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Transatlantic Holdings 10-K 2007 UNITED STATES FORM 10-K (Mark One)
TRANSATLANTIC HOLDINGS, INC.
(212) 770-2000 Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes R No £ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes £ No R 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 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. Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s 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. £ 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 Exchange Act). Yes £ No R The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant computed by reference to the price at which the common equity was last sold, as of June 30, 2006 (the last business day of the registrant’s most recently completed second fiscal quarter) was approximately $1,493,774,222. As of January 31, 2007, there were outstanding 66,045,926 shares of Common Stock, $1.00 par value, of the registrant. Documents Incorporated by Reference Portions of the registrant’s 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 stockholders of the registrant scheduled to be held on May 24, 2007 are incorporated by reference in Part III of this Form 10-K.
TRANSATLANTIC HOLDINGS, INC. AND SUBSIDIARIES Business Risk Factors Unresolved Staff Comments Properties Legal Proceedings Submission of Matters to a Vote of Security Holders Market for the Registrant’s Common Equity, Related Stockholder Matters and
Issuer Purchases of Equity Securities Selected Financial Data Management’s Discussion and Analysis of Financial Condition and Results of
Operations Quantitative and Qualitative Disclosures About Market Risk Financial Statements and Supplementary Data Changes in and Disagreements With Accountants on Accounting and Financial
Disclosure Controls and Procedures Other Information Directors, Executive Officers and Corporate Governance Executive Compensation Security Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters Certain Relationships and Related Transactions, and Director Independence Principal Accounting Fees and Services Exhibits and Financial Statement Schedules
Introduction Transatlantic Holdings, Inc. (the “Company”, and collectively with its subsidiaries, “TRH”) is a holding company incorporated in the state of Delaware. Originally formed in 1986 under the name
PREINCO Holdings, Inc. as a holding company for Putnam Reinsurance Company (“Putnam”), the Company’s name was changed to Transatlantic Holdings, Inc. on April 18, 1990 following the acquisition
on April 17, 1990 of all of the common stock of Transatlantic Reinsurance Company (“TRC”) in exchange for shares of Common Stock of the Company (the “Share Exchange”). Prior to the Share Exchange,
American International Group, Inc. (“AIG”, and collectively, with its subsidiaries, the “AIG Group”) held a direct and indirect interest of approximately 25% in the Company and an indirect interest of
49.99% in TRC. As a result of the Share Exchange, AIG became the beneficial owner of approximately 41% of the Company’s outstanding Common Stock and TRC became a wholly-owned subsidiary of the
Company. In June 1990, certain stockholders of the Company (other than AIG) sold shares of the Company’s Common Stock (“TRH shares”) in a public offering. As of December 31, 2006, 2005 and 2004,
AIG beneficially owned approximately 59% of the Company’s outstanding shares. The Company, through its wholly-owned subsidiaries, TRC, Trans Re Zurich (“TRZ”), acquired by TRC in 1996, and Putnam (contributed by the Company to TRC in 1995), offers reinsurance capacity
for a full range of property and casualty products on both a treaty and facultative basis. These products are offered directly and through brokers, to insurance and reinsurance companies, in both the domestic
and international markets. One or both of TRC and Putnam is licensed, accredited, authorized or can serve as a reinsurer in 50 states and the District of Columbia in the United States and in Puerto Rico and
Guam. TRC is licensed in Canada, Japan, the United Kingdom, the Dominican Republic, the Hong Kong Special Administrative Region, People’s Republic of China and Australia. In addition, TRC is
registered or authorized as a foreign reinsurer in Argentina (where it maintains a representative office in Buenos Aires, Transatlantic Re (Argentina) S.A.), Brazil (where it maintains a representative office in
Rio de Janeiro, Transatlantic Re (Brasil) Ltda.), the Republic of Panama (where it maintains a representative office, TRC (PANAMÁ) S.A.), Bolivia, Chile, Colombia, Ecuador, El Salvador, France,
Guatemala, Honduras, Mexico, Nicaragua, Paraguay, Peru, Uruguay, Venezuela and is authorized to maintain a representative office in Shanghai, People’s Republic of China. TRZ is licensed as a reinsurer in
Switzerland. Transatlantic Polska Sp. z o.o., a subsidiary of TRC, maintains a registered representative office in Warsaw, Poland. TRH’s principal lines of reinsurance include other liability (including directors’ and officers’ liability (“D&O”) and errors and omissions coverages (“E&O”)), ocean marine and aviation, medical malpractice,
auto liability (including non-standard risks), accident and health (“A&H”) and surety and credit in the casualty lines, and fire, allied lines, auto physical damage and homeowners multiple peril lines in the
property lines. Reinsurance is provided for most major lines of insurance on both excess-of-loss and pro rata bases. TRH’s website, which can be found on the Internet at http://www.transre.com, contains frequently updated information about the Company and its operations. Copies of TRH’s recent Forms 10-K, Forms
10-Q and Forms 8-K, and all amendments to those reports, can be accessed free of charge as soon as reasonably practicable after the reports and amendments are electronically filed with or furnished to the
Securities and Exchange Commission by clicking on “Transatlantic Holdings, Inc. Investor Information” on TRH’s website and then clicking on “SEC Filings (including Section 16 Filings—Forms 3, 4 and 5).”
TRH also makes available on its corporate website copies of its charters for its Audit, Nominating and Corporate Governance and Compensation Committees, as well as its Corporate Governance Guidelines,
Director Independence Standards, Director, Executive Officer and Senior Financial Officer Code of Business Conduct and Ethics and Employee Code of Conduct. 1
In addition, copies of any of TRH’s reports on Form 10-K, Form 10-Q and Form 8-K, and all amendments to those reports, as well as any Quarterly Earnings Press Release may be obtained by contacting
TRH’s Investor Relations Department at: Throughout this Annual Report on Form 10-K, TRH presents its operations in the way it believes will be most meaningful. TRH’s unpaid losses and loss adjustment expenses, net of related reinsurance
recoverable, and TRH’s combined ratio and its components are presented in accordance with principles prescribed or permitted by insurance regulatory authorities as these are standard measures in the
insurance and reinsurance industries. The Reinsurance Business Reinsurance is an arrangement whereby one or more companies, the reinsurer(s), agrees to indemnify another (re)insurance company, the ceding company, for all or part of the insurance risks
underwritten by the ceding company. Reinsurance can provide certain basic benefits to the ceding company. It reduces net liability on individual risks, thereby enabling the ceding company to underwrite
more business than its own resources can support and it provides catastrophe protection to lessen the impact of large or multiple losses. There are two major classes of reinsurance: treaty reinsurance and facultative reinsurance. Treaty reinsurance is a contractual arrangement that provides for the automatic reinsuring of a type or
category of risk underwritten by the ceding company. Facultative reinsurance is the reinsurance of individual risks. Rather than agreeing to reinsure all or a portion of a class of risk, the reinsurer separately
rates and underwrites each risk. Facultative reinsurance is normally purchased for risks not covered by treaty reinsurance or for individual risks covered by reinsurance treaties that are in need of capacity
beyond that provided by such treaties. A ceding company’s reinsurance program may involve pro rata and excess-of-loss reinsurance on both a treaty and facultative basis. Under pro rata reinsurance (also referred to as proportional), 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 agrees to reimburse the ceding company for
all losses in excess of a predetermined amount up to a predetermined limit. Premiums paid by the ceding company to the reinsurer for excess-of-loss coverage are generally not proportional to the premiums
that the ceding company receives because the reinsurer does not assume a proportionate risk. In pro rata reinsurance, the reinsurer generally pays the ceding company a ceding commission. Generally, the ceding commission is based on the ceding company’s cost of obtaining the business being
reinsured (i.e., brokers’ and agents’ commissions, local taxes and administrative expenses). Often there is no ceding commission on excess-of-loss reinsurance and therefore the pricing mechanism used by
reinsurers in those instances is a rate applicable to premiums of the individual policy or policies subject to the reinsurance agreement. In general, casualty insurance protects the insured against financial loss arising out of its obligation to others for loss or damage to their person or property. Property insurance protects the insured
against financial loss arising out of the loss of property or its use caused by an insured peril. Property and casualty reinsurance protects the ceding company against loss to the extent of the reinsurance
coverage provided. Casualty insurance can be written on a claims-made or an occurrence basis. Claims-made policies generally provide coverage for claims made during the policy period regardless of when the act causing
the claim occurred. Occurrence policies generally provide coverage in perpetuity for acts committed during the policy period regardless of when the claim is made. Depending on the nature of the business
and statute of limitations, the final claims costs for occurrence business can take many years to be 2
definitively known given that new claims can come in at any time and existing claims may continue to develop. Claims-made business, while also taking a significant time to finalize claims costs, due to the
development of open claims, generally has a shorter period for completion as the number of claims is known shortly after the policy expires. Casualty business as a whole is volatile in that the ultimate claims costs for a policy or portfolio are not known for a significant amount of time. Reasons for this are the complexity of liability theory,
the occurrence nature of some coverages, the potential for litigation, adverse court rulings, unpredictable claims and social inflation trends and reporting lag time between cedents and reinsurers. Property reinsurance is written on an occurrence basis, but, because the loss is generally immediate and manifest, claims are adjusted and closed in a much shorter period. However, due to the
unpredictable nature of fires, hurricanes, earthquakes and other natural or man-made catastrophic events as well as the imperfect models that exist in measuring the probability and potential magnitude of
costs from these events, there is a great deal of volatility in property reinsurance as well. General TRH’s activities in the United States are conducted through its worldwide headquarters in New York, N.Y., its office in Miami, FL and its regional offices in Chicago, IL, Overland Park, KS, San
Francisco, CA and Columbus, OH. The Overland Park, San Francisco and Columbus offices primarily underwrite domestic treaty business directly with insurers. All domestic treaty business is underwritten
by, or under the supervision of, senior officers of TRH located in New York. TRH’s headquarters in New York and offices in Miami, Toronto, London, Paris, Zurich, Hong Kong, Tokyo and Sydney offer
treaty as well as facultative reinsurance. In addition, TRH operates representative offices in Buenos Aires, Rio de Janeiro, Panama, Warsaw and Shanghai, maintains exclusive representative arrangements
with MS Upson Associates c.c. in Johannesburg, South Africa and with NOBARE in Stockholm, Sweden and maintains an arrangement with Momentum Underwriting Management, Ltd. (“Momentum
Underwriting”) in London, England. Momentum Underwriting has the underwriting authority to bind TRH, pursuant to strict underwriting guidelines. TRH reinsures risks from a broad spectrum of industries throughout the United States and foreign countries. Business underwritten by all offices located outside the United States and by the Miami
office (which underwrites business in Latin America and the Caribbean) accounted for approximately 52%, 55% and 51% of worldwide net premiums written in 2006, 2005 and 2004, respectively. The
London branch had net premiums written totaling $744.5 million, $759.3 million and $841.8 million in 2006, 2005 and 2004, respectively, representing 20%, 22% and 22%, respectively, of worldwide net
premiums written in each of those years. TRZ had net premiums written totaling $342.6 million, $369.2 million and $388.7 million in 2006, 2005 and 2004, respectively, representing 9%, 11% and 10%,
respectively, of worldwide net premiums written in each of those years. (See Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) for a discussion of premium
fluctuations between years, Regulation for a discussion of certain conditions associated with international business and Note 16 of Notes to Consolidated Financial Statements for financial data by business
segment.) A portion of the reinsurance written by TRH is assumed from other subsidiaries of AIG and therefore generally reflects their underwriting philosophy and diversified insurance products, except for
insurance business written by other subsidiaries of AIG that is almost entirely reinsured by TRH by prearrangement. Approximately $593 million (15%), $575 million (15%) and $639 million (15%) of gross
premiums written by TRH in the years 2006, 2005 and 2004, respectively, were attributable to reinsurance purchased by other subsidiaries of AIG. (See Relationship with the AIG Group.) In addition, TRH holds a 40% interest in Kuwait Reinsurance Company (K.S.C.), acquired in 2000 in exchange for a $30 million contribution to the capital of that company. Kuwait Reinsurance
Company provides property, casualty and life reinsurance products to clients in Middle Eastern and North African markets. TRH also has an 11% interest in RAM Holdings Ltd., the publicly traded parent
company of RAM Reinsurance Company Ltd., a financial guaranty reinsurer domiciled in Bermuda. 3
Effective January 1, 1995, TRC and Putnam entered into a quota share reinsurance agreement whereby TRC ceded 5% of its total reinsurance liabilities, net of retrocessions, to Putnam. Thereafter,
TRC cedes 5% of its assumed reinsurance, net of other retrocessions, to Putnam pursuant to this quota share reinsurance agreement. Presently all of Putnam’s business is assumed from TRC pursuant to
this quota share reinsurance agreement. This agreement was entered into for operational reasons and had no impact on TRH’s financial position or results of operations. In general, the overall operating results (including investment performance) and other changes to stockholders’ equity of property and casualty insurance and reinsurance companies, and TRH, in
particular, are subject to significant fluctuations due to competition, natural and man-made catastrophic events, economic and social conditions, foreign currency exchange rate fluctuations, interest rates,
operating performance and prospects of investee companies and other factors, such as changes in tax laws, tort laws and the regulatory environment. There were no significant net catastrophe costs for events occurring in 2006. Operating results in 2005 included net pre-tax catastrophe costs of $544 million. Operating results in 2004 included net pre-
tax catastrophe costs of $215 million. (See MD&A.) TRH seeks to focus on more complex risks within the casualty and property lines, and to adjust its mix of business to take advantage of market opportunities. Casualty reinsurance constitutes the larger
portion of TRH’s business, accounting for 73% of net premiums written in 2006, 70% in 2005 and 72% in 2004. The following table presents certain underwriting information concerning TRH’s casualty and
property business for the periods indicated (See MD&A.): Casualty: Other liability(1)(2)(3)(4) Ocean marine and aviation(3)(4) Medical malpractice(2)(3)(4) Auto liability Accident and health Surety and credit(2) Other(4) Total casualty Property: Fire(2)(3)(4) Allied lines(3)(4) Auto physical damage Homeowners multiple peril(2)(3)(4) Other(2)(3)(4) Total property Total (2) In 2006, development on reserves held at December 31, 2005 related to losses that occurred in 2005 and prior years significantly increased net losses and loss adjustment expenses incurred in the other liability, medical malpractice, surety and credit and
other property lines and significantly decreased net losses and loss adjustment expenses incurred in the homeowners multiple peril and fire lines. 2006 catastrophe costs did not have a significant impact on that year’s results. (3) In 2005, development on reserves held at December 31, 2004 related to losses that occurred in 2004 and prior years significantly increased net losses and loss adjustment expenses incurred in the other liability and medical malpractice lines and
significantly decreased net losses and loss adjustment expenses incurred in the fire, homeowners multiple peril, ocean marine and aviation and other property lines. In addition, net pre-tax catastrophe losses of $483 million significantly increased net
losses and loss adjustment expenses incurred in the allied lines, fire, ocean marine and aviation and homeowners multiple peril lines. Also, net ceded reinstatement premiums of $61 million reduced net premiums written and earned primarily in the allied
lines and fire lines. (footnotes continued on next page) 4
(footnotes continued from previous page) Treaty reinsurance constitutes the great majority of TRH’s business, accounting for 95%, 96% and 96% of net premiums written in 2006, 2005 and 2004, respectively. Facultative reinsurance comprises
the balance of net premiums written. The following table presents certain information concerning TRH’s treaty and facultative business for the periods indicated: Gross premiums written Net premiums written Net premiums earned Gross premiums written Net premiums written Net premiums earned (2) In 2005 compared to 2004, domestic treaty net premiums written decreased significantly in the auto liability, medical malpractice and A&H lines. International treaty net premiums written decreased significantly in the auto liability line, offset by significant
increases in the other liability, A&H, boiler and machinery and ocean marine lines. Facultative gross premiums written decreased in 2005 compared to 2004 due principally to a decrease in premiums that, by prearrangement with TRH, were assumed from
an affiliate and then ceded in an equal amount to other affiliates in the property line. Facultative net premiums written, in 2005 compared to 2004, increased principally in the A&H, medical malpractice and boiler and machinery lines. Treaty Reinsurance Treaty reinsurance accounted for approximately $3,655.2 million of gross premiums written and $3,461.6 million of net premiums written in 2006. Approximately 74% of treaty net premiums written
resulted from casualty lines treaties, with the remainder from property lines treaties. In total, approximately 71% of treaty gross premiums written in 2006 represented treaty reinsurance written on a pro
rata basis and the balance represented treaty reinsurance written on an excess-of-loss basis. Approximately 11% of treaty gross premiums written in 2006 were attributable to other subsidiaries of AIG and
were primarily written on a pro rata basis. (See Relationship with the AIG Group.) The majority of TRH’s non-AIG Group treaty premiums were also written on a pro rata basis. As pro rata business is a
proportional sharing of premiums and losses between ceding company and reinsurer, generally, the underwriting results of such business more closely reflect the underwriting results of the business ceded
than do the results of excess-of-loss business. Non-U.S. treaty business accounted for approximately 49% of TRH’s total net premiums written for the year ended December 31, 2006. TRH’s treaty business consists primarily of business within the other liability (including D&O and E&O), ocean marine and aviation, medical malpractice, auto liability (including non-standard risks), A&H,
surety and credit, fire, allied lines, auto physical damage and homeowners multiple peril lines. A significant portion of TRH’s business within these lines (primarily other liability, medical malpractice and
A&H) is derived from complex risks. 5
TRH’s treaty business accepts a portfolio of risks on either a risk attaching basis or loss occurring during (“LOD”) basis. For the risk attaching treaties, if an individual risk covered by the treaty incepts
during the treaty period, TRH’s liability for that policy goes to that treaty year regardless of when the loss occurs. For LOD treaties, TRH covers losses occurring during the treaty coverage period on all in-
force policies, regardless of the date the policies were issued by the ceding company. TRH’s treaty underwriting process emphasizes a team approach among TRH’s underwriters, actuaries and claims staff, as appropriate. Treaties are reviewed for compliance with TRH’s underwriting
guidelines and objectives and most treaties are evaluated in part based upon actuarial analyses conducted by TRH. TRH’s actuarial models used in such analyses are tailored in each case to the exposures
and experience underlying the specific treaty and the loss experience for the risks covered thereunder. Property catastrophe exposed treaties are generally evaluated using industry standard models. These
models are used as a guide for risk assessment and are continually being updated. TRH also frequently conducts underwriting and claims audits at the offices of a prospective ceding company both before
and after entering into major treaties, because reinsurers, including TRH, do not separately evaluate each of the individual risks assumed under their treaties and, consequently, are largely dependent on the
original underwriting decisions made by the ceding company. Such dependence subjects TRH, and reinsurers in general, to the possibility that the ceding companies have not adequately evaluated the risks
to be reinsured and, therefore, that the premiums ceded in connection therewith may not adequately compensate the reinsurer for the risk assumed. TRH offers brokers full service with large capacity for both casualty and property risks. For non-AIG Group business, TRH generally seeks to lead treaty arrangements. The lead reinsurer on a treaty
generally accepts one of the largest percentage shares of the treaty and takes the initiative in negotiating price, terms and conditions. TRH believes that this strategy has enabled it to influence more
effectively the terms and conditions of the treaties in which it has participated. Except where insurance business written by AIG subsidiaries is almost entirely reinsured by TRH by prearrangement, TRH
has generally not set terms and conditions as lead underwriter with respect to treaty reinsurance purchased by other subsidiaries of AIG, although it may do so in the future. When TRH does not lead the
treaty, it may still suggest changes to any aspect of the treaty. In either case, TRH may reject any treaty business offered to it by AIG subsidiaries or others based upon its assessment of all relevant factors.
Such factors include type and level of risk assumed, actuarial and underwriting judgment with respect to rate adequacy, various treaty terms, prior and anticipated loss experience (including exposure to
natural and man-made catastrophes) on the treaty, prior business experience with the ceding company, overall financial position, operating results, the A.M. Best Company (“Best”), Standard & Poor’s
(“S&P”) and Moody’s Investors Service (“Moody’s”) ratings of the ceding company and social, legal, regulatory, environmental and general economic conditions affecting the risks assumed or the ceding
company. TRH currently has approximately 4,200 treaties in effect for the current underwriting year. In 2006, no single treaty exceeded 3% of treaty gross premiums written. No ceding company accounted for
more than 3% of total treaty gross premiums written in 2006 except for other subsidiaries of AIG (see Relationship with the AIG Group). Members of Lloyd’s of London (“Lloyd’s”) in the aggregate
accounted for 5% of treaty gross premiums written. Facultative Reinsurance During 2006, TRH wrote approximately $328.2 million of gross premiums written and $171.8 million of net premiums written of facultative reinsurance. Approximately 63% of facultative net premiums
written represented casualty risks with the balance comprising property risks. TRH provides facultative reinsurance on predominantly an excess-of-loss basis, although some business is written on a pro rata
basis. Non-U.S. facultative business accounted for approximately 3% of TRH’s total net premiums written for the year ended December 31, 2006. TRH’s facultative contracts (also called certificates) provide prospective coverage on virtually the same basis as the original policy issued by the ceding insurer. In 2006, TRH’s facultative book of
business focused on the property, other liability, medical malpractice and A&H lines, although coverage is generally offered for most lines of business, and is written principally on a risk attaching basis for
each risk (i.e., TRH’s liability starts with the underlying policy inception and ends when the underlying 6
policy expires). With respect to facultative contracts, TRH’s clients come to TRH on a risk by risk basis when they wish to obtain a larger policy limit than provided by their existing outward treaty
reinsurance or when their existing treaty reinsurance excludes a class of business or type of coverage they provide to policyholders. Other underwriting expenses associated with facultative business are generally higher in proportion to related premiums than those associated with treaty business, reflecting, among other things, the
more labor-intensive nature of underwriting and servicing facultative business. Approximately 52% of facultative gross premiums written in 2006 were attributable to other subsidiaries of AIG. The large
majority of such facultative gross premiums written in 2006, as well as in 2005 and 2004, were, by prearrangement with TRH, assumed from one AIG subsidiary and ceded in an equal amount to other AIG
subsidiaries. Except for AIG subsidiaries, no single ceding company accounted for more than 5% of total facultative gross premiums written in 2006. Retention Levels and Retrocession Arrangements TRH generally enters into retrocession arrangements for many of the same reasons primary insurers seek reinsurance, including reducing the effect of individual or aggregate losses and increasing gross
premium writings and risk capacity without requiring additional capital. Under TRH’s underwriting guidelines and retrocession arrangements in effect at the end of 2006, generally the maximum net amounts retained and the maximum gross capacities on a per program
basis for treaty business and per risk basis for facultative business are set forth in the table below. Property: Treaty Catastrophe excess-of-loss Other Facultative Casualty: Treaty Marine and aviation Other Facultative Average gross lines and net retentions on risks assumed historically have been smaller than the maximums permissible under the underwriting guidelines. Underwriting guidelines, including gross lines
and net retention levels, may be changed and limited exceptions are made by TRH from time to time. TRH
is exposed to multiple insured losses arising out of a single occurrence (e.g.,
natural or man-made catastrophe) that have the potential to accumulate to material
amounts and affect multiple risks/programs and classes of business. TRH uses
modeling techniques to manage certain such risks to acceptable limits, although
current techniques used to estimate the exposure may not accurately predict
the probability of such an event nor the extent of resulting losses. In addition,
TRH may purchase retrocession protection designed to limit the amount of losses
that it may incur. For 2007, TRH has purchased property and marine catastrophe
reinsurance protection that management deems prudent and cost effective. Based
on preliminary data, TRH estimates that its probable maximum gross loss (“gross
PML”) from any single event in any one geographic zone would approximate
$900 million (before TRH’s property and marine catastrophe reinsurance
protection). TRH defines gross PML as its anticipated maximum loss (taking into
account contract limits), before its retrocession recoveries, caused by a single
catastrophic event affecting a broad contiguous area with an expected likelihood
of occurrence of once in every 250 years. Based upon the above gross PML estimate,
TRH would record catastrophe costs net of reinsurance, including the impact
of reinstatement premiums, of approximately $675 million before tax savings,
or $439 million, net of tax, in such an event. There can be no assurance that
TRH will 7
not experience losses from one or more catastrophic events that exceed, perhaps by a material amount, such gross and net amounts. The Terrorism Risk Insurance Act of 2002 (“TRIA”) was signed into law in November 2002 and extended for two years in December 2005. TRIA provided coverage to the insurance industry for acts
of terrorism, as defined by TRIA. The Terrorism Risk Insurance Extension Act (“TRIEA”) of 2005 greatly increased the portion of the loss the insurance industry would pay in the event of a terrorist
attack and reduced the number of lines covered. This coverage does not apply to reinsurers. In general, TRH does not provide terrorism cover under international property treaties nor does it provide cover
for certified acts of terrorism, as defined by TRIEA, under domestic property treaties. TRH offers terrorism-specific treaty coverages to ceding companies on a limited basis. As respects other lines of
business, TRH assumes terrorism risk in marine, aviation and other casualty treaties after careful underwriting consideration and, in many cases, with limitations. Retrocession arrangements do not relieve TRH from its obligations to the insurers and reinsurers from whom it assumes business. The failure of retrocessionnaires to honor their obligations could result
in losses to TRH. TRH holds substantial amounts of funds and letters of credit to collateralize reinsurance recoverables. Such funds and letters of credit can be drawn on for amounts remaining unpaid
beyond contract terms. In addition, an allowance has been established for estimated unrecoverable amounts. As of December 31, 2006, TRH had in place approximately 160 active retrocessional arrangements for current and prior underwriting years with approximately 330 retrocessionnaires, and reinsurance
recoverable on paid and unpaid losses and loss adjustment expenses (“LAE”) totaled $1.40 billion, including $441.2 million recoverable from affiliates. No unsecured recoverables from a single
retrocessionnaire, other than amounts due from affiliates, are considered material to the financial position of TRH. (See Note 15 of Notes to Consolidated Financial Statements.) Marketing TRH provides property and casualty reinsurance capacity through brokers as well as directly to insurance and reinsurance companies in both the domestic and international markets. TRH believes its
worldwide network of offices and its relationship with the AIG Group help position TRH to take advantage of market opportunities. Business assumed from other subsidiaries of AIG is generally obtained directly from the ceding company. No ceding company, other than such AIG subsidiaries has accounted for 10% or more of
TRH’s consolidated revenues in any of the last five years. Non-AIG Group treaty business is produced primarily through brokers, while non-AIG Group facultative business is produced both directly and through brokers. In 2006, approximately 82% of TRH’s
non-AIG Group business was written through brokers and the balance was written directly. Also in 2006, companies controlled by Aon Corporation (“Aon”) and Marsh & McLennan Companies, Inc.
(“Marsh”), TRH’s largest brokerage sources of non-AIG Group business, accounted for 15% and 14%, respectively, of TRH’s consolidated revenues. In addition, Aon and Marsh each accounted for non-
AIG Group business representing 15% of total gross premiums written in 2006. TRH’s largest 10 brokers accounted for non-AIG Group business aggregating approximately 56% of total gross premiums
written. Brokerage fees generally are paid by reinsurers. TRH believes that its emphasis on seeking the lead position in non-AIG Group reinsurance treaties in which it participates is beneficial in obtaining
business. Brokers do not have the authority to bind TRH with respect to reinsurance agreements, nor does TRH commit in advance to accept any portion of the business that brokers submit to it. Claims Claims are managed by TRH’s 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. In addition to claims assessment, processing and payment, the claims staff conducts comprehensive claims audits of both specific claims
and overall claims procedures at the offices of selected ceding companies, which TRH believes benefit 8
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. Reserves for Unpaid Losses and Loss Adjustment Expenses (“Gross Loss Reserves”) Significant periods of time may elapse between the occurrence of an insured loss, the reporting of the loss to the ceding company and the reinsurer, and the ceding company’s payment of that loss and
subsequent payments to the ceding company by the reinsurer. Insurers and reinsurers establish gross loss reserves, which represent estimates of future amounts needed to pay claims and related expenses
with respect to insured events which have occurred on or before the balance sheet date, including events which have not been reported to the ceding company. Upon receipt of a notice of claim from the ceding company, TRH establishes its own case reserve for the estimated amount of the ultimate settlement, if any. Case reserves usually are based upon the
amount of reserves recommended by the ceding company and may be supplemented by additional amounts as deemed necessary. In certain instances, TRH establishes case reserves even when the ceding
company has not reported any liability to TRH. TRH also establishes reserves to provide for the estimated expenses of settling claims, including legal and other fees, the general expenses of administering the claims adjustment process (i.e., LAE),
and for losses and LAE incurred but not reported (“IBNR”). TRH calculates LAE and IBNR reserves by using generally accepted actuarial reserving techniques to estimate the ultimate liability for losses
and LAE. Such reserves are periodically reassessed by TRH to adjust for changes in the expected loss emergence pattern over time. TRH has an in-house actuarial staff which periodically reviews its unpaid
losses and loss adjustment expenses both gross and net of related reinsurance recoverables, and does not retain any outside actuarial firm to review its loss reserves on an ongoing basis. Gross loss reserves represent the accumulation of case reserves and IBNR. Provisions for inflation and social inflation (e.g., awards by judges and juries which progressively increase in size at a rate
exceeding that of general inflation) are implicitly considered in the overall reserve setting process as an element of the numerous judgments which are made as to expected trends in average claim severity.
Legislative changes may also affect TRH’s liabilities, and evaluation of the impact of such changes is made in the reserve setting process. The methods of determining estimates for unreported losses and establishing resulting reserves and related reinsurance recoverable are continually reviewed and updated, and any resulting adjustments
are reflected in income currently. The process relies upon the basic assumption that past experience, adjusted for the effect of current developments and likely trends, is an appropriate basis for predicting
future events. However, estimation of loss reserves is a difficult process, especially in view of changes in the legal and tort environment which impact the development of loss reserves, and therefore
quantitative techniques frequently have to be supplemented by subjective considerations and managerial judgment. In addition, trends that have affected development of liabilities in the past may not
necessarily occur or affect liability development to the same degree in the future. While the reserving process is difficult and subjective for the ceding companies, the inherent uncertainties of estimating such reserves are even greater for the reinsurer, due primarily to the longer term
nature of much 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, which are subject to change without notice. TRH writes a significant amount of non-proportional assumed
casualty reinsurance as well as proportional assumed reinsurance of excess casualty business for classes such as medical malpractice and D&O, which can exhibit greater volatility over time than most other
classes due to their low frequency, high severity nature, and loss cost trends that are more difficult to predict. Included in TRH’s unpaid losses and loss adjustment expenses net of related reinsurance recoverables (“net loss reserves”) are amounts related to environmental impairment and asbestos-related
illnesses. (See MD&A for more detail regarding the significant uncertainties related to these reserves.) 9
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. Even then, the ultimate net liability may be materially different from the revised estimates which are reflected in TRH’s consolidated
financial statements, and such differences may have, and in recent years have had, a material effect on net income. (See MD&A and Note 2(i) of Notes to Consolidated Financial Statements for further
discussion.) Net losses and LAE incurred consists of the estimated ultimate cost of settling claims incurred within the reporting period (net of related reinsurance recoverable), including IBNR claims, plus changes
in estimates of prior period losses. The “Analysis of Consolidated Net Loss Reserves Development” which follows presents the development of net loss reserves for calendar years 1996 through 2006. 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 reserve of $2,522.7 million as of December 31, 1997, by the end of 2006 (nine
years later) $2,284.9 million had actually been paid in settlement of those net loss reserves. In addition, as reflected in the lower section of the table, the original net loss reserve of $2,522.7 million was
reestimated to be $2,632.6 million at December 31, 2006. 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 redundancy (deficiency) 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 $109.8 million at December 31, 2006 related to December 31, 1997 net loss reserves of $2,522.7 million, represents the cumulative
amount by which net loss reserves as of year-end 1997 have developed adversely from 1998 through 2006. Each amount other than the original reserves in the following table includes the effects of all changes in amounts for prior periods. For example, if a loss settled in 2003 for $150,000 was first reserved in
2000 at $100,000 and remained unchanged until settlement, the $50,000 deficiency (actual loss minus original estimate) would be included in the cumulative net redundancy (deficiency) in each of the years
in the period 2000 through 2002 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. The “Analysis of Net Unpaid Losses and Loss Adjustment Expenses and Net Reestimated Liability” presents additional information regarding the development of gross loss reserves. 10
ANALYSIS OF CONSOLIDATED NET LOSS RESERVES DEVELOPMENT(1)(2) Net
loss reserves, as of December 31:(3) Cumulative
paid as of: One
year later Two
years later Three
years later Four
years later Five
years later Six
years later Seven
years later Eight
years later Nine
years later Ten
years later Net
reestimated liability as of:(3) End
of year One
year later Two
years later Three
years later Four
years later Five
years later Six
years later Seven
years later Eight
years later Nine
years later Ten
years later Net
redundancy (deficiency) as of December 31, 2006 (2) Data have been affected by transactions between TRH and the AIG Group. (See Relationship with the AIG Group and Notes 13 and 15 of Notes to Consolidated Financial Statements.) (3) Represents unpaid losses and loss adjustment expenses, net of related reinsurance recoverables. 11
ANALYSIS OF NET UNPAID LOSSES AND LOSS ADJUSTMENT EXPENSES End of year: Gross liability Related reinsurance recoverable Net liability One year later: Gross reestimated liability Reestimated related reinsurance recoverable Net reestimated liability Two years later: Gross reestimated liability Reestimated related reinsurance recoverable Net reestimated liability Three years later: Gross reestimated liability Reestimated related reinsurance recoverable Net reestimated liability Four years later: Gross reestimated liability Reestimated related reinsurance recoverable Net reestimated liability Five years later: Gross reestimated liability Reestimated related reinsurance recoverable Net reestimated liability Six years later: Gross reestimated liability Reestimated related reinsurance recoverable Net reestimated liability Seven years later: Gross reestimated liability Reestimated related reinsurance recoverable Net reestimated liability Eight years later: Gross reestimated liability Reestimated related reinsurance recoverable Net reestimated liability Nine years later: Gross reestimated liability Reestimated related reinsurance recoverable Net reestimated liability Ten years later: Gross reestimated liability Reestimated related reinsurance recoverable Net reestimated liability Gross redundancy (deficiency) as of December 31, 2006
12
The trend depicted in the latest development year in the net reestimated liability portion of the “Analysis of Consolidated Net Loss Reserves Development” table and in the “Analysis of Net Unpaid
Losses and Loss Adjustment Expenses and Net Reestimated Liability” table reflects net adverse development. Net adverse development of $181.1 million was recorded in 2006 on losses occurring in all
prior years. This net adverse development was comprised of $339.7 million related to losses occurring in 2002 and prior, partially offset by favorable development of $158.6 million related primarily to 2005
and, to a much lesser extent, 2004 and 2003. (See MD&A.) In general, the deficiencies shown in the tables for years 1998 through 2005 developed principally in 2002 through 2006 and resulted largely from losses occurring between 1998 and 2001 in certain
casualty lines. Such adverse development involved an unexpected increase in the frequency and severity of large claims reported in late 2002 through 2006, as was common in the industry, related to non-
proportional assumed casualty reinsurance as well as proportional assumed reinsurance of excess casualty business for such volatile classes as medical malpractice, D&O, E&O and other general casualty. (See
MD&A.) In addition, the redundancy shown in the table in 1996 resulted from favorable development of reserves in the other liability line for losses occurring from 1986 through 1995, partially offset by
continued adverse development of reserves in the other liability line for losses occurring prior to 1984. The length of time needed for reserves to be ultimately paid has generally been decreasing over the past ten years due, in part, to a shift in the business mix towards lines with shorter loss payment
patterns and the higher incidence (compared to earlier years) of catastrophe losses paid in more recent years. See Note 5 of Notes to Consolidated Financial Statements for a reconciliation of beginning and ending gross and net loss reserves. For TRH’s domestic subsidiaries (TRC and Putnam), there is no
difference in reserves for losses and LAE, net of related reinsurance recoverable, whether determined in accordance with accounting principles generally accepted in the United States of America or
statutory accounting principles. Investment Operations TRH’s investments must comply with the insurance laws of the state of New York, the state of domicile of TRC and Putnam, and of the other states and jurisdictions in which the Company and its
subsidiaries are regulated. These laws prescribe the kind, quality and concentration of investments which may be made by insurance companies. In general, these laws permit investments, within specified
limits and subject to certain qualifications, in federal, state and municipal obligations, corporate fixed maturities, preferred and common stocks, real estate mortgages and real estate. The Finance Committee
of the Company’s Board of Directors and senior management oversee investments, establish TRH’s investment strategy and implement investment decisions with the assistance of certain subsidiaries of
AIG, which act as financial advisors and managers of TRH’s investment portfolio and, in connection therewith, make the selection of particular investments. Other than as set forth above, there are no
guidelines or policies with respect to the specific composition of TRH’s overall investment portfolio or the composition of its fixed maturity portfolio by rating or maturity. A significant portion of TRH’s
domestic investments are in tax-exempt fixed maturities. TRH’s current investment strategy seeks to maximize after-tax income through a high quality diversified taxable fixed maturity and tax-exempt municipal fixed maturity portfolio, while maintaining an
adequate level of liquidity. TRH adjusts its mix of taxable and tax-exempt investments, as appropriate, generally as a result of strategic investment and tax planning considerations. Tax-exempt fixed
maturities carry lower pre-tax yields than taxable fixed maturities that are comparable in risk and term to maturity due to their tax-advantaged status. (See MD&A.) The majority of the equity portfolio is
structured to achieve capital appreciation primarily through investment in quality growth companies. Other invested assets represent investments in limited partnerships. TRH engages in securities lending transactions whereby certain securities (i.e., fixed maturities and common stocks available for sale) from its portfolio are loaned to third parties. In these transactions,
initial collateral, principally cash, is received by TRH in an amount exceeding the fair value of the loaned security. Such funds are held in a pooled account of the lending agent in these transactions (an 13
AIG subsidiary) and are carried as an investment on the balance sheet (at cost, which approximates fair value). A liability is recorded in an amount equal to the collateral received to recognize TRH’s
obligation to return such funds when the related loaned securities are returned. The fair value of the loaned securities is monitored on a daily basis with additional collateral obtained or refunded as such
value fluctuates. Fees received net of fees paid related to these transactions are recorded in net investment income. The following table reflects investment results for TRH for each of the five years in the period ended December 31, 2006. INVESTMENT RESULTS 2006 2005 2004 2003 2002 (2) Pre-tax net investment income divided by average investments. The following table summarizes the investments and cash of TRH (on the basis of carrying value) as of December 31, 2006: Fixed maturities: Held to maturity (at amortized cost): States, domestic municipalities and political subdivisions Available for sale (at fair value): Corporate U.S. Government and government agencies Foreign government States, foreign and domestic municipalities and political subdivisions Total fixed maturities Equities: Available for sale: Common stocks Nonredeemable preferred stocks Trading, principally common stocks Total equities Other invested assets Short-term investment of funds received under securities loan agreements Short-term investments Cash and cash equivalents Total investments and cash The carrying values of available for sale and trading securities are subject to significant volatility from changes in their fair values. (See MD&A.) As of December 31, 2006, the fair value of the total investment portfolio was $11,373.7 million. 14
The following table indicates the composition of the fixed maturity portfolio of TRH by rating as of December 31, 2006: Breakdown of Fixed Maturity Portfolio by Rating Aaa Aa A Baa Not rated Total At December 31, 2006, TRH had no real estate or derivative instruments. In addition, TRH’s operations are exposed to market risk which could result in the loss of fair value resulting from adverse fluctuations in interest rates, equity prices and foreign currency exchange
rates. TRH has performed Value at Risk (“VaR”) analyses to estimate the maximum potential loss of fair value that could occur over a period of one month at a confidence level of 95%. (See MD&A.) Competition The reinsurance business is a mature, highly competitive industry in virtually all lines of business. See MD&A for a discussion of market conditions and trends in competition intensity in recent years. Competition in the types of reinsurance in which TRH engages is based on many factors, including the perceived overall financial strength of the reinsurer, Best, S&P and Moody’s ratings, the states or
other jurisdictions where the reinsurer is licensed, accredited, authorized or can serve as a reinsurer, capacity and coverages offered, premiums charged, specific terms and conditions of the reinsurance
offered, value-added services offered, speed of claims payment and reputation and experience in the lines of business underwritten. These factors also operate in the aggregate across the reinsurance
industry, generally in combination with prevailing economic conditions. Reinsurance purchases are also sensitive to cyclical movements in reinsurance rates, terms and conditions and ultimately the
reinsurance industry’s overall financial results. TRH competes in the United States and international reinsurance markets with numerous major international reinsurance companies and numerous domestic reinsurance companies, some of which
have greater financial and other resources than TRH. TRH’s competitors include independent reinsurance companies, subsidiaries or affiliates of established worldwide insurance companies, reinsurance
departments of certain primary insurance companies, domestic and European underwriting syndicates and in some instances with government owned or subsidized facilities. Although most reinsurance
companies operate in the broker market, TRH’s largest competitors also work directly with ceding companies, competing with brokers. Traditional reinsurers as well as capital market participants from time to time produce alternative products (such as reinsurance securitizations, catastrophe bonds and various derivatives such as swaps)
that may compete with certain types of reinsurance, such as property catastrophe. Over time, these numerous initiatives could significantly affect supply, pricing and competition in the reinsurance industry. Employees At December 31, 2006, TRH had approximately 515 employees. Approximately 235 employees were located in the New York headquarters; 60 employees were located in other locations in the United
States and 220 employees were located in offices outside of the United States. Regulation The rates and contract terms of reinsurance agreements are generally not subject to regulation by any governmental authority. This contrasts with primary insurance agreements, the rates and policy
terms of which are generally closely regulated by governmental authorities. As a practical matter, 15
however, the rates charged by primary insurers and the policy terms of primary insurance agreements may affect the rates charged and the policy terms associated with reinsurance agreements. The Company, TRC, TRZ and Putnam are subject to the insurance statutes, including insurance holding company statutes, of various states and jurisdictions. The insurance holding company laws and
regulations vary from jurisdiction to jurisdiction, but generally require domestic insurance holding companies and insurers and reinsurers that are subsidiaries of insurance holding companies to register with
the applicable state regulatory authority and to file with that authority certain reports which provide information concerning their capital structure, ownership, financial condition, affiliated company
transactions and general business operations. Such holding company laws generally also require prior regulatory agency approval of changes in direct or indirect control of an insurer or reinsurer and of certain material intercorporate transfers of
assets within the holding company structure. The New York Insurance Law provides that no corporation or other person, except an authorized insurer, may acquire direct control of TRC or Putnam, or
acquire control of the Company and thus indirect control of TRC and Putnam, unless such corporation or person has obtained the prior approval of the New York State Insurance Department (the “NYS
ID”) for such acquisition. For the purposes of the New York Insurance Law, any investor acquiring ten percent or more of TRH shares would be presumed to be acquiring “control” of the Company and its
subsidiaries, unless the NYS ID determines upon application that such investor would not control the Company. An investor who would be deemed to be acquiring control of the Company would be
required to obtain the approval of the NYS ID prior to such acquisition. In addition, such investor would become subject to various ongoing reporting requirements in New York and in certain other states.
(See Control of the Company for additional discussion.) TRC, TRZ and Putnam, in common with other reinsurers, are subject to regulation and supervision by the states and by other jurisdictions in which they do business. Within the United States, the
method of such regulation varies but generally has its source in statutes that delegate regulatory and supervisory powers to a state insurance official. The regulation and supervision relate primarily to the
standards of solvency that must be met and maintained, including risk-based capital measurements, the licensing of reinsurance, the nature of and limitations on investments, restrictions on the size of risks
which may be insured under a single contract, deposits of securities for the benefit of ceding companies, methods of accounting, periodic audits of the affairs and financial reports of insurance companies, the
form and content of reports of financial condition required to be filed, and reserves for unearned premiums, losses and other purposes. As required by the state of New York, TRC and Putnam use the
Codification of Statutory Accounting Principles as primary guidance on statutory accounting. In general, such regulation is for the protection of the ceding companies and, ultimately, their policyholders
rather than security holders. Risk Based Capital (“RBC”) is designed to measure the adequacy of an insurer’s statutory surplus in relation to the risks inherent in its business. Thus, inadequately capitalized insurance companies
may be identified. The RBC formula develops a risk adjusted target level of statutory surplus by applying certain factors to various asset, premium and reserve items. Higher factors are applied to items
deemed to have more risk by the National Association of Insurance Commissioners (“NAIC”) and lower factors are applied to items that are deemed to have less risk. Thus, the target level of statutory
surplus varies not only as a result of the insurer’s size, but also on the risk profile of the insurer’s operations. The RBC Model Law provides for four incremental levels of regulatory attention for insurers
whose surplus is below the calculated RBC target. These levels of attention range in severity from requiring the insurer to submit a plan for corrective action to placing the insurer under regulatory control.
At December 31, 2006, the statutory surpluses of TRC and Putnam each significantly exceeded the level of surplus required under RBC requirements for regulatory attention. Through the “credit for reinsurance” mechanism, TRC and Putnam are indirectly subject to the effects of regulatory requirements imposed by the states in which TRC’s and Putnam’s ceding companies
are licensed. In general, an insurer which obtains reinsurance from a reinsurer that is licensed, accredited or authorized by the state in which the insurer files statutory financial statements is permitted to
take a credit on its statutory financial statements in an aggregate amount equal to the reinsurance recoverable on paid losses and the liabilities for unearned premiums and loss and LAE reserves ceded to
the reinsurer, subject to certain limitations where amounts of reinsurance recoverable 16
on paid losses are more than 90 days overdue. Certain states impose additional requirements that make it difficult to become so authorized, and certain states do not allow credit for reinsurance ceded to
reinsurers that are not licensed or accredited in that state without additional provision for security. In addition to licensing requirements, TRH’s international operations are also regulated in various jurisdictions with respect to currency, amount and type of security deposits, amount and type of
reserves and amount and type of local investment. International operations and assets held abroad may be adversely affected by political and other developments in foreign countries, including possible tax
changes, nationalization and changes in regulatory policy, as well as by consequences of hostilities and unrest. The risks of such occurrences and their overall effect upon TRH vary from country to country
and cannot easily be predicted. Regulations governing constitution of technical reserves and remittance balances in some countries may hinder remittance of profits and repatriation of assets. In December 2006, the NAIC adopted a proposal from its Reinsurance Task Force that dramatically modifies the collateral requirements under current credit for reinsurance guidelines. This proposal,
if adopted by the states, will implicitly recognize that reinsurers domiciled in certain countries outside of the U.S. are subject to financial scrutiny similar to their U.S. domiciled counterparts. Consequently,
collateral requirements under credit for reinsurance rules will be based, in part, on domicile and, in part, on the reinsurer’s financial strength rating as assigned by the Reinsurer Evaluation Office of the
NAIC. TRH does not presently expect this proposal to have a material effect on its operations. However, such proposal is expected to reduce the amount of collateral that many non-U.S. domiciled
companies will need to post to secure their obligations to U.S. domiciled insurers and reinsurers. Within the European Union (the “EU”), the EU Reinsurance Directive of November 2005 (the “Directive”) will be phased in commencing October 2007 and fully implemented no later than October
2008. This directive will lift barriers to trade within the EU for companies that are domiciled in an EU country. TRH operates branches within the EU and is evaluating the potential impact of the
implementation of the Directive which could vary from country to country. Relationship with the AIG Group AIG AIG is a holding company which, through its subsidiaries, is engaged in a broad range of insurance and insurance-related activities in the United States and abroad. AIG’s primary activities include
both general and life insurance operations. Other significant activities include financial services, retirement services and asset management. AIG subsidiaries other than TRH, collectively, are among the
largest purchasers of reinsurance in the insurance industry based on premiums ceded. Control of the Company As of December 31, 2006, 2005 and 2004, AIG beneficially owned approximately 59% of the Company’s outstanding shares. As of February 26, 2007, three of the Company’s nine current directors were
active executive officers of AIG, or in the case of Thomas R. Tizzio retired, and held a number of executive positions with AIG, including the following: Steven J. Bensinger is an Executive Vice President
and Chief Financial Officer; Martin J. Sullivan is a Director, President and Chief Executive Officer; and Thomas R. Tizzio is a Retired Senior Vice Chairman and Honorary Director. As of December 31, 2005, three of the Company’s eight directors were active executive officers of AIG and held a number of executive positions with AIG, including the following: Mr. Bensinger was
an Executive Vice President and Chief Financial Officer; Mr. Sullivan was a Director, President and Chief Executive Officer; and Mr. Tizzio was an Honorary Director and Senior Vice Chairman—General
Insurance. Messrs. Bensinger and Sullivan were elected to TRH’s Board on May 19, 2005. Between April 4, 2005 and May 19, 2005, only one, Mr. Tizzio, of the Company’s six directors was an active executive officer of AIG. For 2004 and through April 3, 2005, four of the Company’s nine directors were active executive officers of AIG, or in the case of Edward E. Matthews retired, and held a number of executive positions
with AIG, including the following: Maurice R. Greenberg was a Director, Chairman and Chief 17
Executive Officer; Mr. Mathews was an Honorary Director and Senior Advisor; Howard I. Smith was a Director, Vice Chairman and Chief Financial Officer; and Mr. Tizzio served as an Honorary Director
and Senior Vice Chairman—General Insurance. On April 4, 2005, Messrs. Greenberg, Matthews and Smith resigned from TRH’s Board. AIG Group Reinsurance AIG offers TRH the opportunity to participate in a significant amount of property and casualty reinsurance purchased by other subsidiaries of AIG. TRH either accepts or rejects such reinsurance
offered based upon TRH’s assessment of risk selection, pricing, terms and conditions. Except where insurance business written by AIG subsidiaries is almost entirely reinsured by TRH by prearrangement,
TRH has generally not set terms and conditions as lead underwriter with respect to the treaty reinsurance purchased by other subsidiaries of AIG; however, TRH may in the future set terms and conditions
with respect to such business as lead underwriter and intends that the terms and conditions of any such reinsurance will be negotiated on an arm’s length basis. The operating management of TRH is not
employed by the AIG Group, and the Underwriting Committee of the Board of Directors of the Company, which includes directors of the Company who are not employees of the AIG Group, monitor
TRH’s underwriting policies. Approximately $593 million (15%), $575 million (15%) and $639 million (15%) of gross premiums written by TRH in the years 2006, 2005 and 2004, respectively, were attributable to reinsurance
purchased by other subsidiaries of AIG, for the production of which TRH recorded ceding commissions totaling approximately $140 million, $122 million and $122 million, respectively, in such years. (The
amounts discussed in the preceding sentence include transactions with C.V. Starr & Co., Inc. (“Starr”) as described in Transactions with Starr.) In 2006, the great majority of such gross premiums written were
recorded in the property, other liability, medical malpractice and ocean marine and aviation lines. In 2005, the great majority of such gross premiums written were recorded in the property, other liability,
medical malpractice and ocean marine and aviation lines. In 2004, the great majority of such gross premiums written were recorded in the property, other liability, auto liability, medical malpractice and
ocean marine and aviation lines. Of the premiums assumed from other subsidiaries of AIG, $227 million, $209 million and $306 million in 2006, 2005 and 2004, respectively, represent premiums resulting
from certain insurance business written by other AIG subsidiaries that is almost entirely reinsured by TRH by prearrangement, for the production of which TRH recorded ceding commissions to such AIG
subsidiaries totaling approximately $40 million, $37 million and $40 million, respectively, in such years. TRH has no goal with respect to the proportion of AIG Group subsidiary versus non-AIG Group
subsidiary business it accepts. TRH’s objective in determining its business mix is to evaluate each underwriting opportunity individually with a view to maximizing overall underwriting results. TRH retroceded premiums written to other subsidiaries of AIG in the years 2006, 2005 and 2004 of approximately $135 million, $95 million and $153 million, respectively, and received ceding
commissions of approximately $14 million, $9 million and $16 million, respectively, for the production of such business in such years. Virtually the entire amount of such retrocessions to AIG subsidiaries in
2006 and 2005, and the great majority of such retrocessions in 2004, consist of amounts which, by prearrangement with TRH, were assumed from a subsidiary of AIG and then ceded in an equal amount to
other subsidiaries of AIG. (See Note 15 of Notes to Consolidated Financial Statements.) Senior Notes Purchased by AIG Subsidiaries In December 2005, certain subsidiaries of AIG purchased $450 million aggregate principal amount of the Company’s 5.75% senior notes due in 2015. Such amount comprised 60% of the total amount
of such notes offered. (See Note 6 of Notes to Consolidated Financial Statements.) Transactions with Starr and Compensation of Certain TRH Employees from Starr International Company (“SICO”) According to the Schedule 13D/A filed on November 20, 2006 by Starr, SICO, Edward E. Matthews, Maurice R. Greenberg, the Maurice R. and Corinne P. Greenberg Family Foundation, Inc., 18
the Maurice R. and Corinne P. Greenberg Joint Tenancy Company, LLC and the Universal Foundation, Inc., these reporting persons may be deemed to beneficially own in the aggregate approximately
365.9 million shares of AIG common stock. Based on the shares of AIG common stock outstanding as of October 31, 2006, this beneficial ownership represents approximately 14% of the voting stock of
AIG. Throughout 2005 and 2004 certain directors of TRH were also stockholders, executive officers or directors of Starr. On January 9, 2006, Starr released a press release indicating that all AIG executives
and officers had tendered their shares in Starr pursuant to Starr’s tender offer. In 2006, no TRH directors were stockholders, executive officers or directors of Starr. For
2004 and through April 3, 2005, Messrs. Greenberg, Matthews and Smith were directors
of TRH and also stockholders, executive officers or directors of Starr. On April
4, 2005, Messrs. Greenberg, Matthews and Smith resigned from the Board of Directors
of TRH. For 2004 and 2005, Messrs. Orlich and Tizzio were also stockholders,
executive officers or directors of Starr. From May 19, 2005, when Messrs. Bensinger
and Sullivan were elected to the Board of TRH, through approximately December
31, 2005, Messrs. Bensinger and Sullivan were also stockholders, executive officers
or directors of Starr. Transactions with Starr Throughout 2006, 2005 and 2004, certain of Starr’s subsidiaries operated as insurance agencies or brokers for insurance subsidiaries of AIG and, in such capacity, produced reinsurance business for
TRH. Net commissions related to Starr subsidiaries were insignificant in 2006. Net commissions related to Starr subsidiaries totaled $11 million and $13 million in 2005 and 2004, respectively, for such
reinsurance purchased by subsidiaries of AIG totaling $59 million and $77 million, respectively, in such years. Compensation of Certain TRH Employees from SICO SICO is a private holding company which has no direct ownership interest in TRH but which has a significant ownership interest in AIG. SICO has provided a series of two-year Deferred
Compensation Profit Participation Plans (the “SICO Plans”) to certain TRH employees through December 31, 2004. The SICO Plans came into being in 1975 when the voting shareholders and Board
of Directors of SICO, a private holding company whose principal asset is AIG common stock, decided that a portion of the capital value of SICO should be used to provide an incentive plan for the
current and succeeding managements of all American International companies, including TRH. None of the costs of the various benefits provided under the SICO Plans has been paid by TRH. Following AIG’s determination in 2005 to record a charge for the deferred compensation amounts
paid to TRH employees by SICO, TRH determined that, as a subsidiary of AIG, it was appropriate to record the compensation expense related to its employees’ participation in such plans, with an
offsetting amount credited to additional paid-in capital reflecting amounts deemed contributed by AIG to TRH. The SICO Plans provide that shares currently owned by SICO are set aside by SICO for the benefit of the participant and distributed upon retirement. The SICO Board of Directors currently may
permit an early payout of units under certain circumstances. Prior to payout, the participant is not entitled to vote, dispose of or receive dividends with respect to such shares, and shares are subject to
forfeiture under certain conditions, including but not limited to the participant’s voluntary termination of employment prior to normal retirement age. Under the SICO Plans, SICO’s Board of Directors
may elect to pay a participant cash in lieu of shares of AIG common stock. Following notification in December 2005 from SICO to participants in the SICO Plans that it will settle specific future awards
under the SICO Plans with shares rather than cash, the accounting for the SICO Plans changed from variable to fixed measurement accounting. The impact of such change is insignificant to the amount
of expense recorded in 2005. In 2006 and 2005, TRH recorded compensation expense (included in the Consolidated Statements of Operations in “Other, net”) related to the SICO Plans of $1.1 million and $3.3 million,
respectively, with a corresponding increase to additional paid-in capital. TRH will continue to record compensation expense and increases to additional paid-in capital related to the SICO Plans in
future periods. 19
As total SICO compensation expense for each year prior to 2005 would not have been material to any such prior year, TRH recorded in 2005 the total amount of compensation expense related to
the SICO Plans that would have been recorded in all prior periods through December 31, 2004 as a reduction to retained earnings of $8.3 million, which is net of income tax savings that TRH expects to
realize of $3.0 million. The entire amount of such prior year compensation cost, before tax effect, of $11.3 million, was considered a contribution to capital, and was recorded as an increase to additional
paid-in capital. In making this determination, TRH evaluated the impact that expense recognition would have had on all prior years to which SICO Plans compensation would have applied. In addition, these
amounts were calculated as variable stock awards, which considered the fair value of AIG common stock at each measurement date, and included any distributions made under the SICO Plans. In addition, during 2005, AIG initiated the 2005–2006 Deferred Compensation Profit Participation Plan (the “AIG DCPPP”) that has been modeled after the SICO Plans and includes certain TRH
employees as participants. TRH will bear the costs related to TRH employees’ participation in the AIG DCPPP. Compensation expense related to the AIG DCPPP was not material in 2006. The risks described below could materially affect TRH’s business, results of operations, cash flows or financial condition. The occurrence of severe catastrophic events could have a material adverse effect on TRH’s financial condition, results of operations and operating cash flows. Because TRH underwrites property and casualty reinsurance and has large aggregate exposures to natural and man-made disasters, TRH expects that its loss experience will from time to time include
infrequent events of great severity. The frequency and severity of catastrophe losses are inherently unpredictable. Consequently, the occurrence of losses from a severe catastrophe or series of catastrophes
could have a material adverse effect on TRH’s financial condition, results of operations and cash flows. Increases in the values and geographic concentrations of insured property and the effects of inflation
have historically resulted in increased severity of industry losses in recent years, and TRH expects that those factors will increase the severity of catastrophe losses in the future. If TRH is required to increase its liabilities for loss reserves, TRH’s financial condition, results of operations and cash flows may be materially adversely affected. Significant periods of time may elapse between the occurrence of an insured loss, the reporting of the loss to the ceding company and the reinsurer, and the ceding company’s payment of that loss and
subsequent payments to the ceding company by the reinsurer. TRH is required by applicable insurance laws and regulations and accounting principles generally accepted in the United States of America
(“GAAP”) to establish liabilities on its consolidated balance sheet for payment of losses and LAE that will arise in the future from its reinsurance products for losses that have occurred as of the balance
sheet date. Under GAAP, TRH is not permitted to establish liabilities until an event occurs that may give rise to a loss. Once such an event occurs, liabilities are established in TRH’s financial statements
for TRH’s losses, based upon estimates of losses incurred by the ceding companies. As a result, only liabilities applicable to losses incurred up to the reporting date may be established, with no allowance for
the provision of a contingency reserve to account for unexpected future losses. Losses arising from future events will be estimated and recognized at the time the loss occurs. At any time, these liabilities
may prove to be inadequate to cover TRH’s actual losses and LAE. To the extent these liabilities may be insufficient to cover actual losses or LAE, TRH will have to add to these liabilities and incur a
charge to its earnings, which could have a material adverse effect on TRH’s financial condition, results of operations and cash flows. (See MD&A for further discussion of the risks and uncertainties related to
loss reserves.) 20
If TRH’s risk management methods and pricing models are not effective, TRH’s financial condition, results of operations and cash flows could be materially adversely affected. TRH’s property and casualty reinsurance contracts cover unpredictable events such as hurricanes, windstorms, hailstorms, earthquakes, volcanic eruptions, fires, industrial explosions, freezes, riots,
floods and other natural or man-made disasters, including those that may result from terrorist activity. TRH is also exposed to multiple insured losses arising out of a single occurrence that have the
potential to accumulate to material amounts and affect multiple risks/programs and classes of business. TRH uses modeling techniques to manage certain of such risks to acceptable limits, although current
techniques used to estimate the exposure may not accurately predict the probability of such an event nor the extent of resulting losses. In addition, TRH may purchase retrocession protection designed to
limit the amount of losses that TRH may incur. Retrocession arrangements do not relieve TRH from its obligations to the insurers and reinsurers from whom it assumes business, and the failure of
retrocessionnaires to honor their obligations could result in losses to TRH. Moreover, from time to time, market conditions may limit and in some cases prevent reinsurers from obtaining the types and
amounts of reinsurance that they consider adequate for their risk management. It is likely that TRH will face more difficulty than in the past to obtain certain retrocession protection, and will also be
required to pay higher prices for such protections than in the recent past. If TRH is unable to obtain retrocessional coverage in the amounts it desires or on acceptable terms, TRH’s capacity and appetite
for risk could change, and TRH’s financial condition and results of operations may be materially adversely affected. Various provisions of TRH’s contracts, such as limitations to or exclusions from coverage or choice of forum, may not be enforceable in the manner TRH intends, due to, among other things, disputes
relating to coverage and choice of legal forum. Underwriting is a matter of judgment, involving important assumptions about matters that are inherently difficult to predict and beyond TRH’s control, and
for which historical experience and probability analysis may not provide sufficient guidance. One or more catastrophic or other events could result in claims that substantially exceed TRH’s expectations,
which could have a material adverse effect on TRH’s financial condition, results of operations and cash flows. Increased competition could adversely affect TRH’s profitability. The property and casualty reinsurance industry is highly competitive in virtually all lines. TRH faces competition from new market entrants and from existing market participants that devote increasing
amounts of capital to the types of business written by TRH. Over the past few years, generally increased market capacity, domestic and international merger and acquisition activity, and Lloyd’s of London,
which has strengthened its capital base, and limited catastrophe activity in 2006, have added to competitive pressures. As a result of certain 2005 catastrophe events, namely, Hurricane Katrina, the insurance
industry’s largest natural catastrophe loss ever, and two subsequent substantial hurricanes, existing insurers and reinsurers have been raising new capital and significant investments have been made in new
insurance and reinsurance companies in Bermuda. The ultimate impact on the market of these events is uncertain. Competition in the types of reinsurance in which TRH is engaged is based on many factors, including the perceived overall financial strength of the reinsurer, the ratings of Best, S&P and Moody’s, the
states or other jurisdictions where the reinsurer is licensed, accredited, authorized or can serve as a reinsurer, capacity and coverages offered, premiums charged, specific terms and conditions of the
reinsurance offered, services offered, speed of claims payment and reputation and experience in the lines of business underwritten. TRH competes in the United States and international reinsurance markets with numerous major international reinsurance companies and numerous domestic reinsurance companies, some of which
have greater financial and other resources than TRH has. TRH’s competitors include independent reinsurance companies, subsidiaries or affiliates of established worldwide insurance companies, reinsurance
departments of certain primary insurance companies, domestic and European underwriting syndicates and in some instances with government owned or subsidized facilities. Certain of these competitors
have been operating for substantially longer than TRH has and have established long-term and continuing business relationships throughout the industry, which can be a significant competitive advantage. 21
Traditional reinsurers as well as capital market participants from time to time produce alternative products or reinsurance vehicles (such as reinsurance securitizations, catastrophe bonds, various
derivatives such as swaps, and sidecars) that may compete with certain types of reinsurance, such as property catastrophe. Capital markets, including hedge funds, have become more active in assuming more
reinsurance risk other than from investing in various companies. Numerous hedge funds have provided both pro rata and excess-of-loss reinsurance and retrocessional protections through captive companies
or other alternative transactions on a fully collateralized basis for property and energy catastrophe business. Over time, these numerous initiatives could significantly affect supply, pricing and competition in
the reinsurance industry. In December 2006, the Florida legislature adopted legislation, since signed into law, which directed the Florida Hurricane Catastrophe Fund to more than double its catastrophe reinsurance fund limit.
The rate for this coverage is mandated to be significantly below the prevailing market rate. The same law froze current property insurance rates and imposed a moratorium on policy non-renewals. Several
other Southeast states have publicly indicated that they are considering similar proposals. While it is too early to make a prediction of the full impact of this law, given TRH’s historical participation in this
market, TRH does not presently expect the impact of this legislation to materially reduce its premiums assumed as a result of the loss of some catastrophe excess-of-loss premiums covering Florida risks.
However, this measure will likely reduce the demand for catastrophe reinsurance within the Florida market and may compel current market participants to seek greater participation and thus increase
competition in other regions such as Latin America, the Caribbean, and the Coastal Mid-Atlantic and New England states. The property and casualty reinsurance business is historically cyclical, and TRH expects to experience periods with excess underwriting capacity and unfavorable pricing. Historically, property and casualty reinsurers have experienced significant fluctuations in operating results. Demand for reinsurance is influenced significantly by underwriting results of primary insurers
and prevailing general economic and market conditions, all of which affect ceding companies’ decisions as to the amount or portion of risk that they retain for their own accounts and consequently
reinsurance premium rates. The supply of reinsurance is related to prevailing prices, the levels of insured losses, and levels of industry surplus, among other factors, that, in turn, may fluctuate in response to
changes in rates of return on investments being earned in the reinsurance industry. In addition, the supply of reinsurance is affected by a reinsurer’s confidence in its ability to accurately assess the
probability of expected underwriting outcomes, particularly as respects catastrophe losses. As a result, the property and casualty reinsurance business historically has been a cyclical industry, characterized
by periods of intense price competition due to excessive underwriting capacity as well as periods when shortages of capacity permitted favorable pricing. The cyclical trends in the industry and the industry’s profitability can also be affected significantly by volatile and unpredictable developments, including what TRH believes to be a trend of courts to
grant increasingly larger awards for certain damages, changes in the political, social or economic environment, natural disasters (such as catastrophic hurricanes, windstorms, tornadoes, earthquakes and
floods), man-made disasters (such as those arising from terrorist activities), fluctuations in interest rates, changes in the investment environment that affect market prices of and returns on investments and
inflationary pressures that may tend to affect the size of losses experienced by primary insurers. TRH cannot predict whether market conditions will improve, remain constant or deteriorate. A return to
unfavorable market conditions may affect TRH’s ability to write reinsurance at rates that it considers appropriate relative to the risk assumed. If TRH cannot write property and casualty reinsurance at
appropriate rates, its ability to transact reinsurance business would be significantly and adversely affected. A downgrade in the ratings assigned to TRH’s operating subsidiaries could adversely affect TRH’s ability to write new business and may adversely impact TRH’s existing agreements. Best, S&P and Moody’s are generally considered to be significant rating agencies with respect to the evaluation of insurance and reinsurance companies. Ratings are used by ceding companies and
reinsurance intermediaries as an important means of assessing the financial strength and quality of reinsurers. These ratings are subject to periodic review at the discretion of each respective rating agency 22
and may be revised downward or revoked at their sole discretion. Rating agencies also may increase their scrutiny of rated companies, revise their rating standards or take other action. In addition, a ceding
company’s own rating may be adversely affected by a downgrade in the rating of its reinsurer or an affiliated company. Therefore, a downgrade of TRH’s rating may dissuade a ceding company from
reinsuring with TRH and may influence a ceding company to reinsure with a competitor of TRH that has a higher financial strength rating. Best maintains a financial strength rating of A+ (Superior) and issuer credit ratings of aa– on the Company’s major operating subsidiaries, TRC, Putnam and TRZ. The outlook for these ratings is stable.
These financial strength ratings represent the second highest rating level and these issuer credit ratings represent the fourth highest rating level. S&P maintains counterparty credit and insurer financial strength ratings on each of TRC, Putnam and TRZ of AA– (Very Strong). This rating is the fourth highest rating level. The outlook for the AA–
rating is presently negative, due to S&P’s view that Transatlantic’s operating performance has produced lower returns in recent years than would be expected at the AA rating level. While also describing the
conditions that would contribute to a revision back to a stable outlook, S&P commented that if TRH’s operating results remain below S&P’s expectations, the group could be reviewed for possible downgrade. Moody’s maintains an insurance financial strength rating of Aa3 (Excellent) on TRC. The outlook for the rating is stable. This rating is the fourth highest rating level. The Company’s 5.75% senior notes due in 2015 are presently rated A2 by Moody’s and A- by S&P. The outlook for the Moody’s rating is stable and the outlook for the S&P rating is currently negative for
the same reason discussed earlier. If these debt ratings were lowered, future borrowing costs, if any, may increase. Approximately 35% of TRH’s in-force treaty contracts as of December 31, 2006 permit the ceding company to cancel the contract if TRH is downgraded below a certain rating level, generally A-.
Treaty business accounted for approximately 95% of TRH’s net premiums written in 2006. In addition, 11% of TRH’s in-force treaty contracts as of December 31, 2006 permit the ceding company to cancel
the contract in the event of a significant decline in the statutory surplus of TRH’s principal operating subsidiary, TRC, generally of at least 20%. Contracts may contain one or both of the aforementioned contractual provisions, certain other cancellation triggers or other stipulations, such as a requirement to post collateral for all or a portion of
TRH’s obligations under the contract. The two most significant reasons for contract cancellations are discussed in more detail above. Whether a ceding company would exercise any of these cancellation
rights would depend on, among other factors, the reason and extent of such downgrade or surplus reduction, the prevailing market conditions and the pricing and availability of replacement reinsurance
coverage, among other factors. When a contract is cancelled on a “cut-off” basis, as opposed to a “run-off” basis, the liability of the reinsurer under policies which became effective under the treaty prior to the cancellation date of
such treaty ceases with respect to losses resulting from events taking place on and after said cancellation date. Accordingly, unearned premiums on that business as of the cut-off date are returned to the
ceding company, net of a proportionate share of the original ceding commission. In the accounting period of the cancellation effective date, the amount of unearned premiums returned would be recorded as
a reduction of gross premiums written with a like reduction in gross unearned premiums with no effect on gross premiums earned. Thus, the canceling of a contract generally has future implications to
TRH’s business but rarely affects premiums already earned. TRH cannot predict in advance the extent to which these cancellation rights would be exercised, if at all, or what effect such cancellations would have on TRH’s financial condition or future operations,
but such effect potentially could be material. TRH may secure its obligations under its various reinsurance contracts using trusts and letters of credit. TRH may enter into agreements with ceding companies that require TRH to provide collateral
for its obligations under certain reinsurance contracts with these ceding companies under various circumstances, including where TRH’s obligations to these ceding companies exceed negotiated thresholds.
These thresholds may vary depending on TRH’s ratings and a downgrade of TRH’s ratings 23
or a failure to achieve a certain rating may increase the amount of collateral TRH is required to provide. TRH may provide the collateral by delivering letters of credit to the ceding company, depositing
assets into trust for the benefit of the ceding company or permitting the ceding company to withhold funds that would otherwise be delivered to TRH under the reinsurance contract. The amount of
collateral TRH is required to provide typically represents all or a portion of the obligations TRH may owe the ceding company, often including estimates made by the ceding company of IBNR claims.
Since TRH may be required to provide collateral based on the ceding company’s estimate, TRH may be obligated to provide collateral that exceeds its estimates of the ultimate liability to the ceding
company. These financial strength ratings are current opinions of the rating agencies. As such, they may be changed, suspended or withdrawn at any time by the rating agencies as a result of changes in, or
unavailability of, information or based on other circumstances, including TRH’s relationship with AIG. Ratings may also be withdrawn at the request of TRH’s management. Ratings are not a
recommendation to buy, sell or hold securities and each rating should be evaluated independently of any other rating. The current investigations into certain non-traditional, or loss mitigation, insurance products and other legal matters could have a material adverse effect on TRH’s financial condition or results of
operations. Various regulators including the United States Department of Justice (the “DOJ”), the Securities and Exchange Commission (the “SEC”), the Office of the New York State Attorney General (the
“NYAG”) and the NYS ID have been conducting investigations relating to certain insurance and reinsurance business practices, non-traditional insurance products and assumed reinsurance transactions
within the industry and at AIG. In connection with these investigations, AIG requested that TRH, as a subsidiary of AIG, review its documents and practices, and TRH has cooperated with AIG in all such
requests. On February 9, 2006, AIG announced that it has reached a resolution of claims and matters under investigation by the DOJ, SEC, NYAG and NYS ID. AIG stated that the settlements resolved
investigations conducted by the SEC, NYAG and NYS ID against AIG and conclude negotiations with these authorities and the DOJ in connection with the accounting, financial reporting and insurance
brokerage practices of AIG and its subsidiaries, as well as claims relating to the underpayment of certain workers compensation premium taxes and other assessments. As part of these settlements, AIG has agreed to retain, for a period of three years, an Independent Consultant who will conduct a review that will include, among other things, the adequacy of AIG’s
internal controls over financial reporting, the policies, procedures and effectiveness of AIG’s regulatory, compliance and legal functions and the remediation plan that AIG has implemented as a result of its
own internal review. TRH, as a subsidiary of AIG, will cooperate with the terms of the settlements that are applicable to TRH. In April 2005, TRH received subpoenas from the Insurance Departments of Florida and Georgia seeking information relating to finite insurance and reinsurance transactions. In addition, TRH has
received a subpoena from the NYS ID seeking information relating to TRC’s relationship and transactions with Sunrise Professional Indemnity, Ltd., a foreign reinsurer providing reinsurance to TRC, and
Gallagher Healthcare Insurance Services, Inc., a provider of insurance and risk management services to healthcare providers and a wholly owned subsidiary of Arthur J. Gallagher & Co., Inc. TRH has responded to these subpoenas and continues to cooperate with these regulatory requests. There have been no further inquiries concerning the matters raised by the subpoenas received from
the States of Florida and Georgia. From time to time, TRH is contacted by regulators from states and other jurisdictions who have commenced investigations and/or inquiries into insurance and reinsurance industry practices as well as
insurance brokerage practices. TRH has cooperated, and will continue to cooperate, with all these investigations, including by producing documents and other information in response to subpoenas. While TRH does not believe that any of these inquiries will have a material impact on TRH’s business or financial results, it is not possible to predict with any certainty at this time what impact, if any,
these inquiries may have on TRH’s business or financial results. 24
TRH’s businesses are heavily regulated, and changes in regulation may reduce TRH’s profitability and limit its growth. The Company’s reinsurance subsidiaries are subject to extensive regulation and supervision in the jurisdictions in which they conduct business. This regulation is generally designed to protect the
interests of policyholders, as opposed to reinsurers and their stockholders and other investors, and relates to authorization to transact certain lines of business, capital and surplus requirements, investment
limitations, underwriting limitations, transactions with affiliates, dividend limitations, changes in control and a variety of other financial and non-financial components of an insurance company’s business. In recent years, the state insurance regulatory framework in the U.S. has come under increased federal scrutiny, and some state legislatures have considered or enacted laws that may alter or increase
state authority to regulate insurance and reinsurance companies and insurance holding companies. Further, the NAIC and state insurance regulators are re-examining existing laws and regulations,
specifically focusing on modifications to holding company regulations, interpretations of existing laws and the development of new laws. Any proposed or future legislation or NAIC initiatives may be more
restrictive than current regulatory requirements or may result in higher costs. In October 2005, the European Council of Ministers, in an effort to create a uniform scheme of regulation for European domiciled reinsurers, adopted the Directive. The Directive is scheduled to be
fully implemented by all EU member countries no later than October 2008. TRH operates in Europe by means of licensed branches and will not necessarily be impacted the same way as EU domiciled
reinsurers. At the present time, it is not clear how the Directive will impact non-EU companies that operate in the European Market. It is possible that implementation, as respects non-EU reinsurers, will
vary in each EU country and may manifest itself in the form of increased administrative costs and fees, organizational expenses related to required changes to operating structure and/or increased
collateralization requirements. TRH’s offices that operate in jurisdictions outside the United States are subject to certain limitations and risks that are unique to foreign operations. In addition to licensing requirements, TRH’s international operations are also regulated in various jurisdictions with respect to currency, amount and type of security deposits, amount and type of
reserves, amount and type of local investment and other matters. International operations and assets held abroad may be adversely affected by political and other developments in foreign countries,
including possibilities of tax changes, nationalization and changes in regulatory policy, as well as by consequences of hostilities and unrest. The risks of such occurrences and their overall effect upon TRH
vary from country to country and cannot easily be predicted. In addition, TRH’s results of operations and net unrealized currency translation gain or loss (a component of accumulated other comprehensive
income) are subject to volatility as the value of the foreign currencies fluctuate relative to the U.S. dollar. Regulations governing constitution of technical reserves and remittance balances in some countries
may hinder remittance of profits and repatriation of assets. TRH may be adversely affected by the impact of market volatility and interest rate and foreign currency exchange rate fluctuation on its invested assets. TRH’s principal invested assets are fixed maturity investments, which are subject to the market risk of potential losses from adverse changes in interest rates and may also be adversely affected by
foreign currency exchange rate fluctuations. Depending on TRH’s classification of its investments as available- for-sale, trading or other, changes in the fair value of TRH’s securities are reflected in the
Consolidated Balance Sheet and/or Statement of Operations. TRH’s investment portfolio is also subject to credit risk resulting from adverse changes in the issuers’ ability to repay the debt. These risks
could materially adversely affect TRH’s results of operations and/or financial condition. A principal exposure to foreign currency risk is TRH’s obligation to settle claims in foreign currencies. The possibility exists that TRH may incur foreign currency exchange gains or losses as TRH
ultimately settles claims required to be paid in foreign currencies. To mitigate this risk, TRH also maintains investments denominated in certain of the same major foreign currencies in which the claims
payments will be made. To the extent TRH does not seek to hedge its foreign currency risk or hedges 25
prove ineffective, the resulting impact of a movement in foreign currency exchange rate could materially adversely affect TRH’s results of operations. Item 1B. Unresolved Staff Comments None. As of December 31, 2006, the office space of TRH’s New York headquarters and its Chicago and Toronto offices are rented from the AIG Group, which leases it from others. The lease for the office
space occupied by TRH’s New York headquarters expires in 2021. The Overland Park, San Francisco, Columbus, Miami, Buenos Aires, Rio de Janeiro, Panama, London, Paris, Zurich, Warsaw, Hong
Kong, Shanghai, Tokyo and Sydney offices are rented from third parties. TRH, in common with the reinsurance industry in general, is subject to litigation in the normal course of its business. TRH does not believe that any pending litigation will have a material adverse
effect on its consolidated results of operations, financial position or cash flows. Various regulators including the DOJ, the SEC, the NYAG and the NYS ID have been conducting investigations relating to certain insurance and reinsurance business practices, non-traditional
insurance products and assumed reinsurance transactions within the industry and at AIG. In connection with these investigations, AIG requested that TRH, as a subsidiary of AIG, review its documents and
practices, and TRH has cooperated with AIG in all such requests. On February 9, 2006, AIG announced that it has reached a resolution of claims and matters under investigation by the DOJ, SEC, NYAG and NYS ID. AIG stated that the settlements resolved
investigations conducted by the SEC, NYAG and NYS ID against AIG and conclude negotiations with these authorities and the DOJ in connection with the accounting, financial reporting and insurance
brokerage practices of AIG and its subsidiaries, as well as claims relating to the underpayment of certain workers compensation premium taxes and other assessments. As part of these settlements, AIG has agreed to retain, for a period of three years, an Independent Consultant who will conduct a review that will include, among other things, the adequacy of AIG’s
internal controls over financial reporting, the policies, procedures and effectiveness of AIG’s regulatory, compliance and legal functions and the remediation plan that AIG has implemented as a result of its
own internal review. TRH, as a subsidiary of AIG, will cooperate with the terms of the settlements that are applicable to TRH. In April 2005, TRH received subpoenas from the Insurance Departments of Florida and Georgia seeking information relating to finite insurance and reinsurance transactions. In addition, TRH has
received a subpoena from the NYS ID seeking information relating to TRC’s relationship and transactions with Sunrise Professional Indemnity, Ltd., a foreign reinsurer providing reinsurance to TRC, and
Gallagher Healthcare Insurance Services, Inc., a provider of insurance and risk management services to healthcare providers and a wholly owned subsidiary of Arthur J. Gallagher & Co., Inc. TRH has responded to these subpoenas and continues to cooperate with these regulatory requests. There have been no further inquiries concerning the matters raised by the subpoenas received from
the States of Florida and Georgia. While TRH does not believe that any of these inquiries will have a material impact on TRH’s business or financial results, it is not possible to predict with any certainty at
this time what impact, if any, these inquiries may have on TRH’s business or financial results. There were no matters submitted to a vote of security holders during the fourth quarter of 2006. 26
The following table sets forth the high and low closing sales prices and the dividends declared per share of Transatlantic Holdings, Inc. (the “Company”) Common Stock (“TRH shares”) on the New
York Stock Exchange Composite Tape for each of the four quarters of 2006 and 2005: First Quarter Second Quarter Third Quarter Fourth Quarter The Company paid each dividend in the quarter following the quarter of declaration. The declaration and payment of future dividends, if any, by the Company will be at the discretion of the Board of Directors and will depend upon many factors, including the Company’s consolidated
earnings, financial condition and business needs, capital and surplus requirements of the Company’s operating subsidiaries, regulatory considerations and other factors. As of January 31, 2007, the approximate number of holders of TRH shares, including those whose TRH shares are held in nominee name, was 37,000. In November 2000, the Board of Directors authorized the purchase of up to 200,000 shares (375,000 shares after adjustment for subsequent stock splits) of TRH shares in the open market or through
negotiated transactions. The purchase program has no set expiration or termination date. As of December 31, 2006, 170,050 shares may still be purchased pursuant to this authorization. No shares were
purchased in the fourth quarter of 2006. The preceding does not include 23,206 shares related to options exercised in the three months ended December 31, 2006 that were attested to in satisfaction of the
exercise price by holders of the Company’s employee or director stock options. Performance Graph The following Performance Graph compares the cumulative total return to stockholders on TRH shares for a five-year period (December 31, 2001 to December 31, 2006) with the cumulative total
return of the S&P 500 stock index (the “New Broad Equity Market Index”) and a peer group of companies (the “New Peer Group”) consisting of fifteen reinsurance companies to which TRH compares its
business and operations: Arch Capital Group Ltd., Axis Capital Holdings Ltd. (included from July 1, 2003), Converium Holding AG, Endurance Specialty Holdings Ltd. (included from February 28, 2003),
Everest Re Group Ltd., IPC Holdings Ltd., Max Re Capital Ltd., Montpelier Re Holdings Ltd. (included from October 10, 2002), Odyssey Re Holdings Corp., Partner Re Ltd., Platinum Underwriters
Holdings, Ltd. (included from October 29, 2002), PXRE Group Ltd., Renaissance Re Holdings Ltd, SCOR and Swiss Reinsurance Co. The performance of certain companies is included for a shorter period
since they were not public companies for the entire five-year performance period. Dividend reinvestment has been assumed and returns have been weighted to reflect relative stock market capitalization. 27
The Performance Graph also compares the cumulative total return to stockholders on TRH shares with the cumulative total return of the S&P Midcap 400 Index (the “Old Broad Equity Market Index”)
and the cumulative total return of the S&P 500 Property & Casualty Insurance Index (the “Old Published Line-of-Business Index”) to which TRH compared itself in the Performance Graph included in its
Definitive Proxy Statement in connection with TRH’s 2006 Annual Meeting of Stockholders. The New Peer Group has been added as it represents those companies TRH competes with in the reinsurance
market and to which it compares itself. The Old Published Line-of-Business Index includes insurance companies that do not compete with TRH in the reinsurance market. The New Broad Equity Market
Index has been added as it represents a broad measure to which TRH more closely compares itself with. The Old Broad Equity Market Index was previously used as TRH was briefly included within the
index in the past. TRH no longer believes that the Old Published Line-of-Business Index and the Old Broad Equity Market Index reflect measures that TRH compares itself to. Cumulative Total Return to Stockholders Transatlantic Holdings, Inc. S&P 500 Index Peer Group S&P Midcap 400 Index S&P 500 Property & Casualty Insurance 28
Item 6. Selected Financial Data TRANSATLANTIC HOLDINGS, INC. AND SUBSIDIARIES The Selected Financial Data should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the consolidated financial statements and
accompanying notes included elsewhere herein. Statement of Operations Data: Net premiums written Net premiums earned Net investment income Realized net capital gains (losses) Revenues Income (loss) before income taxes(1) Net income Per Common Share:(2) Net income: Basic Diluted Cash dividends declared Share Data:(2) Weighted average common shares outstanding: Basic Diluted Balance Sheet Data (at year end): Investments and cash Assets Unpaid losses and loss adjustment expenses Unearned premiums 5.75% senior notes due December 14, 2015(3) Stockholders’ equity (2) Share and per share data have been retroactively adjusted, as appropriate, to reflect common stock splits. (3) Includes amounts payable to affiliates and others as follows: 2006—Affiliates $447,980; Others $298,653; 2005—Affiliates $447,812; Others $298,541. 29
Cautionary Statement Regarding Forward-Looking Information This Annual Report on Form 10-K and other publicly available documents may include, and Transatlantic Holdings, Inc. and its subsidiaries (collectively, “TRH”) officers and representatives may from
time to time make, statements which may constitute “forward-looking statements” within the meaning of the U.S. federal securities laws. These forward-looking statements are identified, including without
limitation, by their use of such terms and phrases as: These statements are not historical facts but instead represent only TRH’s belief regarding future events and financial performance, many of which, by their nature, are inherently uncertain and outside
of TRH’s control. These statements may address, among other things, TRH’s strategy and expectations for growth, product development, government and industry regulatory actions, legal matters, market
conditions, financial results and reserves, as well as the expected impact on TRH of natural and man-made (e.g., terrorist attacks) catastrophic events and political, economic, legal and social conditions. It is possible that TRH’s actual results, financial condition and expected outcomes may differ, possibly materially, from those anticipated in these forward-looking statements. Important factors that
could cause TRH’s actual results to differ, possibly materially, from those discussed in the specific forward-looking statements may include, but are not limited to, uncertainties relating to economic
conditions and cyclical industry conditions, credit quality, government, regulatory and accounting policies, volatile and unpredictable developments (including natural and man-made catastrophes), the legal
environment, legal and regulatory proceedings, the reserving process, the competitive environment in which TRH operates, interest rate and foreign currency exchange rate fluctuations, and the
uncertainties inherent in international operations. These factors are further discussed throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations and in Item 1A of this Form 10-K. TRH is not under any
obligation to (and expressly disclaims any such obligations to) update or alter any forward-looking statement, whether written or oral, that may be made from time to time, whether as a result of new
information, future events or otherwise. 30
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Throughout this Annual Report on Form 10-K, Transatlantic Holdings, Inc. and its subsidiaries (“TRH”) presents its operations in the way it believes will be most meaningful. TRH’s unpaid losses and
loss adjustment expenses net of related reinsurance recoverable (“net loss reserves”) and TRH’s combined ratio and its components are presented in accordance with principles prescribed or permitted by
insurance regulatory authorities, as these are standard measures in the insurance and reinsurance industries. Financial Statements The following discussion refers to the consolidated financial statements of TRH as of December 31, 2006 and 2005 and for each of the three years in the period ended December 31, 2006, which are
presented elsewhere herein. Financial data discussed below have been affected by certain transactions between TRH and related parties. (See Notes 6, 11, 12, 13 and 15 of Notes to Consolidated Financial
Statements.) Executive Overview The operations of Transatlantic Holdings, Inc. (the “Company”) are conducted principally by its three major operating subsidiaries—Transatlantic Reinsurance Company (“TRC”), Trans Re Zurich
(“TRZ”) and Putnam Reinsurance Company (“Putnam”)—and managed based on its geographic segments. Through its operations on six continents, TRH offers reinsurance capacity on both a treaty and
facultative basis—structuring programs for a full range of property and casualty products, with an emphasis on specialty lines, which may exhibit greater volatility of results over time than most other lines.
Such capacity is offered through reinsurance brokers and, to a lesser extent, directly to domestic and foreign insurance and reinsurance entities. TRH conducts its business and assesses performance through segments organized along geographic lines. Financial data from branches in the United States that underwrite primarily domestic business,
as well as stock compensation expense and revenues and expenses of the Company, are reported in the Domestic segment. In addition, assets purchased with the proceeds from the $750 million aggregate
principal amount of senior notes (issued in December 2005), related investment returns and the interest expense on such senior notes are also reflected in the Domestic segment. Data from the London and
Paris branches and from TRZ are reported in the aggregate as International—Europe and considered as one segment due to operational and regional similarities. Data from the Miami (which serves Latin
America and the Caribbean), Toronto, Hong Kong and Tokyo branches are grouped as International—Other and represent the aggregation of non-material segments. TRH’s operating strategy emphasizes product and geographic diversification as key elements in managing its level of risk concentration. TRH also adjusts its mix of business to take advantage of
market opportunities. Over time, TRH has also capitalized on market opportunities when they arise by strategically expanding operations in an existing location or opening a branch or representative office
in new locations, except for the acquisition of TRZ in 1996. TRH’s operations that serve international markets leverage TRH’s product knowledge, worldwide resources and financial strength, typically
utilizing indigenous management and staff with a thorough knowledge of local markets and product characteristics. In 2006, casualty lines comprised 73% of TRH’s net premiums written, while property lines totaled 27%. In addition, treaty reinsurance totaled 95% of net premiums written, with the balance
representing facultative accounts. Moreover, business written by international operations represented 52% of net premiums written in 2006. American International Group, Inc. (“AIG”), which through its subsidiaries is one of the largest providers of insurance and investment products and services to businesses and individuals around the
world, beneficially owned approximately 59% of the Common Stock of the Company (“TRH shares”) as of December 31, 2006, 2005 and 2004. TRH’s major sources of revenues are net premiums earned for reinsurance risks undertaken and net investment income earned on investments made. The great majority of TRH’s investments are in 31
fixed maturity securities with an average duration of 5.9 years as of December 31, 2006. In general, premiums are received significantly in advance of related claims payments. The following table
summarizes TRH’s revenues, income (loss) before income taxes and net income for the periods indicated: Revenues Income (loss) before income taxes Net income Consolidated Results Revenues in 2006 increased compared to 2005 due primarily to increases in Domestic and, to a lesser extent, International—Other net premiums earned and consolidated net investment income, offset, in
part, by decreases in International—Europe net premiums earned and decreases in Domestic and International—Europe realized net capital gains (losses). The increase in International—Other net premiums
earned occurred principally in the Miami branch (serving Latin America and the Caribbean) and, to a lesser extent, in the Toronto branch. The London and Paris branches reported the great majority of the
decrease in International—Europe net premiums earned in 2006. The most significant increases in consolidated net premiums earned occurred in the other liability, accident & health (“A&H”) and property lines,
partially offset by a significant decrease in the auto liability line. The changes in net premiums earned generally reflected prevailing market conditions over recent periods, as discussed below. Net
investment income increased in 2006 due largely to an increase in fixed maturity investment income and, to a lesser extent, to an increase in investment income from limited parnerships. The increase in
fixed maturity investment income was due, in part, to investment returns from continued positive operating cash flows and the investment of the net proceeds from the issuance of $750 million principal
amount senior notes in December 2005. Revenues in 2005 decreased compared to 2004 due primarily to significant decreases in domestic net premiums earned, partially offset by increases in international net premiums earned and
consolidated net investment income. The decline in domestic net premiums earned in 2005 compared to 2004 resulted, in part, from higher ceding company retentions in recent periods and the softening of
primary and reinsurance rates in most classes prior to the occurrence of significant catastrophe loss events in the latter half of 2005. The most significant declines in net premiums earned occurred in the auto
liability and medical malpractice lines. While there were no significant catastrophe losses occurring in 2006, the year 2006 includes pre-tax net catastrophe costs of $29 million related to events which occurred in prior years. (See Note 9 of
Notes to Consolidated Financial Statements.) The year 2005 was the worst year ever in recorded history for insured catastrophe losses. In addition, Hurricane Katrina was the largest insured catastrophe loss in reported history. An industry source
has projected insurance and reinsurance industry costs related to Hurricane Katrina of approximately $40 billion. Results for 2005 and 2004 were materially affected by catastrophe costs. Results for 2005 include net pre-tax catastrophe costs of $544 million, or $354 million after tax, principally arising from
Hurricanes Katrina ($304 million on a pre-tax basis), Rita ($44 million on a pre-tax basis) and Wilma ($111 million on a pre-tax basis) and, to a lesser extent, from Central European floods and European
Windstorm Erwin. Such catastrophe costs consist of pre-tax net catastrophe losses of $483 million (gross $870 million; ceded $387 million) and net ceded reinstatement premiums of $61 million (gross $72
million; ceded $133 million). Reinstatement premiums may arise on both assumed and ceded business as a result of contractual provisions found in many excess-of-loss catastrophe contracts that require 32
additional premiums to be paid in the event of a loss to reinstate coverage for the remaining portion of the contract period in the amount of the loss. Net pre-tax catastrophe costs of $215 million (gross $270 million; ceded $55 million), or $140 million after tax, dramatically affected 2004 results. These losses resulted from Hurricanes Charley, Frances,
Ivan and Jeanne, that affected the Southeastern United States and the Caribbean, typhoons that affected Japan and the tsunami which principally affected South Asia. Income (loss) before income taxes and net income increased in 2006 as compared to 2005 principally due to increased underwriting profit (loss) and net investment income, offset, in part, by interest
expense on TRH’s senior notes and decreased realized net capital gains. The increased underwriting profit (loss) in 2006 reflect an improved combined ratio resulting largely from reduced significant net
catastrophe costs and, to a lesser extent, lower net adverse loss reserve development. (See Note 16 of Notes to Consolidated Financial Statements for underwriting profit (loss) by segment.) Decreases in net
catastrophe costs and lower net adverse loss reserve development in the aggregate increased underwriting profit (loss) by $618.4 million in 2006 compared to 2005. The reasons for the increase in net
investment income are as discussed earlier. The significant tax expense in 2006 compared to the tax benefit recognized in 2005 tempered the impact of the above changes on net income. Income (loss) before income taxes and net income decreased in 2005 as compared to 2004 due primarily to decreased underwriting profit (loss) resulting primarily from significantly higher net
catastrophe costs. Significant tax savings were recognized in 2005 as a result of catastrophe costs, and considers the fact that TRH is able to carry back tax-basis net operating losses to prior years and carry
forward minimum tax credits indefinitely. (See Note 4 of Notes to Consolidated Financial Statements.) These tax savings somewhat tempered the impact of catastrophe losses on net income in 2005
compared to 2004. Underwriting profit (loss) is defined as net premiums earned less net losses and loss adjustment expenses (“LAE”) incurred, net commissions and other underwriting expenses, plus (minus) the increase
(decrease) in deferred acquisition costs. (See Operational Review for further discussion.) Market Conditions and Outlook The market conditions in which TRH operates have historically been cyclical. For the period under discussion, the reinsurance market has been characterized by significant competition worldwide in
most lines of business. Attracted by improved rates, terms and conditions, additional capital entered the market in late 2001 through the formation of new companies, principally in Bermuda, and with
additional capital added to certain existing companies. The new capacity spurred additional competition, most significantly in shorter tail, catastrophe related lines, both domestically and internationally.
Despite increased capacity, market conditions for reinsurers generally improved throughout 2002 and 2003 as rates increased and terms and conditions generally became more restrictive. In 2004, property lines experienced meaningful rate decreases on both primary and reinsurance contracts, but remained generally favorable with respect to catastrophe business. Despite the prevalence
of modest rate reductions on primary business, casualty rates generally remained firm on the treaty reinsurance side. Rates, terms and conditions were generally stronger for longer tail casualty lines due, in
part, to elevated industry-wide loss activity in prior years (that also materially affected TRH), principally related to losses occurring in 1997 through 2001. Overall, market conditions in the reinsurance
sector for 2004 generally remained favorable for most classes. The generally softening property market conditions prevalent in 2004 continued through the first half of 2005 on both primary and reinsurance business. In addition, market conditions in many casualty
lines also softened for a significant portion of 2005. However, pricing, terms and conditions on short tail lines of business, such as property, marine and energy, improved significantly in the United States
and, to some degree, outside the United States, after Hurricanes Katrina, Rita and Wilma. These improvements had little effect on 2005 results. They were driven by several factors, including the amount of
industry capital consumed by the catastrophe losses in that year (an industry record), market-wide adjustments for the failure of traditional property catastrophe models to accurately 33
capture the severity of a Hurricane Katrina type loss and the modification of capital adequacy models by certain rating agencies to increase capital charges related to catastrophe exposures. Searching for a
proper return and looking to minimize the uncertainty of property catastrophe modeling, the market arrived at meaningfully higher pricing parameters, higher attachment points, tighter terms and
conditions for such programs and a more conservative management of aggregate exposure. These improvements were most significant in the U.S. nationwide property and energy catastrophe programs as
well as in energy pro rata contracts. To a lesser extent, U.S. regional property catastrophe, international property catastrophe, marine excess-of-loss, property per risk excess-of-loss and property pro rata
programs saw improvements. Other lines of business, including casualty lines, while not experiencing much deterioration in terms, did not see the same magnitude of improvement in market conditions. Much like the influx of capital after the event of September 11, 2001, a large amount of capital flowed into the market after the major catastrophe events of 2005. Unlike 2001, however, the hurricanes
of 2005 had a disproportionate effect on reinsurers and much of the capital raised went to existing reinsurers. Some of the capital also went to new reinsurance companies that were started in Bermuda in
the fourth quarter of 2005. The capital raised by existing reinsurers was not just to replace some of the capital lost in the catastrophe events of 2005, but also to meet the higher capital thresholds required by
the rating agencies to support catastrophe exposure. Also, due to the severe impact on capital that the hurricanes had on property monoline carriers, the rating agencies imposed higher hurdles for ratings
for this type of (re)insurer. Nevertheless, most of the start up companies achieved a rating of at least A– from Best by year end. While these new companies did write a fair amount of property catastrophe
and energy excess-of-loss business in 2006, they did not slow the momentum of rate increases in these lines and, in fact, these companies have already begun to look to diversify their writings in order to
fully apply their capital. In addition to new company formations, capital markets, including hedge funds, have become more active in assuming reinsurance risk other than from investing in various companies. Numerous hedge
funds have provided both pro rata and excess-of-loss reinsurance and retrocessional protections through captive companies or other alternative transactions on a fully collateralized basis for property and
energy catastrophe business. One type of an alternative transaction is a vehicle known as a “sidecar”. Sidecars are essentially reinsurance companies set up as a special purpose reinsurer to reinsure a
discrete group of risks. The sidecar may have an equity investment from its sponsor as well as additional capital provided by hedge funds and other institutional investors and may also have a debt portion
that is provided by a bank or other financial institution. Hedge funds and other investment vehicles also formed or sponsored reinsurers or used other reinsurance companies as conduits to offer traditional reinsurance as well as industry loss warranties
(ILWs) and other forms of index-based protections. While rates for property catastrophe and other lines of business exposed to natural peril losses in U.S. peak zones (areas with concentrations of coastal exposures to hurricanes or general exposure to
earthquakes) improved meaningfully at January 1, 2006, rates in these areas experienced more significant increases starting April 1, 2006 and this trend continued throughout the remainder of the year.
These improvements were a confluence of capital depletion from the 2005 storms, model changes by the generally accepted catastrophe loss models and stricter rating agency requirements. With the exception of some parts of the Caribbean, catastrophe exposed lines of business in other parts of the world did not enjoy the same magnitude of rate increases in 2006. International property
business continued to see increased competition from established European reinsurers and from newer Bermudian companies that sought to diversify their books. Casualty business experienced downward
pressure worldwide, with international rates coming under more pressure than U.S. rates. Other terms and conditions on this business generally held up well worldwide. Given the amount of capital attracted by year end 2006 as a result of the dislocation in the U.S. markets in 2005, catastrophe exposed accounts renewing on January 1, 2007 saw a slowing of upward rate
movements on programs. Nevertheless, TRH anticipates rates for U.S. catastrophe exposed business will remain at an attractive level through 2007. 34
It is unclear whether certain casualty lines rates will continue to fall, but outside of certain excess & surplus lines and certain poor performing accounts, it seems unlikely that there will be significant rate
movements upwards. One major factor keeping casualty rates from sliding too much is the actuarial, claims and underwriting barriers to entry for certain specialty casualty lines of business. TRH has been
underwriting casualty business for over 20 years and has developed a favorable reputation for knowledge and commitment to the casualty marketplace. This expertise is difficult to duplicate and has kept
some newer markets from entering these lines. Furthermore, many buyers of casualty reinsurance have been far more cautious about the ability and willingness of reinsurers to pay claims that may not come
due for many years. TRH’s capital base, financial ratings and favorable claims paying record has generally proven to be a competitive advantage. With fewer reinsurers qualified, in the market’s view, to
write casualty reinsurance, capacity in these lines may be more restricted and may keep upward pressure on rates. Due to the favorable trading conditions for most insurance companies since 2001, many potential buyers of reinsurance have more than replenished the capital lost since then. In many cases, companies’
capitalization is now higher than ever and they may choose to rely less on reinsurance as a form of capital and retain more business. In formulating a reinsurance purchasing strategy, the ceding company
will also consider the perceived volatility of the business to be ceded. In addition, certain historical retrocession protections obtained by TRH in the past are either unavailable or significantly more expensive in the current environment. The existence of favorable market conditions in certain regions and lines of business do not necessarily translate into ultimate pricing adequacy for business written under such conditions. In addition,
there is no guarantee that these conditions will remain in effect as TRH cannot predict, with any reasonable certainty, future market conditions. Additionally, as a practical matter, the rates charged by primary insurers and the policy terms of primary insurance agreements may affect the rates charged and the policy terms associated with
reinsurance agreements, particularly for pro rata reinsurance business. Further information related to items discussed in this Executive Overview may be found throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”). Critical Accounting Estimates This discussion and analysis of financial condition and results of operations are based upon TRH’s consolidated financial statements which have been prepared in accordance with accounting principles
generally accepted in the United States of America. The preparation of these financial statements requires the use of estimates and judgments that affect the reported amounts and related disclosures. TRH
relies on historical experience and on various other assumptions that it believes to be reasonable under the circumstances, to make judgments about the carrying values of assets and liabilities that are not
readily apparent from other sources. Actual results may differ materially from these estimates. TRH believes its most critical accounting estimates are those with respect to loss reserves, premium revenues and deferred acquisition costs, as they require management’s most significant exercise of
judgment on both a quantitative and qualitative basis used in the preparation of TRH’s consolidated financial statements and footnotes. The accounting estimates that result require the use of assumptions
about certain matters that are highly uncertain at the time of estimation. A discussion of these most critical accounting estimates follows: Loss Reserves Estimates of loss reserves take into account TRH’s assumptions with respect to many factors that will affect ultimate loss costs but are not yet known. The ultimate process by which actual carried
reserves are determined considers not only actuarial estimates but a myriad of other factors. Such factors, both internal and external, which contribute to the variability and unpredictability of loss costs,
include trends related to jury awards, social inflation, medical inflation, worldwide economic conditions, tort reforms, court interpretations of coverages, the regulatory environment, underlying policy
pricing, 35
terms and conditions and claims handling, among others. In addition, information gathered through underwriting and claims audits are also considered. To the extent that these assumptions underlying the
loss reserve estimates are significantly incorrect, ultimate losses may be materially different from the estimates included in the financial statements and may materially affect results of operations. The
impact of those differences is reflected in the period they become known. The reserving process is inherently difficult and subjective, especially in view of changes in the legal and tort environment which impact the development of loss reserves, and therefore quantitative
techniques frequently have to be supplemented by subjective considerations and managerial judgment. Trends that have affected development of liabilities in the past may not necessarily occur or affect
development to the same degree in the future. While this process is difficult for ceding companies, the inherent uncertainties of estimating loss reserves are even greater for reinsurers, due primarily to the longer term nature of much 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, which are subject to change without notice. Nevertheless, data received from cedants is subjected to audits from time to time by TRH
claims and underwriting personnel, to help ensure that reported data is supported by proper documentation and conforms to contract terms, and analyzed, as appropriate, by TRH underwriting and actuarial
personnel. Such analysis often includes a detailed review of reported data to assess the underwriting results of reinsurance assumed and to explain any significant departures from expected performance.
Over time, reported loss information is ultimately corroborated when such information eventually attains paid status. Standard actuarial methodologies employed to estimate ultimate losses incorporate the inherent “lag” from the time claims are reported to the cedant to when the cedant reports the claims to the
reinsurer. Certain actuarial methodologies may be more appropriate than others in instances where this “lag” may not be consistent from period to period, so additional actuarial judgment is employed in
the selection of methodologies to best incorporate the potential impact of this situation. Generally, for each longer tail line of business, significant actuarial judgments are made with respect to the following factors used in the loss reserve setting process: • ELRs for the latest accident years generally reflect the ELRs from prior accident years adjusted for the loss trend (see loss trend factor discussion immediately above), as well as the impact of rate
level changes and other quantifiable factors. For certain longer tail lines of business that are typically lower frequency, higher severity classes, such as excess medical malpractice and directors’ and
officers’ liability (“D&O”), ELRs are often utilized for the last several accident years. • Loss development factors are used to arrive at the ultimate amount of losses incurred for each accident year based on reported loss information. These factors, which are initially calculated based on
historical loss development patterns (i.e., the emergence of reported losses over time relative to the ultimate losses to be paid), are then adjusted for current trends. During the loss settlement period, which can be many years in duration, additional facts regarding individual claims and trends usually become known. As these facts and trends emerge, it usually
becomes necessary to refine and adjust the loss reserves upward or downward and even then the ultimate net liability may be materially different from the revised estimates. A comprehensive annual loss reserve review is conducted in the fourth quarter of each year. These reviews are conducted in full detail for each class or line of business for each underwriting office and
thus consist of more than one hundred individual analyses. The purpose of these reviews is to confirm the reasonableness of the carried loss reserve. In completing these detailed actuarial reserve analyses, 36
TRH is required to make numerous assumptions, including the selection of loss development factors and ELRs. Additionally, TRH needs to select the most appropriate actuarial method(s) to employ for
each class of business. The methodologies that TRH typically employs include paid loss development, incurred loss development, paid Bornhuetter-Ferguson (“B-F”) and incurred B-F methods. Triangles of written premium,
paid losses and incurred losses are organized by underwriting year evaluated at six month intervals. The data triangles are split by branch, contract type (i.e., treaty versus facultative), line of business and
often between excess-of-loss and pro rata business. The line of business groupings vary by branch and are reviewed annually to ensure proper balance between homogeneity and credibility of data. In the
loss development methods, paid and incurred losses by underwriting year are projected to an ultimate basis by applying appropriate age to ultimate development factors to the inception to date paid and
incurred losses. The development factors are selected based on curves fitted to the historical average which best represent the data. In the B-F methods, estimates of unpaid and unreported losses are
arrived at by multiplying underwriting year earned premium by an ELR and an estimated percentage of unpaid or unreported losses. These percentages of unpaid or unreported losses are derived from the
loss development factors described above. In the course of these detailed loss reserve reviews for each business grouping, a point estimate of the loss reserve need is determined. The sum of these point
estimates for each of the individual groupings provides an overall actuarial estimate of the loss reserve for each underwriting office and ultimately an actuarial estimate of the loss reserve for TRH as a
whole. This amount is then evaluated against actual carried loss reserves. Any changes to the carried loss reserve that are deemed appropriate are reflected in earnings in the period of change. TRH’s annual loss reserve review for 2006 did not include the calculation of a range of loss reserve estimates. Because the majority of the loss reserves relate to reinsurance of long-tail casualty lines
driven by severity rather than frequency of claims, and because management does not believe that credible probabilistic values can be assigned to a range, a better understanding of the volatility of loss
reserve estimates can be gained via an analysis of the sensitivity of these estimates to changes in the critical assumptions used in the loss reserve review process as opposed to creating a range. There is potential for significant variation in the development of loss reserves when actual costs differ from those costs implied by the assumptions used to test the loss reserves. This is particularly true
for assumed reinsurance of long-tail casualty classes. Among the most critical assumptions are those made for ELRs and loss development factors, as described earlier. An analysis of the sensitivity of the loss reserve indications to these key assumptions can be performed by measuring the effect of various changes to the assumptions utilized in the reviews. In general,
it is believed that the vast majority of potential volatility in the loss reserves results from the longer tailed classes of business. For the purpose of these sensitivity analyses, only loss reserves from these
longer tailed classes, which represent approximately 65% of total loss reserves, were included in the calculations. Additionally, only those underwriting years where it is believed reasonable for deviations
from the original assumptions to occur were utilized. Generally, the last 11 years were included in the analysis. This sensitivity analysis was performed on unpaid losses and loss adjustment expenses (“gross
loss reserves”) and net loss reserves. The results derived from these analyses were roughly equivalent. While noting that there exists the potential for greater variations, TRH believes utilizing 5% changes to the assumptions made for both loss development factors and ELRs provides a reasonable
benchmark for a sensitivity analysis of the loss reserve estimates. For example, changing the ELRs by 5 percentage points has an impact of about $135 million (either positively or negatively) on the loss
reserve estimate. While considerably less likely for most classes of business, we note that changing the ELRs by 10 percentage points has an effect of about $270 million. As previously described, another
key assumption is the selection of loss development patterns. The effect of a 5% deviation from the loss development factors utilized in the loss reserve review would be about $200 million. Because a
downward deviation of 5% results in negative future development of reported losses for certain years, this scenario is not believed to be as likely as that of an upward deviation of this amount. Due to the assumptions and methodologies utilized by TRH in its reviews of longer tailed classes of business, changes to the ELRs generally have a much greater impact on the assessment of loss 37
reserves for the most recent few underwriting years while deviations from the loss development factors utilized in the reviews generally are more critical to the loss reserve indications for older underwriting
years (i.e., 2002 and prior). Management believes that it is reasonable to simultaneously vary both of the assumptions previously discussed by 5%. The effect of varying these assumptions together by 5% is
about $340 million. We also note that the classes of business for which these assumptions are most critical are medical malpractice and D&O, particularly for excess-of-loss business, and excess casualty. Net loss reserves include amounts for risks related to environmental impairment and asbestos-related illnesses. The majority of TRH’s environmental and asbestos-related liabilities arose from contracts
entered into after 1985 that were underwritten specifically as environmental or asbestos-related coverages rather than as standard general liability coverages, where the environmental or asbestos-related
liabilities were neither clearly defined nor specifically excluded. The reserves carried for these claims, including loss and loss adjustment expenses incurred but not reported (“IBNR”), are based upon
known facts and current law. However, significant uncertainty exists in determining the amount of ultimate liability for environmental impairment and asbestos-related losses, particularly for those occurring
in 1985 and prior. This uncertainty is due to inconsistent court resolutions and judicial interpretations with respect to underlying policy intent and coverage and uncertainties as to the allocation of
responsibility for resultant damages, among other things. See discussion of net adverse development on losses occurring in prior years (which includes a discussion of the causative factors of such net adverse development) under Results of Operations and further
discussion and detail information about gross loss reserves under Financial Condition and Liquidity. Premium Revenues Management must make certain judgments in the determination of premiums written and earned by TRH. For pro rata treaty contracts, premiums written and earned are based on reports received
from ceding companies. Generally for excess-of-loss treaty contracts, premiums are recorded as written based on contract terms and are earned ratably over the terms of the related coverages provided. In
recent years, treaty contracts have generated approximately 95% of TRH’s premium revenues. Unearned premiums and prepaid reinsurance premiums represent the portion of gross premiums assumed and
reinsurance ceded, respectively, relating to the unexpired terms of such coverages. The relationship between net premiums written and net premiums earned will, therefore, vary depending generally on the
volume and inception dates of the business assumed and ceded and the mix of such business between pro rata and excess-of-loss reinsurance. Premiums written and earned, along with related costs, for which data has not been reported by the ceding companies, are estimated based on historical patterns and other relevant information. Such
estimates of premiums earned are considered when establishing the reserve for loss and LAE IBNR. The differences between these estimates and the actual data subsequently reported, which may be material
as a result of the diversity of cedants and reporting practices and the inherent difficulty in estimating premium inflows, among other factors, are recorded in the period when the actual data becomes available
and may materially affect results of operations. In the Consolidated Statements of Operations, premiums written and earned and the change in unearned premiums are presented net of reinsurance ceded. Estimates of gross premiums written less related ceding commission by major class of business included in the appropriate components of the Consolidated Statement of Operations for the years ended
December 31, 2006 and 2005 and the Consolidated Balance Sheet as of December 31, 2006 and 2005 were as follows: 38
2006 Major Class Casualty: Other liability Ocean marine and aviation Medical malpractice Auto liability Accident and health Surety and credit Other Total casualty Property: Fire Allied lines Auto physical damage Homeowners multiple peril Other Total property Total 2005 Major Class Casualty: Other liability Ocean marine and aviation Medical malpractice Auto liability Accident and health Surety and credit Other Total casualty Property: Fire Allied lines Auto physical damage Homeowners multiple peril Other Total property Total TRH has provided no allowance for bad debts related to the premium estimates based on its historical experience, general profile of its cedants and the ability TRH has in most cases to significantly
offset these premium receivables with losses and LAE or other amounts payable to the same parties. Deferred Acquisition Costs Acquisition costs, consisting primarily of net commissions incurred on business conducted through reinsurance contracts or certificates, are deferred and then amortized over the period in which the
related premiums are earned, generally one year. The evaluation of recoverability of acquisition costs to be deferred considers the expected profitability of the underlying treaties and facultative certificates,
which may vary materially from actual results. If the actual profitability varies from the expected 39
profitability, the impact of such differences are recorded, as appropriate, when actual results become known and may have a material effect on results of operations. Operational Review Results of Operations TRH derives its revenue from two principal sources: premiums from reinsurance assumed net of reinsurance ceded (i.e., net premiums earned) and income from investments. The following table shows
net premiums written, net premiums earned and net investment income of TRH for the periods indicated: Net premiums written Net premiums earned Net investment income The increase in net premiums written in 2006 compared to 2005 generally reflected prevailing market conditions, as discussed earlier. Excluding the impact of the reduction in net ceded reinstatement
premiums and the impact of changes in foreign currency exchange rates, net premiums written would have increased approximately 2.5% in 2006 compared to 2005. Premium growth continues to be
mitigated by increased ceding company retentions in certain lines. The decrease in net premiums written in 2005 compared to 2004 resulted largely from softer market conditions, including certain pricing
decreases, significant net ceded reinstatement premiums related to catastrophe losses and higher ceding company retentions. Excluding the impact of changes in foreign currency exchange rates and net
ceded reinstatement premiums from 2005, net premiums written would have declined approximately 6.4% in 2005 compared to 2004. In 2006 and 2005, as compared to the respective immediately prior year,
premium changes were primarily from treaty business. On a worldwide basis, casualty lines business represented 73.3% of net premiums written in 2006 versus 70.2% and 72.4% in 2005 and 2004,
respectively. The balance represented property lines. Treaty business represented 95.3% of net premiums written in 2006 versus 95.5% and 96.4% in 2005 and 2004, respectively. The balance represented
facultative accounts. The following table summarizes the net effect of changes in foreign currency exchange rates compared to the U.S. dollar on the percentage change in net premiums written in 2006 and 2005 compared
to its respective immediate prior year. Increase (decrease) in original currency Foreign exchange effect Increase (decrease) as reported in U.S. dollars Domestic net premiums written increased in 2006 by $182.9 million, or 11.7%, from the prior year to $1,751.2 million due to generally favorable market conditions in certain lines and reduced net ceded
reinstatement premiums. Significant increases in domestic net premiums written were recorded in the other liability (principally D&O and errors and omissions coverages (“E&O”) and the general casualty
class) ($153.1 million), A&H ($33.3 million) and auto liability ($33.0 million) lines. These increases were partially offset by a significant decrease in the surety ($21.5 million) line. International net premiums written in 2006 totaled $1,882.2 million, a decrease of $15.8 million from 2005 due, in part, to some weakness in market conditions in Europe and increased ceding company
retentions. Significant decreases in TRZ and the Paris and London branches of $26.6 million, $16.5 million and $14.8 million, respectively, were mostly offset by significant increases in the Miami and
Toronto branches of $37.1 million and $14.6 million, respectively. The increased premium volume in the Miami branch benefited from favorable market conditions in Latin America following significant 40
catastrophe losses affecting the region in 2005. International net premiums written decreased significantly in the auto liability ($53.4 million) and property ($48.9 million) lines. These decreases were partially
offset by significant increases in the ocean marine ($41.9 million), credit ($25.1 million) and A&H ($24.0 million) lines. The overall change in international net premiums written includes the impact of changes
in foreign currency exchange rates between the U.S. dollar and the currencies in which TRH does business as discussed earlier. International business represented 51.8% of 2006 net premiums written
compared to 54.8% in 2005. Domestic net premiums written decreased in 2005 by $271.7 million, or 14.8%, from the prior year to $1,568.3 million due to higher ceding company retentions in recent periods, significant net ceded
reinstatement premiums related to catastrophe losses and the softening of primary and reinsurance rates in most classes prior to the occurrence of significant catastrophe loss events in the latter half of 2005.
Significant decreases in domestic net premiums written were recorded in the auto liability ($127.6 million), medical malpractice ($94.2 million) and A&H ($26.3 million) lines. Net premiums written by international operations totaled $1,898.0 million in 2005, decreasing $11.2 million compared to 2004. Market conditions softened in many classes and there was a tendency of
ceding companies to increase their retention levels. Significant decreases in net premiums written in London and TRZ of $82.5 million and $19.5 million, respectively, were mostly offset by significant
increases in Paris, Hong Kong, Miami and Toronto of $47.7 million, $21.7 million, $15.2 million and $15.1 million, respectively. International net premiums written decreased significantly in the auto liability
($175.3 million) line offset by significant increases in the other liability ($47.2 million), A&H ($45.0 million), boiler and machinery ($34.0 million) and ocean marine ($28.0 million) lines. In addition,
international net premiums written in 2005 benefited slightly from the effect of changes in the foreign currency exchange rates between the U.S. dollar and the currencies in which TRH does business.
International business represented 54.8% of 2005 net premiums written compared to 50.9% in 2004. Reinstatement premiums were not significant in 2006 and 2004. Net premiums written and earned in 2005 include net ceded reinstatement premiums (related to catastrophe losses) of $61.1 million
(gross $72.3 million; ceded $133.4 million), principally related to domestic operations, of which $19.1 million relates to gross adverse development on catastrophe events occurring in 2004. Generally, reasons for changes in gross premiums written between years are similar to those for net premiums written, except as discussed earlier as regards reinstatement premiums and changes in
premiums assumed from an affiliate that, by prearrangement, were ceded in an equal amount to other affiliates. The decrease in ceded premiums written and earned in 2006 compared to 2005 is due to a
reduction in ceded reinstatement premiums related to 2005 and 2004 catastrophes, partially offset by increases in premiums assumed from an affiliate that, by prearrangement, were ceded in an equal
amount to other affiliates. As further discussed in Notes 13 and 15 of Notes to Consolidated Financial Statements, TRH transacts a significant amount of business assumed and ceded with other subsidiaries of AIG. TRH either
accepts or rejects the proposed transactions with such companies based on its assessment of risk selection, pricing, terms and conditions. As premiums written are primarily earned ratably over the terms of the related coverages, the reasons for changes in net premiums earned are generally similar to the reasons for changes in net
premiums written over time. Net investment income increased in 2006 compared to 2005 due generally to investment returns from continued positive operating cash flows, the investment of the net proceeds from issuance of $750
million principal amount senior notes in December 2005 and increases in investment income from limited partnerships. Net investment income increased in 2005 compared to 2004 due to the investment
(principally in fixed maturities) of significant positive cash flows from operating activities generated in recent periods. (See Note 3(c) of Notes to Consolidated Financial Statements for a breakdown of the
components of net investment income and the cash flow discussion under Financial Condition and Liquidity.) For 2006, 2005 and 2004, the pre-tax effective yields on investments were 4.2%, 3.9% and 4.1%, respectively. The pre-tax effective yield on investments represents pre-tax net investment income 41
divided by the average balance sheet carrying value of investments and interest-bearing cash. Generally, market interest rates on fixed maturities increased during the first half of 2006, losing much of that
increase in the second half of the year. The increase in the pre-tax effective yield on investments in 2006 compared to 2005 was due, in part, to increased investment income from limited partnerships offset,
in part, by a significant increase in 2006 in the asset amount of short-term investment of funds received under securities loan agreement, which asset produces minimal net investment income. In addition, a
portion of the increase in investment yield in 2006 compared to 2005 and the decline in investment yield in 2005 compared to 2004 relates to the investment in December 2005 of significant net proceeds
from the issuance of senior notes. Such investments generated limited investment income in 2005, due to the minimal amount of time that they were owned. (See Note 2(c) of Notes to Consolidated
Financial Statements.) Realized net capital gains totaled $10.9 million in 2006, $39.9 million in 2005 and $22.2 million in 2004. Realized net capital gains include investment dispositions, which reflect TRH’s investment and
tax planning strategies to maximize after-tax income, and write-downs of securities that, in the opinion of management, had experienced a decline in fair value that was other-than-temporary. In 2006,
realized net capital gains included charges for write-downs for other-than-temporary declines in fair value totaling $1.3 million related to fixed maturities available for sale and $0.1 million related to equities
available for sale. In addition, realized net capital gains in 2006 were reduced by net foreign currency transaction losses, principally related to non-functional currencies, of $11.2 million. In 2005, realized net
capital gains included charges for write-downs for other-than-temporary declines in fair value totaling $1.7 million related to equities available for sale. In 2004, realized net capital gains included charges for
write-downs for other-than-temporary declines in fair value totaling $6.2 million related to other invested assets. Upon the ultimate disposition of securities which have recorded write-downs, a portion of
the write-downs may be recoverable depending on market conditions at the time of disposition. (See Note 2(c) of Notes to Consolidated Financial Statements for criteria used in determination of such write-
downs.) The property and casualty insurance and reinsurance industries use the combined ratio as a measure of underwriting profitability. The combined ratio reflects only underwriting results, and does not
include income from investments. Generally, a combined ratio under 100% indicates an underwriting profit and a combined ratio exceeding 100% indicates an underwriting loss. Underwriting profitability is
subject to significant fluctuations due to competition, natural and man-made catastrophic events, economic and social conditions, foreign currency exchange rate fluctuations, interest rates and other factors.
The loss and LAE ratio (“loss ratio”) represents net losses and LAE incurred divided by net premiums earned. The underwriting expense ratio represents the sum of net commissions and other underwriting
expenses expressed as a percentage of net premiums written. The combined ratio represents the sum of the loss ratio and the underwriting expense ratio. The following table presents loss ratios, underwriting expense ratios and combined ratios for consolidated TRH, and separately for its domestic and international components, for the years indicated: 42
Consolidated: Loss ratio Underwriting expense ratio Combined ratio Domestic: Loss ratio Underwriting expense ratio Combined ratio International: Loss ratio Underwriting expense ratio Combined ratio The improvement in the loss ratio for consolidated TRH in 2006 as compared to 2005 reflects improvements from both domestic and international operations. Two factors in the improvement in the
loss ratio for consolidated TRH are lower net catastrophe costs and, to a much lesser extent, lower net adverse loss reserve development, primarily from domestic operations. There were no significant net catastrophe costs for events occurring in 2006. Net catastrophe costs (related to events principally occurring in 2005) in the aggregate added 0.8%, 1.1% and 0.6% to the
2006 combined ratios for consolidated, domestic and international, respectively. (See discussion under Note 9 of Notes to Consolidated Financial Statements for the amounts of net catastrophe costs by
segment and the amounts of consolidated gross and ceded catastrophe losses incurred and reinstatement premiums.) (See discussion in Item 1. Business of Retention Levels and Retrocession Arrangements
which discusses maximum gross capacity and maximum net retention by major category and the magnitude of TRH’s exposure to multiple insured losses arising from a single occurrence (i.e., catastrophe
losses).) However, in 2006, TRH determined that its estimates of the ultimate amounts of net losses occurring in 2005 and prior years needed to be increased as a result of greater than expected loss activity in
2006. As a result of that determination, TRH increased net losses and LAE incurred by $181.1 million, representing significant net adverse development in 2006 of losses occurring in all prior years. This net
adverse development was comprised of $339.7 million related to losses occurring in 2002 and prior, partially offset by favorable development of $158.6 million related primarily to 2005. The detail of the
$181.1 million net adverse development by line of business related to all prior years is presented in the table below: Other liability Fire Homeowners multiple peril Medical malpractice Fidelity Ocean marine and aviation Other, net Total (1) Amount of reestimation represents the amount of net losses and LAE incurred in 2006 related to losses occurring in 2005 and prior years. As presented in the table above, the line of business with the most significant net adverse development recorded in 2006 was the other liability line, arising principally from losses occurring in 43
2000 to 2002. The other liability line includes certain specialty casualty classes, such as D&O and E&O, and general casualty classes. In addition, significant net adverse development was recorded in 2006 in the
medical malpractice line, arising principally from losses occurring between 1998 and 2002, the fidelity line, arising principally from losses occurring between 1999 and 2005, and the ocean marine and aviation
line, arising principally from losses occurring in 2005. The large majority of such net adverse development related to domestic operations. These increases to incurred losses were offset, in part, by net
favorable development occurring most significantly in the fire line, arising principally from losses occurring in 2005, and the homeowners multiple peril line, arising principally from losses occurring between
2004 and 2005. Additionally, included in the above total net adverse development amounts are amounts related to the net adverse development of significant catastrophe losses occurring in prior years, a component of
net catastrophe costs. Such net adverse development for 2006 totaled $29.7 million and related principally to catastrophe loss events occurring in 2005. TRH writes a significant amount of non-proportional assumed casualty reinsurance as well as proportional assumed reinsurance of excess casualty business for such volatile classes as medical
malpractice, D&O, E&O and general casualty. At the primary level, there are significant risk factors which contribute to the variability and unpredictability of the loss trend factor for this business such as jury
awards, social inflation, medical inflation, tort reforms and court interpretations of coverage. In addition, as a reinsurer, TRH is also highly dependent upon the claims reserving and reporting practices of its
cedants, which vary greatly by size, specialization and country of origin and whose practices are subject to change without notice. Based on information presently available, TRH believes its current loss reserves are adequate, but there can be no assurance that TRH’s loss reserves will not develop adversely due to, for example, the
inherent volatility in loss trend factors and variability of reporting practices for those classes, among other factors, and materially exceed the carried loss reserves as of December 31, 2006 and thus,
materially affect net income. The main reason for the decrease in gross and ceded losses and LAE incurred in 2006 compared to 2005 is the decrease in gross and ceded catastrophe losses (See Note 9 of Notes to Consolidated
Financial Statements.) in 2006 partially offset by $199 million increase in gross and ceded losses and LAE incurred related to business assumed from an affiliate which, by prearrangement with TRH, was
then ceded in an equal amount to other affiliates. TRH’s 2005 results include net catastrophe costs of $543.9 million (domestic $385.8 million; international $158.1 million) principally related to Hurricanes Katrina, Rita and Wilma and, to a lesser
extent, to Central European floods and European Windstorm Erwin. Such net catastrophe costs include net ceded reinstatement premiums of $61.1 million (domestic $56.2 million; international $4.9
million). Approximately $123.9 million of net catastrophe costs included in international operations relate to hurricanes occurring in the Americas. Net catastrophe costs in the aggregate added 16.0%,
26.3% and 8.2% to the combined ratios for consolidated TRH, domestic and international, respectively. In addition, in 2005, TRH determined that its estimates of the ultimate amounts of net losses occurring in 2004 and prior years needed to be increased as a result of greater than expected loss activity in
2005. As a result of that determination, TRH increased net losses and LAE incurred by $268.8 million, representing significant net adverse development in 2005 of losses occurring in all prior years. This net
adverse development was comprised of $524.9 million related to losses occurring in 2002 and prior, partially offset by favorable development of $256.1 million related primarily to 2004 and, to a lesser
extent, to 2003. The detail of the $268.8 million net adverse development by line of business related to all prior years is presented in the table below: 44
Lines of Business Other liability Fire Medical malpractice Ocean marine and aviation Homeowners multiple peril Other, net Total As presented in the table above, the lines of business with the most significant net adverse development recorded in 2005 were the other liability line, arising principally from losses occurring in 1996 to
2002, and the medical malpractice line, arising principally from losses occurring between 1997 and 2001. The large majority of such net adverse development related to domestic operations. These increases
to incurred losses were offset, in part, by net favorable development occurring most significantly in the fire line, which arose principally from losses occurring in 2004, and in the ocean marine and aviation
line, which arose principally from losses occurring in 2001 through 2004. Additionally, included in the above total net adverse development amounts are amounts related to the net adverse development of significant catastrophe losses occurring in prior years, a component of
net catastrophe costs. Such net adverse development for 2005 totaled $14.2 million related principally to catastrophe loss events occurring in 2004. A significant reason for the increase in gross and ceded losses and LAE incurred in 2005 compared to 2004 is the increase in gross and ceded catastrophe losses. TRH’s 2004 results include pre-tax net catastrophe costs of $215.0 million (domestic $98.1 million; international $116.9 million) related to Hurricanes Charley, Frances, Ivan and Jeanne, that affected
the Southeastern United States and the Caribbean, typhoons that affected Japan and the tsunami which principally affected South Asia. Such events in the aggregate added 5.9%, 5.4% and 6.3% to the
combined ratios for consolidated TRH, domestic and international, respectively. In addition, in 2004, TRH determined that its estimates of the ultimate amounts of net losses occurring in 2003 and prior years needed to be increased as a result of greater than expected loss activity in
2004. As a result of that determination, TRH increased net losses and LAE incurred by $317.4 million, representing significant net adverse development in 2004 of losses occurring in all prior years. The
detail of the net adverse development by line of business is presented in the table below: Lines of Business Other liability Medical malpractice Fire Fidelity Ocean marine and aviation Other, net Total 45
As presented in the table above, the vast majority of net adverse development recorded in 2004 relates to the other liability and medical malpractice lines for losses occurring between 1998 and 2001,
principally in domestic and, to a lesser extent, London operations. These increases to incurred losses were offset, in part, by favorable development across most lines on losses occurring in 2003 and, to a
lesser extent, on losses occurring during 2002 in the other liability, aviation and fire lines. While TRH believes that it has taken appropriate steps to manage its exposure to possible future catastrophe losses, the occurrence of one or more natural or man-made catastrophic events of
unanticipated frequency or severity, such as a terrorist attack, earthquake or hurricane, that causes insured losses could have a material adverse effect on TRH’s results of operations, liquidity or financial
condition. Current techniques and models may not accurately predict the probability of catastrophic events in the future and the extent of the resulting losses (as was the case with Hurricane Katrina).
Moreover, one or more catastrophe losses could weaken TRH’s retrocessionnaires and result in an inability of TRH to collect reinsurance recoverables. The underwriting expense ratio for consolidated TRH increased in 2006 compared to 2005 due to an increase of 0.5% in the other underwriting expense component of the ratio and 0.2% in the net
commission component of the ratio. The increase in the other underwriting expense component is due largely to increased employee compensation and benefits expenses. The underwriting expense ratio for consolidated TRH increased in 2005 compared to 2004 due to an increase of 0.4% in each of the net commission and other underwriting expense components of the
ratio. Deferred acquisition costs vary as the components of net unearned premiums change and the deferral rate changes. Acquisition costs, consisting primarily of net commissions incurred, are charged to
earnings over the period in which the related premiums are earned. In December 2005, the Company completed a public offering of $750 million principal amount of its 5.75% senior notes due in 2015 (the “Senior Notes”). 2006 includes interest expense incurred in
connection with the Senior Notes of $43.4 million and interest paid of $43.1 million. 2005 includes interest expense incurred in connection with the Senior Notes of $2.1 million. No interest was paid in 2005. Expenses related to stock compensation agreements totaled $10.9 million, $9.6 million and $2.9 million in 2006, 2005 and 2004, respectively. The majority of such expenses are in “Other, net” in the
Consolidated Statements of Operations. (See Recent Accounting Standards herein for a discussion of the Change in Accounting Principle.) “Other, net”, also contains general corporate expenses and other
miscellaneous items. Income (loss) before income taxes was $539.9 million in 2006, $(46.1) million in 2005 and $276.2 million in 2004. The increase in income (loss) before income taxes in 2006 compared to 2005 resulted
primarily from increased underwriting profit (loss) and net investment income offset, in part, by increased interest expense and decreased realized net capital gains, each in 2006 as compared to 2005. The
increased underwriting profit(loss) in 2006 resulted primarily from lower net pre-tax catastrophe costs and lower net adverse loss reserve development. The lower net pre-tax catastrophe costs and lower net
adverse loss reserve development in the aggregate increased income (loss) before income taxes by approximately $618.4 million in 2006 compared to 2005. The decrease in (loss) income before income taxes
in 2005 compared to the prior year resulted primarily from $543.9 million of net pre-tax catastrophe costs in 2005 compared to $215.0 million of net pre-tax catastrophe costs in 2004 offset, in part, by
increased net investment income and realized net capital gains, both in 2005 as compared to 2004. Federal and foreign income tax expense (benefit) of $111.8 million, $(84.0) million and $21.6 million were recorded in 2006, 2005 and 2004, respectively. The 2005 tax benefit, which exceeds the amount
of pre-tax loss in 2005, resulted from TRH carrying its current year tax net operating loss back to prior years ($61.2 million current tax benefit on the Consolidated Statement of Operations and a current tax
recoverable in the same amount included in other assets on the Consolidated Balance Sheet) and recording a deferred tax benefit on the Consolidated Statement of Operations (also included on the
Consolidated Balance Sheet as a deferred tax asset) of $20.9 million for a minimum tax credit 46
carryforward. In 2006, TRH generated an additional $6.6 million deferred tax benefit from a minimum tax credit carryforward. The Company and its domestic subsidiaries, TRC (which includes foreign operations) and Putnam, filed consolidated federal income tax returns for the years under discussion, except those for 2006
which are not yet due. The tax burden among the companies is allocated in accordance with a tax sharing agreement. TRC also includes as part of its taxable income or loss those items of income of the
non-U.S. subsidiary, TRZ, which are subject to U.S. income tax currently, pursuant to Subpart F income rules of the Internal Revenue Code, and included, as appropriate, in the consolidated federal income
tax return. The effective tax rates, which represent the sum of current and deferred income taxes (benefits) divided by income (loss) before income taxes, were 20.7% in 2006, 182.2% in 2005 and 7.8% in 2004.
The major adjustments reconciling the expected tax expense to actual tax expense in each of the three years under discussion (as detailed in Note 4 of Notes to Consolidated Financial Statements) are
similar in terms of their nature and relative size, except that the adjustment for tax-exempt interest has increased as the size of the tax-exempt fixed maturity portfolio has grown in 2006 and 2005 over the
respective immediate prior year. With respect to the unusual effective tax rate in 2005, it is important to note that while the actual tax benefit derived from tax-exempt interest income and the dividends received deduction in 2005 is
not significantly different from 2006 and 2004, the percentage impact in the effective tax rate calculation from such items is significantly greater. The greater impact is caused by the fact that income (loss)
before income taxes (i.e., denominator in the effective tax rate calculation) is a lower absolute value in 2005 compared to 2006 and 2004, due largely to the greater amount of catastrophe costs in 2005. The
effective tax rate for 2006 reflects the fact that there were no significant net catastrophe costs during the year. Net income and net income per common share on a diluted basis, respectively, were as follows: 2006—$428.2 million, $6.46; 2005—$37.9 million, $0.57; 2004—$254.6 million, $3.85. Reasons for the changes
between years are as discussed earlier. (See Note 8 of Notes to Consolidated Financial Statements.) Segment Results (a) Domestic: 2006 compared to 2005—Domestic revenues increased from the prior year due primarily to increases in net premiums earned, for reasons similar to those discussed earlier in MD&A for the increase in net
premiums written, and, to a lesser extent, increased net investment income offset, in part, by a decrease in realized net capital gains. The increase in net premiums earned in 2006 occurred primarily in the
other liability, property, A&H and auto liability lines offset, in part, by a significant decrease in the surety line. The increase in net investment income in 2006 is due, in part, to investment returns from the
investment of the $745 million net proceeds from the issuance of the Senior Notes, continued positive operating cash flows and increases in investment income from limited partnerships. Income (loss)
before income taxes for 2006 increased due primarily to an increase in underwriting profit (loss) and, to a lesser extent, by increased net investment income. The increase in underwriting profit (loss) is
caused principally by decreased net catastrophe costs, which totaled $18.2 million in 2006 compared to $385.8 million in 2005. Both years included significant adverse development of losses occurring in prior
years, though such development was lower in 2006 then 2005, in certain more volatile casualty classes, as discussed earlier under Results of Operations. Assets increased $247 million in 2006 as increases in investments and cash were partially offset by reductions in reinsurance recoverable on paid and unpaid losses and LAE. The increase in investments
and cash was due largely to $445.4 million of net operating cash flows. 2005 compared to 2004—Domestic revenues decreased from the prior year due primarily to decreases in net premiums earned for reasons similar to those discussed earlier in MD&A for the decline in net
premiums written. The decrease in net premiums earned in 2005 compared to 2004 occurred primarily in the auto liability, medical malpractice and property lines. (Loss) income before 47
income taxes for 2005 decreased compared to the prior year due primarily to a decrease in underwriting profit (loss), slightly offset by increased net investment income and realized net capital gains, each in
2005. The decrease in underwriting profit (loss) is caused principally by increased net pre-tax catastrophe costs of $385.8 million in 2005, principally from Hurricanes Katrina, Rita and Wilma, compared to
$98.1 million in 2004. 2005 catastrophe costs include net ceded reinstatement premiums of $56.2 million. Both years included significant adverse development of losses occurring in prior years in certain
more volatile casualty classes, as discussed earlier under Results of Operations. In addition, Domestic assets increased approximately $2.0 billion in 2005 compared to year end 2004, primarily due to increased investments and cash of $1.1 billion, increased reinsurance recoverable
on paid and unpaid losses of $610 million (due, in part, to reinsurance recoverable related to 2005 catastrophe losses), and increased deferred and current income tax recoverables (current recoverable
included in other assets) totaling $141 million. The increase in investments and cash resulted principally from $745 million of net proceeds from the issuance of senior notes and $297 million of positive
operating cash flows. (b) International—Europe (London and Paris branches and TRZ): 2006 compared to 2005—Revenues decreased due principally to a decrease in net premiums earned in the London and Paris branches and, to a lesser extent, a decrease in realized net capital gains
(losses), partially offset by increased net investment income. Net premiums earned decreased principally in the auto liability, other liability and property lines offset, in part, by increases in the ocean marine,
A&H and credit lines. The decrease in net premiums earned is due, in part, to some weakness in market conditions and increased ceding company retentions. Income before income taxes for 2006 increased
due primarily to an increase in underwriting profit (loss) in the London branch and TRZ and, to a lesser extent, to increased net investment income in each location. The increase in underwriting profit
(loss) is caused principally by decreased net catastrophe costs, which totaled $16.9 million in 2006 compared to $119.6 million in 2005. Assets increased $1.37 billion in 2006 due largely to an increase of $1.1 billion in the short-term investment of funds received under securities loan agreements for reasons discussed in Financial
Condition and Liquidity and an increase of $400 million in fixed maturities available for sale reflecting significant positive operating cash flows in recent periods. 2005 compared to 2004—Net premiums written decreased due to decreases in the auto liability line, mostly in London and TRZ, offset by increases in the other liability, A&H, boiler and machinery and
ocean marine lines. European revenues increased compared to the prior year primarily due to increases in net investment income in each location. The increase in net investment income is due, in part, to
the investment of positive operating cash flows in recent periods. Income before income taxes for 2005 decreased compared to the prior year due primarily to a decrease in underwriting profit (loss) in each
of the locations, offset, in part, by increases in net investment income in each location. The decrease in underwriting profit (loss) is caused principally by increased net pre-tax catastrophe costs of $119.6
million in 2005, principally from Hurricanes Katrina and Rita, Central European floods and European Windstorm Erwin, compared to $26.3 million in 2004. 2005 catastrophe costs were tempered slightly by
$5.1 million of net assumed reinstatement premiums. Assets decreased $236 million due largely to a reduction in the short-term investment of funds received under securities loan agreements and the impact of the strengthening U.S. dollar in 2005 against
the currencies in which investments are denominated, partially offset by positive operating cash flows. (c) International—Other (Miami (serving Latin America and the Caribbean), Toronto, Hong Kong and Tokyo branches): 2006 compared to 2005—Revenues increased in 2006 due primarily to increases in net premiums earned in all branches, with the largest increases in the Miami and Toronto branches. These increases
generally occurred in the property line along with relatively minor increases spread among several other lines. The increased net premiums earned in the Miami branch benefited from favorable market
conditions in Latin America following significant catastrophe losses affecting the region in 2005. Income before income taxes increased in 2006 due to increases in underwriting profit (loss) and net
investment income. The increase in underwriting profit (loss) is caused in part by decreased net catastrophe costs, 48
which totaled ($6.4) million in 2006 compared to $38.5 million in 2005, and generally improved loss experience in 2006. Assets increased by $284 million in 2006 due principally to increases in reinsurance recoverable from affiliates on paid and unpaid losses and LAE, and increases in investments and cash. 2005 compared to 2004—Revenues increased in 2005 versus the prior year due primarily to increases in net premiums earned in most offices, with the largest increases in the Miami and Hong Kong
branches. These increases generally occurred in the auto liability and property lines. Income before income taxes increased in 2005 compared to the prior year due to increases in underwriting profit (loss).
The increase in underwriting profit (loss) is caused, in part, by decreased net pre-tax catastrophe cost, which totaled $38.5 million in 2005, principally from Hurricane Wilma, compared to $90.6 million in
2004. 2005 catastrophe costs include net ceded reinstatement premiums of $10.0 million. Financial Condition and Liquidity As a holding company, the Company’s assets consist primarily of the stock of TRC and the Company’s future cash flows depend on the availability of dividends or other statutorily permissible payments
from TRC and its wholly-owned operating subsidiaries, TRZ and Putnam. (See Note 14 of Notes to Consolidated Financial Statements for a discussion of restrictions on dividend payment.) In 2006 and
2005, the Company received cash dividends from TRC of $88.0 million and $36.5 million, respectively. The increase in such dividends in 2006 was primarily to allow the Company to make interest payments
on the Senior Notes. As of December 31, 2006, TRC could pay dividends to the Company of $305.9 million without regulatory approval. In 2005, TRC, the primary operating subsidiary, received a capital
contribution of $745 million from the Company. These funds were obtained by the Company in connection with its public offering of the Senior Notes. (See Note 6 of Notes to Consolidated Financial
Statements.) The Company uses cash primarily to pay interest to the holders of the Senior Notes and dividends to its common stockholders. Sources of funds for the operating subsidiaries consist primarily of premiums, reinsurance recoverables, investment income, proceeds from sales, redemptions and the maturing of investments and funds
received under securities loan agreements. Funds are applied by the operating subsidiaries primarily to payments of claims, ceded reinsurance premiums, insurance operating expenses, income taxes and
investments in fixed income and equity securities. Premiums are generally received substantially in advance of related claims payments. Cash and cash equivalents, which are principally interest-bearing, are
maintained for the payment of claims and expenses as they become due. TRH does not anticipate any material capital expenditures in the foreseeable future. While the expected payout pattern of liabilities (see contractual obligations table later in this section) is considered in the investment management process, it is not the only factor considered as TRH
has historically funded its claims payments from current operating cash flows. As a result of such funding history, TRH does not maintain a credit facility. TRH’s primary investment goal is to maximize
after-tax income through a high quality diversified taxable fixed maturity and tax-exempt municipal fixed maturity portfolio, while maintaining an adequate level of liquidity. See discussion later in this
section of the potential liquidity strain that could arise as a result of a significant acceleration of paid losses beyond TRH’s ability to fund such payments. At December 31, 2006, total investments and cash were $11,336.1 million compared to $9,241.8 million at December 31, 2005. The increase was caused, in large part, by $845.4 million of cash provided
by operating activities, $1,039.0 million of net funds received under securities loan agreements and by an increase of approximately $230 million due to the foreign exchange impact caused by the weakening
U.S. dollar against the currencies in which the investments are denominated during 2006. TRH’s fixed maturity investments, approximately 73.4% of total investments and cash as of December 31, 2006, are predominantly investment grade, liquid securities, approximately 97.4% of which
will mature in less than 10 years. The duration of the fixed maturity portfolio was 5.9 years as of December 31, 2006. Also as of that date, approximately 7.9% of total investments and cash were in common
and nonredeemable preferred stocks, approximately 1.6% of total investments and cash were in other invested assets, consisting of investments in limited partnerships, approximately 14.9% of total 49
investments and cash were in the short-term investment of funds received under securities loan agreements, approximately 0.4% of total investments and cash consisted of short-term investments and the
remaining 1.8% consisted of cash and cash equivalents. Based on the foregoing, TRH considers its liquidity to be adequate through the end of 2007 and thereafter for a period the length of which is difficult
to predict, but which TRH believes will be at least one year. Activity within the fixed maturities available for sale portfolio for the years under discussion generally represented strategic portfolio realignments to maximize after-tax income. TRH adjusts its mix of
taxable and tax-exempt investments, as appropriate, generally as a result of strategic investment and tax planning considerations. TRH purchases certain fixed maturities which are classified as held-to-
maturity and carried at amortized cost if TRH has the positive intent and ability to hold each of these securities to maturity. TRH purchased certain equities, which are classified as trading, to meet short
term investment objectives. In 2006, TRH increased its holdings in nonredeemable preferred stocks, consistent with its overall investment objectives. In addition, TRH engages in securities lending
transactions whereby certain securities (i.e., fixed maturities and common stocks available for sale) from its portfolio were loaned to third parties. (See Note 2(c) of Notes to Consolidated Financial
Statements.) In these transactions, initial collateral, principally cash, is received by TRH in an amount exceeding the fair value of the loaned security and is invested in a pooled account (shown on the
balance sheet at cost, which approximates fair value) of the lending agent, an AIG subsidiary, in these transactions. A liability is recorded in an amount equal to the collateral received to recognize TRH’s
obligation to return such funds when the related loaned securities are returned. The fair values of fixed maturities and common stocks available for sale that are on loan are reflected parenthetically as
pledged on the balance sheet and totaled $1,577.9 million and $41.2 million, respectively, as of December 31, 2006. The increase in short-term investment of funds received under securities loan agreements
in 2006 reflects increased demand to borrow securities denominated in certain European currencies. At December 31, 2006, gross unrealized gains and losses on all fixed maturities (including those held to maturity and carried at amortized cost) amounted to $189.4 million and $34.0 million,
respectively. At December 31, 2006, gross unrealized gains and losses on equities available for sale amounted to $59.9 million and $4.8 million, respectively. As of December 31, 2006, 95.6% of the fixed maturity portfolio was rated Aaa or Aa, 3.9% was rated A, an additional 0.4% was also rated investment grade and 0.1% was not rated. Also, as of
December 31, 2006, TRH had no derivative instruments. Generally, reserve changes result from the setting of reserves on current accident year business, the adjustment of prior accident year reserves based on new information (i.e., reserve development) and
payments of losses and loss adjustment expenses for which reserves were previously established. At December 31, 2006, gross loss reserves totaled $7.47 billion, an increase of $354.7 million, or 5.0% over 2005. The increase in gross loss reserves includes the impact of net changes in foreign currency
exchange rates since the end of 2005 and gross loss reserve development. 50
The components of gross loss reserves as of December 31, 2006 and 2005 by major class of business, split between reported (“case”) amounts and IBNR amounts is presented below: 2006 Casualty: Other liability Ocean marine and aviation Medical malpractice Auto liability Accident and health Surety and credit Other Total casualty Property: Fire Allied lines Auto physical damage Homeowners multiple peril Other Total property Total 2005 Casualty: Other liability Ocean marine and aviation Medical malpractice Auto liability Accident and health Surety and credit Other Total casualty Property: Fire Allied lines Auto physical damage Homeowners multiple peril Other Total property Total Gross loss reserves represent the accumulation of estimates for losses occurring on or prior to the balance sheet date. Gross loss reserves are principally based on reports and individual case estimates
received from ceding companies. The IBNR portion of gross loss reserves is based on past experience and other factors. The methods used to determine such estimates and to establish the resulting reserves
are continually reviewed and updated. Any adjustments are reflected in income currently. At December 31, 2006, reinsurance recoverable on gross loss reserves totaled $1.25 billion (a component of reinsurance recoverable on paid and unpaid losses on the Consolidated Balance Sheet which
is net of an allowance for uncollectible reinsurance recoverable of $12 million), a decrease of $161.1 million, or 11.4%, from the prior year end. The decrease in reinsurance recoverable on gross loss 51
reserves in 2006 was due, in part, to a decrease in reinsurance recoverable on ceded losses related to catastrophes occurring in 2005 offset, in part, by increases in reinsurance recoverable from affiliates. Of
the amount of reinsurance recoverable on paid and unpaid losses and LAE, which totaled $1.40 billion as of December 31, 2006, $666 million represented balances that were unsecured. Of such unsecured
balances, $155 million was due from affiliates (which are rated AA+) and 90% of the remaining balance was due from companies rated A– or better. (See Note 15 of Notes to Consolidated Financial
Statements.) Net loss reserves totaled $6.21 billion at December 31, 2006, an increase of $516.8 million, or 9.1%, from the prior year end. The increase in net loss reserves includes the impacts of net foreign currency
exchange rate changes of $159 million and net loss reserve development. 2006 included paid losses and LAE, net of reinsurance recovered, related to net catastrophe losses of approximately $240 million,
principally related to events occurring in 2005. An analysis of the change in net loss reserves from year-end 2005 to year-end 2006 is included in Note 5 of Notes to Consolidated Financial Statements. Net loss reserves include amounts for risks related to environmental impairment and asbestos-related illnesses totaling $124 million and $99 million at December 31, 2006 and 2005, respectively, including
$30 million and $27 million at the aforementioned dates, respectively, related to such losses occurring in 1985 and prior. As TRC, the major operating subsidiary of the Company, commenced operations in
1978, the great majority of TRH’s environmental and asbestos-related liabilities arose from contracts entered into after 1985 that were underwritten specifically as environmental or asbestos-related coverages
rather than as standard general liability coverages, where the environmental or asbestos-related liabilities were neither clearly defined nor specifically excluded. The reserves carried for these claims, including
IBNR, are based upon known facts and current law. However, significant uncertainty exists in determining the amount of ultimate liability for environmental impairment and asbestos-related losses,
particularly for those occurring in 1985 and prior. This uncertainty is due to inconsistent court resolutions and judicial interpretations with respect to underlying policy intent and coverage and uncertainties as
to the allocation of responsibility for resultant damages, among other things. Because the reserving process is inherently difficult and subjective, actual losses may materially differ from reserves and related reinsurance recoverables reflected in TRH’s consolidated financial
statements, and accordingly, may have a material effect on future results of operations. And while there is also the possibility of changes in statutes, laws, regulations and other factors that could have a
material effect on these liabilities and, accordingly, future earnings, TRH believes that its loss reserves carried at December 31, 2006 are adequate. See Critical Accounting Estimates for a discussion of the significant assumptions and factors considered in the reserve setting process. In the ordinary course of business, TRH is involved in lawsuits, arbitrations and other formal and informal dispute resolution procedures, the outcomes of which will determine TRH’s rights and
obligations under reinsurance agreements and other more general contracts. In some disputes, TRH seeks to enforce its rights under an agreement or to collect funds owing to it. In other matters, TRH is
resisting attempts by others to enforce alleged rights. Such disputes are resolved through formal and informal means, including litigation, arbitration and mediation. In all such matters, TRH believes that its positions are legally and commercially reasonable. TRH also regularly evaluates those positions, and where appropriate, establishes or adjusts loss reserves to
reflect its evaluation. TRH’s aggregate loss reserves take into account the possibility that TRH may not ultimately prevail in each and every disputed matter. TRH takes into consideration changes in
judicial interpretation of legal liability and policy coverages, changes in claims handling practices and inflation. TRH considers not only monetary increases in the cost of what it reinsures, but also changes
in societal factors that influence jury verdicts and case law, TRH’s approach to claim resolution, and, in turn, claim costs. TRH believes its aggregate loss reserves reduce the potential that an adverse
resolution of one or more of these matters, at any point in time, would have a material impact on TRH’s financial condition or results of operations. However, there can be no assurance that adverse
resolutions of such matters in any one period or in the aggregate will not result in a material adverse effect on TRH’s results of operations. 52
For 2006, TRH’s operating cash flows totaled $845.4 million, an increase of $215.1 million from 2005. The increase, which emanated mainly from domestic sources, is due, in large part, to increased
investment income received and increased recoveries of reinsurance recoverables, partially offset by interest paid on the Senior Notes. For 2005, TRH’s operating cash flows totaled $630.3 million, a decrease of $274.6 million from 2004. The decrease was caused largely by increased losses and LAE paid, due, in large part, to significant
catastrophe losses paid, relating mostly to events occurring in 2004, decreased premiums received, net of commissions, and the net purchase of equities, trading offset, in part, by increased investment
income collected and lower income taxes paid. As significant losses from catastrophes occurring in 2005 remain unpaid, TRH expects that payments related to these events will have a material adverse impact on operating cash flows in 2007 and
perhaps thereafter. If paid losses accelerated significantly beyond TRH’s ability to fund such paid losses from current operating cash flows, TRH would be compelled to liquidate a portion of its investment portfolio and/or
arrange for financing. Such events that may cause such a liquidity strain could be the result of several catastrophic events occurring in a relatively short period of time. Additional strain on liquidity could
occur if the investments sold to fund such paid losses were sold in a depressed marketplace and/or reinsurance recoverable on such paid losses became uncollectible. Of total consolidated operating cash flows, $400.1 million, $332.9 million and $583.7 million, were derived from international operations in 2006, 2005 and 2004, respectively. In each of such years,
London was the most significant source of international operating cash flows. TRH believes that its balance of cash and cash equivalents of $205.3 million as of December 31, 2006 and its future cash flows will be sufficient to meet TRH’s cash requirements through the end of
2006 and thereafter for a period the length of which is difficult to predict, but which TRH believes will be at least one year. TRH’s operations are exposed to market risk. Market risk is the risk of loss of fair value resulting from adverse fluctuations in interest rates, equity prices and foreign currency exchange rates. TRH’s
market risk exposures arise from the following: • Much of TRH’s capital is invested in fixed income or equity securities. TRH analyzes market risk using Value at Risk (“VaR”). VaR is a summary statistical measure that applies the estimated volatility and correlation of market factors of TRH’s market position. The
output from the VaR calculation is the maximum loss that could occur over a defined period of time given a certain probability. VaR measures not only the size of individual exposures but also the
interaction between different market exposures, thereby providing a portfolio approach to measuring market risk. While VaR models are relatively sophisticated, the quantitative market risk information generated is limited by the assumptions and parameters established in creating the related models. TRH believes
that statistical models alone do not provide a reliable method of monitoring and controlling market risk. Therefore, such models are tools and do not substitute for the experience or judgment of senior
management. TRH has performed VaR analyses to estimate the maximum potential loss of fair value for financial instruments for each type of market risk. In this analysis, financial instrument assets include all
investments and cash and accrued investment income. Financial instrument liabilities include unpaid losses and LAE and unearned premiums, each net of reinsurance, and the Senior Notes. TRH calculated the VaR with respect to net fair values for 2006 and 2005. The VaR number represents the maximum potential loss as of those dates that could be incurred with a 95% confidence (i.e.,
only 5% of historical scenarios show losses greater than the VaR figure) within a one-month holding period. TRH uses the historical simulation methodology that entails repricing all assets and liabilities
under explicit changes in market rates within a specific historical time period. TRH uses the most recent three years of historical market information for interest rates, equity index prices and 53
foreign currency exchange rates. For each scenario, each transaction was repriced. Scenario values are then calculated by netting the values of all the underlying assets and liabilities. The following table presents the year-end, average, high and low VaRs on a diversified basis and of each component of market risk for 2006 and 2005. The diversified VaR is usually smaller than the
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