The table shown below presents selected financial data for each of the five years ended December 31, 2005. This financial information was prepared in accordance with GAAP. The GAAP statement of income data for the years ended December 31, 2005, 2004, 2003, 2002 and 2001 and the GAAP balance sheet data at December 31, 2005, 2004, 2003, 2002 and 2001 were derived from Crum & Forster Holdings Corp.’s consolidated financial statements, which have been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm. The consolidated balance sheets at December 31, 2005 and 2004, and the related consolidated statements of income, of shareholder’s equity, of comprehensive income and of cash flows for each of the three years ended December 31, 2005, and accompanying notes, appear in “Item 8. Financial Statements and Supplementary Data”. The combined statutory data has been derived from annual statutory financial statements, which have been filed with the domiciliary states of the Company’s insurance subsidiaries, and prepared in accordance with SAP, which differs from GAAP.
The following discussion and analysis should be read in conjunction with Crum & Forster’s consolidated financial statements and accompanying notes included in “Item 8. Financial Statements and Supplementary Data”. Certain information constitutes forward-looking statements that involve risks and uncertainties. For further discussion of forward-looking statements, see “Statements Regarding Forward - Looking Information”. Actual results may differ materially from the results discussed in these forward-looking statements as a result of certain factors, including, but not limited to, those set forth under “Item 1A. Risk Factors”.
The most significant accounting estimates relate to the Company’s reserves for unpaid losses and LAE. Unpaid losses and LAE include reserves for both reported (case reserves) and unreported losses and LAE. When the Company is notified of insured losses, claims personnel set up case reserves for the estimated amount of settlement, if any, which excludes estimates of expenses to settle claims, such as legal and other fees and the general expenses of administering the claims adjustment process. The estimate reflects the judgment of claims personnel, or of independent claims adjusters hired by the Company, the scope of coverage available for the reported claim under each individual policy assuming application of controlling state contract law, general reserving practices, the experience and knowledge of such personnel regarding the nature of the specific claim and, where appropriate, advice of counsel, with the goal of setting the reserve at the ultimate expected loss amount as soon as sufficient information becomes available. The facts of the specific claim are investigated and case reserves are established as soon as reasonably possible as follows:
Workers’ Compensation. An individual investigation of each reported accident is undertaken and the claims personnel, using their experience and judgment, establish a case reserve in an amount estimated to be the most likely ultimate loss amount to be paid considering the unique statutory scheme of the applicable jurisdiction. Claims personnel make assumptions as to the likely cost of necessary medical treatment, including prescription medications, estimated time of disability, degree of permanency, and, depending on the severity of the individual case, the necessity and cost of vocational, rehabilitative, or long term care as well as other amounts provided for under the applicable statutory scheme such as funeral and dependant benefits, transportation costs, and employee attorney fees.
In all lines of business, throughout the life of the loss, claims personnel evaluate any new information that is received, analyze the impact of new information on the existing reserve, and, if warranted, increase or decrease the case reserve as appropriate.
The following table presents the impact of a 2% change in ultimate loss and ALAE ratio for each line of business for the accident years shown. The years were selected to include those years where we consider a 2% change in ultimates to be a reasonably likely outcome. The 2% change was selected to represent a reasonably likely change in one of the factors described above. For example, for workers’ compensation, this could be due to changes in medical inflation or claim settlement rates. For general liability, this could be due to court award inflation.
Losses and LAE are charged to income as they are incurred. During the loss settlement period, reserves established in prior years are adjusted as loss experience develops and new information becomes available. Adjustments to previously estimated reserves, both positive and negative, are reflected in the Company’s financial results in the periods in which they are made, and are referred to as prior period development. Due to the high level of uncertainty, revisions to these estimated reserves could have a material impact on the Company’s results of operations in the period recognized, and actual payments for claims and LAE could ultimately be significantly different from estimates.
Asbestos is the most significant and difficult mass tort for the insurance industry in terms of claim volume and dollar exposure. The litigation environment has become increasingly adverse. Plaintiffs, including individuals that do not appear to be impaired by asbestos exposure, often are able to choose from a number of potential venues to bring an action in the court that they expect will be most advantageous to their claims. Many of the lawsuits are filed in a small number of plaintiff-oriented jurisdictions, where significant verdicts historically have been rendered against commercial defendants. Tort reform in certain jurisdictions initially resulted in increased filings by plaintiffs seeking to avoid the potential effective date of the reform legislation in 2003. In 2005 and 2004, insurers, including Crum & Forster, generally experienced either flat or slightly decreased frequency in numbers of newly reported asbestos-related claims due to, among other things, tort reform in certain jurisdictions previously known for large volume filings. It is generally expected throughout the industry that this trend will continue. Management believes that the insurance industry has been adversely affected by judicial interpretations that have had the effect of maximizing insurance recoveries for asbestos claims, from both a coverage and liability perspective. Even when these claims are resolved without loss payment, as a large portion of them are, significant costs are incurred to defend the claims. Generally, only policies underwritten prior to 1986 have potential asbestos exposure since most policies underwritten after that date contain an absolute asbestos exclusion.
Bankruptcy filings by various defendants in the asbestos arena continue to result in larger claim values to be paid by the remaining solvent defendants, including certain Crum & Forster policyholders. To date, this continued flow of claims has forced at least 72 manufacturers and users of asbestos products into bankruptcy. These bankruptcies have, in turn, aggravated both the volume and the value of claims against viable asbestos defendants. Accordingly, there is a high degree of uncertainty with respect to future exposure from asbestos claims, both in identifying which additional policyholders may become targets in the future and in predicting the total number of asbestos claimants.
In 2005, the Company increased asbestos reserves by $31.6 million, or approximately 8% of net unpaid asbestos losses and ALAE at December 31, 2004. A change in the reserve estimate for one policyholder represented over 90% of such increase. The increase for this policyholder is attributable to an unexpected adverse court decision. The asbestos, environmental and other latent reserve range comprises approximately 33% of the Company’s total range of reserves before corporate aggregate reinsurance at December 31, 2005, while comprising only approximately 19% of the Company’s total carried reserves of $2.5 billion before corporate aggregate reinsurance at such date. The aforementioned policyholder comprises approximately 4% of the asbestos, environmental and other latent reserve range and 1% of the total reserve range at December 31, 2005. For additional information on the Company’s range of reserves for each line of business, see “Item 1. Business-Reserves.”
In 2004, the Company increased asbestos reserves by $90.5 million, or approximately 25% of net unpaid asbestos losses and ALAE at December 31, 2003. Changes in the reserve estimates for eight policyholders represented over 80% of such increase. While the Company experienced some increase in the number of claims for known policyholders, an increase in average severity of claim payments and a corresponding increase in defense costs was the principal reason for the asbestos reserve strengthening. Some of the increase was attributable to rising asbestos-related bankruptcies in 2000 through 2002. Solvent defendants in many jurisdictions were left to pay some or all of the portion of the judgments or settlements that should have been paid by the bankrupt defendants. The large unexpected number of bankruptcies filed from 2000 to 2002 resulted in the claim severity increasing beginning in 2003 and continuing through 2004, outside of any known historical trend. In addition, the Company also received multiple allegations of reclassification of products claims (that are subject to an aggregate limit) as premises/operations claims (that are not subject to an aggregate limit).
During 2003, the Company increased asbestos reserves by $149.8 million, or approximately 57% of net unpaid asbestos losses and ALAE at December 31, 2002. Changes in the reserve estimates for 19 policyholders represented approximately 80% of such increase. This increase was largely due to a significant increase in the number of new policyholders presenting claims for asbestos exposures. The policyholders presenting claims for the first time were largely the peripheral defendants described above. In addition, the Company’s policyholder with the largest estimated liabilities had begun to be targeted by plaintiffs in three states where the policyholder had not previously had a material number of claims. Other policyholders also saw an increase in the number of claimants in part in response to legislative reform described above.
Most sites have multiple PRPs. Most insurance policies issued to PRPs did not expressly cover the costs of pollution cleanup since pollution was not a recognized hazard at the time many of these policies were issued. Over time, judicial interpretations in many cases have found that the scope of coverage of the policies included pollution exposure. Since 1986, however, most general liability policies exclude coverage for such exposures.
In addition to asbestos and environmental pollution, the Company faces exposure to other types of latent mass tort claims. These other latent claims include those associated with silica, chemicals, lead, sick building syndrome, gas and vapors, repetitive stress, paint and mold.
For additional discussion on the Company’s reserves, see “Item 1. Business-Reserves” and Notes 4 and 5 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
At December 31, 2005, the Company had unrealized losses of $108.9 million in investments in available-for-sale fixed income and equity securities of which $61.6 million was associated with fixed income securities issued by the U.S. government and its agencies and authorities. Of the remaining unrealized losses, $24.5 million was attributable to corporate fixed income securities and $22.8 million related to equity securities. The corporate fixed income securities unrealized loss related to nine securities of four issuers, of which $10.3 million was in an unrealized loss position for greater than 12 consecutive months, and the equity securities unrealized loss related to eight securities, almost all of which were in an unrealized loss position for less than 12 consecutive months. One of the aforementioned equity securities had a cost of $133.2 million and accounted for $13.9 million of the unrealized losses on equity securities. The factors that management considered for this security, issued by a pharmaceutical company, included the Company’s ability and intent to hold the security until a recovery in value, the duration and severity of the impairment, the issuer’s financial strength, other issuer-specific matters including product pipeline, patent expirations, litigation exposure and business conditions affecting the issuer.
Management’s evaluation of other than temporary losses is particularly sensitive to assumptions it makes relative to forecasts of an issuer’s financial performance and near term prospects such as earnings trends, dividends, analysts forecasts and collateral supporting fixed income securities. Although management is unable to quantify the likelihood of changes to these assumptions that may occur in the future, any change in assumptions could result in recognition of impairments in the future in an amount potentially greater than the unrealized losses on the securities at December 31, 2005.
In certain circumstances, including the significant deterioration of a reinsurer’s financial strength rating, the Company may engage in commutation discussions with an individual reinsurer, essentially canceling and settling the contract at its net present value. The outcome of such discussions may result in a lump sum settlement that is less than the recorded recoverable balance. Losses arising from commutations could have an adverse impact on the Company’s results of operations.
The Company recognizes deferred tax assets and liabilities based on differences between the financial statement carrying amounts and the tax bases of assets and liabilities. Management regularly reviews the Company’s deferred tax assets for recoverability based on history of earnings, expectations for future earnings and expected timing of reversals of temporary differences.
The Company is a national commercial property and casualty insurance company with a focused underwriting strategy, targeting specialty classes of business and underserved market opportunities. Operating through its home office and regional branch network, the Company writes a broad range of commercial coverage, including workers’ compensation, general liability, property, commercial automobile, commercial multi-peril and surety. The Company generally conducts business on a brokerage basis through more than 1,000 producers located throughout the United States.
With respect to the Company’s underwriting operations, management monitors key indicators of growth and profitability. Growth is generally measured in terms of gross premiums written. Management further monitors growth in its gross premiums written in terms of its rate of retention of existing policyholders, increases or decreases in the pricing of renewed policies and the growth in new business premiums. Underwriting profitability is measured both in dollars and by the combined ratio, a standard industry measure. Underwriting profit or loss equals premiums earned less losses and LAE, policy acquisition costs and other underwriting expenses. The combined ratio expresses underwriting results as a percentage of premiums earned and generally comprises two components: the loss ratio, which is the percentage of losses and LAE to premiums earned, and the expense ratio, which is the percentage of the sum of policy acquisition costs and other underwriting expenses to premiums earned. A combined ratio less than 100% indicates an underwriting profit; a combined ratio greater than 100% indicates an underwriting loss.
The property and casualty insurance business is cyclical and influenced by many factors, including price competition, economic conditions, natural and man-made disasters (for example, hurricanes, earthquakes and terrorism), availability and cost of reinsurance, interest rates, state regulations, court decisions and changes in the law. Commencing in mid-2000 through mid-2003, insurers generally achieved significant rate increases and improved terms and conditions. In 2003, however, market capacity expanded, particularly for property risks. In the fourth quarter of 2003 and through 2004 and 2005, property risks were generally written at or below expiring prices. Price increases in casualty lines slowed considerably in 2004 while casualty risks were generally written at or below expiring prices in 2005.
Market competition intensified throughout 2004, particularly in the third and fourth quarters, and this trend has continued through 2005. Renewal pricing in the Company’s casualty lines decreased by approximately 4% in 2005 and renewal pricing in the Company’s property lines declined by approximately 7% in 2005. The Company’s overall renewal retention rate has declined from approximately 65% in 2004 to 61% in 2005. The casualty renewal retention rate declined by approximately two percentage points and the property renewal retention rate declined by approximately six percentage points in 2005. New business in 2005 declined by approximately 9%, with a more significant decrease in the casualty lines of business and a more modest decrease for property lines. In the southeast United States, catastrophe-exposed property risks are generally seeing significant price increases in the aftermath of severe 2005 hurricane activities; however, intense competition continues in other regions and lines of business.
Net income declined to $24.2 million in 2004 from $135.7 million in 2003, primarily due to lower investment results. Underwriting results for 2004, compared to 2003, were marked by higher catastrophe losses offset by decreased adverse development of prior years’ losses and LAE. Catastrophe losses were higher in 2004 than in 2003, principally due to approximately $96 million of losses, including reinstatement premiums of $13 million, associated with four hurricanes in Florida in the third quarter. Adverse development of prior years’ losses and LAE in 2004 amounted to $69.3 million as compared to $118 million in 2003 and included adverse development of latent reserves of $100.5 million and $153.6 million in 2004 and 2003, respectively.
For further discussion of loss development in each year, see “Results of Operations-Losses and loss adjustment expenses”. For further discussion of investment results, see “-Results of Operations -Investment results”, “-Liquidity and Capital Resources” and Note 3 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
For the year ended December 31, 2005, gross premiums written in casualty lines, which include the workers’ compensation, general liability and commercial automobile lines of business, decreased by $23.5 million, or 3.1%, as compared to the year ended December 31, 2004. The decrease was due to a reduction in renewal retention rates, price decreases on renewal polices and a reduction in new business. The casualty market has seen a noticeable acceleration of softening market conditions in 2005 which adversely affected both renewal retention rates and new business production in the year.
For the year ended December 31, 2005, gross premiums written in property lines, which include the property, commercial multi-peril and surety lines of business, decreased by $17.7 million, or 4.6%, as compared to the year ended December 31, 2004. This decrease was primarily due to a reduction in renewal retention rates and price decreases on renewal policies, and a reduction in new business. During 2005, property premiums were adversely affected by a reduction in the surety line of business as a result of a decision by management to restrict writings of contract surety business in response to a greater than expected emergence of surety claims.
Property production has also been affected in 2005 by softening market conditions, characterized by increased capacity in the marketplace and decreasing rates. Following hurricanes Katrina, Rita and Wilma, property premium rates increased, often substantially, in hurricane prone regions and stabilized or declined at a lower rate elsewhere in the country.
For the year ended December 31, 2004, gross premiums written in property lines decreased by $7.9 million, or 2%, as compared to the year ended December 31, 2003. This decrease was primarily due to reductions in new business and price decreases on renewal policies, partially offset by an increase in the renewal retention rate.
The lower decrease in premiums earned relative to net premiums written was principally attributable to the lag in recognition of the decrease in premiums written in the latter part of 2005.
For the year ended December 31, 2004, premiums earned increased by $138.8 million, or 18.1%, as compared to the year ended December 31, 2003. The larger increase in premiums earned relative to net premiums written was principally attributable to the lag in recognition of the increased premiums written in the latter part of 2003.
The Company’s losses and LAE reflect the effect of corporate aggregate reinsurance, including the amortization of deferred gain on retroactive reinsurance and cessions to prospective reinsurance contracts. For further discussion of the accounting for reinsurance coverage and the amortization of deferred income on retroactive reinsurance, see “Item 1. Business-Reinsurance” and Note 2 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
The adverse development before corporate aggregate reinsurance in calendar year 2003 of $132.2 million (17.2 loss ratio points) was primarily due to strengthening of asbestos reserves. Based on its internal actuarial reserve review, the Company strengthened its asbestos, environmental and other latent reserves by $153.6 million, of which asbestos liabilities accounted for $149.8 million, largely due to a significant increase in the number of new policyholders presenting claims for asbestos exposures. These reserve increases were partially offset by favorable non-latent development of $53.1 million in accident years 1998 and prior and $34.9 million in accident year 2002, primarily in the workers’ compensation and commercial automobile lines. Adverse development of $56.8 million was also recognized for accident year 2001 in all liability lines.
The accident year loss and LAE ratio increased from 65.3% for accident year 2003 to 76.5% for accident year 2005. This increase primarily reflects the effects of the 2005 hurricanes, including reinsurance reinstatement premiums of $39.3 million. Catastrophes added 10.2, 9.8 and 4.3 points to the Company’s accident year loss and LAE ratio in 2005, 2004 and 2003, respectively, and added approximately 57.1, 44.7 and 15.9 points to the property accident year loss and LAE ratios, respectively. The accident year loss and LAE ratios represent management’s estimate, at December 31, 2005, of the ultimate cost, expressed as a percentage of net premiums earned for each respective year, of covered claims or events, including settlement costs. For casualty lines of business in particular, where the “tail”, or period from the occurrence of the claim to final settlement, may span several years, the estimates are based on a number of assumptions and, accordingly, are subject to significant variability. See “Results of Operations-Losses and loss adjustment expenses”.
The workers’ compensation loss ratio decrease from accident year 2003 to 2004 and subsequent increase to accident year 2005 included the favorable impact of substantial price increases in 2003 and reflect the effects of price softening in 2005. The Company has expanded its workers’ compensation writings in California since 2000 and monitors the price adequacy of the business. Management believes that this business is currently still profitable.
The property loss ratio increase of approximately 66.6 percentage points from accident year 2003 to 2005 reflects higher catastrophe losses in 2004 and 2005, higher reinstatement premium costs for catastrophe reinsurance, and reductions in pricing through 2004 and most of 2005. The 2003 accident year general liability loss ratio of 80.9% is a result of large loss activity; accident years 2004 and 2005 are emerging as expected. The Company’s estimate of surety accident year loss ratios has deteriorated significantly as a result of adverse surety claims emergence, particularly for accident year 2004.
The Company’s other underwriting expense ratio increased slightly in 2005, to 14.4% in 2005 from 14.3% in 2004. In 2005, excluding reinsurance reinstatement premiums associated with catastrophe losses, the other underwriting expense ratio would have decreased to 13.8%. The other underwriting expense ratio decreased to 14.3% in 2004 from 16.5% in 2003, primarily reflecting premium growth rates in excess of expense growth rates.
The Company manages its investment portfolio with an emphasis on total return. Total return for the period is the sum of investment income (including pre-tax equity in earnings of investees), realized investment gains and losses and changes in the market value of the portfolio expressed as a percentage of the average book value of the portfolio during the period. Total rate of return on investments was 7.6%, 6.5% and 13.7% for the years ended December 31, 2005, 2004 and 2003, respectively. The increase in the Company’s total return on investments in 2005 as compared to 2004 was primarily due to higher investment income as discussed below. The decrease in the Company’s total return on investments in 2004 as compared to 2003 was the result of the significant rally in U.S. Treasury bonds in 2003, compared to a moderate weakening of the bond market in 2004. The following paragraphs discuss each component of the total return on investments.
Realized investment gains were $84.2 million in 2005, $79.5 million in 2004 and $268.2 million in 2003. The increase in realized investment gains of $4.7 million in 2005 is principally the result of gains in U.S. Treasury securities, as well as a gain arising on the sale of one million shares of Zenith National Insurance Corp. common stock, partially offset by net realized investment losses arising from changes in the fair value of the Company’s derivatives and equity securities. Favorable conditions in the U.S. bond markets resulted in significant realized investment gains in 2003. Investment results in 2003 also benefited from $40.7 million of realized investment gains generated from the sale of Hub International Limited securities to an affiliate. For further information on this transaction, see Note 3 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”. Included in realized investment gains in 2005 and 2003 were $3.9 million and $13.8 million, respectively, of losses related to other than temporary impairments. No other than temporary impairments were recorded in 2004. Also included in realized investment gains are certain gains on sales of investments in Fairfax affiliates. For further information on realized investment gains on sales of investments in affiliates, see Note 3 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
In July 2004 and January 2005, as an economic hedge against a decline in the U.S. equity markets, the Company executed short-sales totaling approximately $300 million of Standard & Poor’s Depositary Receipts (“SPDRs”). Simultaneously, the Company purchased two-year S&P Index call options (“Options”) limiting the potential loss on the future purchase of the SPDRs to $60 million. The cost of the Options was $8.2 million. Both the obligations to purchase the SPDRs and the Options are carried at fair value in the consolidated financial statements. Changes in the fair value of the SPDRs and the Options are recorded in realized investment gains and losses and amounted to realized losses of $16.6 million and $15.2 million in 2005 and 2004, respectively. The Company also incurs investment expense in an amount equal to the dividend earnings on the SPDRs sold. Investment expense of $5.7 million and $2.5 million relating to this transaction was recorded for the years ended December 31, 2005 and 2004, respectively.
Pursuant to a non-interest bearing standby credit agreement between Fairfax and the Company, under certain circumstances the Company has the ability to borrow up to $40 million from Fairfax to meet certain corporate obligations. Borrowings under this agreement, if any, bear no interest and are due in June 2018. Through December 31, 2005, there have been no borrowings under this agreement.
Cash used in financing activities, which relates principally to holding company activities, was $73.5 million and $62.5 million in 2005 and 2004, respectively. Cash used in financing activities in both years was principally dividends paid to Fairfax. Cash provided by financing activities was $0.4 million for 2003. Financing cash flows in 2003 were the result of offering costs from the issuance of the senior notes, which were not paid until 2004.
Shareholder’s equity was $961.2 million at December 31, 2005, as compared to $881.2 million at December 31, 2004. The increase was primarily the result of current year earnings, partially offset by dividends paid to Fairfax during 2005 and a decrease in net unrealized investment gains.
The Company’s insurance subsidiaries also maintain a substantial position in highly liquid, short term and other marketable securities in order to provide available cash in the event of unanticipated large claim payments. Management believes that, for the foreseeable future, cash flows from operations at its insurance subsidiaries will be sufficient to meet their operating liquidity needs.
Cash used in investing activities was $135.7 million in 2005 and $1,715.5 million in 2004. The reason for the significant amount of cash used in investing activities in 2004 as compared to 2005 was primarily the result of the reinvestment of over $1 billion of cash and cash equivalents into higher yielding, longer-term investments in the first quarter of 2004.
In 2003, cash provided by investing activities was $1,484.9 million. Sales of fixed income securities generated proceeds, net of purchases, of $1,501.8 million. The proceeds from such sales were invested in low-yielding short-term investments until reinvested in the first quarter of 2004.
The Company’s investment portfolio has exposure to credit risk primarily related to fixed income securities. Management attempts to control this exposure by emphasizing investment grade credit quality in the fixed income securities purchased. Management believes that this concentration in investment grade securities reduces the Company’s exposure to credit risk to an acceptable level. At December 31, 2005 and 2004, 93.2% and 95.6% of the Company’s fixed income securities were rated investment grade, respectively. Fixed income securities and cash and cash equivalents of $323.7 million and $292.4 million were on deposit with various state regulatory authorities at December 31, 2005 and 2004, respectively, as required by insurance laws.
The Company’s combined statutory policyholders’ surplus was $1,314 million at December 31, 2005, as compared to $1,206.5 million at December 31, 2004. Statutory surplus is an important measure utilized by management, regulators and rating agencies to assess the Company’s ability to support its business operations. The increase in the Company’s combined statutory surplus in 2005 as compared to 2004 was primarily attributable to statutory net income of $151.9 million and unrealized capital gains on equity securities of $58.8 million, offset by dividends of $93.4 million paid in 2005 to the Company’s parent. Effective March 30, 2004, the State of Delaware enacted legislation to adopt certain insurance accounting standards promulgated by the NAIC. The adoption of such standards resulted in an increase in the Company’s combined statutory policyholders’ surplus of $28.1 million, principally relating to the recognition of goodwill. The Company’s ratio of statutory net premiums written to surplus, a measure of operating leverage, remained relatively stable in 2005, 2004 and 2003 and, according to data from A.M. Best, was below the property and casualty commercial lines sector ratios of 1.0x, 1.1x and 1.2x, respectively.
The liability for unpaid losses and LAE includes reserves for unpaid reported losses and LAE and for IBNR losses. The amounts shown above represent management’s best estimate of the expected timing of payments for losses and LAE given information currently available. Actual results may differ significantly from these estimates. For additional information on the Company’s unpaid losses and LAE, see “Item 1. Business-Reserves”, “Item 1A. Risk Factors -The Company may incur a reduction in its net income if its reserves are insufficient” and “-Critical Accounting Policies and Estimates-Unpaid losses and loss adjustment expenses”.
The Company and its subsidiaries lease office space and equipment under long-term leases expiring through the year 2022. The amounts above represent the minimum contractual rentals for such operating leases at December 31, 2005. For more information on the Company’s operating leases, see Note 11 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
In July 2004 and January 2005, the Company executed short-sales of SPDRs totaling approximately $300 million. The Company has no contractual timeframe within which it must purchase the SPDRs previously sold and any decision to purchase the SPDRs will be based upon economic and market conditions. For purposes of the above chart, the Company has reflected the purchase obligation in 2006. The actual purchase date may differ from this estimate. For additional information on the SPDRs transaction, see “ -Results of Operations -Investment results” and Note 3 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
Included in other long-term liabilities are expected contributions to postretirement health care and life insurance benefit plans sponsored by the Company and payments under certain incentive and bonus plans.
The incentive and bonus plans included herein are compensation arrangements for certain of the Company’s executives. These agreements are discussed further in “Item 11. Executive Compensation”. The amounts shown above represent management’s best estimate of the liabilities under these plans, including an estimated payment of $11.3 million in 2009, based upon the December 31, 2005 valuation of the Long Term Incentive Plan. Actual payments could be materially different from those estimates.
Consolidated Statements of Income for the Years Ended December 31, 2005, 2004 and 2003
Consolidated Statements of Cash Flows for the Years Ended December 31, 2005, 2004 and 2003
Goodwill is subject to an assessment of impairment on an annual basis or more frequently under certain circumstances. The assessment of impairment involves a two-step process whereby an initial assessment for potential impairment is performed followed by a measurement of the impairment, if any. Impairments are charged to operations in the period in which the impairment occurs. The Company’s annual impairment test in 2005 and 2004 resulted in a conclusion that no goodwill impairment has occurred. Goodwill in the amount of $7,311 is included in other assets on the consolidated balance sheets at December 31, 2005 and 2004.
The Company reinsures, in the ordinary course of business, certain risks with other insurance and reinsurance companies (“reinsurers”). These arrangements provide the means for greater diversification of business and serve to limit the net loss potential of unusually severe or frequent losses. The ceding of insurance does not discharge the original insurer from its primary liability to its policyholder; however, the reinsurer that accepts the risk assumes an obligation to the original insurer (“ceding insurer”). The ceding insurer retains a contingent liability with respect to reinsurance ceded to the extent that any reinsuring company might not be able, or willing, to meet its obligations. Reinsurance recoverable includes the balances due from reinsurers for paid and unpaid losses and LAE that are expected to be recovered from reinsurers. Reserves for uncollectible reinsurance are determined based upon regular reviews of the financial condition of reinsurers and assessments of other available information. Prepaid reinsurance premiums represent the portion of premiums ceded to reinsurers applicable to the unexpired terms of the ceded contracts.
Premiums withheld from reinsurers pursuant to the related reinsurance contracts are included in funds held under reinsurance contracts on the consolidated balance sheets. Interest accrues on these funds in accordance with the contract terms and is included as a reduction of investment income on the consolidated statements of income. Interest on funds held under reinsurance contracts is charged at rates between 7% and 7.5% per annum as specified in the related reinsurance contract.
Deferred income taxes are provided for temporary differences between the financial statement and tax basis of assets and liabilities. Such differences relate principally to deferred income on retroactive reinsurance, unpaid losses and LAE, net operating loss carryforwards, unearned premiums, employee benefit plans, unrealized net appreciation of investments and deferred policy acquisition costs. A valuation allowance against deferred tax assets is recorded if it is more likely than not that all, or some portion of, the benefits related to deferred tax assets will not be realized.
Accumulated other comprehensive income includes unrealized investment gains and losses on the Company’s available-for-sale securities and foreign currency translation gains and losses arising from the translation of financial statements of equity investees denominated in foreign currencies. At December 31, 2005 and 2004, unrealized investment gains included in accumulated other comprehensive income were $42,153 and $45,479, net of tax, respectively. At December 31, 2005 and 2004, foreign currency translation gains were $11,290 and $10,396, net of tax, respectively.
Certain individual available-for-sale securities had gross unrealized losses at December 31, 2005 totaling $108,950, which represented 5.3% of the cost or amortized cost of such securities in the aggregate, of which $86,120 was attributed to fixed income securities and $22,830 was attributed to equity securities. U.S. Treasury securities, the majority of which mature in 2020 or beyond, accounted for $61,610 of the gross unrealized losses in the fixed income portfolio.
At December 31, 2005, the unrealized losses of corporate fixed income securities in the amount of $24,501 relate to nine securities of four issuers. One issuer operates in the telecommunications industry and its securities had gross unrealized losses totaling $17,976, representing five securities and approximately 73% of the gross unrealized losses on corporate fixed income securities. Of this amount, $15,888 related to three securities for which such loss exceeded 10% of their amortized cost at December 31, 2005. Of these three securities, unrealized losses of $2,111 were in respect of two securities that have been in an unrealized loss position for greater than twelve consecutive months. The remaining unrealized loss of $2,088 of this issuer is related to two securities that have been in an unrealized loss position for greater than twelve consecutive months at December 31, 2005, but such loss was less than 10% of their amortized cost. The issuer maintains a significant cash position to meet its obligations and the Company has the ability and intent to hold such securities for a period of time sufficient to allow a market recovery, or to maturity, if necessary.
Another issuer is a special purpose trust, which contains U.S. Treasury strips and fixed income securities of the telecommunications issuer discussed above. This trust’s securities had unrealized losses totaling $6,083, or approximately 25% of the gross unrealized losses on corporate fixed income securities, which was less than 10% of their amortized cost at December 31, 2005. The underlying securities within the trust have been in an unrealized loss position for greater than twelve consecutive months at December 31, 2005. Receipt of the par value of this trust’s securities at maturity is based upon the par value of the Treasury strips and the securities are considered fully recoverable. In addition, the Company has the ability and intent to hold these securities for a period of time sufficient to allow a market recovery, or to maturity, if necessary.
The remaining two issuers have aggregate unrealized losses of $442 at December 31, 2005 and have been in such position for less than six months.
The unrealized losses attributable to equity securities in the amount of $22,830 are in respect of eight securities at December 31, 2005. Approximately $19,854, or 87%, of these unrealized losses were attributable to two securities whose unrealized losses exceeded 10% of their cost. Of this amount, $13,906 was attributed to an equity security in the pharmaceutical industry, which has been in an unrealized loss position for less than twelve consecutive months at December 31, 2005. The Company’s evaluation of this issuer indicates that it has significant financial strength. Management believes that it is undervalued based upon a number of factors, including historical earnings multiples and dividend yields and trades below its intrinsic value. The Company has the ability and intent to hold such securities for a period of time sufficient to allow a market recovery.
The other equity security noted above operates in the property reinsurance industry and is an affiliate of the Company. The security has unrealized losses of $5,948 and has also been in an unrealized loss position for less than twelve consecutive months at December 31, 2005. Management believes that the value of this security has been affected by the 2005 catastrophe losses, particularly hurricanes Katrina, Rita and Wilma. The Company has the ability and intent to hold such securities for a period of time sufficient to allow a market recovery.
Includes interest of $8,923 and $343 in 2005 and 2004, respectively, on cash collateral pledged for short-sale obligations.
Income on other invested assets includes earnings of investment companies and similar equity method investees of $19,026, $5,205 and $11,229 in 2005, 2004 and 2003, respectively, and other interest income. Pre-tax earnings of other equity method investees were $26,451, $19,197 and $2,411 in 2005, 2004 and 2003, respectively. Interest on funds held under reinsurance contracts is charged at rates between 7% and 7.5% per annum, as specified in the related reinsurance contract.
Included in realized investment losses of other invested assets for the years ended December 31, 2005 and 2004 are net losses of $16,603 and $15,237, respectively, related to the change in fair value of short-sale obligations and related option contracts and losses of $30,245 and $3,981, respectively, related to the Company’s credit default swaps. These transactions are discussed further below. Included in realized investment losses for the years ended December 31, 2005 and 2003 are $3,889 and $13,846, respectively, related to losses on other than temporary impairments. No such impairments were recorded in the year ended December 31, 2004.
The Company’s investments in Northbridge Financial Corporation (“Northbridge”), HWIC Asia Fund (“HWIC”), Odyssey Re Holdings Corp. (“Odyssey”) common shares, TRG Holding Corporation (“TRG”), Dalton Greater China Fund (“Dalton”), MFXchange Holdings Inc. (“MFX”) and Pacific Century Fund I (“Pacific”) are accounted for using the equity method and are included in other invested assets on the consolidated balance sheets. The fair market value of the Company’s investment in Northbridge was $232,312 and $188,962, respectively, at December 31, 2005 and 2004. The fair market value of the Company’s investment in Odyssey common shares was $20,064 and $20,168, respectively, at December 31, 2005 and 2004. Earnings from Northbridge, Odyssey common shares, TRG and MFX are included in equity in earnings of investees, net of tax, on the consolidated statements of income. Earnings from HWIC, Dalton and Pacific are included in investment income on the consolidated statements of income. The Company’s investments in Zenith National Insurance Corp. (“Zenith”), Advent Capital (Holdings) PLC (“Advent”) and Odyssey preferred shares are carried at fair value and are included in equity securities on the consolidated balance sheets. Changes in the fair value of Zenith, Advent and Odyssey preferred shares are recorded in accumulated other comprehensive income, net of tax.
In June 2005, Advent, an affiliate of the Company, completed a public offering of its common stock. The Company purchased its pro-rata share equal to $8,321 in the offering and, accordingly, suffered no dilution of its 11.4% ownership interest. Concurrent with the offering, Advent’s common stock was listed for trading on the Alternative Investment Market of the London Stock Exchange. At December 31, 2005, the Company’s investment in Advent has a fair value of $13,347 and an unrealized loss of $5,948 as compared to a fair value of $14,036 and an unrealized gain of $3,063 at December 31, 2004.
In June 2004, the Company sold two million shares of the common stock of Russel Metals, Inc., then a Fairfax affiliate, for total proceeds of $15,590, resulting in a realized investment gain of $9,930.
In December 2003, the Company redeemed approximately 1.8 million shares in HWIC at $33.50 per share or total proceeds of $59,999 and realized investment gains of $15,717. The Company reinvested $75,000 in HWIC during 2004.
The Company’s aggregate share of its equity investees’ balance sheets is summarized as follows:
The difference between the Company’s aggregate share of shareholders’ equity or partners’ capital and the carrying value on the consolidated balance sheets is primarily due to goodwill arising on the acquisition of the equity investees.
The Company holds a 16.5% interest in HWIC at December 31, 2005. For the years ended December 31, 2005, 2004 and 2003, pre-tax equity in earnings of HWIC were $11,996, $2,223 and $14,059, respectively, and were included in investment income on the consolidated statements of income. No dividends have been received from HWIC.
The Company actively monitors and evaluates the financial condition of its reinsurers and prepares estimates of the uncollectible amounts due from reinsurers. Such estimates are made based on periodic evaluation of balances due from reinsurers, judgments regarding reinsurers’ solvency, known disputes, reporting characteristics of the underlying reinsured business, historical experience, current economic conditions and the state of reinsurer relations in general and with the Crum & Forster companies in particular. Management attempts to mitigate collection risk from reinsurers by obtaining collateral and by entering into reinsurance arrangements only with reinsurers that have credit ratings and statutory surplus above certain levels. Reinsurance recoverable on the consolidated balance sheets is stated net of reserves for uncollectible reinsurance of $34,441 and $40,930 at December 31, 2005 and 2004, respectively.
Crum & Forster’s underwriting results are significantly affected by reinsurance. The Company purchases reinsurance to limit its exposure to loss from any one claim or occurrence (“per risk or per occurrence reinsurance”), from aggregate loss experience for an accident year that exceeds an amount the Company is willing to accept and from adverse development of prior years’ loss and LAE reserves (the latter two types of reinsurance are referred to herein as “corporate aggregate reinsurance”, as distinct from the aforementioned “per risk or per occurrence reinsurance”). The Company’s corporate aggregate reinsurance contracts are of the type commonly referred to as “finite” reinsurance and cover or covered, in varying amounts and on varying terms, accident years 2002 and prior. Per risk or per occurrence reinsurance designed to limit exposure to loss from any one claim or occurrence generally responds at the individual claim or occurrence level and is priced based on underlying loss costs and exposures. As a result, loss experience, net of the effect of this reinsurance, is generally consistent with the underlying gross loss experience. Reinsurance designed to limit accident year losses in the aggregate or adverse development of prior years’ loss and LAE reserves may significantly affect the reported loss experience for a given period in amounts or directions that are not consistent with the loss experience of the underlying policies. The prices paid for corporate aggregate reinsurance may also affect the underwriting expense ratios by reducing the net premiums earned, upon which the ratio is calculated.
Therefore, management believes that presenting the Company’s results net of per risk or per occurrence reinsurance but before benefit of corporate aggregate reinsurance generally provides a more accurate portrayal of the actual loss experience of the underlying policies.
The effect of prospective and retroactive corporate aggregate reinsurance on components of the Company’s consolidated statements of income is summarized as follows (increase (decrease) in indicated components):
At December 31, 2005, reinsurance recoverable includes $420,645 and $428,808 related to prospective and retroactive corporate aggregate reinsurance contracts, respectively, of which $491,841 has been recognized as a reduction of incurred losses and LAE on the Company’s consolidated statements of income. A summary of these corporate aggregate reinsurance contracts and the amounts of reinsurance recoverable thereunder follows:
The Company entered into an aggregate stop loss agreement with unaffiliated reinsurers covering accident year 2000, which provided coverage of $118,493 and was fully utilized by the Company at December 31, 2004. This stop loss agreement covered the casualty lines of business. The contract provided 29 loss ratio points of coverage in excess of a loss and ALAE ratio of 66% for covered losses. Premiums for this contract aggregated $76,353. The contract is on a funds held basis with interest credited at 7.5%. Premiums and losses ceded pursuant to the contract in 2004 were $7,595 and $9,994, respectively, and there were no cessions to the contract in 2003. Premium cessions prior to 2003 were $68,758. At December 31, 2005 and 2004, the Company had reinsurance recoverable balances of $53,145 and $76,547, respectively, related to this agreement.
Loss cessions to prospective corporate aggregate reinsurance in 2003 of $1,130 includes the benefit of cessions to the accident year 2001 portion of the aforementioned accident year 2000 through 2002 treaty with nSpire, a Fairfax affiliate, of $55,098, partially offset by charges of $53,968 associated with the commutation of two prospective corporate aggregate reinsurance contracts. The commutation charge of $53,968 included $27,193 arising from the commutation of the accident year 2001 portion of the aforementioned accident year 2000 through 2002 treaty with nSpire and $26,775 related to commutation of a contract with an unrelated party covering accident years 1992 and prior.
In 2001, the Company entered into adverse development contracts with two unaffiliated reinsurers. One contract, covering substantially all lines of business, provides $400,000 of limit in excess of a retention for accident years 2000 and prior, subject to a $200,000 sub-limit on 1998 and prior accident years and an asbestos and environmental sub-limit of $100,000. Premiums are currently based on 35% of amounts ceded plus additional reinsurer margin of $8,000. The contract contains provisions that would increase the premium rate to as high as 62% under conditions that Company management considers unlikely. The contract is on a funds held basis with interest credited at 7%. At December 31, 2005, the Company had ceded cumulative losses of $377,020, which is comprised of $6,009 in 2005, $140,565 in 2004, $10,446 in 2003 and $220,000 prior to 2003 and paid premiums of $154,103, which is comprised of $4,105 in 2005, $58,056 in 2004, $3,656 in 2003 and $88,286 prior to 2003, related to this contract. Of the $22,980 remaining coverage on this contract, $18,800 is available for asbestos development.
The second contract, covering substantially all lines of business, provides $100,000 of limit in excess of a retention for accident periods prior to August 13, 1998, the date of acquisition of the Company by Fairfax. The contract contains sub-limits relating to asbestos, environmental and latent, construction defect and other losses and is subject to a maximum economic loss provision. Premium for this contract was $32,597. The contract is on a funds held basis with interest credited at 7%. The Company may commute the contract any time the funds withheld balance is positive. At December 31, 2005, the Company had ceded cumulative losses of $32,540, which is comprised of ($32,709) in 2005, ($22,888) in 2004 and $88,137 in 2003, and had a return of premium of ($1,539) in 2004 and paid premiums of $33,636 in 2003 and $500 prior to 2003 under this contract. None of the $67,460 remaining coverage on this treaty is available for asbestos development.
The premiums for both contracts are included in funds held under reinsurance contracts on the consolidated balance sheets. The arrangements described above are recorded as retroactive reinsurance, with reinsurance recoverable due from reinsurers in excess of premiums paid for the coverage reflected on the balance sheets as deferred income on retroactive reinsurance. Such deferred income is amortized based on the expected amount and timing of future recoveries, using the interest method. The Company amortized deferred income of $8,058 in 2005, $18,324 in 2004, $13,048 in 2003, and $10,256 prior to 2003. This amortization of deferred income is included as a reduction of losses and LAE in the consolidated statements of income.
In 1998, in connection with the acquisition of the Company by Fairfax, the Company entered into an aggregate stop loss agreement with an unaffiliated reinsurer, which provided coverage of $367,500 in excess of a retention and has been fully utilized by the Company. The contract provided coverage for loss reserve development for accident periods prior to August 13, 1998, the date of acquisition of the Company by Fairfax. The initial premium of $75,000 was paid by the former parent of the Company. This contract is treated as prospective reinsurance. There were no premium cessions to the contract in 2005, 2004 and 2003 and reinsurance recoverable on the contract was $367,500 at both December 31, 2005 and 2004. The Company amended the contract in 2001 to provide an additional $19,248 of coverage for a premium of $7,925, which was recorded in 2001. This contract amendment is treated as retroactive reinsurance and has been fully utilized by the Company. Amortization of deferred income on this amendment is included in the amortization amounts discussed previously.
On June 5, 2003, concurrent with the merger of entities under common control described in Note 1 above, Crum & Forster Funding Corp., an unaffiliated special purpose entity, issued $300,000 aggregate principal amount of senior notes (the “Notes”) in a private placement, with the sole intent of having obligations under such Notes only until the Company could assume such obligations. On June 30, 2003, the Company assumed Crum & Forster Funding Corp.’s obligations under the Notes. The Notes, which bear interest payable semi-annually at 10-3/8%, mature on June 15, 2013. The net proceeds from the offering of approximately $290,955 were used to fund an interest escrow account in the amount of approximately $63,115 to make the first four semi-annual interest payments on the Notes and to pay a dividend to Fairfax in the amount of $217,885, with the remainder used to pay related financing costs. The Notes contain certain restrictions on incurrence of additional indebtedness, dividend payments to Fairfax, asset sales and certain transactions with affiliates. In addition, the Company was required by the terms of the Notes to use its best efforts to register the Notes, or similar instruments with substantially the same terms to be exchanged for the Notes, with the Securities and Exchange Commission. Pursuant to an exchange offer, which was completed on April 20, 2004, the Company issued $300,000 aggregate principal amount of registered notes with substantially the same terms as the Notes, in exchange for all of the outstanding Notes. As required by the terms of the Notes, additional interest of $279 was incurred for the period from December 28, 2003 through April 19, 2004, after which such additional interest was no longer payable on the Notes.
For the years ended December 31, 2005, 2004 and 2003, interest expense on the Notes was $32,915, $33,159 and $18,677 respectively, including additional interest described above, accretion of the discount on the Notes and amortization of related deferred financing costs. At December 31, 2005 and 2004, respectively, deferred financing costs in conjunction with the issuance of the Notes totaled $8,626 and $9,787 and were included in other assets on the consolidated balance sheet. These deferred financing costs are being amortized to interest expense on a straight-line basis over the ten-year duration of the Notes.
The fair value of the long-term debt, determined from quoted market prices, was $315,750 and $336,000 respectively, at December 31, 2005 and 2004.
The Company and its subsidiaries have entered into various reinsurance arrangements with affiliates. The approximate amounts by which income, expense, assets and liabilities are increased (decreased) in the consolidated financial statements, with respect to reinsurance assumed and ceded, are summarized as follows:
In the normal course of business, nSpire, a Fairfax affiliate, participates in reinsurance agreements covering substantially all reinsured lines of business. For the years ended December 31, 2005, 2004 and 2003, the Company ceded to nSpire premiums of $44,301, $43,750 and $29,698, respectively. The Company had reinsurance recoverable of $110,987 and $26,539 at December 31, 2005 and 2004, respectively, related to these reinsurance agreements. The 2005 increase in reinsurance recoverable balances due from nSpire is primarily due to losses related to hurricanes Katrina, Rita and Wilma. Pursuant to the terms of the reinsurance agreements between nSpire and the Company, nSpire, as a foreign reinsurer, is required to collateralize in full reinsurance balances due to the Company. The recoverable from nSpire is fully secured by a combination of letters of credit, trust agreements and premium balances due nSpire. The letters of credit were issued or confirmed by a syndicate of U.S., Canadian and Bermudian banks. There are no regulatory or other restrictions on payments to the Company from nSpire.
Reinsurance recoverable from TIG Insurance Company (“TIG”) totaled $142,516 and $134,340 at December 31, 2005 and 2004, respectively. TIG is domiciled in California and cessions to domestic insurance companies do not require collateral to be recognized for statutory reporting purposes. The Company has considered several factors in assessing the collectibility of reinsurance recoverable balances from TIG. TIG is a runoff company with a B+ (stable) financial strength rating from A.M. Best, a financial strength rating of BB (positive) from Standard and Poor’s and BB+ (stable) from Fitch, all nationally recognized rating agencies. TIG is a sizable regulated entity with policyholders’ surplus of $597,289 at December 31, 2005 and is subject to periodic independent examination by the California Insurance Department. TIG also had short-term liquidity represented by cash and short-term investments of $189,563 at December 31, 2005. The Company has thirteen years of experience with TIG, during which the balances due from TIG have declined from approximately $267,000 to $142,516 at December 31, 2005, principally through settlement of underlying claims. There are no regulatory or other restrictions on payments to the Company from TIG.
Effective March 1, 1999, the Company entered into a reinsurance agreement with Fairmont Specialty Insurance Company (“Fairmont”, formerly Ranger Insurance Company), a subsidiary of Fairfax, covering 100% of policies that are classified as excess liability for public entities and that incept, renew, have an anniversary date or come into effect on or after March 1, 1999. This business was produced by an agency affiliate of Fairmont. Effective June 30, 2002, this agreement was terminated and a new agreement was signed with TIG covering the same business, at substantially the same terms. The new agreement covers policies written on or after July 1, 2002. The agreement was terminated effective September 1, 2003. The Company ceded premiums of $17,679 in 2003 to TIG under these agreements. At December 31, 2005 and 2004, the Company had reinsurance recoverable of $14,897 and $14,776, respectively, from Fairmont, and $16,429 and $8,922, respectively, from TIG, related to these agreements.
Effective February 1, 2002, the Company entered into an arrangement with TIG whereby the Company issued policies on behalf of TIG totaling $22,923 in gross premiums written. The Company entered into reinsurance agreements under which approximately 30% of the total risk under these policies was ceded to TIG with the remaining 70% ceded to third party reinsurers.
This arrangement with TIG was terminated as of June 30, 2002. At December 31, 2005 and 2004, the Company had reinsurance recoverable of $3,766 and $3,196, respectively, from TIG related to this agreement.
In December 2004, the Company sold corporate fixed income securities with a face value of $62,500 to various affiliates of Fairfax. The bonds were sold at fair market value ($52,292 in the aggregate) and the Company realized a gain on these transactions of $12,114.
Under an agreement effective September 1, 2001, US Fire has agreed to obtain certain information technology services, including production and operations support and systems development, on a non-exclusive basis from Fairfax Information Technology Services, Inc. (“FITS”), a wholly-owned subsidiary of Fairfax. Payments for these services for the years ended December 31, 2005, 2004 and 2003 were $13,932, $14,464 and $15,089, respectively. Of such payments, $9,972, $9,064 and $7,346 were charged directly to expense for 2005, 2004 and 2003, respectively. The remaining $3,960, $5,400 and $7,743 related to ongoing systems development costs for 2005, 2004 and 2003, respectively. The Company expenses these costs over a five-year period, beginning on the date the development project is placed in service. In 2005, 2004 and 2003, $2,019, $2,576 and $2,577, respectively, were charged to operations and approximately $18,036 and $16,318 were included in other assets for the years ended December 31, 2005 and 2004, respectively.
In addition, FITS entered into an agreement with the Company effective January 1, 2001 pursuant to which FITS is provided certain management and general services by the Company. Under this agreement, $145, $49 and $54 were billed by the Company for the years ended December 31, 2005, 2004 and 2003, respectively.
Effective January 1, 2000, the Company entered into a service agreement with TIG to obtain certain services relating to issuing policies and handling claims. Payments for these services were $18, $113 and $250 for the years ended December 31, 2005, 2004 and 2003, respectively.
The Company receives income from subleases of office space to Fairfax affiliates. Sublease income received from affiliates in 2005, 2004 and 2003 amounted to $477, $399 and $398, respectively.
The Company sponsors a qualified defined contribution plan pursuant to sections 401(k) and 401(a) of the Internal Revenue Code, for which all employees are eligible after completing one year of service. The Company makes an annual contribution equal to 3% of base salary and a matching contribution equal to one-half of each employee’s contribution up to the first 6% of base salary. Certain employees also have the opportunity to participate in a non-qualified plan that permits contributions that would otherwise be limited by IRS regulations. Total defined contribution plan expense was $3,671, $3,154 and $3,548 for the years ended December 31, 2005, 2004 and 2003, respectively.
The weighted average discount rate used in determining the accumulated postretirement benefit obligation was 5.5% and 5.75% at December 31, 2005 and 2004, respectively. For purposes of measuring the accumulated postretirement benefit obligation at December 31, 2005, the health care cost trend rates are assumed to decline gradually from 8.5% for participants under age 65 and 10.5% for participants over age 65 in 2005 to 5.25% for all participants in the year 2010 and thereafter. Increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation at December 31, 2005 by $1,358, and the aggregate of the service and interest cost components of net periodic postretirement benefit expense for 2005 by $75. Conversely, decreasing the assumed health care cost trend rates by one percentage point in each year would decrease the accumulated postretirement benefit obligation at December 31, 2005 by $996, and the aggregate of the service and interest cost components of net periodic postretirement benefit expense for 2005 by $55. The Company’s expected contribution to the Plan in 2006 is $1,436.
At December 31, 2005, the future benefit payments, net of estimated participant contributions, are expected to be as follows:
Certain employees of the Company have been granted shares of restricted common stock of Fairfax under the Fairfax Financial 1999 Restricted Share Plan. The restricted stock vests over periods ranging from five to ten years. Restricted stock expense of $431, $1,048 and $1,174 for the years ended December 31, 2005, 2004 and 2003, respectively, is included in the consolidated statements of income.
The Company has a long term incentive plan (the “LTIP” or “Plan”) for certain employees who hold senior management or officer positions. The Plan provides for the award of phantom stock that will fully vest on January 1, 2009. LTIP expense of $2,629 and $2,000 for the years ended December 31, 2005 and 2004, respectively, is included in the consolidated statements of income.
The Company and its subsidiaries lease office space consisting principally of a 20 year home office lease which has minimum lease payments remaining of $51,095 and equipment under long-term leases expiring through the year 2022. Minimum annual rentals are summarized as follows:
The amounts above are reduced by space subleased to other companies in the aggregate amount of $844.
It is possible that other governmental and enforcement agencies will seek to review information related to these matters, or that Fairfax and entities in its consolidated group, including the Company, or other parties with whom they interact, such as customers or shareholders, may become subject to direct requests for information or other inquiries by such agencies. These inquiries are ongoing and Fairfax and entities in its consolidated group, including the Company, continue to comply with requests for information from the SEC and the U.S. Attorney’s Office. At the present time, the Company cannot predict the outcome from these continuing inquiries, or the ultimate effect on its financial statements, which effect could be material and adverse.
The principal differences between statutory policyholders’ surplus and shareholder’s equity determined in accordance with GAAP relate to accounting for deferred gains on retroactive insurance, unrealized gains and losses on fixed income securities, deferred policy acquisition costs and deferred federal income taxes. At December 31, 2005, Fairfax owned 10.3% of the outstanding shares of Zenith, which requires the investment to be valued as an affiliate under the Codification of Statutory Accounting Principles adopted by the NAIC in 1998. US Fire’s state of domicile has granted a permitted accounting practice to treat Zenith as a non-affiliated investment based on the absence of control by US Fire. At December 31, 2005, this permitted accounting practice did not change statutory surplus from what it would have been had prescribed accounting practice been followed. at December 31, 2004, this permitted accounting practice increased statutory surplus by $11,305 over what it would have been had prescribed accounting practice been followed.