To manage reinsurance and insurance liability exposure, make investment decisions and assess overall enterprise risk, we model our underwriting and investing activities on an integrated basis. Our integrated risk management, as well as terms and conditions of our products, provides flexibility in making decisions regarding investments. Our investments are currently comprised of a high grade fixed maturities portfolio and an alternative investment portfolio that currently employs 11 strategies invested in approximately 50 underlying trading entities and two strategic reinsurance private equity investments. Our investment portfolio is designed to provide diversification and to generate positive returns while attempting to reduce the frequency and severity of loss outcomes. Based on fair value at December 31, 2005, the allocation of invested assets was approximately 70.9% in cash and fixed maturities and 29.1% in alternative investments.
Our principal operating subsidiary is Max Re. At December 31, 2005, Max Re had $1,165.7 million of shareholders’ equity. We conduct our European activities through Max Europe Holdings and its operating subsidiaries, Max Re Europe and Max Insurance Europe. We also provide underwriting and administrative services on a fee basis through Max Re Managers. We hold all of our alternative investments in Max Re Diversified, other than reinsurance private equity investments that are held by Max Re.
Our financial results for the year ended December 31, 2005 were significantly impacted by Hurricanes Katrina and Wilma and, to a lesser extent, Hurricane Rita and other natural catastrophes. As a result, our overall property and casualty underwriting results produced a 105.3% combined ratio (total losses and expenses as a percentage of net premiums earned) compared to 93.2% in the year ended December 31, 2004. We recognized approximately $123.4 million in underwriting losses as a result of hurricanes and a further $34.0 million in reinsurance private equity investment losses associated with hurricanes during the year. Net income for the year is $6.7 million after recording a reduction in net income of $157.4 million from hurricane related activity.
During the year ended December 31, 2005, our total gross premiums written increased 19.4% compared with the year ended December 31, 2004. Our property and casualty reinsurance, property and casualty insurance and life and annuity reinsurance business all contributed to our volume growth.
Gross premiums written for the life and annuity reinsurance segment increased to $275.0 million during the year ended December 31, 2005 compared to $212.3 million during the year 2004, principally due to increased premium production during the year. We recognized $311.2 million in benefit expenses during the year ended December 31, 2005 compared to $238.2 million for the year ended December 31, 2004. The increase in benefits is principally due to the life and annuity reinsurance transactions written during the year ended December 31, 2005.
Losses and benefits represented our largest expense and accounted for 68.8% of total liabilities at December 31, 2005. We establish loss expenses and reserves using a combination of loss reserving techniques and actuarial methods. Loss expenses and
reserves are reviewed regularly to reflect new information that we receive. We conduct regular quarterly internal reviews of reserves and, in addition, the adequacy of our reserves is reviewed annually, during the fourth quarter of the year, by independent actuaries to corroborate management’s estimates. As a result of new information received and settling certain contracts with clients during the year ended December 31, 2005, we recognized approximately $118.8 million in net adverse development on prior year reinsurance reserves. The adverse development includes $159.3 million attributable to two property and casualty reinsurance contracts, partially offset by $40.5 million in favorable development on remaining property and casualty reinsurance contracts. The notification of additional losses on these contracts triggered additional premiums written and ceded, together with interest on such premiums, in the net amount of $141.3 million, which is recorded as premium in our financial statements.
Net income for the year ended December 31, 2005 was $6.7 million compared to $133.7 million for the year ended December 31, 2004. The decline in net income is principally attributable to the losses associated with hurricanes Katrina, Rita and Wilma and lower income from our alternative investment portfolio offset by higher interest income from our fixed maturities portfolio compared to the year ended December 31, 2004.
We continually assess our liquidity needs by monitoring and evaluating new business prospects and opportunities and the development of our existing operations. During the year ended December 31, 2005, we generated $389.9 million of cash from operations and invested $549.8 million in fixed maturities. We expect to continue to generate positive operating cash flow through premium receipts and investment returns, which will be partially offset by paid losses on reinsurance and insurance obligations, as well as operating expenses. Further, we raised approximately $284.1 million of additional cash in October and November 2005 in connection with a public offering of our common shares, which we
used to increase the capital and surplus of our operating subsidiaries, to expand underwriting capacity, particularly in property and property catastrophe reinsurance and insurance lines and for general corporate purposes.
Reinsurance and insurance premiums are a function of the amount and type of contracts written as well as prevailing market prices. Property and casualty premiums are earned over the terms of the underlying contracts. Life and annuity reinsurance premiums are generally earned when the premium is due from policyholders. Each of our reinsurance contracts contains unique pricing, terms and conditions and expected profit margins. Therefore, the amount of premiums is not necessarily an accurate indicator of our anticipated profitability. Premium estimates are based upon information in underlying contracts, data received from clients and from premium audits. Changes in premium estimates are expected and may result in significant adjustments in any period. These estimates change over time as additional information regarding the underlying business volume of our clients is obtained. There is often a delay in the receipt of updated premium information from clients due to the time lag in preparing and reporting the data to us. After review by our underwriters, we increase or decrease premium estimates as updated information from our clients is received.
Our principal expenses are losses and benefits, acquisition costs, interest expense and general and administrative expenses. Losses and benefits are based on the amount and type of reinsurance and insurance contracts written by us during the current reporting period and information received during the current reporting period from clients pertaining to contracts written in prior years. We record losses and benefits based on actuarial estimates of the expected losses and benefits to be incurred on each contract written. The ultimate losses and benefits depend on the actual costs to settle these liabilities. We increase or decrease losses and benefits estimates as actual claim reports are received. Our ability to estimate losses and benefits accurately at the time of pricing our contracts is a critical factor in determining profitability.
Acquisition costs consist principally of ceding commissions paid to ceding clients and brokerage expenses, and typically represent a negotiated percentage of the premiums on reinsurance and insurance contracts written. The acquisition costs are net of ceding commissions associated with premiums ceded to our quota share partners on our reinsurance and insurance business. These ceding commissions are designed to compensate us for the costs of producing the portfolio of risks ceded to our reinsurers. We defer and amortize these costs over the period in which the related premiums are earned.
For quota share or proportional contracts we are entitled to receive premium as the ceding client collects the premium under contractual reporting and payment terms, which are usually quarterly. Premiums are usually collected over a two year period on our quota share or proportional contracts. For excess of loss contracts, premium is generally paid in contractually stipulated installments with payment terms ranging from payment at the inception of the contract to four quarterly payments. As a result of recognizing the estimated gross premium written at the inception of the policy and collecting that premium over an extended period, we include a premium receivable asset on our balance sheet. We actively monitor our premium receivable asset to consider whether we need an allowance for doubtful accounts. As part of this process we consider the credit quality of our cedants and monitor premium receipts versus expectations. We also seek to include a right of offset in the contract terms. Since commencing our operations, we have not written off any premiums receivable and, currently, no premiums receivables are significantly beyond their due dates or in dispute.
Our investments are carried at fair value or amounts that approximate fair value. Fair value for our investments in fixed maturities is generally based on quoted market prices or pricing models. At December 31, 2005, the valuation of approximately 95% of our fixed maturities investments was based on quoted market prices. Fair value for our alternative investments is generally based on the net asset value reported by the respective investment fund managers or, for our reinsurance equity investments, based on the carried amount under the equity method of accounting. The investment fund managers generally carry their trading positions and investments at fair value. We rely on the financial reports from these entities for recording the net gains on alternative investments in our statement of income.
Investments in unquoted equities, where we have a meaningful ownership position and significant influence over operating and financial policies of the investee, are carried under the equity method of accounting. Under this method, we initially record the investments at cost and periodically adjust the carrying values to recognize our proportionate share of income or loss and dividends from these investments. Future adverse changes in general market, global and economic conditions, changes to the interest and currency rate environment or poor operating results by our investments carried under the equity method of accounting could result in losses.
We operate in three segments: property and casualty reinsurance, property and casualty insurance and life and annuity reinsurance. We consider the property and casualty reinsurance and the property and casualty insurance segments separately, following organizational changes that were made in the second quarter of 2005. Previously, we viewed reinsurance and insurance as being two products within the property and casualty segment. Within the property and casualty reinsurance segment, we offer quota share and excess of loss capacity providing coverage for a portfolio of underlying risks written by our clients. In the property and casualty insurance segment, we generally offer excess of loss capacity on specific risks related to one insured. Within the life and annuity reinsurance segment, we currently offer reinsurance products focusing on existing blocks of business, which take the form of co-insurance transactions. In co-insurance transactions, risks are reinsured on the same basis as the original policies. We also have a corporate function that includes our investment and financing activities. We do not allocate assets by segment.
Gross premiums written. Gross premiums written for the property and casualty reinsurance segment for the year ended December 31, 2005 were $615.7 million compared to $583.2 million for the year ended December 31, 2004, an increase of 5.6%. This increase included additional premiums of $182.0 million arising from the notification of additional losses on two contracts written in prior years. This increase was largely offset by the non-renewal of four reinsurance contracts that accounted for approximately $174.5 million of premium in the year ended December 31, 2004. We chose not to renew these contracts as the renewal terms and conditions did not meet our current underwriting criteria. There were no other significant changes to premium estimates on prior period contracts.
Gross premiums written for the property and casualty reinsurance segment for the year ended December 31, 2004 were $583.2 million compared to $738.3 million for the year ended December 31, 2003, a decrease of 21.0%. The decline in premiums written reflects the non-renewal of one reinsurance contract that accounted for $110.0 million of premium in the year ended December 31, 2003. In addition, we terminated an accident and health reinsurance contract during its term, which resulted in us writing $50.0 million less premium in the 2004 year compared to the same period in 2003. We also had $37.3 million of decreases in premium estimates relating to contracts written in prior periods. The
Reinsurance premiums ceded. Reinsurance premiums ceded for property and casualty reinsurance for the year ended December 31, 2005 were $65.9 million compared to $47.6 million for the year ended December 31, 2004, an increase of 38.4%. The increase included $40.7 million of reinsurance premiums ceded which were directly related to the $182.0 million of additional premiums written on two contracts written in a prior year, as described above. Reinsurance premiums ceded were principally related to our purchase of specific reinsurance to manage the risks associated with our reinsurance underwriting and to manage the exposure retained by us on certain transactions, therefore the ratio of gross premiums written to reinsurance premiums ceded may fluctuate based on our assessment of exposure and the availability of reinsurance capacity at attractive prices.
Reinsurance premiums ceded for property and casualty reinsurance for the year ended December 31, 2004 were $47.6 million compared to $75.9 million for the year ended December 31, 2003, a decrease of 37.3%. The majority of the premium ceded relates to our quota share and aggregate stop loss agreements with Grand Central Re. Effective January 1, 2004, Grand Central Re stopped accepting new business and, accordingly, there is a decline in premium ceded in the year ended December 31, 2004 as compared to 2003, with the 2004 amounts relating to additional premiums ceded on contracts written in prior years.
Net premiums earned. Net premiums earned for property and casualty reinsurance increased by 1.9% to $593.0 million for the year ended December 31, 2005 despite the non-renewal of four reinsurance contracts that accounted for approximately $173.2 million of net premiums earned in the year ended December 31, 2004. The non-renewals were largely offset by $141.3 million of additional net premiums earned on two contracts written in a prior years.
Losses. Losses relating to property and casualty reinsurance were $532.3 million for the year ended December 31, 2005 compared to $435.4 million for the year ended December 31, 2004, an increase of 22.3%. The losses for the year ended December 31, 2005 include $73.4 million of losses attributable to the hurricanes in the United States and $159.3 million of net losses pertaining to additional losses notified on two contracts written in a prior year. The loss ratio for our property and casualty reinsurance segment for the year ended December 31, 2005 was 89.8% compared to 74.8% for the year ended December 31, 2004. Excluding hurricane losses in 2005, the adjusted loss ratio for our property and casualty reinsurance segment is 77.4%, which is higher than in 2004 due to the additional losses posted on prior period contracts.
Losses relating to property and casualty reinsurance were $435.4 million for the year ended December 31, 2004 compared to $442.7 million for the year ended December 31, 2003, a decrease of 1.7%, which is comparable to the decrease in our premiums earned for this product line. The loss ratio for our property and casualty reinsurance segment for the year ended December 31, 2004 was 74.8% compared to 74.4% for the year ended December 31, 2003.
Acquisition costs were $110.9 million for the year ended December 31, 2004 compared to $144.6 million for the year ended December 31, 2003, a decrease of 23.3%. The decrease in acquisition costs for the year ended December 31, 2004 is due to lower average acquisition costs on premiums earned derived from a change in mix of property and casualty business written and earned.
General and administrative expenses. General and administrative expenses were $15.0 million for the year ended December 31, 2005 compared to $12.1 million for the year ended December 31, 2004, an increase of 24.0%. The increase resulted principally from ongoing personnel costs associated with our reinsurance staff, including hiring additional property underwriters. The general and administrative expense to net premiums earned ratio was 2.5% for the year ended December 31, 2005 compared to 2.1% for the year ended December 31, 2004.
Net income (loss). Net loss attributable to property and casualty reinsurance for the year ended December 31, 2005 was $27.9 million compared to $23.7 million of income for the year ended December 31, 2004. The net loss for the year ended December 31, 2005 was principally attributable to $73.4 million of losses recognized due to Hurricanes Katrina, Rita and Wilma compared to $6.0 million for hurricanes in 2004.
Losses. Losses relating to insurance were $175.5 million for the year ended December 31, 2005 compared to $90.6 million for the year ended December 31, 2004, an increase of 93.7%, and includes $50.0 million in losses recorded related to the hurricanes in the United States. The loss ratio for our insurance segment for the year ended December 31, 2005 was 101.5% compared to 73.0% for 2004. Excluding hurricane losses in 2005, the adjusted loss ratio for our property and casualty insurance segment is 72.6%. As our portfolio of insurance contracts matures and we receive more reports and updates of losses, we will continue to refine our estimated reserves. Our present estimate of reserves are based on client specific historic loss data, supplemented with industry loss data and reported losses. During the year ended December 31, 2005, there were no increases in loss reserves relating to prior year contracts.
Losses relating to insurance were $90.6 million for the year ended December 31, 2004 compared to $34.6 million for the year ended December 31, 2003, an increase of 161.9%, which is consistent with the increase in our premiums earned for the year 2004. The loss ratio for insurance for the year ended December 31, 2003 was 75.4%.
Acquisition costs were $2.5 million for the year ended December 31, 2004 compared to $3.1 million for the year ended December 31, 2003. The decline in acquisition costs principally reflects the increase in acquisition costs recovered from our quota share partners.
General and administrative expenses were $6.8 million for the year ended December 31, 2004 compared to $4.9 million for the year ended December 31, 2003, an increase of 38.8%. The increase resulted principally from expenses associated with additional staff within our excess liability and professional lines teams.
Our segment results do not include investment income or interest expense, which are included in the corporate function.
Gross premiums written for the life and annuity reinsurance segment for the year ended December 31, 2004 were $212.3 million compared to $108.3 million for the year ended December 31, 2003, an increase of 96.0%. We wrote two medium-sized life transactions in 2003. The level of business written in future periods will vary, perhaps materially, based upon market conditions and the opportunities presented to us.
Benefits. Benefits relating to the life and annuity reinsurance segment were $311.2 million for the year ended December 31, 2005 compared to $238.3 million for the year ended December 31, 2004, an increase of 30.6%. The increase was principally due to the recognition of losses associated with the premiums written and earned in the current year.
Benefits relating to the life and annuity reinsurance segment increased 107.3% to $238.3 million for the year ended December 31, 2004 from $114.9 million for the year ended December 31, 2003. The increase was largely due to the recognition of losses associated with the premiums written and earned in the year ended December 31, 2004, as well as loss accretion on benefit reserves.
General and administrative expenses. General and administrative expenses were $3.5 million for the year ended December 31, 2005 compared to $4.5 million for the year ended December 31, 2004 and $4.5 million for the year ended December 31, 2003. General and administrative expenses have varied in proportion to staffing levels in each of the years.
Net loss attributable to the life and annuity reinsurance segment was $34.7 million for the year ended December 31, 2004 compared to $34.7 million for the year ended December 31, 2003 despite increased premium volume in the year 2004. Additional benefit charges were recorded in 2003 as reserve estimates were updated with no corresponding increase in 2004.
Net investment income, excluding realized and unrealized gains and losses, for the year ended December 31, 2004 increased $22.7 million to $82.8 million compared to $60.1 million for the year ended December 31, 2003, an increase of 37.8%. The increase was principally attributable to the growth in the fixed maturities portfolio from $1,604.4 million to $2,156.0 million, resulting from cash flow from operations since December 31, 2003. The average investment yield on the cash, fixed maturities investments and funds withheld by clients for the year ended December 31, 2004 was 4.2% compared to an average yield of 3.8% for the year ended December 31, 2003.
Interest expense. Interest expense was $32.0 million for the year ended December 31, 2005 compared to $33.6 million for the year ended December 31, 2004, a decrease of 4.8%. Interest expense includes $7.4 million of interest expense pertaining to the Grand Central Re quota share funds withheld for the year ended December 31, 2005 compared to $8.1 million for the year ended December 31, 2004. The interest expense on the Grand Central Re funds withheld is based on the average of two total return fixed maturity indices that had a lower total return for the year ended December 31, 2005 compared to 2004.
Losses and benefits recoverable from reinsurers. Losses and benefits recoverable from reinsurers totaled $522.1 million at December 31, 2005 compared to $388.1 million at December 31, 2004, an increase of 34.5%, principally reflecting losses ceded under our reinsurance and retrocessional agreements. Grand Central Re, our largest retrocessionaire, accounted for 38.6% of our losses and benefits recoverable at December 31, 2005 compared to 51.1% of our losses and benefits recoverable at December 31, 2004. In September 2004, Grand Central Re requested that A.M. Best Company withdraw its financial strength rating. Consequently, A.M. Best Company has assigned a financial strength rating of “NR-4” to Grand Central Re. We retain funds from Grand Central Re amounting to approximately 87.3% of its loss recoverable obligations.
Bank loans. In February 2003, Max Re completed a $150.0 million sale of shares of Max Re Diversified to a third party financial institution. Simultaneous with the sale, Max Re entered into a total return swap with the purchaser of these shares whereby Max Re receives the return earned on the Max Re Diversified shares in exchange for a variable rate of interest based on LIBOR plus a spread. Max Re Diversified shares owned by Max Re with a fair value of $100.4 million at December 31, 2005 were pledged as collateral to which we are exposed to credit risk. Under GAAP, these transactions are viewed on a combined basis and are accounted for as a financing transaction, which results in the recording of a $150.0 million bank loan. In February 2005, the parties amended the swap transaction principally to extend the swap termination date to February 2007, with
provisions for earlier termination in the event that we fail to comply with certain covenants. We were in compliance with all covenants of our bank loan at December 31, 2005.
Shareholders’ equity. Our shareholders’ equity increased to $1,217.2 million at December 31, 2005 from $937.0 million at December 31, 2004, an increase of 29.9%, principally reflecting our sale of common shares in an underwritten public offering that resulted in net proceeds of approximately $284.1 million combined with net income of $6.7 million partially offset by a decrease in accumulated other comprehensive income of $17.2 million for the year ended December 31, 2005. Additionally, $10.1 million of loans receivable from common share sales were repaid during the year ended December 31, 2005.
Liquidity. We generated $389.9 million of cash from operations during the year ended December 31, 2005 compared to $597.7 million for the year ended December 31, 2004. The decrease in operating cash flow principally reflects the commutation of a large reinsurance contract. Two principal factors impacting our operating cash flow are premium collections and timing of loss and benefit payments. We principally write casualty business, which generally has a long claim-tail and it is expected that we will generate significant operating cash flow as we build loss and benefit reserves on our balance sheet. We believe that our reserves currently have an average duration of approximately five years and we expect to see increases in the amount of expected loss payments in future periods with a resulting decrease in operating cash flow. We do not expect loss payments to exceed the premiums generated and therefore expect to have continued positive cash flow. However, actual premiums written and collected and losses paid in any period could vary from our expectations and could have a meaningful effect on operating cash flow.
While we tailor our fixed maturities portfolio to expected loss payments, increased loss amounts or settlement of losses earlier than anticipated can result in greater cash needs. We maintain a meaningful working cash balance (typically greater than $100.0 million), have generated positive cash flow from operations in each of our six years of operating history and can access our credit facility described in Note 15 of our audited consolidated financial statements. We believe that we currently maintain sufficient liquidity to cover existing requirements and provide for contingent liquidity. Nonetheless, it is possible that significant deviations in expected loss payments can occur, potentially requiring us to liquidate a portion of our fixed maturities portfolio at a gain or loss.
In the ordinary course of business, we are required to provide letters of credit or other regulatory approved security to certain of our clients to meet contractual and regulatory requirements. We have three credit facilities as of December 31, 2005 providing an aggregate of $520.0 million of letter of credit capacity. Each of our credit facilities requires that we comply with certain substantially similar covenants, including a minimum consolidated tangible net worth, a minimum insurer financial strength rating and restrictions on the payment of dividends. We were in compliance with all the covenants of each of our credit facilities at December 31, 2005.
We filed an unallocated universal shelf registration statement with the SEC on September 26, 2005, which the SEC declared effective on October 4, 2005. The securities registered under the shelf registration statement for possible future sales include up to $635.9 million of common shares, preferred shares and various types of debt securities. The shelf registration statement also includes common shares held by Capital Z Investments, L.P., which we refer to as “Cap Z,” and common shares issuable upon warrants owned by Cap Z. The common shares held by and issuable upon exercise of warrants by Cap Z account for $135.9 million of the $635.9 million of securities registered under the shelf registration statement, with the remaining $500.0 million available for securities offerings by us. To effect any such sales from time to time, we will file one or more supplements to the registration statement, which will provide details of any proposed offering or sale.
Furthermore, life and annuity benefits recorded in the financial statements at December 31, 2005 are computed on a discounted basis, whereas the expected payments by period in the table above are the estimated payments at a future time and do not reflect a discount of the amount payable.
In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS 123(R)-Share-Based Payment (SFAS 123(R)), a revision of SFAS No. 123-Accounting for Stock-Based Compensation (SFAS 123). Both statements supersede APB Opinion No. 25, Accounting for Stock Issued to Employees. SFAS 123(R) requires companies to recognize the cost of employee services received in share-based payment transactions, thereby reflecting the economic effect of those transactions in the financial statements. SFAS 123(R) also eliminates alternative methods of accounting for stock-based compensation in order to allow for greater comparability between companies. We have adopted the new standard using a modified prospective method. Under the modified prospective method, we are required to record compensation costs for new and modified awards over the related vesting period of such awards prospectively and record compensation cost prospectively for the unvested portion, at the date of adoption, of previously issued and outstanding awards over the remaining vesting period of such awards. On January 1, 2003 we adopted the expense recognition provision of SFAS 123 for all stock options granted on or after January 1, 2003. The calculation of fair value is similar under SFAS 123 and SFAS 123(R), but the revised statement requires, among other things, estimates of the number of awards that are expected to vest, no decrease in recognition of compensation cost if vested