CATA experienced increased competition and decreased rates in its property and casualty and commercial surety lines of business during 2007, compared with 2006. CATA experienced generally unchanged rates in its property and casualty and commercial surety lines of business in 2006, compared with 2005.
The increases in net investment income at AIHL in 2007 and 2006 primarily reflect a larger invested asset base, primarily due to the impact of strong operating cash flow. The increase in net investment income for 2007 also reflects the net positive effect of the acquisition of EDC as invested assets acquired were greater than our purchase price. The increase in net investment income for 2006 also reflects a larger invested asset base in 2006 as a result of capital contributions to AIHL by Alleghany and receipt of net proceeds from the initial public offering of Darwin common stock in May 2006.
Equity Securities Portfolio. As of December 31, 2007, the equity securities portfolio of AIHL and its subsidiaries, on a consolidated basis, was carried at a fair value of approximately $760.3 million, with an original cost of approximately $632.5 million. In 2007, AIHL had dividend income on its portfolio of $11.7 million, compared to $5.2 million in 2006 and $4.1 million in 2005. AIHL and its subsidiaries may, from time to time, make significant investments in the common stock of a public company, subject to limitations imposed by applicable regulations.
Corporate activities 2007 results also reflect lower gains on sales of real property by Alleghany Properties in 2007 compared with 2006, partially offset by lower corporate administrative and interest expense. Gains on sales of real property were $14.7 million during 2007, compared with gains on sales of real property of $24.3 million in 2006 and $11.2 million in 2005. Lower corporate administration expenses are primarily due to decreased expenses for benefits incurred and other employee-related costs. Lower interest expense in 2007 from 2006 is primarily due to the maturity of our $80.0 million of floating rate notes in January of 2007 of Alleghany Funding. Net investment income for 2007 includes $4.1 million of earnings from Alleghany’s equity investment in Homesite, net of purchase accounting adjustments.
In March 2006, FASB Statement No. 155, “Accounting for certain Hybrid Instruments, an amendment to FASB Statement No. 133 and 140,” was issued. This Statement permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation, and establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. This Statement is effective for all financial instruments acquired or issued after the beginning of an entity’s first fiscal year that begins after September 15, 2006. We have adopted the provisions of this Statement as of January 1, 2007, and the implementation did not have any material impact on our results of operations and financial condition.
Premiums and discounts arising from the purchase of certain debt securities are treated as a yield adjustment over the estimated useful life of the securities, adjusted for anticipated prepayments using the retrospective interest method. Under this method, the effective yield on a security is estimated. Such estimates are based on the prepayment terms of the security, past actual cash flows and assumptions as to future expected cash flow. The future cash flow assumptions consider various prepayment assumptions based on historical experience, as well as current market conditions. Periodically, the effective yield is re-estimated to reflect actual prepayments and updated future cash flow assumptions. Upon a re-estimation, the security’s book value is restated at the most recently calculated effective yield, assuming that yield had been in effect since the security was purchased. This treatment results in an increase or decrease to net investment income (amortization of premium or discount) at the new measurement date.
Alleghany follows Statement of Financial Accounting Standards No. 123 (revised), “Share Based Payment” (“SFAS 123R”). SFAS 123R requires that the cost resulting from all share-based compensation transactions be recognized in the financial statements, establishes fair value as the measurement objective in accounting for share-based compensation arrangements, and requires the application of the fair value based measurement method in accounting for share-based compensation transactions with employees. SFAS 123R was adopted by Alleghany for awards made or modified on or after January 1, 2006. Prior to SFAS 123R, Alleghany followed Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). SFAS 123 established accounting and reporting standards for share-based employee compensation plans and allowed companies to choose between the “fair value based method of accounting” as defined in SFAS 123 and the “intrinsic value based method of accounting” as prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB25”). Alleghany had elected to continue to follow the “intrinsic value based method of accounting” for awards granted prior to 2003, and accordingly, no expense was recognized with respect to stock option grants. Effective January 1, 2003, Alleghany adopted the “fair value based method of accounting” of SFAS 123, using the prospective transition method for awards granted after January 1, 2003. The fair value based method under SFAS 123 is similar to that employed under SFAS 123R. The impact of the adoption of SFAS 123R on Alleghany’s consolidated financial results and financial condition was immaterial. Both SFAS 123 and SFAS 123R treat non-employee directors as employees for accounting purposes.
Alleghany’s insurance operating units, domiciled principally in the States of California, New Hampshire, Delaware, Wisconsin, Nebraska, Arkansas and Oklahoma, prepare statutory financial statements in accordance with the accounting practices prescribed or permitted by the insurance departments of the states of domicile. Prescribed statutory accounting practices are those practices that are incorporated directly or by reference in state laws, regulations and general administrative rules applicable to all insurance enterprises domiciled in a particular state. Permitted statutory accounting practices include practices not prescribed by the domiciliary state, but allowed by the domiciliary state regulatory authority. The impact of any permitted accounting practices on statutory surplus of Alleghany is not material.
The proceeds from sales of available-for-sale securities were $944.6 million, $320.1 million and $656.7 million, in 2007, 2006, and 2005, respectively. The amounts of gross realized gains and gross realized losses of available-for-sale securities were, respectively, $103.1 million and $2.7 million in 2007, $38.6 million and $5.7 million in 2006 and $152.3 million and $3.9 million in 2005.
As of December 31, 2007, Alleghany held a total of 273 debt and equity investments that were in an unrealized loss position, of which 142 investments were in an unrealized loss position continuously for 12 months or more. Of the 142 positions, all relate to debt securities.
On June 23, 2006, Alleghany completed an offering of 1,132,000 shares of its 5.75 percent mandatory convertible preferred stock (the “Preferred Stock”) at a public offering price of $264.60 per share, resulting in net proceeds of $290.4 million. The annual dividend on each share of Preferred Stock is $15.2144. Dividends on the Preferred Stock accrue and accumulate from the date of issuance, and, to the extent Alleghany is legally permitted to pay dividends and Alleghany’s board of directors declares a dividend payable, Alleghany will pay dividends in cash on a quarterly basis. Each share of Preferred Stock has a liquidation preference of $264.60, plus any accrued, cumulated and unpaid dividends. Each share of Preferred Stock will automatically convert on June 15, 2009 into between 0.8475 and 1.0000 shares of Alleghany’s Common Stock depending on the average market price per share of Common Stock over the 20 trading day period ending on the third trading day prior to such date. The conversion rate is also subject to anti-dilution adjustments. At any time prior to June 15, 2009, holders of the Preferred Stock may elect to convert each share of Preferred Stock into 0.8475 shares of Common Stock, subject to anti-dilution adjustments. All of the above data has not been adjusted for subsequent stock dividends.
Notes receivable: The carrying amount approximated fair value as the interest rates approximated market rates.