The following table sets forth our selected historical consolidated financial information for the periods ended and as of the dates indicated. AXIS Specialty Bermuda was incorporated on November 8, 2001 and commenced operations on November 20, 2001. AXIS Capital was incorporated on December 9, 2002. On December 31, 2002, AXIS Specialty Bermuda and its subsidiaries became wholly owned subsidiaries of AXIS Capital pursuant to an exchange offer. In the Exchange Offer, the shareholders of AXIS Specialty Bermuda exchanged their shares for identical shareholdings in AXIS Capital. Following the Exchange Offer, AXIS Specialty Bermuda distributed all of its wholly-owned subsidiaries to AXIS Capital. The exchange offer represents a business combination of companies under common control and has been accounted for at historical cost. As a result, the consolidated financial information presented gives effect to the exchange of equity interests as though it occurred as of the inception date of AXIS Specialty Bermuda on November 8, 2001.
The selected income statement data for the years ended December 31, 2005, 2004, 2003 and 2002 and the period ended December 31, 2001 and the selected balance sheet data as of December 31, 2005, 2004, 2003, 2002 and 2001 are derived from our audited Consolidated Financial Statements. Consolidated Financial Statements and Notes are presented under Item 8 of this report. These financial statements have been prepared in accordance with U.S. GAAP and have been audited by Deloitte & Touche, our independent registered public accounting firm.
(2) The net loss and loss expense ratio is calculated by dividing net losses and loss expenses by net premiums earned.
(4) The general and administrative expense ratio is calculated by dividing general and administrative expenses by net premiums earned.
(5) The combined ratio is the sum of the net loss and loss expense ratio, the acquisition cost ratio and the general and administrative expense ratio.
The markets in which we operate have historically been cyclical. During periods of excess underwriting capacity, as defined by availability of capital, competition can result in lower pricing and less favorable policy terms and conditions for insurers and reinsurers. During periods of reduced underwriting capacity, pricing and policy terms and conditions are generally more favorable for insurers and reinsurers. Historically, underwriting capacity has been impacted by several factors, including industry losses, catastrophes, changes in legal and regulatory guidelines, investment results and the ratings and financial strength of competitors.
We derive our revenues primarily from the sale of our insurance policies and reinsurance contracts. Insurance and reinsurance premiums are a function of the number and type of contracts we write, as well as prevailing market prices.
Our expenses primarily consist of net losses and loss expenses, acquisition costs, general and administrative expenses and interest expense. Net losses and loss expenses are management’s best estimate of the ultimate cost of claims incurred during a reporting period. Many of our lines of business have loss experience characterized as low frequency and high severity, which may cause volatility in our results of operations from period to period. Also, we have substantial exposure to unexpected losses resulting from natural disasters, man-made catastrophes and other catastrophic events. The incidence and occurrence of such catastrophes are inherently unpredictable and our losses from catastrophes could be substantial. Although we attempt to manage our exposure to such events across the organization in a variety of ways, including transfer of risk to other reinsurers, a single catastrophic event could affect all of our business segments and the frequency or severity of a catastrophic event could exceed our estimates.
Acquisition costs relate to the fees, commissions and taxes paid to obtain business. We offset commissions received on ceded premiums against acquisition costs. Typically, acquisition costs are based on a percentage of the premium written and will vary by each line of business that we underwrite. Our commissions have included amounts accrued under incentive commission arrangements. However, we have not entered into any such arrangements with brokers for 2005, or thereafter.
General and administrative expenses consist primarily of personnel and general operating expenses. With effect from January 1, 2004, we allocated all of our general and administrative costs, except for corporate expenses, to our underwriting segments. Our corporate costs include holding company costs necessary to support our worldwide insurance and reinsurance operations and costs associated with operating as a publicly-traded company. Prior periods have not been restated to reflect the full allocation of general and administrative costs as our business segments were not fully operational throughout 2003 and 2002. We do not allocate our assets by segment as we evaluate the underwriting results of each segment separately from the results of our investment portfolio.
Our objective as an insurance and reinsurance company is to generate superior returns on capital that appropriately reward us for the risks we assume and to grow revenue only when we deem the returns meet or exceed our requirements. To achieve this objective, we must be able to accurately assess the potential losses associated with the risks that we insure and reinsure, to manage our investment portfolio risk appropriately, and to control acquisition costs and infrastructure
Because we have a limited operating history and are exposed to volatility in our results of operations, period to period comparisons of our results of operations may not be meaningful. In addition, the amount of premiums written with respect to any particular segment or line of business may vary from year to year as a result of changes in market conditions and our view of the long-term profit potential of individual lines of business.
This discussion and analysis should be read in conjunction with the audited Consolidated Financial Statements and notes presented under Item 8 included in this report.
purchase, Sheffield Insurance Corporation was licensed to write insurance in Illinois and Alabama and eligible to write surplus lines insurance in 39 states and the District of Columbia. In addition, we added a team of insurance professionals from Combined Specialty Group, Inc. In the first half of 2003, we acquired the renewal rights to a book of directors’ and officers’ liability insurance and related lines business written by the Financial Insurance Solutions (“FIS”) group of Kemper in exchange for an agreement to make an override payment. The override payment was based on a percentage of gross written premiums of all FIS accounts that we renewed. We purchased this company and agreed to acquire these rights as the foundation for commencing our U.S. insurance operations.
On August 1, 2005, we completed the purchase of Fireman’s Fund Insurance Company of Wisconsin for $28.5 million and subsequently renamed it AXIS Insurance Company (“AXIS Insurance U.S.”). At the time of purchase, Fireman’s Fund Insurance Company of Wisconsin was licensed in 46 states of the United States and the District of Columbia. The purchase of AXIS Insurance U.S. was made to expand our ability to write insurance on an admitted basis within the U.S.
There are certain accounting policies that we consider to be critical due to the amount of judgment and uncertainty inherent in the application of those policies. In calculating financial statement estimates, the use of different assumptions could produce materially different estimates. We believe the following critical accounting policies affect significant estimates used in the preparation of our consolidated financial statements.
For reported losses, we establish case reserves within the parameters of the coverage provided in our insurance or reinsurance contracts. With respect to our insurance operations, we are notified of insured losses by brokers and insureds and record a case reserve for the estimated amount of the ultimate expected liability arising from the claim. The estimate reflects the judgment of our claims personnel based on general reserving practices, the experience and knowledge of such personnel regarding the nature of the specific claim and, where appropriate, advice of counsel. Reserves are also established to provide for the estimated expense of settling claims, including legal and other fees and the general expenses of administering the claims adjustment process.
point estimate for baseline ultimate loss and loss expenses. The selection of an actuarial methodology and the associated loss ratio is applied at a line of business level to determine the ultimate loss and loss expenses by line of business. The actuarial method is dependent upon characteristics specific to each line of business, including: the extent of company-specific loss experience, the maturity of the line of business and the type of coverage. The actuarial methods utilized include the Bornhuetter-Ferguson method, the initial expected loss ratio method and the chain ladder (“loss emergence”) method. The Bornhuetter-Ferguson method takes as a starting point an assumed ultimate loss and loss expense ratio developed by the actuaries and blends in the loss and loss expense ratio implied by the experience to date. The chain ladder method uses the historical development profile of incurred claims experience to project the more recent, less developed profile of claims experience and to generate ultimate loss and loss expenses. The initial expected loss ratio method estimates ultimate loss and loss expenses based on pricing information. Due to our limited loss experience, for most lines of business the independent actuaries utilize the Bornhuetter- Ferguson method to derive a single point estimate of baseline ultimate loss and loss expenses.
To reduce some of this uncertainty, our independent actuaries perform, in conjunction with management, an analysis of additional factors to be considered when establishing our IBNR. These uncertainties are intended to compensate for our limited operating history and claims loss development patterns, which require the use of industry information that may not be indicative of our actual loss experience. As at December 31, 2005, we recorded additional IBNR for uncertainties relating to the timing of the emergence of claims. We anticipate that these uncertainties may vary over time. A combination of the baseline estimate of IBNR and the reserves for the additional uncertainties produces a single point estimate that constitutes management’s and the actuaries’ best estimate of IBNR.
The following table provides a breakdown of reserves for losses and loss expenses by segment by type of exposure as of December 31, 2005, 2004 and 2003.
Reinsurance Recoverable Balances. Reinsurance recoverable balances include amounts owed to us in respect of paid and unpaid ceded losses and loss expenses and are presented net of a reserve for non-recoverability. As at December 31, 2005 and 2004, reinsurance recoverable balances were $1,518.1 million and $596.3 million, respectively. In establishing our reinsurance recoverable balances, significant judgment is exercised by management in determining the amount of unpaid losses and loss expenses to be ceded as well as our ability to cede losses and loss expenses under our reinsurance contracts.
Although our reinsurance recoverable balances are derived from our determination of contractual provisions, the recoverability of such amounts may ultimately differ due to the potential for a reinsurer to become financially impaired or insolvent or for a contractual dispute over contract language or coverage. Consequently, we review our reinsurance recoverable balances on a quarterly basis to determine if there is a need to provide against non-recoverability. In performing this review, we use judgment in assessing the credit worthiness of our reinsurers and the contractual provisions of our reinsurance agreements. As at December 31, 2005 and 2004, we had a reserve for non-recoverability of $15.6 million and $3.2 million, respectively. In the event that the credit worthiness of our reinsurers were to deteriorate, actual uncollectible amounts could be significantly greater than our reserve for non-recoverability.
We also write business on a line slip basis, under which we assume a fixed percentage of the premiums and losses on a particular risk or group of risks along with numerous other unrelated insurers. Statement of Financial Accounting Standard No. 60 “Accounting and Reporting By Insurance Enterprises” requires that if the ultimate premium is reasonably estimable, the estimated ultimate premium should be recognized as revenue over the period of the contract. Although a premium estimate is not contractually stated for business written on a line slip basis, we believe that the premium is reasonably estimable because we receive an initial estimate of the expected premium written from the client via the broker. This estimate has been derived by reference to one or more of the following: the historical premium volume experienced by the line slip; historical premium volume of similar line slips; and industry information on the underlying business. We may, if we believe appropriate, adjust the initial estimates provided by the broker to reflect management’s best
Premiums. Our gross written premiums increased $381.6 million, which was primarily generated by an increase in gross premiums written of $426.1 million by our reinsurance segment. This was largely due to new opportunities within our property book, an increase in reinstatement premiums following incurred losses from Hurricane Katrina and greater market penetration in Continental Europe.
The $146.3 million increase in premium ceded was largely due to an increase in the level of reinsurance purchased by our insurance segment. This was primarily a result of an increase in premiums written by U.S. insurance.
Net Investment Income. Net investment income increased by $104.6 million due to a combination of higher investment balances and higher investment yields. Net investment income consisted of $246.2 million of interest on cash and fixed maturity investments and $17.0 million of income from other investments, offset by $6.5 million of net investment expenses. Included in net investment income was $9.5 million of unrealized gains from other investments. Net investment income for the year ended December 31, 2004 consisted of $156.6 million of interest on cash and fixed maturity investments and $2.5 million of income from other investments, offset by $7.0 million of net investment expenses.
The annualized effective yield (calculated by dividing the net investment income generated from invested assets by the average balance of the assets managed by our portfolio managers) increased by 0.5% to 3.9%. The increase in the effective yield was primarily due to higher U.S. interest rates at the short end of the yield curve. The yield may vary significantly from period to period due primarily to the timing of cash flows, changes in interest rates and changes in asset allocation.
Net Realized Losses/Gains. Net realized losses increased by $30.5 million. The increase was generated by a movement in net realized losses of $40.6 million offset by net realized and unrealized gains of $10.1 million from investment derivatives that we use to hedge foreign exchange risk in our investment portfolio. We invest our portfolio to produce a total return. In assessing returns under this approach, we include investment income, realized gains and losses and unrealized gains and losses generated by the investment portfolio. As a result, there can be significant changes in the levels of our net realized gains (losses) from year to year. Some of our mortgage-backed securities are required to be classified as derivatives, and as such, included within net realized losses was $0.4 million in realized losses from these securities.
The total return for our invested assets for the year ended December 31, 2005 (calculated using beginning and ending market portfolio values, adjusted for external cash flows) was 2.3% versus 3.4% for the year ended December 31, 2004. The total return for an investment portfolio consists of price and income return. These components are primarily affected by the timing of cash flows, changes in interest rates and changes in asset allocation. The decrease in total return was due to an increase in intermediate U.S. interest rates that negatively impacted the price of fixed income
We have an extensive process for estimating our net loss and loss expenses from these hurricanes that begins before landfall. We run industry catastrophe models to generate a list of potentially impacted policies and determine an initial loss estimate, which is based on a combination of the output of the models as well as management’s experience and knowledge of our business. In the days and weeks following the event, we gather loss information from a numbers of sources,
With respect to Hurricane Wilma, there has been a delay in substantiating some of our initial estimates because insureds have focused on damages caused by Hurricanes Katrina and Rita.
During the year ended December 31, 2004, we incurred estimated net losses and loss expenses of $266.3 million from Hurricanes Charley, Frances, Ivan and Jeanne, which swept across the Caribbean and Southeastern United States in August and September 2004.
During the year ended December 31, 2005, we experienced favorable prior period development of $383.0 million, or 15.0 percentage points, compared with $181.7 million, or 9.0 percentage points, for the year ended December 31, 2004. This increase was largely due to favorable development on prior year loss and loss expense reserves in our global insurance sub-segment.
At December 31, 2005, we had two remaining incentive commission arrangements with brokers from 2004 that had yet to be resolved. Although we have accrued our best estimate of the amounts due under these arrangements, given the uncertainties that exist surrounding the calculation and payment of these incentive commissions, our estimates are subject to change. Any changes in the estimate are recorded during the period in which the change is identified. We have not entered into any incentive commission arrangements with brokers for business underwritten in 2005 and, therefore, have not accrued any fees regarding these arrangements for the year ended December 31, 2005. The level of commissions charged in 2005 by brokers has generally remained consistent with prior periods.
Net premiums earned increased by $0.6 billion. Premiums are earned over the term of the policies in proportion to the risks to which they relate. As the level of net premiums written increases, the level of net premiums earned also increases. As we experienced an increase in net premiums written in all of our segments for the year ended December 31, 2004 compared to the year ended December 31, 2003, our net premiums earned increased.
The annualized effective yield (calculated by dividing the net investment income generated from invested assets by the average balance of the assets managed by our portfolio managers) for the year ended December 31, 2004 was 3.4% compared with 2.6% for the year ended December 31, 2003. The increase in the effective yield was primarily due to higher U.S. interest rates at the short end of the yield curve. The 2003 yield also was reduced by the additional charge for the amortization expense on our mortgage-backed securities portfolio. The yield may vary significantly from period to period due primarily to the timing of cash flows, changes in interest rates and changes in asset allocation.
Acquisition Costs. Acquisition costs increased by $94.3 million, primarily a result of the increase in the volume of gross premiums earned. The acquisition cost ratio for the year ended December 31, 2004 was 13.8% compared to 13.0% for the year ended December 31, 2003. This increase resulted primarily from an increase in the acquisition cost ratio from our insurance segment.
General and Administrative Expenses. General and administrative expenses increased by $50.8 million, primarily driven by the establishment and expansion of operations in Europe and the U.S. In addition, we incurred $3.8 million of fees in connection with our preparation for compliance with
section 404 of the Sarbanes-Oxley Act of 2002. Following the adoption of Financial Accounting Standard No. 148, we began to expense stock options and stock awards over the vesting period using the fair value method. For the year ended December 31, 2004, we expensed $17.3 million compared to $8.5 million for the year ended December 31, 2003. The general and administrative expense ratio for the year ended December 31, 2004 was 9.2% compared to 9.5% for the year ended December 31, 2003. The decrease in the ratio was caused by an increase in the volume of net premiums earned.
Foreign Exchange. Our functional currency is the U.S. dollar; however, some of our business is written in other currencies. For the year ended December 31, 2004, we experienced a gain of $14.5 million compared to a gain of $32.2 million for the year ended December 31, 2003. While the Euro and Sterling appreciated by 7.6% and 7.4%, respectively, in 2004, these increases were less than the appreciation experienced by these currencies in 2003 and, therefore, our gains were less than in 2003.
We evaluate the performance of each underwriting segment based on underwriting results. We allocate all of our general and administrative costs, except our corporate expenses, to our underwriting segments. Our corporate expenses include holding company costs necessary to support our worldwide insurance and reinsurance operations and costs associated with operating as a publicly-traded company. We do not allocate our assets by segment as we evaluate the underwriting results of each segment separately from the results of our investment portfolio.
Our insurance segment provides specialty lines of business on a worldwide basis.
The following table summarizes the underwriting results and ratios for the insurance segment for the years ended December 31, 2005 and 2004:
Premiums. The decrease in gross premiums written was due to a decrease of $234.2 million in gross premiums written in global insurance that was partially offset by an increase of $189.7 million in gross written premiums in U.S. insurance.
The table below shows gross premiums written in global insurance by line of business for the years ended December 31, 2005 and 2004:
Our global insurance property account experienced a decrease in the level of gross premiums written due primarily to the non-renewal of a significant number of contracts where pricing did not meet our underwriting criteria. The increase in our professional lines and other specialty business was due to the addition of a London market-based professional lines underwriting team in early 2004. In addition, in mid-2005 we secured a new specialty program that generated $13.0 million of gross premiums written.
The table below shows gross premiums written in U.S. insurance by line of business for the years ended December 31, 2005 and 2004:
The increase in our U.S. liability account was primarily due to additional umbrella and excess liability gross premiums written of $50.9 million following our decision to target this class of business and increase the number of dedicated underwriters. In addition, we wrote $13.7 million of new specialty program liability business, which primarily covers recreational marine watercraft risk. These increases were offset by a $9.0 million decrease on our primary casualty account, principally the result of an increasingly competitive pricing environment. The increase in our property account was largely driven by an increase of $34.7 million in premiums generated by our specialty program business and an increase in our inland marine business due to an increase in the number of dedicated underwriters. The increase in our other specialty account was due to the fact that we began to underwrite this class of business in late 2004; consequently, the year ended December 31, 2005 includes a full year of gross premiums written. The increase in gross premiums written in our
The following table shows the derivation of net premiums earned in our insurance segment for the years ended December 31, 2005 and 2004:
Gross premiums are earned over the period of the insured risks, which is generally one to two years. Despite the fall in gross premiums written in 2005, our gross premiums earned increased as we continued to earn premiums written in prior years from risk attaching or multi-year policies.
The net loss and loss expense ratio for global insurance was 65.9% for the year ended December 31, 2005 compared to 56.7% for the year ended December 31, 2004. The increase was due to the impact of Hurricanes Katrina, Rita and Wilma from which we incurred estimated net loss and loss expenses of $288.6 million, or 38.6 percentage points. During the year ended December 31, 2004,
The losses from Hurricanes Katrina and Rita were primarily generated from our onshore property and offshore energy business within our property and marine books of business following property damage and business interruption claims. Our gross loss and loss expenses estimates were $428.0 million and $175.0 million for Hurricanes Katrina and Rita, respectively, and were primarily based on loss information received from our clients, brokers and loss adjustors. Our losses with respect to Hurricane Wilma were primarily derived from our property book. Our gross loss and loss expenses estimate of $25.0 million was primarily derived from a review of our in-force contracts and preliminary loss information from our clients, brokers and loss adjustors in combination with the output of industry models. Actual losses from these hurricanes may differ materially from our estimates of loss and loss expenses. Our gross loss and loss expenses estimates were reduced by reinsurance recoveries, primarily from excess of loss reinsurance contracts, by $234.7 million on Hurricane Katrina, $101.7 million on Hurricane Rita and $0.3 million on Hurricane Wilma.
During the year ended December 31, 2005, we experienced favorable development in prior year loss and loss expense reserves of $242.3 million, or 32.4 percentage points, compared to $92.5 million, or 11.6 percentage points, for the year ended December 31, 2004. In estimating the ultimate cost of losses, we primarily use the Bornhuetter-Ferguson method. This method takes as a starting point an initial expected loss and loss expense ratio and blends in the loss and loss expense ratio implied by our experience to date. Given our limited operating history, our initial expected loss and loss expense ratios have primarily been based on industry data; however, in 2005, as loss experience continued to emerge from prior years, we began to utilize our own specific loss information in establishing initial net loss and loss expense ratios on short tail lines of business.
The losses from these hurricanes were generated from our property book of business. Our estimates of gross loss and loss expenses were $350.0 million, $50.0 million and $121.0 million for Hurricanes Katrina, Rita and Wilma, respectively. Our estimate of our gross loss and losses expenses on Hurricanes Katrina and Rita were primarily based upon loss information received from our clients, brokers and loss adjustors. Our estimate on Hurricane Wilma was based upon a combination of the output of industry models, a review of our in-force contracts and preliminary loss information from our clients, brokers and loss adjustors. Actual losses from these hurricanes may differ materially from our estimates of loss and loss expenses. U.S. insurance purchases significant reinsurance protection on a per risk and excess of loss basis, which reduced our gross losses by $294.0 million in respect of Hurricane Katrina, $35.0 million in respect of Hurricane Rita and $75.0 million in respect of Hurricane Wilma.
Acquisition Costs. The decrease in the acquisition cost ratio was driven by a decrease in the acquisition cost ratio of global insurance.
Premiums. The table below shows gross premiums written in global insurance by line of business for the years ended December 31, 2004 and 2003.
The table below shows gross premiums written in U.S. insurance by line of business for the years ended December 31, 2004 and 2003:
the effect of a reduction in rates for our directors and officers’ liability insurance, which caused us to decline to renew some contracts where rates did not meet our targeted levels.
The following table shows the derivation of net premiums earned in our insurance segment for the years ended December 31, 2004 and 2003:
Net Losses and Loss Expenses. The net loss and loss expense ratio for the year ended December 31, 2004 was 59.9% compared to 53.3% for the year ended December 31, 2003, an increase of 6.6 percentage points. The increase in net loss and loss expenses and the net loss and loss expense ratio was primarily due to an increase in the level of net loss and loss expenses due to significant hurricane activity.
The net loss and loss expense ratio for global insurance was 56.7% for the year ended December 31, 2004 compared to 50.8% for the year ended December 31, 2003. During the year ended December 31, 2004, we experienced significant net losses and loss expenses of $50.3 million, or 6.3 percentage points, from Hurricanes Charley, Frances, Ivan and Jeanne in our property, energy and marine books of business. These losses primarily accounted for the increase in the level of reported case reserves. Our estimates for the losses incurred from these hurricanes were derived from formal loss advices, the output of industry models, a review of in-force contracts and preliminary indications from clients. Consequently, actual losses from these hurricanes may vary materially from estimated losses. The increase in our reinsurance recoveries was primarily driven by recoveries of $33.9 million from losses caused by Hurricanes Frances and Ivan.
During the year ended December 31, 2004, we experienced favorable development on our prior accident years of $92.5 million compared to $27.7 million during the year ended December 31, 2003.
This reduced the net loss ratio by 11.6 percentage points for the year ended December 31, 2004 and 3.6 percentage points for the year ended December 31, 2003. We primarily use the Bornhuetter-Ferguson method to estimate the ultimate cost of losses; it takes as a starting point an assumed ultimate loss and loss expense ratio and blends in the loss and loss expense ratio implied by the experience to date. If actual claims are less than expected, this generates favorable loss development. During the year ended December 31, 2004, the favorable development was generated primarily on our 2003 accident year and was derived from our energy, property, terrorism and aviation war lines of business. For the year ended December 31, 2003, the favorable development was generated on our 2002 accident year and was derived from our marine, aviation war, energy and property lines of business.
The net loss and loss expense ratio for U.S. insurance was 67.2% for the year ended December 31, 2004 compared to 64.5% for the year ended December 31, 2003. The increase was primarily driven by losses from Hurricanes Charley, Frances, Ivan and Jeanne from which we incurred net losses and loss expenses of $46.8 million, or 13.4 percentage points. Our hurricane losses benefited from reinsurance recoveries of $187.1 million. Our estimates for the losses incurred from these hurricanes were derived from formal loss advices, the output of industry models, a review of in-force contracts and preliminary indications from clients. Consequently, actual losses from these hurricanes may vary materially from estimated losses.
Acquisition Costs. The increase in the acquisition cost ratio was driven by an increase in the acquisition cost ratios of both global and U.S. insurance.
Acquisition costs for global insurance for the year ended December 31, 2004 were $125.0 million compared to $99.5 million for the year ended December 31, 2003, an increase of $25.5 million. The acquisition cost ratio for the year ended December 31, 2004 was 15.7% compared with 13.0% for the year ended December 31, 2003. The increase in the acquisition cost ratio was partially caused by higher amortized reinsurance costs, which reduced the level of net premiums earned. As a percentage of gross premiums earned, the level of acquisition costs was 13.7% for the year ended December 31, 2004 compared to 12.0% for the year ended December 31, 2003. The increase of 1.7 percentage points in the level of the gross acquisition ratio was primarily due to additional commissions.
Acquisition costs for U.S. insurance for the year ended December 31, 2004 were $10.8 million compared to $2.6 million for the year ended December 31, 2003, an increase of $8.2 million. The acquisition cost ratio for the year ended December 31, 2004 was 3.1% compared to 1.6% for the year ended December 31, 2003. As a percentage of gross premiums earned, the acquisition cost ratio was 1.6% for the year ended December 31, 2004 compared to 0.7% for the year ended December 31, 2003. The increase was primarily driven by a reduction in the level of commissions received on ceded premiums, which are offset against acquisition costs. Excluding the impact of commissions received on ceded premiums, the acquisition cost ratio as a percentage of gross premiums earned was consistent at 14.1% for the year ended December 31, 2004 and 14.7% for the year ended December 31, 2003.
General and Administrative Expenses. The 5.6 percentage point increase in our general and administrative expenses ratio for the year ended December 31, 2004 was due to an increase in U.S. insurance business, which has a higher general and administrative expense ratio than global insurance.
The following table summarizes the underwriting results and ratios in our reinsurance segment for the years ended December 31, 2005 and 2004:
Premiums. The table below shows gross premiums written by line of business in our reinsurance segment for the years ended December 31, 2005 and 2004:
The increase in our catastrophe account was primarily due to the impact of the 2005 hurricanes. We recorded $71.3 million in reinstatement premiums on the 2005 hurricanes, compared to $18.0 million on the 2004 hurricanes. In addition, $10.1 million of gross premiums written were from additional reinsurance protection written for clients following the exhaustion of their reinsurance coverage as a result of Hurricane Katrina. Although we experienced rate decreases in our catastrophe book during 2005, we wrote some new business and our renewal business was focused primarily on U.S. exposures where rate reductions were less severe than those for non-U.S. business. In addition, we experienced rate increases on some national accounts impacted by hurricane losses in 2004. We believe that catastrophe rates will increase in 2006, particularly on U.S. related exposures impacted by hurricane losses in 2005.
Premiums ceded for the year ended December 31, 2005 were $27.6 million compared to $32.3 million for the year ended December 31, 2004, a decrease of $4.7 million. Within our reinsurance
The following table shows the derivation of net premiums earned in our reinsurance segment for the years ended December 31, 2005 and 2004:
Ceded premiums are amortized over the contract term. Consequently, the level of ceded premiums amortized increased in 2005 as premiums ceded in 2004 continued to be amortized in 2005.
Our losses were primarily generated from our catastrophe and property lines of business as we write negligible amounts of offshore energy reinsurance. Our estimates for the losses incurred from Hurricanes Katrina and Rita were derived from a review of in-force contracts and loss information from clients and brokers in combination with the output of industry models. Our estimate for Hurricane Wilma was derived from the output of industry models, market share analyses, a review of in-force contracts and preliminary loss information from our clients and brokers. Actual losses from these hurricanes may differ materially from our estimates of loss and loss expenses. Our estimated gross losses were reduced by $76.5 million of reinsurance recoveries that were triggered by the occurrence of a series of large industry loss events. This reinsurance has predetermined industry loss triggers based on the size and number of industry losses calculated by independent third parties. Based on a combination of public information, our own assessment of each industry loss and historical industry development factors, we believe that these industry loss trigger points have been exceeded; however, these industry loss figures are only estimates and as such are subject to change. Consequently, actual reinsurance recoveries could be materially reduced.
During the year ended December 31, 2005, we experienced favorable prior period development of $114.3 million, or 8.5 percentage points, compared to $74.9 million, or 8.5 percentage points, for the year ended December 31, 2004. In estimating the ultimate cost of losses, we primarily use the Bornhuetter-Ferguson method. This method takes as a starting point an initial expected loss and loss expense ratio and blends in the loss and loss expense ratio implied by our experience to date. Any
General and Administrative Expenses. The 1.1 percentage point decrease in the general and administrative expense ratio was primarily due to an increase in the level of net premiums earned.
(1) For the year ended December 31, 2003, we did not allocate any of our general and administrative expenses, except for the personnel expenses of our underwriters; therefore, the general and administrative amounts, expense ratios and combined ratios for the two periods are not comparable.
Premiums. The table below shows gross premiums written by line of business in our reinsurance segment for the years ended December 31, 2004 and 2003:
Premiums ceded increased by $19.7 million due partly to $6.1 million of reinstatement premiums on coverages exhausted by losses from Hurricanes Charley, Frances, Ivan and Jeanne. Our global reinsurance segment purchases reinsurance to protect against a large industry loss or series of losses.
Other Insurance Related Income. Other insurance related income related to the movement in the fair value of a reinsurance contract that met the definition of a derivative.
During the year ended December 31, 2004, we experienced favorable development on our prior accident years of $74.9 million compared to $28.1 million during the year ended December 31, 2003. This reduced the net loss ratio by 8.5 percentage points for the year ended December 31, 2004, and 5.6 percentage points for the year ended December 31, 2003. We primarily use the Bornhuetter-Ferguson method to estimate the ultimate cost of losses; it takes as a starting point an assumed ultimate loss and loss expense ratio and blends in the loss and loss expense ratio implied by the experience to date. If actual claims are less than expected, this generates favorable loss development. During the year ended December 31, 2004, the favorable development was generated primarily on our 2003 accident year and was derived primarily from our property catastrophe line of business. For the year ended December 31, 2003, the favorable development was generated on our 2002 accident year and was derived primarily from our property catastrophe line of business.
Acquisition Costs. Acquisition costs increased due to an increase in the level of net premiums earned. The acquisition cost ratio decreased primarily due to a reduction in the level of commissions incurred.
We are a holding company and have no substantial operations of our own. Our assets consist primarily of our investments in subsidiaries. At December 31, 2005, we had operating subsidiaries in
Bermuda, Ireland and the United States, a branch in the United Kingdom, a branch in Switzerland and a representative office in Singapore. Accordingly, our future cash flows depend upon the availability of dividends or other statutorily permissible payments from our subsidiaries. The ability to pay dividends or distributions is limited by the applicable laws and regulations of Bermuda, Ireland and the United States, which subject our insurance subsidiaries to significant regulatory restrictions. These laws and regulations require, among other things, some of our insurance subsidiaries to maintain minimum solvency requirements and limit the amount of dividends that these subsidiaries can pay to us, which in turn may limit our ability to pay dividends and make other payments.
At December 31, 2005, the maximum amount of distributions that our subsidiaries could pay to AXIS Capital under applicable laws and regulations without prior regulatory approval was approximately $1.2 billion.
At December 31, 2005, our shareholders’ equity was $3.5 billion compared to $3.2 billion at December 31, 2004. The increase of $0.3 billion was primarily due to net income of $90.1 million for the year, the issuance of series A and B preferred shares of $500.0 million and the issuance of $200.1 million of common shares and was offset by a common share repurchase of $350.0 million pursuant to a share repurchase program that has been exhausted.
At December 31, 2005, our total investments at fair market value, accrued interest receivable and cash net of unsettled investment trades were $7.8 billion compared to $6.0 billion at December 31, 2004. Our investment portfolio consisted primarily of fixed income securities at December 31, 2005 and was managed by several external investment management firms. At December 31, 2005, all of these fixed income securities were investment grade, with 82.1% rated Aa3 or AA- or better by an internationally recognized rating agency. The weighted-average rating of our fixed income portfolio was AAA based on ratings assigned by Standard & Poor’s. During 2005, we continued to increase the size of the allocation to other investments within our investment portfolio. At December 31, 2005, other investments were $409.5 million compared to $105.8 million at December 31, 2004 and consisted of investments in funds of funds, a fund that invests in U.S. dollar high yield credit, funds that primarily invest in senior secured bank loans and a portfolio of investments in collateralized loan obligations. We regularly review our investment portfolio for other than temporary impairments and determined at December 31, 2005 that no impairment exists. For additional information regarding the investment portfolio and an analysis of sector, rating and maturity distributions, refer to note 6 in our Consolidated Financial Statements included in Item 8 in this report.
At December 31, 2005, we had $4.7 billion of reserves for loss and loss expenses compared to $2.4 billion at December 31, 2004, an increase of $2.3 billion. The increase was primarily due to loss and loss expense reserves relating to Hurricanes Katrina, Rita and Wilma. Of this balance, $2.7 billion, or 57.5%, was incurred but not reported reserves, compared to $1.8 billion, or 75.6%, at December 31, 2004. The percentage of IBNR reserves to total loss reserves was lower at December 31, 2005 and reflects the significant case reserves established for Hurricane Katrina, Rita and Wilma during the year. For a number of the policies exposed to these hurricane losses, coverage limits have been exhausted and, therefore, the potential for adverse loss development is limited. Consequently, no additional general IBNR reserves have been established. For further discussion and analysis on our reserve for loss and loss expenses refer to note 7 in our Consolidated Financial Statements included in Item 8 in this report.
Our cash flows from operations generally represent the difference between: (1) premiums collected, reinsurance recoveries and investment earnings realized; and (2) losses and loss expenses paid, reinsurance purchased and underwriting and other expenses paid. Cash flows from operations may differ substantially, however, from net income. The potential for a large claim under one of our insurance or reinsurance contracts means that substantial and unpredictable payments may need to be made within relatively short periods of time.
During the year ended December 31, 2004, we generated a net operating cash inflow of $1.6 billion, primarily relating to premiums received and investment income. During the same period, we paid gross losses of $338.7 million and received reinsurance recoveries of $35.1 million. We invested a net cash amount of $1,991.0 million during the period, and at December 31, 2004 had a cash balance of $632.3 million. During the year ended December 31, 2004, net cash of $416.5 million
During 2005, we declared four quarterly dividends of $0.15 per common share. The dividends were paid on April 14, 2005, July 14, 2005, October 14, 2005 and January 17, 2006. During 2004, we declared four quarterly dividends of $0.125 per common share. The dividends were paid on April 14, 2004, July 14, 2004, October 14, 2004 and January 12, 2005.
On an ongoing basis, our sources of funds primarily consist of premiums written, reinsurance recoveries, investment income and proceeds from sales and redemptions of investments. Cash is used primarily to pay losses and loss expenses, reinsurance premiums, acquisition costs and general and administrative expenses, to purchase new investments and to fund dividend and interest payments. Many of our lines of business have loss experience characterized as low frequency and high severity, which may cause volatility in our results of operations and our operating cash flows.
On November 23, 2005, we issued $250.0 million of 7.50% series B preferred shares with a liquidation preference of $100.00 per share. We may redeem the shares on or after December 1, 2015 at a redemption price of $100.00 per share. Dividends on the series B preferred shares if, as and when declared by our board of directors will be payable initially at a fixed rate per annum equal to 7.50% of the liquidation preference on the first day of March, June, September and December of each year, commencing on March 1, 2006, up to but not including December 1, 2015. Commencing on March 1, 2016, the dividend rate on the series B preferred shares will be payable at a floating rate. During a floating rate period, the floating rate per annum will be reset quarterly at a rate equal to 3.4525% plus the 3-month LIBOR Rate. Dividends on the series B preferred shares are non-cumulative. Consequently, if our board of directors does not declare a dividend for any dividend period, holders of the series B preferred shares will not be entitled to receive a dividend for such period, and such undeclared dividend will not accumulate and will not be payable.
On August 25, 2005, we entered into a $1.5 billion credit agreement with a syndicate of lenders replacing our existing $750 million credit facility. The credit agreement is an unsecured five-year facility that allows us and our operating subsidiaries to issue letters of credit up to the full amount of the facility and to borrow up to $500 million for general corporate purposes, with total usage not to exceed $1.5 billion. The credit agreement contains various loan covenants, including limitations on the incurrence of future indebtedness, future liens, fundamental changes, investments and certain transactions with affiliates. The facility also requires that we maintain (1) a minimum consolidated net worth of $2.0 billion plus (a) 25% of consolidated net income (if positive) of AXIS Capital for each semi-annual fiscal period ending on or after December 31, 2005 plus (b) an amount equal to 25% of the net cash proceeds received by AXIS Capital from the issuance of its capital stock during each such semi-annual fiscal period; and (2) a maximum debt to total capitalization ratio of 0.35:1.0. We were in compliance with all covenants contained in the credit agreement at December 31, 2005. As at December 31, 2005, we had letters of credit of $658.1 million (2004: $421.7 million) outstanding. There was no debt outstanding under the credit agreements as at December 31, 2005 or 2004.
We did not make any significant capital expenditures during the year ended December 31, 2005. We currently expect capital expenditures for 2006 to be less than $50 million.
Consolidated Statements of Operations for the years ended December 31, 2005, 2004 and
Consolidated Statements of Comprehensive Income for the years ended December 31, 2005, 2004 and 2003
We have audited the accompanying consolidated balance sheets of AXIS Capital Holdings Limited and subsidiaries (the “Company”) as of December 31, 2005 and 2004, and the related consolidated statements of operations, comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
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, 2005, 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 March 8, 2006 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
Purchases and sales of investments are recorded on a trade date basis. Realized gains or losses on sales of investments are determined based on the specific identification method. Net investment income includes interest and dividend income together with amortization of market premiums and discounts and is net of investment fees. For mortgage-backed securities and any other holdings for
Cash and cash equivalents include fixed interest deposits placed with a maturity of under 90 days when purchased.
The Company routinely assesses whether declines in fair value of its investments represent impairments that are other than temporary. There are several factors that are considered in the assessment of a security, which include (i) the time period during which there has been a significant decline below cost, (ii) the extent of the decline below cost, (iii) the Company’s intent and ability to hold the security, (iv) the potential for the security to recover in value, (v) an analysis of the financial condition of the issuer and (vi) an analysis of the collateral structure and credit support of the security, if applicable. Where the Company has determined that there is an other than temporary impairment in the fair value of the security, the cost of the security is written down to the fair value and the unrealized loss at the time of the determination is charged to income.
Premiums written are recorded in accordance with the terms of the underlying policies. Reinsurance premiums assumed are estimated based upon information received from ceding companies and any subsequent differences arising on such estimates are recorded in the period they are determined. Premiums are generally contractually stated except for business written on a line slip or proportional basis. Under FAS No. 60 “Accounting and Reporting by Insurance Enterprises” a company is permitted to book premium as long as it is reasonably estimable. For line slip premiums, the Company receives an initial estimate of expected premium from the client via the broker. In the case of proportional contracts, the Company receives an estimate of the expected premium to be ceded from its client. The Company actively monitors the emergence of actual premium data on line
Acquisition costs, primarily fees and commissions paid to brokers and taxes, vary with and are directly related to the acquisition of policies and are deferred and amortized over the period in which the related premiums are earned. Deferred acquisition costs are reviewed to determine if they are recoverable from future income, including investment income. If such costs are estimated to be unrecoverable, they are expensed.
not yet paid, the cost of additional case reserves on claims reported to us but not considered to be adequately reserved and the anticipated cost of claims incurred but not reported (“IBNR”).
Applying these loss and loss expense ratios to earned premium derives the estimated baseline ultimate costs of the losses from which paid losses and reported case reserves are deducted to generate baseline IBNR. The actuarial methodologies used to derive the baseline estimate can not fully allow for all uncertainties within the Company’s business. To reduce some of these uncertainties, the independent actuaries perform, in conjunction with management, an analysis of additional factors to be considered when establishing IBNR. These uncertainties may vary over time, but generally contemplate matters such as the timing and emergence of claims or short term market trends that might alter our otherwise consistent baseline approach. A combination of the baseline estimate of IBNR and the reserves for the additional uncertainties constitutes management’s and the actuaries’ best estimate of IBNR.
The Company accounts for stock compensation in accordance with FAS No. 123, “Accounting for Stock-Based Compensation.” Compensation expense for stock options and for restricted stock awards granted to employees is recorded over the vesting period using the fair value method.
The Company reports segment results in accordance with FAS No. 131 “Segment Reporting.” Under FAS 131, reportable segments represent an aggregation of operating segments that meet certain criteria for aggregation.
The Company accounts for its derivative instruments using FAS No. 133 “Accounting for Derivative Instruments and Hedging Activities.” FAS 133 requires an entity to recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value with movements in fair value reflected in earnings. The Company may enter into derivative instruments such as futures, options, interest rate swaps and foreign currency forward contracts in order to manage duration and foreign currency exposure, obtain exposure to a particular financial market or for yield enhancement. The Company manages the exposure to these instruments based on guidelines established by management and these derivative instruments are carried at fair value with the corresponding changes in fair value recognized in income in the period that they occur.
From time to time the Company enters into insurance and reinsurance contracts that meet the definition of a derivative contract under FAS 133. The Company has recorded these contracts at fair value with any changes in the value reflected in other insurance related income in the consolidated statements of operations. Generally, the contracts are modeled on prevailing market conditions and certain other factors relating to the structure of the contracts. The Company’s model takes into account movements on credit spreads and credit qualities and when data is not readily available from the market, the Company uses data from independent counterparties.
The Company currently uses foreign currency forward contracts as part of its process to manage foreign currency exposures in the balance sheet. Foreign currency forward contracts are purchased as
The Company has recorded the purchase of numerous U.S. state licenses as intangible assets with indefinite lives as they provide a legal right to transact business indefinitely and could be resold.
In December 2004, the FASB issued Statement No. 123 (revised 2004), Share-Based Payment (“FAS 123R”). FAS 123R replaces FASB Statement No. 123 “Accounting for Stock-Based Compensation” and supersedes APB opinion No.25 “Accounting for Stock Issued to Employees”. The statement requires all entities to recognize compensation expense in an amount equal to the fair value of share-based payments granted to employees and is effective for the first quarter of 2006. The Company already records compensation expense for awards of stock options and restricted stock to employees based on the fair value of the awards; consequently, this statement is not expected to have a material impact on the Company’s results of operations or financial condition.
The following tables summarize the underwriting results, income (loss) before income taxes, ratios and the reserves for losses and loss expenses for the Company’s reportable operating segments and sub-segments for the years ended December 31, 2005, 2004 and 2003.
The following table shows an analysis of the Company’s gross premiums written by domicile of subsidiary for the years ended December 31, 2005, 2004 and 2003:
On August 1, 2005, the Company completed the purchase of Fireman’s Fund Insurance Company of Wisconsin, which is licensed in 46 states of the United States and the District of Columbia. Fireman’s Fund Insurance Company of Wisconsin was subsequently redomiciled to the state of Illinois and renamed AXIS Insurance Company (“AXIS Insurance U.S.”). The Company paid a purchase price of $28.5 million. The Company does not consider this to be a material acquisition. The purchase of AXIS Insurance U.S. was made to expand the Company’s ability to write insurance on an admitted basis within the U.S.
At the date of acquisition, Fireman’s Fund Insurance Company assumed all known, unknown and contingent liabilities of AXIS Insurance U.S. relating to events occurring on or before the acquisition date. In addition, Fireman’s Fund Insurance Company entered into a reinsurance agreement to fully assume $22.9 million of outstanding loss reserves of AXIS Insurance U.S. on the acquisition date. These loss reserves and a reinsurance recoverable of the same amount were recorded on the date of acquisition. To the extent Fireman’s Fund Insurance Company does not meet its obligation under these agreements, AXIS Insurance U.S. remains liable for these liabilities.
On February 28, 2003, the Company completed the acquisition of all of the issued and outstanding shares of capital stock of Sheffield Insurance Corporation, an Illinois domiciled surplus lines company, and subsequently renamed it AXIS Surplus Insurance Company (“AXIS Surplus U.S.”). The Company paid a purchase price of $34.7 million. The results of operations of AXIS Surplus U.S. have been included in the consolidated financial statements from the effective purchase date of January 1, 2003. The purchase of AXIS Surplus U.S. was made to expand the Company’s ability to write insurance on a non-admitted basis within the U.S.
The following table summarizes the estimated fair values of the assets acquired and the liabilities assumed at the date of the acquisition of AXIS Surplus U.S.
The following table shows an analysis of intangible assets for the years ended December 31, 2005, 2004 and 2003:
The following table summarizes the fixed income securities in an unrealized loss position at December 31, 2005 and the aggregate fair value and gross unrealized loss by length of time the security has continuously been in an unrealized loss position:
The Company recently expanded its investment strategy to other asset sectors. At December 31, 2005, the Company had $409.5 million of other investments at fair value (2004: $105.8 million), representing 5.3% of total cash and investments. These investments consist of the following at December 31, 2005:
We are required to maintain assets on deposit with various regulatory authorities to support our insurance and reinsurance operations. The assets on deposit are available to settle insurance and reinsurance liabilities. We also utilize trust funds in certain large transactions where the trust funds are set up for the benefit of the ceding companies and generally take the place of Letter of Credit requirements. The assets on deposit and used for collateral are primarily highly rated fixed maturity securities. The components of the fair value of the restricted assets at December 31, 2005 and 2004 are as follows:
The following table represents an analysis of paid and unpaid losses and loss expenses and a reconciliation of the beginning and ending unpaid losses and loss expenses for the periods indicated:
The Company writes business with loss experience generally characterized as low frequency and high severity in nature, which results in volatility in its financial results. The Company incurred net losses and loss expenses of $1,019.1 million relating to Hurricanes Katrina, Rita and Wilma. The Company’s estimates for the losses incurred from these hurricanes were derived from a combination of the output of industry models, market share analyses, a review of in-force contracts and preliminary loss information from the Company’s clients, brokers and loss adjustors. Consequently, actual losses from these hurricanes may vary materially from estimated losses.
The following table summarized the net favorable development of losses and loss expenses by segment:
The Company commenced operations in November 2001 and has a limited operating history. This has necessitated the use of industry loss development patterns in deriving IBNR instead of actual claims loss emergence patterns. The Company has primarily written short tail lines of business. Consequently, as Company-specific claims loss patterns emerge, favorable prior period loss development has developed. In 2005, the Company began to utilize its own specific loss information in establishing initial net loss and loss expense ratios on these short tail lines of business.
Global insurance experienced $242.3 million of net favorable prior period development, representing 27.5% of the reserve for losses and loss expenses at December 31, 2004. This compares with 2004 net favorable prior period development of $92.5 million, or 19.2%, of the reserve for losses
U.S. Insurance experienced $26.4 million of net favorable prior period development, representing 3.5% of the reserve for losses and loss expenses at December 31, 2004. This compares with 2004 net favorable prior period development of $14.3 million, or 6.4% of the reserve for losses and loss expenses at December 31, 2003. The favorable development related to the 2004 accident year property account.
Of the reinsurance recoverable balance for Reinsurance 38.5% is fully collaterized.
During the year ended December 31, 2005, the Company recorded realized and unrealized (losses) gains on foreign currency forward contracts in its investment portfolio of $7.3 million (2004: ($3.0) million; 2003: $0.5 million). As at December 31, 2005, the net contractual amount of these foreign currency forward contracts was $27.1 million (2004: $30.0 million; 2003: $3.8 million) with an unrealized loss of $0.2 million (2004:$0.1 million; 2003: $negligible).
With effect from July 1, 2003, the Company adopted FAS No. 149 “Amendment of Statement 133 on Derivative Instruments and Hedging Activities”. As a result, some of its mortgage-backed securities are required to be classified as derivatives and the unrealized gains (losses) associated with these securities that were previously recorded in accumulated other comprehensive gain (loss) are now recorded in net realized gains (losses). During the year ended December 31, 2005, the Company recorded realized and unrealized (losses) gains on mortgage-backed investment derivatives of ($0.4) million (2004: $0.3 million; 2003: $(5.5) million). As at December 31, 2005, the Company did not hold any mortgage-backed investment derivatives in its investment portfolio.
During the year ended December 31, 2005, the Company recorded realized and unrealized (losses) gains of $4.9 million (2004: $nil; 2003: $nil) on foreign currency forward contracts used to manage foreign currency exposures in the balance sheet. As at December 31, 2005, the net contractual amount of these foreign currency forward contracts was $59.9 million (2004: $nil; 2003: $nil) with an unrealized gain of $0.7 million (2004: $nil; 2003: $nil).
As at December 31, 2005, the Company had a $1.5 billion credit facility agreement with a syndicate of lenders replacing its previous $750 million credit facility. The credit agreement is an unsecured five-year facility that allows the Company and its operating subsidiaries to issue letters of credit up to the full amount of the facility and to borrow up to $500 million for general corporate purposes, with total usage not to exceed $1.5 billion. The credit agreement contains various loan covenants, including limitations on the incurrence of future indebtedness, future liens, fundamental changes, investments and certain transactions with affiliates. The facility also requires that the Company maintain 1) a minimum consolidated net worth of $2.0 billion plus (A) 25% of consolidated net income (if positive) of AXIS Capital for each semi-annual fiscal period ending on or after December 31, 2005 plus (B) an amount equal to 25% of the net cash proceeds received by AXIS Capital from the issuance of its capital stock during each such semi-annual fiscal period; and 2) a minimum debt to total capitalization ratio 0.35:1.0. The Company was in compliance with all covenants contained in the credit agreement at December 31, 2005. As at December 31, 2005, the Company had letters of credit of $685.1 million (2004: $421.7 million) outstanding. There was no debt outstanding under the credit facility as at December 31, 2005 or December 31, 2004.
Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of investments and reinsurance recoverable balances. The investment portfolio is managed by external advisors in accordance with prudent standards of diversification. Specific
The Company and its subsidiaries lease office space in the countries in which they operate under operating leases which expire at various dates. The Company renews and enters into new leases in the ordinary course of business as required. Total rent expense with respect to these operating leases for the year ended December 31, 2005 was approximately $7,920 (2004: $7,139: 2003: $5,088).
The following securities that would result in the issuance of common shares were not included in the computation of diluted earnings per common share because the effect would be antidilutive: 1,106,499, 1,664,500 and 113,000 for the years ended December 31, 2005, 2004 and 2003, respectively.
Effective January 1, 2004, the Company implemented supplemental retirement plans (“SERPs”) for two executives. The SERP for Mr. Charman requires the Company to make annual payments to Mr. Charman upon his retirement for a period of 20 years. The benefits vest over a period of two years commencing in 2006. Commencing at age 56, Mr. Charman is entitled to an annual payment of $750,000 compounded by 3% annually for each year commencing from inception. The SERP for Mr. Butt requires the Company to make annual payments to Mr. Butt upon his retirement for a period of 10 years. The benefits vest over a period of two years commencing in 2006. Commencing at age 66, Mr. Butt is entitled to an annual payment of $250,000 compounded by 3% annually for each year commencing from inception. If either Mr. Charman or Mr. Butt dies, is permanently disabled or a change of control of the Company occurs, the remaining benefits under his plan are payable by the Company in a lump sum. The benefits received under the SERPs will be reduced by the benefits received by the executives under the Company’s Bermuda retirement plan. The measurement date of the plan was January 1, 2005. The plan was fully funded in January 2006.
The following table shows the components of expense for the years ended December 31, 2005 and 2004 and the amounts included in the Company’s Condensed Consolidated Balance Sheet as of December 31, 2005 and 2004 for the Company’s supplemental retirement plans established for the benefit of the Company’s Chairman and its Chief Executive Officer and President.
Effective January 1, 2003, the Company adopted, prospectively, the fair value recognition provisions of FAS No. 123 “Accounting for Stock-Based Compensation (“SFAS No. 123”) for all stock options granted after January 1, 2003. During the year ended December 31, 2005, the Company expensed $5,193 (2004: $2,955; 2003: $425) related to the grant of options. The weighted average fair value of options granted during 2005 was $7,052 (2004: $7,331; 2003: $1,099). The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants in 2005: risk free interest rates of 4.19% (2004: 4.4%; 2003: 4.0%), expected life of 6.9 years (2004 and 2003: 7 years), a dividend yield of 2.45% (2004: 1.9%; 2003: 1.0) and an expected volatility of 21.92% (2004: 23%).
The following table summarizes information about the Company’s stock options for options outstanding as of December 31, 2005:
During the year ended December 31, 2005, 895,750 (2004: 550,500; 2003: 79,800) restricted common shares with a fair value of $24.6 million (2004: $16.3 million; 2003: $1.6 million) were awarded to employees of the Company and its subsidiaries and 171,600 restricted common shares
were cancelled (2004: 9,600; 2003: 36,000) bringing the total issued to date to 3,570,170 (2004: 2,674,420; 2003: 2,112,320). Of the total issued to date, 200,000 shares were awarded outside of the plan to an employee of the Company and vested immediately upon issuance. The other restricted shares generally vest three years after the date of grant or upon the employee’s earlier retirement, death, permanent disability or a change in control of the Company. Restricted shares are entitled to vote and to receive dividends but may not be transferred during the period of restriction and are forfeited if the employee’s employment terminates prior to vesting. Compensation equivalent to the estimated fair market value at the date of grant is amortized over a three-year vesting period. During the year ended December 31, 2005, the Company expensed $19,965 (2004: $14,091; 2003: $8,185) in respect of restricted stock.
The maximum number of shares that may be offered for purchase under the plan pursuant to share purchase rights is 1,200,000. Share purchase rights may only be granted to employees. In order to assist employees in purchasing shares pursuant to a grant of share purchase rights, the Company guaranteed full recourse loans secured by the shares purchased with the loan proceeds to employees who were not executive officers of the Company. At December 31, 2005, the maximum guaranteed amount was $4.7 million (2004: $ 4.7 million). During the year ended December 31, 2005, there were no share purchase rights exercisable for common shares (2004: nil; 2003: 583,240) awarded to employees of the Company and its subsidiaries. At December 31, 2005, 921,560 common shares were issued pursuant to outstanding share purchase rights and no unexercised share purchase rights were outstanding.
AXIS Specialty and AXIS Capital entered into agreements in November 2001 and December 2002 with J.P. Morgan Investment Management Inc. and its affiliates (“J.P. Morgan Investment Management”) under which J.P. Morgan Investment Management was appointed as an investment manager of part of the Company’s investment portfolio. These agreements were entered into on an arms length basis on terms available generally in the market. During the year ended December 31, 2005, AXIS Specialty incurred $638 (2004: $688; 2003: $530) of fees pursuant to these agreements of which $321 (2004: $178; 2003: $146) was included in accounts payable and accrued expenses.
The Company’s subsidiaries use Marsh & McLennan Companies, Inc (“Marsh”) and its subsidiaries for accounting and human resources consulting services and placement of insurance. During the year ended December 31, 2005, the Company incurred $613 (2004: $648; 2003: $1,172) in fees in connection with these transactions of which $0 (2004: $51) was included in accounts payable and accrued expenses. In addition, the Company pays brokerage and commissions to Marsh, which vary based on the amount of business produced. During the year ended December 31, 2005, the Company incurred $92.1 million (2004: $109.0 million; 2003: $86.1 million) in brokerage fees and commissions in connection with these transactions.
During the year ended December 31, 2005, the Company invested in various collateralized loan obligations. The collateral manager of three of these investments was Blackstone Debt Advisors L.P., who as collateral manager is entitled to management fees payable by the collateralized obligations in the ordinary course of business. An underwriter for some of these investments was an affiliate of Credit Suisse Boston LLC, who is entitled to underwriting fees in the ordinary course of business.
The Company invested in a fund of funds that is managed by Blackstone Alternative Asset Management, LP, who is entitled to management fees in the ordinary course of business. During the year ended December 31, 2005, estimated management fees paid were $0.3 million (2004: $nil).
The Company’s U.S. subsidiaries are subject to federal, state and local corporate income taxes and other taxes applicable to U.S. corporations. The provision for federal income taxes has been determined under the principles of the consolidated tax provisions of the U.S. Internal Revenue Code and Regulations thereunder. Should the U.S. subsidiaries pay a dividend to the Company, withholding taxes will apply.
The valuation allowance is primarily related to net unrealized losses on the Company’s fixed maturity investments. The Company believes it is necessary to establish a valuation allowance against the deferred tax asset arising from net unrealized losses on fixed maturity investments due to the inability to guarantee the reversal of these losses. The establishment of the valuation allowance related to the net unrealized losses has been recorded as a component of other comprehensive income consistent with the treatment of the net unrealized losses. Management believes it is more likely than not that the tax benefit of the remaining net deferred tax assets will be realized. The net deferred tax asset is included in other assets in the consolidated balance sheet.
The weighted average expected tax provision has been calculated using the pre-tax accounting income (loss) in each jurisdiction multiplied by that jurisdiction’s applicable statutory tax rate. Reconciliation of the difference between the provision for income taxes and the expected tax provision at the weighted average tax rate for the years December 31, 2005, 2004 and 2003 is provided below:
The Company’s insurance and reinsurance operations are subject to insurance laws and regulations in the jurisdictions in which they operate, including Bermuda, Ireland and the United States. Statutory capital and surplus as reported to the relevant regulatory authorities for the principal operating subsidiaries of the Company as of December 31, 2005 and 2004 was as follows:
The difference between statutory financial statements and statements prepared in accordance with U.S. GAAP vary by jurisdiction; however, the primary difference is that statutory financial statements do not reflect deferred policy acquisition costs, certain net deferred tax assets, intangible assets, unrealized appreciation on debt securities or certain unauthorized reinsurance recoverables. The Company’s U.S. operations required statutory capital and surplus is determined using risk based capital tests, which is the threshold that constitutes the authorized control level. If a Company falls below the control level, the commissioner is authorized to take whatever regulatory actions considered necessary to protect policyholders and creditors.
Except as noted for the U.S. operations, there are no other statutory restrictions on the payment of dividends from retained earnings by any of the Company’s subsidiaries as applicable minimum levels of statutory capital and surplus requirements have been met and all regulatory requirements and licensing rules complied with.