• Under Bermuda law, a single creditor could make a statutory demand upon us for satisfaction of obligations owed to that creditor. If the statutory demand is held to be valid, and we are unable to satisfy our obligations to that creditor, the creditor may institute proceedings seeking the liquidation of our business.
• In preparing our financial statements, we use estimates and assumptions based upon the best information available and management’s best judgment at the time our financial statements are prepared. The most significant estimates relate to policyholder benefit reserves for the life and annuity business, the recoverability of deferred acquisition costs and the fair value of the embedded derivatives related to our remaining annuity reinsurance agreement. These estimates require us to make assumptions about, among other things, future mortality, persistency, lapses, expenses and investment performance based upon historical results and information provided to us by our ceding companies. While we believe these estimates to be reasonable, we cannot assure you that they will be accurate. If these estimates prove to be inaccurate, they could have a significant adverse impact on our financial condition and results of operations.
• As of the date of this report, approximately $56.4 million of the assets supporting the policies we reinsure were held and managed by our ceding companies or their investment managers under modified coinsurance and coinsurance funds withheld arrangements. A significant portion of our total investments is therefore dependent upon the investment decisions of third parties over whom we have limited, if any, control.
• Our ability to satisfy our obligations under our reinsurance contracts is significantly affected by the performance of our investments and the invested assets held and managed by our ceding companies. For example, if the invested assets held and managed by the ceding company under our annuity
reinsurance agreement with the Lafayette Life Insurance Company (“Lafayette”) do not accumulate at rates sufficient to allow us to meet our obligations, we could be forced to fund any shortfalls in these policy benefits, which would adversely affect our business.
• The annuity products reinsured under our annuity reinsurance agreement with Lafayette allow policyholders to withdraw their funds under certain circumstances. In addition, this annuity reinsurance agreement and certain of our life reinsurance agreements provide recapture rights that allow the ceding company to reassume all or a portion of the risk formerly ceded to us. Because our financial strength ratings have been withdrawn, certain of these agreements can be recaptured. Although we attempt to manage our investment portfolio so that we have sufficient liquidity to support anticipated withdrawals and recaptures, we cannot assure you that we will be able to dispose of assets on favorable terms in the future to support withdrawals and recaptures.
• Terrorist attacks may negatively affect our results of operations in that we may experience higher than expected death claims in a given period, such as occurred in 2001 with the attack on the World Trade Center. There can be no assurance that there will not be further terrorist attacks against the United States or United States businesses. In addition, the United States has entered into armed conflicts, which could have a further impact on our business in ways we cannot currently anticipate. Political and economic instability in some regions of the world may also result and could negatively impact our business.
• When we purchase reinsurance from another reinsurance company, known as a retrocessionaire, to cover certain risks that we have ourselves reinsured, we are subject to the risk that the retrocessionaire will be unable to pay amounts due to us because of its own financial troubles. The failure of a retrocessionaire to pay amounts due to us will not absolve us of our responsibility to pay our customers for risks that we have insured. Failure of our retrocessionaires to pay us could have a material adverse effect on our business, results of operations and financial condition. In particular, when we purchased our United States operating subsidiary, Annuity and Life Reassurance America, Inc., 100% of the risks related to the directly written life and annuity policies existing at the date of our purchase transaction were ceded to Reassure America Life Insurance Company, a subsidiary of the seller, Swiss Re Life and Health, America. As the direct issuer of those policies, Annuity and Life Reassurance America remains liable to policyholders in the event the reinsurer is unable to pay its obligations to us under the
reinsurance agreement. Reserves ceded under this reinsurance agreement amounted to approximately $82.2 million and $88.2 million at December 31, 2004 and December 31, 2003, respectively. Reassure America Life Insurance Company’s financial strength is rated A+ (Superior) by A.M. Best as of December 31, 2004.
• We are subject to the laws and regulations of the jurisdictions in which we conduct business. These laws and regulations cover many aspects of our business, including licensure, premium rates, marketing practices and capital adequacy. Recently, the insurance and reinsurance regulatory framework has become subject to increased scrutiny in many jurisdictions and regulators have started to reexamine existing laws and regulations. Changes in these laws and regulations could have an adverse affect on our operations. Further deterioration in our financial condition could expose our operations in the United States and Bermuda to increased levels of regulatory scrutiny and possibly to the winding up of our operations.
• As a holding company, we have no significant operations or assets other than our ownership of the capital stock of our subsidiaries. Dividends and other permitted payments from our subsidiaries are our sole source of funds to pay expenses and dividends, and any limitations imposed on our subsidiaries to make such payments to us may cause us to have insufficient funds to operate our business and satisfy our obligations.
Our company has encountered significant difficulties during the last four years. In addition to reporting significant operating losses for those years, we have reduced our operations significantly through the novation, termination and recapture of many of our life and annuity reinsurance agreements. We plan to continue to receive premiums and pay claims under our remaining reinsurance treaties; however, we are not currently underwriting any new treaties or accepting any new business from our existing treaties.
On October 26, 2004, Connecticut General Life Insurance Company (“CIGNA”) agreed to recapture its guaranteed minimum death benefit (“GMDB”) and guaranteed minimum income benefit (“GMIB”) agreement with us. We agreed with CIGNA to a mutual release of all past, present and future claims under the agreement, including all obligations for claims and premiums that had accrued under the agreement since July 1, 2004. We also agreed with CIGNA to a mutual release of all claims under the letter of credit that we had posted as collateral under the agreement, and that CIGNA would retain the $11.0 million it previously drew under the letter of credit. In addition, on October 26, 2004, we issued CIGNA a warrant dated as of September 30, 2004 to acquire one million of our common shares at an exercise price of $1.00
On December 31, 2004, we entered into a binding letter of intent with Transamerica that provided for the novation of our life reinsurance agreements with Scottish Re Limited (“Scottish Re”) and Fidelity and Guaranty Life Insurance Company (‘F&G”) to Transamerica as of December 31, 2004. The letter of intent also provided that, upon consummation of the novation of the life reinsurance agreements, Transamerica would terminate its annuity reinsurance agreement with us and recapture all business ceded under the agreement effective as of December 1, 2004. Our annuity reinsurance agreement with Transamerica has generated substantial losses since 2001 and has required us to make significant cash payments to Transamerica. Terminating or restructuring this agreement has been a key strategic objective, as well as a critical step to pursuing any strategic alternatives.
In connection with the novations of the life reinsurance agreements, approximately $28.9 million of collateral held in a trust with respect to our life reinsurance agreement with Scottish Re was transferred to Transamerica. In addition, $23.8 million of the letters of credit posted on behalf of our life reinsurance agreement with F&G were cancelled and the collateral securing those letters of credit was released to us. Approximately $39.6 million was paid to Transamerica in connection with the novation and recapture transactions from this collateral, including $18.5 million as consideration for the novations, a $14.0 million termination premium and approximately $7.1 million for amounts due to Transamerica as of December 1, 2004. Following those payments, approximately $13.1 million of cash and securities previously posted as collateral was released to us. We recorded a loss of approximately $60.6 million during the fourth quarter of 2004 relating to these novation and recapture transactions. On March 30, 2005, we received a demand letter from Transamerica stating that $7.0 million was owed to Transamerica as an adjustment to the F&G policy benefit reserves. If we and Transamerica are unable to resolve this issue through continued discussions, we would seek adjudication of the dispute in accordance with the provisions of the Master Agreement, which calls for the matter to be submitted to a Fellow of the Society of Actuaries whose determination shall be final, binding and conclusive. While there can be no assurances, we believe that Transamerica is not entitled to this $7.0 million. Presently, we are unable to determine the amounts, if any, that may be due to or from Transamerica resulting from adjustments to the policy benefit reserves.
Set forth below is a summary of the accounting policies that management believes are critical to the preparation of our consolidated financial statements. This summary should be read in conjunction with the discussion of our accounting policies included in Note 4 to the consolidated financial statements included elsewhere in this report.
be inaccurate, or if lapse rates exceed our assumptions, we may be required to record additional charges, which would adversely impact our results of operations.
Consistent with our accounting policies, we review the key assumptions used in determining the carrying value of our deferred acquisition cost associated with our annuity reinsurance agreement each quarter. A change in these assumptions could result in additional charges that would adversely impact future results of operations. If our assumptions for total returns prove to be inaccurate, or if lapse rates exceed our assumptions, we may be required to record additional write downs of deferred acquisition costs, which would adversely impact future results of operations. Assuming no change in lapse assumptions, the net impact of a 100 basis point decrease in our total return assumptions in all future years would have required an additional write down of deferred acquisition costs of approximately $1,800,000 as of December 31, 2004.
Recognition of Revenues and Expenses. Reinsurance premium revenues from life products with mortality risk are recognized when due from the policyholders. Premiums from universal life and investment-type contracts are recorded on our balance sheet as interest sensitive contracts liability. Revenues from these investment-type contracts consist of income earned on the assets and amounts assessed during the period against policyholders’ account balances for mortality charges, policy administration charges and surrender charges. Items that are charged to expense represent interest credited to policyholder accounts and other benefits in excess of related policyholders’ account balances, including LMIG payments. We make estimates at the end of each reporting period regarding premiums and benefits for ceding companies who do not report such information in a timely manner. These estimates can have a significant effect on the amounts we report in our financial statements.
Until the third quarter of 2004, we reinsured certain minimum guarantees associated with variable annuity agreements through our combined GMDB/GMIB agreement with CIGNA. Our obligations for the GMDB/GMIB agreement with CIGNA were reflected on our balance sheet as “Reserves for future policy benefits.” This agreement was recaptured by CIGNA, and under the terms of the recapture, the parties
AICPA Statement of Position (SOP 03-1). In July 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants (“AICPA”) issued Statement of Position 03-1 (“SOP”), Accounting and Reporting by Insurance Enterprises for Certain Non-Traditional Long-Duration Contracts and for Separate Accounts, which provides guidance on accounting and reporting by insurance enterprises for certain nontraditional long-duration contracts and for separate accounts. The SOP is effective for financial statements for fiscal years beginning after December 15, 2003. We adopted the SOP as of January 1, 2004.
If actual events differ significantly from the underlying estimates and assumptions used by us in the application of any of the aforementioned accounting policies, there could be a material adverse effect on our results of operations and financial condition.
On December 31, 2004, we entered into a binding letter of intent with Transamerica that provided for the novation of our life reinsurance agreements with Scottish Re and F&G to Transamerica as of December 31, 2004. The letter of intent also provided that, upon consummation of the novation of the life reinsurance agreements, Transamerica would terminate its annuity reinsurance agreement with us and recapture all business ceded under the agreement effective as of December 1, 2004. Pursuant to the letter of intent with Transamerica, on January 31, 2005, we executed definitive documents and novated our life reinsurance agreements with Scottish Re and F&G to Transamerica as of December 31, 2004. In consideration of these novations, we paid Transamerica $18,500,000, representing a transfer of reserves related to the life reinsurance agreements that were novated. Also, on January 31, 2005, we completed an amendment to our annuity reinsurance agreement with Transamerica, pursuant to which our agreement with Transamerica was terminated, and Transamerica recaptured all business ceded under the agreement effective as of December 1, 2004. In consideration of the recapture, we paid Transamerica all amounts owed under the annuity reinsurance agreement through November 30, 2004, which was approximately $7,100,000, along with a termination premium of $14,000,000.
We have recorded substantial charges in the fourth quarter of 2004 relating to the transactions with Transamerica described above. These charges are due to payments to Transamerica and the write off of deferred acquisition costs and funds withheld at interest assets in excess of reserves for interest sensitive contract liabilities and life reinsurance reserves related to the contracts that were novated and terminated. We have incurred a loss of approximately $60,627,000 relating to these novation and recapture transactions. This includes the write off of deferred acquisition costs of approximately $63,100,000 for the recapture of our agreement with Transamerica, approximately $13,300,000 for the novation of our life reinsurance agreement with Scottish Re, and approximately $11,600,000 for the novation of our life reinsurance agreement with F&G. This loss also includes the termination premium paid to Transamerica of $14,000,000 as well as the payment of $18,500,000 to Transamerica, which represented a transfer of reserves related to the agreements that were novated. These charges were partially offset by the release of reserves for the life reinsurance agreements that were novated of approximately $36,900,000 and reserves for interest sensitive contract liabilities under the annuity reinsurance agreement in excess funds withheld at interest assets of approximately $23,000,000.
The net loss of $(132,155,584) for during the year ended December 31, 2003 was primarily the result of losses associated with recaptures and terminations of life and annuity reinsurance agreements and adverse claims experience under our life reinsurance agreements. During the year ended December 31, 2003, we recorded charges in connection with the recapture and termination of a number of our life and annuity reinsurance agreements, including those with the Ohio National Life Insurance Company, Hartford Life, and XL Life Ltd. As a result of these and all other recaptures and terminations, we incurred charges of approximately $90,830,000 for the year ended December 31, 2003. These charges reflect the effect of a $9,000,000 benefit resulting from the comprehensive settlement with XL Life Ltd in the third quarter of 2003. Reduced investment gains and significant operating expenses due to litigation costs and employee retention and severance costs also contributed to our net loss for the year ended December 31, 2003.
Net Investment Income. Total net investment income for the year ended December 31, 2004 was $21,697,563, as compared with $29,042,223 for the year ended December 31, 2003. Net investment income is comprised of income earned on our general account assets and income earned on assets held and managed by our reinsurance ceding companies under modified coinsurance contracts, which we refer to as Funds withheld.
Net investment income earned on our general account assets for the year ended December 31, 2004 was approximately $5,335,000, as compared to $6,936,000, respectively, for the year ended December 31, 2003. The average annualized yield rate earned on our general account assets for the year ended December 31, 2004 was 3.51%, as compared with 2.53% for the year ended December 31, 2003. The increase in the effective yield rate was largely due to moving a greater portion of our invested assets from cash and cash equivalents to longer duration investments during the second quarter of 2004, but the impact was offset by the lower level of invested assets in the year ended December 31, 2004 as compared to 2003. We held a larger cash position in 2003 in an effort to maximize our collateral funding ability and to minimize the impact of changing interest rates on our collateral obligations. Because the amount of our cash and invested assets has decreased significantly due to payments associated with the novation of certain life reinsurance agreements to Transamerica on December 31, 2004, we expect our net investment income earned on our general account assets for 2005 to be substantially less than 2004.
Net investment income earned on Funds withheld for the year ended December 31, 2004 was approximately $16,362,000, as compared to approximately $22,106,000 for the year ended December 31, 2003. The decrease in investment income on our Funds withheld during the year ended December 31, 2004 was primarily due to a decreased asset base underlying our annuity reinsurance agreements, which was largely the result of four such annuity agreements being recaptured in 2003, as well as realized capital losses on the Funds withheld assets. The average annualized yield rates earned on Funds withheld were approximately 2.88% for the year ended December 31, 2004, as compared with 2.68% for the year ended December 31, 2003. For purposes of calculating the average yield rates earned on our Funds withheld at interest, we include our share of the investment income and net realized capital gains and losses as reported
Operating Expenses. Operating expenses for the year ended December 31, 2004 were $14,628,524 or 19.5% of total revenue (excluding the net change in fair value of embedded derivatives), as compared to $18,034,021 or 8.6% of total revenue (excluding the net change in fair value of embedded derivatives) for the year ended December 31, 2003. This proportionate increase in expenses for the year ended December 31, 2004 reflects the accrual of $5,000,000 for the anticipated settlement of the purported shareholder class action lawsuit, as well as increased professional and consulting fees partially offset by reduced employee compensation costs. Costs associated with capital raising efforts and the pursuit of other strategic alternatives of approximately $914,000 also contributed to the proportionate increase in operating expenses for the period.
Net Loss. For the year ended December 31, 2003, we had a consolidated net loss of $(132,155,584), or $(5.11) per primary and fully diluted common share, as compared to a net loss of $(128,887,285), or $(5.01) per primary and fully diluted common share for the year ended December 31, 2002. The loss for 2003 was primarily the result of losses associated with recaptures and terminations of life and annuity reinsurance agreements, as well as adverse claims experience under our life reinsurance agreements. Reduced investment gains and significant operating expenses due to litigation costs and employee retention and severance costs also contributed to our net loss for the year ended December 31, 2003.
We also recorded a loss of approximately $3,067,000 for our annuity reinsurance agreement with Transamerica during 2003. This agreement was our largest annuity reinsurance agreement, and represented approximately $604 million, or approximately 90%, of our Funds withheld at interest receivable as of December 31, 2003. Our GMDB/GMIB contract with CIGNA resulted in a loss of approximately $1,934,000 in 2003. Other life and annuity reinsurance agreements that were not recaptured in 2003 resulted in losses of approximately $5,778,000, and operating expenses exceeded investment income and net realized investment gains by approximately $5,703,000 in 2003.
Net Investment Income. Net investment income for the year ended December 31, 2003 was $29,042,223, a decrease of 72% from net investment income of $102,138,985 for the year ended December 31, 2002. The decrease in net investment income was primarily the result of a significant decrease in invested assets underlying our Funds withheld receivable as a result of the termination of several annuity reinsurance contracts, including our agreement with Ohio National, and lapses on policies underlying our annuity reinsurance agreement with Transamerica. Net investment income earned on Funds withheld for the year ended December 31, 2003 was $22,106,000, as compared with $76,208,000 for the year ended December 31, 2002. The decrease in net investment income for the year ended December 31, 2003 was also the result of our return of approximately $147,000,000 of invested assets on December 31, 2002 in connection with the termination of a reinsurance agreement that provided cash deposits to us that were used to secure collateral obligations of our U.S. based cedents. Lower investment returns resulting from our decision to shift a large portion of our invested assets into short duration assets also contributed to the reductions in net investment income. The average yield rate earned on our general account assets declined to approximately 2.53% for the year ended December 31, 2003, as compared with 5.28% for the year ended December 31, 2002.
The average yield rate earned on Funds withheld was 2.68% for the year ended December 31, 2003, as compared with 5.25% for the year ended December 31, 2002. This reduction in yield rates is primarily the result of the termination of our annuity reinsurance agreement with Ohio National in the first quarter of 2003 and a lower yield on the assets supporting our obligations under our Transamerica annuity reinsurance agreement. For purposes of calculating the average yield rates earned on our Funds withheld at interest, we
Net Realized Investment Gains. Net realized investment gains were $6,406,587 for the year ended December 31, 2003, as compared with realized gains of $19,749,266 for the year ended December 31, 2002. The decrease in net realized investment gains for the year ended December 31, 2003 was the result of a smaller invested asset base and the decision to maintain a significant portion of our portfolio in short duration investments. We plan to continue to hold a relatively large portion of our assets in short duration investments until interest rate rise or we conclude they are not going to rise in the foreseeable future. Accordingly, although realized gains and losses will fluctuate from period to period, we do not anticipate realizing significant investment gains or losses in 2004 due to our smaller invested asset base and our current decision to hold those assets predominantly in short duration investments. However, we will adjust our investment strategy based on developments in the markets and our business and those adjustments may result in realized gains or losses being recognized. We make decisions concerning the sales of invested assets based on a variety of market, business and other factors.
Claims and Policy Benefits. Claims and policy benefits includes both life and variable annuity benefits, including guaranteed minimum death benefits, guaranteed minimum income benefits and enhanced earnings benefits. Claims and policy benefits for the year ended December 31, 2003 were $198,002,905 or 119% of net premium, as compared with $352,408,801 or 102% of net premium for the year ended December 31, 2002. The absolute declines in claim and policy benefits in 2003 were the result of the significant reduction of life insurance in force from $117.5 billion at December 31, 2002 to approximately $17.5 billion at December 31, 2003 and the termination of several annuity reinsurance agreements during 2003. Claims and policy benefits for 2003 related to agreements that were recaptured or terminated in 2003 were $ 143,179,000. As a result of the recaptures and terminations of reinsurance agreements during 2003, we began 2004 with a book of business that is significantly smaller than we had during 2003. This will reduce claims and policy benefits in absolute terms in future periods, but may increase volatility in the level of claims and policy benefits as a percentage of premiums.
We continue to monitor and analyze our experience under our remaining life and annuity reinsurance agreements. During the year 2003, we decreased our reserves associated with variable annuity reinsurance
Collateral Costs. Collateral costs in 2002 comprised fees charged by a reinsurer to provide cash deposits to us and other related expenses. This arrangement was terminated as of December 31, 2002 and we therefore recorded no such collateral costs in 2003. In 2002, these deposits had been used to fund excess statutory reserve requirements of our clients and had been recorded on our consolidated balance sheet as a deposit liability. Collateral costs were $12,948,115 for the year ended December 31, 2002.
Life segment policy benefits and expenses for the year ended December 31, 2004 declined 80% to $50,271,120 from $256,769,309 for the year ended December 31, 2003. Policy benefits and expenses for 2004 includes approximately $24,900,000 for the write-down of deferred acquisition costs partially offset by the release of life reinsurance reserves of approximately $18,300,000 related to our agreements with Scottish Re and F&G that were novated to Transamerica as of December 31, 2004. Claims and policy
Annuity segment revenue for the year ended December 31, 2004 declined 54% to $23,847,196 from $52,122,419 for the year ended December 31, 2003. This decline is due to a decrease in embedded derivative gains of approximately $14,512,000, as well as a reduction in investment income of approximately $5,744,000 and reduced surrender fees from our Transamerica annuity reinsurance agreement, which decreased by approximately $3,765,000 for the year ended December 31, 2004 as compared to the year ended December 31, 2003.
Corporate Segment. The corporate segment includes all of our capital gains and losses, investment income on undeployed invested assets, costs associated with our efforts to raise capital and pursue other strategic alternatives, costs relating to the anticipated settlement of the purported shareholder class action lawsuit and a proportionate share of operating expenses based upon how stockholders’ equity is deployed to the life and annuity segments. As a result, the corporate segment, while small relative to our total company, will likely have volatile results.
segment results for the year ended December 31, 2004 was due to net realized investment gains declining to $439,536, as compared to $6,406,587 for the year ended December 31, 2003.
During 2004, we novated, negotiated the recapture of and terminated a significant amount of our reinsurance business. In particular, as discussed elsewhere in this report, we negotiated the termination and recapture of our annuity reinsurance agreement with Transamerica, novated certain life reinsurance agreements to Transamerica and negotiated the recapture of our GMDB/GMIB agreement with CIGNA. Our audited consolidated statement of operations for the year ended December 31, 2004 included in this report reflects revenues and expenses from each novated, recaptured or terminated agreement from January 1, 2004 through the effective date of its novation, recapture or termination, as well as the cost of its novation, recapture or termination, as well as the cost of its novation, recapture or termination. We expect that our statement of operations will be substantially different in 2005 and subsequent years as a result of these transactions. Accordingly, we have prepared a pro forma statement of operations to assist you in understanding the operating results generated in 2004 by our remaining book of business. The pro forma statement of operations is set forth in Item 6. Selected Financial Data - Pro Forma Selected Financial Data included elsewhere in this report.
At December 31, 2004 and at December 31, 2003, there were no below investment-grade securities held in the portfolio. The market value of non-rated securities held at December 31, 2004 was approximately $1,000,000. The fair value of such investments varies depending on economic and market conditions, the level of interest rates and the perceived creditworthiness of the issuer. As noted above, our investment guidelines require our overall fixed income portfolio to maintain a minimum weighted average credit quality of “A” and limit the amount of our investments in fixed income securities that are non-rated or below investment grade at the time of purchase. We monitor the creditworthiness of the portfolio as a whole, and when the fair market value of a security declines for reasons other than changes in interest rates or other perceived temporary conditions, the security is written down to its fair value. At December 31, 2004 and 2003, there were no impaired securities in our portfolio.
At December 31, 2004, approximately 17% of our mortgage-backed investment portfolio consisted of securities with planned repayment schedules, as compared with 7% at December 31, 2003. These investments are designed to amortize in a more predictable manner by shifting the primary risk of prepayment of the underlying collateral to investors in other tranches of the CMO.
Our results of operations and our financial condition are significantly affected by the performance of our investments and by changes in interest rates. During a period of declining interest rates, if our investments are prematurely sold, called, prepaid or redeemed, we may be unable to reinvest the proceeds in securities of equivalent risk with comparable rates of return. During a period of rising interest rates, the fair value of our invested assets could decline. In addition, rising interest rates could also cause disintermediation, which in turn could cause us to sell investments at prices and times when the fair values of such investments are less than their amortized cost. We believe that our traditional life insurance liabilities are not highly interest rate sensitive and, therefore, the effects of fluctuating interest rates on these liabilities are not significant. For interest sensitive liabilities, we are primarily dependent upon asset/ liability matching or other strategies to minimize the impact of changes in interest rates. If we do not appropriately match our asset management strategy to our obligations, we could sustain losses. We may use interest rate swaps and other financial instruments as tools to mitigate the effects of asset/liability mismatches or the effect of interest rate changes on our balance sheet. In general, however, we do not hedge our investment risk. Our results of operations are also affected by the performance of assets held and managed by our ceding companies under our remaining modified coinsurance and coinsurance funds withheld arrangements, as discussed below under Funds Withheld at Interest.
The effective yield rate equals (i) net investment income divided by (ii) the average of total adjusted invested assets (fixed maturities at amortized cost, including assets on deposit with reinsurers) at the end of each calendar quarter included in the indicated period.
As of December 31, 2004, our ceding companies had approximately $56.4 million in assets that were held and managed by or for them under our modified coinsurance and coinsurance funds withheld arrangements. Approximately $51.3 million of the funds withheld at interest relates to our modified coinsurance annuity reinsurance agreement with Lafayette, with the remaining $5.1 million related to a coinsurance funds withheld life reinsurance agreement. At December 31, 2004, the assets held and managed under our agreement with Lafayette were invested in fixed income securities having a weighted average credit quality of “A” and a weighted average duration of 3.7 years. At December 31, 2004, none of the assets were invested in below investment grade securities.
Our remaining annuity reinsurance agreement covers general account fixed deferred annuity policies and is structured as a modified coinsurance arrangement. In this type of arrangement, the ceding company invests the premiums received from policyholders or engages an investment manager to do so, credits interest to policyholders’ accounts, processes surrenders and engages in other administrative activities. The ceding company is also required to carry reserves for these annuity policies based upon certain statutory rules in the state in which the ceding company is domiciled. The underlying investments purchased with the premiums received from policyholders support these statutory reserves.
Historically, when a ceding company enters into an annuity reinsurance agreement structured as a modified coinsurance arrangement with us, a portion of the ceding company’s liability to the policyholders is ceded to us. Our remaining modified coinsurance arrangement is on a quota share basis, so the portion that is ceded to us is a fixed percentage of the liabilities arising from the underlying policies. Our share of the ceding company’s liability is included on our balance sheet as “Interest sensitive contracts liabilities.” However, unlike other reinsurance arrangements in which we receive cash or investments as consideration for assuming a portion of the ceding company’s liability, under these types of arrangements, we have established a receivable called “Funds withheld at interest” that is equal to our fixed portion of the statutory reserves carried by the ceding company. We are allocated our share of the investment income and realized capital gains and losses that arise from the securities in the investment portfolio underlying the statutory reserve.
The average yield rate earned on the assets held and managed by our ceding companies under our annuity reinsurance agreements, which included Transamerica through November 2004, was approximately 2.88% for the year ended December 31, 2004. The average yield rates earned on the assets held and managed by our ceding companies under our annuity reinsurance agreements was approximately 2.68% for the year ended December 31, 2003. The average yield rate earned on the invested premiums funding our annuity obligations for the Transamerica annuity reinsurance agreement was approximately 2.65% for the
year ended December 31, 2004. The average yield rate earned on the invested premiums funding our annuity obligations for our annuity reinsurance agreement with Lafayette was approximately 4.79% for the year ended December 31, 2004. For purposes of calculating the average yield rate earned on assets held and managed by our ceding companies, we include our share of the investment income and net realized capital gains and losses as reported to us through our settlements with our ceding companies. As noted elsewhere in this report, our annuity reinsurance agreement with Transamerica was terminated, and Transamerica recaptured all business ceded under the agreement effective as of December 1, 2004. As a result the aforementioned yield rates include the yield earned on invested premiums that funded our obligations under the Transamerica reinsurance agreement until the effective termination date.
Our only remaining annuity reinsurance agreement at December 31, 2004 is with Lafayette. Approximately $51.3 million, or 91%, of our funds withheld at interest receivable, approximately $57.8 million, or 100%, of our interest sensitive contracts liability, and approximately $3.4 million, or 55%, of the deferred acquisition costs on our balance sheet related to this agreement as of December 31, 2004. As a result of the changes to our remaining book of business, especially the termination of our annuity reinsurance agreement with Ohio National in February 2003 and the termination of our annuity reinsurance agreement with Transamerica in December 2004, we expect that the assets and liabilities associated with the Lafayette agreement will represent a significant portion of our total assets and liabilities in future periods. The amount of deferred acquisition costs we record as an asset on our balance sheet related to our agreement with Lafayette is based on a series of assumptions related to the investment performance of the assets supporting our liabilities under the agreement, as well as future lapse rates for the underlying policies. These assumed lapse rates include assumptions regarding future full surrenders, partial withdrawals, annuitizations and policyholder deaths. While we believe the investment and lapse estimates to be reasonable, they are estimates of future events and we cannot assure you that they will prove to be accurate. If such assumptions turn out to be inaccurate, we could be required to write off additional deferred acquisition costs, which would have a significant adverse impact on our results of operations in future periods.
The assets funding the policyholder obligations under our annuity reinsurance agreement with Lafayette have an average credit quality of “A-” and an average duration of 3.7 years. The premiums paid in connection with the underlying policies have been invested in investment grade bonds and mortgage backed securities.
According to information provided by Lafayette, at December 31, 2004, the assets funding the policyholder obligations under our annuity reinsurance agreement were comprised of the following:
As assigned by Standard & Poor’s, or, if unrated by Standard & Poor’s, based on equivalent rating assigned by the National Association of Insurance Commissioners.
Book values are statutory book values reported to us by the ceding company for the underlying investments and represent the value of our Funds withheld at interest receivable. We present statutory book values in the above table because that is the basis upon which we settle with the ceding company under the agreement. We believe this presents a better understanding of potential future returns and cash flows under the agreement.
According to information provided by Lafayette, at December 31, 2004, the maturity distribution of the assets funding the policyholder obligations under our annuity reinsurance agreement was approximately as follows:
The following table shows our contractual obligations and commitments including our payments due by period. The table does not include any obligations under our annuity and life reinsurance agreements.
(1) We lease office space in Bermuda and the United States; these leases expire in March 2006 and May 2005, respectively. Our United States operating subsidiary has recently entered into a new lease of office space to replace its existing quarters which came into effect on February 1, 2005 and expires on January 31, 2007.
(2) The amounts due under employment agreements represent base salary and housing and travel allowances for employees with the Company as of December 31, 2004. The amounts presented do not include any pension benefits, bonuses earned or other compensation incentives that may be payable under the employment agreements.
Pursuant to an engagement letter dated January 19, 2004, as amended in March 2005 (“Engagement Letter”), we engaged UBS Securities LLC (“UBS”) to serve as our financial advisor and capital markets advisor in connection with identifying strategic alternatives available to us. The Engagement Letter provides that if, during the term of the Engagement Letter, we close an equity investment, we are obligated
We have two reinsurance operating subsidiaries, one of which is based in and operates out of Bermuda, and the other of which is based in and operates out of the United States. Our Bermuda operating subsidiary reinsures a large portion of the reinsurance business written by our U.S. operating subsidiary. The primary purpose of this reinsurance is to provide reinsurance capacity to our U.S. operating subsidiary so that it can compete in its market place. Our Bermuda operating subsidiary also has made capital infusions into the U.S. operating subsidiary to allow the U.S. company to maintain targeted statutory surplus levels and to provide cash and securities as collateral for the reinsurance cessions the U.S. operating subsidiary makes to the Bermuda operating company. At December 31, 2004, approximately $51,300,000 of our cash and cash equivalents and fixed income securities were held by the U.S. operating subsidiary and were not available to us or our Bermuda operating subsidiary to fund our liquidity or collateral needs.
In connection with the novations of the life reinsurance agreements, approximately $28,900,000 of collateral held in a trust established with respect to our life reinsurance agreement with Scottish Re was transferred to Transamerica. In addition, $23,800,000 of the letters of credit we posted on behalf of our life reinsurance agreement with F&G were cancelled and the collateral securing those letters of credit was released to us. Approximately $39,600,000 was paid to Transamerica in connection with the novation and recapture transactions from this collateral, including $18,500,000 as consideration for the novations, a $14,000,000 termination premium and approximately $7,100,000 for amounts due to Transamerica as of December 1, 2004. Following those payments, approximately $13,100,000 of cash and securities previously posted as collateral was released to us. We recorded a loss of approximately $60,627,000 during the fourth quarter of 2004 relating to these novation and recapture transactions. On March 30, 2005, we received a demand letter from Transamerica stating that $7,000,000 was owed to Transamerica as an adjustment to the F&G policy benefit reserves. If we and Transamerica are unable to resolve this issue through continued discussions, we would seek adjudication of the dispute in accordance with the provisions of the Master Agreement, which calls for the matter to be submitted to a Fellow of the Society of Actuaries whose determination shall be final, binding and conclusive. While there can be no assurances, we believe that Transamerica is not entitled to this $7,000,000. Presently, we are unable to determine the amounts, if any, that may be due to or from Transamerica resulting from adjustments to the policy benefit reserves.
Although our liquidity position has improved following the novation and recapture transactions we completed with Transamerica, a large portion of our cash and investments is held by our U.S. operating subsidiary or is posted as collateral under our remaining life reinsurance agreements and is unavailable to fund our operations or those of our Bermuda operating subsidiary.
At December 31, 2004, our total capitalization, which consisted entirely of equity, was $66,417,212. During 2001, our Board of Directors approved a share repurchase program of up to an aggregate of $25,000,000 of our common shares from time to time in the future if market conditions so dictate. As of December 31, 2004, no shares had been repurchased under this program.
For the year ended December 31, 2004, we utilized $59,066,808 of our cash and equivalents to fund operating activities, as compared with using cash and equivalents of $112,176,985 to fund our operating activities for the year ended December 31, 2003. The utilization of our cash and equivalents during 2004 primarily reflects approximately $23,300,000 of payments for unearned premiums associated with the recapture of our life reinsurance agreement with the Metropolitan Life Insurance Companies that was effective in 2003, payments of approximately $23,900,000 to Transamerica, and an $11,000,000 payment of policy benefits associated with the recapture of our GMDB/GMIB reinsurance agreement with CIGNA.
To the Audit Committee of the Board of Directors and Stockholders
We have audited the accompanying consolidated balance sheets of Annuity and Life Re (Holdings), Ltd. and subsidiaries (the “Company”) as of December 31, 2004, and the related consolidated statements of operations, comprehensive loss, changes in stockholder’s equity, and cash flows for the year ended December 31, 2004. Our audit also included financial statement schedule II, condensed financial information for the Registrant as of December 31, 2004 and for the year then ended. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.
As discussed in Note 4(l) to the consolidated financial statements, as of January 1, 2004, the Company changed its method of accounting for certain nontraditional long-duration contracts.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 11, 2005 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an adverse opinion on the effectiveness of the Company’s internal control over financial reporting because of the existence of material weaknesses.
We have audited the accompanying consolidated balance sheet of Annuity and Life Re (Holdings), Ltd. and subsidiaries as of December 31, 2003 and the related consolidated statements of operations, comprehensive loss, stockholders’ equity and cash flows for each of the years in the two-year period ended December 31, 2003. In connection with our audits of the consolidated financial statements, we have also audited the accompanying financial statement schedule as of December 31, 2003 and for each of the years in the two-year period ended December 31, 2003. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Annuity and Life Re (Holdings), Ltd. and its subsidiaries as of December 31, 2003 and the results of their operations and cash flows for the years ended December 31, 2003 and 2002 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule as of December 31, 2003 and for each of the years in the two-year period ended December 31, 2003, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information contained therein.
The consolidated financial statements and financial statement schedule for the years ended December 31, 2003 and 2002 have been prepared assuming that the Company will continue as a going concern. As discussed in Note 3 to the consolidated financial statements, the Company has suffered significant losses from operations and experienced liquidity demands that raise substantial doubt about its ability to continue as a going concern. Management’s plans with regard to these matters are also described in Note 3. The consolidated financial statements and financial statement schedule do not include any adjustments that might result from the outcome of this uncertainty.
Annuity and Life Re (Holdings), Ltd. (“Holdings”) was incorporated on December 2, 1997 under the laws of Bermuda. Holdings provides annuity and life reinsurance to insurers and reinsurers through its wholly-owned subsidiaries: Annuity and Life Reassurance, Ltd., which is licensed under the laws of Bermuda as a long term insurer; and Annuity and Life Re America, Inc., an insurance holding company based in the United States, and Annuity and Life Reassurance America, Inc., a life insurance company domiciled in the United States. Holdings, Annuity and Life Reassurance, Ltd., Annuity and Life Re America, Inc. and Annuity and Life Reassurance America, Inc. are collectively referred to herein as the “Company.”
On July 28, 2004, Connecticut General Life Insurance Company (“CIGNA”), the ceding company under the Company’s then only remaining guaranteed minimum death benefit (“GMDB”) and guaranteed minimum income benefit (“GMIB”) reinsurance agreement drew $11 million on a letter of credit that had been issued for CIGNA’s benefit. As of June 30, 2004, CIGNA was seeking $49 million of collateral in addition to the $11 million of collateral the Company had previously provided in the form of a fully collateralized letter of credit. The Company did not agree that the aggregate $60 million collateral requirement asserted by CIGNA was required to be posted and did not post any additional collateral for this agreement. On October 26, 2004, the Company entered into a Commutation and Release Agreement with CIGNA providing for the recapture by CIGNA of the GMDB/GMIB agreement. The Commutation and Release Agreement also provides for a mutual release by each of the parties of all past, present and future claims under the GMDB/GMIB agreement, including all obligations for claims and premiums that had accrued under the agreement since July 1, 2004. The parties also agreed to a mutual release of all claims under the letter of credit, and that CIGNA would retain the $11 million it previously drew under the letter of credit. In addition, the Company issued CIGNA a warrant dated as of September 30, 2004 to acquire one million of its common shares at an exercise price of $1.00 per share (as per Note 7). The warrant expires on September 30, 2014. After giving effect to the Commutation and Release Agreement with CIGNA, the Company no longer has any exposure to GMDB or GMIB.
On July 20, 2004, the Company announced that it had reached an agreement in principle with the plaintiffs, subject to full documentation by the parties to the settlement, notice to the class, court approval and other steps required to consummate a class action settlement, to settle the lawsuit. In August 2004, the parties to the settlement executed and filed a Stipulation setting forth their settlement agreement, and sought court approval. The parties to the settlement are the plaintiffs and the class (which consists, subject to certain exclusions, of persons who purchased the Company’s common shares between March 15, 2000 and November 19, 2002), the Company, all individual defendants and XL Capital Ltd. The settlement is without any admission of liability or wrongdoing. The Company, along with its directors and officers’ liability carrier, and XL Capital Ltd have agreed to pay an aggregate of $16.5 million. The Company’s share of the settlement was $2.5 million in cash, which it paid into escrow in August 2004, and an additional $2.5 million to be paid in cash or in common shares (subject to a cap of 19.9% of the Company’s outstanding shares) at the Company’s election. On January 10, 2005, the Company elected to pay the remaining $2.5 million in cash, which it paid into escrow on that date. The Company recorded its $5.0 million portion of the settlement as an operating expense in 2004.
The terminations and novations of the reinsurance agreements described in Note 2 (a) reduced the Company’s obligations to post collateral and reduced the cash drain on operations. These terminations and novations combined with the settlement of the class action lawsuit described in Note 2 (a), resolved a number of the contingencies that faced the Company as of December 31, 2003 (see Note 3). After taking into consideration the Company’s current security and regulatory requirements (see Note 5), and the return of approximately $13.1 million of cash and securities pledged as collateral for letters of credit (see Note 2 (a)), the Company believes it has sufficient cash and investments as of December 31, 2004 to fund its operations for at least the next 12 months.
In addition, the Company is required to post collateral for the statutory reserves ceded to it by U.S. based insurers and did not have sufficient available cash and investments at December 31, 2003 to satisfy the collateral requirements asserted by Connecticut General Life Insurance Company (“CIGNA”), the ceding company under the Company’s remaining guaranteed minimum death benefit (“GMDB”) and guaranteed minimum income benefit (“GMIB”) agreement. As of December 31, 2002, CIGNA had asserted that the Company was required to post $59 million of collateral in addition to the $11 million of collateral the Company had previously provided. As of December 31, 2003, CIGNA was seeking $49 million of collateral in addition to the $11 million of collateral the Company had previously provided. The Company does not agree that the aggregate $60 million collateral requirement currently asserted by CIGNA is required to be posted, and has not posted any additional collateral for the agreement. As a result, CIGNA may institute arbitration or litigation proceedings against the Company. If the Company does not prevail in any such arbitration or litigation proceedings, it would have a material adverse effect on the Company’s financial condition and the Company may be required to liquidate its operations. As of December 31, 2003, the Company had met all the collateral obligations of its remaining ceding companies with the exception of those asserted by CIGNA.
The consolidated financial statements include the accounts of Holdings and its subsidiaries, Annuity and Life Reassurance, Ltd., Annuity and Life Re America, Inc. and Annuity and Life Reassurance America, Inc. All significant inter-company accounts and transactions have been eliminated upon consolidation.
For contracts with a single premium or a limited number of premium payments due over a significantly shorter period than the total period over which benefits are provided (“limited payment contracts”), reinsurance premiums are recorded as net premiums when due with any excess profit deferred and recognized in net premiums in a constant relationship to the insurance in force or, for annuities, in relation to the amount of expected future benefit payments.
The costs of acquiring new business, principally allowances, which vary with and are primarily related to the production of new business, are deferred. Where a ceding company pays a bonus interest amount in the first year of a policy to induce a policyholder to acquire the product, and this bonus interest amount is distinct from and incremental to the expected ongoing interest crediting amount, the bonus interest is capitalized and amortized to policy acquisition costs in a manner similar to deferred acquisition costs. Deferred policy acquisition costs are subject to recoverability testing at the time of policy issuance and loss recognition testing at the end of each accounting period.
For traditional life and annuity policies with life contingencies, deferred policy acquisition costs are charged to expense using assumptions consistent with those used in computing policy reserves. Assumptions as to anticipated premiums are estimated at the date of the policy issuance, or the effective date of the most recent premium rate increase, and are consistently applied during the life of the contracts. Deviations from estimated experience are reflected in the results of operations in the period such deviations occur. For these contracts, the amortization periods are generally the estimated life of the policies.
The Company has classified as insurance licenses the cost in excess of fair value of net assets acquired in a purchase transaction. Prior to January 1, 2002, the Company had been amortizing these insurance licenses on a straight-line basis over 20 years. In June 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 142 - Goodwill and Other Intangible Assets. Under SFAS No. 142 the insurance licenses are no longer amortized, but are subjected to an initial impairment test on adoption of SFAS No. 142 and an annual impairment test in subsequent years. The Company adopted SFAS No. 142 on January 1, 2002. In 2003, the Company determined that an impairment charge was necessary and the entire amount was written off and charged to operating expenses. The amount carried at December 31, 2002 was $2,128,000.
The development of reserves for policy benefits and for claims incurred but not reported (“IBNR”) for the Company’s products requires management to make estimates and assumptions regarding mortality, lapse, persistency, expenses and investment experience. Such estimates are primarily based on historical experience and information provided by ceding companies. Actual results could differ materially from those estimates. Management considers all of the Company’s reinsurance contracts to be long duration contracts. Management monitors actual experience and, where circumstances warrant, will revise its assumptions and the related reserve estimates.
The Company’s liability for contracts providing reinsurance for life insurance policies is recorded in the balance sheet as reserves for future policy benefits. The reserve is estimated using a net level premium method utilizing actuarial assumptions for mortality, persistency, interest and expenses established when the contract is underwritten. These assumptions are based on anticipated experience with a margin for adverse deviation. If the reserves for future policy benefits plus the present value of expected future gross premiums are insufficient to provide for expected future benefits and expenses, deferred policy acquisition costs are written down and, if required, a premium deficiency reserve is established, by a charge to claims and policy benefits. Benefit liabilities for traditional annuities that contain mortality risk are recorded at the present value of expected future benefit payments. Reserves are also established to cover death claims that
Realized gains and losses on investments are recognized in the results of operations, using the specific identification method. Changes in fair values of securities classified as available for sale are reflected in accumulated other comprehensive income.
The Company calculates basic earnings per common share and earnings per common share assuming dilution. Basic earnings per common share is calculated by dividing net income attributable to common stockholders by the weighted average number of common shares outstanding during the period. Restricted common stock issued to employees (see Note 10) is not included in calculating basic earnings per common share until it has vested.
In December 2002, the FASB issued SFAS No. 148 - Accounting for Stock-Based Compensation - Transition and Disclosure, an amendment of SFAS No. 123. This statement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. On January 1, 2003, the Company voluntarily adopted the fair value based method of accounting for stock-based employee compensation under the prospective method described in SFAS No. 148. Under this method, the Company applies fair value accounting to all grants of employee stock options subsequent to December 31, 2002. Previously, the Company had applied the intrinsic value method when accounting for its stock-based compensation and continues to apply the intrinsic value method to stock-based compensation issued prior to January 1, 2003, whereby all stock options granted were at market value with no corresponding charges to compensation expense. SFAS No. 148 also amends the disclosure requirements of SFAS No. 123 to require more prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The following table provides the required disclosure for grants made prior to the Company’s adoption of the prospective method described in SFAS No. 148.
The fair value of the options is estimated on the date of grant using the Black-Scholes option-pricing model. The following table details the assumptions and fair values for options issued in the past four years:
In July 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountant’s (“AICPA”) issued Statement of Position (“SOP”) 03-1, Accounting and Reporting by Insurance Enterprises for Certain Non-Traditional Long-Duration Contracts and for Separate Accounts. The SOP is effective for financial statements for fiscal years beginning after December 15, 2003 and provides guidance on accounting and reporting by insurance enterprises for certain nontraditional long-duration contracts and for separate accounts. The SOP changed the manner in which life insurance companies account for certain types of insurance and reinsurance contracts.
The SOP provides guidance for reserving for contracts with guaranteed minimum death and guaranteed minimum income benefits. The SOP requires projections of a wide number of future economic scenarios that impact the present value of premiums earned and claims paid. Based on these projections and historical experience, a Benefit Ratio is determined. The reserve is then determined by applying the Benefit Ratio to premiums received and then deducting claims paid, both with interest. The SOP also provides guidance for reserving for annuity agreements with more than one potential account balance. These types of exposures are reserved for based upon the highest contractually determinable balance for each policyholder, without consideration of surrender fees.
On January 1, 2004, the Company adopted this new accounting standard. At that time, the Company had a combined GMDB/GMIB agreement with CIGNA and an annuity reinsurance agreement with Transamerica that were both affected by the adoption of the new SOP. The cumulative effect of the change in accounting principle was a net loss of $365,960. As a result of adopting the SOP, the amount of reserves carried for the Company’s GMDB/GMIB reinsurance agreement with CIGNA was reduced by $1,878,760, favorably impacting the Company’s results of operations. Also, as a result of the SOP, the Company increased its reserves for interest sensitive contracts liability for its Transamerica contract by $38,398,730 to $611,486,170, and increased its deferred policy acquisition costs for that contract by $36,154,010 to $65,907,500. The impact of the adoption of the SOP on the Company’s accounting for the Transamerica annuity reinsurance agreement was a net charge to income of $2,244,720.
The SOP is no longer applicable under the Company’s remaining contracts (see Note 2). The Company was unable to analyze and account for the impact of the adoption of the SOP on its accounting for the Transamerica annuity reinsurance agreement and its agreement with CIGNA for periods prior to its adoption on January 1, 2004.
(c) At December 31, 2004 and 2003, letters of credit totaling approximately $35,100,000 and $53,700,000, respectively, issued in the ordinary course of the Company’s business, had been issued by its bankers
in favor of certain ceding insurance companies to provide security and meet regulatory requirements. At December 31, 2004 and 2003, cash and investments of approximately $41,300,000 and $56,800,000, respectively, were pledged as collateral for letters of credit.
At December 31, 2004 and 2003, cash and investments of approximately $28,900,000 and $96,000,000, respectively, were held in trust for the benefit of certain ceding insurance companies to provide security and to meet regulatory requirements. Approximately $51,300,000 of cash and investments held at December 31, 2004 were held by the Company’s U.S. operating subsidiary and was unavailable to fund the operations of the Company’s Bermuda operating subsidiary.
(d) The maturity distribution of fixed income securities held as of December 31, 2004 and 2003 is shown below. Actual maturity dates may differ from contractual maturity dates because certain borrowers have the ability to prepay their obligations without penalty.
(e) Investment income, net of related expenses, earned during the years ended December 31, 2004, 2003 and 2002 was as follows:
The following table shows the Company’s contractual obligations under its operating leases over the periods indicated:
In connection with the initial capitalization of the Company, the Company issued Class A Warrants that initially entitled the holders to purchase up to 3,059,990 common shares of the Company. The initial exercise price of the Class A Warrants was $15.00, which was equal to the price of the Company’s common shares in the initial public offering. As the result of our issuance of warrants to Hartford Life Insurance Co. and CIGNA, discussed below, the effect of anti-dilution adjustment provisions in the Class A Warrants has increased the number of shares issuable upon exercise of the Class A Warrants to 3,265,515 common shares and the exercise price of the Class A Warrants has been adjusted to $14.06. The Class A Warrants are all currently exercisable and will expire on January 15, 2008. No Class A Warrants had been exercised at December 31, 2004.
The calculation of the diluted loss per common share does not include the incremental number of shares from the assumed exercise of options and warrants, or the vesting of unvested restricted stock grants. At December 31, 2004, 5,689,713 warrants, 719,035 options, and 377,368 shares of unvested restricted stock were outstanding. The inclusion of these potential common shares would be considered antidilutive due to the decrease in loss per common share resulting from the conversion, exercise, or contingent issuance of these securities.
As a result of the Company’s discussions with XL Life, the Company and XL Life and its affiliate agreed to mutually discharge their respective rights and obligations under all of the agreements described in the preceding paragraph in a comprehensive settlement effective as of July 1, 2003. Under the terms of the comprehensive settlement, the Company paid $6.0 million to XL Life and was released from any and all obligations to XL Life and its affiliate under all of the agreements among the parties. In addition, as part of the comprehensive settlement, the Company was obligated to pay $2.0 million to XL Life if prior to June 30, 2004 the Company’s stock traded above $2.00 per share for a period of 20 out of any 30 consecutive trading days and the Company raised an aggregate $35.0 million of equity or debt. Because these two events did not occur prior to June 30, 2004, the Company was not required to make any such payment to XL Life and is no longer obligated to do so.
Each person who becomes an eligible non-employee director, as defined in the plan, is automatically granted an option to purchase 15,000 common shares on the date he or she becomes an eligible non-employee director. These options have an exercise price equal to the greater of par value per common share or the fair market value of the optioned common shares on the date the options are granted and are exercisable in three equal installments commencing with the first anniversary of the grant date. In addition, subject to certain conditions, each non-employee director is automatically granted an option to purchase 5,000 common shares at each successive annual general meeting. These options have an exercise price equal to the greater of fair market value of the optioned common shares on the date the options are granted or par value and are immediately exercisable if granted after April 8, 1999.
In 2002, the Board of Directors adopted a Restricted Stock Plan (the “Plan”) under which it may grant common shares to key employees. The aggregate number of common shares that may be granted under the Plan is 1,200,000, and the Compensation Committee of the Board of Directors administers the Plan. Since the inception of the Plan, the Company has issued 976,000 shares of restricted stock. As a result of certain employees terminating their employment with the Company, 227,133 shares of restricted stock were cancelled in 2003 and 115,667 shares of restricted stock were cancelled in 2004. Also, 47,500 shares of restricted stock vested in 2003 and 2004 prior to certain employees terminating their employment with the Company. The following table summarizes the vesting schedule for the shares of restricted stock issued to current employees and outstanding as of December 31, 2004:
The fair value as determined at the date of grant of the restricted stock awards that were outstanding on December 31, 2004 was approximately $1,514,000 and is reflected in the Company’s balance sheet as common shares and additional paid-in-capital. The fair value of the outstanding restricted stock is being amortized on a straight-line basis over the three-year vesting period. Based on the vesting of the restricted stock, and offset partially by cancellations of restricted stock, approximately $216,000 was expensed in the year ended December 31, 2004. The unamortized balance of outstanding restricted stock is reflected in the balance sheet as a component of unamortized stock-based compensation and was approximately $334,000 at December 31, 2004 and was approximately $1,269,000 at December 31, 2003.
Retrocession agreements do not relieve the Company from its obligations to its ceding companies and failure of the Company’s reinsurers to honor their obligations could result in losses to the Company. The Company evaluates the financial condition of its reinsurers and monitors any concentrations of credit risk that may develop to minimize its exposure. The parties to the retrocession agreements described above have current credit rating of A+ or better, as assigned by A.M. Best.
As described in Note 2(a), the Company and Transamerica entered into a Master Agreement to novate the Company’s reinsurance contracts with F&G and Scottish Re to Transamerica effective December 31, 2004. In accordance with the terms of the Master Agreement, the Company and Transamerica have been in discussions regarding possible adjustments to the policy benefit reserves transferred to Transamerica as part of the F&G novation. On March 30, 2005, the Company received a demand letter from Transamerica stating that $7,000,000 was owed to Transamerica as an adjustment to the F&G policy benefit reserves. If the Company and Transamerica are unable to resolve this issue through continued discussions, the Company would seek adjudication of the dispute in accordance with the provisions of the Master Agreement, which calls for the matter to be submitted to a Fellow of the Society of Actuaries whose determination shall be final, binding and conclusive. While there can be no assurances, the Company believes that Transamerica is not entitled to this $7,000,000. Presently, the Company is unable to determine the amounts, if any, that may be due to or from Transamerica resulting from adjustments to the policy benefit reserves.
Pursuant to an engagement letter dated January 19, 2004, as amended (the “Engagement Letter”), the Company engaged UBS Securities LLC (“UBS”) to serve as its financial advisor and capital markets advisor in connection with identifying strategic alternatives available to the Company. The Engagement Letter provides that if, during the term of the Engagement Letter, the Company closes an equity investment, the Company is obligated to pay UBS a minimum transaction fee of $1,000,000. If the Company closes a sale transaction during the term of the Engagement Letter, the Company is obligated to pay UBS a minimum transaction fee of either $1,500,000 or $2,000,000, depending on whether the other party to that transaction is one identified in the Engagement Letter. In any case, the transaction fee payable to UBS may increase as the transaction value increases. Any transaction fee payable to UBS under the Engagement Letter will be offset by certain fees paid by the Company to UBS prior to the closing of the equity investment or sale transaction. At December 31, 2004, such fees totaled $240,000. The Company is also obligated to pay a transaction fee to UBS if, during the one year period following the expiration or termination of the Engagement Letter, the Company either consummates or enters into an agreement that results in an equity investment or sale transaction with any party identified to the Company by UBS as part of their engagement or with which the Company had discussions during the term of the Engagement Letter.
As a result of the life reinsurance agreements that were novated to Transamerica as of December 31, 2004, certain of the Company’s remaining agreements, which previously did not represent a significant percentage of the Company’s business, have become more prominent. The Company’s three largest life reinsurance agreements are now with National States Insurance Company (“National States”), John Hancock Mutual Life Insurance Company (“John Hancock”) and Omega Reinsurance Corporation (“Omega”). For the year ended December 31, 2004, the Company recorded losses of approximately $2.8 million related to its life reinsurance agreement with National States. Premiums associated with this agreement for the year ended December 31, 2004 were approximately $11.3 million. For the year ended December 31, 2004, the Company recorded gross profits of approximately $1.8 million related to its life reinsurance agreement with John Hancock. Premiums associated with this agreement for the year ended December 31, 2004 were approximately $2.1 million. For the year ended December 31, 2004, the Company recorded gross profits of approximately $1.0 million related to its life reinsurance agreement with
Omega. Premiums associated with this agreement for the year ended December 31, 2004 were approximately $1.4 million.
No deferred tax asset or liability related to operations has been recognized. Stand alone net operating results for the Company’s U.S. operations for the year ended 2004, 2003, and 2002 was a loss of $(610,000), a loss of $(12,230,000), and a loss of $(781,000), respectively. The tax basis net operating loss carry forward at December 31, 2004 was $9,661,000, which begins expiring in 2015. The Company does not expect that its future taxable net income will be sufficient to offset its deferred tax asset within a
The Unaudited quarterly financial data for the following years ended December 31 are as follows:
Issue of stock warrants includes $1,250,000 that was issued to Hartford Life in 2003 but recorded in the Parent Company as of January 1, 2004. In 2003, the warrants had been recorded in the Bermuda operating subsidiary.