Enstar, though various of its subsidiaries, owns the following properties: 1) two apartments in Guildford, England; 2) a building in Norwich, U.K. and 3) an apartment in New York, NY. The lease on the office space for Castlewood (EU) Limited expires on March 31, 2007 and the Company has secured new office space in Guildford, U.K. with a lease commencement date of July 1, 2007. It is intended that the current office lease will be renewed on a month to month basis until June 2007.
The following selected historical financial information of Enstar for each of the past five fiscal years has been derived from Enstar’s audited historical financial statements. This information is only a summary and should be read in conjunction with management’s discussion and analysis of results of operations and financial condition of Enstar and the audited consolidated financial statements and notes thereto of Enstar included elsewhere in this annual report.
Since its inception, Enstar has made several acquisitions which impact the comparability of the information reflected in the Enstar Summary Historical Financial Data. See “Business - Acquisitions to Date” beginning on page 6 for information about Enstar’s acquisitions.
Enstar Group Limited (formerly Castlewood Holdings Limited), or Enstar, was formed in August 2001 under the laws of Bermuda to acquire and manage insurance and reinsurance companies in run-off, and to provide management, consulting and other services to the insurance and reinsurance industry. On January 31, 2007, Enstar completed the merger, or the Merger, of CWMS Subsidiary Corp., a Georgia corporation and wholly-owned subsidiary of Enstar, or CWMS, with and into The Enstar Group Inc., a Georgia corporation, or EGI. As a result of
Since its formation, Enstar, through its subsidiaries, has completed several acquisitions of insurance and reinsurance companies and is now administering those businesses in run-off. Enstar derives its net earnings from the ownership and management of these companies primarily by settling insurance and reinsurance claims below the recorded loss reserves and from returns on the portfolio of investments retained to pay future claims. In addition, Enstar has formed other businesses that provide management and consultancy services, claims inspection services and reinsurance collection services to Enstar affiliates and third-party clients for both fixed and success-based fees.
In the sale of a run-off company, a purchaser, such as Enstar, typically pays a discount to the book value of the company based on the risks assumed and the relative value to the seller of no longer having to manage the company in run-off. Such a transaction can be beneficial to the seller because it receives an up-front payment for the company, eliminates the need for its management to devote any attention to the disposed company and removes the risk that the established reserves related to the run-off business may prove to be inadequate. The seller is also able to redeploy its management and financial resources to its core businesses.
Enstar manages its business through two operating segments: reinsurance and consulting.
Enstar’s consulting segment comprises the operations and financial results of those subsidiaries which provide management and consulting services, forensic claims inspections services and reinsurance collection services to third party clients. This segment also provides management services to the reinsurance segment in return for management fees. The financial results of this segment primarily consist of fee income less overhead expenses comprised of staff costs, information technology costs, certain premises costs, travel costs and certain professional fees.
As of December 31, 2006, Enstar had $1,774.3 million of total assets and $318.6 million of shareholders’ equity. Enstar operates its business internationally through its insurance and reinsurance subsidiaries and its consulting subsidiaries in the United Kingdom, the United States and Bermuda.
The majority of cash and all of the investment balances are held within Enstar’s reinsurance segment.
Net loss and loss adjustment expense liabilities are reviewed by Enstar’s management each quarter and by independent actuaries annually. Reserves reflect management’s best estimate of the remaining unpaid portion of these liabilities. Prior period estimates of net loss and loss adjustment expense liabilities may change as Enstar’s management considers the combined impact of commutations, policy buy-backs, settlement of losses on carried reserves and the trend of incurred loss development compared to prior forecasts.
Commutations provide an opportunity for Enstar to exit exposures to entire policies with insureds and reinsureds at a discount to the previously estimated ultimate liability. Enstar’s internal and external actuaries eliminate all prior historical loss development that relates to commuted exposures and apply their actuarial
methodologies to the remaining aggregate exposures and revised historical loss development information to reassess estimates of ultimate liabilities.
Policy buy-backs provide an opportunity for Enstar to settle individual policies and losses usually at a discount to carried advised loss reserves. As part of Enstar’s routine claims settlement operations, claims will settle at either below or above the carried advised loss reserve. The impact of policy buy-backs and the routine settlement of claims updates historical loss development information to which actuarial methodologies are applied often resulting in revised estimates of ultimate liabilities. Enstar’s actuarial methodologies include industry benchmarking which, under certain methodologies (discussed further under “- Critical Accounting Policies” below), compares the trend of Enstar’s loss development to that of the industry. To the extent that the trend of Enstar’s loss development compared to the industry changes in any period it is likely to have an impact on the estimate of ultimate liabilities. Additionally, consolidated net reductions, or potentially increases, in loss and loss adjustment expense liabilities include reductions, or potentially increases, in the provisions for future losses and loss adjustment expenses related to the current period’s run-off activity. Net reductions in net loss and loss adjustment expense liabilities are reported as negative expenses by Enstar in its reinsurance segment. The unallocated loss adjustment expenses paid by the reinsurance segment comprise management fees paid to the consulting segment and are eliminated on consolidation. The consulting segment costs in providing run-off services are classified as salaries and general and administrative expenses. For more information on how the reserves are calculated, see “- Critical Accounting Policies - Loss and Loss Adjustment Expenses” below.
As Enstar’s reinsurance subsidiaries are in run-off, its premium income is insignificant, consisting primarily of adjustment premiums triggered by loss payments.
On September 15, 2006, Enstar’s board of directors and shareholders adopted the Enstar Group Limited 2006-2010 Annual Incentive Compensation Plan (the “Annual Incentive Plan”), which will be administered by a Compensation Committee appointed by Enstar’s board of directors (the “Plan Committee”). No awards have been granted under the Annual Incentive Plan.
Enstar includes in its net income its proportionate share in the equity of earnings by companies in which it holds a significant influence. Such investments are carried on the equity basis whereby the investment is initially recorded at cost and adjusted to reflect Enstar’s share of net earnings.
Negative goodwill represents the excess of the fair value of businesses acquired by Enstar over the cost of such businesses. In accordance with FAS 141 “Business Combinations,” this amount is recognized upon the acquisition of the businesses as an extraordinary gain. The fair values of the reinsurance assets and liabilities acquired are derived from probability-weighted ranges of the associated projected cash flows, based on actuarially prepared information and Enstar’s management run-off strategy. Any amendment to the fair values resulting from changes in such information or strategy will be recognized when they occur. For more information on how the goodwill is determined, see “- Critical Accounting Policies - Goodwill” below.
Certain amounts in Enstar’s consolidated financial statements require the use of best estimates and assumptions to determine reported values. These amounts could ultimately be materially different than what has been provided for in Enstar’s consolidated financial statements. Enstar considers the assessment of loss reserves and reinsurance recoverable to be the values requiring the most inherently subjective and complex estimates. In addition, the assessment of the possible impairment of goodwill involves certain estimates and assumptions. As such, the accounting policies for these amounts are of critical importance to Enstar’s consolidated financial statements.
The following table provides a breakdown of gross loss and loss adjustment expense reserves by type of exposure as of December 31, 2006 and 2005:
As of December 31, 2006, the IBNR reserves (net of reinsurance balances receivable) accounted for $359.4 million, or 41.2%, of Enstar’s total loss reserves. The reserve for IBNR (net of reinsurance balance receivable) accounted for $326.3 million, or 55.0%, of Enstar’s total loss reserves at December 31, 2005.
Because a significant amount of time can lapse between the assumption of risk, the occurrence of a loss event, the reporting of the event to an insurance or reinsurance company and the ultimate payment of the claim on the loss event, the liability for unpaid losses and loss adjustment expenses is based largely upon estimates. Enstar’s management must use considerable judgment in the process of developing these estimates. The liability for unpaid losses and loss adjustment expenses for property and casualty business includes amounts determined from loss reports on individual cases and amounts for IBNR reserves. Such reserves are estimated by management based upon loss reports received from ceding companies, supplemented by Enstar’s own estimates of losses for which no ceding company loss reports have yet been received.
In establishing reserves, management also considers independent actuarial estimates of ultimate losses. Enstar’s actuaries employ generally accepted actuarial methodologies to estimate ultimate losses and loss adjustment expenses. A loss reserve study is prepared by an independent actuary annually in order to provide additional insight into the reasonableness of Enstar’s reserves for losses and loss adjustment expenses.
accordingly, remain at the primary layer and, thus, rarely impact excess insurance policies. As the vast majority of Enstar’s policies are excess policies, this trend has had only a marginal effect on our asbestos exposures thus far.
Asbestos claims fall into two general categories: impaired and unimpaired bodily injury claims. Property damage claims represent only a small fraction of asbestos claims. Impaired claims primarily include individuals suffering from mesothelioma or a cancer such as lung cancer. Unimpaired claims include asbestosis and those whose lung regions contain pleural plaques. Unimpaired claims are not life threatening and do not cause changes to one’s ability to function or to one’s lifestyle.
Furthermore, because of the reinsurance nature of the claims Enstar manages, it focuses on the activities at the (re)insured level rather than at the individual claims level. The counterparties with whom Enstar typically interacts are generally insurers or large industrial concerns and not individual claimants. Claims do not follow any consistent pattern. They arise from many insureds or locations and in a broad range of circumstances. An insured may present one large claim or hundreds or thousands of small claims. Plaintiffs’ counsel frequently aggregate thousands of claims within one lawsuit. The deductibles to which claims are subject vary from policy to policy and year to year. Often claims data is only available to reinsurers, such as Enstar, on an aggregated basis. Accordingly, Enstar has not found claim count information or average reserve amounts to be reliable indicators of exposure for its reserve estimation process or for management of its liabilities. Enstar has found data accumulation and claims management more effective and meaningful at the (re)insured level rather than at the underlying claim level. As such, we have designed our reserving methodologies to be independent of claim count information. As the level of exposures to a (re)insured can vary substantially, Enstar focuses on the aggregate exposures and pursues commutations and policy buy-backs with the larger (re)insureds.
Enstar employs approximately thirty-one full time equivalent employees, including three U.S. attorneys, actuaries, and experienced claims-handlers to directly administer its asbestos and environmental liabilities. Enstar has established a provision for future expenses of $43.0 million, which reflects the total anticipated costs to administer these claims to expiration.
Enstar’s future asbestos loss development may be influenced by many factors including:
The influence of each of these factors is not easily quantifiable and Enstar’s historical asbestos loss development is of limited value in determining future asbestos loss development using traditional actuarial reserving techniques.
The influence of each of these factors is not easily quantifiable and, as with asbestos-related exposures, Enstar’s historical environmental loss development is of limited value in determining future environmental loss development using traditional actuarial reserving techniques.
Finally, the issue of lead paint liability represents a potential emerging trend in latent claim activity that could potentially lead to future reserve adjustments. After a series of successful defense efforts by defendant lead pigment manufacturers in lead paint litigation, last year a Rhode Island court ruled in favor of the government in a nuisance claim against the defendant manufacturers. Although the damages portion of the case has yet to be decided, the plaintiff could receive a significant award. Further, there are similar pending claims in several jurisdictions including California and Ohio. As insureds have met policy terms and conditions to establish coverage for lead paint public nuisance claims as opposed to traditional bodily injury and property damage claims there is the potential for significant impact to excess insurers should plaintiffs prevail in successive nuisance claims pending in other jurisdictions.
In addition to the specific considerations for each method described below, many general factors are considered in the application of the methods and the interpretation of results for each portfolio of exposures. These factors include the mix of product types (e.g. primary insurance versus reinsurance of primary versus reinsurance of reinsurance), the average attachment point of coverages (e.g. first-dollar primary versus umbrella over primary versus high-excess), payment and reporting lags related to the international domicile of Enstar subsidiaries, payment and reporting pattern acceleration due to large “wholesale” settlements (e.g. policy buy-backs and commutations) pursued by Enstar, lists of individual risks remaining and general trends within the legal and tort environments.
1. Paid Survival Ratio Method. In this method, Enstar’s expected annual average payment amount is multiplied by an expected future number of payment years to get an indicated reserve. Enstar’s historical calendar year payments are examined to determine an expected future annual average payment amount. This amount is multiplied by an expected number of future payment years to estimate a reserve. Trends in calendar year payment activity are considered when selecting an expected future annual average payment amount. Accepted industry benchmarks are used in determining an expected number of future payment years. Each year, annual payments data is updated, trends in payments are re-evaluated and changes to benchmark future payment years are reviewed. This
4. IBNR:Case Ratio Method. In this method, the ratio of estimated industry IBNR reserves to industry case reserves is multiplied by Enstar’s case reserves to estimate Enstar IBNR reserves. Specific considerations in the application of this method include the presence of policies reserved at policy limits, changes in overall industry case reserve adequacy and recent loss reporting history for Enstar. Each year, Enstar case reserves are updated, industry reserves are updated and the applicability of the industry IBNR:case ratio is reviewed. This method has the advantage that it incorporates the most recent estimates of amounts needed to settle open cases included in current case reserves. A potential disadvantage is that results could be misleading where Enstar case reserve adequacy differs significantly from overall industry case reserve adequacy.
The five methodologies discussed above are applied for each of the 21 asbestos reserving categories and each of the 24 environmental reserving categories. As is common in actuarial practice, no one methodology is exclusively or consistently relied upon when selecting a recorded reserve. Consistent reliance on a single methodology to select a recorded reserve would be inappropriate in light of the dynamic nature of both the asbestos and environmental liabilities in general, and the actual Enstar exposure portfolios in particular.
In selecting a recorded reserve, management considers the range of results produced by the methods, and the strengths and weaknesses of the methods in relation to the data available and the specific characteristics of the portfolio under consideration. Trends in both Enstar data and industry data are also considered in the reserve selection process. Recent trends or changes in the relevant tort and legal environments are also considered when assessing methodology results and selecting an appropriate recorded reserve amount for each portfolio.
The following key assumptions were used to estimate Asbestos and Environmental reserves at December 31, 2006:
1. $65 billion Ultimate Industry Asbestos losses - this level of industry-wide losses and its comparison to industry-wide paid, incurred and outstanding case reserves is the base benchmarking assumption applied to Paid Market Share, Reserve-to-Paid, IBNR: Case Ratio and the Ultimate-to-Incurred asbestos reserving methodologies.
3. Loss reporting lag - Enstar’s subsidiaries assumed a mix of insurance and reinsurance exposures generally through the London Market. As the available industry benchmark loss information, as supplied by our independent consulting actuaries, is compiled largely from U.S. direct insurance company experience, Enstar’s loss reporting is expected to lag relative to available industry benchmark information. This time-lag used by each of Enstar’s insurance subsidiaries varies between from 2 to 5 years depending on the relative mix of domicile, percentages of product mix of insurance, reinsurance and retrocessional reinsurance, primary insurance, excess insurance, reinsurance of direct, and reinsurance of reinsurance within any given exposure category. Exposure portfolios written from a non-U.S. domicile are assumed to have a greater time-lag than portfolios written from a U.S. domicile. Portfolios with a larger proportion of reinsurance exposures are assumed to have a greater time-lag than portfolios with a larger proportion of insurance exposures.
The assumptions above as to Ultimate Industry Asbestos and Environmental losses have not changed from the immediately preceding period. For certain Asbestos & Environmental portfolios, assumptions as to the appropriate loss reporting lag have changed from the immediately preceding period. For Enstar as a whole, the average selected lag for Asbestos has increased from 2 years to 3 years and the average selected lag for Environmental has increased from 2 years to 2.5 years. The changes arise largely as a result of the level of loss reporting during the year in certain of Enstar’s insurance companies relative to loss reporting trends within the industry. The changes to the lag assumptions had the effect of increasing gross reserves by $81.1 million and increasing net reserves by $6.4 million.
ALAE at December 31, 2006 and differs from the table on page 55 which demonstrates the range of outcomes produced by the various methodologies.
Guidance from industry publications is more varied in respect of estimates of ultimate industry environmental losses. Consistent with an industry published estimate, Enstar believes the reasonable range for ultimate industry environmental losses is between $30 billion and $40 billion. Enstar has selected the midpoint of this range as the basis for its environmental loss reserving based on advice supplied by its independent consulting actuaries. Another industry publication, released prior to the one relied upon by Enstar, indicates that ultimate industry environmental losses could be $56 billion. However, based on our own loss experience, including successful settlement activity by the company, the decline in new claims notified in recent years and improvements in environmental clean-up technology, Enstar does not believe that the $56 billion estimate would be a reasonable basis for its reserving for environmental losses.
Non-Latent Claims. Non-latent claims are less significant to Enstar, both in terms of reserves held and in terms of risk of significant reserve deficiency. For non-latent loss exposure, a range of traditional loss development extrapolation techniques is applied. Incremental paid and incurred loss development methodologies are the most commonly used methods. Traditional cumulative paid and incurred loss development methods are used where inception-to-date, cumulative paid and reported incurred loss development history is available.
These methods assume that cohorts, or groups, of losses from similar exposures will increase over time in a predictable manner. Historical paid and incurred loss development experience is examined for earlier accident years to make inferences about how later accident years’ losses will develop. Where company-specific loss information is not available or not reliable, industry loss development information published by industry sources such as the Reinsurance Association of America is considered. These methods calculate an estimate of ultimate losses and then
Quarterly Reserve Reviews. In addition to an in-depth annual review, Enstar also performs quarterly reserve reviews. This is done by examining quarterly paid and incurred loss development to determine whether it is consistent with reserves established during the preceding annual reserve review. Loss development is reviewed separately for each major exposure type (e.g. asbestos, environmental, etc.), for each relevant Enstar subsidiary, and for large “wholesale” commutation settlements versus “routine” paid and advised losses. This process is undertaken to determine whether loss development experience during a quarter warrants any change to held reserves.
In addition, loss development is examined separately for each relevant Enstar subsidiary. While the most significant exposures for most Enstar subsidiaries are latent asbestos and environmental exposures, there are differing profiles to the exposure across Enstar’s subsidiaries. Companies can differ in their exposure profile due to the mix of insurance versus reinsurance, the mix of primary versus excess insurance, the underwriting years of participation and other criteria. These differing profiles lead to different expectations for quarterly and annual loss development by company.
Enstar’s quarterly paid and incurred loss development is often driven by large, “wholesale” settlements - such as commutations and policy buy-backs - which settle many individual claims in a single transaction. This allows for monitoring of the potential profitability of large settlements which, in turn, can provide information about the adequacy of reserves on remaining exposures which have not yet been settled. For example, if it were found that large settlements were consistently leading to large negative, or favorable, incurred losses upon settlement, it might be an indication that reserves on remaining exposures are redundant. Conversely, if it were found that large settlements were consistently leading to large positive, or adverse, incurred losses upon settlement, it might be an indication - particularly if the size of the losses were increasing - that certain loss reserves on remaining exposures are deficient. Moreover, removing the loss development resulting from large settlements allows for a review of loss development related only to those contracts which remain exposed to losses. Were this not done, it is possible that savings on large wholesale settlements could mask significant underlying development on remaining exposures.
Quarterly loss development is expected to be fairly erratic for the types of exposure insured and reinsured by Enstar. Several quarters of low incurred loss development can be followed by spikes of relatively large incurred losses. This is characteristic of latent claims and other insurance losses which are reported and settled many years after the inception of the policy. Given the high degree of statistical uncertainty, and potential volatility, it would be unusual to adjust reserves on the basis of one, or even several, quarters of loss development activity. As such, unless the incurred loss activity in any one quarter is of such significance that management is able to quantify the impact on the ultimate liability for loss and loss adjustment expenses, reductions or increases in loss and loss adjustment expense liabilities are carried out in the fourth quarter based on the annual reserve review described above.
As described above, Enstar’s management regularly reviews and updates reserve estimates using the most current information available and employing various actuarial methods. Adjustments resulting from changes in Enstar’s estimates are recorded in the period when such adjustments are determined. The ultimate liability for loss and loss adjustment expenses is likely to differ from the original estimate due to a number of factors, primarily
Enstar’s acquired reinsurance subsidiaries, prior to acquisition by Enstar, used retrocessional agreements to reduce their exposure to the risk of insurance and reinsurance they assumed. Loss reserves represent total gross losses, and reinsurance receivable represents anticipated recoveries of a portion of those unpaid losses as well as amounts receivable from reinsurers with respect to claims that have already been paid. While reinsurance arrangements are designed to limit losses and to permit recovery of a portion of direct unpaid losses, reinsurance does not relieve Enstar of its liabilities to its insureds or reinsureds. Therefore, Enstar evaluates and monitors concentration of credit risk among its reinsurers, including companies that are insolvent, in run-off or facing financial difficulties. Provisions are made for amounts considered potentially uncollectible.
In July 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes. FIN 48 prescribes detailed guidance for the financial statement recognition, measurement and disclosure of uncertain tax positions recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” Tax positions must meet a more-likely-than-not recognition threshold at the effective date to be recognized upon the adoption of FIN 48 and in subsequent periods. FIN 48 will be effective for fiscal years beginning after December 15, 2006 and the provisions of FIN 48 will be applied to all tax positions upon initial adoption of the Interpretation. The cumulative effect of applying the provisions of this Interpretation will be reported as an adjustment to the opening balance of retained earnings for that fiscal year. We are currently evaluating the potential impact of FIN 48 on its financial statements when adopted.
In September 2006, the FASB issued FAS No. 157, Fair Value Measurement (“FAS 157”). This Statement provides guidance for using fair value to measure assets and liabilities. Under this standard, the definition of fair value focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price). FAS 157 clarifies that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy with the highest priority being quoted prices in active markets and the lowest priority to unobservable data. Further, FAS 157 requires tabular disclosures of the fair value measurements by level within the fair value hierarchy. FAS 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those
Enstar reported consolidated net earnings of approximately $82.3 million for the year ended December 31, 2006 compared to approximately $80.7 million in 2005. Included as part of net earnings for 2006 is an extraordinary gain of $31.0 million relating to negative goodwill, net of minority interest. As a result, net earnings before extraordinary gain for 2006 were approximately $51.3 million compared to $80.7 million in 2005. The decrease was primarily a result of a lower net reduction in loss and loss adjustment expense liabilities and higher general and administrative expenses offset by higher consulting fee income, investment income and increased foreign exchange gains.
Net investment income for the year ended December 31, 2006 increased by $19.9 million to $48.1 million, compared to $28.2 million for the year ended December 31, 2005. The increase was attributable to the increase in prevailing interest rates during the year along with an increase in average cash and investment balances from $913.5 million to $1,093.2 million for the years ended December 31, 2005 and 2006, respectively, relating to cash and investment portfolios of reinsurance companies acquired in the year.
Net realized (losses)/gains for the year ended December 31, 2006 and 2005 were $(0.1) million and $1.3 million, respectively. Based on Enstar’s current investment strategy, Enstar does not expect net realized gains and losses to be significant in the foreseeable future.
Net reduction in loss and loss adjustment expense liabilities for the year ended December 31, 2006 was $31.9 million and was attributable to a reduction in estimates of net ultimate losses of $21.4 million, a reduction in estimates of loss adjustment expense liabilities of $15.1 million, to reflect 2006 run-off activity compared to a reduction of $10.5 million in 2005 (the larger reduction relating to companies acquired during 2006), a reduction in aggregate provisions for bad debt of $6.3 million compared to $20.2 million in 2005, resulting from the collection of certain reinsurance receivables against which bad debt provisions had been provided in earlier periods, partially offset by the amortization, over the estimated payout period, of fair value adjustments relating to companies acquired amounting to $10.9 million compared to $7.9 million in 2005, the increased charge reflecting amortization
The adverse incurred loss development of $59.2 million relating to one of Enstar’s insurance companies was comprised of net paid loss settlements of $81.3 million less reductions in case and LAE reserves of $22.1 million and resulted from the settlement of case and LAE reserves above carried levels and from new loss advices, partially offset by approximately 10 commutations of assumed and ceded exposures below carried reserves levels. Actuarial analysis of the remaining unsettled loss liabilities resulted in an increase in the estimate of IBNR loss reserves of $35.0 million after consideration of the $59.2 million adverse incurred loss development during the year, and the application of the actuarial methodologies to loss data pertaining to the remaining non-commuted exposures. Other factors contributing to the increase include the establishment of a reserve to cover potential exposure to lead paint claims, a significant increase in asbestos reserves related to the entity’s single largest cedant (following a detailed review of the underlying exposures), and a change in the assumed asbestos and environmental loss reporting time-lag as discussed further below. Of the 10 commutations completed for this entity, two were among its top ten cedant and/or reinsurance exposures. The remaining 8 were of a smaller size, consistent with Enstar’s approach of targeting significant numbers of cedant and reinsurer relationships as well as targeting significant individual cedant and reinsurer relationships. The entity in question also benefits from substantial stop loss reinsurance protection whereby the adverse loss development of $59.2 million was largely offset by a recoverable from a single AA rated reinsurer. The increase in estimated net ultimate losses of $3.4 million was retained by Enstar.
The favorable incurred loss development of $21.3 million, relating to Enstar’s remaining insurance and reinsurance companies, whereby net advised case reserves of $15.3 million were settled for net paid loss recoveries of $6.0 million, arose from approximately 35 commutations of assumed and ceded exposures at less than case and LAE reserves, where receipts from ceded commutations exceeded settlements of assumed exposures, and the settlement of non-commuted losses in the year below carried reserves. Enstar adopts a disciplined approach, through claims adjusting and the inspection of underlying policyholder records, to the review and settlement of non-commuted claims such that settlements may often be achieved below the level of the originally advised loss.
The net reduction in the estimate of IBNR loss and loss adjustment expense liabilities relating to Enstar’s remaining insurance and reinsurance companies (i.e. excluding the net $55.8 million reduction in IBNR reserves relating to the entity referred to above) amounted to $3.5 million. This net reduction is comprised of an increase of $19.8 million resulting from (i) a change in assumptions as to the appropriate loss reporting time lag for Asbestos related exposures from 2 to 3 years and for environmental exposures from 2 to 2.5 years which resulted in an increase in net IBNR reserves of $6.4 million, and (ii) a reduction in ceded IBNR recoverables of $13.4 million resulting from the commutation of ceded reinsurance protections. The increase in IBNR of $19.8 million is offset by a reduction of $23.3 million resulting from the application Enstar’s reserving methodologies to (i) the reduced historical incurred loss development information relating to remaining exposures after the 35 commutations, and (ii) reduced case and LAE reserves in the aggregate.
Of the 35 commutations completed during 2006 for the remaining Enstar reinsurance and insurance companies, ten were among their top ten cedant and/or reinsurance exposures. The remaining twenty-five were of a smaller size, consistent with Enstar’s approach of targeting significant numbers of cedant and reinsurer relationships as well as targeting significant individual cedant and reinsurer relationships.
The following table shows the components of the movement in net reduction in loss and loss adjustment expense liabilities for the years ended December 31, 2006 and 2005.
Enstar expects that staff costs will increase moderately in 2007 as it continues to grow and add staff. Bonus accrual expenses will be variable and dependent on the overall profit of Enstar.
General and administrative expenses attributable to the consulting segment increased by $3.5 million during the year ended December 31, 2006, as compared to the year ended December 31, 2005. This increase was due primarily to increases in rent and rent related costs due to an increase in office space along with an increase in professional fees and travel relating to due diligence work on potential acquisition opportunities. Enstar expects that general and administrative expenses attributable to the consulting segment will continue to increase in 2007 due to growth in its U.S. operations, due diligence work on potential acquisitions, continued growth in staff resources and additional costs associated with its reporting obligations as a public company.
Enstar recorded a foreign exchange gain of $10.8 million for the year ended December 31, 2006, as compared to a foreign exchange loss of $4.6 million for 2005. The gain for the year ended December 31, 2006 arose primarily as a result of having surplus British Pounds that arose as a result of Enstar’s acquisitions of Brampton, Cavell, and Unione Italiana (U.K.) Reinsurance Company, or Unione, at a time when the British Pound has strengthened against the U.S. Dollar. The foreign exchange loss in 2005 arose as a result of having surplus British Pounds and Euros at various points in the year at a time when the both the British Pound and Euro were weakening against the U.S. Dollar. The U.S. Dollar to British Pound rate at January 1, 2005, December 31, 2005 and December 31, 2006 was $1.92, $1.72 and $1.959, respectively. Similarly, the U.S. Dollar to Euro rate at January 1, 2005, December 31, 2005 and December 31, 2006 was $1.36, $1.18 and $1.32, respectively.
As Enstar’s functional currency is the U.S. Dollar, it seeks to manage its exposure to foreign currency exchange by broadly matching foreign currency assets against foreign currency liabilities. The 2006 and 2005 currency mismatches were addressed and corrected by converting surplus foreign currency to U.S. Dollars at the time the mismatch was identified.
Enstar’s share of equity in earnings of partly-owned companies for the years ended December 31, 2006 and 2005, was $0.5 million and $0.2 million, respectively. These amounts represent Enstar’s proportionate share of equity in the earnings of B.H. Acquisition.
On January 31, 2007, B.H. Acquisition became a wholly-owned subsidiary of Enstar and, as a result, Enstar will, for 2007, consolidate the results of B.H. Acquisition rather than report its proportionate share of B.H. Acquisition’s income.
Income taxes of $0.3 million and $(0.9) million were recorded for the years ended December 31, 2006 and 2005, respectively. The income taxes recovered (incurred) were in respect of Enstar’s U.K and U.S subsidiaries.
Internal management fees of $16.0 million and $9.3 million were paid in 2005 and 2004, respectively, by Enstar’s reinsurance companies to its consulting companies. The increase in fees paid in 2005 by the reinsurance segment to the consulting segment was due primarily to the acquisition of new reinsurance entities by Enstar in 2005 and late 2004.
Net reduction in loss and loss adjustment expense liabilities for the years ended December 31, 2005 and 2004 were $96.0 million and $13.7 million, respectively. The net reduction in loss and loss adjustment expense liabilities for 2005 was attributable to a reduction in estimates of ultimate losses of $73.2 million, a reduction in estimates of loss adjustment expense liabilities of $10.5 million relating to 2005 run-off activity compared to a reduction of $14.7 million in 2004 (the lower reduction being due to an increase in the ultimate length of time, and therefore, cost by which management expects to conclude the run-off of certain liabilities), a reduction in aggregate provisions for bad debt of $20.2 million resulting from the collection of certain reinsurance receivables against which bad debt provisions had been provided in earlier periods compared to no change in 2004, partially offset by the amortization, over the estimated payout period, of fair value adjustments relating to companies acquired in late 2004 amounting to $7.9 million compared to zero amortization charge in 2004. The reduction in estimates of net ultimate losses of $73.2 million that arose from the completion of approximately 68 commutations of assumed and ceded exposures, the settlement of losses in the year below carried reserves, lower than expected incurred adverse loss development and the resulting reductions in actuarial estimates of IBNR losses. In 2004, the estimate of net ultimate losses increased by $1.0 million primarily as a result of adverse development of incurred asbestos and environmental losses partially offset by the completion of approximately 36 commutations of assumed and ceded exposures and settlement of losses below carried reserves.
Net change in case and LAE reserves comprises the movement during the year in specific case reserve liabilities as a result of claims settlements or changes advised to Enstar by its policyholders and attorneys, less changes in case reserves recoverable advised by Enstar to its reinsurers as a result of the settlement or movement of assumed claims. Net change in IBNR represents the change in Enstar’s actuarial estimates of losses incurred but not reported.
General and administrative expenses attributable to the consulting segment increased by approximately $2.4 million during 2005, as compared to 2004. This increase was due primarily to an increase in professional fees of $1.0 million and rent and rent-related costs of $0.8 million due to Enstar’s continued growth in the United Kingdom.
Negative goodwill of $21.8 million was recorded for the year ended December 31, 2004. This amount represents the excess of the fair value of net assets acquired of $26.2 million over the cost of $4.4 million in relation to Enstar’s acquisition of Mercantile Indemnity Company Ltd., Harper Insurance Limited and Longmynd Insurance Company Ltd. The negative goodwill arose primarily as the result of a negotiated discount between the cost of acquisition and the fair value of net assets acquired for an acquisition where indemnities for aggregate adverse loss development were received. The aggregate adverse loss development indemnities provide coverage capped at the worst plausible loss and loss adjustment expense reserve levels. This excess has, in accordance with FAS 141 “Business Combinations,” been recognized as an extraordinary gain in 2004.
As Enstar is a holding company and has no substantial operations of its own, its assets consist primarily of its investments in subsidiaries. The potential sources of the cash flows to the holding company consist of dividends, advances and loans from its subsidiary companies.
Enstar’s future cash flows depend upon the availability of dividends or other statutorily permissible payments from Enstar’s subsidiaries. The ability to pay dividends and make other distributions is limited by the applicable laws and regulations of the jurisdictions in which Enstar’s insurance and reinsurance subsidiaries operate, including Bermuda, The United Kingdom and Europe, which subject these subsidiaries to significant regulatory restrictions. These laws and regulations require, among other things, certain of Enstar’s insurance and reinsurance subsidiaries to maintain minimum solvency requirements and limit the amount of dividends and other payments that these subsidiaries can pay to Enstar, which in turn may limit Enstar’s ability to pay dividends and make other payments. As of December 31, 2006 and 2005, the insurance and reinsurance subsidiaries’ solvency and liquidity were in excess of the minimum levels required. Retained earnings of Enstar’s insurance and reinsurance subsidiaries are not currently restricted as minimum capital solvency margins are covered by share capital and additional paid-in-capital. However, as of December 31, 2006 and 2005, retained earnings of $9.7 million and $8.5 million, respectively, of one of B.H. Acquisition’s subsidiaries requires regulatory approval prior to distribution. On January 31, 2007, B.H. Acquisition became a wholly-owned subsidiary of Enstar.
Enstar maintains a short duration conservative investment strategy whereby, as of December 31, 2006, 74.5% of its invested assets are held with a maturity of less than one year and 95.4% have maturities of less than five years. Excluding the impact of commutations, Enstar expects that approximately 12.7% of the gross reserves are expected to be settled within one year and approximately 54.1% of the reserves settled within five years. However, Enstar’s strategy of commuting its liabilities has the potential to accelerate the natural payout of losses to less than five years. Therefore, the relatively short-duration investment portfolio is maintained in order to provide liquidity for commutation opportunities and preclude Enstar from having to liquidate longer dated securities thereby allowing Enstar to maintain its fixed income securities on a held-to-maturity basis. As such, Enstar does not anticipate having to sell longer dated investments in order to meet future policyholder liabilities. However, if Enstar had to sell a portion of its held-to-maturity portfolio to meet policyholder liabilities it would, at that point, amend the classification of the held-to-maturity portfolio to an available-for-sale portfolio. This reclassification would require the investment portfolio to be recorded at market value as opposed to amortized cost. As of December 31, 2006 such a reclassification would result in a reduction in the value of Enstar’s cash and investments of $4.6 million, reflecting the unrealized loss position of the held to maturity portfolio as of December 31, 2006.
At December 31, 2006, total cash and investments were $1.26 billion, compared to $884.9 million at December 31, 2005. The increase of $376.2 million was primarily due to cash and investments of $570.5 acquired on the acquisition of subsidiaries offset by: 1) net paid losses relating to claims of $77.3 million; 2) purchase costs of acquisitions, net of external financing, of $80.8 million; and 3) dividends and share redemptions of $50.6 million.
Enstar primarily generates its cash from the acquisitions it completes. These acquired cash and investment balances are classified as cash provided by investing activities.
Net cash used in financing activities was $0.8 million during the year ended December 31, 2005 compared to $12.4 million for the year ended December 31, 2004. The cash used for both years was exclusively for distributions to shareholders.
$25.2 million of the principal, plus accumulated interest. As of December 31, 2006, $19.4 million of principal and accumulated interest was payable to the bank.
The following table shows Enstar’s aggregate contractual obligations by time period remaining to due date as of December 31, 2006:
As of December 31, 2006, Enstar did not have any off-balance sheet arrangements.
December 31, 2006, the capital contributed to the Fund was $1.6 million with the remaining commitment being $8.4 million. The $10 million represents 8.5% of the total commitments made to GSC.
Schedule I - Summary of Investments - Other Than Investment in Related Parties
We have audited the accompanying consolidated balance sheets of Enstar Group Limited and subsidiaries (the “Company”) as of December 31, 2006 and 2005, and the related consolidated statements of earnings, comprehensive income, changes in shareholders’ equity and cash flows for the years ended December 31, 2006, 2005 and 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
Enstar Group Limited (formerly Castlewood Holdings Limited) (“Enstar” or the “Company”) was formed in August 2001 under the laws of Bermuda to acquire and manage insurance and reinsurance companies in run-off, and to provide management, consulting and other services to the insurance and reinsurance industry. On January 31, 2007, Enstar completed the merger (the “Merger”) of CWMS Subsidiary Corp., a Georgia corporation and wholly-owned subsidiary of Enstar, with and into The Enstar Group Inc. (“EGI”), a Georgia corporation. As a result of the Merger, EGI, renamed Enstar USA, Inc., is now a wholly-owned subsidiary of Enstar. Prior to the Merger, EGI owned approximately 32% economic and 50% voting interest in Enstar.
Investment in partly-owned company - Investment in partly-owned company, where the Company has significant influence, is carried on the equity basis whereby the investment is initially recorded at cost and adjusted to reflect the Company’s share of after-tax earnings or losses, unrealized investment gains and losses and reduced by dividends received.
Consulting fee income - Fixed fee income is recognized in accordance with the term of the agreements. Fees based on hourly charge rates are recognized as services are provided. Performance fees are recognized when all of the contractual requirements specified in the agreement are met.
Assets and liabilities of subsidiaries are translated into U.S. dollars at the year-end rates of exchange. Revenues and expenses of subsidiaries are translated into U.S. dollars at the average rates of exchange for the years. The resultant translation adjustment for self-sustaining subsidiaries is classified as a separate component of other comprehensive income, and for integrated operations is included in net earnings.
securities. Diluted earnings per share is defined as net earnings available to ordinary shareholders divided by the weighted average number of ordinary and ordinary share equivalents outstanding calculated using the treasury stock method for all potentially dilutive securities. When the effect of dilutive securities would be anti-dilutive, these securities are excluded from the calculation of diluted earnings per share.
In February 2007, the FASB issued FAS No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115”. FAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This statement is expected to expand the use of fair value measurement, which is consistent with the FASB’s long-term measurement
objectives for accounting for financial instruments. The fair value option established will permit all entities to choose to measure eligible items at fair value at a specified election dates. An entity shall record unrealized gains and losses on items for which the fair value option has been elected through net income in the statement of operations at each subsequent reporting date. This statement is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. The Company is currently evaluating the potential impact of FAS 159 on its financial statements when adopted.
The negative goodwill arose primarily as a result of a negotiated discount between the cost of acquisition and fair value of net assets acquired for an acquisition where indemnities for aggregate adverse loss development were received by Castlewood.
The seller of Harper has indemnified Enstar for adverse loss development subject to certain limits. Reinsurance balances receivable acquired include $88,379 in relation to these indemnities.
2005 - In 2005, Enstar completed the acquisition of Fieldmill Insurance Company Limited (formerly Harleysville Insurance Company (UK) Limited).
On February 23, 2007, Enstar repurchased 7,180 Enstar ordinary shares from T. Whit Armstrong for total consideration of $726. This repurchase was done in accordance with the letter agreement dated May 23, 2006, between T. Whit Armstong, T. Wayne Davis and Enstar pursuant to which Enstar agreed to repurchase from Messrs. Armstrong and Davis, upon their request, during a 30-day period commencing January 15, 2007, at then prevailing market prices, such number of Enstar ordinary shares as provides an amount sufficient for Messrs. Armstrong and Davis to pay taxes on compensation income resulting from the exercise of options by them on May 23, 2006 for 50,000 shares of EGI common stock in the aggregate. Mr. Davis did not elect to sell shares under the agreement. Messrs. Armstrong and Davis are directors of the Company.
Cash and cash equivalents in the amount of $62,746 and $65,117 as of December 31, 2006 and 2005 respectively, are restricted for use as collateral against letters of credit, in the amount of $41,483 and $47,848 as of December 31, 2006 and 2005, respectively, and as guarantee under trust agreements. Letters of credit are issued to ceding insurers as security for the obligations of insurance subsidiaries under reinsurance agreements with those ceding insurers.
The amortized cost and estimated fair values as at December 31, 2006 of debt securities classified as held-to-maturity by contractual maturity are shown below.
The estimated fair value of investments in debt securities and short-term investments classified as trading securities as of December 31, 2006 was as follows:
The trading portfolio consists of those investments which Enstar intends to sell in the short-term as part of the post-sale restructuring of the investment portfolio of newly acquired companies.
The Company has a capital commitment of up to $10,000 in the GSC European Mezzanine Fund II, LP (“GSC”). As of December 31, 2006, the capital contributed to GSC was $1,694 with the remaining commitment being $8,306. The $10,000 represents 8.5% of the total commitments made to GSC.
As of December 31, 2006 and 2005, consolidated retained earnings include $10,234 and $9,716, respectively of undistributed earnings of BH.
During 2006, the Company incurred interest expense on its facility and loan agreements of $1,989 (2005: $Nil). Included within this amount was $285 of interest expense incurred on the loan from BH.
The Class A and B shares were issued to EGI and Trident II L.P. and its affiliates (“Trident”), respectively, upon the acquisition of Castlewood Limited by the Company. Class E shares are non-voting and were issued to the shareholders of Castlewood Limited (the “Principals”), together with Class C shares, upon the acquisition of Castlewood Limited by the Company.
Fourth, distributions are made to each of the shareholders pro-rata to their shareholding.
All outstanding Class E shares were fully redeemed during the second quarter of 2006.
The Company provides pension benefits to eligible employees through various plans sponsored by the Company. All pension plans are structured as defined contribution plans. Pension expense for the years ended December 31, 2006, 2005 and 2004 was $1,506, $1,342 and $1,126, respectively.
During 2002, the Company entered into an agreement with employees that provided for stock awards. Employee stock awards for 153 Class C ordinary shares and 1,007,552 Class E ordinary shares were granted to the employees. The shares vest over a period of 4 years. The Company has charged compensation expense of $Nil, $259 and $481 relating to these restricted share awards in 2006, 2005 and 2004, respectively. The Class E shares were fully redeemed in 2006.
During 2004, the Company established an employee share plan. Employee stock awards for the 2006, 2005 and 2004 years are summarized as follows:
Compensation costs of $22,393, $3,780 and $3,125 relating to the issuance of the share-awards have been recognized in the Company’s statement of earnings for the years ended December 31, 2006, 2005 and 2004. The determination of the share-award expenses for 2006 was based on the fair-market value per common share of EGI as of the grant date and is recognized over the vesting period. The determination of the share-award expenses for 2005 and 2004 were based on the Company’s book value per share at December 31, 2005 and 2004, respectively, which approximated fair value.
As of December 31, 2006, there was remaining $2,993 of total unrecognized compensation costs related to the non-vested share awards. These costs are expected to be recognized over a weighted average period of 0.80 years
On September 15, 2006, Enstar’s board of directors and shareholders adopted the Enstar Group Limited 2006-2010 Annual Incentive Compensation Plan (the “Annual Incentive Plan”) and the 2006 Equity Incentive Plan (the “Equity Incentive Plan”), which reserves 1,200,000 ordinary shares for future awards. Both plans will be administered by the Compensation Committee appointed by Enstar’s board of directors (the “Plan Committee”). No awards have been granted under either the Annual Incentive Plan or the Equity Incentive Plan. As a result of the cancellation of the current annual incentive compensation plan, $21,193 of unpaid bonus accrual was reversed during the quarter ended June 30, 2006.
The Annual Incentive Plan provides for the annual grant of bonus compensation (each, a “bonus award”), to certain officers and employees of Enstar and its subsidiaries, including Enstar’s senior executive officers. Bonus awards for each calendar year from 2006 through 2010 will be determined based on Enstar’s consolidated net after-tax profits. The Plan Committee shall determine the amount of bonus awards in any calendar year, based on a percentage of Enstar’s consolidated net after-tax profits. The percentage will be 15% unless the Plan Committee exercises its discretion to change the percentage no later than 30 days after year-end. The Plan Committee will determine, in its sole discretion, the amount of bonus awards payable to each participant.
The accrued expense relating to the Annual Incentive Plan for the year ended December 31, 2006 was $14,533. Accrued expense for the previous annual incentive plan cancelled in the quarter ended June 30, 2006, for the years ended December 31, 2005 and 2004 was $14,243 and $6,473, respectively.
The following table sets forth the comparison of basic and diluted earnings per share for the years ended December 31, 2006, 2005 and 2004:
On December 22, 2006, the Company received management fees for advisory services provided to J.C. Flowers II L.P. (the “Flowers Fund”), a private investment fund, in the amount of $910. Of this amount $516 was earned at December 31, 2006.
On June 7, 2006, the commitment made by the Company in March 2006 to invest an aggregate of $75,000 in the Flowers Fund was accepted by the Flowers Fund. The Company’s commitment may be drawn down by the Flowers Fund over approximately the next six years. As at December 31, 2006 the Flowers Fund had drawn down a total of $15,245 of the Company’s $75,000 commitment to the Flowers Fund.
In December 2005 JCF Re Holdings LP (“JCF Re”), a Cayman Limited partnership, entered into a subscription and shareholders agreement with Fitzwilliam for the establishment of a segregated cell and paid $1,932 to Fitzwilliam as capital and contributed surplus. During 2005, Fitzwilliam recorded management fees of $40 from JCF Re.
In 2004, Hudson invested $9,147 in Cassandra for a 27% interest. JC Flowers I LP also owned 27% interest in Cassandra. Mr. Flowers is the managing member of JCF Associates I LLC, which is the general partner of JC Flowers I LP.
During the years ended December 31, 2006, 2005 and 2004, Enstar earned consulting fees of $1,250, $1,250 and $1,250, respectively from subsidiaries of BH.
In April 2005, Castlewood (US) Inc. entered into a lease agreement for use of certain office space with one of its directors running through to 2008 for an annual cost of $140. For the years ended December 31, 2006 and 2005, Castlewood (US) Inc. incurred rent expense of $140 and $119, respectively.
The Company has operating subsidiaries and branch operations in the United Kingdom, United States and Europe and is subject to the relevant taxes in those jurisdictions. The weighted average expected tax provision has been calculated using pre-tax accounting income in each jurisdiction multiplied by that jurisdictions applicable statutory tax rate.
Deferred income taxes arise from the recognition of temporary differences between income determined for financial reporting purposes and income tax purposes. Such differences result from differing bases of depreciation and amortization, run-off costs and employee compensation for tax and book purposes.
As of December 31, 2006 and 2005, United Kingdom insurance subsidiaries and branch operations had tax loss carryforwards, which do not expire, and deductions available for tax purposes of approximately $511,046 and $272,254, respectively. Certain of the Company’s U.K. insurance and reinsurance subsidiaries, have tax loss
The Company’s insurance and reinsurance operations are subject to insurance laws and regulations in the jurisdictions in which they operate, including Bermuda, Europe and the United Kingdom. Statutory capital and surplus as reported to the relevant regulatory authorities for the insurance and reinsurance subsidiaries of the Company as of December 31, 2006 and 2005 was as follows:
b) Loan Commitments - During 2006, Enstar entered into three separate loan facilities. As at December 31, 2006, the total outstanding loans payable was $62,148 (2005: $Nil), which are repayable within three to four years.
We have audited the consolidated financial statements of Enstar Group Limited and subsidiaries (the “Company”) as of December 31, 2006 and 2005, and for the years ended December 31, 2006, 2005 and 2004, and have issued our report thereon dated March 16, 2007, such consolidated financial statements and report are included elsewhere in this annual report. Our audits also included the financial statement schedules of the Company listed in the accompanying index at Item 15. These financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion based on our audits. In our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects the information set forth therein.
Enstar Group Limited (“Enstar ‘”) (formerly Castlewood Holdings Limited) was incorporated under the laws of Bermuda on August 16, 2001 and with its subsidiaries (collectively the “Company”) acquires and manages insurance and reinsurance companies in run-off, and provides management, consultancy and other services to the insurance and reinsurance industry.
Note 1: The discount rate is an assumed interest rate equivalent to a risk-free rate for securities with similar duration to the reserves for loss and loss expenses acquired.