of the uncertainty following our A.M. Best downgrade and the subsequent decision to engage in a self- managed run-off of our other
In 2006, we generated approximately $80.6 million of net premiums written, including $61.7 million from Syndicate 4000, after premiums ceded on purchased reinsurance protection as compared to approximately $390.0 million of net premiums written, after premiums ceded on purchased reinsurance protection in 2005. The reduction reflects our decision to engage in a self-managed run-off as well as the purchase of more reinsurance protection in 2006 than in 2005 and the return of premiums of approximately $97.8 million to our clients as we sought to reduce our loss exposures through policy cancellations.
Our net losses and loss expenses incurred were $156.1 million in 2006 as compared to $324.2 million in 2005. Our loss ratio, which is a function of our selected ultimate loss ratios and specific loss events, was 69.3% in 2006 as compared to 89.0% in 2005. In 2006 we recorded net favorable development in the selection of certain prior period accident year ultimate net loss ratios in
Our general and administrative expenses in 2006 were $100.0 million, including $12.9 million of direct expenses related to our Lloyd’s business. Our general and administrative expenses excluding those direct costs associated with our Lloyd’s business were $87.1 million in 2006 as compared to $100.9 million in 2005. Since December 31, 2005, we have reduced our workforce, excluding Lloyd’s, from 183 employees as of December 31, 2005 to 81 employees as of December 31, 2006. Our workforce is now allocated to underwriting in our Lloyd’s syndicate, run-off of our exited business lines, claims handling, finance, actuarial, general corporate and administrative functions. During the years ended December 31, 2006 and 2005, we recorded severance costs of approximately $14.3 million and $6.4 million as a result of employee reductions following our decision to place our specialty insurance and reinsurance lines, other than Syndicate 4000, into self-managed run-off. This severance cost relates to the cost associated with those employees who have been provided notice and those who we expect to be terminating in the future. We continue to seek to reduce our general and administrative expenses (including through further employee reductions) and expect, barring unforeseen circumstances, that our 2007 general and administrative expenses will be lower than those incurred during 2006.
In 2006 we also recorded amortization and impairment charges of $1.7 million with respect to our intangible assets associated with our U.S. insurance licenses. At December 31, 2006, the carrying value of these licenses approximates their estimated net realizable value.
Our investment portfolio yielded net investment income and net realized losses of $30.0 million during the year ended December 31, 2006, an increase of $15.8 million from the year ended December 31, 2005. This increase is primarily attributable to an increase in our invested assets and higher market interest rates. Our average annualized effective yield (calculated by dividing net investment income by the average amortized cost of invested assets, net of amounts payable or receivable for investments purchased or sold) was approximately 5.0% for the year ended December 31, 2006 compared to 3.5% for the year ended December 31, 2005, reflecting higher market interest rates.
the affected investments were reduced to their estimated fair value, which becomes their new cost basis. The recognition of the losses within net realized losses on investments has no effect on our shareholders’ equity, the market value of our investments, our cash flows or our liquidity.
• Technical services. Prior to the sale of ESC in the third quarter of 2006, our technical services segment provided diversified environmental investigation, remediation and engineering services, assessment services, other technical and information management services primarily in the environmental area in the U.S. Our technical services segment also provided technical and information management services to our specialty insurance run-off and reinsurance run-off segments. Following the sale of ESC, the technical services segment consists of our two environmental liability assumption programs. The results for the prior years have been reclassified to conform with the presentation of ESC in discontinued operations for the year ended December 31, 2006.
We have created a Lloyd’s operating segment for the results of Syndicate 4000 which was previously aggregated with our specialty insurance run-off reportable segment. We believe it is no longer appropriate to aggregate Lloyd’s and specialty insurance run-off operating segments given the different economic characteristics of the specialty insurance run-off segment that is no longer writing new or renewal business while our Lloyd’s syndicate continues to write new and renewal business.
During the fourth quarter of 2006 we ceased allocating our indirect corporate, general and administrative expenses to our operating segments. Prior to the fourth quarter of 2006, we allocated
corporate general and administrative expenses to each segment based upon each product line’s allocated capital for the relevant reporting period. We allocated capital to each of our product lines through the estimated value-at-risk method, which used statistical analyses of historical market trends and volatility to estimate the probable amounts of capital at risk for each reporting period. Since our decision to conduct a self-managed run-off of most of our businesses, we no longer allocate capital to our segments and corporate expenses are no longer evaluated at the segment level. We also do not allocate net investment income, and depreciation and amortization at the segment level.
We record premiums written at the time that there is sufficient evidence of agreement to the significant terms of the contract but no earlier than the effective date of the policy. The amount of our insurance and reinsurance premiums written and earned depends on the number and type of policies we write, the amount of reinsurance protection we provide, as well as prevailing market prices. Furthermore, the amount of net premiums earned depends upon the type of contracts we have written, the contractual periods of the contracts we write, policy cancellations and commutations, the inception date of the contracts, the expired portions of the contract periods and the type of purchased reinsurance protection. Because of all these factors, the amount of premiums written and ceded may not result in a correlative level of profitability.
Our investment income depends on the average invested assets in our investment portfolios and the yield that we earn on those invested assets. Our investment yield is a function of market interest rates and the credit quality and maturity period of our invested assets. Our investment portfolio consists principally of fixed income securities, short-term investments, cash, and cash equivalents. In addition, we realize capital gains or losses on sales of investments as a result of changing market conditions, including changes in market interest rates and changes in the credit quality of our invested assets. We also recognize capital losses on investments as a result of other than temporary impairment charges. Under U.S. GAAP, our available-for-sale investments are carried at fair market value with unrealized gains and losses, to the extent we believe that such losses are temporary, on the investments included on our balance sheet in accumulated other comprehensive income (loss) net of income taxes as a separate component of shareholders’ equity. Our trading investments that relate to
deposits associated with non-risk bearing contracts are recorded at estimated fair value with the change in fair value included in net realized gains and losses on investments in the consolidated statement of operations and comprehensive loss. The objective of our current investment strategy is to preserve investment principal, maintain liquidity and manage duration risk between investment assets and insurance liabilities (when they become due, at the time of either loss settlement, cancellations or commutations), while maximizing investment returns through a diversified portfolio.
Our expenses primarily consist of net loss and loss expenses, general and administrative expenses and acquisition expenses.
General and administrative expenses consist primarily of personnel related expenses (including severance costs), professional fees, leases and other operating overheads. From time to time we engage administrative service providers and legal, accounting, tax and financial advisors. These general and administrative expenses may be incurred directly by a segment or indirectly at the corporate level.
Until the sale of ESC in September 2006, we also incurred expenses directly related to and arising from our environmental remediation activities. These direct costs primarily include remediation contract related expenses. These costs are a function of, and are proportional to, the level of remediation revenues earned from the completion of remediation activities.
Substantially all of our revenues were generated by our underwriting subsidiaries in the U.S., Bermuda and Europe. Technical services revenues were derived from the operations of ESC until its sale on September 16, 2006 and from the operations of our environmental liability assumption programs.
Net investment income and net realized losses. Net investment income and net realized losses totaled $30.0 million for the year ended December 31, 2006, an increase of $15.8 million compared to $14.2 million for the year ended December 31, 2005. The increase is primarily due to an increase in net investment income of $18.7 million because of our larger amount of invested assets and increases in market interest rates, which is offset by an increase in net realized losses of $2.9 million, of which $16.9 million is attributable to other than temporary impairment losses recognized during the year ended December 31, 2006, compared to other than temporary losses of $10.2 million in 2005.
Net investment income was $45.9 million for the year ended December 31, 2006 an increase of $18.7 million, or 69.0% compared to $27.2 million for the year ended December 31, 2005. This was derived primarily from interest earned on fixed maturity and short term investments plus amortization of discounts on fixed maturity investments, partially offset by investment management fees. Our average annualized effective yield (calculated by dividing net investment income by the average amortized cost of invested assets, net of amounts payable or receivable for investments purchased or sold) was approximately 5.0% for the year ended December 31, 2006 compared to 3.5% for the year ended December 31, 2005, reflecting rises in market interest rates. Net realized losses of $15.9 million were generated primarily from our other than temporary impairment charge of $16.9 million and also as we sought to manage our total investment returns and the duration of our investment portfolios.
As of December 31, 2006, the average duration of our investment portfolio was approximately 2.5 years with an average credit rating of approximately ‘‘AA+’’, compared to 2.6 years with an average credit rating of approximately ‘‘AA+’’ as at December 31, 2005.
• the reduced number of insurance and reinsurance contracts we entered into and the associated net premiums earned as our insurance and reinsurance portfolios begin to run-off;
• the limited number of natural catastrophe events reported during 2006 compared to 2005 to which our in-force contracts were exposed;
In estimating reserves we may utilize a variety of standard actuarial methods that we believe are in line with industry practice, including the expected loss ratio method, the Bornhuetter-Ferguson method, paid loss development method and reported loss development method. The loss reserves are based on the loss development characteristics of the specific line of business and specific contracts within that line of business and considers coverage, type of business, maturity of loss data and claims.
General and administrative expenses. General and administrative expenses were $100.0 million for the year ended December 31, 2006, a decrease of $9.6 million, or 8.8%, compared to $109.6 million for the year ended December 31, 2005. General and administrative expenses were comprised of
Depreciation and amortization of intangible assets. Depreciation, amortization and impairment of intangible assets was $5.0 million for the year ended December 31, 2006, an increase of $2.0 million compared to $3.0 million for the year ended December 31, 2005. The majority of the increase relates to an impairment charge of $1.7 million with respect to our intangible assets associated with our U.S. insurance licenses. At December 31, 2006, the carrying value of these licenses approximates their estimated net realizable value. We also wrote-off approximately $0.8 million of leasehold improvements during the fourth quarter of 2006 associated with our anticipated relocation of our New York operations.
Technical services revenues. Technical services revenues were $22.0 million for the period ended December 31, 2006 compared to $50.8 million for year ended December 31, 2005. The decrease is mainly due to ESC generating significant inter-company revenue for the remediation of the sites of one of our environmental liability assumption programs during the second and third quarter of 2005 as compared to the period from January 1, 2006 to September 15, 2006 when there was much less remediation activity. The decrease is also due to our exit from the environmental insurance business during the first half of 2006.
Loss on impairment of goodwill. Loss on impairment of goodwill was $12.6 million for the period ended December 31, 2006 and relates to our determination that the carrying value of its previously carried goodwill asset related to ESC was impaired during the second quarter of 2006.
Years ended December 31, 2005 compared to year ended December 31, 2004
Substantially all of our revenues were generated by our underwriting subsidiaries in the U.S., Bermuda and Europe. Technical services revenues were derived from the operations of ESC and our two environmental liability assumption programs.
Premiums. Gross premiums written were $608.9 million for the year ended December 31, 2005, an increase of $114.5 million, or 23.2%, compared to $494.4 million for the year ended December 31, 2004. The increase in our gross premiums written was largely due to the contribution of $80.7 million, or 13.3%, of our gross premiums written, from our Lloyd’s syndicate, which commenced during December 2004. The increase also reflected continued growth in all of our specialty insurance segment product lines and our marine, technical risk and aviation product line in our specialty reinsurance segment. Shortly after Hurricane Rita, we discontinued writing new and most renewal business in our technical risk property and property reinsurance lines of business (other than our program business), which accounted for approximately $97.1 million, or 15.9%, of our gross premium written during the year ended December 31, 2005.
Net premiums earned were $364.1 million for the year ended December 31, 2005, an increase of $127.0 million, or 53.5%, compared to $237.1 million for the year ended December 31, 2004, reflecting the growth in premiums written and the earning and amortization of premiums written and ceded during the years ended December 31, 2004 and 2005. Our net premiums written are typically earned over the risk periods of the underlying insurance policies which are generally twelve months. Net premiums written that are not yet earned and are deferred as unearned premium reserves, net of deferred reinsurance premiums, totaled $224.5 million at December 31, 2005 and were earned and recognized in our results of operations in 2006.
Technical services revenues. Technical services revenues were $19.0 million for the year ended December 31, 2005 an increase of $18.6 million, compared to $0.4 million for the year ended December 31, 2004. This increase in technical services revenues was primarily attributable to increased remediation revenues associated with our liability assumption program in Buffalo, New York.
Net investment income and net realized (losses) gains. Net investment income and net realized (losses) gains totaled $14.2 million for the year ended December 31, 2005, a decrease of $0.3 million, or 2.6%, compared to $14.5 million for the year ended December 31, 2004. The decrease was primarily due to an increase in net investment income of $12.9 million because of our larger amount of invested assets and rises in market interest rates, which was offset by an increase in net realized losses of $13.2 million, of which $10.2 million was attributable to other than temporary impairment losses recognized during the year ended December 31, 2005.
Net investment income was $27.2 million for the year ended December 31, 2005 and was derived primarily from interest earned on fixed maturity and short term investments, partially offset by investment management fees and amortization of discounts on fixed maturity investments. Our average annualized effective yield (calculated by dividing net investment income by the average amortized cost of invested assets, net of amounts payable or receivable for investments purchased or sold) was approximately 3.5% for the year ended December 31, 2005, compared to 2.7% for the year ended December 31, 2004, reflecting rises in market interest rates. Net realized losses of $13.0 million were generated primarily from our other than temporary impairment charge of $10.2 million and also as we sought to manage our total investment returns and the duration of our investment portfolios.
Net losses and loss expenses. Net losses and loss expenses were $324.2 million for the year ended December 31, 2005, an increase of $125.3 million, or 63.0%, compared to $198.9 million for the year ended December 31, 2004. Net losses and loss expenses are a function of our net premiums earned and our expected ultimate losses and loss expenses for reported and unreported claims on contracts of insurance and reinsurance underwritten. The increase in net losses and loss expenses was due to:
• general reserve strengthening relating primarily to our HBW program, Lloyd’s, professional and environmental lines.
Included in our expected ultimate losses during the year ended December 31, 2005 are specific loss estimates on contracts of reinsurance and insurance insuring claims arising from Hurricanes Katrina, Rita and Wilma. Our preliminary loss estimates for the 2005 hurricanes totaled $83.3 million (excluding the negative impact of reinstatement premiums of $4.1 million), which was included in net losses and loss expenses for the year ended December 31, 2005, compared to $61.3 million included in net losses and loss expenses for the year ended December 31, 2004 from Hurricanes Charley, Frances, Ivan and Jeanne. Our estimate of our exposure to ultimate claim costs associated with these hurricanes was primarily based on currently available information, claims notifications received to date, industry loss estimates, output from industry models, a review of affected contracts and discussions with cedents and brokers.
With respect to the year ended December 31, 2005, in establishing our reserves for losses and loss expenses, we reviewed reserve estimates of an actuary employed with our company and of an external actuarial specialist. Our reserves for losses and loss expenses were also reviewed by our independent registered public accounting firm during its auditing procedures. We recorded these reserves as of the year ended December 31, 2005 based on the highest aggregate reserve amount of the estimates we reviewed. As part of our year-end closing process, we strengthened our loss reserves for 2005 by approximately $13.2 million. Given the immaturity of our business and very limited claims history, we relied on pricing, loss and expense data accumulated by our consulting actuary, historical industry results, and to a limited extent, our own reported claims history in establishing loss ratios for each line of business. Although we had not experienced significant reported claims in our casualty insurance line, we worked closely with our independent loss specialist and concluded to generally strengthen our loss ratios in our HBW program, Lloyd’s and environmental lines with respect to the year ended December 31, 2005.
states and no longer needed to utilize fronting companies to the same extent in order to write our business. Third, our ceding commission income that we were recovering on our specialty insurance segment’s reinsurance treaties increased during 2005 as a result of the restructuring of those treaties during the second quarter of 2005. Finally, we paid less commission in our HBW program during 2005 because the contracts contain sliding scale commission provisions that vary with changes in the selected loss ratio. Deferred acquisition costs include, as of December 31, 2005, $33.1 million of acquisition expenses on written contracts of insurance and reinsurance that will be amortized in future periods as the premiums written to which they relate are earned.
Interest expense. Interest expense was $4.2 million for the year ended December 31, 2005, an increase of $4.1 million compared to $0.1 million for the year ended December 31, 2004 and related to the interest expense on our junior subordinated debentures.
Prior to the second quarter of 2006, we principally provided insurance and reinsurance protection for risks that are often unusual or difficult to place, that did not fit the underwriting criteria of standard commercial product carriers and that required extensive technical underwriting and assessment resources in order to be profitably underwritten. Following our decision to engage in a self-managed run-off, we changed the composition of our reportable segments to recognize that our run-off insurance and run-off reinsurance segments were the specialty insurance run-off and specialty reinsurance run-off segments respectively, and to separate the Lloyd’s operating segment from our specialty insurance run-off reportable segment.
In the fourth quarter of 2006 we revised our expense allocation methodology to only allocate direct general and administrative expenses among our segments. Indirect corporate general and administrative expenses are no longer allocated and this has been reflected in the years ended December 31, 2006, 2005 and 2004.
The following is a discussion of our net underwriting results and profitability measures by segment for the years ended December 31, 2006, 2005 and 2004.
(2) Negative premium amounts reflect the impact of premiums returned to our clients on policy cancellation.
Net premiums earned during the year ended December 31, 2006 were $113.3 million, a decrease of $47.3 million, compared to $160.6 million for the year ended December 31, 2005, representing the reductions of premiums written and the return of premiums to our clients. Gross premiums written and ceded premiums are earned over the period of each insured risk. The terms of our insurance contracts range from between one and ten years with the majority of our contracts being for a one year period.
• favorable development in our ultimate loss ratio selections in certain product lines, particularly in our professional insurance product line in which our selected ultimate net loss ratio for maturing accident periods has reduced to approximately 61.6% in 2006 from approximately 68.2% in 2005, resulting in a reduction of net loss and loss expense reserves of approximately $3.5 million.
We incurred net losses and loss expenses of approximately $3.9 million related to the tornadoes that occurred in the first quarter of 2006. Our estimated ultimate losses during the year ended December 31, 2006 also included estimated gross and net losses of $5.2 million and $2.6 million related to damage caused by an oil pipeline in California which ruptured during a mudslide in the first quarter of 2005, for which the damage is covered by an insurance contract written in our environmental liability product line. There remains the possibility of further negative development on this loss in the future, particularly if the timing of the completion of the remediation plan for the spill is further delayed. Offsetting this adverse development during 2006, we recorded approximately $13.9 million of net favorable development to several of our insurance product lines for which actual loss experience in maturing accident periods was better than expected. We continue to participate in lines of business where claims may not be reported for some period of time after those claims are incurred.
Our specialty insurance run-off segment net loss ratio was 58.0% for the year ended December 31, 2006 a decrease of 17.2% compared to a net loss ratio of 75.2% for the year ended December 31, 2005. The decrease in the specialty insurance run-off segment net loss ratio is primarily due to the significant loss estimates arising in 2005 from Hurricanes Katrina, Rita and Wilma as well as to the loss estimates arising in 2005 from the ruptured oil pipeline loss. The 2005 hurricanes did not contribute any loss ratio percentage points to the specialty insurance run-off segment net loss ratio in 2006 compared to 7.0% in 2005. As discussed above, the reduction in certain of our product lines ultimate net loss ratios for more mature accident periods also contributed to the lower insurance run-off segment net loss ratio in 2006.
General and administrative expenses. General and administrative expenses totaled $18.4 million for the year ended December 31, 2006 compared to $21.8 million for the year ended December 31, 2005. The decrease in our general and administrative expense was due to the cost saving measures taken in response to discontinuing writing new and renewal business in 2006.
The negative gross written premium on our marine, technical risk and aviation product line was primarily due to cancellations of certain treaty contracts and reductions in estimated reinsurance premiums written on certain of our treaty quota share contracts, resulting in reduced premiums.
Net losses and loss expenses. Net losses and loss expenses were $40.0 million for the year ended December 31, 2006 compared to $178.9 million for the year ended December 31, 2005. The decrease in net losses and loss expenses incurred was due to lower net earned premium in 2006 and to fewer significant loss occurrences, particularly compared to those related to the 2005 hurricanes. Net losses and loss expenses are also a function of our net premiums earned and our expected ultimate losses and loss expenses for reported and unreported claims on contracts of reinsurance underwritten.
General and administrative expenses. Direct general and administrative expenses totaled $6.4 million for the year ended December 31, 2005 compared to $9.8 million for the year ended December 31, 2006, reflecting the cost saving measures taken during 2006 in response to the decision to run-off most of our remaining reinsurance lines.
The table below shows gross and net premiums written by product line for the years ended December 31, 2006 and 2005.
Net premiums earned during the year ended December 31, 2006 were $65.5 million, an increase of $29.0 million, compared to $36.5 million for the year ended December 31, 2005, representing the earning and expensing of premiums written and ceded during the years ended December 31, 2004, 2005 and 2006. The increase in our net premiums earned was largely due to the growth of our net premiums written by Syndicate 4000. This increase was partially offset by the effect of the A.M. Best’s ratings downgrade and subsequent uncertainties around the business and achievements of gross premium estimates resulting in the acceleration of the minimum ceded earned premium as described above. Gross premiums written and ceded premiums are being earned over the period of each insured risk which is typically one year.
Net losses and loss expenses. Net losses and loss expenses were $50.4 million for the year ended December 31, 2006, an increase of $25.7 million, compared to $24.7 million for the year ended
Our Lloyd’s segment net loss ratio was 76.9% for the year ended December 31, 2006, an increase of 9.4% compared to a net loss ratio of 67.5% for the year ended December 31, 2005. The increase in the Lloyd’s segment net loss ratio is primarily due to the effect of the excess of loss reinsurance contract we entered into that requires us to cede minimum fixed amounts of our premium, regardless of the amount of gross premium written in Syndicate 4000 in the year ended December 31, 2006
Acquisition expenses. Acquisition expenses were $12.0 million for the year ended December 31, 2006, an increase of $6.9 million compared to $5.1 million for the year ended December 31, 2005. The increase in acquisition expenses was driven by a higher level of earned premium in 2006.
General and administrative expenses. General and administrative expenses were $12.9 million for the year ended December 31, 2006, an increase of $4.2 million, compared to $8.7 million for the year ended December 31, 2005. The increase in our general and administrative expense from 2005 to 2006 was mainly due to the fact that 2005 was a start-up year for Syndicate 4000 and 2006 reflects the general and administrative expenses of a fully operating Syndicate 4000, including an additional number of employees hired throughout 2006 as well as increases in contributions to Lloyd’s central fund and managing agent expenses. General and administrative expenses includes a number of fixed costs including the Lloyd’s central fund contributions which are based on a percentage of underwriting capacity set at the start of the underwriting year, and employee and related expenses.
The following table summarizes and compares our technical services segment results for the years ended December 31, 2006 and 2005.
Premiums. Gross and net premiums written were $311.3 million and $194.9 million for the year ended December 31, 2005 compared to $236.4 million and $164.8 million for the year ended December 31, 2004. The increase reflected continued growth in all of our specialty insurance run-off segment product lines. However, shortly after Hurricane Rita, we discontinued writing new and most renewal business in our technical risk property line of business (other than our program business), which accounted for approximately $13.4 million, or 3.4%, of our specialty insurance run-off segment’s gross premiums written during the year ended December 31, 2005. We also retroceded substantially all the in-force business, as of October 1, 2005, in this line (other than our program business) by a portfolio transfer to a third-party reinsurer.
During the year ended December 31, 2005, we continued to write the HBW program in our technical risk property product line which accounted for approximately $165.9 million, or 88.5%, of the technical risk property line of business and 53.3% of total specialty insurance run-off segment gross premiums written in the year ended December 31, 2005. The HBW program accounted for $108.9 million, or 95.2%, of the technical risk property product line and 46.1% of the total Specialty insurance run-off segment gross premiums written for the year ended December 31, 2004. We are no longer writing business in our technical risk property line other than the programs that are part of that line. The policies in the program are underwritten by a third-party agent which follows our underwriting guidelines.
Premiums ceded were $116.4 million during the year ended December 31, 2005, an increase of $44.7 million compared to $71.7 million for the year ended December 31, 2004. The increase in premiums ceded reflects the increase in our gross premiums written, approximately $10.6 million of premiums ceded resulting from the October 2005 portfolio transfer of substantially all of our in-force technical risk property insurance and property reinsurance business and approximately $5.5 million from reinsurance treaties that we have entered into for our specialty insurance run-off product lines to help limit our net loss exposures to natural catastrophe events. The increase of premiums ceded is attributable to a lesser extent to the development of the reinsurance program for our specialty insurance run-off segment product lines, which was restructured during the year ended December 31, 2005, as described above.
Net losses and loss expenses. Net losses and loss expenses were $120.7 million for the year ended December 31, 2005, an increase of $71.5 million compared to $49.2 million for the year ended December 31, 2004. Net losses and loss expenses are a function of our net premiums earned and our expected ultimate losses and loss expenses for reported and unreported claims on contracts of insurance and reinsurance underwritten. The increase in net losses and loss expenses is due to:
• the increase in loss occurrences, particularly those related to the 2005 hurricanes and the first quarter 2005 rupture of an oil pipeline in California during a mudslide;
• the growth in the number of insurance contracts we entered into and the associated net premiums earned; and
Included in our expected ultimate losses in our specialty insurance run-off segment during the year ended December 31, 2005 are specific loss estimates on contracts of insurance insuring claims arising from Hurricanes Katrina, Rita and Wilma. Our estimate of our specialty insurance run-off segment’s exposure to ultimate claim costs associated with these hurricanes was $11.4 million (excluding the negative impact of net reinstatement premiums of $2.5 million), compared to $0.6 million included in net losses and loss expenses for the year ended December 31, 2004 from Hurricanes Charley, Frances, Ivan and Jeanne. Our preliminary estimate of our exposure to ultimate claim costs associated with these hurricanes is based on currently available information, claims notifications received to date, industry loss estimates, output from industry models, a review of affected contracts and discussion and brokers.
Given the immaturity of our business and very limited claims history, we have relied on pricing, loss and expense data accumulated by our consulting actuary, historical industry results, and to a limited extent, our own reported claims history in establishing loss ratios for each line of business. Although we have not experienced significant reported claims in our specialty insurance run-off lines, other than those related to the 2005 hurricanes and the oil pipeline claim, we have worked closely with our independent loss specialist and concluded to generally strengthen our loss ratios in our HBW program, Lloyd’s and environmental lines with respect to the year ended December 31, 2005.
pipeline in California which ruptured during a mudslide in the first quarter of 2005, for which the damage is covered by an insurance contract issued by our environmental liability product line.
Our specialty insurance run-off segment net loss ratio was 75.2% for the year ended December 31, 2005 an increase of 8.9% compared to a net loss ratio of 66.3% for the year ended December 31, 2004. The increase in the specialty insurance run-off segment net loss ratio is due to the loss estimates arising from Hurricanes Katrina, Rita and Wilma as well as to the loss estimates arising from the ruptured oil pipeline loss. However, the extent of the impact of the actual catastrophes in 2005 was mitigated by our purchased reinsurance protection in our specialty insurance run-off segment and increased net premiums earned in our specialty insurance run-off segment compared to the year ended December 31, 2004. The 2005 hurricanes contributed 7.0% loss ratio percentage points to the specialty insurance run-off segment net loss ratio.
Premiums. Gross and net premiums written were $216.9 million and $133.5 million for the year ended December 31, 2005 compared to $251.8 million and $249.2 million of gross and net premiums for the year ended December 31, 2004. The decrease in our specialty reinsurance run-off segment’s net premiums written reflects the decrease in our property and casualty reinsurance business lines as a result of our decision to discontinue the writing of new and renewal business in our property reinsurance business line and the commutation of two treaties in our casualty reinsurance business line. The decline was partially offset by growth in our marine reinsurance business line during 2005.
Net premiums earned of $166.9 million for the year ended December 31, 2005 have increased by $5.0 million compared to $161.9 million for the year ended December 31, 2004. The increase reflects the earning of premiums on contracts written during the years ended December 31, 2005 and 2004 and is offset by the impact of the decision to discontinue the writing of new and renewal business in our property reinsurance line of business, the October 2005 portfolio transfer of substantially all of our in-force technical risk property insurance and property reinsurance business, the commutation of two treaties in our casualty reinsurance business line and the purchase of additional retrocessional protection. Gross premiums written in our specialty reinsurance run-off segment are being earned over the periods of reinsured or underlying insured risks which are typically one year.
Our specialty reinsurance run-off segment net loss ratio was 107.2% for the year ended December 31, 2005 compared to 92.1% for the year ended December 31, 2004. The increase in the specialty reinsurance run-off segment net loss ratio is due to the magnitude of the loss estimates arising from Hurricanes Katrina, Rita and Wilma described above. However, the extent of the impact of the actual catastrophes in 2005 was mitigated by our purchased retrocessional protection during the year ended December 31, 2005. The 2005 hurricanes contributed 43.7% loss ratio percentage points to the segment loss ratio.
Premiums. Gross and net premiums written were $80.7 million and $61.6 million for the year ended December 31, 2005 compared to $6.1 million and $5.6 million for the year ended December 31, 2004. The increase in our gross premiums written was largely due to the continued growth in our Lloyd’s segment, which commenced operations in December 2004.
Premiums ceded were $19.1 million during the year ended December 31, 2005, an increase of $18.5 million, compared to $0.6 million for the year ended December 31, 2004. The increase in premiums ceded reflects the increase in our gross premium written described above.
Net premiums earned during the year ended December 31, 2005 were $36.5 million, an increase of $35.6 million, compared to $0.9 million for the year ended December 31, 2005, representing amortization of premiums written and ceded during the years ended December 31, 2005 and 2004. The increase in our net premiums earned was largely due to the growth of our net premiums written from our Lloyd’s syndicate, which commenced in December 2004. Gross premiums written and ceded premiums are being earned over the period of each insured risk which is typically one year.
Net losses and loss expenses. Net losses and loss expenses were $24.7 million for the year ended December 31, 2005, an increase of $24.1 million, compared to $0.6 million for the year ended December 31, 2004. Net losses and loss expenses are a function of our net premiums earned and our expected ultimate losses and loss expenses for reported and unreported claims on contracts of insurance underwritten. The increase in net losses and loss expenses is primarily due to the increase in our net premiums earned in 2005 as a result of commencing operations in December 2004.
General and administrative expenses. Direct general and administrative expenses were $18.5 million for the year ended December 31, 2005, an increase of $17.7 million, compared to $0.8 million for the year ended December 31, 2004. The increase is attributable to increased staffing levels, higher overhead allocation arising from the development of our infrastructure and Sarbanes- Oxley Section 404 compliance efforts, and professional fees associated with the environmental liability assumption program in Buffalo, New York.
The analysis of consolidated losses and loss expense development shown below presents the subsequent development of our estimated year end liability for net loss and loss expenses at the end of each balance sheet date for all periods ended December 31, net of loss and loss adjustment expenses recoverable. The top line of the table shows our estimated liability for unpaid losses and loss expense reserves, net of loss and loss expenses recoverable, recorded at the balance sheet date for each of the indicated periods. This net liability for loss and loss expenses represents the estimated amount of losses and loss expenses for claims arising from all prior years’ accident periods that were unpaid at the balance sheet date. The upper portion of the table shows our re-estimated amount of the previously recorded net liability as of the end of each succeeding year. The estimate for our liability for loss and loss expense changes as more information becomes known about the frequency and severity of claims for individual years and, accordingly, as we update our actuarial techniques and selections of the appropriate method. The ‘‘Cumulative deficiency (redundancy)’’ line represents the aggregate change in our estimates over all prior years. The lower portion of the table presents the amounts paid as of subsequent periods on those claims for which we recorded reserves as of each
balance sheet date. Conditions and trends that have affected development of the liabilities in the past may not necessarily be indicative of events or development that may occur in the future. Accordingly, it is not appropriate to extrapolate future redundancies or deficiencies based on the tables below.
Prior to 2005 we had not experienced significant favorable or adverse development in our estimation of loss and loss expense reserves since we started our operations in 2003 and only wrote a small number of contracts during that year. We grew and diversified our product lines during 2004 and 2005.
In 2004 we recorded approximately $61.3 million in net loss and loss expenses in our property and marine reinsurance product lines associated with the four 2004 Florida hurricanes, Charley, Frances, Ivan and Jeanne. During the year ended December 31, 2005, we increased these loss estimates to approximately $67.2 million as additional information was reported to us by clients and others. This adverse development of $5.9 million was partially offset in 2005 by net favorable development of approximately $1.9 million in certain of our other short-tail policies and product lines, which began to mature with actual loss experience that was better than our expected losses recorded during or before 2004. In 2006, we saw further favorable experience in our 2004 reserves as a result of lower than expected actual reported losses. We also transitioned our ultimate loss selection method in our professional insurance product line from the expected loss ratio method to the Bornhuetter-Ferguson method which reduced our 2004 and 2005 accident period reserves by approximately $3.5 million in 2006.
In addition to the favorable loss development of $3.5 million in our professional insurance product line described above, in 2006 we also recorded approximately $10.4 million of net favorable
As a holding company, Quanta Holdings has and will continue to have funding needs for general corporate expenses, the payment of principal and interest on borrowings, dividends on our preferred shares, taxes, and the payment of other obligations. Funds to meet these obligations are expected to come primarily from dividends, interest, return of capital and other statutorily permissible payments from our operating subsidiaries. We believe that the operating subsidiaries have sufficient assets to pay their respective currently foreseen insurance liabilities as they become due. However, the ability of our operating subsidiaries to make payments to Quanta Holdings is limited by the applicable laws and regulations of the domiciles in which the subsidiaries operate. These laws and regulations subject our subsidiaries to significant restrictions and require, among other things, the maintenance of minimum solvency requirements and limitations regarding the amount of dividends, or the approval of certain regulators in the event of a return of capital, that these subsidiaries can ultimately pay to Quanta Holdings. In addition, following the withdrawal of our A.M. Best rating, the Bermuda Monetary Authority, the regulator of our most significant subsidiary, Quanta Bermuda, amended Quanta Bermuda’s license to, among other things, restrict it from making any dividend payments to Quanta Holdings without the approval of the BMA or to enter into new transactions. Additionally, there remain significant restrictions regarding our ability to remove the funds deposited to support our underwriting capacity of Syndicate 4000 at Lloyd’s. We are working with applicable regulatory authorities to facilitate our ability, as the business we wrote expires over time, to pay dividends or return capital from our insurance operating subsidiaries to the holding company. The paying of dividends or return of capital to the holding company will require regulatory approval. In addition, because we have regulated subsidiaries which are owned by other regulated subsidiaries, which we refer to as ‘‘stacked subsidiaries,’’ obtaining approval to dividend funds or return capital requires the approval of a number of regulators before the funds can be made available to Quanta Holdings. Working with these regulators takes a significant amount of time, requires many steps, may result in payments of smaller amounts of funds from one subsidiary to another or to Quanta Holdings and we will be required to meet many conditions. For further information regarding these restrictions, see ‘‘Item 1. Business-Regulation.’’
approximately $204.9 million represents net unrestricted investments held by our operating subsidiaries of which approximately $21.4 million is held by Quanta Bermuda. Additionally, Quanta Indemnity Company, Quanta Specialty Lines Insurance Company and Quanta Reinsurance U.S. Ltd, which are subsidiaries of Quanta Bermuda, hold approximately $161.5 million of net unrestricted investments. The remaining amount of the net unrestricted investments balance is held by Quanta Europe. Any distributions from these subsidiaries are subject to significant legal, regulatory and compliance requirements.
Some of our insurance and many of our reinsurance contracts contain termination rights that were triggered by the A.M. Best rating downgrades. Some of these insurance and reinsurance contracts also require us to post additional security. Further, the downgrade in our rating from ‘‘B++’’ (very good) to ‘‘B’’ (fair) triggered additional termination provisions and required the posting of additional security in certain of our other insurance and reinsurance contracts. We were required to post additional security either through the issuance of letters of credit or the placement of securities in trust under the terms of those insurance or reinsurance contracts. In addition, many of our insurance contracts and certain of our reinsurance contracts provide for cancellation at the option of the policyholder regardless of our financial strength rating. Accordingly, we may also elect to post security under these other contracts.
As of December 31, 2006 and March 5, 2007, we had obligations related to fully secured letters of credit of approximately $235.4 million and $170.0 million.
Our investment strategy seeks to preserve principal and maintain liquidity while trying to maximize total return through a high quality, diversified portfolio. Investment decision making is guided mainly by the nature and timing of our expected liability payouts, management’s forecast of our cash flows and the possibility that we will have unexpected cash demands, for example, to satisfy claims due to catastrophic losses. Our investment portfolio currently consists mainly of highly rated and liquid fixed income securities. However, to the extent our insurance liabilities are correlated with an asset class outside our minimum criteria, our investment guidelines will allow a deviation from those minimum criteria provided such deviations reduce overall risk.
Our insurance and reinsurance premiums receivable balances totaled $34.6 million as of December 31, 2006 compared to $115.1 million at December 31, 2005. The decrease in premiums receivable reflects the collection of outstanding premiums, cancellations of policies, the impact of A.M. Best’s downgrades on our ability to write business and our decision to cease underwriting or seeking new business and to place most of our remaining specialty insurance and reinsurance lines into orderly run-off during the second quarter of 2006, offset in part by net premiums written during the twelve months ended December 31, 2006. Included in our premiums receivable of $34.6 million are approximately $23.9 million of written premium installments that, on December 31, 2006 were not yet due under the terms of the related insurance and reinsurance contracts. Based on our review of the remaining balance of $10.7 million, which represents premium installments that were due to us on December 31, 2006, we have established a provision for uncollectible premiums receivable of $0.9 million.
million as of December 31, 2005. The decrease in our deferred acquisition costs and in unearned premiums, net of deferred reinsurance is due to lower premiums written, as a result of the A.M. Best’s ratings downgrade and our decision to cease underwriting or seeking new business and to place most of our remaining specialty insurance and reinsurance lines into orderly run-off. These amounts represent premiums and acquisition expenses on written contracts of insurance and reinsurance that will be recognized in earnings in future periods.
(2) This table does not give effect to warrants and options outstanding of 2,542,813 and 786,764 at December 31, 2006 compared to 2,542,813 and 3,402,194 at December 31, 2005.
Upon liquidation, dissolution or winding-up, the holders of our series A preferred shares will be entitled to receive from our assets legally available for distribution to shareholders a liquidation preference of $25 per share, plus declared but unpaid dividends and additional amounts, if any, to the date fixed for distribution. Dividends on our series A preferred shares will be payable on a non-cumulative basis only when, as and if declared by our board of directors, quarterly in arrears on the fifteenth day of March, June, September and December of each year, commencing on March 15, 2006. Dividends declared on our series A preferred shares will be payable at a rate equal to 10.25% of the liquidation preference per annum (equivalent to $2.5625 per share).
The cash flows from discontinued operations are combined, in the statement of cash flows, with the cash flows from continuing operations within each category. We do not expect the absence of cash flows from our discontinued operations to significantly affect our future liquidity and capital resources.
The A.M. Best rating action discussed above caused a default under our credit facility led by JPMorgan (the ‘‘JPMorgan credit facility’’) during 2006. The lenders waived the default under the JPMorgan credit facility until October 27, 2006 and on that date we entered into a new credit facility described below. We have started to transition all of the outstanding letters of credit, which secure our claims obligations, from the JPMorgan credit facility to the credit facility described below. As of December 31, 2006, we had approximately $110.9 million of letters of credit outstanding under the JPMorgan credit facility, which are fully secured by a letter of credit issued by the ING credit facility described below. These letters of credit are principally used to secure our obligations to pay claims.
The ING credit facility includes customary representations and warranties, affirmative and negative covenants, and events of default. The ING credit facility has a financial covenant requiring us to maintain a minimum consolidated tangible net worth, as well as covenants restricting our activities, such as the incurrence of additional indebtedness and liens, the sale of assets, and the payment of dividends and other restricted payments.
As of December 31, 2006, we had cash and cash equivalents and investments of approximately $948.2 million. We estimate that our cash and cash equivalents and investment balances include approximately $273.6 million that is pledged as collateral for letters of credit, approximately $200.8 million held in trust funds for the benefit of ceding companies and to fund our obligations associated with the assumption of an environmental remediation liability, $189.6 million that is held by Lloyd’s to support our underwriting activities, $39.3 million held in trust funds that are related to our deposit liabilities and $29.9 million that is on deposit with, or has been pledged to, U.S. state insurance departments. Within our corporate structure, some of our subsidiaries also owe and are owed amounts to and from each other. For example, at December 31, 2006 Quanta Holdings owed approximately $43.0 million to Quanta Bermuda.
Some of our insurance and many of our reinsurance contracts contain termination rights that were triggered by the A.M. Best rating action. Some of these insurance and reinsurance contracts also required us to post additional security either through the issuance of letters of credit or the placement of securities in trust under the terms of those insurance or reinsurance contracts. We may also elect to post security under other insurance contracts in order to maintain that business. As of December 31, 2006, we had cash and cash equivalent and investment balances of approximately $215.0 million that were available to post as security or place in trust.
Any dividend payments on our series A preferred shares are payable by our holding company, Quanta Holdings. Quanta Holdings is dependent on dividends and other payments from its operating subsidiaries to satisfy these obligations and the obligations under our trust preferred securities. The potential for a large claim under one of our insurance or reinsurance contracts means that we may need to make substantial and unpredictable payments within relatively short periods of time. As a result of our decision to cease underwriting or seeking new business and to place most of our remaining specialty insurance and reinsurance lines into orderly run-off, we have incurred substantial costs, including severance payments, in connection with the implementation of any changes based on such decision. This decision also involves significant risks that may result in restructuring charges and unforeseen expenses and costs associated with exiting lines of business and complications or delays, including, among others things, the risk of failure. During the year ended December 31, 2006, we have incurred severance charges of $14.3 million. Additionally, we have entered into agreements with James J. Ritchie, Peter D. Johnson and Jonathan J.R. Dodd, and a number of other key employees that provide for specified severance payments in the event of termination without cause or following a change of control. In the event of payout to all employees covered by these agreements, our cash requirements would include payments in an aggregate amount of up to approximately $9.6 million to all such employees. Of this amount, $3.7 million has been recognized within our severance charges of $14.3 million.
We incurred capital expenditures of $0.2 million during the year ended December 31, 2006. As we continue to manage the run-off of our specialty insurance and reinsurance business other than our Lloyd’s business, we are unable to quantify the amounts of future capital expenditures we may have to incur.
We will work with applicable regulatory authorities to facilitate dividends or capital return from our subsidiaries to Quanta Holdings. We anticipate that, in all cases, the paying of dividends or capital return to Quanta Holdings will require regulatory approval. Working with these regulators will take a long period of time and requires the Company to meet many conditions. The ING credit facility, as well as any future credit agreements or other agreements relating to our indebtedness, also contains provisions prohibiting or limiting the payment of dividends on our shares under certain circumstances.
Our reserve for losses and loss expenses consists of case reserves and IBNR. In assessing the adequacy of these reserves, it must be noted that the actual costs of settling claims is uncertain as it depends upon future events. Many of these events will be out of our control and could potentially affect the ultimate liability and timing of any potential payment. There is necessarily a range of possible outcomes and the eventual outcome will certainly differ from the projections currently made. This uncertainty is heightened by the short time in which we have operated, thereby providing limited
Company-specific claims loss emergence patterns. Consequently, we must use industry benchmarks, on a line by line basis, in deriving IBNR which, despite management’s and our independent actuary’s care in selecting them, will differ from actual experience.
Other than as described under ‘‘Liquidity’’ related to our trust preferred securities offerings through the Quanta Trust I and Quanta Trust II (together ‘‘Quanta Trust I and II’’), as of December 31, 2006, we have not entered into any off-balance sheet arrangements with special purpose entities or variable interest entities. We did not consolidate Quanta Trust I and II, the issuer of the trust preferred securities and a variable interest entity, since we are not the primary beneficiary of Quanta Trust I or II. As of December 31, 2006, we have recorded the $61.9 million of Debentures, which were issued to Quanta Trust I and II, on our consolidated balance sheet. The net proceeds of $58.4 million from the sale of the Debentures to Quanta Trust I and II were used for working capital purposes and our business. Distributions will be payable at a variable per annum rate of interest, reset quarterly, equal to LIBOR plus 385 basis points by the Company to Quanta Trust I and equal to LIBOR plus 350 basis points by the Company to Quanta Trust II as described above under ‘‘Commitments.’’ The Debentures are redeemable at the Company’s option at par beginning March 15, 2010.
As of December 31, 2006, we have approximately $273.6 million that was pledged as collateral for letters of credit, approximately $200.8 million held in trust funds for the benefit of ceding companies and to fund our obligations associated with the assumption of an environmental remediation liability, $189.6 million that is held by Lloyd’s to support our underwriting activities, $39.3 million held in trust funds that are related to our deposit liabilities and $29.9 million that is on deposit with, or has been pledged to, U.S. state insurance departments.
Reinsurance premiums written on certain types of contracts, notably treaty quota share contracts, may not be known definitively on the inception date of the contract and therefore include estimates of premiums written. These estimates are based on data provided by the ceding companies or brokers, our underwriters’ judgment and underlying economic conditions. A key assumption used in our estimates of reinsurance premiums written is the estimate of the amount of the ceding companies’ underlying subject premium written, and in some cases, earned during any reporting period. Our estimates of written premiums are re-evaluated over the term of the contract period as underwriting information becomes available and as actual premiums are reported by the ceding companies or brokers. For certain excess of loss reinsurance contracts we record the minimum premium, as defined in the contract, as our estimated premium written at inception of the contract. Subsequent changes to
our premium estimates are recorded as adjustments to premiums written and premiums receivable in the period in which they become known and could be material. Adjustments may significantly impact net income, our financial position and liquidity in the period in which they are determined, particularly when the subject contract is fully or substantially expired resulting in the premium adjustment being fully or substantially earned. At December 31, 2006 our premiums receivable included approximately $12.3 million of estimated reinsurance premiums receivable.
Retrospective rating adjustments are necessarily based on underwriting results that include certain estimates relating to premiums and losses, and are therefore subject to adjustment as underwriting experience develops especially in the case of reinstatement premiums. The primary factor that could change our estimate of reinstatement premiums written and ceded is our best estimate of ultimate losses incurred.
No. 60, ‘‘Accounting and Reporting by Insurance Enterprises’’ (‘‘SFAS 60’’). For these contracts we follow the deposit method of accounting as prescribed in American Institute of Certified Public Accountants, known as the AICPA, Statement of Position 98-7, ‘‘Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk’’ (‘‘SOP 98-7’’). The deposit method of accounting requires that the premium we receive or pay, less any explicitly defined margins or fees retained or paid, are accounted for as deposit asset or deposit liabilities on our consolidated balance sheet. Explicitly defined fees retained or paid are deferred and recognized in other income in our consolidated statement of operations and comprehensive (loss) income according to the nature of the product or service provided.
We wrote non-traditional contracts of insurance and reinsurance that were deemed not to meet risk transfer criteria and accordingly we have accounted for these transactions as deposits held on behalf of clients. During the years ended December 31, 2006 and 2005, we recognized in other income $3.5 million and $2.5 million of fees and revenues relating to non-traditional contracts which were accounted for using the deposit method. If these contracts were deemed to transfer risk, gross premium relating to these contracts would total approximately $87.2 million and $110.7 million in the years ended December 31, 2006 and 2005.
We believe the arrangement, including the client’s option to recapture, and the assumption of the life insurance contracts constitute one contract with minimal mortality, credit or other insurance or economic risk which results in deposit accounting. Although we believe the client will exercise the recapture, it is not assured that this will be the case. If the client does not recapture the underlying insurance contracts in the future, we may be viewed as having had the risks described above and, as a
In respect of life reinsurance arrangements written on a coinsurance basis, where investment assets have been transferred to us, such assets have been recorded within our trading investment portfolio and are separately presented as Investments related to deposit liabilities in the consolidated balance sheet. A deposit liability has been recorded in the consolidated balance sheet in accordance with SFAS 97 ‘‘Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments’’ for non-risk investment contracts as an interest bearing instrument using the effective yield method. The investments related to the deposit liability are held in trust funds and are pledged to the ceding companies.
In respect of the life reinsurance arrangements written on a modified coinsurance basis, the ceding company’s net statutory reserves and assets are withheld and remain legally owned by the ceding company. These modified coinsurance contracts represent ‘‘non-cash’’ financial reinsurance transactions, whereby, in accordance with the contract terms, there are no net cash flows at inception of contracts, nor are there expected to be net cash flows through the life of the contracts, other than our explicitly defined fees. Notional contract assets and liabilities contemplated by the contract terms are offset in accordance with Financial Accounting Standards Board (‘‘FASB’’) Interpretation No. 39 (‘‘FIN 39’’) ‘‘Offsetting of Amounts Related to Certain Contracts’’ and as such we do not present such assets or deposit liabilities in its consolidated balance sheet.
As of December 31, 2006, our reinsurance recoverables recorded in the consolidated balance sheet were $221.2 million, of which approximately 26%, 12% and 11% were due from three reinsurers of which one was rated ‘‘A+’’ and two were rated ‘‘A’’ by A.M. Best.
As of December 31, 2006, our net deferred tax assets were $49.1 million against which we provided a 100% valuation allowance on the basis that, given our limited operating history, the realization of deferred tax assets from our anticipated future taxable income is neither assured nor accurately determinable. If we subsequently assess that the valuation allowance, or any portion thereof, is no longer required an income tax benefit will be recorded in net income in the period in which such assessment is made.
Our publicly traded and non-publicly traded fixed maturity, short-term investments and equity securities that are classified as available-for-sale are recorded at estimated fair value with the
difference between cost or amortized cost and fair value, net of the effect of taxes, included as a separate component of accumulated other comprehensive income (loss) in the consolidated balance sheet to the extent that unrealized losses are considered temporary. Our publicly traded and non-publicly traded fixed maturity and short-term investments that are classified as trading are recorded at estimated fair value with the change in fair value included in net realized gains on investments in the consolidated statement of operations and comprehensive (loss) income.
In accordance with SFAS No. 115, ‘‘Accounting for Certain Investments in Debt and Equity Securities,’’ we periodically review our investments to determine whether an impairment, being a decline in fair value of a security below its amortized cost, is other than temporary. If such a decline is classified as other than temporary, we would write down, to fair value, the impaired security resulting in a new cost basis of the security and the amount of the write-down would be charged to the statement of operations and comprehensive (loss) income as a realized loss. The new cost basis would not be changed for subsequent recoveries in fair value. Some of the factors that we consider in determining whether an impairment is other than temporary include (1) the amount of the impairment, (2) the period of time for which the fair value has been below the amortized cost, (3) specific reasons or market conditions which could affect the security, including the financial condition of the issuer and relevant industry conditions or rating agency actions, and (4) our ability and intent to hold the security for sufficient time to allow for possible recovery.
We believe that the estimation of future ultimate loss liabilities is the most significant judgment made by management and is inherently subject to significant accounting uncertainties. These uncertainties are driven by many variables that are difficult to quantify and include:
• the period of time between the occurrence of an insured loss and actual settlement, known as the ‘‘tail’’ of the loss,
• the selection of appropriate reserving methodologies and data variables used in those methodologies,
• our own historical claim experiences because of our limited operating history.
We have a system of controls in place that assists us in our loss estimation process and the evaluation of the completeness of the data received from our clients and others. These controls include the use of employed actuaries who are experienced in the lines of business we have underwritten, the requirement to obtain up to date information from our clients or brokers, the use of several actuarial methodologies to calculate estimated losses in each of our product lines, the use of industry data for large or well-known losses, the right to perform claims audits of our clients and the requirement that our underwriters or loss adjusters contact our clients and brokers directly if he or she did not expect a loss of certain magnitude. We have established a large loss committee that is tasked with the review of all claims in excess of a certain amount and we also require that certain claims must be approved by a member of senior management to validate the reported loss and case reserve. In addition, our loss and loss expense estimates, data and reserving assumptions are reviewed annually by an independent recognized actuarial firm.
The estimation of unpaid loss liabilities is also affected by the type or structure of the policies we have written. In the case of our direct insurance business we often assume risks for which we believe
We establish loss and loss expense reserves (to cover expenses related to settling claims, including legal and other fees) to provide for the ultimate cost of settlement and administration of claims for incurred losses. Our loss and loss expense reserves fall into two categories: reserves for unpaid reported losses and for losses incurred but not reported, or IBNR, claims. Reported claim reserves are based initially on claim reports received from insureds, brokers or ceding companies. In certain but infrequent instances, such as the receipt of inconsistent, incorrect or inadequate supporting documentation, we may supplement the reported loss with additional ultimate settlement costs assessed by our claims professionals.
IBNR reserves are calculated using a variety of generally accepted statistical and actuarial techniques developed in the insurance industry. In applying these techniques, we rely on the most recent information available, including pricing information, industry data and on our historical loss and loss expense experience. Where our historical loss information is limited, we increase our reliance on individual pricing analyses and industry loss information to guide our estimates. We may also utilize commercially available computer models to evaluate future trends and to estimate ultimate claim costs. From time to time we engage independent external actuarial specialists to review our estimates of loss and loss expense reserves and our reserving methods. Even though our reserving techniques are actuarially sound, there may still be significant subsequent adjustments to loss and loss expense reserves due to the nature of our business and the risks written.
As of December 31, 2006 the primary reserving method we used to estimate the ultimate cost of losses for our specialty reinsurance run-off lines and our professional, environmental, fidelity and
The primary reserving method we used to estimate the ultimate cost of losses for our other immature accident years in our specialty insurance run-off business lines and in our Lloyd’s buinesses was an expected loss ratio methodology whereby earned premiums are multiplied by an expected loss ratio to derive ultimate losses and deducts any paid losses and loss expenses to arrive at estimated losses and loss expense reserves. This method is commonly applied when there is insufficient historical loss development experience available.
Our loss development factors and expected loss ratios are monitored regularly and updated as appropriate but at least once a year. Key assumptions materially affect our estimates for reserves for losses and loss expenses. Our initial expected loss and loss expense ratios for our specialty reinsurance run-off business lines is derived from loss exposure information provided by brokers and ceding companies and from loss and loss expense ratios established during the pricing of individual contracts. Our initial expected losses and loss expense ratios selected for our specialty insurance run-off lines are based on benchmarks derived by our underwriters and actuaries during the initial pricing of the business and from comparable market information. Our expected loss ratios are periodically adjusted for any information provided by our clients, rating increases and changes in terms and conditions that have been observed in the market. Loss development factors are developed from our annual analysis of our historical loss development patterns by line of business and from available industry data. These key assumptions did not materially change between December 31, 2005 and December 31, 2006. In the fourth quarter of 2006 we transitioned our loss selection method from the expected loss ratio method to the Bornhuetter-Ferguson method for the maturing accident periods in 2004 and 2005 in our professional insurance product line. This resulted in our loss ratio selection decreasing from approximately 68% to 62% for these accident periods as a result of favorable historical loss experience. This had the effect of reducing our net loss reserves by approximately $3.5 million in the fourth quarter of 2006.
We continually review our reserve estimate and reserving methodologies taking into account all currently known information and updated assumptions related to unknown information. Loss and loss expense reserves established in prior periods are adjusted as claim experience develops and new information becomes available. Any adjustments to previously established reserves, resulting from a change in estimate, may significantly impact current period underwriting results and net income by reducing net income if previous period reserve estimates prove to be deficient or improve net income if prior period reserves become redundant. Losses and loss expense arising from future insured events will be estimated and provided for at the time the losses are incurred and could be substantial.
When we receive consideration for the assumption of a remediation liability that is in excess of our estimate of the related environmental remediation liability, we initially defer the excess amount and record it in deferred income on the consolidated balance sheet. This deferred remediation revenue is recognized in earnings over the anticipated remediation period using the cost recovery or percentage-of-completion method that is based on the ratio of remediation expenses actually incurred and paid to total anticipated remediation costs. As of December 31, 2006, we had deferred approximately $0.2 million of remediation revenue that was included in deferred income.
The majority of our other accounts receivable balances comprise amounts due under technical services arrangements with customers. We establish bad debt allowances, or valuation reserves, based on specific identification of likely losses of accounts with individual customers. We periodically re-evaluate these valuation reserve estimates, if any, and adjust them as more information about the ultimate collectibility of accounts receivable becomes available. Circumstances that could cause these valuation reserves to be revised include changes in our clients’ financial standing such as liquidity and credit quality, and other factors that negatively impact our clients’ ability to pay their obligations as they become due.
price equal to the market value of the underlying common stock on the date of grant. Effective January 1, 2006, we adopted the fair value recognition provisions of FASB Statement No. 123(R), Share-Based Payment (‘‘SFAS 123(R)’’), using the modified-prospective-transition method. Under that transition method, compensation cost recognized in 2006 includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123(R). Results for prior periods have not been restated.
As a result of adopting SFAS 123(R) on January 1, 2006, our net loss for the year ended December 31, 2006, is $0.4 million higher than if it had continued to account for share-based compensation under APB 25.
We recognize expenses related to Annual Variable Cash Incentive Plan awards by applying the graded vesting method as prescribed by Financial Accounting Standards Board Interpretation No. 28 ‘‘Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans’’ (‘‘FIN 28’’). We continually review and adjust our provisions for Annual Variable Cash Incentive Plan awards and other bonus awards taking into account known information and updated assumptions related to unknown information. Award provisions are necessarily an estimate and amounts established in prior periods are adjusted in our current results of operations as new information becomes available to us. Any adjustments we make to previously established provisions or the establishment of new provisions may significantly impact our current period results and net income.
See Note 2(w) to the consolidated financial statements which are included in ‘‘Item 8.-Financial Statements and Supplementary Data’’ for a discussion of recent accounting pronouncements.