The most significant accounting estimates relate to the Company’s reserves for unpaid losses and LAE. Unpaid losses and LAE include reserves for both reported (case reserves) and IBNR.
When the Company is notified of insured losses, claims personnel set up case reserves for the estimated amount of settlement, if any, which excludes estimates of expenses to settle claims, such as legal and other fees and the general expenses of administering the claims adjustment process. The estimate reflects the judgment of claims personnel, or of independent claims adjusters hired by the Company, the scope of coverage available for the reported claim under each individual policy assuming application of controlling state contract law, general reserving practices, the experience and knowledge of such personnel regarding the nature of the specific claim and, where appropriate, advice of counsel, with the goal of setting the reserve at the ultimate expected loss amount as soon as sufficient information becomes available. The facts of the specific claim are investigated and case reserves are established as soon as reasonably possible as follows:
General Liability - an individual investigation of each loss reported is undertaken and the claims personnel, using their experience and judgment, establish a case reserve in an amount estimated to be the most likely ultimate loss amount to be paid considering the assumed jurisdiction where the claim is pending and the applicable law of allowable direct and consequential damages and defenses; the effect, if any, of the particular venue, including settlement and verdict values; and, where applicable, the advice of counsel retained to represent the defendant in the individual case.
Property - an individual investigation of each loss reported is undertaken by claims personnel, including conducting on site physical inspections of the covered property in determining the scope of damage. Case reserves are established consistent with the coverages provided under the specific policy applicable to the loss. Depending upon the severity of the loss and coverage part or parts implicated in the specific claim reported, claims personnel may retain the services of experts such as certified building consultants, salvors, forensic accountants, or construction engineers to assist in projecting the ultimate loss to be reserved and paid on an individual claim basis. In the event of a catastrophe loss, assumptions are made based upon the number of risks in the affected area and the severity of the catastrophic events.
Workers’ Compensation - medical inflation, willingness of insured to settle claims, case reserve for known claims, long payment period for the medical portion of claims, expected loss ratios for more recent accident years and legal jurisdiction of the claim.
The following table presents the impact of a 2% change in ultimate loss and ALAE ratio for each line of business for the accident years shown. The years were selected to include those years where management considers a 2% change in ultimates to be a reasonably likely outcome. The 2% change was selected to represent a reasonably likely change in one of the factors described above. For example, for workers’ compensation, this could be due to changes in medical inflation or claim settlement rates. For general liability, this could be due to court award inflation.
Consideration may also be given to the results of actuarial reserve reviews conducted by the Company’s independent actuaries. Management considers a “best estimate” to be one where the total reserves have an equal likelihood of developing a redundancy or deficiency as the loss experience matures. Following the completion of each semi-annual internal actuarial reserve review, management reviews the actuarial reserve valuation with the Company’s actuaries and compares the indicated reserve levels by line of business to the corresponding recorded reserves. In general, management’s best estimate will approximate the internal actuaries’ point estimates. There may, however, be circumstances in which management chooses not to adjust its best estimate for assumptions made by its actuaries regarding emerging trends - positive or negative - until the passage of further time or additional information has confirmed the credibility of the trend. At December 31, 2007, the Company’s actuaries concurred with the reasonableness of management’s best estimate.
The Company recorded $50.2 million, $85.9 million and $60.5 million of prior period favorable loss development before corporate aggregate reinsurance for 2007, 2006 and 2005, respectively. After corporate aggregate reinsurance, the prior period favorable loss development was $63.9 million, $96.2 million and $68.6 million for 2007, 2006 and 2005, respectively. In 2007, the net favorable development before corporate aggregate reinsurance was primarily attributable to favorable development across all major casualty lines as well as commercial multi-peril with the largest redundancy being recognized in workers’ compensation. Specifically, favorable development in the workers’ compensation line was principally attributable to favorable results in non-California for older accident years due to favorable claim settlements and continued recognition of favorable development for California in accident years 2004 and 2005 due to the impact of industry reforms. Favorable development for general liability and commercial multi-peril exposures in accident years 2003 through 2006 was due to the selection of faster loss development factors, recognizing decreased loss activity in those years. The favorable development in these lines was partially offset by $54.5 million of adverse development of asbestos, environmental and other latent liabilities. Of the $54.5 million adverse development, $24.3 million of the increase was in asbestos reserves, $22.2 million was in environmental reserves and $8.0 million was in other latent reserves. The strengthening of asbestos reserves was principally due to developments related to one asbestos policyholder. The strengthening of environmental reserves was due to a newly reported large claim, identification of additional policies associated with existing policyholders and a slight increase in the number of sites for policyholders with previously reported claims. In addition, the Company also incurred losses for settlements which secured broader releases on certain active exposures. For other latent reserves, the increase was due in part to a policyholder with both asbestos and silica claims. In 2007, the exposures for silica were identified as the predominant exposure for this policyholder and the reserves were established in other latent.
The net favorable development in 2005 before corporate aggregate reinsurance was comprised of three principal components: (i) adverse development of asbestos, environmental and other latent liabilities of $44.6 million, primarily due to developments related to one asbestos policyholder and largely offset by favorable emergence of non-latent umbrella and other casualty reserves in accident years 1998 and prior, (ii) $24.7 million of strengthening of prior year reserves for the surety line of business, a line the Company exited in 2005, and (iii) net favorable development of the Company’s remaining property and casualty reserves of $97.5 million, arising from accident years 1999 through 2004.
Asbestos is the most significant and difficult mass tort for the insurance industry in terms of claim volume and dollar exposure. The litigation environment has become increasingly adverse. Plaintiffs, including individuals that do not appear to be impaired by asbestos exposure, often are able to choose from a number of potential venues to bring an action in the court that they expect will be most advantageous to their claims. Many of the lawsuits are filed in a small number of plaintiff-oriented jurisdictions, where significant verdicts historically have been rendered against commercial defendants. Management believes that the insurance industry has been adversely affected by judicial interpretations that have had the effect of maximizing insurance recoveries for asbestos claims, from both a coverage and liability perspective. Even when these claims are resolved without loss payment, as a large portion of them are, significant costs are incurred to defend the claims.
Tort reform in certain jurisdictions initially resulted in increased filings by plaintiffs seeking to avoid the potential effective date of the reform legislation in 2003. Since 2004, insurers, including Crum & Forster, generally experienced either flat or slightly decreased frequency in numbers of newly reported asbestos-related claims due to, among other things, tort reform in certain jurisdictions previously known for large volume filings. It is generally expected throughout the industry that this trend will continue. Offsetting this trend is the general industry view that the severity of the new claims being presented has significantly increased, likely as a result of fewer non-malignancy claims being made.
Reserves for asbestos cannot be estimated with traditional loss reserving techniques that rely on historical accident year loss development factors. Since each policyholder presents different liability and coverage issues, the Company evaluates its asbestos exposure on a policyholder-by-policyholder basis. Crum & Forster utilizes sophisticated methodologies, which draw upon Company experience and supplemental databases, to assess asbestos liabilities on reported claims. These methodologies utilize comprehensive ground-up, exposure-based analyses.
In 2007, the trends noted previously have continued, including stable numbers of claimants filing asbestos claims against the Company’s policyholders, increased value of claims against viable asbestos defendants as co-defendants seek bankruptcy protection and an increased number of policyholders asserting that their asbestos claims are not subject to aggregate limits and that each individual bodily injury claim should be treated as a separate occurrence. In general, a small percentage of policyholders account for the majority of paid losses. In 2007, 90% of gross payments for loss and allocated loss adjustment expenses were made on behalf of approximately 2% of policyholders.
As a result of the processes, procedures and analyses described above, management believes that the reserves carried for asbestos claims at December 31, 2007 are adequate based upon known facts, current law and management’s judgment. However, there are a number of uncertainties surrounding the ultimate value of these claims, which may result in changes in these estimates as new information emerges. Among these are the following: the unpredictability inherent in litigation; any impact from the bankruptcy protection sought by asbestos producers and defendants; an unanticipated increase in the number of asbestos claimants; the resolution of disputes pertaining to the amount of coverage for “non-product” claims asserted under premises/operations general liability policies; and future developments regarding the ability to recover reinsurance on asbestos claims. It is also not possible to predict, nor has management assumed, any changes in the legal, social or economic environments and their impact on future asbestos claim development. The carried asbestos reserves also do not reflect any effects of future legislation.
An analysis of gross and net reserves from asbestos exposures is presented in Note 5 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
There is great uncertainty involved in estimating liabilities related to these exposures. First, the number of waste sites subject to cleanup is unknown. Currently, approximately 1,245 cleanup sites are included in the EPA’s National Priorities List. State authorities have identified many additional sites. Second, the liabilities of the policyholders themselves are difficult to estimate. At any given site, the allocation of remediation cost among the PRPs varies greatly depending upon a variety of factors. Third, different courts have been presented with liability and coverage issues regarding pollution claims and have reached inconsistent decisions on several issues. These uncertainties are unlikely to be resolved in the near future.
New reports for environmental claims are trending downward while the cost of the remedy in certain jurisdictions has increased. Claims against Fortune 500 companies are declining, and, while policyholders with single-site exposures are still active, the Company has resolved the majority of disputes with respect to policyholders with a large number of sites. In many cases, claims are being settled more expeditiously due to improved site remediation technology and effective policy buybacks. However, due to the high level of uncertainty, revisions to these reserve estimates could have a material impact on the Company’s results of operations in the period recognized and the ultimate actual payments for claims and ALAE could turn out to be significantly different from estimates.
For additional discussion on the Company’s reserves, see “Item 1. Business - Reserves” and Notes 4 and 5 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
Declines in the market value of invested assets below carrying value are evaluated for other than temporary impairment losses on a quarterly basis. Management considers an impairment as “other than temporary” if evidence indicating that an investment’s carrying amount is recoverable within a reasonable period of time, which in the case of fixed income securities, may mean until maturity, is outweighed by evidence to the contrary. Management also considers its ability and intent to hold an investment until such recovery of the security’s fair value. Notwithstanding the foregoing, with respect to fixed income securities, an impairment may be considered other than temporary if it is probable that the Company will be unable to collect all amounts due under the terms of the securities. Recognition of impairment losses for declines in the value of fixed income and equity securities attributable to issuer-specific events are based upon all relevant facts and circumstances for each investment. Factors considered by management include, but are not limited to, the impact of issuer-specific events, current and expected future market and economic conditions, the nature of the investment, the number of investment positions with losses, the severity and duration of the impairment and the volatility of the security’s market price.
Derivatives and hybrid financial instruments currently held by the Company include credit default swaps, warrants, options purchased to limit the potential loss on the Company’s short-sales of Standard & Poor’s Depositary Receipts (“SPDRs”) and convertible securities. These securities are carried at estimated fair values on the consolidated balance sheets, with changes in fair value recorded in net income in the period in which they occur. The Company obtains market-derived fair values for its credit default swaps from third-party providers, principally broker-dealers. In addition, the Company assesses the reasonableness of the fair values obtained from these providers by comparing the fair values to values produced using individual issuer credit default swap yield curves, by referencing them to movements in credit spreads and by comparing them to recent market transaction prices for similar credit default swaps where available. The fair values of credit default swaps are subject to significant volatility arising from the potential differences in the perceived risk of default of the underlying issuers, movements in credit spreads and the length of time to the contracts’ maturity. Due to the inherent uncertainties of these valuations as well as the volatility in interest rates and stock market conditions, realized values may differ from estimates reflected in the consolidated financial statements.
At December 31, 2007, the fair value of the derivatives and hybrid financial instruments was $240,015 and $125,848, respectively. At December 31, 2006, the fair value of the derivatives and hybrid financial instruments was $43,643 and $0, respectively. Gains or losses arising from changes in the fair value of these securities are recorded in realized investment gains and losses in the consolidated statements of income. For the years ended December 31, 2007, 2006 and 2005, realized investment gains (losses) resulting from the net change in fair value of the derivatives and hybrid financial instruments was $200,367, $(27,969) and $(36,918), respectively.
At December 31, 2007 and 2006, reinsurance recoverable was $1,539.8 million and $1,733.9 million, net of reserves for uncollectible reinsurance of $50.0 million and $42.8 million, respectively. Bad debt expense for the years ended December 31, 2007, 2006 and 2005 related to uncollectible reinsurance was $8.0 million, $9.5 million and $7.2 million, respectively. While management believes the allowance for uncollectible reinsurance recoverable is adequate based on information currently available, failure of reinsurers to meet their obligations could have a material adverse impact on the Company’s financial position and results of operations. At December 31, 2007, the five largest gross reinsurance recoverable balances aggregated $1,001.1 million, or approximately 65.0% of the total reinsurance recoverable balance. Application of collateral reduces the unsecured exposure to these five reinsurers to $352.7 million. The largest unsecured balance at December 31, 2007 was $150.1 million, due from an unaffiliated company rated A+ by A.M. Best.
Although realization is not assured, management believes the recorded deferred tax assets are fully recoverable based on estimates of the future profitability of Crum & Forster’s taxable subsidiaries and current forecasts for the periods through which losses may be carried back and/or forward. The Company has several material deferred tax assets, including deferred gain on retroactive reinsurance, loss reserve discounting, undistributed income of foreign investments and unearned premium adjustment. The realizability of these reversing deferred tax assets is considered in conjunction with similar originating deferred tax assets and other taxable income.
The Company is a national commercial property and casualty insurance company with a focused underwriting strategy, targeting specialty classes of business and underserved market opportunities. Operating through its home office and regional branch network, the Company writes a broad range of commercial coverage, including workers’ compensation, general liability, commercial automobile, property, commercial multi-peril, accident and health and other lines of business. The Company generally conducts business on a brokerage basis through more than 1,300 producers located throughout the United States.
The property and casualty insurance business is cyclical and influenced by many factors, including price competition, economic conditions, natural and man-made disasters (for example, hurricanes, earthquakes and terrorism), availability and cost of reinsurance, interest rates, state regulations, court decisions and changes in the law. The property and casualty market has experienced increased competition since 2004. Price increases in casualty lines slowed considerably in 2004 and since 2005 casualty risks have generally been written at or below expiring prices. The casualty market softened throughout 2006, particularly for California workers’ compensation policies in reaction to workers’ compensation system reforms and very favorable industry accident year results. In 2007, pricing pressure for casualty accounts intensified countrywide, particularly for larger accounts with competitors focusing on retaining their renewals, making it very challenging to acquire new business. While property risks were generally written at or below expiring prices commencing through 2004 and 2005, the property market experienced a brief turnaround in the first nine months of 2006 in the wake of the 2005 hurricane activity. However, the market began to soften again in the fourth quarter of 2006, fueled by the mild hurricane season and this market softening has continued through 2007, becoming more pronounced mid-year, with several major competitors offering more capacity in the coastal wind areas and greater capacity and more competitive pricing in non-catastrophe exposed business.
The decrease in net income in the year ended December 31, 2007 as compared to 2006, was due to the combined effects of lower underwriting profit, lower investment earnings and higher debt retirement costs, partially offset by higher equity in earnings from investees. The decline in underwriting profit was primarily attributable to lower favorable development of prior years’ losses and LAE of $63.9 million in 2007, as compared to $96.2 million in 2006, partially offset by an improved accident year loss ratio. The decline in investment income and realized investment gains was primarily attributable to the significant level of realized investment gains achieved on the sale of certain fixed income and equity securities, as well as higher earnings from HWIC Asia Fund (“HWIC”), an affiliated equity method investee, and higher earnings from other partnerships in 2006. Partially offsetting these effects were the significant mark-to-market gains on the Company’s credit default swaps in 2007.
For the year ended December 31, 2007, gross premiums written associated with the Company’s core commercial lines of business (excluding accident and health and “other” lines of business in the table above) declined by approximately $167.8 million, or 13.4%, as compared to the year ended December 31, 2006, primarily due to a decline in new business of 28% and price decreases on renewal policies of approximately 8%, partially offset by a modest increase in the renewal retention rate of approximately two percentage points. The decline in new business was largely due to a decrease in property and general liability writings. The decline in gross premiums written in the core commercial lines was partially offset by significant growth from the accident and health business.
For the year ended December 31, 2007, gross premiums written in casualty lines, which include workers’ compensation, general liability and commercial automobile lines of business, decreased by $81.8 million, or 10.3%, as compared to the year ended December 31, 2006, due to a decline in new business of approximately 24% and price decreases on renewal policies of approximately 8%, partially offset by an increase in renewal retention rates of approximately three percentage points. The decline in new business was largely due to a decrease in general liability writings, attributable to the non-admitted business, where the market became significantly softer, leading to fewer new policies and at a reduced average premium per policy.
For the year ended December 31, 2007, other gross premiums written, which include the accident and health, surety, personal automobile and homeowners lines of business, increased by $61.2 million, or 63.4%, as compared to the year ended December 31, 2006 primarily due to significant growth in the Company’s accident and health book of business. Previously written in the “B++” rated Fairmont companies, the accident and health business has particularly benefited from Crum & Forster’s “A−” A.M. Best rating.
For the year ended December 31, 2006, net premiums written increased by $297.5 million, or 34.2%, as compared to the year ended December 31, 2005, which was generally in line with the growth in gross premiums written after giving effect to increased retention on various lines of business and corresponding reduced premium cessions as well as reinsurance reinstatement premiums of $39.3 million associated with catastrophe losses in 2005. Offsetting the increase in part were higher property catastrophe reinsurance costs in 2006. Excluding Fairmont, net premiums written increased by $133.1 million or 15.3%.
For the year ended December 31, 2006, premiums earned increased by $189.8 million, or 21.2%, as compared to the year ended December 31, 2005. Excluding Fairmont, premiums earned increased by $81.8 million, or 9.1%, in the year ended December 31, 2006 as compared to the year ended December 31, 2005. The lower increase in premiums earned relative to net premiums written was principally attributable to the lag in recognition of the increase in premiums written throughout 2006.
The Company’s losses and LAE reflect the effect of corporate aggregate reinsurance, including the amortization of deferred gain on retroactive reinsurance. For further discussion of the accounting for reinsurance coverage and the amortization of deferred income on retroactive reinsurance, see “Item 1. Business - Reinsurance” and Note 6 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
In 2007, the Company recognized net favorable prior year loss development of $50.2 million (4.2 loss ratio points) prior to corporate aggregate reinsurance activity. The net favorable development was comprised of favorable development across all major casualty lines as well as commercial multi-peril, with the largest redundancy being recognized in workers’ compensation. Specifically, favorable development in the workers’ compensation line was principally attributable to favorable results in non-California for older accident years due to favorable claims settlements and continued recognition of favorable development for California in accident years 2004 and 2005 due to the impact of industry reforms. Favorable development for general liability and commercial multi-peril exposures in accident years 2003 through 2006 was due to the selection of faster loss development factors, recognizing decreased loss activity in those years. The favorable development in these lines was partially offset by $54.5 million of adverse development of asbestos, environmental and other latent liabilities.
Accident year loss and LAE ratios, as estimated at December 31, 2007 by line of business, net of per risk reinsurance but before the benefit of corporate aggregate reinsurance, are summarized as follows:
The accident year loss and LAE ratios represent management’s estimate, at December 31, 2007, of the ultimate cost, expressed as a percentage of net premiums earned for each respective year, of covered claims or events, including settlement costs. For casualty lines of business in particular, where the “tail”, or period from the occurrence of the claim to final settlement, may span several years, the estimates are based on a number of assumptions and, accordingly, are subject to significant variability. See “- Critical Accounting Policies and Estimates - Unpaid Losses and Loss Adjustment Expenses”.
Underwriting expenses are comprised of policy acquisition costs and other underwriting expenses. Policy acquisition costs are those costs that vary with and are primarily related to the acquisition of new and renewal policies and are comprised of commissions paid to producers and premium taxes. Other underwriting expenses consist of all other operating expenses associated with the Company’s underwriting activities, including salaries and benefits, information technology and rent. The Company’s underwriting expense ratio was 28.7%, 29.0% and 28.5% for the years ended December 31, 2007, 2006 and 2005, respectively. The policy acquisition ratio and the other underwriting expense ratio components of the underwriting expense ratio follow:
The Company’s policy acquisition expense ratio increased to 15.0% for the year ended December 31, 2007 from 14.3% for the year ended December 31, 2006, primarily due to higher direct commission rates and lower reinsurance ceding commissions attributable to higher retained limits. The Company’s policy acquisition expense ratio increased to 14.3% in 2006 compared to 14.1% in 2005 as a result of lower reinsurance ceding commissions, partially offset by the favorable effect of a lack of reinsurance reinstatement premiums associated with catastrophes in 2006. The Company’s other underwriting expense ratio improved to 13.7% for the year ended December 31, 2007, from 14.7% for the year ended December 31, 2006, primarily due to the growth in earned premiums. The Company is currently operating in a soft market and, should such conditions persist and premiums earned decline, the other underwriting expense ratio may be adversely affected in 2008.
The Company manages its investment portfolio with an emphasis on total return on assets under management. Total return for the period is the sum of investment income (including pre-tax equity in earnings of investees), realized investment gains and losses and changes in the market value of the portfolio expressed as a percentage of the average book value of the portfolio during the period. Total rate of return on investments was 13.3%, 7.2% and 6.6% for the years ended December 31, 2007, 2006 and 2005, respectively. General economic conditions, stock market conditions, fluctuations in interest rates and many other factors can affect the returns on investments and the Company’s ability to control the timing of the realization of investment income. In addition, the Company also owns a number of investments in derivative securities, including credit default swaps, and equity method investments, which are subject to greater volatility than fixed income investments. Although these derivative securities and equity method investments may provide higher expected returns, they present greater risk and are less liquid than fixed income investments. As a result of these factors, the Company’s return on its investments may fluctuate from year to year.
The increase in investment income of $88.9 million, or 67.8%, in 2006 as compared to 2005 was primarily attributable to higher earnings from HWIC of $48.5 million and higher partnership earnings of approximately $20.2 million. For further details on certain accounting adjustments in respect of investments, see Note 14 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”. Additionally, in 2006, the Company also benefited from increased interest income earned on cash and cash equivalents due to higher short term interest rates and greater invested portfolio assets as well as lower funds held interest expense associated with a retroactive reinsurance contract. For further discussion of corporate aggregate reinsurance activity, see Note 6 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
Included in realized investment gains are mark-to-market gains or losses attributable to changes in fair value of the Company’s derivative securities, short-sale obligations and hybrid financial instruments. In 2007, realized investment gains included $156.7 million of mark-to-market gains as compared to mark-to-market losses of $73.5 million included in realized investment gains in 2006. The increase in realized investment gains of $61.3 million, or 35.5%, in 2007 as compared to 2006 was primarily due to significant gains on the credit default swaps. During 2007, the Company recorded net gains of $19.3 million on sales of $121.3 million notional amount of credit default swaps and net mark-to-market gains on credit default swaps of $210.4 million, as compared to net mark to market losses of $23.9 million in 2006. Partially offsetting the increase in realized investment gains on the credit default swaps was a decline in the level of net gains achieved on the sale of fixed income and equity securities to $15.1 million in 2007 as compared to $239.6 million in 2006, which included a $106.6 million gain on the sale of Zenith common stock and a $45.0 million gain on the sale of a fixed income security.
The increase in realized investment gains of $88.6 million in 2006 over 2005 was due to combined effects of the aforementioned specific gains as well as higher realized gains from the sale of equity securities, partially offset by lower realized investment gains on the sale of U.S. Treasury securities, higher realized losses on the change in fair value of the short-sale obligations and other derivatives and other than temporary impairment charges. For further details on certain accounting adjustments in respect of investments, see Note 14 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
Included in realized investment gains in 2007, 2006 and 2005 were $25.4 million, $15.9 million and $3.9 million, respectively, of losses related to other than temporary impairments.
The increase in pre-tax equity in earnings of investees of $15.6 million, or 77.2%, in 2007 as compared to 2006 was primarily attributable to higher earnings from Northbridge. In 2007, Northbridge reported significant realized investment gains, attributable to the gain on the sale of its investment in Hub International Limited. Northbridge contributed $35.1 million, $17.9 million and $26.3 million, to the Company’s pre-tax equity in earnings of investees in 2007, 2006 and 2005, respectively. The decrease in pre-tax equity in earnings of investees in 2006 as compared to 2005 was primarily attributable to lower earnings from Northbridge. Northbridge’s earnings in the year ended December 31, 2006 were affected by equity adjustments and mark-to-market adjustments in respect of the derivative features embedded in convertible securities. For further details on certain accounting adjustments in respect of investments, see Note 14 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
As a holding company with no direct operations, Crum & Forster Holdings Corp.’s (referred to in this section as the Company) assets consist primarily of its investments in the capital stock of its insurance subsidiaries. The Company requires cash to meet its annual debt service obligations (approximately $26.0 million per year), to pay corporate expenses and, ultimately, to repay the $334.3 million aggregate principal amount of senior notes, $4.3 million of which is due in 2013 and $330.0 million of which is due in 2017. After June 15, 2008, the Company may redeem, and intends to redeem as soon after June 15, 2008 as administratively possible, the $4.3 million senior notes due 2013 at the redemption price of 105.188%. The Company’s ability to satisfy its corporate obligations is primarily dependent on the dividend paying capacity of its subsidiaries. State insurance laws restrict the amount of shareholder dividends that insurance companies may pay without prior approval of regulatory authorities.
The ability of the Company’s insurance subsidiaries to pay dividends depends, among other things, on such subsidiaries having positive statutory earned surplus. The Company’s principal insurance subsidiaries are US Fire and North River. At December 31, 2007, US Fire reported statutory earned surplus of $481.2 million and North River reported statutory earned surplus of $80.2 million. On March 29, 2007, US Fire paid a dividend in the amount of $97.3 million to the Company. The payment included $9.0 million of HWIC Asia Fund stock at market value and $88.3 million of cash. On May 14, 2007, North River paid a cash dividend in the amount of $40.9 million to the Company.
Cash used in financing activities was $118.5 million, $90.0 million and $73.5 million in 2007, 2006 and 2005, respectively, and was primarily in respect of dividends paid to Fairfax as well as refinancing of the Company’s long-term debt in 2007. On March 29, 2007, May 29, 2007 and September 11, 2007, the Company paid cash shareholder dividends to Fairfax of $61.0 million, $30.0 million and $37.8 million, respectively. In addition, on September 11, 2007 and December 19, 2007, the Company paid further dividends to Fairfax of $41.9 million and $13.0 million, respectively, consisting of promissory notes.
Pursuant to a non-interest bearing standby credit agreement between Fairfax and the Company, under certain circumstances the Company has the ability to borrow up to $40 million from Fairfax to meet certain corporate obligations. Borrowings under this agreement, if any, bear no interest and are due in June 2018. Through December 31, 2007, there have been no borrowings under this agreement.
The table below shows a summary of cash flow from operations:
The unfavorable variance in operating cash flows in 2007 from 2006 is primarily attributable to higher net paid losses and higher underwriting expenses in the face of declining premiums due to competitive market conditions. The increase in net paid losses was primarily due to additional losses associated with the Fairmont business which was acquired in 2006 as well as higher net paid losses in the workers’ compensation and automobile lines of business. Expense growth reflected increased compensation and technology costs. The increase in cash flows from operations in 2006 as compared to 2005 reflected general business expansion driven by the assumption of the Fairmont business, partially offset by higher income taxes paid as a result of higher realized investment gains.
In 2007, 2006 and 2005, the Company pledged cash and U.S. Treasury securities as collateral for the Company’s short-sale obligations. The fair value of such collateral was $1,043.4 million, $535.6 million, and $496.9 million at December 31, 2007, 2006 and 2005, respectively. At December 31, 2007, the collateral was comprised of $734.9 million in cash and $308.5 million in U.S. Treasury securities. Interest earned on the collateral is included in investment income.
Statutory surplus is an important measure utilized by management, regulators and rating agencies to assess the Company’s ability to support its business operations. The increase in the Company’s combined statutory surplus in 2007 as compared to 2006 was primarily attributable to statutory net income of $191.7 million and statutory net unrealized capital gains of approximately $175 million (which are different from GAAP unrealized capital gains), partially offset by dividends of $138.2 million paid to the insurance companies’ parent. The increase in the Company’s combined statutory surplus in 2006 as compared to 2005 was primarily attributable to statutory net income of $253.3 million partially offset by dividends of $127.0 million paid to the insurance companies’ parent, and statutory net unrealized capital losses of $101.7 million. The Company’s ratio of statutory net premiums written to surplus, a measure of operating leverage, improved in 2007 and, according to data from A.M. Best, was below the property and casualty commercial lines sector ratios for 2007, 2006 and 2005 of 0.9x, 1.0x and 1.0x, respectively.
Estimates of future payments pursuant to the Company’s contractual obligations at December 31, 2007 are summarized as follows:
The Company has outstanding $334.3 million aggregate principal amount of senior notes comprised of $330.0 million 73/4% senior notes due 2017 and $4.3 million of 103/8% senior notes due 2013. Interest payments on such notes are approximately $26.0 million per year. After June 15, 2008, the Company may redeem, and intends to redeem as soon after June 15, 2008 as administratively possible, the $4.3 million senior notes due 2013, at the redemption price of 105.188%. For additional information on the Company’s senior notes, see Note 7 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data” and “- Liquidity and Capital Resources - Holding Company”.
The Company and its subsidiaries lease office space and equipment under long-term leases expiring through the year 2022. The amounts above represent the minimum contractual rentals for such operating leases at December 31, 2007. For more information on the Company’s operating leases, see Note 11 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
Included in other long-term liabilities are expected contributions to postretirement medical and life insurance benefit plans sponsored by the Company, estimated payments under the Company’s long-term incentive plans and retirement payments totaling approximately $7.1 million to the Company’s President and Chief Executive Officer, Mr. Antonopoulos. Mr. Antonopoulos retired as Chairman and Chief Executive Officer of Crum & Forster’s principal insurance subsidiaries as of January 1, 2008 and will retire as President and Chief Executive Officer of the Company as of March 8, 2008.
The postretirement medical and life insurance benefit obligations are estimated ultimate payments required to provide such benefits. Actual payments may differ significantly from these estimates. Although the Company provides various benefit plans, programs and arrangements to its employees, the Company has reserved the right to amend, modify or terminate these plans, programs or arrangements at any time, subject to the terms and conditions of such plans, programs or arrangements and applicable law. For more information on the Company’s postretirement benefit plans, see Note 10 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
The Company’s long-term incentive plans, which include the Crum & Forster Holdings Corp. Long Term Incentive Plan (“2004 LTIP”) and the Crum & Forster Holdings Corp. 2007 Long Term Incentive Plan (“2007 LTIP”), are compensation arrangements for certain of the Company’s employees who hold senior management or officer positions. Included in the amounts in the contractual obligations table above are estimated 2004 LTIP payments of $16.0 million in 2009 and $6.0 million in 2017. These amounts are based upon the December 31, 2007 valuation of the plan and are management’s best estimates. The actual payments could be materially different from these estimates. In addition, 2007 LTIP payments totaling $12.5 million are due in 2012.
Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2007, 2006 and 2005
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, of shareholder’s equity, of comprehensive income and of cash flows present fairly, in all material respects, the financial position of Crum & Forster Holdings Corp., an indirect wholly-owned subsidiary of Fairfax Financial Holdings Limited, and its subsidiaries at December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform our audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
These consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”) and include the accounts of the Company, Crum & Forster Holding Inc. and their wholly-owned subsidiaries, including United States Fire Insurance Company (“US Fire”), The North River Insurance Company (“North River”), Crum & Forster Indemnity Company (“CF Indemnity”) and Crum and Forster Insurance Company (“CF Insurance”). US Fire owns 100% of the stock of Crum & Forster Specialty Insurance Company. North River owns 100% of the stock of Seneca Insurance Company, Inc. and its subsidiaries. All material intercompany accounts and transactions have been eliminated in consolidation.
Effective January 1, 2006, Fairfax announced that certain of the business of the insurance companies of Fairmont Specialty Group, affiliates of Fairfax, would be conducted as Fairmont Specialty, a division of Crum & Forster (“Fairmont”), thereby giving Fairmont access to the “A-” A.M. Best rating of Crum & Forster. The Fairmont business is comprised of standard commercial and personal lines, bail bonds and accident and health coverages. In return for the opportunity to quote Fairmont Specialty Group’s renewals effective January 1, 2006 and thereafter, the Company hired substantially all Fairmont Specialty Group employees and assumed certain operating obligations. Pending regulatory approval of Crum & Forster company rate and form filings for the Fairmont business, the policies underwritten by Fairmont were issued initially by the insurance companies of Fairmont Specialty Group and assumed by the Company through a 100% quota share reinsurance agreement. As of December 31, 2007, substantially all Fairmont business is written directly by Crum & Forster.
The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and disclosure of contingent assets and liabilities. Such estimates and assumptions may differ from actual results. Certain amounts in the Company’s prior year consolidated financial statements have been reclassified to conform to the 2007 presentation.
Investments in entities that are consolidated subsidiaries of Fairfax, but are less than 50% owned by the Company as well as investments in certain partnerships, are carried under the equity method of accounting. For all other investments, the Company determines if it exercises significant influence based upon its ownership of shares without consideration of the ownership interest of other Fairfax affiliates. The Company’s pro-rata share of earnings of equity method investees is recorded in the consolidated statements of income. Earnings of investment companies and similar equity method investees are reported in investment income and earnings of other equity method investees are reported as equity in earnings of investees, net of tax. The carrying value of investment companies and similar equity method investees, includes limited partnerships, and is based upon the Company’s share of net asset value of each investee, as determined by the general partner. Dividends received from equity method investees reduce the carrying value of the investment.
Prior to January 1, 2007, in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”), the Company bifurcated all derivatives embedded in its convertible securities. The original host instruments were recorded at fair value in fixed income investments and the embedded derivatives were recorded at fair value in other invested assets. In February 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements Nos. 133 and 140 (“SFAS 155”). SFAS 155 applies to certain “hybrid financial instruments” which are instruments that contain embedded derivatives. The standard establishes a requirement to evaluate beneficial interests in securitized financial assets to determine if the interests represent freestanding derivatives or are hybrid financial instruments requiring bifurcation. SFAS 155 also permits an election for fair value measurement of any hybrid financial instrument that otherwise would require bifurcation under SFAS 133. Changes in fair value are recorded as realized investment gains or losses. The fair value election can be applied to existing instruments on an instrument-by-instrument basis at the date of adoption and to new instruments on a prospective basis. The statement was effective for fiscal years beginning after September 15, 2006. The Company elected fair value measurement of its convertible securities, effective with its adoption of SFAS 155 on January 1, 2007. At December 31, 2006, the fair value of the host instruments included in fixed income securities was $136,222 and the fair value of embedded derivatives included in other invested assets was $7,372. Upon adoption of SFAS 155, the Company recorded a cumulative adjustment of $10,146, net of an adjustment of $301 in respect of adoption of SFAS 155 by one of the Company’s equity method investees, net of tax, to reclassify unrealized investment gains associated with the host instruments to opening retained earnings. At December 31, 2007, the fair value of the Company’s hybrid financial instruments was $125,848.
All derivative and hybrid financial instruments are recognized as assets on the consolidated balance sheets and are measured at fair value. The majority of the Company’s derivative securities are credit default swaps for which the Company obtains fair values from third-party providers, principally broker-dealers. In addition, the Company assesses the reasonableness of the fair values obtained from these providers by comparing the fair values to values produced using individual issuer credit default swap yield curves, by referencing them to movements in credit spreads and by comparing them to recent market transaction prices for similar credit default swaps where available. The Company’s hybrid financial instruments are valued using market price data based on broker-dealer quotations. Broker-dealer quotations include quoted prices for identical or similar securities. Gains or losses arising from changes in the fair value of derivatives and hybrid financial instruments are recorded in realized investment gains and losses on the consolidated statements of income.
The Company considers highly liquid investments, which have an original maturity of three months or less, to be cash equivalents. Cash and cash equivalents on the balance sheet do not include cash pledged as security for the Company’s short-sale obligations.
Goodwill is subject to an assessment of impairment on an annual basis or more frequently under certain circumstances. The assessment of impairment involves a two-step process whereby an initial assessment for potential impairment is performed followed by a measurement of the impairment, if any. Impairments are charged to operations in the period in which the impairment occurs. The Company’s annual impairment tests in 2007 and 2006 resulted in a conclusion that no goodwill impairment has occurred. Goodwill in the amount of $7,311 is included in other assets on the consolidated balance sheets at December 31, 2007 and 2006.
For retroactive reinsurance contracts, the excess of reinsurance recoverable due from reinsurers pursuant to the contracts over premiums paid for such reinsurance coverage is deferred and amortized as a reduction of losses and LAE over the expected period of recovery using the interest method.
Insurance premiums are earned ratably over the terms of the related policies after deductions for premiums ceded to reinsurers. Unearned premium reserves are established for the unexpired portion of policy premiums. Premiums are accrued for retrospectively rated policies and on policies subject to audit based on estimates throughout the contract or policy term. The reserve for uncollectible premiums includes both specific allowances for probable uncollectible amounts and a non-specific reserve determined principally on the basis of past collection experience. At December 31, 2007 and 2006, the reserve for uncollectible premiums was $22,535 and $25,331, respectively.
The aggregate carrying value of the Company’s investment portfolio was $4,547,529 and $3,926,276 at December 31, 2007 and 2006, respectively, and is comprised of available-for-sale securities, other invested assets, hybrid financial instruments, short-term investments, cash and cash equivalents and assets pledged for short-sale obligations.
Certain individual available-for-sale securities had gross unrealized losses at December 31, 2007 totaling $81,405, which represented 4.8% of the cost or amortized cost of such securities in the aggregate, of which $46,362 was attributed to fixed income securities and $35,043 was attributed to equity securities.
The number of continuous months in which securities in an unrealized loss position at December 31, 2007 were in such a position is summarized as follows:
Substantially all of the gross unrealized losses of $46,362 in the fixed income portfolio at December 31, 2007 are attributable to U.S. Treasury securities. These securities are backed by the full faith and credit of the United States government and the Company has the ability and intent to hold such securities for a period of time sufficient to allow a market recovery, or to maturity if necessary. One fixed income security had a loss that exceeded 10% of its cost at December 31, 2007.
The number of continuous months in which securities in an unrealized loss position at December 31, 2006 were in such a position is summarized as follows:
The components of investment income for the years ended December 31, 2007, 2006 and 2005 are summarized as follows:
The Company’s investments in Northbridge, HWIC Asia Fund (“HWIC”), TPF, L.P. (“TPF”), Dalton Greater China Fund (“Dalton”), TRG Holding Corporation (“TRG”), Rutland Fund A (“Rutland”) and MFXchange Holdings Inc. (“MFX”) are accounted for using the equity method and are included in other invested assets on the consolidated balance sheets. The fair market value of the Company’s investment in Northbridge was $289,812 and $204,617, respectively, at December 31, 2007 and 2006. Northbridge is publicly traded on the Toronto Stock Exchange and its shares are registered and trading. The fair market value of the Company’s investment in Odyssey Re Holdings Corp. (“Odyssey”) common shares was $29,840 at December 31, 2006. Earnings from Northbridge, TRG, MFX and Odyssey common shares are included in equity in earnings of investees, net of tax, on the consolidated statements of income. Earnings from HWIC, TPF, Dalton and Rutland are included in investment income on the consolidated statements of income. The Company’s investments in Advent, Odyssey preferred shares and Chou Associates Management Fund (“Chou”) are carried at fair value and are included in equity securities on the consolidated balance sheets. Changes in the fair value of Advent, Odyssey preferred shares and Chou are recorded in accumulated other comprehensive income, net of tax.
The Company’s related party investment transactions are noted below. All transactions were completed at fair market value.
On October 31 2007, the Company invested an additional $20,000 in TPF and on November 30, 2007, the Company purchased a 6% convertible debenture of TPF for $2,500.
On August 3, 2007, the Company sold its 5.1% ownership interest in Chou for proceeds of $28,145 and a realized investment gain of $2,839.
In January and December 2006, Advent completed public offerings of its common stock. The Company did not participate in the January offering and accordingly, suffered a dilution of its ownership interest from 11.4% to 6.8%. US Fire purchased $3,954 in the December offering, thereby increasing the Company’s ownership interest to 8.1%. In June 2006, the Company recorded a $5,379 other than temporary impairment charge in respect of its investment in Advent.
In July and December 2006, the Company purchased a total of 338,586 units of Chou for consideration of $25,362. Chou invests primarily in equity securities of Canadian and foreign businesses considered by the manager to be undervalued. At the time of the transaction, the President and Chief Executive Officer of Chou was a Vice President of Fairfax.
In June 2006, the Company redeemed approximately 1.7 million shares, or 78%, of its interest in HWIC for proceeds of $118,675 and a realized investment gain of $5,053. The Company reinvested $25,000 in HWIC in December 2006.
The Company’s investment portfolio includes investments accounted for using the equity method. These investments consist of equity interests of between 1.4% and 38.6% at December 31, 2007 with a total carrying value of $384,030 and $307,818 at December 31, 2007 and 2006, respectively, and are included in other invested assets on the consolidated balance sheets. For the years ended December 31, 2007, 2006 and 2005, earnings of equity method investees were $48,831, $108,011 and $45,477, respectively. Earnings of investment companies and similar equity method investees of $12,985, $87,762 and $19,026 in 2007, 2006 and 2005, respectively, are included in investment income on the consolidated statements of income. Pre-tax earnings of other equity method investees of $35,846, $20,249 and $26,451 in 2007, 2006 and 2005, respectively, are included in equity in earnings of investees, net of tax, on the consolidated statements of income. Dividends received from other equity method investees were $5,318, $5,113 and $4,766 in 2007, 2006 and 2005, respectively.
The difference between the Company’s aggregate share of shareholders’ equity or partners’ capital and the carrying value on the consolidated balance sheets is primarily due to purchase accounting adjustments.
The Company purchased its investment in Northbridge in May 2003 and holds a 15.5% interest at December 31, 2007. For the years ended December 31, 2007, 2006 and 2005, pre-tax equity in earnings of Northbridge were $35,079, $17,907 and $26,319, respectively, and were included in equity in earnings of investees, net of tax, on the consolidated statements of income. Dividends received from Northbridge were $4,795, $4,545 and $4,205 in 2007, 2006 and 2005, respectively.
Other invested assets include investments in partnerships in which the Company has an ownership interest of less than 20% and does not have the ability to exercise significant influence. These investments are accounted for using the cost method. At December 31, 2007 and 2006, the cost of the Company’s cost method investments was $7,462 and $6,388, respectively, and their fair values were $14,601 and $7,657, respectively.
The Company has purchased credit default swaps on securities issued by various U.S. companies in the banking, mortgage and insurance industries. These credit default swaps are acquired by Fairfax and assigned to the Company to facilitate administration of counterparty credit risk and collateral maintenance. The credit default swaps serve as economic hedges against declines in the fair value of various financial assets owned by the Company arising from potential financial difficulties associated with any or all of these issuers or the industries in which they operate. The credit default swaps are recorded at fair value, in other invested assets on the consolidated balance sheets, with changes in fair value recorded as realized investment gains or losses in the period in which they occur. The Company obtains market-derived fair values for its credit default swaps from third-party providers, principally broker-dealers. In addition, the Company assesses the reasonableness of the fair values obtained from these providers by comparing the fair values to values produced using individual issuer credit default swap yield curves, by referencing them to movements in credit spreads and by comparing them to recent market transaction prices for similar credit default swaps where available. The fair values of credit default swaps are subject to significant volatility arising from the potential differences in the perceived risk of default of the underlying issuers, movements in credit spreads and the length of time to the contracts’ maturity. Due to the inherent uncertainties of these valuations as well as the volatility in interest rates and stock market conditions, realized values may differ from estimates reflected in the consolidated financial statements.
As an economic hedge against deteriorating conditions in the credit markets, the Company holds short positions on securities of certain U.S. financial guarantee insurance companies, mortgage insurance companies and financial institutions totaling approximately $12,522 and $24,931 at December 31, 2007 and December 31, 2006, respectively. The obligation to purchase these securities is included, at fair value, in short-sale obligations on the consolidated balance sheets and amounted to $12,152 and $24,605, at December 31, 2007 and December 31, 2006, respectively.
The Company also owns convertible securities with embedded derivatives within its fixed income portfolio, which allow the Company to convert the fixed income securities to equity securities. As a result of the adoption of SFAS 155 on January 1, 2007, the Company no longer bifurcates the derivatives embedded in its convertible securities, and, beginning on January 1, 2007, changes in the fair value of these hybrid financial instruments are recorded as realized investment gains or losses in the consolidated statements of income in the period in which they occur. Prior to the adoption of SFAS 155, the Company bifurcated all derivatives embedded in its convertible securities. The original host instruments were recorded at fair value in fixed income investments and the embedded derivatives were recorded at fair value in other invested assets with changes in the fair value of the host instrument recorded as unrealized investment gains or losses, and, changes in the fair value of the embedded derivative recorded as realized investment gains or losses.
Upon adoption of SFAS 155, the Company recorded a cumulative adjustment of $10,146, inclusive of an adjustment of $301, in respect of adoption of SFAS 155 by one of the Company’s equity method investees, net of tax, to reclassify unrealized investment gains associated with the host instruments to opening retained earnings. At December 31, 2007, the fair value of the Company’s hybrid financial instruments was $125,848.
The Company has investments in warrants, which are contracts that grant the holder the right to purchase an underlying financial instrument at a given price and time. The fair value of the warrants was $5,902 and $9,644 at December 31, 2007 and 2006.
Changes in the fair value of the transactions described above, including gains or losses on closed transactions, have been included in realized investment gains and losses in the consolidated statements of income as follows:
For 2006 and 2005, gains and losses noted above are primarily attributable to mark-to-market gains or losses in each year. Further analysis of the 2007 realized gains on disposal is summarized as follows:
From January 1, 2008 to February 15, 2008, the Company sold an additional $555,000 notional amount of credit default swaps (including virtually all of its credit default swaps referenced to U.S. financial guarantee insurance companies) for gross proceeds of $127,856 and gains on sale in excess of the mark-to-market value as at December 31, 2007 of $27,100. The net mark-to-market gain for the January 1 to February 15, 2008 period on the $4,777,000 notional amount of credit default swaps remaining at February 15, 2008 (including 2008 purchases of $132,000 notional amount of credit default swaps for $3,836) was $141,394 (representing total net gains related to credit default swaps for this period of $168,494).
In connection with the short-sale transactions described above, the Company has pledged cash and U.S. Treasury securities as collateral for the obligation to purchase the securities sold short. These assets are recorded in assets pledged for short-sale obligations on the consolidated balance sheets. At December 31, 2007 and 2006, the fair value of the assets pledged for the purchase of the short-sale obligations totaled $1,043,436 and $535,594, respectively. Of the $1,043,436 held at December 31, 2007, $734,956 was held in cash and $308,480 was held in U.S. Treasury securities. The Company is required to post collateral on the short-sale transactions equal to between 130% and 150% of the market value of the shorted securities, of which 100% must be held in cash or cash equivalents to avoid margin interest fees. The Company pledges U.S. Treasury securities for the remainder of the collateral requirement.
For the years ended December 31, 2007, 2006 and 2005, the Company’s loss and LAE ratios were 63.5%, 61.5% and 68.8%, respectively, of which 68.9%, 70.3% and 76.5%, respectively, were attributable to losses occurring in the current accident year and (5.4)%, (8.8)% and (7.7)%, respectively, were attributable to favorable development of prior years’ losses. The improvement in accident year 2007 as compared to 2006 is primarily due to lower catastrophe losses, partially offset by the adverse effects of price softening in the California workers’ compensation business which the Company has experienced since 2005. In addition, accident year 2006 was also adversely affected by unfavorable loss emergence in property, due to an increased frequency of large fire losses as noted below. Refer to Note 13 to the consolidated financial statements for a schedule of the accident year loss and LAE ratios by line of business.
Accident year 2005 was significantly affected by severe hurricane activity. Excluding the major storm activity in 2005 (hurricanes Katrina, Rita and Wilma), the accident year loss and LAE ratio was 67.2%, compared to 70.3% for accident year 2006, a year free of major catastrophe activity. The increase in the accident year loss and LAE ratio in 2006, exclusive of the major catastrophes in the prior year, was largely attributable to the property line of business in which the Company experienced increased frequency of fire losses and a significant rise in the cost of reinsurance. Commercial automobile was also adversely affected by an increase in large claims in 2006. In 2005, hurricanes Katrina, Rita and Wilma accounted for approximately $389,700 and $57,000 of gross and net losses and LAE, respectively, and required a reinstatement premium of $39,300 under the Company’s property catastrophe reinsurance treaty.
In 2006, the net favorable development was comprised of favorable development across all major casualty lines with the largest redundancy being recognized in workers’ compensation, principally attributable to favorable results in California in accident years 2004 and 2005, consistent with industry-wide experience. Additionally, favorable development was also experienced in umbrella and other general liability exposures, due in part to favorable settlements of claims in accident years 2000 and prior and in commercial automobile liability for accident years 2005 and prior. The favorable development was partially offset by $33,897 of adverse development of asbestos, environmental and other latent liabilities.
In 2005, the net favorable development was comprised of three principal components: (i) adverse development of asbestos, environmental and other latent liabilities of $44,646, primarily due to developments related to one asbestos policyholder and largely offset by favorable emergence of non-latent umbrella and other casualty reserves in accident years 1998 and prior, (ii) $24,699 of strengthening of prior year reserves for the surety line of business, a line the Company exited in 2005, and (iii) net favorable development of the Company’s remaining property and casualty reserves of approximately $99,700, arising from accident years 1999 through 2004.
The Company discounts workers’ compensation indemnity reserves using an interest rate of 5%. The amount of related discount was $62,337 and $66,428, at December 31, 2007 and 2006, respectively.
The increase in environmental losses incurred in 2007 was attributable to a newly reported large claim, identification of additional policies associated with existing policyholders and a slight increase in the number of sites for policyholders with previously reported claims. Incurred losses also include settlements which secured broader releases on certain active exposures.
The components of the Company’s net premiums written and premiums earned are summarized as follows:
At December 31, 2007, the Company had reinsurance recoverable of $1,539,783, due from approximately 260 reinsurers. At such date, the five largest gross reinsurance recoverable balances aggregated $1,001,148, or approximately 65.0% of the total reinsurance recoverable balance. Application of collateral reduces the unsecured exposure to these five reinsurers to $352,739. The collateral received with respect to these top five reinsurers is in the form of clean, unconditional, irrevocable and evergreen letters of credit in the amount of $38,061, irrevocable trusts in the amount of $410,000 and funds held in the amount of $218,889, with two reinsurers’ collateral exceeding their reinsurance recoverable balances. The letters of credit are in compliance with the National Association of Insurance Commissioners (“NAIC”) regulations and are confirmed by Lloyds TSB Bank which is an NAIC approved bank that is not related to Fairfax or any Fairfax affiliates. The irrevocable trusts are in compliance with NAIC regulations and are principally composed of cash and fixed income securities of various issuers, virtually all of which are investment grade rated securities. None of the issuers of the fixed income securities is related to Fairfax or any Fairfax affiliates. The funds held balances are held in the Company’s general account and equal premiums plus interest thereon credited at the rates stipulated in the related reinsurance contracts. There is no limitation on the ability of the Company to access these funds in accordance with the reinsurance agreements. The largest unsecured balance at December 31, 2007 was $150,111 with an unaffiliated company rated A+ by A.M. Best Company.
Total amounts recognized as a reduction of losses and LAE include the $389,010 below, $28,719 on the 2000 accident year prospective aggregate stop loss contract and $76,248 of amortization of deferred gains on the retroactive reinsurance contracts.
The Company entered into an aggregate stop loss agreement with unaffiliated reinsurers covering accident year 2000, which provided coverage of $118,493 and was fully utilized by the Company at December 31, 2004. This stop loss agreement covered the casualty lines of business. The contract provided 29 loss ratio points of coverage in excess of a loss and ALAE ratio of 66% for covered losses. The contract is on a funds held basis with interest credited at 7.5%. Premiums and losses ceded pursuant to the contract were $7,595 and $9,994, respectively, in 2004 and there have been no cessions to the contract since 2004. Premiums and losses ceded prior to 2004 were $68,758 and $108,499, respectively. At December 31, 2007 and 2006, the Company had reinsurance recoverable balances of $28,719 and $37,651, respectively, and funds held balances of $26,749 and $33,333, respectively, related to this agreement.
At December 31, 2007, one prospective contract, covering accident years 2000 through 2002, has an unused limit available of $96,272 in the event the net loss and LAE ratio for accident year 2002, before the effect of this contract, exceeds 70%. The subject loss and LAE ratio as valued at December 31, 2007 is 62.4%. No additional premium or funds held interest would be due under this contract upon usage of the remaining limit. Coverage of accident years 2000 and 2001 under this contract has been exhausted and recovered. The reinsurer under this contract is nSpire Re Limited, a Fairfax affiliate.
In 2001, the Company entered into adverse development contracts with two unaffiliated reinsurers. The first contract, covering substantially all lines of business, provides $400,000 of limit in excess of a retention for accident years 2000 and prior, subject to a $200,000 sublimit on 1998 and prior accident years and an asbestos and environmental sublimit of $100,000. Premiums are currently based on 35% of amounts ceded plus additional reinsurer margin of $8,000. The contract contains provisions that would increase the premium rate to as high as 62% under conditions that Company management considers unlikely. The contract is on a funds held basis with interest credited at 7%. At December 31, 2007, the Company had ceded cumulative losses of $369,000, which is comprised of $(3,577) in 2007, $(4,443) in 2006, $6,009 in 2005 and $371,011 prior to 2005 and paid premiums of $152,034, which is comprised of $(1,273) in 2007, $(796) in 2006, $4,105 in 2005 and $149,998 prior to 2005, related to this contract. At December 31, 2007 and 2006, the Company had reinsurance recoverable balances of $369,000 and $372,577, respectively, and funds held balances of $218,889 and $206,384, respectively, related to this agreement.
The premiums for both contracts are included in funds held under reinsurance contracts on the consolidated balance sheets, subject to the offset discussed above. The arrangements described above are recorded as retroactive reinsurance, with reinsurance recoverable due from reinsurers in excess of premiums paid for the coverage reflected on the balance sheets as deferred income on retroactive reinsurance. Such deferred income is amortized based on the expected amount and timing of future recoveries, using the interest method. The Company amortized deferred income of $13,673 in 2007, $12,889 in 2006, $8,058 in 2005 and $41,628 prior to 2005. This amortization of deferred income is included as a reduction of losses and LAE in the consolidated statements of income.
In 1998, in connection with the acquisition of the Company by Fairfax, the Company entered into an aggregate stop loss agreement with an unaffiliated reinsurer, which provided coverage of $367,500 in excess of a retention and has been fully utilized by the Company. The contract provided coverage for loss reserve development for accident periods prior to August 13, 1998, the date of acquisition of the Company by Fairfax. The initial premium of $75,000 was paid by the former parent of the Company. This contract is treated as prospective reinsurance. There were no premium cessions to the contract in 2007, 2006 and 2005 and reinsurance recoverable on the contract was $367,500 at both December 31, 2007 and 2006. The Company amended the contract in 2001 to provide an additional $19,248 of coverage for a premium of $7,925, which was recorded in 2001. This contract amendment is treated as retroactive reinsurance and has been fully utilized by the Company. Amortization of deferred income on this amendment is included in the amortization amounts discussed previously.
On May 7, 2007, the Company issued pursuant to a private offering (the “Offering”) $330,000 aggregate principal amount of 73/4% senior notes due May 1, 2017 (the “2017 Notes”) at an issue price of 100%. Net proceeds of the Offering to the Company, after commissions and expenses, were approximately $325,100. In connection with the sale of the 2017 Notes, the Company entered into a registration rights agreement under which the Company agreed to use its reasonable best efforts to register with the SEC notes having substantially the same terms as the 2017 Notes, as part of an offer to exchange freely tradeable exchange notes for the 2017 Notes. The Company filed a registration statement on Form S-4 with the SEC, in connection with the exchange offer, on June 29, 2007, which was declared effective by the SEC on July 13, 2007. The exchange offer was completed on August 16, 2007.
On May 21, 2007, the Company completed a cash tender offer (the “Tender Offer”) to purchase any and all of its outstanding $300,000 aggregate principal amount of 103/8% senior notes due June 15, 2013 (the “2013 Notes”). In conjunction with the Tender Offer, the Company entered into a supplemental indenture eliminating substantially all restrictive covenants and certain event of default provisions contained in the indenture under which the 2013 Notes were issued. Pursuant to the Tender Offer, all but $4,270 aggregate principal amount of the 2013 Notes were purchased and cancelled. The Company paid total consideration of approximately $325,700 to purchase the 2013 Notes tendered and, in addition, paid accrued interest of approximately $12,100. The purchase of the 2013 Notes was funded with proceeds from the sale of the 2017 Notes and available cash on hand.
After June 15, 2008, the Company may redeem the 2013 Notes at its option, in whole or in part, upon not less than 30 nor more than 60 days’ notice, at the following redemption prices (expressed as percentages of the principal amount thereof) if redeemed during the twelve-month period commencing on June 15 of the year set forth below:
For the years ended December 31, 2007, 2006 and 2005, total interest expense on the notes was $29,850, $32,986 and $32,915, respectively, including amortization of related deferred financing costs, and, in respect of the 2013 Notes, accretion of the discount. At December 31, 2007 and 2006, deferred financing costs in conjunction with the issuance of the notes totaled $5,983 and $7,465, respectively, and were included in other assets on the consolidated balance sheet. These deferred financing costs are being amortized to interest expense on a straight-line basis over the duration of the notes.
The fair value of the long-term debt, determined from quoted market prices, was $329,616 and $326,250, respectively, at December 31, 2007 and 2006.
In 2007, the Company entered into a new tax sharing agreement that provided for the utilization of the company’s net operating losses and will avoid the generation of holding company NOLs going forward, provided the Company’s subsidiaries earn sufficient taxable income to offset holding company losses. Based on projections of estimated future operations, management expects the deferred income tax asset to be recovered from taxable income in future years. For further details on the Company’s tax sharing arrangements, see Note 2 to the consolidated financial statements.
In 2008, the Internal Revenue Service is expected to complete its audit of tax years 2003 and 2004 and commence its audit of tax years 2005 and 2006 in respect of the Fairfax Group companies. Income tax returns filed with various state and foreign jurisdictions remain open to examination in accordance with the statutes of the respective jurisdictions.
The decrease in premiums written and earned and losses and LAE assumed in the year ended December 31, 2007, as compared to 2006, was principally due to the Fairmont business, which the Company assumed at the start of 2006. Prior to 2007, the majority of policies underwritten by Fairmont were issued initially by Fairmont and assumed by the Company through a 100% quota share reinsurance agreement. By the end of 2007, substantially all Fairmont business was being written directly by Crum & Forster. For further details on Fairmont, see Note 1 to the consolidated financial statements. For the years ended December 31, 2007 and 2006, the Company assumed premiums of $18,769 and $134,334, respectively, from Fairmont and had unpaid losses and LAE balances of $48,383 and $45,380 in respect of assumed losses from Fairmont at December 31, 2007 and 2006, respectively.
For the years ended December 31, 2007, 2006 and 2005, the Company ceded premiums of $12,461, $35,515 and $44,301, respectively, to nSpire and had reinsurance recoverable balances of $42,772 and $71,905 at December 31, 2007 and 2006, respectively. Pursuant to the terms of the reinsurance agreements between Wentworth and nSpire and the Company, both Wentworth and nSpire, as foreign reinsurers, are required to collateralize in full reinsurance balances due to the Company. This collateral is comprised of irrevocable trusts in compliance with NAIC regulations. There are no regulatory or other restrictions on payments to the Company from either Wentworth or nSpire.
The Company and its subsidiaries have entered into agreements with Hamblin Watsa Investment Counsel Ltd. (“Hamblin Watsa”), a wholly-owned subsidiary of Fairfax, for investment management services, and with Fairfax for investment administration services. Pursuant to the agreements, fees, based upon assets under management, totaled $7,134, $17,528, and $13,924 for the years ended December 31, 2007, 2006 and 2005, respectively, and were included as investment expenses in the consolidated statements of income.
On December 11, 2007, the Company sold 116,000 shares of HWIC stock to Fairfax in exchange for a note of $12,993 and a realized investment gain of $2,658. The transaction was completed at fair market value. The note was subsequently dividended to Fairfax.
On March 15, 2007, the Company sold its 1.1% ownership interest in Odyssey to TIG, for proceeds of $30,160 and a realized investment gain of $8,300. The transaction was completed at fair market value.
Since 2001, the Company has obtained certain information technology services, including production and operations support and systems development, on a non-exclusive basis from Fairfax Information Technology Services, Inc. (“FITS”), a wholly-owned subsidiary of Fairfax. Payments for these services, including billings for services subcontracted by FITS to other vendors, for the years ended December 31, 2007, 2006 and 2005 were $36,500, $33,125 and $22,980, respectively. The increase in 2006 as compared to 2005 primarily reflects additional services performed by FITS that were previously purchased from an unaffiliated vendor, as well as additional services in support of the Fairmont business. Of such fees, $30,462, $29,158 and $19,243 were charged directly to expense for 2007, 2006 and 2005, respectively. The remaining $6,038, $3,967 and $3,738 were software license fees capitalized in 2007, 2006 and 2005, respectively. The Company amortizes such fees over a seven-year or ten-year period beginning on the date the software is placed in service. In 2007, 2006 and 2005, software license amortization of $2,863, $3,287, and $2,019, respectively, was charged to operations, and $22,155 and $18,981 were included in other assets for the years ended December 31, 2007 and 2006, respectively.
Under an agreement effective July 1, 2000, the Company appointed RiverStone Claims Management LLC (“RiverStone”), a wholly-owned subsidiary of Fairfax, as its claims manager to handle its asbestos, environmental, other latent and construction defects claims. During 2006, the parties decided to terminate the arrangement effective December 31, 2006 and the Company established an internal unit for managing these claims. The expense incurred for RiverStone’s claims services was $0 in 2007 and $3,600 for each of the years ended December 31, 2006 and 2005. In 2007 and 2006, additional expenses of $147 and $401, respectively, were incurred for claim file legal expense reviews and overhead costs related to the transitioning of files. The Company also engages RiverStone on a contingent basis to assist in reinsurance commutation negotiations. The fees for such services were $0, $101 and $58, respectively, for 2007, 2006 and 2005.
Under a marketing agreement effective March 1, 2006, the Company receives commission payments from MFXChange Ireland Limited (“MFX”) for the introduction of customers to MFX. Under this agreement the Company received $291 in the year ended December 31, 2007. No commission payments were received in 2006.
The Company sponsors a qualified defined contribution plan pursuant to sections 401(k) and 401(a) of the Internal Revenue Code for which all employees are eligible. The Company makes an annual contribution equal to 3% of base salary and a matching contribution equal to one-half of each employee’s contribution up to the first 6% of base salary. Certain employees also have the opportunity to participate in a non-qualified plan that permits contributions that would otherwise be limited by IRS regulations. Total defined contribution plan expense was $6,091, $4,495 and $3,671 for the years ended December 31, 2007, 2006 and 2005, respectively.
The Company provides postretirement health care and life insurance benefits to certain retired employees. Medical benefits are provided to employees who were at least age 50 on January 1, 1994, and upon retirement are at least age 55 and have at least 15 years of service. Employees hired before August 1, 1990 are eligible for retiree life insurance coverage based on defined age, service and salary criteria.
The Medicare Prescription Drug, Improvement and Modernization Act of 2003, which was enacted in December 2003, introduced a prescription drug benefit under Medicare (Medicare Part D) as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D.
At December 31, 2007, the future benefit payments through 2017, net of estimated participant contributions, are expected to be as follows:
In 2004, the Company established the Crum & Forster Holdings Corp. Long Term Incentive Plan (“2004 LTIP”) for certain employees who hold senior management or officer positions. The 2004 LTIP provides for the award of phantom stock, the value of which is based on the book value of the Company, that will fully vest on January 1, 2009. 2004 LTIP expense of $4,760, $4,112 and $2,629 for the years ended December 31, 2007, 2006 and 2005, respectively, is included in the consolidated statements of income. In 2007, the Company established an additional long-term incentive plan, the Crum & Forster Holdings Corp. 2007 Long Term Incentive Plan (“2007 LTIP”), for certain employees who hold senior management or officer positions. The 2007 LTIP provides for cash awards that will fully vest on January 1, 2012. 2007 LTIP expense of $2,500 is included in the consolidated statement of income for the year ended December 31, 2007.
Certain employees of the Company have been granted shares of restricted common stock of Fairfax under the Fairfax Financial 1999 Restricted Share Plan. The restricted stock vests over periods ranging from five to ten years. Restricted stock expense of $564, $633, and $431 for the years ended December 31, 2007, 2006 and 2005, respectively, is included in the consolidated statements of income.
All employees of the Company are eligible to participate in the Fairfax Financial Holdings Limited Employee Share Ownership Plan (the “Plan”). The Plan provides an opportunity to purchase Fairfax subordinate voting shares through a combination of employee and company contributions. Employees may elect to contribute from 1% to 10% of base salary through regular payroll deductions, and the Company is required to make matching contributions equal to 30% of the employee contributions. In addition, the Company is required to make an annual contribution equal to 20% of employee contributions upon Fairfax and the Company achieving certain financial objectives. The Plan expense of $213, $165 and $118 for the years ended December 31, 2007, 2006 and 2005, respectively, is included in the consolidated statements of income.
The Company and its subsidiaries lease office space and equipment under non-cancelable operating leases. These include a 20-year lease for the Company’s home office which expires on December 31, 2022 and has minimum lease payments remaining of $46,034. Minimum annual rentals are summarized as follows:
Crum & Forster Holdings Corp. and US Fire, among numerous other insurance company and insurance broker defendants, have been named as defendants in a class action suit filed by policyholders alleging, among other things, that the defendants used the contingent commission structure to deprive policyholders of free competition in the market for insurance. The action was filed in the U.S. District Court for the District of New Jersey. Plaintiffs seek certification of a nationwide class consisting of all persons who between August 26, 1994 and the date of the class certification engaged the services of any one of the broker defendants and who entered into or renewed a contract of insurance with one of the insurer defendants. On August 31, 2007, the Court dismissed the antitrust claims with prejudice. On September 28, 2007, the court dismissed the RICO case with prejudice and declined to accept supplemental jurisdiction over plaintiffs’ state law claims. On October 24, 2007, plaintiffs filed an appeal of the trial court’s dismissals with the U.S. Court of Appeal for the Third Circuit. The plaintiffs’ opening brief was filed and served on February 19, 2008. Absent an extension, the insurers’ opposition briefs will be due on March 20, 2008, and reply briefs will be due on April 3, 2008. Crum & Forster Holdings Corp. and US Fire continue to be named as defendants and intend to vigorously defend the action.
Kelly-Moore Paint Company, Inc. (“Kelly-Moore”) filed litigation against the Company in the San Francisco Superior Court (California) in connection with certain general liability and umbrella liability policies issued to it. The litigation seeks coverage for bodily injury claims arising out of exposure to asbestos-containing products that Kelly-Moore and/or a subsidiary sold between 1960 and 1978. It also seeks breach of contract and bad faith damages. In May 2006, Kelly-Moore filed a second amended complaint seeking to recover from the Company defense costs it allegedly paid to defend asbestos claims. Kelly-Moore also seeks payment of sums for contribution and/or subrogation pursuant to three other excess insurers’ assigned claims based on defense payments allegedly made on Kelly-Moore’s behalf. The Company has learned through discovery and submissions to the court filed by Kelly-Moore that Kelly-Moore is seeking $53 million for the defense costs, plus interest, and an additional $33 million for the contribution/subrogation claims. Kelly-Moore also seeks to recover extra-contractual damages as part of its bad faith claim. The Company anticipates that Kelly-Moore will allege it is entitled to bad faith and punitive damages in a material amount. The Company filed a cross-complaint against Kelly-Moore seeking reimbursement of certain substantial loss and expense payments made to or on behalf of Kelly-Moore to date. The parties are currently engaged in pre-trial motions and discovery. Jury selection is scheduled to commence on March 3, 2008 and trial is set to begin with opening statements on March 5, 2008. While the Company does not believe that any of these allegations has merit as a matter of law, we cannot predict with certainty the ultimate outcome of the claims. It is possible that a judgment in a substantial and material amount will be entered at the trial court level. In that circumstance, the Company will aggressively pursue an appeal. Ultimately, the Company does not expect the outcome to have a material adverse effect on the Company’s financial condition. The Company has been vigorously defending against the claims of Kelly-Moore, and will continue to do so.
The Company’s insurance subsidiaries are domiciled in the states of Delaware, New Jersey, New York and Arizona. The maximum dividend that could be paid by the insurance companies to the Company in 2008, without prior regulatory approval, is $163.3 million.
Accounting Adjustments in Respect of Certain Investments Related to Prior Periods
The cumulative charge to net income in the year ended December 31, 2006 was $3,089 pre-tax ($2,008 after-tax) for these adjustments. Of the $3,089 pre-tax charge, $4,255 was recorded as a charge to realized investment gains, $3,534 was recorded as a charge to equity in earnings of investees (including $456 of previously waived immaterial adjustments) and $4,700 was recorded as an increase to investment income on the consolidated statements of income. Additionally, the Company recorded a $7,369 increase to accumulated other comprehensive income, net of tax, that together with the aforementioned $2,008 charge to net income, resulted in a $5,361 increase in shareholder’s equity.
The Company’s quarterly financial data is summarized in the table below. This quarterly financial data is unaudited. However, in the opinion of management, all adjustments (consisting of normal recurring accruals) necessary to present fairly the results of operations for such periods have been made.