Crum & Forster’s principal offices are located in space leased by the Company in Morristown, New Jersey. The lease covers approximately 201,887 square feet of office space at 305 Madison Avenue. The term of the lease ends December 31, 2022, and provides for up to four consecutive additional terms totaling twenty-five years.
The following discussion and analysis should be read in conjunction with Crum & Forster’s consolidated financial statements and accompanying notes included in “Item 8. Financial Statements and Supplementary Data”. Certain information constitutes forward-looking statements that involve risks and uncertainties. For further discussion of forward-looking statements, see “Statements Regarding Forward - Looking Information”. Actual results may differ materially from the results discussed in these forward-looking statements as a result of certain factors including, but not limited to, those set forth under “Item 1A. Risk Factors”.
The most significant accounting estimates relate to the Company’s reserves for unpaid losses and LAE. Unpaid losses and LAE include reserves for both reported (case reserves) and unreported losses and LAE.
Property. An individual investigation of each loss reported is undertaken by claims personnel, including conducting on site physical inspections of the covered property in determining the scope of damage. Case reserves are established consistent with the coverages provided under the specific policy applicable to the loss. Depending upon the severity of the loss and coverage part or parts implicated in the specific claim reported, claims personnel may retain the services of experts such as certified building consultants, salvors, forensic accountants, or construction engineers to assist in projecting the ultimate loss to be reserved and paid on an individual claim basis. In the event of a catastrophe loss, assumptions are made based upon the number of risks in the affected area and the severity of the catastrophic events.
Commercial Automobile - cost to repair damaged property, medical and court award inflation and expected loss ratios for more recent accident years.
The Company recorded $(85.9) million, $(60.5) million and $97.6 million of prior period (favorable) adverse loss development before corporate aggregate reinsurance for 2006, 2005 and 2004 respectively. After corporate aggregate reinsurance, the prior period (favorable) adverse loss development was $(96.2) million, $(68.6) million and $69.3 million for 2006, 2005 and 2004, respectively. In 2006, the net favorable development before corporate aggregate reinsurance was comprised principally of favorable development across all major casualty lines, with the largest redundancy being recognized in workers’ compensation, principally attributable to the favorable results in California in accident years 2005 and 2004, consistent with industry-wide experience. Additionally, favorable development was also experienced in umbrella and other general liability exposures, due in part to favorable settlements of claims in accident years 2000 and prior and in commercial automobile liability for accident years 2005 and prior. The favorable development was partially offset by adverse development of $33.9 million of asbestos, environmental and other latent liabilities.
Tort reform in certain jurisdictions initially resulted in increased filings by plaintiffs seeking to avoid the potential effective date of the reform legislation in 2003. Since 2004, insurers, including Crum & Forster, generally experienced either flat or slightly decreased frequency in numbers of newly reported asbestos-related claims due to, among other things, tort reform in certain jurisdictions previously known for large volume filings. It is generally expected throughout the industry that this trend will continue.
In 1994, Congress enacted a new section of the bankruptcy code aimed at facilitating the reorganization of businesses with large asbestos liabilities. Under this law, an asbestos defendant can receive a discharge from present and future asbestos claims by following the provisions of the bankruptcy code. Insurers of the defendant have typically been excluded from the pre-petition negotiations between the asbestos defendant and the asbestos plaintiffs’ lawyers, although the typical plan presumes the insurers will pay for claims under negotiation. These “pre-packaged bankruptcies” can inflate claim costs and accelerate the timing of claims payments, and it is likely that additional defendants will seek protection under this provision in the future. Bankruptcy filings by various defendants in the asbestos arena continue to result in larger claim values to be paid by the remaining solvent defendants, including certain Crum & Forster policyholders. To date, this continued flow of claims has forced at least 75 manufacturers and users of asbestos products into bankruptcy. These bankruptcies have, in turn, aggravated both the volume and the value of claims against viable asbestos defendants. Accordingly, there is a high degree of uncertainty with respect to future exposure from asbestos claims, both in identifying which additional policyholders may become targets in the future and in predicting the total number of asbestos claimants.
As noted above, there have been numerous bankruptcies of asbestos defendants stemming from an increase in asbestos claimants. These bankruptcies represent companies that were heavily exposed to asbestos liabilities. The Company’s future exposure to the asbestos liabilities resulting from the bankruptcies of those entities, however, is limited.
The Company’s exposure and potential future exposure to those entities is summarized as follows:
In the course of the policyholder-by-policyholder evaluation, the following factors are considered: available insurance coverage, including the role of any umbrella or excess insurance issued to the policyholder; limits, deductibles and self-insured retentions; an analysis of each policyholder’s potential liability; the jurisdictions involved; past and anticipated future asbestos claim filings against the policyholder; loss development on pending claims; past settlement values of similar claims; allocated claim adjustment expenses; the potential role of other insurance; and applicable coverage defenses. The evaluations are based on current trends without any assumption of potentially favorable or unfavorable legislation in the future.
The reported and adjusted asbestos survival ratios based on asbestos loss and ALAE reserves, net of per risk reinsurance but before the benefit of corporate aggregate reinsurance, are presented below:
Net of per risk reinsurance, but before the benefit of corporate aggregate reinsurance.
As a result of the processes, procedures and analyses described above, management believes that the reserves carried for asbestos claims at December 31, 2006 are appropriate based upon known facts, current law and management’s judgment. However, there are a number of uncertainties surrounding the ultimate value of these claims, which may result in changes in these estimates as new information emerges. Among these are the following: the unpredictability inherent in litigation; any impact from the bankruptcy protection sought by asbestos producers and defendants; an unanticipated increase in the number of asbestos claimants; the resolution of disputes pertaining to the amount of coverage for “non-product” claims asserted under premises/operations general liability policies; and future developments regarding the ability to recover reinsurance on asbestos claims. It is also not possible to predict, nor has management assumed, any changes in the legal, social or economic environments and their impact on future asbestos claim development. The carried asbestos reserves also do not reflect any effects of future legislation.
There is great uncertainty involved in estimating liabilities related to these exposures. First, the number of waste sites subject to cleanup is unknown. Currently, approximately 1,240 cleanup sites are included in the EPA’s National Priorities List. State authorities have identified many additional sites. Second, the liabilities of the policyholders themselves are difficult to estimate. At any given site, the allocation of remediation cost among the PRPs varies greatly depending upon a variety of factors. Third, different courts have been presented with liability and coverage issues regarding pollution claims and have reached inconsistent decisions on several issues. These uncertainties are unlikely to be resolved in the near future.
An analysis of gross and net reserves from environmental exposures is presented in Note 5 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
At December 31, 2006, the Company had unrealized losses of $140.8 million in investments in available-for-sale fixed income and equity securities (including $5.3 million of unrealized losses in respect of fixed income securities held for short-sale obligations) of which $129.7 million was associated with fixed income securities and $11.1 million related to equity securities. Substantially all of the gross unrealized losses of $129.7 million are attributable to U.S. Treasury securities. These securities are backed by the full faith and credit of the United States government and the Company has the ability and intent to hold such securities for a period of time sufficient to allow a market recovery, or to maturity if necessary. The equity securities unrealized loss related to four securities, all of which were in an unrealized loss position for less than 12 consecutive months and the Company has the ability and intent to hold such securities for a period of time sufficient to allow a market recovery. For the years ended December 31, 2006 and 2005, charges for other than temporary impairments amounted to $15.9 million and $3.9 million, respectively. There were no other than temporary impairments recorded for the year ended December 31, 2004.
Although realization is not assured, management believes the recorded deferred tax assets are fully recoverable based on estimates of the future profitability of Crum & Forster’s taxable subsidiaries and current forecasts for the periods through which losses may be carried back and/or forward. The Company has several material deferred tax assets, including deferred gain on retroactive reinsurance, loss reserve discounting, net operating losses and unearned premium adjustment. The realizability of these reversing deferred tax assets is considered in conjunction with similar originating deferred tax assets and other taxable income. The Company’s current projections of future taxable income are based on assumptions of modest business growth and relatively stable combined ratios, with portfolio yields approximating current levels. Since 2002, the Company’s operating subsidiaries have recorded positive taxable income of $1,386.1 million that included capital gains and other investment income during that period of approximately $1.5 billion. This taxable income was sufficient to absorb the operating companies’ net operating loss carryovers of $228.9 million arising prior to 2002. The current net operating losses of $164.5 million relate primarily to the Company’s debt. Under tax planning strategies allowed pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 109 the Company may elect to file a consolidated tax return for tax sharing purposes. Should such an election be made, the Company projects that these net operating losses can be fully utilized against the operating companies’ income, based on the assumptions discussed above.
The Company’s objective is to expand opportunistically into classes of business or market segments that are consistent with its underwriting expertise and have the potential to generate an underwriting profit. Management believes the Company’s ability to identify and react to changing market conditions provides it with a competitive advantage.
Underwriting profit or loss expressed in dollars is considered a non-GAAP financial measure. The table at the beginning of the Results of Operations section that follows presents the separate contribution of underwriting and investment operations to income before income taxes on a GAAP basis. An understanding of a property and casualty insurance company’s financial condition, results of operations and profit and growth prospects begins with an assessment of the entity’s ability to underwrite effectively. Underwriting is the core business of such companies; investment operations are a separate function. Management monitors the Company’s consolidated results on this basis and likewise reports such results to its board of directors. Rating agencies and securities analysts also focus separately on underwriting and investment results. In annual and quarterly statements to state insurance regulators prepared in accordance with SAP, underwriting profit or loss is presented separately from investment results. Underwriting profit or loss, together with the related combined ratio, are widely followed measures in the property and casualty insurance industry.
In 2005, net income was $155.9 million as compared to $24.2 million in 2004. The increase in net income from 2004 to 2005 was primarily due to better underwriting results and higher investment income. Favorable development of prior years’ losses and LAE in 2005 amounted to $68.6 million compared to adverse development of $69.3 million in 2004, which included adverse development of latent reserves of $100.5 million.
Gross premiums written by line of business are summarized as follows:
For the year ended December 31, 2006, gross premiums written in casualty lines, which include the workers’ compensation, general liability and commercial automobile lines of business, increased by $64.9 million, or 8.9%, as compared to the year ended December 31, 2005. This increase includes $63.4 million of Fairmont’s premiums. Excluding Fairmont, gross premiums written in casualty lines remained level during the year ended December 31, 2006 compared to the prior year, primarily due to modest increases in renewal retention rates and new business partially offset by price decreases on renewal policies.
The casualty market has experienced an acceleration of softening market conditions during 2006. Specifically, the Company has been affected by declining market prices for California workers’ compensation business as a consequence of system reforms and very favorable industry accident year results in recent years. California workers’ compensation gross premiums written totaled $97.4 million, $136.6 million and $156.1 million in 2006, 2005 and 2004, respectively. The declining premiums reflect the combination of a reduction in renewal retention rates, less new business and a decline in pricing.
For the year ended December 31, 2006, gross premiums written in property lines, which include the property and commercial multi-peril lines of business, increased by $111.5 million, or 32.1%, as compared to the year ended December 31, 2005. This increase includes $33.5 million of Fairmont’s premiums. Excluding Fairmont, gross premiums written in property lines increased by $78.0 million, or 22.4%, in the year ended December 31, 2006, primarily due to significant rate increases and an increase in new business, partially offset by a reduction in renewal retention rates. The increase in pricing and new business is attributable to a significant hardening of the property market in the aftermath of the 2005 hurricane activity, due to limited availability of catastrophe reinsurance and higher reinsurance rates.
For the year ended December 31, 2005, gross premiums written in property lines declined by $3.3 million or 1% as compared to the year ended December 31, 2004, primarily due to a reduction in renewal retention rates, price decreases on renewal policies, and a reduction in new business.
For the year ended December 31, 2006, other gross premiums written, which include the accident and health, personal automobile, homeowners and surety lines of business, increased by $77.4 million, or over 400%, as compared to the year ended December 31, 2005. The increase includes $90.1 million of Fairmont’s premiums. Excluding Fairmont, other gross premiums written decreased by $12.7 million, or 66.1%, in the year ended December 31, 2006, principally attributable to a reduction in the surety line of business as a result of a decision by management to restrict writings of contract surety business, in response to a greater than expected emergence of surety claims.
Net premiums written by line of business are summarized as follows:
Percentage represents the percentage of net premiums written to gross premiums written.
Premiums earned reflect the amount of net premiums written applicable to the portion of the policy term that expires in a given period. The Company generally earns premiums on a pro-rata basis over the period in which the coverage is provided. For the year ended December 31, 2006, premiums earned increased by $189.8 million, or 21.2 %, as compared to the year ended December 31, 2005. Excluding Fairmont, premiums earned increased by $81.8 million, or 9.1%, in the year ended December 31, 2006 as compared to the year ended December 31, 2005. The lower increase in premiums earned relative to net premiums written was principally attributable to the lag in recognition of the increase in premiums written throughout 2006. For the year ended December 31, 2005, premiums earned decreased by $13.5 million, or 1.5%, as compared to the year ended December 31, 2004. The lower decrease in premiums earned relative to net premiums written was principally attributable to the lag in recognition of the decrease in premiums written in the latter part of 2005.
The Company’s losses and LAE reflect the effect of corporate aggregate reinsurance, including the amortization of deferred gain on retroactive reinsurance and cessions to prospective reinsurance contracts. For further discussion of the accounting for reinsurance coverage and the amortization of deferred income on retroactive reinsurance, see “Item 1. Business-Reinsurance” and Note 6 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
In 2006, the Company recognized net favorable prior year loss development of $85.9 million (7.9 loss ratio points) prior to corporate aggregate reinsurance activity. The net favorable development was comprised principally of favorable development across all major casualty lines, with the largest redundancy being recognized in workers’ compensation, principally attributable to the favorable results in California in accident years 2005 and 2004, consistent with industry-wide experience. Additionally, favorable development was also experienced in umbrella and other general liability exposures, due in part to favorable settlements of claims in accident years 2000 and prior and in commercial automobile liability for accident years 2005 and prior. The favorable development was offset by adverse development of asbestos, environmental and other latent liabilities of $33.9 million.
The adverse development before corporate aggregate reinsurance in calendar year 2004 of $97.6 million (10.7 loss ratio points) was primarily due to deficiencies in asbestos reserves of $90.5 million, recorded following the Company’s internal actuarial review and an independent actuarial firm’s ground-up study of such reserves. The asbestos reserve increase was driven mainly by an increase in the average severity of claims for known policyholders and allegations of reclassification of products claims (that are subject to an aggregate limit) as premises/operations claims (that are not subject to an aggregate limit). Additionally, environmental reserves were strengthened by $10 million in 2004. The Company also recognized favorable development of $37.5 million for accident year 2003, primarily in the property and workers’ compensation lines of business and $30.7 million in 1998 and prior, principally in non-latent general liability. This was largely offset by unfavorable non-latent development of $68.8 million for accident years 1999 and 2000, principally in the workers’ compensation and general liability lines.
The accident year loss and LAE ratio decreased from 75.4% for accident year 2005 to 70.3% for accident year 2006. This decrease primarily reflects the lack of major catastrophe activity in 2006 while accident year 2005 includes the effects of the 2005 hurricanes (Katrina, Rita and Wilma) of $94.2 million. Accident year 2004 includes the effects of four hurricanes in Florida of $70.7 million. Catastrophes added approximately 2.3, 9.7 and 9.8 points to the Company’s accident year loss and LAE ratios in 2006, 2005 and 2004, respectively, and added approximately 9.9, 57.0 and 44.5 points to the property accident year loss and LAE ratios, respectively. The increase in the accident year loss and LAE ratio in 2006, exclusive of the major catastrophes in the prior years, was largely attributable to the property line of business in which the Company experienced increased frequency of large fire losses and a significant rise in the cost of reinsurance. Commercial automobile was also adversely affected by an increase in large claims in 2006. The accident year loss and LAE ratios represent management’s estimate, at December 31, 2006, of the ultimate cost, expressed as a percentage of net premiums earned for each respective year, of covered claims or events, including settlement costs. For casualty lines of business in particular, where the “tail”, or period from the occurrence of the claim to final settlement, may span several years, the estimates are based on a number of assumptions and, accordingly, are subject to significant variability. See “Critical Accounting Policies and Estimates - Losses and loss adjustment expenses”.
Underwriting expenses are comprised of policy acquisition costs and other underwriting expenses. Policy acquisition costs are those costs that vary with and are primarily related to the acquisition of new and renewal policies and are comprised of commissions paid to producers and premium taxes. Other underwriting expenses consist of all other operating expenses associated with the Company’s underwriting activities, including salaries and benefits, information technology and rent. The Company’s underwriting expense ratio was 29.0%, 28.5% and 27.9% for the years ended December 31, 2006, 2005 and 2004, respectively. The policy acquisition ratio and the other underwriting expense ratio components of the underwriting expense ratio follow:
The Company’s policy acquisition expense ratio increased to 14.3% in 2006 compared to 14.1% in 2005 as a result of lower reinsurance ceding commissions, partially offset by the favorable effect of a lack of reinsurance reinstatement premiums associated with catastrophes in 2006. The Company’s policy acquisition expense ratio increased to 14.1% in 2005 from 13.6% in 2004, primarily due to higher reinsurance reinstatement premiums associated with catastrophe losses.
In July 2004 and January 2005, as an economic hedge against a decline in the U.S. equity markets, the Company executed short-sales of Standard & Poor’s Depositary Receipts (“SPDRs”) totaling approximately $300 million. Simultaneously, the Company purchased S&P Index call options (“Options”) limiting the potential loss on the future purchase of the SPDRs. The cost of the Options was $8.2 million. Certain of these options expired in July 2006 and replacement options were purchased at a cost of $1.9 million bringing the total cost of the Options purchased through December 31, 2006, to $10.1 million. At December 31, 2006, the Options limit the potential loss to the Company on the future purchase of the SPDRs to approximately $70 million. Both the obligations to purchase the SPDRs and the Options are carried at fair value on the consolidated financial statements. The fair value of the obligations to purchase the SPDRs is included in short-sale obligations and the fair value of the Options is included in other invested assets on the consolidated balance sheets. The fair values of the SPDRs obligation and the Options at December 31, 2006 amounted to a liability of $375.6 million and an asset of $9.9 million, as compared to a liability of $329.7 million and an asset of $6.4 million at December 31, 2005.
In June 2006, as an economic hedge against a rising interest rate environment and deteriorating conditions in the residential housing market, the Company sold short securities of certain U.S. mortgage insurance companies totaling $24.9 million. The fair value of the obligations to purchase these short-sale securities is included in short-sale obligations on the consolidated balance sheets and amounted to $24.6 million at December 31, 2006.
The obligations to purchase the short-sale securities discussed above and the Options are carried at fair value on the consolidated financial statements and related changes in fair value are recorded in realized investment gains and losses. Changes in the fair value of the short-sale transactions and related Options amounted to realized losses of $43.8 million, $16.6 million and $15.2 million in 2006, 2005 and 2004, respectively. The Company also incurs investment expense in an amount equal to the dividend earnings on the SPDRs sold. Investment expense of $6.5 million, $5.7 million and $2.5 million relating to this transaction was recorded for the years ended December 31, 2006, 2005 and 2004, respectively.
As a holding company with no direct operations, Crum & Forster Holdings Corp.’s assets consist primarily of its investments in the capital stock of its insurance subsidiaries and deferred tax assets associated with holding company net operating losses. Crum & Forster Holdings Corp. requires cash to meet its annual debt service obligations (approximately $31.1 million per year), to pay corporate expenses and, ultimately, to repay the $300 million aggregate principal amount of senior notes due 2013. Crum & Forster Holdings Corp.’s ability to satisfy its corporate obligations is primarily dependent on the dividend paying capacity of its subsidiaries. State insurance laws restrict the amount of shareholder dividends that insurance companies may pay without prior approval of regulatory authorities. The subsidiaries’ combined 2007 maximum dividend capacity, without prior regulatory approval, is $138.4 million. For a detailed discussion of shareholder dividend regulations, see “Item 1. Business-Insurance Regulatory Matters”.
The ability of Crum & Forster Holdings Corp.’s insurance subsidiaries to pay dividends depends, among other things, on such subsidiaries having positive statutory earned surplus. The Company’s principal insurance subsidiaries are US Fire and North River. At December 31, 2006, US Fire reported statutory earned surplus of $292.4 million and North River reported statutory earned surplus of $95.3 million. On March 29, 2006, US Fire paid its parent company a cash shareholder dividend of $94.5 million. On May 12, 2006, North River paid its parent company a cash shareholder dividend of $32.5 million. On March 30, 2006 and May 22, 2006, Crum & Forster Holdings Corp. paid cash shareholder dividends of $80 million and $10 million, respectively, to Fairfax
Pursuant to a non-interest bearing standby credit agreement between Fairfax and the Company, under certain circumstances the Company has the ability to borrow up to $40 million from Fairfax to meet certain corporate obligations. Borrowings under this agreement, if any, bear no interest and are due in June 2018. Through December 31, 2006, there have been no borrowings under this agreement.
For further information on the Company’s long-term debt see Note 8 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
Cash used in financing activities, which relates to holding company activities, was $90.0 million, $73.5 million and $62.5 million in 2006, 2005 and 2004, respectively. Cash used in financing activities in all three years was principally dividends paid to Fairfax.
Shareholder’s equity was $1,093.1 million at December 31, 2006, as compared to $961.2 million at December 31, 2005. The increase was primarily the result of current year earnings, partially offset by dividends paid to Fairfax during 2006 and a decrease in net unrealized investment gains.
Cash provided by investing activities was $121.9 million in 2006, compared to cash used in investing activities of $135.7 million in 2005 and $1,715.5 million in 2004. The increase in cash provided by investing activities in 2006 was primarily attributable to higher proceeds received from the sale of equity securities and other invested assets. The reason for the significant amount of cash used in investing activities in 2004 as compared to 2005 was primarily the result of the reinvestment of over $1 billion of cash and cash equivalents into higher yielding, longer-term investments in the first quarter of 2004.
In 2006, 2005 and 2004, the Company pledged cash and U.S. Treasury securities as collateral for the Company’s short-sale obligations (see “Results of Operations -Investment results”). The fair value of such collateral was $535.6 million, $496.9 million and $277.9 million at December 31, 2006, 2005 and 2004, respectively.
At December 31, 2006 and 2005, 98.8% and 93.2% of the Company’s fixed income securities were rated investment grade, respectively. Fixed income securities and cash and cash equivalents of $382.6 million and $323.7 million were on deposit with various state regulatory authorities at December 31, 2006 and 2005, respectively, as required by insurance laws.
The Company’s combined policyholders’ surplus and statutory operating leverage (the ratio of statutory net premiums written to end of year surplus) are summarized below:
The Company’s combined statutory policyholders’ surplus was $1,406.8 million at December 31, 2006, as compared to $1,314 million at December 31, 2005. Statutory surplus is an important measure utilized by management, regulators and rating agencies to assess the Company’s ability to support its business operations. The increase in the Company’s combined statutory surplus in 2006 as compared to 2005 was primarily attributable to statutory net income of $253.3 million offset by dividends of $127.0 million paid to the Company’s parent in 2006. The increase in the Company’s combined statutory surplus in 2005 as compared to 2004 was primarily attributable to statutory net income of $151.9 million and unrealized capital gains on equity securities of $58.8 million, offset by dividends of $93.4 million paid in 2005 to the Company’s parent. Effective March 30, 2004, the State of Delaware enacted legislation to adopt certain insurance accounting standards promulgated by the NAIC. The adoption of such standards resulted in an increase in the Company’s combined statutory policyholders’ surplus of $28.1 million, principally relating to the recognition of goodwill. The Company’s ratio of statutory net premiums written to surplus, a measure of operating leverage, remained relatively stable in 2006, 2005 and 2004 and, according to data from A.M. Best, was below the property and casualty commercial lines sector ratios of 1.0x, 1.0x and 1.1x, respectively.
The Company has outstanding $300 million aggregate principal amount of 10-3/8% senior notes due 2013. Interest payments on such notes are approximately $31.1 million per year. For additional information on the Company’s senior notes, see Note 7 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data” and “ -Liquidity and Capital Resources-Holding company”.
The Company and its subsidiaries lease office space and equipment under long-term leases expiring through the year 2022. The amounts above represent the minimum contractual rentals for such operating leases at December 31, 2006. For more information on the Company’s operating leases, see Note 11 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
In July 2004 and January 2005, the Company executed short-sales of SPDRs totaling approximately $300 million. In June 2006, the Company sold short securities of certain U.S. mortgage insurance companies totaling $24.9 million. The Company has no contractual timeframe within which it must purchase the SPDRs or securities previously sold and any decision to purchase will be based upon economic and market conditions. For purposes of the above chart, the Company has reflected the purchase obligation in 2007. The actual purchase date may differ from this estimate. For additional information on the short-sale transactions, see “ -Results of Operations -Investment results” and Note 3 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data”.
For discussion of regulatory issues, see “Item 1. Business-Insurance Regulatory Matters”.
Consolidated Statements of Shareholder’s Equity for the Years Ended December 31, 2006, 2005 and 2004
Consolidated Statements of Comprehensive Income for the Years Ended December 31, 2006, 2005 and 2004
The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and disclosure of contingent assets and liabilities. Such estimates and assumptions may differ from actual results. Certain amounts in the Company’s prior year consolidated financial statements have been reclassified to conform to the 2006 presentation.
Unrealized losses that are deemed other than temporary are charged to operations. The Company considers an impairment as “other than temporary” if evidence indicating that an investment’s carrying amount is recoverable within a reasonable period of time which, in the case of fixed income securities, may mean until maturity, is outweighed by evidence to the contrary. The Company also considers its ability and intent to hold an investment until such recovery of the security’s fair value. Notwithstanding the foregoing, with respect to fixed income securities, an impairment may be considered other than temporary if it is probable that the Company will be unable to collect all amounts due under the terms of the securities. Recognition of impairment losses for declines in the value of fixed income investments and equity securities attributable to issuer-specific events are based upon all relevant facts and circumstances for each investment. Factors considered by management include, but are not limited to, the impact of issuer-specific events, current and expected future market and economic conditions, the nature of the investment, the number of investment positions with losses, the severity and duration of the impairment and the volatility of the security’s market price.
Reserves for uncollectible reinsurance are determined based upon regular reviews of the financial condition of reinsurers and assessments of other available information. Prepaid reinsurance premiums represent the portion of premiums ceded to reinsurers applicable to the unexpired terms of the ceded contracts.
Financial statements of foreign investees accounted for using the equity method are translated into U.S. dollars in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 52, Foreign Currency Translation. Under SFAS No. 52, investments in entities accounted for under the equity method are translated into U.S. dollars at the rate of exchange in effect at the date of the transaction and related equity earnings are translated at the average rate in effect during the period. At each balance sheet date, the carrying amounts are translated into U.S. dollars at the rate in effect at the balance sheet date and any translation gains or losses are recorded in other comprehensive income.
Accumulated other comprehensive income includes unrealized investment gains and losses on the Company’s available-for-sale securities and foreign currency translation gains and losses arising from the translation of financial statements of equity method investees denominated in foreign currencies. At December 31, 2006 and 2005, unrealized investment gains and losses included in accumulated other comprehensive (loss) income were $(49,499) and $42,153, net of tax, respectively. At December 31, 2006 and 2005, foreign currency translation gains were $12,576 and $11,290, net of tax, respectively. In addition, at December 31, 2006, accumulated other comprehensive income includes an adjustment of $(55), net of tax, in respect of the adoption of SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans-an amendment of FASB Statements No. 87, 88, 106, and 132(R) (“SFAS 158”). See Note 10 to the consolidated financial statements for further details of the impact of SFAS 158 on the Company’s consolidated financial statements.
In February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements Nos. 133 and 140 (“SFAS 155”). SFAS 155 applies to certain “hybrid financial instruments” which are instruments that contain embedded derivatives. The standard establishes a requirement to evaluate beneficial interests in securitized financial assets to determine if the interests represent freestanding derivatives or are hybrid financial instruments containing embedded derivatives requiring bifurcation. SFAS 155 also permits an election for fair value measurement of any hybrid financial instrument containing an embedded derivative that otherwise would require bifurcation under SFAS 133. Changes in fair value are recorded as realized investment gains or losses. The fair value election can be applied to existing instruments on an instrument-by-instrument basis at the date of adoption and to new instruments on a prospective basis. The statement is applicable in fiscal years beginning after September 15, 2006. The Company expects to elect fair value measurement of hybrid financial instruments under SFAS 155 effective with its adoption on January 1, 2007. Prior to January 1, 2007, the Company bifurcated the embedded derivatives in its investments in convertible securities and changes in the fair value of the host instrument were recorded as unrealized investment gains and losses while changes in the fair value of the embedded derivative were recorded as realized investment gains and losses. At December 31, 2006, the fair value of the host instruments included in fixed income securities was $136,222 and the fair value of embedded derivatives included in other invested assets was $7,372. Upon adopting SFAS 155, the Company will record a cumulative adjustment of $10,445 to reclassify unrealized investment gains, net of tax, to opening retained earnings.
The aggregate carrying value of the Company’s investment portfolio, including assets pledged for short-sale obligations, was $3,926,276 and $3,720,538 at December 31, 2006 and 2005, respectively, and is comprised of available-for-sale securities, other invested assets, short-term investments and cash and cash equivalents.
Includes U.S. Treasury securities pledged for short-sale obligations at a fair value of $182,551 (amortized cost of $183,579).
The amortized cost and fair value of fixed income securities by contractual maturity are shown below. Actual maturities may differ from maturities shown below due to the existence of call features. At December 31, 2006, securities containing call features represented approximately 1% of the total fair value of the fixed income portfolio.
The components of investment income for the years ended December 31, 2006, 2005 and 2004 are summarized as follows:
Includes interest of $16,893, $8,923 and $343 in 2006, 2005 and 2004, respectively, on cash collateral pledged for short-sale obligations, as well as interest on short-term investments.
At December 31, 2006, cost includes a charge of $5,379 in respect of an other than temporary impairment charge.
The Company’s investments in Northbridge Financial Corporation (“Northbridge”), HWIC Asia Fund (“HWIC”), Odyssey Re Holdings Corp. (“Odyssey”) common shares, Dalton Greater China Fund (“Dalton”), TRG Holding Corporation (“TRG”), Rutland Fund A (“Rutland”) and MFXchange Holdings Inc. (“MFX”) are accounted for using the equity method and are included in other invested assets on the consolidated balance sheets. The fair market value of the Company’s investment in Northbridge was $204,617 and $232,312, respectively, at December 31, 2006 and 2005. The fair market value of the Company’s investment in Odyssey common shares was $29,840 and $20,064, respectively, at December 31, 2006 and 2005. Earnings from Northbridge, Odyssey common shares, TRG and MFX are included in equity in earnings of investees, net of tax, on the consolidated statements of income. Earnings from HWIC, Dalton and Rutland are included in investment income on the consolidated statements of income. The Company’s investments in Chou Associates Management Fund (“Chou”), Advent and Odyssey preferred shares are carried at fair value and are included in equity securities on the consolidated balance sheets. Changes in the fair value of Chou, Advent and Odyssey preferred shares are recorded in accumulated other comprehensive income, net of tax. The Company determined that the cumulative effect on its results of Odyssey’s restatement of its financial statements as of and for the six years ended December 31, 2005, was not material.
In December 2005, the Company acquired 398,837 units of Dalton for $7,895. Dalton is a fund that focuses on shares listed in Hong Kong, Taiwan and the People’s Republic of China.
The Company holds a 36.3% interest in HWIC at December 31, 2006. For the years ended December 31, 2006, 2005 and 2004, pre-tax equity in earnings of HWIC were $60,457, $11,996 and $2,223, respectively, and were included in investment income on the consolidated statements of income. No dividends have been received from HWIC. During 2006 the Company redeemed approximately 1.7 million shares, or 78%, of its interest in HWIC resulting in a realized investment gain of $5,053.
At December 31, 2006 and 2005, the fair value of the Company’s derivative contracts, which are included in other invested assets on the consolidated balance sheets, was $43,643 and $40,528, respectively. The Company’s derivatives are comprised of the Options discussed above, credit default swaps, warrants and options embedded within certain securities in the Company’s fixed income portfolio.
In connection with the short-sale transactions described above, the Company has pledged cash and U. S. Treasury securities as collateral for the obligation to purchase the securities sold short. These assets are recorded in assets pledged for short-sale obligations on the consolidated balance sheets. At December 31, 2006 and 2005, the fair value of the assets pledged for the purchase of the short-sale obligations totaled $535,594 and $496,903, respectively.
For the years ended December 31, 2006, 2005 and 2004, the Company’s loss and LAE ratios were 61.5%, 68.8% and 83.9%, respectively, of which 70.3%, 76.5% and 76.3%, respectively, were attributable to losses occurring in the current accident year and (8.8)%, (7.7)% and 7.6%, respectively, were attributable to adverse/(favorable) development of prior years’ losses. Accident years 2005 and 2004 were significantly affected by severe hurricane activity. Excluding the major storm activity in 2005 (hurricanes Katrina, Rita and Wilma) and 2004 (hurricanes Charley, Frances, Ivan and Jeanne), the accident year loss and LAE ratios were 67.2% and 66.2%, respectively, compared to 70.3% for accident year 2006, a year free of major catastrophe activity. The increase in the accident year loss and LAE ratio in 2006, exclusive of the major catastrophes in the prior years, was largely attributable to the property line of business in which the Company experienced increased frequency of fire losses and a significant rise in the cost of reinsurance. Commercial automobile was also adversely affected by an increase in large claims in 2006. Refer to Note 13 to the consolidated financial statements for a schedule of the accident year loss and LAE ratios by line of business.
In 2005, hurricanes Katrina, Rita and Wilma accounted for approximately $389,700 and $57,000 of gross and net losses and LAE, respectively, and gave rise to the payment of $39,300 of reinstatement premiums under the Company’s property catastrophe reinsurance treaty. In 2004, hurricanes Charley, Frances, Ivan and Jeanne accounted for approximately $149,300 and $83,000 of gross and net losses and LAE, respectively, and gave rise to the payment of $13,000 of reinstatement premiums under the Company’s property catastrophe reinsurance treaty.
In 2005, the Company recognized net favorable prior year loss development of $68,564 (7.7 loss ratio points), including $8,058 of amortization of deferred gains on retroactive reinsurance. The net favorable development was comprised of three principal components: (i) adverse development of asbestos, environmental and other latent liabilities of $44,646, primarily due to developments related to one asbestos policyholder and largely offset by favorable emergence of non-latent umbrella and other casualty reserves in accident years 1998 and prior, (ii) $24,699 of strengthening of prior year reserves for the surety line of business, a line the Company exited in 2005, and (iii) net favorable development of the Company’s remaining property and casualty reserves of approximately $99,700, arising from accident years 1999 through 2004.
The Company uses tabular reserving for workers’ compensation indemnity reserves and discounts such reserves using an interest rate of 5%. The amount of related discount was $66,428 and $71,181 at December 31, 2006 and 2005, respectively.
The Company also maintains reserves for other latent exposures such as those associated with gas and vapors, lead, mold, chemical, welding fumes and pesticides. Changes in the Company’s liability for other latent exposures are summarized as follows:
At December 31, 2006, the Company had reinsurance recoverable of $1,733,926, due from approximately 280 reinsurers. At such date, the five largest gross reinsurance recoverable balances aggregated $1,054,137, or approximately 61% of the total reinsurance recoverable balance. Application of collateral reduces the unsecured exposure to these five reinsurers to $389,100. The collateral received with respect to these top five reinsurers is in the form of clean, unconditional, irrevocable and evergreen letters of credit in the amount of $38,061, irrevocable trusts in the amount of $440,567 and funds held in the amount of $206,384, with two reinsurers’ collateral exceeding their reinsurance recoverable balances. The letters of credit are in compliance with NAIC regulations and are confirmed by Lloyds TSB Bank which is an NAIC approved bank that is not related to Fairfax or any Fairfax affiliates. The irrevocable trusts are in compliance with NAIC regulations and are principally composed of cash and fixed income securities of various issuers, virtually all of which are investment grade rated securities. None of the issuers of the fixed income securities is related to Fairfax or any Fairfax affiliates. The funds withheld balances are held in the Company’s general account and equal premiums plus interest thereon credited at the rates stipulated in the related reinsurance contracts. There is no limitation on the ability of the Company to access these funds in accordance with the reinsurance agreements. The largest unsecured balance at December 31, 2006 was $166,192 with an unaffiliated company rated A+ by A.M. Best Company.
At December 31, 2006, reinsurance recoverable includes $405,151 and $391,825 related to prospective and retroactive corporate aggregate reinsurance contracts, respectively, of which $489,236 has been recognized as a reduction of incurred losses and LAE on the Company’s consolidated statements of income. A summary of these corporate aggregate reinsurance contracts and the amounts of reinsurance recoverable thereunder follows:
Includes $389,010 which has been recognized as a reduction of losses and LAE less $21,510 for additional premiums due on retrospectively rated insurance policies that inure to the benefit of the reinsurer. Total amounts recognized as a reduction of losses and LAE include the $389,010 above, $37,651 on the 2000 accident year prospective aggregate stop loss contract and $62,575 of amortization of deferred gains on the retroactive reinsurance contracts.
Favorable development of the losses covered under this contract resulted in a reduction in the reinsurance recoverable balance from $32,540 at December 31, 2005 to $0 at December 31, 2006.
The Company entered into an aggregate stop loss agreement with unaffiliated reinsurers covering accident year 2000, which provided coverage of $118,493 and was fully utilized by the Company at December 31, 2004. This stop loss agreement covered the casualty lines of business. The contract provided 29 loss ratio points of coverage in excess of a loss and ALAE ratio of 66% for covered losses. The contract is on a funds held basis with interest credited at 7.5%. Premiums and losses ceded pursuant to the contract were $7,595 and $9,994, respectively, in 2004 and there were no cessions to the contract in 2005 and 2006. Premiums and losses ceded prior to 2004 were $68,758 and $108,499, respectively. At December 31, 2006 and 2005, the Company had reinsurance recoverable balances of $37,651 and $53,145, respectively, and funds held balances of $33,333 and $45,769, respectively, related to this agreement.
In 2001, the Company entered into adverse development contracts with two unaffiliated reinsurers. The first contract, covering substantially all lines of business, provides $400,000 of limit in excess of a retention for accident years 2000 and prior, subject to a $200,000 sub-limit on 1998 and prior accident years and an asbestos and environmental sub-limit of $100,000. Premiums are currently based on 35% of amounts ceded plus additional reinsurer margin of $8,000. The contract contains provisions that would increase the premium rate to as high as 62% under conditions that Company management considers unlikely. The contract is on a funds held basis with interest credited at 7%. At December 31, 2006, the Company had ceded cumulative losses of $372,577, which is comprised of $(4,443) in 2006, $6,009 in 2005, $140,565 in 2004 and $230,446 prior to 2004 and paid premiums of $153,307, which is comprised of $(796) in 2006, $4,105 in 2005, $58,056 in 2004 and $91,942 prior to 2004, related to this contract. Of the $27,423 remaining coverage on this contract, less than $1 million is available for asbestos development.
At December 31, 2006 and 2005, the Company had reinsurance recoverable balances of $372,577 and $377,020, respectively, and funds held balances of $206,384 and $193,944, respectively, related to this agreement.
The premiums for both contracts are included in funds held under reinsurance contracts on the consolidated balance sheets, subject to the offset discussed above. The arrangements described above are recorded as retroactive reinsurance, with reinsurance recoverable due from reinsurers in excess of premiums paid for the coverage reflected on the balance sheets as deferred income on retroactive reinsurance. Such deferred income is amortized based on the expected amount and timing of future recoveries, using the interest method. The Company amortized deferred income of $12,889 in 2006, $8,058 in 2005, $18,324 in 2004 and $23,304 prior to 2004. This amortization of deferred income is included as a reduction of losses and LAE in the consolidated statements of income.
In 1998, in connection with the acquisition of the Company by Fairfax, the Company entered into an aggregate stop loss agreement with an unaffiliated reinsurer, which provided coverage of $367,500 in excess of a retention and has been fully utilized by the Company. The contract provided coverage for loss reserve development for accident periods prior to August 13, 1998, the date of acquisition of the Company by Fairfax. The initial premium of $75,000 was paid by the former parent of the Company. This contract is treated as prospective reinsurance. There were no premium cessions to the contract in 2006, 2005 and 2004 and reinsurance recoverable on the contract was $367,500 at both December 31, 2006 and 2005. The Company amended the contract in 2001 to provide an additional $19,248 of coverage for a premium of $7,925, which was recorded in 2001. This contract amendment is treated as retroactive reinsurance and has been fully utilized by the Company. Amortization of deferred income on this amendment is included in the amortization amounts discussed previously.
For additional information on reinsurance transactions with related parties, see Note 9 to the consolidated financial statements.
In 2003, the Company issued $300,000 aggregate principal amount of senior notes (the “Notes”) in a private placement. The Notes, which bear interest payable semi-annually at 10-3/8%, mature on June 15, 2013. The net proceeds from the offering of approximately $290,955 were used to fund an interest escrow account in the amount of approximately $63,115 to make the first four semi-annual interest payments on the Notes and to pay a dividend to Fairfax in the amount of $217,885, with the remainder used to pay related financing costs. The Notes contain certain restrictions on incurrence of additional indebtedness, dividend payments to Fairfax, asset sales and certain transactions with affiliates. In addition, the Company was required by the terms of the Notes to use its best efforts to register the Notes, or similar instruments with substantially the same terms to be exchanged for the Notes, with the SEC. Pursuant to an exchange offer, which was completed on April 20, 2004, the Company issued $300,000 aggregate principal amount of registered notes with substantially the same terms as the Notes, in exchange for all of the outstanding Notes. As required by the terms of the Notes, additional interest of $279 was incurred for the period from December 28, 2003 through April 19, 2004, after which such additional interest was no longer payable on the Notes.
For the years ended December 31, 2006, 2005 and 2004, interest expense on the Notes was $32,986, $32,915 and $33,159 respectively, including additional interest described above, accretion of the discount on the Notes and amortization of related deferred financing costs. At December 31, 2006 and 2005, deferred financing costs in conjunction with the issuance of the Notes totaled $7,465 and $8,626, respectively, and were included in other assets on the consolidated balance sheet. These deferred financing costs are being amortized to interest expense on a straight-line basis over the ten-year duration of the Notes.
The fair value of the long-term debt, determined from quoted market prices, was $326,250 and $315,750, respectively, at December 31, 2006 and 2005.
Concurrent with the issuance of the Notes, the Company entered into a non-interest bearing standby credit agreement, subordinate to the Notes, whereby Fairfax agreed, under certain conditions, to lend up to $40,000 to Crum & Forster in order to meet certain corporate obligations. Borrowings under this agreement, if any, are due in June 2018. Through December 31, 2006, there have been no borrowings under this agreement.
Components of deferred income tax assets and liabilities are summarized as follows:
Deferred tax assets of $60,550 at December 31, 2006 attributed to investments above include the effects of undistributed income of foreign investments. At December 31, 2006, the Company had net operating and other loss carryforwards of approximately $164,526. These will expire between 2009 and 2026. Based on projections of estimated future operations, management expects the deferred income tax asset to be recovered from taxable income in future years.
Income tax expense shown on the consolidated statements of income excludes $7,087, $9,258 and $6,719 of deferred income taxes on equity in earnings of investees in 2006, 2005 and 2004, respectively. Total income tax expense in 2006, 2005 and 2004, inclusive of these amounts, was $163,243, $74,578 and $11,235, respectively, and the related effective tax rate was 34.3%, 32.4% and 31.7% respectively.
Included in accounts payable and other liabilities on the consolidated balance sheets at December 31, 2006 and 2005, respectively, is $41,230 and $0 in respect of current income taxes payable.
The increase in premiums written and earned in the year ended December 31, 2006, as compared to the prior two years, is principally due to the assumption of the Fairmont business. For further details see Note 1 to the consolidated financial statements. The decrease in losses ceded in the year ended December 31, 2006, as compared to 2005 and 2004, is primarily due to the aforementioned assumption of the Fairmont business and lower losses ceded in respect of hurricanes.
In the normal course of business, the Company has several reinsurance agreements in effect with Odyssey America Reinsurance Corporation (“Odyssey America”) and its subsidiaries, affiliates of Fairfax. Under these agreements, Odyssey America participates on contracts covering substantially all reinsured lines of business. For the years ended December 31, 2006, 2005 and 2004, the Company ceded $2,911, $8,879 and $7,247, respectively, in premiums to Odyssey America and had reinsurance recoverable of $16,499 and $35,626 at December 31, 2006 and 2005, respectively, under these reinsurance agreements.
Reinsurance recoverable from TIG Insurance Company (“TIG”) totaled $137,514 and $142,516 at December 31, 2006 and 2005, respectively. TIG is domiciled in California and cessions to domestic insurance companies do not require collateral to be recognized for statutory reporting purposes. The Company has considered several factors in assessing the collectibility of reinsurance recoverable balances from TIG. TIG is a runoff company with a B+ (stable) financial strength rating from A.M. Best, a financial strength rating of BB (negative) from Standard and Poor’s and BB+ (stable) from Fitch, all nationally recognized rating agencies. TIG is a sizable regulated entity with policyholders’ surplus of $683,376 at December 31, 2006 and is subject to periodic independent examination by the California Insurance Department. TIG also had short-term liquidity represented by cash and short-term investments of $405,058 at December 31, 2006. The Company has thirteen years of experience with TIG, during which the balances due from TIG have declined from approximately $267,000 to $137,514 at December 31, 2006, principally through settlement of underlying claims. There are no regulatory or other restrictions on payments to the Company from TIG.
Effective February 1, 2002, the Company entered into an arrangement with TIG whereby the Company issued policies on behalf of TIG totaling $22,923 in gross premiums written. The Company entered into reinsurance agreements under which approximately 30% of the total risk under these policies was ceded to TIG with the remaining 70% ceded to third party reinsurers. This arrangement with TIG was terminated as of June 30, 2002. At December 31, 2006 and 2005, the Company had reinsurance recoverable of $3,272 and $3,766, respectively, from TIG related to this agreement.
Effective January 1, 2006, the Company, in connection with its assumption of the Fairmont business, entered into a reinsurance agreement with Markel Insurance Company of Canada (“Markel”), a subsidiary of Fairfax, under which the Company has agreed to provide commercial auto coverage to U.S. or Canadian domiciled companies, for which Markel has written the Canadian auto coverage business, and to cede 100% of the coverage provided by the Company to Markel. During the year ended December 31, 2006, the Company ceded premiums of $1,175 to Markel and had a reinsurance recoverable balance of $285 at December 31, 2006.
In December 2006, the Company acquired from TIG approximately 42 million additional units of a special purpose trust which contains U.S. Treasury strips and fixed income securities for cash consideration of $63,587. The Company owned approximately 46.5% of this special purpose trust at December 31, 2006.
Under an agreement effective July 1, 2000, the Company appointed RiverStone Claims Management LLC (“RiverStone”), a wholly-owned subsidiary of Fairfax, as its claims manager to handle its asbestos, environmental, other latent and construction defects claims. During 2006, the parties decided to terminate the arrangement effective December 31, 2006. The Company established a specialized unit for managing asbestos, environmental and other latent claims and all open matters were transferred to the new unit by year-end. The expense incurred for RiverStone’s claims services was $3,600 for each of the years ended December 31, 2006, 2005 and 2004. In 2006, additional expenses of $390 and $12 were incurred for claim file legal expense reviews and overhead costs related to the transitioning of files, respectively. The Company also engages RiverStone on a contingent basis to assist in reinsurance commutation negotiations. The fees for such services were $101, $58 and $5 in 2006, 2005 and 2004, respectively.
Under an agreement effective September 1, 2001, US Fire obtains certain information technology services, including production and operations support and systems development, on a non-exclusive basis from Fairfax Information Technology Services, Inc. (“FITS”), a wholly-owned subsidiary of Fairfax. Payments for these services, including billings for services subcontracted by FITS to other vendors, for the years ended December 31, 2006, 2005 and 2004 were $33,125, $22,980 and $26,401, respectively. The 2006 increase primarily reflects additional services performed by FITS that were previously purchased from an unaffiliated vendor, as well as additional services in support of the Fairmont business. Of such fees, $29,158, $19,243 and $21,001 were charged directly to expense for 2006, 2005 and 2004, respectively. The remaining $3,967, $3,738 and $5,400 were software license fees capitalized in 2006, 2005 and 2004, respectively. The Company amortizes such fees over a five-year period beginning on the date the software is placed in service. In 2006, 2005 and 2004, software license amortization of $3,287, $2,019 and $2,576, respectively, was charged to operations, and $18,981 and $18,036 were included in other assets for the years ended December 31, 2006 and 2005, respectively.
Effective January 1, 2000, the Company entered into a service agreement with TIG to obtain certain services relating to issuing policies and handling claims. Payments for these services were $0, $18 and $113 for the years ended December 31, 2006, 2005 and 2004, respectively. This agreement was terminated in 2006.
The Company receives loss adjustment services from Cunningham Lindsey U.S., Inc., an affiliate of Fairfax. Expenses incurred for these services were $213, $33 and $64 for the years ended December 31, 2006, 2005 and 2004, respectively.
The Company sponsors a qualified defined contribution plan pursuant to sections 401(k) and 401(a) of the Internal Revenue Code for which all employees are eligible after completing one hour of service. The Company makes an annual contribution equal to 3% of base salary and a matching contribution equal to one-half of each employee’s contribution up to the first 6% of base salary. Certain employees also have the opportunity to participate in a non-qualified plan that permits contributions that would otherwise be limited by IRS regulations. Total defined contribution plan expense was $4,495, $3,671 and $3,154 for the years ended December 31, 2006, 2005 and 2004, respectively.
In September 2006, the FASB issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans-an amendment of FASB Statements No. 87, 88, 106, and 132(R) (“SFAS 158”). SFAS 158 requires companies to recognize the overfunded or underfunded status of a defined benefit pension or other postretirement plan as an asset or liability in their balance sheets and to recognize changes in that funded status in the year in which the changes occur through other comprehensive income, effective for fiscal years ending after December 15, 2006. The Company adopted SFAS 158 effective December 31, 2006. In addition, SFAS 158 also requires companies to measure the funded status of the plan as of the date of their fiscal year end, with limited exceptions, effective for fiscal years ending after December 15, 2008. The Company uses a December 31 measurement date for its postretirement health care and life insurance plans and is therefore not affected by this provision. The adoption of SFAS 158 did not materially affect the Company’s financial position at December 31, 2006.
A reconciliation of the changes in the postretirement plans’ benefit obligation, fair value of assets, a statement of the funded status and accrued benefit cost is presented below.
The components of net periodic benefit cost are summarized as follows:
Conversely, decreasing the assumed health care cost trend rates by one percentage point in each year would decrease the accumulated postretirement benefit obligation at December 31, 2006 by $1,058, and the aggregate of the service and interest cost components of net periodic postretirement benefit expense for 2006 by $55. The Company’s expected contribution to the Plan in 2007 is $1,144.
The Company has established a long-term incentive plan (“LTIP”) for certain employees who hold senior management or officer positions. The LTIP provides for the award of phantom stock, the value of which is based on the book value of the Company, that will fully vest on January 1, 2009. LTIP expense of $4,112, $2,629 and $2,000 for the years ended December 31, 2006, 2005 and 2004, respectively, is included in the consolidated statements of income.
Certain employees of the Company have been granted shares of restricted common stock of Fairfax under the Fairfax Financial 1999 Restricted Share Plan. The restricted stock vests over periods ranging from five to ten years. Restricted stock expense of $633, $431 and $1,048 for the years ended December 31, 2006, 2005 and 2004, respectively, is included in the consolidated statements of income.
All employees of the Company are eligible to participate in the Fairfax Financial Holdings Limited Employee Share Ownership Plan (the “Plan”). The Plan provides an opportunity to purchase Fairfax subordinate voting shares through a combination of employee and company contributions. Employees may elect to contribute from 1% to 10% of base salary through regular payroll deductions, and the Company is required to make matching contributions equal to 30% of the employee contributions. In addition, the Company is required to make an annual contribution equal to 20% of employee contributions upon Fairfax and the Company achieving certain financial objectives. The Plan expense of $165, $118 and $93 for the years ended December 31, 2006, 2005 and 2004, respectively, is included in the consolidated statements of income.
The Company and its subsidiaries lease office space and equipment under non-cancelable operating leases. These include a 20-year lease for the Company’s home office which expires on December 31, 2022 and has minimum lease payments remaining of $48,565. Minimum annual rentals are summarized as follows:
The Company has purchased structured settlement annuities from various insurance companies in order to settle certain claim liabilities. Should these other companies become unable to make the annuity payments, the Company would be liable. The value of these annuities included in reinsurance recoverable in the consolidated balance sheets at December 31, 2006 and 2005 was approximately $147,190 and $152,521, respectively. Approximately 79% of this balance is due from insurance companies rated A- or better by A.M. Best Company.
On September 7, 2005, Fairfax announced that it had received a subpoena from the SEC requesting documents regarding any non-traditional insurance or reinsurance transactions entered into or offered by Fairfax and the entities in its consolidated group, which includes the Company. The U.S. Attorney’s Office for the Southern District of New York is reviewing documents provided to the SEC in response to the subpoena and is participating in the investigation of these matters. Fairfax and entities in its consolidated group are cooperating fully with these requests. Fairfax and certain of the entities in its consolidated group, including the Company, have prepared presentations and provided documents to the SEC and the U.S. Attorney’s Office, and employees of Fairfax and certain of the entities in its consolidated group, including senior officers, have attended or have been requested to attend interviews conducted by the SEC and the U.S. Attorney’s Office. The Company is cooperating fully in addressing its obligations under this subpoena. This inquiry is ongoing and the Company continues to comply with requests from the SEC and the U.S. Attorney’s office. At the present time, the Company cannot predict the outcome of these matters, or the ultimate effect on the Company’s consolidated financial statements, which effect could be material and adverse. No assurance can be made that the Company will not be subject to further requests or other regulatory proceedings of a similar kind.
Crum & Forster Holdings Corp. and US Fire, among numerous other insurance company and insurance broker defendants, have been named as defendants in a class action suit filed by policyholders alleging, among other things, that the defendants used the contingent commission structure to deprive policyholders of free competition in the market for insurance. The action is pending in the U.S. District Court for the District of New Jersey. Plaintiffs seek certification of a nationwide class consisting of all persons who between August 26, 1994 and the date of class certification engaged the services of any one of the broker defendants and who entered into or renewed a contract of insurance with one of the insurer defendants. In October 2006, the court partially granted defendants’ motion to dismiss the plaintiffs’ complaint, subject to plaintiffs’ filing an amended statement of their case. Plaintiffs thereafter filed their “supplemental statement of particularity” and amended case statement. In response, defendants filed a renewed motion to dismiss. That motion will be argued before the court in March 2007. Crum & Forster Holdings Corp. and US Fire continue to vigorously defend the action.
In the ordinary course of their business, Crum & Forster’s subsidiaries receive claims asserting alleged injuries and damages from asbestos and other hazardous waste and toxic substances and are subject to related coverage litigation. The conditions surrounding the final resolution of these claims and the related litigation continue to change. Currently, it is not possible to predict judicial and legislative changes and their impact on the future development of asbestos and environmental claims and litigation. This trend will be affected by future court decisions and interpretations, as well as changes in applicable legislation and the possible implementation of a proposed federal compensation scheme for asbestos-related injuries. As a result of these uncertainties, additional liabilities may arise for amounts in excess of current reserves for asbestos, environmental and other latent exposures. These additional amounts, or a range of these additional amounts, cannot currently be reasonably estimated. As a result of these claims, management continually reviews required reserves and reinsurance recoverable. In each of these areas of exposure, the Company litigates individual cases when appropriate and endeavors to settle other claims on favorable terms.
The Company does not allocate investment results or certain corporate expenses for purposes of evaluating financial performance of each line of business. For additional information on current accident year losses and prior years’ development, see Note 4 to the consolidated financial statements.
14. Accounting Adjustments in Respect of Certain Investments Related to Prior Periods
Management evaluated the financial impact of these accounting adjustments in accordance with SEC Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements, which considers the effect of misstatements from both a balance sheet and income statement perspective, and concluded that the effect both individually and in the aggregate was not material to any prior period consolidated financial statements and accordingly, prior period consolidated financial statements were not restated. The Company recorded cumulative adjustments in the second and third quarters. The net effect of the adjustments recorded in the third quarter was a charge to investment income for the three months ended September 30, 2006 of $6,962 pre-tax ($4,525 after-tax). The net effect of the adjustments recorded in the second quarter was a charge to net income for the three months ended June 30, 2006 of $5,678 pre-tax ($3,691 after- tax). Of the $5,678 pre-tax charge, $4,255 was recorded as a charge to realized investment gains, $3,534 ($2,297 after-tax) was recorded as a charge to equity in earnings of investees (including $456 of previously waived immaterial adjustments) and $2,111 was recorded as an increase to investment income on the consolidated statements of income.
Includes adjustments described in Note 14 to the consolidated financial statements.