We believe that these facilities are sufficient for our current purposes. If we expand our operations in the future, we may require additional office space, which we believe will be available on commercially reasonable terms.
PREDECESSOR QUANTA CAPITAL HOLDINGS LTD. (3) ------------------------------------ ------------------------------------------ FOR THE FOR THE FOR THE YEAR ENDED PERIOD PERIOD FROM FOR THE YEAR FOR THE YEAR DECEMBER 31, ENDED MAY 23, 2003 ENDED ENDED ----------------------- SEPTEMBER TO DECEMBER DECEMBER 31, DECEMBER 31, 2001 2002 3, 2003 31, 2003 2004 2005 ---------- ---------- ---------- ------------ ------------ ------------
SUMMARY BALANCE SHEET DATA Cash and cash equivalents $ 74 $ 73 $ 413 $ 47,251 $ 75,257 $ 260,978 Available-for-sale Investments at fair value -- -- -- 467,036 559,430 699,121 Trading Investments at fair value related to deposit liabilities -- -- -- -- 40,492 38,316 Premiums receivable -- -- -- 10,961 146,784 146,837 Losses and loss adjustment expenses recoverable -- -- -- 3,263 13,519 190,353 Deferred acquisition costs -- -- -- 6,616 41,496 33,117 Deferred reinsurance premiums -- -- -- 1,925 47,416 112,096 Goodwill and other intangibles assets -- -- -- 21,351 20,617 24,877 Total assets 10,160 10,131 11,249 573,761 980,733 1,552,091 Reserves for losses and loss expenses -- -- -- 4,454 159,794 533,983
Unearned premiums -- -- -- 20,044 247,936 336,550 Environmental liabilities assumed -- -- -- 7,018 6,518 5,911 Deposit liabilities -- -- -- -- 43,365 51,509 Junior subordinated debentures -- -- -- -- 41,238 61,857 Total liabilities 4,003 3,681 5,199 86,278 549,824 1,096,089 Redeemable preferred shares -- -- -- -- -- 71,838 Total shareholders' equity $ 6,157 $ 6,450 $ 6,051 $487,483 $430,909 $ 384,164
(1) As an S corporation, ESC, our predecessor, was not subject to U.S. federal income taxes. At the time of its acquisition, ESC became subject to U.S. income tax. Accordingly, the predecessor historical operating earnings have been adjusted, on a pro forma basis, to reflect taxes at a 38.9% rate including a 35% statutory rate for U.S. federal income taxes and a 3.9% rate, based on a 6% statutory rate for Virginia state income taxes less the related federal tax benefit.
The following discussion and analysis of our results of operations, financial condition and liquidity and capital resources should be read in conjunction with our audited consolidated financial statements and related notes for the year ended December 31, 2005 contained in this annual report on pages to and with the risk factors appearing under "Item 1A. Risk Factors" in this annual report.
Through our operating subsidiaries in Bermuda, the U.S. and Europe, we focus on writing coverage for specialized classes of risks through teams of experienced and technically qualified underwriters. Specialty lines of business are often unusual or difficult to place and do not fit the underwriting criteria of standard commercial product providers. We have used our Bermuda operations primarily to insure U.S. risks from Bermuda on a non-admitted basis and also, from time to time, to underwrite some European risks. We also write specialty products in the United States on an admitted basis through our subsidiary, Quanta Indemnity, which is a U.S. licensed insurer with licenses in 44 states and is an accredited reinsurer in Washington, D.C. Further, during 2005 we wrote specialty insurance from the United States on an excess and surplus lines basis and U.S. reinsurance on a non-admitted basis through our subsidiary, Quanta Specialty Lines. Since the fourth quarter of 2004, we are underwriting European Union sourced specialty business through Quanta Europe, our Irish subsidiary located in Dublin, Ireland, which is the headquarters of our European business. We are also underwriting through our wholly-owned Lloyd's syndicate, which we call Syndicate 4000. Since February 2005, we are serving our London-based clients for European insurance and reinsurance business through our Quanta Europe branch in London.
FOR THE YEAR ENDED DECEMBER 31, 2005 -------------------------------------------- GROSS LOSSES CEDED LOSSES AND LOSS AND LOSS NET LOSSES AND EXPENSES EXPENSES LOSS EXPENSES ------------ ------------ -------------- ($ in thousands)
LOSSES AND LOSS EXPENSES BY EVENT Katrina and Rita $169,803 $ (97,668) $72,135 Wilma 29,304 (18,100) 11,204 -------- --------- ------- 199,107 (115,768) 83,339 -------- --------- ------- Reinstatement premiums Katrina and Rita (8,833) 13,367 4,534 Wilma (979) 502 (477) -------- --------- ------- (9,812) 13,869 4,057 -------- --------- -------
-------- --------- ------- NET COST OF 2005 HURRICANES $189,295 $(101,899) $87,396 ======== ========= =======
On December 14, 2005, we issued 13,136,841 common shares at $4.75 per share and 3,000,000 shares of our series A preferred shares at $25.00 per share with a liquidation preference of $25.00 per share. The gross proceeds to the Company were $137.4 million before the payment of underwriting fees, of which $62.4 million was from the sale of common shares and $75.0 million was from the sale of preferred shares. In addition, on December 29, 2005, the underwriters exercised a portion of their over-allotment option to acquire additional series A preferred shares at the offering price of $25.00. This resulted in the sale, on January 11, 2006 of 130,525 shares of our series A preferred shares for gross proceeds of $3.3 million.
We expect the downgrade of our rating and qualification of our rating with negative implications to continue to have a significant adverse effect on our business. Currently, we are not writing new business in our professional liability, environmental and fidelity and crime product lines or in our reinsurance and structured products lines and we are running-off our surety line. We have also been removed from the approved listing of several of our important brokers, including Aon Corporation and Marsh Inc. The downgrade of our financial rating or the continued qualification of our current rating continues to cause concern about our viability among brokers and other marketing sources, resulting in a movement of business away from us to other stronger or more highly rated carriers. We believe the recent downgrade of our financial rating is also adversely affecting our Lloyd's operations.
Certain of our insurance and many of our reinsurance contracts contain termination rights triggered by the A.M. Best rating downgrade. Many of our other insurance contracts and certain of our reinsurance contracts provide for cancellation at the option of the policyholder regardless of our financial strength rating. A cancellation typically results in the termination of the policy and our ongoing obligations and the return of premiums to our client that usually approximates our unearned premium reserve as of the date of the cancellation. Whether a client would exercise such rights would depend, among other things, on the reasons for the downgrade, the extent of the downgrade, the prevailing market conditions, whether we have posted security in respect of our obligations and the pricing and availability of replacement coverage. We cannot predict in advance how many of our
Many of our other insurance contracts and certain of our reinsurance contracts provide for cancellation at the option of the policyholder regardless of our financial strength rating, including those placed by the program manager of our HBW program. HBW gross premiums written during the year ended December 31, 2005 totaled approximately $165.9 million, of which approximately $140.3 million was casualty premium, $15.0 million was warranty premium and $10.6 million was property premium, by class of risk. HBW net premiums written during the year ended December 31, 2005 totaled approximately $108.9 million, of which approximately $84.7 million was casualty premium, $15.0 million was warranty premium and $9.2 million was property premium, by class of risk. Based on our discussions with the program manager, we understand that it will divert a substantial portion of the HBW program business to other carriers. However, we expect to continue to write a small portion of the casualty business through our Lloyd's syndicate. We understand that the new carriers can begin writing casualty business in some states beginning in March 2006, but will need time to file and obtain approval of rate and policy forms with regulatory authorities in other states in which the program manager is writing. Until the new carriers are able to obtain these approvals, we will continue to write casualty business for the program manager. Other than the business that we intend to write through our Lloyd's syndicate, we expect that substantially all of the HBW program business will be diverted to other carriers by December 31, 2006. Consequently, we estimate that the gross and net premiums written under the HBW program during 2006 will be less than 25% of the gross and net premiums written during 2005. While we expect to be able to continue to write business through our Lloyd's syndicate, we expect that the premiums written under our HBW program during 2007 will be significantly less than 2006 as the HBW program manager is able to move that business to new carriers.
We are working diligently to implement key steps designed to preserve shareholder value and respond to the rating actions taken by A.M. Best. A special committee of our Board of Directors has engaged Friedman, Billings, Ramsey & Co., Inc. and J.P. Morgan Securities Inc., as financial advisors, to assist us in evaluating strategic alternatives, including the potential sale of some or all of our businesses, the run off of certain product lines or the business or a combination of alternatives. Our financial advisors will also help us evaluate the potential use of excess capital to repay debt or to return value to our shareholders.
Prior to the recent A.M. Best action, we had begun taking steps to reduce our costs, including the reduction of personnel following the exit of our technical risk property and property reinsurance lines, and reducing certain infrastructure costs, such as the reduction of consulting costs, the reduction of our office space and consolidation of our personnel in Bermuda. In connection with our evaluation of our business lines, we have accelerated steps to reduce infrastructure costs and personnel expenses. We believe that a more efficient expense structure is critical in allowing us to produce profitable results and more easily deploy our resources to those lines of business that become more attractive under our current A.M. Best ratings and as market conditions and our business change.
We have determined to run off our surety line. We also will consider running off other selected lines as an alternative to sale of all or portions of our business. If our Board of Directors concludes that no other alternatives would be in the best interests of our shareholders, it may determine that the best alternative is to place all our insurance and reinsurance businesses in run off and eventually wind up our operations over some period of time, which is not currently determinable. If the run off alternative is selected, then during 2006 and future periods we expect to continue to pay losses and expenses as they become due and will continue to earn investment income on our investment portfolio.
We believe that our portfolio is not diversified either among classes of risks or source of origination. For example, during the year ended December 31, 2005, our HBW program accounted for approximately 42.3% of our specialty insurance segment gross premiums written. In addition, the HBW program and the other insurance programs we write, accounted for 44.9% of our specialty insurance segment gross premiums written in the year ended December 31, 2005. As described below, our specialty reinsurance segment showed significant concentrations across certain risk classes. In addition, our specialty reinsurance segment generated approximately 42.0%, 25.5% and 10.6% of its gross premiums written through three brokers. The exit from our property reinsurance and technical risk property insurance line and the casualty reinsurance commutations, have further reduced our diversification in our product lines and will cause the concentrations across certain of our risk classes to increase. Further, as a result of the recent rating action by A.M. Best, we expect that concentrations in
We have determined that $607.2 million of investment securities, with unrealized losses of approximately $10.2 million were other-than-temporarily impaired as of December 31, 2005. The realization of these losses represents the maximum amount of potential losses in our investment securities if we would have sold all of these securities at December 31, 2005. As a result of our decision, the affected investments were reduced to their estimated fair value, which becomes their new cost basis. The recognition of the losses has no affect on our shareholders' equity, the market value of our investments, our cash flows or our liquidity. The evaluation for other-than-temporary impairments requires the application of significant judgment, including our intent and ability to hold the investment for a period of time sufficient to allow for possible recovery. We believe we have sufficient assets to pay our currently foreseen liabilities as they become due and we have no immediate intent to liquidate the investments securities affected by our decision. However, due to the general uncertainties surrounding our business resulting from A.M. Best's March 2006 downgrade of our financial strength ratings and our decision to explore strategic alternatives, we concluded that there are no absolute assurances that we will have the ability to hold the affected investments for a sufficient period of time. It is possible that the investment securities' fair values could change in subsequent periods, resulting in further material impairment charges.
o Specialty reinsurance. Our specialty reinsurance segment includes our traditional, structured and program specialty reinsurance products. Our specialty reinsurance products included in our specialty reinsurance segment results include property, casualty and marine and aviation products. We currently do not write reinsurance on a program basis. After the end of the third quarter of 2005, we discontinued the writing
o Technical services. Our technical services segment provides diversified environmental investigation, remediation and engineering services, assessment services, other technical and information management services primarily in the environmental area in the U.S. Our technical services segment also provides technical and information management services to our specialty insurance and reinsurance segments.
The determination of these reportable segments reflects how we manage and monitor the performance of our insurance and reinsurance operations and may change from time to time. We refer to the specialty insurance and specialty reinsurance segments as our underwriting segments. We refer to our risk consulting and management operations as our technical services segment. We evaluate each segment based on its underwriting or technical services results, as applicable, including items of revenue and expense that are associated with, and directly related to, each segment.
We allocate corporate general and administrative expenses to each segment based upon each product line's allocated capital for the current reporting period. We allocate capital to each of our product lines through the estimated value-at-risk method, which uses statistical analyses of historical market trends and volatility to estimate the probable amounts of capital at risk for each reporting period. We do not manage our assets by segment and, as a result, net investment income, and depreciation and amortization are not evaluated at the segment level.
We record premiums written at the time that there is sufficient evidence of agreement to the significant terms of the contract but no earlier than the effective date of the policy. The amount of our insurance and reinsurance premiums written and earned depends on the number and type of policies we write, the amount of reinsurance protection we provide, as well as prevailing market prices. Furthermore, the amount of net premiums earned depends upon the type of contracts we write, the contractual periods of the contracts we write, the inception date of the contracts, the expired portions of the contract periods and the type of purchased reinsurance protection. Because of all these factors, the amount of premiums written and ceded may not result in a correlative level of profitability.
assets. We also recognize capital losses on investments as a result of other than temporary impairment charges. Under U.S. GAAP, our available-for-sale investments are carried at fair market value with unrealized gains and losses on the investments included on our balance sheet in accumulated other comprehensive income (loss) net of income taxes as a separate component of shareholders' equity. Our trading investments that relate to deposits associated with non-risk bearing contracts are recorded at estimated fair value with the change in fair value included in net realized gains and losses on investments in the consolidated statement of operations and comprehensive loss. The objective of our current investment strategy is to preserve investment principal, maintain liquidity and to manage duration risk between investment assets and insurance liabilities, while maximizing investment returns through a diversified portfolio. Our investment returns are benchmarked against certain specified indices. However, the volatility in claim payments and the interest rate environment can significantly affect the returns we generate on our investment portfolios.
ESC is our predecessor for accounting purposes and its business is wholly attributable to the technical services segment. Accordingly, we compare the results of operations of ESC for the year ended December 31, 2005 to the year ended December 31, 2004, and the year ended December 31, 2004 to the pro forma financial information for the year ended December 31, 2003 within the discussion of our technical services segment under "Results by Segments."
Results of operations for the years ended December 31, 2005 and 2004 were as follows:
REVENUES Gross premiums written....................... $ 608,935 $ 494,412 ========= ========= Net premiums written......................... $ 390,041 $ 419,541 ========= ========= Net premiums earned.......................... $ 364,075 $ 237,140 Technical services revenues.................. 47,265 32,485 Net investment income........................ 27,181 14,307 Net realized (losses) gains on investments... (13,020) 228 Net foreign exchange gains................... 331 978 Other income................................. 5,279 2,017 --------- --------- Total revenues............................ 431,111 287,155 --------- --------- EXPENSES Net losses and loss expenses................. (324,084) (198,916) Acquisition expenses......................... (69,624) (53,995) Direct technical services costs.............. (37,027) (23,182) General and administrative expenses.......... (97,930) (63,392) Interest expense ............................ (4,165) (71) Depreciation and amortization of intangible assets.................................... (3,989) (2,180) --------- --------- Total expenses............................ (536,819) (341,736) --------- --------- Income taxes................................. 244 -- --------- --------- Net loss .................................... $(105,952) $ (54,581) ========= =========
Substantially all of our revenues were generated by our underwriting subsidiaries in the U.S., Bermuda and Europe. Technical services revenues were derived from the operations of ESC, QLT Buffalo LLC and QLT of Alabama, LLC.
Premiums. Gross premiums written were $608.9 million for the year ended December 31, 2005, an increase of $114.5 million, or 23.2%, compared to $494.4 million for the year ended December 31, 2004. The increase in our gross premiums written was largely due to the contribution of $80.7 million, or 13.3%, of our gross premiums written, from our Lloyd's syndicate, which commenced in December 2004. The increase also reflected continued growth in all of our specialty insurance segment product lines and our marine, technical risk and aviation product line in our specialty reinsurance segment. Shortly after Hurricane Rita, we discontinued writing new and most renewal business in our technical risk property and property reinsurance lines of business (other than our program business), which accounted for approximately $97.1 million, or 15.9%, of our gross premium written during the year ended December 31, 2005.
fidelity product lines, which was ceded on an excess of loss basis. The unexpired portions of this business were then transferred, effective April 1, 2005, into our 2005 reinsurance treaty, which is ceded on a proportional quota share basis.
Net premiums earned were $364.1 million for the year ended December 31, 2005, an increase of $127.0 million, or 53.5%, compared to $237.1 million for the year ended December 31, 2004, reflecting the growth in premiums written and the earning and amortization of premiums written and ceded during the years ended December 31, 2004 and 2005. Our net premiums written are typically earned over the risk periods of the underlying insurance policies which are generally twelve months. Net premiums written that are not yet earned and are deferred as unearned premium reserves, net of deferred reinsurance premiums, totaled $224.5 million at December 31, 2005 and will be earned and recognized in our results of operations in future periods. Because we only began to write insurance and reinsurance business during the fourth quarter of 2003 and because our Lloyd's syndicate commenced operations in December 2004, we believe that our net premiums earned are not representative of a fully developed and diversified portfolio of insurance and reinsurance contracts.
Net investment income was $27.2 million for the year ended December 31, 2005 and was derived primarily from interest earned on fixed maturity and short term investments, partially offset by investment management fees and amortization of discounts on fixed maturity investments. Our average annualized effective yield (calculated by dividing net investment income by the average amortized cost of invested assets, net of amounts payable or receivable for investments purchased or sold) was approximately 3.5% for the year ended December 31, 2005 compared to 2.7% for the year ended December 31, 2004, reflecting rises in market interest rates. Net realized losses of $13.0 million were generated primarily from our other than temporary impairment charge of $10.2 million and also as we sought to manage our total investment returns and the duration of our investment portfolios.
As of December 31, 2005, the average duration of our investment portfolio was approximately 2.6 years with an average credit rating of approximately "AA+".
Net losses and loss expenses. Net losses and loss expenses were $324.1 million for the year ended December 31, 2005 an increase of $125.2 million, or 62.9%, compared to $198.9 million for the year ended December 31, 2004. Net losses and loss expenses are a function of our net premiums earned and our expected ultimate losses and loss expenses for reported and unreported claims on contracts of insurance and reinsurance underwritten. The increase in net losses and loss expenses is due to:
o the increase in loss occurrences, particularly those related to the 2005 hurricanes and the first quarter 2005 rupture of an oil pipeline in California during a mudslide; and
Included in our expected ultimate losses during the year ended December 31, 2005 are specific loss estimates on contracts of reinsurance and insurance insuring claims arising from Hurricanes Katrina, Rita and Wilma. Our preliminary loss estimates for the 2005 hurricanes based on currently available information totals $87.4 million (including reinstatement premiums), of which $83.3 million is included in net losses and loss expenses for the year ended December 31, 2005 compared to $61.3 million included in net losses and loss expenses for the year ended December 31, 2004 from Hurricanes Charley, Frances, Ivan and Jeanne. Our estimate of our exposure to ultimate claim costs associated with these hurricanes is primarily based on currently available information, claims notifications received to date, industry loss estimates, output from industry models, a review of affected contracts and discussion with cedents and brokers. The actual amount of losses from the hurricanes may vary significantly from the estimate.
the impact of the actual catastrophes in 2005 was mitigated by our purchased reinsurance and retrocessional protection and increased net premiums earned compared to the year ended December 31, 2004.
Our general and administrative expense ratio was 24.8% for the year ended December 31, 2005 compared to 23.4% for the year ended December 31, 2004. The increase was due to the additional number of employees hired and development of our infrastructure as we grew our lines of business during 2005 and also due to the impact of the transactions that lowered net earned premiums. In 2005, we have changed the denominator in the calculation of our general and administrative expense ratio to net premiums earned, instead of net premiums written.
Depreciation and amortization of intangible assets. Depreciation and amortization of intangible assets was $4.0 million for the year ended December 31, 2005, an increase of $1.8 million compared to $2.2 million for the year ended December 31, 2004 and consisted of amortization of intangible assets related to the acquisition of ESC and depreciation of fixed assets. The increase in depreciation and amortization is due to the purchase of additional fixed assets throughout 2004 and 2005 as we grew our lines of business.
We have not recorded any net deferred income tax benefits or assets relating to tax operating losses generated by our subsidiaries since our results of operations include a 100% valuation allowance against net deferred tax assets. For the year ended December 31, 2005, the net valuation allowance increased by approximately $11.5 million, to $24.8 million.
Comparisons between the year ended December 31, 2004 and the period from May 23, 2003 (date of incorporation) to December 31, 2003 are not meaningful because we commenced substantive operations on September 3, 2003 and during the period from May 23, 2003 (date of incorporation) to December 31, 2003, we wrote only a small number of insurance and reinsurance contracts.
Results of operations for the period from May 23, 2003 (date of incorporation) to December 31, 2003 were as follows:
($ in thousands) ---------------- REVENUES Gross premiums written ...................................... $ 20,465 ======== Net premiums written ........................................ $ 20,060 ======== Net premiums earned ......................................... $ 1,940 Technical services revenues ................................. 11,680 Net investment income ....................................... 2,290 Net realized gains on investments ........................... 109 Net foreign exchange losses ................................. -- Other income ................................................ 126 -------- Total revenues ........................................... 16,145
EXPENSES Net losses and loss expenses ................................ (1,191) Acquisition expenses ........................................ (164) Direct technical services costs ............................. (8,637) General and administrative expenses ......................... (44,196) Depreciation and amortization of intangible assets ................................................... (434) Total expenses ........................................... (54,622) -------- Income taxes ................................................ -- -------- Net loss .................................................... $(38,477) ========
Premiums. We commenced writing insurance and reinsurance business during the fourth quarter of 2003 and wrote $20.5 million of gross premiums written for the period ended December 31, 2003. Of this premium, 63.5%, or $13.0 million, was written by our specialty reinsurance segment and 36.5%, or $7.5 million, was written by our specialty insurance segment. We ceded a small amount of our insurance risk, amounting to $0.4 million in premiums ceded. Net premiums earned in the period were $1.9 million reflecting the short duration of the period between the inception date of the contracts and December 31, 2003.
Net investment income and net realized gains. Net investment income and net realized gains totaled $2.4 million for the period. Net investment income was $2.3 million and was derived primarily from interest earned on fixed maturity investments, and short term investments. Subsequent to the private offering of our shares on September 3, 2003 and our acquisition of ESC, our investments in cash assets increased by over $487 million representing cash proceeds from the private offering, net of placement fees and associated costs, of approximately $505.6 million less $18.5 million used to purchase ESC. Our average annualized effective yield (calculated by dividing net investment income by the time weighted average amortized cost of invested assets) for the period from September 3, 2003 (private offering) to December 31, 2003 was approximately 1.4%. Initially our invested assets were held entirely in cash, liquidity funds and overnight cash deposits. In October 2003, we and our asset managers established an investment program to invest in a broader array of assets such as fixed income securities, in accordance with our investment guidelines as approved by our board of directors. As a result, our annualized effective yields have increased through 2004 as we moved the majority of our invested assets into longer term fixed income securities and similar instruments.
As of December 31, 2003, the average maturity duration of our investment portfolio was approximately 2.5 years with an average credit rating of approximately "AA."
EXPENSES. Total expenses were $54.6 million for the period and were comprised of net losses and loss expenses incurred of $1.2 million, net acquisition expenses of $0.2 million, direct technical services costs of $8.6 million, general and administrative expenses of $44.2 million and depreciation and amortization of $0.4 million.
We principally provide insurance and reinsurance protection for risks that are often unusual or difficult to place, that do not fit the underwriting criteria of standard commercial product carriers and that require extensive technical underwriting and assessment resources in order to be profitably underwritten. In measuring the performance of our specialty insurance and specialty reinsurance segments, we consider each segment's net underwriting income and a number of financial ratios. Net underwriting income is the sum of net premiums earned less net losses and loss expenses, acquisition expenses and direct and allocated general and administrative expenses.
Net premiums earned ............... $ 197,131 $ 75,167 $ 121,964 Other income ...................... 1,200 -- 1,200 Net losses and loss expenses ....................... (145,362) (49,805) (95,557) Acquisition expenses .............. (26,910) (14,287) (12,623) General and administrative expenses(1) ................... (65,181) (34,303) (30,878) --------- --------- --------- Net underwriting loss ............. $ (39,122) $ (23,228) $ (15,894) ========= ========= ========= RATIOS:
---------- (1) Includes $2.4 million and $2.3 million of expenses charged by our technical services segment for technical and information management services for the years ended December 31, 2005 and 2004.
---------- (1) The gross and net premiums written generated by our HBW program is written in our technical risk property product line, as described below.
During the year ended December 31, 2005, we continued to write, in our technical risk property product line, the HBW program, which accounted for approximately $165.9 million, or 88.5%, of the technical risk property line of business and 42.3% of total specialty insurance segment gross premiums written in the year ended December 31, 2005. The HBW program accounted for $108.9 million, or 95.2%, of the technical risk property product line and 42.5% of the total specialty insurance segment net premiums written for the year ended December 31, 2005. We are no longer writing business in our technical risk property line other than the programs that are part of that line. The policies in the program are underwritten by a third-party agent which follows our underwriting guidelines. We believe that this agent is an established specialist in this technical field. Our HBW gross premiums written during the year ended December 31, 2005 are summarized in the table below by specialty risk class.
Premiums ceded were $135.5 million during the year ended December 31, 2005, an increase of $63.2 million compared to $72.3 million for the year ended December 31, 2004. The increase in premiums ceded reflects the increase in our gross premiums written, approximately $10.6 million of premiums ceded resulting from the Property Transaction and approximately $5.5 million from reinsurance treaties that we have entered into for our specialty insurance product lines to help limit our net loss exposures to natural catastrophe events. The increase of premiums ceded is attributable
Net premiums earned during the year ended December 31, 2005 were $197.1 million, an increase of $121.9 million, compared to $75.2 million for the year ended December 31, 2004 representing growth of premiums written and the earning and amortization of premiums written and ceded during the years ended December 31, 2004 and 2005. Gross premiums written and ceded premiums are earned over the period of each insured risk. The terms of our insurance contracts range from between one and ten years with the majority of our contracts being for a one year period.
Other income. Other income was $1.2 million for the year ended December 31, 2005 and related to income, including fees, recognized on non-traditional insurance contracts. A more detailed description of these non-traditional contracts is provided under "- Non-Traditional Contracts" below.
o the increase in loss occurrences, particularly those related to the 2005 hurricanes and the first quarter 2005 rupture of an oil pipeline in California during a mudslide;
o general reserve strengthening relating primarily to our HBW program, Lloyd's, professional and environmental lines.
Included in our expected ultimate losses in our specialty insurance segment during the year ended December 31, 2005 are specific loss estimates on contracts of insurance insuring claims arising from Hurricanes Katrina, Rita and Wilma. Our estimate of our specialty insurance segment's exposure to ultimate claim costs associated with these hurricanes based on currently available information is $13.9 million (including reinstatement premiums), of which $11.4 million is included in net losses and loss expenses for the year ended December 31, 2005, compared to $0.6 million included in net losses and loss expenses for the year ended December 31, 2004 from Hurricanes Charley, Frances, Ivan and Jeanne. Our preliminary estimate of our exposure to ultimate claim costs associated with these hurricanes is based on currently available information, claims notifications received to date, industry loss estimates, output from industry models, a review of affected contracts and discussion and brokers. The actual amount of losses from the hurricanes may vary significantly from the estimate.
Our expected ultimate losses during the year ended December 31, 2005 also include estimated gross and net loss estimates of $21.6 million and $13.0 million related to damage caused by an oil pipeline in California which ruptured during a mudslide in the first quarter of 2005, for which the damage is covered by an insurance contract issued by our environmental liability product line. There remains the possibility of further negative development on this loss in the future, particularly if the
timing of the completion of the remediation plan for the spill is further delayed. In addition to the hurricanes and the oil pipeline loss, as of December 31, 2005, we have received a limited amount of significant reported losses. However, we participate in lines of business where claims may not be reported for some period of time after those claims are incurred.
Our specialty insurance segment net loss ratio was 73.7% for the year ended December 31, 2005 an increase of 7.4% compared to a net loss ratio of 66.3% for the year ended December 31, 2004. The increase in the specialty insurance segment net loss ratio is due to the loss estimates arising from Hurricanes Katrina, Rita and Wilma as well as to the loss estimates arising from the ruptured oil pipeline loss. However, the extent of the impact of the actual catastrophes in 2005 was mitigated by our purchased reinsurance protection in our specialty insurance segment and increased net premiums earned in our specialty insurance segment compared to the year ended December 31, 2004. The 2005 hurricanes contributed 6.6% loss ratio percentage points to the specialty insurance segment net loss ratio.
Our acquisition expense ratio was 13.7% for the year ended December 31, 2005 a decrease of 5.3% compared to 19.0% for the year ended December 31, 2004. The reduction in our acquisition expense ratio in the specialty insurance segment is primarily due to three factors. First, we are paying less fronting costs because we are licensed in more states and no longer need to utilize fronting companies to the same extent in order to write our insurance business. Second, our ceding commission income that we are recovering on our specialty insurance segment's reinsurance treaties increased during 2005 as a result of the restructuring of those treaties during the second quarter of 2005. Third, we paid less commission in our HBW program during the year ended December 31, 2005 as a result of the contracts containing sliding scale commission provisions that vary with changes in the selected loss ratio. The selected loss ratio under the HBW contracts increased from 56.8% in 2004 to 64.8% in 2005. Deferred acquisition costs include, as of December 31, 2005, $17.5 million of acquisition expenses on written contracts of insurance that will be amortized in future periods as the premiums written to which they relate are earned.
General and administrative expenses. Direct and allocated indirect general and administrative expenses totaled $65.2 million for the year ended December 31, 2005 an increase of $30.9 million, or 90.0%, compared to $34.3 million for the year ended December 31, 2004. The increase in our general and administrative expense was due to the additional number of employees hired throughout 2004 and 2005, especially in Europe. The increase is also attributed to severance costs, increases in auditing fees, fees associated with ongoing efforts relating to Sarbanes-Oxley Section 404 compliance and costs relating to information technology development, which were allocated to our specialty insurance segment. Our general and administrative expense ratio decreased to 33.1% for the year ended December 31, 2005, compared to 45.6% for the year ended December 31, 2004 due primarily to the increase in our specialty insurance segment's net premiums earned.
---------- (1) Includes $0.7 million and zero of expenses charged by our technical services segment for information management services for the years ended December 31, 2005 and 2004.
Our property reinsurance gross premiums written during the year ended December 31, 2005 are summarized in the table below by risk class.
Our casualty reinsurance gross premiums written included in our other casualty category, were spread across 23 different risk classes, none of which accounted for more than 10% of our casualty reinsurance premiums written for the year ended December 31, 2005.
Our marine, technical risk and aviation reinsurance gross premiums written during the year ended December 31, 2005 are summarized in the table below by risk class.
Ceded premiums were $83.4 million during the year ended December 31, 2005 compared to $2.6 million for the year ended December 31, 2004. The increase in our ceded premiums written reflects approximately $34.1 million of purchased retrocession protection, including reinstatement premiums, in our specialty reinsurance property and marine, technical risk and aviation product lines. We obtained the retrocession protection to help limit our net loss exposures to natural catastrophe events. We also purchased additional retrocessional coverage for our marine, technical risk and aviation reinsurance product line to limit our future probable maximum losses during the fourth quarter of 2005. These retrocession treaties provide us with protection on an excess of loss, quota share treaty and facultative basis for policies written in our reinsurance product lines of business. Ceded premiums also includes $46.7 million of premium ceded to the third-party reinsurer under the Property Transaction. Ceded premiums are earned over the period of each insured risk.
Net premiums earned of $166.9 million for the year ended December 31, 2005 have increased by $5.0 million compared to the year ended December 31, 2004. The increase reflects the earning of premiums on contracts written during the years ended December 31, 2005 and 2004 and is offset by the impact of the decision to discontinue the writing of new and renewal business in our property reinsurance line of business, the Property Transaction, the Casualty Reinsurance Transaction and the purchase of additional retrocessional protection. Gross premiums written in our specialty reinsurance
Other income. Other income was $2.0 million for the year ended December 31, 2005 compared to $1.6 million for the year ended December 31, 2004, and related to income, including fees, recognized on non-traditional reinsurance contracts. A more detailed description of these non-traditional contracts is provided under "- Non-Traditional Contracts" below.
Included in our expected ultimate losses during the year ended December 31, 2005 are specific loss estimates on contracts of reinsurance insuring claims arising from Hurricanes Katrina, Rita and Wilma. Our estimate of our specialty reinsurance segment's exposure to ultimate claim costs associated with these hurricanes based on currently available information is $73.5 million (including reinstatement premiums), of which $71.9 million is included in net losses and loss expenses for the year ended December 31, 2005 compared to $60.7 million included in net losses and loss expenses for the year ended December 31, 2004 from Hurricanes Charley, Frances, Ivan and Jeanne. Our preliminary estimate of ultimate losses from these events is primarily based on currently available information, claims notifications received to date, industry loss estimates, output from industry models, a review of affected contracts and discussion with cedents and brokers. The actual amount of losses from the hurricanes may vary significantly from the estimate. Other than the hurricane losses, as of December 31, 2005, we have received a limited amount of significant reported losses in our specialty reinsurance segment. However, we participate in lines of business where claims may not be reported for some period of time after those claims are incurred.
Acquisition expenses. Acquisition expenses were $42.7 million for the year ended December 31, 2005 an increase of $3.0 million, or 7.6%, compared to $39.7 million for the year ended December 31, 2004. The increase in acquisition expenses was due to the increase in the number of reinsurance contracts we entered into and the associated net premiums earned. These acquisition expenses primarily represented brokerage and ceding commissions.
Gross Net premiums premiums written written -------- -------- ($ in thousands) Environmental liability $3,816 $3,816 Professional liability 2,729 2,324 Fidelity and crime 924 924 ------ ------ Total $7,469 $7,064 ====== ======
Premiums. Gross and net written reinsurance premiums were $13.0 million for the period ended December 31, 2003. The table below shows gross and net premiums written by line of business:
Gross Net premiums premiums written written -------- -------- ($ in thousands) Casualty $ 7,463 $ 7,463 Property 5,533 5,533 -------- -------- Total $12,996 $12,996 ======= =======
Net losses and loss expenses. Net losses and loss expenses incurred of $1.0 million reflect a loss and loss expense ratio of 63.0%. For the period ended December 31, 2003, we adopted an expected loss ratio methodology to estimate our ultimate cost of reinsurance losses. As of December 31, 2003, we had not received any notifications of reported losses on our specialty reinsurance lines of business.
Direct technical services costs. Direct technical services costs were $37.0 million for the year ended December 31, 2005, an increase of $13.8 million, or 59.7%, compared to $23.2 million for the year ended December 31, 2004. The increase in direct technical services costs was primarily attributable to increased direct subcontractor expenses which resulted from the Buffalo, New York remediation project undertaken during the year ended December 31, 2005 compared to the year ended December 31, 2004. Direct technical services costs, as a percentage of revenue was 73.3% for the year ended December 31, 2005 compared to 66.7% for the year ended December 31, 2004, reflecting the increased usage of subcontractors for environmental projects in 2005 as compared to 2004.
General and administrative expenses. Direct and indirect allocated general and administrative expenses were $10.7 million for the year ended December 31, 2005, an increase of $0.6 million, or 6.1% compared to $10.1 million for the year ended December 31, 2004. The increase is attributable to increased staffing levels, higher overhead allocation arising from the development of our infrastructure and Sarbanes-Oxley Section 404 compliance efforts, and professional fees associated with the environmental liability assumption program in Buffalo, New York.
YEAR ENDED DECEMBER 31, 2004 COMPARED TO PERIOD FROM SEPTEMBER 3, 2003 TO DECEMBER 31, 2003 AND PERIOD FROM JANUARY 1, 2003 TO SEPTEMBER 3, 2003
The following table summarizes and compares our technical services segment results for the year ended December 31, 2004 and, on a pro forma basis, the year ended December 31, 2003. Substantially all of these results were generated by the operations of our predecessor, ESC. The pro forma technical services segment results for the year ended December 31, 2003 are derived from the aggregation of segment results for the period from September 3, 2003 to December 31, 2003 and the segment results of ESC for the period January 1, 2003 to September 3, 2003 (the date of our acquisition of ESC). We believe that our comparative discussion on this pro forma basis provides a more meaningful analysis of the results of the technical services segment.
Technical services revenues ....... $ 34,752 $12,261 $ 20,350 $ 32,611 Other income ...................... 586 100 14 114 Direct technical services costs ... (23,182) (8,637) (12,992) (21,629) General and administrative expenses ....................... (10,055) (2,657) (5,820) (8,477) -------- ------- -------- -------- Net technical services income ..... $ 2,101 $ 1,067 $ 1,552 $ 2,619 ======== ======= ======== ========
Technical services revenues. Technical services revenues were $34.8 million for the year ended December 31, 2004, an increase of $2.2 million, or 6.6%, compared to $32.6 million for the pro forma year ended December 31, 2003. The increase of $2.2 million in technical services revenues consists of a $0.8 million increase in subcontractor revenue and a $1.4 million increase in direct labor revenue. The increase in subcontractor revenue during the year ended December 31, 2004 was the result of an increase in subcontractor remediation activity. The increase in direct labor revenue is a result of an increase in client spending on environmental projects.
Other income. Other income totaled $0.6 million for the year ended December 31, 2004, an increase of $0.5 million, compared to $0.1 million for the pro forma year ended December 31, 2003. The increase was primarily generated from our liability assumption program under which we assume specified environmental liabilities. This income represents fees earned relating to the remediation services performed. ESC did not engage in environmental liability assumption program activity during the period from January 1, 2003 to September 3, 2003.
General and administrative expenses. Direct and indirect allocated general and administrative expenses were $10.1 million for the year ended December 31, 2004, an increase of $1.6 million, or 18.6% compared to $8.5 million for the pro forma year ended December 31, 2003. The increase is primarily attributable to a general increase in underlying general and administrative expenses and increased salary and benefit expense related to hiring additional staff during the year ended December 31, 2004 compared to the pro forma year ended December 31, 2003.
We estimate that we currently have net cash and cash equivalent balances and other investments of approximately $341.9 million that are available to post as security or place in trust. We currently believe that we have sufficient assets to pay our foreseen liabilities as they become due and meet our foreseen collateral requirements. However, we cannot draw letters of credit or borrow under the credit agreement if we have incurred a material adverse effect or if a default exists under the agreement. A downgrade in our rating below "B++" (very good) will cause a default in our credit facility. The obligations under the credit facility are currently fully secured by investments and cash. If a default occurs under the credit agreement, our lenders may require us to cash collateralize a portion or all of the outstanding letters of credit issued under the facility, which may be accomplished through the substitution or liquidation of collateral. The lenders would also have the right, among other things, to cancel outstanding letters of credit issued under the facility. If we fail to maintain or enter into adequate letter of credit facilities on a timely basis, we would be required to place securities in trust or similar arrangements, which would be more difficult and costly to establish and administer.
Our board of directors established our investment policies and created guidelines for hiring external investment managers. Management implements our investment strategy with the assistance of the external managers. Our investment guidelines specify minimum criteria on the overall credit quality, liquidity and risk-return characteristics of our investment portfolio and include limitations on the size of particular holdings, as well as restrictions on investments in different asset classes. The board of directors monitors our overall investment returns and reviews compliance with our investment guidelines.
Our investment strategy seeks to preserve principal and maintain liquidity while trying to maximize total return through a high quality, diversified portfolio. Investment decision making is guided mainly by the nature and timing of our expected liability payouts, management's forecast of our cash flows and the possibility that we will have unexpected cash demands, for example, to satisfy claims due to catastrophic losses. Our investment portfolio currently consists mainly of highly rated and liquid fixed income securities. However, to the extent our insurance liabilities are correlated with an asset class outside our minimum criteria, our investment guidelines will allow a deviation from those minimum criteria provided such deviations reduce overall risk.
We have determined that $607.2 million of investment securities, with unrealized losses of approximately $10.2 million were other-than- temporarily impaired as of December 31, 2005. The realization of these losses represents the maximum amount of potential losses in our investment securities if we would have sold all of these securities at December 31, 2005. As a result of our decision, the affected investments were reduced to their estimated fair value, which becomes their new cost basis. The recognition of the losses has no affect on our shareholders' equity, the market value of our investments, our cash flows or our liquidity. The evaluation for other-than-temporary impairments requires the application of significant judgment, including our intent and ability to hold the investment for a period of time sufficient to allow for possible recovery. We believe we have sufficient assets to pay our currently foreseen liabilities as they become due and we have no immediate intent to liquidate the investments securities affected by our decision. However, due to the general uncertainties surrounding our business resulting from A.M. Best's March 2006 downgrade of our financial strength ratings and our decision to explore strategic alternatives, we concluded that there are no absolute assurances that we will have the ability to hold the affected investments for a sufficient period of time. It is possible that the investment securities' fair values could change in subsequent periods, resulting in further material impairment charges.
Our available-for-sale investments, excluding trading investments related to deposit liabilities, totaled $699.1 million as of December 31, 2005 compared to $559.4 million at December 31, 2004. The market value of our total investment portfolio was $737.4 million, of which $662.5 million related to available-for-sale fixed maturity investments, $36.6 million related to available for sale short-term investments and $38.3 million to trading investments related to deposit liabilities. The majority of our investment portfolio consists of fixed maturity investments which are managed by the following external investment advisors: Pacific Investment Management Company LLC, JP Morgan Investment Management Inc. and Deutsche Asset Management. Custodians of our externally managed investment portfolios are JP Morgan Chase Bank N.A., Citibank N.A. and Comerica Incorporated.
Our deferred acquisition costs and unearned premiums, net of deferred reinsurance premiums, totaled $33.1 million and $224.5 million, respectively, as of December 31, 2005 compared to $41.5 million and $200.5 million as of December 31, 2004. The decrease in our deferred acquisition costs during the year ended December 31, 2005 is due to the ceding commission income that we are recovering on our specialty insurance segments reinsurance treaties and as a result of recovering commission income from the third-party reinsurer under the Property Transaction. The increase in unearned premiums, net of deferred reinsurance, is due to the growth in our premiums written during the year ended December 31, 2005, which is in part offset by an increase in deferred reinsurance premiums as a result of the ceding of premiums from the third-party reinsurer under the Property Transaction. These amounts represent premiums and acquisition expenses on written contracts of insurance and reinsurance that will be recognized in earnings in future periods. Substantially all of these amounts will be recognized over the next 12 months.
Our reserves for losses and loss adjustment expenses, net of reinsurance recoverable, totaled $343.6 million as December 31, 2005 compared to $146.3 million as of December 31, 2004. The increase in our net loss and loss expense reserves reflects the growth in our business, the associated
insured risks we assumed during the year ended December 31, 2005 and include our estimate of ultimate unpaid net loss expenses totaling $71.9 million relating to Hurricanes Katrina, Rita and Wilma, our remaining unpaid loss expenses totaling $5.4 million relating to Hurricanes Charley, Frances, Ivan and Jeanne and $4.7 million relating to the environmental claim that we incurred during the year ended December 31, 2005. The increase also represents general strengthening of our loss reserves for 2005 by approximately $13.2 million as part of our year-end closing process. Given the immaturity of our business and very limited claims history, we have relied on pricing, loss and expense data accumulated by our consulting actuary, historical industry results, and to a limited extent, our own reported claims history in establishing loss ratios for each line of business. Although we have not experienced significant reported claims in our casualty insurance line, we have worked closely with our independent loss specialist and concluded to generally strengthen our loss ratios in our HBW program, Lloyd's, professional and environmental lines with respect to the year ended December 31, 2005. Our estimate of our unpaid exposure to ultimate claim costs associated with these losses is based on currently available information, claim notifications received to date, industry loss estimates, output from industry models, a review of affected contracts and discussion with clients, cedants and brokers. The actual amount of future loss payments relating to these loss events may vary significantly from this estimate. As of December 31, 2005 we have received a limited amount of other reported losses. However, we participate in lines of business where claims may not be reported for some period of time after those claims are incurred. A description of the method we use to determine our loss reserves is included above under "Results of operations."
LOSSES AND LOSS ADJUSTMENT EXPENSES A.M. BEST REINSURER RECOVERABLE RATING --------- ------------------- --------- ($ in millions) Everest Reinsurance Company $ 41.8 A+ Lloyd's 32.3 A XL Capital Ltd. 11.5 A+ Arch Reinsurance 10.9 A- Allianz Marine & Aviation 10.7 A+ New Reinsurance Company 10.0 A+ PXRE Group Ltd. 9.2 B+ Glacier Reinsurance AG 7.7 A- The Toa Reinsurance Company, Ltd. (Tokyo) 6.5 A Aspen Insurance 6.2 A Transatlantic Reinsurance Company 6.1 A Odyssey America Reinsurance 5.5 A Max Re 5.2 A- Ritchie Risk-Linked Strategies Ltd. 5.0 NR(1) Other Reinsurers Rated A- or Better 16.9 A- All Other Reinsurers 4.9 Various ------ Total $190.4 ======
Our shareholders' equity was $384.2 million as of December 31, 2005 compared to $430.9 million as of December 31, 2004, reflecting a decrease of $46.7 million that was primarily the result of a net loss of $105.9 million for the year ended December 31, 2005 partially offset by the net proceeds from the common shares issued during December 2005 of $58.3 million and a net change in unrealized gains on our investment portfolios of $0.9 million. As of December 31, 2005, we have provided a 100% cumulative valuation allowance against our deferred tax assets in the amount of $24.8 million. These deferred tax assets were generated primarily from net operating losses. As a start-up company with limited operating history, the realization of these deferred tax assets is neither assured nor accurately determinable.
On and after December 15, 2010, we may redeem our series A preferred shares, in whole or in part, at any time, at the redemption price set forth in the Certificate of Designation relating to preferred shares, plus declared but unpaid dividends and additional amounts, if any, to the date of redemption. We may not redeem our series A preferred shares before December 15, 2010 except that
we may redeem our series A preferred shares before that date pursuant to certain tax redemption provisions described in the Certificate of Designation. If we experience a change of control, we may be required to make offers to redeem our series A preferred shares at a price of $25.25 per share, plus declared but unpaid dividends and additional amounts, if any, to the date of redemption and on the terms described in the Certificate of Designation. Our series A preferred shares have no stated maturity and are not subject to any sinking fund and are not convertible into any of our other securities or property.
We estimate that we currently have investments of approximately $1,011.7 million, including cash and cash equivalent balances of approximately $197.1 million. We estimate that our cash and cash equivalents and investment balances include approximately $260.5 million that is pledged as collateral for letters of credit, approximately $169.5 million held in trust funds for the benefit of ceding companies and to fund our obligations associated with the assumption of an environmental remediation liability, $156.4 million that is held by Lloyd's to support our underwriting activities, $52.7 million held in trust funds that are related to our deposit liabilities and $30.7 million that is on deposit with, or has been pledged to, U.S. state insurance departments. After giving effect to these assets pledged or placed in trust, we estimate that we presently have net investments of $341.9 million, including net cash and cash equivalents of approximately $107.9 million. We believe our operating subsidiaries currently have sufficient assets to pay their respective foreseen liabilities as they become due. We also believe that our operating subsidiaries can distribute sufficient funds to Quanta Holdings to enable Quanta Holdings to pay its currently foreseen liabilities as they become due, subject to the constraints under the Companies Act that affect our ability to pay dividends on our shares.
On July 11, 2005, Quanta Holdings and certain designated insurance subsidiaries entered into an amended and restated credit agreement, dated July 11, 2005, providing for a secured bank letter of credit facility and a revolving credit facility with a syndicate of lenders in the amount of $250 million. Up to $25 million may be borrowed under the facility on a revolving basis for general corporate purposes and working capital requirements. The facility is secured by specified investments of the borrowers. We have approximately $228.9 million of secured letters of credit issued and outstanding under the facility. We have not made any borrowings under the revolving credit facility. The obligations under the credit facility are currently fully secured by investments and cash. The availability to a borrower is based on the amount of eligible investments pledged by that borrower. Regulatory restrictions will also limit the amount of investments that may be pledged by our U.S. insurance borrowers and, consequently, the amount available for letters of credit and borrowings under the facility to those borrowers. In addition, we cannot draw letters of credit or borrow under the credit agreement if we have incurred a material adverse effect or if a default exists under the agreement.
The credit agreement has certain financial covenants, including a leverage ratio (consolidated indebtedness to consolidated total capital) of not greater than 0.35 to 1, a minimum consolidated net worth of at least $301 million which shall be increased immediately following the last day of each fiscal quarter by an amount equal to 50% of the net income of the Company and its subsidiaries and maintenance of the Company's insurance ratings. In addition, the credit agreement contains certain covenants restricting the activities of Quanta Holdings and its subsidiaries, such as the incurrence of additional indebtedness, liens and dividends and other payments to Quanta Holdings. A ratings downgrade below B++ would also create an event of default under the credit agreement. If a default occurs under the credit agreement, our lenders may require us to cash collateralize a portion or all of the outstanding letters of credit issued under the facility, which may be accomplished through the substitution or liquidation of collateral. The lenders would also have the right, among other things, to cancel outstanding letters of credit issued under the facility. Quanta Holdings has unconditionally and irrevocably guaranteed all of the obligations of its subsidiaries to the lenders. The facility terminates on July 11, 2008.
On February 24, 2005, we participated in a private placement of $20.0 million of floating rate capital securities issued by Quanta Capital Statutory Trust II ("Quanta Trust II"), a subsidiary Delaware trust formed on February 24, 2004. The trust preferred securities mature on September 15, 2035, are redeemable at our option at par beginning September 15, 2010, and require quarterly distributions of interest by Quanta Trust II to the holder of the trust preferred securities. Distributions will be payable at a variable per annum rate of interest, reset quarterly, equal to LIBOR plus 350 basis points. Quanta Trust II used the proceeds from the sale of the trust preferred securities and the issuance of its common securities to purchase $20.6 million of junior subordinated debt securities, due March 15, 2035, in the principal amount of $20.6 million issued by us (the "Trust II Debentures" and, together with the Trust I Debentures, the "Debentures").
We estimate that we currently have investments of approximately $1,011.7 million, including cash and cash equivalent balances of approximately $197.1 million. We estimate that our cash and cash equivalents and investment balances include approximately $260.5 million that is pledged as collateral for letters of credit, approximately $169.5 million held in trust funds for the benefit of ceding companies and to fund our obligations associated with the assumption of an environmental remediation liability, $156.4 million that is held by Lloyd's to support our underwriting activities, $52.7 million held in trust funds that are related to our deposit liabilities and $30.7 million that is on deposit with, or has been pledged to, U.S. state insurance departments. After giving effect to these assets pledged or placed in trust, we estimate that we presently have net investments of $341.9 million, including net cash and cash equivalents of approximately $107.9 million. Substantially all of our capital has been distributed among our rated operating subsidiaries based on our assessment of the levels of capital that we believe are prudent to support our business, the applicable regulatory requirements, and the recommendations of the insurance regulatory authorities and rating agencies.
If A.M. Best downgrades our financial strength ratings below our current rating of "B++," we will be in default under our credit agreement. We cannot draw letters of credit or borrow under our existing credit agreement if we have incurred a material adverse effect or if a default exists under the agreement. If we fail to maintain or enter into adequate letter of credit facilities on a timely basis, we may be unable to provide necessary security to cedent companies under our existing retrocessional and reinsurance contracts that have the right to require the posting of additional security by reason of the downgrade of our A.M. Best rating. We cannot assure you that we will be able to increase the commitment under our existing bank credit facility or obtain additional credit facilities at terms acceptable to us. Our inability to maintain or enter into adequate credit facilities would have a material adverse effect on our results of operations. The obligations under the credit facility are currently fully secured. If a default occurs under the credit agreement, our lenders may require us to cash collateralize a portion or all of the outstanding letters of credit issued under the facility, which may be accomplished through the substitution or liquidation of collateral. The lenders would also have the right, among other things, to cancel outstanding letters of credit issued under the facility. If we fail to maintain or enter into adequate letter of credit facilities on a timely basis, we would be required to place securities in trust or similar arrangements, which would be more difficult and costly to establish and administer.
implementation also involve significant uncertainties and risks that may result in restructuring charges and unforeseen expenses and costs associated with exiting lines of business and complications or delays, including, among others things, the risk of failure. We estimate that severance charges that will be incurred in the first quarter of 2005 will be approximately $5.2 million. Additionally, in order to retain the services of our chief financial officer, Jonathan J.R. Dodd, and a number of other key employees, we have entered into retention agreements with these employees that provide for specified severance payments in the event of termination without cause or following a change of control. In the event of payout to all employees covered by these retention agreements, our cash requirements would include a total payment of approximately $9.1 million to all such employees.
Rating Capital." Substantially all of our capital has been distributed among our rated operating subsidiaries based on our assessment of the levels of capital that we believe are prudent to support our expected levels of business, the applicable regulatory requirements, and the recommendations of the insurance regulatory authorities and rating agencies.
pay dividends, as well as our ability to pay dividends, is subject to regulatory, contractual, rating agency and other constraints. Furthermore, the terms of our letter of credit and revolving credit facility prohibit us from repurchasing shares and paying dividends on our shares without the consent of our lenders. We have obtained a consent under our current letter of credit and revolving credit facility for the payment of dividends on our series A preferred shares. However, the facility prohibits us from paying dividends on our series A preferred shares so long as there is a default under that agreement. Future credit agreements or other agreements relating to our indebtedness may also contain provisions prohibiting or limiting the payment of dividends on our shares under certain circumstances. If we experience a change of control, we may be required to make offers to redeem our series A preferred shares at a price of $25.25 per share, plus declared but unpaid dividends and additional amounts, if any, to the date of redemption and on the terms described in the Certificate of Designation. Our series A preferred shares have no stated maturity and are not subject to any sinking fund and are not convertible into any of our other securities or property.
While our financial advisors will also help us evaluate the potential use of excess capital to return value to our shareholders, in addition to the restrictions described above relating to our operating subsidiaries, we may be limited in the amount of any dividends that could be paid on, or the amount of any redemption of, our shares. Under Bermuda law, we may not declare or pay a dividend or redeem our shares (including our series A preferred shares) at any time if we have reasonable
We have contractual obligations relating to our reserves for losses and loss expenses and commitments under the trust preferred securities, preferred shares and non-cancelable operating leases for property and office equipment described above under "Liquidity" as of December 31, 2005 as follows:
PAYMENTS DUE BY PERIOD ($IN THOUSANDS) ------------------------------------------------------------ LESS THAN 1 MORE THAN 5 CONTRACTUAL OBLIGATIONS ($000'S) TOTAL YEAR 1-3 YEARS 3-5 YEARS YEARS ------------------------------------ -------- ----------- --------- --------- -----------
---------- (1) The interest on the long-term debt obligation is based on a spread above LIBOR. We have reflected the interest due based upon the current interest rate at December 31, 2005 on the facility.
(2) Dividends on our 10.25% series A preferred shares is based on a dividend of $2.5625 per share. We have not estimated dividends payable on our series A preferred shares as they are perpetual and have no fixed mandatory redemption date unless a change of control occurs or we are able to redeem the preferred shares. We do not have the right to redeem our series A preferred shares until on or after December 15, 2010. Assuming 3,000,000 shares of our series A preferred shares are outstanding during any applicable period, we would be required to pay dividends, on an annual basis, of an aggregate of approximately $7.7 million.
Other than as described under "Liquidity" related to our trust preferred securities offerings through the Quanta Trust I and Quanta Trust II (together "Quanta Trust I and II"), as of December 31, 2005, we have not entered into any off-balance sheet arrangements with special purpose entities or variable interest entities. We did not consolidate Quanta Trust I and II, the issuer of the trust preferred securities and a variable interest entity, since we are not the primary beneficiary of Quanta Trust I or II. As of December 31, 2005, we have recorded the $61.9 million of Debentures, which were issued to Quanta Trust I and II, on our consolidated balance sheet. The net proceeds of $58.4 million from the sale of the Debentures to Quanta Trust I and II were used for working capital purposes and our business. Distributions will be payable at a variable per annum rate of interest, reset quarterly, equal to LIBOR plus 385 basis points by the Company to Quanta Trust I and equal to LIBOR plus 350 basis points by the Company to Quanta Trust II as described above under "Commitments." The Debentures are redeemable at the Company's option at par beginning March 15, 2010.
Our Bermuda, United Kingdom, and Irish operating subsidiaries are not licensed, accredited or otherwise approved as reinsurers anywhere in the United States. Many U.S. jurisdictions do not permit insurance companies to take credit on their U.S. statutory financial statements for reinsurance to cover unpaid liabilities, such as loss and loss adjustment expense and unearned premium reserves, obtained from unlicensed or non-admitted insurers without appropriate security acceptable to U.S. insurance commissioners. Typically, this type of security will take the form of a letter of credit issued by an acceptable bank, the establishment of a trust, funds withheld or a combination of these elements.
As described under "Liquidity" above we entered into a secured bank credit facility with a syndicate of lenders that allows us to provide to our insured clients up to $250 million in letters of credit as security under the terms of insurance and reinsurance contracts. The availability to a borrower is based on the amount of eligible investments pledged by that borrower and no material adverse change provisions. Regulatory restrictions will also limit the amount of investments that may be pledged by our U.S. insurance borrowers and, consequently, the amount available for letters of credit and borrowings under the facility to those borrowers. We currently have approximately $260.5 million of secured letters of credit issued and outstanding under the facility.
Ratings by independent agencies are an important factor in establishing the competitive position of insurance and reinsurance companies and are important to our ability to market and sell our
products. Rating organizations continually review the financial positions of insurers. S&P maintains a letter scale rating system ranging from "AAA" (Extremely Strong) to "R" (under regulatory supervision). A.M. Best maintains a letter scale rating system ranging from "A++" (Superior) to "F" (in liquidation). The objective of S&P and A.M. Best's ratings systems is to provide an opinion of an insurer's or reinsurer's financial strength and ability to meet ongoing obligations to its policyholders. These ratings reflect our ability to pay policyholder claims and are not applicable to our securities, nor are they a recommendation to buy, sell or hold our shares. These ratings are subject to periodic review by, and may be revised or revoked at the sole discretion of, S&P and A.M. Best.
Insurance premiums written are generally defined in the associated policies, are recorded on the inception date of the policies and are earned over the terms of the policies in proportion to the amount of insurance protection provided. Typically this results in the earning of premium on a pro rata as to time basis over the term of the related insurance coverage.
Reinsurance premiums on multi-year losses occurring reinsurance contracts that are payable in annual installments are recorded as premiums written on an annual basis at inception and on the contract anniversary dates if the reinsured has the ability to cancel, commute or change the coverage during the contract term or if the contract provides for varying amounts of reinsurance coverage for each annual period for which there is a specified premium installment.
For those contracts that transfer significant underwriting risk only and for reinsurance contracts where it is not reasonably possible that we can realize a significant loss even though we assume significant insurance risk, the deposit asset or liability is measured based on the unexpired portion of the coverage provided. The deposit asset or liability is adjusted for any losses incurred or recoverable based on the present value of the expected future cash flows arising from the loss event with the adjustment being recorded in net losses and loss expenses within our results of operations.
During the years ended December 31, 2005 and 2004, we recognized in "other income" $2.5 million and $1.2 million of fees and revenues relating to non-traditional contracts which we accounted for using the deposit method. If these contracts transferred risk as determined by Statement of Financial Accounting Standards ("SFAS") No. 113 "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts", gross premium relating to these contracts would total approximately $110.7 million and $44.0 million in the years ended December 31, 2005 and 2004.
Of the $2.5 million and $1.2 million, $0.7 million and $0.1 million of other income recognized during the years ended December 31, 2005 and 2004 relate to fees earned from a surplus relief life reinsurance arrangement with a U.S. insurance company which meets the Company's definition of a non-traditional contract. As of December 31, 2005 and 2004, the Company has provided approximately $13.1 million and $13.8 million of statutory surplus relief to the U.S. insurance company under this contract. In the fourth quarter of 2004, under this contract the Company entered into an arrangement with a client and assumed, through novation agreements, several life reinsurance contracts it had made. Because the Company assumed these contracts, the client, which is subject to insurance regulation in the United States and therefore is required to maintain a certain amount of statutory capital, may reduce its statutory capital requirements. In exchange for the Company's assumption of the contracts it received a fee. The arrangement, among other things, also provides that on certain dates and during specific periods, the client has the right but not the obligation to recapture the life reinsurance contracts the Company has assumed, provided that the underlying cedants do not reasonably withhold their consent to this recapture. The Company believes that its client is economically incentivized to exercise the recapture provision in the future, as the amount of expected profit on the underlying life reinsurance contracts emerges over time.
In respect of the life reinsurance arrangements written on a coinsurance basis, where investment assets have been transferred to the Company, such assets have been recorded within the Company's trading investment portfolio and are separately presented as Investments related to deposit liabilities in the consolidated balance sheet. A deposit liability has been recorded in the consolidated balance sheet in accordance with SFAS 97 "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments" for non-risk investment contracts as an interest bearing instrument using the effective yield method. The Investments related to deposit liability are held in trust funds and are pledged to the ceding companies.
In respect of the life reinsurance arrangements written on a modified coinsurance basis, the ceding company's net statutory reserves and assets are withheld and remain legally owned by the ceding company. These modified coinsurance contracts represent "non-cash" financial reinsurance transactions, whereby, in accordance with the contract terms, there are no net cash flows at inception
of contracts, nor are there expected to be net cash flows through the life of the contracts, other than the Company's explicitly defined fees. Notional contract assets and liabilities contemplated by the contract terms are offset in accordance with FIN 39 and as such the Company does not present such assets or deposit liabilities in its consolidated balance sheet.
Certain of the Company's coinsurance and modified coinsurance agreements may contain provisions that qualify as embedded derivatives under Derivatives Implementation Group Issue No. B36 "Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposures That Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor under Those Instruments" ("DIG Issue B36") The value of embedded derivatives in these contracts is currently considered immaterial. The Company monitors the performance of these treaties on a quarterly basis. Significant adverse performance or changes in the Company's expectations of future cashflows on these treaties could result in losses associated with the embedded derivative.
Of the $2.5 million and $1.2 million, $0.2 million and $0.8 million of other income recognized during the years ended December 31, 2005 and 2004 relate to explicitly defined margins on one short duration contract written by the Company's specialty reinsurance segment that does not meet the risk transfer provisions of SFAS 113. This contract was written on a funds withheld basis, such that the deposit liability of $21.7 million and $6.2 million recorded is equal to a funds withheld asset according to the contract terms. In accordance with Financial Accounting Standards Board ("FASB") Interpretation No. 39 ("FIN 39") "Offsetting of Amounts Related to Certain Contracts", the funds withheld asset and the deposit liability have been offset in the consolidated balance sheet.
In accordance with SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," we periodically review our investments to determine whether an impairment, being a decline in fair value of a security below its amortized cost, is other than temporary. If such a decline is classified as other than temporary, we would write down, to fair value, the impaired security resulting in a new cost basis of the security and the amount of the write-down would be charged to the
The estimation of future ultimate loss liabilities is the most significant judgment made by management and is inherently subject to significant uncertainties. These uncertainties are driven by many variables that are difficult to quantify and include, for example, the period of time between the occurrence of an insured loss and actual settlement, fluctuations in inflation, prevailing economic, social and judicial trends, legislative changes, internal and third-party claims handling procedures, and the lack of complete historical data on which to base loss expectations. It may also be difficult for us to accurately estimate ultimate losses based on our own historical claim experiences because of our limited operating history.
amount of relevant loss experience that we can use to quantify the emergence, severity and payout characteristics of the loss liabilities is limited for policies that are written with the expectation that potential losses will be characterized by lower frequency but higher severity claims, such as many of our reinsurance contracts written.
The primary reserving method we used to estimate the ultimate cost of losses for our other specialty insurance business lines was an expected loss ratio methodology whereby earned premiums are multiplied by an expected loss ratio to derive ultimate losses and deducts any paid losses and loss expenses to arrive at estimated losses and loss expense reserves. This method is commonly applied when there is insufficient historical loss development experience available. Our initial expected losses and loss expense ratios selected are based on benchmarks derived by our underwriters and actuaries during the initial pricing of the business and from comparable market information. These benchmarks are then adjusted for any rating increases and changes in terms and conditions that have been observed in the market.
As of December 31, 2003, given our limited operating history and historical claims experience, the primary reserving method adopted was an expected loss ratio methodology whereby earned
As of December 31, 2005, a 10% change in our reserves for loss and loss expenses of $343.6 million would equate to a $34.4 million change in our reserves for loss and loss expenses, which would represent 32.4% of our net loss for the year ended December 31, 2005 and 8.9% of our shareholders' equity as of December 31, 2005.
In our technical services segment we assume environmental liabilities in exchange for remediation fees and contracts to perform the required remediation in accordance with the underlying remediation agreements. We estimate our initial and ongoing ultimate liabilities for such environmental remediation obligations using actual experience, past experience with similar remediation projects, technical engineering examinations of the contaminated sites and state, local and federal guidelines. However, we cannot assure you that actual remediation costs will not significantly differ from our estimated amounts. We continually review our estimates for ultimate remediation costs taking into account all currently known information and updated assumptions related to unknown information. Any adjustments to previously established liabilities, resulting from a change in our estimates, may significantly impact our current period operating results. As of December 31, 2005, we had assumed two environmental remediation projects for which we have recorded an estimated liability of $5.9 million.
When we receive consideration for the assumption of a remediation liability that is in excess of our estimate of the related environmental remediation liability, we initially defer the excess amount and record it in deferred income on the consolidated balance sheet. This deferred remediation revenue is recognized in earnings over the anticipated remediation period using the cost recovery or percentage-of-completion method that is based on the ratio of remediation expenses actually incurred and paid to total anticipated remediation costs. As of December 31, 2005, we had deferred approximately $0.5 million of remediation revenue that was included in deferred income.
Technical services revenue is primarily derived from short-term technical services arrangements with customers. Generally, technical services revenue is earned in the period for which
The majority of our other accounts receivable balances comprise amounts due under technical services arrangements with customers. We establish bad debt allowances, or valuation reserves, based on specific identification of likely losses of accounts with individual customers. We periodically re-evaluate these valuation reserve estimates, if any, and adjust them as more information about the ultimate collectibility of accounts receivable becomes available. Circumstances that could cause these valuation reserves to be revised include changes in our clients' financial standing such as liquidity and credit quality, and other factors that negatively impact our clients' ability to pay their obligations as they become due.
In March 2005, the Staff of the SEC issued Staff Accounting Bulletin No. 107 ("SAB 107") providing guidance on SFAS 123(R). SAB 107 was issued to assist issuers in their initial implementation of SFAS 123(R) and enhance the information received by investors and other users of the financial statements.
As permitted by SFAS 123, the Company currently accounts for share-based payments to employees using APB 25's intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of SFAS 123(R)'s fair value method will have a significant impact on our result of operations, although it will have no impact on our overall financial position. The impact of adoption of SFAS 123(R) during the year ended December 31, 2006 will be approximately $1.4 million, however, this may vary depending on levels of share-based payments granted during 2006. However, had we adopted SFAS 123(R) in prior periods, the impact of that standard would have approximated the impact of SFAS 123 as described in the disclosure of pro forma net loss and loss per share in Note 2(s) to our consolidated financial statements.
We primarily enter into investment related derivative transactions, as permitted by our investment guidelines, and typically for the purposes of managing investment duration, interest rate and foreign currency exposure, and enhancing total investment returns. We may also, as part of our business, enter into derivative transactions for the purpose of replicating approved investment, insurance or reinsurance transactions that meet our investment or our underwriting guidelines. As of December 31, 2004, we held in our available-for-sale fixed maturity portfolio a mortality-risk-linked security for which the repayment of principal was dependent on the performance of a specified mortality index. The component of the bond that was linked to the mortality index had been determined, under SFAS 133, to be an embedded derivative that was not clearly and closely related to its host contract (a debt security) and was therefore bifurcated and accounted for as a derivative under SFAS 133. This security was sold during the year ended December 31, 2005. We have not designated any of our derivative instruments as hedging instruments.
which was 25% of the award and was paid in 2005 and the second of which will be 75% of the award and will be paid in 2006. Unvested amounts are subject to be adjustments to the extent that estimates of calendar year profit and estimated net present value deviate from initial estimates as assumptions are updated and actual information becomes known.
We recognize expenses related to Annual Incentive Plan awards by applying the graded vesting method as prescribed by Financial Accounting Standards Board Interpretation No. 28 "Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans" ("FIN 28"). We continually review and adjust our provisions for Annual Incentive Plan awards and other bonus awards taking into account known information and updated assumptions related to unknown information. Award provisions are necessarily an estimate and amounts established in prior periods are adjusted in our current results of operations as new information becomes available to us. Any adjustments we make to previously established provisions or the establishment of new provisions may significantly impact our current period results and net income.