The following is a discussion and analysis of our results of operations for the year ended December 31, 2007 compared to the year ended December 31, 2006 and for the year ended December 31, 2006 compared to the year ended December 31, 2005, and also a discussion of our financial condition as of December 31, 2007. This discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes that are included in this Annual Report on Form 10-K.
In continuation of our long-term strategic initiative to build our franchise, we acquired Max Specialty in April 2007 and expanded into the excess and surplus lines business in the United States. This segment operates across three divisions, brokerage, contract binding and marine, offering property, ocean cargo, inland marine, casualty, general liability and umbrella insurance products. We believe our platform will allow us to continue to utilize our capital efficiently by expanding our specialty insurance products as we target these niche markets.
To manage our reinsurance and insurance liability exposure, make our investment decisions and assess our 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 comprise a high grade fixed maturities portfolio and an alternative investment portfolio that as of December 31, 2007 employed nine strategies invested in 35 underlying trading entities and one strategic reinsurance private equity investment. 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 values at December 31, 2007, the allocation of invested assets was 79.3% in cash and fixed maturities and 20.7% in alternative investments.
Our principal operating subsidiary is Max Bermuda. At December 31, 2007, Max Bermuda had $1,659.1 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 conduct our U.S. operations through Max USA and its operating subsidiary, Max Specialty. We hold all of our alternative investments in Max Diversified, other than our reinsurance private equity investment in Grand Central Re, which is held by Max Bermuda. During the fourth quarter of 2007, we began implementation of our global service companies initiative whereby we seek to improve the efficiency of certain corporate services across the group. Pursuant to this initiative, we formed MCS Ireland and its two subsidiaries, MCS USA and MCS BDA, to house those internal support services that will be provided across the group.
Our combined property and casualty segments produced an aggregate combined ratio for the year ended December 31, 2007 of 88.2%, with combined net income of $179.3 million. We establish reserves for losses and loss expenses using a combination of loss reserving techniques, actuarial methods and management judgment. Reserves for losses and loss expenses are reviewed regularly to reflect new information that we receive. We conduct regular quarterly internal reviews of loss reserves and, in addition, the adequacy of our loss reserves is reviewed annually, during the fourth quarter of the year, by independent actuaries whose recommendations are a significant component of management’s estimation process. As a result of our internal reserve reviews, for the year ended December 31, 2007, we recorded $48.5 million of favorable development on prior period net loss reserves in our property and casualty segments. We also benefited from a $15.2 million release of net loss reserves resulting from an agreement to settle a large block of prior period loss reserves in our property and casualty reinsurance segment for less than originally estimated.
We manage our exposure to underwriting volatility by carefully selecting line sizes of business assumed, diversifying our underlying exposures and purchasing reinsurance and retrocessional protection. We believe our retrocessional protection is a key component of our diversified strategy and will result in lower volatility in years with losses significantly higher or lower than expected.
We believe our fixed maturities investment portfolio has limited exposure to the sub-prime loan market and we have not recognized any losses in income related to sub-prime credit or liquidity issues. At December 31, 2007, our fixed maturities securities with exposure to sub-prime borrowers total $54.2 million in fair value, or 1.5% of total fixed maturities, and $58.0 million in amortized cost, for a net unrealized loss of $3.8 million. By fair value, 90.0% of these securities are AAA-rated with the remainder AA-rated. All have significant levels of subordination coverage available to absorb future credit losses. We have determined that a write-down for impairment of these securities is not necessary based on a consideration of relevant factors including prepayment rates, subordination levels, default rates, credit ratings, weighted average life, credit default insurance and cash flow testing. Together with our investment managers, we continue to monitor our potential exposure to sub-prime borrowers and we will make adjustments to the investment portfolio as necessary.
Our underwriting and investment performance resulted in an annualized return on average shareholders’ equity of 20.7% for the year ended December 31, 2007. Book value per common share increased 19.4%, from $23.06 at December 31, 2006 to $27.54 at December 31, 2007. Our shareholders’ equity as of December 31, 2007 has increased by $193.8 million,
or 13.9%, since December 31, 2006. This growth is net of the effect of our share repurchase program, under which we have spent $114.4 million to repurchase 4,289,251 shares in the year ended December 31, 2007. At December 31, 2007, the remaining authorization under our share repurchase program was $75.3 million and we believe our share price remains attractive for repurchasing at recent valuations. Subsequent to December 31, 2007, we commenced with an accelerated share repurchase program under which we committed to repurchase $50.0 million of shares, and the Board of Directors approved an increase in the repurchase program. Following the increase on February 12, 2008, the amount available under the Board-approved share repurchase program was $100.0 million. In addition, on February 8, 2008 we repurchased 1,031,178 shares issued upon the exercise of warrants by an original shareholder. The repurchase amount for these shares was $29.7 million. We believe our active capital management provides us with the flexibility to pursue growth opportunities and assist us in maximizing returns to our shareholders.
Our net investment income is a function of the average invested assets and the average yield that we earn on those invested assets. The investment yield on our fixed maturities investments is a function of market interest rates as well as the credit quality and maturity of our fixed maturities portfolio. We recognize realized capital gains or losses on our fixed maturities investments at the time of sale. The realized capital gains or losses reflect the results of changing market conditions, including changes in market interest rates and changes in the market’s perception of the credit quality of our fixed maturities holdings. Our net gains on alternative investments are a function of the success of the funds in which we are invested, which depends on, among other things, the underlying strategies of the funds, the ability of the fund managers to execute the fund strategies, general economic and investment market conditions.
General and administrative expenses are principally employee salaries, bonuses and related personnel costs, office rent, amortization of leasehold improvements and other operating costs. These costs do not vary with the amount of premiums written.
Certain contracts that we write are retrospectively rated and we are entitled to additional premium should losses exceed pre-determined, contractual thresholds. These additional premiums are based upon contractual terms and the only element of management judgment involved is with respect to the estimate of the amount of losses that we expect to be ceded to us. Additional premiums are recognized at the time loss thresholds specified in the contract are exceeded and are earned over the policy period. Changes in estimates of losses recorded on contracts with additional premium features will result in changes in additional premiums based on contractual terms.
For each of the years ended December 31, 2007, 2006 and 2005, additional premiums relate to contracts where the coverage period had expired. Therefore, these additional premiums, representing revisions to our initial estimate of ultimate premiums as a result of changes in the estimate of loss reserves, were fully earned since the exposure period has ended.
Our life and annuity reinsurance premiums are recorded at the inception of the contract based on actual premiums received and are fully earned at that time. We may periodically receive additional premiums which are recorded and earned when received. Additional premium receipts are generally small.
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 material premiums receivable are significantly beyond their due dates or in dispute.
Bornheutter-Ferguson Reported Loss Method. The Bornheutter-Ferguson reported loss method is similar to the Bornheutter-Ferguson paid loss method with the exception that it uses reported losses and reported loss development factors.
Although these actuarial methods for establishing reserves have been developed over time, assumptions about anticipated size of loss and loss emergence patterns are subject to fluctuation. Newly reported loss information from our clients or insureds is the principal contributor to changes in our loss reserve estimates. The selection of appropriate actuarial methods to establish reserves may change over time as the underlying loss information becomes more seasoned. Additional discussion of the reserving practices by business segment is included below.
Losses and benefits, net of related reinsurance recoverables, are charged to income as incurred. Unpaid losses (including loss adjustment expenses) represent the accumulation of:
The table below breaks our reserves as of December 31, 2007 into these components by segment.
Mitigating the uncertainty inherent in the reserves of our property and casualty reinsurance portfolio is the fact that a large portion of our recorded reinsurance reserves are attributable to contracts that are booked at contractual aggregate limits. As of December 31, 2007 and December 31, 2006 approximately 33% and 42%, respectively, of the total property and casualty reinsurance reserves are on contracts that are recorded at contractual aggregate limits.
and casualty insurance losses and loss expenses, together with management judgment. As noted above, these methods include paid loss development, incurred loss development, paid and incurred Bornhuetter-Ferguson methods and frequency-severity methods. This actuarial data is analyzed by product, type of risk, coverage and accident or policy year. Industry loss experience is also used to supplement our own data in selecting long term trend and development factors and in areas where our own data or the insureds’ data is limited. The table below breaks our insurance reserves as of December 31, 2007 and 2006 into casualty (long claim-tail) and property (short claim-tail) components.
On a gross basis, the majority of the U.S. excess and surplus lines insurance business we have written is property business. On a net of reinsurance basis, the earned premium is approximately equally split between property and casualty. Our U.S. excess and surplus lines insurance property loss reserves, which include case reserves, amounts for IBNR reserves and loss adjustment expenses, both allocated and unallocated, are compiled on a portfolio basis and are computed on an undiscounted basis.
The following table presents the development of balance sheet property and casualty loss reserves calculated in accordance with GAAP, as of December 31, 2000 through December 31, 2007. This table does not present accident or policy year development data. The top line of the table shows the gross reserves at the balance sheet date for each of the indicated years and is reconciled to the net reserve by adjusting for reinsurance recoverables. This represents the estimated amount of net claims and claim expenses arising in the current year and all prior years that are unpaid at the balance sheet date, including IBNR reserves. The table also shows the re-estimated amount of the previously recorded reserves as adjusted for new information received as of the end of each succeeding year. The estimate changes as more information becomes known about the frequency and severity of claims for individual years. The “net cumulative redundancy (deficiency)” represents the aggregate change to date from the original estimate on the third line of the table “reserve for property and casualty losses, originally stated, net of reinsurance.” The “gross cumulative redundancy (deficiency)” represents the aggregate change to date from the original gross estimate on the top line of the table. The table also shows the cumulative net paid amounts as of successive years with respect to the net reserve liability.
(2) The difference between the loss development included above and that reflected in the reconciliation of losses and loss adjustment expenses in Note 6 to the consolidated financial statements of $593 relates to amortization of deferred charges on retroactive reinsurance.
(3) The difference between the reinsurance recoverable included above and that reflected in the reconciliation of losses and loss adjustment expenses in Note 6 to the consolidated financial statements of $1,165 relates to the remaining net deferred loss on retroactive reinsurance.
Adverse development of $20.0 million on a marine reinsurance quota share contract that had losses in relation to the 2005 hurricanes.
Our balance sheet reserves for 2001 and each subsequent balance sheet date through 2004 in the above tables continue to show the effects of the development on two specific contracts recorded in 2005. The first contract increased 2001 reserves by $50.2 million, with the recording of such increased losses triggering additional premiums and interest on additional premiums of $49.3 million, which are not reflected in the table above. The second contract increased 2002 reserves by $49.6 million, 2003 reserves by $64.8 million and 2004 reserves by $15.3 million, for a total increase of $129.7 million. The adverse development triggered additional premiums and interest on such additional premiums of $105.3 million, which are not reflected in the table above.
For additional information on our reserves, including a reconciliation of losses and loss adjustment expense reserves for the years ended December 31, 2007, 2006 and 2005, please refer to Note 6 of our audited consolidated financial statements included herein.
Our life and annuity reinsurance benefit reserves are compiled by our life and annuity actuaries on a contract-by-contract basis and are computed on a discounted basis using standard actuarial techniques and cash flow models. We establish and review our life and annuity reinsurance benefit reserves regularly based upon cash flow projection models utilizing data provided by clients and actuarial models. We establish and maintain our life and annuity reinsurance reserves at a level that we estimate will, when taken together with future premium payments and interest income expected to be earned on associated premiums, be sufficient to support all future cash flow benefit and third party servicing obligations as they become payable.
There have been no material reserve adjustments to our life and annuity reinsurance benefit reserves during the years ended December 31, 2007, 2006 and 2005.
In order to reduce the likelihood of needing to sell investments before maturity, especially given the unpredictable and potentially significant cash flow requirements of our property catastrophe business, we maintain significant cash and cash equivalent balances and can access our credit facility, which is described in Note 17 of our audited consolidated financial statements. We believe we have the ability to hold those securities in an unrealized loss position until such time as they reach maturity or the fair value increases. The only time we would expect to realize an other than temporary impairment on a fixed maturity security is if there were concern about receiving the interest payments and the maturity value of the investment. We perform regular reviews of our fixed maturities portfolio and utilize a model that considers numerous indicators in order to identify investments that are showing signs of potential other than temporary impairments. The indicators include the issuer’s financial condition and ability to make future scheduled interest and principal payments, the nature of collateral or other credit support and significant economic events that have occurred that affect the industry in which the issuer participates.
We utilize dynamic financial analysis to determine our overall asset and liability risk and the potential for adverse scenarios producing projected losses and potential adverse cash flow. This analysis is accomplished through a stochastic simulation of future periods with each asset and liability cash flow individually modeled. This 5000 path stochastic simulation utilizes the expected volatility of each of our individual asset and liability cash flows. We construct our asset portfolio based on the expected cash flows from our liability portfolio. Fixed maturities securities are purchased to meet cash flows along the entire maturity spectrum of the liabilities. In our dynamic financial analysis modeling we assume that alternative investments will liquidate in years five through ten, so fixed maturities securities are purchased to meet liability cash flows in years one through five and for liability cash flows beyond ten years. Our liability cash flows are highly variable. Because of this risk, we maintain a significant cash balance, which has consistently exceeded $250.0 million, and presently we have aggregate letter of credit facilities of up to $720.0 million, with an additional $200.0 million available subject to certain conditions. We have also generated over $300.0 million of positive operating cash flow in each of the five years ended December 31, 2007.
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: (i) quoted market prices for identical or similar instruments in active markets, or quoted market prices; or (ii) model-derived valuations from independent pricing sources in which all significant inputs and significant value drivers are observable in active markets, or model-derived valuations. The ability to obtain quoted market prices is reduced in periods of decreasing liquidity, and this increases the use of model-derived valuations and the uncertainty surrounding the fair value estimates. We obtain fair value estimates from multiple independent pricing sources in an effort to mitigate some of the uncertainty surrounding the fair value estimates.
We have constructed our alternative investment portfolio to have significantly less risk, as measured by standard deviation of return, than a common stock portfolio, which is the equity investment choice of many insurance organizations. For the five years ended December 31, 2007, our Max Diversified alternative investment portfolio has produced an annual standard deviation of return of 4.35% compared to the annual standard deviation of return of 8.61% for the S&P 500 Index. The annualized five year return on our Max Diversified alternative investment portfolio of 10.98% compares to the S&P 500 Index return of 12.12% for the same period, and with lower volatility as measured by standard deviation. There is significant risk in all investment activities, and the results of our alternative investment portfolio will vary over time with the investment markets. Our Max Diversified alternative investments have produced consistently positive results for every annual period since inception and have shown approximately one-half the volatility of the S&P 500 Index.
Despite the lower volatility of the alternative investment portfolio there is potential for losses, as there is for any investment portfolio. We approach our investment strategies based on long term performance and believe the annualized five year return of our Max Diversified portfolio of 10.98% demonstrates a superior return profile compared to other alternative investment vehicles.
Investments in reinsurance private equities, where we have a meaningful ownership position and the ability to exercise 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. At December 31, 2007, our total investment in reinsurance private equity was an interest in Grand Central Re of $3.9 million.
Property and casualty reinsurance - This segment generally offers quota share and excess of loss capacity providing coverage for a portfolio of underlying risks written by our clients.
Property and casualty insurance - This segment generally offers excess of loss capacity on specific risks related to individual insureds.
U.S. excess and surplus lines insurance - This segment comprises the underwriting operations of all of the company’s U.S.-based business. Max Specialty offers property and casualty coverage as an eligible non-admitted insurer on an excess and surplus basis in the United States.
Life and annuity reinsurance - This segment generally offers 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.
Gross premiums written for the property and casualty reinsurance segment for the year ended December 31, 2006 were $423.6 million compared to $615.7 million for the year ended December 31, 2005, a decrease of 31.2%. Additional premiums of $182.0 million arising from the notification of additional losses on two excess of loss contracts written in prior years are included in the gross premiums written for the year ended December 31, 2005 compared with additional premiums of $16.7 million in the year ended December 31, 2006. This decrease in additional premiums is the primary reason for the 31.2% decrease in gross premiums written. 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, 2006 reflected our emphasis on writing a greater number of smaller transactions.
Net premiums earned for property and casualty reinsurance decreased by 30.4% to $422.8 million for the year ended December 31, 2006 from $607.1 million in 2005. The decrease was primarily the result of the decrease in additional premiums described above.
During the year ended December 31, 2007, we received information on a number of contracts that indicated lower than expected losses. As a result, we recognized $5.0 million in favorable development of prior year reserves. These contracts contained provisions for the adjustment of ceding commissions within a range based on losses incurred on the contract. As a result, the favorable development was largely offset by additional acquisition costs.
The increase in our property and property catastrophe business as a percentage of total net earned premium in a year with lower than expected large loss events has led to a decline in our average loss ratio for the segment, which has been partially offset by the purchase of additional excess of loss reinsurance in 2007.
Losses relating to property and casualty reinsurance were $296.0 million for the year ended December 31, 2006 compared to $552.8 million for the year ended December 31, 2005, a decrease of 46.5%. The losses for the year ended December 31, 2006 reflect expected loss activity on our casualty business combined with below average catastrophe losses on our recently expanded property reinsurance business. The losses for the year ended December 31, 2005 include $73.4 million of losses attributable to the hurricanes in the United States and $179.9 million of net losses pertaining to additional losses notified on two excess of loss contracts written in a prior year. The loss ratio for our property and casualty reinsurance segment for the year ended December 31, 2006 was 70.0% compared to 91.1% for the year ended December 31, 2005. Excluding hurricane losses and losses that triggered additional premiums in 2005, the adjusted loss ratio for our property and casualty reinsurance segment is 66.3%. The adjusted 2005 loss ratio is lower in part due to a large commutation that was made during the 2005 year.
Acquisition costs. Acquisition costs were $60.9 million for the year ended December 31, 2007 compared to $77.3 million for the year ended December 31, 2006, a decrease of 21.2%. The percentage decrease in acquisition costs is lower than the percentage decrease in net premiums earned due to the adjustment of the ceding commission on a number of contracts as described in the losses section above. Acquisition costs vary from contract to contract depending on characteristics such as the type of business, the clients’ cost to administer the underlying contracts and the involvement of a broker. These factors may result in differences in the ratio of acquisition costs to net premiums earned from period to period.
Interest expense was $(3.8) million for the year ended December 31, 2006 compared to $11.5 million for the year ended December 31, 2005. Interest expense includes the $12.0 million reduction described in the paragraph above and $7.0 million of interest expense pertaining to the funds withheld on the variable quota share retrocession agreement with Grand Central Re for the year ended December 31, 2006 compared to $6.0 million for the year ended December 31, 2005. The interest expense on the Grand Central Re funds withheld is based on the average of two total return fixed maturity indices, which had a higher total return for the year ended December 31, 2006 compared to the year ended December 31, 2005.
General and administrative expenses. General and administrative expenses were $28.4 million for the year ended December 31, 2007 compared to $23.5 million for the year ended December 31, 2006, an increase of 20.9%. The increase partially reflects an increasingly mature book of business and the additional claims and underwriting staff hired since December 31, 2006, in order to service a larger client base. The increase also reflects higher incentive based compensation stemming from the net income generated by this segment for the year ended December 31, 2007.
General and administrative expenses were $23.5 million for the year ended December 31, 2006 compared to $15.0 million for the year ended December 31, 2005, an increase of 56.7%. The increase resulted principally from personnel costs associated with an increased headcount within our reinsurance staff. In addition there was an increase in incentive-based compensation as a result of net income that exceeded plan for the year ended December 31, 2006.
Net income. Net income attributable to property and casualty reinsurance for the year ended December 31, 2007 was $132.5 million compared to $88.6 million for the year ended December 31, 2006. Major components of the increase were $15.2 million release of net loss reserves related to an the agreement to settle a large block of prior period reserves and the net favorable development of $16.0 million on various lines of business. Additionally, the 16.97% return on alternative investments for the year ended December 31, 2007 compared to a 6.96% return in the year ended December 31, 2006, accounted for $32.8 million of the increase. Partially offsetting these increases was the increase in interest expense of $15.7 million compared to the prior year.
We continue to monitor pricing and market trends closely and changes to our premium mix reflect the risk types where we believe our price requirements, terms and conditions are being met. As a result, our gross insurance premium volume and mix may vary from period to period. In addition, changes in client appetite for risk retentions will vary with market conditions and may also cause fluctuations in our premium volume and mix. For the foreseeable future, we expect to see softening rates for our excess liability, professional liability and property lines of business and increased competition in all lines of business that we write.
Gross premiums written for the property and casualty insurance segment for the year ended December 31, 2006 were $396.6 million compared to $355.3 million for the year ended December 31, 2005, an increase of 11.6%. The increase was the result of the expansion of our property insurance business from 9.6% of insurance premium volume in 2005 to 15.4% in 2006. In addition, 5.6% of the insurance premium volume relates to our aviation insurance business, which we began writing in October 2006.
Reinsurance premiums ceded. Reinsurance premiums ceded for insurance for the year ended December 31, 2007 were $202.0 million compared to $194.5 million for the year ended December 31, 2006, an increase of 3.9%. Reinsurance premiums ceded were principally related to our quota share treaties that are utilized to manage our retained exposure and, therefore, will tend to increase when gross premiums written increase. However, the increase in premiums ceded, despite the decrease in gross premiums written, is principally related to increasing the percentage ceded to our property quota share treaty and to reinstatement premiums recognized in relation to our aviation excess of loss reinsurance contracts that were triggered by aviation losses, including a Brazilian airline crash, in 2007. As a result, the ratio of reinsurance premiums ceded to gross premiums written for the year ended December 31, 2007 was 52.8% compared to 49.0% for the year ended December 31, 2006.
Net premiums earned. Net premiums earned on insurance increased by 0.9% to $199.6 million for the year ended December 31, 2007 compared to the year ended December 31, 2006 and by 14.5% to $197.9 million for the year ended December 31, 2006 compared to the year ended December 31, 2005. The increases are attributable to our expansion of the insurance segment over the past three years and reflects the earning pattern of a mature portfolio of insurance contracts.
Losses relating to insurance were $124.2 million for the year ended December 31, 2006 compared to $175.5 million for the year ended December 31, 2005, a decrease of 29.2%. The decrease is principally due to a reduction of the expected ultimate losses on our 2003 excess liability insurance business and larger weighting of property business with lower average loss ratios. Our loss reserve analysis on this business, which has seasoned due to the passage of time, continued to show lower reported losses than originally estimated, which caused us to recognize positive development of $20.5 million during the year ended December 31, 2006. In addition, a low level of attritional property insurance losses during the year ended December 31, 2006 compared to $50.0 million of catastrophe losses due to hurricane activity during the year ended December 31, 2005 has affected the comparability between the two periods. The loss ratio for our insurance segment for the year ended December 31, 2006 was 62.8% compared to 101.5% for the same period in 2005. Excluding hurricane losses, the adjusted loss ratio for our property and casualty insurance segment was 72.6% in 2005.
General and administrative expenses were $15.6 million for the year ended December 31, 2006 compared to $9.9 million for the year ended December 31, 2005, an increase of 57.6%. The increase resulted principally from expenses associated with an increased headcount within our insurance staff. In addition there has been an increase in incentive-based compensation as a result of the improved net income for the year ended December 31, 2006.
The loss ratio is calculated by dividing losses (shown as (b)) by net premium earned (shown as (a)). The combined ratio is calculated by dividing total losses and expenses (shown as (c)) by net premiums earned (shown as (a)). Due to the start-up nature of the U.S. excess and surplus lines insurance segment, the calculated combined ratio does not provide a meaningful result and is therefore shown as N/A.
Gross premiums written and net premiums earned. Gross premiums written by the U.S. excess and surplus lines segment for the year ended December 31, 2007 were $28.2 million produced by the brokerage division and $20.0 million produced by the contract binding division. Gross premiums written for the year ended December 31, 2007 were below our original expectations, which we partially attribute to the longer than anticipated time required acquiring access to all U.S. states, and, in particular, California. Our maintenance of underwriting discipline in the face of a softening market environment also contributed to the lower than expected premium volume. We expect the volume of underwriting submissions received and gross premiums written to increase in 2008 as we further establish our presence in the specialty niche markets where we offer our products. Our ability to write business for a full year in 2008 is a significant difference from our position in 2007 and is expected to contribute to increased premium volume in 2008 compared to 2007. Reinsurance premiums ceded reflect the purchase of quota share and excess of loss reinsurance coverage to manage our retained exposure for both the brokerage and contract binding divisions.
Net investment income. Net investment income, which excludes realized and unrealized gains and losses, comprises principally interest on cash and fixed maturities investments held by Max Specialty. The average annualized investment yield on cash and fixed maturities held by Max Specialty for the year ended December 31, 2007 was 5.08%.
Net loss. Net loss attributable to the U.S. excess and surplus lines insurance segment for the year ended December 31, 2007 was $11.1 million. The net loss is principally attributable to the start-up nature of this segment. Gross premium written volume has not yet grown to a level commensurate with the infrastructure put in place in 2007. We expect growth in general and administrative expenses to slow in 2008 and gross premium written to increase as we move into our first full year of operations.
Benefits. Benefits relating to the life and annuity reinsurance segment were $345.6 million for the year ended December 31, 2007 compared to $77.8 million for the year ended December 31, 2006. Benefits relating to new contracts were $299.3 million and $41.9 million for the years ended December 31, 2007 and 2006, respectively. Except for new contracts written during the year, benefits in each period represent expected changes in existing policy and claim liabilities, plus the effect of unexpected changes in our existing policy and claim liabilities. There were no material unexpected changes in our policy and claim liabilities in the years ended December 31, 2007, 2006 and 2005.
Net investment income from our cash and fixed maturities portfolio, excluding realized and unrealized gains and losses, for the year ended December 31, 2006 increased $43.2 million to $150.0 million compared to $106.8 million for the year ended December 31, 2005, an increase of 40.4%. The increase was principally attributable to the growth in the cash and fixed maturities portfolio from $2,996.9 million at December 31, 2005 to $3,470.0 million at December 31, 2006, resulting from cash flow from operations since December 31, 2005 and the additional capital we raised in the fourth quarter of 2005 in connection with a public offering of our common shares. The average annualized investment yield on the cash, fixed maturities investments and funds withheld by clients for the year ended December 31, 2006 was 4.73% compared to 4.29% for the year ended December 31, 2005 reflecting an increase in average interest rates in 2006 compared to 2005.
Net gains on the alternative investment portfolio were $84.8 million, or 6.96%, including a gain of $10.0 million from our private equity reinsurance investments, for the year ended December 31, 2006 compared to $39.9 million, or 3.34%, including a loss of $26.2 million from our private equity reinsurance investments, for the year ended December 31, 2005. For 2006, the return from our Max Diversified fund of funds portfolio was 6.30%. The return for the year ended December 31, 2006 is net of $35.0 million stemming from energy trading losses in certain hedge fund investments included in our Diversified Arbitrage strategy. This return is compared to the returns available in the capital markets as represented by the Merrill Lynch Master Bond Index returning 4.32% and the Standard & Poor’s 500 Index returning 11.85%. For 2005, the return from our Max Diversified fund portfolio was 5.88%. This return is compared to the returns available in the capital markets as represented by the Merrill Lynch Master Bond Index returning 2.55% and the Standard & Poor’s 500 Index returning 3.0%.
On December 28, 2006, as part of our plan to reduce our allocation to alternative investments, Max Bermuda consummated the sale of one of its private equity investments, an approximately 5% interest in DaVinci Re Holdings Ltd. and its operating subsidiary DaVinci Reinsurance Ltd., a Bermuda property catastrophe reinsurer, for a sale price equal to book value.
Net realized losses on sale of fixed maturities. Our fixed maturities investment strategy is not intended to generate significant realized gains and losses as more fully discussed below. The net realized losses for the years ended December 31, 2007, December 31, 2006 and December 31, 2005 of $4.0 million, $5.8 million and $0.7 million, respectively, are principally the result of the sale of fixed maturities in connection with normal portfolio rebalancing transactions. Net realized losses for the year ended December 31, 2007 includes $1.7 million of gross realized losses resulting from the sale of fixed maturities triggered by an agreement to settle a block of prior period reserves.
We perform regular reviews of our fixed maturities portfolio in order to identify investments that are showing signs of potential other than temporary impairments. The indicators include the issuer’s financial condition and ability to make future scheduled interest and principal payments, the nature of collateral or other credit support and significant economic events that have occurred that affect the industry in which the issuer participates. At December 31, 2007, our fixed maturities portfolio contains securities with a total fair value of $144.7 million that are insured against credit default. For the year ended December 31, 2007, net realized losses include $1.1 million for the recognition of an other than temporary impairment on one security for which we believe there is significant doubt regarding collecting the final maturity value. There were no other than temporary impairment losses in the years ended December 31, 2006 and 2005.
Liabilities for life and annuity benefits. Life and annuity benefits totaled $1,203.5 million at December 31, 2007 compared to $895.6 million at December 31, 2006. The increase was principally attributable to new life and annuity reinsurance contracts written during the year ended December 31, 2007, which added $299.3 million to reserves, together with changes in policy and claims liabilities, and foreign exchange movements on liabilities. This was partially offset by benefit payments of $96.6 million during the year.
Losses and benefits recoverable from reinsurers. Losses and benefits recoverable from reinsurers totaled $578.3 million at December 31, 2007 compared to $538.0 million at December 31, 2006, an increase of 7.5%, principally reflecting losses ceded under our reinsurance and retrocessional agreements resulting from net earned premiums during the year ended December 31, 2007. Grand Central Re, our largest retrocessionaire, accounted for 20.4% of our losses and benefits recoverable at December 31, 2007. A.M. Best has assigned a financial strength rating of “NR-4” to Grand Central Re. We retain funds from Grand Central Re amounting to approximately 107.5% of its loss recoverable obligations.
Senior notes. On April 16, 2007, Max USA privately issued $100.0 million principal amount of 7.20% senior notes, due April 14, 2017, with interest payable on April 16 and October 16 of each year, beginning on October 16, 2007. The senior notes are Max USA’s senior unsecured obligations and rank equally in right of payment with all existing and future senior unsecured indebtedness of Max USA. The senior notes are fully and unconditionally guaranteed by Max Capital. The effective interest rate related to the senior notes, based on the net proceeds received, was approximately 7.27%. The net proceeds from the sale of the senior notes were $99.5 million and they were used to repay the $100.0 million short-term borrowing of Max USA under the revolving credit facility.
As a holding company, Max Capital’s principal assets are its investments in the common shares of its principal subsidiary, Max Bermuda, and its other subsidiaries. Max Capital’s principal source of funds is from interest income on cash balances and cash dividends from its subsidiaries, including Max Bermuda. The payment of dividends is limited under Bermuda insurance laws. In particular, Max Bermuda may not declare or pay any dividends if it is in breach of its minimum solvency or liquidity levels under Bermuda law or if the declaration or payment of the dividends would cause it to fail to meet the minimum solvency or liquidity levels under Bermuda law. At December 31, 2007, Max Bermuda, which is required to have approximately $270.0 million in statutory capital and surplus in order to pay dividends, had approximately $1,600.0 million in statutory capital and surplus.
The financial strength ratings of our reinsurance and insurance subsidiaries are currently “A-” by A.M. Best, “A” by Fitch, and “A3” by Moody’s. These ratings reflect each rating agency’s opinion of our financial strength, operating performance and ability to meet obligations. If an independent rating agency downgrades or withdraws any of our ratings, we could be severely limited or prevented from writing any new insurance or reinsurance contracts, which would significantly and negatively affect our business. Insurer financial strength ratings are based upon factors relevant to policyholders and are not directed toward the protection of investors.
The amounts in this table represent our gross estimates of known liabilities as of December 31, 2007 and do not include any allowance for claims for future events within the time period specified. Accordingly, it is highly likely that the total amounts paid out in the time periods shown will be greater than that indicated in the table.
Furthermore, life and annuity benefits recorded in the financial statements at December 31, 2007 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.
Financial Accounting Standard No. 159-The Fair Value Option for Financial Assets and Financial Liabilities