We currently lease office space in Hamilton, Bermuda where our executive and principal offices are located, and in Dublin, Ireland; George Town, Grand Cayman; Singapore; Dubai; Japan; Denver, Colorado; Charlotte, North Carolina; London, United Kingdom and Windsor, United Kingdom. Our life reinsurance business operates out of the Bermuda, Charlotte, Denver, Dublin, Singapore, Dubai, Japan, London and Windsor offices while our wealth management business operates out of the Grand Cayman office.
The Cayman lease is month to month, the Japan lease expires in 2007, the Dublin, Dubai and Singapore leases expire in 2008, the Denver lease expires in 2009 with an option to lease office space for an additional five years, the Bermuda lease expires in 2011 and the London and Charlotte leases expire in 2016. The Windsor lease expires in 2023 but there is an option to break the lease in 2013. Certain of the offices have lease renewal options for terms ranging from 1 to 5 years.
(1) Scottish Re Holdings Limited was acquired on December 31, 2001 and is included in balance sheet data for 2002-2006 and income statement data for years 2002-2006.
The ING individual life reinsurance business was acquired on December 31, 2004 and is included in balance sheet data for years 2004-2006 and income statement data for years 2005 and 2006.
o Financial condition: our financial strength ratings, financial leverage, liquidity and growth in return on equity and book value per share.
We derive revenue primarily from premiums from reinsurance assumed on life business from existing treaties and from premiums on new treaties, investment income, realized gains and losses from our investment portfolio and fees from our financial solutions and wealth management businesses.
Our primary business is life reinsurance, which involves reinsuring life insurance policies, with premiums earned typically over a period of 10 to 30 years. Each year, however, a portion of the business under existing treaties terminates due to, among other things, lapses or surrenders of underlying policies, deaths of policyholders occasionally and the exercise of recapture options by ceding companies.
Our investment income includes interest earned on our fixed income investments and income from funds withheld at interest under modified coinsurance agreements or coinsurance funds withheld agreements. Under GAAP, because our fixed income investments are held as available for sale, these securities are carried at fair value, and unrealized appreciation/depreciation on these securities is not included in investment income on our statements of income (loss), but is included in comprehensive income as a separate component of shareholders' equity. Realized gains and losses include gains and losses on investment securities that we sell during a period, write downs of securities deemed to be other than temporarily impaired and foreign currency exchange gains and losses.
In addition, our profits can be affected by a number of factors that are not within our control. For example, movements in interest rates can affect the volume of business that we write, the income earned from our investments, the interest we credit on interest sensitive contracts, the level of surrender activity on contracts that we reinsure and the rate at which we amortize deferred acquisition costs. Other external factors that can affect profitability include mortality experience that varies from our assumed mortality. In addition, while death claims are reasonably predictable over a period of many years, claims become less predictable over shorter periods and are subject to significant fluctuation from quarter to quarter and year to year. Other factors include changes in regulation or tax laws which may affect the attractiveness of our products or the costs of doing business and changes in foreign currency exchange rates.
Claims payable for incurred but not reported losses are determined using case basis estimates and lag studies of past experience. The time lag from the date of the claim or death to when the ceding company reports the claim to us can vary significantly by ceding company, but generally averages around 2 months. We update our
Occasionally, we experience processing backlogs and establish reserves for processing backlogs with a goal of clearing all backlogs as quickly as possible. There were no significant processing backlogs at December 31, 2006.
Reinsurance premiums from traditional life policies and annuity policies with life contingencies are generally recognized as revenue when due from policyholders and are reported net of amounts retroceded. Traditional life policies include those contracts with fixed and guaranteed premiums and benefits, and consist principally of whole life and term insurance policies. For our traditional life reinsurance business, we estimate assumed premiums using actuarial model projections at the treaty level. Consistent with reinsurance industry practices, these models use the most recent policy level data available from our ceding companies and our estimate of new business for treaties still open to new business. The estimated premiums from the models are then compared to historical trends in reported assumed premiums by treaty and other information and adjusted if appropriate. Actual results could differ from these estimates. The adjustments in a given period have generally not been significant to the overall premiums or results of operations. However, in the second quarter of 2006, we made an adjustment to reduce premium accruals by approximately $8.0 million related to prior periods.
The development of policy reserves and amortization of deferred acquisition costs for our products requires management to make estimates and assumptions regarding mortality, lapse, expenses and investment experience. Such estimates are primarily based on historical experience and information provided by ceding companies. Actual results could differ materially from those estimates. Management monitors actual experience, and should circumstances warrant, will revise its assumptions and the related reserve estimates.
Present value of in-force business is established upon the acquisition of block of business and is amortized over the expected life of the business at the time of acquisition. The amortization each year will be a function of the gross profits or revenues each year in relation to the total gross profits or revenues expected over the life of the business, discounted at the assumed net credit rate. The determination of the initial value and the subsequent amortization require management to make estimates and assumptions regarding the future business results that could differ materially from actual results. Estimates and assumptions involved in the present value of in-force business and subsequent amortization are similar to those necessary in the establishment of reserves and amortization of deferred acquisition costs.
As the discussion above indicates, there are risks and uncertainties associated with determining whether declines in the fair value of investments are other-than-temporary. These include subsequent significant changes in general overall economic conditions, as well as specific business conditions affecting particular issuers, future financial market effects such as interest rate spreads, future rating agency actions and significant accounting, fraud or corporate governance issues that may adversely affect certain investments. In addition, there are often significant estimates and assumptions that we use to estimate the fair values of securities, including projections of expected future cash flows and pricing of private securities. We continually monitor developments and update underlying assumptions and financial models based upon new information.
Future quarterly tax amounts will continue to be dependent upon the relationship between pre-tax GAAP profits and statutory profits and will also be impacted by the size and timing of certain statutory related deferred tax liabilities. Moreover, management will continue to assess and determine the need for the amount of the valuation allowance in subsequent periods in accordance with the requirements of SFAS No. 109 or in accordance with FIN 48.
In December 2003, the Financial Accounting Standards Board ("FASB") revised FASB Interpretation No. 46 and 46R, "Consolidation of Variable Interest Entities" ("FIN 46" and "FIN 46R"), which was originally issued in January 2003. FIN 46R addresses whether certain types of entities, referred to as variable interest entities ("VIEs"), should be consolidated in a company's financial statements. A company must consolidate a VIE in which it has an ownership, contractual or other financial interest if it is determined to be the primary beneficiary. A primary beneficiary has a variable interest that will absorb a majority of the expected losses if they occur, receive a majority of the entity's expected returns, or both. We are the primary beneficiary of certain of the collateral finance facilities discussed in Note 7 to the Consolidated Financial Statements and have consolidated the variable interest entities in accordance with FIN 46R. The Stingray Investor Trust, discussed in Note 7 to the Consolidated Financial Statements, is a variable interest entity but we are not considered to be the primary beneficiary of the Investor Trust. Accordingly, it is not consolidated in accordance with FIN 46R.
embedded derivatives requiring bifurcation. In addition, reinsurance contracts with experience refunds are also considered to be arrangements containing embedded derivatives requiring bifurcation. The change in the value of embedded derivatives increased revenues by $5.8 million in 2006 compared to a decrease of $8.5 million in 2005. The primary reason for the increase was related to the realization of losses on certain securities held under a modified coinsurance arrangement that were sold from the modified coinsurance arrangement in the first quarter of 2006 in order to provide collateral for the Ballantyne Re securitization.
Net investment income increased by 73% in 2006 to $616.6 million compared to $355.8 million in 2005. The increase in investment income is primarily due to the income on higher total investments from the new securitization structures, including Ballantyne Re, Orkney Re II and HSBC II, combined with higher interest rates.
The loss before income taxes and minority interest was $147.5 million in 2006 compared to income before income taxes and minority interest of $113.6 million in 2005.
Prior to the second quarter of 2006, these tax planning strategies provided justification to support our deferred tax asset. The combination of the increased pressure on our existing tax planning strategies, the operating loss for the period, and the prospects of a ratings downgrade during the second quarter led management to conclude that it was no longer "more likely than not" that the full amount of the gross deferred tax asset could be realized. Accordingly, we established a valuation allowance of $112.4 million during the second quarter. During the third quarter we established an additional valuation allowance on deferred tax assets principally related to current period tax benefits not being recognized and an additional valuation allowance established on prior period deferred tax assets resulting from revised statutory and tax projections related to certain legal entities.
Income tax expense in the fourth quarter of 2006 was $118.2 principally related to an approximate $91.0 million valuation allowance established on deferred tax assets. The valuation allowance resulted from a specific tax planning strategy no longer available to us. In this regard, we have a deferred tax asset resulting from reserves and a net operating loss associated with the Orkney I securitization. In accordance with SFAS No. 109, a portion of this gross deferred tax asset was historically supported by the reversal of deferred tax liabilities within the carry forward period and the remaining portion was supported by a tax planning strategy. The tax planning strategy involved our ability to request a change from the use of statutory accounting principles to GAAP in the filings with the South Carolina Department of Insurance. This change would have eliminated the gross deferred tax asset relating to reserves and the net operating loss. While the request would effectively put us back to the default method of accounting in South Carolina, it nevertheless required the approval of the South Carolina Department of Insurance. In prior periods, we concluded that this tax planning strategy was both prudent and feasible.
At December 31, 2006, we believe that it is more likely than not that the remaining gross deferred tax assets, net of the valuation allowance of $304.9 million, will reduce taxes payable in future years. At the end of the fourth quarter, the remaining gross deferred tax asset is supported by the reversal of deferred tax liabilities within the carry forward period and a tax planning strategy related to SFAS No. 115 and management's ability to retain certain securities with unrealized losses.
Future quarterly tax amounts will continue to be dependent upon the relationship between pre-tax GAAP profits and statutory profits and will also be impacted by the size and timing of certain statutory related deferred tax liabilities. Moreover, management will continue to assess and determine the need for the amount of the valuation allowance in subsequent periods in accordance with the requirements of SFAS No. 109 and FIN 48.
Total revenues increased by 182% in 2005 to $2,297.3 million compared to 2004. The increase in premiums earned is primarily due to the acquisition of the ING business on December 31, 2004 and growth in the traditional solutions line of business in our Life Reinsurance North America Segment. The key drivers of the 2005 increase in investment income were the growth in our invested assets which arises from business growth and the ING acquisition, net proceeds of $120.4 million from our offering of 5,000,000 non-cumulative perpetual preferred shares in July 2005 and investment income earned on the invested assets from our Regulation XXX initiatives completed during the year.
When analyzing the impact of net investment income on our results, it is important to understand that a portion of the investment income earned is credited to the policyholders of our fixed annuity products. The interest credited to policyholders is included in expenses. Annuity product interest rate margins represent the excess of the yield on earning assets over the average crediting rate.
Net realized gains were $12.0 million higher in 2005 than 2004. Improvements in the credit markets in 2005 resulted in less write downs for other than temporary impairments of available for sale securities - $2.4 million in 2005 as compared to $9.9 million in 2004. We also realized a gain of $2.2 million in 2005 compared to a loss of $2.2 million for the same period in 2004, resulting from the mark to market adjustment of an interest rate swap. This derivative has not been designated as a hedge and, accordingly, changes in fair value are recorded in the determination of net income.
The change in the value of embedded derivatives decreased revenues by $8.5 million in 2005 compared to an increase of $4.6 million in 2004. This change in value arose principally because of the asset/liability mismatch on modified coinsurance contracts assumed in the ING acquisition, coupled with a decrease in risk free interest rates and widening of credit spreads.
Included in the 2005 tax benefit is a $2.5 million expense related to the write-off of a deferred tax asset related to state income taxes. The 2005 income tax benefit is in respect of certain of our U.S. taxable entities and our U.K. entities, offset by income tax expenses arising on our Irish entity and other U.S. entities.
Finally, premiums earned in 2006 were lower than in 2005 due to the termination of new business on certain treaties, an overall reduction in new business volume and a decrease in renewal premiums as a result of the rating downgrades in mid 2006. Traditional life reinsurance new business face amounts assumed was $56.0 billion in 2006 compared to $131.0 billion in 2005.
Investment income for 2006 increased 71% to $584.4 million compared to $341.5 million for 2005. The increase was principally due to the growth in our average invested assets but also favorably impacted by an increase in interest rates. Our total invested assets have increased significantly because of growth in our Life Reinsurance North America Segment, including the closing of a large equity-indexed annuity contract at the end of 2005 and the investment of the proceeds of our Regulation XXX transactions that closed in December 2005 and May 2006. The Life Reinsurance North America Segment also benefited from a large portion of the proceeds from the December 2005 equity issuance which were contributed to this segment. Additionally contributing to the favorable increase is $63.2 million of investment income on the previously described equity-indexed annuity treaty which was substantially offset by fluctuations in reserves, interest credited and net acquisition costs. Our investment portfolio maintained an average quality rating of AA- and increased its average book yield from 5.1% in 2005 to 5.6% in 2006.
Realized losses for 2006 were $19.0 million compared to a $1.1 million gain in 2005. The net realized loss for the year includes losses related to selling investments in the first quarter of 2006 in preparation of funding the Ballantyne Re transaction. These gains were effectively offset by gains in the change in value of embedded derivatives. The change in value of embedded derivatives for 2006 resulted in a $5.8 million gain compared to a loss of $8.5 million in 2005. The primary reason for the increase was related to the realization of losses on certain securities held under a modified coinsurance arrangement that were sold in the first quarter of 2006 in order to provide collateral for the Ballantyne Re securitization.
Claims and other policy benefits for 2006 increased 9% to $1,490.3 million compared to $1,365.6 million for 2005. Claims and other policy benefits as a percentage of net earned premiums were 87% and 75% for 2006 and 2005, respectively. In the first quarter of 2006, although gross claims were within expectations in the aggregate, a higher number of smaller claims within our retention limit resulted in retrocession recoveries below our expectations, which resulted in approximately $16.0 million of adverse mortality, principally within our ING block. We experienced a similar situation in the fourth quarter of 2006, although at a much lower level. Mortality was within expectations for the second and third quarters of 2006 but again adverse in the fourth quarter of 2006 by approximately $14.0 million. In addition to the lower than expected retrocession recoveries, the fourth quarter of 2006 mortality experience was due to a combination of higher claim volume and higher average claim size. Offsetting our adverse mortality in the first and fourth quarters were favorable experience refunds of $5.8 million and $3.4 million, respectively, which are recorded in premiums as previously noted. For the full year ended 2006, our actual net mortality (excluding experience refunds) was approximately 103% of expected on over $1.1 billion in claims.
Collateral finance facilities expenses for 2006 increased 376% to $205.2 million compared to $43.1 million in 2005. This increase is due to the interest costs relating to the Regulation XXX transactions. In addition, beginning in the second half of 2005, a portion of the cost of the Stingray facility was charged to the Life Reinsurance North America Segment. Due to rating agency downgrades, our 2006 collateral finance facilities expenses increased by $5.8 million relating to additional fees to be paid to the financial guarantors of our securitization transactions.
Net premiums earned increased by $1.3 billion, or 289%, in 2005 compared to 2004 primarily as a result of the favorable impact of the ING acquisition. The remaining increase was due to the increases in the amounts of life insurance in-force on existing business and on new business written during the year. New business face amounts assumed was $131 billion in 2005 compared to $64 billion in 2004. As of December 31, 2005, we had approximately $1.02 trillion of life reinsurance in-force compared to just under $1.0 trillion at December 31, 2004.
Claims and policy benefits increased by 297% in 2005 compared to 2004. The increase was primarily due to the impact of the ING acquisition. Claims and other policy benefits, as a percentage of net premiums, were 75.2% and 73.7% in 2005 and 2004, respectively. Death claims are reasonably predictable over a period of many years, but are less predictable over shorter periods and are subject to fluctuation from quarter to quarter. During the second quarter of 2005, we experienced higher than expected mortality which resulted in higher claims of approximately $14 million. This was due principally to a higher than expected number of large claims being incurred. Mortality was within expectations for the remainder of 2005 and, therefore, overall mortality in 2005 was slightly higher than expected. Conversely, in 2004, mortality experience was slightly better than anticipated.
In 2005, interest credited to interest sensitive contract liabilities increased by 25% to $133.0 million from $106.5 million in 2004. The increase was due to interest credited on new reinsurance treaties and increases in interest credited on existing treaties due to increasing average liability balances. Interest contract liabilities were $3.9 billion at December 31, 2005 compared to with $3.2 billion at December 31, 2004.
The collateral finance facility costs associated with the Regulation XXX financing transactions completed in 2005 contributed to the significant increase in the collateral finance facilities expense in 2005. These facilities are described in Note 7 to the Consolidated Financial Statements.
Net premiums earned during 2006 increased by 3% to $122.7 million compared to $119.1 million in 2005. There was an increase of premiums earned from a number of new UK protection treaties over the course of 2006 amounting to $14.5 million. In addition, a number of clean up activities within the portfolio took place in 2006 both positive and negative, with an overall impact of reducing premium by $2.0 million reflecting updated data received from cedants but also a business initiative to reduce historic backlogs in processing. In addition, in 2005 premiums were grossed up as a result of updated information from two Lloyds syndicates which accounted for increased premium of $9.0 million, related to prior periods.
Investment income in 2006 increased 109% to $24.1 million compared to $11.5 million in 2005. The increase was mainly due to a single large annuity agreement which provided $11.3 million of additional investment income during the year.
Realized losses for 2006 were $11.6 million compared to a $1.3 million gain for 2005. The net realized loss for the year to date includes a $7.2 million loss related to the rebalancing of the investment portfolio in respect of the annuity agreement in the second quarter of 2006 and a further loss of $3.3 million arising from a previously unrealized loss position becoming realized upon the recapture of this annuity agreement in the third quarter of 2006. These losses were caused by rising GBP interest rates and were offset by reductions in the liability value that we had to pay the ceding company upon termination of the transaction.
Acquisition costs and other insurance expenses increased by 80% in 2006 to $37.3 million compared to $20.7 million in 2005. In general, acquisition costs and other insurance expenses have increased due to a shift in business mix towards long term protection business which carries a higher average commission rate. In addition, collateral costs of $3.5 million in relation to the recapture of the annuity agreement increased other insurance expenses in the year, but were offset by $4.0 million of reduced costs previously described in 2005 due to one-off cost adjustments in respect of our Lloyd's of London syndicates. Our deferred acquisition costs are principally related to our U.K. protection business written in late 2005 and 2006. Given the relatively small amount of in-force business in the Life Reinsurance International Segment, the assessment of the recoverability of deferred acquisition costs is very dependent upon projections of new business margins. Based on the impact of the rating downgrades and other market developments within the U.K., we revised our estimate of the future margins on this business and determined that a substantial portion of our deferred acquisition costs were unrecoverable and, accordingly, a write-off of $11.8 million deferred acquisition costs was made in the fourth quarter of 2006.
An impairment review was undertaken during the fourth quarter of 2006 of the goodwill balance carried within the Life Reinsurance International Segment related to previously acquired business, resulting in a full write-down of $33.8 million.
Net premiums earned decreased $3.5 million, or 3%, in 2005 compared to 2004. During 2004, we reviewed the pricing and profitability of all contracts written in this segment and, as a result, decided not to renew treaties which did not meet our profitability goals. Accordingly, premiums earned decreased in 2005 as compared to 2004. In addition, during 2005 there was an increase in net premiums of $9.0 million due to revised reporting received on our share of two Lloyd's of London life syndicates offset by revisions to premium accruals of $2.2 million based on improved underlying data. During 2004, premiums earned included $4.2 million relating to revised reporting received on a share of two Lloyd's of London life syndicates.
During 2005, acquisition costs and other insurance expenses increased by $3.1 million, or 18%, to $20.7 million from $17.6 million in 2004. Acquisition costs include the amortization of the present value of in-force business. Acquisition costs for 2005 included $4.3 million due to revised reporting received on our share of two Lloyd's of London life syndicates and the write-off of an uncollectible receivable of $1.2 million. In 2004, we
recognized profit commission income of $1.8 million arising from a run off book of business and also included $2.4 million expense relating to our share of two Lloyd's of London life syndicates.
Investment income increased by 190% in 2006 to $8.2 million compared to $2.8 million in 2005. Investment income arises in the Corporate and Other Segment due to capital not specifically allocated to the Life Reinsurance North America or Life Reinsurance International Segments. Investment income will increase or decrease as capital is raised and deployed to the operating segments. The increase is principally due to an increase in investment assets arising from the borrowing under the Stingray facility, a portion of the proceeds received from the equity issuance in December 2005 and settlement of the forward share sale agreement during the third quarter of 2006.
Interest expense increased by 7% in 2006 to $10.6 million compared to $9.9 million in 2005. This increase was as a result of our utilization of our credit facilities and reverse repurchase agreements during the current year. Other interest expense included interest on the 4.5% Senior Convertible Notes and the 1.0% dividend payable on the convertible preferred shares of our HyCU's. Nearly all of the 4.5% Senior Convertible Notes were repurchased and retired in December 2006 with the remaining $8,000 retired in January 2007.
Collateral finance facilities expense increased by 129% in 2006 to $11.5 million compared to $5.0 million in 2005. The collateral finance facilities expense consisted entirely of the put premium and interest costs under the Stingray facility. Costs increased during the current year due to borrowing under the Stingray facility in August 2006.
Interest expense includes interest on the 4.5% Senior Convertible Notes and the 1.0% dividend payable on the convertible preferred shares of our HyCU's. In addition, interest expense in 2005 included $0.8 million in interest expense on the Cypress Notes. These were converted into Class C Warrants on April 7, 2005.
At December 31, 2006 and 2005, the portfolio controlled by us consisting of fixed income securities, preferred stock and cash was $8.7 billion and $6.7 billion, respectively. The portfolio controlled by us excludes the assets held by ceding insurers under modified coinsurance and funds withheld coinsurance arrangements. The majority of these assets are publicly traded securities; however, at December 31, 2006, $532.9 million and $452.9 million, respectively, represent investments in private securities. Of the total portfolio controlled by us, $8.2 billion and $5.4 billion at December 31, 2006 and 2005, respectively, represented the fixed income and preferred stock portfolios managed by external investment managers and $0.5 billion and $1.3 billion, respectively, represented other cash balances. The data in the tables below exclude assets held by ceding insurers under modified coinsurance and funds withheld coinsurance agreements.
At December 31, 2006, the average Standard & Poor's rating of our portfolio was "AA" the average effective duration was 2.9 years and the average book yield was 5.5% as compared to an average rating of "AA" an average effective duration of 2.9 years and an average book yield of 4.9% at December 31, 2005. At December 31,
2006, the unrealized depreciation on investments, net of tax and deferred acquisition costs, was $41.0 million as compared to unrealized appreciation on investments, net of tax and deferred acquisition costs, of $17.9 million at December 31, 2005. The unrealized appreciation/depreciation on investments is included in our consolidated balance sheet as part of shareholders' equity.
The following table presents the fixed income investment portfolio credit exposure by Standard & Poor's ratings, where available, and otherwise by ratings provided by other agencies.
Based on our analysis of each security whose price has been below market for greater than twelve months, we believe that the financial strength, liquidity, leverage, future outlook, and our ability and intent to hold the security until recovery support the view that the security was not "other-than-temporarily" impaired as of December 31, 2006. The unrealized losses on fixed maturity securities are primarily a result of rising interest rates, changes in credit spreads and the long-dated maturities of the securities. Additionally, as of December 31, 2006, approximately 98% of the gross unrealized losses are associated with investment grade securities.
The following tables analyze the industry analysis of the unrealized losses at December 31, 2006 and 2005 by industry:
* Other industries each represent less than 3% of estimated fair value
When we originate each new reinsurance transaction, the price and terms are based on results of simulation models in which projected investment cash flows will match liability cash flows within reasonable tolerances. The investment portfolio characteristics found to be most suitable for the liability are used to design the investment guidelines and target duration for the portfolio. We currently manage our asset/liability processes for one hundred individual portfolios.
Funds withheld at interest arise on modified coinsurance agreements and funds withheld coinsurance agreements. In economic substance, these agreements are identical to coinsurance treaties except that the ceding company retains control of and title to the assets. The ceding company holds assets backing the statutory reserves in a segregated portfolio, which is managed by the ceding company or by investment managers appointed by the ceding company. These treaties transfer a quota share of the risks. The funds withheld at interest represent our share of the ceding companies' statutory reserves. The cash flows exchanged with each monthly settlement are netted and include, among other items, our quota share of investment income on our proportionate share of the portfolio, realized losses, realized gains (amortized to reflect the statutory rules relating to interest maintenance reserve), interest credited and expense allowances.
At December 31, 2006, the market value of the assets representing funds withheld at interest totaled $1.9 billion with an average rating of "A" an average effective duration of 5.0 years and an average book yield of 5.9% as compared to $2.6 billion with an average rating of "A+" an average effective duration of 5.1 years and an average book yield of 5.6% at December 31, 2005. These are fixed income investments and include marketable securities, commercial mortgages, private placements and cash. The market value of the funds withheld amounted to $1.9 billion and $2.6 billion at December 31, 2006 and December 31, 2005, respectively.
The investment objectives for these arrangements are included in the modified coinsurance and funds withheld coinsurance agreements. The primary objective is to maximize current income, consistent with the long-term preservation of capital. The overall investment strategy is executed within the context of prudent asset/liability management. The investment guidelines permit investments in fixed maturity securities, and include marketable securities, commercial mortgages, private placements and cash. The maximum percentage of below investment grade securities is 10% and other guidelines limit risk, ensure issuer and industry diversification, as well as, maintain liquidity and overall portfolio credit quality.
According to data provided by our ceding companies, the following table reflects the market value of assets backing the funds withheld at interest portfolio by sector.
Net cash used in investing activities was $2,799.9 million in 2006 compared to net cash used in investing activities of $1,857.9 million in 2005. The increase in net cash used in investing activities principally relates to the purchases of fixed maturity securities. In the current year, these were primarily related to the investment of the proceeds of the Regulation XXX transactions closed in December 2005 and May 2006 and the excess cash generated by operating and financing activities. In 2005, these were primarily related to the investment of the proceeds of the collateral finance facilities and the excess cash generated by operating and financing activities and investment of funds received on the ING acquisition.
Net cash provided by financing activities was $1,539.6 million in 2006 and $2,117.8 million in 2005. The current year financings included $1,771.8 million raised in collateral finance facilities, $265.0 million from the drawdown of the Stingray facility, $147.4 million from the prepaid variable share forward contract, reduced by $522.3 million related to net withdrawals from interest sensitive contracts and $115.0 million repayment of long term debt. Prior year financings mainly relate to collateral finance facilities proceeds.
On July 14, 2005, Scottish Annuity & Life Insurance Company (Cayman) Ltd., Scottish Re (Dublin) Limited, Scottish Re (U.S.), Inc. and Scottish Re Limited entered into a $200.0 million, three-year revolving unsecured senior credit facility with a syndicate of banks to provide capacity for borrowing and extending letters of credit. All outstanding letters of credit under this facility were cancelled and the facility was terminated effective January 19, 2007.
On August 18, 2005, Scottish Re (Dublin) Limited entered into a $30.0 million three-year revolving, unsecured letter of credit facility with a syndicate of banks. Effective September 22, 2006, Scottish Annuity & Life Insurance Company (Cayman) Ltd. and Scottish Re (Dublin) Limited terminated the $30 Million Credit Agreement. All letters of credit outstanding under the agreement, in an aggregate of $10.0 million, were cancelled.
On November 21, 2006, Scottish Annuity & Life Insurance Company (Cayman) Ltd. and Scottish Re Limited entered into a one year, $5.0 million letter of credit facility on a fully secured basis. Outstanding letters of credit at December 31, 2006 and February 23, 2007 were $1.6 million and $75,000, respectively.
We are a holding company whose primary uses of liquidity include, but are not limited to, operating expenses, the immediate capital needs of our operating companies, dividends paid to our shareholders and interest payments on our indebtedness. See Note 9 "Debt Obligations" in the Notes to the Consolidated Financial Statements. The primary sources of our liquidity include proceeds from our capital raising efforts, interest income on corporate investments and dividends from operating subsidiaries. The holding company also receives funding from its subsidiaries through transfer pricing reflecting services performed by the holding company on behalf of its subsidiaries. We will continue to be dependent upon these sources of liquidity. On December 6, 2006, we repurchased nearly all of the $115.0 million 4.5% Senior Convertible Notes issued by Scottish Re, which note holders had the right to put to us. The remaining $8,000 in Senior Convertible Notes were subsequently repurchased and cancelled in January 2007.
The decrease in shareholders' equity at December 31, 2006 as compared to December 31, 2005 was primarily due to the net loss available to ordinary shareholders of $376.7 million for 2006, partially offset by the settlement of the prepaid variable share forward contract in which we received $147.3 million in the aggregate and issued an aggregate 6,578,948 ordinary shares.
The increase in capitalization at December 31, 2005 compared to December 31, 2004 was principally due to net proceeds of $174.1 million on the issuance of 7,660,000 ordinary shares (including an over allotment option of 1,410,000 shares), net proceeds of $168.3 million on the issuance of 5,000,000 non-cumulative perpetual preferred shares, the conversion of the 7% Convertible Junior Subordinated Note to ordinary shares and net income for the year ended December 31, 2005 of $130.2 million. These increases were partially offset by the net costs of the variable equity sale forward contracts of $13.8 million, decrease in other comprehensive income of $41.6 million and increase in dividends declared of $6.6 million. Other comprehensive income consists of the unrealized appreciation/depreciation on investments and the cumulative translation adjustment arising from the translation of Scottish Re Holdings Limited's balance sheet at exchange rates as of December 31, 2005.
Effective December 1, 2006, we executed an amendment to our bank credit facility agreement that permitted the payment of up to $115.0 million from Scottish Annuity & Life Insurance Company (Cayman) Ltd. to Scottish Re Group Limited. The payment was transferred on December 4, 2006. These actions enabled us to repurchase nearly all of the $115.0 million 4.5% Senior Convertible Notes which note holders had the right to put to us on December 6, 2006. We subsequently repurchased the remaining $8,000 in Senior Convertible Notes that were not put in order to retire the full issue. The notes were purchased at a repurchase price of 100% of their principal amount plus accrued and unpaid interest and additional amounts, if any, in cash.
On July 28, 2006, the Board of Directors suspended the dividend on our ordinary shares. All future payments of dividends are at the discretion of our Board of Directors and will depend on our income, capital requirements, insurance regulatory conditions, operating conditions and such other factors as the Board of Directors may deem relevant.
o Scottish Re (U.S.), Inc. and Scottish Re Life Corporation are licensed, accredited, approved or authorized to write reinsurance in 50 states and the District of Columbia. As a result, they generally are not required to provide collateral in order for their U.S. customers to receive reserve credit; however, Scottish Re (U.S.), Inc. may agree to provide a reserve credit trust, security trust, or letter of credit to mitigate the counter-party risk from the customer's perspective, thereby enabling transactions that otherwise would be unavailable or would be available only on significantly less attractive terms.
Pursuant to the terms of our acquisition of the individual life reinsurance business of ING, ING is obligated to maintain collateral for the Regulation XXX and AXXX statutory reserve requirements of the acquired business for the duration of such requirements. We pay ING a fee based on the face amount of the collateral provided until satisfactory alternative collateral arrangements are made. We are entitled to a partial rebate of this fee to the extent satisfactory alternative collateral arrangements are implemented prior to the end of 2007.
In 2005 and 2006, we completed three transactions that collectively provided approximately $3.7 billion in collateral arrangements to fund Regulation XXX statutory reserve requirements that were assumed in connection with the acquisition of ING's individual life reinsurance business.
On November 26, 2006, we entered into an amended and restated forbearance agreement with HSBC, pursuant to which HSBC has agreed not to make demands for additional collateral under our collateral finance facilities with HSBC so long as certain conditions are met during the forbearance period which ends on December 31, 2008. This amended forbearance agreement will terminate if the Transaction is not completed. We will likely face demands from HSBC for additional collateral in this event, thereby further exacerbating our tight liquidity and capital position. Any breach by us of our obligation to post collateral could result in an acceleration of our obligations under these collateral finance facilities, which would require us to seek bankruptcy protection under applicable law if we were unable promptly to access alternative sources of capital. (See Note 2 to the Consolidated Financial Statements).
On January 12, 2005, we entered into a put agreement with Stingray Investor Trust ("Stingray") for an aggregate value of $325.0 million. Under the terms of the put agreement, we acquired an irrevocable put option to issue funding agreements to Stingray in return for the assets in a portfolio of 30 day commercial paper. This put option may be exercised at any time. In addition, we may be required to issue funding agreements to Stingray under certain circumstances, including, but not limited to, the non-payment of the put option premium and a non-payment of interest under any outstanding funding agreements under the put agreement. The facility matures on January 12, 2015. This transaction may also provide collateral for Scottish Re (U.S.), Inc. for reinsurance obligations under inter-company reinsurance agreements. At December 31, 2006, $58.0 million was in use for this purpose. We drew down most of the remaining funds, in the amount of $265.0 million, under this facility on August 14, 2006. The put premium and interest costs incurred during the years ended December 31, 2006 and 2005 amounted to $10.2 million and $4.7 million, respectively, and is included in collateral finance facilities expense in the consolidated statements of income (loss). In accordance with FIN 46R, we are not considered to be the primary beneficiary of Stingray and, as a result, we are not required to consolidate Stingray. We are not responsible for any losses incurred by the Stingray Pass Through Trust. The $265.0 million of funds drawn on the facility are included in interest sensitive contract liabilities on our balance sheet.
On February 11, 2005, Orkney Holdings, LLC, a Delaware limited liability company ("Orkney I"), issued and sold in a private offering an aggregate of $850.0 million Series A Floating Rate Insured Notes due February 11, 2035 (the "Orkney Notes"). Orkney I was organized for the limited purpose of holding the stock of Orkney Re, Inc., a South Carolina special purpose captive insurance company, and issuing the Orkney Notes. Scottish Re (U.S.), Inc. holds all of the limited liability company interest in Orkney I, and has contributed capital to Orkney I in the amount of $268.5 million. Proceeds from this offering were used to fund the Regulation XXX reserve requirements for a defined block of level premium term life insurance policies issued between January 1, 2000 and December 31, 2003 reinsured by Scottish Re (U.S.), Inc. to Orkney Re, Inc. Proceeds from the Orkney Notes have been deposited into a series of trusts that collateralize the notes.
In accordance with FIN 46R, Orkney I is considered to be a variable interest entity and we are considered to hold the primary beneficial interest. As a result, Orkney I has been consolidated in our financial statements. The assets of Orkney I have been recorded as fixed maturity investments and cash and cash equivalents. Our consolidated statements of income (loss) show the investment return of Orkney I as investment income and the cost of the facility is reflected in collateral finance facilities expense.
On December 21, 2005, Orkney Re II plc, an orphan special purpose vehicle incorporated under the laws of Ireland ("Orkney II"), whose issued ordinary shares are held by a share trustee and its nominees in trust for charitable purposes, issued in a private offering $450.0 million of debt to external investors. The debt consisted of $382.5 million Series A-1 Floating Rate Guaranteed Notes (the "Series A-1 Notes"), $42.5 million in aggregate principal amount of Series A-2 Floating Rate Notes (the "Series A-2 Notes"), and $25.0 million Series B Floating Rate Notes (the "Series B Notes"), all due December 31, 2035 (collectively, the "Orkney II Notes"). The Orkney II Notes are listed on the Irish Stock Exchange. Proceeds from this offering were used to fund the Regulation XXX reserve requirements for a defined block of level premium term life insurance policies issued between January 1, 2004 and December 31, 2004 reinsured by Scottish Re (U.S.), Inc. to Orkney II. Proceeds from the Orkney II Notes have been deposited into a series of trusts that collateralize the notes.
The debt issued to Scottish Annuity & Life Insurance Company (Cayman) Ltd. consisted of $30.0 million of Series C Floating Rate Notes due December 21, 2036. These notes accrue interest only. Payment of interest does not occur until the Orkney II Notes are fully repaid. Scottish Re Group Limited owns $0.5 million Series D Convertible Notes due December 21, 2036 and 76,190,000 Preference Shares of $1.00 each in capital.
Interest on the principal amount of the Orkney II Notes is payable quarterly at a rate equivalent to three-month LIBOR plus 0.425% for the Series A-1 Notes, three-month LIBOR plus 0.73% for the Series A-2 Notes, and three-month LIBOR plus 3.0% for the Series B Notes. At December 31, 2006, the interest rate on the Series A-1 Notes was 5.80%, Series A-2 Notes was 6.11%, and Series B Notes was 8.38%. The Orkney II Notes also contain a customary limitation on lien provisions and customary events of default provisions, which, if breached, could result in the accelerated maturity of the Orkney II Notes. Orkney II has the option to redeem all or a portion of the Orkney II Notes prior to and on or after February 11, 2007, subject to certain call premiums.
On December 22, 2005, we entered into a second collateral finance facility with HSBC ("HSBC II"). This facility is a 20 year collateral finance facility that provides up to $1.0 billion of Regulation XXX collateral support for the business acquired from ING and can be used to collateralize reinsurance obligations under inter-company reinsurance agreements. Simultaneously, we entered into a total return swap with HSBC under which we are entitled to the total return of the investment portfolio of the trust established for this facility. In accordance with FIN 46R, the trust is considered to be a variable interest entity and we are deemed to hold the primary beneficial interest in the trust. As a result, the trust has been consolidated in our financial statements. The assets of the trust have been recorded as fixed maturity investments, cash and cash equivalents. Our consolidated statements of income (loss) show the investment return of the trust as investment income and the cost of the facility is reflected in collateral finance facilities expense. The creditors of the trust have no recourse against our general assets. As at December 31, 2006, $529.0 million of this facility was being utilized.
See HSBC I above for a discussion of the additional collateral paid to HSBC under this facility.
o $100.0 million of Class A-3 Floating Rate Guaranteed Notes Series A,
o $100.0 million of Class A-3 Floating Rate Guaranteed Notes Series B,
o $100.0 million of Class A-3 Floating Rate Guaranteed Notes Series D,
o $42.0 million of Class C-1 Subordinated Variable Interest Rate Notes.
The debt issued to Scottish Annuity & Life Insurance Company (Cayman) Ltd. consisted of $8.0 million of Class C-1 Subordinated Variable Interest Rate Notes and $170.0 million Class C-2 Subordinated Variable Interest Rate Notes, which Scottish Annuity & Life Insurance Company (Cayman) Ltd. intends to hold (collectively, the "SALIC Notes", and together with the Notes, the "Ballantyne Notes"). Concurrently with its offering of the Ballantyne Notes, Ballantyne Re issued (i) $500,000 of Class D Convertible Notes, which were purchased by Scottish Re Group Limited, (ii) 163.0 million Redeemable Preference Shares of U.S. $1.00 par value per share which were purchased by Scottish Annuity & Life Insurance Company (Cayman) Ltd., and (iii) 18.2 million Non-Redeemable Preference Shares of U.S. $1.00 par value per share which were also purchased by Scottish Annuity & Life Insurance Company (Cayman) Ltd.
Interest on the principal amount of the Ballantyne Notes is payable in intervals ranging from every 28 days to monthly to annually, depending on the note, initially at a rate equivalent to one-month LIBOR plus 0.61% for the
On December 22, 2005, we entered into a long term reinsurance facility ("Reinsurance Facility"), with a third-party Bermuda-domiciled reinsurer that provides up to $1.0 billion of Regulation XXX collateral support for the business acquired from ING. The Bermuda reinsurer provides security in the form of letters of credit in trust equal to the statutory reserves. All risks and returns arising out of the underlying book of business are retained by us.
At December 31, 2006, we had $3.8 billion of collateral finance facility obligations relating to the HSBC I, HSBC II, Orkney I, Orkney II and Ballantyne Re transactions. In connection with these transactions, we have assets in trust of approximately $5.6 billion that represent assets supporting the economic reserves, excess reserves, additional funding amounts and surplus in the transactions. The assets in trust are managed in accordance with predefined investment guidelines as to permitted investments, portfolio quality, diversification and duration.
Scottish Annuity & Life Insurance Company (Cayman) Ltd. has agreed with Scottish Re Life Corporation that it will (1) cause Scottish Re Life Corporation to maintain capital and surplus equal to at least 175% of Company Action Level RBC, as defined under the laws of the State of Delaware and (2) provide Scottish Re Life Corporation with enough liquidity to meet its obligations in a timely manner.
All of our regulated insurance entities are in excess of their minimum regulatory capital requirements as of December 31, 2006. See Risk Factors beginning on page 22 for a discussion of the potential impact on our regulatory capital requirements if the Transaction is not consummated.
On May 4, 2006, we entered into an agreement that provides two classes totaling $155.0 million of collateralized catastrophe protection with Tartan Capital Limited ("Tartan"), a special purpose Cayman Islands company which was funded through a catastrophe bond transaction. This coverage is for the period January 1, 2006 to December 31, 2008 and provides Scottish Annuity & Life Insurance Company (Cayman) Ltd. with protection from losses arising from higher than normal mortality levels within the United States, as reported by the U.S. Centers for Disease Control and Prevention or other designated reporting agency. This coverage is based on a mortality index, which is based on age and gender weighted mortality rates for the United States constructed from publicly available data sources, as defined at inception, and which compares the mortality rates over consecutive 2 year periods to a reference index value. Upon the occurrence of a loss event, where the indexed losses exceeds the trigger level for a given tranche, the percentage of the original principal for each tranche paid to Scottish Annuity & Life Insurance Company (Cayman) Ltd. increases linearly between the trigger level and exhaustion level. Since the amount of any recovery is based on the mortality index, the amount of the recovery may be different than the ultimate claims paid by Scottish Annuity and Life Insurance Company (Cayman) Ltd.'s and any of its affiliates resulting from the loss event.
In accordance with SFAS No. 133, this contract is considered to be a derivative. We record this contract at fair value which is included in "Other assets" and "Other liabilities" in the consolidated balance sheets with any changes in the value reflected in "Acquisition costs and other insurance expenses" in the consolidated statements of income (loss). There is no quoted market value available for this derivative. The fair value is estimated utilizing published mortality data. Expenses related to this transaction are included in "Acquisition costs and other insurance expenses" in the Corporate and Other Segment.
Our long-term debt is described in Note 9 to the Consolidated Financial Statements. Long-term debt includes capital securities with various maturities up to 2034. They are however, redeemable at earlier dates. They have been included in the above table at the earliest redemption date.
Life claims payable are included in "Reserves for Future Policy Benefits" in the consolidated balance sheets. Life claims payable include benefit and claim liabilities for which we believe the amount and timing of the payment is essentially fixed and determinable. Such amounts generally relate to incurred and reported death claims and amounted to $500.5 million at December 31, 2006. As of December 31, 2006, reserves for future policy benefits of approximately $3.9 billion related primarily to reinsurance of traditional life insurance and related policies and approximately $3.4 billion of interest sensitive contract liabilities, primarily deferred annuities, have been excluded from this table because these amounts are generally comprised of policies or contracts where (i) we are not currently making payments and will not make payments in the future until the occurrence of an insurable event, such as death or disability or (ii) the occurrence of a payment triggering event, such as a surrender of a policy or contract. The timing of payment on these liabilities is not reasonably fixed and determinable since the insurable event or payment triggering event has not yet occurred, and we have no control over the timing of such occurrence. In addition to timing of payments, significant uncertainties relating to these liabilities include mortality, morbidity and persistency.
In July 2006, the FASB issued FASB Interpretation No. 48 ("FIN 48"), "Accounting for Uncertainty in Income Taxes". FIN 48 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 SFAS No. 109. 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.
In December 2004, the FASB revised SFAS No. 123 by issuing SFAS No. 123(R) which requires us to recognize, in the determination of income, the grant date fair value of all stock options and other equity based compensation issued to employees. We adopted SFAS No. 123(R) on January 1, 2006.
In March 2006, the FASB issued Statement No. 156 ("SFAS No. 156"), "Accounting for Servicing of Financing Assets", which permits an entity to choose either of the following measurement methods for each class of separately recognized servicing assets and servicing liabilities:
o Amortization method -- amortize servicing assets or servicing liabilities in proportion to and over the period of net servicing income or net servicing loss and assess the servicing assets or liabilities for impairment or increased obligation based on fair value at each reporting date. This method is consistent with current subsequent measurement guidance for servicing rights.
SFAS No. 156 is effective as of the beginning of an entity's first fiscal year that begins after September 15, 2006. We are currently assessing the impact of SFAS No. 156 on our results of operations and financial position.
o our ability to consummate the Transaction (including obtaining necessary regulatory approvals and shareholder approval) and realize the benefits of such transaction;
o uncertainties in our ability to raise equity capital or other sources of funding to support ongoing capital and liquidity needs;
o changes in expectations regarding future realization of gross deferred tax assets;
o risk that an ownership change will result in a limitation on our ability to fully utilize tax net operating losses;