The majority of our employees work out of our headquarter offices located in approximately 30,000 square feet of leased office space on the second floor of 9 Farm Springs Road in Farmington, Connecticut, for which we paid rent of $0.6 million in 2007. The terms of our principal lease extend our tenancy through 2011 and require that we take occupancy of the remaining second floor space (approximately 7,000 sq. ft.) adjacent to our existing offices. In addition, we signed a sublease in December 2007 under which we will be permitted to occupy an additional 17,600 square feet within our Farmington headquarters building, upon the existing tenant’s vacancy later in 2008. We believe that the space available to us under our principal lease and the sublease will be sufficient to meet our needs at the headquarters location for the foreseeable future. In addition to our Farmington headquarters, we rent a small office for DNA employees in New York City. Finally, in connection with our acquisition of AMS, Allsouth and Raincross, we entered into a short term lease for the 8,000 sq. ft. building already occupied by those corporations in St. Pete Beach, FL.
The selected historical consolidated financial statements for the periods ended December 31, 2005, 2004, and 2003 give retroactive effect to Darwin’s reorganization. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Our History” and Note 1(b) to the audited condensed consolidated financial statements.
In February 2004, Alleghany formed Darwin Group, Inc. (“Darwin Group”), a wholly-owned subsidiary of Alleghany, in order to acquire DNA, an admitted insurance company domiciled in Delaware, from Aegis Holding, Inc., a subsidiary of Associated Electric & Gas Insurance Services Limited. At the time of acquisition, DNA (then named U.S. Aegis Insurance Company) was licensed in 40 states. As of December 31, 2007, DNA was licensed in 50 jurisdictions (including the District of Columbia) and was eligible to write on a surplus lines basis in one additional state (Arkansas).
In November 2007, Darwin Group, through its subsidiary DNA, acquired Midway Insurance Company of Illinois from Fireman’s Fund Insurance Company (“Fireman’s Fund”). It has a license in one state (Illinois), but has been dormant for several years. Midway Insurance Company of Illinois’ name has been changed to Vantapro Specialty Insurance Company (Vantapro) and an application has been filed to redomesticate Vantapro to Arkansas.
Effective October 1, 2005, Darwin Group, through its subsidiary DNA, entered into a series of reinsurance and commutation agreements with the Capitol Companies. Overall, these reinsurance agreements had the effect of transferring to DNA all of the in-force business produced by DPUI and issued on policies of the Capitol Companies, along with the corresponding financial statement effects of these policies. In addition, in November 2005, Alleghany made a capital contribution of $135,000 to Darwin Group, which subsequently contributed this capital to DNA.
The estimate of Darwin’s loss and LAE reserves reflects the types of contracts written by Darwin. Darwin’s insurance contracts are predominantly written on a “claims-made” basis. Claims-made insurance contracts are commonly used in Darwin’s lines of business and provide coverage for claims related to covered events described in the insurance contract that are made against the insured during the term of the contract and reported to the insurer during a period provided for in the contract.
For both claims-made and occurrence contracts, a significant amount of time can elapse between the occurrence of an insured event, the reporting of the occurrence to the insurer and the final settlement of the claim (including related settlement costs). Since reporting periods are defined and limited in time under claims-made contracts but are not defined and limited in time under occurrence contracts, the ultimate settlement period for similar losses incurred under claims-made contracts is generally shorter than under occurrence contracts.
Case and IBNR reserves together constitute the reserve for losses and ALAE. In addition, a ULAE reserve is established on a formula basis as a percentage of loss and ALAE case and IBNR reserves. In total, these amounts represent management’s best estimate, as of each reserve evaluation date, of ultimate settlement costs based on the assessment of facts and circumstances known at that time.
a) Darwin’s initial expected loss ratio. Darwin selects this ratio based primarily on historical insurance industry results. “Loss ratio” means the ratio of loss and ALAE to premiums earned.
2) The Expected Loss Ratio methodology. This methodology applies the expected loss and ALAE ratio to premiums earned (which is the portion of property and casualty premiums written that apply to the expired portion of the policy term). Darwin’s selected expected loss and ALAE ratios under this method are based primarily on historical insurance industry results adjusted for price and loss trends by product line.
The actuarial weights may be subject to revision as losses are reported and develop toward ultimate values. For example, if all claims reported in an experience year are settled and closed more quickly than expected based upon industry data, the weight applied to the indication for that year resulting from the B-F methodology may be adjusted.
The weight applied to the B-F indication for each experience year is 0% at 12 months of maturity and increases to 100% no later than 72 months of maturity. For example, assuming no judgmental acceleration based on our experience, losses reported to Darwin during 2004:
Complementary weights are applied to the Expected Loss Ratio methodology for each experience year. This is designed to provide both stability (Expected Loss Ratio method) and moderate responsiveness (B-F method) in determining loss and ALAE reserves.
In using the weighted loss and ALAE ratios to select our ultimate loss and ALAE incurred, we have adopted the weighted gross loss and ALAE ratios by product line for accident year 2006 earlier in the emergence and development of our 2006 loss experience than we had for prior accident years. We did this because the volume and credibility of our 2006 experience were sufficient to allow earlier estimates by product line than we have reported in previous years.
In the fourth quarter of 2007, we selectively revised weights for the first time. Specifically, for accident years 2003 and 2004, a detailed review of the remaining open claims strengthened our confidence that loss emergence for certain lines of business is significantly better than expected. We therefore began adjusting loss ratios for these lines of business more quickly toward the B-F indications than would occur using our standard weights as discussed above. In general, such adjustments will be considered each quarter as loss experience for each accident year matures.
As mentioned above, ULAE represents claims-related expenses that do not arise from and cannot be assigned to specific claims, such as the general expense of maintaining an internal claims department. In the fourth quarter of 2006, we revised our methodology for calculating the ULAE reserve. Darwin’s experience had matured to the point that we adopted a generally accepted methodology that assumes that (1) 50% of ULAE is incurred when a claim is first reported, analyzed and a case reserve is established, and (2) the remaining 50% of ULAE is incurred over the life of the claim. The ULAE reserve is determined by applying a fixed percentage to 50% of our loss and ALAE case reserves and 100% of our loss and ALAE IBNR reserves. We selected a fixed percentage of 3.2% based on our analysis of insurance industry averages.
Darwin’s loss reserve analysis calculates a point estimate rather than a range of reserve estimates. This is done because a significant portion of Darwin’s loss and LAE reserves relate to lines of business that are driven by severity rather than frequency of claims. High severity lines of business tend to produce a wide range of reserve estimates which limit the usefulness of the range for selecting reserves. We believe that point estimates based on appropriate
Darwin could be exposed to losses resulting from a significant liability event, such as an unexpected adverse court decision that impacts multiple insureds, or the occurrence of an unusually high number of liability losses in one reporting period. Such events could have a material adverse impact on Darwin’s results during such period, and such impact may not be mitigated by the Company’s current reinsurance structure. In general, liability claims are susceptible to changes in the legal environment, such as changes in laws impacting claims or changes resulting from judicial decisions interpreting insurance contracts. However, it is often difficult to quantify the impact that such changes in the environment might have on Darwin’s reserves. Not all environmental changes are necessarily detrimental to Darwin’s loss ratio and reserves. For example, recent medical malpractice tort reform legislation at the state level could result in mitigation of loss which, if not offset by significant reductions in price levels, would result in improvement in Darwin’s loss and LAE ratio.
For the twelve months ended December 31, 2007 and 2006, Darwin experienced average price decreases on its renewal policies of 11.6% and 5.1%, respectively, across all its product lines. We believe that these decreases are not unusual during the insurance pricing cycle. Without mitigating factors, such as favorable loss emergence, such reductions in prior price levels could result in a commensurate increase in the expected loss and LAE ratio that is utilized in actuarial methodologies.
The tables below present the potential changes in Darwin’s loss reserves as of December 31, 2007 (assuming no benefit from reinsurance), before and after the effect of tax, that could result based upon changes of the key assumptions underlying our selected loss reserving methodologies:
The results summarized above assume no benefit of reinsurance. The effect of Darwin’s reinsurance program on the scenarios reflected above would depend on the nature of the loss activity that generated a change in loss development/emergence. Darwin’s reinsurance program is predominantly excess of loss in structure and will respond to the occurrence of individual large losses (severity). If the changes were produced by a large number (frequency) of small losses, the reinsurance would not respond and the scenario results would be unchanged.
Reinsurance and Reinsurance Recoverables. Darwin purchases third-party treaty reinsurance for substantially all of its lines of business. Treaty reinsurance provides protection over entire classes or lines of business to mitigate the volatility of our book of business by limiting exposure to a frequency of severity losses. On a limited basis, Darwin has purchased facultative reinsurance (which is reinsurance obtained on a case-by-case basis for all or
We purchase both fixed rate and variable rate excess of loss reinsurance. Fixed rate excess of loss reinsurance, under which we cede a fixed percentage of premiums to our reinsurers depending upon the policy limits written, provides indemnification to us in excess of a fixed amount of losses incurred up to a maximum recoverable amount. The maximum amount recoverable is expressed as either a dollar amount or a loss ratio cap which is expressed as a percentage of the maximum amount of the ceded premium. In some instances the contracts are expressed as the greater of a dollar amount or a loss ratio cap. The maximum amounts recoverable when expressed as a loss ratio cap vary from a minimum of 250% to a maximum in excess of 700% of ceded premium payable within the terms of the contracts.
Darwin’s estimated loss and LAE reserve experience has resulted in downward adjustment of ceded premium for the variable-rated excess of loss contracts. For the years ended December 31, 2007, 2006 and 2005, these amounts were $7.4 million, $1.7 million and $0.3 million, respectively. The total ceded premium recoverable balances arising from these adjustments were $9.4 million and $2.0 million as of December 31, 2007 and 2006, respectively.
Reinsurance contracts that do not result in a reasonable possibility that the reinsurer may realize a significant loss from the insurance risk assumed and that do not provide for the transfer of significant insurance risk generally do not meet the requirements for reinsurance accounting and are accounted for as deposits.
Darwin performs analyses of its reinsurance contracts to ascertain whether or not they meet the risk transfer provisions of Financial Accounting Standards Board (FASB) Statement No. 113, Accounting for Reinsurance
Reinsurance recoverables on paid and unpaid losses (including amounts related to settlement expenses and claims incurred but not reported) and ceded unearned reinsurance premiums are reported as assets. Amounts recoverable on unpaid losses from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured business.
Investment Valuation. Darwin holds its equity and fixed-income securities as available for sale, and as such, these securities are recorded at fair value. Unrealized gains and losses during the year, net of the related tax effect applicable to available-for-sale securities, are excluded from earnings and reflected in other comprehensive income (loss) and the cumulative effect is reported as a separate component of common stockholders’ equity until realized.
Certain asset-backed and municipal securities held by Darwin are backed by a financial guarantee insurance policy from a mono-line insurance guarantor (“mono-lines”) to strengthen the overall credit quality of the security. These mono-lines have historically been rated at the highest credit quality ratings from the major rating agencies (Standard & Poors’, Moody’s and Fitch). Recent volatility in the credit market, particularly related to the sub-prime credit market, has caused large losses for these mono-lines, reduced their capital and put their credit ratings at risk. Several have been downgraded and/or are on a negative credit watch list by the major rating agencies. When a security is backed by a mono-line insurance company guarantee, and that mono-line has a credit rating higher than the underlying credit rating of the issuer, it may trade at a price higher than it would if there was no guarantee. A subsequent downgrade of that mono-line insurance carrier’s credit rating could have an adverse impact on the fair market value of the securities that are backed by that mono-line carrier’s insurance guarantee. When acquiring fixed income securities that are backed by a financial guarantee insurance policy, Darwin’s investment philosophy is to evaluate the credit quality of the underlying issuer assuming that no insurance guarantee is in place and purchase those securities based upon the assumption that no insurance policy would be available to make payment on the securities.
Deferred Taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amount of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. At December 31, 2007, net deferred tax assets of $13.5 million were recorded, which consisted of gross deferred tax assets of $21.3 million and gross deferred tax liabilities of $7.8 million. At December 31, 2006, net deferred tax assets of $8.7 million were recorded, which consisted of gross deferred tax assets of $14.2 million and gross deferred tax liabilities of $5.5 million.
Since its inception, and until the initial public offering on May 19, 2006, Darwin filed a consolidated federal income tax return with its ultimate parent, Alleghany. Darwin filed its own consolidated federal income tax return for the period May 19, 2006 through December 31, 2006 and will continue to file its own return for all subsequent tax reporting periods. Alleghany included the Darwin results from January 1, 2006 through May 18, 2006 in the parent’s December 31, 2006 consolidated tax return. The Alleghany tax sharing agreement requires Darwin to retain tax records, to cooperate with Alleghany in tax matters, and to bear its share of costs of tax return preparation, tax audits and contests, and interest and penalties related to Darwin’s tax liabilities reflected in the Alleghany consolidated income tax return. Also, provided Darwin performed every obligation under the tax sharing agreement, Alleghany agreed to indemnify the Company for any federal income taxes imposed on the Alleghany consolidated group. Alleghany’s 2004 income tax return is currently under examination by the Internal Revenue Service. Alleghany’s 2005 and 2006 income tax returns remain open to examination.
Intangible Assets. Darwin recognized intangible assets in connection with the acquisitions of DNA, Darwin Select and Vantapro. Darwin accounts for intangible assets in accordance with SFAS No. 142, Goodwill and Other Intangible Assets (SFAS No. 142). Management has determined that these intangible assets have an indefinite life.
SFAS No. 142 requires that intangible assets with indefinite useful lives be capitalized and tested for impairment at least annually. An annual assessment is performed by Darwin to evaluate the continued recoverability of the intangible asset balance. The Company did not recognize any impairment of intangibles during fiscal years ended December 31, 2007, 2006, and 2005.
The critical accounting estimates described above should be read in conjunction with Darwin’s other accounting policies as they are described in Note 2 to the December 31, 2007 consolidated financial statements presented in this 10-K. The accounting policies described in Note 2 require Darwin to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities but do not meet the level of materiality required for a determination that the accounting policy is a critical accounting policy. On an ongoing basis, Darwin evaluates its estimates, including those related to the value of long-lived assets, bad debts, deferred insurance acquisition costs, and contingencies and litigation. Darwin’s estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.
Net earnings. Darwin reported net earnings of $32.2 million for the year ended December 31, 2007 compared to $16.0 million for the year ended December 31, 2006, an increase of $16.2 million or 102.0%. The increase in net earnings is primarily due to increases in net premiums earned (which is the portion of net premiums written that is recognized for accounting purposes as income during a period) and net investment income partially offset by an increase in total costs and expenses for 2007 compared to 2006. Darwin reported a combined ratio of 84.1% for the year ended December 31, 2007 compared with a combined ratio of 94.3% for the year ended December 31, 2006. The improvement in combined ratios primarily reflects the favorable development of prior year loss reserves. Darwin recognized approximately $16.2 million in earnings ($10.5 million, net of tax) in 2007 from the change in estimate of prior year loss reserves and the corresponding ceded premium, net of incentive compensation and profit-sharing expenses. For 2006, Darwin recognized approximately $3.2 million ($2.1 million, net of taxes) from the change in estimate of prior year loss reserves and the corresponding ceded premium, net of incentive compensation expenses. Darwin’s net investment income increased to $22.6 million in 2007 compared to $16.4 million in 2006 as a result of an increase in average invested assets.
Gross premiums written. Gross premiums written were $280.3 million for the year ended December 31, 2007 compared to $246.3 million for the year ended December 31, 2006, an increase of $34.0 million, or 13.8%. The increase in gross premiums written during 2007 compared to 2006 reflects significant growth across most of Darwin’s lines of business. Of the $280.3 million of gross premiums written in 2007, $140.0 million was attributable to E&O business, $100.8 million was attributable to medical malpractice liability business, $38.8 million was attributable to D&O business and $0.7 million was attributable to general liability business.
Our E&O gross premiums written increased by $29.0 million or 26.1% to $140.0 million for the year ended December 31, 2007, compared to $111.0 million for the year ended December 31, 2006. This increase resulted from the writing of new E&O policies of approximately $55.0 million and the renewal of policies for $85.0 million of gross premiums written for the year ended December 31, 2007. New business writings were primarily in our managed care, psychologists, lawyers and insurance agents E&O classes of business. Darwin experienced a
decrease in average rate for our E&O business in 2007 of approximately 12.5% when compared to 2006. These decreases in rate were primarily the result of competitive pricing pressures in our managed care, lawyers and insurance agents E&O classes of business.
Net premiums written. Net premiums written were $199.7 million for the year ended December 31, 2007 compared to $157.0 million for the year ended December 31, 2006, an increase of $42.7 million or 27.2%. The growth in net premiums written is attributable to the growth in gross premiums written and mix of retained business and the reductions to ceded premiums noted above.
Other underwriting, acquisition and operating expenses. Other underwriting, acquisition and operating expenses were $28.3 million for the year ended December 31, 2007 compared to $21.6 million for the year ended December 31, 2006, an increase of $6.7 million or 30.9%. This increase is primarily attributable to an increase in personnel costs incurred to support the growth in premiums and general expenses incurred in connection with the expansion of our business. The ratio of other underwriting, acquisition and operating expenses to premiums earned decreased to 15.6% in 2007 from 16.3% in 2006 as earned premiums grew at a faster pace than our expenses.
Other expenses. Other expenses incurred were $5.9 million for the year ended December 31, 2007 compared to $0.8 million for the year ended December 31, 2006, an increase of $5.1 million. These expenses were primarily attributable to Darwin’s long-term incentive plan which is based on net underwriting profitability. The increase in
2007 compared to 2006 is primarily due to the more favorable underwriting results primarily attributable to the favorable loss development recognized in 2007, as noted above.
Our D&O gross premiums written increased by $7.7 million to $40.6 million for the year ended December 31, 2006, compared to $32.9 million for the year ended December 31, 2005. This increase resulted from the writing of new policies for D&O gross premiums written of approximately $21.0 million, primarily for publicly-held
companies with market capitalizations of less than $2 billion, and the renewal of policies for $19.6 million of gross premiums written for the year ended December 31, 2006. Our weighted average premium rate for D&O business renewed in 2006 decreased by 1.5% when compared to 2005.
Net premiums earned. Net premiums earned were $132.4 million for the year ended December 31, 2006 compared to $84.7 million for the year ended December 31, 2005, an increase of $47.7 million or 56.3%. The increase in net premiums earned is attributable to the growth in net premiums written across the lines of business as described above. The ratio of net premiums earned to net premiums written was 84.3% for the year ended December 31, 2006 and 84.2% for the year ended December 31, 2005.
Commissions and brokerage expenses. Commissions and brokerage expenses were $14.6 million for the year ended December 31, 2006 compared to $9.2 million for the year ended December 31, 2005, an increase of $5.4 million or 58.9%. The increase in commissions and brokerage expenses is attributable to growth in net
Darwin’s total expense ratio decreased to 27.4% for the year ended December 31, 2006 compared to 28.1% for the year ended December 31, 2005. The decrease in the total expense ratio for the year ended December 31, 2006 compared to the year ended December 31, 2005 is due to a decrease in other underwriting, acquisition and operating expenses as a percentage of net premiums earned. Growth in our business has been at a greater rate than growth of our operating expenses, which has allowed us to spread our other underwriting, acquisition and operating expenses over a larger premium base.
Darwin Select is domiciled in Arkansas. Under Arkansas law, Darwin Select may not pay an “extraordinary” dividend, which is defined as any dividend or distribution, the fair market value of which, together with that of other dividends or distributions made within the preceding 12 months, exceeds the greater of (i) 10% of statutory surplus as of the prior year-end or (ii) statutory net income less realized capital gains for such prior year, until thirty days after the Insurance Commissioner of the State of Arkansas (“Arkansas Commissioner”) has received notice of such dividend and has either (i) not disapproved such dividend within such thirty day period or (ii) approved such dividends within such thirty day period. In addition, Darwin Select must provide notice to the Arkansas Commissioner of all dividends and other distributions to stockholders within five business days after the declaration thereof and at least ten days prior to the payment. As of December 31, 2007, Darwin Select could pay approximately $4.6 million in dividends to DNA without prior approval of the Commissioner. Darwin Select did not pay any dividends in 2007 and 2006.
Credit Agreements. In March 2007, the Company entered into a three-year secured credit agreement with a bank syndicate (Credit Agreement), which provides commitments for revolving credit loans in an aggregate principal amount of up to $25.0 million. The loan is secured by the common stock of DNA. Borrowing under the Credit Agreement is intended to be used for general corporate purposes and for strategic merger and acquisition purposes. The cost of funds drawn down is at an annual interest rate of LIBOR plus 112.5 basis points. The Credit Agreement also has a commitment fee of 0.25% per annum for any unused amount of the aggregate principal amount.
Capital Resources. Total stockholders’ equity increased to $254.2 million as of December 31, 2007 from $217.9 million as of December 31, 2006, an increase of $36.3 million or 16.7%. The increase was primarily due to the net income for the year ended December 31, 2007 of $32.2 million, $2.6 million of unrealized gains after taxes on fixed securities, and $1.5 million of stock-based compensation, excess tax benefits on shares vested and proceeds on options exercised during the period. Total stockholders’ equity increased to $217.9 million as of December 31, 2006 from $197.4 million as of December 31, 2005, an increase of $20.5 million or 10.4%. The increase was primarily due to the net income for the year ended December 31, 2006 of $16.0 million, $1.0 million of unrealized gains after taxes on fixed securities, and $1.3 million of stock-based compensation and the corresponding tax benefits on shares vested during the period.
The net proceeds from the offering were used to redeem all of the shares of Series A Preferred Stock at the aggregate liquidation preference of $2.3 million and all of the shares of Series C Convertible Preferred Stock with an aggregate liquidation preference of $2.5 million. The remaining proceeds of $81.5 million were used to redeem a portion of the shares of Series B Convertible Preferred Stock at a redemption price per share, on an as-converted basis, equal to the public offering price less underwriting costs ($14.88 per share) or 5,478,904 shares of Common Stock on an as-converted basis. The remaining outstanding shares of the Series B Convertible Preferred Stock were converted into 9,371,096 shares of Common Stock. As a result of the Company’s initial public offering and use of net proceeds of the offering, Alleghany’s ownership in the Company was reduced to approximately 55%.
premium volume and limited paid loss activity on current and prior accident years. Cash flows used in investing activities increased to $152.1 million in 2007 as compared to $91.9 million in 2006 primarily due to the fact that in 2007 a greater amount of cash flows generated from operations and available cash balances were invested in our investment portfolio. Cash flows from financing activities increased during 2007 to $5.3 million for 2007 compared to 0.3 million for 2006. The 2007 amount was due to the borrowing of $5.0 million under the credit facility in December 2007 and to $0.3 million in excess tax benefit on vesting restricted shares and proceeds from stock options exercised.
Investment Securities. At December 31, 2007, we had cash, short-term investments and other investments of $564.4 million, including cash, short-term investments and fixed maturities due within one year of approximately $120.6 million and fixed maturities of $114.2 million maturing within one to five years. Total cash, short-term investments and fixed maturities due within one year represented 21.4% of Darwin’s total investment portfolio and cash balances at December 31, 2007. This compares to December 31, 2006, when we had cash, short-term investments and other investments of $426.3 million, including cash, short-term investments and fixed maturities due within one year of approximately $103.5 million and fixed maturities of $67.6 million maturing within one to five years. Total cash, short-term investments and fixed maturities due within one year represented 24.3% of Darwin’s total investment portfolio and cash balances at December 31, 2006.
Darwin has obligations to make certain payments for losses and LAE pursuant to insurance policies we issue. These future payments are reflected as reserves on our financial statements. With respect to reserves for losses and LAE, there is typically no minimum contractual commitment associated with insurance contracts and the timing and ultimate amount of actual claims related to these reserves is uncertain. The table above estimates the expected payment pattern of loss and LAE reserves. Given our limited loss experience and operating history, we have utilized
industry experience in estimating these amounts. Our actual future payment experience could differ materially. For additional information regarding reserves for losses and LAE, including information regarding the timing of payments of these expenses, see “Critical Accounting Estimates - Loss and LAE Reserves.”
The decrease in the investment yields from December 31, 2006 to December 31, 2007 was primarily due to lower interest rates. The five-year treasury yield rate decreased 125 basis points to a rate of 3.45% as of December 31, 2007 from a rate of 4.70% as of December 31, 2006.
The table below compares returns on our total investments to a comparable public index. While there is no directly comparable index to our portfolio, the Lehman Intermediate Aggregate Bond Index is a widely used industry benchmark. Both our performance and the indices include changes in unrealized gains and losses. While the broader Lehman index benefited from investors transferring money into treasuries which have experienced an
increased yield in response to the volatility in the credit markets, Darwin’s investment portfolio is more heavily weighted towards municipal securities which have not experienced the positive impact.
Ratings are the lowest rating assigned by Standard & Poor’s, a division of The McGraw-Hill Companies, Inc., or Moody’s Investors Service. Where a rating is not available from either rating agency, ratings are determined by other independent sources.
The maturity distribution of fixed income securities held as of December 31, 2007 and December 31, 2006 are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
We regularly review investment securities for impairment in accordance with our impairment policy, which includes both quantitative and qualitative criteria. Quantitative criteria include length of time and amount that each security is in an unrealized loss position and for fixed maturity securities, whether the issuer is in compliance with terms and covenants of the security. Our qualitative criteria include the underlying financial strength of the issuer of the security and specific prospects for the issuer as well as our intent to hold the security until recovery.
An investment in a preferred equity or fixed maturity security which is available for sale is impaired if its fair value falls below its cost or amortized cost, and the decline is considered to be other-than-temporary. Darwin’s assessment of a decline in fair value includes a current judgment as to the financial position and future prospects of the issuing entity of the security, the length of time and extent to which fair value has been below cost, and Darwin’s ability and intent to hold the investment for a period of time sufficient to allow for an anticipated recovery. As of December 31, 2007, Darwin did not own any fixed maturity or equity securities which were considered to be impaired.
The following table presents the gross unrealized losses and estimated fair values of our investment securities, aggregated by investment type and length of time that individual investment securities have been in a continuous unrealized loss position, as of December 31, 2007.
is backed by a mono-line insurance company guarantee, and that mono-line has a credit rating higher than the underlying credit rating of the issuer, it may trade at a price higher than it would if there was no guarantee. A subsequent downgrade of that mono-line insurance carrier’s credit rating could have an adverse impact on the fair market value of the securities that are backed by that mono-line carrier’s insurance guarantee.
Darwin’s fixed income securities portfolio currently includes approximately $124.3 million, or 22.3% of Darwin’s total investments, in securities that are backed by mono-line insurance companies that have been, or could be, negatively impacted by the credit markets. Based on a review by our investment managers of these underlying securities which are presented in the table below, we have determined that the average credit quality of the underlying securities is AA−. Furthermore, since purchased by Darwin, these securities are currently in a $1.3 million unrealized gain position. Based on these facts, we have determined that no impairment adjustment is necessary for these securities.
In September 2005, the Accounting Standards Executive Committee issued Statement of Position 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts (SOP 05-1). SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature of coverage within a contract. Darwin adopted SOP 05-01 as of January 1, 2007, and the implementation did not have a material impact on the Company’s results of operations or financial condition.
provisions of this Statement as of January 1, 2007, and the implementation did not have a material impact on the Company’s results of operations or financial condition.
In February 2007, FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115, was issued. This Statement permits entities to choose to measure many financial instruments and certain other items at fair value, at specified election dates, with unrealized gains and losses reported in earnings at each subsequent reporting date. This Statement is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. Early adoption is permitted as of the beginning of a fiscal year that begins on or before November 15, 2007, provided the entity also elects to apply the provisions of FASB Statement No. 157, Fair Value Measurements. Darwin does not anticipate that this Statement will have a material impact on the Company’s results of operations or financial condition.