Our corporate offices are located in 101,420 total square feet of leased space in Stamford, Connecticut. Our other locations occupy a total of 139,489 square feet, all of which are leased. The Americas division operates out of offices in New York, Stamford, Mexico City, Miami, Santiago and Toronto, the EuroAsia division operates out of offices in Paris, Singapore, Stockholm and Tokyo, the London Market division operates out of offices in London and Bristol, and the U.S. Insurance division operates out of offices in New York, Chicago and Napa.
In September 2004, we renewed the lease at our corporate offices in Stamford, Connecticut, under a lease agreement beginning upon the termination of the current lease in October 2007 and expiring in October 2022. Upon signing the lease, we received a construction allowance of $3.1 million. We have three renewal options on the current premises that could extend the lease through September 2032, if all renewal options are exercised.
The following selected financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and notes thereto that are included in this Form 10-K. Financial information in the table reflects the results of operations and financial position of OdysseyRe.
Based on our common shares outstanding of: 71,140,948 as of December 31, 2006; 69,127,532 as of December 31, 2005; 64,754,978 as of December 31, 2004; 64,996,166 as of December 31, 2003; and 65,003,963 as of December 31, 2002.
Our gross premiums written for the year ended December 31, 2006 were $2,335.7 million, a decrease of $291.2 million, or 11.1%, compared to gross premiums written for the year ended December 31, 2005 of $2,626.9 million. Gross premiums written included reinstatement premiums related to catastrophe events of $5.4 million and $70.4 million for the years ended December 31, 2006 and 2005, respectively. Our business outside of the United States accounted for 45.8% of our gross premiums written for the year ended December 31, 2006, compared to 44.8% for the year ended December 31, 2005. For the years ended December 31, 2006 and 2005, our net premiums written were $2,160.9 million and $2,301.7 million, respectively. For the year ended December 31, 2006, we had net income available to common shareholders of $499.6 million and for the year ended December 31, 2005, we had a net loss available to common shareholders of $117.7 million. As of December 31, 2006, we had total assets of $8.9 billion and total shareholders’ equity of $2.1 billion.
For the year ended December 31, 2005, the total current year catastrophe losses of $537.9 million include net losses and LAE of $445.9 million, which is after reinsurance of $241.1 million, related to Hurricanes Katrina, Rita and Wilma, which occurred during the third and fourth quarters of 2005. In addition to the net losses and LAE, we assumed $9.9 million in net reinstatement premiums received, resulting in an underwriting loss of $436.0 million related to these three hurricanes. In addition, for the year ended December 31, 2005, we incurred losses of $25.6 million related to Windstorm Erwin. For the year ended December 31, 2006, the loss estimates for Hurricanes Katrina, Rita and Wilma were increased by $49.4 million (11.1% of 2005 estimate) attributable to unexpected loss emergence on marine and Florida proportional property accounts. This increase was partially
The U.S. Insurance division writes specialty insurance lines and classes of business, such as medical malpractice, professional liability and non-standard personal auto.
The consolidated financial statements and related notes included in Item 8 of this Form 10-K, have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) and include the accounts of Odyssey Re Holdings Corp. and its subsidiaries. For a discussion of our significant accounting policies, see Note 3 to our consolidated financial statements.
The following table displays, by division, the estimates included in our consolidated financial statements as of and for the years ended December 31, 2006, 2005 and 2004 related to gross premiums written, acquisition costs, premiums receivable and unearned premium reserves (in millions):
Management must make judgments about the ultimate premiums written and earned by us. Reported premiums written and earned are based upon reports received from ceding companies, supplemented by our internal estimates of premiums written for which ceding company reports have not been received. We establish our own estimates based on discussions and correspondence with our ceding companies and brokers during the contract negotiation process and over the contract risk period. The determination of premium estimates requires a review of our experience with the ceding companies, familiarity with each market, an analysis and understanding of the characteristics of each line of business and the ability to project the impact of current economic indicators on the volume of business written and ceded by our cedants. Premium estimates are updated when new information is received. Differences between such estimates and actual amounts are recorded in the period in which estimates are changed or the actual amounts are determined.
Our estimate of ultimate loss is determined based on a review of the results of several commonly accepted actuarial projection methodologies incorporating the quantitative and qualitative information described above. The specific methodologies we utilize in our loss reserve review process include, but may not be limited to (i) incurred and paid loss development methods, (ii) incurred and paid Bornhuetter Ferguson (“BF”) methods and (iii) loss ratio methods. The incurred and paid loss development methods utilize loss development patterns derived from historical loss emergence trends usually based on cedant supplied claim information to determine ultimate loss. These methods assume that the ratio of losses in one period to losses in an earlier period will remain constant in the future. Loss ratio methods multiply expected loss ratios, derived from aggregated analyses of internally developed pricing trends, by premium to determine ultimate loss. The incurred and paid BF methods are a blend of the loss development and loss ratio methods. These methods utilize both loss development patterns, as well as expected loss ratios, to determine ultimate loss. When using the BF methods, the initial treaty year ultimate loss is based predominantly on expected loss ratios. As loss experience matures, the estimate of ultimate loss using this methodology is based predominantly on loss development patterns. We generally do not utilize methodologies that are dependent on claim counts reported, claim counts settled or claim counts open. Due to the nature of our business, this information is not routinely provided by the ceding company for every treaty.
Consequently, actuarial methods utilizing this information generally cannot be relied upon by us in our loss reserve estimation process. As a result, for much or our business, the separate analysis of frequency and severity loss activity underlying overall loss emergence trends is not practical. Generally, we rely on BF and loss ratio methods for estimating ultimate loss liabilities for more recent treaty years. These methodologies, at least in part, apply a loss ratio, determined from aggregated analysis of internally developed pricing trends across reserve cells, to premium earned on that business. Adjustment to premium estimates generate appropriate adjustments to ultimate loss estimates in the quarter in which they occur using the BF and loss ratio methods. To estimate losses for more mature treaty years, we generally rely on the incurred loss development methodology, which does not rely on premium estimates. In addition, we may use other methods to estimate liabilities for specific types of claims. For property catastrophe losses, we may utilize vendor catastrophe models to estimate ultimate loss soon after a loss occurs, where loss information is not yet reported to us from cedants. The provision for asbestos loss liabilities is established based on an annual review of internal and external trends in reported loss and claim payments. IBNR is determined by subtracting the total of paid loss and case reserves including ACRs from ultimate loss.
We complete comprehensive reserve reviews, which include a reassessment of loss development and expected loss ratio assumptions, on an annual basis. The results of these reviews are reflected in the period they are completed. Quarterly, we compare actual loss emergence to expectations established by the comprehensive loss reserve review process. In the event that loss trends diverge from expected trends, we may have to adjust our reserves for losses and LAE accordingly. Any adjustments will be reflected in the periods in which they become known, potentially resulting in adverse effects to our financial results. We believe that the recorded estimates represent the best estimate of unpaid losses and LAE based on the information available at December 31, 2006.
The ultimate settlement value of loss and LAE related to business written in prior periods, for the years ended December 31, 2006, 2005, and 2004, exceeded our estimates of reserves for losses and LAE as previously established at December 31, 2005, 2004, and 2003 by 3.6%, 5.4%, and 8.0%, respectively. Any future impact to income of changes in losses and LAE estimates may vary considerably from historical experience. Our estimates of ultimate loss exposures are based upon the information we have available at any give point in time and our assumptions based upon that information. Every 1% point difference in the ultimate settlement value of loss exposures compared to our estimate of reserves for losses and loss adjustment expenses as of December 31, 2006 will impact pre-tax income by $44.0 million.
The Americas division reported net adverse loss development for prior years of $212.7 million, $213.2 million, and $184.8 million for the years ended December 31, 2006, 2005, and 2004, respectively. For the year ended December 31, 2006, the increase in prior year loss estimates includes a $43.0 million increase in loss estimates for property catastrophes, principally due to unexpected marine loss emergence on Hurricane Rita and the triggering of industry loss warranty contracts written by us for Hurricane Wilma due to unexpected deterioration in industry-wide Wilma loss estimates as well as unexpected loss emergence on Florida proportional property contracts in the period. In addition, asbestos loss estimates were increased by $27.1 million resulting from the annual review of these liabilities. The remaining net adverse loss development on prior years of $142.6 million is principally attributable to increased loss estimates due to loss emergence greater than expectations in 2006 on U.S. casualty business written in 2001 and prior. Partially offsetting this increase is a decline in loss estimates due to loss emergence less than expectations for United States casualty business in more recent years. For the year ended December 31, 2005, the increase in prior year loss estimates includes a $5.9 million increase in the loss estimates for prior period catastrophe losses due to greater than expected loss emergence on the 2004 Florida Hurricanes, and $41.2 million for increased asbestos loss estimates resulting from the annual review of these liabilities. The remaining net adverse loss development on prior years of $166.1 million is principally attributable to loss emergence greater than expectations in 2005 on U.S. casualty business written in 2001 and prior, partially offset by a decline in loss estimates for United States casualty business in more recent years due to loss emergence less than expectations in the period. For the year ended December 31, 2004, the increase in prior year loss estimates includes a $5.7 million increase in loss estimates for prior period catastrophe losses due to greater than expected loss emergence in 2004 on the Mexico floods which occurred in 2003, and $30.0 million for increased asbestos loss estimates resulting from the annual review of these liabilities.
The remaining net adverse loss development on prior years of $149.1 million is principally attributable to loss emergence greater than expectations in 2004 on U.S. casualty business written in 2001 and prior, partially offset by a decline in loss estimates for United States casualty business in more recent years due to emergence less than expectations in the period. The difficulty in anticipating the ultimate losses attributable to U.S. casualty business is due to calendar period emergence exceeding expectations that were established based on information available in prior years. This includes estimating the cost of known claims and, more importantly, estimating the cost of claims where no reports have yet been made. In addition, the ability to anticipate the ultimate value of losses is made difficult by the long period of time that elapses before an actual loss is known and determinable, particularly for professional liability lines where claims are often litigated to achieve settlement. In particular, competitive market conditions during the 1997 to 2001 period have resulted in unexpectedly prolonged emergence patterns as a result of: (i) an increasing level of deductibles, (ii) expanded coverage, (iii) expanded policy terms and (iv) a proliferation of corporate improprieties and bankruptcies. Losses attributable to general liability and excess workers’ compensation classes of business during the 1997 to 2001 period have also demonstrated a higher incidence of severity due to relatively broad coverage available under policy forms used during these periods. These factors have adversely impacted our ability to estimate losses and LAE in subsequent periods attributable to business written during this period.
The EuroAsia division reported net favorable loss development for prior years of $9.0 million and $8.7 million for the years ended December 31, 2006 and 2005, respectively, and net adverse loss development of $6.6 million for the year ended December 31, 2004. For the year ended December 31, 2006, the reduction in prior year loss estimates is driven by favorable emergence on prior period catastrophe losses, marine and credit lines of business in the period. For the year ended December 31, 2005, the reduction in prior year loss estimates is principally attributable to favorable loss emergence on liability and bond exposures, partially offset by adverse development on prior year catastrophes of $7.4 million predominantly attributable to unexpected claim emergence in the period on Typhoon Songda and the Indonesian earthquake and resulting tsunami. For the year ended December 31, 2004, the increase in prior year loss estimates is principally related to emergence exceeding our expectations on bond exposures in 2004.
The London Market division reported net favorable development for prior years of $24.8 million, $22.8 million, and $0.2 million for the years ended December 31, 2006, 2005, and 2004, respectively. For the year ended December 31, 2006, the reduction in prior year loss estimates is principally related to favorable loss emergence on satellite, accident and health, non-catastrophe property, and aviation exposures, partially offset by $3.6 million of net adverse loss development on prior period catastrophe losses in 2006. For the year ended December 31, 2005, the reduction in prior year loss estimates is principally due to favorable emergence on aviation, satellite and non-catastrophe property exposures, partially offset by $1.7 million of net adverse loss development on prior period catastrophe losses in the period.
Provision for IBNR in unpaid losses and LAE at December 31, 2006 is $2,274.6 million. For illustration purposes, a change in the expected loss ratio expectations for recent treaty years that increases the year ended December 31, 2006 calendar year loss ratio by 2.5 loss ratio points would increase IBNR by $55.6 million. A change in loss emergence trends that increases unpaid losses and LAE at December 31, 2006 by 2.5% would increase IBNR by $110.1 million.
Several additional factors have emerged in recent years regarding asbestos exposure that further compound the difficulty in estimating ultimate losses for this exposure. These factors include: (i) continued growth in the number of claims filed due to an increasingly aggressive plaintiffs’ bar; (ii) an increase in claims involving defendants formerly regarded as peripheral; (iii) growth in the use of bankruptcy filings by companies as a result of asbestos liabilities, which companies in some cases attempt to resolve asbestos liabilities in a manner that is prejudicial to insurers; (iv) concentration of claims in states with laws or jury pools particularly favorable to plaintiffs; and (v) the potential that states or the federal government may enact legislation on asbestos litigation reform.
We believe that these uncertainties and factors make projections of these exposures, particularly asbestos, subject to less predictability relative to non-environmental and non-asbestos exposures. Current estimates, as of December 31, 2006, of our asbestos and environmental losses and LAE, net of reinsurance, are $189.0 million and $26.7 million, respectively. See Note 10 to the consolidated financial statements for additional historical information on losses and LAE reserves for these exposures.
December 31, 2005. Based on our annual reserve study, we decreased environmental net loss reserves by $2.2 million based on the observed trends in our internal loss data.
The following table provides historical gross asbestos and environmental outstanding claim information for the years ended December 31, 2006 and 2005 (in millions):
over the estimated remaining settlement period of the underlying claims. As of December 31, 2005, we have utilized the full limit of $175.0 million under the 1995 Stop Loss Agreement. We ceded losses of $17.5 million to the 1995 Stop Loss Agreement for the years ended December 2005 and 2004, resulting in income of $11.3 million ($7.3 million after tax) and $8.7 million ($5.7 million after tax) for the years ended December 31, 2005 and 2004, respectively. There were no cessions to this agreement in 2006. We received $78.0 million in cash from nSpire Re on March 29, 2006, which reduced the outstanding recoverable. As the $78.0 million was received in advance of the payment of the underlying claims by us, it is included as an adjustment to net unpaid losses and loss adjustment expenses, which increased by $78.0 million. In connection with the receipt of this cash, for the three months ended March 31, 2006, we have recognized $19.3 million ($12.5 million after tax) of the cumulative deferred gain, an increase of $17.9 million ($11.7 million after tax) over the anticipated deferred gain amortization, as a reduction in losses and loss adjustment expenses. During the three months ended June 30, 2006, we amortized an additional $1.1 million of the deferred gain.
We have the ability to cede losses that are attributable to the covered periods to these agreements in any future period, to the extent there is remaining coverage, even in cases where the losses emerge in periods long after the period when the business was written. We have the ability to cede losses to multiple agreements in a calendar period, to the extent that the losses pertain to coverage periods with remaining limits. Our ability to cede losses in any given calendar year that are attributable to prior periods will depend on the nature of the risk which generated the loss, the time period from which the losses originate and whether there are limits remaining covering the subject period. Losses attributable to prior periods are ceded to the treaties and recorded in the period in which they are ceded. Additional premiums are generally due under an agreement if additional losses are ceded to the agreement, subject to a maximum amount. Additional premiums, if any, are determined and recorded in the period when losses are ceded. When additional premiums are due, the interest on the funds attributable to the additional premiums ceded is typically calculated based on the inception period of the contract and the cumulative interest expense is recognized in the period when additional premiums are due.
outstanding commissions receivable. During the second quarter of 2006, the commutation of these contracts decreased our paid and unpaid reinsurance recoverables as of December 31, 2005 by $71.0 million. This commutation covered all outstanding Whole Account Excess of Loss Agreements applicable to underwriting and accident years 1999 and prior as well as the reinsurer’s participation on underwriting years 2000 and 2001.
The following table shows the amount of loss and LAE attributable to each coverage period ceded to the Whole Account Excess of Loss Agreements for the years ended December 31, 2006, 2005 and 2004 (in millions):
The maximum coverage available under the Whole Account Excess of Loss Agreements is based on a proportion of net premiums earned during each of the coverage periods, subject to a predetermined aggregate limit. The maximum coverage available will increase or decrease as premium adjustments applicable to a particular coverage period, if any, are recognized. The attachment point represents the aggregate amount of losses, and in certain cases, acquisition costs, expressed as a proportion of net premiums earned, that will be retained by us. Losses attributable to business written during a particular period in excess of the attachment point, subject to a maximum limit, are ceded to the reinsurer. The following table provides a summary of the significant terms of the Whole Account Excess of Loss Agreements that were in effect as of December 31, 2006 (in millions).
The following table provides a summary of the cumulative experience, including the income (loss) before income taxes, under each agreement since its inception. Several of these agreements were purchased by predecessor companies prior to the period in which they were included in our consolidated financial statements. As a result, amounts recorded in our consolidated statement of operations include only the amounts ceded subsequent to the date in which the covered company was included in our consolidated financial statements (in millions).
The Whole Account Excess of Loss Agreements provide that we may withhold a significant portion of the premium payable to the retrocessionaires in funds held accounts, which, under certain circumstances, may be set-off against the retrocessionaires’ losses and other obligations owed to us. These funds are shown as a liability in our consolidated balance sheets as funds held under reinsurance contracts. Interest on the funds held account, calculated using a contractual fixed interest rate of approximately 7.0% for those agreements with amounts ceded, is credited quarterly by us, which results in an increase in the funds held account balance and is recorded as an
expense, reducing our investment income. Loss payments are deducted from the funds held account balance, which reduces the liability as such payments are made.
We record deferred income taxes as net assets or liabilities on our consolidated balance sheets to reflect the net tax effect of the temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and their respective tax bases. As of December 31, 2006 and 2005, a net deferred tax asset of $185.0 million and $138.8 million, respectively, was recorded. In recording this deferred tax asset, we have made estimates and judgments that future taxable income will be sufficient to realize the value of the net deferred tax asset. Accordingly, deferred tax assets have not been reduced by a valuation allowance, as management believes it is more likely than not that the deferred tax assets will be realized.
In assessing the value of our debt and equity securities held as investments, and possible impairments of such securities, we review (i) the issuer’s current financial position and disclosures related thereto, (ii) general and specific market and industry developments, (iii) the timely payment by the issuer of its principal, interest and other obligations, (iv) the outlook and expected financial performance of the issuer, (v) current and historical valuation parameters for the issuer and similar companies, (vi) relevant forecasts, analyses and recommendations by research analysts, rating agencies and investment advisors, and (vii) other information we may consider relevant. In addition, we consider our ability and intent to hold the security to recovery when evaluating possible impairments. Risks and uncertainties are inherent in our other-than-temporary decline in value assessment methodology.
Risks and uncertainties include, but are not limited to, incorrect or overly optimistic assumptions about financial condition or liquidity, incorrect or overly optimistic assumptions about future prospects, inadequacy of any underlying collateral, unfavorable changes in economic or social conditions and unfavorable changes in interest rates.
Gross Premiums Written. Gross premiums written for the year ended December 31, 2006 decreased by $291.2 million, or 11.1%, to $2,335.7 million compared to $2,626.9 million for the year ended December 31, 2005, as reflected in the following table (in millions):
Newline - Gross premiums written of $202.5 million for the year ended December 31, 2006 decreased $39.8 million, or 16.4%, compared to $242.3 million for the year ended December 31, 2005. The decline in gross premiums written is primarily related to financial lines, in particular liability and professional indemnity, as well as the effects of currency movements during the year. This decrease reflects the more competitive market conditions where we are experiencing lower prices in certain classes or choosing to non-renew business that does not meet our underwriting criteria.
Professional liability gross premiums written increased $16.8 million, or 14.7%, to $131.0 million for the year ended December 31, 2006, from $114.2 million for the year ended December 31, 2005. This primarily resulted from expansion in the environmental specialists and architects and engineers classes of business.
Ceded Premiums Written. Ceded premiums written for the year ended December 31, 2006 decreased by $150.5 million, or 46.3%, to $174.8 million (7.5% of gross premiums written) from $325.3 million (12.4% of gross premiums written) for the year ended December 31, 2005. These amounts include reinstatement premiums paid of $2.9 million and $65.7 million for the years ended December 31, 2006 and 2005, respectively. Excluding
reinstatement premiums in each period, ceded premiums written were $171.9 million for the year ended December 31, 2006 a decrease of $87.7 million, or 33.8%, as compared to $259.6 million for the year ended December 31, 2005.
Excluding the effect of reinstatement premiums in both 2006 and 2005, ceded premiums written decreased in all divisions. Decreases in the Americas division of $16.2 million, EuroAsia division of $10.5 million and London Market division of $11.4 million is the result of a decrease in retrocessional business purchased in 2006. The decrease in the U.S. Insurance division of $49.6 million is due to this division increasing its retentions on all classes of business and purchasing more excess of loss reinsurance compared to quota share reinsurance.
The decrease in losses and LAE was principally related to a decline in current year catastrophe events of $503.0 million, ($34.9 million for the year ended December 31, 2006 compared to $537.9 million for the year ended December 31, 2005), and a decline in net adverse loss development on prior years of $32.8 million ($139.9 million for the year ended December 31, 2006 compared to $172.7 for the year ended December 31, 2005). Losses and LAE for the year ended December 31, 2006 include net adverse loss development of $139.9 million attributable to 2005 and prior years, which reflects $42.6 million for prior year catastrophe events, principally due to an increase in loss estimates on marine business for Hurricane Rita and the triggering of industry loss warranty contracts for Hurricane Wilma due to an unexpected deterioration in industry-wide Wilma loss estimates as well as unexpected loss emergence on Florida proportional accounts in the period. In addition, asbestos loss estimates were increased by $27.1 million resulting from the annual review of these liabilities. The remaining net adverse loss development of $70.2 million is principally attributable to loss emergence greater than expectations in 2006 on U.S. casualty classes of business. For the year ended December 31, 2005, current year
catastrophe events of $537.9 million include $445.9 million related to Hurricanes Katrina, Rita, and Wilma, and $25.6 million related to Windstorm Erwin. Losses and LAE incurred during the year ended December 31, 2005 include net adverse loss development of $172.7 million attributable to 2004 and prior years, which includes $15.0 million for prior year catastrophe events due principally to greater than expected emergence on the 2004 Florida Hurricanes in the period and $41.2 million for increased asbestos loss estimates resulting from the annual review of these liabilities. The remaining net adverse loss development of $116.5 million is principally attributable to loss emergence greater than expectations in 2005 on U.S. casualty classes of business.
Ceded losses and LAE incurred for the year ended December 31, 2006 decreased by $315.3 million, or 68.2%, to $147.2 million, from $462.5 million for the year ended December 31, 2005. This decrease is principally attributable to a decrease of $281.6 million in property catastrophe cessions due to the decline in current year catastrophe events and a $46.8 million decrease in ceded losses related to our U.S. insurance operations ($55.6 million for the year ended December 31, 2006 compared to $102.4 million for the year ended December 31, 2005) due to increased retentions. Cessions to the Whole Account Excess of Loss Agreements for the years ended December 31, 2006 and 2005 were $9.7 million and $16.5 million, respectively. As of December 31, 2006, the aggregate limits on the Whole Account Excess of Loss Agreements have been fully utilized.
The following tables reflect total losses and LAE as reported for each division and include the impact of catastrophe losses and prior period reserve development, expressed as a percentage of net premiums earned (“NPE”), for the years ended December 31, 2006 and 2005 (in millions):
Americas Division - Losses and LAE decreased $420.4 million, or 35.4%, to $765.8 million for the year ended December 31, 2006, from $1,186.2 million for the year ended December 31, 2005. This resulted in a loss and LAE ratio of 78.5% for the year ended December 31, 2006, compared to 112.8% for the year ended December 31, 2005. The decrease in losses and LAE was principally due to a decrease in current year catastrophes of $335.6 million and a decline in net earned premium of $76.1 million, or 7.2%. Losses and LAE for the year ended December 31, 2006 include net adverse loss development of $212.7 million attributable to 2005 and prior years, which reflect $43.0 million from prior period catastrophe losses, principally Hurricanes Rita and Wilma, due to loss emergence greater than expected in the period. In addition, asbestos loss estimates were increased by $27.1 million resulting from the annual review of these liabilities. The remaining net adverse loss development of $142.6 million is principally attributable to loss emergence greater than expectations in 2006 on U.S. casualty classes of business. Losses and LAE for the year ended December 31, 2005 include net adverse loss development of $213.2 million attributable to 2004 and prior years, which reflect $5.9 million on prior period catastrophes principally due to loss emergence greater than expected in the period on the 2004 Florida Hurricanes and $41.2 million for increased asbestos loss estimates resulting from the annual review of these liabilities. The remaining net adverse loss development of $166.1 million is principally attributable to loss emergence greater than expectations in 2005 on U.S. casualty classes of business.
EuroAsia Division - Losses and LAE decreased $5.6 million, or 1.7%, to $320.4 million for the year ended December 31, 2006, from $326.0 million for the year ended December 31, 2005. This resulted in a loss and LAE ratio of 60.3% for the year ended December 31, 2006, compared to 63.2% for the year ended December 31, 2005. This decrease is principally due to a reduction in current year catastrophe losses of $29.9 million, partially offset by an increase in net premiums earned of $15.2 million, or 2.9%. Losses and LAE for the year ended December 31, 2006 include a benefit of $9.0 million attributable to 2005 and prior years, principally due to favorable emergence on property, marine and credit lines of business in the period. Losses & LAE in the year ended December 31, 2005 include a decrease of $8.7 million attributable to 2004 and prior years, principally related to favorable emergence on liability and bond exposures in the period, and includes adverse loss development on prior period catastrophes of $7.4 million predominantly attributable to Typhoon Songda and the Indonesian earthquake and resulting tsunami.
London Market Division - Losses and LAE decreased $166.3 million, or 47.7%, to $182.5 million for the year ended December 31, 2006, from $348.8 million for the year ended December 31, 2005. This resulted in a loss and LAE ratio of 54.7% for the year ended December 31, 2006, compared to 90.3% for the year ended December 31, 2005. The decrease in losses and LAE was principally related to a decrease in current year catastrophes of $137.1 million and a decline in net premiums earned of $52.6 million, or 13.6%. Losses and LAE
U.S. Insurance Division - Losses and LAE increased $14.9 million, or 7.4%, to $215.5 million for the year ended December 31, 2006, from $200.6 million for the year ended December 31, 2005. This resulted in a loss and LAE ratio of 55.8% for the year ended December 31, 2006, compared to 62.0% for the year ended December 31, 2005. The increase in losses and LAE was related to a 19.3% increase in net premiums earned and was partially offset by a decrease of $39.0 million on losses and LAE attributable to 2005 and prior years, principally due to favorable loss emergence on medical malpractice in the period. For the year ended December 31, 2005, losses and LAE related to 2004 and prior years decreased by $9.0 million, principally due to loss emergence less than expectations in 2005 on medical malpractice and general liability exposures.
Acquisition Costs. Acquisition costs for the year ended December 31, 2006 were $464.1 million, a decrease of $6.1 million or 1.3%, compared to $470.2 million for the year ended December 31, 2005. The resulting acquisition expense ratio, expressed as a percentage of net premiums earned, was 20.9% for the year ended December 31, 2006, compared to 20.6% for the year ended December 31, 2005, an increase of 0.3 points. The London Market and U.S. Insurance divisions’ acquisition ratio increased by 2.1 points and 1.5 points respectively, due to the change in composition of the mix of business written and increased retentions, while the Americas and EuroAsia divisions had a slight decrease of 0.6 points and 0.1 points, respectively.
Net Investment Income. Net investment income for the year ended December 31, 2006 increased by $267.0 million, or 121.3%, to $487.1 million, from $220.1 million for the year ended December 31, 2005. Net investment income is comprised of gross investment income of $517.4 million less investment expenses of $30.3 million for the year ended December 31, 2006, compared to gross investment income of $247.8 million less investment expenses of $27.7 million for the year ended December 31, 2005. Higher net investment income for the year ended December 31, 2006 is primarily attributable to the following:
an increase of $970.7 million or 17.5% in average invested assets for the year ended December 31, 2006 over 2005, and higher short term rates over the period. Investment income from cash and short-term investments was $122.5 million for the year ended December 31, 2006, an increase of $68.0 million, or 124.6%, over 2005.
an increase of $135.7 million for the year ended December 31, 2006 over 2005 related to HWIC Asia, an investment vehicle which is included in common stock, at equity. Net investment income on equity securities includes, in accordance with the equity method of accounting, realized investment gains attributable to our equity investment in HWIC Asia. During 2006, we fully redeemed our interest in HWIC Asia. Our equity in the net income of HWIC Asia Fund is comprised of the following items (in millions):
tion of restricted share grants. The decrease of $5.9 million for the year ended December 31, 2006 over 2005 is primarily comprised of: (i) a decrease of $5.7 million related to consulting fees in implementing procedures and documentation for Sarbanes-Oxley, (ii) a decrease of $1.0 million related to the renewal of the employment contract of our Chief Executive Officer, which is reflected in 2005, offset by, (iii) an increase of $1.4 million as a result of higher amortization expense of restricted stock.
Preferred Dividends. We recorded preferred dividends related to our Series A and Series B non-cumulative perpetual preferred shares of $8.3 million and $1.9 million for the years ended December 31, 2006 and 2005, respectively. The increase is due to the payment of a full year of preferred dividends in 2006, as opposed to two and a half months in 2005, as the preferred shares were first issued in October 2005.
Gross premiums written include reinstatement premiums of $70.4 million and $16.8 million for the years ended December 31, 2005 and 2004, respectively. Reinstatement premiums were primarily related to reinstating the coverage under property catastrophe excess of loss reinsurance contracts following Hurricanes Katrina, Rita and Wilma in 2005 and the 2004 Florida Hurricanes. The higher level of reinstatement premiums in 2005 as compared to 2004 was attributable to the significant number of full limit losses resulting from Hurricanes Katrina, Rita and Wilma in 2005. Excluding reinstatement premiums in each period, gross premiums written would be $2,556.5 million and $2,634.0 million for the years ended December 31, 2005 and 2004, respectively, representing a decrease of $77.5 million, or 2.9%.
United States - Gross premiums written of $929.9 million for the year ended December 31, 2005 decreased $117.9 million, or 11.3%, compared to $1,047.8 million for the year ended December 31, 2004. The decrease in the United States is primarily attributable to the non-renewal of a large workers compensation quota share treaty, which accounted for a decrease in gross premiums written of $93.2 million in 2005. Gross premiums written across casualty classes of business decreased by $64.9 million, or 13.0%, as compared to 2004, due to more competitive market conditions, particularly in professional liability classes and non standard auto. This decrease is partially offset by increased gross premiums written relating to higher reinstatement premiums of $28.0 for the year ended December 31, 2005, compared to $3.2 million for 2004, which contributed to the overall increase in property gross premiums written of $41.3 million over the period.
$11.8 million (all related to the London branch) for the years ended December 31, 2005 and 2004, respectively, which principally relate to Hurricanes Katrina, Rita and Wilma in 2005, and the 2004 Florida Hurricanes. Excluding reinstatement premiums in each period, gross premiums written would be $398.4 million and $435.9 million for the years ended December 31, 2005 and 2004, respectively, representing a decrease of $37.5 million, or 8.6% over the period. Gross premiums written across each unit of the London Market division are as follows:
Professional liability gross premiums written increased $49.1 million, or 75.5%, for the year ended December 31, 2005 to $114.2 million for the year ended December 31, 2005 from 2004. This primarily resulted from expansion in the environmental specialists and architects and engineers classes of business.
Our personal auto business, which primarily includes non-standard auto business written in California and Florida, increased $10.9 million, or 11.8%, to $103.6 million for the year ended December 31, 2005 from 2004 due to the full year effect of a program administrator which was added in April 2004.
Ceded Premiums Written. Ceded premiums written for the year ended December 31, 2005 increased by $36.3 million, or 12.6%, to $325.3 million (12.4% of gross premiums written) from $289.0 million (10.9% of gross premiums written) for the year ended December 31, 2004. These amounts include reinstatement premiums paid of $65.7 million and $20.8 million for the years ended December 31, 2005 and 2004, respectively. Ceded premiums written for the year ended December 31, 2004 included $12.0 million related to First Capital. Excluding First Capital and reinstatement premiums in each period, ceded premiums written were $259.6 million
for the year ended December 31, 2005 an increase of $3.4 million, or 1.3%, as compared to $256.2 million for the year ended December 31, 2004.
Net Premiums Earned. Net premiums earned for the year ended December 31, 2005 decreased by $56.7 million, or 2.4%, to $2,276.8 million, from $2,333.5 million for the year ended December 31, 2004. Net premiums earned decreased in the Americas division by $178.9 million, or 14.5%, and in the London Market division by $36.7 million, or 8.7%, offset by increases in the EuroAsia division of $33.8 million, or 7.0%, and in the U.S. Insurance division of $125.0 million, or 63.0%. Included in net premiums earned are $4.7 million of net reinstatement premiums received for the year ended December 31, 2005 and $4.0 million in net reinstatement premiums paid in 2004, related to catastrophes. Excluding reinstatement premiums, net premiums earned decreased by $65.4 million, or 2.8%, for the year ended December 31, 2005 over 2004, which is consistent with the decrease in gross and net premiums written.
Losses and Loss Adjustment Expenses. Losses and LAE increased $430.5 million, or 26.4%, to $2,061.6 million for the year ended December 31, 2005, from $1,631.1 million for the year ended December 31, 2004 as follows (in millions):
The increase in losses and LAE was principally related to losses of $537.9 million related to current year catastrophe events, of which $445.9 million is attributable to Hurricanes Katrina, Rita and Wilma. The remaining catastrophe losses are principally related to other events occurring in the year, including Hurricanes Emily, Dennis and Stanley, Windstorm Erwin and floods in India and Europe. Losses and LAE in 2005 include net adverse loss development of $172.7 million attributable to 2004 and prior years, of which $15.0 million is related to prior year catastrophe events, principally the 2004 Florida Hurricanes, Typhoon Songda and the Indonesian earthquake and resulting tsunami, due to loss emergence greater than expectations in the period. In addition, asbestos loss estimates were increased by $41.2 million resulting from the annual review of these liabilities. The remaining net adverse loss
Ceded losses and LAE for the year ended December 31, 2005 increased by $139.6 million, or 43.2%, to $462.5 million, from $322.9 million for the year ended December 31, 2004. The increase in ceded incurred losses and LAE primarily relates to increases in cessions to our catastrophe program reinsurance recoverables of $241.1 million relating to Hurricanes Katrina, Rita and Wilma. Cessions to the Whole Account Excess of Loss Agreements for the years ending December 31, 2005 and 2004 are $16.5 million and $5.1 million, respectively. As of December 31, 2005, the 1994, 1998, 2000 and 2001 Whole Account Excess of Loss Agreements have remaining aggregate limits of $62.7 million, $9.6 million, $0.9 million and $85.4 million, respectively.
The following tables reflect total losses and LAE as reported for each division and include the impact of catastrophe losses and prior period reserve development, expressed as a percentage of net premiums earned (“NPE”), for the years ended December 31, 2005 and 2004 (in millions):
Americas Division - Losses and LAE increased $278.6 million, or 30.7%, to $1,186.2 million for the year ended December 31, 2005, from $907.6 million for the year ended December 31, 2004. This resulted in a loss and LAE ratio of 112.8% for the year ended December 31, 2005, compared to 73.8% for the year ended December 31, 2004. The increase in losses and LAE was due to losses of $354.2 million related to catastrophe events, of which $313.1 million is attributable to Hurricanes Katrina, Rita and Wilma, with the remainder principally related to other events occurring in 2005, including Hurricanes Emily and Dennis. Losses and LAE in the 2005 period include net adverse loss development of $213.2 million attributable to 2004 and prior years, of which $41.2 million is related to increased asbestos loss estimates resulting from the annual review of these liabilities, and $5.9 million is related to prior year catastrophe events due to loss emergence greater than expectations in the period principally attributable to the 2004 Florida Hurricanes. The remaining net adverse loss development of $166.1 million is principally attributable to loss emergence greater than expectations in 2005 on U.S. casualty classes of business. For the year ended December 31, 2004, losses and LAE reflect $100.3 million for property catastrophe events including the 2004 Florida Hurricanes. Losses and LAE in the 2004 period include net adverse loss development of $184.8 million attributable to 2003 and prior years, of which $30.0 million is related to increased asbestos loss estimates resulting from the annual review of these liabilities, and $5.7 million is related to prior year catastrophe events due to loss emergence greater than expectations in the period. The remaining net adverse development of $149.1 million is principally attributable to loss emergence greater than expectations in 2004 on U.S. casualty classes of business, partially offset by a $21.1 million reduction in environmental pollution estimates due to better than expected emergence in the period.
London Market Division - Losses and LAE increased by $55.2 million, or 18.8%, to $348.8 million for the year ended December 31, 2005 from $293.6 million for the year ended December 31, 2004. This resulted in a loss and LAE ratio of 90.3% for the year ended December 31, 2005, compared to 69.4% for the year ended
U.S. Insurance Division - Losses and LAE increased by $70.5 million, or 54.2%, to $200.6 million for the year ended December 31, 2005, from $130.1 million for the year ended December 31, 2004. This resulted in a loss and LAE ratio of 62.0% for the year ended December 31, 2005, compared to 65.6% for the year ended December 31, 2004. The increase in losses and LAE was related to the 63.0% increase in net premiums earned, losses of $0.4 million related to Hurricane Katrina and favorable loss development of $9.0 million on losses and LAE attributable to 2004 and prior years due to favorable loss emergence on medical malpractice and general liability exposures in the period. For the year ended December 31, 2004, losses and LAE related to 2003 and prior years include favorable loss development of $1.2 million due to favorable loss emergence on private passenger automobile liability in 2004.
The property and casualty reinsurance and insurance industry uses the combined ratio as a measure of underwriting profitability. The GAAP combined ratio is the sum of losses and LAE as a percentage of net premiums earned, plus underwriting expenses, which include acquisition costs and other underwriting expenses, as a percentage of net premiums earned. The combined ratio reflects only underwriting results, and does not include investment results. Underwriting profitability is subject to significant fluctuations due to catastrophic events, competition, economic and social conditions, foreign currency fluctuations and other factors. Our combined ratio was 117.6% for the year ended December 31, 2005, compared to 97.2% for the year ended December 31, 2004. The following table reflects the combined ratio for the years ended December 31, 2005 and 2004 for each of our divisions:
Net Investment Income. Net investment income for the year ended December 31, 2005 increased by $55.9 million, or 34.0%, to $220.1 million, from $164.2 million for the year ended December 31, 2004 driven by an $845.6 million or 16.5% increase in total investments and cash over the period. Net investment income is comprised of gross investment income of $247.8 million less investment expenses of $27.7 million for the year ended December 31, 2005, compared to gross investment income of $194.8 million less investment expenses of $30.6 million for the year ended December 31, 2004. Higher net investment income for the year ended December 31, 2005 is primarily attributable to the following:
realized investment gains attributable to our equity investment in HWIC Asia. Our equity in the net income of HWIC Asia is comprised of the following items (in millions):
Excluding the positive impact of realized capital gains attributable to our equity investment in HWIC Asia and the negative impact of the 2005 loss attributable to Advent, net investment income for the year ended December 31, 2005 was $207.6 million, an increase of $47.9 million or 30.0%, from $159.7 million for the year ended December 31, 2004. We believe this figure is more representative of investment income from our ongoing investment activities.
Interest expense on funds held, which is included in investment expenses, and primarily relates to our Whole Account and Facultative Excess of Loss Agreements, was $18.7 million for the year ended December 31, 2005, representing a decrease of $1.4 million, or 7.0%, from $20.1 million for the year ended December 31, 2004. The lower amount of interest expense was due to reduced amounts ceded to the treaties in 2004, which resulted in lower interest expense associated with ceded amounts during the period.
During the year ended December 31, 2005, net realized investment gains were reduced by other-than-temporary impairment losses in the amount of $54.9 million, with $37.3 million relating to fixed income securities and other invested assets and $17.6 million relating to equity securities. Other-than temporary impairments reflect situations where the market value was below the cost of the securities and the ability of the security to recover its value could not be reasonably determined. Other-than temporary impairments also include $19.4 million for securities which have no quoted prices, to reflect the deterioration in the underlying financial position of the securities. There were no other-than-temporary impairment losses during the year ended December 31, 2004.
Interest Expense. We incurred interest expense, related to our debt obligations, of $30.0 million and $25.6 million for the years ended December 31, 2005 and 2004, respectively. The higher amount of interest expense primarily reflects our $125.0 million senior notes offering completed in May 2005.
Federal and Foreign Income Tax Benefit/ Provision. As a result of our loss for the year ended December 31, 2005, our federal and foreign income tax provision for the year ended December 31, 2005 decreased by $170.2 million, to a benefit of $66.1 million, compared to a provision of $104.1 million for the year ended December 31, 2004. Our effective tax rates were 36.4% and 33.7% for the years ended December 31, 2005 and 2004, respectively.
On February 22, 2006, we issued $100.0 million aggregate principal amount of floating rate senior debentures, pursuant to a private placement. The net proceeds from the offering, after fees and expenses, were $99.3 million. Use of proceeds was for general corporate purposes, including a capital contribution to Odyssey America. The debentures were sold in two tranches, $50.0 million of Series A due March 15, 2021, and $50.0 million of Series B due March 15, 2016. Interest on each series of debentures is due quarterly on March 15, June 15, September 15 and December 15. The interest rate on each series of debentures is equal to the three-month LIBOR, which is calculated on a quarterly basis, plus 2.20%. The interest rate from February 22, 2006 through March 16, 2006 on each series of debentures was 6.97% per annum. Pursuant to the terms of the indentures, as a result of the delay in filing our 2005 Annual Report on Form 10-K, the annual interest rate on each series of debentures was increased, as of March 17, 2006, to the three-month LIBOR as of March 15, 2006 plus 3.20%, which equaled 8.12%. This interest rate remained in effect until the filing of our Annual Report on Form 10-K on March 31, 2006, after which it reverted to 6.97% through June 14, 2006. As of December 31, 2006, the current annual interest rate on each series of debentures is 7.56%. The Series A debentures are callable by us in 2011 at their par value, plus accrued and unpaid interest, and the Series B debentures are callable by us in 2009 at their par value, plus accrued and unpaid interest.
During the second quarter of 2005, we issued $125.0 million aggregate principal amount of senior notes due May 1, 2015. The issue was sold at a discount of $0.8 million, which is being amortized over the life of the notes. Interest accrues on the senior notes at a fixed rate of 6.875% per annum which is due semi-annually on May 1 and November 1. These senior notes are reflected on our December 31, 2006 consolidated balance sheet at a value of $124.3 million.
Please see Note 13 to our consolidated financial statements included in this Form 10-K for complete disclosure of our debt obligations, common shares and preferred shares.
Odyssey America’s liquidity requirements are principally met by cash flows from operating activities, which principally result from collections of premiums, reinsurance recoverables and investment income, net of paid losses, acquisition costs and underwriting and investment expenses. We seek to maintain sufficient liquidity to satisfy the timing of projected claim payments and operating expenses. The estimate, timing and ultimate amount of actual claim payments is inherently uncertain and will vary based on many factors including the frequency and severity of losses across various lines of business. Claim payments can accelerate due to a variety of factors, including losses stemming from catastrophic events, which are typically paid out in a short period of time, legal settlements or emerging claim issues. We estimate claim payments, net of associated reinsurance recoveries, of approximately $1.3 billion during 2007. The timing and certainty of associated reinsurance collections which may be due to us can add uncertainty to our liquidity position to the extent amounts are not received on a timely basis. As of December 31, 2006, our operating subsidiaries maintained cash and cash equivalents of $2.0 billion, which is readily available for expected claim payments. In addition, our liquidity is enhanced through the collection of premiums on new business written through the year. We believe our cash resources, together with readily marketable securities, are sufficient to satisfy expected payment obligations, including any unexpected acceleration in claim payments or timing differences in collecting reinsurance recoverables.
Cash provided by operations was $752.3 million for the year ended December 31, 2006, compared to $395.7 million for the year ended December 31, 2005.
Total investments and cash amounted to $7.1 billion as of December 31, 2006, an increase of $1.1 billion compared to December 31, 2005. Our average invested assets were $6.5 billion for the year ended December 31, 2006, as compared to $5.5 billion for the year ended December 31, 2005. It is anticipated that our cash and cash equivalents will continue to be reinvested on a basis consistent with our long-term, value oriented investment philosophy. Cash and short-term investments, excluding our cash collateral for borrowed securities, represented 32.6% and 28.9%, respectively, of our total investments and cash as of December 31, 2006 and December 31, 2005. Total fixed income securities were $3.5 billion as of December 31, 2006. The fixed income securities portfolio has a weighted average security rating of “AA” as measured by Standard and Poor’s. The duration of our investment portfolio, including cash and cash equivalents, was 4.7 years, which exceeds the duration of our liabilities. We believe this difference is mitigated by the significant amount of cash and cash equivalents maintained within our portfolio.
During the second quarter of 2004, Odyssey America pledged U.S. Treasury Notes with a par value of $162.0 million (“the pledged assets”), or approximately £110.0 million equivalent, to the Society and Council of Lloyd’s on behalf of Advent Capital (Holdings) PLC (“Advent”) to support Advent’s underwriting activities for the 2001 to 2005 underwriting years of account. Advent is 44.5% owned by Fairfax and its affiliates, which includes 8.1% held by us. nSpire Re Limited (“nSpire Re”), a subsidiary of Fairfax, had previously pledged assets at Lloyd’s on behalf of Advent pursuant to a November 2000 agreement with Advent. Advent is responsible for the payment of any losses to support its underwriting activities and the capital resources of Advent, including its newly deposited funds at Lloyd’s, are first available to support any losses prior to a draw down of Odyssey America’s pledged assets. In consideration of Odyssey America pledging the assets, nSpire Re agreed to pay Odyssey America a fee equal to 2.0% per annum of the pledged assets, which we consider to be representative of commercial market terms. The pledged assets continue to be owned by Odyssey America, and Odyssey America receives any investment income thereon. The securities are carried at fair value and are included in investments and cash in our consolidated balance sheets. Interest earned on the securities is included in investment income. As additional consideration for, and further protection of, the pledged assets, nSpire Re has provided Odyssey America with indemnification in the event of a draw down on the pledged assets. Odyssey America retains the right to withdraw the pledged assets at any time upon 180 days advance written notice to nSpire Re. nSpire Re retains the obligation to pledge assets on behalf of Advent. In any event, the placement of funds at Lloyd’s will automatically terminate effective no later than December 31, 2008 and any remaining pledged assets will revert to Odyssey America at that time. The pledge of assets is not considered material to our liquidity and capital resources. In January 2006, Odyssey America received assets with a par value of $48.6 million, representing a permanent reduction and unconditional release of such amount, prior to the stated termination date, following the deposit by Advent of £38.0 million in new funds at Lloyd’s. In September 2006, Odyssey America received assets with a par value of $10.7 million, representing a permanent reduction and unconditional release of such amount, prior to the stated termination date, following the deposit by Advent of such amount in new funds at Lloyd’s. Following these returns of assets, and as of December 31, 2006, Odyssey America continues to have a par value of $102.7 million, or approximately £52.5 million equivalent, pledged to Lloyd’s in support of Advent and will continue to receive a fee for these pledged assets. The fair market value of the pledged assets is $128.2 million, or approximately £65.5 million equivalent. We believe that the financial resources of Advent provide adequate protection to support its liabilities in the ordinary course of business.
In February 2006, the FASB issued SFAS 155, “Accounting for Certain Hybrid Financial Instruments - an amendment of SFAS 133 and 140.” SFAS 155 amends SFAS 133, “Accounting for Derivative Instruments and Hedging Activities,” and SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” and clarifies SFAS 133 Implementation Issue D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” 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 have required bifurcation under SFAS 133, including financial instruments previously recorded by us under SFAS 133. The fair value election can be applied to existing instruments on an instrument-by-instrument basis at the date of adoption and can be applied to new instruments on a prospective basis. SFAS 155 will be effective in fiscal years that begin after September 15, 2006. We expect 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, we bifurcated the embedded derivatives in its investments in convertible securities and changes in the fair value of the host instrument will be recorded as unrealized investment gains and losses while changes in the fair value of the embedded derivative will be recorded as realized investment gains and losses. As of December 31, 2006, the fair value of the host instruments included in fixed income securities was $268.1 million and the fair value of embedded derivatives included in other invested assets was $15.1 million. Upon adopting SFAS 155, we will record a cumulative adjustment of $16.5 million to reclassify unrealized investment gains, net of tax, to opening retained earnings. Subsequent to January 1, 2007, changes in the fair value of securities accounted for in accordance with SFAS 155 will be recorded in realized investment gains or losses.
In June 2006, the FASB issued FASB Interpretation 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes.” The Interpretation clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with SFAS 109, “Accounting for Income Taxes.” Specifically, the Interpretation prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Interpretation also provides guidance on the related derecognition, classification, interest and penalties, accounting for interim periods, disclosure and transition of uncertain tax positions. The Interpretation is effective for fiscal years beginning after
December 15, 2006. We have completed a thorough analysis of FIN 48 and do not expect any material effect on our consolidated financial statements.
In August 2006, the SEC issued a final rule entitled “Executive Compensation and Related Person Disclosure.” The rule amends the disclosure requirements for executive and director compensation, related person transactions, director independence and other corporate governance matters and security ownership of officers and directors. These amendments apply to disclosure in proxy and information statements, periodic reports, current reports and other filings. The rule is effective in current reports on Form 8-K for reportable events that occur on or after November 7, 2006 and in annual filings for fiscal years ending on or after December 15, 2006. We will provide this information in its 2006 Proxy Statement and other relevant filings.
In September 2006, the SEC issued Staff Accounting Bulletin 108 (“SAB 108”) “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB 108 provides guidance on evaluating a misstatement and determining its materiality using the iron curtain (balance sheet analysis) and rollover (income statement analysis) approaches, as well as correcting errors under the approaches and transition guidance. SAB 108 is effective for fiscal years ending on or after November 15, 2006. There was no effect to our consolidated financial statements resulting from the adoption of SAB 108.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115,” which provides a fair value option to measure many financial instruments and certain other assets and liabilities at fair value on an instrument-by-instrument basis. SFAS No. 159 is effective for us beginning in the first quarter of 2008. We are evaluating the impact of the adoption of SFAS 159 on our consolidated financial statements.
We have certain business arrangements with affiliated companies that have financial implications. A description of these arrangements is provided in Note 16 to our consolidated financial statements included in this Form 10-K.
The preceding table indicates an asymmetric market value response to equivalent basis point shifts, up and down, in interest rates. This partly reflects exposure to fixed income securities containing a put feature. In total, securities with a put feature represent approximately 4% and 5% of the fair market value of the total fixed income portfolio as of December 31, 2006 and December 31, 2005, respectively. The asymmetric market value response reflects our ability to put these bonds back to the issuer for early maturity in a rising interest rate environment (thereby limiting market value loss) but to hold these bonds to their much longer full maturity dates in a falling interest rate environment (thereby maximizing the full benefit of higher market values in that environment).
As of December 31, 2006, we had net unrealized gains of $36.0 million, before taxes, related to our total investments and cash. This net amount was comprised of gross unrealized appreciation of $150.1 million, offset by gross unrealized depreciation of $114.1 million, which includes gross unrealized appreciation of $123.3 million and gross unrealized depreciation of $109.9 million related to fixed income securities and common stocks carried at fair value.
We purchase interest rate options from time to time to protect us from movements in interest rates. During the first quarter of 2006, we purchased a 20-year swaption contract with a notional amount of $550.0 million, which provides an economic hedge against a decline in our fixed income portfolio as a result of an increase in interest rates. This contract replaced a 10-year swaption with a notional amount of $1.0 billion, initially purchased during the second quarter of 2005, which was closed during the first quarter of 2006 for consideration of $4.1 million, resulting in a realized loss of $1.7 million. The swaption gives us the option, but not the obligation, to enter into an interest rate swap contract under which we would receive a floating interest rate and pay a fixed interest rate based on the notional amount of the contract of $550.0 million. The cost of the swaption was $9.6 million. This contract was closed and not replaced during the third quarter of 2006 for consideration of $8.2 million, resulting in a realized loss of $1.4 million.
As of December 31, 2006 and December 31, 2005, 89.5% and 81.7%, respectively, of the aggregate fair value of our fixed income securities consisted of securities rated investment grade, with 10.5% and 18.3%, respectively, rated below investment grade.
We have purchased credit default swaps, which are included in other invested assets, that provide a hedge against adverse movements in the fair value of investments and other corporate assets resulting from systemic financial and credit risk. Under a credit default swap, we agree to pay at specified periods fixed premium amounts based on an agreed notional principal amount in exchange for the credit default protection on a specified asset. Credit default swaps are recorded at fair value, with the related changes in fair value recognized as a realized gain or loss in the period in which they occur. The total cost of the credit default swaps was $75.6 million as of December 31, 2006 and 2005, and the fair value was $13.5 million and $36.2 million, as of December 31, 2006 and 2005, respectively. The notional amount of credit default swaps was $3.3 billion as of December 31, 2006 and 2005. The net change in the fair value of the credit default swaps resulted in a net realized loss of $22.6 million, $36.2 million and $4.5 million for the years ended December 31, 2006, 2005 and 2004, respectively.
As of December 31, 2006, our holdings of financial instruments without quoted prices, or “non-traded investments,” included a collateral loan, which was fully impaired during 2005. We routinely evaluate the carrying value of these investments by reviewing the respective borrowers’ current financial positions, and the timeliness of their interest and principal payments. As a result of this review, we recognized an other-than-temporary write-down of $17.0 million for the year ended December 31, 2005 related to one of the loans. In addition, a collateral loan, which had a value of $7.3 million as of December 31, 2005, was fully paid during 2006. As of December 31, 2005, our holdings consisted of these two collateral loans totaling $7.3 million. These collateral loans, which are included in other investments, were valued at their unpaid principal balances, reduced by amounts recorded as an other-than-temporary write-down.
In the third quarter of 2004, we sold short Standard & Poor’s 500 depository receipts (“SPDRs”) and the Financial Select SPDR Fund (“XLF”) as an economic hedge against a general decline in our equity portfolio. In order to reduce the margin maintenance requirements for these short positions, we replaced the short positions with total return swaps, which had aggregate notional amounts of $581.4 million and $451.8 million as of December 31, 2006 and December 31, 2005, respectively. The margin maintenance requirement related to the total return swaps was $10.5 million and $96.4 million as of December 31, 2006 and December 31, 2005, respectively. During the year ended December 31, 2006, total return swap contracts with an aggregate notional amount of $969.8 million expired at a net realized loss of $73.0 million. These total return swap contracts were replaced by total return swap contracts with an aggregate notional amount of $1,099.4 million. The swap transactions terminate during 2007. As of December 31, 2006 and December 31, 2005, we have provided $52.1 million and $104.3 million, respectively, of U.S. Treasury bills as collateral for the swap transactions. The swap transactions are recorded at fair value in other liabilities and changes in the fair value are recorded as realized gains or losses in the consolidated statement of operations in the period in which they occur. For the twelve months ended December 31, 2006, 2005 and 2004, the net change in the fair value of the swap transactions resulted in a net realized loss of $73.5 million, $11.8 million and $44.9 million, respectively.
notional amount of $830.2 million. A call option gives the purchaser the right, but not the obligation, to purchase an underlying security at a specific price or prices at or for a certain time. Our maximum potential loss on the swap and option transactions was $0.9 million and $90.4 million as of December 31, 2006 and December 31, 2005, respectively. We plan to continue to purchase short-dated call options in 2007 in an effort to reduce the maximum potential loss on the swaps to approximately 20% of the swap notional value. The call options are recorded at fair value in other invested assets, and changes in the fair value are recorded as a realized gain or loss in the consolidated statement of operations. For the year ended December 31, 2006, 2005 and 2004, the net change in the fair value of these call options resulted in a net realized loss of $0.4 million, $10.6 million and, a net realized gain of $6.7 million, respectively.
We hold options on certain securities within our fixed income portfolio, which allow us to extend the maturity date of fixed income securities or convert fixed income securities to equity securities. The par value and the imputed cost of the options on these securities were $289.8 million and $19.6 million as of December 31, 2006, respectively, and $385.2 million and $33.1 million as of December 31, 2005, respectively. The options are recorded at fair value of $15.1 million and $34.9 million as of December 31, 2006 and December 31, 2005, respectively, in other invested assets and the change in fair value is recorded as a realized gain or loss in the consolidated statement of operations. For the twelve months ended December 31, 2006, 2005 and 2004, the change in the fair value of the options resulted in a realized gain of $1.1 million, $21.0 million and $9.2 million, respectively.
In assessing the value of our debt and equity securities held as investments and possible impairments of such securities, we review (i) the issuer’s current financial position and disclosures related thereto, (ii) general and specific market and industry developments, (iii) the timely payment by the issuer of its principal, interest and other obligations, (iv) the outlook and expected financial performance of the issuer, (v) current and historical valuation parameters for the issuer and similar companies, (vi) relevant forecasts, analyses and recommendations by research analysts, rating agencies and investment advisors, and (vii) other information we may consider relevant. In addition, we consider our intent and ability to hold the security to recovery when evaluating possible impairments.
Based on our review, we recognized other-than-temporary impairment losses in the amount of $28.1 million, before taxes, which were recognized in our consolidated statement of operations as a reduction to our net realized gains for the year ended December 31, 2006.
have been in a continuous unrealized loss position, as of December 31, 2006 and December 31, 2005 (in millions):
We believe the gross unrealized depreciation is temporary in nature and we have not recorded a realized investment loss related to these securities. Given the size of our investment portfolio and capital position, we have the ability and intent to hold these securities until the fair value recovers the gross unrealized depreciation.
For further detail on our losses and LAE, see Note 9 to our consolidated financial statements included in this Form 10-K. Our reserves for losses and LAE do not have contractual maturity dates. However, based on historical payment patterns, we have included an estimate of when we expect our losses and LAE to be paid in the table above. The exact timing of the payment of claims cannot be predicted with certainty. We maintain a portfolio of
II. Condensed Financial Information of Registrant as of December 31, 2006 and 2005 and for the years ended December 31, 2006, 2005 and 2004
III. Supplementary Insurance Information as of December 31, 2006 and 2005 and for the years ended December 31, 2006, 2005 and 2004
VI. Supplementary Information (for Property-Casualty Insurance Underwriters) as of December 31, 2006, 2005, 2004 and for the years ended December 31, 2006, 2005 and 2004
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Odyssey Re Holdings Corp. and its subsidiaries at December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Also, in our opinion, management’s assessment, included in Management’s Report on Internal Controls over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2006 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
Odyssey Re Holdings Corp. (together with its subsidiaries, the “Company” or “OdysseyRe”) is an underwriter of reinsurance, providing a full range of property and casualty products on a worldwide basis, and an underwriter of specialty insurance, primarily in the United States. Odyssey Re Holdings Corp. was formed as a holding company and incorporated in Delaware in 2001 in conjunction with its initial public offering. Odyssey Re Holdings Corp. owns all of the common shares of Odyssey America Reinsurance Corporation (“Odyssey America”), its principal operating subsidiary, which is domiciled in the state of Connecticut. Odyssey America directly or indirectly owns all of the common shares of the following domestic and foreign subsidiaries: Clearwater Insurance Company (“Clearwater”); Clearwater Select Insurance Company (“Clearwater Select”); Odyssey UK Holdings Corporation (“UK Holdings”); Newline Underwriting Management Ltd., which owns and manages Newline Syndicate 1218, a member of Lloyd’s of London (collectively, “Newline”); Newline Insurance Company Limited; Hudson Insurance Company (“Hudson”); Hudson Specialty Insurance Company (“Hudson Specialty”) and Napa River Insurance Services, Inc. The Company’s majority shareholder, Fairfax Financial Holdings Limited (“Fairfax”), a publicly traded financial services holding company based in Canada, reduced its ownership of OdysseyRe from 78.5% as of September 30, 2006 to 59.6% as of December 31, 2006.
On March 31, 2006, the Company restated its consolidated financial statements as of and for the years ended December 31, 2000 through 2004, as well as its unaudited financial information as of and for the nine months ended September 30, 2005, to correct for accounting errors associated with certain reinsurance contracts entered into by the Company between 1998 and 2004. On August 28, 2006, the Company restated its balance sheets as of March 31, 2006 (unaudited) and December 31, 2005 and its statements of operations, shareholders equity and cash flows for the three months ended March 31, 2006 and 2005 (unaudited), to correct for accounting errors associated with certain investments held by the Company, and on October 16, 2006 the Company filed an Annual Report on Form 10-K/ A to reflect the impact of this restatement on its consolidated financial statements as of and for the years ended December 31, 2001 through 2005. The total cumulative impact of these restatements through December 31, 2005 was to decrease shareholders’ equity by $19.6 million, after tax. The aggregate net effect of the restatements for the year ended December 31, 2005 was to increase net loss available to common shareholders by $17.3 million and for the year ended December 31, 2004, was to increase net income available to common shareholders by $18.3 million. The effects of the restatements are reflected in the Company’s consolidated financial statements and accompanying notes included herein.
(a) Basis of Presentation. The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The consolidated financial statements include the accounts of the Company and its subsidiaries. Intercompany transactions have been eliminated. The preparation of the consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions, which could differ materially from actual results, that affect the reported amounts of assets, liabilities, revenues and expenses and disclosure of contingent assets and liabilities. Certain amounts from prior periods have been reclassified to conform with current presentations.
approximates fair value. The Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents.
The net amount of unrealized appreciation or depreciation of the Company’s investments, net of applicable deferred income taxes, is reflected in shareholders’ equity in accumulated other comprehensive income. A decline in the fair value of an investment below its cost or amortized cost that is deemed other-than-temporary is charged to net income as a realized capital loss, resulting in a new cost or amortized cost basis for the investment. Realized investment gains or losses are determined on the basis of average cost. Investment income, which is reported net of applicable investment expenses, is recorded as earned.
recorded liabilities exceed the amounts paid, reinsurance receivables are increased to reflect the difference, and the resulting gain is deferred and amortized over the estimated settlement period. If the amounts paid for retroactive reinsurance exceed the recorded liabilities, the Company will increase the related liabilities or reduce the reinsurance receivable, or both, at the time the reinsurance contract is effective, and the excess is charged to net income. Changes in the estimated amount of liabilities relating to the underlying reinsured contracts are recognized in net income in the period of the change. Prospective and retroactive provisions within a single contract are accounted for separately unless impracticable, in which case, the contract will be accounted for as a retroactive contract.
(e) Goodwill and Intangible Assets. The Company accounts for goodwill and intangible assets in accordance with SFAS 141, “Business Combinations.” A purchase price paid that is in excess of net assets (“goodwill”) arising from a business combination is recorded as an asset, and is not amortized. Intangible assets with a finite life are amortized over the estimated useful life of the asset. Intangible assets with an indefinite useful life are not amortized. Goodwill and intangible assets are tested for impairment on an annual basis or more frequently if events or changes in circumstances indicate that the carrying amount may not be recoverable. If the goodwill or intangible asset is impaired, it is written down to its realizable value with a corresponding expense reflected in the consolidated statements of operations. Unimpaired goodwill and intangible assets with an indefinite useful life are carried at $30.5 million and are reflected in other assets as of both December 31, 2006 and 2005, respectively. As of December 31, 2006 and 2005, intangible assets with a finite life are also reflected in other assets with a value of $5.1 million and $5.9 million, respectively. For the years ended December 31, 2006, 2005 and 2004, the Company amortized $0.8 million, $0.8 million and $0.9 million, respectively, related to its intangible assets with a finite life.
For such contracts, the Company initially records the amount of consideration paid or received as a deposit liability. Revenue or expense is recognized over the term of the contract, with any deferred amount recorded as a component of assets or liabilities until such time it is earned. The ultimate asset or liability under these contracts is estimated, and the asset or liability is initially established, which represents consideration received, is increased or decreased over the term of the contracts. The change during the period is recorded in the Company’s consolidated statements of operations, where increases and decreases in the ultimate asset or liability are shown in other expense, net. As of December 31, 2006 and 2005, the Company had reflected in other assets $8.5 million and $0.5 million, respectively, and in other liabilities $0.7 million and $2.5 million, respectively, related to deposit contracts. In cases where cedants retain the consideration on a funds held basis, the Company records those assets in other assets, and records the related investment income on the assets in the Company’s consolidated statements of operations as investment income.
(i) Derivatives. The Company utilizes derivative instruments to manage against adverse changes in the value of its assets and liabilities. Derivatives include credit default swaps, total return swaps, interest rate swaps, and other equity and credit derivatives. In addition, the Company holds options on certain securities within its fixed income portfolio, which allows the Company to extend the maturity date on fixed income securities or convert fixed income securities to equity securities. Conversion options and maturity extension features are bifurcated from the fixed income security and measured separately at fair value. All derivative instruments are recognized as either assets or liabilities on the consolidated balance sheet and are measured at their fair value. Gains or losses from changes in the derivative values are accounted for based on how the derivative is used and whether it qualifies for hedge accounting. As the Company’s derivative instruments do not qualify for hedge accounting, changes in fair value are included in realized investment gains and losses in the consolidated statements of operations. Margin balances required by counterparties in support of derivative positions are included in collateral for borrowed securities.
(j) Operating Segments. The Company has four operating segments to reflect the manner in which management monitors and evaluates the Company’s financial performance. The Company’s four segments include: Americas, EuroAsia, London Market and U.S. Insurance (See Note 14).
(o) Funds Held Balances. Funds held under reinsurance contracts is an account used to record a liability, in accordance with the contractual terms, arising from the Company’s receipt of a deposit from a reinsurer or the withholding of a portion of the premiums due as a guarantee that a reinsurer will meet its loss and other
Depreciation and amortization expense for the years ended December 31, 2006, 2005 and 2004 was $5.0 million, $7.3 million and $5.1 million, respectively.
In September 2006, the FASB issued SFAS 157, “Fair Value Measurements,” to define existing fair value measurements, create a framework for measuring fair value, and expand disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The Company is currently evaluating the impact of the adoption of SFAS 157, if any, on the Company’s financial position or results of operations.
In September 2006, the SEC issued Staff Accounting Bulletin 108 (“SAB 108”) “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB 108 provides guidance on evaluating a misstatement and determining its materiality using the iron curtain (balance sheet analysis) and rollover (income statement analysis) approaches, as well as correcting errors under the approaches and transition guidance. SAB 108 is effective for fiscal years ending on or after November 15, 2006. There was no effect to the Company’s consolidated financial statements resulting from the adoption of SAB 108.
On November 15, 2004, the Company acquired Overseas Partners US Reinsurance Company (“Opus Re”), a reinsurance company domiciled in the state of Delaware, the name of which has been changed to Clearwater Select Insurance Company. The purchase price of $43.0 million, which was based on the fair value of the net assets of Opus Re at the date of acquisition, was comprised of $237.8 million of assets, principally investments, and $194.8 million of liabilities, principally unpaid losses and loss adjustment expense reserves. The Company recorded an intangible asset with an indefinite life of $5.8 million, which as of December 31, 2006 and 2005 was not impaired. There was no goodwill recognized related to the acquisition of Opus Re. Following the acquisition, Clearwater Select was contributed to Clearwater.
Net income (loss) per common share for the years ended December 31, 2006, 2005 and 2004 has been computed in the following table based upon weighted average common shares outstanding (in thousands, except share amounts):
In calculating diluted earnings per share, the Company is required to evaluate each stock option and restricted stock grant to determine if it is dilutive or antidilutive in nature. For the year ended December 31, 2006, 140,153 existing stock options and restricted stock awards outstanding were excluded from the computation of weighted average common shares for diluted earnings per common share, due to the antidilutive effect. For the year ended December 31, 2005, the Company incurred a loss; therefore, all stock options, restricted stock awards and shares related to the 4.375% convertible senior debentures were excluded from the weighted average shares for diluted earnings per common share, due to the antidilutive effect during the year. Had a loss not been recorded, the Company would have evaluated the dilutive effect of 6,049,782 shares for the year ended December 31, 2005. For the year ended December 31, 2004, all outstanding stock options and restricted shares were dilutive, and were included in the calculation of diluted earnings per common share.
Common stocks accounted for under the equity method of accounting were carried at $567.0 million as of December 31, 2005, reflecting gross unrealized appreciation of $199.0 million and gross unrealized depreciation of $4.0 million. Other invested assets, including amounts that were accounted for under the equity method of accounting, were carried at $238.1 million as of December 31, 2005, reflecting gross unrealized appreciation of $5.8 million and gross unrealized depreciation of $2.1 million.
The following table sets forth the components of net investment income for the years ended December 31, 2006, 2005, and 2004 (in thousands):
Included in gross realized investment losses for the years ended December 31, 2006 and 2005 are $28.1 million and $54.9 million, respectively, related to realized investment losses on the other-than-temporary write-down of fixed income, equity and other investments. The amount for 2006 reflects $8.1 million attributable to other invested assets and a $2.9 million and $17.1 million write-down on fixed income and equity securities, respectively. The amount for 2005 reflects $17.9 million attributable to fixed income securities, $17.6 million related to equity securities and $19.4 million attributable to other securities. The Company did not recognize any other-than-temporary write-down of investments for the year ended December 31, 2004.
For common stocks, at equity, as of December 31, 2006, the relative ownership held by the Company is: Hub International Limited (26.1% owned by Fairfax, which includes 13.3% owned by the Company), Fairfax Asia Limited (100% owned by Fairfax, which includes a 29.5% economic interest owned by the Company), TRG Holding Corporation (100% owned by Fairfax, which includes 13.0% owned by the Company), Advent Capital (Holdings) PLC (44.5% owned by Fairfax, which includes 8.1% owned by the Company) and
During 2006, the Company redeemed its interest in HWIC Asia, an investment vehicle that primarily invests in public foreign equities, resulting in a realized gain of $75.1 million. HWIC Asia had been reflected in the Company’s consolidated financial statements in accordance with the equity method of accounting since the second quarter of 2005. The carrying value of investments reflected in the value of HWIC Asia is established at their fair value based on quoted market prices. In accordance with the equity method of accounting, interest and dividend income, and realized gains and losses of HWIC Asia are included in net investment income. Prior to the redemption of HWIC Asia, the net amount of unrealized appreciation or depreciation of the Company’s proportional interest in investments held by HWIC Asia, net of applicable deferred income taxes, was reflected in the Company’s shareholders’ equity in accumulated other comprehensive income. The Company recorded unrealized appreciation, net of deferred income taxes, of $112.2 million as of December 31, 2005 related to its interest in HWIC Asia.
A summary of HWIC Asia’s financial information, and the Company’s proportionate share of HWIC Asia as of August 16, 2006, the date of the Company’s redemption of HWIC Asia, and December 31, 2005, and for the
The aggregate of the Company’s equity investees’ summarized financial information, and the Company’s proportionate share thereof, as of December 31, 2006 and 2005 and for the years ended December 31, 2006, 2005 and 2004, follows (in thousands):
Due to the timing of when financial information is reported by equity investees, results attributable to these investments are generally reported in the Company’s consolidated financial statements on a one month or one quarter lag.
As of December 31, 2006, the Company’s holdings of financial instruments without quoted prices, or “non-traded investments,” included a collateral loan, which was fully impaired during 2005. The Company routinely evaluates the carrying values of these investments by reviewing the borrowers’ current financial position and the timeliness of their interest and principal payments. As a result of this review, the Company recognized an other-than-temporary write-down of $17.0 million for the year ended December 31, 2005 related to this loan. In addition, a collateral loan, which had a value of $7.3 million as of December 31, 2005, was fully paid during 2006. As of December 31, 2005, the Company’s holdings consisted of these two collateral loans totaling $7.3 million. These collateral loans, which are included in other investments, were valued at their unpaid principal balances, reduced by amounts recorded as an other-than-temporary impairments.
In the third quarter of 2004, the Company sold short Standard & Poor’s 500 depository receipts (“SPDRs”) and the Financial Select SPDR Fund (“XLF”) as an economic hedge against a general decline in our equity portfolio. In order to reduce the margin maintenance requirements for these short positions, the Company replaced the short positions with total return swaps, which had aggregate notional amounts of $581.4 million and $451.8 million as of December 31, 2006 and December 31, 2005, respectively. The margin maintenance requirement related to the total return swaps was $10.5 million and $96.4 million as of December 31, 2006 and
December 31, 2005, respectively. During the year ended December 31, 2006, total return swap contracts with an aggregate notional amount of $969.8 million expired at a net realized loss of $73.0 million. These total return swap contracts were replaced by total return swap contracts with an aggregate notional amount of $1,099.4 million. The swap transactions terminate during the first half of 2007. As of December 31, 2006 and December 31, 2005, the Company has provided $52.1 million and $104.3 million, respectively, of U.S. Treasury bills as collateral for the swap transactions. The swap transactions are recorded at fair value in other liabilities and changes in the fair value are recorded as realized gains or losses in the consolidated statement of operations in the period in which they occur. For the twelve months ended December 31, 2006, 2005 and 2004, the net change in the fair value of the swap transactions resulted in a net realized loss of $73.5 million, $11.8 million and $44.9 million, respectively.
In connection with the swap transactions, the Company owns SPDRs and XLF index call options at a cost of $9.4 million and $13.6 million, respectively, with a strike price of approximately 99.8% and 120.0% of the notional amount of the swap transactions as of December 31, 2006 and December 31, 2005, respectively. During the year ended December 31, 2006, call options, with a notional amount of $789.0 million, expired at a net realized loss of $7.2 million. These call options were replaced with call options purchased for $11.8 million and having a notional amount of $830.2 million. A call option gives the purchaser the right, but not the obligation, to purchase an underlying security at a specific price or prices at or for a certain time. Our maximum potential loss on the swap and option transactions was $0.9 million and $90.4 million as of December 31, 2006 and December 31, 2005, respectively. The call options are recorded at fair value in other invested assets, and changes in the fair value are recorded as a realized gain or loss in the consolidated statement of operations. For the year ended December 31, 2006, 2005 and 2004, the net change in the fair value of these call options resulted in a net realized loss of $0.4 million, $10.6 million and, a net realized gain of $6.7 million, respectively.
In addition, as of December 31, 2006 and 2005, the Company had sold short $115.3 million and $83.5 million, respectively, primarily equity securities, for which it recorded a liability equal to the underlying fair value of the securities of $119.8 million and $82.5 million, respectively. A net realized gain of $3.0 million and $4.3 million for the years ended December 31, 2006 and 2005, respectively, and a net realized loss of $13.3 million for the year ended December 31, 2004 were recognized in the Company’s statements of operations. As of December 31, 2006 and 2005, the Company provided cash and fixed income securities of $208.6 million and $161.7 million, respectively, as collateral for the borrowed securities. The Company’s net investment income for the years ended December 31, 2006, 2005 and 2004 was reduced by $7.2 million, $5.0 million and $2.7 million, respectively, related to dividend and interest payments associated with the borrowed securities.
The Company has purchased credit default swaps, which are included in other invested assets, that provide a hedge against adverse movements in the fair value of investments and other corporate assets resulting from systemic financial and credit risk. Under a credit default swap, the Company agrees to pay at specified periods fixed premium amounts based on an agreed notional principal amount in exchange for the credit default protection on a specified asset. Credit default swaps are recorded at fair value, with the related changes in fair value recognized as a realized gain or loss in the period in which they occur. The total cost of the credit default swaps was $75.6 million as of December 31, 2006 and 2005, and the fair value was $13.5 million and $36.2 million, as of December 31, 2006 and 2005, respectively. The notional amount of the credit default swaps was $3.3 billion as of December 31, 2006 and 2005. The net change in the fair value of the credit default swaps
The Company purchases interest rate options from time to time to protect it from movements in interest rates. During the first quarter of 2006, the Company purchased a 20-year swaption contract with a notional amount of $550.0 million, which provides an economic hedge against a decline in our fixed income portfolio as a result of an increase in interest rates. This contract replaced a 10-year swaption with the notional amount of $1.0 billion, initially purchased during the second quarter of 2005, which was closed during the first quarter of 2006 for consideration of $4.1 million, resulting in a realized loss of $1.7 million. The swaption gives the Company the option, but not the obligation, to enter into an interest rate swap contract under which we would receive a floating interest rate and pay a fixed interest rate based on the notional amount of the contract of $550.0 million. The cost of the swaption was $9.6 million. This contract was closed and not replaced, during the third quarter of 2006 for consideration of $8.2 million resulting in a realized loss of $1.4 million.
The Company holds options on certain securities within its fixed income portfolio, which allows the Company to extend the maturity date of fixed income securities or convert fixed income securities to equity securities. The par value and the imputed cost of the options on these securities were $289.8 million and $19.6 million as of December 31, 2006, respectively, and $385.2 million and $33.1 million as of December 31, 2005, respectively. The options are recorded at fair value of $15.1 million and $34.9 million as of December 31, 2006 and 2005, respectively, in other invested assets and the change in fair value is recorded as a realized gain or loss in the consolidated statement of operations. For the years ended December 31, 2006, 2005 and 2004, the change in the fair value of the options resulted in a realized gain of $1.1 million, $21.0 million and $9.2 million, respectively.
Counterparties to the derivative instruments expose the Company to credit risk in the event of non-performance. The Company believes this risk is low, given the diversification among various highly rated counterparties. The credit risk exposure is represented by the fair value of the derivative instruments.
The Company is required to maintain assets on deposit with various regulatory authorities to support its insurance and reinsurance operations. These requirements are generally promulgated in the statutes and regulations of the individual jurisdictions. The assets on deposit are available to settle insurance and reinsurance liabilities. The Company utilizes trust funds in certain transactions where the trust funds are set up for the benefit of the ceding companies and generally take the place of letter of credit requirements. As of December 31, 2006, restricted assets totaled $1.1 billion, with $738.3 million included in fixed income securities and the remaining balance of $370.7 million included in short term investments, cash and cash equivalents. Of the $1.1 billion held in restricted assets, $209.9 million was held for foreign regulatory requirements, which included $86.5 million in fixed income securities and the remaining balance of $123.4 million held in short term investments, cash and cash equivalents.
The following table shows the components of the change in accumulated other comprehensive income, net of deferred income taxes, for the years ending December 31, 2006, 2005 and 2004 (in thousands):
liability may be more or less than the amounts provided, for which any adjustments will be reflected in the periods in which they become known.
The Company is exposed to losses arising from a variety of catastrophic events, such as hurricanes, windstorms and floods. The loss estimates for these events represent the Company’s best estimate based on the most recent information available. The Company uses various approaches in estimating its loss, including a detailed review of exposed contracts and information from ceding companies. As additional information becomes available, including information from ceding companies, actual losses may exceed the Company’s estimated
losses, potentially resulting in adverse effects to the Company’s financial results. The extraordinary nature of these losses, including potential legal and regulatory implications, creates substantial uncertainty and complexity in estimating these losses. Considerable time may elapse before the adequacy of the Company’s estimates can be determined.
For the year ended December 31, 2004, the total catastrophe losses of $138.8 million include net losses and loss adjustment expenses of $93.4 million, net of reinsurance of $77.8 million, related to the 2004 Florida Hurricanes. For the years ended December 31, 2006 and 2005, incurred loss estimates for the 2004 Florida Hurricanes were increased $2.0 million and $3.4 million due to unexpected loss emergence during these years.
of reinsurance, for the years ended December 31, 2006, 2005 and 2004, is set forth in the table below (in thousands):
net of reinsurance, on December 31, 2006, divided by the average paid asbestos and environmental claims for the last three years of $19.3 million which are net of reinsurance but prior to amounts subject to cession to the 1995 Stop Loss Agreement.
The Company utilizes retrocessional agreements principally to reduce and spread the risk of loss on its insurance and reinsurance business and to limit its exposure to multiple claims arising from a single occurrence. There is a credit risk with respect to reinsurance, which would become an ultimate liability of the Company in the event that such reinsuring companies are unable, at some later date, to meet their obligations under the reinsurance agreements in force. Reinsurance recoverables are recorded as assets and a reserve for uncollectible reinsurance recoverables is established, based on the Company’s evaluation of each retrocessionaires’ ability to meet their obligations under the agreements. Premiums written and earned are stated net of reinsurance ceded in the consolidated statements of operations. Direct, reinsurance assumed, reinsurance ceded and net amounts for the years ended December 31, 2006, 2005 and 2004 follow (in thousands):
The total amount of reinsurance recoverable on paid and unpaid losses as of December 31, 2006 and 2005 was $798.8 million and $1,347.7 million, respectively. The Company has established a reserve for potentially uncollectible reinsurance recoverables based upon an evaluation of each retrocessionaire and the Company’s assessment as to the collectibility of individual balances. The reserve for uncollectible recoverables as of December 31, 2006 and 2005 was $42.5 million and $30.9 million, respectively, and has been netted against reinsurance recoverables on loss payments in the consolidated balance sheets. The Company has also established a reserve for potentially uncollectible assumed reinsurance balances of $1.9 million and $6.3 million as of December 31, 2006 and 2005, respectively, which has been netted against premiums receivable.
Loss Agreement as retroactive reinsurance. Accordingly, losses ceded under the contract in excess of $97.0 million in the aggregate had been recorded as a deferred gain rather than as a benefit in the applicable periods. The deferred gain had been amortized into income over the estimated remaining settlement period of the underlying claims. As of December 31, 2005, the Company has utilized the full limit of $175.0 million under the 1995 Stop Loss Agreement. The Company ceded losses of $17.5 million to the 1995 Stop Loss Agreement in each of the years ended December 31, 2005 and 2004, resulting in income of $11.3 million ($7.3 million after tax) and $8.7 million ($5.7 million after tax) for the years ended December 31, 2005 and 2004, respectively. There were no cessions to this agreement in 2006. The Company received $78.0 million in cash from nSpire Re on March 29, 2006, which reduced the outstanding recoverable. As the $78.0 million was received in advance of the payment of the underlying claims by the Company, it is included as an adjustment to net unpaid losses and loss adjustment expenses, which increased by $78.0 million. In connection with the receipt of this cash, for the three months ended March 31, 2006, the Company has recognized $19.3 million ($12.5 million after tax) of the cumulative deferred gain, an increase of $17.9 million ($11.7 million after tax) over the anticipated deferred gain amortization, as a reduction in losses and loss adjustment expenses.
In each calendar year, subject to certain limits, the Company has the ability to cede losses that are attributable to the covered period until all applicable losses are paid and settled, which is typically several years beyond the covered period, or until the contract is terminated by the Company. The ability of the Company to cede losses in any given calendar year that are attributable to prior periods will depend on the nature of the risk which generated the loss, the time period from which the losses originate and whether there are limits remaining covering the subject period. Losses attributable to prior periods are ceded to the treaties and recorded in the period in which they are ceded. Additional premiums, if any, are determined and recorded in the period when losses are ceded. When additional premiums are due, the interest on the funds attributable to the additional premiums ceded is typically calculated based on the inception period of the contract and the cumulative interest expense is recognized in the period when additional premiums are due. As of December 31, 2006, the limits for the other retrocessional agreements have been fully utilized or commuted.
The income (loss) before income taxes reflected in the Company’s statements of operations related to the Company’s Whole Account Excess of Loss Agreements and Facultative Excess of Loss Agreement, including the effect of commutations, for the years ended December 31, 2006, 2005 and 2004 is as follows (in thousands):
The Company has recorded interest expense associated with other ceded reinsurance agreements, and not reflected in the table above, of $571 thousand, $372 thousand and $18 thousand for the years ended December 31, 2006, 2005 and 2004, respectively.
Reinsurance recoverables were $1,347.7 million and collateral was $755.7 million, or 56.1% of the reinsurance recoverable balance, as of December 31, 2005.
Several individual reinsurers are part of the same corporate group. The following table shows the five largest aggregate amounts that are recoverable from all individual entities that form part of the same corporate group as of December 31, 2006 and the amount of collateral held from each group (in thousands).
The components of debt obligations as of December 31, 2006 and 2005 are as follows (in thousands):
On February 22, 2006, the Company issued $100.0 million aggregate principal amount of floating rate senior debentures, pursuant to a private placement. The net proceeds from the offering of $99.3 million, after fees and expenses, were used for general corporate purposes, including a capital contribution to Odyssey America. The debentures were sold in two tranches, $50.0 million of Series A due March 15, 2021 and $50.0 million of Series B due March 15, 2016. Interest on each series of debentures is due quarterly on March 15, June 15, September 15 and December 15. The interest rate on each series of debentures is equal to the three-month LIBOR, which is calculated on a quarterly basis, plus 2.20%. The interest rate from February 22, 2006 through March 16, 2006 on each series of debentures was 6.97% per annum. Pursuant to the terms of the indentures, as a result of the delay in filing the Company’s 2005 Annual Report on Form 10-K, the annual interest rate on each series of debentures was increased, as of March 17, 2006, to the three-month LIBOR as of March 15, 2006 plus 3.20%, which equaled 8.12%. This interest rate remained in effect until the filing of the Company’s Annual Report on Form 10-K on March 31, 2006, after which it reverted to the initial annual rate of 6.97% through June 14, 2006. As of December 31, 2006, the current annual interest rate on each series of debentures is 7.56%. The Series A debentures are callable by the Company in 2011 at their par value, plus accrued and unpaid interest, and the Series B debentures are callable by the Company in 2009 at their par value, plus accrued and unpaid interest.
As of December 31, 2006, a subsidiary of Fairfax owned 253,599 shares and 70,000 shares of the Company’s Series A and Series B preferred stock, respectively.
The financial results of these divisions for the years ended December 31, 2006, 2005 and 2004 are as follows (in thousands):
The Company does not maintain separate balance sheet data for each of its operating segments. Accordingly, the Company does not review and evaluate the financial results of its operating segments based upon balance sheet data.
The components of the federal and foreign income tax provision (benefit) included in the consolidated statements of operations for the years ended December 31, 2006, 2005 and 2004 follow (in thousands):
Deferred federal and foreign income taxes reflect the tax impact of temporary differences between the amount of assets and liabilities for financial reporting purposes and such amounts as measured by tax laws and regulations. Components of federal and foreign income tax assets and liabilities as of December 31, 2006, and 2005 follow (in thousands):
Management believes that it is more likely than not that the Company will realize the benefits of its net deferred tax assets and, accordingly, no valuation allowance has been recorded as of December 31, 2006 and 2005.
Domestic pre-tax income (loss) was $513.2 million, ($225.9) million and $203.4 million for the years ended December 31, 2006, 2005 and 2004, respectively. Foreign pre-tax income was $226.0 million, $44.0 million and $105.9 million for the years ended December 31, 2006, 2005 and 2004, respectively.
As a result of Fairfax reducing its ownership of the Company to below 80% during the third quarter of 2006, the Company was deconsolidated from the United States tax group of Fairfax, and, accordingly, the Company will file a separate consolidated tax return for the period August 29, 2006 to December 31, 2006 and for each subsequent tax year. The deconsolidation has no effect on the Company’s tax position. Prior to August 29, 2006, the Company was a member of the United States tax group of Fairfax and made payments to Fairfax in accordance with its tax sharing agreements. The Company paid federal and foreign income taxes of $59.3 million, $63.4 million and $116.6 million for the years ended December 31, 2006, 2005 and 2004, respectively. The Company, as of December 31, 2006, has a current tax payable of $68.1 million, which reflects $75.8 million payable to Fairfax, principally offset by foreign tax payables and receivables from the federal government. The Company’s tax recoverable was $96.1 million as of December 31, 2005. The federal income tax provision is allocated to each of the Company’s subsidiaries in the consolidated group pursuant to a written agreement, on the basis of each subsidiary’s separate taxable income.
Odyssey America participated in providing quota share reinsurance to Gulf Insurance Company (“Gulf”) from January 1, 1996 to December 31, 2002, under which Gulf issued policies that guaranteed the residual value of automobile leases incepting during this period (“Treaties”). In March 2003, Gulf requested a payment of approximately $30.0 million, which included a “special payment” of $26.0 million, due on April 28, 2003, representing Odyssey America’s purported share of a settlement (“Settlement”) between Gulf and one of the insureds whose policies, Gulf contends, were reinsured under the Treaties. In July 2003, Gulf initiated litigation against Odyssey America, demanding payment relating to the Settlement and other amounts under the Treaties. Odyssey America answered the complaint. Among other things, Odyssey America contends that (i) Gulf breached its duty to Odyssey America of utmost good faith when it placed the Treaties by failing to disclose material information concerning the policy it issued to the insured; and (ii) the Settlement is not covered under the terms of the Treaties. Among the remedies Odyssey America seeks is rescission of the Treaties. The Company is vigorously asserting its claims and defending itself against any claims asserted by Gulf. The Company estimates that the amount in dispute under the Treaties that has not been recorded by the Company as of December 31, 2006 could range between $35 million to $40 million, after taxes. It is presently anticipated that the case will go to trial in the second half of 2007. It is not possible to make any determination regarding the likely outcome of this matter at this time.
During the second quarter of 2004, Odyssey America pledged U.S. Treasury Notes with a par value of $162.0 million (“the pledged assets”), or approximately £110.0 million equivalent, to the Society and Council of Lloyd’s on behalf of Advent Capital (Holdings) PLC (“Advent”) to support Advent’s underwriting activities for the 2001 to 2005 underwriting years of account. Advent is 44.5% owned by Fairfax and its affiliates, which includes 8.1% held by OdysseyRe. nSpire Re Limited (“nSpire Re”), a subsidiary of Fairfax, had previously pledged assets at Lloyd’s on behalf of Advent pursuant to a November 2000 agreement with Advent. Advent is responsible for the payment of any losses to support its underwriting activities and the capital resources of Advent, including its newly deposited funds at Lloyd’s, are first available to support any losses prior to a draw down of Odyssey America’s pledged assets. In consideration of Odyssey America pledging the assets, nSpire Re agreed to pay Odyssey America a fee equal to 2.0% per annum of the pledged assets, which the Company considers to be representative of commercial market terms. The pledged assets continue to be owned by Odyssey America, and Odyssey America receives any investment income thereon. The securities are carried at fair value and are included in investments and cash in OdysseyRe’s consolidated balance sheets. Interest earned on the securities is included in investment income. As additional consideration for, and further protection of, the pledged assets, nSpire Re has provided Odyssey America with indemnification in the event of a draw down on the pledged assets. Odyssey America retains the right to withdraw the pledged assets at any time upon 180 days advance written notice to nSpire Re. nSpire Re retains the obligation to pledge assets on behalf of Advent. In any event, the placement of funds at Lloyd’s will automatically terminate effective no later than December 31, 2008 and any remaining pledged assets will revert to Odyssey America at that time. The pledge of assets is not considered
The Company participates in Lloyd’s through its 100% ownership of Newline where the Company provides 100% of the capacity for Newline Syndicate 1218 (“Syndicate 1218”). The results of Syndicate 1218 are consolidated in the financial statements of the Company. In support of its capacity at Lloyd’s, Odyssey America has pledged U.S. Treasury Notes and cash with a fair value of $247.7 million as of December 31, 2006, in a deposit trust account in favor of the Society and Council of Lloyd’s. These securities may be substituted with other securities at the discretion of the Company, subject to approval by Lloyd’s. The securities are carried at fair value and are included in investments and cash in the Company’s consolidated balance sheets. Interest earned on the securities is included in investment income. The pledge of assets in support of Syndicate 1218 provides the Company with the ability to participate in writing business through Lloyd’s, which remains an important part of the Company’s business. The pledged assets effectively secure the contingent obligations of Syndicate 1218 should it not meet its obligations. Odyssey America’s contingent liability to the Society and Council of Lloyd’s is limited to the aggregate amount of the pledged assets. The Company has the ability to remove funds at Lloyd’s annually, subject to certain minimum amounts required to support its outstanding liabilities as determined under risk based capital models and approved by Lloyd’s. The funds used to support outstanding liabilities are adjusted annually and the obligations of the Company to support these liabilities will continue until they are settled or the liabilities are reinsured by a third party approved by Lloyd’s. The Company expects to continue to actively operate Syndicate 1218 and support its requirements at Lloyd’s. The Company believes that Syndicate 1218 maintains sufficient liquidity and financial resources to support its ultimate liabilities and the Company does not anticipate that the pledged assets will be utilized.
Odyssey America and CTR were each 100% owned by Fairfax, was provided by Odyssey America to facilitate the transfer of renewal rights to CTR’s business, together with certain CTR employees, to Odyssey America in 2000 in order to further expand the Company’s international reinsurance business. The guarantee was terminated effective December 31, 2001. There were no amounts received from CTR under the guarantee, and the Company did not provide any direct consideration for the renewal rights to the business of CTR. CTR was dissolved and its assets and liabilities were assumed by subsidiaries of Fairfax that have the responsibility for the run-off of its liabilities. Although CTR’s liabilities were assumed by Fairfax subsidiaries, the guarantee only pertains to those liabilities attaching to the policies written by CTR. Fairfax has agreed to indemnify Odyssey America for all its obligations incurred under its guarantee. The Company believes that the financial resources of the Fairfax subsidiaries that have assumed CTR’s liabilities provide adequate protection to satisfy the obligations that are subject to this guarantee. The Company does not expect to make payments under this guarantee and does not consider its potential exposure under this guarantee to be material to its liquidity and capital resources.
The Company organized O.R.E Holdings Limited (“ORE”), a corporation domiciled in Mauritius, on December 30, 2003 to act as a holding company for various investments in India. On January 29, 2004, ORE was capitalized by the Company in the amount of $16.7 million. ORE is consolidated in the Company’s consolidated financial statements. During 2004, ORE entered into a joint venture agreement relating to the purchase by ORE of 45% of Cheran Enterprises Private Limited (“CEPL”). CEPL is a corporation domiciled in India, engaged in the purchase, development and sale of commercial real estate properties. The joint venture agreement governing CEPL contains a provision whereby Odyssey America could be called upon to provide a guarantee of a credit facility, if such facility were established by CEPL, in an amount up to $65.0 million for the funding of proposed developments. The credit agreement was never established, and the requisite conditions for any future provision of the guarantee no longer exist. ORE’s Indian joint venture partner is claiming that the guarantee should be available and is pursuing legal actions against the Company. The Company finds this claim without merit and is vigorously defending the legal actions. The Company recognized an other-than-temporary write-down of $7.5 million and $2.4 million in the carrying value of ORE for the years ended December 31, 2006 and 2005, respectively.
Odyssey America, the Company’s principal operating subsidiary, is subject to state regulatory restrictions that limit the maximum amount of dividends payable. In any 12-month period, Odyssey America may pay dividends equal to the greater of (i) 10% of statutory capital and surplus as of the prior year end or (ii) net income for such prior year without prior approval of the Insurance Commissioner of the State of Connecticut (the “Connecticut Commissioner”). The maximum amount of dividends which Odyssey America may pay in 2007, without such prior approval is $561.7 million, based on Odyssey America’s separate financial statements. Connecticut law further provides that (i) Odyssey America must report to the Connecticut Commissioner, for informational purposes, all dividends and other distributions within five business days after the declaration thereof and at least ten days prior to payment and (ii) Odyssey America may not pay any dividend or distribution in excess of its earned surplus, as reflected in its most recent statutory annual statement on file with the Connecticut Commissioner, without the Connecticut Commissioner’s approval.
The following is the consolidated statutory basis net income (loss) and policyholders’ surplus of Odyssey America and its subsidiaries, for each of the years ended and as of December 31, 2006, 2005 and 2004 (in thousands):
The statutory provision for potentially uncollectible reinsurance recoverables due from unauthorized companies is reduced to the extent collateral is held by Clearwater or Hudson. Pursuant to indemnification agreements between the Company and Clearwater, and between the Company and Hudson, the Company provides letters of credit and/or cash in respect of uncollateralized balances due from unauthorized reinsurers.
The Company has entered into various reinsurance arrangements with Fairfax and its affiliates. The approximate amounts included in or deducted from income, expense, assets and liabilities in the accompanying consolidated financial statements, with respect to reinsurance assumed and ceded, as of and for the years ended December 31, 2006, 2005 and 2004 follow (in thousands):
The Company’s subsidiaries have entered into investment management agreements with Fairfax and its wholly-owned subsidiary, Hamblin Watsa Investment Counsel Ltd. These agreements provide for an annual base
Due to expense sharing and investment management agreements with Fairfax and its affiliates, the Company has accrued on its consolidated balance sheet amounts receivable from affiliates of $0.9 million and $1.1 million as of December 31, 2006 and 2005, respectively, and amounts payable to affiliates of $4.3 million and $4.5 million as of December 31, 2006 and 2005, respectively.
As of December 31, 2006, the Company has invested $26.4 million in a Canadian investment fund managed by an officer of Fairfax. The fund is 23.8% owned by Fairfax, which includes 4.7% owned by the Company. Certain subsidiaries of Fairfax have also invested in the fund. The officer receives no remuneration or benefits associated with his position as an officer of Fairfax, and derives all of his compensation from his management of the investment fund. In the ordinary course of the Company’s investment activities, the Company makes investments in investment funds, limited partnerships and other investment vehicles in which Fairfax or its affiliates may also be investors.
The weighted average assumptions used to calculate the net periodic benefit cost for the years ended December 31, 2006, 2005 and 2004 are as follows:
The accumulated benefit obligation for the Plan is $45.8 million and $41.1 million as of the 2006 and 2005 measurement dates, respectively. As the fair value of the Plan assets exceeds the accumulated benefit obligation, the Company did not recognize an additional minimum pension liability under SFAS 132 as of the 2006 and 2005 measurement dates.
The Company also maintains two non-qualified excess benefit plans (“Excess Plans”) that provide more highly compensated officers and employees with defined retirement benefits in excess of qualified plan limits imposed by federal tax law. The following tables set forth the combined amounts recognized for the Supplemental Plan, which has a measurement date of October 1, and the Supplemental Employee Retirement Plan, which has a measurement date of December 31, in the Company’s consolidated financial statements as of December 31, 2006 and 2005 (in thousands):
The weighted average assumptions used to calculate the benefit obligation as of December 31, 2006 and 2005 are as follows:
The Company provides certain health care and life insurance (“postretirement”) benefits for retired employees. Substantially all employees may become eligible for these benefits if they reach retirement age while working for the Company. The Company’s cost for providing postretirement benefits other than pensions is accounted for in accordance with SFAS 106 “Employers’ Accounting for Postretirement Benefits Other Than Pensions.” The following tables set forth the amounts recognized for the postretirement benefit plan, which has a measurement date of January 1, in the Company’s consolidated financial statements as of December 31, 2006 and 2005 (in thousands):
The net amount recognized in the consolidated balance sheets related to the accrued benefit cost of $13.0 million and $10.3 million, as of December 31, 2006 and 2005, respectively, is included in other liabilities. The net amount of pre-tax accumulated other comprehensive loss is $0.9 million as of December 31, 2006.
Net periodic benefit cost included in the Company’s consolidated statements of operations for the years ended December 31, 2006, 2005 and 2004 is comprised of the following components (in thousands):
The annual assumed rate of increase in the per capita cost of covered benefits (i.e., health care cost trend rate) is assumed to be 9.0% in 2006 and decreasing to 5.0% in 2013 and remaining constant thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. For example, increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation by $2.3 million (17.4% of benefit obligation as of December 31, 2006) and the service and interest cost components of net periodic postretirement benefit costs by $0.5 million for 2006. Decreasing the assumed health care cost trend rates by one percentage point in each year would decrease the accumulated postretirement benefit obligation, and the service and interest cost components of net periodic postretirement benefit cost for 2006 by $1.8 million and $0.4 million, respectively.
As a result of the adoption of SFAS 158, the Company recognized a $0.5 million, after-tax, reduction in accumulated other comprehensive income related to the postretirement plan, as of December 31, 2006, of which, on an after tax basis, $0.8 million related to net losses, while $0.3 million related to prior service credit. The Company estimates that it will record $0.1 million in prior service cost to net periodic benefit cost during the year ended December 31, 2007.
Effective January 1, 2006, the Company adopted, on a prospective basis, SFAS 123(R) “Share-Based Payments,” which is a revision of SFAS 123 “Accounting for Stock Based Compensation” and supersedes Accounting Principles Board Opinion (“APB”) 25. The prospective method requires the application of the fair value based method to compensation awards granted, modified or settled on or after the date of adoption. The approach to account for share-based payments in SFAS 123(R) is similar to the approach described in SFAS 123, however, SFAS 123(R) requires the expense related to all share-based payments to employees, including grants of employee stock options, to be recognized in the consolidated financial statements. Pro forma disclosure of the impact of fair value share-based payments is no longer an alternative to financial statement recognition. The Company had previously adopted the expense recognition provisions of SFAS 123, on a prospective basis, effective January 1, 2003, and since that date has included the expense related to stock options granted subsequent to January 1, 2003 in its statements of operations. In addition, the Company has historically expensed the compensation cost associated with its restricted shares plan beginning with the initial grant in 2001. Accordingly, the effect of adopting SFAS 123(R) did not have a material effect on the Company’s results of operations or financial position. Subsequent to January 1, 2006, deferred compensation related to restricted stock grants will be recognized in additional paid-in capital. In accordance with SFAS 123(R), compensation cost associated with stock options recognized during 2006 includes: 1) quarterly amortization related to the remaining unvested portion of all stock option awards granted prior to January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123; and 2) quarterly amortization related to all stock option awards granted on or after December 31, 2005, based on the grant-date fair value estimated.
The following table summarizes stock option activity for the 2002 Option Plan for the year ended December 31, 2006:
The fair value of options granted during the year ended December 31, 2006 and 2005, estimated as of the grant date using the Black-Scholes option pricing model, was $9.21 and $6.89 per share, respectively. The Company did not grant stock options during the year ended December 31, 2004. The weighted-average remaining contractual term for options outstanding as of December 31, 2006, 2005 and 2004 was 5.9 years, 6.8 years and 7.7 years, respectively. The weighted-average remaining contractual term for options vested and exercisable as of December 31, 2006 was 5.7 years. As of December 31, 2006, the aggregate intrinsic value was $9.2 million for options outstanding and $7.8 million for options vested and exercisable.
As of December 31, 2006, there was $1.6 million of unrecognized compensation cost related to unvested options granted from the 2001 Option Plan, which is expected to be recognized over a remaining weighted-average vesting period of 2.1 years. The total fair value of the options exercised from the 2001 Option Plan during the year ended December 31, 2006 was $1.1 million, as compared to the total fair value of the options exercised during the year ended December 31, 2005 of $0.1 million and was immaterial for the year ended December 31, 2004.
The weighted-average remaining contractual term for options outstanding as of December 31, 2006, 2005 and 2004 was 7.4 years, 7.1 years and 7.1 years, respectively. The weighted-average remaining contractual term for options vested and exercisable as of December 31, 2006 was 6.3 years. As of December 31, 2006, the aggregate fair value was $5.3 million for options outstanding and $0.8 million for options vested and exercisable.
In 2001, the Company adopted the Restricted Share Plan, which provides for the grant of restricted shares of the Company’s common stock to directors, officers and key employees of the Company. Shares granted under the Restricted Share Plan generally vest and become exercisable in equal installments over three years or five years from the grant dates. Amounts granted in 2001 vest and become exercisable in two equal installments on the fifth and tenth anniversary of the grant dates. Awards under each of the Restricted Share Plan and the 2001 Option Plan (described above) may not exceed an aggregate of 10% of the Company’s issued and outstanding shares of common stock as of the last business day of the previous calendar year. The Company had 69,127,532 issued and outstanding shares of common stock as of December 31, 2005.
In accordance with SFAS 123(R), the fair value of restricted share awards is estimated on the date of grant based on the market price of the Company’s stock and is amortized to compensation expense on a straight-line basis over the related vesting periods. As of December 31, 2006, there was $10.5 million of unrecognized compensation cost related to unvested restricted share awards, which is expected to be recognized over a remaining weighted-average vesting period of 3.2 years. SFAS 123(R) requires that the deferred stock-based compensation on the consolidated balance sheet on the date of adoption be netted against additional paid-in capital. As of December 31, 2005, there was approximately $1.8 million of deferred stock-based compensation that was netted against additional paid-in capital on January 1, 2006. The total fair value of the restricted share awards vested during the year ended December 31, 2006, 2005 and 2004 was $5.8 million, $1.8 million and $1.8 million, respectively. As of December 31, 2006, the aggregate fair value was $25.5 million for restricted share awards outstanding.
The following table summarizes restricted share activity for the Restricted Share Plan for the year ended December 31, 2006:
In 2001, the Company established the Employee Share Purchase Plan (the “ESPP”). Under the terms of the ESPP, eligible employees may elect to purchase Company common shares in an amount up to 10% of their annual base salary. The Company issues or purchases, on the employee’s behalf, the Company’s common shares equal to 30% of the employee’s contribution. In the event that the Company achieves a return on equity of at least 15% in any calendar year, as computed in accordance with GAAP, additional shares are purchased by the Company for the employee’s benefit in an amount equal to 20% of the employee’s contribution during that year. During the years ended December 31, 2006, 2005 and 2004, the Company purchased 83,046 shares, 74,764 shares and 67,819 shares, respectively, on behalf of employees pursuant to the ESPP, at average purchase prices of $27.58, $24.93 and $24.20, respectively. The compensation expense recognized by the Company for purchases of the Company’s common shares under the ESPP was $0.5 million, $0.4 million and $0.5 million for the years ended December 31, 2006, 2005 and 2004, respectively.
For the years ended December 31 2006, 2005 and 2004, the Company received $2.7 million, $1.5 million and $0.4 million, respectively, in cash from employees for the exercise of stock options. For the year ended December 31 2006, 2005 and 2004, the Company recognized an expense related to all stock based compensation of $5.6 million, $4.2 million and $2.8 million, respectively. Of the $5.6 million expense for the year ended December 31, 2006, $0.6 million relates to the adoption of SFAS 123(R). The total tax benefit recognized for the year ended December 31, 2006, 2005 and 2004 was $2.0 million, $1.5 million and $1.0 million, respectively. For the year ended December 31, 2006, the additional stock based compensation expense as a result of the adoption of SFAS 123(R) caused income before income taxes to decrease by $0.6 million, net income to decrease by $0.4 million, and basic and diluted earnings per share to decrease by $0.01.
Had compensation costs of option awards and employees’ purchase rights been determined under a fair value alternative method as stated in SFAS 148 “Accounting for Stock-Based Compensation - Transition and Disclosure, an amendment of SFAS 123,” the Company would have been required to prepare a fair value model for such options and employees’ purchase rights and record such amount in the consolidated financial statements as compensation expense, and the Company’s net income (loss) and income (loss) per common share for the years ended December 31, 2005 and 2004 would have been reduced to the following pro forma amounts (in thousands, except per share data):
The Company previously underwrote assumed financial guaranty reinsurance. The maximum exposure to loss, in the event of nonperformance by the underlying insured and assuming underlying collateral proved to be of no value, related to this business was $31.0 million and $35.3 million as of December 31, 2006 and 2005, respectively. It is the responsibility of the ceding insurer to collect and maintain collateral under financial guaranty reinsurance. The Company ceased writing financial guaranty business in 1992.
As of December 31, 2006, financial guaranty reinsurance in force had a remaining maturity term of one (1) to 20 years. The approximate distribution of the estimated debt service (principal and interest) of bonds, by type and unearned premiums, for the years ended December 31, 2006 and 2005 is as follows (in millions):
Hub International Limited (“Hub”), which is 13.3% owned by the Company (see Note 7(d)), announced on February 26, 2007 that it has agreed to be acquired by a group of private equity firms. The private equity firms have agreed to pay $40.00 per share in cash for Hub. The transaction is subject to Hub shareholder approval, Canadian court approval, and regulatory approvals in the United States and Canada, and is expected to be completed toward the end of the second quarter of 2007. The Company expects to recognize pre-tax income of approximately $110.0 million ($71.5 million, after tax), principally through realized gains, related to the sale of its ownership in Hub.
On February 8, 2007, the Company was added as a co-defendant in an amended complaint in an existing action against its majority shareholder, Fairfax Financial Holdings Limited, and certain of Fairfax’s officers and directors, who include certain current and former directors of the Company. The amended and consolidated complaint has been filed in the United States District Court for the Southern District of New York by the lead plaintiffs, who seek to represent a class of all purchasers and acquirers of securities of Fairfax between May 21, 2003 and March 22, 2006, inclusive, and allege, among other things, that the defendants violated U.S. federal securities laws by making material misstatements or failing to disclose certain material information. The amended complaint seeks, among other things, certification of the putative class, unspecified compensatory damages, unspecified injunctive relief, reasonable costs and attorneys’ fees and other relief. The Company intends to vigorously defend against the allegations. At this early stage of the proceedings, it is not possible to make any determination regarding the likely outcome of this matter.
To the Board of Directors and Shareholders of Odyssey Re Holdings Corp.
The condensed financial statements should be read in conjunction with the accompanying notes and with the consolidated financial statements and notes thereto.
(1) Dividends received from subsidiaries, which were previously reported as a financing activity, have been appropriately classified as an operating activity beginning in 2006, with conforming changes in 2005 and 2004.