We have entered into a lease for office space in Bermuda that contains 5,400 square feet. The lease expires on September 30, 2010. The annual lease payment for this office space is approximately $244,300.
(4) Included in our predecessor information are amounts relating to the period from January 1, 2003 to September 3, 2003. The information relating to the period ended December 31, 2003 refers to the period September 3, 2003 to December 31, 2003.
Quanta Holdings was incorporated on May 23, 2003 as a Bermuda holding company formed to provide specialty lines insurance, reinsurance, risk assessment and risk technical services on a global basis through its affiliated companies. From the beginning of 2004 until the second half of 2006 we mainly provided specialty lines insurance and reinsurance services on a global basis and to a lesser extent provided risk assessment and risk technical services. Following A.M. Best’s rating action in the first quarter of 2006 in the wake of losses from the 2005 hurricanes and subsequent decisions by our Board of Directors after a review of strategic alternatives, we substantially ceased writing new business and began conducting a self-managed run-off of our remaining insurance and reinsurance businesses with the exception of our business at Lloyd’s which we had been conducting since the beginning of 2005 and which is more fully described below. On September 15, 2006, we sold Environmental Strategies Consulting LLC (‘‘ESC’’) for total consideration of $12.5 million. Prior to its sale, we provided environmental consulting services through ESC.
On February 13, 2008, we sold our business at Lloyd’s and from that date forward our operations have been limited to the run off of our insurance and reinsurance businesses. On March 13, 2008, we announced the payment of a special dividend in the aggregate amount of $122.7 million payable in cash on March 28, 2008. Our Board of Directors is currently considering and evaluating strategic alternatives that may include the sale of our company or some or all of our remaining businesses or assets, or a combination of one or more alternatives. There can be no assurance as to the timing, structure or terms of such a transaction.
• In the fourth quarter of 2007, we recorded $9.8 million of net losses and loss expenses in our Lloyd’s segment related to Syndicate 4000’s professional liability exposure to the subprime mortgage developments in the United States. We expect claims activity within the D&O and E&O insurance markets to rise as a result of an increase in class action lawsuits filed against public companies due to market losses and related stock price depreciation associated with the subprime mortgage and credit crisis in the United States. Furthermore, we recorded a premium deficiency reserve amounting to approximately $8.0 million. This premium deficiency reserve relates to the write-off of deferred acquisition costs that are deemed irrecoverable from the future earning of unearned premium reserves because we expect that potential future subprime reported losses on claims made policies may exceed those unearned premium reserves.
• We recognized net gains on commutation of reinsurance contracts of approximately $9.7 million which consisted of net favorable loss development of approximately $9.0 million
• In the fourth quarter of 2007, we recorded approximately $4.7 million of charges (including $1.0 million of legal costs) related to our decision to rescind a non-traditional statutory surplus relief life reinsurance contract, which is more fully described below.
At December 31, 2007, our unrestricted cash and invested assets totaled approximately $228.8 million. As of March 3, 2008, our total unrestricted assets increased to $352.9 million primarily as a result of the release of our funds at Lloyd’s. This amount will reduce significantly on March 28, 2008 mainly as a result of the dividend payment more fully described below. As at December 31, 2007, our cash and invested assets, which were invested in instruments with an average rating of ‘‘AAA’’, totaled $801.7 million. At December 31, 2007, a total of $331.9 million were restricted, or pledged, under letters of credit or trusts established for the benefit of our clients or deposited with U.S. regulatory authorities and approximately $241.0 million was pledged or deposited with Lloyd’s in support of our participation in Syndicate 4000. We continue to seek ways to reduce these restrictions and encumbrances including through commutations, cancellations and transfers and negotiations with our clients, through claim payments and obtaining recoveries from our reinsurers and by reducing the collateral requirements we have under our credit facility.
Our total gross loss reserves were $525.1 million at December 31, 2007 as compared to $623.6 million at December 31, 2006. Included in these amounts are $160.3 million and $99.6 million relating to our gross loss reserves in our Lloyd’s segment at December 31, 2007 and 2006. The decrease on our total gross loss reserves primarily reflects claims paid during the year of $89.3 million (which includes the effect of continued contract commutations of $47.1 million), net favorable loss development on our maturing policy years of $39.1 million, as more fully described below, and a reduction in our losses and loss expense reserves of $5.1 million as a result of
cancellations on policies primarily in our HBW program and the related reduction in reserves associated with those cancellations. This is partially offset by the increase in reserves in our Lloyd’s segment as it continued to expand its business during 2007 and incurred subprime related professional liability losses. Our loss reserves represent obligations with short and long term duration. We believe that our shorter term obligations include reinsurance property, reinsurance marine, fidelity, technical risk property, surety and portions of our programs business, including the property component of HBW. The total gross loss and loss expense reserves associated with these lines was approximately $89.3 million at December 31, 2007. We believe that our longer term obligations include reinsurance casualty, professional, environmental, the warranty portion of our HBW program. The total gross loss and loss expense reserves associated with these lines, excluding Lloyd’s, were approximately $275.5 million at December 31, 2007. The actual period over which we will pay losses for both of our short and long term business could significantly vary from our expectations given the immaturity of our business and our limited claims paying history and run-off status. Excluding Lloyd’s, we estimate that approximately 74% of our total gross loss and loss expense reserves are recorded as incurred but not reported, or IBNR, reserves and there can be no certainty as to when these IBNR amounts may become reported, and ultimately, paid losses. Furthermore, our loss and loss expense reserves may change significantly in future periods as we seek to commute, cancel or otherwise transfer our insurance and reinsurance contracts.
During the year ended December 31, 2007, we recorded total net favorable loss development (including those arising from commutations) related to prior year accident periods of $39.1 million. This amount includes favorable loss development as follows:
• $9.0 million relating to the commutations of a number of our reinsurance policies;
• $8.0 million in our Lloyd’s segment particularly in relation to the 2005 and 2006 underwriting years;
• $65.5 million of estimated loss and loss expense reserves arising from the earning of our unearned premium reserves; and
• $9.8 million of net loss and loss expenses recorded in our Lloyd’s segment related to our estimate of claims associated with Syndicate 4000’s professional liability exposure to the subprime mortgage developments in the United States more fully described below under ‘‘Our Lloyd’s Business’’.
We also recorded a reduction in our losses and loss expense reserves of $5.1 million as a result of cancellations on policies, primarily in our HBW program.
With respect to our remaining policies with current and future exposure periods, our gross unearned premium reserves were approximately $95.6 million at December 31, 2007, which includes $58.5 million relating to our Lloyd’s segment. Some of these policies have exposure periods that extend beyond one year. Excluding Lloyd’s, we believe that approximately 30.6% of our gross unearned premium reserves will be earned within one year. The balance will be earned after one year over the remaining term of the underlying exposure periods to the extent these premiums are not returned following future commutations or cancellations. In the first quarter of 2007 we purchased 100% quota share reinsurance for future losses from natural peril or catastrophe or accidental events that may occur in our technical risk property product line. This reinsurance purchase resulted in approximately $4.8 million in ceded premium in the first quarter of 2007, and we believe that this significantly reduces our future net loss exposure from these events. We continue to seek to reduce these exposure periods through policy commutation, cancellation and loss portfolio transfers and, where appropriate, through the purchase of reinsurance protection.
The specialty insurance and reinsurance business that is subject to our self-managed run-off is still exposed to new losses on unexpired policies particularly on our HBW program and in our environmental line of business and adverse development on recorded loss and loss expense reserves. During the run-off we will continue to pay losses as they fall due and collect outstanding loss and loss expenses recoverable from our reinsurers. As we continue to run-off and wind-up our businesses we have sought and will be seeking, over time and subject to the approval of our regulators, to extract capital from our subsidiaries.
We believe that important factors that have a direct impact on the amount of capital that may ultimately be available to our shareholders and the timing of when it will be available include our ability to (1) determine which portion of our business to maintain, commute, cancel, transfer, or otherwise mitigate, as the case may be, (2) mitigate exposures to our capital by purchasing additional reinsurance, (3) make available sufficient assets to facilitate distributions from our subsidiaries, (4) invest our assets in a way that balances risk with return and that is adequately matched with the expected payment periods of our obligations, (5) reduce our expenses, (6) manage our claims and collect premiums receivable and losses recoverable, (7) achieve the release of cash and investment encumbrances relating to reinsurance deposits and other security requirements, (8) manage our capital structure and (9) obtain the approval of our regulators to extract capital from our subsidiaries and distribute it to Quanta Holdings. This process will take a long period of time and require us to meet many conditions. We have engaged our regulators in this process. Following approval from the Bermuda Monetary Authority we declared a dividend of $1.75 per share or $122.7 million which is payable on March 28, 2008 to shareholders of record on March 25, 2008. We refer to this as the March dividend payment.
As of December 31, 2007 our total capital was approximately $350.7 million. Following the March dividend payment of $122.7 million our capital will decrease and will be subject to regulation mainly in Bermuda and the United States (in Colorado and in Indiana).
• contributed $124.0 million and $96.4 million in gross and net written premium to our results for the year ended December 31, 2007 as compared to $91.8 million and $61.7 million in gross and net written premiums for the year ended December 31, 2006.
• incurred charges amounting to $17.8 million related to our estimate of claims associated with exposures to professional liability exposure to the subprime mortgage developments in the United States. We have initially based these charges and our net reserves for losses to a significant degree on industry loss estimates of the total expected losses. Any adjustment to these charges will have an impact on the gain or loss on the sale of our interest at Lloyd’s we expect to record in the first quarter of 2008 and may have a material impact on our results for the period.
• had a net loss ratio of 66.7% for the year ended December 31, 2007 as compared to 76.9% for the year ended December 31, 2006.
During the fourth quarter of 2007, charges of $17.8 million in our Lloyd’s segment’s professional liability exposure to the subprime mortgage developments in the United States include the following:
• $5.9 million of incurred but not reported reserves, net of reinsurance recoverable. Our estimate of IBNR is primarily based on publicly available industry loss estimates for D&O and E&O insurance combined with our estimate of the market share of Lloyd’s in this market as well as our estimate of Syndicate 4000’s market share in the Lloyd’s professional products market.
Our net income available to common shareholders was $22.4 million for the year ended December 31, 2007 as compared to a net loss available to common shareholders of $64.8 million for the year ended December 31, 2006. Our 2007 results were impacted by total net favorable loss development of $39.1 million across all segments (including gains on commutation of a number of reinsurance policies of $9.0 million), losses incurred in our Lloyd’s segment related to our estimate of claims associated with exposures to subprime in certain professional lines of $9.8 million (and the associated premium deficiency of $8.0 million), a charge of $4.7 million (including $1.0 million of legal costs) in relation to the decision to rescind one of our non-traditional statutory surplus relief life reinsurance contracts, the gain on repurchase of junior subordinated debentures of $4.4 million and the gain on repurchase of our Series A preferred shares of $2.4 million. Our 2006 results were impacted primarily by the A.M. Best downgrade and our decision to engage in a self-managed run-off in all our business lines other than our Lloyd’s business. As a result, we received significantly lower revenues from premiums earned and had significantly higher costs related to employee severance, professional, legal and advisory fees. Our 2006 results were also impacted to a lesser extent by adverse reserve developments on hurricanes Katrina, Rita and Wilma, the oil pipeline claim and other than temporary impairment charges on our invested assets.
In 2007, we generated approximately $77.9 million of net premiums written, including $96.4 million from Syndicate 4000, after premiums ceded on purchased reinsurance protection as compared to approximately $80.6 million of net premiums written, after premiums ceded on purchased reinsurance protection in 2006. The reduction reflects the continuation of our self-managed run-off as well as the purchase of more additional reinsurance protection in 2007 than in 2006, and the return of premiums to our clients through policy cancellations and commutations of approximately $24.9 million in 2007 and $97.8 million in 2006 as we sought to reduce our loss exposures. These amounts were partially offset by an increase in the net premiums written by Syndicate 4000.
Similarly, our net premiums earned were $87.2 million in 2007 as compared to $225.3 million in 2006. Our net premiums earned were impacted by significantly lower premium writings and, to a lesser extent, by premium returns associated with policy cancellations. Subsequent to the sale of our interest in Syndicate 4000, we expect continued decreases in net premiums earned in future periods as we do not expect to underwrite new policies. The reductions in premium revenues will likely have a material adverse effect on our future operating results, financial position and liquidity. Historically, net premiums earned have been our primary source of revenue. In 2006 net premiums
Our general and administrative expenses in 2007 were $59.9 million, including $13.8 million of direct expenses related to our Lloyd’s business. Our general and administrative expenses excluding those direct costs associated with our Lloyd’s business were $46.1 million in 2007 as compared to $87.1 million in 2006. In the fourth quarter of 2007 our total general and administrative expenses were $13.2 million compared to $16.0 million in the same period in 2006, and our headcount has reduced to 47 as at December 31, 2007, compared to 81 on December 31, 2006. Our workforce is now allocated to the run-off of our existing business lines, finance, actuarial, general corporate and administrative functions and claims handling. During the years ended December 31, 2007 and 2006, we recorded severance costs of approximately $0.3 million and $14.3 million as a result of employee reductions following our decision to place our specialty insurance and reinsurance lines, other than Syndicate 4000, into run-off. This severance cost relates to the cost associated with those employees who have been provided notice and those who we expect to be terminating in the future and excludes those who we deem to be part of our run-off operation. We continue to seek to reduce our general and administrative expenses (including through further employee reductions) and expect, barring unforeseen circumstances that our 2008 general and administrative expenses will be lower than those incurred during 2007.
Our investment portfolio generated net investment income of $41.9 million during the year ended December 31, 2007, compared to $45.9 million for the year ended December 31, 2006. This decrease is primarily attributable to a decrease in a lower level of invested assets. The lower level of invested assets is a result of the repurchases of our Series A preferred shares and of our junior subordinated debentures, our insurance and reinsurance business being in run-off, reduced cash inflows from premiums written and increased cash outflows associated with loss and loss expenses, commutations and overhead payments. Our average annualized effective yield (calculated by dividing net investment income by the average amortized cost of invested assets, net of amounts payable or receivable for investments purchased or sold) was approximately 4.7% for the year ended December 31, 2007 compared to 5.0% for the year ended December 31, 2006.
policies is in line with the representations made by our client to us. During our monitoring process in 2007, it became apparent that this transaction was not performing as anticipated. We continue to obtain facts to evaluate and to analyze the performance of the life insurance policies that are underlying this transaction. We continue to evaluate the validity of data received from the client and the validity of risks ceded to us by our client as provided for by the terms of the reinsurance contract. On February 27, 2008, we exercised our right to cancel the contract ab initio, as we believe there have been material breaches of the contract as defined within the contract. As a result of this rescission notice, and in accordance with the cancellation provisions in the contract, at December 31, 2007 we recorded the return of all fee income, net of commissions, in the amount of $3.7 million reflecting net fee income earned since inception of the contract. Included in contingencies on the consolidated balance sheet is an amount of $2.5 million of fees due to be returned upon the rescission of this contract. In addition we have recorded an estimated $1.0 million in legal costs that may be incurred in pursuing cancellation and any other legal remedies. We have provided approximately $29.6 million of letters of credit and trust collateral in support of the amount of statutory surplus relief that the U.S. life insurance company has obtained. While the final outcome cannot be ascertained at this time, based on current facts and circumstances, knowledge of the data that has been received and our understanding of the original contract, we believe that the outcome could have a further material adverse effect on its financial position and results of operations in the future. We will continue to pursue any legal remedies against the insurance company that we believe are available and warranted under the circumstances.
The upper portion of the table shows our re-estimated amount of the previously recorded net liability as of the end of each succeeding calendar year. The estimate for our liability for loss and loss expense changes as more information becomes known about the frequency and severity of claims for individual years and, accordingly, as we update our actuarial techniques and selections of the appropriate method. The ‘‘Cumulative increase (decrease)’’ line represents the aggregate change in our estimates over all prior years. These increases or decreases in net liabilities generally arise either from net unfavorable or favorable loss development where the emergence of actual reported claims has been worse or better than expected or where we have cancelled or commuted policies. As described earlier, as our business has matured we have placed more reliance on the Bornhuetter-Ferguson actuarial methodologies which utilize our historical loss data in developing our estimate of ultimate loss liabilities.
• approximately $13.0 million in net loss and loss expenses associated with an oil pipeline claim in our environmental product line;
• an increase of $5.9 million in loss estimates for the 2004 hurricanes as new information was reported to us by our clients; and
During the year ended December 31, 2006, we recorded a decrease in our loss reserves of $6.3 million. The decreases from the 2004 and 2005 accident years were $1.7 million and $4.6 million and were primarily driven by the following:
• $10.4 million of net favorable loss development in several of our product lines, including our fidelity, the property component of HBW, environmental and surety lines where actual loss experience in these product lines was better than expected for the 2005 accident year; and
• $3.5 million of net favorable loss development as a result of transitioning our ultimate loss selection method in our professional insurance product line from the expected loss ratio method to the Bornhuetter-Ferguson method of which $1.7 million related to 2004 and $1.8 million related to 2005.
These net favorable developments of $13.9 million were offset mainly by:
• a $5.0 million increase in our loss estimates in relation to the 2005 hurricanes as new information was reported to us by our clients and others; and
• $14.9 million in several product lines related to mature accident periods in which aggregate loss experience was better than expected for the 2004, 2005 and 2006 accident years. This included approximately $14.7 million in our professional liability and $2.2 million in environmental product lines, offset by a small amount of additional reported losses in our other product lines;
• $9.0 million related to the commutations of a number of our reinsurance policies relating to the 2005 and 2006 accident years;
• $8.0 million recorded in our Lloyd’s segment of which $6.7 million related to 2005 and $1.3 million related to 2006 accident year;
• $5.8 million in relation to the 2005 hurricanes as new information was reported to us by our clients and others;
• $5.1 million related to cancellations on policies, primarily in our HBW program, and the related reduction in reserves associated with those cancellations of which $3.6 million related to the 2006 accident year and $1.5 million related to the 2005 accident year;
• Specialty insurance run-off. Our specialty insurance run-off segment includes the remaining policies written in our traditional, structured and program specialty insurance product line until the second quarter of 2006 and those policies that we were required by regulation to write in the remainder of 2006 and 2007. Our traditional specialty insurance products included technical risk property, professional liability, environmental liability, fidelity and crime, surety, trade credit and political risk and marine and aviation. These products were written both on a direct basis with insured clients or by reinsuring policies that were issued on our behalf by third-party insurers and reinsurers. Our specialty insurance programs include the HBW program.
• Lloyd’s. Syndicate 4000 at Lloyd’s, our Lloyd’s segment, was created in December 2004 and wrote traditional specialty insurance products including professional liability (professional indemnity and directors’ and officers’ coverage), fidelity and crime (financial institutions), specie and fine art and kidnap and ransom. For the 2007 underwriting year, we provided 90% of the capital of Syndicate 4000 as compared to all of the capital commitment from Syndicate 4000’s inception through the 2006 underwriting year. The remaining 10% of Syndicate 4000’s
During 2006, we created a Lloyd’s operating segment for the results of Syndicate 4000 which was previously aggregated with our specialty insurance run-off reportable segment. We believe it is no longer appropriate to aggregate Lloyd’s and specialty insurance run-off operating segments given the different economic characteristics of the specialty insurance run-off segment that is no longer writing new or renewal business while our Lloyd’s syndicate continued to write new and renewal business.
The geographic locations in which we have conducted our business are the United States, Europe and Bermuda. The location of the risks that are the subject of our remaining insurance and reinsurance policies may be anywhere in the world.
We record premiums written at the time that there is sufficient evidence of agreement to the significant terms of the contract but no earlier than the effective date of the policy. The amount of our insurance premiums written and earned depends on the number and type of policies we write, as well as prevailing market prices. Furthermore, the amount of net premiums earned depends upon the type of contracts we have written, the contractual periods of the contracts we write, policy cancellations and commutations, the inception date of the contracts, the expired portions of the
segment. In this report we only present financial ratios related to our Lloyd’s segment as our specialty insurance and reinsurance segments are in run-off.
Our specialty insurance and reinsurance run-off segments are both in run-off. A comparison between our results for the year ended December 31, 2007 and 2006 highlights the differences between running-off our business, which includes, among other things, returning premium upon contract commutations and cancellations, on the one hand, during the year ended December 31, 2007 and writing and earning premium on the other hand in the beginning of the year ended December 31, 2006 before our A.M. Best rating downgrading in March 2006. As a result, a comparison of our results of these periods may not be a meaningful means of analyzing our results of operations.
Results of operations for the years ended December 31, 2007 and 2006 were as follows:
Premiums. Gross premiums written were $106.6 million for the year ended December 31, 2007, a decrease of $52.1 million, compared to $158.7 million for the year ended December 31, 2006. The decrease in our gross premiums written reflects the decision to discontinue writing new business in our insurance and reinsurance lines of business, other than in our Lloyd’s segment and the effect of premium returns to our clients when policies are cancelled.
Our Lloyd’s segment contributed $124.0 million of total gross written premiums in 2007, compared to $91.8 million in 2006. We believe this increase is due to the enhanced ability of Syndicate 4000 to attract new and secure renewal business during the year because of the provision of third party capital to the syndicate, the establishment of the Pembroke Managing Agency and the fact that Syndicate 4000, in its third year, benefited from increased market recognition.
Gain on repurchase of junior subordinated debentures. During the year ended December 31, 2007, we repurchased all of our junior subordinated debentures for an aggregate purchase price of $54.5 million. We originally issued and sold $60.0 million of the junior subordinated debentures in private placements. A gain on repurchase of $4.4 million was recognized, net of repurchase costs of $0.5 million and write off of original deferred issuance costs of $1.7 million.
Other income. Other income was $0.4 million for the year ended December 31, 2007 compared to $3.7 million for the year ended December 31, 2006. The decrease in other income is due to the return of fee income as a result of our decision to cancel one of our non-traditional statutory surplus relief life reinsurance contracts as described more fully in ‘‘Our results’’ above. At December 31, 2007 we have recorded the return of all fee income, net of commissions, in the amount of $3.7 million reflecting net fee income earned since inception of the contract.
• favorable loss experience in mature accident periods in certain of our product lines; and
• favorable loss experience arising on commutation of certain assumed reinsurance contracts.
This decrease was partially offset by net losses incurred in our Lloyd’s segment of $9.8 million related to Syndicate 4000’s professional liability exposure to the subprime mortgage developments in the United States.
Our total net loss ratio (calculated by dividing net losses and loss expenses by net premiums earned) was 35.6% for the year ended December 31, 2007, a decrease of 33.7% compared to a total net loss ratio of 69.3% for the year ended December 31, 2006. The decrease in the total net loss and loss expense ratio is due to the significant favorable development recognized in our insurance and reinsurance run-off segments and the commutation of several assumed reinsurance contracts.
Acquisition expenses. Acquisition expenses were $26.7 million for the year ended December 31, 2007, a decrease of $15.8 million, compared to $42.5 million for the year ended December 31, 2006. The decrease in acquisition expenses is due to the decrease in net premiums earned and the number of insurance contracts we entered into in 2007 as compared to the number of insurance and reinsurance contract we entered into in 2006.
General and administrative expenses. General and administrative expenses were $59.9 million for the year ended December 31, 2007, a decrease of $40.1 million, compared to $100.0 million for the year ended December 31, 2006. General and administrative expenses were comprised of $28.2 million of personnel related expenses (including $0.3 million of severance costs), $16.3 million of professional fees (which includes Lloyd’s managing agency fees, legal fees, audit fees, consulting and actuarial) and $15.4 million of other expenses during the year ended December 31, 2007 compared to $55.2 million of personnel related expenses (including $14.3 million of severance costs) and, $22.6 million of professional fees and $22.2 million of other expenses during the year ended December 31, 2006. The decrease in general and administrative expenses is due to the cost saving measures taken in response to the decision to cease writing new business in 2006, including the reduction of workforce headcount that was 47 as of December 31, 2007 compared to 81 as of December 31, 2006.
Interest expense. Interest expense was $3.6 million for the year ended December 31, 2007, a decrease of $1.9 million compared to $5.5 million for the year ended December 31, 2006. Interest expense for the year ended December 31, 2007 consists of incurred interest on our junior subordinated debentures. Due to the repurchase of the junior subordinated debentures in the third quarter of 2007, we did not incur a full year of interest in 2007 as compared to 2006 when we recorded incurred interest for the entire year.
Depreciation and amortization of intangible assets. Depreciation and amortization of intangible assets was $1.0 million for the year ended December 31, 2007, a decrease of $4.0 million compared
We have recorded a net deferred income tax benefit of $5.3 million related to tax operating losses generated in our Lloyd’s segment for the year ended December 31, 2007. For the year ended December 31, 2007, the net valuation allowance increased by approximately $1.8 million, to $50.9 million.
(3) Transaction costs include advisory fees directly associated with the sale.
Gain on repurchase of preferred shares. During the year ended December 31, 2007, we repurchased all of our Series A preferred shares at a price of $22.50 per share. The aggregate purchase price for the Series A preferred shares was $70.4 million which resulted in a gain of $2.4 million, net of repurchase costs of $2.2 million and write off of original deferred issuance costs of $3.3 million, increasing net income to common shareholders.
Results of operations for the years ended December 31, 2006 and 2005 were as follows:
Substantially all of our revenues were generated by our underwriting subsidiaries in the U.S., Bermuda and Europe. Technical services revenues were derived from the operations of ESC through its sale on September 16, 2006 and from the operations of QLT Buffalo LLC and QLT of Alabama, LLC.
Premiums. Gross premiums written were $158.7 million for the year ended December 31, 2006, a decrease of $450.2 million, or 73.9%, compared to $608.9 million for the year ended December 31, 2005. The decrease in our gross premiums written reflects the decision to discontinue writing new business in our insurance and reinsurance lines of business, other than in our Lloyd’s segment.
Net investment income was $45.9 million for the year ended December 31, 2006 an increase of $18.7 million, or 68.8% compared to $27.2 million for the year ended December 31, 2005. This was derived primarily from interest earned on fixed maturity and short term investments plus amortization of discounts on fixed maturity investments, partially offset by investment management fees. Our average annualized effective yield (calculated by dividing net investment income by the average amortized cost of invested assets, net of amounts payable or receivable for investments purchased or sold) was approximately 5.0% for the year ended December 31, 2006 compared to 3.5% for the year ended December 31, 2005, reflecting rises in market interest rates. Net realized losses of $15.9 million were generated primarily from our other than temporary impairment charge of $16.9 million.
Our expected ultimate losses during the year ended December 31, 2006 included adverse development of approximately $5.0 million related to the 2005 hurricanes and additional net losses of $2.6 million related to damage caused by an oil pipeline in California which ruptured during a mudslide in the first quarter of 2005, for which the damage is covered by an insurance contract issued by our environmental liability product line. This development in 2006 was primarily related to extended remediation activities required by the relevant environmental agencies.
Our acquisition expense ratio for the year ended December 31, 2006 was 18.9%, which is comparable to our acquisition expense ratio of 19.1% for the year ended December 31, 2005. Deferred acquisition costs include, as of December 31, 2006, $12.1 million of acquisition expenses on written contracts of insurance and reinsurance.
General and administrative expenses. General and administrative expenses were $100.0 million for the year ended December 31, 2006, a decrease of $9.6 million, or 8.8%, compared to $109.6 million for the year ended December 31, 2005. General and administrative expenses were comprised of $55.2 million of personnel related expenses (including $14.3 million of severance costs) and $44.8 million of other expenses during the year ended December 31, 2006 compared to $52.4 million of personnel related expenses (including $6.4 million of severance costs) and $57.2 million of other expenses during the year ended December 31, 2005. The decrease in general and administrative expenses is due to the cost saving measures taken in response to the decision to cease writing new business in 2006 but were mitigated by increased severance costs and to a lesser extent, the increased fees associated with ongoing efforts relating to Sarbanes-Oxley Section 404 compliance and costs relating to information technology development.
Depreciation and amortization of intangible assets. Depreciation and amortization of intangible assets was $5.0 million for the year ended December 31, 2006, an increase of $2.0 million compared to $3.0 million for the year ended December 31, 2005. The majority of the increase relates to an
impairment charge of $1.7 million with respect to our intangible assets associated with our U.S. insurance licenses. At December 31, 2006, the carrying value of these licenses approximates their estimated net realizable value.
ESC’s technical services revenues include the inter-company revenues charged by ESC to the QLT’s and to our underwriting segment.
Technical services revenues. Technical services revenues were $22.0 million for the period ended December 31, 2006 compared to $50.8 million for year ended December 31, 2005. The decrease was mainly due to ESC generating significant inter-company revenue for the remediation of the sites of QLT Buffalo, LLC during the second and third quarter of 2005 as compared to the period from January 1, 2006 to September 15, 2006 when there was much less remediation activity. The decrease was also due to our exit from the environmental insurance business.
We created the specialty insurance run-off segment and the specialty reinsurance run-off segment in the third quarter of 2006 following our decision to pursue a self-managed run-off. A comparison between our results for the year ended December 31, 2007 and 2006 for our specialty insurance run-off and specialty reinsurance run-off highlights the differences between running off our business, which includes, among other things, returning premium upon contract commutations and cancellations, on the one hand, during the year ended December 31, 2007 and writing and earning premium following the entering of insurance agreements on the other hand during the year ended December 31, 2006. As a result, a comparison of our results for these periods may not enable a meaningful analysis of our results of operations. Furthermore, our results for the year ended December 31, 2007 are not representative of the actual results that we expect to achieve in future periods as policy cancellations and other run-off activities mainly consist of individual transactions following negotiations between us and third parties that do not follow specified timelines.
For the 2007 underwriting year, Syndicate 4000 had total stamp capacity of £73 million ($147 million) as compared to £82 million ($160 million) for the 2006 underwriting year. This stamp capacity represents the ultimate premium amount (gross premium but net of acquisition expenses) that Syndicate 4000 is permitted to write for the underwriting year.
Following the sale of ESC in the third quarter of 2006, the technical services segment is composed of our two environmental liability assumption programs. The results for the year ended December 31, 2006 have been reclassified to conform to the presentation of ESC in discontinued operations.
The following is a discussion of our net underwriting results and profitability measures by segment for the years ended December 31, 2007, 2006 and 2005.
The following table shows the results of the specialty insurance run-off segment for the years ended December 31, 2007 and 2006:
We ceased to write the HBW program in our technical risk property product line under the terms of the managing agency agreement which expired on December 2, 2006. This program accounted for the substantial majority of total specialty insurance run-off segment gross and net premiums written in the year ended December 31, 2006. The policies in our HBW program were underwritten by a third-party agent which was instructed to follow our underwriting guidelines.
Acquisition expenses. Acquisition expenses were $0.4 million for the year ended December 31, 2007 compared to $18.0 million for the year ended December 31, 2006. The decrease in acquisition expenses was due to the substantial decline in the number of insurance contracts we entered into and the associated net premiums earned. These acquisition expenses primarily represented brokerage fees, commission fees and premium tax expenses and were net of ceding commissions earned on purchased reinsurance treaties.
The following table shows the results of the specialty reinsurance run-off segment for the years ended December 31, 2007 and 2006:
Premiums. Gross and net premiums written were $3.4 million and $(1.0) million for the year ended December 31, 2007 compared to $6.8 million and $(7.2) million of gross and net premiums written for the year ended December 31, 2006. The decrease in our specialty reinsurance run-off
Gross written premiums in our specialty reinsurance run-off segment of $3.4 million for the year ended December 31, 2007 consisted primarily of $4.8 million in premium estimates, partially offset by the impact of the policy commutations in the amount of $1.4 million.
Other income. Other income was $2.6 million for the year ended December 31, 2007 compared to $0.8 million for the year ended December 31, 2006, and related to income, including fees, recognized on non-traditional reinsurance contracts.
Net losses and loss expenses. Net losses and loss expenses had a favorable impact of $6.1 million for the year ended December 31, 2007 compared to an expense of $40.0 million for the year ended December 31, 2006. The decrease in net losses and loss expenses incurred was due to favorable loss reserve developments, lower net earned premium in 2007 and fewer significant loss occurrences, particularly compared to those relating to the development of losses related to the 2005 hurricanes. Net losses and loss expenses are also a function of our net premiums earned and our expected ultimate losses and loss expenses for reported and unreported claims on contracts of reinsurance underwritten. For the year ended December 31, 2007, we recognized favorable development of $9.0 million relating to commutations and $6.7 million relating to the 2004 and 2005 hurricanes.
Included in our expected ultimate losses during the year ended December 31, 2007 are specific loss estimates on contracts of reinsurance insuring claims arising from Hurricanes Katrina, Rita and Wilma. Our estimate of our specialty reinsurance run-off segment’s exposure to ultimate claim costs associated with these hurricanes based on currently available information is $72.6 million compared to $76.6 million for the year ended December 31, 2006. Our estimate of ultimate losses from these events is primarily based on currently available information, claims notifications received to date, industry loss estimates, output from industry models, a review of affected contracts and discussion with cedants and brokers. The actual amount of losses from the hurricanes may vary significantly from the estimate.
The following table shows the results of the Lloyd’s segment for the years ended December 31, 2007 and 2006:
Premiums. Stamp capacity is the measure of the amount of premium Syndicate 4000 is authorized to write and is determined based on a business plan approved by the Council of Lloyd’s and the funds provided by the capital providers. The stamp capacity of Syndicate 4000 for 2007 was £73 million ($147 million) which equates to the amount of premium that can be written in the 2007 underwriting year (premium being defined for these purposes only as gross premium less acquisition expenses). We provided 90%, or £65.7 million ($132 million) of the stamp capacity for the 2007 underwriting year. Syndicate 4000 had stamp capacity of £82 million ($160 million) during 2006, all of which was provided by us.
Gross and net premiums written were $124.0 million and $96.4 million for the year ended December 31, 2007 compared to $91.8 million and $61.7 million for the year ended December 31, 2006. Despite our reduced participation in Syndicate 4000 in 2007, gross and net premiums written have increased as Syndicate 4000 was better able to attract new and secure renewal business during the year because of the provision of third party capital to the syndicate, the establishment of the Pembroke Managing Agency and the fact that Syndicate 4000, in its third year, benefited from increased market recognition. Beginning in 2007, Syndicate 4000’s reported gross written premiums include estimates of unreported premiums and premiums received but not yet processed at Lloyd’s because of time delays between underlying policies being written or adjusted and the inclusion of those policies or policy adjustments in the Lloyd’s underwriting systems. Policy adjustments typically include reinstatement premiums or adjustment premiums related to underwriting experience or the volume of underlying insurance business.
The table below shows gross and net premiums written by product line for the years ended December 31, 2007 and 2006.
In the ordinary course of business, Syndicate 4000 reinsures certain insurance risks with the purpose of limiting maximum loss exposure. Premiums ceded to reinsurers were $27.7 million during the year ended December 31, 2007, compared to premiums ceded to reinsurers of $30.0 million for the year ended December 31, 2006. Despite the fact that gross written premium of Syndicate 4000 increased during the year ended December 31, 2007, as a percentage of written premium, the premiums ceded for the year ended December 31, 2006 was greater than the premiums ceded for the year ended December 31, 2007. This is due to the Company being subject to an excess of loss reinsurance contract that was purchased for the 2006 underwriting year which required us to cede minimum fixed amounts of premium, regardless of the amount of gross premium we actually wrote. For the 2007 underwriting year we have purchased a similar excess of loss reinsurance contract with slightly lower fixed minimum ceded premium requirements. Following a revision of the ultimate premium forecast for the 2007 underwriting year, due to market underwriting conditions, we have, however, slightly increased the proportion of ceded premium on this 2007 excess of loss treaty. The adjustment resulted in additional premium ceded of $1.8 million for the year ended December 31, 2007.
Net premiums earned during the year ended December 31, 2007 were $80.8 million, an increase of $15.3 million, compared to $65.5 million for the year ended December 31, 2006. The increase in net premiums earned was primarily due to growth in Syndicate 4000’s business and the earning of premiums written in prior periods. Gross premiums written and ceded premiums are being earned over the period of each insured risk which is typically one year. There was a negligible impact on net premiums earned arising from the increase in proportion of ceded premium on the 2007 excess of loss reinsurance contract.
The impact of the subprime mortgage loss and loss expenses for the year ended December 31, 2007 is partially offset by $8.0 million of net favorable loss developments on the results of prior underwriting years, in particular, net favorable loss development has occurred in relation to the 2005 underwriting year and, to a lesser extent, in relation to the 2006 underwriting year.
Our Lloyd’s segment’s net loss ratio was 66.7% for the year ended December 31, 2007 as compared to a net loss ratio of 76.9% for the year ended December 31, 2006. The net loss ratio for the year ended December 31, 2007 was adversely impacted by the subprime loss and loss expenses recorded in the fourth quarter of 2007. This has been partially offset by net favorable loss development in certain product lines for more mature accident periods, specifically in respect of the
2005 underwriting year of account where actual loss experience has been better than expected. Additionally, the net loss ratio for the year ended December 31, 2006 and to a lesser extent for the year ended December 31, 2007 was adversely impacted by the excess of loss reinsurance contracts that we purchased for the 2006 underwriting year, which requires us to cede minimum fixed amounts of our premium regardless of the amount of gross premium we actually wrote. We expect that ceding minimum fixed amounts of premiums will continue to adversely impact, to a lesser extent, net loss ratios as the 2006 underwriting year continues to mature.
Acquisition expenses. Acquisition expenses were $27.4 million for the year ended December 31, 2007, an increase of $15.4 million compared to $12.0 million for the year ended December 31, 2006. The increase in acquisition expenses was driven by the premium deficiency reserve of approximately $8.0 million related to the subprime mortgage developments in the United States in certain professional lines. These charges relate to the write-off of deferred acquisition costs that are deemed irrecoverable from the future earning of unearned premium reserves because we expect that potential future reported losses may exceed those unearned premium reserves.
Our acquisition expense ratio was 33.9% for the year ended December 31, 2007, an increase of 15.5%, compared to 18.4% for the year ended December 31, 2006. The increase is primarily attributable to four factors. First, in connection with the above premium deficiency, the additional charge of $8.0 million resulted in an increase in the acquisition expense ratio of 9.9%. Second, in connection with a change in the estimates of acquisition expenses, we recognized a cumulative adjustment which resulted in an increased acquisition expense ratio. We expect that this change in estimating acquisition expenses will have a lesser impact on the acquisition expense ratio in the future. Third, there was an increase in premium written in the specie and fine art and kidnap and ransom business. This business generally carries higher acquisition expenses than professional and financial institution product lines. Finally, the continuing effect of the excess of loss reinsurance contract that we purchased for the 2006 underwriting year which required us to cede minimum fixed amounts of premium regardless of the amount of gross premium we actually wrote continues to have an impact, but to a declining extent, as we continue to earn this premium throughout 2007.
General and administrative expenses. General and administrative expenses were $13.8 million for the year ended December 31, 2007, an increase of $0.9 million, compared to $12.9 million for the year ended December 31, 2006. The general and administrative expense ratio for the year ended December 31, 2007 was 17.1%, compared to 19.7% for the year ended December 31, 2006. Many of the general and administrative expenses incurred by Syndicate 4000 are fixed costs such as the Lloyd’s central fund contributions, managing agency fees, both of which are based on a percentage of underwriting capacity set at the start of the underwriting year, and employee related expenses. Syndicate 4000’s Lloyd’s central fund contribution for the 2007 underwriting year was reduced to 1% of stamp capacity from 2% for the 2006 underwriting year. In addition, the lower stamp capacity for 2007 than for 2006 also contributes to lower central fund charges. These reduced costs are partially offset by increased managing agency fees in 2007.
As a result of the sale of our interests in Syndicate 4000 on February 13, 2008, this segment, as well as the results of the period from January 1, 2008 to February 13, 2008, will be reclassified into discontinued operations in 2008.
The following table summarizes our net underwriting results and profitability measures for our segments for the years ended December 31, 2006 and 2005.
During 2006 we returned or transferred approximately $59.4 million of gross written premiums since our decision to run-off these product lines and to reduce the amount of our in-force policy exposures.
(1) The gross and net premiums written generated by our HBW program is included in our technical risk property product line, as described below.
• favorable development in our ultimate loss ratio selections in certain product lines, particularly in our professional insurance product line in which our selected ultimate net loss ratio for mature accident periods has reduced to approximately 61.6% in 2006 from approximately 68.2% in 2005, resulting in a reduction of net loss and loss expense reserves of approximately $3.5 million.
Our expected ultimate losses during the year ended December 31, 2006 also included estimated gross and net losses of $5.2 million and $2.6 million related to damage caused by an oil pipeline in California which ruptured during a mudslide in the first quarter of 2005, for which the damage is covered by an insurance contract issued by our environmental liability product line.
Our specialty insurance run-off segment net loss ratio was 58.0% for the year ended December 31, 2006 a decrease of 17.2% compared to a net loss ratio of 75.2% for the year ended December 31, 2005. The decrease in the specialty insurance run-off segment net loss ratio is primarily due to the significant loss estimates arising in 2005 from Hurricanes Katrina, Rita and Wilma as well
as to the loss estimates arising in 2005 from the ruptured oil pipeline loss. The 2005 hurricanes did not contribute any loss ratio percentage points to the specialty insurance run-off segment net loss ratio in 2006 compared to 7.0% in 2005. As discussed above, the reduction in certain of our product line’s ultimate net loss ratio for mature accident periods also contributed to the lower insurance run-off segment net loss in 2006.
Our acquisition expense ratio was 15.9% for the year ended December 31, 2006 compared to 13.6% for the year ended December 31, 2005. The increase in our acquisition expense ratio in the specialty insurance run-off segment is primarily due to the impact of purchased reinsurance protection in 2006 and 2005 which reduced net earned premium by a higher proportion in 2006 than 2005. The increase is also due, to a lesser extent, to the return of premiums to canceling policies, including, in some instances, earned premium. Deferred acquisition costs include, as of December 31, 2006, $7.2 million of acquisition expenses on written contracts of insurance that will be amortized in future periods as the premiums written to which they relate are earned.
Ceded premiums were $14.0 million during the year ended December 31, 2006 compared to $83.4 million for the year ended December 31, 2005. The decrease in our ceded premiums written largely reflects our decision to discontinue writing business in our reinsurance product lines in 2006. We also purchased additional retrocessional coverage for our marine, technical risk and aviation reinsurance product line to limit our future probable maximum losses during 2006. These retrocession treaties provide us with protection on an excess of loss, quota share treaty and facultative basis for policies written in our reinsurance product lines of business. Ceded premiums also includes $8.7 million of premium ceded to a third-party reinsurer under the October 2005 portfolio transfer of substantially all of our in-force technical risk property insurance and property reinsurance business. Ceded premiums are earned over the period of each insured risk.
Our specialty reinsurance run-off segment net loss ratio was 86.1% for the year ended December 31, 2006 compared to 107.2% for the year ended December 31, 2005. The decrease in the specialty reinsurance run-off segment net loss ratio is due in part to the magnitude of the loss estimates arising from Hurricanes Katrina, Rita and Wilma described above in 2005. This is mitigated by the impact of ceded earned premium relating to additional purchased reinsurance protection in our marine, technical risk and aviation product line.
Premiums. Gross and net premiums written were $91.8 million and $61.7 million for the year ended December 31, 2006 compared to $80.7 million and $61.6 million for the year ended December 31, 2005. The increase in our gross premiums written was largely due to the continued growth in this segment, which commenced operations in December 2004. This increase was partially offset by the adverse effects on our Lloyd’s business following A.M. Best’s ratings action relating to other Quanta insurance companies which we believe created uncertainty about the future of Syndicate 4000 in the Lloyd’s market place.
Premiums ceded were $30.0 million during the year ended December 31, 2006, an increase of $10.9 million, compared to $19.1 million for the year ended December 31, 2005. The increase in premiums ceded reflects the increase in our gross premium written described above and reflects the acceleration of minimum ceded written premium relating to our excess of loss reinsurance treaties. Minimum and deposit ceded premium is written in proportion to our expected gross written premiums.
Net losses and loss expenses. Net losses and loss expenses were $50.4 million for the year ended December 31, 2006, an increase of $25.7 million, compared to $24.7 million for the year ended December 31, 2005. Net losses and loss expenses are a function of our net premiums earned and our expected ultimate losses and loss expenses for reported and unreported claims on contracts of insurance underwritten. The increase in net losses and loss expenses is primarily due to the increase in our net premiums earned.
As of December 31, 2007 and February 29, 2008, to the face amounts of our fully secured outstanding letters of credit were approximately $91.6 million and $84.7 million.
Our investment strategy seeks to preserve principal and maintain liquidity while trying to maximize total return through a high quality, diversified portfolio. Investment decision making is guided mainly by the nature and timing of our expected liability payouts, management’s forecast of our cash flows and the possibility that we will have unexpected cash demands, for example, to satisfy claims due to catastrophic losses. Our investment portfolio currently consists mainly of highly rated and liquid fixed income securities. However, to the extent our insurance liabilities are correlated with an asset class outside our minimum criteria, our investment guidelines will allow a deviation from those minimum criteria provided such deviations reduce overall risk. We have no immediate intent to liquidate our investment portfolios, other than in normal course of our investment management policies. However, we may be required to sell securities to satisfy return premium, to pay claims or to meet loss obligations on contracts that are cancelled or commuted.
investments, $22.3 million related to cash and cash equivalents, $131.0 million related to restricted cash and cash equivalents, $88.9 million related to trading short-term investments. Of the above amounts, $39.2 million related to trading investments related to deposit liabilities. The majority of our investment portfolio consists of fixed maturity and cash investments which are currently managed by Deutsche Asset Management, our external investment advisors. Custodians of our externally managed investment portfolios are Comerica Incorporated, JP Morgan Chase Bank N.A. and Citibank N.A.
Our portfolio of investment grade fixed maturity investments includes mortgage-backed and asset-backed securities and collateralized mortgage obligations. These types of securities have cash flows that are backed by the principal and interest payments of a group of underlying mortgages or other receivables. During 2007, delinquency and default rates have increased on these types of securities, and particularly on securities backed by subprime mortgages. Generally, subprime mortgages are considered to be those made to borrowers who do not qualify for market interest rates for one or more possible reasons, such as a low credit score, a limited or lack of credit history or a lack of earnings documentation. As a result of the increasing default rates of subprime borrowers, there is a greater risk of defaults on mortgage-backed and asset-backed securities and collateralized mortgage obligations, especially those that are non-investment grade. Therefore, fixed maturities securities backed by subprime mortgages have exhibited significant declines in fair value and liquidity. These factors combined with the contraction in liquidity in the principal markets for these securities makes the estimate of fair value increasingly uncertain. The fair values of our holdings in securities exposed to subprime borrowers are generally not based on quoted prices for identical securities, but are based on model-derived valuations from our independent pricing sources in which significant inputs and significant value drivers are observable in active markets. Should we need to liquidate these securities within a short period of time, the actual realized proceeds may be significantly different from the fair values estimated at December 31, 2007. We believe our exposure to subprime credit risk is limited although there can be no assurance that events in the subprime mortgage sector will not adversely affect the value of our investments. We have determined that a write-down for impairment of these securities is not necessary based on a consideration of relevant factors including prepayment rates, subordination levels, default rates, credit ratings, weighted average life, credit default insurance and historic and current cashflows. Together with our investment managers, we continue to monitor our potential exposure to subprime borrowers and we will make adjustments to the investment portfolio as necessary.
We currently believe that at December 31, 2007 our exposure to subprime mortgages was approximately $5.4 million, which represents less than one percent of our total cash and investments, and our exposure to Alt-A mortgages was approximately $6.2 million. Alt-A mortgages are considered to be those made to borrowers who do not qualify for market interest rates but who are considered to have less credit risk than subprime borrowers.
Our total investments and cash and cash equivalents totaled $801.7 million as of December 31, 2007 compared to $948.2 million as of December 31, 2006. This included restricted cash at December 31, 2007 and 2006 of $131.0 million and $68.1 million. The decrease in these total invested assets was due to the payment of losses, the repurchase of our Series A preferred shares and our junior subordinated debentures as well as the payment of general and administrative expenses and reinsurance balances payable. This decrease was partially offset by the receipt of net investment income, premiums receivable and reinsurance recoverables.
Our insurance and reinsurance premiums receivable balances totaled $57.9 million as of December 31, 2007 compared to $34.6 million as of December 31, 2006. Included in these amounts are $45.4 million and $13.4 million relating to our premiums receivable balances in our Lloyd’s segment as of December 31, 2007 and 2006. The increase in premiums receivable reflects new business written by our Lloyd’s segment. Included in our premiums receivable, as part of our Lloyd’s segment, are approximately $12.5 million of written premium installments that are not yet currently due under the terms of the related insurance and reinsurance contracts. As of December 31, 2007, based on our review of the remaining balance of $45.4 million, which represents premium installments that are currently due, we have established a provision for uncollectible premiums receivable of $0.4 million.
Our deferred acquisition costs and unearned premiums, net of deferred reinsurance premiums, totaled $5.0 million and $75.6 million, respectively, as of December 31, 2007 compared to $12.1 million and $83.9 million as of December 31, 2006. Included in these amounts are $0.9 million and $46.3 million relating to our deferred acquisition costs and unearned premiums, net of deferred reinsurance premiums, from our participation in Syndicate 4000 within our Lloyd’s segment as of December 31, 2007 and $5.0 million and $29.9 million as of December 31, 2006. The decrease in unearned premiums, net of deferred reinsurance, is due to lower premiums written in our run-off segments following our decision to cease underwriting or seeking new business as well as the earning of premiums previously written. This is further decreased by the movement of unearned premiums on our commutation activities. These amounts represent premiums and acquisition expenses on written contracts of insurance and reinsurance that will be recognized in earnings in future periods.
Our reserves for losses and loss adjustment expenses as of December 31, 2007 includes our estimate of gross and net unpaid loss expenses, including incurred but not reported losses, totaling $43.3 million and $26.9 million relating to Hurricanes Katrina, Rita and Wilma. Our estimate of our unpaid exposure to ultimate claim costs associated with these losses is based on currently available information, claim notifications received to date, industry loss estimates, output from industry models, a review of affected contracts and discussion with clients, cedants and brokers. The actual amount of future loss payments relating to these loss events may vary significantly from this estimate.
The following table lists our largest reinsurers measured by the amount of losses and loss adjustment expenses recoverable at December 31, 2007 and the reinsurers’ financial strength rating from A.M. Best:
No reinsurers other than those included above accounted for more than 10% of the losses and loss adjustment expense recoverable balance as at December 31, 2007.
The following table shows our capitalization as of December 31, 2007 and December 31, 2006 (in thousands):
(2) During the year ended December 31, 2007, we repurchased all of our junior subordinated debentures for an aggregate purchase price of $54.5 million. We originally issued and sold $60.0 million of the junior subordinated debentures in private placements. A gain on repurchase of $4.4 million was recognized, net of repurchase costs of $0.5 million and write off of original deferred issuance costs of $1.7 million.
(4) This table does not give effect to warrants, options, restricted shares and performance share units outstanding for 2,542,813, 573,004 and 109,882 at December 31, 2007 compared to 2,542,813, 801,066 and 184,939 at December 31, 2006.
(5) The debt to total capital ratio is calculated as the sum of the revolving credit facility, junior subordinated debentures and redeemable preferred shares, or Total Debt, divided by the sum of Total Debt and Total Shareholders’ Equity, or Total Capitalization.
On October 27, 2006, we entered into a Credit Agreement with a syndicate of lenders and ING Bank N.V., London Branch, as the mandated lead arranger, providing for a secured bank letter of credit facility (the ‘‘ING credit facility’’). The ING credit facility provides for an aggregate commitment of $240.0 million for a period of three years terminating on October 27, 2009. During the course of the year we reduced the aggregate commitment under the ING facility from $240.0 million to $110.0 million at December 31, 2007. Effective February 11, 2008, the ING credit facility was reduced by a further $15.0 million to $95.0 million. As of December 31, 2007 we had approximately $91.6 million of letters of credit outstanding under the ING credit facility.
Under the 2007 LTIP, if any participant is involuntarily terminated without cause, then the participant will receive a pro-rata portion of the total amount available to participants under the 2007 LTIP. In the event specified change of control events are completed prior to 2010, participants will become immediately vested in their payouts under the 2007 LTIP and will receive an award based on the share price received by our shareholders in the change of control transaction, plus any dividends previously paid to the shareholders. For the year ended December 31, 2007, the amount expensed in relation to the 2007 LTIP was $0.6 million.
We incurred an insignificant amount of capital expenditure during the year ended December 31, 2007. As we continue to manage the run-off of our specialty insurance and reinsurance business, we are unable to quantify the amounts of future capital expenditures we may have to incur.
As described under ‘‘Liquidity’’ above we entered into the ING credit facility providing for the issuance of letters of credit for a period of three years terminating on October 27, 2009. Regulatory restrictions also limit the amount of investments that may be pledged by our U.S. insurance borrowers and, consequently, the amount available for letters of credit and borrowings under the facility to those borrowers. As of December 31, 2007 and December 31, 2006, we had approximately $91.6 million and $235.4 million of secured letters of credit issued and outstanding under the facility. If we fail to maintain or enter into adequate letter of credit facilities on a timely basis, we may be unable to provide necessary security to cedant companies that have the right to require the posting of additional security by reason of the downgrade of our A.M. Best rating.
As of March 3, 2008, we have approximately $96.8 million that was pledged as collateral for letters of credit, approximately $152.5 million held in trust funds for the benefit of ceding companies and to fund our obligations associated with the assumption of an environmental remediation liability, $37.3 million held in trust funds that are related to our deposit liabilities and $27.9 million that is on deposit with, or has been pledged to, U.S. state insurance departments.
Some of our insurance and many of our reinsurance contracts contain termination rights that were triggered by the A.M. Best rating downgrade. Some of these insurance and reinsurance contracts also require us to post additional security. As a result, we may be required to post additional security either through the issuance of letters of credit or the placement of securities in trust under the terms of those insurance or reinsurance contracts. We may also elect to post security under other insurance contracts. We currently have net cash and cash equivalent balances of approximately $22.3 million that are available to post as security or place in trust. However, the distribution of these funds from each of our operating subsidiaries is subject to significant legal, regulatory and compliance requirements.
Insurance and reinsurance premiums written are earned over the terms of the associated insurance policies and reinsurance contracts in proportion to the amount of insurance protection provided. Typically this results in the earning of premium on a pro rata over time basis over the term of the related insurance or reinsurance coverage. Premiums written on risks attaching reinsurance contracts are recorded in the period in which the underlying policies or risks are expected to incept
and are earned on a pro rata over time basis over the expected term of the underlying policies. As a result, premiums earned on risks attaching reinsurance contracts usually extend beyond the original term of the reinsurance contract resulting in recognition of premium earnings over an extended period, typically up to 24 months. The term of the insurance or reinsurance coverage provided may be cancelled by the insured or ceding company resulting in a return of written premium.
Prior to commencing our self-managed run-off, in the normal course of operations, we entered into certain contracts that do not meet the risk transfer provisions of Statement of Financial Accounting Standards (‘‘SFAS’’) No. 113, ‘‘Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts’’ (‘‘SFAS 113’’) for financial reporting purposes either due to insufficient underwriting risk or insufficient timing risk or do not provide the indemnification required for insurance accounting under SFAS No. 60, ‘‘Accounting and Reporting by Insurance Enterprises’’ (‘‘SFAS 60’’). For these contracts we follow the deposit method of accounting as prescribed in American Institute of Certified Public Accountants (‘‘AICPA’’) Statement of Position 98-7, ‘‘Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk’’ (‘‘SOP 98-7’’). The deposit method of accounting requires that the premium we receive or pay, less any explicitly defined fees retained or paid, is accounted for as a deposit asset or a deposit liability on the consolidated balance sheet. Explicitly defined fees retained or paid are deferred and earned to other income in the consolidated statement of operations and according to the nature of, and in proportion to, the product or service provided.
As we actively run off our business lines, we seeks to mitigate our exposures to historical underwriting risks through early settlement of our obligations to policyholders or ceding companies by entering into commutations or other arrangements. These negotiated commutation agreements eliminate the risk of adverse claim experience as they provide for full and final settlement of all current and future policy obligations with respect to the transaction to which they relate.
We wrote non-traditional contracts of insurance and reinsurance that were deemed not to meet risk transfer criteria and accordingly we have accounted for these transactions as deposits held on behalf of clients. During the years ended December 31, 2007, 2006 and 2005, we recognized within other income $(0.1) million, $3.5 million and $2.5 million of fees and revenues relating to non-traditional contracts which were accounted for using the deposit method. If these contracts were deemed to transfer risk, gross premium relating to these contracts would total approximately $43.5 million, $87.2 million and $110.7 million in the years ended December 31, 2007, 2006 and 2005.
In the fourth quarter of 2004, we entered into a surplus relief life reinsurance arrangement with a U.S. insurance company and assumed several life reinsurance contracts, through novation agreements. When we assumed these underlying contracts, the client, who is subject to insurance regulation in the United States and therefore is required to maintain a certain amount of statutory capital, was able to reduce its statutory capital requirements. In exchange for our assumption of the contracts we received a fee. The arrangement, among other things, provides that on certain dates and during specific periods, the client has the right but not the obligation to recapture the life reinsurance contracts we have assumed, provided that the underlying cedants do not reasonably withhold their consent to this recapture. Of the $(0.1) million, $3.5 million and $2.5 million, $0.1 million, $0.6 million and $0.7 million of other income recognized during the years ended December 31, 2007, 2006 and 2005 relate to fees earned from this surplus relief life reinsurance arrangement with a U.S. insurance company that meets our definition of a non-traditional contract. As of December 31, 2007, 2006 and 2005, we provided approximately $8.4 million, $10.8 million and $13.1 million (unaudited) of statutory surplus relief to the U.S. insurance company under this contract.
In respect of the life reinsurance arrangements written on a modified coinsurance basis, the ceding company’s net statutory reserves and assets are withheld and remain legally owned by the ceding company. These modified coinsurance contracts represent ‘‘non-cash’’ financial reinsurance transactions, whereby, in accordance with the contract terms, there are no net cash flows at inception of contracts, nor are there expected to be net cash flows through the life of the contracts, other than our explicitly defined fees. Notional contract assets and liabilities contemplated by the contract terms are partially offset in accordance with Financial Accounting Standards Board (‘‘FASB’’) Interpretation No. 39 (‘‘FIN 39’’) ‘‘Offsetting of Amounts Related to Certain Contracts‘‘ and as such we do not present such assets or deposit liabilities in our consolidated balance sheet.
Certain of our coinsurance and modified coinsurance agreements may contain provisions that qualify as embedded derivatives under Derivatives Implementation Group Issue No. B36 ‘‘Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposures That Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor under Those Instruments’’ (‘‘DIG Issue B36’’). The value of embedded derivatives in these contracts is currently considered immaterial. We monitor the performance of these treaties on a quarterly basis. Significant adverse performance or changes in our expectations of future cashflows on these treaties could result in losses associated with the embedded derivative.
Included in other income is $1.5 million, $0.6 million and $0.2 million of other income recognized during the years ended December 31, 2007, 2006 and 2005 relate to explicitly defined margins on one short duration contract written by our specialty reinsurance segment that did not meet the risk transfer provisions of SFAS 113. The contract was commuted during the year ended December 31, 2007, resulting in a gain on commutation of $0.8 million, but was originally written on a funds withheld basis, such that a deposit liability of $21.3 million and $21.7 million at December 31, 2006 and 2005 was recorded and was equal to a funds withheld asset according to the contract terms. In accordance with FIN 39, the funds withheld asset and the deposit liability have been offset in the consolidated balance sheet.
Net deferred acquisition costs are carried at their estimated realizable value and are limited to the amount expected to be recovered from future net earned premiums, after deducting anticipated losses and other costs and considering anticipated investment income. Any limitation is referred to as a premium deficiency.
Reinsurance recoverable, under the terms of ceded reinsurance contracts, includes loss and loss adjustment expenses recoverable and deferred reinsurance premiums. We estimate loss and loss adjustment expenses recoverable using methodologies and assumptions consistent with those used in estimating reserves for losses and loss adjustment expenses. The estimation of loss and loss adjustment expenses recoverable is a significant judgment made by management and is inherently subject to significant uncertainties. We are subject to credit risk with respect to the reinsurance ceded because the ceding of risk does not relieve us from our original obligations to our insureds. To the extent reinsurers default, we must settle these obligations without the benefit of reinsurance protection. Failure of our reinsurers to honor their obligations could result in credit losses. We establish allowances for amounts recoverable that are considered potentially uncollectible from our reinsurers. The valuation of this allowance for uncollectible reinsurance recoverable includes a review of the credit ratings of the reinsurance recoverables by reinsurer, an analysis of default probabilities as well as identifying whether coverage issues exist. These factors require management judgment and the impact of any adjustments to those factors is reflected in net income in the period that the adjustment is determined.
Income taxes have been recognized in accordance with the provisions of SFAS No. 109, ‘‘Accounting for Income Taxes’’, on those operations that are subject to income taxes. Deferred tax assets and liabilities result from temporary differences between the carrying amounts of existing assets and liabilities recorded in the consolidated financial statements and their respective tax bases. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the consolidated statement of operations in the period that includes the enactment date. A valuation allowance for a portion or all of deferred tax assets is recorded as a reduction to deferred tax assets if it is more likely than not that such portion or all of such deferred tax assets will not be realized.
We adopted the provisions of FASB Interpretation No. 48, ‘‘Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement No. 109’’ (‘‘FIN 48’’) on January 1, 2007. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return and provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. During May 2007, the FASB issued FASB Staff Position No. FIN 48-1, ‘‘Definition of Settlement in FASB Interpretation No.48’’ (‘‘FSP FIN 48-1’’). FSP FIN 48-1 amends FIN 48 to provide guidance on how an enterprise should determine whether a tax position is
effectively settled for the purpose of recognizing previously unrecognized tax benefits. The adoption of FIN 48 and FSP FIN48-1 has not affected our financial position or results of operations.
Commencing January 1, 2007, we elected for early adoption of the fair value option for all fixed maturity investments and therefore also adopted SFAS 157. We elected to early adopt the fair value option to simplify the accounting, as this adoption reduces the burden of the monitoring of differences between the cost and fair value of our investments, including the assessment as to whether declines in value are temporary in nature, mitigates a potential volatility in earnings and further removes an element of management judgment. SFAS 159 has been applied to our entire investment portfolio but not to any other assets or liabilities. Prior to January 1, 2007, investments were considered ‘‘Available for Sale’’ and were carried at fair value, except those investments held in relation to our deposit liabilities. This adoption requires all investments to now be reported as ‘‘Trading’’ under SFAS 115, although it does not amend the carrying value of fixed maturity investments as they continue to be carried at fair value. As a result all unrealized gains and losses, amounting to approximately $10.0 million, in our investment portfolio were reclassified from accumulated other comprehensive loss within shareholders’ equity on the consolidated balance sheets to retained earnings as of January 1, 2007.
• Level I - Valuations based on quoted prices in active markets for identical assets or liabilities that the Company has the ability to access. Since valuations are based on quoted prices that are readily and regularly available in an active market, valuation of these products does not entail a significant degree of judgment.
• Level II - Valuations based on quoted prices in active markets for similar assets or liabilities, quoted prices in markets that are not active or for which all significant inputs are observable, directly or indirectly.
Prior to the adoption of SFAS 159 and due to our decision to place our insurance and reinsurance lines, except Syndicate 4000, into orderly run-off, we concluded that we may no longer have the ability or intent to hold our securities for a sufficient period of time to allow recovery. Accordingly, during the years ended December 31, 2006 and 2005, we recorded $16.9 million and $10.2 million in other than temporary impairment losses. The realization of these losses represents the maximum amount of potential losses in our investment securities if we sold all of these securities at the time the impairments were recorded and was primarily attributable to changes in interest rates and not changes in credit quality. As a result of this decision, the affected investments were reduced to their estimated fair value, which became their new cost basis. The recognition of the losses had no effect on our shareholders’ equity, the market value of our investments, our cash flows or liquidity.
We capitalize software costs when the preliminary project stage is completed and management commits to fund the software project which it deems probable will be completed and used to perform the intended function. This policy is in accordance with AICPA Statement of Position 98-1 ‘‘Accounting for the costs of computer software developed or obtained for internal use’’ (‘‘SOP 98-1’’). Software costs that are capitalized include only external direct costs of materials and services consumed in developing, or obtained for internal use computer software.
Our loss reserves fall into two categories: case reserves for reported losses and loss expenses and reserves for losses and loss expenses incurred but not reported, or IBNR reserves. Case reserves are based initially on claim reports received from insureds, brokers or ceding companies, and may be supplemented by our claims professionals with estimates of additional ultimate settlement costs. IBNR reserves are estimated by management using generally accepted statistical and actuarial techniques
As of December 31, 2007 the primary reserving method used by us to estimate the ultimate cost of losses for our specialty reinsurance run-off lines and professional, environmental, fidelity and technical risk property specialty insurance run-off business lines was the Bornhuetter-Ferguson actuarial method for which we use both historical paid and historical reported data. The Bornhuetter-Ferguson actuarial method utilizes the expected loss (initial expected loss and loss expense ratio multiplied by earned premium) multiplied by loss development factors derived by our internal actuaries from our own actual loss and loss expense experience in each product line and also from industry statistics. Our initial expected loss and loss expense ratio for the specialty reinsurance business lines is derived from loss exposure information provided by brokers and ceding companies and from loss and loss expense ratios established during the pricing of individual contracts. Our initial expected losses and loss expense ratios selected for the professional, environmental, fidelity and technical risk property specialty insurance lines are based on benchmarks derived by our underwriters and actuaries during the initial pricing of the business and from comparable market information. These benchmarks are then adjusted for any rating increases and changes in terms and conditions that have been observed in the market.
Since we ceased writing business in 2006, we believe that the reported and paid loss data in our specialty runoff business is mature enough to further rely on the following actuarial methods: Reported Development Method, Paid Development Method, Paid Bornhuetter-Ferguson Method and Reported Bornhuetter-Ferguson Method. In our Lloyd’s business, for the non-subprime exposure, for the 2006 underwriting year and prior we relied on the Bornhuetter-Ferguson actuarial method and for 2007 underwriting year we used an expected loss ratio methodology. For the subprime exposure, multiple methods were used to derive an estimate of the ultimate cost of losses. For example one method used was related to the industry estimates of ultimate losses and calculating our ultimate cost of losses based on Syndicates 4000’s share of the market premium. Another method considered an internal loss exposure analysis commissioned by Syndicate 4000 based on the risk characteristics of the Syndicate 4000 portfolio of policies written.
Even though our reserving techniques represent a reasonable and appropriate basis for estimating ultimate claim costs and management believes that the reserves for losses and loss expenses are sufficient to cover claims from losses occurring up to the consolidated balance sheet date, ultimate losses and loss expenses may be subject to significant volatility as a result of significant uncertainties. These uncertainties are driven by many variables that are difficult to quantify. These uncertainties include, for example, the period of time between the occurrence of an insured loss and actual settlement, fluctuations in inflation, prevailing economic, social and judicial trends, legislative changes, internal and third party claims handling procedures, the lack of complete historical data on which to base loss expectations and the run-off status of our operations, except Syndicate 4000. Accordingly, ultimate liabilities may differ materially from the amounts recorded in the consolidated financial statements.
The estimation of unpaid loss liabilities will also vary in subjectivity depending on the lines or classes of business involved. Short-tail business describes lines of business for which losses become known and paid in a relatively short period of time after the loss actually occurs. Typically, there will be less variability in the estimates of ultimate amount of losses from claims incurred in the short-tail
The amount of consideration received for the assumption of remediation liabilities in excess of the expected environmental remediation liability is initially deferred and recorded in deferred income on the consolidated balance sheet and subsequently recognized in earnings over the remediation period using the cost recovery or percentage-of-completion method. These methods are based on the ratio of remediation expenses actually incurred and paid to total estimated remediation costs. As of December 31, 2007 and 2006, we had deferred approximately $0.1 million and $0.2 million of technical services remediation revenues. Anticipated remediation losses, if any, are recorded in the period in which we become aware of such losses.
We have a long-term stock-based incentive plan (the ’’Incentive Plan’’), which is described more fully in Note 17. Prior to January 1, 2006, we accounted for the Incentive Plan under the recognition and measurement provisions of APB Opinion No. 25 , Accounting for Stock Issued to Employees (‘‘APB 25’’) and related Interpretations, as permitted by FASB Statement No. 123 , Accounting for Stock-Based Compensation (‘‘SFAS 123’’). No stock-based employee compensation cost was recognized in the Statement of Operations for the year ended December 31, 2005, as all options granted under the Incentive Plan had an exercise price equal to the market value of the underlying common stock on the date of grant. Effective January 1, 2006, we adopted the fair value recognition provisions of FASB Statement No. 123(R), Share-Based Payment (‘‘SFAS 123(R)’’), using the modified-prospective-transition method. Under that transition method, compensation cost recognized in 2006 also includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation cost for all share-based payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123(R). Results for prior periods have not been restated.
As a result of adopting SFAS 123(R) on January 1, 2006, our net income for the year ended December 31, 2007 is $0.3 million lower and the net loss for the year ended December 31, 2006, is
The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS 123 to options granted under the Company’s stock option plans in the period prior to January 1, 2006. For purposes of this pro forma disclosure, the value of the options is estimated using a Black-Scholes-Merton option-pricing formula and amortized to expense over the options’ vesting periods.
Included in the pro-forma stock-based employee compensation expense for the year ended December 31, 2005 is $1.0 million related to the accelerated vesting of 649,830 options granted to the Company’s former Chief Executive Officer that were modified upon his resignation.
We engage in certain derivative related activities and have adopted Statement of Financial Accounting Standards (‘‘SFAS’’) No. 133, ‘‘Accounting for Derivative Instruments and Hedging Activities’’ (‘‘SFAS 133’’) and SFAS 149, ‘‘Amendment of Statement No. 133 on Derivative Instruments and Hedging Activities.’’
Although we do not currently hold any derivative instruments, we expect we would primarily enter into investment related derivative transactions, as permitted by our investment guidelines, and typically for the purposes of managing investment duration, interest rate and foreign currency exposure, and enhancing total investment returns. We may also, as part of our business, enter into derivative transactions for the purpose of replicating approved investment, insurance or reinsurance transactions that meet our investment or our underwriting guidelines. As of December 31, 2004, we held in our available-for-sale fixed maturity portfolio a mortality-risk-linked security for which the repayment of principal was dependent on the performance of a specified mortality index. The component of the bond that was linked to the mortality index had been determined, under SFAS 133, to be an embedded derivative that was not clearly and closely related to its host contract (a debt
DIG Issue B36 indicates that our life financial reinsurance contracts where we notionally receive a financial instrument with an investment return based on our underlying referenced pool of assets may contain an embedded derivative that must be bifurcated and accounted for in accordance with SFAS 133 since the economic characteristics are not clearly and closely related to the host instrument. Although our life financial reinsurance arrangements may contain embedded derivatives we believe that due to the terms of these contracts, including the experience refund provisions contained within the treaties, the value of embedded derivatives contained in these contracts is currently considered to be immaterial.
During the year ended December 31, 2004, we adopted an Annual Variable Cash Compensation Plan (the ‘‘Annual Variable Cash Incentive Plan’’) which was generally available to employees in 2004 and 2005. Awards paid under this plan were dependent on performance measured at an individual and line of business level for the years ended December 31, 2004 and 2005. In general, the Annual Variable Cash Incentive Plan provided for an annual bonus award to employees that was based on a sharing of profit in excess of a minimum return on capital to shareholders (as calculated under the Annual Variable Cash Incentive Plan). Profit for each calendar year was measured by estimating the ultimate net present value of after-tax profit generated from business during that calendar year and, up until December 31, 2006, was re-estimated on an annual basis through the vesting period. Annual Incentive Plan awards for 2004 and 2005 have now fully vested and all amounts have been paid.
Following the determination to engage in a self-managed run-off, employees will generally receive a bonus based on individual performance that was comprised of a guaranteed and variable element for the 2006 financial year and that is 100% discretionary for the 2007 financial year. The bonus based on the 2006 financial year was paid in the second quarter of 2007. The bonus based on the 2007 financial year is expected to be paid on or around March 15, 2008.
permanent disability or normal retirement. Under the 2007 LTIP, if any participant voluntarily terminates his or her employment (other than by retirement) or that person is terminated for cause prior to December 31, 2009, the entire award will be forfeited by that participant. If any participant is involuntarily terminated without cause, then the participant will receive a pro-rata portion of the total amount available to participants under the 2007 LTIP. In the event specified change of control events are completed prior to 2010, participants will become immediately vested in their payouts under the 2007 LTIP and will receive an award based on the share price received by our shareholders in the change of control transaction, plus any dividends previously paid to the shareholders.
Expenses related to the Annual Variable Cash Incentive Plan and the 2007 LTIP awards are recognized by applying provisions of FASB Statement No. 123(R), ‘‘Share-Based Payment’’ (‘‘SFAS 123(R)’’). We continually review and adjust our provisions for Annual Variable Cash Incentive Plan awards, 2007 LTIP awards and other bonus awards by taking into account known information and updated assumptions related to unknown information. Award provisions are an estimate and amounts established in prior periods are adjusted in current operations as new information becomes available. Any adjustments to previously established provisions or the establishment of new provisions may significantly impact current period results and net income. We expense the vested portion of the 2007 LTIP plan using the fair value recognition provisions of SFAS 123(R). In order to do this we utilize the Black-Scholes valuation model which uses various assumptions, including stock price volatility and interest rates.