The following tables set forth our selected historical consolidated financial information for the years 2002 through 2006. Refer to Item 1, “Our Business Strategy” for a discussion of our business expansion over this period. This data should also be read in conjunction with the Consolidated Financial Statements and the accompanying notes presented under Item 8 and with the Management’s Discussion and Analysis of Financial Condition and Results of Operations under
Return on average common equity (‘ROACE’) represents the level of net income available to common shareholders generated from the average of the opening and closing common shareholders’ equity during the period. Our objective is to generate superior returns on capital that appropriately reward our shareholders for the risks assumed by the Company and to grow revenue only when we deem the returns meet or exceed our requirements. Diluted book value per common share is a non-GAAP financial measure; for further information refer to ‘Non-GAAP Financial Measures” at the end of Item 7. We consider diluted book value per common share an appropriate measure of our returns to common shareholders, as we believe growth in our book value on a diluted basis ultimately translates into growth of our stock price. Our dividend policy is an integral part of the value we create for our shareholders. The board of directors reviews our dividend policy on a regular basis and has increased the annual dividend in each of the last three years.
The changes in ROACE and diluted book value per common share in the last three years have correlated with movements in our net income available to common shareholders. The following table breaks out net income into three components; underwriting income/loss, investment income and net realized gains/losses, and other revenues and expenses. Underwriting income on a segment basis is a measure of underwriting profitability that takes into account net premiums earned and other insurance related income as revenue and net losses and loss expenses, acquisition costs and underwriting related general and administrative costs as expenses. Underwriting income is the difference between these revenue and expense items. Because our investment portfolio is managed on a total return basis we have reviewed investment income and net realized gains/losses together. Other revenues and expenses represent corporate expenses, foreign exchange gains/losses, interest expense and income tax expense; these have been condensed in the table below but are reviewed individually in the discussion following.
Premiums: Gross and net premiums written and earned in our insurance and reinsurance segments in the years ended December 31 were as follows:
Changes in net premiums earned reflect period to period changes in net premiums written and business mix, together with normal variability in earning patterns. The increase in net premiums written in each of the last two years reflects the continued growth of our global underwriting platform since our inception five years ago. Our underwriting objective is to achieve both profitability and diversity in our portfolio, not simply total premium growth, and in the last three years we have balanced our organic growth and expansions with disciplined underwriting in the face of competitive pricing pressures. Refer to Item 1, “Our Business Strategy” for further discussion. For a detailed account of the movements above refer to the segments discussion below.
Acquisition Cost Ratio: Our acquisition costs ratio was 14.4%, 13.2% and 13.8% in 2006, 2005 and 2004, respectively. Acquisition costs relate to the commissions, taxes and other fees paid to obtain business offset by commissions received on ceded premiums. Typically, our acquisition costs are based on a percentage of the premium written and will vary by each line of business that we underwrite. Historically, our acquisition costs have included incentive commission costs however we discontinued such arrangements with brokers at the end of 2004. Incentive commissions represented 2.1 percentage points of our 2004 acquisition cost ratio. Our ratio otherwise increased in 2005 compared to 2004 reflecting an increase in the relative share of net premiums earned generated by our reinsurance segment (see above)
Our investment portfolio is structured to preserve capital and provide us with a high level of liquidity. Additionally we invest our portfolio with a focus on total return rather than establishing yield or income targets.
The following table provides a breakdown of investment income, net realized investment gains/losses and also the associated yields and returns:
Net realized investment losses/gains: The majority of our portfolio is invested in the fixed income market and as a result the level of realized gains and losses on these investments are highly correlated to fluctuations in interest rates. The effect of increasing interest rates throughout 2005 and 2006 negatively impacted the price of fixed income resulting in larger unrealized loss positions and consequently, portfolio turnover caused increased realized losses. Additionally, we recognized realized losses of $4.6 million (2005 and 2004: nil) from securities that were considered to be other than temporarily impaired.
Foreign exchange gains (losses): Our reporting currency is the U.S. dollar; however, some of our business is written in other currencies. The gains in 2006 and 2004 were principally made on the revaluation of asset balances denominated in Sterling and Euro following an appreciation of Sterling and the Euro against the U.S. dollar, whereas these currencies depreciated against the U.S dollar in 2005 resulting in an exchange loss.
Interest expense: Interest expense primarily consists of interest due on our senior notes that we issued in November 2004, which bear interest at 5.75%. In December, 2006, we entered into a $400.0 million repurchase agreement that we anticipate renewing throughout 2007. The repurchase agreement bears interest at a rate of 3 month LIBOR plus 0.9% per annum and therefore we anticipate interest costs to increase significantly during 2007. For further detail refer to “liability under repurchase agreement” in the commitments and contingencies section, below.
Underwriting Results by Segment: Years ended December 31, 2006, 2005 and 2004
Our business consists of two underwriting segments: insurance and reinsurance. Our insurance segment is further divided into two sub-segments: global insurance and U.S. insurance.
The mix of business in our insurance segment has evolved over the last three years in response to market conditions and opportunities. We have significantly reduced our participation on aviation and aviation war business since 2004 due to pricing pressures; however, growth in professional lines and political risk business mitigated the decline in total premium in the segment.
Our loss ratio in 2005 included 33.8 percentage points of net losses incurred relating to Hurricanes Katrina, Rita and Wilma while our 2004 loss ratio included 8.5 percentage points relating to Hurricanes Charley, Frances, Ivan and Jeanne. In 2006 there was an absence of major catastrophes and therefore our reported loss ratio was significantly lower. Our underwriting results have also been significantly impacted by development on prior year net loss reserves. In 2006, we experienced net favorable prior year development of 12.8 percentage points compared to 22.4 percentage points and 9.3 percentage points in 2005 and 2004, respectively.
Several premium trends that characterized 2005 continued into 2006. We continued to reduce our participation on terrorism and war risk and aviation and aerospace lines due to pricing considerably below our threshold for this business. Simultaneously, we grew our professional lines with the addition of a London market-based underwriting team in early 2004 and the acquisition of a large specialty program in mid-2005. While total gross premiums written decreased in 2005 over 2004, we experienced an increase of 11.3% in 2006 over 2005 due to several factors. During 2005, the property and offshore energy markets were characterized by strong competition, particularly on non-U.S. exposures, with pricing pressure leading to reductions in our renewal participation. However, this trend reversed in 2006 for natural perils-
Ceded premiums: The percentage of premiums ceded in our global insurance sub-segment varies depending on our analysis of the relative attractiveness of reinsurance buying opportunities. Premiums ceded as a percentage of gross premiums written was 11.2%, 24.5% and 14.8% in 2006, 2005 and 2004, respectively. The significant increase in ceded premiums in 2005 was largely due to higher reinstatement premiums following our utilization of reinsurance protections on Hurricanes Katrina, Rita and Wilma. In 2006, there were few attractive reinsurance buying opportunities and we concentrated on reducing our gross exposures in order to mitigate volatility in our portfolio.
Between 2005 and 2006 net premiums earned decreased by 0.2% despite an increase in net premiums written of 30.9%. This partially relates to the significant reduction in aviation and aviation war premium since 2004. This business is primarily renewed in the fourth quarter. Consequently, 2005 includes the earn-out of significantly more aviation and aviation war premium from the 2004 underwriting year than was earned in 2006 from the 2005 underwriting year. In assessing net premiums earned, another significant consideration relates to our political risk book. This line typically provides multi-year insurance coverage and therefore the premium is earned over a number of years. Less than 10% of premiums written in 2006 were earned in 2006. This was also due to the fact that a significant amount of premiums were written in the last quarter.
Acquisition Costs: Incentive commission costs accounted for 3.3 percentage points of our 2004 acquisition cost ratio however we discontinued such arrangements at the end of that year. Our acquisition cost ratio has otherwise increased in each of the last two years reflecting changes in our mix of business.
increase in umbrella and excess premiums, growth in our liability book was tempered during 2006 by a reduction in excess and surplus primary business due to a more competitive market.
Changes in net premiums earned reflect period to period changes in net premiums written and business mix, together with normal variability in earning patterns. The increase in net premiums earned in each of the last two years reflects growth in our net premiums written. Changes in mix of business over this period have not significantly impacted this trend.
Although major losses are an inevitable part of our business, the hurricane losses in 2004 and 2005 had such a significant impact that we have highlighted them separately above. Net favorable development in each of the last three years has been driven by lower than expected frequency and severity on our property accounts. In 2006, approximately 86.0% of the net favorable development related to the 2005 accident year.
Our loss ratio also fluctuates year on year depending on a number of other variables that include the level of estimated attritional losses, changes in our business mix and changes in pricing and other assumptions used to establish our loss ratios.
Our reinsurance segment provides treaty property and casualty reinsurance on a worldwide basis through our offices in Bermuda, the U.S and Europe. We initially began writing traditional catastrophe and property reinsurance from our Bermuda office, however, following the commencement of our U.S and European operations in 2003, we have since expanded into specialty property risks, casualty, motor, credit and bond and other select risks. The substantial increase in gross premiums written between 2004 and 2005 primarily reflects the early growth and market penetration of these new operations. In 2006, although we further increased our participation on all these lines of business, growth was naturally less significant than in earlier periods. In addition unfavorable foreign exchange rates reduced gross premiums written in 2006 relative to 2005.
Changes in net premiums earned reflect period to period changes in net premiums written and business mix, together with normal variability in earning patterns. The increase in net premiums earned in each of the last two years has largely correlated to the growth in our net premiums written over this period. Changes in mix of business over this period have not significantly impacted this trend.
Generally, overall discipline throughout the global reinsurance marketplace continues. We continue to experience the ongoing trend of greater risk and retention appetite in the industry bringing to bear modest price reductions. For property catastrophe business, major buyers dropped lower layers in favor of larger limits at the upper end of their programs, whilst, for casualty reinsurance business, cedants tended to retain more business. Critically, we have not seen major slippage in terms and conditions.
As a holding company we have no substantial operations of our own and our assets consist primarily of our investments in subsidiaries. Accordingly, our future cash flows depend primarily upon the availability of dividends or other statutorily permissible payments from our subsidiaries. See Item 8, Note 17, to the Consolidated Financial Statements for further discussion.
Investing cash flows: Generally, positive cash flows from our operating and financing activities are invested in the Company’s investment portfolio. For further discussion of our investment activities, including our strategy and current durations refer to Item 1 and also Note 6 of the Consolidated Financial Statements included in Item 8 of this report.
Long-term debt: Long-term debt represents senior notes we issued during 2004; for further information refer to Item 8, Note 10 (a) of the Consolidated Financial Statements.
Credit facilities: At December 31, 2006 and 2005 we had a credit facility agreement of $1.5 billion and letters of credit outstanding on the facility of $365.0 million and $685.1 million, respectively. For further information refer to Item 8, Note 10 b) of the Consolidated Financial Statements.
$29.42 per share raising aggregate net proceeds of $200.1 million. In addition, we issued $250.0 million of series B preferred shares under this shelf registration statement. The remaining capacity at December 31, 2006 was $1,050.0 million.
The following table provides an analysis of our contractual obligations by period due:
Estimated gross loss payments: Estimated gross loss payments represent actuarial and statistical projections of our expected ultimate settlement and administration costs of claims incurred. There are numerous factors and assumptions involved in estimating loss and loss expense reserves. For further discussion refer to our critical accounting estimates section below. Given the limited loss payout pattern information specific to our experience, we have used industry data, on a line by line basis, to estimate our expected payments. The amount and timing of actual loss payments may differ materially from the estimated payouts in the table above.
Liability under repurchase agreement: On December 20, 2006 we entered into a repurchase agreement to fund our investment in a life settlement contracts portfolio. Under the arrangement we sold a $400.0 million asset-backed note which we have agreed to repurchase on March 16, 2007 for a predetermined price. The agreement provides for the ability to renew for the duration of the asset-backed note. We may renew the repurchase agreement at its maturity.
Further information on the above contractual obligations, refer to Item 8, Notes to the Consolidated Financial Statements.
There are certain accounting policies that we consider to be critical due to the amount of judgment and uncertainty inherent in the application of those policies. In calculating financial statement estimates, the use of different assumptions could produce materially different estimates. We believe the following
Following the occurrence of a reinsured loss, an insured notifies its insurance company which then reports the information to its reinsurer, generally via a broker. The period of time that elapses between the notification to the insurance company and the reinsurance company varies depending upon a number of factors such as: the type of business; whether the reinsurance is written on an excess of loss or proportional basis; the size of the loss; and whether the loss information is provided by brokers or cedants. Typically, the delay can vary from a few weeks to several months. In addition, as reinsurers, we do not separately evaluate each of the underlying risks assumed and, therefore, we rely upon our cedants’ underwriting, risk management and claims administration practices. These factors necessarily create a higher degree of uncertainty in establishing our estimate of loss reserves for our reinsurance operations than for our insurance operations.
Our estimate of our ultimate loss and loss expenses is determined in consultation with Ernst & Young and is based on generally accepted actuarial principles. Ernst & Young receives all Large Claims Information Database (“LCID”) flash reports and has access to our claims information and individual contracts as part of their quarterly review. Ernst & Young utilize various actuarial methodologies to arrive at a single point estimate for baseline ultimate loss and loss expenses. The selection of an actuarial methodology and the associated loss ratio is applied at a line of business level to determine the ultimate loss and loss expenses by line of business. The actuarial method is dependent upon characteristics specific to each line of business, including: the extent of company-specific loss experience, the maturity of the line of business and the type of coverage. The actuarial methods utilized include the Bornhuetter-Ferguson method, the initial expected loss ratio method (“IELR”) and the chain ladder (“loss emergence”) method. The Bornhuetter-Ferguson method takes as a starting point an assumed ultimate loss and loss expense ratio developed by the actuaries and blends in the loss and loss expense ratio implied by the experience to date. The chain ladder method uses the historical development profile of incurred claims experience to project the more recent, less developed profile of claims experience and to generate ultimate loss and loss expenses. The IELR method estimates ultimate loss and loss expenses based on pricing information and industry data. Due to our limited loss experience, for most lines of business the independent actuaries primarily utilize the Bornhuetter-Ferguson and IELR methods to derive a single point estimate of baseline ultimate loss and loss expenses.
In estimating our ultimate loss and loss expenses, our independent actuaries utilize actuarial methodologies that rely on the use of various assumptions. At December 31, 2006, the key assumptions used by our actuaries were the establishment of initial expected loss ratios and the establishment of development factors. Both of these assumptions are largely based upon loss information, which may not be indicative of our actual loss experience. A 5% change in our gross loss reserves equates to $250.8 million and represents 27.1% of our income before income taxes for 2006 and 5.7% of our shareholders’ equity at December 31, 2006. For a summary of the cumulative redundancies on our loss reserves since our inception refer to “Reserves” in Item 1 of this report.
Reinsurance recoverable balances include amounts owed to us in respect of paid and unpaid ceded losses and loss expenses and are presented net of a reserve for non-recoverability. At December 31, 2006 and 2005, reinsurance recoverable balances were $1,359.2 million and $1,518.1 million, respectively. In establishing our reinsurance recoverable balances, significant judgment is exercised by management in determining the amount of unpaid losses and loss expenses to be ceded as well as our ability to cede losses and loss expenses under our reinsurance contracts.
To estimate this valuation provision, we start with a default analysis by applying specific percentages against each recovery, net of collateral, based on the financial strength rating of the reinsurer using A.M. Best credit ratings. These percentages are based on historical industry default statistics developed by Standards & Poor (S&P) and are then adjusted by us based on industry knowledge and best judgment. For example, when a recoverable is expected to be paid in a brief period of time by a highly rated reinsurer, such as certain property catastrophe claims, we may not apply a default factor to such amount. We also apply case-specific valuation allowances against certain reinsurance recoverable balances that we deem
See Item 8, Note 8 to the Consolidated Financial Statements for an analysis of reinsurance recoverable and valuation provision by segment. For an analysis of credit risk with respect our reinsurance recoverable balances at December 31, 2006, refer to Item 8, Note 11, (a) to the Consolidated Financial Statements.
For business written under a proportional contract, similar to our line slip business, we are able to reasonably estimate the premium written by reference to an initial estimate of expected ceded premium received from our clients. In most cases, the treaties are not new and the client can use historical experience to estimate the amount of premium. We may adjust the initial estimate of premium, and any adjustment is usually a result of the underwriter’s prior experience with a client. We actively monitor the development of actual premium data and, if an adjustment in the premium estimate is warranted, it will be
A CLO is an asset-backed security that is primarily supported by commercial loans. We invest in both senior debt and equity tranches of CLOs. The fair value of senior debt tranches is based on available market prices; accordingly, there is little measurement uncertainty. However, for equity tranches the fair value is derived by amortizing the invested amounts at rates which incorporate certain assumptions such as market default rates, weighted average spread earned and recovery rates over the expected life of the security. We use significant judgment in establishing appropriate assumptions, which are reviewed annually to incorporate current market conditions.
The fair value for investment funds is determined by management using the net asset values provided by the third party administrators of these funds. Generally, the fair value is determined based upon the valuation criteria established by the governing documents of such investments. Further, the valuation for certain funds is reported on a one month lag, which contributes to the fair value measurement uncertainty at a point in time. Additionally, some funds are subject to restrictions on redemptions and sales and therefore limit our ability to liquidate these investments in the short term. Accordingly, the estimated fair value may differ materially from the values that would have been used had ready markets existed for these funds.
See Item 8, Note 2 (l) to the Consolidated Financial Statements for a discussion on recently issued accounting pronouncements not yet adopted.
We have presented diluted book value per common share calculated using the “If-Converted” method, rather than the “Treasury Stock” method, which is a non-GAAP financial measure. We have included this measure because it takes into account the effect of dilutive securities and, therefore, we believe this is a better measure of calculating shareholder returns than book value per share. The following table is a reconciliation of diluted book value per share to book value per share:
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of AXIS Capital Holdings Limited and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America.
These consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”). The consolidated financial statements include the accounts of the Company as well as all variable interest entities (VIEs) for which the Company is the primary beneficiary, as defined under FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities (FIN 46). FIN 46 requires a VIE to be consolidated if a party with an ownership, contractual or other financial interest in the VIE is obligated to absorb a majority of the risk of loss from the VIE’s activities, is entitled to receive a majority of the VIE’s residual returns or both. All significant inter-company accounts and transactions have been eliminated. All amounts are reported in U.S. dollars.
· the premium estimates for business written on a line slip or proportional basis;
While the amounts included in the consolidated financial statements reflect management’s best estimates and assumptions, these amounts could ultimately differ from those estimates.
Investments that are considered to be “available for sale” under the definition included in FAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, are reported at fair value at the balance sheet date. The fair value of investments is based upon quoted market values where available or by reference to broker or underwriter bid indications. The net unrealized gain or loss on investments, net of tax, is included as accumulated other comprehensive income (loss) in shareholders’ equity.
The Company invests in both senior debt and equity tranches of CLOs. The fair value of senior debt tranches is based on available market prices; whereas, the fair value of equity tranches is derived by amortizing the invested amounts at rates which incorporate certain assumptions such as market default rates, weighted average spread earned and recovery rates over the expected life of the security. Any adjustments required due to the change in effective yields and maturities are recognized on a prospective basis through yield adjustments.
Investment funds include a short duration high yield fund, credit funds and fund of hedge funds. The fair value for these investment funds is determined by management using the net asset value provided by the third party administrators of these funds.
The Company assesses quarterly whether declines in fair value of its investments represent impairments that are other than temporary. There are several factors that are considered in the assessment of a security, which include (i) the time period during which there has been a significant decline below cost, (ii) the extent of the decline below cost, (iii) the Company’s intent and ability to hold the security, (iv) the potential for the security to recover in value, (v) an analysis of the financial condition of the issuer and (vi) an analysis of the collateral structure and credit support of the security, if applicable. Where the Company has determined that there is an other than temporary impairment in the fair value of the security, the cost of the security is written down to the fair value and the unrealized loss at the time of the determination is charged to net realized investment (losses)gains in the Consolidated Statement of Operations.
Premiums written are recorded in accordance with the terms of the underlying policies. Reinsurance premiums assumed are estimated based upon information received from ceding companies and any subsequent differences arising on such estimates are recorded in the period they are determined. Premiums are generally contractually stated except for business written on a line slip or proportional basis. Under FAS No. 60, Accounting and Reporting by Insurance Enterprises, a company is permitted to book premium as long as it is reasonably estimable. For line slip premiums, the Company receives an initial estimate of expected premium from the client via the broker. In the case of proportional contracts, the Company receives an estimate of the expected premium to be ceded from its client. The Company monitors the emergence of actual premium data on line slip policies and proportional reinsurance contracts and adjusts its estimates of written premiums to reflect reported premiums on a periodic basis as additional information becomes available.
Premiums are earned over the terms of the policies in proportion to the risks to which they relate. Unearned premiums represent the portion of premiums written that is applicable to the unexpired portion of the policies in force. Reinstatement premiums are recognized at the time a loss event occurs where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms and are earned on a pro-rata basis over the remaining risk period.
Reinsurance recoverables are based on contracts in force and are presented net of a reserve for uncollectible reinsurance. The method for determining the reinsurance recoverable on unpaid losses and loss expenses involves actuarial estimates of unpaid losses and loss expenses as well as a determination of the Company’s ability to cede unpaid losses and loss expenses under its reinsurance treaties.
The reserve for uncollectible reinsurance is based on an estimate of the amount of the reinsurance recoverable balance that will ultimately not be recovered due to reinsurer insolvency, contractual disputes or some other reason. The valuation of this reserve for uncollectible reinsurance includes several processes including a review of the credit ratings of the reinsurance recoverables by reinsurer, an analysis of default probabilities as well as coverage issues. These factors require considerable management judgment and the factors are reviewed in detail on a regular basis with any resulting adjustments reflected in losses and loss expenses in our Consolidated Statement of Operations in the period that collection issues are identified.
IBNR is estimated by management in consultation with the independent actuaries who use actuarial models to derive IBNR. The Bornhuetter-Ferguson and initial expected loss ratio (“IELR”) methods are primarily used although the chain ladder (“loss emergence”) method is also utilized for some lines of business. The Bornhuetter-Ferguson method takes as a starting point an assumed ultimate loss and loss expense ratio and blends in the loss and loss expense ratio implied by the experience to date.
For the insurance segment, the assumed ultimate loss and loss expense ratios are based on benchmarks derived from the independent actuaries wider market experience together with our limited historical data. These benchmarks are then adjusted for rating increases or decreases and changes in terms and conditions that have been observed by the market and by the Company. For the reinsurance segment, the assumed ultimate loss and loss expense ratios are based on contract-­by-­contract initial expected loss ratios derived during pricing together with benchmarks derived from the independent actuaries wider market experience.
While management believes that the reserves for unpaid losses and loss expenses are sufficient to pay losses that fall within coverages assumed by the Company, the actual losses and loss expenses incurred by the Company may be materially greater or less than the reserve provided. Due to the limited length of time that the Company has been operating, actual loss experience is limited; this increases the potential for material deviation from currently estimated amounts. The methods of determining such estimates and establishing the resulting reserve are reviewed quarterly and any adjustments are reflected in income in the period in which they become known.
The functional currency of the Company and its subsidiaries is the U.S. dollar. Monetary assets and liabilities denominated in foreign currencies are translated at year end exchange rates, with the resulting foreign exchange gains and losses recognized in the Consolidated Statements of Operations. Revenues and expenses in foreign currencies are translated at average exchange rates during the year.
Effective January 1, 2006, the Company adopted the provisions of FAS No. 123 (revised 2004), Share-Based Payments (“FAS 123 (R)”) using the modified prospective approach. Under both FAS 123 and FAS 123 (R), compensation expense for stock options and for restricted stock awards granted to employees is based on the grant-date fair value and recorded over the requisite service period. However, FAS 123(R) requires an estimate of forfeiture benefits at the time of grant be incorporated into the
The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions to all of its stock-based compensation.
The Company currently uses foreign currency forward contracts in its investment portfolios to minimize the effect of fluctuating foreign currencies and to gain exposure to interest rate differentials between differing market rates. Foreign currency forward contracts purchased are not specifically identifiable against cash, any single security or any groups of securities and, therefore, do not qualify and are not designated as a hedge for financial reporting purposes. Realized and unrealized gains (losses) on foreign currency forward contracts that are purchased as part of the Company’s investment strategies are recognized in realized investment gains (losses) in the Consolidated Statements of Operations.
The Company currently uses foreign currency forward contracts as part of its process to manage foreign currency exposures in the balance sheet. Foreign currency forward contracts are purchased as economic hedges to minimize the effect of fluctuating foreign currencies but are not specifically identifiable against cash, any single security or any groups of securities, insurance and reinsurance premium balances receivable or the reserve for losses and loss expenses and, therefore, do not qualify and are not designated as a hedge for financial reporting purposes. Realized and unrealized gains (losses) on foreign currency forward contracts that are purchased as economic hedges of the Company’s net foreign exposure are recognized in foreign exchange losses (gains) in the Consolidated Statements of Operations.
A valuation allowance against deferred tax assets is recorded when management’s assessment indicates that it is more likely than not that a portion of the deferred tax asset will not be realized in the foreseeable future.
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”). This Interpretation prescribes detailed guidance for the financial statement recognition, measurement and disclosure of uncertain tax positions recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. Tax positions must meet a more-likely-than-not recognition threshold at the effective date to be recognized upon the adoption of FIN 48 and in subsequent periods. FIN 48 will be effective for fiscal years beginning after December 15, 2006 and the provisions of FIN 48 will be applied to all tax positions upon initial adoption of the Interpretation. The cumulative effect of applying the provisions of this Interpretation will be reported as an adjustment to the opening balance of retained earnings for that fiscal year. The Company will adopt FIN 48 effective January 1, 2007. This interpretation will not have a significant impact on the Company’s financial condition, results of operations and cash flows.
The Company has two underwriting segments: insurance and reinsurance. These have been determined on the basis of underlying information reviewed by the Company’s chief decision maker, the Chief Executive Officer.
Global insurance provides specialty lines coverage, predominantly through the London broker network. The product lines in this segment are property, marine, terrorism and war risk, aviation and aerospace, political risk and professional lines and other specialty.
The following table presents our gross premiums written by geographical location of subsidiary:
Insurance Company of Wisconsin was subsequently redomiciled to the state of Illinois and renamed AXIS Insurance Company (“AXIS Insurance U.S.”). The Company paid a purchase price of $28.5 million. The Company does not consider this to be a material acquisition. The purchase of AXIS Insurance U.S. was made to expand the Company’s ability to write insurance on an admitted basis within the U.S.
In addition to the loss reserves and related reinsurance recoverable, the assets of AXIS Insurance U.S. included fixed income securities and accrued interest of $18.8 million, cash equivalents of $0.7 million and licenses of $9.0 million (recorded as an intangible asset with an indefinite life: refer to Note 5, below). These assets were recorded at their fair values on the date of acquisition. The purchase price has been fully allocated against the fair values of the assets and liabilities; consequently, no goodwill was recorded.
All fixed maturity investments are held as available for sale. The amortized cost and fair values are as follows:
The Company’s process for identifying declines in the fair value of investments that are other than temporary involves consideration of several factors. These factors include, the time period during which there has been a significant decline in value, the significance of the decline, an analysis of financial condition of the issuer, and the Company’s intent and ability to hold the investment for a sufficient period of time for the value to recover. Where the Company’s analysis of the above factors results in the Company’s conclusion that declines in fair values are other than temporary, the cost of the security is written down to fair value and the previously unrealized loss is therefore realized in the period in which such determination is made.
The contractual maturities of fixed maturity investments are shown below. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
On December 20, 2006, the Company purchased a 20-year asset-backed note (“Note”) in the amount of $400.0 million issued by a special-purpose entity (“SPE”). The Note has a scheduled maturity date of December 20, 2026 and earns interest at a rate of 8% payable annually in arrears on December 20 of each year. Through the purchase of this Note, the Company is assuming longevity risk on 222 life insurance policies for a period of 20 years. This SPE was determined to be a VIE and the Company is its primary beneficiary. Accordingly, the Company has consolidated the SPE, as well as the underlying SPEs, in its
The other liability represents the underlying policyholders’ retained beneficial interest in the life insurance policies. This liability is reported at fair value and is included in other liabilities in the Consolidated Balance Sheets. The Note is collateralized by the net assets of the SPE. The creditors of the SPE do not have recourse to the general credit of the Company.
The Company is required to maintain assets on deposit with various regulatory authorities to support our insurance and reinsurance operations. The assets on deposit are available to settle insurance and reinsurance liabilities. The Company also utilizes trust funds in certain large transactions where the trust funds are set up for the benefit of the ceding companies and generally take the place of Letter of Credit requirements. The assets on deposit and used for collateral are primarily highly rated fixed maturity securities. Additionally, to securitize the repurchase agreements the Company has pledged its investments in the life settlement contracts. The components of the fair value of the restricted assets are as follows:
Net loss and loss expenses incurred include net favorable prior period reserve development of $216.5 million, $383.0 million and $181.7 million during 2006, 2005 and 2004, respectively. Prior period development arises from changes to loss estimates recognized in the current year that relate to loss reserves first reported in previous calendar years. These reserve changes were made as part of our regular quarterly reserving process and primarily arose from better than expected emergence of actual claims relative to expectations on our short tail lines of business. The following table summarizes the net favorable development by segment.
The Company purchases treaty and facultative reinsurance to reduce exposure to large losses or a series of large losses. Facultative reinsurance provides for all or a portion of the insurance provided by a single policy and each policy reinsured is individually negotiated. Treaty reinsurance provides for a specified type or category of risks. The reinsurance agreements are written on either an excess of loss or quota share basis. Excess of loss covers provide a contractually set amount of cover after an excess point
The breakdown of ceded premiums by type of cover was as follows:
During 2006, the Company recorded realized and unrealized gains of $6.4 million (2005: $4.9 million; 2004: $nil) on foreign currency forward contracts used to manage foreign currency exposures in the balance sheet. At December 31, 2006, the net contractual amount of these foreign currency forward contracts was $9.7 million (2005: $59.9 million) with an unrealized loss of $0.9 million (2005: $0.7 million gain).
During 2005, the Company terminated all existing reinsurance contracts that were accounted for as derivatives. The change in fair value of these contracts resulted in a net loss of $5.9 million during 2005 and a net gain of $11.3 million in 2004.
As at December 31, 2006, the Company had a $1.5 billion credit facility agreement with a syndicate of lenders. The credit agreement is an unsecured five-year facility that allows the Company and its operating subsidiaries to issue letters of credit up to the full amount of the facility and to borrow up to $500 million for general corporate purposes, with total usage not to exceed $1.5 billion. The credit facility will expire on August 25, 2010. The credit agreement contains various loan covenants, including limitations on the incurrence of future indebtedness, future liens, fundamental changes, investments and certain transactions with affiliates. The facility also requires that the Company maintain 1) a minimum consolidated net worth of $2.0 billion plus (A) 25% of consolidated net income (if positive) of AXIS Capital for each semi-annual fiscal period ending on or after December 31, 2005 plus (B) an amount equal to 25% of the net cash proceeds received by AXIS Capital from the issuance of its capital stock during each such semi-annual fiscal period; and 2) a minimum debt to total capitalization ratio 0.35:1.0. The Company was in compliance with all covenants at December 31, 2006 and 2005. At December 31, 2006, the Company had letters of
credit of $365.0 million (2005: $685.1 million) outstanding. There was no debt outstanding under the credit facility at December 31, 2006 and 2005.
The Company produces its business through brokers and direct relationships with insurance companies. During 2006, three brokers accounted for 52.1% (2005: 52.1%; 2004: 58.9%) of the total gross premiums written by the Company. Marsh, Inc. (including its subsidiary Guy Carpenter and Company) accounted for 24.5% (2005: 28.0%; 2004: 30.2%), Aon Corporation for 17.3% (2005: 15.7%; 2004: 19.3%) and Willis Group Holdings Ltd. for 10.3% (2005: 8.4%; 2004: 9.4%). No other broker and no one insured or reinsured accounted for more than 10% of gross premiums written in each of the last three years.
The Company and its subsidiaries lease office space in the countries in which they operate under operating leases which expire at various dates. The Company renews and enters into new leases in the ordinary course of business as required. Total rent expense with respect to these operating leases during 2006 was $10.2 million (2005: $7.9 million: 2004: $7.1 million). Future minimum lease payments under the leases are expected to be as follows:
During 2006, the Company made certain commitments with respect to an additional investment in an alternative investment fund. At December 31, 2006, the total outstanding investment commitment was $19.4 million (2005: nil) which the Company funded during January 2007.
Except as noted below, the Company is not a party to any material legal proceedings. From time to time, the Company is subject to routine legal proceedings, including arbitrations, arising in the ordinary course of business. These legal proceedings generally relate to claims asserted by or against the Company in the ordinary course of insurance or reinsurance operations. In the opinion of management, the eventual outcome of these legal proceedings is not expected to have a material adverse effect on the Company’s financial condition or results of operations.
In 2005, a putative class action lawsuit was filed against the U.S. insurance subsidiaries. In re Insurance Brokerage Antitrust Litigation was filed on August 1, 2005 in the United States District Court for the District of New Jersey and includes as defendants numerous insurance brokers and insurance companies. The lawsuit alleges antitrust and Racketeer Influenced and Corrupt Organizations Act (“RICO”) violations in connection with the payment of contingent commissions and manipulation of insurance bids and seeks damages in an unspecified amount. On October 3, 2006, the court granted in part motions to dismiss filed by the defendants, and ordered plaintiffs to file supplemental pleadings setting forth sufficient facts to allege their antitrust and RICO claims. After plaintiffs filed their supplemental pleadings, defendants renewed their motions to dismiss, which are pending before the court. Management believes that the lawsuit is completely without merit and the Company continues to vigorously defend the filed action.
In connection with the life settlement contracts portfolio, the Company is committed to pay estimated life insurance premiums of $636.6 million over the life of the underlying contracts, of which the Company expects to pay $59.2 million during 2007.
On March 14, 2005, the Company announced that its Board had authorized an additional repurchase of up to $150.0 million of its common shares under the Company’s share repurchase plan. No repurchases were effected under this authorization.
On October 5, 2005, the Company issued $250.0 million of 7.25% series A preferred shares, par value $0.0125 per share, with a liquidation preference of $25.00 per share. The Company may redeem the shares on and after October 15, 2010 at a redemption price of $25.00 per share. Dividends on the series A preferred shares are non-cumulative. Consequently, if the board of directors does not authorize and declare a dividend for any dividend period, holders of the series A preferred shares will not be entitled to receive a dividend for such period, and such undeclared dividend will not accumulate and be payable. Holders of series A preferred shares will be entitled to receive, only when, as and if declared by the board of directors, non-cumulative cash dividends from the original issue date, quarterly in arrears on the fifteenth day of January, April, July and October of each year, commencing on January 15, 2006, without accumulation of any undeclared dividends. To the extent declared, these dividends will accumulate, with respect to each dividend period, in an amount per share equal to 7.25% of the liquidation preference per annum.
The holders of the series A and B preferred shares will have no voting rights except as described below. Whenever dividends payable on the series A and B preferred shares have not been declared by the board of directors and paid for an aggregate amount equivalent to six full quarterly dividends (whether or
not consecutive) on all of the series A and B preferred shares or any class or series of parity stock then outstanding, the holders of the series A and B preferred shares, together with the holders of each such class or series of parity stock, will have the right, voting together as a single class regardless of class or series, to elect two directors to the Company’s board of directors. The Company will use its best efforts to effectuate the election or appointment of these two directors. Whenever dividends on the series A and B preferred shares and the parity stock then outstanding have been paid in full, or declared and sufficient funds have been set aside, for at least four dividend periods, the right of holders of the series A and B preferred shares and the parity stock to be represented by directors will cease (but subject always to the same provision for the vesting of such rights in the case of any future suspension of payments in an amount equivalent to dividends for six full dividend periods whether or not consecutive), and the terms of office of the additional directors elected or appointed to the board of directors will terminate.
At December 31, 2006, 19,644,253 common shares (2005: 19,650,509; 2004: 19,619,152) would be issued pursuant to the warrants, if all warrants were exercised at an average price of $12.44 (2005: $12.46; 2004: $12.48). All warrants were exercisable on November 20, 2001. At December 31, 2006, the Company had accrued $30.6 million (2005: $19.8 million) of cash dividends relating to the anti-dilution provision in respect of the warrants. The expiration date for the warrants is November 20, 2011.
The warrants were granted to the founding shareholders as an inducement to purchase stock in the Company and therefore no compensation expense has been recorded in connection with the warrants. The fair value of the warrants at November 20, 2001 of $65.1 million has been included in additional paid-in capital. This value has been calculated using the Black-Scholes option-pricing model. The three main assumptions used were: risk-free interest rate of 5.1%; expected life of 7 years; and a dividend yield of nil.
At December 31, 2006 the following benefit payments are expected to be paid in the years indicated:
The Company has adopted a Long-Term Equity Compensation Plan (“LTEC”) that provides for the grant of non-qualified stock options, incentive stock options, stock appreciation rights, restricted stock awards, performance share and performance unit awards and share purchase rights. The maximum number of common shares with respect to which awards may be granted under the plan is 14,855,192, of which 1,200,000 are available for issuance pursuant to share purchase rights and the remainder of which are available for issuance under all other awards. The plan is administered by the Compensation Committee of the Board of Directors.
Options granted under LTEC plan generally expire 10 years after the date of grant and generally vest ratably on an annual basis over three years from the date of grant. Exercise prices are established at the fair value of the Company’s common shares at the date of grant, based on the closing price of the Company’s shares on the New York Stock Exchange. Upon exercise, new shares are issued by the Company.
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:
The grants in 2006 reflect modifications to grants made in prior years to an employee pursuant to a severance agreement. The earlier grants were deemed cancelled and new grants issued at the new terms.
The following table summarizes information about the Company’s stock options for options granted under the LTEC and outstanding as of December 31, 2006:
Options granted under the plan generally expire 10 years after the date of grant and generally vest ratably on an annual basis over three years from the date of grant. Exercise prices are established at the fair value of the Company’s common shares at the date of grant, based on the closing price of the Company’s shares on the New York Stock Exchange. Upon exercise, new shares are issued by the Company.
The following table summarizes information about the Company’s stock options granted under the DLTECP and for options outstanding as of December 31, 2006:
The following is a summary of restricted stock granted under the DLTECP and related activity:
In addition, directors may elect to receive their fees in common shares rather than cash. As at December 31, 2006, 44,834 (2005: 40,235; 2004: 32,625) common shares had been granted under the plan in lieu of fees. All awards are made at the fair value of the common shares at the time of the grant.
The transactions listed below are classified as related party transactions, as each counterparty had or has had either a direct or indirect shareholding in the Company or has been a board member during any period covered by the financial statements.
Under current Bermuda law, the Company is not required to pay any taxes in Bermuda on its income or capital gains.
The Company’s net deferred tax assets and net current tax liabilities are included in other assets and other liabilities respectively, in the Consolidated Balance Sheets.
Deferred income taxes reflect the tax impact of temporary differences between the carrying amounts of assets and liabilities for financial reporting and income tax purposes. Significant components of the net deferred tax asset (liability) were as follows:
regulatory approval is limited to unassigned surplus (statutory equivalent of retained earnings) and cannot exceed 10% of total statutory capital and surplus. At December 31, 2006, the maximum dividend that the Company’s U.S. insurance operations could pay without regulatory approval was approximately $16.1million.
Total statutory net income of our operating subsidiaries was $980.3 million, $100.7 million and $425.5 million for 2006, 2005 and 2004, respectively. The difference between statutory financial statements and statements prepared in accordance with U.S. GAAP vary by jurisdiction; however, the primary difference is that statutory financial statements do not reflect deferred policy acquisition costs, certain net deferred tax assets, intangible assets, unrealized appreciation on debt securities or certain unauthorized reinsurance recoverables.