The Company leases office space in Bermuda where the Company’s principal executive offices are located. Additionally, the Company leases office space in various locations, including Beijing, Dublin, Greenwich (Connecticut), Hong Kong, Mexico City, Montreal, Paris, Santiago, Seoul, Singapore, Tokyo, Toronto and Zurich.
The Company adopted SFAS 150 and FIN46(R) in 2003. (See Note 2 to Consolidated Financial Statements.)
The Company is a leading global reinsurer with a broadly diversified portfolio of risks. The Company writes all lines of business in virtually all markets worldwide, and differentiates itself through its approach to risk, its strategy to manage risk, and its financial strength. Through its broad product and geographic diversification, its excellent execution capabilities, and its local presence in most major markets, the Company is able to respond quickly to market needs, and capitalize on business opportunities virtually anywhere in the world.
Reinsurance is by its nature a risk assumption business. The Company’s philosophy is to assume its clients’ risks, thereby removing the volatility associated with these risks, and then manage those risks and the risk-related volatility. The Company’s ability to succeed in the risk assumption business is dependent on its ability to accurately analyze and quantify risk, to understand volatility and how risks aggregate or correlate, and to establish the appropriate capital requirements and absolute limits for the risks assumed.
In the second half of 2003, the Company began to see a flattening in the rate of improvements in the terms and conditions of the most profitable lines and a slower rate of improvement in those lines that had not yet reached their peak in terms of profitability. From the middle of 2003 to the end of 2004, this resulted in a slower growth rate in pricing, although there was good pricing discipline in the industry.
Within the Company’s Life segment, the reinsurance market is differentiated between mortality and longevity products, with mortality being the largest market and longevity being smaller, but growing. For the mortality markets in which the Company writes business, the Company observed stable pricing for continental Europe and Latin America. In contrast, there are much more competitive conditions in the U.K. and Ireland, and while these two markets remain attractive, appropriate risk selection and pricing is important.
A key challenge facing the Company is to successfully manage through the less profitable portion of the reinsurance cycle. The Company is confident in its long-term strategy, and believes that by closely monitoring the progression of each line of business, being selective in the business that it writes, and maintaining the diversification and balance of its portfolio, it will continue to optimize returns. Individual lines of business and markets have their own unique characteristics and are at different stages of the reinsurance pricing cycle at any given point in time. Management believes it has achieved appropriate portfolio diversification by product, geography, line and type of business, length of tail, and distribution channel, and that this diversification, in addition to the financial strength of the Company and its strong global franchise, will help to mitigate cyclical declines in underwriting profitability and to achieve a more balanced return over time.
Management is focused on ensuring that the structure and culture of the organization promote intelligent, prudent, transparent and ethical decision-making. Management believes that a sound enterprise culture starts with the tone at the top. The Executive Management holds regular company-wide information sessions to present and review Management’s latest decisions, whether operational, financial or structural, as well as the financial results for the Company. Employees are encouraged to address questions related to the Company’s results, strategy or Management decisions, either anonymously or otherwise to Management so that they can be answered during these information sessions. Management believes that these sessions provide a consistent message to all employees about the Company’s value of transparency. Management also strives to promote a work environment that (i) aligns the skill set of individuals with challenges encountered by the Company, (ii) includes segregation of duties to ensure objectivity in decision making, and (iii) provides a compensation structure that encourages and rewards intelligent and ethical behavior. To that effect, the Company has a written Code of Business Conduct and Ethics and provides employees with a direct communication channel to the Audit Committee in the event they become aware of questionable behavior of Management or anyone else. Finally, Management believes that building a sound internal control environment, including a strong internal audit function, helps ensure that behaviors are consistent with the Company’s cultural values.
The Company aims to be a reliable and financially secure partner to its cedants. This means that the Company must maintain sufficient liquidity at all times so that it can support cedants by settling claims quickly. The Company generates cash flows primarily from its underwriting and investment operations. Management believes that a profitable, well-run reinsurance organization will generate sufficient cash from premium receipts to pay claims, acquisition costs and operating expenses in most years. To the extent that underwriting cash flows are not sufficient to cover operating outflows in any year, the Company may utilize cash flows generated from investments and may ultimately liquidate assets from its investment portfolio. Management ensures that its liquidity requirements are supported by maintaining a high-quality, well-balanced and liquid portfolio, and by matching the duration of its investment portfolio with that of its net reinsurance liabilities. In 2007, the Company expects to continue to generate positive operating cash flows. Management also maintains credit facilities with banks that can provide efficient access to cash in the event of an unforeseen cash requirement.
A key challenge in the reinsurance industry is to create economic value through the intelligent assumption of reinsurance and investment risk, but also to limit or mitigate those risks that can destroy tangible as well as
intangible value. Management believes that every organization faces numerous risks that could threaten the successful achievement of a company’s goals and objectives. These include choice of strategy and markets, economic and business cycles, competition, changes in regulation, data quality and security, fraud, business interruption and management continuity; all factors which can be viewed as either strategic or operational risks that are common to any industry. (See Risk Factors in Item 1A of Part I of this report). In addition to these risks, the Company operates as an assumer of risk and its results are primarily determined by how well the Company understands, prices and manages risk. While many industries and companies start with a return goal and then attempt to shed risks that may derail that goal, the Company starts with a capital-based risk appetite and then looks for risks that meet its return targets within that framework. Management believes that this construct allows the Company to balance the cedants’ need for absolute certainty of claims payment with shareholders’ need for an adequate return on their capital.
The Executive Management and the Board are responsible for managing strategic risks and setting key risk policies and limits. The Board approves maximum limits as a percentage the Company’s economic value, while the Executive Management operates at levels equal to or lower than the maximum limits approved by the Board, depending on current market conditions and the distribution of the Company’s portfolio of risks. The strategic risks include the direction and governance of the Company, as well as its response to key external factors faced by the reinsurance industry. Operational risks are managed by designated functions within the organization. They include failures or weaknesses in financial reporting and controls, non-compliance, poor cash management, fraud, breach of information technology security and reliance on third party vendors. The Company seeks to minimize these risks through robust processes and controls. Controls and monitoring processes throughout the organization seek to ensure that the Executive Management and the Board have a comprehensive view of the Company’s risks and related mitigation strategies at all times. Individual business units manage assumed risks, subject to the limits and policies established by the Executive Management and the Board. These are the reinsurance risks that the Company’s clients want to transfer and are the core of the Company’s business. They also include the capital market risks that the Company assumes in the investment of its assets.
In 2004, the Company formed two operating subsidiaries in Ireland, Partner Reinsurance Ireland Limited (Partner Reinsurance Ireland) and PartnerRe Ireland Insurance Limited (PartnerRe Ireland Insurance). Both companies became operational in 2005.
The Company’s Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States (U.S. GAAP). The Consolidated Financial Statements include the accounts of the Company and its subsidiaries, including those that meet the consolidation requirements of variable interest entities (VIEs). Intercompany accounts and transactions have been eliminated. The Company assesses the consolidation of VIEs based on whether the Company is the primary beneficiary of the entity in accordance with FASB Interpretation No. 46 (revised December 2003) “Consolidation of Variable Interest Entities” (FIN 46(R)). See Note 2(r) and Note 12 for additional information concerning FIN 46(R). Entities in which the Company has an ownership of more than 20% and less than 50% of the voting shares are accounted for using the equity method. (See Note 3(i) and Note 21 for additional information concerning the Company’s equity ownership in Channel Re Holdings Ltd. (Channel Re Holdings)).
The liabilities for policy benefits for ordinary life and accident and health policies have been established based upon information reported by ceding companies, supplemented by the Company’s actuarial estimates of mortality, critical illness, persistency and future investment income, with appropriate provision to reflect uncertainty. Future policy benefit reserves for annuity and universal life products are carried at their accumulated values. Reserves for policy claims and benefits include both mortality and critical illness claims in the process of settlement, and claims that have been incurred but not yet reported. Interest rate assumptions used to estimate liabilities for policy benefits for life and annuity contracts at December 31, 2006 and 2005 ranged from 1.0% to 4.9% in 2006 and 1.5% to 5.5% in 2005, respectively. Actual experience in a particular period may vary from the assumed experience and, where warranted, the assumptions and the related reserve estimates are revised accordingly. Any revisions are recorded in the period they are determined, which may affect the Company’s operating results in future periods.
to individual life and annuity business are deferred and amortized over the premium-paying periods in proportion to anticipated premium income, allowing for lapses, terminations and anticipated investment income. Acquisition costs related to universal life and single premium annuity contracts for which there is no significant mortality or critical illness risk are deferred and amortized over the lives of the policies as a percentage of the estimated gross profits expected to be realized on the policies.
In the normal course of its operations, the Company enters into certain contracts that do not meet the risk transfer provisions of SFAS No. 113 “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts”. These contracts are accounted for using the deposit accounting method in accordance with Statement of Position 98-7 “Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Risk”. For those contracts, the Company originally records deposit liabilities for an amount equivalent to the consideration received. The consideration to be retained by the Company, irrespective of the experience of the contracts, is earned over the expected settlement period of the contracts, with any unearned portion recorded as a component of deposit liabilities. Actuarial studies are used to estimate the final liabilities under these contracts and the appropriate accretion rates to increase or decrease the liabilities over the term of the contracts. The change for the period is recorded in other income in the Consolidated Statements of Operations.
Other invested assets consist primarily of investments in non-publicly traded companies (principally Channel Re Holdings-see Note 3(i) and Note 21), private placement equity investments, private placement bond investments, derivative financial instruments and other specialty asset classes. The investment in Channel Re Holdings is accounted for using the equity method. The Company’s share of Channel Re Holdings’ net income and other comprehensive income is reported in the Company’s net income and accumulated other comprehensive income, respectively, on a one-quarter lag. The Company calculates its share of Channel Re Holdings’ net income and other comprehensive income on the basis of the Company’s ownership percentage of Channel Re Holdings’ common shares currently outstanding. Other investments are recorded based on valuation techniques depending on the nature of the individual assets. The valuation techniques used by the Company’s investment managers are reviewed by the Company and are generally commensurate with standard valuation techniques for each asset class.
Certain subsidiaries and branches of the Company operate in jurisdictions where they are subject to taxation. Current and deferred income taxes are charged or credited to net income, or, in certain cases, to accumulated other comprehensive income, based upon enacted tax laws and rates applicable in the relevant jurisdiction in the period in which the tax becomes accruable or realizable. Deferred income taxes are provided for all temporary differences between the bases of assets and liabilities used in the Consolidated Balance Sheets and those used in the various jurisdictional tax returns. When Management’s assessment indicates that it is more likely than not that deferred income tax assets will not be realized, a valuation allowance is recorded against the deferred tax assets. The Company also establishes tax liabilities related to tax years that are open to audit when such liabilities are probable and reasonably estimable.
SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133), as amended on January 1, 2001, requires the recognition of all derivative financial instruments, including embedded derivative instruments, as either assets or liabilities in the Consolidated Balance Sheets and measurement of those instruments at fair value. The accounting for gains and losses associated with changes in the fair value of a derivative and the effect on the Consolidated Financial Statements depends on its hedge designation and whether the hedge is highly effective in achieving offsetting changes in the fair value of the asset or liability being hedged.
The Company’s investment strategy allows for the use of derivative instruments, subject to strict limitations. The Company utilizes various derivative instruments such as futures contracts, credit default swaps, written covered call options, foreign currency option contracts and foreign exchange forward contracts for the purpose of replicating investment positions, managing market exposure and duration risks, or enhancing investment performance. These instruments are recorded at fair value as assets and liabilities in the Consolidated Balance Sheets and changes in fair value are included in net realized investment gains and losses in the Consolidated Statements of Operations. The fair values of those derivatives are based on quoted market prices, or internal valuation models where quoted market prices are not available. Margin balances required by counterparties, which are equal to a percentage of the total value of open futures contracts, are included in cash and cash equivalents.
The Company currently uses five types of share-based compensation: stock options, restricted shares (RS), restricted share units (RSU), stock appreciation rights (SAR) and shares issued under the Company’s employee stock purchase plans. The Company adopted the fair value provisions of SFAS No. 123 “Accounting for Stock-Based Compensation” (SFAS 123), as amended by SFAS No. 148 “Accounting for Stock-Based Compensation-Transition and Disclosure” (SFAS 148), in 2003 and elected to use the prospective transition method as described in SFAS 123, which resulted in the expensing of options granted subsequent to January 1, 2003.
Effective December 31, 2006, the Company adopted SFAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans-an amendment of FASB Statements No. 87, 88, 106 and 132(R)” (SFAS 158). This statement requires an entity to, among other things: (a) recognize an asset or a liability in the Consolidated Balance Sheets for the funded status of defined benefit plans that are overfunded or underfunded, respectively, measured as the difference between the fair value of plan assets and the pension
obligation; (b) recognize changes in the funded status of defined benefit plans in the year in which the changes occur as a component of other comprehensive income, net of tax; and (c) measure defined benefit plan assets and obligations as of the date of the employer’s balance sheet date (see Note 9).
In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (FIN 48). The interpretation requires companies to recognize the tax benefits of uncertain tax positions only where the position is “more likely than not” to be sustained assuming examination by tax authorities. The amount recognized is the amount that represents the largest amount of tax benefit for those items with a greater than 50% likelihood of being ultimately realized. A liability must be recognized for any tax benefit (along with any interest and penalty, if applicable) claimed in a tax return in excess of the amount allowed under the interpretation. FIN 48 requires a tabular reconciliation of the change in the aggregate unrecognized tax benefits claimed in tax returns and requires disclosure for those uncertain tax positions where it is reasonably possible that the estimate of the tax benefit will change significantly in the next 12 months. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company will adopt FIN 48 as of January 1, 2007. The adoption of FIN 48 is expected to reduce the Company’s consolidated shareholders’ equity by approximately $5 million to $10 million, with no material impact on net income.
SFAS 157 will be effective for fiscal years beginning after November 15, 2007. The Company is currently evaluating the impact of the adoption of SFAS 157 on its consolidated shareholders’ equity or net income.
In February 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement No. 115 (SFAS 159). SFAS 159 allows entities to choose, at specified election dates, to measure eligible financial assets and liabilities at fair value that are not otherwise required to be measured at fair value. If a company elects the fair value option for an eligible item, changes in that item’s fair value in subsequent reporting periods must be recognized in current earnings. SFAS 159 also establishes presentation and disclosure requirements designed to draw comparisons between entities that elect different measurement attributes for similar assets and liabilities.
SFAS 159 will be effective for fiscal years beginning after November 15, 2007. The Company is currently evaluating the impact of the adoption of SFAS 159 on its consolidated shareholders’ equity or net income.
The distribution of available for sale fixed maturities and short-term investments at December 31, 2006 by contractual maturity is shown below (in thousands of U.S. dollars). Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
Proceeds from the sale of investments classified as available for sale for the years ended December 31, 2006, 2005 and 2004 were $13,550.3 million, $9,968.0 million and $7,299.4 million, respectively. Realized investment gains and losses on securities classified as available for sale for the years ended December 31, 2006, 2005 and 2004 were as follows (in thousands of U.S. dollars):
The components of the net realized investments gains on available for sale securities for the years ended December 31, 2006, 2005 and 2004 were as follows (in thousands of U.S. dollars):
For the years ended December 31, 2006, 2005 and 2004, the Company recorded a net gain of $0.6 million, a net loss of $2.8 million and a net loss of $1.5 million, respectively, in net realized investment gains and losses in the Consolidated Statements of Operations, representing the ineffectiveness of its designated fair value hedging activities.
The components of net investment income for the years ended December 31, 2006, 2005 and 2004 were as follows (in thousands of U.S. dollars):
At December 31, 2006 and 2005, the net unrealized investment gains on trading securities were approximately $21.5 million and $9.9 million, respectively. For the years ended December 31, 2006, 2005 and 2004, the change in net unrealized investment gains and losses on trading securities (including the impact of foreign exchange) resulted in a net gain of $11.4 million, a net gain of $2.0 million and a net loss of $1.6 million, respectively, being recognized in net realized investment gains and losses in the Consolidated Statements of Operations.
Included in net payable for securities purchased at December 31, 2006 and 2005 were gross payable and receivable balances for unsettled trades and equity securities sold but not yet purchased, which represent sales of securities not owned at the time of the sale. The components of net payable for securities purchased at December 31, 2006 and 2005 were as follows (in thousands of U.S. dollars):
Other invested assets primarily include the Company’s investment in Channel Re Holdings, a non-publicly traded financial guaranty reinsurer based in Bermuda, which assumed a portfolio of in-force business from MBIA, and which participates in new MBIA reinsurance treaties and provides facultative reinsurance support to MBIA. The Company’s investment represents 20% of the common stock of Channel Reinsurance Ltd., which is a subsidiary and the primary asset of Channel Re Holdings. The Company’s share of Channel Re Holdings, net income was $11.7 million, $9.4 million and $6.0 million for the years ended December 31, 2006, 2005 and 2004 respectively (See Note 21).
The Company’s unpaid losses and loss expenses for its non-life operations are composed of the reserves for its Non-life and ART segments.
Within the Company’s U.S. P&C sub-segment, the Company reported net adverse loss development for prior years in 2006, 2005 and 2004. This primarily affected the property and motor line in 2006, the casualty line in 2005, and the motor line in 2004. The net adverse loss development in 2006 was primarily due to net adverse development of $11 million related to the 2005 hurricanes, partially offset by loss reductions which were driven by lower than expected loss activity. The net adverse loss development in the casualty line in 2005 was primarily due to a revaluation of the loss development assumptions used by the Company to estimate future liabilities in a number of recent underwriting years on a limited number of treaties, predominantly in the specialty casualty line. During 2004, the Company observed an industry-wide deterioration of loss development for prior accident years in the motor line, particularly on non-proportional treaties. Other than for losses related to the 2005 hurricanes, losses reported by cedants during these three years included no significant losses but a series of attritional losses. Attritional losses are losses that may not be significant on an individual basis, but are monitored on an aggregated basis by the Company to identify trends that may be meaningful from a reserving standpoint. Upon consideration of the attritional loss information received during 2006, 2005 and 2004, the Company revised assumptions used to perform its actuarial analysis and increased its expected ultimate loss ratios, which had the effect of increasing loss reserves for prior accident years in 2006, 2005 and 2004.
The Company’s estimated losses resulting from Hurricane Katrina are subject to an unusual level of uncertainty arising out of these losses’ extremely complex and unique causation and related coverage issues associated with the attribution of losses to wind or flood damage or other perils such as fire, business interruption or riot and civil commotion. For instance, many of the Company’s cedants’ underlying policies exclude flood damage; however, water damage directly related to wind damage may be covered. The Company expects that these issues will not be resolved for a considerable period of time and given recent litigation developments and the evolving out of court settlement trends that may affect some of the Company’s cedants in the future, an additional IBNR reserve of $20 million has been established during the year ended December 31, 2006. These loss estimates will be reviewed continually and the ultimate liability may be in excess of, or less than, the amounts provided.
The Company’s actual losses from Hurricane Katrina may exceed the estimated losses as a result of, among other things, an increase in industry insured loss estimates, the receipt of additional information from cedants, brokers and loss adjusters, and the attribution of losses to coverages that, for the purpose of the estimates, the Company assumed would not be exposed.
The Company’s net reserve for unpaid losses and loss expenses at December 31, 2006 and 2005 included $95.2 million and $96.6 million, respectively, that represents estimates of its net ultimate liability for asbestos and environmental claims. The gross liability for such claims at December 31, 2006 and 2005 was $104.9 million and $108.0 million, respectively, of which $98.3 million and $98.0 million, respectively, relate to U.S. casualty exposures arising from business written by PartnerRe SA and PartnerRe U.S. Ultimate loss estimates for such claims cannot be estimated using traditional reserving techniques and there are significant uncertainties in estimating the amount of the Company’s potential losses for these claims. In view of the changes in the legal and tort environment that affect the development of such claims, the uncertainties inherent in estimating asbestos and environmental claims are not likely to be resolved in the near future. There can be no assurance that the reserves established by the Company will not be adversely affected by development of other latent exposures, and further, there can be no assurance that the reserves established by the Company will be adequate. The Company does, however, actively evaluate potential exposure to asbestos and environmental claims and establishes additional reserves as appropriate. The Company believes that it has made a reasonable provision for these exposures and is unaware of any specific issues that would materially affect its loss and loss expense estimates.
The Life segment reported net favorable development for prior accident years during the year ended December 31, 2006 of $12 million. The net favorable development was primarily related to the refinement of the Company’s reserving methodologies related to certain proportional guaranteed minimum death benefit treaties and the receipt of additional reported loss information from its cedants. The Company reported no development on prior accident years during the years ended December 31, 2005 and 2004.
The Company uses retrocessional agreements to reduce its exposure to risk of loss on reinsurance assumed. These agreements provide for recovery of a portion of losses and loss expenses from retrocessionaires. The Company remains liable to its cedants to the extent that the retrocessionaires do not meet their obligations under these agreements, and therefore the Company evaluates the financial condition of its reinsurers and monitors concentration of credit risk on an ongoing basis. Provisions are made for amounts considered potentially uncollectible. The allowance for uncollectible reinsurance recoverable was $10.9 million and $13.6 million at December 31, 2006 and 2005, respectively.
Income tax returns are open for examination for the tax years 2003-2006 in France, Switzerland and the United States. As a global organization, the Company may be subject to a variety of transfer pricing or permanent establishment challenges by taxing authorities in various jurisdictions. Management believes that adequate provision has been made in the Consolidated Financial Statements for any potential assessments that may result from tax examinations for all open tax years.
As of December 31, 2006, the Company had net deferred tax assets of $62.9 million relating to operating loss carryforwards primarily in France. French tax law allows tax losses to be carried forward for an unlimited period.
Realization of the deferred tax asset is dependent on generating sufficient taxable income in future periods. Although realization is not assured, Management believes that it is more likely than not that the deferred tax asset will be realized.
The following table summarizes the changes in accumulated other comprehensive income and the related tax benefit for the years ended December 31, 2006, 2005 and 2004 (in thousands of U.S. dollars):
The Company was party to agreements with Atradius N.V. since December 2003 (a company in which a board member is a supervisory director) and Novelis since May 2006 (a company in which a board member is a director).
The Company was party to agreements with Barclays Bank PLC (a company in which a board member was a non-executive director) and their respective affiliates and Atis Real (a company in which a board member was a director). Barclays Bank PLC and Atis Real were no longer related parties of the Company subsequent to April 2005 and June 2005, respectively.
Since 1999, the Company has maintained an active pension plan for its Zurich office employees (the Zurich Plan), which was classified and accounted for as a defined contribution plan. Recent amendments to the Zurich Plan during 2006, in conjunction with changes to Swiss pension law (BVG) have led the Company to conclude that the current features of the plan now make it a hybrid plan, which is accounted for as a defined benefit pension plan for the year ended December 31, 2006.
At December 31, 2006 the funded status of the Zurich Plan was as follows (in thousands of U.S. dollars):
At December 31, 2006 the funded status at the end of the year was included in accounts payable, accrued expenses and other in the Consolidated Balance Sheet. Employer contributions for the year ended December 31, 2006 of $3.9 million were paid by the Company prior to the conversion of the Zurich Plan to a defined benefit plan.
The components of net periodic benefit cost for the year ended December 31, 2006 consisted of (in thousands of U.S. dollars):
The incremental effect of applying FAS 158 (see Note 2(q)) was to decrease total assets by $5.7 million, increase total liabilities by $1.2 million and decrease total shareholders’ equity (accumulated other comprehensive income) by $6.9 million. Total pension obligation recognized in accumulated other comprehensive income at December 31, 2006 was $7.3 million (net of $2.1 million of taxes) and included the transition adjustment under FAS 158 of $6.9 million (net of $1.9 million of taxes). Of this transition adjustment, $1.1 million pre-tax is expected to be recognized in net periodic benefit cost in 2007.
At December 31, 2006, estimated employer contributions to be paid in 2007 were $4.3 million and future benefit payments were estimated to be paid as follows (in thousands of U.S. dollars):
Prior to June 1999, the Company had defined benefit plans in place covering substantially all of its employees. All active employees previously enrolled in defined benefit plans have been transferred to defined contribution plans or the Zurich Plan. Benefit accruals under the former defined benefit plans were either frozen, except for certain disabled participants, or rolled into defined contribution plans or the Zurich Plan. At December 31, 2006, the frozen defined benefit plan had plan assets of $7.6 million with a pension obligation of $6.4 million, resulting in the defined benefit plans being overfunded by $1.2 million. In addition to the amounts recognized with respect to the Zurich Plan, the Company has also recognized $0.4 million in accumulated other comprehensive income as a result of applying FAS 158 to the frozen defined benefit plans.
ratably or with a cliff-vest provision, are expensed ratably over the vesting period and have a ten-year contractual term. Shares available for grant under the EIP at the time of replacement were transferred and became available for grant under the EEP, including an additional 1.0 million common shares approved by shareholders for issuance under the EEP.
The Non-Employee Directors’ Stock Plan (Directors’ Stock Plan), which is shareholder-approved, permits the grant of up to 0.5 million stock options, RS, RSU, alternative awards and other share-based awards. Under the Directors’ Stock Plan, the exercise price of the stock options will be equivalent to the fair market value of the stock options at the time of grant, as defined in the Directors’ Stock Plan. Awards issued under the Directors’ Stock Plan generally vest at the time of grant, are expensed immediately and have a ten year contractual term. At December 31, 2006, 0.3 million shares remained available for issuance under this plan.
For the years ended December 31, 2006, 2005 and 2004, the Company’s stock compensation expense was $23.0 million, $15.1 million and $7.8 million, respectively with a tax benefit of $2.2 million, $nil and $nil, respectively. The adoption of SFAS 123(R) resulted in additional compensation expense in 2006 of $2.0 million, or approximately $0.03 per basic and diluted share.
During 2006, 2005 and 2004 the Company issued 83,435, 462,019 and 938,225 stock options with a weighted average grant-date fair value of $14.87, $17.15 and $14.66 respectively.
In 2006, 2005 and 2004 285,382, 609,799 and 497,600 stock options with a total grant-date value of $4.1 million, $8.1 million and $5.8 million were exercised, respectively. The aggregate intrinsic value of stock options exercised for the year ended December 31, 2006, 2005 and 2004 was $5.6 million, $12.2 million and $11.1 million, respectively. The Company received $14.1 million, $27.0 million and $18.4 million from stock option exercises for the years ended December 31, 2006, 2005 and 2004, respectively.
In 2006, the Company’s U.S. subsidiaries deducted $3.7 million from their taxable income upon exercises of stock options. The corresponding tax benefit realized on options exercised was $1.3 million. Shareholders’ equity at December 31, 2006 reflects a tax benefit of $0.9 million related to compensation expense deductions for stock options exercised by employees of the Company’s U.S. subsidiaries.
The activity related to the Company’s stock options issued for the years ended December 31, 2006, 2005 and 2004 was as follows:
Stock options vested and expected to vest and the weighted average exercise price for these stock options was 3,085,474 stock options and $53.37, respectively, at December 31, 2006. The aggregate intrinsic value and weighted average remaining contractual term of stock options vested and expected to vest at December 31, 2006 was $55.1 million and 5.9 years, respectively. The aggregate intrinsic value and weighted average remaining contractual term of stock options exercisable at December 31, 2006 was $46.5 million and 5.6 years, respectively.
In 2000, the Company issued under the EIP 10,000 restricted shares with a weighted-average grant date fair value of $54.50 per share. These shares vested in December 2004. In 2004, the Company issued 5,000 restricted shares with a weighted-average grant date fair value of $55.13 per share. These shares vest in three equal installments on the anniversary of the grant.
The Company values RSU issued under all plans at the fair market value of its common shares at the time of grant. During 2006 and 2005, the Company issued 118,193 and 223,231 RSU with a weighted average grant date fair value of $61.77 and $62.71, respectively.
The activity related to the Company’s RSU for the year ended December 31, 2006 was as follows:
Of the 398,912 RSU outstanding at December 31, 2006, 85,880 RSU are subject to a 5 year delivery date restriction from the grant date and were not released for conversion into shares.
Total unrecognized stock-based compensation expense related to unvested RSU was approximately $8.6 million at December 31, 2006, which is expected to be recognized over a weighted-average period of 1.9 years.
Beginning in 2006, the Company issued 174,770 SAR with a weighted average grant date fair value of $14.37.
Total unrecognized stock-based compensation expense related to unvested SAR was approximately $1.5 million at December 31, 2006, which is expected to be recognized over a weighted-average period of 2.2 years.
The Company used the simplified method for vanilla options under SAB 107 to determine the expected life of SAR. Expected volatility is based on the historical volatility of the Company’s common shares over a period equivalent to the expected life of the Company’s SAR. The risk-free interest rate is based on the market yield of U.S treasury securities with maturities equivalent to the expected life of the Company’s SAR. The dividend yield is based on the average dividend yield of the Company’s shares over the expected life of the Company’s SAR.
The following table illustrates the net effect on net income available to common shareholders and net income per share as if the fair value provisions of SFAS 123 had been applied retroactively to all outstanding share-based compensation issued (in thousands of U.S. dollars, except per share data):
The reinsurance subsidiaries are required to file annual statements with insurance regulatory authorities prepared on an accounting basis prescribed or permitted by such authorities (statutory basis), maintain minimum levels of solvency and liquidity and comply with risk-based capital requirements and licensing rules. As of December 31, 2006, the reinsurance subsidiaries’ solvency, liquidity and risk-based capital amounts were in excess of the minimum levels required. The typical adjustments to insurance statutory basis amounts to convert to U.S. GAAP include elimination of certain statutory reserves, deferral of certain acquisition costs, recognition of deferred income taxes, valuation of bonds at market and presentation of ceded reinsurance balances gross of assumed balances.
The statutory net income (loss) of the Company’s reinsurance subsidiaries for the years ended December 31, 2006, 2005 and 2004, were as follows (in thousands of U.S. dollars):
On November 7, 2006, PartnerRe Finance II Inc. (PartnerRe Finance II), an indirect wholly-owned subsidiary of the Company, issued $250 million aggregate principal amount of 6.440% Fixed-to-Floating Rate Junior Subordinated CENts. The CENts will mature on December 1, 2066 and may be redeemed at the option of the issuer, in whole or in part, after December 1, 2016 or earlier upon occurrence of specific rating agency or tax events. Interest on the CENts will be payable semi-annually commencing on June 1, 2007 to December 1, 2016 at an annual fixed rate of 6.440% and will be payable quarterly thereafter until maturity at an annual rate of 3-month LIBOR plus a margin equal to 2.325%. PartnerRe Finance II may elect to defer one or more interest payments for up to ten years, although interest will continue to accrue and compound at the rate of interest applicable to the CENts. The CENts will be ranked as junior subordinated unsecured obligations of PartnerRe Finance II. The Company has fully and unconditionally guaranteed on a subordinated basis all obligations of PartnerRe Finance II under the CENts. The Company’s obligations under this guarantee are unsecured and will rank junior in priority of payments to the Company’s current long-term debt (see Note 6). The Company used a portion of the net proceeds from the CENts to effect the redemption of all of the $200 million liquidation amount of the 7.90% trust preferred securities issued in 2001 by PartnerRe Capital Trust I and the remaining net proceeds were used for general corporate purposes.
The Company does not consolidate PartnerRe Finance II, which issued the CENts, as it does not meet the consolidation requirements under FIN 46(R). The Company has reflected the debt related to the CENts on its December 31, 2006 Consolidated Balance Sheet.
In November 2001, PartnerRe Capital Trust I (the Trust), a Delaware statutory business trust, issued $200 million of 7.90% Preferred Securities (trust preferred securities). The Trust is wholly owned by PartnerRe Finance I Inc. (PartnerRe Finance I), a Delaware corporation formed solely for the purpose of issuing Junior Subordinated Debt securities to the Trust. PartnerRe Finance I is an indirect, wholly owned subsidiary of the Company.
The sole asset of the Trust consisted of 7.90% Junior Subordinated Debt securities (the Subordinated Debentures) with a principal amount of $206.2 million issued by PartnerRe Finance I. The Subordinated Debentures were redeemable on or after November 21, 2006 and had a maturity date of December 31, 2031. The Subordinated Debentures were unsecured obligations of PartnerRe Finance I. Interest on the Subordinated Debentures was payable quarterly at an annual rate of 7.90%.
On December 21, 2006, the Trust redeemed all of its outstanding 7.90% trust preferred securities concurrently with the redemption of the underlying Subordinated Debentures. The redemptions were conducted pursuant to the terms of the documents governing the trust preferred securities, including the trust agreement relating to the Trust and the junior subordinated indenture of PartnerRe Finance I. The aggregate redemption price for the trust preferred securities was $203.5 million, which included all unpaid distributions accrued to the date of redemption.
In October 2005, the Company issued 2.4 million of its common shares at $61.25 per share, net of underwriting discounts, and the net proceeds to the Company were $149 million, net of underwriting discounts and other transaction costs. The Company used the proceeds of this capital issuance for general corporate purposes.
and unpaid dividends without interest. Dividends on the Series C preferred shares are cumulative from the date of issuance and are payable quarterly in arrears. A portion of the net proceeds from the sale ($250.0 million) was used to redeem the Company’s existing Series A preferred shares. The remaining net proceeds were used for general corporate purposes. In the event of liquidation of the Company, the holders of outstanding preferred shares would have preference over the common shareholders and would receive a distribution of $25.00 per share, or an aggregate value of $290 million, plus accrued and unpaid dividends.
(1) Diluted net loss per share has not been shown for 2005 because the effect of dilutive securities would have been anti-dilutive. Dilutive securities, under the form of options and others, that could potentially dilute basic net loss per share were not included in the computation of diluted net loss per share because to do so would have been antidilutive. The weighted average number of common and common share equivalents outstanding for the period would have amounted to 55,869.3 thousand shares, if these securities had been included.
In October 2005, the Company entered into a forward sale agreement under which it will sell approximately 6.7 million of its common shares to an affiliate of Citigroup Global Markets Inc., which affiliate is referred to as the forward counterparty. Under the forward sale agreement, the Company will deliver common shares to the forward counterparty on one or more settlement dates chosen by the Company prior to October 2008. The purchase price the Company will receive from the forward counterparty will vary depending upon the market price of its common shares over a 40 trading day period surrounding the maturity of the forward sale agreement in October 2008, subject to a maximum price per share of $79.75 and a minimum price per share of $59.53 as of December 31, 2006. If the Company elects to settle all or a portion of the forward sale agreement prior to its maturity, the Company will deliver common shares to the forward counterparty and will initially receive the present value of the minimum price per share, and the remaining payment, if any, due to the Company will be made at maturity of the agreement based on the excess of the market price of the Company’s common shares over the minimum price per share at maturity of the contract. Settlement of the forward sale agreement may be accelerated by the forward counterparty upon the occurrence of certain events, and the maximum and minimum purchase prices will be reduced or increased quarterly depending on the amount of the Company’s dividends.
The Company’s investment portfolio is managed following prudent standards of diversification and a prudent investment philosophy. The Company is not exposed to any significant credit concentration risk on its investments, except for debt securities issued by the U.S. and other AAA-rated sovereign governments. The Company’s investment strategy allows for the use of derivative securities, subject to strict limitations. Derivative instruments may be used to replicate investment positions or to manage currency and market exposures and duration risk that would be allowed under the Company’s investment policy if implemented in other ways. The Company keeps cash and cash equivalents in several banks and may keep up to $500 million, excluding custodial accounts, at any point in time in any one bank.
The Company leases office space under operating leases expiring in various years through 2017. The leases are renewable at the option of the lessee under certain circumstances. The following is a schedule of future minimum rental payments, exclusive of escalation clauses, on non-cancelable leases as of December 31, 2006 (in thousands of U.S. dollars):
Rent expense for the years ended December 31, 2006, 2005 and 2004, was $25.3 million, $24.9 million and $20.6 million, respectively.
The Company also entered into non-cancelable operating subleases expiring in various years through 2010. The minimum rental income to be received by the Company in the future is $6.1 million. The leases are renewable at the option of the lessee under certain circumstances.
Under the terms of the Company’s forward sale agreement (see Note 14), the Company will pay approximately $20.6 million, including interest, in contract fees through 2008. Contract fees and interest paid for the years ended December 31, 2006 and 2005, was $10.8 million and $nil, respectively.
The Company’s reinsurance subsidiaries, and the insurance and reinsurance industry in general, are subject to litigation and arbitration in the normal course of their business operations. In addition to claims litigation, the Company and its subsidiaries may be subject to lawsuits and regulatory actions in the normal course of business that do not arise from or directly relate to claims on reinsurance treaties. This category of business litigation typically involves, inter alia, allegations of underwriting errors or misconduct, employment claims or regulatory activity. While the outcome of the business litigation cannot be predicted with certainty, the Company is disputing and will continue to dispute all allegations against the Company and/or its subsidiaries that Management believes are without merit.
In June 2005, the Company received a subpoena from the United States Attorney for the Southern District of New York requesting information relating to the Company’s finite reinsurance products. In addition, the Company’s wholly owned subsidiary, PartnerRe U.S., received a subpoena from the Florida Office of Insurance Regulation in April 2005 requesting information in connection with its investigation of insurance industry practices related to finite reinsurance activities. The Company has responded promptly to all requests for information.
In January 2007, PartnerRe U.S. received a subpoena from the Attorney General for the State of Connecticut requesting information relating to the Company’s participation in certain underwriting agreements that existed in 2002 and prior. The Company is cooperating fully with this request for information.
Foreign exchange forward contracts outstanding as of December 31, 2006 and 2005, were as follows (in thousands of U.S. dollars):
Exchange traded treasury note futures are used by the Company for the purposes of managing portfolio duration. The notional value of the treasury futures was a long position of $1,170 million and a short position of $200 million, respectively, at December 31, 2006 and 2005. The fair value for futures contracts was a net unrealized loss of $11.2 million and $0.5 million, respectively, at December 31, 2006 and 2005.
The Company utilizes credit default swaps to mitigate the risk associated with its underwriting operations, most notably in the credit/surety line, and to replicate investment positions or to manage market exposures. The credit default swaps are recorded at fair value with the changes in fair value reported in net realized gains and losses in the Consolidated Statements of Operations. The Company uses internal valuation models to estimate the fair value of these derivatives. The fair value of credit default swaps (the Company’s net liabilities) was a net unrealized loss of $2.5 million and $1.7 million, respectively, at December 31, 2006 and 2005. The notional value of the Company’s credit default swaps was $288 million and $255 million, respectively, at December 31, 2006 and 2005.
As part of the Company’s investment strategy, the Company utilizes, to a limited extent, equity short sales, which represent the sales of securities not owned at the time of the sale. These short sales are incorporated within a market neutral strategy, which involves holding long equity securities and a similar amount of offsetting short equity securities to manage market exposure and to generate absolute positive returns. The fair values for equity short sales are based on quoted market prices with the changes in fair value reported in net realized gains and losses in the Consolidated Statements of Operations. The fair value of equities sold but not yet purchased was $70 million and $102 million, respectively, at December 31, 2006 and 2005 (see Note 3(h)). At December 31, 2006 and 2005, the net unrealized investment loss on equities sold but not yet purchased was $nil and $3.4 million, respectively.
As a part of the Company’s ART operations, the Company has entered into total return swaps referencing various structured finance obligations. The Company has also entered into interest rate swaps to mitigate interest rate risk on certain total return swaps. The fair value of those derivatives (the Company’s net liabilities or assets) was a net unrealized loss of $0.3 million and a net unrealized gain of $8.7 million, respectively, at December 31, 2006 and 2005. The notional value of the Company’s total return and interest rate swaps was $315 million and $319 million, respectively, at December 31, 2006 and 2005.
iii. a minimum consolidated tangible net worth of $2,100 million, for periods ended prior to June 30, 2006, and $2,100 million plus 50% of cumulative net income (if positive) since July 1, 2005 through the most recent June 30 or December 31, for periods subsequent to June 30, 2006. For the purposes of this covenant, consolidated tangible net worth includes trust preferred securities and excludes goodwill. Minimum tangible net worth required at December 31, 2006 and 2005 was $2,314 million and $2,100 million, respectively.
Additionally, the syndicated unsecured credit facility allows for an adjustment to the level of pricing should the Company experience a change in its senior unsecured debt ratings. The pricing grid provides the Company
The Company has estimated that claims relating to its exposure to Windstorm Kyrill, which hit Europe in January 2007, are expected to be between $50-$65 million, before taxes. Claims are expected to emanate from several European countries with the largest number from Germany and Austria. The Company’s loss estimate is based on the assessment of individual treaties as well as client data.
Management measures results for the Non-life segment on the basis of the loss ratio, acquisition ratio, technical ratio, other operating expense ratio and combined ratio (defined below). Management measures results for the Non-life sub-segments on the basis of the loss ratio, acquisition ratio and technical ratio (defined below). Management measures results for the ART segment on the basis of the underwriting result, which includes revenues from net premiums earned, other income and net investment income for ART, and expenses from losses and loss expenses, acquisition costs and other operating expenses. The interest in earnings of equity investments, which includes the Company’s share of Channel Re Holdings’ net income, is also part of the ART segment. Management measures results for the Life segment on the basis of the allocated underwriting result, which includes revenues from net premiums earned and allocated net investment income for Life, and expenses from losses and loss expenses and life policy benefits, acquisition costs and other operating expenses.
(A) This segment includes the Company’s share of Channel Re Holdings’ net income in the amount of $11.7 million for the period of October 2005 to September 2006, as the Company reports the results of Channel Re Holdings on a one-quarter lag.
(1) Allocated Underwriting Result is defined as net premiums earned and allocated net investment income less life policy benefits, acquisition costs and other operating expenses.
(C) This segment includes the Company’s share of Channel Re Holdings’ net income in the amount of $6.0 million for the period of February 2004 (when Channel Re Holdings commenced business) to September 2004, as the Company reports the results of Channel Re Holdings on a one-quarter lag.
The following table provides the geographic distribution of gross premiums written based on the location of the underlying risk for the years ended December 31, 2006, 2005 and 2004:
The Company had two brokers that individually accounted for 10% or more of its gross premiums written during the years ended December 31, 2006, 2005 and 2004. The brokers accounted for 20%, 17% and 16% and 18%, 16% and 16%, respectively, of gross premiums written for the years ended December 31, 2006, 2005 and 2004.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of PartnerRe Ltd. and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America.