Our reinsurance group leases a total of approximately 9,100 square feet in Hamilton, Bermuda under a lease expiring in 2012, and approximately 19,200 square feet in Morristown, New Jersey under a lease expiring in 2011.
Our insurance group leases approximately 8,750 square feet in Hamilton, Bermuda for our Bermuda insurance operations. The principal U.S. office of our insurance group is located at One Liberty Plaza, New York, New York where we lease approximately 118,400 square feet. Such lease expires in 2014, with
the exception of a portion of that lease for approximately 28,390 square feet that expires in 2010. Our insurance group also leases a total of approximately 206,200 square feet for its other primary U.S. offices and its office in Canada.
For the years ended December 31, 2006, 2005 and 2004, our rental expense, net of income from subleases, was approximately $12.9 million, $11.1 million and $12.4 million, respectively. Our future minimum rental charges for the remaining terms of our existing leases, exclusive of escalation clauses and maintenance costs and net of rental income, will be approximately $83.0 million. We believe that the above described office space is adequate for our needs. However, as we continue to develop our business, we may open additional office locations during 2007.
(2) Net income per share is based on the basic and diluted weighted average number of common shares and common share equivalents outstanding.
(3) In our securities lending transactions, we receive collateral in excess of the fair value of the fixed maturities and short-term investments pledged under securities lending agreements. For purposes of this table, we have excluded $891.4 million and $893.4 million, respectively, of collateral received which is reflected as “short-term investment of funds received under securities lending agreements, at fair value” and included $860.8 million and $863.9 million, respectively, of “fixed maturities and short-term investments pledged under securities lending agreements, at fair value” at December 31, 2006 and 2005.
(5) Book value per share excludes the effects of stock options and, in periods prior to 2005, class B warrants. Diluted shares outstanding and diluted book value per share as of December 31, 2001 have been adjusted on a pro forma basis to reflect the issuance of additional series A convertible preference shares on June 28, 2002 and December 16, 2002 pursuant to post-closing purchase price adjustment mechanisms under the Subscription Agreement.
In addition, the weather-related catastrophic events that occurred in the second half of 2005 have resulted in substantial improvements in market conditions in property and certain marine business. We have increased our writings in these lines of business and, as a result, these lines, which are volatile, will represent a larger proportion of our overall book of business in future periods, which may increase the volatility in our results of operations. In order to support this expansion, we sold $325 million of non-cumulative preferred shares in 2006 and signed a quota-share reinsurance treaty with Flatiron Re Ltd., a dedicated reinsurance vehicle, which has allowed us to increase our participation in property and marine lines without significantly increasing our probable maximum loss. The treaty with Flatiron Re Ltd. provides for a profit commission based on the reported underwriting results on a cumulative basis. We record such profit commission based on underwriting experience recorded each quarter. The profit commission arrangement with Flatiron Re Ltd. may increase the volatility of our reported results of operations on both a quarterly and annual basis. As a result, our writings in the property and marine lines of business in 2006 represented a larger proportion of our overall book of business than in 2005.
In October 2001, we launched an underwriting initiative to meet current and future demand in the global insurance and reinsurance markets that included the recruitment of new insurance and reinsurance management teams and an equity capital infusion of $763.2 million in the form of convertible preference shares. In April 2002, we completed an offering of common shares and received net proceeds of $179.2 million and, in September 2002, we received proceeds of $74.3 million from the exercise of class A warrants by our principal shareholders and certain other investors. In March 2004, we completed a public offering of common shares and received net proceeds of $179.3 million and, in May 2004, we completed a public offering of $300 million principal amount of 7.35% senior notes due May 1, 2034 and received net proceeds of $296.4 million, of which $200 million of the net proceeds was used to repay all amounts outstanding under our existing credit facility. In 2006, we issued $325.0 million of non-cumulative preferred shares in public offerings and received net proceeds of $314.4 million.
In the 2005 fourth quarter, all remaining outstanding convertible preference shares were converted to common shares. Since the preference shares were treated as common share equivalents in our reported financial results, the conversion had no impact on diluted earnings per share or diluted book value per share. However, the convertible preference shares were not included in basic calculations prior to their conversion to common shares and, due to the timing of the conversions, basic average shares outstanding and basic earnings per share for 2005 only reflect the impact of the preference share conversion for a small portion of the year. Management does not believe that the comparison of basic earnings per share is
of future amounts required to pay losses and loss adjustment expenses for insured or reinsured events which have occurred at or before the balance sheet date. Loss Reserves do not reflect contingency reserve allowances to account for future loss occurrences. Losses arising from future events will be estimated and recognized at the time the losses are incurred and could be substantial.
At December 31, 2006 and 2005, our Loss Reserves, net of unpaid losses and loss adjustment expenses recoverable, by type and by operating segment were as follows:
Loss Reserves for our insurance operations are comprised of (1) case reserves for claims reported and (2) reserves for losses that have occurred but for which claims have not yet been reported, referred to as IBNR reserves. For our insurance operations, generally, claims personnel determine whether to establish a case reserve for the estimated amount of the ultimate settlement of individual claims. The estimate reflects the judgment of claims personnel based on general corporate reserving practices, the experience and knowledge of such personnel regarding the nature and value of the specific type of claim and, where appropriate, advice of counsel. Our insurance operations also contract with a number of outside third party administrators in the claims process who, in certain cases, have limited authority to establish case reserves. The work of such administrators is reviewed and monitored by our claims personnel. Loss Reserves are also established to provide for loss adjustment expenses (“LAE”) and represent the estimated expense of settling claims, including legal and other fees and the general expenses of administering the claims adjustment process. Periodically, adjustments to the reported or case reserves may be made as additional information regarding the claims is reported or payments are made. IBNR reserves are established to provide for incurred claims which have not yet been reported to an insurer or reinsurer at the balance sheet date as well as to adjust for any projected variance in case reserving. IBNR reserves are derived by subtracting paid losses and LAE and case reserves from estimates of ultimate losses and loss adjustment expenses. Actuaries estimate ultimate losses and LAE using various generally accepted actuarial methods applied to known losses and other relevant information. Like case reserves, IBNR reserves are adjusted as additional information becomes known or payments are made. The process of estimating reserves involves a considerable degree of judgment by management and, as of any given date, is inherently uncertain.
Ultimate losses and LAE are generally determined by extrapolation of claim emergence and settlement patterns observed in the past that can reasonably be expected to persist into the future. In forecasting ultimate losses and LAE with respect to any line of business, past experience with respect to
that line of business is the primary resource, developed through both industry and company experience, but cannot be relied upon in isolation. Uncertainties in estimating ultimate losses and LAE are magnified by the time lag between when a claim actually occurs and when it is reported and settled. This time lag is sometimes referred to as the “claim-tail”. The claim-tail for most property coverages is typically short (usually several months up to a few years). The claim-tail for certain professional liability, executive assurance and healthcare coverages, which are generally written on a claims-made basis, is typically longer than property coverages but shorter than casualty lines. The claim-tail for liability/casualty coverages, such as general liability, products liability, multiple peril coverage, and workers’ compensation, may be especially long as claims are often reported and ultimately paid or settled years, even decades, after the related loss events occur. During the long claims reporting and settlement period, additional facts regarding coverages written in prior accident years, as well as about actual claims and trends, may become known and, as a result, our insurance operations may adjust their reserves. If management determines that an adjustment is appropriate, the adjustment is recorded in the accounting period in which such determination is made in accordance with GAAP. Accordingly, should Loss Reserves need to be increased or decreased in the future from amounts currently established, future results of operations would be negatively or positively impacted, respectively.
At December 31, 2006 and 2005, Loss Reserves for our insurance operations by major line of business, net of unpaid losses and loss adjustment expenses recoverable, were as follows:
· Expected loss methods-these methods are based on the assumption that ultimate losses vary proportionately with premiums. Expected loss and LAE ratios are typically developed based upon the information derived by underwriters and actuaries during the initial pricing of the business, supplemented by industry data available from organizations, such as statistical bureaus and consulting firms, where appropriate. These ratios consider, among other things, rate increases and changes in terms and conditions that have been observed in the market. Expected loss methods are useful for estimating ultimate losses and LAE in the early years of long-tailed lines of business, when little or no paid or incurred loss information is available, and is commonly applied when limited loss experience exists for a company.
· Historical incurred loss development methods-these methods assume that the ratio of losses in one period to losses in an earlier period will remain constant in the future. These methods use incurred losses (i.e., the sum of cumulative historical loss payments plus outstanding case reserves) over discrete periods of time to estimate future losses. Historical incurred loss development methods may be preferable to historical paid loss development methods because they explicitly take into account open cases and the claims adjusters’ evaluations of the cost to settle all known claims. However, historical incurred loss development methods necessarily assume that case reserving practices are consistently applied over time. Therefore, when there have been significant changes in how case reserves are established, using incurred loss data to project ultimate losses may be less reliable than other methods.
· Historical paid loss development methods-these methods, like historical incurred loss development methods, assume that the ratio of losses in one period to losses in an earlier period will remain constant. These methods use historical loss payments over discrete periods of time to estimate future losses and necessarily assume that factors that have affected paid losses in the past, such as inflation or the effects of litigation, will remain constant in the future. Because historical paid loss development methods do not use incurred losses to estimate ultimate losses, they may be more reliable than the other methods that use incurred losses in situations where there are significant changes in how incurred losses are established by a company’s claims adjusters. However, historical
· Adjusted historical paid and incurred loss development methods-these methods take traditional historical paid and incurred loss development methods and adjust them for the estimated impact of changes from the past in factors such as inflation, the speed of claim payments or the adequacy of case reserves. Adjusted historical paid and incurred loss development methods are often more reliable methods of predicting ultimate losses in periods of significant change, provided the actuaries can develop methods to reasonably quantify the impact of changes. As such, these methods utilize more judgment than historical paid and incurred loss development methods.
· Additional analyses-other methodologies are often used in the reserving process for specific types of claims or events, such as catastrophic or other specific major events. These include vendor catastrophe models, which are typically used in the estimation of Loss Reserves at the early stage of known catastrophic events before information has been reported to an insurer or reinsurer, and analyses of specific industry events, such as large lawsuits or claims.
In the initial reserving process for property, marine and aviation business, which are primarily short-tail exposures, our insurance operations primarily rely on the expected loss method. For catastrophe-
In the initial reserving process for construction and surety business, consisting of primary and excess casualty and contract surety coverages written on an occurrence and claims-made basis, our insurance
operations primarily rely on the expected loss method. Such business is subject to the assumptions and development characteristics noted above for casualty business. As time passes, for a given accident year, additional weight is given to the paid and incurred B-F loss development methods and historical paid and incurred loss development methods in the reserving process. The expected loss ratios used in the initial reserving process for our insurance operations’ construction and surety business for recent accident years have not varied significantly from earlier accident years due to the medium-tail nature of the business written and the limited number of years of historical experience available for use in actuarial methods. As the credibility of historical experience for earlier accident years increases, the experience from these accident years will be given a greater weighting in the actuarial analysis to determine future accident year expected loss ratios, adjusted for anticipated changes in the regulatory environment, pricing, loss trends, terms and conditions and reinsurance structure.
For the years ended December 31, 2004 to 2006, on average, our insurance segment has reported approximately $16 million of estimated net favorable development in prior year Loss Reserves, or approximately 1.4% of average beginning Loss Reserves. Of such amount, approximately $19 million came from long-tail lines, or 4.1% of average beginning Loss Reserves, and $6 million from medium-tail lines, or 1.1% of beginning Loss Reserves, offset partially by adverse development on $9 million from short-tail lines, or 5% of average beginning Loss Reserves. The average adverse development on short-tail lines resulted from $31 million of adverse development recorded in 2006 on the 2005 catastrophic events. For the year ended December 31, 2006, estimated net favorable development in prior year Loss Reserves was $8 million, or 0.5% of beginning Loss Reserves. Such amount consisted of approximately $32 million from long-tail lines, or 4.5% of beginning Loss Reserves, and $20 million from medium-tail lines, or 2.5% of beginning Loss Reserves, partially offset by adverse development of $44 million from short-tail lines (which included $31 million of adverse development on the 2005 catastrophic events), or 14.2% of beginning Loss Reserves. For informational purposes, based on historical results, applying the 1.4% average estimated net favorable development in average beginning Loss Reserves for the years ended December 31, 2004 to 2006 to our insurance segment’s net Loss Reserves of $2.42 billion at December 31, 2006 would result in an increase in income before income taxes of approximately $33 million, or $0.43 per diluted share, and applying the 0.5% of estimated net favorable development in beginning Loss Reserves for the year ended December 31, 2006 to such Loss Reserves would result in an increase in income before income taxes of approximately $11 million, or $0.14 per diluted share. The amounts noted above are informational only and should not be considered projections of future events. Future favorable or adverse development in our insurance segment’s Loss Reserves is subject to numerous factors, and no assurances can be given that we will experience favorable development in our Loss Reserves or that our ultimate losses will not be significantly different than the amounts shown above, and such differences could directly and significantly impact earnings favorably or unfavorably in the period they are determined. Because of our insurance segment’s limited operating history, the sensitivity analysis above is one way to gauge the impact of changes in the assumptions in our reserving process. For another estimate of potential variability in our insurance segment’s Loss Reserves, see “-Simulation Results.” Refer to “Results of Operations” for a discussion on net favorable or adverse development of our insurance operations’ prior year Loss Reserves.
Loss Reserves for our reinsurance operations are comprised of (1) case reserves for claims reported, (2) additional case reserves (“ACRs”) and (3) IBNR reserves. Our reinsurance operations receive reports of claims notices from ceding companies and record case reserves based upon the amount of reserves recommended by the ceding company. Case reserves on known events may be supplemented by ACRs, which are often estimated by our reinsurance operations’ claims personnel ahead of official notification from the ceding company, or when our reinsurance operations’ judgment regarding the size or severity of the known event differs from the ceding company. In certain instances, our reinsurance operations establish ACRs even when the ceding company does not report any liability on a known event. In addition,
At December 31, 2006 and 2005, Loss Reserves for our reinsurance operations by major line of business, net of unpaid losses and loss adjustment expenses recoverable, were as follows:
In the initial reserving process for short-tail lines, consisting of property excluding property catastrophe and property catastrophe exposures, our reinsurance operations primarily rely on the expected loss method. For known catastrophic events, our reinsurance operations’ reserving process also includes the usage of catastrophe models and a heavy reliance on analysis which includes ceding company inquiries and management judgment. The development of property losses may be unstable, especially where there is high catastrophic exposure, may be characterized by high severity, low frequency losses for excess and catastrophe-exposed business and may be highly correlated across contracts. As time passes, for a given underwriting year, additional weight is given to the paid and incurred B-F loss development methods and historical paid and incurred loss development methods in the reserving process. Our reinsurance operations make a number of key assumptions in reserving for short-tail lines, including that historical paid and reported development patterns are stable, catastrophe models provide useful information about our exposure to catastrophic events that have occurred and our underwriters’ judgment and guidance received from ceding companies as to potential loss exposures may be relied on. The expected loss ratios used in the initial reserving process for our reinsurance operations’ property exposures have varied over time due to changes in pricing, reinsurance structure, estimates of catastrophe losses, terms and conditions and geographical distribution. As losses in property lines are reported relatively quickly, expected loss ratios are selected for the current underwriting year incorporating the experience for earlier underwriting years, adjusted for rate changes, inflation, changes in reinsurance programs, expectations about present and future market conditions and expected attritional losses based on modeling. Due to the short-tail nature of
For the years ended December 31, 2004 to 2006, on average, our reinsurance segment has reported approximately $82 million of estimated net favorable development in prior year Loss Reserves, or 5.1% of average beginning Loss Reserves. Of such amount, approximately $66 million came from short-tail lines, or 10.6% of average beginning Loss Reserves, and $16 million came from medium-tail and long-tail lines, or 1.6% of average beginning Loss Reserves. For the year ended December 31, 2006, estimated net favorable development in prior year Loss Reserves was $69 million, or 3.1% of beginning Loss Reserves. Of such amount, approximately $37 million came from short-tail lines, or 5.3% of beginning Loss Reserves, and $32 million came from medium-tail and long-tail lines, or 2.1% of beginning Loss Reserves. The $69 million of estimated net favorable development during 2006 reflected approximately $38 million of adverse development on the 2005 catastrophic events, primarily in short-tail lines. For informational purposes, based on our reinsurance segment’s historical results, applying the 5.1% average estimated net favorable development in average beginning Loss Reserves for the years ended December 31, 2004 to 2006 to our reinsurance segment’s net Loss Reserves of $2.5 billion at December 31, 2006 would result in an increase in income before income taxes of approximately $126 million, or $1.66 per diluted share, while using the 3.1% of estimated net favorable development in beginning Loss Reserves for the year ended December 31, 2006 to such Loss Reserves would result in an increase in income before income taxes of approximately $77 million, or $1.01 per diluted share. The amounts noted above are informational only and should not be considered projections of future events. Future favorable or adverse development in our reinsurance segment’s Loss Reserves is subject to numerous factors, and no assurances can be given that we will experience favorable development in our Loss Reserves or that our ultimate losses will not be significantly different than the amounts shown above, and such differences could directly and significantly impact earnings favorably or unfavorably in the period they are determined. Because of our reinsurance segment’s limited operating history, the sensitivity analysis above is one way to gauge the impact of changes in the assumptions in our reserving process. For another estimate of potential variability in our reinsurance segment’s Loss Reserves, see “-Simulation Results.” Refer to “Results of Operations” for additional discussion on net favorable or adverse development of our reinsurance operations’ prior year Loss Reserves.
The simulation results shown for each segment do not add to the total simulation results, as the individual segment simulation results do not reflect the diversification effects across our segments. For informational purposes, based on the total simulation results, a change in our Loss Reserves to the amount indicated at the 90th percentile would result in a decrease in income before income taxes of approximately $973 million, or $12.77 per diluted share, while a change in our Loss Reserves to the amount indicated at the 10th percentile would result in an increase in income before income taxes of approximately $884 million, or $11.59 per diluted share. The simulation results noted above are informational only, and no assurance can be given that our ultimate losses will not be significantly different than the simulation results shown above, and such differences could directly and significantly impact earnings favorably or unfavorably in the period they are determined.
Estimates for our insurance operations related to Hurricanes Katrina, Rita and Wilma and other catastrophic events that occurred in the second half of 2005 are based on currently available information derived from modeling techniques, industry assessments of exposure, claims information obtained from its clients and brokers to date and a review of its in-force contracts. Actual losses from these events may vary materially from the insurance operations’ estimates due to the inherent uncertainties in making such determinations resulting from several factors, including the preliminary nature of available information, the potential inaccuracies and inadequacies in the data provided by clients and brokers, the modeling techniques and the application of such techniques, the contingent nature of business interruption exposures, the effects of any resultant demand surge on claims activity and attendant coverage issues. In addition, actual losses may increase if reinsurers dispute or fail to meet their obligations to our insurance operations or the reinsurance protections purchased by our insurance operations are exhausted or are otherwise unavailable.
percentage for all business bound outside of this period will continue to be 45%, subject to adjustment as provided under the Flatiron Treaty. Arch Re Bermuda pays to Flatiron Re Ltd. a reinsurance premium in the amount of the ceded percentage of the original gross written premium on the business reinsured with Flatiron Re Ltd. less a ceding commission, which includes a reimbursement of direct acquisition expenses as well as a commission to Arch Re Bermuda for generating the business. The Flatiron Treaty also provides for a profit commission to Arch Re Bermuda based on the underwriting results for the 2006 and 2007 underwriting years on a cumulative basis. Arch Re Bermuda records such profit commission based on underwriting experience recorded each quarter. As a result, the profit commission arrangement with Flatiron Re Ltd. may increase the volatility of our reported results of operations on both a quarterly and annual basis.
estimate of premiums written as of the inception date of the treaty. Estimates of premiums written under pro rata contracts are recorded in the period in which the underlying risks are expected to incept and are based on information provided by the brokers and the ceding companies. For multi-year reinsurance treaties which are payable in annual installments, generally, only the initial annual installment is included as premiums written at policy inception due to the ability of the reinsured to commute or cancel coverage during the term of the policy. The remaining annual installments are included as premiums written at each successive anniversary date within the multi-year term.
The amount of reinsurance premium estimates included in premiums receivable and the amount of related acquisition expenses by type of business were as follows at December 31, 2006 and 2005:
A significant portion of amounts included as premiums receivable, which represent estimated premiums written, net of commissions, are not currently due based on the terms of the underlying contracts. Based on currently available information, management believes that the premium estimates included in premiums receivable will be collectible and, therefore, no provision for doubtful accounts has been recorded on the premium estimates at December 31, 2006.
We also write certain business that is intended to provide insurers with risk management solutions that complement traditional reinsurance. Under these contracts, we assume a measured amount of insurance risk in exchange for an anticipated margin, which is typically lower than on traditional reinsurance contracts. The terms and conditions of these contracts may include additional or return premiums based on loss experience, loss corridors, sublimits and caps. Examples of such business include aggregate stop-loss coverages, financial quota share coverages and multi-year retrospectively rated excess of loss coverages. If these contracts are deemed to transfer risk, they are accounted for as reinsurance.
For purposes of managing risk, we reinsure a portion of our exposures, paying to reinsurers a part of the premiums received on the policies we write, and we may also use retrocessional protection. Ceded premiums written represented approximately 29.5% of gross premiums written for 2006, compared to 21.8% for 2005 and 18.8% for 2004.
We monitor the financial condition of our reinsurers and attempt to place coverages only with substantial, financially sound carriers. At December 31, 2006 and 2005, approximately 92.3% and 92.6%, respectively, of our reinsurance recoverables on paid and unpaid losses (not including prepaid reinsurance premiums) of $1.67 billion and $1.47 billion, respectively, were due from carriers which had an A.M. Best rating of “A-” or better. At December 31, 2006 and 2005, the largest reinsurance recoverables from any one carrier were less than 5.1% and 5.6%, respectively, of our total shareholders’ equity.
(1) The financial strength ratings are as of January 30, 2007 and were assigned by A.M. Best based on its opinion of the insurer’s financial strength as of such date. An explanation of the ratings listed in the table follows: the ratings of “A++” and “A+” are designated “Superior”; the “A” and “A-” ratings
are designated “Excellent”; and the rating of “B++” is designated “Very Good.” Additionally, A.M. Best has five classifications within the “Not Rated” or “NR” category. Reasons for an “NR” rating being assigned by A.M. Best include insufficient data, size or operating experience, companies which are in run-off with no active business writings or are dormant, companies which disagree with their rating and request that a rating not be published or insurers that request not to be formally evaluated for the purposes of assigning a rating opinion.
(4) Flatiron Re Ltd. is required to contribute funds into a trust for the benefit of Arch Re Bermuda. The recoverable from Flatiron Re Ltd. was fully collateralized through such trust at December 31, 2006. See note 11, “Commitments and Contingencies,” of the notes accompanying our consolidated financial statements for further details on the Flatiron Treaty.
(5) In connection with our acquisition of Arch Specialty in February 2002, the seller, Sentry, agreed to reinsure and guarantee all liabilities arising out of Arch Specialty’s business prior to the closing of the acquisition. In addition to the guarantee provided by Sentry, substantially all of the recoverable from Sentry is still subject to the original reinsurance agreements inuring to Arch Specialty and, to the extent Sentry fails to comply with its payment obligations to us, we may seek reimbursement from the third party reinsurers under such agreements.
We currently classify all of our fixed maturity investments, short-term investments and other investments as “available for sale” and, accordingly, they are carried at estimated fair value. The fair value of fixed maturity securities is generally determined from quotations received from a nationally recognized pricing service. Short-term investments comprise securities due to mature within one year of the date of issue. Short-term investments include certain cash equivalents which are part of our investment portfolios under the management of external and internal investment managers. Other investments are carried at estimated fair value. Fair value is initially considered to be equal to the cost of such investment until the investment is revalued based on substantive events or other factors which could indicate a diminution or appreciation in value.
In accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” FASB Staff Position Nos. FAS115-1 and FAS124-1, ”The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” and Securities and Exchange Commission Staff Accounting Bulletin No. 59, “Other-Than-Temporary Impairment of Certain Investments in Debt and Equity Securities,” we review our investments each quarter to determine whether a decline in fair value below the amortized cost basis is other-than-temporary. Our process for identifying declines in the fair value of investments that are other-than-temporary involves consideration of several factors. These factors
Under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”), as amended on January 1, 2001, all derivative financial instruments, including embedded derivative instruments, are required to be recognized as either assets or liabilities in the consolidated balance sheets and measured at fair value. The accounting for gains and losses associated with changes in the fair value of a derivative and the effect on the consolidated financial statements depends on whether it has been designated and qualifies as part of a hedging relationship and whether the hedge is highly effective in achieving offsetting changes in the fair value of the asset or liability hedged.
(“FASB”) Statement No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”). Under SFAS No.123(R), the estimated grant date fair value adjusted for assumed forfeitures of share-based compensation related to stock option awards is recognized as compensation expense over the requisite service period of the grant. Under the fair value method of accounting pursuant to SFAS No. 123(R), the fair value of restricted share and unit awards is measured by the grant date price of our shares. No value is attributed to awards that employees forfeit because they fail to satisfy vesting conditions. As such, the number of shares granted is reduced by assumed forfeitures and adjusted based on actual forfeitures until vesting. Such expense is amortized over the requisite service period of the related awards. The share-based compensation expense associated with awards that have graded vesting features and vest based on service conditions only (i) granted after the effective date of adoption is calculated on a straight-line basis over the requisite service periods of the related awards and (ii) granted prior to the effective date of adoption and that remain unvested as of the date of adoption is calculated on a graded-vesting basis as prescribed under FASB Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans-an interpretation of APB Opinions No. 15 and 25,” over the remaining requisite service periods of the related awards.
Under SFAS No. 123(R), we use the Black-Scholes option pricing model to estimate the fair value of the share-based option awards as of the grant date. The Black-Scholes model, by its design, is highly complex, and requires judgment in determining key data inputs including estimating the risk free interest rate, expected life of the option and expected volatility rate. In addition, judgment is also required in estimating the amount of share-based awards that are expected to be forfeited. The primary data inputs with the greatest degree of judgment are the estimated lives of the share-based awards and the estimated volatility of our stock price. The Black-Scholes model is highly sensitive to changes in these two data inputs. In our process for estimating the fair value of stock options granted, we believe that we have made a good faith fair value estimate in accordance with the provisions of SFAS No. 123(R) as well as guidance from the SEC as contained in Staff Accounting Bulletin No. 107 in a way that is designed to take into account the assumptions that underlie the instrument’s value that marketplace participants would reasonably make. If actual results differ significantly from these estimates, share-based compensation expense and our results of operations could be materially impacted.
See note 2(m), “Significant Accounting Policies-Share-Based Compensation,” of the notes accompanying our consolidated financial statements for more information about the adoption of SFAS No. 123(R).
Net income available to common shareholders was $692.6 million for 2006, compared to $256.5 million for 2005. The improvement in our results of operations was primarily due to a lower level of catastrophic activity in 2006, as discussed in “-Segment Information” below, and growth in investment income. Our net income available to common shareholders for 2006 represented a 24.1% annualized return on average common equity, compared to 10.9% for 2005.
(1) The acquisition expense ratio is adjusted to include certain fee income.
Underwriting Income. The insurance segment’s underwriting income was $163.3 million for 2006, compared to $87.7 million for 2005. The combined ratio for the insurance segment was 89.9% for 2006, compared to 93.8% for 2005. The components of the insurance segment’s underwriting income are discussed below.
Premiums Written. Gross premiums written by the insurance segment were $2.62 billion for 2006, compared to $2.33 billion for 2005, and ceded premiums written were 37.1% of gross premiums written for 2006, compared to 36.3% for 2005. Net premiums written by the insurance segment were $1.65 billion for 2006, compared to $1.48 billion for 2005. Roughly half of the increase was in worldwide property business, primarily as a result of rate increases which were tempered by higher reinsurance costs. The balance of the growth was generated from increases in professional liability business, as a result of growth in policies written and a decrease in the usage of reinsurance in 2006 business, construction business, primarily due to growth in large deductible construction accounts, surety business, and in executive assurance business. This growth was partially offset by a reduction in U.S. primary casualty business in response to increasing competition. For information regarding net premiums written produced by major line of business and geographic location, refer to note 3, “Segment Information,” of the notes accompanying our consolidated financial statements.
Underwriting Expenses. The underwriting expense ratio for the insurance segment was 26.4% in 2006, compared to 25.6% for 2005. The acquisition expense ratio was 10.8% for 2006, compared to 9.7% for 2005. As a result of the surety losses noted above, the insurance segment reduced profit commissions that it had recorded previously by $7.7 million, or 0.5 points of the acquisition expense ratio. The remainder of the increase in the acquisition expense ratio was primarily due to changes in the mix of business. The insurance segment’s other operating expense ratio was 15.6% for 2006, compared to 15.9% for 2005.
Premiums Written. Gross premiums written by the reinsurance segment were $1.70 billion in 2006, compared to $1.75 billion for 2005. Gross premiums written for 2006 reflects a lower level of international casualty business in response to actual and anticipated market conditions, partially offset by growth in international property and marine lines, due to higher rates and an increase in exposure. Catastrophe-exposed property and marine lines have continued to provide attractive opportunities in the wake of the 2005 storms. As a result of the significant catastrophic activity in 2005 and the impact of such events on the insurance market, the reinsurance segment was able to write certain property (both catastrophe and non-catastrophe) and marine business in the 2005 fourth quarter, which resulted in approximately $109.2 million of gross premiums written ($100.2 million on a net basis). Such business did not contribute to the reinsurance segment’s 2006 premiums written.
Net premiums written by the reinsurance segment were $1.37 billion for 2006, compared to $1.66 billion for 2005. Net premiums written for 2006 reflects the lower level of international casualty business
noted above, which more than offset growth in international property and marine lines, net of the amounts ceded to Flatiron Re Ltd. In addition, net premiums written in 2005 included $100.2 million of non-recurring business, as noted above. For information regarding net premiums written produced by major line and type of business and geographic location, refer to note 3, “Segment Information,” of the notes accompanying our consolidated financial statements.
Net Premiums Earned. Net premiums earned for our reinsurance segment were $1.48 billion for 2006, compared to $1.59 billion for 2005, and generally reflect changes in net premiums written over the previous five quarters, including the mix and type of business written.
Fee Income. The reinsurance segment recorded $4.7 million of fee income for 2006, compared to $5.0 million for 2005. The 2006 amount related to certain assumed reinsurance contracts which were deemed, under GAAP, not to transfer insurance risk, and are accounted for using the deposit method of accounting. Of the 2005 amount, $4.5 million related to an industry loss warranty contract. Under this contract, we received payment when industry-wide losses from certain natural perils exceeded a specified amount.
Losses and Loss Adjustment Expenses. Reinsurance segment losses and loss adjustment expenses incurred for 2006 were $773.3 million, or 52.2% of net premiums earned, compared to $1.05 billion, or 66.3% of net premiums earned, for 2005. The reinsurance segment’s 2006 results included approximately $45.9 million related to 2006 catastrophe losses, while the 2005 results included $208.5 million related to Hurricanes Dennis, Emily, Katrina, Rita and Wilma and the European Floods and $24.0 million of other catastrophe losses. The net impact of the change in catastrophic activity resulted in a 12.6 point decrease in the 2006 loss ratio. In addition, losses incurred for 2006 included $68.5 million of estimated net favorable development in prior year loss reserves, compared to $91.2 million of estimated net favorable development in 2005. Of the net favorable development in the reinsurance segment, $37.1 million came from short-tail lines, and $31.4 million came from longer-tail lines. The development resulted from better than anticipated loss emergence and was net of $38.1 million of adverse development on the 2005 catastrophic events, primarily in short-tail lines. The net impact of the change in prior year development was a 1.5 point increase in the 2006 loss ratio.
In its reserving process in 2002 and 2003, the reinsurance segment recognized that there is a possibility that the assumptions made could prove to be inaccurate due to several factors primarily related to the start up nature of its operations. Due to the availability of additional data, and based on reserve analyses, it was determined that it was no longer necessary to continue to include such factors in the reserving process in 2004. Following reserve reviews, and based on the level of claims activity reported to date, the reinsurance segment has reduced the amount it had recorded in 2002 and 2003 by $7.7 million in 2006 and $12.1 million in 2005. Such amounts are reflected in the prior year development shown above.
Underwriting Expenses. The underwriting expense ratio for the reinsurance segment was 28.5% for 2006, compared to 31.2% for 2005. The acquisition expense ratio for 2006 was 24.9%, compared to 27.9%
for 2005. The reinsurance segment’s 2006 results included commission income (in excess of the reimbursement of direct acquisition expenses) on the quota-share reinsurance treaty with Flatiron Re Ltd., which reduced the acquisition expense ratio by 1.6 points in 2006. The 2005 results included $13.3 million of assessments incurred as a result of the 2005 hurricane activity, which added 0.8 points to the 2005 acquisition expense ratio. The reinsurance segment’s other operating expense ratio was 3.6% for 2006, compared to 3.3% for 2005.
Net investment income was $380.2 million for 2006, compared to $232.9 million for 2005. The increase in net investment income in 2006 resulted from a higher level of average invested assets primarily generated by cash flows from operations. In addition, an increase in the pre-tax investment income yield to 4.71% for 2006 from 3.68% for 2005 contributed to the growth in net investment income. These yields were calculated based on amortized cost. Yields on future investment income may vary based on financial market conditions, investment allocation decisions and other factors.
Total return on our portfolio under management, as reported to us by our investment advisors, for 2006 was 5.24%, compared to 2.09% for 2005. Total return is calculated on a pre-tax basis and before investment expenses. The higher total return in 2006 compared to 2005 was primarily due to movements in interest rates during the periods. The increase in interest rates in 2005 was greater than the increase in 2006 and resulted in a lower relative return compared to 2006. For 2006, net realized losses on our fixed maturities of $27.4 million included a provision of $31.6 million for declines in the fair value of investments held in our available for sale portfolio which were considered to be other-than-temporary, based on a review performed during 2006. For 2005, net realized losses on our fixed maturities of $56.8 million included a provision of $25.7 million for declines in the fair value of investments held in our available for sale portfolio which were considered to be other-than-temporary, based on a review performed during 2005. In periods subsequent to the recognition of an other-than-temporary impairment on fixed maturities, we account for such securities as if they had been purchased on the measurement date of the other-than temporary impairment and the provision for the other-than-temporary impairment (reflected as a discount or reduced premium based on the new cost basis) is amortized into net investment income over the remaining life of the fixed maturities, or until such securities are sold. The declines in fair value on such securities were primarily due to the current interest rate environment. The balance of $4.2 million in net realized gains on our fixed maturities in 2006 resulted from the sale of securities, compared to net realized losses from the sale of fixed maturities of $31.1 million for 2005. For the 2006 and 2005 periods, net realized gains or losses from the sale of fixed maturities resulted from our decisions to reduce credit exposure, changes in duration targets, relative value determinations and sales related to rebalancing the portfolio.
Other expenses, which are included in our other operating expenses and part of our corporate and other segment (non-underwriting), were $29.1 million for 2006, compared to $25.8 million for 2005. Such amounts primarily represent certain holding company costs necessary to support our worldwide insurance and reinsurance operations, share based compensation expense and costs associated with operating as a publicly traded company. Other expenses for 2005 included approximately $1.9 million of costs related to an agreement entered into with Robert Clements, former Chairman of our board of directors, and approximately $4.9 million of costs related to an agreement entered into with Dwight Evans, former Chairman and Chief Executive Officer of Arch Worldwide Reinsurance Group. See note 10, “Transactions with Related Parties,” of the notes accompanying our consolidated financial statements.
As required by the provisions of SFAS 123(R), we recorded pre-tax share-based compensation expense related to stock options of $9.2 million in 2006. Under the modified prospective method of transition, no expense related to stock options was recorded in 2005. Therefore, results for 2006 are not comparable to 2005. See note 13, “Share Capital,” of the notes accompanying our consolidated financial statements and “Critical Accounting Policies, Estimates and Recent Accounting Policies-Share-Based Compensation” for more information about the adoption of SFAS No. 123(R).
Net foreign exchange losses for 2006 of $23.9 million consisted of net unrealized losses of $27.3 million and net realized gains of $3.4 million, compared to net foreign exchange gains of $22.2 million for 2005, which consisted of net unrealized gains of $23.3 million and net realized losses of $1.1 million. For the 2006 and 2005 periods, the net unrealized foreign exchange gains or losses recorded were largely offset by changes in the value of our investments held in foreign currencies.
ACGL will be subject to U.S. federal income tax only to the extent that it derives U.S. source income that is subject to U.S. withholding tax or income that is effectively connected with the conduct of a trade or business within the U.S. and is not exempt from U.S. tax under an applicable income tax treaty. ACGL will be subject to a withholding tax on dividends from U.S. investments and interest from certain U.S. taxpayers. ACGL does not consider itself to be engaged in a trade or business within the U.S. and, consequently, does not expect to be subject to direct U.S. income taxation. However, because there is uncertainty as to the activities which constitute being engaged in a trade or business within the United States, there can be no assurances that the U.S. Internal Revenue Service will not contend successfully that ACGL or its non-U.S. subsidiaries are engaged in a trade or business in the United States. If ACGL or any of its non-U.S. subsidiaries were subject to U.S. income tax, ACGL’s shareholders’ equity and earnings could be materially adversely affected. ACGL has subsidiaries and branches that operate in various jurisdictions around the world that are subject to tax in the jurisdictions in which they operate. The
At December 31, 2006 and 2005, we had a valuation allowance of $1.4 million against a deferred tax asset in one of our subsidiaries that currently does not have a business plan to produce significant future taxable income. See note 9, “Income Taxes,” of the notes accompanying our consolidated financial statements.
We have net operating loss carryforwards in our U.S. operating subsidiaries totaling $16.8 million at December 31, 2006. Such net operating losses are currently available to offset future taxable income of the subsidiaries. Under applicable law, the U.S. net operating loss carryforwards expire between 2018 and 2020. Full utilization of our net operating losses would reduce future taxes payable by $5.9 million. In addition, we also have a net capital loss carryforward of $1.2 million which will expire between 2010 -2011 and an alternative minimum tax (“AMT”) credit carryforward in the amount of $1.0 million which can be carried forward without expiration. On November 20, 2001, we underwent an ownership change for U.S. federal income tax purposes as a result of the capital raised at that time. As a result of this ownership change, limitations are imposed upon the utilization by our U.S. operating subsidiaries of existing net operating losses and the alternative minimum tax credit carryforward. Our Swiss branch has a net operating loss carryforward of $0.4 million which is available to offset income of the Swiss branch until it expires in 2013. See note 9, “Income Taxes,” of the notes accompanying our consolidated financial statements.
Net income available to common shareholders was $256.5 million for 2005, compared to $316.9 million for 2004. The lower level of net income available to common shareholders was primarily due to the higher level of catastrophic activity in 2005, as discussed in “-Segment Information” below. Our net income available to common shareholders for 2005 represented a 10.9% return on average equity, compared to 16.0% for 2004. For purposes of computing return on average equity, average equity has been calculated as the average of shareholders’ equity outstanding at the beginning and end of each year.
The increase in diluted average shares outstanding from 2004 to 2005 was due, in part, to increases in the dilutive effects of stock options and nonvested restricted stock calculated using the treasury stock method and the exercise of stock options. Under the treasury stock method, the dilutive impact of options and nonvested stock on diluted weighted average shares outstanding increases as the market price of our common shares increases. In addition, diluted weighted average shares outstanding for 2005 reflects the full weighting of 4.7 million common shares issued in March 2004.
Underwriting Income. The insurance segment had underwriting income of $87.7 million and a combined ratio of 93.8% for 2005, compared to $113.3 million and 91.8% for 2004. The 2005 results included estimated pre-tax net losses in 2005 related to Hurricanes Dennis, Emily, Katrina, Rita and Wilma of $150.3 million, after reinsurance recoveries and net of reinstatement premiums. Before reinsurance recoveries, such estimated losses were $656.5 million. The 2004 results reflected estimated pre-tax net losses related to Hurricanes Charley, Frances, Ivan and Jeanne of $41.8 million, after reinsurance recoveries and net of reinstatement premiums. Before reinsurance recoveries, such estimated losses were $88.9 million. The components of the insurance segment’s underwriting income are discussed below.
Premiums Written. Gross premiums written for our insurance segment were $2.33 billion for 2005, compared to $2.15 billion for 2004. The increase in gross premiums written for 2005 primarily resulted from increased contributions in the property, professional liability and executive assurance lines from the insurance segment’s European operations, which became fully operational in the 2004 fourth quarter. Growth in certain U.S. specialty lines, including construction and surety and professional liability, was offset by reductions due to the sale of the insurance segment’s non-standard auto insurance operations in late 2004, which contributed $96.5 million in the 2004 period, and in casualty and program business. The decrease in casualty business primarily resulted from the non-renewal of one large policy in the 2005 fourth quarter.
For purposes of managing risk, our insurance segment reinsures a portion of its exposures, paying to reinsurers a part of the premiums received on the policies it writes. For 2005, ceded premiums written represented 36.3% of gross premiums written, compared to 35.1% for 2004. The higher ceded percentage for 2005 compared to 2004 primarily resulted from increases in business ceded in the insurance segment’s property and professional liability lines and an increase in program business ceded through a 30% quota share of certain programs with effective dates subsequent to March 31, 2004. Net premiums written for our insurance segment increased to $1.48 billion for 2005, compared to $1.39 billion for 2004, with the increase primarily as a result of the reasons discussed above. For information regarding net premiums written produced by major type of business and geographic location, refer to note 3, “Segment Information,” of the notes accompanying our consolidated financial statements.
Fee Income. Policy-related fee income for our insurance segment was $3.4 million for 2005, compared to $15.3 million for 2004. The 2005 amounts were earned on our alternative markets business, and the 2004 amounts included a significant contribution from our non-standard automobile business, which was sold in late 2004. Other underwriting-related fee income for our insurance segment was $2.0 million for 2005, compared to $3.3 million for 2004. Other underwriting-related fee income for our insurance segment primarily relates to miscellaneous income from certain aviation business, certain service fee reimbursements received and non-recurring revenue from the insurance segment’s alternative markets business.
Net Premiums Earned. Net premiums earned for our reinsurance segment increased to $1.59 billion for 2005, compared to $1.57 billion for 2004. The increase in net premiums earned in 2005 primarily reflects changes in net premiums written over the previous five quarters, including the mix and type of
The loss ratio for 2005 also reflected net favorable development in prior year reserves of $91.2 million, compared to $85.3 million for 2004. The net favorable development in both periods was primarily due to short-tail lines, mainly property, and resulted from better than anticipated loss emergence. The net impact of the change in prior year development was a 0.4 point reduction in the 2005 loss ratio, compared to the 2004 ratio. In its reserving process in 2002 and 2003, the reinsurance segment recognized that there is a possibility that the assumptions made could prove to be inaccurate due to several factors primarily related to the start up nature of its operations. Due to the availability of additional data, and based on reserve analyses, it was determined that it was no longer necessary to continue to include such factors in the reserving process in 2004. Following reserve reviews, and based on the level of claims activity reported to date, the reinsurance segment has reduced the amount it had recorded in 2002 and 2003 by $12.1 million in 2005 and $7.3 million in 2004. Such amounts are reflected in the prior year development shown above.
The net favorable development in both periods was partially offset by increased acquisition expenses, primarily as a result of the commutation of certain treaties. Such activity resulted in an increase to acquisition expenses of approximately $9.0 million in 2005, compared to $21.7 million in 2004. The net decrease in acquisition expenses related to the commutation activity resulted in a 0.8 point decrease in the 2005 acquisition expense ratio, compared to the 2004 ratio. The remainder of the change in the loss ratio for 2005, compared to 2004, resulted from better results recorded in the reinsurance segment’s property lines of business and changes in their mix of business. For a discussion of the reserves for losses and loss adjustment expenses, please refer to the section above entitled “Critical Accounting Policies, Estimates and Recent Accounting Pronouncements-Reserves for Losses and Loss Adjustment Expenses.”
Net investment income was $232.9 million for 2005, compared to $143.7 million for 2004. The increase in net investment income was due, in part, to growth in average invested assets and an increase in the pre-tax investment income yield (net of investment expenses) to 3.7% for 2005, compared to 3.0% for 2004. These yields were calculated based on the amortized cost of the portfolio. Yields on future investment income may vary based on financial market conditions, investment allocation decisions and other factors. The increase in investment income yields was primarily due to higher yields available in financial markets as we reduced the average effective duration from 3.7 years at December 31, 2004 to 3.3 years at
December 31, 2005 and we maintained the average Standard & Poor’s quality of our portfolio at “AA+.” The average yield to maturity (book yield) increased from 3.5% at December 31, 2004 to 4.2% at December 31, 2005.
Following is a summary of net realized gains or losses for the years ended December 31, 2005 and 2004:
ACGL is a holding company whose assets primarily consist of the shares in its subsidiaries. Generally, ACGL depends on its available cash resources, liquid investments and dividends or other distributions from its subsidiaries to make payments, including the payment of debt service obligations and operating expenses it may incur and any dividends or liquidation amounts with respect to the series A non-cumulative and series B non-cumulative preferred shares and common shares. For the years ended December 31, 2006, 2005 and 2004, ACGL received dividends of $22.1 million, $22.1 million and $11.0 million from Arch Re Bermuda. Such amounts were used to pay interest on ACGL’s senior notes.
reinsurance subsidiaries. Accordingly, Arch Re Bermuda can pay approximately $830.9 million to ACGL during 2007 without providing an affidavit to the Bermuda Monetary Authority, as discussed above. Our U.S. insurance and reinsurance subsidiaries can pay approximately $117.5 million in dividends or distributions to Arch-U.S., our U.S. holding company, which is owned by Arch Re Bermuda, during 2007 without prior regulatory approval. Such dividends or distributions may be subject to applicable withholding or other taxes. Arch-Europe can pay approximately £4.5 million, or $8.8 million, in dividends to ACGL during 2007 without prior notice and approval by the FSA. In addition, the ability of our insurance and reinsurance subsidiaries to pay dividends is also constrained by our dependence on the financial strength ratings of our insurance and reinsurance subsidiaries from independent rating agencies. The ratings from these agencies depend to a large extent on the capitalization levels of our insurance and reinsurance subsidiaries. We believe that ACGL has sufficient cash resources and available dividend capacity to service its indebtedness and other current outstanding obligations.
Our insurance and reinsurance subsidiaries are required to maintain assets on deposit, which primarily consist of fixed maturities, with various regulatory authorities to support their operations. The assets on deposit are available to settle insurance and reinsurance liabilities to third parties. Our insurance and reinsurance subsidiaries also have investments in segregated portfolios primarily to provide collateral or guarantees for letters of credit to third parties. At December 31, 2006 and 2005, such amounts approximated $1.17 billion and $1.0 billion, respectively. In addition, Arch Re Bermuda maintains assets in trust accounts as collateral for insurance and reinsurance transactions with affiliated companies. At December 31, 2006 and 2005, such amounts approximated $3.6 billion and $2.77 billion, respectively.
Consolidated cash provided by operating activities was $1.61 billion for the year ended December 31, 2006, compared to $1.45 billion for the year ended December 31, 2005. Payments related to the 2004 and 2005 catastrophic events reduced operating cash flows by $179.8 million for the year ended December 31, 2006. Cash flow from operating activities are provided by premiums collected, fee income, investment income and collected reinsurance recoverables, offset by losses and loss adjustment expense payments, reinsurance premiums paid, operating costs and current taxes paid.
To the extent that our existing capital is insufficient to fund our future operating requirements or maintain such ratings, we may need to raise additional funds through financings or limit our growth. If we are not able to obtain adequate capital, our business, results of operations and financial condition could be adversely affected, which could include, among other things, the following possible outcomes: (1) potential downgrades in the financial strength ratings assigned by ratings agencies to our operating subsidiaries, which could place those operating subsidiaries at a competitive disadvantage compared to higher-rated competitors; (2) reductions in the amount of business that our operating subsidiaries are able to write in order to meet capital adequacy-based tests enforced by statutory agencies; and (3) any resultant ratings downgrades could, among other things, affect our ability to write business and increase the cost of bank credit and letters of credit.
In addition to common share capital, we depend on external sources of finance to support our underwriting activities, which can be in the form (or any combination) of debt securities, preference shares,
common equity and bank credit facilities providing loans and/or letters of credit. Any equity or debt financing, if available at all, may be on terms that are unfavorable to us. In the case of equity financings, dilution to our shareholders could result, and, in any case, such securities may have rights, preferences and privileges that are senior to those of our outstanding securities.
hailstorms, explosions, severe winter weather and fires. Catastrophes can also cause losses in non-property business such as workers’ compensation or general liability. In addition to the nature of property business, we believe that economic and geographic trends affecting insured property, including inflation, property value appreciation and geographic concentration, tend to generally increase the size of losses from catastrophic events over time.
For our natural catastrophe exposed business, we seek to limit the amount of exposure we will assume from any one insured or reinsured and the amount of the exposure to catastrophe losses in any geographic zone. We monitor our exposure to catastrophic events, including earthquake and wind and periodically reevaluate the estimated probable maximum pre-tax loss for such exposures. Our estimated probable maximum pre-tax loss is determined through the use of modeling techniques, but such estimate does not represent our total potential loss for such exposures. We seek to limit the probable maximum pre-tax loss to a specific level for severe catastrophic events. Currently, we generally seek to limit the probable maximum pre-tax loss to approximately 25% of total shareholders’ equity for a severe catastrophic event in any geographic zone that could be expected to occur once in every 250 years, although we reserve the right to change this threshold at any time. There can be no assurances that we will not suffer pre-tax losses greater than 25% of our total shareholders’ equity from one or more catastrophic events due to several factors, including the inherent uncertainties in estimating the frequency and severity of such events and the margin of error in making such determinations resulting from potential inaccuracies and inadequacies in the data provided by clients and brokers, the modeling techniques and the application of such techniques or as a result of a decision to change the percentage of shareholders’ equity exposed to a single catastrophic event. In addition, depending on business opportunities and the mix of business that may comprise our insurance and reinsurance portfolio, we may seek to adjust our self-imposed limitations on probable maximum pre-tax loss for catastrophe exposed business. See “Critical Accounting Policies, Estimates and Recent Accounting Pronouncements-Ceded Reinsurance” for a discussion of our catastrophe reinsurance programs.
Issuance of letters of credit and borrowings under the Credit Agreement are subject to our compliance with certain covenants and conditions, including absence of a material adverse change. These covenants require, among other things, that we maintain a debt to shareholders’ equity ratio of not greater than 0.35 to 1 and shareholders’ equity in excess of $1.95 billion plus 25% of future aggregate net income for each quarterly period (not including any future net losses) beginning after June 30, 2006 and 25% of future aggregate proceeds from the issuance of common or preferred equity and that our principal insurance and reinsurance subsidiaries maintain at least a “B++” rating from A.M. Best. In addition, certain of our subsidiaries which are party to the Credit Agreement are required to maintain minimum shareholders’ equity levels. We were in compliance with all covenants contained in the Credit Agreement at December 31, 2006. The Credit Agreement expires on August 30, 2011.
Including the secured letter of credit portion of the Credit Agreement and another letter of credit facility (together, the “LOC Facilities”), we have access to letter of credit facilities for up to a total of $1.45 billion. The principal purpose of the LOC Facilities is to issue, as required, evergreen standby letters of credit in favor of primary insurance or reinsurance counterparties with which we have entered into reinsurance arrangements to ensure that such counterparties are permitted to take credit for reinsurance obtained from our reinsurance subsidiaries in United States jurisdictions where such subsidiaries are not licensed or otherwise admitted as an insurer, as required under insurance regulations in the United States, and to comply with requirements of Lloyd’s of London in connection with qualifying quota share and other arrangements. The amount of letters of credit issued is driven by, among other things, the timing and payment of catastrophe losses, loss development of existing reserves, the payment pattern of such reserves, the further expansion of our business and the loss experience of such business. When issued, certain letters of credit are secured by a portion of our investment portfolio. In addition, the LOC Facilities also require the maintenance of certain covenants, which we were in compliance with at December 31, 2006. At such date, we had approximately $663.7 million in outstanding letters of credit under the LOC Facilities, which were secured by investments totaling $728.7 million. The other letter of credit facility was amended and restated in December 2006. It is anticipated that the LOC Facilities will be renewed (or replaced) on expiry, but such renewal (or replacement) will be subject to the availability of credit from banks which we utilize. In addition to letters of credit, we have established and may establish additional insurance trust accounts in the U.S. and Canada to secure our reinsurance amounts payable as required. See note 7, “Investment Information,” of the notes accompanying our consolidated financial statements.
The following table provides an analysis of our contractual commitments at December 31, 2006:
On December 29, 2005, Arch Re Bermuda entered into a quota share reinsurance treaty with Flatiron Re Ltd., a newly-formed Bermuda reinsurance company, pursuant to which Flatiron Re Ltd. is assuming a 45% quota share (the “Flatiron Treaty”) of certain lines of property and marine business underwritten by Arch Re Bermuda for unaffiliated third parties for the 2006 and 2007 underwriting years (January 1, 2006 to December 31, 2007). The quota share is subject to decrease by Arch Re Bermuda under certain circumstances. In addition, in certain circumstances, Flatiron Re Ltd. may extend at its option the coverage provided by the Flatiron Treaty to Arch Re Bermuda’s 2008 underwriting year. Effective June 28, 2006, the parties amended the Flatiron Treaty to increase the percentage ceded to Flatiron Re Ltd. from 45% to 70% of all covered business bound by Arch Re Bermuda from (and including) June 28, 2006 until (and including) August 15, 2006 provided such business did not incept beyond September 30, 2006. The ceding percentage for all business bound outside of this period will continue to be 45%, subject to adjustment as provided under the Flatiron Treaty. As a result of the terms of the Flatiron Treaty, we determined that Flatiron Re Ltd. is a variable interest entity. However, Arch Re Bermuda is not the primary beneficiary of Flatiron Re Ltd. and, as such, we are not required to consolidate the assets, liabilities and results of operations of Flatiron Re Ltd. per FIN 46R. See note 11, “Commitments and Contingencies,” of the notes accompanying our consolidated financial statements for further details on the Flatiron Treaty.
(2) Includes certain securities transactions entered into but not settled at the balance sheet date. Net of such amounts, total cash and investments were approximately $9.09 billion at December 31, 2006 and $7.11 billion at December 31, 2005.
At December 31, 2006, our fixed income portfolio, which includes fixed maturity securities and short-term investments, had a “AAA” average Standard & Poor’s quality rating, an average effective duration of 3.2 years, and an average yield to maturity (imbedded book yield), before investment expenses, of 4.97%. At December 31, 2005, our fixed income portfolio had a “AA+” average Standard & Poor’s quality rating, an average effective duration of 3.3 years, and an average yield to maturity (imbedded book yield), before investment expenses, of 4.19%.
We participate in a securities lending program under which certain of our fixed income portfolio securities are loaned to third parties, primarily major brokerage firms, for short periods of time through a lending agent. Such securities have been reclassified as “Fixed maturities and short-term investments pledged under securities lending agreements, at fair value.” We maintain control over the securities we lend, retain the earnings and cash flows associated with the loaned securities and receive a fee from the borrower for the temporary use of the securities. Collateral received, primarily in the form of cash, is required at a rate of 102% of the fair value of the loaned securities (or 104% of the fair value of the loaned securities when the collateral and loaned securities are denominated in non-U.S. currencies) including accrued investment income and is monitored and maintained by the lending agent. Such collateral is reinvested and is reflected as “Short-term investment of funds received under securities lending agreements, at fair value.” At December 31, 2006, the fair value and amortized cost of fixed maturities and short-term investments pledged under securities lending agreements were $860.8 million and $854.8 million, respectively, while collateral received totaled $891.4 million at fair value and amortized cost. At December 31, 2005, the fair value and amortized cost of fixed maturities and short-term investments pledged under securities lending agreements were $863.9 million and $858.4 million, respectively, while collateral received totaled $893.4 million at fair value and amortized cost.
As part of our investment strategy, we seek to establish a level of cash and highly liquid short-term and intermediate-term securities which, combined with expected cash flow, is believed by us to be adequate to meet our foreseeable payment obligations. Our investment strategy allows for the use of derivative securities. Derivative instruments may be used to enhance investment performance, replicate investment positions or manage market exposures and duration risk that would be allowed under our investment guidelines if implemented in other ways. We began using equity futures to replicate equity investment positions in the 2006 first quarter. The fair values of those derivatives are based on quoted market prices.
Our portfolio includes investments, such as mortgage-backed securities, which are subject to prepayment risk. At December 31, 2006, our investments in mortgage-backed securities, excluding commercial mortgage-backed securities, amounted to approximately $1.18 billion, or 12.7% of total investments and cash, compared to $376.8 million, or 5.3%, at December 31, 2005. Such amounts are classified as “available for sale” and are not held for trading purposes. In addition, our fixed maturities at December 31, 2006 include exposures to certain corporate sectors, such as the financial sector (8.0% of total investments and cash) and the industrial sector (4.8% of total investments and cash).
We expanded our investment strategy in 2005 to include other asset sectors. Alternative investment funds primarily include funds that invest in investment grade and non-investment grade fixed income securities and funds that invest in senior floating rate loans; equity securities include certain investments in mutual funds and other preferred stocks; and privately held securities include our investment in Aeolus LP. See note 10, “Transactions with Related Parties,” of the notes accompanying our consolidated financial statements for further details on the Company’s investment in Aeolus, L.P. Our investment commitments related to other investments totaled approximately $28.4 million and $8.4 million, respectively, at December 31, 2006 and 2005.
The following presents the calculation of book value per common share for December 31, 2006 and 2005. The shares and per share numbers set forth below exclude the effects of 5,669,994 and 5,637,108 stock options and 91,514 and 93,545 restricted stock units outstanding at December 31, 2006 and 2005, respectively.
In accordance with the SEC’s Financial Reporting Release No. 48, we performed a sensitivity analysis to determine the effects that market risk exposures could have on the future earnings, fair values or cash flows of our financial instruments as of December 31, 2006. Market risk represents the risk of changes in the fair value of a financial instrument and consists of several components, including liquidity, basis and price risks.
The sensitivity analysis performed as of December 31, 2006 presents hypothetical losses in cash flows, earnings and fair values of market sensitive instruments which were held by us on December 31, 2006 and are sensitive to changes in interest rates and equity security prices. This risk management discussion and the estimated amounts generated from the following sensitivity analysis represent forward-looking statements of market risk assuming certain adverse market conditions occur. Actual results in the future may differ materially from these projected results due to actual developments in the global financial markets. The analysis methods used by us to assess and mitigate risk should not be considered projections of future events of losses.
The focus of the SEC’s market risk rules is on price risk. For purposes of specific risk analysis, we employ sensitivity analysis to determine the effects that market risk exposures could have on the future earnings, fair values or cash flows of our financial instruments. The financial instruments included in the following sensitivity analysis consist of all of our investments and cash.
Another method that attempts to measure portfolio risk is Value-at-Risk (“VaR”). VaR attempts to take into account a broad cross-section of risks facing a portfolio by utilizing relevant securities volatility data skewed towards the most recent months and quarters. VaR measures the amount of a portfolio at risk for outcomes 1.65 standard deviations from the mean based on normal market conditions over a one year time horizon and is expressed as a percentage of the portfolio’s initial value. In other words, 95% of the time, should the risks taken into account in the VaR model perform per their historical tendencies, the portfolio’s loss in any one year period is expected to be less than or equal to the calculated VaR, stated as a percentage of the measured portfolio’s initial value. As of December 31, 2006, our portfolio’s VaR was estimated to be 3.66%, compared to an estimated 3.29% at December 31, 2005.