Odyssey Re Holdings 10-K 2006
Documents found in this filing:
As filed with the Securities and Exchange Commission on March 31, 2006
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
ANNUAL REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended: December 31, 2005
Commission File Number: 1-16535
Odyssey Re Holdings Corp.
(Exact Name of Registrant as Specified in its Charter)
Odyssey Re Holdings Corp.
300 First Stamford Place, Stamford, Connecticut 06902
(Address, including zip code, and telephone number,
including area code, of registrants principal executive offices)
Securities registered pursuant to Section 12(b) of the Act:
Securities Registered Pursuant to Section 12(g) of the Act:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes o No þ
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Securities Exchange Act. Yes o No þ
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No þ
The aggregate market value of the shares of all classes of voting shares of the Registrant held by non-affiliates of the Registrant on June 30, 2005 was $308.5 million, computed upon the basis of the closing sale price of the Common Stock on that date. For purposes of this computation, shares held by directors (and shares held by entities in which they serve as officers) and officers of the Registrant have been excluded. Such exclusion is not intended, nor shall it be deemed, to be an admission that such persons are affiliates of the Registrant.
As of March 13, 2006, there were 69,112,119 outstanding shares of Common Stock, par value $0.01 per share, of the Registrant.
Documents Incorporated by Reference
Portions of the Registrants definitive proxy statement filed or to be filed with the Securities and Exchange Commission pursuant to Regulation 14A involving the election of directors at the annual meeting of the shareholders of the Registrant scheduled to be held on or about April 28, 2006 are incorporated by reference in Part III of this Form 10-K.
ODYSSEY RE HOLDINGS CORP.
TABLE OF CONTENTS
References in this Annual Report on Form 10-K to OdysseyRe, the Company, we, us and our refer to Odyssey Re Holdings Corp. and, unless the context otherwise requires or otherwise as expressly stated, its subsidiaries, including Odyssey America, Clearwater, Newline, Hudson, Hudson Specialty and Clearwater Select (as defined herein).
Financial results presented herein reflect a restatement of our consolidated financial statements as of and for the years ended December 31, 2000 through 2004, as well as our results as of and for the nine months ended September 30, 2005, as discussed in more detail in Note 2 and Note 21 to the consolidated financial statements included in this Form 10-K.
SAFE HARBOR DISCLOSURE
In connection with, and because it desires to take advantage of, the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, we caution readers regarding certain forward-looking statements contained in this Annual Report on Form 10-K. This Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act).
We have included in this Form 10-K filing, and from time to time our management may make, written or oral statements that may include forward-looking statements that reflect our current views with respect to future events and financial performance. These forward-looking statements relate to, among other things, our plans and objectives for future operations. These forward-looking statements are subject to uncertainties and other factors that could cause actual results to differ materially from such statements. These uncertainties and other factors include, but are not limited to:
The words believe, anticipate, project, expect, intend, will likely result, will seek to or will continue and similar expressions identify forward-looking statements. We caution readers not to place undue reliance on these forward-looking statements, which speak only as of their dates. We have described some important factors that could cause our actual results to differ materially from our expectations in this Annual Report on Form 10-K, including factors discussed below in Item 1A Risk Factors. Except as otherwise required by federal securities laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
OdysseyRe is a leading United States based underwriter of reinsurance, providing a full range of property and casualty products on a worldwide basis. We offer both treaty and facultative reinsurance to property and casualty insurers and reinsurers. We also write specialty insurance business, primarily focused on liability lines, in the United States. Our global presence is established through 15 offices, with principal locations in the United States, London, Paris, Singapore and Latin America. We had gross premiums written of $2.6 billion in 2005 and our shareholders equity as of December 31, 2005 was $1.6 billion. For the year ended December 31, 2005, reinsurance represented 71.0% of our gross premiums written, and primary insurance represented the remaining 29.0%.
The United States is our largest market, generating 55.2% of our gross premiums for the year ended December 31, 2005, with the remaining 44.8% comprised of international business. Our operations are managed through four divisions: Americas, EuroAsia, London Market and U.S. Insurance. The Americas division is comprised of our reinsurance operations in the United States, Canada and Latin America. The Americas division primarily writes treaty property, general casualty, specialty casualty, surety, and facultative casualty reinsurance business, primarily through professional reinsurance brokers. The EuroAsia division, headquartered in Paris, writes primarily treaty and facultative property reinsurance. Our London Market division operates through two distribution channels, Newline at Lloyds, where the business focus is casualty insurance, and our London branch, which focuses on worldwide property and casualty reinsurance. The U.S. Insurance division writes specialty insurance in the United States, including medical malpractice, professional liability and non-standard personal auto. Across our operations, 58.2% of our gross premiums written was generated from casualty business, 32.4% from property business and 9.4% from specialty classes, including marine and aviation and surety and credit.
Odyssey Re Holdings Corp. was incorporated on March 21, 2001 in the state of Delaware. In June 2001, we completed our initial public offering. Prior to our initial public offering, we were wholly owned by Fairfax Financial Holdings Limited (Fairfax), a publicly traded Canadian financial services company. As of December 31, 2005, Fairfax owned 80.2% of our common shares.
Following is a summary of our principal operating subsidiaries:
Restatement of Financial Results
We have restated our consolidated financial statements as of and for the years ended December 31, 2000 through 2004, as well as our unaudited statements as of and for the nine months ended September 30, 2005, to correct for accounting errors associated with reinsurance contracts entered into by us between 1998 and 2004. Our decision to restate our financial results follows a re-evaluation by us of the accounting considerations previously applied to these transactions. The effects of the restatement are reflected in our consolidated financial statements and accompanying notes included herein. Amounts for the nine months ended September 30, 2005 are unaudited. See also Item 6 Selected Financial Data, Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations and Note 2 and Note 21 to our consolidated financial statements.
The total cumulative impact of the restatement through September 30, 2005 is to decrease shareholders equity by $35.6 million, after-tax. The aggregate net effect of the restatement for each period is to increase the net loss for the nine months ended September 30, 2005 by $5.1 million, increase 2004 net income by $11.4 million, decrease 2003 net income by $2.3 million, decrease 2002 net income by $5.6 million, increase 2001 net loss by $30.7 million and decrease 2000 net income by $3.3 million. The $35.6 million after-tax cumulative decrease to shareholders equity as of September 30, 2005 will be offset by net income of $12.5 million to be recognized for the three months ended March 31, 2006 in connection with one of the restated contracts as discussed below.
The nature of the corrections relate to:
Securities and Exchange Commission Subpoena
On September 7, 2005, we announced that we had been advised by Fairfax, our majority shareholder, that it had received a subpoena from the Securities and Exchange Commission (SEC) requesting documents regarding any non-traditional insurance and reinsurance transactions entered into or offered by Fairfax and any of its affiliates, which included OdysseyRe. The United States Attorneys Office for the Southern District of New York is reviewing documents provided to the SEC in response to the subpoena, and is participating in the investigation into these matters. In addition, we have provided information and made a presentation to the SEC and the U.S. Attorneys office relating to the restatement of our financial results announced by us on February 9, 2006. We are cooperating fully in addressing our obligations under this subpoena. Fairfax, and Fairfaxs chairman and chief executive officer, V. Prem Watsa, who is also the chairman of OdysseyRe, have received subpoenas from the SEC in connection with the answer to a question on Fairfaxs February 10, 2006 investor conference call
concerning the review of Fairfaxs finite contracts. Our independent registered public accountants have received a subpoena from the SEC relating to the above matters. This inquiry is ongoing, and we continue to comply with requests from the SEC and the U.S. Attorneys office.
Our objective is to build shareholder value by achieving an average annual growth in book value per share of 15% over the long-term by focusing on underwriting profitability and generating superior investment returns. Our compounded annual growth in book value per share from December 31, 2001, the year the Company became publicly traded, to December 31, 2005 was 16.3%. We intend to continue to achieve our objective through:
Overview of Reinsurance
Reinsurance is an arrangement in which the reinsurer agrees to indemnify an insurance or reinsurance company, the ceding company, against all or a portion of the insurance risks underwritten by the ceding company under one or more insurance or reinsurance contracts. Reinsurance can provide a ceding company with several benefits, including a reduction in net liability on individual risks or classes of risks, and catastrophe protection from large or multiple losses. Reinsurance also provides a ceding company with additional underwriting capacity by permitting it to accept larger risks. Reinsurance, however, does not discharge the ceding company from its liability to policyholders. Rather, reinsurance serves to indemnify a ceding company for losses payable by the ceding company to its policyholders.
There are two basic types of reinsurance arrangements: treaty and facultative reinsurance. In treaty reinsurance, the ceding company is obligated to cede and the reinsurer is obligated to assume a specified portion of a type or category of risks insured by the ceding company. Treaty reinsurers do not separately evaluate each of the individual risks assumed under their treaties and are largely dependent on the individual underwriting decisions made by the ceding company. Accordingly, reinsurers will carefully evaluate the ceding companys risk management and underwriting practices in deciding whether to provide treaty reinsurance and in appropriately pricing the treaty.
In facultative reinsurance, the ceding company cedes and the reinsurer assumes all or part of the risk under a single insurance or reinsurance contract. Facultative reinsurance is negotiated separately for each contract that is reinsured. Facultative reinsurance normally is purchased by ceding companies for individual risks not covered by
their reinsurance treaties, for amounts in excess of the dollar limits of their reinsurance treaties or for unusual risks.
Both treaty and facultative reinsurance can be written on either a proportional, also known as pro rata, basis or on an excess of loss basis. Under proportional reinsurance, the ceding company and the reinsurer share the premiums as well as the losses and expenses in an agreed proportion. Under excess of loss reinsurance, the reinsurer indemnifies the ceding company against all or a specified portion of losses and expenses in excess of a specified dollar amount, known as the ceding companys retention or the reinsurers attachment point.
Excess of loss reinsurance is often written in layers. A reinsurer accepts the risk just above the ceding companys retention up to a specified amount, at which point that reinsurer or another reinsurer accepts the excess liability up to an additional specified amount, or such liability reverts to the ceding company. The reinsurer taking on the risk just above the ceding companys retention layer is said to write working layer or low layer excess of loss reinsurance. A loss that reaches just beyond the ceding companys retention will create a loss for the lower layer reinsurer, but not for the reinsurers on the higher layers. Loss activity in lower layer reinsurance tends to be more predictable than in higher layers.
Premiums payable by the ceding company to a reinsurer for excess of loss reinsurance are not directly proportional to the premiums that the ceding company receives because the reinsurer does not assume a proportional risk. In contrast, premiums that the ceding company pays to the reinsurer for proportional reinsurance are proportional to the premiums that the ceding company receives, consistent with the proportional sharing of risk. In addition, in proportional reinsurance, the reinsurer generally pays the ceding company a ceding commission. The ceding commission generally is based on the ceding companys cost of acquiring the business being reinsured (commissions, premium taxes, assessments and administrative expenses) and also may include a profit factor for producing the business.
Reinsurance may be written for insurance or reinsurance contracts covering casualty risks or property risks. In general, casualty insurance protects against financial loss arising out of an insureds obligation for loss or damage to a third partys property or person. Property insurance protects an insured against a financial loss arising out of the loss of property or its use caused by an insured peril or event. Property catastrophe coverage is generally all risk in nature and is written on an excess of loss basis, with exposure to losses from earthquake, hurricanes and other natural or man made catastrophes such as storms, floods, fire or tornados. There tends to be a greater delay in the reporting and settlement of casualty reinsurance claims as compared to property claims due to the nature of the underlying coverage and the greater potential for litigation involving casualty risks.
Reinsurers may purchase reinsurance to cover their own risk exposure. Reinsurance of a reinsurers business is called a retrocession. Reinsurance companies cede risks under retrocessional agreements to other reinsurers, known as retrocessionaires, for reasons similar to those that cause insurers to purchase reinsurance: to reduce net liability on individual risks or classes of risks, to protect against catastrophic losses, to stabilize financial ratios and to obtain additional underwriting capacity.
Reinsurance can be written through professional reinsurance brokers or directly with ceding companies.
Lines of Business
Our reinsurance operations primarily consist of the following lines of business:
Our insurance operations primarily consist of the following lines of business:
The following table sets forth our gross premiums written, by line of business, for each of the three years in the period ended December 31, 2005:
For the year ended December 31, 2005, total reinsurance gross premiums written were $1,863.6 million, or 71.0% of our gross premiums written, and the remaining $763.3 million, or 29.0%, was insurance business. Our insurance premiums include our U.S. Insurance division and business written in our Lloyds syndicate, which is part of our London Market division. Treaty reinsurance represents 66.0% of our total gross premiums written and 92.9% of our total reinsurance gross premiums written. Facultative reinsurance is 5.0% of our gross premiums written and 7.1% of our total reinsurance business. During 2005, 56.5% of our total reinsurance gross premiums written was proportional and 43.5% was excess of loss.
We write property catastrophe excess of loss reinsurance, covering loss or damage from unpredictable events such as hurricanes, windstorms, hailstorms, freezes or floods, which provides aggregate exposure limits and requires cedants to incur losses in specified amounts before our obligation to pay is triggered. For the year ended December 31, 2005, $239.5 million, or 9.1%, of our gross premiums written were derived from property catastrophe excess of loss reinsurance. We also write property business, which has exposure to catastrophes, on a proportional basis, in North America and Latin America. In addition, the EuroAsia division writes largely property business, with exposure to catastrophes, primarily in Europe, Japan, the Pacific Rim and the Middle East.
Treaty casualty business accounted for $691.9 million, or 26.4%, of gross premiums written for the year ended December 31, 2005, of which 58.4% was written on a proportional basis and 41.6% was written on an excess of loss basis. Our treaty casualty portfolio principally consists of specialty casualty products, including professional liability, directors and officers liability, excess and surplus lines, workers compensation and accident and health, as well as general casualty products, including general liability and auto liability. Treaty property business represented $793.8 million, or 30.2%, of gross premiums written for the year ended December 31, 2005, primarily consisting of commercial property and homeowners coverage, of which 55.3% was written on a proportional basis and 44.7% was written on an excess of loss basis. Treaty marine and aerospace business accounted for $141.8 million, or 5.4%, of gross premiums written for the year ended December 31, 2005, of which 31.1% was written on an excess of loss basis and 68.9% on a proportional basis. Surety, credit and other miscellaneous reinsurance lines accounted for 4.0% of gross premiums written in 2005.
Facultative reinsurance accounted for $132.4 million, or 5.0%, of gross premiums written for the year ended December 31, 2005, with 97.6% derived from the Americas division and 2.4% from the EuroAsia division. With respect to facultative business in the United States, we write only casualty reinsurance, including general liability, umbrella liability, directors and officers liability, professional liability and commercial auto lines; with respect to facultative business in Latin America and EuroAsia, we write primarily property reinsurance.
We operate at Lloyds through our wholly owned syndicate, Newline, which is focused on casualty insurance. Our Lloyds membership provides strong brand recognition, extensive broker and distribution channels, worldwide licensing and augments our ability to write insurance business on an excess and surplus lines basis in the United States.
We provide insurance products through our U.S. Insurance division. This business is comprised of specialty insurance business underwritten on both an admitted and non-admitted basis. Business is generated through national and regional agencies and brokers, as well as through program administrators. Each program administrator has strictly defined limitations on lines of business, premium capacity and policy limits. Many program administrators have limited geographic scope and all are limited regarding the type of business they may accept on our behalf. We underwrite medical malpractice insurance primarily on a non-admitted basis. Coverage is written on a claims-made basis, providing a wide range of limits and retentions.
As a general matter, we target specific classes of business depending on the market conditions prevailing at any given point in time. We actively seek to grow our participation in classes experiencing improvements, and reduce or eliminate participation in those classes suffering from intense competition or poor fundamentals. Consequently, the classes of business for which we provide reinsurance are diverse in nature and the product mix within the reinsurance and insurance portfolios may change over time. From time to time, we may consider opportunistic expansion or entry into new classes of business or ventures, either through organic growth or the acquisition of other companies or books of business.
We currently expect our gross premiums written to decline by up to 12% for the year ended December 31, 2006 as compared to 2005. This primarily reflects a reduction in the amount of reinsurance business we will write in 2006 on a proportional basis in certain classes of business, particularly for catastrophe exposed property business in the United States. Where appropriate, we intend to migrate proportional business to an excess of loss basis, which has the effect of reducing written premiums attributable to the coverage. We believe this more effectively allocates our capital resources in line with the underlying characteristics of the business. Proportional business represented 56.5% of our reinsurance gross premiums written for the year ended December 31, 2005, compared to 60.5% in 2004. Included in our gross premiums written in 2005 is $70.4 million in reinstatement premiums primarily attributable to the 2005 hurricanes. In the absence of similar catastrophes in 2006, we would not expect these premium amounts to recur in 2006. In addition, while pricing generally remains adequate across the casualty market, we expect a decline in casualty classes of business, reflecting lower levels of reinsurance purchased by our customers and increased competition in certain specialty classes.
Our business is organized across four operating divisions: the Americas, EuroAsia, London Market, and U.S. Insurance divisions. The table below illustrates gross premiums written by division for each of the three years in the period ended December 31, 2005.
The Americas is our largest division, accounting for $1.1 billion, or 43.1%, of our gross premiums written for the year ended December 31, 2005. The Americas division is organized into three major units: the United States, Latin America and Canada. The Americas division writes treaty, casualty and property, and facultative casualty reinsurance in the United States and Canada. In Latin America we write treaty and facultative property reinsurance along with other short-tail lines. The Americas division currently has 319 employees and operates through six offices: Stamford, New York City, Mexico City, Miami, Santiago and Toronto. The Americas divisions principal client base includes small to medium-sized regional and specialty ceding companies, as well as various specialized departments of major insurance companies. Business is generated mainly through brokers.
The following table displays gross premiums written by each of the units within the Americas division for each of the three years in the period ended December 31, 2005.
The United States unit provides treaty reinsurance of virtually all classes of non-life insurance. In addition to the specialty casualty and general casualty reinsurance lines, the unit also writes commercial and personal property as well as marine and aerospace, accident and health, and surety lines. Facultative casualty is also written in the United States unit, mainly for general liability, umbrella liability, directors and officers liability, professional liability and commercial auto. The United States unit operates out of offices in Stamford and New
York City. The following table displays gross premiums written, by business segment, for the United States for each of the last three years in the period ended December 31, 2005.
The Latin America unit writes primarily treaty and facultative business throughout Latin America and the Caribbean. The business is predominantly commercial property in nature, and also includes auto and marine lines. The Latin America unit has its principal office in Mexico City, with satellite offices in Miami and Santiago, Chile. The Canadian unit, which operates out of an office in Toronto, writes primarily property, crop hail and auto liability coverage.
The following table displays gross premiums written for the Americas division, by type of business, for each of the three years in the period ended December 31, 2005.
The EuroAsia division accounted for $543.8 million, or 20.7%, of our gross premiums written for the year ended December 31, 2005. The division primarily writes property business and short tail treaty business. The EuroAsia division, employing 87 employees currently, operates out of four offices, with principal offices in Paris and Singapore and satellite offices in Stockholm and Tokyo. Business is produced through a strong network of global and regional brokers. The EuroAsia division underwrites through brokers for 66.1% of the business and
33.9% directly. Our top five brokers for the EuroAsia division in 2005, which included Aon Corp., Benfield Group, Ltd., Gras Savoye, Guy Carpenter & Co., Inc. and Willis Group Holdings Ltd., generated 44.2% of the divisions business in 2005.
The Paris branch office is the headquarters of the EuroAsia division and the underwriting center in charge of Europe, the Middle East and Africa, with an office in Stockholm, Sweden, covering the Nordic countries and Russia. The Paris branch writes primarily property, motor, credit and bond, accident and health, marine and aerospace and liability business. The Asia Pacific Rim unit, headquartered in Singapore with an office in Tokyo, writes reinsurance on both a treaty and facultative basis. The primary lines of business offered in the Asia Pacific Rim include property, marine, motor, accident and health, credit and bond coverages, and liability business. During 2005, Europe represented 66.4% of gross premiums written while Asia represented 21.3% and the Middle East, Africa and America comprised the remaining 12.3%.
The following table displays gross premiums written for the EuroAsia division, by type of coverage, for each of the last three years in the period ended December 31, 2005.
The property business, including the property component of motor business, in EuroAsia is 58.6% proportional, 40.4% excess of loss and 1.0% facultative. Per risk coverages account for 53.3% of the property business, while 25.3% relates to catastrophe coverage. The remaining property coverages include lines such as crop and facultative.
The following table displays gross premiums written for the EuroAsia division, by type of business, for each of the three years in the period ended December 31, 2005. Gross premiums written for the years ended December 31, 2004 and 2003 included $24.9 million and $17.6 million, respectively, attributable to the consolidation of First Capital Insurance Limited (First Capital), which writes business in Singapore. Starting in
the fourth quarter of 2004, the Companys economic interest in First Capital declined to less than 50%, and First Capital is no longer consolidated in our consolidated financial statements.
The London Market division accounted for $431.6 million, or 16.4%, of our gross written premiums for the year ended December 31, 2005. The London Market division, with 73 employees in our London and Bristol offices, currently operates through two platforms: Newline and the London branch. Newlines business focus is international casualty insurance, while the London branch writes worldwide treaty reinsurance. Our underwriting platforms are run by an integrated management team with a common business approach. In December 2005, we received approval from the Financial Services Authority to establish a new UK insurance entity, Newline Insurance Company Limited, which will complement the current structure and provide another distribution channel for our London insurance operations. Business is distributed through a diverse group of brokers with the top five brokers representing 57.1% of gross premiums written. Our top London Market division brokers include Aon, HSBC Insurance Brokers, Heath Lambert, Marsh Inc. and Willis.
For the year ended December 31, 2005, the London branch had gross premiums written of $189.3 million, or 43.9% of the total London Market division. The London branch writes worldwide treaty reinsurance through three business units: property, marine and aerospace, and international casualty. The property unit (comprising mainly retrocessional and catastrophe excess of loss business) represents just under one half of the total gross premiums written for the year ended December 31, 2005. Geographically, 87.1% of the branch business is located in the UK, Western Europe and the United States and is distributed through a diverse group of global and regional brokers.
For the year ended December 31, 2005, Newline had gross premiums written of $242.3 million, or 56.1% of the total London Market division. Newline writes international casualty insurance in five sectors: professional indemnity, directors and officers liability, crime, financial institution professional indemnity and liability. Newlines target market is generally small to medium sized accounts which could be either private or public companies. The United Kingdom, Australia and Western Europe represent 84.8% of Newlines business.
The following table displays gross premiums written for the London Market division, by type of business, for each of the three years in the period ended December 31, 2005.
Trademarked as Hudson Insurance Group, the U.S. Insurance division provides underwriting capacity on an admitted and non-admitted basis to medical malpractice and specialty insurance markets nationwide. The U.S. Insurance division generated $521.0 million, or 19.8%, of our gross premiums written for the year ended December 31, 2005. The U.S. Insurance division employs 113 people and operates from offices in New York, Chicago and Napa. Approximately 75.7% of the divisions business is written in 10 states/ territories, with the top five states/ territories representing 60.7% of the divisions total premiums.
Our medical malpractice business provides coverage to a wide variety of insureds, including small and mid-sized hospitals, physicians and physician groups, and is primarily focused on 12 states throughout the United States. Coverage is generally offered on a claims-made basis and is written on a surplus lines basis to provide rate and form flexibility. This business is distributed primarily through regional brokers.
In addition, the U.S. Insurance division provides primary coverage for a variety of risks, including non-standard personal auto, commercial auto, specialty liability and other niche markets. We manage a limited number of active program administrator relationships, with a majority of our business concentrated in our top ten relationships. We perform extensive due diligence on all new and existing program administrators and look to do business with organizations that have a long and well-documented track record in their area of expertise. Strong monitoring systems are in place and our program administrators are incentivized to produce profitable insurance business rather than to merely generate volume.
The following table displays gross premiums written for the U.S. Insurance division, by type of business, for each of the three years in the period ended December 31, 2005.
The following table provides additional detail regarding our medical malpractice business for each of the three years in the period ended December 31, 2005.
Retention Levels and Retrocession Arrangements
We impose maximum retentions on a per risk basis. We believe that the levels of gross capacity per property risk that are in place are sufficient to achieve our objective of attracting business in the international markets. The following table illustrates the current gross capacity, cession (reinsurance retrocession) and net retention generally applicable under our underwriting guidelines. Larger limits may be written, subject to the approval of senior management.
We purchase reinsurance to increase our aggregate premium capacity, to reduce and spread the risk of loss on insurance and reinsurance underwritten and to limit our exposure with respect to multiple claims arising from a single occurrence. We are subject to accumulation risk with respect to catastrophic events involving multiple treaties, facultative certificates and insurance policies. To protect against this risk, we purchase catastrophe excess of loss reinsurance protection. The retention, the level of capacity purchased, the geographic scope of the coverage and the cost each vary from year to year. The maximum recovery from a major United States catastrophic event in 2005 was $75.0 million, which is increased by proportional protection covering targeted portions of our property business. Specific reinsurance protections are also placed to protect selected portions of our portfolio. As of December 31, 2005, our catastrophe excess of loss reinsurance protection available for losses in the United States was exhausted by losses incurred by Hurricanes Katrina, Rita and Wilma. Depending on the cost and availability, we may elect not to purchase new or renewal coverage for catastrophe risks across our reinsurance portfolio in 2006. The ultimate amount of coverage we purchase will be considered in establishing the maximum amount of catastrophe exposure assumed by us during 2006.
When we enter into retrocessional agreements, we cede to reinsurers a portion of our risks and pay premiums based upon the risk and exposure of the policies subject to the reinsurance. Although the reinsurer is liable to us for the reinsurance ceded, we retain the ultimate liability in the event the reinsurer is unable to meet its obligation at some later date.
Our ten largest reinsurers represent 54.6% of our total reinsurance recoverables as of December 31, 2005. Amounts due from all other reinsurers are diversified, with no other individual reinsurer representing more than $28.1 million of reinsurance recoverables as of December 31, 2005, and the average balance is less than $2.0 million. Our reinsurance recoverables attributable to losses from Hurricanes Katrina, Rita and Wilma were $223.7 million as of December 31, 2005.
The following table shows the total amount which is recoverable from each of our ten largest reinsurers for paid and unpaid losses as of December 31, 2005, the amount of collateral held, and each reinsurers A.M. Best rating (in millions).
For additional information on our retrocession agreements, please refer to Notes 10 and 11 to the consolidated financial statements included in this report.
Reinsurance claims are managed by our professional claims staff, whose responsibilities include the review of initial loss reports, creation of claim files, determination of whether further investigation is required,
establishment and adjustment of case reserves, and payment of claims. Claims staff recognize that fair interpretation of our reinsurance agreements and timely payment of covered claims is a valuable service to clients and enhances our reputation. In addition to claims assessment, processing and payment, our claims staff conducts comprehensive claims audits of both specific claims and overall claims procedures at the offices of selected ceding companies, which we believe benefits all parties to the reinsurance arrangement. Claims audits are conducted in the ordinary course of business. In certain instances, a claims audit may be performed prior to assuming reinsurance business.
A dedicated claims unit manages the claims related to environmental impairment and asbestos-related illness liabilities, due to the significantly greater uncertainty involving these exposures. This unit performs audits of cedants with significant asbestos and environmental exposure to assess our potential liabilities. This unit also monitors developments within the insurance industry that may have a potential impact on our reserves.
For our medical malpractice business, written by the U.S. Insurance division, we employ a professional claims staff to confirm coverage, investigate, and administer all other aspects of the adjusting process from the inception to the final resolution of insurance claims. Insurance claims relating to our specialty insurance business conducted through program administrators are generally handled by third party administrators, typically specialists in defined business, who have limited authority and are subject to continuous oversight and review by our internal professional claims staff.
Reserves for Unpaid Losses and Loss Adjustment Expenses
We establish reserves to recognize liabilities for unpaid losses and loss adjustment expenses (LAE), which are balance sheet liabilities representing estimates of future amounts needed to pay claims and related expenses with respect to insured events that have occurred on or before the balance sheet date, including events which have not yet been reported to the ceding company. Significant periods of time may elapse between the occurrence of an insured loss, the reporting of the loss by the insured to the ceding company, the reporting of the loss by the ceding company to the reinsurer, the ceding companys payment of that loss and subsequent payments to the ceding company by the reinsurer.
We rely on loss information received from ceding companies to establish our estimate of losses and LAE. The types of information we receive from ceding companies generally vary by the type of contract. Proportional/quota share contracts are generally reported on at least a quarterly basis, providing premium and loss activity as estimated by the ceding company. Our experienced accounting staff have the primary responsibility for managing the handling of information received on these types of contracts. Our claims staff may also assist in the analysis, depending on the size or type of individual loss reported on proportional/quota share contracts. Cedant reporting for facultative and excess of loss contracts includes detailed individual claim information, including the description of injury, confirmation of cedant liability, and the cedants current estimate of liability. Our experienced claims staff has the responsibility for managing and analyzing the individual claim information. Based on the claims staffs evaluation of the claim, we may choose to establish additional case reserves over that reported by the ceding company. Due to potential differences in ceding company reporting practices, our accounting, claims, and internal audit departments perform reviews on ceding carriers to ensure that their underwriting and claims procedures meet our standards.
We also establish reserves to provide for incurred but not reported claims and the estimated expenses of settling claims (IBNR), including legal and other fees, and the general expenses of administering the claims adjustment process, known as loss adjustment expenses. We periodically revise such reserves to adjust for changes in the expected loss development pattern over time.
We rely on the underwriting and claim information provided by the ceding companies to compile our analysis of losses and LAE. This data is aggregated by geographic region and type of business to facilitate analysis. We calculate incurred but not reported loss and LAE reserves using generally accepted actuarial reserving techniques to project the ultimate liability for losses and LAE. IBNR includes a provision for losses incurred but not yet reported to us as well as anticipated additional emergence on claims already reported by the ceding companies or claimants. The actuarial techniques for projecting loss and LAE reserves rely on historical paid and case reserve loss emergence patterns and insurance and reinsurance pricing trends to establish the claims
emergence of future periods with respect to all reported and unreported insured events that have occurred on or before the balance sheet date. The process relies upon the assumption that past experience, supplemented by qualitative judgment where quantitative methods provide incomplete results, is an appropriate basis for predicting future events. The estimation of loss reserves is a complex process, especially in view of changes in the legal and social environment which impact the development of loss reserves, therefore quantitative techniques frequently have to be supplemented by qualitative assessments by management. These qualitative assessments may be required where emerging trends in claims frequency and severity, litigation, social and legislative changes are not fully contemplated in quantitative techniques.
Estimates of reserves for unpaid losses and LAE are contingent upon legislative, regulatory, social, economic and legal events that may or may not occur in the future, thereby affecting assumptions of claims frequency and severity. The eventual outcome of these events may be different from the assumptions underlying our reserve estimates. In the event that loss trends diverge from expected trends, we adjust our reserves to reflect the actual emergence which is known during the period. On a quarterly basis, we compare actual emergence in the quarter and cumulatively since the implementation of the last reserve review to the expectation of reported loss for the period. Variation in actual emergence from expectations may result in a change in loss and LAE reserve. Any adjustments will be reflected in the periods in which they become known, potentially resulting in adverse effects to our financial results. Changes in expected claim payment rates, which represent one component of loss and LAE emergence, may also impact our liquidity and capital resources, as discussed in Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations.
The reserving process is complex and the inherent uncertainties of estimating such reserves are significant, due primarily to the longer-term nature of most reinsurance business, the diversity of development patterns among different types of reinsurance treaties or facultative contracts, the necessary reliance on the ceding companies for information regarding reported claims and differing reserving practices among ceding companies. As a result, actual losses and LAE may deviate, perhaps substantially, from estimates of reserves reflected in our consolidated financial statements. During the loss settlement period, which can be many years in duration, additional facts regarding individual claims and trends usually become known. As these become apparent, it usually becomes necessary to refine and adjust the reserves upward or downward, and even then, the ultimate net liability may be less than or greater than the revised estimates.
We have exposure to asbestos and environmental pollution and latent injury damage claims on policies written prior to the mid 1980s. Included in our reserves are amounts related to environmental impairment and asbestos-related illnesses, which, net of related reinsurance recoverable, totaled $132.8 million and $99.0 million as of December 31, 2005 and 2004, respectively. The majority of our environmental and asbestos-related liabilities arise from contracts entered into before 1986 that were underwritten as standard general liability coverages where the contracts contained terms which, for us and the industry overall, have been interpreted by the courts to provide coverage for asbestos and environmental exposures not contemplated by the original pricing or reserving of the covers. Our estimate of our ultimate liability for these exposures includes case basis reserves and a provision for liabilities incurred but not yet reported. Case basis reserves are a combination of reserves reported to us by ceding companies and additional case reserves determined by our dedicated asbestos and environmental claims unit. We rely on an annual analysis of Company and industry loss emergence trends to estimate the loss and LAE reserve for this exposure, including projections based on historical loss emergence and loss completion factors supplied from other company and industry sources.
Estimation of ultimate liabilities is unusually difficult due to several significant issues surrounding asbestos and environmental exposures. Among the issues are: (a) the long period between exposure and manifestation of an injury; (b) difficulty in identifying the sources of asbestos or environmental contamination; (c) difficulty in allocating responsibility or liability for asbestos or environmental damage; (d) difficulty in determining whether coverage exists; (e) changes in underlying laws and judicial interpretation of those laws; and (f) uncertainty regarding the identity and number of insureds with potential asbestos or environmental exposure.
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: (a) continued growth in the number of claims filed due to a more aggressive plaintiffs bar; (b) an increase in claims involving defendants
formerly regarded as peripheral; (c) 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; (d) the concentration of claims in states with laws or jury pools particularly favorable to plaintiffs; and (e) the potential that states or the U.S. Congress may enact legislation regarding asbestos litigation reform.
We believe these uncertainties and factors make projections of these exposures, particularly asbestos, subject to less predictability relative to non-environmental and non-asbestos exposure. See Note 9 to the consolidated financial statements for additional historical information on loss and LAE reserves for these exposures.
In the event that loss trends diverge from expected trends, we may have to adjust our reserves for loss 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. Management believes that the recorded estimates represent the best estimate of unpaid losses and LAE based on the information available at December 31, 2005. Due to the uncertainty involving estimates of ultimate loss and LAE, including asbestos and environmental exposures, management does not attempt to produce a range around its best estimate of loss.
We have recognized significant increases to estimates for prior years recorded loss liabilities. Net income was adversely impacted in the calendar years where reserve estimates relating to prior years were increased. It is not possible to assure that adverse development on prior years losses will not occur in the future. If adverse development does occur in future years, it may have a material adverse impact on net income.
The Ten Year Analysis of Consolidated Net Losses and Loss Adjustment Expense Reserve Development Table that follows presents the development of balance sheet loss and LAE reserves for calendar years 1995 through 2005. The upper half of the table shows the cumulative amounts paid during successive years related to the opening reserve. For example, with respect to the net loss and LAE reserve of $1,987 million as of December 31, 1995, by the end of 2005, $1,715 million had actually been paid in settlement of those reserves. In addition, as reflected in the lower section of the table, the original reserve of $1,987 million was re-estimated to be $2,073 million as of December 31, 2005. This change from the original estimate would normally result from a combination of a number of factors, including losses being settled for different amounts than originally estimated. The original estimates will also be increased or decreased, as more information becomes known about the individual claims and overall claim frequency and severity patterns. The net deficiency or redundancy depicted in the table, for any particular calendar year, shows the aggregate change in estimates over the period of years subsequent to the calendar year reflected at the top of the respective columns. For example, the net deficiency of $221 million as of December 31, 2005, related to December 31, 1996 net loss and LAE reserves of $1,992 million, represents the cumulative amount by which net reserves for 1996 have developed unfavorably from 1996 through 2005.
Each amount other than the original reserves in the table below includes the effects of all changes in amounts for prior periods. For example, if a loss settled in 1998 for $150,000 was first reserved in 1995 at $100,000 and remained unchanged until settlement, the $50,000 deficiency (actual loss minus original estimate) would be included in the cumulative net deficiency in each of the years in the period 1995 through 1997 shown in the following table. Conditions and trends that have affected development of liability in the past may not necessarily occur in the future. Accordingly, it may not be appropriate to extrapolate future development based on this table.
Ten Year Analysis of Consolidated Losses and Loss Adjustment Expense Reserve Development Table
Presented Net of Reinsurance With Supplemental Gross Data
The incurred loss and LAE liability re-estimate for the year ended December 31, 2005 includes a $173 million provision for an increase in loss and LAE on prior years. Through December 2005, we have also increased estimates of loss on outstanding loss liabilities held at year end 2001, 2002 and 2003 by $840 million, $709 million and $456 million, respectively. This increase in loss estimates is attributable to U.S. casualty
business written in the late 1990s through early 2000s. The U.S. casualty classes of business include general liability, professional liability and excess workers compensation. Competitive conditions, economic uncertainty and the proliferation of claims relating to bankruptcies and other financial and management improprieties in the United States during this period contribute to the difficulty in estimating losses for these years.
For calendar years 2002 through 2005, we experienced claim frequency and severity greater than expectations established based on a review of the prior years loss trends, particularly for business written in the period 1997 through 2000. General liability and excess workers compensation classes of business during these years were adversely impacted by the competitive conditions in the industry at that time, affecting the ability of standard actuarial techniques to generate reliable estimates of ultimate loss. Professional liability was impacted by the increase in frequency and severity of claims relating to bankruptcies and other financial and management improprieties in the late 1990s through early 2000s.
The liability re-estimate reported for year end 1995 losses and LAE at December 31, 2005 results from increased reserves for asbestos liabilities associated with United States casualty contracts generally written prior to 1986. These contracts contained contract terms that, for us and the industry overall, have been interpreted by the courts to provide coverage for asbestos and environmental exposures that were not contemplated by the original pricing or reserving of the covers. Our estimates of environmental liabilities have declined over the most recent calendar years.
We believe that the recorded estimates represent the best estimate of unpaid losses and LAE based on the information available at December 31, 2005. In the event that loss trends diverge from expected trends, we may have to adjust our reserves for loss 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.
The following table is derived from the Ten Year Analysis of Consolidated Net Losses and Loss Adjustment Expense Reserve Development Table above. It summarizes the effect of re-estimating prior year loss reserves as of December 31, 2005, net of reinsurance, on pre-tax income for the latest ten calendar years through December 31, 2005. Each column represents the calendar year development by each accident year. For example, in calendar year 2005, the impact of re-estimates of prior year loss reserves reduced pre-tax income by $172.7 million.
The significant increases in reserves on accident years 1996 through 2001 relate principally to casualty reinsurance written in the United States. The late 1990s and early 2000s saw a proliferation of claims relating to bankruptcies and corporate improprieties. This resulted in an increase in the frequency and severity of claims in professional liability lines. Additionally, general liability and excess workers compensation classes of business in this period reflected increasing competitive conditions. These factors have impacted our ability to estimate loss and LAE for this exposure, particularly in the 2002 through 2005 calendar year period.
Improvements in competitive conditions and economic environment beginning in 2001 have resulted in a generally downward trend on re-estimated reserves for accident year 2002 through 2004 losses. Initial loss estimates for these more recent accident years did not fully anticipate the improvements in competitive and economic conditions achieved since the late 1990s through the early 2000s.
The following table summarizes our provision for unpaid losses and LAE for the years ended December 31, 2005, 2004 and 2003 (in millions):
The above amounts reflect tabular reserving for workers compensation indemnity reserves that are considered fixed and determinable. We discount such reserves using an interest rate of 3.5% and standard mortality assumptions. The amount of loss reserve discount as of December 31, 2005, 2004 and 2003 was $90.3 million, $76.7 million and $66.7 million, respectively.
Gross and net development for asbestos and environmental reserves for the last three calendar years are provided in the following table (in millions):
Our survival ratio for environmental and asbestos-related liabilities as of December 31, 2005 is 11 years. Our underlying survival ratio for environmental-related liabilities is seven years and for asbestos-related liabilities is 12 years. The survival ratio represents the asbestos and environmental reserves, net of reinsurance, divided by the average paid environmental and asbestos claims for the last three years of $18.3 million, which is net of reinsurance but prior to amounts subject to cession to the 1995 Stop Loss Agreement (see Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations Reinsurance and Retrocessions.).
Favorable emergence for environmental claims for the year ended December 31, 2005 was offset by unfavorable emergence for asbestos claims. Net losses and LAE for asbestos claims increased $41.2 million for the year ended December 31, 2005. Environmental net losses and LAE declined $0.9 million for the year ended December 31, 2005.
As of December 31, 2005, we held cash and investments totaling $5.9 billion, with a net unrealized gain of $164.7 million, before taxes. Our overall strategy is to maximize the total return of the investment portfolio, while prudently preserving invested capital and providing sufficient liquidity for the payment of claims and other policy obligations.
Our investment guidelines stress preservation of capital, market liquidity, diversification of risk and a long-term, value-oriented strategy. We seek to invest in securities that we believe are selling below their intrinsic value, in order to protect capital from loss and generate above-average, long term total returns.
No attempt is made to forecast the economy, the future level of interest rates or the stock market. Equities are selected on the basis of selling prices which are at a discount to their estimated intrinsic values. Downside protection is obtained by seeking a margin of safety in terms of a sound financial position. Fixed income securities are selected on the basis of yield spreads over Treasury bonds, subject to stringent credit analysis.
Securities meeting these criteria may not be readily available, in which case Treasury bonds are emphasized. Notwithstanding the foregoing, our investments are subject to market risks and fluctuations, as well as to risks inherent in particular securities.
As part of our review and monitoring process, we regularly test the impact of a simultaneous substantial reduction in common stock, preferred stock, and bond prices on our capital to ensure that capital adequacy will be maintained at all times.
The investment portfolio is structured to provide a high level of liquidity. The table below shows the aggregate amounts of investments in fixed income securities, equity securities, cash and cash equivalents and other invested assets comprising our portfolio of invested assets.
As of December 31, 2005, our fixed income securities had a dollar weighted average rating of AA, as measured by Standard & Poors, and an average yield to maturity, based on market values, of 7.1% before investment expenses. As of December 31, 2005 the duration of our fixed income securities was 9.9 years. Including cash and cash equivalents, the duration was 6.0 years.
Market Sensitive Instruments. Our investment portfolio includes investments that are subject to changes in market values as interest rates change. The aggregate hypothetical loss generated from an immediate adverse parallel shift in the treasury yield curve of 100 or 200 basis points would cause a decrease in total return of 9.3% and 16.9%, respectively, which equates to a decrease in market value of $243.3 million and $445.7 million, respectively, on a fixed income portfolio valued at $2.6 billion as of December 31, 2005. The foregoing reflects the use of an immediate time horizon, since this presents the worst-case scenario. Credit spreads are assumed to remain constant in these hypothetical examples.
The following table summarizes the fair value of our investments (other than equity securities, cash collateral for borrowed securities and other invested assets) at the dates indicated.
The following table summarizes the fair value by contractual maturities of our fixed income securities at the dates indicated.
The contractual maturities reflected above may differ from the actual maturities due to the existence of call or put features. As of December 31, 2005 and 2004, approximately 4% and 4%, respectively, of the fixed income securities shown above had a call feature which, at the issuers option, allowed the issuer to repurchase the securities on one or more dates prior to their maturity. As of December 31, 2005 and 2004, approximately 5% and 4%, respectively, of the fixed income securities shown above had a put feature, which, if exercised at our option, would require the issuer to repurchase the investments on one or more dates prior to their maturity. For the investments shown above, if the call feature or put feature is exercised, the actual maturities will be shorter than the contractual maturities shown above. In the case of securities that are subject to early call by the issuer, the actual maturities will be the same as the contractual maturities shown above if the issuer does not exercise its call feature. In the case of securities containing put features, the actual maturities will be the same as the contractual maturities shown above if the investor elects not to exercise its put feature, but to hold the securities to their final maturity dates.
Quality of Debt Securities in Portfolio. The following table summarizes the composition of the fair value of our fixed income securities portfolio at the dates indicated by rating as assigned by Standard & Poors or Moodys, using the higher of these ratings for any security where there is a split rating.
As of December 31, 2005, 14.6% of our fixed income securities were rated BB/ Ba2 or lower, compared to 13.3% as of December 31, 2004. During 2005, the ratings of certain fixed income securities in the automotive sector declined, largely contributing to the increase in BB/Ba2 securities. In addition, we acquired certain non investment grade securities during 2005, as we believe these securities will provide a favorable investment return.
The Company and its subsidiaries are assigned financial strength (insurance) and credit ratings from internationally recognized rating agencies, which include A.M. Best Company, Inc., Standard & Poors Insurance Rating Services and Moodys Investors Service. Financial strength ratings represent the opinions of the rating agencies of the financial strength of a company and its capacity to meet the obligations of insurance and reinsurance contracts. The rating agencies consider many factors in determining the financial strength rating of an
insurance or reinsurance company, including the relative level of statutory surplus necessary to support the business operations of the company.
These ratings are used by insurers, reinsurers and intermediaries as an important means of assessing the financial strength and quality of reinsurers and insurers. The financial strength ratings of our principal operating subsidiaries are: A.M. Best: A (Excellent), Standard & Poors: A- (Strong), and Moodys: A3 (Good Financial Security).
Our senior unsecured debt is currently rated BBB- by Standard & Poors, Baa3 by Moodys and bbb by A.M. Best. Our series A and series B preferred shares are currently rated BB by Standard & Poors, Ba2 by Moodys and bb+ by A.M. Best.
Following our announcement on March 16, 2006 that the filing of our annual report on Form 10-K would be delayed in connection with the restatement of our consolidated financial statements, Standard & Poors placed on CreditWatch with negative implications our counterparty credit, senior unsecured debt and preferred stock ratings and the financial strength ratings of our principal operating subsidiaries. In addition, Moodys revised from stable to negative the outlook for our senior debt and preferred stock and the insurance financial strength ratings of our principal operating subsidiaries. Further, A.M. Best placed under review with negative implications our debt ratings and the financial strength ratings of our principal operating subsidiaries.
We provide property and casualty reinsurance capacity in the United States market primarily through brokers, and in international markets through brokers and directly to insurers and reinsurers. We focus our marketing on potential clients and brokers that have the ability and expertise to provide the detailed and accurate underwriting information we need to properly evaluate each piece of business. Further, we seek relationships with new clients that will further diversify our existing book of business without sacrificing our underwriting discipline.
We believe that the willingness of a primary insurer or reinsurer to use a specific reinsurer is not based solely on pricing. Other factors include the clients perception of the reinsurers financial security, its claims-paying ability ratings, its ability to design customized products to serve the clients needs, the quality of its overall service, and its commitment to provide the client with reinsurance capacity. We believe we have developed a reputation with our clients for prompt responses on underwriting submissions and timely claims payments. Additionally, we believe our level of capital and surplus demonstrates our strong financial position and intent to continue providing reinsurance capacity.
The reinsurance broker market consists of several significant national and international brokers and a number of smaller specialized brokers. Brokers do not have the authority to bind us with respect to reinsurance agreements, nor do we commit in advance to accept any portion of the business that brokers submit. Brokerage fees generally are paid by reinsurers and are included as an underwriting expense in the consolidated financial statements. Our five largest reinsurance brokers accounted for an aggregate of 62.7% of our reinsurance gross premiums written in 2005.
Direct distribution is an important channel for us in the overseas markets served by the Latin America unit of the Americas division and the EuroAsia division. Direct placement of reinsurance enables us to access clients who prefer to place their reinsurance directly with their reinsurers based upon the reinsurers in-depth understanding of the ceding companys needs.
Our primary insurance business generated through the U.S. Insurance division is written principally through national and regional agencies and brokers, as well as through general agency relationships. Newlines primary market business is written through agency and direct distribution channels.
The following table shows our gross premiums written, by distribution source, for the year ended December 31, 2005 (in millions).
The worldwide property and casualty reinsurance business is highly competitive. Our competitors include independent reinsurance companies, subsidiaries or affiliates of established worldwide insurance companies, reinsurance departments of certain primary insurance companies, and domestic and European underwriting syndicates. Some of these competitors have longer operating histories, larger capital bases and greater underwriting, marketing, and administrative resources than OdysseyRe.
Globally, the competitive marketplace of the 1990s resulted in decreasing prices and broadening contract terms. Poor financial results associated with those years, compounded by the September 11, 2001 terrorist attack, have resulted in changes in management and ownership of several reinsurers, with some competitors withdrawing from key markets. Improving trends, apparent in 2001, continued in 2002 and 2003 and for certain classes of business in 2004; however, during 2004, the improving trends of recent years moderated considerably. Despite the high level of catastrophe claims in 2004, particularly the Florida hurricanes, property rate reductions still occurred as most reinsurers continued to be profitable.
In 2005, an unprecedented level of hurricane losses, including Hurricane Katrina, the largest insured loss in the industrys history, caused many reinsurers including the Company to report significant net losses. Following the 2005 hurricanes, many reinsurers, including the Company, raised additional capital in the fourth quarter of 2005, and a number of new reinsurers were formed. Nonetheless, the magnitude of the 2005 hurricane losses across the industry caused rating agencies to increase capital requirements, prompting both reinsurers and their insurance company clients to reassess their catastrophe pricing and aggregate loss monitoring parameters and procedures. The result has been an increase in catastrophe pricing, particularly for wind exposures in the U.S. The impact on non-catastrophe pricing has been to mitigate the trend towards rate weakening, with many markets experiencing an environment of little or no rate change. We believe that current rates should provide adequate returns. We expect these conditions to continue during 2006, but the competitive landscape is still evolving and the depth and breadth of market changes for the balance of 2006 remain uncertain.
Given the magnitude of recent hurricane losses for the insurance and reinsurance industry in general and expectations for an active Atlantic hurricane season in 2006, we believe there is a heightened perception of risk among ceding companies, reinsurers and rating agencies. Accordingly, demand for property catastrophe reinsurance may increase beyond current levels. We expect that, as revisions to catastrophe models are released and new rating agency capital requirements are better understood, there will be continued U.S. market hardening
for property and marine business. Outside of the catastrophe exposed risks, we expect a generally stable pricing environment.
United States insurance companies that are licensed to underwrite insurance are also licensed to underwrite reinsurance, making the commercial access into the reinsurance business relatively uncomplicated. In addition, Bermuda reinsurers that initially specialized in catastrophe reinsurance are now broadening their product offerings. The potential for securitization of reinsurance and insurance risks through capital markets provides an additional source of potential competition.
In our primary insurance business, we face competition from independent insurance companies, subsidiaries or affiliates of major worldwide companies and others, some of which have greater financial and other resources than we do. Primary insurers compete on the basis of various factors including distribution channels, product, price, service, financial strength and reputation. While our U.S. Insurance divisions largest single segment, medical malpractice, grew more competitive in 2005, loss trends are expected to moderate as tort reform measures are adopted across the various states. We continue to see a positive flow of business in those states we have chosen as our target markets.
We also face competition from Lloyds syndicates, larger multi-national insurance groups, and alternative risk management programs. Pricing is a primary means of competition in the specialty insurance and reinsurance business. We are committed to maintaining our underwriting standards and as a result, our premium volume will vary based on existing market conditions.
As of December 31, 2005, we had 592 employees. We believe our relationship with our employees is satisfactory.
We are subject to regulation under the insurance statutes, including insurance holding company statutes, of various jurisdictions, including Connecticut, the domiciliary state of Odyssey America, Delaware, the domiciliary state of Clearwater, Hudson and Clearwater Select, New York, the domiciliary state of Hudson Specialty, and the United Kingdom, the domiciliary jurisdiction of Newline. Newline is also subject to regulation by the Council of Lloyds. In addition, we are subject to regulation by the insurance regulators of other states and foreign jurisdictions in which we or our operating subsidiaries do business.
The terms and conditions of reinsurance agreements with respect to rates or policy terms generally are not subject to regulation by any governmental authority. This contrasts with primary insurance policies and agreements issued by primary insurers such as Hudson, the rates and policy terms of which are generally regulated closely by state insurance departments. As a practical matter, however, the rates charged by primary insurers influence the rates that can be charged by reinsurers.
Our reinsurance operations are subject primarily to regulation and supervision that relates to licensing requirements of reinsurers, the standards of solvency that reinsurers must meet and maintain, the nature of and limitations on investments, restrictions on the size of risks that may be reinsured, the amount of security deposits necessary to secure the faithful performance of a reinsurers insurance obligations, methods of accounting, periodic examinations of the financial condition and affairs of reinsurers, the form and content of any financial statements that reinsurers must file with state insurance regulators and the level of minimal reserves necessary to cover unearned premiums, losses and other purposes. In general, these regulations are designed to protect ceding insurers and, ultimately, their policyholders, rather than shareholders. We believe that we and our subsidiaries are in material compliance with all applicable laws and regulations pertaining to our business and operations.
State insurance holding company statutes provide a regulatory apparatus which is designed to protect the financial condition of domestic insurers operating within a holding company system. All holding company statutes require disclosure and, in some instances, prior approval of significant transactions between the domestic insurer and an affiliate. Such transactions typically include service arrangements, sales, purchases, exchanges, loans and extensions of credit, reinsurance agreements, and investments between an insurance company and its affiliates, in some cases involving certain aggregate percentages of a companys admitted assets or policyholders surplus, or dividends that exceed certain percentages. State regulators also require prior notice or regulatory approval of acquisitions of control of an insurer or its holding company.
Under the Connecticut, Delaware and New York Insurance laws and regulations, no person, corporation or other entity may acquire control of us or our operating subsidiaries unless such person, corporation or entity has obtained the prior approval of the Connecticut, Delaware and/or New York insurance commissioner or commissioners, as the case may be, for the acquisition. For the purposes of the Connecticut, Delaware and New York Insurance laws, any person acquiring, directly or indirectly, 10% or more of the voting securities of an insurance company is presumed to have acquired control of that company. To obtain the approval of any acquisition of control, any prospective acquiror must file an application with the relevant insurance commissioner. This application requires the acquiror to disclose its background, financial condition, the financial condition of its affiliates, the source and amount of funds by which it will effect the acquisition, the criteria used in determining the nature and amount of consideration to be paid for the acquisition, proposed changes in the management and operations of the insurance company and any other related matters.
The United Kingdom Insurance Companies Act of 1982 also requires prior approval by the Financial Services Authority of anyone proposing to become a controller of an insurance company or reinsurance company that carries on business in the United Kingdom but which is incorporated outside the United Kingdom. In this case, any company or individual who is entitled to exercise or control the exercise of 15% or more of the voting power at any general meeting of the insurance company or reinsurance company or of a body corporate of which it is a subsidiary, is considered a controller. A purchaser of 15% or more of our outstanding common shares will be a controller of Odyssey America, which is authorized to carry on reinsurance business in the United Kingdom through the London Branch. Other than our subsidiaries in the London Market division, none of our other insurance or reinsurance subsidiaries is authorized to carry on business in the United Kingdom.
Under the bylaws made by Lloyds pursuant to the Lloyds Act of 1982, the prior written approval of the Council of Lloyds is required of anyone proposing to become a controller of any Lloyds Managing Agency. Any company or individual that holds 10% or more of the shares in the managing agency company, or is entitled to exercise or control the exercise of 10% or more of the voting power at any general meeting of the Lloyds Managing Agency or, in both cases, of another company of which the Lloyds Managing Agency is a subsidiary, is considered a controller. A purchaser of more than 10% of our outstanding common shares will be a controller of the United Kingdom Lloyds Managing Agency subsidiary, Newline.
The requirements under the Connecticut, Delaware and New York Insurance laws and the United Kingdom Insurance Companies Act of 1982 (and other applicable states and foreign jurisdictions), and the rules of the Council of Lloyds, may deter, delay or prevent certain transactions affecting the control or ownership of our common shares, including transactions that could be advantageous to our shareholders.
Because our operations are conducted primarily at the subsidiary level, we are dependent upon dividends from our subsidiaries to meet our debt and other obligations and to declare and pay dividends on our common shares in the future should our Board of Directors decide to do so. The payment of dividends to us by our operating subsidiaries is subject to limitations imposed by law in Connecticut, Delaware, New York and the United Kingdom.
Under the Connecticut and Delaware Insurance Codes, before a Connecticut or Delaware domiciled insurer, as the case may be, may pay any dividend it must have given notice within five days following the declaration
thereof and 10 days prior to the payment thereof to the Connecticut or Delaware Insurance Commissioners, as the case may be. During this 10-day period, the Connecticut or Delaware Insurance Commissioner, as the case may be, may, by order, limit or disallow the payment of ordinary dividends if he or she finds the insurer to be presently or potentially in financial distress. Under Connecticut and Delaware Insurance Regulations, the Insurance Commissioner may issue an order suspending or limiting the declaration or payment of dividends by an insurer if he or she determines that the continued operation of the insurer may be hazardous to its policyholders. A Connecticut domiciled insurer may only pay dividends out of earned surplus, defined as the insurers unassigned funds surplus reduced by 25% of unrealized appreciation in value or revaluation of assets or unrealized profits on investments, as defined in such insurers annual statutory financial statement. A Delaware domiciled insurer may only pay cash dividends from the portion of its available and accumulated surplus funds derived from realized net operating profits and realized capital gains. Additionally, a Connecticut or Delaware domiciled insurer may not pay any extraordinary dividend or distribution until (i) 30 days after the insurance commissioner has received notice of a declaration of the dividend or distribution and has not within that period disapproved the payment or (ii) the insurance commissioner has approved the payment within the 30-day period. Under the Connecticut insurance laws, an extraordinary dividend of a property and casualty insurer is a dividend, the amount of which, together with all other dividends and distributions made in the preceding 12 months, exceeds the greater of (i) 10% of the insurers surplus with respect to policyholders as of the end of the prior calendar year or (ii) the insurers net income for the prior calendar year (not including pro rata distributions of any class of the insurers own securities). The Connecticut Insurance Department has stated that the preceding 12-month period ends the month prior to the month in which the insurer seeks to pay the dividend. Under the Delaware insurance laws, an extraordinary dividend of a property and casualty insurer is a dividend, the amount of which, together with all other dividends and distributions made in the preceding 12 months, exceeds the greater of (i) 10% of an insurers surplus with respect to policyholders, as of the end of the prior calendar year or (ii) the insurers statutory net income, not including realized capital gains, for the prior calendar year. Under these definitions, the maximum amount that will be available for the payment of dividends by Odyssey America for the year ending December 31, 2006 without requiring prior approval of regulatory authorities is $207.1 million.
New York law provides that an insurer domiciled in New York must obtain the prior approval of the state insurance commissioner for the declaration or payment of any dividend that, together with dividends declared or paid in the preceding 12 months, exceeds the lesser of (i) 10% of policyholders surplus, as shown by its last statement on file with the New York Insurance Department and (ii) adjusted net investment income (which does not include realized gains or losses) for the preceding 12-month period. Adjusted net investment income includes a carryforward of undistributed net investment income for two years. Such declaration or payment is further limited by earned surplus, as determined in accordance with statutory accounting practices prescribed or permitted in New York. Under New York law, an insurer domiciled in New York may not pay dividends to shareholders except out of earned surplus, which in this case is defined as the portion of the surplus that represents the net earnings, gains or profits, after the deduction of all losses, that have not been distributed to the shareholders as dividends or transferred to stated capital or capital surplus or applied to other purposes permitted by law but does not include unrealized appreciation of assets.
United Kingdom law prohibits any U.K. company, including Newline, from declaring a dividend to its shareholders unless such company has profits available for distribution. The determination of whether a company has profits available for distribution is based on a companys accumulated realized profits less its accumulated realized losses. While there are no statutory restrictions imposed by the United Kingdom insurance regulatory laws upon an insurers ability to declare dividends, insurance regulators in the United Kingdom strictly control the maintenance of each insurance companys solvency margin within their jurisdiction and may restrict an insurer from declaring a dividend beyond a level which the regulators determine would adversely affect an insurers solvency requirements. It is common practice in the United Kingdom to notify regulators in advance of any significant dividend payment.
A primary insurer ordinarily will enter into a reinsurance agreement only if it can obtain credit for the reinsurance ceded on its statutory financial statements. In general, credit for reinsurance is allowed in the following circumstances: (1) if the reinsurer is licensed in the state in which the primary insurer is domiciled or, in some instances, in certain states in which the primary insurer is licensed; (2) if the reinsurer is an accredited or otherwise approved reinsurer in the state in which the primary insurer is domiciled or, in some instances, in certain states in which the primary insurer is licensed; (3) in some instances, if the reinsurer (a) is domiciled in a state that is deemed to have substantially similar credit for reinsurance standards as the state in which the primary insurer is domiciled and (b) meets certain financial requirements; or (4) if none of the above apply, to the extent that the reinsurance obligations of the reinsurer are collateralized appropriately, typically through the posting of a letter of credit for the benefit of the primary insurer or the deposit of assets into a trust fund established for the benefit of the primary insurer. Therefore, as a result of the requirements relating to the provision of credit for reinsurance, we are indirectly subject to certain regulatory requirements imposed by jurisdictions in which ceding companies are licensed.
State insurance laws contain rules governing the types and amounts of investments that are permissible for domiciled insurers. These rules are designed to ensure the safety and liquidity of an insurers investment portfolio. Investments in excess of statutory guidelines do not constitute admitted assets (i.e., assets permitted by insurance laws to be included in a domestic insurers statutory financial statements) unless special approval is obtained from the regulatory authority. Non-admitted assets are not considered for the purposes of various financial ratios and tests, including those governing solvency and the ability to write premiums. An insurer may hold an investment authorized under more than one provision of the insurance laws under the provision of its choice (except as otherwise expressly provided by law).
The liquidation of insurance companies, including reinsurers, is generally conducted pursuant to state insurance law. In the event of the liquidation of one of our operating insurance subsidiaries, liquidation proceedings would be conducted by the insurance regulator of the state in which the subsidiary is domiciled, as the domestic receiver of its properties, assets and business. Liquidators located in other states (known as ancillary liquidators) in which we conduct business may have jurisdiction over assets or properties located in such states under certain circumstances. Under Connecticut, Delaware and New York law, all creditors of our operating insurance subsidiaries, including but not limited to reinsureds under their reinsurance agreements, would be entitled to payment of their allowed claims in full from the assets of the operating subsidiaries before we, as a shareholder of our operating subsidiaries, would be entitled to receive any distribution.
Some states have adopted and others are considering legislative proposals that would authorize the establishment of an interstate compact concerning various aspects of insurer insolvency proceedings, including interstate governance of receiverships and guaranty funds.
The NAIC is an organization that assists state insurance supervisory officials in achieving insurance regulatory objectives, including the maintenance and improvement of state regulation. From time to time various regulatory and legislative changes have been proposed in the insurance industry, some of which could have an effect on reinsurers. The NAIC has instituted its Financial Regulation Standards and Accreditation Program (FRSAP) in response to federal initiatives to regulate the business of insurance. FRSAP provides a set of standards designed to establish effective state regulation of the financial condition of insurance companies. Under FRSAP, a state must adopt certain laws and regulations, institute required regulatory practices and procedures, and have adequate personnel to enforce such items in order to become an accredited state. If a state is not accredited, accredited states are not able to accept certain financial examination reports of insurers prepared solely by the regulatory agency in such unaccredited state. Connecticut and Delaware are accredited under
FRSAP. New York, Hudson Specialtys state of domicile, is not accredited under FRSAP. There can be no assurance that, should New York remain unaccredited, other states that are accredited will continue to accept financial examination reports prepared solely by New York. We do not believe that the refusal by an accredited state to accept financial examination reports prepared by New York, should that occur, would have a material adverse impact on our insurance businesses.
In order to enhance the regulation of insurer solvency, the NAIC has adopted a formula and model law to implement risk-based capital requirements for property and casualty insurance companies. Connecticut, Delaware and New York have each adopted risk-based capital legislation for property and casualty insurance and reinsurance companies that is similar to the NAIC risk-based capital requirement. These risk-based capital requirements are designed to assess capital adequacy and to raise the level of protection that statutory surplus provides for policyholder obligations. The risk-based capital model for property and casualty insurance companies measures three major areas of risk facing property and casualty insurers: (1) underwriting, which encompasses the risk of adverse loss development and inadequate pricing; (2) declines in asset values arising from credit risk; and (3) declines in asset values arising from investment risks. Insurers having less statutory surplus than required by the risk-based capital calculation will be subject to varying degrees of company or regulatory action, depending on the level of capital inadequacy. The surplus levels (as calculated for statutory annual statement purposes) of our operating insurance companies are above the risk-based capital thresholds that would require either company or regulatory action.
The NAIC adopted the Codification of Statutory Accounting Principles (Codification) which is intended to standardize regulatory accounting and reporting for the insurance industry. The Codification provides guidance for areas where statutory accounting has been silent and changes current statutory accounting in some areas. However, statutory accounting principles will continue to be established by individual state laws and permitted practices. The states of Connecticut and Delaware have adopted the Codification. New York has adopted the Codification, with certain modifications to reflect provisions required by New York law or policy.
Our operating subsidiaries that write primary insurance are required to be members of guaranty associations in each state in which they write business. These associations are organized to pay covered claims (as defined and limited by various guaranty association statutes) under insurance policies issued by primary insurance companies that have become insolvent. These state guaranty funds make assessments against member insurers to obtain the funds necessary to pay association covered claims. New York has a pre-assessment guaranty fund, which makes assessments prior to the occurrence of an insolvency, in contrast with other states, which make assessments after an insolvency takes place. In addition, primary insurers are required to participate in mandatory property and casualty shared market mechanisms or pooling arrangements that provide various coverages to individuals or other entities that are otherwise unable to purchase such coverage in the commercial insurance marketplace. Our operating subsidiaries participation in such shared markets or pooling mechanisms is generally proportionate to the amount of direct premiums written in respect of primary insurance for the type of coverage written by the applicable pooling mechanism.
From time to time various regulatory and legislative changes have been proposed in the insurance and reinsurance industry that could have an effect on reinsurers. Among the proposals that in the past have been or are at present being considered is the possible introduction of federal regulation in addition to, or in lieu of, the current system of state regulation of insurers. In addition, there are a variety of proposals being considered by various state legislatures. We are unable to predict whether any of these laws and regulations will be adopted, the form in which any such laws and regulations would be adopted, or the effect, if any, these developments would have on our operations and financial condition.
The Fairness in Asbestos Injury Resolution Act of 2005 (FAIR) would have largely removed asbestos claims from the courts in favor of an administrative process that would pay awards out of a trust fund on a no fault basis to claimants meeting asbestos exposure and medical criteria. The proposed trust would have been funded by contributions from corporate defendants, insurers and existing bankruptcy trusts. In February 2006, the U.S. Senate effectively denied passage of FAIR. At this time, we are unable to predict what asbestos-related legislation, if any, may be proposed in the future, or the impact such legislation may have on our operations.
Government intervention in the insurance and reinsurance markets, both in the U.S. and worldwide, continues to evolve. Federal and state legislators and regulators have considered numerous statutory and regulatory initiatives. While we cannot predict the exact nature, timing, or scope of other such proposals, if adopted they could adversely affect our business by:
The Terrorism Risk Insurance Act of 2002 (TRIA) established a program under which the U.S. federal government will share with the insurance industry the risk of loss from certain acts of international terrorism. With the enactment on December 22, 2005 of the Terrorism Risk Insurance Extension Act of 2005, TRIA has now been modified and extended through December 31, 2007. The program is applicable to most commercial property and casualty lines of business (with the notable exception of reinsurance), and participation by insurers writing such lines is mandatory. Under TRIA, all applicable terrorism exclusions contained in policies in force on November 26, 2002 were voided. For policies in force on or after November 26, 2002, insurers are required to provide coverage for losses arising from acts of terrorism as defined by TRIA on terms and in amounts which may not differ materially from other policy coverages.
Under TRIA, the federal government will reimburse insurers for a percentage of covered losses above a defined insurer deductible. The deductible for each participating insurer is based on a percentage of the combined direct earned premiums in the preceding calendar year of the insurer, defined to include its subsidiaries and affiliates. In 2006, the deductible is equal to 17.5% of the insurers combined direct earned premiums for 2005. Further, the 2005 amendments to TRIA established a per event trigger for federal participation in aggregate insured losses of $50 million for losses occurring after March 31, 2006 and before January 1, 2007, and $100 million for losses occurring in 2007. Under certain circumstances, the federal government may require insurers to levy premium surcharges on policyholders to recoup for the federal government its reimbursements paid.
While the provisions of TRIA and the purchase of certain terrorism reinsurance coverage mitigate our exposure in the event of a large-scale terrorist attack, our effective deductible is significant. Further, our exposure to losses from terrorist acts is not limited to TRIA events since domestic terrorism is generally not excluded from our policies and, regardless of TRIA, some state insurance regulators do not permit terrorism exclusions for various coverages or causes of loss. Accordingly, we continue to monitor carefully our concentrations of risk.
Primary insurance companies providing commercial property and casualty insurance in the U.S., such as Hudson and Hudson Specialty, are required to participate in the TRIA program. TRIA generally does not purport to govern the obligations of reinsurers, such as Odyssey America. The TRIA program is scheduled to expire at the end of 2007, and it is unclear at this time whether Congress will further extend the program beyond 2007, and it is possible that the non-renewal of TRIA could adversely affect the industry, including us.
The New York Attorney Generals office and other governmental and regulatory bodies are investigating allegations relating to a wide range of practices in the insurance and reinsurance industry, including contingent commissions payments and allegations of price fixing, market allocation, or bid rigging. As of the date hereof, we have not been contacted by any of these parties with respect to these practices, although we have received and responded to inquiries and informational requests from several state insurance departments as part of the industry-wide review being conducted by these states. We intend to cooperate with these requests and others we may receive from governmental and regulatory bodies.
We have undertaken to review our practices in light of the matters being reviewed by the New York Attorney General and other governmental authorities. This review is ongoing. We are actively monitoring these ongoing, industry-wide investigations. It is possible that these investigations or related regulatory developments will mandate changes in industry practices in a fashion that increases our costs of doing business or requires us to alter aspects of the manner in which we conduct our business.
Our internet address is www.odysseyre.com. The information on our website is not incorporated by reference into this Annual Report on Form 10-K. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Sections 13(a) or 15(d) of the Exchange Act, are accessible free of charge through this website as soon as reasonably practicable after they have been electronically filed with or furnished to the Securities and Exchange Commission. Our Code of Business Conduct, Code of Ethics for Senior Financial Officers, Corporate Governance Guidelines and the charters for our Audit and Compensation Committees are also available on our website. In addition, you may obtain, free of charge, copies of any of the above reports or documents upon request to the Secretary of the Company.
Factors that could cause our actual results to differ materially from those described in the forward-looking statements contained in this Form 10-K and other documents we file with the Securities and Exchange Commission include the risks described below. You should also refer to the other information in this Annual Report on Form 10-K, including the consolidated financial statements and accompanying notes thereto.
Our statements of operations for the year ended December 31, 2005 include a pre-tax underwriting loss of $436.0 million from Hurricanes Katrina, Rita and Wilma. The loss estimate represents our best estimate based on the most recent information available. We used various approaches in estimating this loss, including a detailed review of exposed contracts and information from ceding companies. As additional information becomes available, such estimates may be revised, potentially resulting in adverse effects to our financial results. The extraordinary nature and scale of this loss, including legal and regulatory implications, adds substantial uncertainty and complexity to the estimating process. Considerable time may elapse before the adequacy of our estimates can be determined.
Our estimates are subject to a high level of uncertainty arising out of extremely complex and unique causation and coverage issues, including the appropriate attribution of losses to flood as opposed to other perils such as wind, fire or riot and civil commotion. The underlying policies generally contain exclusions for flood damage; however, water damage caused by wind may be covered. We expect that causation and coverage issues may not be resolved for a considerable period of time and may be influenced by evolving legal and regulatory developments.
Our actual losses from Hurricanes Katrina, Rita and Wilma may vary materially from our estimates as a result of, among other things, an increase in industry insured loss estimates, the receipt of additional information from clients, the attribution of losses to coverages that for the purpose of our estimates we assumed would not be exposed, the contingent nature of business interruption exposures, and inflation in repair costs due to the limited availability of labor and materials, in which case our financial results could be further materially adversely affected. In addition, actual losses may increase if our reinsurers fail to meet their obligations.
Based on our current estimate of losses related to Hurricane Katrina, we have limited retrocession protection with respect to Hurricane Katrina, meaning that we have limited retrocession coverage available should our Hurricane Katrina losses prove to be greater than currently estimated. We cannot be sure that retrocessional coverage will be available to us on acceptable terms, or at all, in the future.
Our success is dependent upon our ability to assess accurately the risks associated with the businesses that we reinsure or insure. If we fail to accurately assess the risks we assume, we may fail to establish appropriate premium rates and our reserves may be inadequate to cover our losses, which could have a material adverse effect on our financial condition or reduce our net income.
As of December 31, 2005, we had net unpaid losses and LAE of $3,910.9 million. We incurred losses and LAE of $2,061.6 million, $1,631.1 million and $1,336.0 million for the years ended December 31, 2005, 2004 and 2003, respectively.
Reinsurance and insurance claim reserves represent estimates involving actuarial and statistical projections at a given point in time of our expectations of the ultimate settlement and administration costs of claims incurred. The process of establishing loss reserves is complex and imprecise because it is subject to variables that are influenced by significant judgmental factors. We utilize both proprietary and commercially available actuarial models as well as historical industry loss development patterns to assist in the establishment of appropriate claim reserves. In contrast to casualty losses, which frequently can be determined only through lengthy and unpredictable litigation, non-casualty property losses tend to be reported promptly and usually are settled within a shorter period of time. Nevertheless, for both casualty and property losses, actual claims and claim expenses paid may deviate, perhaps substantially, from the reserve estimates reflected in our consolidated financial statements.
In addition, because we, like other reinsurers, do not separately evaluate each of the individual risks assumed under our reinsurance treaties, we are largely dependent on the original underwriting decisions made by ceding companies. We are subject to the risk that the ceding companies may not have adequately evaluated the risks to be reinsured and that the premiums ceded may not adequately compensate us for the risks we assume. If our claim reserves are determined to be inadequate, we will be required to increase claim reserves with a corresponding reduction in our net income in the period in which the deficiency is rectified. It is possible that claims in respect of events that have occurred could exceed our claim reserves and have a material adverse effect on our results of operations in a particular period or our financial condition.
Even though most insurance contracts have policy limits, the nature of property and casualty insurance and reinsurance is that losses can exceed policy limits for a variety of reasons and could significantly exceed the premiums received on the underlying policies.
Catastrophes can be caused by various events, including natural events such as hurricanes, windstorms, earthquakes, hailstorms, severe winter weather and fires, and unnatural events such as acts of war, terrorist attacks, explosions and riots. The incidence and severity of catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Most catastrophes are restricted to small geographic areas; however, hurricanes, windstorms and earthquakes may produce significant damage in large, heavily populated areas, and
most of our past catastrophe-related claims have resulted from severe storms. Catastrophes can cause losses in a variety of property and casualty lines for which we provide reinsurance.
Insurance companies are not permitted to reserve for a catastrophe until it has occurred. It is therefore possible that a catastrophic event or multiple catastrophic events could have a material adverse effect upon our results of operations and financial condition. It is possible that our models have not adequately captured some catastrophe risks or other risks. We believe it is impossible to completely eliminate our exposure to unforeseen or unpredictable events.
Third party rating agencies assess and rate the claims-paying ability of reinsurers and insurers based upon criteria established by the rating agencies. Periodically the rating agencies evaluate us to confirm that we continue to meet the criteria of the ratings previously assigned to us. The claims-paying ability ratings assigned by rating agencies to reinsurance or insurance companies represent independent opinions of financial strength and ability to meet policyholder obligations, and are not directed toward the protection of investors. Ratings by rating agencies are not ratings of securities or recommendations to buy, hold or sell any security. In the event our companies were to be downgraded by any or all of the rating agencies, some of our business would be subject to provisions which could cause, among other things, early termination of contracts, or a requirement to post collateral at the direction of our counterparty. We cannot precisely estimate the amount of premium that would be at risk to such a development, or the amount of additional collateral that might be required to maintain existing business, as these amounts would depend on the particular facts and circumstances at the time, including the degree of the downgrade, the time elapsed on the impacted in-force policies, and the effects of any related catastrophic event on the industry generally. We cannot assure you that our premiums would not decline, or that our profitability would not be affected, perhaps materially, following a ratings downgrade.
Our principal operating subsidiaries maintain a rating of A (Excellent) from A.M. Best, an A- (Strong) counterparty credit and financial strength rating from Standard & Poors and an A3 (Good Financial Security) financial strength rating from Moodys. Financial strength ratings are used by insurers and reinsurance and insurance intermediaries as an important means of assessing the financial strength and quality of reinsurers.
Following our announcement on March 16, 2006 that the filing of our annual report on Form 10-K would be delayed in connection with the restatement of our consolidated financial results, Standard & Poors placed on CreditWatch with negative implications our counterparty credit, senior unsecured debt and preferred stock ratings and the financial strength ratings of our principal operating subsidiaries. In addition, Moodys revised from stable to negative the outlook for our senior debt and preferred stock and the insurance financial strength ratings of our principal operating subsidiaries. Further, A.M. Best placed under review with negative implications our debt ratings and the financial strength ratings of our principal operating subsidiaries.
Investment returns are an important part of our overall profitability and our operating results depend in part on the performance of our investment portfolio. Accordingly, fluctuations in the fixed income or equity markets could impair our profitability, financial condition or cash flows. We derive our investment income from interest and dividends, together with realized gains on the sale of investment assets. The portion derived from realized gains generally fluctuates from year to year. For the years ended December 31, 2005, 2004 and 2003, net realized gains accounted for 27.3%, 40.6% and 60.2%, respectively, of our total investment income (including realized gains and losses). Realized gains are typically a less predictable source of investment income than interest and dividends, particularly in the short term.
The return on our portfolio and the risks associated with our investments are also affected by our asset mix, which can change materially depending on market conditions. Investments in cash or short-term investments generally produce a lower return than other investments. As of December 31, 2005, 29.1%, or $1.7 billion, of our
invested assets were held in cash and short-term investments pending our identifying suitable opportunities for reinvestment in line with our long-term value-oriented investment philosophy.
The volatility of our claims submissions may force us to liquidate securities, which may cause us to incur capital losses. If we structure our investments improperly relative to our liabilities, we may be forced to liquidate investments prior to maturity at a significant loss to cover such liabilities. Realized and unrealized investment losses resulting from an other than temporary decline in value could significantly decrease our assets, thereby affecting our ability to conduct business.
Our operating results depend in part on the performance of our investment portfolio. The ability to achieve our investment objectives is affected by general economic conditions that are beyond our control. General economic conditions can adversely affect the markets for interest-rate-sensitive securities, including the extent and timing of investor participation in such markets, the level and volatility of interest rates and, consequently, the value of fixed income securities. Interest rates are highly sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions and other factors beyond our control. General economic conditions, stock market conditions and many other factors can also adversely affect the equities markets and, consequently, the value of the equity securities we own. We may not be able to realize our investment objectives, which could reduce our net income significantly.
On September 7, 2005, we announced that we had been advised by Fairfax, our majority shareholder, that it had received a subpoena from the Securities and Exchange Commission (SEC) requesting documents regarding any non-traditional insurance and reinsurance transactions entered into or offered by Fairfax and any of its affiliates, which included OdysseyRe. The United States Attorneys Office for the Southern District of New York is reviewing documents provided to the SEC in response to the subpoena, and is participating in the investigation into these matters. In addition, we have provided information and made a presentation to the SEC and the U.S. Attorneys office relating to the restatement of our financial results announced by us on February 9, 2006. We are cooperating fully in addressing our obligations under this subpoena. Fairfax, and Fairfaxs chairman and chief executive officer, V. Prem Watsa, who is also the chairman of OdysseyRe, have received subpoenas from the SEC in connection with the answer to a question on Fairfaxs February 10, 2006 investor conference call concerning the review of Fairfaxs finite contracts. Our independent registered public accountants have received a subpoena from the SEC relating to the above matters.
This inquiry is ongoing, and we continue to comply with requests from the SEC and the U.S. Attorneys office. We cannot assure you that we will not be subject to further requests or other regulatory proceedings of a similar kind. It is possible that other governmental and enforcement agencies will seek to review this information as well, or that we, or other parties with whom we interact, such as customers or shareholders, may become subject to direct requests for information or other inquiries by such agencies.
The outcome and ultimate effect on our consolidated financial statements of these matters, including questions by the SEC with respect to our accounting for these transactions, cannot be predicted at the present time; however, such effects could be material and adverse. The financial cost to us to address these matters has been and is likely to continue to be significant. We expect that these matters will continue to require significant management attention, which could divert managements attention away from our business. Our business, or the market price for our securities, also could be materially adversely affected by negative publicity related to this inquiry or similar proceedings, if any.
Recently, the insurance industry has experienced substantial volatility as a result of current investigations, litigation and regulatory activity by various insurance, governmental and enforcement authorities concerning certain practices within the insurance industry. These practices include the payment of contingent commissions by insurance companies to insurance brokers and agents and the extent to which such compensation has been disclosed, the solicitation and provision of fictitious or inflated quotes, the alleged illegal tying of the placement
of insurance business to the purchase of reinsurance, and the sale and purchase of finite reinsurance or other non-traditional or loss mitigation insurance products and the accounting treatment for those products. We have received inquiries and informational requests from insurance departments in certain states in which our insurance subsidiaries operate. We cannot predict at this time the effect that current investigations, litigation and regulatory activity will have on the reinsurance industry or our business. Our involvement in any investigations and related lawsuits would cause us to incur legal costs and, if we were found to have violated any laws, we could be required to pay fines and damages, perhaps in material amounts. In addition, we could be materially adversely affected by the negative publicity for the insurance industry related to these proceedings, and by any new industry-wide regulations or practices that may result from these proceedings. It is possible that these investigations or related regulatory developments will mandate changes in industry practices in a fashion that increases our costs of doing business or requires us to alter aspects of the manner in which we conduct our business.
The reinsurance industry is highly competitive. We compete, and will continue to compete, with major United States and non-United States reinsurers and certain underwriting syndicates and insurers, some of which have greater financial, marketing and management resources than we do. In addition, we may not be aware of other companies that may be planning to enter the reinsurance market or existing reinsurers that may be planning to raise additional capital. Competition in the types of reinsurance business that we underwrite is based on many factors, including premiums charged and other terms and conditions offered, services provided, financial ratings assigned by independent rating agencies, speed of claims payment, reputation, perceived financial strength and the experience of the reinsurer in the line of reinsurance to be written. Increased competition could cause us and other reinsurance providers to charge lower premium rates and obtain less favorable policy terms, which could adversely affect our ability to generate revenue and grow our business.
We also are aware that other financial institutions, such as banks, are now able to offer services similar to our own. In addition, we have recently seen the creation of alternative products from capital market participants that are intended to compete with reinsurance products. We are unable to predict the extent to which these new, proposed or potential initiatives may affect the demand for our products or the risks that may be available for us to consider underwriting.
Our primary insurance is a business segment that is growing, and the primary insurance business is also highly competitive. Primary insurers compete on the basis of factors including selling effort, product, price, service and financial strength. We seek primary insurance pricing that will result in adequate returns on the capital allocated to our primary insurance business. Our business plans for these business units could be adversely impacted by the loss of primary insurance business to competitors offering competitive insurance products at lower prices.
This competition could affect our ability to attract and retain business.
Unanticipated developments in the law as well as changes in social and environmental conditions could result in unexpected claims for coverage under our insurance and reinsurance contracts. These developments and changes may adversely affect us, perhaps materially. For example, we could be subject to developments that impose additional coverage obligations on us beyond our underwriting intent, or to increases in the number or size of claims to which we are subject. With respect to our casualty businesses, these legal, social and environmental changes may not become apparent until some time after their occurrence. Our exposure to these uncertainties could be exacerbated by the increased willingness of some market participants to dispute insurance and reinsurance contract and policy wordings.
The full effects of these and other unforeseen emerging claim and coverage issues are extremely hard to predict. As a result, the full extent of our liability under our coverages, and in particular our casualty insurance policies and reinsurance contracts, may not be known for many years after a policy or contract is issued. Our exposure to this uncertainty will grow as our long-tail casualty businesses grow, because in these lines of
business claims can typically be made for many years, making them more susceptible to these trends than in the property insurance business, which is more typically short-tail. In addition, we could be adversely affected by the growing trend of plaintiffs targeting participants in the property-liability insurance industry in purported class action litigation relating to claim handling and other practices.
Insureds, insurers and insurance and reinsurance intermediaries use financial ratings as an important means of assessing the financial strength and quality of insurers and reinsurers. In addition, the rating of a company purchasing reinsurance may be affected by the rating of its reinsurer. For these reasons, credit committees of insurance and reinsurance companies regularly review and in some cases revise their requirements with respect to the insurers and reinsurers from whom they purchase insurance and reinsurance.
If one or more of our current or potential customers were to raise their minimum required financial strength or claims paying ratings above the ratings held by us or our insurance and reinsurance subsidiaries, or if they were to materially increase their collateral requirements, the demand for our products could be reduced, our premiums could decline, and our profitability could be adversely affected.
Many insurance industry participants are consolidating to enhance their market power. These entities may try to use their market power to negotiate price reductions for our products and services. If competitive pressures compel us to reduce our prices, our operating margins would decrease. As the insurance industry consolidates, competition for customers will become more intense and the importance of acquiring and properly servicing each customer will become greater. We could incur greater expenses relating to customer acquisition and retention, further reducing our operating margins. In addition, insurance companies that merge may be able to spread their risks across a consolidated, larger capital base so that they require less reinsurance.
Historically, we have experienced fluctuations in operating results due to competition, frequency of occurrence or severity of catastrophic events, levels of capacity, general economic conditions and other factors. Demand for reinsurance is influenced significantly by underwriting results of primary insurers and prevailing general economic conditions. In addition, the larger insurers created by the consolidation discussed above may require less reinsurance. The supply of reinsurance is related to prevailing prices and levels of surplus capacity that, in turn, may fluctuate in response to changes in rates of return being realized in the reinsurance industry. It is possible that premium rates or other terms and conditions of trade could vary in the future, that the present level of demand will not continue or that the present level of supply of reinsurance could increase as a result of capital provided by recent or future market entrants or by existing reinsurers.
General pricing across the industry and other terms and conditions have become less favorable than they have been in the recent past, the degree to which varies by class of business and region. All of these factors can reduce our profitability and we have no way to determine to what extent they will impact us in the future.
Fairfax beneficially owns, through wholly owned subsidiaries, 80.2% of our outstanding common shares. Consequently, Fairfax can determine the outcome of our corporate actions requiring board or shareholder approval, such as:
In addition, Fairfax has provided us, and continues to provide us, with certain services for which it receives customary compensation. Through various subsidiaries, Fairfax engages in the business of underwriting insurance as well as other financial services; and from time to time, we may engage in transactions with those other businesses in the ordinary course of business under market terms and conditions. At December 31, 2005, all of our directors other than Mr. Barnard also were directors or officers of Fairfax or certain of its subsidiaries. Conflicts of interest could arise between us and Fairfax or one of its other subsidiaries, and any conflict of interest may be resolved in a manner that does not favor us.
Fairfax has stated that it intends to retain control of us and cannot foresee any circumstances under which it would sell a sufficient number of our common shares to cause it not to retain such control. Any decision regarding the ownership of us that Fairfax may make at some future time will be in its absolute discretion.
Our capital requirements depend on many factors, including our ability to write business, and rating agency capital requirements. To the extent that our existing capital is insufficient to meet these requirements, we may need to raise additional funds through financings. Any financing, if available at all, may be on terms that are not favorable to us. If our need for capital arises because of significant losses, the occurrence of these losses may make it more difficult for us to raise the necessary capital. If we cannot obtain adequate capital on favorable terms or at all, our business, operating results and financial condition would be adversely affected.
The current agreements governing our $150 million bank credit facility and our 7.49% senior notes due 2006 (of which $40.0 million in principal amount remain outstanding) contain certain covenants that limit our ability to, among other things, borrow money, make particular types of investments or other restricted payments, sell assets, merge or consolidate. These agreements also require us to maintain specific financial ratios. If we fail to comply with these covenants or meet these financial ratios, the lenders under our credit facility or our noteholders could declare a default and demand immediate repayment of all amounts owed to them.
We are a holding company, and our principal source of funds is cash dividends and other permitted payments from our operating subsidiaries, principally Odyssey America. If we are unable to receive dividends from our operating subsidiaries, or if they are able to pay only limited amounts, we may be unable to pay dividends or make payments on our indebtedness. The payment of dividends by our operating subsidiaries is subject to restrictions set forth in the insurance laws and regulations of Connecticut, Delaware, New York and the United Kingdom. See Regulatory Matters Regulation of Insurers and Reinsurers Dividends.
We are substantially dependent on a small number of key employees, in particular Andrew Barnard, Robert Giammarco and Michael Wacek. We believe that the experience and reputations in the reinsurance industry of Messrs. Barnard, Giammarco and Wacek are important factors in our ability to attract new business. We have entered into employment agreements with Messrs. Barnard and Wacek and are in the process of entering into an employment agreement with Mr. Giammarco. Our success has been, and will continue to be, dependent on our ability to retain the services of our existing key employees and to attract and retain additional qualified personnel in the future. The loss of the services of Mr. Barnard, Mr. Giammarco or Mr. Wacek or any other key employee, or the inability to identify, hire and retain other highly qualified personnel in the future, could adversely affect the quality and profitability of our business operations. We do not currently maintain key employee insurance with respect to any of our employees.
We market our reinsurance products worldwide primarily through reinsurance brokers, as well as directly to our customers. Five reinsurance brokerage firms accounted for 62.7% of our reinsurance gross premiums written for the year ended December 31, 2005. Loss of all or a substantial portion of the business provided by these brokers could have a material adverse effect on us.
In accordance with industry practice, we frequently pay amounts owing in respect of claims under our policies to reinsurance brokers, for payment over to the ceding insurers. In the event that a broker fails to make such a payment, depending on the jurisdiction, we might remain liable to the ceding insurer for the deficiency. Conversely, in certain jurisdictions, when the ceding insurer pays premiums for such policies to reinsurance brokers for payment over to us, such premiums will be deemed to have been paid and the ceding insurer will no longer be liable to us for those amounts, whether or not we have actually received such premiums. Consequently, in connection with the settlement of reinsurance balances, we assume a degree of credit risk associated with brokers around the world.
Our functional currency is the United States dollar. A portion of our premiums are written in currencies other than the United States dollar and a portion of our loss reserves are also in foreign currencies. Moreover, we maintain a portion of our investments in currencies other than the United States dollar. We may, from time to time, experience losses resulting from fluctuations in the values of foreign currencies, which could adversely affect our operating results.
We attempt to limit our risk of loss through retrocessional arrangements, reinsurance agreements with other reinsurers referred to as retrocessionaires. The availability and cost of retrocessional protection is subject to market conditions, which are beyond our control. As a result, we may not be able to successfully alleviate risk through retrocessional arrangements. In addition, we are subject to credit risk with respect to our retrocessions because the ceding of risk to retrocessionaires does not relieve us of our liability to the companies we reinsured.
We purchase reinsurance coverage to insure against a portion of our risk on policies we write directly. We expect that limiting our insurance risks through reinsurance will continue to be important to us. Reinsurance does not affect our direct liability to our policyholders on the business we write. A reinsurers insolvency or inability or unwillingness to make timely payments under the terms of its reinsurance agreements with us could have a material adverse effect on us. In addition, we cannot assure you that reinsurance will remain available to us to the same extent and on the same terms as are currently available.
Hudson, which writes insurance in 44 states and the District of Columbia on an admitted basis, is subject to extensive regulation under state statutes that delegate regulatory, supervisory and administrative powers to state insurance commissioners. Such regulation generally is designed to protect policyholders rather than investors, and relates to such matters as: rate setting; limitations on dividends and transactions with affiliates; solvency standards which must be met and maintained; the licensing of insurers and their agents; the examination of the affairs of insurance companies, which includes periodic market conduct examinations by the regulatory authorities; annual and other reports, prepared on a statutory accounting basis; establishment and maintenance of reserves for unearned premiums and losses; and requirements regarding numerous other matters. We could be required to allocate considerable time and resources to comply with these requirements, and could be adversely affected if a regulatory authority believed we had failed to comply with applicable law or regulation. We plan to grow Hudsons business and, accordingly, expect our regulatory burden to increase.
Our primary insurance operations rely on program managers, and other agents and brokers participating in our programs, to produce and service a substantial portion of our business in this segment. In these arrangements, we typically grant the program manager the right to bind us to newly issued insurance policies, subject to underwriting guidelines we provide and other contractual restrictions and obligations. Should our managers issue policies that contravene these guidelines, restrictions or obligations, we could nonetheless be deemed liable for such policies. Although we would intend to resist claims that exceed or expand on our underwriting intention, it is possible that we would not prevail in such an action, or that our program managers would be unable to substantially indemnify us for their contractual breach. We also rely on our managers, or other third parties we retain, to collect premiums and to pay valid claims. This exposes us to their credit and operational risk, without necessarily relieving us of our obligations to potential insureds. We could also be exposed to potential liabilities relating to the claims practices of the third party administrators we have retained to manage claims activity that we expect to arise in our program operations. Although we have implemented monitoring and other oversight protocols, we cannot assure you that these measures will be sufficient to alleviate all of these exposures.
We are also subject to the risk that our successful program managers will not renew their programs with us. Our contracts are generally for defined terms of as little as one year, and either party can cancel the contract in a relatively short period of time. We cannot assure you that we will retain the programs that produce profitable business or that our insureds will renew with us. Failure to retain or replace these producers would impair our ability to execute our growth strategy, and our financial results could be adversely affected.
The insurance industry is highly regulated and is subject to changing political, economic and regulatory influences. These factors affect the practices and operation of insurance and reinsurance organizations. Federal and state legislatures have periodically considered programs to reform or amend the United States insurance system at both the federal and state level. Recently, the insurance and reinsurance regulatory framework has been subject to increased scrutiny in many jurisdictions, including the United States and various states in the United States.
Changes in current insurance regulation may include increased governmental involvement in the insurance industry or may otherwise change the business and economic environment in which insurance industry participants operate. In the United States, for example, the states of Hawaii and Florida have implemented arrangements whereby property insurance in catastrophe prone areas is provided through state-sponsored entities. The California Earthquake Authority, the first privately financed, publicly operated residential earthquake insurance pool, provides earthquake insurance to California homeowners.
Such changes could cause us to make unplanned modifications of products or services, or may result in delays or cancellations of sales of products and services by insurers or reinsurers. Insurance industry participants may respond to changes by reducing their investments or postponing investment decisions, including investments in our products and services. We cannot predict the future impact of changing law or regulation on our operations; any changes could have a material adverse effect on us or the insurance industry in general.
Increasingly, governmental authorities in both the U.S. and worldwide appear to be interested in the potential risks posed by the reinsurance industry as a whole, and to commercial and financial systems in general. While we cannot predict the exact nature, timing or scope of possible governmental initiatives, we believe it is likely there will be increased regulatory intervention in our industry in the future.
For example, we could be adversely affected by governmental or regulatory proposals that:
Our business is highly dependent upon the successful and uninterrupted functioning of our computer and data processing systems. We rely on these systems to perform actuarial and other modeling functions necessary for writing business, as well as to process and make claims payments. We have a highly trained staff that is committed to the continual development and maintenance of these systems. However, the failure of these systems could interrupt our operations or materially impact our ability to rapidly evaluate and commit to new business opportunities. If sustained or repeated, a system failure could result in the loss of existing or potential business relationships, or compromise our ability to pay claims in a timely manner. This could result in a material adverse effect on our business results.
Our insurance may not adequately compensate us for material losses that may occur due to disruptions in our service as a result of computer and data processing systems failure. We do not maintain redundant systems or facilities for all of our services.
In addition, a security breach of our computer systems could damage our reputation or result in liability. We retain confidential information regarding our business dealings in our computer systems. We may be required to spend significant capital and other resources to protect against security breaches or to alleviate problems caused by such breaches. Any well-publicized compromise of security could deter people from conducting transactions that involve transmitting confidential information to our systems. Therefore, it is critical that these facilities and infrastructure remain secure and are perceived by the marketplace to be secure. Despite the implementation of security measures, this infrastructure may be vulnerable to physical break-ins, computer viruses, programming errors, attacks by third parties or similar disruptive problems. In addition, we could be subject to liability if hackers were able to penetrate our network security or otherwise misappropriate confidential information.
In response to the tightening of supply in certain insurance and reinsurance markets resulting from, among other things, the September 11, 2001 terrorist attack, the Terrorism Risk Insurance Act of 2002, or TRIA, was enacted to ensure the availability of commercial insurance coverage for terrorist acts in the United States. This law initially established a federal assistance program through the end of 2005 to help the commercial property and casualty insurance industry cover claims related to future terrorism-related losses and required that coverage for terrorist acts be offered by insurers. Although TRIA recently has been modified and extended through 2007, it is possible that TRIA will not be renewed beyond 2007, or could be adversely amended, which could adversely
affect the insurance industry if a material subsequent event occurred. Given these uncertainties, we are currently unable to determine with certainty the impact that TRIAs amendment or non-renewal could have on us.
Fairfax, through its subsidiaries, TIG Insurance Group, TIG Insurance Company, ORH Holdings Inc., United States Fire Insurance Company, Fairfax Financial (US) LLC and Fairfax Inc., owns 80.2% of our outstanding common shares. Consequently, Fairfax is in a position to determine the outcome of corporate actions requiring board or shareholder approval, including:
At December 31, 2005 all of our directors other than Mr. Barnard were directors or officers of Fairfax or certain of its subsidiaries. Conflicts of interest could arise between us and Fairfax or one of its subsidiaries, and any conflict of interest may be resolved in a manner that does not favor us.
Fairfax has stated that it intends to retain control of us and cannot foresee any circumstances under which it would sell a sufficient number of our common shares to cause it not to retain such control. In order to retain control, Fairfax may decide not to enter into a transaction in which our shareholders would receive consideration for their shares that is much higher than the cost of their investment in our common shares or the then current market price of our common shares. Any decision regarding the ownership of us that Fairfax may make at some future time will be in its absolute discretion.
Significant price and value fluctuations have occurred with respect to the securities of insurance and insurance-related companies. Our common share price is likely to be volatile in the future. In the past, following periods of downward volatility in the market price of a companys securities, class action litigation has often been pursued against such companies. If similar litigation were pursued against us, it could result in substantial costs and a diversion of our managements attention and resources.
Our certificate of incorporation and bylaws, as well as Delaware corporate law, contain provisions that could delay or prevent changes in our management or a change of control that a shareholder might consider favorable and may prevent you from receiving a takeover premium for your shares. These provisions include, for example,
These provisions apply even if the offer may be considered beneficial by some of our shareholders. If a change in management or a change of control is delayed or prevented, the market price of our common shares could decline.
Our corporate offices are located in 101,420 total square feet of leased space in Stamford, Connecticut. Our other locations occupy a total of 121,086 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.
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 Americas purported share of a settlement (Settlement) between Gulf and one of the insureds whose policies, Gulf contends, were reinsured under the Treaties (the Disputed Policies). 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. Discovery has commenced and is expected to be completed in the second quarter of 2006. 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 Disputed Policies are not covered under the terms of the Treaties. Among the remedies Odyssey America seeks is rescission of the Treaties. We are vigorously asserting our claims and defending ourself against any claims asserted by Gulf. We estimate that the amount in dispute under the Treaties, that has not been recorded by us as of December 31, 2005, could range between $35 million to $40 million, after taxes. If Odyssey America is ultimately found to be liable for all or a portion of this amount, any such amount will be recorded in the period in which it is judicially determined. It is presently anticipated that the case will not go to trial prior to the third quarter of 2006. It is not possible to make any determination regarding the likely outcome of this matter at this time.
In January 2004, two retrocessionaires of Odyssey America under the common control of London Reinsurance Group Inc. (together, London Life) filed for arbitration under a series of aggregate stop loss agreements covering the years 1994 and 1996-2001 (the Agreements). London Life had alleged that Odyssey America improperly administered the Agreements and sought a determination of its liability under the Agreements. Odyssey America sought enforcement of the Agreements. The arbitration hearing commenced in November 2005 and concluded in January 2006. On March 9, 2006, the arbitration panel issued its decision (Interim Final Award and Decision), confirming the enforceability of the Agreements and resolving in Odyssey Americas favor substantially all issues in dispute regarding Odyssey Americas administration of the Agreements. The arbitration panel directed the parties to resolve two remaining items representing, in the aggregate, less than $1.0 million, pretax. The resolution of this arbitration will have no material impact on the Companys consolidated financial statements.
On September 7, 2005, we announced that we had been advised by Fairfax, our majority shareholder, that it had received a subpoena from the Securities and Exchange Commission (SEC) requesting documents regarding any non-traditional insurance and reinsurance transactions entered into or offered by Fairfax and any of its affiliates, which included OdysseyRe. The United States Attorneys Office for the Southern District of New York is reviewing documents provided to the SEC in response to the subpoena, and is participating in the investigation into these matters. In addition, we have provided information and made a presentation to the SEC and the U.S. Attorneys office relating to the restatement of our financial results announced by us on February 9,
2006. We are cooperating fully in addressing our obligations under this subpoena. Fairfax, and Fairfaxs chairman and chief executive officer, V. Prem Watsa, who is also the chairman of OdysseyRe, have received subpoenas from the SEC in connection with the answer to a question on Fairfaxs February 10, 2006 investor conference call concerning the review of Fairfaxs finite contracts. Our independent registered public accountants have received a subpoena from the SEC relating to the above matters. This inquiry is ongoing, and we continue to comply with requests from the SEC and the U.S. Attorneys office. The outcome and ultimate effect on our consolidated financial statements of these matters, including questions by the SEC with respect to our accounting for these transactions, cannot be predicted at the present time; however, such effects could be material and adverse.
The Company and its subsidiaries are involved from time to time in ordinary litigation and arbitration proceedings as part of our business operations; in managements opinion, the outcome of these suits, individually or collectively, is not likely to result in judgments that would be material to our financial condition or results of operations.
No matters were submitted to a vote of security holders during the fourth quarter of 2005.
Market Information and Holders of Common Shares
The principal United States market on which of our common shares are traded is the New York Stock Exchange (NYSE). As of March 1, 2006, the approximate number of holders of our common shares, including those whose common shares are held in nominee name, was 10,500. Quarterly high and low sales prices per share of our common shares, as reported by the New York Stock Exchange composite for each quarter in the years ended December 31, 2005 and 2004, are as follows:
Fairfax owns 80.2% of our outstanding common shares through its subsidiaries, TIG Insurance Group (52.2%), TIG Insurance Company (5.7%), ORH Holdings Inc. (8.9%), Fairfax Financial (U.S.) LLC (6.2%), United States Fire Insurance Company (1.2%) and Fairfax Inc. (6.0%).
In each of the four quarters of 2005, we declared a dividend of $0.03125 per common share, resulting in an aggregate annual dividend of $0.125 per common share, totaling $8.3 million. The dividends were paid on March 31, 2005, June 30, 2005, September 30, 2005 and December 31, 2005. In each of the four quarters of 2004, we declared a dividend of $0.03125 per common share, resulting in an aggregate annual dividend of $0.125 per common share, totaling $8.1 million. The dividends were paid on March 31, 2004, June 30, 2004, September 30, 2004 and December 31, 2004.
While it is the intention of our Board of Directors to declare quarterly cash dividends, the declaration and payment of future dividends, if any, by us will be at the discretion of our Board of Directors and will depend on, among other things, our financial condition, general business conditions and legal restrictions regarding the payment of dividends by us, and other factors. The payment of dividends by us is subject to limitations imposed by laws in Connecticut, Delaware, New York and the United Kingdom. For a detailed description of these limitations, see Part I, Item 1 Business Regulatory Markets Regulation of Insurers and Reinsurers Dividends.
Issuer Purchases of Equity Securities
The following table sets forth purchases made by us of our common shares under our stock repurchase program during the three months ended December 31, 2005. All of the shares repurchased are used to support the grant of restricted shares and the exercise of stock options which vest during the period.
We intend to continue to make open market repurchases of our common shares to support the grant of restricted shares and the exercise of stock options. As of December 31, 2005, we had 115,325 common shares held in treasury to support such grants and exercises. We also may continue to repurchase our Convertible Notes in open-market transactions.
Item 6. Selected Financial Data
The following selected financial data should be read in connection with Managements 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.
As further described in Note 2 to the consolidated financial statements, we have restated our consolidated financial statements as of and for the years ended December 31, 2000 through 2004, as well as our statements as of and for the nine months ended September 30, 2005. Accordingly, the following selected financial data includes the effects of the restatement adjustments. A reconciliation of previously reported consolidated financial statements to the restated consolidated financial statements as of and for the years ended December 31, 2000 through 2002 follows the table. A reconciliation of previously reported consolidated financial statements to our restated consolidated financial statements as of and for the years ended December 31, 2003 and 2004 and as of and for the nine months ended September 30, 2005 is included in Note 2 to our consolidated financial statements.
We encourage you to read the consolidated financial statements included in this Form 10-K because they contain our complete consolidated financial statements for the years ended December 31, 2005, 2004, and 2003. The results of operations for the year ended December 31, 2005 are not necessarily indicative of future results.
Restatement of Financial Results
The effect of the restatement of our consolidated financial statements, as of and for the nine months ended September 30, 2005 and as of and for the years ended December 31, 2004 and 2003, is included in Note 2 to our consolidated financial statements. The effect of the restatement on our quarterly consolidated financial statements is included in Note 21 to our consolidated financial statements. The previously reported restatement adjustment and restated amounts for those accounts in our consolidated financial statements as of and for the years ended December 31, 2002, 2001 and 2000 affected by this restatement is as follows:
The following discussion and analysis should be read in conjunction with the Selected Financial Data, consolidated financial statements and related notes and the discussion under Critical Accounting Estimates and Safe Harbor Disclosure. As further described in Note 2 to the consolidated financial statements and Item 6 Selected Financial Data, we have restated our consolidated financial statements as of and for the years ended December 31, 2000 through 2004, as well as our results as of and for the nine months ended September 30, 2005. Managements Discussion and Analysis has been updated to reflect the effect of the restatement.
Odyssey Re Holdings Corp. is a holding company, incorporated in the state of Delaware, which owns all of the common shares of Odyssey America Reinsurance Corporation, its primary operating subsidiary. Odyssey America directly or indirectly owns all of the capital stock of the following companies: Clearwater Insurance Company; Clearwater Select Insurance Company; Odyssey UK Holdings Corporation; Newline Underwriting
Management Ltd., which owns and manages Newline Syndicate 1218 at Lloyds; Hudson Insurance Company; and Hudson Specialty Insurance Company.
We are a leading United States based underwriter of reinsurance, providing a full range of property and casualty products on a worldwide basis. We offer a broad range of both treaty and facultative reinsurance to property and casualty insurers and reinsurers. We also write specialty insurance in the United States.
Our gross premiums written for the year ended December 31, 2005 were $2,626.9 million, a decrease of $23.9 million, or 0.9%, compared to gross premiums written for the year ended December 31, 2004 of $2,650.8 million. Our business outside of the United States accounted for 44.8% of our gross premiums written for the year ended December 31, 2005, compared to 45.7% for the year ended December 31, 2004. For the years ended December 31, 2005 and 2004, our net premiums written were $2,301.7 million and $2,361.8 million, respectively. For the year ended December 31, 2005, we had a net loss available to common shareholders of $105.4 million and for the year ended December 31, 2004, we had net income of $198.3 million. As of December 31, 2005, we had total assets of $8.6 billion and total shareholders equity of $1.6 billion.
The property and casualty reinsurance and insurance industries use the combined ratio as a measure of underwriting profitability. The GAAP combined ratio is the sum of losses and loss adjustment expenses (LAE) incurred 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.
Our consolidated statement of operations for the year ended December 31, 2005 includes a pre-tax underwriting loss of $436.0 million from Hurricanes Katrina, Rita and Wilma, which occurred during the third and fourth quarters of 2005. The underwriting loss from Hurricanes Katrina, Rita and Wilma is comprised of losses and LAE of $445.9 million, which is after reinsurance recoverables of $241.1 million, reduced by $9.9 million in net reinstatement premiums received. The loss estimate represents our best estimate based on the most recent information available. We used various approaches in estimating the loss, including a detailed review of exposed contracts and information from ceding companies. As additional information becomes available, these estimates may be revised, potentially resulting in adverse effects to our financial results. The extraordinary nature of these catastrophes, including potential legal and regulatory implications, creates substantial complexity and uncertainty in estimating these losses. Considerable time may elapse before the adequacy of our estimates can be determined.
Our consolidated statement of operations for the year ended December 31, 2004 includes a pre-tax underwriting loss of $97.4 million from Hurricanes Charley, Frances, Ivan and Jeanne, which occurred in the third quarter of 2004 (the 2004 Florida Hurricanes). The underwriting loss from the 2004 Florida Hurricanes is comprised of losses and LAE of $93.4 million, which is after reinsurance recoverables of $77.8 million, increased by $4.0 million in net reinstatement premiums paid. As a result of the complexity and uncertainty in estimating losses from the 2004 Florida Hurricanes, we incurred an additional pre-tax underwriting loss of $12.6 million, net of applicable reinstatement premiums, for the year ended December 31, 2005.
Our consolidated statement of operations for the year ended December 31, 2003 includes net losses and LAE of $73.3 million from catastrophe losses recognized during the period. The largest of the 2003 catastrophe losses relate to $12.7 million for Typhoon Maemi, which occurred in South Korea in September 2003, and $10.0 million for floods which occurred in France in December 2003.
We operate our business through four divisions: the Americas, EuroAsia, London Market and U.S. Insurance.
The Americas division is our largest division and writes casualty, surety and property treaty reinsurance, and facultative casualty reinsurance, in the United States and Canada, and primarily treaty and facultative property reinsurance in Central and South America.
The EuroAsia division consists of our international reinsurance business, which is geographically dispersed, mainly throughout the European Union, followed by Japan, Eastern Europe, the Pacific Rim, and the Middle East.
The London Market division is comprised of our Lloyds of London business, in which we participate through our 100% ownership of Newline and our London branch office. The London Market division writes insurance and reinsurance business worldwide, principally through brokers.
The U.S. Insurance division writes specialty insurance lines and classes of business, such as medical malpractice, professional liability and non-standard personal auto.
Restatement of Consolidated Financial Statements
We have restated our consolidated financial statements as of and for the years ended December 31, 2000 through 2004, as well as our unaudited statements as of and for the nine months ended September 30, 2005, to correct for accounting errors associated with reinsurance contracts entered into by us between 1998 and 2004. Our decision to restate our financial results follows a re-evaluation by us of the accounting considerations previously applied to these transactions. The effects of the restatement are reflected in our consolidated financial statements and accompanying notes included herein. Amounts for the nine months ended September 30, 2005 are unaudited.
The total cumulative impact of the restatement through September 30, 2005 is to decrease shareholders equity by $35.6 million, after-tax. The aggregate net effect of the restatement for each period is to increase the net loss for the nine months ended September 30, 2005 by $5.1 million, increase 2004 net income by $11.4 million, decrease 2003 net income by $2.3 million, decrease 2002 net income by $5.6 million, increase 2001 net loss by $30.7 million and decrease 2000 net income by $3.3 million. The $35.6 million after-tax cumulative decrease to shareholders equity as of September 30, 2005 will be offset by net income of $12.5 million to be recognized for the three months ended March 31, 2006 in connection with one of the restated contracts as discussed below.
The nature of the corrections relate to:
Critical Accounting Estimates
The accompanying consolidated financial statements and related notes have been prepared in accordance with accounting principles generally accepted in the United States (U.S. 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 the notes to our consolidated financial statements.
Critical accounting estimates are defined as those that are both important to the portrayal of our financial condition and results of operations and require us to exercise significant judgment. The preparation of consolidated financial statements in accordance with U.S. GAAP requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of material contingent assets and liabilities, including litigation contingencies. These estimates, by necessity, are based on assumptions about numerous factors.
We review our critical accounting estimates and assumptions quarterly. These reviews include the estimate of reinsurance premiums and premium related amounts, establishing deferred acquisition costs, an evaluation of the adequacy of reserves for unpaid losses and LAE, review of our reinsurance and retrocession agreements, an analysis of the recoverability of deferred income tax assets and an evaluation of the investment portfolio for other-than-temporary declines in estimated fair value. Actual results may differ materially from the estimates and assumptions used in preparing the consolidated financial statements.
We derive our revenues from two principal sources: premiums from insurance placed and reinsurance assumed, net of premiums ceded (net premiums written), and income from investments. Net premiums written are earned (net premiums earned) as revenue over the terms of the underlying contracts or certificates in force. The relationship between net premiums written and net premiums earned will, therefore, vary depending on the volume and inception dates of the business assumed and ceded and the mix of such business between proportional and excess of loss reinsurance.
Consistent with our significant accounting policies, for our reinsurance business we utilize estimates in establishing premiums written, the corresponding acquisition expenses and unearned premium reserves. These estimates are required to reflect differences in the timing of the receipt of accounts from the ceding company and the actual due dates of the accounts at the close of each accounting period.
The following table displays, by division, the estimates included in our consolidated financial statements for the years ended December 31, 2005, 2004 and 2003 related to gross premiums written, acquisition costs, premiums receivable and unearned premium reserves (in millions):
Premium estimates, the corresponding acquisition costs, premiums receivable and unearned premium reserves are established on a contract level for significant accounts due but not reported by the ceding company at the end of each accounting period. The estimated ultimate premium for the contract, actual accounts reported by the ceding company, and our own experience on the contract are considered in establishing the estimate at the end of each accounting period. Subsequent adjustments based on actual results are recorded in the period in which they become known. The estimated premiums receivable balances are considered fully collectible. The estimates primarily represent the most current two underwriting years of account for which all corresponding reported accounts have been settled within contract terms. The estimates are considered critical accounting estimates because changes in these estimates can materially affect net income.
The difference between estimates and the actual accounts received may be material as a result of different reporting practices by ceding companies across geographic locations. Estimates may be subject to material fluctuations on an individual contract level compared to the actual information received, and any differences are recorded in the respective financial period in which they become known. Since the assumptions used to determine the estimates are reviewed quarterly and compared to the information received during the quarter, the variance in the aggregate estimates compared to the actual information when received is minimized. In addition, during the quarters review of these contracts, any change in original estimate compared to the new estimate is reflected in the appropriate financial period.
In any specific financial period, the original estimated premium for a specific contract may vary from actual premium reported through the life of the contract by up to 10% to 15% due to the reporting patterns of the ceding companies and, in some cases, movements in foreign exchange rates over the period. However, historically, the final reported premium compared to the original estimated premium has deviated by smaller amounts.
Our estimates are based on contract and policy terms. Estimates are based on information typically received in the form of a bordereau, broker notifications and/or discussions with ceding companies. These estimates, by necessity, are based on assumptions regarding numerous factors. These can include premium or loss trends, which can be influenced by local conditions in a particular region, or other economic factors and legal or legislative developments which can develop over time. The risk associated with estimating the performance under our contracts with our ceding companies is the impact of events or trends that could not have been reasonably anticipated at the time the estimates were performed. Our business is diversified across ceding companies and there is no individual non-affiliated ceding company which represents more than 1.5% of our gross premiums written in 2005. As a result, we believe the risks of material changes over time are mitigated.
We review information received from ceding companies for reasonableness based on past experience with the particular ceding company or our general experience across the subject class of business. We also query information provided by ceding companies for reasonableness. Reinsurance contracts under which we assume business generally contain specific provisions which allow us to perform audits of the ceding company to ensure compliance with the terms and conditions of the contract, including accurate and timely reporting of information.
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.
Acquisition costs consist of commissions and brokerage expenses incurred on insurance and reinsurance business written. These costs are deferred and amortized over the period in which the related premiums are earned, which is generally one year. Deferred acquisition costs are limited to their estimated realizable value based on the related unearned premiums, which considers anticipated losses and LAE and estimated remaining costs of servicing the business, all based on our historical experience. The estimates are continually reviewed by us and any adjustments are made in the accounting period in which an adjustment is considered necessary.
Our losses and LAE reserves, for both reported and unreported claims obligations, are maintained to cover the estimated ultimate liability for all of our insurance and reinsurance obligations. Losses and LAE reserves are categorized in one of three ways: (i) case reserves, which represent unpaid losses and LAE as reported by cedants to us, (ii) additional case reserves (ACRs), which are reserves we establish in excess of the case reserves reported by the cedant on individual claim events, and (iii) incurred but not reported reserves (IBNR), which are reserves for losses and LAE that have been incurred, but have not yet been reported to us, as well as additional amounts relating to losses already reported, that are in excess of case and ACR reserves. Incurred but not reported reserves are estimates based on all information currently available to us and are reevaluated quarterly utilizing the most recent information supplied from our cedants.
We rely on initial and subsequent claims reports received from ceding companies to establish our estimate of losses and LAE. The types of information that we receive from ceding companies generally vary by the type of contract. Proportional, or quota share, contracts are typically reported on a quarterly basis, providing premium and loss activity as estimated by the ceding company. Reporting for excess of loss and facultative contracts includes detailed individual claim information, including a description of the loss, confirmation of liability by the cedant and the cedants current estimate of the ultimate liability under the claim. Upon receipt of claims notices from cedants, we review the nature of the claim against the scope of coverage provided under the contract. Questions arise from time to time regarding the interpretation of the characteristics of a particular claim measured against the scope of contract terms and conditions. Reinsurance contracts under which we assume business generally contain specific dispute resolution provisions in the event that there is a coverage dispute with the ceding company. The resolution of any individual dispute may impact estimates of ultimate claim liabilities. Reported claims are in various stages of the settlement process. Each claim is settled individually based on its merits, and certain claims may take several years to ultimately settle, particularly where legal action is involved. Based on an assessment of the circumstances supporting the claim, we may choose to establish additional case reserves over the amount reported by the ceding company. Aggregate case reserves established in addition to reserves recommended by the ceding company were $14.6 million and $26.4 million as of December 31, 2005 and 2004, respectively. Due to potential differences in ceding company reserving and reporting practices, we perform periodic audits of our ceding companies to ensure the underwriting and claims procedures of the cedant are consistent with representations made by the cedant during the underwriting process and meet the terms of the reinsurance contract. Our estimates of ultimate loss liabilities make appropriate adjustment for inconsistencies uncovered in this audit process. We also monitor our internal processes to ensure that information received from ceding companies is processed in a timely manner.
The reserve methodologies employed by us are dependent on the nature and quality of the data that we collect from ceding companies. This data primarily consists of loss amounts reported by the ceding companies, loss payments made by the ceding companies, and premiums written and earned reported by the ceding companies or estimated by us. For many classes of business, the actuarial methods used by us to project our liabilities recorded presently but that will be paid in the future (future liabilities) generally do not include 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 companies for every treaty. Consequently, actuarial methods relying on this information generally cannot be relied on by us for much of our loss reserve estimation process.
Underwriting and claim information provided by our ceding companies is aggregated by the year in which each treaty is written into groups of business by geographic region and type of business to facilitate analysis, generally referred to as reserve cells. These reserve cell groupings of business are reviewed annually and change over time as our business mix changes. We supplement this information with claims and underwriting audits of specific contracts, internally developed pricing, as well as loss trend data developed from industry sources. This information is used to develop point estimates of carried reserves for each business segment. These individual point estimates, when aggregated, represent the total carried losses and LAE reserves carried in our consolidated financial statements. Due to the uncertainty involving estimates of ultimate loss exposures, we do not attempt to produce a range around our point estimate of loss. The actuarial techniques for projecting losses and LAE reserves by reserve cell rely on historical paid and case reserve loss emergence patterns and insurance and reinsurance pricing trends to establish the claims emergence of future periods with respect to all reported and unreported insured events that have occurred on or before the balance sheet date. The process relies upon the assumption that past experience, supplemented by qualitative judgment where quantitative methods provide incomplete results, is an appropriate basis for predicting future events. The estimation of loss reserves is a complex process, especially in view of changes in the legal, social and economic environment which impact the development of loss reserves. Qualitative reassessments by management may be required where emerging trends and issues in claims frequency and severity and litigation, and in the social, economic, legislative and regulatory environments cannot be fully addressed or contemplated by past experience trends. Examples of events that could require qualitative reassessments of loss estimates by management would include shifts in laws, such as asbestos litigation reform, or developments involving the Terrorism Risk Insurance Act of 2002 that could affect claims related to future terrorism-related losses. Our best reasoned judgment on the impact of these types of trends and events will necessarily be based upon our evaluation of the historical effects of events of similar scope or magnitude that have occurred in the past.
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. 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 analyses of pricing trends across reserve cells, to premium earned on that business. Adjustments 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.
The most significant assumptions underlying our December 31, 2005 estimate of losses and LAE reserves are as follows: (i) that the information developed from internal and external sources can be used to develop reasonable estimates of loss experience for business written by us; (ii) that historical loss emergence trends are indicative of future loss development trends; and (iii) that no provision is made for extraordinary future
emergence of new classes of losses or types of losses not sufficiently represented in our historical data base or that are not yet quantifiable.
Due to the uncertainty involving estimates of ultimate loss exposures, we do not attempt to produce a range around our point estimate of loss. Actual results exceeded our estimates of losses and LAE in 2005, 2004 and 2003 by 5.4%, 8.0% and 6.9%, 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 best information we have available at any given point in time and our assumptions based upon that information. Every 1% point difference in actual results compared to our reserves as of December 31, 2005 will impact pre-tax income by $39.1 million.
If an unfavorable change were to occur for the following assumptions, the approximate decrease in pre-tax income would be as follows (in millions):
A) Frequency and Severity of Outstanding Claim Reserves as of December 31, 2005:
B) Calendar Year 2005 Loss and LAE Incurred:
Historically, our actual results have varied considerably in certain instances from our estimates of losses and LAE because historical loss emergence trends have not been indicative of future emergence for certain segments of our business. For calendar years 2003 through 2005, we experienced claim frequency and severity greater than expectations that were established based on a review of the prior years loss trends, particularly for business written in the period 1997 through 2000. General liability and excess workers compensation classes of business during these years were adversely impacted by the highly competitive conditions in the industry at that time, which resulted in price competition and relatively broader coverage terms, thereby affecting the ability of standard actuarial techniques to generate reliable estimates of ultimate loss. Similarly, directors and officers professional liability lines were impacted by the increase in frequency and severity of claims resulting from an increase in shareholder lawsuits against corporations and their officers and directors, corporate bankruptcies and other financial and management improprieties in the late 1990s through the early 2000s. For calendar years 2005 through 2003, the net impact of changes in losses and LAE estimates for all segments reduced pre-tax income by $172.7 million, $190.0 million and $127.9 million, respectively.
The Americas division reported net adverse loss development for prior years of $214.0 million, $184.8 million, and $92.9 million for calendar years 2005, 2004 and 2003, respectively. These increases were principally related to increased loss estimates for United States casualty business written in the period 1997 through 2001. Partially offsetting this increase was a decline in loss estimates for United States casualty business written in 2003 and 2004. Based on the review of cedant reported losses received during 2005, 2004 and 2003, we revised our loss development and expected loss ratio assumptions we use in performing our actuarial analysis, which generated a substantial increase in ultimate losses on United States casualty business written in the period 1997 through 2001, partially offset by a decline in U.S. casualty ultimate losses in more recent years. The specific lines of business generating most of the increase include general liability, professional liability and excess workers compensation. The difficulty in anticipating the ultimate losses attributable to business written during 1997 through 2001 for these lines of business is due to an increase in the frequency and severity of claims over
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 which elapses before an actual loss is known and determinable, particularly for professional liability lines, where claims are often litigated to achieve a settlement. 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. Additionally, in calendar year 2005, the annual review of internal and external trends in asbestos loss reporting and claim payments caused us to increase our asbestos loss development assumptions. As a result of these changes to assumptions, asbestos ultimate loss increased by $41.2 million.
The EuroAsia division reported net favorable loss development for prior years of $8.7 million in calendar year 2005, and net adverse loss development for calendar years 2004 and 2003 of $6.6 million and $11.0 million, respectively. The reduction in prior year loss estimates for calendar year 2005 is driven by favorable loss emergence trends in miscellaneous property lines including property risk (non-catastrophe), aviation and bonding. These reserve reductions more than offset prior year loss estimate increases for property catastrophe and French motor liability coverages. The increase in prior period loss estimates during calendar years 2004 and 2003 are principally related to greater than expected loss emergence on bond and facultative exposures, respectively.
The London Market division reported net favorable loss development for prior years of $23.6 million and $0.2 million for calendar years 2005 and 2004, respectively, and net adverse loss development of $22.6 million for calendar year 2003. The reduction in prior year loss estimates during calendar year 2005 results from favorable loss emergence trends for satellite, non-catastrophe property and auto liability business written during 2002 through 2004. The increase in prior year loss estimates during calendar year 2003 is due to greater than expected loss emergence on U.S. casualty business written in the late 1990s through early 2000s. The London Market division discontinued the underwriting units that concentrated on writing U.S. casualty business by 2002.
The U.S. Insurance division reported net favorable loss development for prior years of $9.0 million and $1.2 million for calendar years 2005 and 2004, respectively, and net adverse development for the 2003 calendar year of $1.4 million. The reduction in prior year loss estimates during calendar year 2005 results from favorable loss emergence trends for medical malpractice.
The following table provides detail on loss and LAE development, by division, for the calendar years 2005 through 2003 (in millions):
The following table sets forth our liabilities for unpaid losses and LAE for the years ended December 31, 2005, 2004 and 2003 (in millions):
Estimates of reserves for unpaid losses and LAE are contingent upon legislative, regulatory, social, economic and legal events and trends that may or may not occur or develop in the future, thereby affecting assumptions of claims frequency and severity. Examples of emerging claim and coverage issues and trends in recent years that could affect reserve estimates include: (i) developments in tort liability law; (ii) legislative attempts at asbestos liability reform; (iii) uncertainties regarding the future scope of the Terrorism Risk Insurance Act of 2002; (iv) an increase in shareholder derivative suits against corporations and their officers and directors; and (v) increasing governmental focus on, and involvement in, the insurance and reinsurance industry generally. The eventual outcome of these events and trends may be different from the assumptions underlying our loss reserve estimates. In the event that loss trends diverge from expected trends during the period, we adjust our reserves to reflect the change in losses indicated by revised expected loss trends. On a quarterly basis, we compare actual emergence of the total value of newly reported losses to the total value of losses expected to be reported during the period and the cumulative value since the date of our last reserve review. Variation in actual loss emergence from expectations may result in a change in our estimate of losses and LAE reserves. Any adjustments will be reflected in the periods in which they become known, potentially resulting in adverse effects to our financial results. Changes in expected claim payment rates, which represent one component of losses and LAE emergence, may impact our liquidity and capital resources, as discussed in Liquidity and Capital Resources.
The following table summarizes, by type of reserve, the unpaid losses and LAE reserve as of December 31, 2005 and 2004. Case reserves represent unpaid claim reports provided by cedants to us plus additional reserves determined by us. IBNR is the estimate of unreported loss liabilities established by us.