See also Note 12 to our Consolidated Financial Statements included in this Form 10-K.
The following Management’s Discussion and Analysis should be read in conjunction with the Selected Financial Data, the Consolidated Financial Statements and the related Notes thereto.
We underwrite a variety of specialty lines of business identified as diversified financial products; group life, accident and health; aviation; London market account; and other specialty lines of business. Products in each line are marketed by our insurance companies and agencies, through a network of independent agents and brokers, directly to customers or through third party administrators. With the exception of our public company directors’ and officers’ liability business, certain international aviation and special financial product risks, and our London market business, the majority of our business is generally lower limit, smaller premium business that is less susceptible to price competition, severity of loss or catastrophe risk.
Non-risk-bearing fee and commission income received by our underwriting agency and broker operations;
Ceding commissions in excess of policy acquisition costs earned by our insurance company operations;
We produced $2.4 billion of revenue in 2007, an increase of 15% over 2006, primarily from higher net earned premium, which resulted from both recent acquisitions and organic growth in certain lines of business, and from increased investment income.
Net earnings increased 16% to $395.4 million ($3.38 per diluted share) in 2007 from $342.3 million ($2.93 per diluted share) in 2006. The increase in 2007 net earnings resulted from growth in underwriting profits, the absence of a large commutation loss, favorable prior year loss reserve development, and higher net investment income. Net earnings increased 79% to $342.3 million ($2.93 per diluted share) in 2006 from $191.2 million ($1.75 per diluted share) in 2005. Net earnings in 2006 included after-tax losses of $13.1 million ($0.11 per diluted share) due to a reinsurance commutation and $9.3 million ($0.08 per diluted share) for costs related to our stock option investigation. Net earnings in 2005 included after-tax losses of $58.2 million ($0.53 per diluted share) due to the combined effects of five hurricanes and $16.9 million ($0.15 per diluted share) due to a reinsurance commutation. Growth in underwriting profit, net investment income, other operating income, favorable prior year loss development and the lack of hurricane losses contributed to the increase in 2006 net earnings.
Net investment income increased 35% in 2007 and 55% in 2006. These increases were primarily due to higher investment assets, which increased to $4.7 billion at December 31, 2007 compared to $3.9 billion at December 31, 2006 and $3.3 billion at December 31, 2005, and higher interest rates. The growth in investment assets resulted from the following: cash flow from operations; higher retentions; commutations of reinsurance recoverables; our public offerings of common stock in 2005; and the increase in net loss reserves, particularly from our diversified financial products line of business, which generally has a longer time period between reporting and payment of claims. Average yields on our short-term investments increased from 4.5% in 2006 to 5.2% in 2007 and our long-term tax equivalent yield increased from 5.2% in 2006 to 5.4% in 2007. We continue to invest our funds primarily in fixed income securities, with a weighted average duration of 4.9 years at December 31, 2007.
At December 31, 2007, our unrealized gain on fixed income securities was $25.0 million, compared to an unrealized loss of $1.6 million at December 31, 2006, due to fluctuations in market interest rates. The change in the unrealized gain or loss, net of the related income tax effect, is recorded in other comprehensive income and fluctuates with changes in market interest rates. Our general policy has been to hold our fixed income securities, which are classified as available for sale, through periods of fluctuating interest rates and to not realize significant gains or losses from their sale. The unrealized gain on our fixed income securities increased to $72.7 million at January 31, 2008 due to a decrease in interest rates.
In 2007, we had a $13.2 million net realized investment gain compared to a net loss of $0.8 million in 2006 and a net gain of $1.4 million in 2005. The 2007 gain included $13.4 million of embedded currency conversion gains on certain available for sale fixed income securities that we sold in December 2007. These securities were denominated in foreign currencies and were purchased to economically hedge liabilities, principally loss and loss expense payables, denominated in matching functional currencies. This realized gain was offset by a $13.4 million foreign currency loss recorded in other operating expense. See the discussion of other operating expense below.
Other operating income decreased $33.5 million in 2007 and increased $37.2 million in 2006. The 2007 decrease and the 2006 increase were due to changes in the net gains from trading securities and the sales of strategic investments. Period to period comparisons in this category may vary substantially depending on market values of trading securities and other financial instruments and on income from strategic investments or dispositions of such investments. The following table details the components of other operating income.
Other operating expense, which includes compensation expense, increased 9% in 2007 and 23% in 2006. The increase in 2007 is primarily due to inclusion of a full year of operations of the Health Products Division, acquired in the last quarter of 2006, partially offset by lower costs related to our stock option investigation. In addition, 2007 included a $13.4 million charge to correct the accounting for embedded currency conversion gains on certain fixed income securities classified as available for sale. Since 2005, we used certain available for sale fixed income securities, denominated in British pound sterling, to economically hedge foreign currency exposure on certain insurance reserves and other liabilities, denominated in the same currency. We incorrectly recorded the unrealized exchange rate fluctuations on these securities through earnings as an offset
to the opposite fluctuations in the liabilities they hedged, rather than through other comprehensive income within shareholders’ equity. In 2007, to correct our accounting, we reversed $13.4 million of cumulative unrealized exchange rate gains. We recorded this reversal as a charge to our gain or loss from currency conversion account, with an offsetting credit to other comprehensive income. We reported our net loss from currency conversion, which included this $13.4 million charge, as a component of other operating expense in the consolidated statements of earnings. In 2007, we sold these available for sale securities and realized the $13.4 million of embedded cumulative currency conversion gains. This gain was included in the net realized investment gain (loss) line of our consolidated statements of earnings. The offsetting effect of these transactions had no impact on our 2007 consolidated net earnings. See the discussion above related to realized investment gains. Our 2006 other operating expense increased for stock option expense under Statement of Financial Accounting Standards (SFAS) No. 123(R); higher professional fees, legal costs and other expenses related to our stock option investigation; and operating expenses of subsidiaries acquired in 2006 and the second half of 2005. We had 1,682 employees at December 31, 2007, compared to 1,660 a year earlier.
In 2007 and 2006, we expensed $11.3 million ($7.4 million after-tax or $0.06 per diluted share) and $13.1 million ($9.4 million after-tax or $0.08 per diluted share) of stock-based compensation, after the effect of the deferral and amortization of related policy acquisition costs. Effective January 1, 2006, we adopted SFAS No. 123(R), Share-Based Payment, using the modified prospective method. We are recognizing compensation expense for all previously-granted but unvested stock options as of January 1, 2006, and for all options granted after that date. Prior to adoption, we accounted for our stock options in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and recognized compensation expense of $3.0 million in 2005. The 2005 consolidated financial statements were not restated to reflect our adoption of SFAS 123(R). At December 31, 2007, there was approximately $28.8 million of total unrecognized compensation expense related to unvested options that is expected to be recognized over a weighted-average period of 3.0 years.
Net earnings of our insurance company segment increased 32% to $357.8 million in 2007 compared to $272.0 million in 2006 and $126.1 million in 2005. The 2006 net earnings included $13.1 million of after-tax losses related to a commutation. The 2005 net earnings included $75.2 million of after-tax losses related to hurricanes and a commutation. The growth in segment net earnings was driven by improved underwriting results, increased investment income, and the operations of acquired subsidiaries. Also, effective April 1, 2006, we consolidated one of our underwriting agencies into one of our insurance companies; all operations after that date were reported in our insurance company segment. Even though there is pricing competition in all of our markets, our margins remain at an acceptable level of profitability due to our underwriting expertise and discipline.
Aviation - Our domestic aviation business has been stable, while gross written premium of our international business has declined. We have exercised underwriting discipline and written less international business due to competition and the resultant pressure on pricing. However, margins on decreased premium volume are still acceptable. Net written premium increased $12.5 million in 2006 due to a portfolio transfer of in-force premium to a new reinsurance program with a higher retention and decreased $2.5 million in 2007 due to a portfolio transfer with a lower retention.
London market account - Net written premium decreased slightly in 2007 due to competition increasing in this line of business. This followed a large increase in energy writings in 2006 that resulted from significantly increased rates after the 2005 hurricanes. We reduced our aggregate property exposure in Florida and other hurricane-exposed onshore areas in 2006, and we maintained the reduced exposure in 2007. Additionally, due to the tightening of policy terms and conditions, our energy catastrophe exposure was significantly reduced in 2006, even though our business increased, and continued at this reduced level in 2007. Net earned premium increased in both years due to the amount of energy business written in 2006.
Other specialty lines - We experienced growth in our other specialty lines of business from expansion of our Lloyd’s of London syndicate participation, increased writings in several products, and a 2006 acquisition. The changing mix of products affected the retention percentages. Markets for these products are competitive and rates are down slightly.
Annually, we analyze our threshold for risk in each line of business and on an overall consolidated basis, based on a number of factors, including market conditions, pricing, competition and the inherent risks associated with each business type, and then we structure a reinsurance program. Based on our analysis of these factors, we may determine not to purchase reinsurance for some lines of business. We generally purchase reinsurance to reduce our net liability on individual risks and to protect against catastrophe losses and volatility. We purchase reinsurance on a proportional basis to cover loss frequency, individual risk severity and catastrophe exposure. Some of the proportional reinsurance agreements may have maximum loss limits, most of which are at or greater than a 200% loss ratio. We also purchase reinsurance on an excess of loss basis to cover individual risk severity and catastrophe exposure. Additionally, we may obtain facultative reinsurance protection on a single risk. The type and amount of reinsurance we purchase varies year to year based on our risk assessment, our desired retention levels based on profitability and other considerations, and the market availability of quality reinsurance at prices we consider acceptable. Our reinsurance programs renew throughout the year and the price changes in recent years have not been material to our net underwriting results. Our reinsurance generally does not cover war or terrorism risks, which are excluded from most of our policies.
Our reinsurance recoverables decreased in amount and as a percentage of our shareholders’ equity in 2007 and 2006, as we reinsured less business, especially on a proportional basis, and as the 2005 hurricane
We have a reserve of $8.5 million at December 31, 2007 for potential collectibility issues related to reinsurance recoverables, including disputed amounts and associated expenses. While we believe the reserve is adequate based on information currently available, conditions may change or additional information might be obtained that may require us to change the reserve in the future. We periodically review our financial exposure to the reinsurance market and the level of our reserve and continue to take actions in an attempt to mitigate our exposure to possible loss.
Our gross redundant (adverse) reserve development relating to prior years’ losses was $90.6 million in 2007, $3.3 million in 2006, and $(29.3) million in 2005.
The gross losses related to prior accident years on certain run-off assumed accident and health reinsurance business reported in our discontinued lines of business have fluctuated due to our processing of additional information received and our continuing evaluation of gross and net reserves related to this business. We considered a combination of factors including: 1) the nature of the business, which is primarily excess of loss reinsurance, 2) late reported losses by insureds, reinsureds and state guaranty associations and 3) changes in our actuarial assumptions to reflect additional information received during the year. The run-off assumed accident and health reinsurance business is primarily reinsurance that provides excess coverage for large losses related to workers’ compensation policies. This business is slow to develop and may take as many as twenty years to pay out. Losses in lower layers must develop first before our excess coverage attaches. Thus, the losses are reported to excess of loss reinsurers later in the life cycle of the claim. Compounding this late reporting is the fact that a number of large insurance companies that were cedants of this business failed and were taken over by state regulatory authorities in 2002 and 2003. The state guaranty associations covering these failed companies have been slow to report losses to us. Based on the higher amount of actual losses reported, we revised the expected loss ratios used in our actuarial calculations, particularly in 2005. After consideration of all currently available information, we adjusted our gross and net reserves each year to amounts that management determined were appropriate to cover projected losses, given the risk inherent in this type of business. Because of substantial reinsurance, the net effects of these adjustments on our consolidated net earnings have been much less than the gross effects shown above.
Our net redundant (adverse) reserve development relating to prior years’ losses was $26.4 million in 2007, $6.5 million in 2006, and $(25.4) million in 2005, including amounts due to commutations that affected our discontinued line of business. The commutation losses primarily represent the discount for the time value of money on the reinsurance recoverables commuted. The discontinued accident and health business was substantially reinsured; therefore, the impact on our net earnings was substantially less than the amount of the gross losses. Loss reserves on international medical malpractice business, in run-off since we acquired the subsidiary that wrote this business in 2002, were strengthened in 2007 in response to a deteriorating legal and settlement environment. These losses were not reinsured. We reduced our net loss reserves on prior years’ hurricanes in 2006 and 2005 to reflect current estimates of our remaining liabilities. The other net reserve redundancies in 2007 related primarily to reserve reductions in our diversified financial products line of business from the 2003 and 2004 underwriting years. The other net reserve redundancies in 2006 related primarily to a reduction in aviation reserves from the 2004 and 2005 accident years. A portion of these reserves were reinsured. We have no material exposure to environmental or asbestos losses and believe we have provided for all material net incurred losses.
Group life, accident and health - The net loss ratio was higher on business acquired with the Health Products Division in 2006. Over time, as the acquired business is re-underwritten, we expect the loss ratio will decline. The net loss ratio was also higher than expected as more of our business is being written on a net of commission basis. While the net business increased our loss ratio (since the denominator is lower), it reduced our expense ratio such that our combined ratio and margin for this business remain relatively stable.
Aviation - The 2005 hurricanes increased the net loss ratio by 5.0 percentage points in 2005. The 2005 net loss ratio also included a favorable impact from the release of redundant reserves related to 2004 hurricanes. Excluding the impact of the hurricanes, 2005 had worse than expected underwriting experience due to some unusually large international losses, while 2006 underwriting results were better than expected, due in part to the release of redundant reserves on the 2004 and 2005 accident years.
London market account - The loss ratio in 2007 was slightly higher than expected due to adverse development in our London accident and health and energy businesses. The 2005 hurricanes increased the 2005 net loss ratio by 63.2 percentage points. Subsequent reduction of these reserves reduced the 2006 net loss ratio by 9.1 percentage points. The 2006 net loss ratio was also affected by higher than expected attritional losses for energy losses and poor underwriting results on marine business. The London market account line of business can have relatively high year-to-year volatility due to catastrophe exposure.
Other specialty lines - The 2005 hurricanes increased the 2005 net loss ratio by 14.0 percentage points. Subsequent reduction of these reserves reduced the 2006 net loss ratio by 3.9 percentage points. The increase in the 2007 net loss ratio related to losses in our marine and United Kingdom liability lines of business.
Discontinued lines - All years were adversely affected by the commutations and net loss reserve adjustments discussed previously. In addition, loss reserves on our international medical malpractice business, in run-off since we acquired the subsidiary that wrote this business in 2002, were strengthened in 2007 in response to a deteriorating legal and settlement environment.
The net paid loss ratio is the percentage of losses paid, net of reinsurance, divided by net earned premium for that year. The increase in loss and loss adjustment expense payments in 2007 was due to payment of claims related to the Health Products Division business acquired in 2006 and the 2005 hurricanes. Payments in 2006 and 2005 were reduced $100.0 million and $119.7 million, respectively, due to the discontinued accident and health commutations recorded in those years. The commutations decreased our net paid loss ratios by 5.9 and 8.7 percentage points in 2006 and 2005, respectively.
Revenue and net earnings from our other operations segment decreased to $38.9 million and $22.8 million, respectively, in 2007 from $75.1 million and $48.8 million, respectively, in 2006, primarily as a result of less income from trading securities and the sale of strategic investments. The 2006 amounts increased from $35.3 million and $22.6 million, respectively, in 2005 due to increased income from trading securities and the sale of strategic investments. In the fourth quarter of 2006, we began liquidating our trading portfolio, which we substantially completed in the first quarter of 2007 with the exception of two insurance-related securities, and invested the proceeds in fixed income securities. Results of this segment may vary substantially period to period depending on our investment in or disposition of strategic investments and activity in our trading portfolio.
Growth in net written premium and net loss reserves due to organic growth and increased retentions,
Cash provided by operating activities increased $73.0 million in 2007 and $29.4 million in 2006. Cash received from commutations, included in cash provided by operating activities, totaled $101.0 million, $12.8 million and $180.8 million in 2007, 2006 and 2005, respectively. Excluding the commutations, cash
At December 31, 2007, we had $4.7 billion of investment assets, an increase of $744.3 million from the end of 2006. The increase resulted from strong operating cash flows. The majority of our investment assets are held by our insurance companies. We held $3.7 billion of fixed income securities, all of which are classified as available for sale and recorded at market value. The fair value of these fixed income securities and the related investment income fluctuate depending on general economic and market conditions, including the recent downturn in the market due to subprime issues. In 2007 and continuing into 2008, the credit markets have been severely affected by various events. Although this has affected interest rates and caused other companies to record large write-downs of their investments, we have had no realized impairment losses on our fixed income securities.
Our investment policy is determined by our Board of Directors and our Investment and Finance Committee and is reviewed on a regular basis. Our policy for each of our insurance company subsidiaries must comply with applicable state and Federal regulations which prescribe the type, quality and concentration of investments. These regulations permit investments, within specified limits and subject to certain qualifications, in federal, state and municipal obligations, obligations of foreign countries, corporate bonds and preferred and common equity securities. The regulations generally allow certain other types of investments subject to maximum limitations.
This table summarizes our investments by type, substantially all of which are reported at fair value, at December 31, 2007.
At December 31, 2007, we held subprime-related securities with a fair value of $17.8 million, which represented 1.8% of our asset-backed and mortgage-backed securities portfolio and 0.5% of our total fixed income securities portfolio. Our subprime-related securities had a total unrealized loss of $0.6 million at December 31, 2007, and none had an other-than-temporary impairment. The average rating on these bonds was AAA, and all bonds were current as to principal and interest. We had no realized losses from sales of our subprime-related securities during 2007 or through February 15, 2008. We owned no collateralized debt obligations, collateralized loan obligations or auction rate securities at December 31, 2007.
This table indicates the expected maturity distribution of the fair value of our fixed income securities at December 31, 2007.
relatively high level of investments in state and municipal obligations. During 2007, the net pre-tax unrealized gain on our fixed income securities increased $26.7 million due to market value changes resulting from interest rate changes. We estimate that a 1% increase (e.g. from 5% to 6%) in market interest rates would decrease the fair value of our fixed income securities by approximately $179.7 million and a 1% decrease in market interest rates would increase the fair value by a like amount. Fluctuations in interest rates have a minimal effect on the value of our short-term investments due to their very short maturities. In our current position, higher interest rates would have a positive effect on net earnings.
Some of our fixed income securities have call or prepayment options. In addition, mortgage-backed and certain asset-backed securities have prepayment or other market-related credit risk. Prepayment risk exists if the timing of cash flows that result from the repayment of principal might occur earlier than anticipated because of declining interest rates or later than anticipated because of rising interest rates. Credit risk exists if mortgagees default on the underlying mortgages. Net investment income and/or cash flows from investments that carry call or prepayment options and prepayment or credit risk may differ from those anticipated at the time of investment. Calls and prepayments subject us to reinvestment risk should interest rates fall or issuers call their securities and we reinvest the proceeds at lower interest rates. For asset-backed and mortgage-backed securities, prepayment or credit risk could reduce the yield or the return of the remaining principal of these securities. We mitigate this risk by investing in investment grade securities with varied maturity dates, so that only a portion of our portfolio will mature at any point in time.
The following table presents a summary of our total contractual cash payment obligations by estimated payment date at December 31, 2007.
In conjunction with the sales of business assets and subsidiaries, we have provided indemnifications to the buyers. Certain indemnifications cover typical representations and warranties related to our responsibilities
Pursuant to our by-laws, Delaware Corporate law and certain contractual agreements, we are required to advance attorneys’ fees and other expenses and indemnify our current and former directors and officers for liabilities arising from any action, suit or proceeding brought because the individual was acting as an officer or director of our company. Under certain limited circumstances, the individual may be required to reimburse us for any advances or indemnification payments made by us. In addition, we maintain directors’ and officers’ liability insurance, which may cover certain of these costs. We expense payments as advanced and recognize offsets if cash reimbursement is expected or received. It is not possible to determine the maximum potential impact on our future consolidated net earnings of any such indemnification costs, since our by-laws, Delaware law and our contractual agreements do not limit any such advances or indemnification payments.
The principal assets of HCC are the shares of capital stock of its insurance company subsidiaries. Historically, we have not relied on dividends from our insurance companies to meet the parent holding company’s obligations, which are primarily outstanding debt and debt service obligations, dividends to shareholders and corporate expenses, since we have had sufficient cash flow from our agencies and reinsurance brokers to meet our corporate cash flow requirements. However, as more profit is now expected to be earned in our insurance companies, we may have to partially depend on cash flow from our insurance companies in the future.
The payment of dividends by our insurance companies is subject to regulatory restrictions and will depend on the surplus and future earnings of these subsidiaries. HCC’s direct domestic insurance company subsidiaries can pay an aggregate of $160.8 million in dividends in 2008 without obtaining special permission from state regulatory authorities. In 2007, 2006 and 2005, our insurance company subsidiaries paid HCC dividends of $22.6 million, $44.0 million and $50.0 million, respectively. The 2005 dividends were then contributed to another insurance company subsidiary.
In 2007, we entered into three interest rate swap agreements to exchange LIBOR (4.6% at December 31, 2007) for a 4.6% fixed rate on the $200.0 million outstanding balance of our Revolving Loan Facility. The swaps mature in November 2009 and qualify for cash flow hedge accounting treatment.
We believe that our operating cash flows, investments, Revolving Loan Facility, Standby Letter of Credit Facility, shelf registration and other sources of liquidity are sufficient to meet our operating needs for the foreseeable future.
Our operations, like those of other property and casualty insurers, are susceptible to the effects of inflation because premiums are established before the ultimate amounts of loss and loss adjustment expense are known. Although we consider the potential effects of inflation when setting premium rates, our premiums, for competitive reasons, may not fully offset the effects of inflation. However, because the majority of our business is comprised of lines that have relatively short lead times between the occurrence of an insured event, reporting of the claims to us and the final settlement of the claims, or have claims that are not significantly impacted by inflation, the effects of inflation are minimized.
have entered into interest rate swap agreements that fix the interest rate on the $200.0 million outstanding balance of our Revolving Loan Facility at 4.6% through November 2009.
We underwrite risks that are denominated in a number of foreign currencies. As a result, we have receivables and payables in foreign currencies and we establish and maintain loss reserves with respect to our insurance policies in their respective currencies. There could be a negative impact on our net earnings from the effect of exchange rate fluctuations on these assets and liabilities. Our principal area of exposure is related to fluctuations in the exchange rates between the British pound sterling, the Euro and the U.S. dollar. We constantly monitor the balance between our receivables and payables and loss reserves to mitigate the potential exposure should an imbalance be expected to exist for other than a short period of time. Imbalances are generally net liabilities, and we hedge such imbalances with cash and short-term investments denominated in the same foreign currency as the net imbalance. Our loss from currency conversion, excluding a $13.4 million charge, was $1.8 million in 2007 compared to zero in 2006 and $1.0 million in 2005. This charge was to correct the accounting for unrealized cumulative foreign exchange gains related to certain available for sale securities discussed previously. This loss was offset by a $13.4 million realized gain for embedded net foreign currency exchange gains when the securities were sold in 2007.
To record reserves on our lines of business, we utilize expected loss ratios, which management selects based on the following: 1) information used to price the applicable policies, 2) historical loss information where available, 3) any public industry data for that line or similar lines of business and 4) an assessment of current market conditions. Management also considers the point estimates and ranges calculated by our actuaries, together with input from our experienced underwriting and claims personnel. Because of the nature and complexities of the specialized types of business we insure, management may give greater weight to the expectations of our underwriting and claims personnel, who often perform a claim by claim review, rather than to the actuarial estimates. However, we utilize the actuarial point and range estimates to monitor the adequacy and reasonableness of our recorded reserves.
The excess of the total recorded net reserves over the actuarial point estimate was 4.2% of recorded net reserves at December 31, 2007 compared to 2.2% at December 31, 2006. The percentage will vary in total and by line depending on current economic events, the potential volatility of the line, the severity of claims reported and of claims incurred but not reported, management’s judgment with respect to the risk of development, the nature of business acquired in acquisitions and historical development patterns.
In actuarial practice, some of our lines of business are more effectively modeled by a statistical distribution that is skewed or non-symmetric. These distributions are usually skewed towards large losses, which causes the midpoint of the range to be above the actuarial point estimate or mean value of the range. This should be kept in mind when using the midpoint as a proxy for the mean. Our assumptions, estimates and judgments can change based on new information and changes in conditions and, if they change, it will affect the determination of the range amounts.
The majority of the assumed reinsurance in our group life, accident and health line of business is due to medical excess products in our Health Products Division. Although very similar to our direct medical stop-loss business, it is written as excess reinsurance of HMOs, provider groups, hospitals and other insurance companies. Our Lloyd’s of London business is reported as reinsurance. We underwrite the assumed group life, accident and health and Lloyd’s of London business and administer the claims. Disputes, if any, are administered in the normal course of business. We establish loss reserves for this business using the same methods and assumptions we would use to set reserves for comparable direct business.
Diversified financial products - Total net reserves in our diversified financial products line of business increased $189.8 million from 2006 to 2007 as this relatively new line of business continues to grow. The incurred but not reported portion of the total reserves for this line of business is higher than in most of our other lines, since these losses report slower and have a longer duration. The percentage will decrease as the claims start to mature.
Group life, accident and health - The percentage of incurred but not reported reserves decreased in 2007 as we integrated the Health Products Division, acquired in 2006, into our normal reserving practices. The acquired reserves did not include a case basis factor similar to our other medical stop-loss reserves. This refinement caused a reduction in incurred but not reported reserves and an increase in reported loss reserves.
We conducted a detailed review of our loss exposure to current market events, including subprime issues that have recently affected credit markets in the United States. In reviewing our exposure, we considered the types of risks we wrote, the industry of our insured, attachment points with respect to excess business, types of coverage, policy limits, actual claims reported, and current legal interpretations and decisions. Based on that review and our current knowledge, we believe our losses with respect to current events will be contained within the applicable loss reserves that have been recorded for the related exposures.
We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assets and liabilities. We regularly review our deferred tax assets for recoverability and establish a valuation allowance based on our history of earnings, expectations for future earnings, taxable income in carry back years and the expected timing of the reversals of existing temporary differences. Although realization is not assured, we believe that, as of December 31, 2007, it is more likely than not that we will be able to realize the benefit of recorded deferred tax assets, with the exception of certain pre-acquisition tax loss carryforwards for which valuation allowances have been provided. If there is a material change in the tax laws such that the actual effective tax rate changes or the time periods within which the underlying temporary differences become taxable or deductible change, we will need to reevaluate our assumptions, which could result in a change in the valuation allowance required.
relevant facts and circumstances for each investment and are recognized when appropriate. For fixed income securities with unrealized losses due to market conditions or industry-related events where we have the positive intent and ability to hold the investment for a period of time sufficient to allow a market recovery or to maturity, declines in value below cost are not assumed to be other-than-temporary. At December 31, 2007, we had gross unrealized losses on fixed income securities of $18.3 million (0.5% of aggregate fair value) compared to $24.3 million (0.8% of aggregate fair value) at December 31, 2006. We did not have any impairment losses in 2007 or 2006 with respect to these securities.
The FASB has issued SFAS No. 157, Fair Value Measurements, which clarifies the definition of fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurement. SFAS 157 does not require any new fair value measurements and eliminates inconsistencies in guidance found in various prior accounting pronouncements. The FASB has also issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS 159 allows a company to measure fair value of eligible financial assets and liabilities that are not otherwise measured at fair value. Unrealized gains and losses for those items are reported in current earnings at each subsequent reporting date. Both SFAS 157 and SFAS 159 are effective January 1, 2008. We do not expect their adoption to have a material impact on our consolidated financial statements.
The FASB has issued SFAS No. 141 (revised 2007) (SFAS 141(R)), Business Combinations, and SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of Accounting Research Bulletin No. 51. SFAS 141(R) will change the accounting treatment for business combinations and will impact presentation of financial statements on the acquisition date and accounting for acquisitions in subsequent periods. SFAS 160 will change the accounting and reporting for minority interests, which will be recharacterized as noncontrolling interests and classified as a component of shareholders’ equity. SFAS 141(R) and SFAS 160 will be effective January 1, 2009 and early adoption is not permitted. We are evaluating the impact SFAS 141(R) and SFAS 160 will have on our consolidated financial statements.
The financial statements and financial statement schedules listed in the accompanying Index to Consolidated Financial Statements and Schedules are filed as part of this Report.