Item 1: BUSINESS
Overview
Scottish Re Group Limited is a holding company incorporated under the laws of the Cayman Islands with our principal executive office in Bermuda. Through our operating subsidiaries, we are engaged in the reinsurance of life insurance, annuities and annuity-type products. These products are written by life insurance companies and other financial institutions located in the United States, as well as in many other countries around the world. We refer to this business as life reinsurance.
Since our formation in 1998, we have grown to be one of the three largest life reinsurers serving the United States (based on the gross face amount of ordinary life reinsurance business in force in 2004, together with the pro-forma results of the acquisition of the in-force individual life reinsurance business of ING America Insurance Holdings, Inc., which we call ING, on December 31, 2004). On December 22, 2003, we completed the acquisition of 95% of the outstanding capital stock of ERC Life Reinsurance Corporation. ERC Life Reinsurance Corporation's name was subsequently changed to Scottish Re Life Corporation. Scottish Re Life Corporation's business consists primarily of a closed block of traditional life reinsurance business. As of December 31, 2005, the number of lives we reinsured in North America was approximately 13.5 million and our gross face amount of in-force business was approximately $1.02 trillion. On December 31, 2001, we expanded our business outside of North America by acquiring World-Wide Holdings Limited and its subsidiary, World-Wide Reassurance Limited, which were both subsequently renamed Scottish Re Holdings Limited and Scottish Re Limited, respectively. Scottish Re Limited, formed in 1964, is a United Kingdom based reinsurer of group life insurance, individual life insurance and aircrew loss of license insurance in Asia, Europe, Latin America and the Middle East.
Effective December 31, 2004, we acquired the in-force individual life reinsurance business of ING. Pursuant to this transaction, Security Life of Denver Insurance Company and Security Life of Denver International Limited, both subsidiaries of ING, reinsured their in-force individual life reinsurance business to Scottish Re (U.S.), Inc. and Scottish Re Life (Bermuda) Limited on a 100% indemnity reinsurance basis. In addition, Security Life of Denver Insurance Company and Security Life of Denver International Limited transferred to us certain systems and operating assets used in their individual life reinsurance business.
Security Life of Denver Insurance Company and Security Life of Denver International Limited transferred assets of approximately $1.8 billion of their individual life reinsurance business to us and we recorded a corresponding amount of reserves for future policy benefits and other liabilities. Certain of the acquired assets are held in trust for the benefit of Security Life of Denver Insurance Company and Security Life of Denver International Limited to secure our liabilities on the acquired business. The ceding commission paid to us was placed in trust to secure our obligations under the indemnity reinsurance treaties and is subject to release upon our completion of long-term collateral arrangements with respect to the acquired business. In 2005, we completed such arrangements for a portion of the acquired business resulting in a pro-rata release of the ceding commission from the trust.
The acquired business represents the individual life reinsurance division of ING's U.S. life insurance operations, and was written through Security Life of Denver Insurance Company and Security Life of Denver International Limited. The acquired business mainly consists of traditional mortality risk reinsurance written on an automatic basis with more than 100 different ceding insurers. Less than 10% of the acquired business was written on a facultative basis. Most of the business involves guaranteed level premium term life insurance that is subject to the statutory reserve requirements of the Valuation of Life Insurance Policies Model Regulation XXX ("Regulation XXX") as well as universal life insurance that is subject to a similar statutory reserve requirement known as Regulation AXXX.
During 2005, we fully integrated the ING acquisition with our existing U.S. traditional business and migrated our Charlotte based policy administration operations to Denver. We now administer our combined business with an enhanced version of the ING policy administration system, known as SAGE. In addition, the Denver
operation relocated to new premises during the fourth quarter of 2005 and is supported by a technology infrastructure consistent with all of our units. The combination of technology with the experienced complement of approximately 90 life reinsurance administration professionals has created a scalable administrative platform for us.
We have operating companies in Bermuda, the Cayman Islands, Guernsey, Ireland, the United Kingdom and the United States, and a branch office in Singapore. Our flagship subsidiaries are Scottish Annuity & Life Insurance Company (Cayman) Ltd., Scottish Re (U.S.), Inc., Scottish Re (Dublin) Limited and Scottish Re Limited. See ratings section beginning on page 12 of this document for additional information on the above entities.
In 2005, we established Scottish Re Capital Markets, Inc., which is a registered broker dealer, formed to leverage the experience and expertise we have gained through our own efforts securitizing various reserve requirements. We believe Scottish Re Capital Markets, Inc. can successfully assist our clients, both large and small, to effectively and efficiently access the capital markets to meet their reserving needs. By doing so, we expect to develop stronger relationships with our clients and enhance our underwriting and structuring knowledge.
As of December 31, 2005, we had consolidated assets of $12.0 billion and consolidated shareholders' equity of $1.3 billion.
Our Business
Segments
We have three reportable segments: Life Reinsurance North America, Life Reinsurance International and Corporate and Other. The reinsurance operating segments write reinsurance business that is wholly or partially retained in one or more of our reinsurance subsidiaries.
In our Life Reinsurance North America segment, we provide solutions to insurance companies seeking reinsurance of life insurance, annuities and annuity-type products. We reinsure lines of business that may be subject to significant reserve or capital requirements by regulatory and rating agencies. We assume risks associated with primary life insurance policies and annuities, both in-force and new business. We reinsure: (i) mortality, (ii) investment, (iii) persistency and (iv) expense risks. We originate reinsurance business predominantly by marketing our products and services directly to United States life insurance and reinsurance companies.
Prior to 2005, our Life Reinsurance International segment specialized in niche markets in developed countries and broader life insurance markets in the developing world and focused on the reinsurance of short-term group life policies and aircrew "loss of license" insurance. In 2005, the Life Reinsurance International segment became actively engaged in the reinsurance of United Kingdom and Ireland traditional solutions business and annuity products. In addition, the Life Reinsurance International segment established a branch office in Singapore to reinsure similar risks in the Asian market. The life insurance and annuity products are similar to those offered in the Life Reinsurance North America Segment.
Our Corporate and Other segment includes investment income from invested assets not allocated to support reinsurance segment operations and undeployed proceeds from our capital raising efforts, in addition to realized investment gains or losses. General corporate expenses consist of unallocated overhead and executive costs and interest expense related to the 4.5% senior convertible notes and 1% dividend payment on the convertible preferred shares of our Hybrid Capital Units ("HyCUs"). Additionally, the Corporate and Other segment includes results from the wealth management operations, which directly issues variable life insurance and variable annuities and similar products to high net worth individuals and families, for insurance, investment and estate planning purposes.
Life Reinsurance
Reinsurance is an arrangement under which an insurance company known as the reinsurer agrees in a contract called a treaty to assume specified risks of another insurance company known as the ceding company. The reinsurer may assume all or a portion of the insurance underwritten by the ceding company. In exchange for
assuming the risks of the ceding company, the reinsurer receives some or all of the premium and, in certain cases, investment income derived from the assets supporting the reserves of the reinsured policies. Reinsurance permits primary insurers to diversify their risks over larger pools of risks and to write insurance policies in amounts larger than they are willing or able to retain. Also, reinsurers have the ability to structure treaties that allow the ceding companies to achieve other business and financial objectives such as:
o decreasing the volatility of their earnings by reducing their maximum exposure to any one risk,
o improving their capital position by reducing the financial strain associated with new business production or by increasing their risk-based capital ratios,
o entering new lines of business and offering new products, and
o exiting discontinued lines of business.
In addition, reinsurers may also purchase reinsurance, or "retrocession" coverage, to limit their own risk exposure.
We have two categories of life reinsurance business, which we call Traditional Solutions and Financial Solutions.
o Traditional Solutions. In our Traditional Solutions business, we reinsure the mortality risk on life insurance policies written by primary insurers. This business is often referred to as traditional life reinsurance. We write our Traditional Solutions business predominantly on an automatic basis with respect to newly written life insurance policies. This means that we automatically reinsure all policies written by a ceding company that meet the underwriting criteria specified in the treaty with the ceding company. Prior to 2005, the Life Reinsurance International segment offered traditional life reinsurance products outside of North America, focusing primarily on the reinsurance of short-term, group life policies in niche market sectors. In 2005, the Life Reinsurance International segment became actively engaged in the reinsurance of United Kingdom and Ireland traditional solutions business.
o Financial Solutions. In our Financial Solutions business, we offer reinsurance solutions that improve the financial position of our clients by increasing their capital availability and statutory surplus. These solutions include contracts under which we assume the investment and persistency risks of existing, as well as newly written, blocks of business. The products reinsured include annuities and annuity-type products, cash value life insurance and, to a lesser extent, disability products that are in a pay-out phase. This line of business also includes acquired solutions products in which we provide our clients with exit strategies for discontinued lines, closed blocks, or lines not providing a good fit for a client's growth strategies. With our assuming full responsibility and management of these contracts, our clients can focus and concentrate their full efforts and resources on their core strategies. Most of these agreements are coinsurance, coinsurance funds withheld, or modified coinsurance of primarily investment risk such that we recognize profits or losses primarily from the spread between the investment earnings and the interest credited on the underlying deposit liabilities.
The traditional life reinsurance industry has experienced significant growth over the past ten years. According to an industry survey, the face amount of traditional life reinsurance assumed in the United States has grown from approximately $261.0 billion in 1995 to approximately $1.0 trillion in 2004, a 15% compounded annual growth rate. During the same period, the face amount of life insurance written in the United States has grown from approximately $1.1 trillion in 1995 to approximately $2.0 trillion in 2004, a 7% compounded annual growth rate. Many of the international markets in which we operate have also enjoyed significant growth in recent years.
We believe that the following trends have contributed and will continue to contribute to the increasing demand for life reinsurance and increased business opportunities for us:
o Consolidation in the life insurance industry. Consolidation in the life insurance industry may create opportunities for life reinsurers. Life reinsurers provide financial reinsurance to help acquirers finance the cash portion of an acquisition, and we expect that any additional consolidation in the life insurance business may result in incremental opportunities for life reinsurers. In addition, in the context of an acquisition, an acquirer may focus on the most promising lines of business and divest non-core lines of business through reinsurance.
o Consolidation in the life reinsurance industry. There have been a number of merger and acquisition transactions within the life reinsurance industry in recent years. The consolidation of the life reinsurance industry has reduced the amount of life reinsurance capacity available and caused primary insurers to be exposed to concentrated counter-party risk with the larger consolidating reinsurers.
o Increased capital sensitivity. We believe that insurance companies are now more focused on capital efficiency and return on capital. As a result, primary insurers are increasingly utilizing the outside capital provided by reinsurance to help finance growth and to free up capital to pursue new businesses. Changing regulatory environments, in particular, in the United Kingdom and Continental Europe are accelerating this trend in the focus of capital.
o Expanding overseas markets. We believe that the trends described above in the North American market are also influencing the reinsurance industry throughout the world. In addition, we believe there are increasing opportunities in markets such as Asia, Europe, and the Middle East, where the life reinsurance industry is either developing or expanding.
o Changing demographics. We expect that the increasing number of "baby boomers" reaching middle and late middle age will increase the demand for products which address retirement planning, estate planning and survivorship issues. In addition, we believe that longer life expectancies and the reduction in government and employer sponsored benefit programs will increase the demand for life insurance and annuities. We expect this increased demand for insurance to increase demand for reinsurance products in the United States, United Kingdom, Ireland and Asia.
Wealth Management
Our variable life insurance and variable annuity products offer high net worth clients the benefits of investment-oriented insurance products for use in tax and estate planning. We receive fee income based on the assets associated with our products. Our products are targeted towards high net worth individuals and families who generally have a liquid net worth of more than $10.0 million. The wealth management business requires relatively little capital. We no longer actively market this business.
Solutions for Regulation XXX Reserves
Background
The Valuation of Life Insurance Policies Model Regulation, commonly referred to as Regulation XXX, was implemented in the United States for various types of life insurance business beginning January 1, 2000. Regulation XXX significantly increased the level of reserves that United States life insurance and life reinsurance companies must hold on their statutory financial statements for various types of life insurance business, primarily certain level term life products. The reserve levels required under Regulation XXX increase over time and are normally in excess of reserves required under Generally Accepted Accounting Principles in the United States ("US GAAP"). In situations where primary insurers have reinsured business to reinsurers that are unlicensed and unaccredited
in the United States, the reinsurer must provide collateral equal to its reinsurance reserves in order for the ceding company to receive statutory financial statement credit. Reinsurers have historically utilized letters of credit or have placed assets in trust for the benefit of the ceding company as the primary forms of collateral. The increasing nature of the statutory reserves under Regulation XXX will likely require increased levels of collateral from reinsurers in the future to the extent the reinsurer remains unlicensed and unaccredited in the United States. We believe that funding long duration liabilities with shorter-term funding facilities is not suitable or sustainable from a prudent asset liability management perspective because it creates significant refinancing or rollover risk every year.
In order to mitigate the effect of Regulation XXX, we retrocede Regulation XXX reserves to unaffiliated and affiliated unlicensed reinsurers. In our United States domiciled subsidiaries, statutory capital may be significantly reduced if the unaffiliated or affiliated reinsurers were unable to provide the required collateral to support statutory reserve credit and we could not find an alternative source for collateral. In the normal course of business and our capital planning, we are always looking for opportunities to relieve capital strain relating to Regulation XXX statutory reserve requirements. We entered into a number of financing transactions in 2004 and 2005 which secure long-term funding for a large portion of our XXX collateral requirements.
Acquired ING Business
Pursuant to the terms of the acquisition of the individual life reinsurance business of ING, ING is obligated to maintain collateral for the Regulation XXX and AXXX statutory reserve requirements of the acquired business for the duration of such requirements. We pay ING a fee based on the face amount of the collateral provided until satisfactory alternative collateral arrangements are made. We are entitled to a partial rebate of this fee to the extent satisfactory alternative collateral arrangements are implemented prior to the end of 2007.
In 2005, we completed two transactions that together provided approximately $2.0 billion in alternative collateral arrangements to fund Regulation XXX statutory reserve requirements that were assumed in connection with the acquisition of ING's individual life reinsurance business.
The first transaction is a 20-year collateral finance facility with HSBC Bank USA, N.A. ("HSBC II") that provides up to $1.0 billion of collateral to satisfy Regulation XXX statutory reserve requirements and is in addition to the facility with HSBC that was originally completed in 2004. The other arrangement is a long-term reinsurance facility ("Reinsurance Facility") with a third party Bermuda reinsurer which provides collateral to secure Regulation XXX statutory reserve requirements in an amount up to $1.0 billion. The Bermuda reinsurer provides security in the form of letters of credit in trust equal to the statutory reserves. These transactions have allowed us to secure within twelve months of the ING acquisition long-term cost effective financing for approximately 40% of the Regulation XXX reserves business acquired from ING. The HSBC II and the Reinsurance Facility transactions replaced ING collateral and resulted in a refund from ING for fees incurred during 2005 of $6.7 million. Additionally, we believe the transactions demonstrate our ability to quickly integrate a block of acquired business and secure permanent funding.
Scottish Re (U.S.), Inc. Organic Business
On February 11, 2005, we issued $850 million of 30-year maturity securities from our newly formed wholly-owned subsidiary, Orkney Holdings, LLC. Proceeds from this transaction fully fund Regulation XXX reserves associated with business written by Scottish Re (U.S.), Inc. between January 1, 2000 and December 31, 2003. This securitization successfully matches the long-term requirements imposed by Regulation XXX at a cost comparable to short-term pricing. The securities have recourse to Orkney Holdings, LLC and not to any other Scottish Re entity.
On December 21, 2005, we completed our second securitization of excess reserves arising from Regulation XXX by issuing $450.0 million of 30-year maturity securities through an orphaned special purpose vehicle incorporated under the laws of Ireland, Orkney Re II, plc. Proceeds from this transaction fully fund Regulation XXX
reserves associated with business written by Scottish Re (U.S.), Inc. between January 1, 2004 and December 31, 2004. The securities have recourse to Orkney Re II plc and not to any Scottish Re entity.
In 2004 we entered into a 20-year collateral finance facility with HSBC Bank USA, N.A. ("HSBC I") that provides $200.0 million that can be used to satisfy Regulation XXX statutory reserve requirements and collateralize reinsurance obligations under intercompany reinsurance agreements.
In January 2005, we completed another capital markets collateral facility called the Stingray Pass-Through Trust in an aggregate amount of $325.0 million. Under the terms of the agreement, we acquired an irrevocable put option to issue funding agreements up to $325.0 million. The facility also provides collateral for Scottish Re (U.S.), Inc. for reinsurance obligations under intercompany quota share reinsurance agreements.
In the future, we anticipate implementing other capital markets related solutions relating to the financing of our statutory reserve requirements as cost efficient opportunities arise.
Our Strategy
Our strategy is to use our experience and structural advantages to focus on life reinsurance and insurance products where we can deliver specialized advice and products to our customers. We plan to increase the value of our franchise by focusing on the following:
o Expanding the size and depth of our North American reinsurance client base. We will continue to expand our core North American business by attempting to gain a larger share of the North American life reinsurance market both by adding new clients and expanding the business relationships with existing clients. We will leverage the ING acquisition and the sophisticated technology and experienced life reinsurance administration professionals obtained which created a scalable administrative platform.
o Acquisitions. We may pursue selected strategic acquisitions of other life reinsurance businesses. Our recent acquisition of the in-force individual life reinsurance business of ING is an example of this strategy.
o Growing our international business. We will continue to leverage our specialized knowledge and established relationships to gain a larger share of the life reinsurance markets outside of North America. We will explore opportunities in new markets, particularly Asia, as well as seeking to add new clients and expand business relationships with existing clients.
o Maximizing the convergence between the insurance industry and capital markets. We will continue to develop and execute securitizations and other capital markets initiatives to decrease our cost of capital and expand our access to a larger client and product base.
o Enhancing our financial strength. We will continue to enhance our capital position and financial strength to meet the security needs of our customers and the capital requirements of rating agencies. By enhancing our financial strength and capital resources, we would expect to have opportunities to participate in reinsurance transactions in which we might not be currently eligible to participate. We also expect that enhancing our financial position will allow us to reduce our cost of, and improve our access to, capital.
o Leveraging efficient operating structure and organizational flexibility. We will continue to leverage our ability to conduct business in multiple jurisdictions, which provides us with a flexible and efficient operating platform. Moreover, as we grow our businesses and leverage the capabilities of our corporate infrastructure, we expect to improve our operating margins.
Products Offered
Life Reinsurance North America
In our Life Reinsurance North America segment, we reinsure a broad range of life insurance and annuity products. Life insurance products that we reinsure include yearly renewable term, term with multi-year guarantees, ordinary life and variable life. Retail annuity products that we reinsure include fixed immediate annuities, fixed deferred annuities and equity indexed annuities. In addition, we reinsure and may issue directly institutional annuity-type products such as funding agreements, guaranteed investment contracts, pension termination and structured settlement annuities.
For these products, we write reinsurance generally in the form of yearly renewable term, coinsurance or modified coinsurance. Under yearly renewable term, we share only in the mortality risk for which we receive a premium. In a coinsurance or modified coinsurance arrangement, we generally share proportionately in all material risks inherent in the underlying policies including mortality, lapses and investments. Under such agreements, we agree to indemnify the primary insurer for all or a portion of the risks associated with the underlying insurance policy in exchange for a proportionate share of premiums. Coinsurance differs from modified coinsurance with respect to the ownership of the assets supporting the reserves. Under our coinsurance arrangements, ownership of these assets is transferred to us, whereas, in modified coinsurance arrangements, the ceding company retains ownership of these assets, but we share in the investment income and risk associated with the assets.
Our reinsurance treaties are written predominantly on an automatic basis. An automatic treaty provides for a ceding company to cede contractually agreed-upon risks on specific blocks of business to us. The reinsurance may be solicited directly by us or through reinsurance intermediaries and may be written on either:
o a proportional basis under which a specified percentage of each risk in the reinsured class of risk is assumed by us from the ceding company, along with our portion of the underlying premiums in proportion to such assumed risk; or
o an excess of retention basis under which we indemnify the ceding company, up to a contractually specified amount, for a portion of claims exceeding a specified retention amount, in consideration of non-proportional premiums being paid.
In order to diversify our mortality exposure, we have historically sought to limit our consolidated enterprise wide retained exposure under life policies to no more than $500,000 per life for life reinsurance written in our North American operations. This limit was increased to $1.0 million per life for newly underwritten business effective January 1, 2005. Our retention on business acquired in the ING individual life reinsurance acquisition is $2.0 million per life.
Our reinsurance treaties may provide for recapture rights, permitting the ceding company to reassume all or a portion of the risk ceded to us after an agreed-upon period of time (generally 10 years), subject to certain other conditions. Some of our reinsurance treaties allow the ceding company to recapture the ceded risk if we fail to maintain a specified rating or if other financial conditions relating to us are not satisfied. Recapture of business previously ceded does not affect premiums ceded prior to the recapture of such business and typically involves the payment of a recapture fee to us. Nevertheless, we may need to liquidate substantial assets in order to return the assets supporting the reserves to the ceding company, and we may also have to accelerate the amortization of unamortized deferred acquisition costs associated with the recaptured business, which would reduce our earnings.
The potential adverse effects of recapture rights are mitigated by the following factors:
o By recapturing reinsurance, ceding companies increase the amount of risk they retain.
o Ceding companies generally must recapture the same amount of risk on each policy reinsured under a treaty once a retention increase is made after the treaty stated non-recapture period expires and a recapture program is undertaken.
o We price our treaties with the goal of achieving our target return before the recapture date.
Life Reinsurance International
Historically, we reinsured life insurance and aircrew loss of license products. Life insurance products that we reinsured included short-term group and individual life, and to a lesser extent, disability and critical illness. Our current focus is the reinsurance of United Kingdom, Ireland and Asia traditional solutions business as well as annuity products. We will continue to provide products on a facultative basis and will expand our capability to reinsure a broad range of life insurance and annuity products on an automatic treaty basis in our Life Reinsurance International segment.
Historically, our principal international market was the Middle East, where we have been active since the early 1990s. In 2005, approximately 29% of total written premiums in the international business originated from Bahrain, Jordan, Kuwait, Lebanon, Oman, Qatar, Saudi Arabia and the United Arab Emirates.
In Asia, our historical target niche market was Japan, which is experiencing the development of small affinity group mutual organizations known as kyosai, as a parallel sector to large insurance companies. We are now currently focusing our efforts in other countries such as Korea, Taiwan and China.
As noted above, we reinsure aircrew loss of license coverage, which entails the payment of lump sum benefits if aircrew cannot perform their job for medical reasons, as well as temporary benefits for the period of time during which the aircrew is grounded and waiting for the results of the medical examination.
We attempt to diversify mortality risk in our Life Reinsurance International segment by limiting our consolidated enterprise wide retained exposure under life policies to no more than $250,000 per life for our International life reinsurance business.
Wealth Management
Our wealth management business consists of the issuance of variable life insurance policies and variable annuities and similar products to high net worth individuals and families. Premiums, net of expenses, paid by the policyholder with respect to our variable products are placed in a separate account for the benefit of the policyholder. We invest premiums in each separate account with one or more investment managers, some of whom the policyholder may recommend and all of whom are appointed by us in our sole discretion. The policyholder retains the benefits of favorable investment performance, as well as the risk of adverse investment results. Assets held in the separate accounts are generally not subject to the claims of our general creditors. We do not provide any investment management or advisory services directly to any individual variable life or variable annuity policyholder. Our revenues earned from these policies consist of insurance and administrative fees assessed against the assets in each separate account. Our variable products do not guarantee investment returns. We are no longer actively marketing this business. Our wealth management business is included in the Corporate and Other segment.
See Notes to the Consolidated Financial Statements for more information on our Life Reinsurance North America, Life Reinsurance International and Corporate and Other segments.
Marketing
In our life reinsurance business, we market to life insurance and life reinsurance companies. We also target institutions, such as pension plans, that have life insurance-related risks and that we believe would benefit from our reinsurance products based on our analysis of publicly available information and other industry data. Where permitted by law, we actively market our reinsurance products primarily on a direct basis. We also seek to capitalize on the relationships developed by our executive officers and marketing staff with members of the actuarial profession and senior insurance company executives, at both primary insurers and other reinsurers. Finally, we
work with reinsurance intermediaries, brokers and consultants who are engaged in obtaining reinsurance on behalf of their clients.
Risk Management
Life Reinsurance
We bear five principal classes of risk in our life reinsurance products:
o mortality risk,
o investment risk,
o persistency risk,
o expense risk, and
o counter-party risk.
Mortality risk is the risk that death claims exceed what we expect. A greater frequency or higher average size of death benefits than we expected can cause us to pay greater death benefits, adversely affecting our profitability. Even if the total death benefits paid over the life of our contracts do not exceed the expected amount, sporadic timing of deaths can cause us to pay more death benefits in a given time period than expected, adversely impacting our
profitability in that period. We address these risks through selection, diversification and retrocession. We analyze each block of business based on an evaluation of the ceding company's history, management, target market, products and underwriting criteria relative to the industry. In North America, we target primarily first dollar quota share pools of top producing direct writing companies so that we participate proportionately with other reinsurers on all of the ceded risks. In addition, we diversify our risks by participating in annuity and disability products in the payout stage where the mortality risk is the risk of deaths occurring later, rather than earlier, than expected. A mix of these products with life products can help offset general trends in population mortality. We mitigate our risk of exposure to any one block of business or any one individual life by selectively limiting our share to any one pool. We further address the risk of any one large claim by utilizing retrocession above our retention of $1.0 million per life, effective January 1, 2005, for newly underwritten business written in our Life Reinsurance North America Segment. Our retention on business acquired in the ING individual life reinsurance acquisition is $2.0 million per life. Our retention in our Life Reinsurance International Segment is approximately $250,000 per life. In addition, we maintain catastrophe cover on our entire retained life reinsurance business, which, effective January 1, 2005, provides reinsurance for losses of $50.0 million in excess of $10.0 million for our North American risks, and $57.5 million in excess of $2.5 million for our International risks. This catastrophe cover includes protection for terrorism, nuclear, biological and chemical risks.
Our investments, which primarily consist of fixed income securities, are subject to market value, reinvestment and liquidity risk. Our invested assets are funded not only by capital but also by the proceeds of reinsurance transactions, some of which entail substantial deposits of funds or assets. The policies that we reinsure contain provisions that tend to increase benefits to customers depending on movements in interest rates. We analyze the potential results of a transaction, including the cash flows of the liabilities and of the related assets and any risk mitigation measures, and we price transactions to cover our costs, including estimated credit losses, and earn a desirable risk-adjusted return under various scenarios. We use interest rate swaps and may use other hedging instruments as tools to mitigate these risks. We may also retrocede some risks to other reinsurers.
Persistency risk is the risk that policyholders maintain their policies for either longer or shorter periods than expected. Persistency can be affected by surrenders and policy lapses. Surrenders are the voluntary termination of a policy by the policyholder and lapses are the termination of the policy due to non-payment of the premium. Surrenders usually involve the return of the policy's cash surrender value to the policyholder. The risk is that actual persistency is significantly different from the persistency we assumed in pricing. Persistency significantly higher than priced for can cause us to pay greater than expected death benefits in future years, adversely impacting our profitability. Persistency significantly lower than priced for can cause our deferred acquisition costs to be unrecoverable, possibly causing loss recognition that would adversely impact our profitability. For policies with cash surrender benefits, surrenders significantly greater than expected will also cause increased liquidity risk. We address these risks through diversification and surrender charges.
Expense risk is the risk that actual expenses will be higher than those covered in pricing. The risk is that expenses per policy reinsured are higher as a result of a lower number of policies than anticipated, or that our operations are less efficient than anticipated. We address this risk through the use of automation and management of general expenses.
Counter-party risk is the risk that retrocessionaires will be unable to pay claims as they become due. We limit and diversify our counter-party risk by spreading our retrocession over a pool comprised of highly rated retrocessionaires. Our underwriting guidelines provide that any retrocessionaire to whom we cede business must have a financial strength rating of at least "A-" or higher from A.M. Best or an equivalent rating by another major rating agency. However, even if a retrocessionaire does not pay a claim submitted by us, we are still responsible for paying that claim to the ceding company.
Wealth Management
The two principal risks associated with our wealth management business are mortality risk and counter-party risk. Since we do not have the direct investment risks associated with our wealth management products, the principal risk in our variable life insurance business is mortality risk. Mortality risk tends to be more stable when spread across large numbers of insureds. We expect that our variable life insurance policies will have relatively large face amounts and will be held by a relatively small number of policyholders. Consequently, our associated mortality risk exposure will be greater in the aggregate, and our probability of loss less predictable, than an insurer with a broader risk pool. Therefore, pursuant to our underwriting guidelines, we reinsure substantially all of the mortality risk associated with our variable life insurance business with highly rated reinsurers and accordingly rely upon our reinsurers' obligation and ability to pay death claims. The counter-party risk is that one or more of our reinsurers may fail to pay a reinsured death claim under a variable life insurance policy.
Investment Portfolio
General
Our general account investment portfolio consists of investments and cash and cash equivalents, which we control, and funds withheld at interest, which are associated with modified coinsurance agreements. In most modified coinsurance transactions, the ceding insurance company retains the assets supporting the ceded business and manages them for our account. Although the ceding company must adhere to investment guidelines agreed to by us for the management of these assets, we do not control the selection of the specific investments or the timing of the purchase or sale of investments made by the ceding company.
Our general account portfolio consists primarily of investment-grade fixed income securities and cash. We seek to generate attractive levels of investment income while limiting exposure to risks of changing interest rates, excess default experience and adverse changes in asset values. Third party investment managers manage the portfolio. We manage the activities of the managers in an asset-liability management framework, setting duration targets and other investment guidelines for each portfolio segment. We also set investment policy and strategy, monitor compliance and evaluate results in relation to customized benchmarks.
Investment Oversight
Our Finance and Investment Committee reviews our investment portfolio and the performance of our investment managers. In addition, our Finance and Investment Committee approves changes in the investment policy proposed by management and oversees compliance with the investment policy.
Investment Policy
Our investment policy includes limits requiring diversification by asset class, fixed income sector and single issuers and limits exposure to lower-rated securities. It also limits reinvestment risk and requires effective asset-liability management processes including the maintenance of adequate liquidity to meet potential cash outflows and management of exposures to market risks.
We are exposed to three primary sources of investment risk on fixed income investments: market value, reinvestment and liquidity risk. Market value risk is the risk that our invested assets will decrease in value due to a change in the prevailing market yields for similar assets, an unfavorable change in the liquidity of the investment or an unfavorable change in the financial prospects or a downgrade in the credit rating of the issuer of the investment. Reinvestment risk is the risk that interest rates will decline and funds reinvested will earn less than expected. Liquidity risk is the risk that liabilities are surrendered or mature sooner than anticipated, requiring us to sell assets at an undesirable time to provide for policyholder surrenders or withdrawals.
We manage these risks through industry and issuer diversification, overall limits on the amounts of credit risk taken and asset-liability management, which we refer to as ALM. Our primary ALM practices include:
o modeling the cash flows necessary to service each existing and newly written reinsurance liability, considering various interest rate scenarios;
o segmenting portfolios backing material reinsurance transactions and creating customized investment guidelines engineered to support the cash flows for each transaction;
o evaluating and quantifying the risks to earnings and the economic value of shareholders' equity created by gaps between the projected cash flows from existing assets and those required by in-force liabilities; and
o reducing the risks caused by mismatches by opportunistically buying matching new investments.
We generally use foreign denominated securities to manage currency risk if the related reinsurance transaction is denominated in a foreign currency. We may enter into interest rate swaps, futures, forwards and other hedging transactions to manage our risks. We currently use derivatives only to manage interest rate risk rather than as a speculative investment.
Competition and Ratings
Competition in the life reinsurance industry is based on price, financial strength ratings, reputation, experience, relationships and service. We consider Swiss Re, Reinsurance Group of America, Transamerica Reinsurance, Generali USA Life Re and Munich American Reassurance Company to be our primary competitors in the United States. In other markets outside the United States, our competitors include XL Capital Ltd., Max Reinsurance Ltd. and PartnerRe Ltd.
Insurance ratings are used by prospective purchasers of insurance policies, insurers and reinsurance intermediaries in assessing the financial strength and quality of insurers and reinsurers. Rating organizations periodically review the financial performance and condition of insurers, including our insurance subsidiaries.
Rating organizations assign ratings based upon several factors. While most of the factors considered relate to the rated company, some of the factors take into account general economic conditions and circumstances outside the rated company's control. Our insurer financial strength ratings are listed in the table below for each rating agency that meets with our management on a regular basis:
* Negative outlook
A.M. Best: "A- (excellent)" is fourth highest of sixteen rating levels. A.M. Best assigns an "A- (excellent)" rating to companies that have, in its opinion, on balance, excellent balance sheet strength, operating performance and business profile, as well as a strong ability to meet their ongoing obligations to policyholders. A.M. Best maintains a letter scale rating system ranging from "A++ (superior)" to "F (in liquidation)."
Fitch: "A (strong)" is sixth highest of twenty-two rating levels. Fitch assigns an "A (strong)" or "A- (strong)" rating to companies that it characterizes as having, in its opinion, strong capacity to meet policyholder and contract obligations and moderate risk factors and where the impact of any adverse business and economic factors is expected to be small. Fitch's insurer financial strength ratings range from "AAA (exceptionally strong)" to "D (distressed)."
Moody's: "A3 (good)" is the seventh highest designation of Moody's Investors Service ("Moody's") twenty-one rating levels. Moody's assigns an "A3 (good)" rating to companies that offer, in its opinion, good financial security, but possess elements that suggest a susceptibility to impairment sometime in the future. Moody's long term insurance financial strength ratings range from "Aaa (exceptional)" to "C (lowest)."
Standard & Poor's: "A- (strong)" is seventh highest of twenty-two rating levels. Standard & Poor's assigns an "A- (strong)" rating to companies that have, in its opinion, a strong capacity to meet financial commitments, but are somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than insurers with higher ratings. Standard & Poor's insurer financial strength ratings range from "AAA (extremely strong)" to "R (under regulatory supervision)."
The ability to write reinsurance partially depends on an insurer's financial condition and its financial strength ratings. These ratings are based on an insurance company's ability to pay policyholder obligations and are not directed toward the protection of investors. Each of our credit ratings is considered investment grade. Our ability to raise capital for our business and the cost of this capital is influenced by our credit ratings. A security rating is not a recommendation to buy, sell or hold securities. It is subject to revision or withdrawal at any time by the assigning rating organization, and each rating should be evaluated independently of any other rating.
Employees
As of February 28, 2006, we employed approximately 369 full time employees, none of whom are unionized. We believe our relations with our employees are good.
Regulation
General U.S. State Supervision
Various state insurance departments enforce insurance and reinsurance regulation. The extent and nature of regulation varies from state to state. Scottish Re (U.S.), Inc. is a Delaware-domiciled reinsurer, which is licensed, accredited, approved or authorized to write reinsurance in 50 states and the District of Columbia. Scottish Re Life Corporation is a Delaware-domiciled reinsurer, which is licensed, accredited, approved or authorized to conduct reinsurance in 50 states, the District of Columbia, Guam and the Federated States of Micronesia. Orkney Re, Inc. is a special purpose financial captive insurance company formed under the laws of South Carolina.
Insurance Holding Company Regulation
We and our subsidiaries, Scottish Re (U.S.), Inc. and Scottish Re Life Corporation, are subject to regulation under the insurance holding company laws of Delaware. The insurance holding company laws and regulations vary from state to state, but generally require insurers and reinsurers that are subsidiaries of insurance holding companies to register and file with state regulatory authorities certain reports including information concerning their capital structure, ownership, financial condition and general business operations. Generally, all transactions between Scottish Re (U.S.), Inc. and/or Scottish Re Life Corporation and their affiliates must be fair and, if material or of a certain kind, require prior notice and approval or non-disapproval by the Delaware state insurance department. Orkney Re, Inc. is not subject to the South Carolina insurance holding company act, but it is required to obtain the approval of the South Carolina Director of Insurance before it may materially amend any agreements to which it is a party, enter into any new agreements or otherwise amend its business plan. State insurance holding company laws typically place limitations on the amounts of dividends or other distributions payable by insurers and reinsurers.
State insurance holding company laws also require prior notice or state insurance department approval of changes in control of an insurer or reinsurer or its holding company. The insurance laws of Delaware provide that no person, including a corporation or other legal entity, may acquire control of a domestic insurance or reinsurance company unless it has given notice to such company and obtained prior written approval of the state insurance commissioner. Any purchaser of 10% or more of the outstanding voting securities of an insurance or reinsurance company or its holding company is presumed to have acquired control, unless this presumption is rebutted. In addition, many state insurance laws require prior notification to the state insurance department of a change in control of a non-domiciliary insurance company licensed to transact insurance business in that state. While these pre-notification statutes do not authorize the state insurance departments to disapprove the change in control, they authorize regulatory action in the affected state if particular conditions exist such as undue market concentration. Any future transactions that would constitute a change in control of Scottish Re (U.S.), Inc. and Scottish Re Life Corporation or any of their U.S. insurance subsidiaries may require prior notification in the states that have adopted pre-acquisition notification laws. These prior notice and prior approval laws may discourage potential acquisition proposals and may delay, deter or prevent a change of control of us, including transactions that some or all of our shareholders might consider to be desirable.
Dividend Restrictions
State insurance holding company laws typically place limitations on the amounts of dividends or other distributions payable by insurers and reinsurers. Delaware provides that, unless the prior approval of the state insurance commissioner has been obtained, dividends may be paid only from earned surplus and the maximum annual amount payable is limited to the greater of 10% of policyholder surplus at the end of the prior year or 100% of statutory net gain from operations for the prior year.
Orkney Re, Inc. may only pay dividends in accordance with restrictions and guidelines contained in its licensing order issued by the South Carolina Director of Insurance. Any dividends Orkney Re, Inc. pays are subject to the lien of the indenture relating to the long-term debt of its parent entity, Orkney Holdings, LLC.
U.S. Reinsurance Regulation
Scottish Re (U.S.), Inc., Scottish Re Life Corporation and Orkney Re, Inc. are subject to insurance regulation and supervision that in many respects is similar to the regulation of licensed primary insurers. Generally, state regulatory authorities monitor compliance with, and periodically conduct examinations regarding, state mandated standards of solvency, licensing requirements, investment limitations, restrictions on the size of risks which may be reinsured, deposits of securities for the benefit of reinsureds, methods of accounting, and reserves for unearned premiums, losses and other purposes. However, in contrast with primary insurance policies, which are regulated as to rate, form, and content, the terms and conditions of reinsurance agreements are generally not subject to regulation by state insurance regulators.
The ability of any primary insurer to take credit for the reinsurance placed with reinsurers is a significant component of reinsurance regulation. Typically, a primary insurer will only enter into a reinsurance agreement if it can obtain credit on its statutory financial statements for the reinsurance ceded to the reinsurer. Credit is usually granted when the reinsurer is licensed, accredited, approved or authorized to write reinsurance in the state where the primary insurer is domiciled. In addition, many states allow credit for reinsurance ceded to a reinsurer if the reinsurer is licensed in another jurisdiction and meets certain financial requirements, or if the primary insurer is provided with collateral in the form of letters of credit, trusts or funds withheld contracts to secure the reinsurer's obligations.
U.S. Reinsurance Regulation of our Non-U.S. Reinsurance Subsidiaries
Our non-U.S. reinsurance subsidiaries also assume reinsurance from primary U.S. insurers. In order for primary U.S. insurers to obtain financial statement credit for the reinsurance obligations of our non-U.S. reinsurers, our non-U.S. reinsurance subsidiaries must satisfy reinsurance requirements. Non-U.S. reinsurers that are not licensed in a state generally may become accredited by filing certain financial information with the relevant state commissioner and maintaining a U.S. trust fund for the payment of valid reinsurance claims. In addition, many states allow credit for reinsurance ceded to unlicensed and unaccredited reinsurers if the primary insurer is provided with collateral in the form of letters of credit, trusts or funds withheld contracts to secure the reinsurer's obligations.
U.S. Insurance Regulation of our Non-U.S. Insurance Subsidiaries
Our non-U.S. insurance subsidiaries that sell wealth management products are not licensed to conduct insurance business in any jurisdiction in the United States. Therefore, they cannot utilize traditional life insurance marketing channels such as agents, nor can they use mail-order or other direct marketing channels to conduct business with persons in the United States or certain other jurisdictions. Accordingly, they rely primarily on referrals by financial advisors, investment managers, private bankers, attorneys and other intermediaries in the United States to generate wealth management business. None of these intermediaries represents us as agent or in any other capacity, nor do they receive any commissions or other remuneration from us for activities undertaken in the United States. In addition, policy solicitation, issuance and servicing must occur outside of the United States.
NAIC Ratios
The National Association of Insurance Commissioners, which we refer to as the NAIC, has developed a set of financial relationships or tests known as the NAIC Insurance Regulatory Information System to assist state regulators in monitoring the financial condition of insurance companies and identifying companies that require special attention or action by insurance regulatory authorities. A second set of confidential ratios, called Financial Analysis Solvency Tracking System, "FAST," is also used for monitoring. Insurance companies generally submit data quarterly to the NAIC, which in turn analyzes the data using prescribed financial data ratios, each with defined "usual ranges." If an insurance company's results vary significantly from usual ranges, regulators may make further inquiries. Regulators have the authority to impose remedies ranging from increased monitoring to certain business limitations to various degrees of supervision. Our U.S. reinsurance subsidiaries are not currently subject to increased regulatory scrutiny based on our ratios, as computed under these systems.
Statutory accounting principles
United States Statutory Accounting Principles, or SAP, are a basis of accounting developed by U.S. insurance regulators to monitor and regulate the solvency of insurance companies. In developing SAP, insurance regulators were primarily concerned with assuring an insurer's ability to pay all its current and future obligations to policyholders. As a result, statutory accounting focuses on conservatively valuing the assets and liabilities of insurers, generally in accordance with standards specified by the insurer's domiciliary jurisdiction. Uniform statutory accounting practices are established by the NAIC and generally adopted by regulators in the various U.S. jurisdictions. These accounting principles and related regulations determine, among other things, the amounts our insurance subsidiaries may pay to us as dividends.
U.S. GAAP is designed to measure a business on a going-concern basis. It gives consideration to matching of revenue and expenses and, as a result, certain expenses are capitalized when incurred and then amortized over the life of the associated policies. The valuation of assets and liabilities under U.S. GAAP is based in part upon best estimate assumptions made by the insurer. Shareholders' equity represents both amounts currently available and amounts expected to emerge over the life of the business. As a result, the values for assets, liabilities and equity reflected in financial statements prepared in accordance with U.S. GAAP may be different from those reflected in financial statements prepared under SAP.
Regulation of investments
Our U.S. insurance subsidiaries are subject to laws and regulations that require diversification of their investment portfolio and limit the amount of investments in certain asset categories, such as below investment grade fixed maturities, equity real estate, other equity investments and derivatives. Failure to comply with these laws and regulations would cause investments exceeding regulatory limitations to be treated as non-admitted assets for purposes of measuring surplus, and, in some instances, would require divestiture of such non-complying investments. We believe the investments made by our U.S. insurance subsidiaries comply with these laws and regulations.
Market conduct regulation
The laws and regulations of U.S. jurisdictions include numerous provisions governing the marketplace activities of insurers, including provisions governing the form and content of disclosure to consumers, product illustrations, advertising, product replacement, sales and underwriting practices, complaint handling and claims handling. The regulatory authorities in U.S. jurisdictions generally enforce these provisions through periodic market conduct examinations.
Statutory examinations
As part of their regulatory oversight process, insurance departments in U.S. jurisdictions conduct periodic detailed examinations of the books, records, accounts and business practices of insurers domiciled in their jurisdictions. These examinations generally are conducted in co-operation with the insurance departments of two or three other states or jurisdictions, representing each of the NAIC zones, under guidelines promulgated by the NAIC.
Risk-Based Capital
The Risk-Based Capital (RBC) for Insurers Model Act, or the Model Act, as it applies to insurers and reinsurers, was adopted by the NAIC in 1993. The main purpose of the Model Act is to provide a tool for insurance regulators to evaluate the capital of insurers relative to the risks assumed by them and determine whether there is a need for possible corrective action. U.S. insurers and reinsurers are required to report the results of their risk-based capital calculations as part of the statutory annual statements filed with state insurance regulatory authorities.
The Model Act provides for four different levels of regulatory actions based on annual statements, each of which may be triggered if an insurer's Total Adjusted Capital, as defined in the Model Act, is less than a corresponding level of risk-based capital, which we call RBC.
o The Company Action Level is triggered if an insurer's Total Adjusted Capital is less than 200% of its Authorized Control Level RBC, as defined in the Model Act. At the Company Action Level, the insurer must submit a plan to the regulatory authority that discusses proposed corrective actions to improve its capital position.
o The Regulatory Action Level is triggered if an insurer's Total Adjusted Capital is less than 150% of its Authorized Control Level RBC. At the Regulatory Action Level, the regulatory authority will perform a special examination of the insurer and issue an order specifying corrective actions that must be followed.
o The Authorized Control Level is triggered if an insurer's Total Adjusted Capital is less than 100% of its Authorized Control Level RBC, and at that level the regulatory authority is authorized (although not mandated) to take regulatory control of the insurer.
o The Mandatory Control Level is triggered if an insurer's Total Adjusted Capital is less than 70% of its Authorized Control Level RBC, and at that level the regulatory authority must take regulatory control of the insurer. Regulatory control may lead to rehabilitation or liquidation of an insurer.
As of December 31, 2005, the risk-based capital of Scottish Re (U.S.), Inc. and Scottish Re Life Corporation exceeded minimum RBC levels.
The Gramm-Leach-Bliley Act
In November 1999, the Gramm-Leach-Bliley Act of 1999, or the GLBA, was enacted, implementing fundamental changes in the regulation of the financial services industry in the United States. The GLBA permits the transformation of the already converging banking, insurance and securities industries by permitting mergers that combine commercial banks, insurers and securities firms under one holding company, a "financial holding company." Bank holding companies and other entities that qualify and elect to be treated as financial holding companies may engage in activities, and acquire companies engaged in activities, that are "financial" in nature or "incidental" or "complementary" to such financial activities. Such financial activities include acting as principal, agent or broker in the underwriting and sale of life, property, casualty and other forms of insurance and annuities. However, although a bank cannot act as an insurer nor can it own an insurer as a subsidiary in most circumstances, a financial holding company can own any kind of insurer, insurance broker or agent. Under the GLBA, national banks retain their existing ability to sell insurance products in some circumstances.
Under state law, the financial holding company must apply to the insurance commissioner in the insurer's state of domicile for prior approval of the acquisition of the insurer. Under the GLBA, no state may prevent or restrict affiliations between banks and insurers, insurance agents or brokers. Further, states cannot prevent or significantly interfere with bank or bank subsidiary sales activities. Finally, both bank and bank affiliates can obtain licenses as producers.
Until the passage of the GLBA, the Glass-Steagall Act had limited the ability of banks to engage in securities-related businesses, and the Bank Holding Company Act had restricted banks from being affiliated with insurers. With the passage of the GLBA, among other things, bank holding companies may acquire insurers, and insurance holding companies may acquire banks. The ability of banks to affiliate with insurers may materially affect our U.S. reinsurance subsidiary's product lines by substantially increasing the number, size and financial strength of potential competitors.
Bermuda
Our Bermuda subsidiaries are subject to regulation under the Bermuda Companies Act of 1981, and our Bermuda insurance subsidiaries are subject to regulation under the Bermuda Insurance Act of 1978, as amended by the Insurance Amendment Act 1995 (which we refer to as the Bermuda Insurance Act), and the regulations promulgated thereunder. They are required, among other things, to meet and maintain certain standards of solvency,
to file periodic reports in accordance with Bermuda statutory accounting rules, to produce annual audited financial statements and to maintain a minimum level of statutory capital and surplus. In general, the regulation of insurers in Bermuda relies heavily upon the auditors, directors and managers of the Bermuda insurer, each of which must certify that the insurer meets the solvency and capital requirements of the Bermuda Insurance Act.
Under the Bermuda Insurance Act, a Bermuda insurance company carrying on long-term business (which includes the writing of annuity contracts and life insurance policies with respect to human life) must hold all receipts in respect of its long-term business and earnings thereon in a separate long-term business fund. Payments from such long-term business fund may not be made directly or indirectly for any purpose other than those of the insurer's long-term business, except in so far as such payment is made out of surplus certified by the insurer's approved actuary to be available for distribution other than to policyholders. In addition, certain of our Bermuda subsidiaries are authorized by private acts of the Bermuda Legislature (the Scottish Annuity & Life International Insurance Company (Bermuda) Ltd. Consolidation and Amendment Act 2001 and the Scottish Annuity & Life Insurance Company (Bermuda) Limited Consolidation and Amendment Act 2001, which we refer to as the private acts) to establish separate accounts in respect of one or more life insurance policies or annuity contracts. In the event of an inconsistency between the Bermuda Insurance Act and our private acts, the terms of the private acts control subject, however, to later amendments of the Bermuda Insurance Act or other relevant laws. Under our private acts, each insurance subsidiary is permitted to credit to relevant separate accounts such portion of the premiums and other receipts from the related policy or contract, and any property of the insurance subsidiary derived from or purchased with such premiums, as the related policies or contracts stipulate. To the extent provided in the relevant policies or contracts, income, interest or other gains earned from, and any property acquired by, investing or dealing in the assets of the separate account are credited to the separate account, and all expenses, fees or losses relating to the separate account are charged against the separate account. The assets and property held in the separate account are to be used for the sole purpose of paying any and all claims arising from or under the related policies or contracts, and no other person has any right or interest in such assets. Upon the termination of policies or contracts related to a separate account, and the discharge of obligations under the policies or contracts, the insurance subsidiary may terminate the separate account, and credit any remaining assets or property to its general account. In the event of insolvency of one of our Bermuda subsidiaries, the liquidator is bound to recognize the separate nature of each separate account, and is not empowered to apply property identified as the property of any one separate account to pay the claims of creditors of the insurance company or policyholders other than the policyholder to whom the separate account relates. The private acts also permit our Bermuda subsidiaries to issue certain securities based on separate accounts that are subject to similar provisions.
Cayman Islands
Our Cayman Islands subsidiaries are subject to regulation as licensed insurance companies under Cayman Islands law. These subsidiaries hold unrestricted Class B insurance licenses under Cayman Islands Insurance Law and may therefore carry on an insurance business from the Cayman Islands, but may not engage in any Cayman Islands domestic insurance business. Unless specifically exempted, a Cayman Islands insurance company must engage a licensed insurance manager operating in the Cayman Islands to provide insurance expertise and oversight. Our subsidiaries are exempt from this requirement. In addition, under the Cayman Islands Insurance Law, a Cayman Islands insurance company carrying on long-term business (which includes the writing of life insurance policies) must hold all receipts in respect of its long-term business and earnings thereon in a separate long-term business fund. Payments from such long-term business fund may not be made directly or indirectly for any purpose other than those of the insurer's long-term business except in so far as such payments can be made out of any surplus disclosed on an actuarial valuation and certified by an actuary to be distributable otherwise than to policyholders. Every Cayman Islands insurance company carrying on long-term business may establish any number of separate accounts in respect of premiums paid to it to provide (i) annuities on human life and (ii) contracts of insurance on human life, and such respective premiums shall be kept segregated one from the other and independent of all other funds of the Cayman Islands insurer, and, notwithstanding the provisions of any other written law to the contrary, are not chargeable with any liability arising from any other business of the insurer. The scope and the validity of the Cayman Islands law regarding separate accounts have not been tested in the courts of the Cayman Islands.
Guernsey
World-Wide Insurance PCC Limited is a protected cell company incorporated under the laws of the Island of Guernsey and licensed by the Guernsey Financial Services Commission or GFSC, to carry on international insurance business under the Insurance Business (Bailiwick of Guernsey) Law, 2002. The activities of World-Wide Insurance PCC Limited are supervised by the GFSC. Insurers in Guernsey are required to maintain a minimum margin of solvency and to ensure that they have funds available sufficient to meet a total annual aggregate risk retention together with any forecasted annual expenses. In addition, insurance companies are also required to report annually to the GFSC and must also retain a general representative. The GFSC also has powers to investigate and intervene in the affairs of insurance companies in Guernsey.
Ireland
Scottish Re (Dublin) Limited is a reinsurance company incorporated under the laws of Ireland. Under Irish law, a reinsurance company such as Scottish Re (Dublin) Limited is required to maintain a minimum level of paid up share capital. As a general matter, neither Scottish Re (Dublin) Limited is subject to the same level of regulation in Ireland as a direct writing insurance company. However, the Irish Financial Services Regulatory Authority has the power under Section 22 of the Insurance Act, 1989 (as inserted by Section 5 of the Insurance Act, 2000) to direct Irish reinsurance companies to cease writing business indefinitely or for a specified period for, among other grounds, inadequate capitalization, unsuitable directors and/or management or insufficient staff based in Ireland. Section 22A of the Insurance Act, 1989 (as inserted by Section 6 of the Insurance Act, 2000) provides that the Irish Financial Services Regulatory Authority may create regulations to provide for the application of the general insurance laws and regulations in Ireland to reinsurance companies such as Scottish Re (Dublin) Limited where it considers it necessary to do so, in the public interest, in the interest of policyholders and in the interest of the orderly and proper regulation of the insurance industry.
Directive 2005/68/EC of the European Parliament and of the Council of the European Commission dated November 16, 2005 (the "Reinsurance Directive") was published in the Official Journal of the European Union on December 9, 2005. The Reinsurance Directive must be implemented by EU Member States on or before December 10, 2007. It is anticipated that Ireland will implement the Reinsurance Directive during the first quarter of 2006. Once implemented by EU Member States, the Reinsurance Directive will introduce a single passport system for reinsurers similar to that which currently applies to direct insurers. This will mean that EU reinsurers such as our Irish subsidiary, Scottish Re (Dublin) Limited, will be authorized by their home state supervisor and will, on that basis, be entitled to transact business anywhere in the European Union either under the rules of "freedom of establishment" or under the "freedom of services" rules.
Some key provisions of the Reinsurance Directive for life reinsurers such as Scottish Re (Dublin) Limited include the following:
o EU reinsurers will be required to limit their purposes to the business of reinsurance and related operations.
o EU reinsurers will be obliged to establish adequate technical reserves to cover their reinsurance obligations. Additionally, reinsurers will be required to invest the assets covering their technical reserves and their equalization reserves (which are required in the case of credit reinsurers) in accordance with a prescribed set of rules. These rules require a reinsurer to match its investments to its expected claims payments and also require diversity across asset classes and counterparties. Investments in derivatives are permitted only to reduce investment risks or to facilitate efficient portfolio management. In addition, home Member States are permitted to require reinsurers to also comply with the more quantitative rules set out in the Reinsurance Directive provided they are prudentially justified.
o EU reinsurers will be obliged to maintain a solvency margin consisting of the assets of the reinsurer "free of any foreseeable liabilities" less any intangible items. Subject to an absolute minimum of EUR 3.0 million, in the case of life reinsurers, the required solvency margin will be based on the higher of a premium basis or a claims basis calculation. In respect of premiums, a ratio of 18% will apply on the first EUR 50.0 million, with 16% applying on the excess. In respect of claims, a ratio of 26% will apply on the average burden of claims determined by reference to a number of preceding financial years up to EUR 35.0 million with 23% applying on the excess. For unit linked
business, home Member States may require the solvency margin to be calculated in accordance with the rules set out in the Reinsurance Directive applicable to direct life assurance companies.
o One-third of the required solvency margin will constitute a minimum guarantee fund, which must be not less than EUR 3.0 million.
o As regards transitional arrangements, the Reinsurance Directive provides that Member States may allow EU reinsurers which are carrying on business at the date of entry into force of the Reinsurance Directive, two years within which to comply with, inter alia, the requirements regarding establishment of technical provisions and reserves and relating to the solvency margin and the guarantee fund described above. However, the Irish Financial Regulator has embarked on a consultation process with industry on grandfathering requirements for existing reinsurers such as Scottish Re (Dublin) Limited and its current thinking suggests that Irish reinsurers would be expected to comply with the requirements of the Reinsurance Directive regarding the establishment of technical provisions within six months of the Reinsurance Directive being transposed into Irish law. Furthermore, it is expected that Irish reinsurers would be required to comply with the solvency margin requirements and the investment rules described above within 12 months of the transposition of the Reinsurance Directive into Irish law.
All Irish reinsurers, including Scottish Re (Dublin) Limited, will be required to submit a Reinsurance Grandfathering Compliance Submission to the Irish Financial Regulator showing how they will comply with the new regulatory requirements. If Scottish Re (Dublin) Limited was not already in compliance or was unable to demonstrate that it had a compliance plan acceptable to the Irish Financial Regulator, then it might not be allowed by the Irish Financial Regulator to continue to carry on reinsurance business.
United Kingdom
Scottish Re Limited is a reinsurance company incorporated and registered in England and Wales and subject to regulation and supervision in the United Kingdom. On December 1, 2001, the United Kingdom's Financial Services Authority, or FSA, assumed its full powers and responsibilities under the Financial Services and Markets Act 2000, or FSMA. The FSA is now the single statutory regulator responsible for regulating deposit-taking, insurance (including reinsurance), investment and most other financial services business. It is a criminal offense for any person to carry on a regulated activity in the United Kingdom unless that person is authorized by the FSA or falls under an exemption. Scottish Re Limited is authorized to carry on long-term business and certain classes of general business with a requirement that it restricts its business to reinsurance.
The FSA has adopted a risk-based approach to the supervision of insurance companies. Under this approach the FSA periodically performs a formal risk assessment of insurance and reinsurance companies or groups carrying on business in the United Kingdom. After each risk assessment, the FSA will inform the insurer/reinsurer of its views on the insurer's/reinsurer's risk profile. This will include details of any remedial action that the FSA requires and the likely consequences if this action is not taken. The FSA also supervises the management of insurance and reinsurance companies through the approved persons regime, by which any appointment of persons to perform certain specified "controlled functions" within a regulated entity, must be approved by the FSA.
Under FSA rules, insurance and reinsurance companies are required to maintain a margin of solvency at all times, the calculation of which in any particular case depends on the type and amount of business a company writes. The method of calculation of the solvency margin is set out in the FSA rules and, for these purposes, a company's assets and its liabilities are subject to specific valuation rules. Failure to maintain the required solvency margin is one of the grounds on which wide powers of intervention conferred upon the FSA may be exercised.
The acquisition of "control" of any U.K. insurance or reinsurance company will require FSA approval. For these purposes, a party that "controls" a U.K. insurance or reinsurance company includes any company or individual that (together with its or his associates) directly or indirectly acquires 10% or more of the shares in a U.K. authorized insurance or reinsurance company or its parent company, or is entitled to exercise or control the exercise of 10% or more of the voting power in such authorized insurance or reinsurance company or its parent company. In
considering whether to approve an application for approval, the FSA must be satisfied that both the acquirer is a fit and proper person to have such "control" and that the interests of consumers would not be threatened by such acquisition of "control." Failure to make the relevant prior application could result in action being taken by the FSA against both the person who sought to acquire control and against the regulated company.
The Reinsurance Directive has been approved by the United Kingdom and the regulatory authority is expected to take action within the prescribed time period.
New Jurisdictions
If we or any of our subsidiaries were to become subject to the laws of a new jurisdiction where we or that subsidiary is not presently admitted, they may not be in compliance with the laws of the new jurisdiction. Any failure to comply with applicable laws could result in the imposition of significant restrictions on our ability to do business, and could also result in fines and other sanctions, any or all of which could adversely affect our financial results and operations.
Additional Information
Our website address is www.scottishre.com. Forms 10-K, 10-Q, 8-K and all amendments to such reports are available free of charge on our website. These reports are posted to the website as soon as reasonably practical after they have been filed with the SEC. We will also provide electronic or paper copies of these reports on request. Information contained on our website does not constitute part of this Annual Report on Form 10-K.
Item 1A.
Item 1A. RISK FACTORS
Investing in our securities involves certain risks. Any of the following risks could materially adversely affect our business, results of operations or financial condition.
Risks Related to Our Business
A downgrade in the financial ratings of our insurance subsidiaries could make us less competitive.
Ratings are an important factor in attracting business in our life reinsurance business. Rating organizations periodically review the financial performance and condition of insurers, including our insurance subsidiaries. Rating organizations assign ratings based upon several factors. Although most of the factors considered relate to the rated company, some of the factors take into account general economic conditions and circumstances outside the rated company's control. The objective of rating organizations is to provide an opinion of an insurer's financial strength and ability to meet ongoing obligations to its policyholders. These ratings are subject to periodic review by the relevant rating agency and may be revised downward or withdrawn at the sole discretion of the rating agency. In addition, these ratings are not an evaluation directed to investors in our securities and are not recommendations to buy, sell or hold our securities. See "Business - Competition and Ratings" for a description of our subsidiaries' ratings.
A downgrade in or withdrawal of one or more ratings of any of our insurance subsidiaries could adversely affect our ability to sell products, retain existing business (through recapture provisions and non-renewal) and compete for attractive acquisition opportunities.
Inadequate risk analysis and underwriting may result in a decline in our profits.
Our success depends on our ability to accurately assess and manage the risks associated with the business that we reinsure. We have developed risk analysis and underwriting guidelines, policies, and procedures with the objective of controlling the quality of the business as well as the pricing of the risks we are assuming. Among other things, these processes rely heavily on our underwriting, our analysis of mortality trends and lapse rates, and our understanding of medical improvements and their impact on mortality. If these processes are inadequate or are based on inadequate information, we may not establish appropriate premium rates and our reserves may not be adequate to cover our losses.
In addition, we are dependent on the original underwriting decisions made by, and information provided to us by, ceding companies. For example, we incurred a charge to net income of $10.4 million in the third quarter of 2003 when we discovered that one of our ceding insurers had underreported death claims to us over a three-year period. We are also subject to the risk that the ceding clients may not have adequately evaluated the risks to be reinsured and that the premiums ceded may not adequately compensate us for the risks we assume. To the extent actual claims exceed our underlying assumptions, we will be required to increase our liabilities, which will reduce our profits in the period in which we identify the deficiency.
Reserves are estimates based on actuarial and statistical projections, at a given point in time, of what we ultimately expect to pay out on claims and benefits, based on facts and circumstances then known, predictions of future events, estimates of future trends in mortality, morbidity and other variable factors such as persistency, inflation and interest rates. Because of the many assumptions and estimates involved in establishing reserves, the reserving process is inherently uncertain.
Life reinsurance is a highly competitive industry, which could limit our ability to gain or maintain our competitive position.
The life reinsurance industry is highly competitive, and we encounter significant competition from other reinsurance companies, as well as competition from other providers of financial services. Competition in the reinsurance business is based on price, financial strength ratings, reputation, experience, relationships and service. Many of our competitors are significantly larger, have greater financial resources and have longer operating histories than we do. Competition from other reinsurers could adversely affect our competitive position. We consider our major competitors in the United States to include Swiss Re, Reinsurance Group of America Inc., Munich American Reassurance Company, Generali USA Life Re, and Transamerica Reinsurance. In other markets outside the United States, our competitors include XL Capital Ltd, Max Reinsurance Ltd. and PartnerRe Ltd.
Our life reinsurance contracts and variable life insurance policies expose us to mortality risk which could negatively affect our net income.
Mortality risk is the risk that death claims may differ from the amount we assumed in pricing our reinsurance contracts and our variable life insurance policies. Mortality experience that is less favorable than the mortality rates that we assumed will negatively affect our net income. For example, in the second quarter of 2005, we experienced higher than expected mortality, which negatively affected our net income.
If our investment strategy is not successful, we could suffer unexpected losses.
The success of our investment strategy is crucial to the success of our business. Specifically, we are subject to:
o market value risk, which is the risk that our invested assets will decrease in value. This decrease in value may be due to a change in the yields realized on our assets and prevailing market yields for similar assets, an unfavorable change in the liquidity of the investment or an unfavorable change in the financial prospects or a downgrade in the credit rating of the issuer of the investment;
o reinvestment risk, which is the risk that interest rates will decline and funds reinvested will earn less than expected; and
o duration matching risk, which is the risk that liabilities are surrendered or mature sooner than anticipated and that we may have to sell assets at an undesirable time to provide for policyholder surrenders or withdrawals.
We attempt to address such risks in product pricing and in establishing policy reserves. If our assets do not properly match our anticipated liabilities or our investments do not provide sufficient returns to enable us to satisfy our guaranteed fixed benefit obligations then our profits and financial condition would deteriorate. Also, declines in
the value of our investments that provide collateral for reinsurance contracts would require us to post additional collateral.
In addition, our investment portfolio includes mortgage-backed securities, known as MBSs, and collateralized mortgage obligations, known as CMOs. As of December 31, 2005, MBSs and CMOs constituted approximately 16.4% of our invested assets. As with other fixed income investments, the fair value of these securities will fluctuate depending on market and other general economic conditions and the interest rate environment. Changes in interest rates can expose us to prepayment risks on these investments. In periods of declining interest rates, mortgage prepayments generally increase and MBSs and CMOs are prepaid more quickly, requiring us to reinvest the proceeds at the then current market rates.
We may also enter into foreign currency, interest rate and credit derivatives and other hedging transactions in an effort to manage risks. Structuring these derivatives and hedges so as to effectively manage these risks is an inherently uncertain process. If our calculations are incorrect, or if we do not properly structure our derivatives or hedges, we may have unexpected losses and our assets may not be adequate to meet our needed reserves, which could adversely affect our business, earnings and financial condition.
General economic conditions affect the markets for interest-rate-sensitive securities, including the level and volatility of interest rates and the extent and timing of investor participation in such markets. Unexpected changes in general economic conditions could create volatility or illiquidity in these markets in which we hold positions and harm our investment return.
Our strategy includes growth through acquisitions. Our inability to grow through acquisitions or to successfully integrate acquired companies or blocks of business may negatively affect our results of operations.
Much of our growth, particularly in 2005, has been fueled by acquisitions. Our ability to grow through acquisitions depends, among other things, on our ability to identify attractive acquisition candidates. We have completed three major acquisitions since 2001, including the acquisition of the in-force individual life reinsurance business of ING on December 31, 2004, and we may make future acquisitions, either of companies or other selected blocks of business. While we will evaluate business opportunities on a regular basis, we may not be successful in identifying any attractive acquisitions. We may not have, or be able to raise on acceptable terms, sufficient financial resources to make acquisitions. In addition, any acquisition we make is subject to all of the risks inherent in an acquisition strategy, including:
o integrating the acquired financial and operational systems;
o establishing satisfactory budgetary and other financial and accounting controls;
o funding increased capital needs and overhead expenses;
o obtaining management personnel required for expanded operations;
o funding cash flow shortages that may occur if anticipated sales and revenues are not realized or are delayed, whether by general economic or market conditions or unforeseen internal difficulties; and
o the value of assets acquired may be lower than expected or may diminish due to credit defaults or changes in interest rates and liabilities assumed may be greater than expected.
Our failure to manage successfully these operational challenges and risks may impact our results of operations. In addition, disputes can arise over the terms of any acquisition. For example, in connection with the acquisition of Scottish Re Life Corporation, formerly ERC Life Reinsurance Corporation, we are currently in mediation with the seller over the representations made to us at the time of sale. Also, growth by acquisition may divert a substantial amount of management time that would otherwise be devoted to our operations.
We may not be able to grow as quickly as we have in the past.
To the extent that consolidation of the domestic life reinsurance industry leads to an improved pricing environment for reinsurers, such pricing increases may be offset by larger retentions and the amount of risk our
clients retain. While international markets in Europe and Asia may offer better long-term prospects for growth, the timing of the growth is uncertain and is not likely to offset any slow-down in the domestic life reinsurance industry.
In certain reinsurance contracts we do not maintain control of the invested assets, which may limit our ability to control investment risks on these assets and may expose us to credit risk of the ceding company.
As part of our business we enter into reinsurance agreements on a modified coinsurance and funds withheld coinsurance basis. In these transactions, the ceding insurance company retains the assets supporting the ceded business and manages them for our account. As of December 31, 2005, $2.6 billion of assets were held by ceding companies under such agreements and were recorded under "funds withheld at interest" on our balance sheet. Although the ceding company must adhere to general standards agreed to by us for the management of these assets, we do not control the selection of the specific investments or the timing of the purchase or sale of investments made by the ceding company. Accordingly, we may be at risk if the ceding company selects investments that deviate from our agreed standards or if the ceding company performs poorly in the purchase, sale and management of those assets. In addition, these assets are not segregated from the ceding company's other assets, and we may not be able to recover all of these assets in the event of the insolvency of the ceding insurer. In certain other reinsurance arrangements, we may place assets in a trust in order to provide the ceding company with credit for reinsurance on its financial statements. Although we generally have the right to direct the investment of assets in these trusts, in the event of the insolvency of the ceding company, its receiver may attempt to take control of those assets.
Interest rate fluctuations could lower the income we derive from the difference between the interest rates we earn on our investments and interest we pay under our reinsurance contracts.
Significant changes in interest rates expose us to the risk of not earning income or experiencing losses based on the difference between the interest rates earned on investments and the credited interest rates paid on outstanding reinsurance contracts.
Both rising and declining interest rates can negatively affect the income we derive from these interest rate spreads. During periods of falling interest rates, our investment earnings will be lower because new investments in fixed maturity securities will likely bear lower interest rates. We may not be able to fully offset the decline in investment earnings with lower crediting rates on our contracts that reinsure life insurance policies or annuities with cash value components. A majority of our annuity and certain other products have multi-year guarantees and guaranteed floors on their crediting rates.
During periods of rising interest rates, we may be contractually obligated to increase the crediting rates on our contracts that reinsure annuities or life insurance policies with cash value components. We may not, however, have the ability to immediately acquire investments with interest rates sufficient to offset the increased crediting rates under our reinsurance contracts. Although we develop and maintain asset/liability management programs and procedures designed to reduce the volatility of our income when interest rates are rising or falling, significant changes in interest rates caused by factors beyond our control such as changes in governmental monetary policy or political conditions may negatively affect our interest rate spreads.
Changes in interest rates may also affect our business in other ways. Lower interest rates may result in lower sales of certain insurance and investment products of our customers, which would reduce the demand for our reinsurance of these products.
A prolonged economic downturn could reduce the demand for annuity and life insurance products, which could substantially reduce our revenues.
A prolonged general economic downturn or poor performance of the equity and other capital markets, could lower the demand for many annuity and life insurance products. Because we obtain substantially all of our revenues through reinsurance arrangements that cover a portfolio of life insurance products, as well as annuities, our business would be harmed if the demand for annuities or life insurance decreased.
Policyholder withdrawals or recaptures of reinsurance treaties could force us to sell investments at a loss and take a larger than anticipated charge for amortization of deferred acquisition costs.
Some of the products offered by our insurance subsidiaries and some of the products offered by primary insurance companies that we reinsure allow policyholders and contract holders to withdraw their funds under defined circumstances. In addition, our reinsurance agreements may provide for recapture rights on the part of our insurance company customers. Recapture rights permit these customers to reassume all or a portion of the risk formerly ceded to us after an agreed upon time, usually 10 years, subject to various conditions or upon a downgrade of any of our financial strength ratings or our failure to satisfy other financial conditions. Recapture of business previously ceded does not affect premiums ceded prior to the recapture, but may result in immediate payments to our insurance company customers.
In addition, when we issue a new insurance policy or annuity contract or write a reinsurance contract, we defer a portion of the related acquisition costs by establishing a deferred acquisition cost asset on the balance sheet. This asset is amortized over the expected term of the acquired business based on certain assumptions about the performance and persistency of that business and investment experience. To the extent surrender, withdrawal or recapture activity is greater than we assumed, or investment experience is worse than we assumed, we may incur a non-cash charge to write down the deferred acquisition cost asset. Any such charge may be partially offset by recapture and surrender fees.
One of our customers exercised a right of recapture in April 2001, requiring us to pay $185.7 million to the customer. Because we had expected the recapture, we did not have to dispose of assets at a loss and we had already fully amortized the deferred acquisition costs. In December 2002, another of our customers exercised a right of recapture requiring us to pay $49.3 million to the customer. In that case, we did not have to dispose of assets at a loss and we recovered all of our unamortized deferred acquisition costs relating to the transaction. However, because recapture rights can be triggered by circumstances, which may be unforeseeable, such as rating decreases or production shortfalls, we may not be able to anticipate future recaptures and make adequate preparations to reduce their impact on us. If recaptures occur and we do not make adequate preparations, our earnings and financial condition could decline.
With regard to our business generally, the outcome of current industry investigations may have an adverse impact.
The attorneys general and the insurance departments of New York and numerous other states have announced investigations of insurance broker compensation arrangements, bid-rigging and other practices within the insurance industry, and may propose changes in the regulation of broker compensation arrangements and disclosure. Some regulators have also announced investigations into proper uses of finite reinsurance. We received a letter of inquiry from the Delaware Department of Insurance in November 2004 as part of its review of Delaware domestic insurance companies and their arrangements and dealings with producers acting as brokers to which we responded in November 2004. We have not been contacted by any other government agency (including through receipt of a subpoena) in connection with these investigations. It is impossible to predict the outcomes of these investigations, whether they will expand into other industry practices not yet contemplated, whether they will result in changes in insurance regulation or practices, or the impact, if any, of this increased regulatory scrutiny of the insurance industry on us or on the liquidity or trading prices of our ordinary shares.
Government subpoenas we have received may create negative publicity and the risk of regulatory action.
We have received separate subpoenas from the staff of the SEC and the Permanent Subcommittee on Investigations of the United States Senate Committee on Homeland Security and Governmental Affairs ("PSI"). The SEC subpoena seeks documents and other information regarding transactions and trading involving Scottish Re securities by certain former officers and directors of Scottish Re (each of whom left those positions by mid-year 2001), by certain original shareholders of Scottish Re, and by our current Chairman. The PSI subpoena is in connection with the PSI's general review of compliance with anti-money laundering, tax and securities laws and regulations related to financial transactions by individuals and domestic and offshore entities. The PSI subpoena seeks documents regarding the formation of Scottish Re, certain wealth management products and transactions involving the individuals mentioned above. We are fully cooperating with these inquiries. While it is premature for
us to assess the scope or any potential outcome to us of these inquiries, including any potential enforcement actions involving us, these inquiries may result in negative publicity and could have an adverse affect on us.
We cede some of the business that we reinsure to other reinsurance companies who may not pay amounts due to us, which could materially harm our business.
We cede some of the business that we reinsure to other reinsurance companies, known as retrocessionaires. We assume the risk that the retrocessionaire will be unable to pay amounts due to us because of its own financial difficulties. The failure of our retrocessionaires to pay amounts due to us will not absolve us of our responsibility to pay ceding companies for risks that we reinsure. Failure of retrocessionaires to pay us could materially harm our business, results of operations and financial condition.
Natural disasters, catastrophes and disasters caused by humans, including the threat of terrorist attacks and related events, epidemics, and pandemics may adversely affect our business and results of operations.
Natural disasters and terrorist attacks, as well as epidemics and pandemics, can adversely affect our business and results of operations because they accelerate mortality risk. Terrorist attacks in the United States and in other parts of the world and the threat of future attacks could have a negative effect on our business.
We believe our reinsurance programs are sufficient to reasonably limit our net losses for individual life claims relating to potential future natural disasters and terrorist attacks. Our reinsurance programs, including our catastrophe coverage, limited our net losses in individual life claims relating to the September 11, 2001 terrorist attacks to approximately $750,000. However, the consequences of further natural disasters, terrorist attacks, armed conflicts, epidemics and pandemics are unpredictable, and we may not be able to foresee events that could have an adverse effect on our business.
Our international operations subject us to regulatory, foreign currency, and other risks which may affect our business. In 2005, approximately 6% of our earned premiums came from our international operations. Our plan to grow our international operations subjects us to various risks. In addition to the regulatory and foreign currency risks we identify later in this section, these risks include:
o volatility in earnings arising out of mortality swings in the initial years of operating in new markets;
o political and economic instability as well as armed conflict in these regions; and
o uncertainty arising out of foreign government sovereignty over our international operations.
Our inability to attract and retain qualified employees or the loss of any of our key employees could negatively impact our business.
Our success substantially depends upon our ability to attract and retain qualified employees and upon the ability of our senior management and other key employees to implement our business strategy. We believe there are only a limited number of available qualified executives in the business lines in which we compete. We rely substantially upon the services of Scott E. Willkomm, our Chief Executive Officer, Paul Goldean, our General Counsel, David Huntley, the Chief Executive Officer of Scottish Re Limited, Hugh McCormick, our Executive Vice President of Corporate Development, Dean E. Miller, our Chief Financial Officer, Seth Vance, the Chief Executive Officer of Scottish Holdings, Inc., and Clifford J. Wagner, our Chief Actuary. Each of the foregoing members of senior management has employment agreements and we maintain $2,500,000 key man life insurance policies for each of Mr. Willkomm and Mr. Wagner. The loss of the services of members of our senior management, or our inability to hire and retain other talented personnel from the very limited pool of qualified insurance professionals, could delay or prevent us from fully implementing our business strategy which could harm our financial performance.
We are exposed to foreign currency risk which could negatively affect our business.
Our functional currency is the United States dollar. However, our U.K. subsidiaries, Scottish Re Holdings Limited and Scottish Re Limited, maintain operating expense accounts in British pounds, parts of their investment portfolio in Euros and British pounds and receive other currencies in payment of premiums. All of Scottish Re Limited's original U.S. business is settled in United States dollars, all Canadian, Latin American and certain Asia and Middle East business is converted and settled in United States dollars, and all other currencies are converted and settled in either Euros or British pounds. The results of the business recorded in Euros or British pounds are then translated to United States dollars. Scottish Re Limited attempts to limit substantial exposures to foreign currency risk, but does not actively manage currency risks. To the extent our foreign currency exposure is not properly managed or otherwise hedged, we may experience exchange losses, which in turn would lower our results of operations and harm our financial condition.
Our insurance subsidiaries are highly regulated, and changes in these regulations could harm our business.
Our insurance and reinsurance subsidiaries are subject to government regulation in each of the jurisdictions in which they are licensed or authorized to do business. Governmental agencies have broad administrative power to regulate many aspects of the insurance business, which may include trade and claim practices, accounting methods, premium rates, marketing practices, advertising, acceptability of collateral for purposes of taking credit for reinsurance, policy forms, affiliate transactions, changes of control and capital adequacy. These agencies are concerned primarily with the protection of policyholders rather than shareholders. Moreover, insurance laws and regulations, among other things:
o establish solvency requirements, including minimum reserves and capital and surplus requirements;
o limit the amount of dividends, tax distributions, intercompany loans and other payments our insurance subsidiaries can make without prior regulatory approval;
o impose restrictions on the amount and type of investments we may hold; and
o require assessments to pay claims of insolvent insurance companies.
The NAIC continuously examines existing laws and regulations. We cannot predict the effect that any NAIC recommendations or proposed or future legislation or rule making in the United States or elsewhere may have on our financial condition or operations.
If Scottish Re or any of our subsidiaries were to become subject to the laws of a new jurisdiction where Scottish Re or that subsidiary is not presently admitted, they may not be in compliance with the laws of the new jurisdiction. Any failure to comply with applicable laws could result in the imposition of significant restrictions on our ability to do business, and could also result in fines and other sanctions, any or all of which could harm our financial results and operations.
Our ability to pay dividends depends on our subsidiaries' ability to distribute funds to us.
We are a holding company, with our principal assets consisting of the stock of our insurance company subsidiaries. Our ability to pay dividends on our ordinary shares, HyCUs, our non-cumulative perpetual preferred shares, and to pay debt service on any of our indebtedness, depends significantly on the ability of our insurance company subsidiaries, our principal sources of cash flow, to declare and distribute dividends or to advance money to us in the form of intercompany loans. Our insurance company subsidiaries are subject to various state and foreign government statutory and regulatory restrictions applicable to insurance companies generally that limit the amount of dividends, loans and advances and other payments to affiliates. If insurance regulators at any time determine that payment of a dividend or any other payment to an affiliate would be detrimental to an insurance subsidiary's policyholders or creditors, because of the financial condition of the insurance subsidiary or otherwise, the regulators may block dividends or other payments to affiliates that would otherwise be permitted without prior approval.
Our ordinary shares are subject to voting and transfer limitations.
Under our articles of association, our board of directors (or its designee) is required, except for transfers of ordinary shares executed on any recognized securities exchange or inter-dealer quotation system, including the NYSE, to decline to register any transfer of ordinary shares if our directors have any reason to believe that such transfer would result in a person (or any group of which such person is a member) beneficially owning, directly or indirectly, 10% or more of any class of our shares, except that Cypress Merchant B Partners II (Cayman) L.P., Cypress Merchant Banking II-A C.V., 55th Street Partners II (Cayman) L.P. and Cypress Side-by-Side (Cayman) L.P. (collectively, the "Cypress Entities") are each permitted to transfer ordinary shares to another Cypress Entity, so long as the number of ordinary shares beneficially owned directly or indirectly by the Cypress Entities in the aggregate does not exceed 24.9% of a class of our shares. With respect to a transfer of ordinary shares executed on any recognized securities exchange or inter-dealer quotation system, including the NYSE, if our directors have any reason to believe that such transfer would result in a person (or any group of which such person is a member) beneficially owning, directly or indirectly, 10% or more of any class of our shares (24.9% in the case of the Cypress Entities), the directors may demand that such person surrender the ordinary shares to an agent designated by the directors, who will sell the ordinary shares on any recognized securities exchange or inter-dealer quotation system, including the NYSE. After applying the proceeds of the sale toward reimbursing the transferee for the price paid for the ordinary shares, the agent will pay the remaining proceeds to certain charitable organizations designated by the directors. The proceeds of such sale may be used to reimburse the agent for its duties. Similar restrictions apply to issuances and repurchases of ordinary shares by us. Our directors (or their designee) also may, in their absolute discretion, decline to register the transfer of any ordinary shares, except for transfers of ordinary shares executed on any recognized securities exchange or inter-dealer quotation system, including the NYSE, if they have reason to believe that such transfer may expose us, our subsidiaries or shareholders or any person insured or reinsured or proposing to be insured or reinsured by us or any of our subsidiaries to adverse tax or regulatory treatment in any jurisdiction or if they have reason to believe that registration of such transfer under the Securities Act of 1933, as amended, or the Securities Act, under any state "blue sky" or other U.S. securities laws or under the laws of any other jurisdiction is required and such registration has not been duly effected. With respect to a transfer of ordinary shares executed on any recognized securities exchange or inter-dealer quotation system, including the NYSE, if our directors have any reason to believe that such transfer may expose us, our subsidiaries or shareholders or any person insured or reinsured or proposing to be insured or reinsured by us or any of our subsidiaries to adverse tax or regulatory treatment in any jurisdiction, the directors may demand that such person surrender the ordinary shares to an agent designated by the directors, who will sell the ordinary shares on any recognized securities exchange or inter-dealer quotation system, including the NYSE. After applying the proceeds of the sale toward reimbursing the transferee for the price paid for the ordinary shares, the agent will pay the remaining proceeds to certain charitable organizations designated by the directors. The proceeds of such sale may be used to reimburse the agent for its duties. A transferor of ordinary shares will be deemed to own such shares for dividend, voting and reporting purposes until a transfer of such ordinary shares has been registered on our register of members. We are authorized to request information from any holder or prospective acquirer of ordinary shares as necessary to effect registration of any such transaction, and may decline to register any such transaction if complete and accurate information is not received as requested.
In addition, our articles of association generally provide that any person (or any group of which such person is a member) other than the Cypress Entities, holding directly, or by attribution, or otherwise beneficially owning our voting shares carrying 10% or more of the total voting rights attached to all of our outstanding voting shares, will have the voting rights attached to its voting shares reduced so that it may not exercise more than approximately 9.9% of such total voting rights. In addition, in the event the Cypress Entities hold directly or by attribution or otherwise beneficially own voting shares with more than 24.9% of the total voting rights of our voting shares, the voting rights of the Cypress Entities will be reduced so that they may not exercise in the aggregate more than approximately 24.9% of the total voting rights of our voting shares at any given time. Because of the attribution provisions of the Internal Revenue Code of 1986, as amended, or the Code, and the rules of the Securities and Exchange Commission, or the SEC, regarding determination of beneficial ownership, this requirement may have the effect of reducing the voting rights of a shareholder whether or not such shareholder directly holds of record 10% or more of our voting shares. Further, our board of directors (or its designee) has the authority to request from any shareholder certain information for the purpose of determining whether such shareholder's voting rights are to be reduced. Failure to respond to such a notice, or submitting incomplete or inaccurate information, gives our board of directors (or its designee) discretion to disregard all votes attached to such shareholder's ordinary shares.
On April 7, 2005, our shareholders approved amendments to our articles of association permitting certain affiliates of The Cypress Group to own up to 24.9% of our ordinary shares and the issuance of ordinary shares to the Cypress Entities upon the conversion of the 7% Convertible Junior Subordinated Notes. On May 4, 2005, the Cypress Entities obtained insurance regulatory approval in Delaware and the United Kingdom to hold more than 10% of our outstanding shares. The Cypress Entities, at December 31, 2005, hold approximately 17.5% of our issued and outstanding ordinary shares.
Our articles of association make it difficult to replace directors and to effect a change of control.
Our articles of association contain certain provisions that make it more difficult for the shareholders to replace directors even if the shareholders consider it beneficial to do so. In addition, these provisions may make more difficult the acquisition of control of us by means of a tender offer, open market purchase, a proxy fight or otherwise, including by reason of the limitation on transfers of ordinary shares and voting rights described above. While these provisions are designed to encourage persons seeking to acquire control to negotiate with our board of directors, they could have the effect of discouraging a prospective purchaser from making a tender offer or otherwise attempting to obtain control and may prevent a shareholder from receiving the benefit from any premium over the market price of our ordinary shares offered by a bidder in a potential takeover.
Examples of provisions in our articles of association that could have such an effect include:
o election of our directors is staggered, meaning that the members of only one of three classes of our directors are elected each year;
o the total voting power of any shareholder owning 10% or more of the total voting rights attached to our ordinary shares will be reduced to approximately 9.9% of the total voting rights of our ordinary shares;
o our directors must decline to register the transfer of ordinary shares on our share register that would result in a person owning 10% or more of any class of our shares and may decline certain transfers that they believe may have adverse tax or regulatory consequences;
o shareholders do not have the right to act by written consent; and
o our directors have the ability to change the size of the board of directors.
Even in the absence of an attempt to effect a change in management or a takeover attempt, these provisions may adversely affect the prevailing market price of our ordinary shares if they are viewed as discouraging changes in management and takeover attempts in the future.
The Cypress Entities currently own approximately 17.5% of our outstanding ordinary shares. Pursuant to a shareholders' agreement, as long as the Cypress Entities continue to hold the lesser of (i) 9.9% or more of the voting power of our voting securities on an as-converted basis or (ii) 35% or more of the securities purchased on an as-converted basis, the Cypress Entities have the non-assignable right to appoint one director and one non-voting observer to our board of directors. The Cypress Entities' share ownership and ability to nominate persons for election to the board of directors might provide the Cypress Entities with significant influence over potential change in control transactions.
Applicable insurance laws make it difficult to effect a change of control.
Under applicable Delaware insurance laws and regulations, no person may acquire control of us, Scottish Re (U.S.), Inc. or Scottish Re Life Corporation Limited, our Delaware insurance subsidiaries, unless that person has filed a statement containing specified information with the Delaware Insurance Commissioner and approval for such acquisition is obtained. Under applicable laws and regulations, any person acquiring, directly by stock ownership or indirectly (by revocable proxy or otherwise), 10% or more of the voting stock of any other person is presumed to have acquired control of such person, and a person who beneficially acquires 10% or more of our ordinary shares without obtaining the approval of the Delaware Insurance Commissioner would be in violation of Delaware's insurance holding company act and would be subject to injunctive action requiring disposition or seizure of the shares and prohibiting the voting of such shares, as well as other action determined by the Delaware Insurance Commissioner. In addition, because of our ownership of Orkney Re, Inc., our South Carolina special purpose reinsurance captive, any person acquiring control of Orkney Re, Inc., directly or indirectly through acquiring control of us, would be required to obtain approvals from the South Carolina Director of Insurance.
In addition, many state insurance laws require prior notification to the state insurance department of a change in control of a non-domiciliary insurance company licensed to transact insurance in that state. While these pre-notification statutes do not authorize the state insurance departments to disapprove the change in control, they authorize regulatory action in the affected state if particular conditions exist such as undue market concentration. Any future transactions that would constitute a change in control of us, Scottish Re (U.S.), Inc. or Scottish Re Life Corporation Limited may require prior notification in the states that have pre-acquisition notification laws. These prior notice and prior approval laws may discourage potential acquisition proposals and may delay, deter or prevent a change of control of us, including transactions that some or all of our shareholders might consider to be desirable.
Any change in control of Scottish Re Limited would need the approval of the U.K. Financial Services Authority, which is the body responsible for the regulation and supervision of the U.K. insurance and reinsurance industry.
Investors may have difficulties in suing or enforcing judgments against us in the United States.
We are a holding company organized under the laws of the Cayman Islands with its principal executive office in Bermuda. Certain of our directors and officers are residents of various jurisdictions outside the United States. All or a substantial portion of our assets and those of such directors and officers, at any one time, are or may be located in jurisdictions outside the United States. Although we have irrevocably agreed that we may be served with process in New York, New York with respect to actions arising out of or in connection with violations of United States Federal securities laws relating to offers and sales of ordinary shares made hereby, it could be difficult for investors to effect service of process within the United States on our directors and officers who reside outside the United States or to recover against us or such directors and officers on judgments of United States courts predicated upon the civil liability provisions of the United States federal securities laws.
The market price for our ordinary shares may be highly volatile.
The market price for our ordinary shares has fluctuated, ranging between $21.68 and $26.02 per share for the 52 weeks ended December 31, 2005. The overall market and the price of our ordinary shares may continue to be volatile. There may be a significant effect on the market price for our ordinary shares due to, among other things:
- changes in investors' and analysts' perceptions of the risks and conditions of our business,
- the size of the public float of our ordinary shares;
- the announcement of acquisitions by us or our competitors;
- variations in our anticipated or actual operating results or the results of our competitors;
- regulatory developments;
- market conditions; and
- general economic conditions.
Limited trading volume of our ordinary shares may contribute to its price volatility.
Our ordinary shares are traded on the New York Stock Exchange. During the twelve months ended December 31, 2005, the average daily trading volume for our ordinary shares as reported by the NYSE was 245,504 shares. As a result, relatively small trades may have a significant effect on the price of our ordinary shares.
Risks Related to Taxation
If we or any of our non-U.S. subsidiaries is determined to be conducting business in the United States, we could be liable for U.S. federal income taxes which could negatively affect our net income.
We are a holding company incorporated under the laws of the Cayman Islands with our principal executive office in Bermuda. We and our non-U.S. subsidiaries believe they have operated and intend to continue operating in a manner such that neither we nor any of our non-U.S. subsidiaries should be treated as engaging in a trade or business in the United States and thus should not be subject to U.S. federal income taxation on net income. Because there are no definitive standards provided by the Code, regulations or court decisions there is considerable uncertainty as to which activities constitute being engaged in the conduct of a trade or business within the United States and as the determination is essentially factual in nature, the United States Internal Revenue Service, or the IRS, could contend that Scottish Re or one or more of its non-U.S. subsidiaries, is engaged in a trade or business in the United States for U.S. federal income tax purposes, and thus may be subject to U.S. federal income tax and "branch profits" tax on net income. The highest marginal federal income tax rates currently are 35% for a corporation's income that is effectively connected with a U.S. trade or business and 30% for the "branch profits" tax unless the "branch profits" tax is reduced by an applicable income tax treaty.
If we or any of our non-U.S. subsidiaries is treated as a controlled foreign corporation or a passive foreign investment company or if any of our non-U.S. insurance subsidiaries generate more than a permissible amount of related person insurance income, U.S. persons who own our shares may be subject to U.S. federal income taxation on our undistributed earnings and may recognize ordinary income upon disposition of our shares.
We believe that we were not a controlled foreign corporation or a passive foreign investment company, nor have we generated an impermissible amount of related person insurance income for the year ended December 31, 2005. Although no assurances can be given, based upon (i) our current beliefs with respect to the dispersion of our share ownership and (ii) our financial information for the period ending December 31, 2005, we do not expect to be a controlled foreign corporation or a passive foreign investment company or to generate an impermissible amount of related person insurance income for the current year or in the future but we cannot be certain that this will be the case because some of the preceding facts are beyond our control. Our shareholders who are U.S. persons may be required to include in gross income for U.S. federal income tax purposes our undistributed earnings if we are treated as a controlled foreign corporation or a passive foreign investment company or if we have generated more than a permissible amount of related person insurance income. In addition, in certain cases gain on the disposition of our ordinary shares may be treated as ordinary income.
Controlled Foreign Corporation. Each U.S. 10% holder of a controlled foreign corporation on the last day of the controlled foreign corporation's taxable year generally must include in gross income for U.S. federal income tax purposes such shareholder's pro-rata share of the controlled foreign corporation's subpart F income, even if the subpart F income has not been distributed. For purposes of this discussion, the term "U.S. 10% holder" includes only persons who, directly or indirectly through non-U.S. entities (or through the application of certain "constructive" ownership rules, which we refer to as constructively), own 10% or more of the total combined voting power of all classes of stock of the foreign corporation. In general, a non-U.S. company is treated as a controlled foreign corporation if such U.S. 10% holders collectively own more than 50% of the total combined voting power or value of our stock for an uninterrupted period of 30 days or more during any year and a non-U.S. insurance company is treated as a controlled foreign corporation if such U.S. 10% holders collectively own more than 25% of the total combined voting power or value of our stock for an uninterrupted period of 30 days or more during any year.
At the present time, our largest aggregate shareholder, the Cypress Entities, owns collectively approximately 17.5% of our ordinary shares. In order to lessen the risk that Scottish Re or any of its non-U.S. subsidiaries could be characterized as a controlled foreign corporation, our articles of association prohibit the ownership by any person of shares that would equal or exceed 10% (or in the case of the Cypress Entities that would exceed 24.9%) of any class of the issued and outstanding Scottish Re shares and provide a "voting cutback" that would, in certain circumstances, reduce the voting power with respect to Scottish Re shares to the extent necessary to prevent the Cypress Entities from owning more than 24.9% of the voting power of Scottish Re, and any other person owning more than 9.9% of the voting power of Scottish Re. We believe, although not free from doubt, based upon information made available to us regarding our existing shareholder base, that the dispersion of our share ownership (other than with respect to the Cypress Entities) and the provisions of our articles of association
restricting the transfer, issuance and voting power of our shares should prevent any person (other than certain potential U.S. affiliates of the Cypress Entities) from becoming a U.S. 10% holder of Scottish Re; however, we cannot be certain of this belief because of factual uncertainties and some of these provisions have not been directly passed on by the IRS, or by any court, in this context.
If, however, one or more U.S. persons owning (directly, indirectly through non-U.S. entities or constructively) 10% or more of our voting stock were to acquire separately or in the aggregate 25% of the vote or value of the stock of Scottish Re, our non-U.S. insurance subsidiaries would be treated as controlled foreign corporations. In addition, Scottish Re and its other (non-insurance) non-U.S. subsidiaries would be characterized as controlled foreign corporations if such U.S. persons were to acquire more than 50% of the vote or value of the stock of Scottish Re. In either case, any such U.S. 10% holder would be required to include in gross income its pro-rata share of subpart F income of Scottish Re and/or its non-U.S. subsidiaries.
Related Person Insurance Income. If (i) any of our non-U.S. insurance subsidiaries' related person insurance income, or RPII, determined on a gross basis were to equal or exceed 20% of its gross insurance income in any taxable year, (ii) direct or indirect insureds and persons related to such insureds were to own directly or indirectly 20% or more of the voting power or value of Scottish Re's stock or any of our non-U.S. insurance subsidiaries' stock, and (iii) U.S. persons (without regard to whether any U.S. person is a U.S. 10% holder) directly, indirectly or constructively own collectively by voting power or value 25% or more of our aggregate shares (taking into account the relative vote and value of different classes of shares), such U.S. persons who directly or indirectly own our shares on the last day of the taxable year would be required to include in its gross income for U.S. federal income tax purposes, the U.S. person's pro-rata share of our non-U.S. insurance subsidiaries' RPII for the portion of the taxable year during, which any such non-U.S. insurance subsidiary was a controlled foreign corporation under the RPII provisions determined as if such RPII were distributed proportionately to U.S. persons at that date, taking into account any differences existing with respect to the distribution rights applicable to different classes of shares.
Related person insurance income is generally underwriting premium and related investment income attributable to insurance or reinsurance policies when the direct or indirect insureds are direct or indirect U.S. shareholders or are related to such direct or indirect U.S. shareholders. At present, we believe that our non-U.S. insurance subsidiaries should satisfy the 20% RPII ownership exception described herein because the direct or indirect ownership of the shares of Scottish Re or any of its non-U.S. insurance subsidiaries by any shareholders that are direct or indirect insureds of any of Scottish Re's non-U.S. insurance subsidiaries (or any person related to such insureds) should be less than 20% of the voting power or value of Scottish Re or any of its non-U.S. insurance subsidiaries. Even if the 20% RPII ownership exception described above is not met, although no assurances can be given, we do not believe that the 20% gross insurance income threshold has been met and we do not expect such threshold to be met in the future but we cannot be certain of the preceding belief because certain of the preceding facts are beyond our control.
If we are characterized as a controlled foreign corporation under the RPII provisions, U.S. persons who directly or indirectly own our shares on the last day of such taxable year would be required to include in its gross income for U.S. federal income tax purposes, the U.S. person's pro-rata share of the relevant non-U.S. insurance subsidiaries' RPII for the portion of the taxable year during which any such non-U.S. insurance subsidiary was a controlled foreign corporation under the RPII provisions determined as if such RPII were distributed proportionately to such U.S. person at that date, taking into account any differences existing with respect to the distribution rights applicable to different classes of shares.
Dispositions of Our Shares. If we are considered to be a controlled foreign corporation, any gain from the sale or exchange of our shares by a U.S. 10% holder of our shares may be treated as ordinary income to the extent of our earnings and profits during the period that such shareholder held our ordinary shares (with certain adjustments).
If we are considered to have RPII and U.S. persons (without regard to whether any U.S. person is a U.S. 10% holder) collectively own directly, indirectly or constructively 25% or more of the voting power or value of our aggregate shares (taking into account the relative vote and value of different classes of shares), any gain from the disposition of our shares by a U.S. holder will generally be treated as income to the extent of such U.S. holder's portion of our undistributed earnings and profits that were accumulated during the period that the U.S. holder owned the shares (with certain adjustments). In addition, such U.S. holder will be required to comply with certain reporting requirements, regardless of the amount of shares owned directly or indirectly. However, because Scottish Re is not itself directly engaged in the insurance business
and because proposed U.S. Treasury regulations applicable to this situation appear to apply only to sales of shares of corporations that are directly engaged in the insurance business, we do not believe that sale of our shares should be subject to these rules. The IRS, however, could interpret the proposed regulations, or the proposed regulations could be promulgated in final form, in a manner that would cause these rules to apply to dispositions of our ordinary shares.
Passive Foreign Investment Company. In order to avoid significant potential adverse U.S. federal income tax consequences for any U.S. person who owns our shares, we cannot be characterized as a passive foreign investment company, or PFIC, in any year in which such U.S. person is a shareholder. In general, a non-U.S. corporation is a PFIC for a taxable year if 75% or more of its income constitutes passive income or 50% or more of its assets produce passive income. Passive income generally includes interest, dividends and other investment income. Passive income does not, however, include income derived in the active conduct of an insurance business by a corporation that is predominantly engaged in an insurance business. This exception is intended to ensure that income derived by a bona fide insurance company is not treated as passive income, except to the extent such income is attributable to financial reserves in excess of the reasonable needs of the insurance business. Although we believe that Scottish Re and its non-U.S. subsidiaries, taken as a whole, are engaged predominantly in insurance and reinsurance activities that involve significant risk transfer and that are otherwise activities of a type normally undertaken by insurance or reinsurance companies, and do not expect to have financial reserves in excess of the reasonable needs of their insurance businesses, it is possible that the IRS could take the position that we are a PFIC. Although we do not believe that we are or will be a PFIC, the IRS or a court could concur that we are a PFIC with respect to any given year.
If we are a controlled foreign corporation or if any of our non-U.S. insurance subsidiaries generate RPII, U.S. tax-exempt organizations that own our shares may recognize unrelated business taxable income.
A U.S. tax-exempt organization may recognize unrelated business taxable income if a portion of our insurance income is allocated to the organization. In general, insurance income will be allocated to a U.S. tax-exempt organization if either we are a controlled foreign corporation and the tax-exempt shareholder is a U.S. 10% holder or there is RPII and certain exceptions do not apply. Although we do not believe that any U.S. persons should be allocated subpart F insurance income, potential U.S. tax-exempt investors are advised to consult their own tax advisors.
Changes in U.S. federal income tax law could materially adversely affect an investment in our shares.
Legislation has been introduced in the U.S. Congress intended to eliminate certain perceived tax advantages of companies (including insurance companies) that have legal domiciles outside the United States but have certain U.S. connections. While there are no currently pending legislative proposals which, if enacted, would have a material adverse effect on us or our shareholders, it is possible that broader-based legislative proposals could emerge in the future that could have an adverse impact on us, or our shareholders.
Additionally, the U.S. federal income tax laws and interpretations regarding whether a company is engaged in a trade or business within the United States, or is a PFIC, or whether U.S. persons would be required to include in their gross income the subpart F income or the RPII of a controlled foreign corporation are subject to change, possibly on a retroactive basis. There are currently no regulations regarding the application of the PFIC rules to insurance companies and the regulations regarding RPII are still in proposed form. New regulations or pronouncements interpreting or clarifying such rules may be forthcoming. We cannot be certain if, when or in what form such regulations or pronouncements may be provided and whether such guidance will have a retroactive effect.
Future transactions may limit our ability to use our net operating loss carryforwards.
As of December 31, 2005, we had actual net operating loss carryforwards, or NOLs, of approximately $615.5 million. $603.1 million is attributable to the U.S. operations and $12.4 million is attributable to the U.K. operations. The U.K. net operating loss has an unlimited carryforward period. The U.S. NOLs may be used to offset future taxable income and thereby reduce our U.S. federal income taxes otherwise payable. Section 382 of the Code, imposes an annual limit on the ability of a corporation that undergoes an "ownership change" to use its NOLs to reduce its tax liability. It is possible that future transactions (including issuances of new shares and sales of our shares), would cause us to undergo an ownership change. In that event, we would not be able to use our pre-ownership-change NOLs in excess of the limitation imposed by Section 382.
If we do not receive further undertakings from the Cayman Islands, we may become subject to taxes in the Cayman Islands in the future.
Scottish Re and our Cayman Islands subsidiaries, Scottish Annuity & Life Insurance Company (Cayman) Ltd. and The Scottish Annuity Company (Cayman) Ltd., have received undertakings from the Governor-in-Council of the Cayman Islands pursuant to the provisions of the Tax Concessions Law, as amended (1999 Revision), that until the year 2028 with respect to Scottish Re and Scottish Annuity & Life Insurance Company (Cayman) Ltd., and until the year 2024 with respect to The Scottish Annuity Company (Cayman) Ltd., (1) no subsequently enacted Cayman Islands law imposing any tax on profits, income, gains or appreciation shall apply to Scottish Re and its Cayman Islands subsidiaries and (2) no such tax and no tax in the nature of an estate duty or an inheritance tax shall be payable on any shares, debentures or other obligations of Scottish Re and its Cayman Islands subsidiaries. We could be subject to Cayman Islands taxes after the applicable dates.
If Bermuda law changes, we may become subject to taxes in Bermuda in the future.
Bermuda currently imposes no income tax on corporations. The Bermuda Minister of Finance, under The Exempted Undertakings Tax Protection Act 1966 of Bermuda, has assured us that if any legislation is enacted in Bermuda that would impose tax computed on profits or income, or computed on any capital asset, gain or appreciation, or any tax in the nature of estate duty or inheritance tax, then the imposition of any such tax will not be applicable to Scottish Re or any of our Bermuda subsidiaries until March 28, 2016. Scottish Re or any of our Bermuda subsidiaries could be subject to Bermuda taxes after that date.
The impact of letters of commitment from Bermuda and the Cayman Islands to the Organization for Economic Cooperation and Development to eliminate harmful tax practices may impact us negatively.
The Organization for Economic Cooperation and Development, or OECD, has published reports and launched a global dialogue among member and non-member countries on measures to limit harmful tax competition. These measures are largely directed at counteracting the effects of tax havens and preferential tax regimes in countries around the world. In the OECD's report dated April 18, 2002, and updated as of June 2004 and November 2005 via a "Global Forum", Bermuda and the Cayman Islands were not listed as uncooperative tax haven jurisdictions because each had previously committed itself to eliminate harmful tax practices and to embrace international tax standards for transparency, exchange of information and the elimination of any aspects of the regimes for financial and other services that attract business with no substantial domestic activity. We are not able to predict what changes will arise from the commitment or whether such changes will subject us to additional taxes.
Item 1B:
Item 1B: UNRESOLVED STAFF COMMENTS
None.
Item 2:
Item 2: PROPERTIES
We currently lease office space in Hamilton, Bermuda where our executive and principal offices are located, and in Dublin, Ireland; George Town, Grand Cayman; Singapore; Denver, Colorado; Charlotte, North Carolina; and Windsor, England. Our life reinsurance business operates out of the Bermuda, Grand Cayman, Charlotte, Denver and Windsor offices while our wealth management business operates out of the Grand Cayman office. The Bermuda, Dublin and Grand Cayman leases expire in 2006, the Singapore lease expires in 2008, the Denver lease expires in 2010, with an option to lease office space for an additional five year option, the Charlotte lease expires in 2016 and the Windsor lease expires in 2023.
Item 3:
Item 3: LEGAL PROCEEDINGS
In the normal course of our business, we and our subsidiaries are occasionally involved in litigation. The ultimate disposition of such litigation is not expected to have a material adverse effect on our financial condition, liquidity or results of operations.
Item 4:
Item 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
We did not submit any matter to the vote of shareholders during the fourth quarter of 2005.
PART II
Item 5:
Item 5: MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market for the Ordinary Shares
Our ordinary shares, par value $0.01 per share, have been traded on the New York Stock Exchange under the symbol "SCT" since January 23, 2002. Prior to our listing on the New York Stock Exchange our ordinary shares were listed and traded on the NASDAQ National Market under the symbol "SCOT" since November 24, 1998. This table shows for the indicated periods the high and low intraday sales prices per share for our ordinary shares, as reported in The Wall Street Journal, and dividend declared per share.
Per Share High Low Dividend ---- --- -------- Year ended December 31, 2003 First Quarter ............................ $ 18.06 $ 16.55 $ 0.05 Second Quarter ........................... 20.68 17.00 0.05 Third Quarter ............................ 24.43 19.85 0.05 Fourth Quarter ........................... 24.62 18.90 0.05 Year ended December 31, 2004 First Quarter ............................ $ 24.59 $ 20.21 $ 0.05 Second Quarter ........................... 24.40 20.50 0.05 Third Quarter ............................ 23.79 19.59 0.05 Fourth Quarter ........................... 26.15 20.90 0.05 Year ended December 31, 2005 First Quarter ............................ $ 26.00 $ 22.01 $ 0.05 Second Quarter ........................... 24.48 21.68 0.05 Third Quarter ............................ 26.02 23.13 0.05 Fourth Quarter ........................... 25.99 23.15 0.05 Period Ended March 9, 2006 January 1, 2006 to March 9, 2006.......... $ 25.49 $ 23.77 $ -
As of March 9, 2006, we had 29 record holders of our ordinary shares.
We paid cash dividends of $0.20 per ordinary share in each of 2005, 2004 and 2003.
The declaration and payment of future dividends by us will be at the discretion of the Board of Directors and will depend upon many factors, including our earnings, financial condition, business needs, capital and surplus requirements of our operating subsidiaries and regulatory and contractual restrictions.
As a holding company, our principal source of income is dividends or other statutorily permissible payments from its subsidiaries. The ability to pay such dividends is limited by the applicable laws and regulations of the various countries that we operate in, including Bermuda, the United States, Ireland and the U.K. See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Item 8, Note 15 to the Consolidated Financial Statements for further discussion.
Information concerning securities authorized for issuance under equity compensation plans appears in Part III, Item 12, "Security Ownership of Certain Beneficial Owners, Management and Related Stockholder Matters".
Item 6:
Item 6: SELECTED FINANCIAL DATA
The following selected financial data should be read in conjunction with the Consolidated Financial Statements, including the related Notes, and "Management's Discussion and Analysis of Financial Condition and Results of Operations".
(Expressed in Thousands of United States Dollars, except share data)
- -------------- (1) Scottish Re Holdings Limited was acquired on December 31, 2001 and is included in balance sheet data for 2001-2005 and income statement data for years 2002-2005.
Scottish Re Life Corporation was acquired on December 22, 2003 and is included in balance sheet data and income statement data for years 2003-2005. Consolidated statement of income data for the year ended December 31, 2003 includes net income of $1.2 million in respect of Scottish Re Life Corporation.
The ING individual life reinsurance business was acquired on December 31, 2004 and is included in balance sheet data for years 2004 and 2005 and income statement data for 2005.
(2) Reflects reduction for dividends declared on non-cumulative perpetual preferred shares.
(3) Book value per share is calculated as shareholders' equity divided by the number of ordinary shares outstanding.
Item 7:
Item 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion highlights significant factors influencing our consolidated financial position and our results of operations. It should be read in conjunction with the summary of selected financial data, consolidated financial statements and related notes found under Part II, Item 6 and Item 15 contained herein. In addition, you should read our discussion of "Critical Accounting Policies" beginning on page 42 for an explanation of those accounting estimates that we believe are most important to the portrayal of our financial condition and results of operations and that require our most difficult, subjective and complex judgments.
Overview
We are a holding company incorporated under the laws of the Cayman Islands with our principal executive office in Bermuda. We are a reinsurer of life insurance, annuities and annuity-type products. These products are written by life insurance companies and other financial institutions located principally in the United States. We refer to this portion of our business as Life Reinsurance North America. We also specialize in niche markets in developed countries and broader life insurance markets in the developing world. More recently, we have become actively engaged in the reinsurance of United Kingdom and Ireland traditional solutions business and annuity products. We refer to this portion of our business as Life Reinsurance International. Life Reinsurance North America and Life Reinsurance International are each a reporting operating segment. We directly issue variable life insurance and variable annuities and similar products to high net worth individuals and families for insurance, investment and estate planning purposes. In prior years, we referred to this portion of our business as Wealth Management, which was another reportable operating segment. As this business is no longer a material contributor to our results and we are no longer actively marketing this business, we have combined it with the Corporate and Other Segment for all periods presented. Other revenues and expenses not related to Life Reinsurance are reported in the Corporate and Other Segment. The segments are consistent with the way in which we use financial information to evaluate business performance and to determine the allocation of resources. We measure segment performance based on profit or loss from operations before income taxes.
On December 31, 2004, we completed the acquisition of the individual life reinsurance business of ING. We reinsured the liabilities of all of ING's individual life reinsurance business through a 100% coinsurance transaction. ING transferred to us assets of approximately $1.8 billion. Certain of these assets are held in trust to secure the reserve obligations of the business. Additionally, ING transferred to us certain operating assets associated with the business. During 2005, we fully integrated the ING acquisition with our existing U.S. traditional business and migrated our Charlotte based policy administration operations to Denver. We now administer our combined business with an enhanced version of the ING policy administration system, known as SAGE. With the acquisition of the ING life reinsurance business, we have grown to be one of the three largest life reinsurers serving the United States.
On December 22, 2003, we completed the acquisition of 95% of the outstanding capital stock of ERC Life Corporation (renamed Scottish Re Life Reinsurance Corporation), for $169.9 million in cash. Scottish Re Life Corporation's business consists primarily of a closed block of traditional life reinsurance.
In 2005, we established Scottish Re Capital Markets, Inc., which is a registered broker dealer, formed to leverage the experience and expertise we have gained through our own efforts to deal with Regulation XXX and other reserve requirements. We believe Scottish Re Capital Markets can successfully assist our clients, both large and small, to effectively and efficiently access the capital markets to meet their reserving needs.
The most important factors we monitor to evaluate our financial condition and performance include:
o Operations: premiums, changes in the number of treaties and life insurance in force, investment results, claim frequency and severity trends, claims and benefit ratio and acquisition and expense ratios and operating earnings per share;
o Investments: credit quality/experience, stability of long-term returns, cash flows and asset and liability duration; and
o Financial condition: our financial strength ratings, financial leverage and growth in return on equity and book value per share.
2005 Highlights
o Net income was $130.2 million in 2005 compared to $71.4 million in 2004. Net income available to ordinary shareholders per diluted share was $2.64 in 2005 compared to $1.90 in 2004, an increase of 39%;
o Total revenues reached a record $2.3 billion, an increase of 182% compared to last year;
o On January 12, 2005, we completed a private offering of $325.0 million Collateral Facility Securities through Stingray Pass-Through Trust. This transaction allows us to use eligible assets as collateral in our reinsurance business and it will guarantee our ability and capacity to issue $325.0 million of funding agreements in the future, without any capital market or execution risk at the time of issuance;
o On February 11, 2005, we completed our first securitization of excess reserves arising from Regulation XXX through an offering by Orkney Holdings, LLC of $850.0 million aggregate principal amount of 30-year maturity securities;
o In July 2005, we completed a public offering of 5,000,000 non-cumulative perpetual preferred shares with net proceeds of $120.4 million;
o During the fourth quarter of 2005, we fully completed the integration of the ING acquisition with our existing United States traditional business and migrated our Charlotte based policy administration operations to Denver;
o On December 21, 2005, we completed our second securitization of excess reserves arising from Regulation XXX through an offering by an orphaned Irish special purpose reinsurance company of $450.0 million aggregate principal amount of 30-year maturity securities;
o In December 2005, we completed a public offering of 7,660,000 ordinary shares (which included an over allotment option of 1,410,000 shares) in which we raised aggregate net proceeds of $174.1 million. In connection with the offering, we entered into variable share forward sales agreements whereby the forward purchasers agree to pay us an aggregate of approximately $75.0 million on September 29, 2006 and an aggregate of approximately $75.0 million on December 29, 2006; and
o In December 2005, we completed two transactions that together provided approximately $2.0 billion in collateral to fund Regulation XXX reserve requirements that were assumed in connection with the acquisition of ING's individual life reinsurance business.
Revenues, expenses and other factors affecting profitability
Revenues
We derive revenue primarily from premiums from reinsurance assumed on life business from existing treaties and from premiums on new treaties; investment income; realized gains and losses from our investment portfolio and fees from our financial solutions and wealth management businesses.
Our primary business is life reinsurance, which involves reinsuring life insurance policies, with premiums earned typically over a period of 10 to 30 years. Each year, however, a portion of the business under existing treaties
terminates due to, among other things, lapses or surrenders of underlying policies, deaths of policyholders and the exercise of recapture options by ceding companies.
Premiums from reinsurance assumed on life business are included in revenues over the premium paying period of the underlying policies. When we acquire blocks of in-force business, we account for these transactions as purchases, and our results of operations include the net income from these blocks as of their respective dates of acquisition. Reinsurance assumed on annuity business does not generate premium income but generates investment income over time on the assets we receive from the ceding company. We also earn revenues on funding agreements. A deposit received on a funding agreement also does not generate premium income but does create income to the extent we earn an investment return in excess of our interest payment obligations thereon.
Our investment income includes interest earned on our fixed income investments and income from funds withheld at interest under modified coinsurance agreements or coinsurance funds withheld agreements. Under GAAP, because our fixed income investments are held as available for sale, these securities are carried at fair value, and unrealized appreciation/depreciation on these securities is not included in investment income on our statements of income, but is included in comprehensive income as a separate component of shareholders' equity. Realized gains and losses include gains and losses on investment securities that we sell during a period, write downs of securities deemed to be other than temporarily impaired and foreign currency exchange gains and losses.
Expenses
We have six principal types of expenses: claims and policy benefits under our reinsurance contracts; interest credited to interest sensitive contract liabilities; acquisition costs and other insurance expenses; operating expenses; collateral finance facilities expense; and interest expense.
When we issue a life reinsurance contract, we establish reserves for claims and future policy benefits. These reserves are our estimates of what we expect to pay in claims and policy benefits and related expenses under the contract or policy. From time to time, we may change the reserves if our experience leads us to believe that benefit claims and expenses will ultimately be greater than the existing reserve. We report the change in these reserves as an expense during the period when the reserve or additional reserve is established.
In connection with reinsurance of annuity and annuity-type products, we record a liability for interest sensitive contract liabilities, which represents the amount ultimately due to the policyholder. We credit interest to these contracts each period at the rates determined in the underlying contract, and the amount is reported as interest credited to interest sensitive contract liabilities on our consolidated statements of income.
A portion of the costs of acquiring new business, such as commissions, certain internal expenses related to our policy issuance and underwriting departments and other variable selling expenses are capitalized. The resulting deferred acquisition costs asset is amortized over future periods based on our expectations as to the emergence of future gross profits from the underlying contracts. These costs are dependent on the structure, size and type of business written. For certain products, we may retrospectively adjust our amortization when we revise our estimate of current or future gross profits to be realized. The effects of this adjustment are reflected in earnings in the period in which we revise our estimate. Acquisition costs also include letter of credit costs.
Operating expenses consist of salary and salary related expenses, legal and professional fees, rent and office expenses, travel and entertainment expenses, directors' expenses, insurance and other similar expenses, except to the extent capitalized in deferred acquisition costs.
Collateral finance facilities expense includes costs incurred on our Regulation XXX funding arrangements and other collateral finance facilities. See Note 8 to the Consolidated Financial Statements for additional information.
Interest expense consists of interest charges on our long-term debt and HyCU instruments.
Other factors affecting profitability
We seek to generate profits from two principal sources. First, in our Life Reinsurance business, we seek to receive reinsurance premiums and financial reinsurance fees that, together with income from the assets in which those premiums are invested, exceed the amounts we ultimately pay as claims and policy benefits, acquisition costs and ceding commissions. Second, within our investment guidelines, we seek to maximize the return on our unallocated capital.
The following factors affect our profitability:
o the volume of business we write;
o volume and amount of death claims incurred; o our ability to assess and price adequately for the risks we assume;
o the mix of different types of business that we reinsure, because profits on some lines of business emerge later than on other lines;
o our ability to manage our assets and liabilities to manage investment and liquidity risk; and
o our ability to control expenses.
In addition, our profits can be affected by a number of factors that are not within our control. For example, movements in interest rates can affect the volume of business that we write, the income earned from our investments, the interest we credit on interest sensitive contracts, the level of surrender activity on contracts that we reinsure and the rate at which we amortize deferred acquisition costs. Other external factors that can affect profitability include mortality experience that varies from our assumed mortality. In addition, while death claims are reasonably predictable over a period of many years claims become less predictable over shorter periods and are subject to significant fluctuation from quarter to quarter and year to year. Other factors include changes in regulation or tax laws which may affect the attractiveness of our products or the costs of doing business and changes in foreign currency exchange rates.
Critical Accounting Policies
Given the nature of our business, our accounting policies require the use of judgments relating to a variety of assumptions and estimates. Because of the inherent uncertainty in the assumptions and estimates underlying these accounting policies under different conditions or assumptions, the amounts reported in our financial statements could be materially different. Our accounting policies are described in Note 2 to the Consolidated Financial Statements. We believe our most critical accounting policies include the establishment of reserves for future policy benefits, the capitalization and amortization of deferred acquisition costs, the valuation of present value of in-force business, the valuation of investment impairments, the valuation of embedded derivatives, estimates of premiums, the valuation of tax balances and the determination of whether we are the primary beneficiary of a variable interest entity.
Statement of Financial Accounting Standard ("SFAS") No. 60 "Accounting and Reporting by Insurance Enterprises" applies to our traditional life policies with continuing premiums. For these policies, reserves for future policy benefits are computed based upon expected mortality rates, lapse rates, investment yields, expenses and other assumptions established at policy issue, including a margin for adverse deviation. Once these assumptions are made for a given treaty or group of treaties, they will not be changed over the life of the treaty. We periodically review actual historical experience and relative anticipated experience compared to the assumptions used to establish reserves for future policy benefits. Further, we determine whether actual and anticipated experience indicates that existing policy reserves together with the present value of future gross premiums are sufficient to cover the present value of future benefits, settlement and maintenance costs and to recover unamortized acquisition costs. Significant changes in experience or assumptions may require us to provide for expected losses on a group of treaties by establishing additional net reserves. Because of the many assumptions and estimates used in establishing reserves
and the long-term nature of the reinsurance contracts, the reserving process, while based on actuarial science, is inherently uncertain.
We primarily rely on our own valuation and administration systems to establish reserves for future policy benefits. The reserves for future policy benefits may differ from those established by ceding companies due to the use of different assumptions, based principally on actual and anticipated experience, including industry experience and standards. We rely on our ceding companies, however, to provide accurate policy level data, including face amount, age, duration and other characteristics as well as underlying premiums and claims. This data constitutes the primary information used to establish reserves for essentially all of our future policy benefits. The use of reinsurance intermediaries in our transactions with ceding companies has been infrequent. In the few instances in which intermediaries are involved, we receive data from the intermediary in a similar timeframe and fashion as if received directly from the ceding company.
Claims payable for incurred but not reported losses are determined using case basis estimates and lag studies of past experience. The time lag from the date of the claim or death to when the ceding company reports the claim to us can vary significantly by ceding company, but generally averages around 2 months. We update our analysis of incurred but not reported losses, including lag studies, on a quarterly basis and adjust our claim liabilities accordingly. The adjustments in a given period have generally not been significant relative to the overall reserves for future policy benefits or our results of operations.
In the underwriting process, we perform procedures to evaluate the ceding company's process for compiling and reporting data. After entering into a reinsurance contract, we work closely with our ceding companies to help ensure information submitted by them is in accordance with the underlying reinsurance contracts. Additionally, we have a dedicated compliance team that performs extensive audits, including on-site audits and desk reviews, of the information provided by ceding companies. In addition to ceding company audits, we routinely perform analysis, at a treaty level, to compare the actual results of ceding companies against initial pricing and expected results. Generally, there have been few disputes or disagreements with ceding companies and most are resolved through normal administration procedures.
Occasionally, we experience processing backlogs and establish reserves for processing backlogs with a goal of clearing all backlogs as quickly as possible. There were no significant processing backlogs at December 31, 2005.
SFAS No. 97 "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments" applies to investment contracts, limited premium contracts, and universal life-type contracts. For investment and universal life-type contracts, future benefit liabilities are held using the retrospective deposit method, increased for amounts representing unearned revenue or refundable policy charges. Acquisition costs are deferred and recognized as expense as a constant percentage of gross margins using assumptions as to mortality, persistency, and expense established at policy issue without provision for adverse deviation and are revised periodically to reflect emerging actual experience and any material changes in expected future experience. Liabilities and the deferral of acquisition costs are established for limited premium policies under the same practices as used for traditional life policies with the exception that any gross premium in excess of the net premium is deferred and recognized into income as a constant percentage of insurance in force. Should the liabilities for future policy benefits plus the present value of expected future gross premiums for a product be insufficient to provide for expected future benefits and expenses for that product, deferred acquisition costs will be written off and thereafter, if required, a premium deficiency reserve will be established by a charge to income. Changes in the assumptions for mortality, persistency, maintenance expense and interest could result in material changes to the financial statements.
Reinsurance premiums from traditional life policies and annuity policies with life contingencies are generally recognized as revenue when due from policyholders and are reported net of amounts retroceded. Traditional life policies include those contracts with fixed and guaranteed premiums and benefits, and consist principally of whole life and term insurance policies. For our traditional life reinsurance business, we estimate assumed premiums using actuarial model projections at the treaty level. Consistent with reinsurance industry practices, these models use the most recent policy level data available from our ceding companies and our estimate of new business for treaties still open to new business. The estimated premiums from the models are then compared
to historical trends in reported assumed premiums by treaty and other information and adjusted if appropriate. Actual results could differ from these estimates. The adjustments in a given period have generally not been significant to the overall premiums or results of operations.
Based on historical experience, the creditworthiness of ceding companies and our contractual right of offset, uncollectible assumed premium amounts have been infrequent and not material. Any provision for doubtful accounts would be recorded on a specific case-by-case basis.
The development of policy reserves and amortization of deferred acquisition costs for our products requires management to make estimates and assumptions regarding mortality, lapse, expense and investment experience. Such estimates are primarily based on historical experience and information provided by ceding companies. Actual results could differ materially from those estimates. Management monitors actual experience, and should circumstances warrant, will revise its assumptions and the related reserve estimates.
Present value of in-force business is established upon the acquisition of a subsidiary and is amortized over the expected life of the business at the time of acquisition. The amortization each year will be a function of the gross profits or revenues each year in relation to the total gross profits or revenues expected over the life of the business, discounted at the assumed net credit rate. The determination of the initial value and the subsequent amortization require management to make estimates and assumptions regarding the future business results that could differ materially from actual results. Estimates and assumptions involved in the present value of in-force business and subsequent amortization are similar to those necessary in the establishment of reserves and amortization of deferred acquisition costs.
Our primary investments are in fixed maturity securities, including corporate and government bonds, asset and mortgage-backed securities. All our fixed maturity and preferred stock are classified as available-for-sale as defined in SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS No. 115"). Available-for-sale securities are carried at fair value with the difference from amortized cost included in shareholders' equity as a component of accumulated other comprehensive income. The difference is net of related deferred acquisition costs and taxes. Fair values for fixed maturity securities are based on quoted market prices, where available. For fixed maturity securities that are not actively traded, fair values are estimated using values obtained from independent pricing services.
Determining whether a decline in current fair values is other than a temporary decline in value for securities classified as available-for-sale can frequently involve a variety of assumptions and estimates, particularly for investments that are not actively traded on established markets. For instance, assessing the value of some investments requires an analysis of expected future cash flows.
Management reviews securities with material unrealized losses and tests for other than temporary impairments on a quarterly basis. Factors involved in the determination of potential impairment include fair value as compared to cost, length of time the value has been below cost, credit worthiness of the issuer, forecasted financial performance of the issuer, position of the security in the issuer's capital structure, the presence and estimated value of collateral or other credit enhancement, length of time to maturity, interest rates and our intent and ability to hold the security until the market value recovers. When a decline is considered to be "other-than-temporary" the cost basis of the impaired asset is adjusted to its fair value and a corresponding realized investment loss is recognized in the consolidated statements of income. The actual value at which such financial instruments could actually be sold or settled with a willing buyer may differ from such estimated fair values.
As the discussion above indicates, there are risks and uncertainties associated with determining whether declines in the fair value of investments are other-than-temporary. These include subsequent significant changes in general overall economic conditions, as well as specific business conditions affecting particular issuers, future financial market effects such as interest rate spreads, future rating agency actions and significant accounting, fraud or corporate governance issues that may adversely affect certain investments. In addition, there are often significant estimates and assumptions that we use to estimate the fair values of securities, including projections of expected
future cash flows and pricing of private securities. We continually monitor developments and update underlying assumptions and financial models based upon new information.
See "Accounting Pronouncements FSP FAS 115-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" for a discussion of potential changes to the requirements for other-than-temporary impairments in Note 2 to the Consolidated Financial Statements.
Our funds withheld at interest arise on modified coinsurance and funds withheld coinsurance transactions. Derivatives Implementation Group Issue No. B36 "Embedded Derivatives: Bifurcation of a Debt Instrument that Incorporates Both Interest Rate and Credit Rate Risk Exposures that are Unrelated or Only Partially Related to the Creditworthiness of the Issuer of that Instrument" ("DIG B36") indicates that these transactions contain embedded derivatives. The embedded derivative feature in our funds withheld treaties is similar to a fixed-rate total return swap on the assets held by the ceding companies. The swap consists of two parts. The first is the market value of the underlying asset portfolio and the second is a hypothetical loan to the ceding company. The hypothetical loan is based on the expected cash flows of the underlying reinsurance liability. We have developed models to systematically estimate the value of the total return swap. The fair value of the embedded derivative is affected by changes in expected cash flows, credit spreads of the assets and changes in "risk-free" interest rates. The change in fair value is included in our calculation of estimated gross profits and, therefore, also affects the amortization of deferred acquisition costs. In addition to our quota share indemnity funds withheld contracts, we have entered into various financial reinsurance treaties that, although considered funds withheld, do not transfer significant insurance risk and are recorded on a deposit method of accounting. As a result of the experience refund provisions of these treaties the value of the embedded derivative is currently considered immaterial. Changes in our expectations of future cash flows could result in material changes to the financial statements.
We utilize the asset and liability method of accounting for income taxes. Under this method, deferred income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. At December 31, 2005, we have net operating tax losses of $615.5 million against which a valuation allowance of $18.5 million has been established. The deferral of benefits from tax losses is evaluated based upon management's estimates of the future profitability of our taxable entities based on current forecasts and the period for which losses may be carried forward. A valuation allowance may have to be established for any portion of a deferred tax asset that management believes will not be realized. Should the future income of these entities fall below expectations, a further valuation allowance would have to be established, which could be significant.
In December 2003, the FASB revised FASB Interpretation No. 46 and 46R, "Consolidation of Variable Interest Entities" ("FIN 46" and "FIN 46R") which was originally issued in January 2003. FIN 46R addresses whether certain types of entities, referred to as variable interest entities ("VIEs"), should be consolidated in a company's financial statements. A company must consolidate a VIE in which it has an ownership, contractual or other financial interest if it is determined to be the primary beneficiary. A primary beneficiary has a variable interest that will absorb a majority of the expected losses if they occur, receive a majority of the entity's expected returns, or both. We are the primary beneficiary of the collateral finance facilities discussed in Note 8 to the Consolidated Financial Statements, except for the Stingray Investor Trust, and have consolidated the variable interest entities in accordance with FIN 46R. The Stingray Investor Trust, discussed in Note 8 to the Consolidated Financial Statements, is a variable interest entity but we are not considered to be the primary beneficiary of the Investor Trust. Accordingly, it is not consolidated in accordance with FIN 46R.
Consolidated results of operations
Our results of operations for the years ended December 31, 2003 and 2004 do not include the results of the acquisition of the ING individual life reinsurance business, which was completed on December 31, 2004. The results for the year ended December 31, 2003 include net income of $1.2 million in respect of the results of Scottish Re Life Corporation for the period from December 22, 2003 to December 31, 2003. All amounts are reported in thousands of United States dollars, except per share amounts.
Comparison of 2005 to 2004
Revenues
Total revenues increased by 182% in 2005 to $2.3 billion compared to 2004. The increase in premiums earned is primarily due to the acquisition of the ING business on December 31, 2004 and growth in the traditional solutions line of business in our Life Reinsurance North America Segment. The key drivers of the 2005 increase in investment income were the growth in our invested assets which arises from business growth and the ING acquisition, net proceeds of $120.4 million from our offering of 5,000,000 non-cumulative perpetual preferred shares in July 2005 and investment income earned on the invested assets from our Regulation XXX initiatives completed during the year.
When analyzing the impact of net investment income on the results of the segment, it is important to understand that a portion of the investment income earned is credited to the policyholders of our fixed annuity products. The interest credited to policyholders is included in the segment's expenses. Annuity product interest rate margins represent the excess of the yield on earning assets over the average crediting rate.
Net realized gains were $12.0 million higher in 2005 than 2004. Improvements in the credit markets in 2005 resulted in less write downs for other than temporary impairments of available for sale securities - $2.4 million in 2005 as compared to $9.9 million in 2004. We also realized a gain of $2.2 million in 2005 compared to a loss of $2.2 million for the same period in 2004, resulting from the mark to market of an interest rate swap. This derivative
has not been designated as a hedge and, accordingly, changes in fair value are recorded in the determination of net income.
The change in value of the embedded derivatives arises from the application of DIG B36. During the year ended December 31, 2003, we implemented the requirements of DIG B36 which addresses whether SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities" requires bifurcation of a debt instrument into a debt host contract and an embedded derivative if the debt instrument incorporates both interest rate risk and credit risk exposures that are unrelated or only partially related to the creditworthiness of the issuer of that instrument. Under DIG B36 modified coinsurance and coinsurance funds withheld reinsurance agreements where interest is determined by reference to a pool of fixed maturity assets, are arrangements containing embedded derivatives requiring bifurcation. In addition, reinsurance contacts with experience refunds are also considered to be arrangements containing embedded derivatives requiring bifurcation. DIG B36 was effective for fiscal quarters beginning October 1, 2003. The change in the value of embedded derivatives decreased revenues by $8.5 million in 2005 compared to an increase of $4.6 million in 2004. This change in value arose principally because of the asset/liability mismatch on modified coinsurance contracts assumed in the ING acquisition, coupled with a decrease in risk free interest rates and widening of credit spreads.
Expenses
Total benefits and expenses in 2005 increased significantly compared to 2004 from $759.0 million to $2.2 billion or an increase of 188%. The increase in claims and policy benefits, acquisition costs and operating expenses was primarily due to the acquisition of the ING business on December 31, 2004 and continued growth in our Life Reinsurance North America Segment. Growth in interest credited reflects an increase in account balances and crediting rates on these balances. Additional operating costs in 2005 resulted from increased resources to support the growth in our business and $7.0 million of additional costs necessary to meet the requirements of the Sarbanes-Oxley Act of 2002. Collateral finance facilities expense in 2005 is impacted by the increased Regulation XXX financing transactions completed during the year. Interest expense increased in 2005 due to full year of interest on the 2004 trust preferred offerings, interest on the Cypress Notes and increases in LIBOR rates during 2005.
When analyzing the impact of collateral finance facilities on the consolidated results, it is important to understand that this expense is offset by the investment income earned on the fixed maturity investments from the collateral finance facility transactions. The net margin represents the excess of the yield on earning assets over the interest rate costs associated with the collateral finance facility.
Our effective tax rate in each reporting period is determined by dividing the net tax benefit (expense) by our pre-tax income or loss. The change in our effective tax rate is due primarily to the amount in any reporting period of pre-tax earnings attributable to different subsidiaries (which changes from time to time), each of which may have different tax rates. The change in our effective tax rate is due primarily to the relationship of pre-tax income or losses in different jurisdictions. See Note 13 of the Consolidated Financial Statements for additional details.
Included in the 2005 tax benefit is a $2.5 million expense related to a write-off of a deferred tax asset related to state income taxes. The 2005 income tax benefit is in respect of certain of our U.S. taxable entities and our U.K. entities, offset by income tax expenses arising on our Irish entity and other U.S. entities. At December 31, 2005, we believe that it is more likely than not that all gross deferred tax assets will reduce taxes payable in future years except for a valuation allowance of $18.5 million.
Net income increased by 82%, or $58.8 million in 2005 compared to 2004 due to the reasons outlined above.
Comparison of 2004 to 2003
Revenues
Total revenues increased by 46% in 2004 compared to 2003. The increase in premiums earned is primarily due to the impact of the acquisition of Scottish Re Life Corporation on December 22, 2003 and growth in the
traditional solutions line of business in our Life Reinsurance North America Segment. The increase in fee income in 2004 arises principally from our acquisition of Scottish Re Life Corporation. The primary drivers of the increase in investment income in 2004 are the impact of the growth in our invested assets, which arises from business growth and acquisition, net proceeds on our offering of ordinary shares in July 2003, our HyCU offering in the fourth quarter of 2003 and trust preferred debt offerings in the fourth quarter of 2003 and the second quarter of 2004.
During 2004, realized losses amounted to $8.3 million in comparison with realized losses of $4.4 million in 2003. Included in 2004 realized losses is $2.2 million resulting from the mark to market of an interest rate swap not designated as a hedge which was entered into in relation to certain of our investment assets not supporting reinsurance liabilities. In 2004, we recognized losses of $9.9 million in respect of impairments on the portfolio controlled by us compared to $6.3 million in 2003.
DIG B36 was effective for fiscal quarters beginning October 1, 2003. We reviewed all contracts at October 1, 2003 and determined that the value of this derivative, net of related deferred acquisition costs, after taxation was a loss of $19.5 million. This is shown in the consolidated statements of income as a cumulative effect of change in accounting principle for 2003. The change in value of the derivative, net of related deferred amortization costs, for 2004 amounted to a gain of $4.6 million. In the quarter ended December 31, 2003, the change in value of this derivative amounted to a gain of $13.9 million. The change in value is primarily due to movements in risk free interest rates and exposure to changing credit spreads.
Expenses
Total benefits and expenses increased by 46% to $758.9 million in 2004 from $518.3 million in 2003. The increase was due to the acquisition of Scottish Re Life Corporation, continued growth in our Life Reinsurance North America Segment, additional operating costs required to meet the growth in our business, additional operating costs necessary to meet the requirements of the Sarbanes-Oxley Act of 2002, costs relating to due diligence activities and additional interest expense arising from the HyCU offering and trust preferred debt offerings in the fourth quarter of 2003 and the second quarter of 2004.
During 2003, we decided to discontinue our Wealth Management operations in Luxembourg. We have transferred our Luxembourg Wealth Management business to third parties, closed the Luxembourg office and are in the process of liquidating our Luxembourg subsidiary. We have reported the results of the Luxembourg wealth management activities as discontinued operations. Losses incurred in respect of these operations in 2004 and 2003 amounted to $0.2 million and $2.0 million, respectively.
The 2004 income tax benefit is in respect of certain of our U.S. taxable entities and our U.K. and Irish entities, offset by income tax expenses arising on our other U.S. entities. Included in the 2004 income tax benefit is $1.7 million in respect of U.S. state taxes and $10.0 million arising in our Irish entity relating to the acquisition of the ING individual life business. In 2004, we established reserves of $3.3 million in respect of certain tax positions.
Net income increased by 162%, or $44.1 million in 2004 compared to 2003 due to the reasons outlined above.
Segment Operating Results
Life Reinsurance North America
In our Life Reinsurance North America Segment we reinsure life insurance, annuities and annuity-type products through yearly renewable term agreements, coinsurance and modified coinsurance agreements. These reinsurance arrangements are predominantly on an automatic basis. These products are written by life insurance companies and other financial institutions located principally in the United States. The results of the ING acquisition, which we completed on December 31, 2004, are included in the results of this segment for the year ended December 31, 2005.
Comparison of 2005 to 2004
Revenues
Net premiums earned increased by $1.3 billion or 289% in 2005 compared to 2004 primarily as a result of the favorable impact of the ING acquisition. The remaining increase is due to the increases in the amounts of life insurance in-force on existing business and on new business written during the year. New business face amounts assumed was $131 billion in 2005 compared to $64 billion in 2004. As of December 31, 2005, we had approximately $1.02 trillion of life reinsurance in-force. As of December 31, 2004, we had just under $1.0 trillion of life insurance in-force.
Net investment income increased by $135.5 million, or 66% in 2005 compared to 2004. The increase is due to the growth in our average invested assets base because of the ING acquisition, Regulation XXX financing transactions, increased operating cash flows and additional trust preferred securities issued in December 2004.
On the portfolio managed by our external investment managers, the yields on fixed rate assets remained flat at 5.2% in, 2005 compared to 2004. Yields on floating rate assets which are indexed to LIBOR increased to 4.9% in 2005 from 3.4% in 2004, and the yield on our cash and cash equivalents increased to 3.9% in 2005 from 1.8% in 2004.
The change in value of embedded derivatives, net of related deferred amortization costs and taxes, arises from the application of DIG B36. The change in the value of embedded derivatives decreased revenues by $8.5 million in 2005 compared to an increase of $4.6 million in 2004. This change in value arose principally because of the asset/liability mismatch on modified coinsurance contracts assumed in the ING acquisition, coupled with a decrease in risk free interest rates and widening of credit spreads.
Expenses
Claims and policy benefits increased by 297% in 2005 compared to 2004. The increase is primarily due to the impact of the ING acquisition. Claims and other policy benefits, as a percentage of net premiums, were 75.2%, and 73.7% in 2005 and 2004, respectively. Death claims are reasonably predictable over a period of many years, but are less predictable over shorter periods and are subject to fluctuation from quarter to quarter. During the second quarter of 2005, we experienced higher than expected mortality which resulted in higher claims of approximately $14 million. This was due principally to a higher than expected number of large claims being incurred. Mortality was within expectations for the remainder of 2005 and thus overall mortality in 2005 was slightly higher than expected. Conversely, in 2004, mortality experience in this business was slightly better than anticipated.
In 2005, interest credited to interest sensitive contract liabilities increased by 25% to $133.0 million from $106.5 million in 2004. The increase is due to interest credited on new reinsurance treaties and increases in interest credited on existing treaties due to increasing average liability balances. Interest sensitive contract liabilities were $3.9 billion at December 31, 2005 in comparison with $3.2 billion at December 31, 2004.
Acquisition costs and other insurance expenses increased by 205% in 2005 compared to 2004. The increase was a result of the ING acquisition and the increased life and annuity business. Acquisition costs and other insurance expenses, as a percentage of operating revenues, were 18.5% and 19.3% in 2005 and 2004, respectively. Operating revenues are defined as total revenues excluding realized gains (losses) and changes in the fair value of embedded derivatives. Excluding the impact of the $6.7 million rebate received from ING related to fees paid on Regulation XXX reserves, acquisition costs and other insurance expenses as a percentage of operating revenues were 18.8% in 2005. Overall, these percentages will fluctuate due to varying allowance levels within coinsurance-type arrangements, the timing of amounts due to and from ceding companies, as well as the amortization pattern of previously capitalized amounts, which are based on the form of the reinsurance agreement and the underlying insurance policies. Additionally, the mix of first year coinsurance versus yearly renewable term can cause the percentage to fluctuate from period to period.
Operating expenses for 2005 compared to 2004 increased by $30.4 million, or 165%. The increase is primarily the result of the ING acquisition and additional personnel and consulting costs incurred as we expanded our infrastructure in response to our recent and anticipated growth. We increased our head count principally because of hiring additional employees in respect of the acquisition of the ING business and adding management bench strength in key functional areas across the segment. Total employees in this segment have grown from 91 at December 31, 2004 to 226 at December 31, 2005. Operating expenses as a percentage of operating revenues decreased from 2.7% in 2004 to 2.3% in 2005 reflecting the benefits of scale and a portion of the benefits of the integration of ING into our existing operations.
The collateral finance facility costs associated with the Regulation XXX financing transactions completed in 2005 contributed to the significant increase in the collateral finance facilities expense in 2005. These facilities are described in Note 8 to the Consolidated Financial Statements.
Interest expense in this segment arises on the trust preferred securities. The increase in interest expense to $10.8 million, results from the issuance of an additional $50.0 million of the trust preferred securities in December 2004 and an increase in the LIBOR interest rates during 2005.
Comparison of 2004 to 2003
Revenues
The increase in premiums earned in 2004 as compared to 2003 was primarily due to the impact of the acquisition of Scottish Re Life Corporation, on December 22, 2003, which contributed $124.8 million in earned premiums. The remaining increase is due to the increase in the number of client ceding companies and the increase in business from these clients. Excluding the business acquired from ING, as of December 31, 2004, we had approximately $305.1 billion of life reinsurance in force compared to approximately $275.0 billion as of December 31, 2003.
Net investment income increased $70.3 million, or 52% in 2004 as compared to 2003. The increase is due to the growth in our average invested assets base and the favorable impact of marginally increased yields during 2004. At December 31, 2004, total invested assets in this segment, excluding those assets acquired in the purchase of ING, increased to $4.5 billion from $3.6 billion at December 31, 2003. On the portfolio managed by our external investment managers the yields on fixed rate assets less cash were 5.2% and 5.1% for 2004 and 2003, respectively. Yields on floating rate assets are indexed to LIBOR. The yield on our floating rate assets less cash remained flat at 3.4% in 2004 compared to 2003, and the yield on our cash and cash equivalents increased to 1.8% in 2004 from 1.0% in 2003. In 2004, the market value of floating-rate assets increased to $963.8 million, excluding those assets acquired in the purchase of ING, from $301.8 million in 2003 as a result of our increased floating rate liabilities.
Fee income in 2004 increased to $7.9 million from $4.1 million in 2003 principally due to the acquisition of Scottish Re Life Corporation.
The change in value of derivatives, net of related deferred amortization costs, arises from the application of DIG B36, which was implemented on October 1, 2003. During 2004 this amounted to a gain of $4.6 million. This change in value arose principally because of an increase in risk free interest rates. The change in value of the embedded derivatives during the period from October 1, 2003 to December 31, 2003 amounted to a gain of $13.9 million. The gain arose from an increase in the risk free rates.
Expenses
Claims and other policy benefits increased by $172.6 milion, or 101% in 2004 as compared to 2003. The increase is a result of the acquisition of Scottish Re Life Corporation, the increased number of clients and the increase in business from these clients as described above. Claims and other policy benefits, as a percentage of net premiums earned, were 73.7%, and 74.7% in 2004 and 2003, respectively. The mortality experience in this segment has fluctuated. This is somewhat expected as death claims are reasonably predictable over a period of many years, but are less predictable over shorter periods and are subject to significant fluctuation.
Interest credited to interest sensitive contract liabilities was $17.4 million higher in 2004 than 2003. During 2003, we incurred $12.5 million due to revised reporting by a ceding company client in connection with two fixed annuity reinsurance contracts. Excluding this charge, interest credited increased by 6% in comparison with the 2003. Interest credited includes interest in respect of funding agreements. The amounts due on funding agreements are included in interest sensitive contract liabilities on our balance sheet and amount to $500.6 million at December 31, 2004 in comparison with $330.7 million at December 31, 2003. Interest credited on these agreements was $9.0 million in 2004 in comparison with $2.4 million in 2003. Interest sensitive contract liabilities amounted to $3.2 billion at December 31, 2004 in comparison with $2.6 billion at December 31, 2003.
During 2004, acquisition costs and other insurance expenses increased by 59% to $131.7 million from $82.7 million in 2003. The increase was a result of the acquisition of Scottish Re Life Corporation, including the amortization of the present value of in-force arising on this business, and the increased life and annuity business as discussed above.
Operating expenses increased by 113% to $18.4 million in 2004 as compared to 2003. Operating expenses as a percentage of operating revenues increased in 2004 to 2.7% from 2.3% in 2003. The increase is primarily the result of the acquisition of Scottish Re Life Corporation, additional personnel costs incurred as we continue to grow our business and the costs necessary to meet the requirements of the Sarbanes Oxley Act of 2002. The costs of Scottish Re Life Corporation include the cost of the transition services agreement with GE ERC of $2.4 million. Total employees in this segment have grown from 64 at December 31, 2003 to 91 at December 31, 2004.
Interest expense in this segment arises on the trust preferred securities. The increase in interest expense to $4.6 million in 2004 from $1.1 million in 2003 arises from the issuance of an additional $62.0 million of trust preferred securities in October 2003, November 2003 and May 2004. An additional $50.0 million were issued in December 2004.
The interest and costs of the collateral finance facility described in Note 8 to the Consolidated Financial Statements are included in collateral finance facility expenses and amounted to $2.7 million in 2004.
Life Reinsurance International
Prior to 2005, our Life Reinsurance International Segment specialized in niche markets in developed countries and broader life insurance markets in the developing world and focused on the reinsurance of short-term group life policies and aircrew "loss of license" insurance. In 2005, the International Segment became actively engaged in the reinsurance of United Kingdom and Ireland traditional solutions business and annuity products. The life insurance and annuity products are similar to those offered in the Life Reinsurance North America Segment.
Comparison of 2005 to 2004
Revenues
Net premiums earned decreased $3.5 million, or 2.8% in 2005 in comparison with 2004. During 2004, we reviewed the pricing and profitability of all contracts written in this segment and as a result, decided not to renew treaties which did not meet our return hurdles. Accordingly, premiums earned decreased in 2005 as compared to 2004. In addition during 2005, there was a favorable movement of $9.0 million due to revised reporting received on our share of two Lloyd's of London life syndicates offset by revisions to premium accruals based on improved underlying data of $2.2 million. During 2004, premiums earned include $4.2 million relating to revised reporting received on a share of two Lloyd's of London life syndicates.
Investment income in 2005 increased by $1.5 million, or 15% compared to 2004 due to the investment income earned on the proceeds of additional capital contributed to this segment in December 2004 and June 2005.
Expenses
Claims and other policy benefits decreased to $76.9 million, or 6% in 2005 compared to 2004. During 2005, additional information was received from ceding companies that resulted in a review of policy benefits on certain lines of business and a decrease of $7.9 million in claims and other policy benefits. This was partially offset by an increase of $5.3 million due to revised reporting received on our share of two Lloyd's of London life
syndicates. In addition, claims and other policy benefits in 2005 were impacted by the lower levels of premiums written during 2005 and revisions to premium accruals noted in the revenues section above.
During 2005, acquisition costs and other insurance expenses increased by $3.1 million or 18% to $20.7 million from $17.6 million in 2004. Acquisition costs include the amortization of the present value of in-force business. Acquisition costs for 2005 included $4.3 million due to revised reporting received on our share of two Lloyd's of London life syndicates and the write-off of an uncollectible receivable of $1.2 million. In 2004, we recognized profit commission income of $1.8 million arising from a run off book of business and also included $2.4 million expense relating to our share of two Lloyd's of London life syndicates.
Operating expenses have increased by 34% to $25.3 million in 2005 as compared to 2004. The primary drivers of the increase is $3.0 million relating to consulting fees for the review, design and implementation of processes and controls required to assist us in the remediation of the material weakness in internal controls noted in 2004. The remaining increase is principally related to increased personnel costs as resources have been added as we continue to grow our business and include costs for recruitment expenses and professional expenses incurred in addressing implementation of the requirements of the Sarbanes Oxley Act of 2002 and United Kingdom regulatory changes. The number of employees in this segment has grown as we continue to strive to grow our business in existing and prospective markets.
Comparison of 2004 to 2003
Revenues
Premiums earned in our Life Reinsurance International Segment during 2004 decreased 24% to $122.5 million in comparison with $160.9 million in 2003. The majority of business in our Life Reinsurance International Segment is in respect of short duration contracts. We experience considerable reporting delays from some of our cedents on this business. In 2003, as part of the implementation of this Segment's new administrative system, improved data was compiled to allow us to more accurately estimate our premiums earned. As a result, premiums earned in 2003 included $23.4 million in respect of revisions in estimates of premiums earned for past years. Premiums earned from a specific portfolio acquired in 2002 were $11.5 million lower in 2004 compared to 2003 due to the run-off nature of the portfolio. During 2004 we decided not to renew certain contracts which did not meet our return thresholds. Earned premium for general reinsurance business, which consists of aircrew loss of license and related personal accident, decreased 5% from $35.8 million to $34.0 million. Premiums earned in 2004 include $4.2 million relating to a share of two Lloyd's of London life syndicates.
Investment income during 2004 increased to $10.0 million compared to $7.5 million in 2003. A portfolio of business was recaptured in 2004 and resulted in additional investment income of $1.1 million. The remainder of the increase is due to the increased level of invested assets arising principally from growth in business.
Expenses
Claims and other policy benefits decreased by 22% to $81.6 in 2004 from $104.2 million in 2003. In comparison to the prior year, claims have been impacted by the implementation of the new administrative system and the related improvement in the estimates of cedant balances. During 2004 we recognized claims and other policy benefits of $1.8 million in respect of the recapture of the portfolio described above. In addition, during 2004 we incurred $1.0 million in respect of a claim from our stop loss business. Partially offsetting these increases was the release of reserves of $3.1 million relating to recapture of the portfolio described above. Claims and other policy benefits in 2004 also include $2.1 million of claims relating to our share of two Lloyd's of London life syndicates. Claims and other policy benefits in 2003 were favorably impacted by a $3.4 million release of reserves on the sale of our unit linked business in 2003.
During 2004, acquisition costs and other insurance expenses decreased by $12.1 million or 41% to $17.6 million from $29.7 million in 2003. Acquisition costs related to a specific portfolio were $2.3 million lower in 2004 than 2003 due to the run-off nature of the portfolio. Acquisition costs include the amortization of the present value of in-force business. This was $1.8 million lower in 2004 compared to 2003 primarily due to the sale of the unit linked business in 2003. In 2004 we recognized profit commission income of $1.8 million arising from a run-off book of
business. Acquisition costs in 2004 also include $2.4 million relating to our share of two Lloyd's of London life syndicates.
Operating expenses have increased by 63% to $18.8 million in 2004 from $11.5 million in 2003. The increase is principally due to increased personnel costs as resources have been added as we continue to grow our business and also due to implementation of the requirements of the Sarbanes Oxley Act of 2002 and United Kingdom regulatory changes. Other expense increases compared to 2003 include office costs due to the move to larger offices in the second quarter of 2003 and amortization of the costs of a new administration system. Operating expenses in this segment are incurred in pounds sterling. These expenses have increased as a result of the depreciation of the United States dollar in comparison with pounds sterling during 2004.
Corporate and Other
The Corporate and Other Segment is comprised of revenues and expenses that are not included in the Life Reinsurance segments and it includes corporate overhead.
Comparison of 2005 to 2004
Revenues
Investment income arises in the Corporate and Other Segment on capital not specifically allocated to the Life Reinsurance North America or Life Reinsurance International Segments. Investment income will increase or decrease as we raise capital and deploy it in our operating segments. Fee income and acquisition expenses arise from our wealth management operations.
Expenses
Operating expenses include the costs of running our principal office in Bermuda, compensation and other costs for our Board of Directors and legal and professional fees, including those in respect of corporate governance legislation. Operating expenses have increased by 137% to $41.4 million in 2005 from $17.5 million in 2004. The
increases are principally due to increased personnel costs, including recruitment and relocation costs, as we continue to grow our business, the costs of option and restricted stock unit awards granted under our equity incentive compensation plans and professional fees of approximately $7.0 million incurred in respect of the implementation of the requirements of the Sarbanes-Oxley Act of 2002.
The collateral finance facilities expense consists of a portion of the put premium and amortization of facility costs on the Stingray Investor Trust described in Note 8 to the Consolidated Financial Statements. Expenses related to the proportion of the Stingray Investor Trust utilized in 2005 have been allocated to the Life Reinsurance North America segment.
Interest expense includes interest on the 4.5% senior convertible notes and the 1.0% dividend payable on the convertible preferred shares of our HyCU's. In addition, interest expense in 2005 included $0.8 million in interest expense on the Cypress Notes. These were converted into Class C Warrants on April 7, 2005.
Comparison of 2004 to 2003
Operating expenses have increased by 61% to $17.5 million in 2004 from $10.9 million in 2003. These increases relate primarily to increased personnel costs and the costs of corporate governance initiatives, including implementation of the requirements of the Sarbanes-Oxley Act of 2002. Due diligence costs of $4.6 million were incurred in respect of various proposed acquisitions which were not successful. During 2004, interest expense increased by 30% to $8.4 million from $6.4 million in 2003 as a result of the HyCU's issued in December 2003.
Financial Condition
Investments
Scottish Re Controlled Portfolio
At December 31, 2005, the portfolio controlled by us consisted of $6.7 billion of fixed income securities, preferred stock and cash. The portfolio controlled by us excludes the assets held by ceding insurers under modified coinsurance and funds withheld coinsurance arrangements. The majority of these assets are traded, however, $452.9 million represent investments in private securities. Of the total portfolio controlled by us, $5.4 billion represented the fixed income and preferred stock portfolios managed by external investment managers and $1.3 billion represented other cash balances. At December 31, 2004, the portfolio controlled by us consisted of $4.3 billion of fixed income securities, preferred stock and cash. The majority of these assets are traded, however, $330.3 million represented investments in private securities. Of the total portfolio, $3.5 billion represented the fixed income and preferred stock portfolio managed by external investment managers and $752.5 million represented other cash balances. The data in the tables below exclude the assets held by ceding insurers under modified coinsurance and funds withheld coinsurance agreements.
At December 31, 2005, the average Standard & Poor's rating of our portfolio was "AA", the average effective duration was 2.9 years and the average book yield was 4.9% as compared with an average rating of "AA-", an average effective duration of 3.8 years and an average book yield of 4.2% at December 31, 2004. At December 31, 2005, the unrealized depreciation on investments, net of tax and deferred acquisition costs, was $17.9 million as compared with unrealized appreciation on investments, net of tax and deferred acquisition costs, of $13.7 million at December 31, 2004. The unrealized appreciation/ depreciation on investments is included in our consolidated balance sheet as part of shareholders' equity.
In the table below are the total returns earned by our portfolio in 2005, compared to the returns earned by three indices: the Lehman Brothers Global Bond Index, the S&P 500 and a customized index that we developed to take into account our investment guidelines. We believe that this customized index is a more relevant benchmark for our portfolio's performance.
The following table presents the fixed income investment portfolio (market value) credit exposure by category as assigned by Standard & Poor's.
The following table illustrates the fixed income investment portfolio (market value) sector exposure.
Management reviews securities with material unrealized losses and tests for other than temporary impairments on a quarterly basis. Factors involved in the determination of potential impairment include fair value as compared to cost, length of time the value has been below cost, credit worthiness of the issuer, forecasted financial performance of the issuer, position of the security in the issuer's capital structure, the presence and estimated value of collateral or other credit enhancement, length of time to maturity, interest rates and our intent and ability to hold the security until the market value recovers. When a decline is considered to be "other-than-temporary" the cost basis of the impaired asset is adjusted to its fair value and a corresponding realized investment loss is recognized in the consolidated statements of income. The actual value at which such financial instruments could actually be sold or settled with a willing buyer may differ from such estimated fair values.
The following tables present the estimated fair values and gross unrealized losses for the fixed maturity investments and preferred stock that have estimated fair values below amortized cost as of December 31, 2005 and 2004, respectively. These investments are presented by class and grade of security, as well as the length of time the related market value has remained below amortized cost.
At December 31, 2005, our fixed income portfolio had 2,493 positions and $59.2 million of gross unrealized losses. No single position had an unrealized loss greater than $0.5 million. There were $25.5 million of unrealized gains on the remainder of the portfolio. There were 127 private securities in an unrealized loss position totaling $4.3 million. At December 31, 2004, our fixed income portfolio had 1,773 positions and $12.0 million of gross unrealized losses. No single position had an unrealized loss greater than $0.9 million. There were $42.1 million of unrealized gains on the remainder of the portfolio. There were 44 private securities in an unrealized loss position totaling $0.7 million.
We believe that the analysis of each security whose price has been below market for greater than twelve months indicated that the financial strength, liquidity, leverage, future outlook, and our ability and intent to hold the security until recovery support the view that the security was not other-than-temporarily impaired as of December 31, 2005. The unrealized losses on fixed maturity securities are primarily a result of rising interest rates, changes in credit spreads and the long-dated maturities of the securities. Additionally, as at December 31, 2005, approximately 98% of the gross unrealized losses are associated with investment grade securities.
Unrealized losses on securities that have been in an unrealized loss position for periods greater than two years amounted to $1.1 million at December 31, 2005 and $2.1 million at December 31, 2004. Unrealized losses on non-investment grade securities amounted to $1.3 million and $2.1 million at December 31, 2005 and December 31, 2004, respectively. Of these amounts, non-investment grade securities with unrealized losses of $0.1 million at December 31, 2005 and $1.0 million at December 31, 2004 had been in an unrealized loss position for a period
greater than one year, of which there was none at December 31, 2005 and $1.0 million at December 31, 2004 had been in an unrealized loss position for periods greater than 2 years.
The following tables illustrate the industry analysis of the unrealized losses at December 31, 2005 and 2004:
*Other industries each represent less than 3% of estimated fair value
The expected maturity dates of our fixed maturity investments that have an unrealized loss at December 31, 2005 and 2004 are presented in the table below.
At December 31, 2005, there were 1,698 securities with unrealized loss positions, with no security having an unrealized loss greater than $0.5 million. At December 31, 2004, there were 647 securities with unrealized loss positions with no securities having an unrealized loss greater than $0.9 million. The increase in the number of securities with unrealized losses is primarily attributable to increases in interest rates.
At December 31, 2005, there was one security with a fair value that traded continuously at less than 80% of amortized cost for at least six months or 90% of amortized cost for at least 12 months. The unrealized loss on this security amounted to $0.5 million. At December 31, 2004 there were two securities with fair values that traded continuously at less than 80% of amortized cost for at least six months or 90% of amortized cost for at least 12 months. The total unrealized loss on these securities amounted to $1.1 million and the largest unrealized loss position was $0.9 million.
The following tables provide details of the sales proceeds, realized loss, length of time the security had been in an unrealized loss position and reason for sale for securities sold with a realized loss during 2005, 2004 and 2003.
Asset/liability management
We use various sophisticated asset/liability management processes to provide adequate liquidity over the lives of the liabilities and to limit exposure to changes in interest rates, adverse credit default experience and currency risk.
When we originate each new reinsurance transaction, the price and terms are based on results of simulation models in which projected investment cash flows will match liability cash flows within reasonable tolerances. The investment portfolio characteristics found to be most suitable for the liability are used to design the investment guidelines and target duration for the portfolio. We currently manage our asset/liability processes for over eighty individual portfolios.
Liquidity expectations and requirements vary with the type of liability. For liabilities with potentially greater liquidity demands, we select assets to make the corresponding portfolios more liquid and run more frequent simulations reflecting updated experience.
We periodically perform analyses, update guidelines and take other corrective action to keep the assets at the portfolio and enterprise level suitable for the relevant liabilities. Techniques include simulation of in-force assets and liabilities in various interest rate scenarios, adjustment of duration targets for each portfolio, monitoring the gap between actual and target duration at the portfolio, legal entity and enterprise levels. Historically, variations between the maturity of our investment portfolio and our liabilities have been small.
Funds withheld at interest
Funds withheld at interest arise on contracts written under modified coinsurance agreements and funds withheld coinsurance agreements. In substance, these agreements are identical to coinsurance treaties except that the ceding company retains control of and title to the assets. The deposits paid to the ceding company by the underlying policyholders are held in a segregated portfolio and managed by the ceding company or by investment managers appointed by the ceding company. These treaties transfer a quota share of the risks. The funds withheld at interest represent our share of the ceding companies' statutory reserves. The cash flows exchanged with each monthly settlement are netted and include, among other items, our quota share of investment income on our proportionate share of the portfolio, realized losses, realized gains (amortized to reflect the statutory rules relating to interest maintenance reserve), interest credited and expense allowances.
At December 31, 2005, the funds withheld at interest totaled $2.6 billion with an average rating of "A+", an average effective duration of 5.1 years and an average book yield of 5.6% as compared to $2.0 billion with an average rating of "A+", an average effective duration of 3.9 years and an average book yield of 5.2% at December 31, 2004. These are fixed income investments and include marketable securities, commercial mortgages, private placements and cash. The market value of the funds withheld amounted to $2.6 billion and $2.1 billion at December 31, 2005 and December 31, 2004, respectively.
At December 31, 2005, funds withheld at interest were in respect of seven contracts with five ceding companies. At December 31, 2004, funds withheld at interest were in respect of seven contracts with four ceding
companies. At December 31, 2005, we had three contracts with Lincoln National Life Insurance Company that accounted for $1.2 billion or 48% of the funds withheld balances. Additionally we had one contract with Security Life of Denver International Limited that accounted for $0.7 billion or 27% of the funds withheld balances and one contract with Fidelity & Guaranty Life that accounted for $0.6 billion or 23% of the funds withheld balances. The remaining contracts were with Illinois Mutual Insurance Company and American Founders Life Insurance Company. Lincoln National Life Insurance Company has financial strength ratings of "A+" from A.M. Best, "AA-" from Standard & Poor's, "Aa3" from Moody's and "AA" from Fitch. In the event of insolvency of the ceding companies on these arrangements we would need to exert a claim on the assets supporting the contract liabilities. However, the risk of loss is mitigated by our ability to offset amounts owed to the ceding company with the amounts owed to us by the ceding company. Reserves for future policy benefits and interest sensitive contract liabilities relating to these contracts amounted to $2.4 billion and $1.7 billion at December 31, 2005 and 2004, respectively.
The investment objectives for these arrangements are included in the modified coinsurance and funds withheld coinsurance agreements. The primary objective is to maximize current income, consistent with the long-term preservation of capital. The overall investment strategy is executed within the context of prudent asset/liability management. The investment guidelines permit investments in fixed maturity securities, and include marketable securities, commercial mortgages, private placements and cash. The maximum percentage of below investment grade securities is 10% and other guidelines limit risk, ensure issuer and industry diversification, as well as, maintain liquidity and overall portfolio credit quality.
According to data provided by our ceding companies, the following table reflects the market value of assets including cash backing the funds withheld at interest portfolio using the lowest rating assigned by the three major rating agencies.
According to data provided by our ceding companies, the following table reflects the market value of assets backing the funds withheld at interest portfolio by sector.
Liquidity and Capital Resources
Cash flow
Cash provided by operating activities amounted to $365.7 million in 2005 in comparison with $38.9 million in 2004. Operating cash flow includes cash inflows from premiums, fees and investment income and cash outflows for benefits and expenses paid. In periods of growth of new business our operating cash flow may decrease due to first year commissions paid on new business generated. For income recognition purposes these commissions are deferred and amortized over the life of the business. The increase in cash flow from operating activities is principally due to the ING acquisition.
In 2004, the decrease in operating cash flow in comparison with 2003 is partly attributable to settlement of a tax liability of approximately $23.0 million. This liability resulted from actions taken by the former owner of Scottish Re Life Corporation immediately prior to its acquisition in December 2003. When adjusted for this payment, cash inflows from operations in 2004 were $61.9 million compared to inflows of $88.5 million in 2003. This decrease is due to the timing of receipt of reinsurance receivables and settlement of reinsurance payables.
We believe cash flows from operations will be positive over time. However, they may be positive or negative in any one period depending on the amount of new life reinsurance business written, the level of ceding commissions paid in connection with writing that business, the level of renewal premiums earned in the period and the timing of receipt of reinsurance receivables and settlement of reinsurance payables. To address the risk that operating cash flows may not be sufficient in any given period we maintain a high quality, fixed maturity portfolio with positive liquidity characteristics. These securities are available for sale and can be sold to meet obligations if necessary.
Net cash used in investing activities was $1.9 billion and $479.9 million in 2005 and 2004, respectively. The increase in cash used in investing activities and, in particular, the purchases of fixed maturity securities, are primarily related to the investment of the proceeds of the ING acquisition, the collateral finance facilities and the excess cash generated by operating and financing activities. In 2004 we received $414.0 million in cash on the completion of the ING acquisition.
Net cash provided by financing activities was $2.1 billion in 2005 and $937.5 million in 2004. The increase was principally due to the receipt of proceeds on our collateral finance facilities and the issuance of ordinary shares and non-cumulative perpetual preferred shares during 2005.
The Holding Company
We are a holding company whose primary uses of liquidity include, but are not limited to, the immediate capital needs of our operating companies, dividends paid to our shareholders and interest payments on our indebtedness. See Note 10, "Debt Obligations" in the Notes to the Consolidated Financial Statements. The primary sources of our liquidity include proceeds from our capital raising efforts, interest income on corporate investments and dividends from operating subsidiaries. As we continue our expansion efforts, we will continue to be dependent upon these sources of liquidity.
Historically, we have generated positive net cash flows from operations. However, in the event of significant unanticipated cash requirements beyond normal liquidity, we have multiple liquidity alternatives available based on market conditions and the amount and timing of the liquidity need. These options include borrowings under committed credit facilities, the ability to issue long-term debt, capital securities or common equity and, if necessary, the sale of invested assets subject to market conditions.
Capital
Total capitalization is analyzed as follows:
The increase in capitalization at December 31, 2005 compared to December 31, 2004 is principally due to net proceeds of $174.1 million on the issuance of 7,660,000 ordinary shares (including an over allotment option of 1,410,000 shares), net proceeds of $168.3 million on the issuance of 5,000,000 non-cumulative perpetual preferred shares, the conversion of the 7% Convertible Junior Subordinated Note to ordinary shares and net income for the year ended December 31, 2005 of $130.2 million. These increases were partially offset by the net costs of the variable equity sale forward contracts of $13.8 million, decrease in other comprehensive income of $41.6 million and increase in dividends declared of $6.6 million. Other comprehensive income consists of the unrealized appreciation/depreciation on investments and the cumulative translation adjustment arising from the translation of Scottish Re Holdings Limited's balance sheet at exchange rates as of December 31, 2005.
The increase in capitalization at December 31, 2004 compared to December 31, 2003 is due to the net income for the year ended December 31, 2004 of $71.4 million, the issuance of ordinary shares and warrants and notes to the Cypress Entities, totaling $126.9 million, the issuance of trust preferred debt of $82.0 million, the issuance of share capital to employees on the exercise of options of $8.3 million and an increase in other comprehensive income of $2.6 million partially offset by an increase in dividends declared of $0.9 million. Other comprehensive income consists of the unrealized appreciation/depreciation on investments and the cumulative translation adjustment arising from the translation of Scottish Re Holdings Limited's balance sheet at exchange rates as of December 31, 2004.
See Notes 9, 10, 11 and 12 of the Consolidated Financial Statements for additional details on the items noted in the table.
Shareholder dividends
Historically, we have paid quarterly dividends of $0.05 per ordinary share and have paid quarterly dividends on our non-cumulative perpetual preferred shares during 2005. All future payments of dividends are at the discretion of our Board of Directors and will depend on our income, capital requirements, insurance regulatory conditions, operating conditions and such other factors as the Board of Directors may deem relevant. The amount of dividends that we can pay will depend in part on the operations of our reinsurance subsidiaries.
Collateral
We must have sufficient assets available for use as collateral to support borrowings, letters of credit and certain reinsurance transactions. With these reinsurance transactions, the need for collateral or letters of credit arises in five ways:
o when Scottish Annuity & Life Insurance Company (Cayman) Ltd., Scottish Re (Dublin) Limited or Scottish Re Limited enters into a reinsurance treaty with a U.S. customer, we must contribute
assets into a reserve credit trust with a U.S. bank or issue a letter of credit in order that the ceding company may obtain reserve credit for the reinsurance transaction;
o when Scottish Re (U.S.), Inc. enters into a reinsurance transaction, it typically incurs a need for additional statutory capital. This need can be met by its own capital surplus, an infusion of cash or assets from us or an affiliate or by ceding a portion of the transaction to another company within the group or an unrelated reinsurance company, in which case that reinsurer must provide reserve credit by contributing assets in a reserve credit trust or a letter of credit;
o Scottish Re (U.S.), Inc. is licensed, accredited, approved or authorized to write reinsurance in 50 states and the District of Columbia. When Scottish Re (U.S.), Inc. enters into a reinsurance transaction with a customer domiciled in a state in which it is not a licensed, accredited, authorized or approved reinsurer, it likewise must provide a reserve credit trust or letter of credit;
o Scottish Re Life Corporation is licensed, accredited, approved or authorized to write reinsurance in 50 states, the District of Columbia, Guam and the Federated States of Micronesia. When Scottish Re Life Corporation enters into a reinsurance transaction with a customer domiciled in a state in which it is not a licensed, accredited, authorized or approved reinsurer, it likewise must provide a reserve credit trust or letter of credit; and
o even when Scottish Re (U.S.), Inc. is licensed, accredited, approved or authorized to write reinsurance in a state, it may agree with a customer to provide a reserve credit trust or letter of credit voluntarily to mitigate the counter-party risk from the customer's perspective, thereby doing transactions that would be otherwise unavailable or would be available only on significantly less attractive terms.
Assets placed in trust continue to be owned by us, but their use is restricted based on terms of the trust agreements. We have a number of facilities in place to provide the collateral required for our reinsurance business. See Note 8 of the Consolidated Financial Statements.
Credit facilities
On July 14, 2005, Scottish Annuity & Life Insurance Company (Cayman) Ltd., Scottish Re (Dublin) Limited, Scottish Re (U.S.), Inc. and Scottish Re Limited entered into a $200.0 million, three-year revolving unsecured senior credit facility with a syndicate of banks. This facility replaced a 364-day facility which was due to mature in October 2005. The facility may be increased, at our option, to an aggregate principal amount of $300.0 million. The facility provides capacity for borrowing and extending letters of credit. The facility is a direct financial obligation of each of the borrowers; however, Scottish Annuity & Life Insurance Company (Cayman) Ltd. has guaranteed the payment of obligations of Scottish Re (Dublin) Limited, Scottish Re (U.S.), Inc. and Scottish Re Limited. There were no outstanding borrowings at December 31, 2005. Outstanding letters of credit under this facility amounted to $40.9 million at December 31, 2005.
On August 18, 2005, Scottish Re (Dublin) Limited entered into a $30.0 million three-year revolving, unsecured letter of credit facility with a syndicate of banks. The credit facility may be increased, at our option, to an aggregate principal amount of $50.0 million. The facility is a direct financial obligation of Scottish Re (Dublin) Limited, however, Scottish Annuity & Life Insurance Company (Cayman) Ltd. has guaranteed the payment obligations of Scottish Re (Dublin) Limited. There were no outstanding borrowings or letters of credit at December 31, 2005.
The financial covenants of these facilities require that Scottish Annuity & Life Insurance Company (Cayman) Ltd. maintain a minimum amount of consolidated shareholders' equity and maintain the ratio of unencumbered assets to aggregate borrowings under the facilities of 1.2 times borrowings. In addition, these facilities also require us to maintain a minimum amount of consolidated shareholders' equity and a debt to capitalization ratio of less than 30%. There were no outstanding borrowings and letters of credit at December 31,
2005. For the purposes of computing the financial covenants, the collateral finance facilities and their associated costs are excluded.
Failure to comply with the requirements of the credit facilities would, subject to grace periods, result in an event of default and we would be required to repay any outstanding borrowings. At December 31, 2005, we and Scottish Annuity & Life Insurance Company (Cayman) Ltd. were in compliance with the financial covenants noted in the preceding paragraphs.
We also have a reverse repurchase agreement with a major broker/dealer. Under this agreement, we have the ability to sell agency mortgage backed securities with the agreement to repurchase them at a fixed price, providing the dealer with a spread that equates to an effective borrowing cost linked to one-month LIBOR. This agreement is renewable monthly at the discretion of the broker/dealer. At December 31, 2005 and 2004, there were no borrowings under this agreement.
ING Collateral Arrangement
ING is obligated to maintain collateral for the Regulation XXX and AXXX reserve requirements of the business we acquired from them for the duration of such requirements (which relate to state insurance law reserve requirements applying to reserves for level premium term life insurance policies and universal life policies). We will pay ING a fee based on the face amount of the collateral provided until satisfactory alternative collateral arrangements are made. In the normal course of business and our capital planning we are always looking for opportunities to relieve capital strain relating to XXX reserve requirements for our existing business, as well as, the business acquired from ING. We completed two financing solutions relating to these requirements in December 2005 and received a $6.7 million rebate of fees incurred in 2005.
HSBC I
In 2004, we entered into a collateral finance facility with HSBC Bank USA, N.A. ("HSBC I"). This facility provides $200.0 million that can be used to collateralize reinsurance obligations under intercompany reinsurance agreements. Simultaneously, we entered into a total return swap with HSBC Bank USA, N.A. under which we are entitled to the total return of the investment portfolio of the trust established for this facility. In accordance with FIN 46R, the trust is considered to be a variable interest entity and we are deemed to hold the primary beneficial interest in the trust. As a result, the trust has been consolidated in these financial statements. The assets of the trust have been recorded as fixed maturity investments. Our consolidated statements of income show the investment return of the trust as investment income and the cost of the facility is reflected in collateral finance facilities expense. The creditors of the trust have no recourse against our general assets.
Stingray
On January 12, 2005, we entered into a put agreement with Stingray Investor Trust ("Investor Trust") for an aggregate value of $325.0 million. Under the terms of the put agreement, we acquired an irrevocable put option to issue funding agreements to Investor Trust in return for the assets in a portfolio of 30-day commercial paper. This put option may be exercised at any time. In addition, we may be required to issue funding agreements to Investor Trust under certain circumstances, including, but not limited to, the non-payment of the put option premium and a non-payment of interest under any outstanding funding agreements under the put agreement. The facility matures on January 12, 2015. This transaction may also provide collateral for Scottish Re (U.S.), Inc. for reinsurance obligations under intercompany quota share reinsurance agreements and at December 31, 2005, $50.0 million was in use for this purpose. The put premium incurred during the year ended December 31, 2005 amounted to $4.7 million, and is included in collateral finance facilities expense in the consolidated statements of income. In accordance with FIN 46R, we are not considered to be the primary beneficiary of Investor Trust and as a result we are not required to consolidate Investor Trust.
Orkney Re, Inc.
On February 11, 2005, Orkney Holdings, LLC, a Delaware limited liability company, issued and sold in a private offering an aggregate of $850.0 million Series A Floating Rate Insured Notes due February 11, 2035 (the "Orkney Notes"). Orkney Holdings, LLC is organized for the limited purpose of holding the stock of Orkney Re, Inc., a South Carolina special purpose captive insurance company, and issuing the Orkney Notes. All of the common shares of Orkney Holdings, LLC are owned by Scottish Re (U.S.), Inc. Proceeds from this offering were used to fund the Regulation XXX reserve requirements for a defined block of level premium term life insurance policies issued between January 1, 2000 and December 31, 2003 reinsured by Scottish Re (U.S.), Inc. to Orkney Re, Inc. Proceeds from the Orkney Notes have been deposited into a series of trusts that collateralize the notes.
The holders of the Orkney Notes cannot require repayment from us or any of our subsidiaries, other than Orkney Holdings, LLC. The timely payment of interest and ultimate payment of principal for the Orkney Notes are guaranteed by MBIA Insurance Corporation.
Interest on the principal amount of the Orkney Notes is payable quarterly at a rate equivalent to three month LIBOR plus 0.53%. At December 31, 2005, the interest rate was 5.07%. Any payment of principal, including by redemption, or interest on the Orkney Notes is sourced from dividends from Orkney Re, Inc. and the balances available in a series of trust accounts. Dividends may only be made with the prior approval of the Director of Insurance of the State of South Carolina in accordance with the terms of its licensing orders and in accordance with applicable law. The Orkney Notes also contain a customary limitation on lien provisions and customary events of default provisions, which, if breached, could result in the accelerated maturity of the Orkney Notes. Orkney Holdings, LLC has the option to redeem all or a portion of the Orkney Notes prior to and on or after February 11, 2010, subject to certain call premiums.
In accordance with FIN 46R, Orkney Holdings, LLC, is considered to be a variable interest entity and we are considered to hold the primary beneficial interest. As a result, Orkney Holdings, LLC has been consolidated in these financial statements. The assets of Orkney Holdings, LLC have been recorded as fixed maturity investments and cash and cash equivalents. Our consolidated statements of income show the investment return of Orkney Holdings, LLC as investment income and the cost of the facility is reflected in collateral finance facilities expense.
Orkney Re II plc
On December 21, 2005, Orkney Re II plc, an orphan special purpose vehicle incorporated under the laws of Ireland, whose issued ordinary shares are held by a share trustee and its nominees in trust for charitable purposes, issued in a private offering $450.0 million of debt to external investors. The debt consisted of $382.5 million Series A-1 Floating Rate Guaranteed Notes (the "Series A Notes"), $42.5 million in aggregate principal amount of Series A-2 Floating Rate Notes (the "Series B Notes"), and $25.0 million Series B Floating Rate Notes, all due December 31, 2035 (collectively, the "Orkney II Notes"). The Orkney II Notes are listed on the Irish Stock Exchange. Proceeds from this offering were used to fund the Regulation XXX reserve requirements for a defined block of level premium term life insurance policies issued between January 1, 2004 and December 31, 2004 reinsured by Scottish Re (U.S.), Inc. to Orkney Re II plc. Proceeds from the Orkney II Notes have been deposited into a series of trusts that collateralize the notes.
The holders of the Orkney II Notes cannot require repayment from us or any of our subsidiaries, only from Orkney Re II plc. Assured Guaranty (UK) Ltd has guaranteed the timely payment of the scheduled interest payments and the principal on the maturity date, December 21, 2035 of the Series A-1 Notes.
Interest on the principal amount of the Orkney II Notes is payable quarterly at a rate equivalent to three month LIBOR plus 0.425% for the Series A-1 Notes, three month LIBOR plus 0.73% for the Series A-2 Notes, and three month LIBOR plus 3.0% for the Series B Notes. At December 31, 2005, the interest rate on the Series A-1 Notes was 4.96%, Series A-2 Notes was 5.27%, and Series B Notes was 7.50%. The Orkney II Notes also contain a customary limitation on lien provisions and customary events of default provisions, which, if breached, could result in the accelerated maturity of the Orkney II Notes. Orkney Re II plc has the option to redeem all or a portion of the Orkney II Notes prior to and on or after February 11, 2007, subject to certain call premiums.
In accordance with FIN 46R, Orkney Re II plc is considered to be a variable interest entity and we are considered to hold the primary beneficial interest. As a result, Orkney Re II plc has been consolidated in these financial statements. The assets of Orkney Re II plc have been recorded as fixed maturity investments and cash and
cash equivalents. Our consolidated statements of income show the investment return of Orkney II Re plc as investment income and the cost of the facility is reflected in collateral finance facilities expense.
HSBC II
On December 22, 2005, we entered into a second collateral finance facility with HSBC Bank USA, N.A ("HSBC II"). This facility is a 20 year collateral finance facility that provides up to $1.0 billion of Regulation XXX collateral support for the business acquired from ING and can be used to collateralize reinsurance obligations under inter-company reinsurance agreements. Simultaneously, we entered into a total return swap with HSBC Bank USA, N.A. under which we are entitled to the total return of the investment portfolio of the trust established for this facility. In accordance with FIN 46R the trust is considered to be a variable interest entity and we are deemed to hold the primary beneficial interest in the trust. As a result, the trust has been consolidated in these financial statements. The assets of the trust have been recorded as fixed maturity investments and cash and cash equivalents. Our consolidated statements of income show the investment return of the trust as investment income and the cost of the facility is reflected in collateral finance facilities expense. The creditors of the trust have no recourse against our general assets.
Reinsurance Facility
On December 22, 2005, we entered into a long term reinsurance facility with a third party ("Reinsurance Facility"), Bermuda-domiciled reinsurer that provides up to $1.0 billion of Regulation XXX collateral support for the business acquired from ING. The Bermuda reinsurer provides security in the form of letters of credit in trust equal to the statutory reserves. All risks and returns arising out of the underlying book of business are retained by us.
At December 31, 2005, we had $1.986 billion of collateral finance facility obligations relating to the HSBC I, HSBC II, Orkney Re, Inc. and Orkney Re II plc transactions. In connection with these transactions, we have assets in trust of approximately $2.705 billion which represent assets supporting both the economic and excess reserves and surplus in the transactions. The assets in trust are managed in accordance with predefined investment guidelines as to permitted investments, portfolio quality, diversification and duration.
Regulatory Capital Requirements
Scottish Annuity & Life Insurance Company (Cayman) Ltd. has agreed with Scottish Re (U.S.), Inc. that it will (1) cause Scottish Re (U.S.), Inc. to maintain capital and surplus equal to the greater of $20.0 million or such amount necessary to prevent the occurrence of a Company Action Level Event under the risk-based capital laws of the state of Delaware and (2) provide Scottish Re (U.S.), Inc. with enough liquidity to meet its obligations in a timely manner.
Scottish Annuity & Life Insurance Company (Cayman) Ltd. has agreed with Scottish Re Life Corporation that it will (1) cause Scottish Re Life Corporation to maintain capital and surplus equal to at least 175% of Company Action Level RBC, as defined under the laws of the state of Delaware and (2) provide Scottish Re Life Corporation with enough liquidity to meet its obligations in a timely manner.
Scottish Annuity & Life Insurance Company (Cayman) Ltd. and Scottish Re Group Limited have agreed with Scottish Re Limited that in the event Scottish Re Limited is unable to meet its obligations under its insurance or reinsurance agreements, Scottish Annuity & Life Insurance Company (Cayman) Ltd. (or if Scottish Annuity & Life Insurance Company (Cayman) Ltd. cannot fulfill such obligations, then Scottish Re Group Limited will assume all of Scottish Re Limited's obligations under such agreements.
Scottish Re Group Limited and Scottish Annuity & Life Insurance Company (Cayman) Ltd. have executed similar agreements for Scottish Re (Dublin) Limited and Scottish Re Life (Bermuda) Limited and may, from time to time, execute additional agreements guaranteeing the performance and/or obligations of their subsidiaries.
Our business is capital and collateral intensive. We expect that our cash and investments, together with cash generated from our businesses, will be sufficient to meet our current liquidity and letter of credit needs. However, if our business continues to grow significantly, we will need to raise additional capital.
Statutory dividends limitations are outlined in Note 15 to the Consolidated Financial Statements.
Contractual Obligations and Commitments
The following table shows our contractual obligations and commitments as of December 31, 2005, other then those arising from our reinsurance business including our payments due by period:
Our long-term debt is described in Note 10 to the Consolidated Financial Statements. Long-term debt includes the $115.0 million of 4.5% senior convertible notes which are due December 1, 2022. The notes are subject to repurchase by us at a holder's option at various dates, the earliest of which is December 6, 2006. Long-term debt also includes capital securities with various maturities from 2032 onward. They are however, redeemable at earlier dates. They have been included in the above table at the earliest redemption date.
Our mezzanine equity is described in Note 11 to the Consolidated Financial Statements and consists of 5,750,000 HyCUs. On February 15, 2007, we shall receive proceeds from the sale of our ordinary shares of $143.8 million as required by the purchase contract forming part of each HyCU. The proceeds from this offering will be used by us to repay the convertible preferred shares of $143.8 million on May 21, 2007. The table above includes contractual payments and dividends due on the convertible preferred shares.
We lease office space in the countries in which we operate. These leases expire at various dates through 2023.
Amounts due under funding agreements are reported in interest sensitive contract liabilities. These are agreements in which we earn a spread over LIBOR. The contractual repayment terms are detailed in the table above.
Collateral finance facility liabilities include HSBC I and II, and securitization obligations with Orkney Re, Inc., and Orkney Re II plc. These transactions are described in the previous section. These obligations are fully secured by fixed maturity investments and cash and cash equivalents included in our Consolidated Balance Sheet. The liabilities have been included in the table above at the earliest redemption date.
Life claims payable are included in "Reserve for Future Policy Benefits" in the Consolidated Balance Sheet. Life claims payable include benefit and claim liabilities for which we believe the amount and timing of the payment is essentially fixed and determinable. Such amounts generally relate to incurred and reported death claims and amounted to $560.8 million at December 31, 2005. As of December 31, 2005, reserves for future policy benefits of approximately $3.5 billion related primarily to reinsurance of traditional life insurance and related policies and approximately $3.9 billion of interest sensitive contract liabilities, primarily deferred annuities, have been excluded from this table because these amounts are generally comprised of policies or contracts where (i) we are not currently making payments and will not make payments in the future until the occurrence of an insurable event, such as death
or disability or (ii) the occurrence of a payment triggering event, such as a surrender of a policy or contract. The timing of payment on these liabilities is not reasonably fixed and determinable since the insurable event or payment triggering event has not yet occurred, and we have no control over the timing of such occurrence. In addition to timing of payments, significant uncertainties relating to these liabilities include mortality, morbidity and persistency.
Off balance sheet arrangements
We have no obligations, assets or liabilities other than those disclosed in the financial statements forming part of this Form 10-K; no trading activities involving non-exchange traded contracts accounted for at fair value; and no relationships and transactions with persons or entities that derive benefits from their non-independent relationship with us or our related parties.
New Accounting Pronouncements
Statement of Financial Position 03-1"Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Insurance Contracts and for Separate Accounts" ("SOP 03-01")
In July 2003, the Accounting Standards Executive Committee issued SOP 03-01. This SOP provides guidance on accounting and reporting by insurance enterprises for certain nontraditional long-duration contracts and for separate accounts and is effective for financial statements for fiscal years beginning after December 15, 2003. In implementing the SOP, we have made various determinations, such as qualification for separate account treatment, classification of securities in separate account arrangements, significance of mortality and morbidity risk, adjustments to contract holder liabilities and adjustments to estimated gross profits as defined in SFAS No. 97, "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments". Implementation of this SOP did not have a material effect on our financial statements.
EITF 04-8 "The Effect of Contingently Convertible Debt on Diluted Earnings Per Share"(EITF 04-8)
In September 2004, EITF 04-8 was issued. EITF 04-8 requires that certain instruments with embedded conversion features that are contingent upon market price triggers be included in diluted earnings per share calculations regardless of whether the contingency has been met. Our 4.5% senior convertible notes are convertible on the basis of a market price trigger. On October 26, 2004, we amended the terms of these notes so that we are required to settle the principal amount of $115.0 million in cash on conversion or repurchase. As a result, we continue to apply the treasury stock method in calculating diluted earnings per share for amounts in excess of the principal of $115.0 million. Also see Note 10 in the Consolidated Financial Statements.
FASB Interpretation No. 46 and 46R, "Consolidation of Variable Interest Entities" ("FIN 46" and "FIN 46R")
In December 2003, the FASB revised FIN 46, which was originally issued in January 2003. FIN 46R addresses whether certain types of entities, referred to as variable interest entities ("VIEs"), should be consolidated in a company's financial statements. A company must consolidate a VIE in which it has an ownership, contractual or other financial interest if it is determined to be the primary beneficiary. A primary beneficiary has a variable interest that will absorb a majority of the expected losses if they occur, receive a majority of the entity's expected returns, or both. We are the primary beneficiary of the collateral finance facilities discussed in Note 8 to the Consolidated Financial Statements, and have consolidated the variable interest entities in accordance with FIN 46R. The Investor Trust, discussed in Note 8 to the Consolidated Financial Statements, is a variable interest entity but we are not considered to be the primary beneficiary of interest in the Investor Trust. Accordingly, it is not consolidated in accordance with FIN 46R.
SFAS No. 154 "Accounting Changes and Error Corrections" (`SFAS No. 154")
In May 2005, the FASB issued SFAS No. 154, which replaces APB Opinion No. 20, Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS No. 154 requires retrospective application to prior periods' financial statements for changes in accounting principle, unless determination of either the period specific effects or the cumulative effect of the change is impracticable or
otherwise promulgated. SFAS No. 154 is effective for fiscal years beginning after December 15, 2005. SFAS No. 154, upon adoption, is not expected to have a material effect on our results of operations or financial position.
EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments ("EITF 03-1") and FAS 115-1"The meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" ("FSP FAS 115-1")
In June 2005, the FASB completed its review of EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. EITF 03-1 provides accounting guidance regarding the determination of when an impairment of debt and marketable equity securities and investments accounted for under the cost method should be considered other-than-temporary and recognized in income. EITF 03-1 also requires certain quantitative and qualitative disclosures for debt and marketable equity securities classified as available-for-sale or held-to-maturity under SFAS No.115, Accounting for Certain Investments in Debt and Equity Securities, that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. The FASB decided not to provide additional guidance on the meaning of other-than-temporary impairment but has issued in November 2005, FSP FAS 115, which nullifies the guidance in paragraphs 10-18 of EITF 03-1, and references existing other than temporary impairment guidance. FSP FAS 115-1 clarifies that an investor should recognize an impairment loss no later than when the impairment is deemed other-than-temporary, even if a decision to sell the security has not been made, and also provides guidance on the subsequent accounting for an impaired debt security. We have provided the appropriate disclosures in accordance with EITF 03-1. FSP FAS 115-1 is effective for reporting periods beginning after December 15, 2005. The adoption of FSP FAS 115-1 will not have a material effect on our results of operations or financial position.
SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments--an amendment of FASB Statements No. 133 and 140" ("SFAS No. 155")
In February 2006, the FASB issued SFAS No. 155, which resolves issues addressed in SFAS No. 133 Implementation Issue No. D1, "Application of Statement 133 to Beneficial Interests in Securitized Financial Assets." SFAS No. 155, among other things, permits the fair value remeasurement of any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133; and establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. SFAS No. 155 is effective for all financial instruments acquired or issued in a fiscal year beginning after September 15, 2006. We are currently assessing the impact of SFAS No. 155 on our results of operations and financial position.
Forward-Looking Statements
Some of the statements contained in this report are not historical facts and are forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995. Forward looking statements include information with respect to our known and unknown risks, uncertainties and other factors, which may cause the actual results to differ materially from the forward-looking statements. Words such as "anticipates," "expects," "intends," "plans," "believes," "seeks," "estimates," "may," "will," "continue," "project" and similar expressions, as well as statements in the future tense, identify forward-looking statements.
These forward-looking statements are not guarantees of our future performance and are subject to risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements. These risks and uncertainties include:
o uncertainties relating to the ratings accorded to our insurance subsidiaries;
o the risk that our risk analysis and underwriting may be inadequate;
o exposure to mortality experience which differs from our assumptions;
o risks arising from our investment strategy, including risks related to the market value of our investments, fluctuations in interest rates and our need for liquidity;
o uncertainties arising from control of our invested assets by third parties;
o developments in global financial markets that could affect our investment portfolio and fee income;
o changes in the rate of policyholder withdrawals or recapture of reinsurance treaties;
o the risk that our retrocessionaires may not honor their obligations to us;
o terrorist attacks on the United States and the impact of such attacks on the economy in general and on our business in particular;
o political and economic risks in developing countries;
o the impact of acquisitions, including the ability to successfully integrate acquired businesses, the competing demands for our capital and the risk of undisclosed liabilities;
o loss of the services of any of our key employees;
o losses due to foreign currency exchange rate fluctuations;
o uncertainties relating to government and regulatory policies (such as subjecting us to insurance regulation or taxation in additional jurisdictions);
o the competitive environment in which we operate and associated pricing pressures; and
o changes in accounting principles.
The effects of these factors are difficult to predict. New factors emerge from time to time and we cannot assess the potential impact of any such factor on the business or the extent to which any factor, or combination of factors, may cause results to differ materially from those contained in any forward-looking statement. Any forward-looking statement speaks only as of the date of this report and we do not undertake any obligation, other than as may be required under the Federal securities laws, to update any forward-looking statement to reflect events or circumstances after the date of such statement or to reflect the occurrence of unanticipated events.
Item 7A:
Item 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We measure and manage market risks and other risks as part of an enterprise-wide risk management process. The market risks described in this section relate to financial instruments, primarily in our investment portfolio, that are sensitive to changes in interest rates, credit risk premiums or spreads, foreign exchange rates and equity prices.
Our investments, which are primarily fixed income securities, are subject to market value, reinvestment, and liquidity risk. Our invested assets are funded not only by capital but also by the proceeds of reinsurance transactions, some of which entail substantial deposits of funds or assets. The cash flows required to pay future benefits are subject to actuarial uncertainties and, in some cases, the policies that we reinsure contain provisions that tend to increase benefits to customers depending on movements in interest rates. We analyze the potential results of a transaction, including the cash flows of the liabilities and of the related assets, and any risk mitigation measures, and we price transactions to cover our costs, including estimated credit losses, and earn a desirable risk-adjusted return under various scenarios. We use interest rate swaps as tools to mitigate these risks. We may also retrocede some risks to other reinsurers.
Interest Rate Risk
Interest rate risk consists of two components: (1) in a falling rate scenario, we have reinvestment risk, which is the risk that interest rates will decline and funds reinvested will earn less than is necessary to match anticipated liabilities; and (2) in a rising rate scenario, we have the risk that cash outflows will have to be funded by selling assets, which will then be trading at depreciated values. With some annuity liabilities, these risks are compounded by variability in liability cash flows arising from adverse experience in withdrawals, surrenders, mortality, and election of early retirement.
We mitigate both components of risk through asset-liability management, including the technique of simulating future results under a variety of interest rate scenarios and modifying the investment and hedging strategy to mitigate downside risk to earnings. Our investment portfolio is composed of fixed-maturity bond investments, of which the majority is at fixed interest rates. For fixed-rate investments backing reinsurance liabilities, the maturity structure has been designed to have approximately the same exposure to changes in interest rates as the related liabilities. Floating-rate liabilities, including borrowings, are backed primarily by floating-rate assets. In the capital account, however, we own investments that are also sensitive to interest rate changes and this sensitivity is not offset by liabilities. Our overall objective is to limit interest rate exposure.
Credit Risk
Credit risk relates to the uncertainty associated with the continued ability of a given obligor to make timely payments of principal and interest. We measure and manage credit risk not only of bond issuers but also of counter-parties in reinsurance, retrocession and hedging transactions.
In our investment portfolio, credit risk is manifested in three ways:
o actual and anticipated deterioration in the creditworthiness of an issue, as may be reflected in downgrades in its ratings, tend to reduce its market value;
o our managers might react to the actual or expected deterioration and/or downgrade of an issuer by selling some or all of our positions, realizing a loss (or a profit smaller than would have been realized if the deterioration or downgrade had not occurred); and
o the issuer may go into default, ultimately causing us to realize a loss.
One of our key objectives in managing credit risk is to keep actual credit losses below both the amounts that we have assumed and allowed for in pricing reinsurance transactions and the amounts we would have lost, given the general level of experience for comparably rated securities of the same type in the general market. We seek to prevent credit risk, in the aggregate, from becoming the dominant source of risk in our overall book of retained risks as a reinsurer.
We mitigate credit risk by adopting an investment policy, approved by our board of directors, which limits overall exposure to credit risk and requires diversification by limiting exposure to any single issuer. We also use outside professional money management firms and monitor their capabilities, performance and compliance with our investment and risk management policies.
Foreign Currency Risk
Our functional currency is the United States dollar. However, our U.K. subsidiaries, Scottish Re Holdings Limited and Scottish Re Limited, maintain operating expense accounts in British pounds, parts of their investment portfolios in Euros and British pounds, and receive other currencies in payment of premiums. All of Scottish Re Limited's original U.S. business is settled in United States dollars, all Canadian, Latin American and certain Asia and Middle East business is converted and settled in United States dollars, and all other currencies are converted and settled in Euros or British pounds. The results of the business recorded in Euros and in British pounds are then translated to United States dollars. We attempt to limit substantial exposures to foreign currency risk, but do not
actively manage currency risks. To the extent our foreign currency exposure is not properly managed or otherwise hedged, we may experience exchange losses, which in turn would adversely affect our results of operations and financial condition.
We may enter into investment, insurance and reinsurance transactions in the future in currencies other than United States dollars. Our objective is to avoid substantial exposures to foreign currency risk. We will manage these risks using policy limits, asset-liability management techniques and hedging transactions.
Sensitivity Analysis--Change In Interest Rates
We regularly conduct analyses to gauge the financial impact of changes in interest rates on our financial condition. Techniques include, but are not limited to, comparison of option-adjusted duration of assets and liabilities and simulation of future asset and liability cash flows under multiple interest rate scenarios. Financial simulations are also used to evaluate exposure to credit spreads and will be used as we consider investments and liabilities denominated in foreign currencies. On a monthly basis, we measure the gap between the effective duration of the investments and the target duration. For assets supporting liabilities, we set the target duration to minimize interest rate risk for each liability transaction. Our investment policy limits the duration gap to 0.75 years. For floating-rate borrowings and liabilities, we target floating-rate assets, which have a duration near zero. For capital account assets, we target a duration of 3.0 years.
Quantitative Disclosure Of Interest Rate Risk
The following tables provide information as of December 31, 2005 about the interest rate sensitivity of the portion of our investment portfolio managed by external managers. The tables do not include other cash balances of $1.3 billion, or funds withheld at interest of $2.6 billion. The tables show the aggregate amount, by book value and fair value, of the securities that are expected to mature in each of the next five years and thereafter, as well as the weighted average book yield of those securities. The expected maturity is the weighted average life of a security and takes into consideration par amortization (for mortgage-backed securities), call features and sinking fund features.
In addition to the maturity structure of our controlled asset portfolio illustrated below, we have entered into an interest rate swap agreement with a notional amount of $100.0 million and a maturity of July 2009. This swap is used to manage a portion of the interest rate exposure on the balance sheet and has the effect of shortening the duration on our overall controlled portfolio by 0.05 years or approximately equivalent to reducing our four year maturity exposure by $100.0 million.
December 31, 2005 market interest rates were used as discounting rates in the estimation of fair value.
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Item 8:
Item 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information called for by this item is set forth in "Item 15: Exhibits, Financial Statement Schedules and Reports on Form 8-K."
Item 9:
Item 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
There were no changes in or disagreements with accountants on accounting and financial disclosure for the fiscal year ended December 31, 2005.
Item 9A:
Item 9A: CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
The Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness (design and operation) of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended). Based on such evaluation, such officers have concluded that these disclosure controls and procedures are effective as of the end of the period covered by this Annual Report.
Management's Report on Internal Control over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting and for the assessment of the effectiveness of internal control over financial reporting, as defined in Rules 13a-15(f) of the Securities and Exchange Act of 1934, as amended. Under the supervision and with the participation of management, including our principal executive and financial officers, we have conducted an evaluation of the
effectiveness of our internal control over financial reporting as of December 31, 2005. In designing and evaluating the internal control over financial reporting, we recognize that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In making their assessment of internal control over financial reporting, management used criteria established in "Internal Control - Integrated Framework" issued by the Committee of Sponsoring Organizations of the Treadway Commission (the "COSO criteria"). Based on their evaluation, management has concluded that we maintained effective internal control over financial reporting as of December 31, 2005, based on the COSO criteria.
Ernst & Young LLP, the independent registered public accounting firm that audited our consolidated financial statements included in this report, have issued an attestation report on management's assessment of internal control over financial reporting.
Changes in Internal Control over Financial Reporting
There have been no changes in internal control over financial reporting identified in connection with our evaluation that occurred during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting
The Board of Directors and Shareholders Scottish Re Group Limited
We have audited management's assessment, included in the accompanying Management's Report on Internal Control over Financial Reporting, that Scottish Re Group Limited maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control--Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Scottish Re Group Limited's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management's assessment that Scottish Re Group Limited maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Scottish Re Group Limited maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Scottish Re Group Limited as of December 31, 2005 and 2004, and the related consolidated statements of income, comprehensive income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2005 and our report dated March 13, 2006 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP - ---------------------
Philadelphia, Pennsylvania March 13, 2006
NYSE CEO Certification
We filed our 2005 annual CEO certification with the New York Stock Exchange on August 10, 2005. We anticipate filing our 2006 annual CEO certification with the NYSE on or about June 2, 2006. Additionally, we filed with the SEC as exhibits to our Form 10-K for the year ended December 31, 2005 the CEO and CFO certifications required under Section 302 of the Sarbanes Oxley Act of 2002.
Item 9B:
Item 9B: OTHER INFORMATION
None.
PART III
Item 10:
Item 10: DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT
The information required by this Item 10 will be set forth in our Proxy Statement for 2006 Annual Meeting of Shareholders (the "2006 Proxy Statement") under the captions "Proposal for Election of Directors," "Principal Shareholders and Management Ownership" and "Section 16(a) Beneficial Ownership Reporting Compliance" and is incorporated herein by reference.
Item 11:
Item 11: EXECUTIVE COMPENSATION
The information required by this Item 11 will be set forth in the 2006 Proxy Statement under the captions "Management Compensation" and "Report on Executive Compensation" and is incorporated herein by reference.
Item 12:
Item 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by this Item 12 will be set forth in the 2006 Proxy Statement under the caption "Principal Shareholders and Management Ownership" and is incorporated herein by reference.
Item 13:
Item 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item 13 will be set forth in the 2006 Proxy Statement under the caption "Certain Transactions" and is incorporated herein by reference.
Item 14:
Item 14: PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required by this Item 14 will be set forth in the 2006 Proxy Statement under the caption "Fees Billed to the Company by Ernst & Young LLP" and is incorporated herein by reference.
PART IV
Item 15:
Item 15: EXHIBITS, FINANCIAL STATEMENT SCHEDULES
Except as otherwise indicated, the following Exhibits are filed herewith and made a part hereof:
3.1 Memorandum of Association of Scottish Re Group Limited, as amended as of April 7, 2005 (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (6)
3.2 Articles of Association of Scottish Re Group Limited, as amended as of April 7, 2005
(incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (6)
4.1 Specimen Ordinary Share Certificate (incorporated herein by reference to Exhibit 4.1 to Scottish Re Group Limited's Registration Statement on Form S-1). (1)
4.2 Form of Amended and Restated Class A Warrant (incorporated herein by reference to Exhibit 4.2 to Scottish Re Group Limited's Registration Statement on Form S-1). (1)
4.3 Form of Securities Purchase Agreement for the Class A Warrants (incorporated herein by reference to Exhibit
4.4 to Scottish Re Group Limited's Registration Statement on Form S-1). (1) 4.4 Form of Securities Purchase Agreement between Scottish Re Group Limited and the Shareholder Investors (incorporated herein by reference to Exhibit 4.10 to Scottish Re Group Limited's Registration Statement on Form S-1). (1)
4.5 Form of Securities Purchase Agreement between Scottish Re Group Limited and the Non-Shareholder Investors (incorporated herein by reference to Exhibit 4.12 to Scottish Re Group Limited's Registration Statement on Form S-1). (1)
4.6 Certificate of Designations of Convertible Preferred Shares of Scottish Re Group Limited (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (10)
4.7 Certificate of Designations of Scottish Re Group Limited's Non-Cumulative Perpetual Preferred Shares, dated June 28, 2005 (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (16)
4.8 Specimen Stock Certificate for the Company's Non-Cumulative Perpetual Preferred Shares (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (16)
10.1 Employment Agreement dated June 18, 1998 between Scottish Re Group Limited and Michael C. French (incorporated herein by reference to Exhibit 10.1 to Scottish Re Group Limited's Registration Statement on Form S-1). (1)(22)
10.2 Second Amended and Restated 1998 Stock Option Plan effective October 22, 1998 (incorporated herein by reference to Exhibit 10.3 to Scottish Re Group Limited's Registration Statement on Form S-1). (1)(22)
10.3 Form of Stock Option Agreement in connection with 1998 Stock Option Plan (incorporated herein by reference to Exhibit 10.4 to Scottish Re Group Limited's Registration Statement on Form S-1). (1)(22)
10.4 Investment Management Agreement dated October 22, 1998 between Scottish Re Group Limited and General Re-New England Asset Management, Inc. (incorporated herein by reference to Exhibit 10.14 to Scottish Re Group Limited's Registration Statement on Form S-1). (1)
10.5 Form of Omnibus Registration Rights Agreement (incorporated herein by reference to Exhibit 10.17 to Scottish Re Group Limited's Registration Statement on Form S-1). (1)
10.6 1999 Stock Option Plan (incorporated herein by reference to Exhibit 10.14 to Scottish Re Group Limited's 1999 Annual Report on Form 10-K). (2)(22)
10.7 Form of Stock Options Agreement in connection with 1999 Stock Option Plan (incorporated herein by reference to Exhibit 10.15 to Scottish Re Group Limited's 1999 Annual Report on Form 10-K). (2)(22)
10.8 Employment Agreement dated September 18, 2000 between Scottish Re (U.S.), Inc. and Oscar R. Scofield (incorporated herein by reference to Exhibit 10.16 to Scottish Re Group Limited's 2000 Annual Report on Form 10-K). (3)(22)
10.9 Share Purchase Agreement by and between Scottish Re Group Limited and Pacific Life dated August 6, 2001 (incorporated by reference to Scottish Re Group Limited's Current Report on Form 8-K). (7)
10.10 Amendment No. 1, dated November 8, 2001, to Share Purchase Agreement dated August 6, 2001 by and between Scottish Re Group Limited and Pacific Life (incorporated by reference to Scottish Re Group Limited's Current Report on Form 8-K). (5)
10.11 2001 Stock Option Plan (incorporated herein by reference to Exhibit 10.17 to Scottish Re Group Limited's 2001 Annual Report on Form 10-K). (4)(22)
10.12 Form of Nonqualified Stock Option Agreement in connection with 2001 Stock Option Plan (incorporated herein by reference to Exhibit 10.17 to Scottish Re Group Limited's 2001 Annual Report on Form 10-K). (4)(22)
10.13 Tax Deed of Covenant dated December 31, 2001 between Scottish Re Group Limited and Pacific Life (incorporated by reference to Scottish Re Group Limited's Current Report on Form 8-K). (5)
10.14 Letter Agreement dated December 28, 2001 between Scottish Re Group Limited and Pacific Life (incorporated by reference to Scottish Re Group Limited's Current Report on Form 8-K). (5)
10.15 Form of Indemnification Agreement between Scottish Re Group Limited and each of its directors and officers (incorporated by reference to Scottish Re Group Limited's Amended Quarterly Report on Form 10-Q/A for the period ended September 30, 2002). (8)(22) 10.16 Employment Agreement dated July 1, 2002 between Scottish Annuity & Life Insurance Company (Cayman) Ltd. and Thomas A. McAvity, Jr. (incorporated by reference to Scottish Re Group Limited's Amended Quarterly Report on Form 10-Q/A for the period ended September 30, 2002). (8)(22)
10.17 Employment Agreement dated June 1, 2002 between Scottish Re Group Limited and Paul Goldean (incorporated herein by reference to Scottish Re Group Limited's Quarterly Report on Form 10-Q for the period ended March 31, 2004). (14)(22)
10.18 Employment Agreement dated July 1, 2002 between Scottish Re Group Limited and Elizabeth Murphy (incorporated by reference to Scottish Re Group Limited's Amended Quarterly Report on Form 10-Q/A for the period ended September 30, 2002). (8)(22)
10.19 Employment Agreement dated June 1, 2002 between Scottish Re Group Limited and Clifford J. Wagner (incorporated by reference to Scottish Re Group Limited's Amended Quarterly Report on Form 10-Q/A for the period ended September 30, 2002). (8)(22)
10.20 Employment Agreement dated July 8, 2002 between Scottish Re Group Limited and Scott E. Willkomm (incorporated by reference to Scottish Re Group Limited's Amended Quarterly Report on Form 10-Q/A for the period ended September 30, 2002). (8)(22)
10.21 Employment Agreement dated February 10, 2003 between Scottish Re Group Limited and Michael C. French (incorporated herein by reference to Scottish Re Group Limited's 2002 Annual Report on Form 10-K). (12)(22)
10.22 Employment Agreement dated February 10, 2003 between Scottish Re (U.S.), Inc. and Oscar R. Scofield (incorporated herein by reference to Scottish Re Group Limited's 2002 Annual Report on Form 10-K). (12)(22)
10.23 Amended Employment Agreement dated February 10, 2003 between Scottish Re Group Limited and Thomas A. McAvity (incorporated herein by reference to Scottish Re Group Limited's 2002 Annual Report on Form 10-K). (12)(22)
10.24 Indenture, dated November 22, 2002, between Scottish Re Group Limited and The Bank of New York (incorporated herein by reference to Scottish Re Group Limited's Registration Statement on Form S-3). (9)
10.25 Registration Rights Agreement, dated November 22, 2002, by and among Scottish Re Group Limited and Bear Stearns & Co. and Putnam Lovell Securities Inc. (incorporated herein by reference to Scottish Re Group Limited's Registration Statement on Form S-3). (9)
10.26 Employment Agreement dated May 1, 2003 between Scottish Re Holdings Limited and David Huntley (incorporated herein by reference to Scottish Re Group Limited's Quarterly Report on Form 10-Q for the period ended September 30, 2003). (13)(22)
10.27 Stock Purchase Agreement, dated as of October 24, 2003, by and among Scottish Re Group Limited, Scottish Holdings, Inc. and Employers Reinsurance Corporation (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (11)
10.28 Tax Matters Agreement, dated as of January 22, 2003, by and among Scottish Re Group Limited, Scottish Holdings, Inc. and Employers Reinsurance Corporation (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (11)
10.29 Transition Services Agreement, dated as of January 22, 2003, by and among Scottish Holdings, Inc. and Employers Reinsurance Corporation (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (11)
10.30 Employment Agreement dated April 21, 2004, by and among Scottish Holdings, Inc. and Seth W. Vance (incorporated herein by reference to Scottish Re Group Limited's Quarterly Report on Form 10-Q for the period ended March 31, 2004). (14)(22)
10.31 Amendment to Employment Agreement dated March 29, 2004, by and between Scottish Re (U.S.), Inc. and Oscar R. Scofield (incorporated herein by reference to Scottish Re Group Limited's Quarterly Report on Form 10-Q for the period ended June 30, 2004, filed with the SEC on August 9, 2004). (22)
10.32 Asset Purchase Agreement, dated as of October 17, 2004, by and among Security Life of Denver Insurance Company, Security Life of Denver International Limited, ING America Insurance Holdings, Inc. (for purposes of Section 11.11), Scottish Re Group Limited, Scottish Re (U.S.), Inc., Scottish Annuity & Life Insurance Company (Cayman) Ltd. (for purposes of Section 5.26) and Scottish Re Life Corporation (for purposes of Section 5.24) (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (15) 10.33 Securities Purchase Agreement, dated as of October 17, 2004, by and among Scottish Re Group Limited and Cypress Merchant B Partners II (Cayman) L.P., Cypress Merchant Banking II-A C.V., 55th Street Partners II (Cayman) L.P. and Cypress Side-by-Side (Cayman) L.P. (including form of Subordinated Note, Class C Warrant, Shareholders' Agreement and Amendments to Articles of Association) (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (15)
10.33 Securities Purchase Agreement, dated as of October 17, 2004, by and among Scottish Re Group Limited and Cypress Merchant B Partners II (Cayman) L.P., Cypress Merchant Banking II-A C.V., 55th Street Partners II (Cayman) L.P. and Cypress Side-by-Side (Cayman) L.P. (including form of Subordinated Note, Class C Warrant, Shareholders' Agreement and Amendments to
Articles of Association) (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (15)
10.34 Form of Voting Agreement, by and among Cypress Merchant B Partners II (Cayman) L.P., Cypress Merchant Banking II-A C.V., 55th Street Partners II (Cayman) L.P. and Cypress Side-by-Side (Cayman) L.P., Scottish Re Group Limited and, respectively, each director and each officer of Scottish Re Group Limited (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (15)
10.35 Voting Agreement, dated as of October 15, 2004, by and among Scottish Re Group Limited, Cypress Merchant B Partners II (Cayman) L.P., Cypress Merchant Banking II-A C.V., 55th Street Partners II (Cayman) L.P. and Cypress Side-by-Side (Cayman) L.P. and Pacific Life Insurance Company (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (15)
10.36 Letter Agreement, dated as of October 17, 2004, by and among Scottish Re Group Limited and Cypress Merchant B Partners II (Cayman) L.P., Cypress Merchant Banking II-A C.V., 55th Street Partners II (Cayman) L.P. and Cypress Side-by-Side (Cayman) L.P. (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (15)
10.37 First Supplemental Indenture, dated as of October 26, 2004, between Scottish Re Group Limited and The Bank of New York (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K, filed with the SEC on October 29, 2004).
10.38 Amendment to Employment Agreement dated as of March 29, 2004, by and among Scottish Re Group Limited and Michael C. French (incorporated herein by reference to Scottish Re Group Limited's Quarterly Report on Form 10-Q for the quarter ended September 30, 2004, filed with the SEC on November 8, 2004). (22)
10.39 Employment Agreement, dated as of March 29, 2004, by and among Scottish Re Group Limited and Deborah G. Percy (incorporated herein by reference to Scottish Re Group Limited's Quarterly Report on Form 10-Q for the quarter ended September 30, 2004, filed with the SEC on November 8, 2004). (22)
10.40 Employment Agreement, dated as of January 1, 2005, between Scottish Holdings, Inc. and Gary Dombowsky (incorporated herein by reference to Scottish Re Group Limited's 2004 Annual Report on Form 10-K). (20)(22)
10.41 Amendment to Employment Agreement, dated as of February 7, 2005, between Scottish Re Group Limited and Michael C. French (incorporated herein by reference to Scottish Re Group Limited's 2004 Annual Report on Form 10-K). (20)(22)
10.42 Employment Agreement, dated as of February 1, 2005, between Scottish Re Group Limited and Hugh T. McCormick (incorporated herein by reference to Scottish Re Group Limited's 2004 Annual Report on Form 10-K). (20)(22)
10.43 Employment Agreement, dated as of December 1, 2004, between Scottish Holdings, Inc. and Kenneth R. Stott (incorporated herein by reference to Scottish Re Group Limited's 2004 Annual Report on Form 10-K). (20)(22)
10.44 Credit Agreement, dated as of December 29, 2004, among Scottish Annuity & Life Insurance Company (Cayman) Ltd., Scottish Re (Dublin) Limited, Scottish Re (U.S.), Inc., and Scottish Re Limited, as borrowers, Bear Stearns Corporate Lending, Inc. and Wachovia Bank, National Association as Co-Syndication Agents, Bank of America, N.A., as Administrative Agent and L/C Issuer, and The Other Lenders Party Hereto, Banc of America Securities LLC, as Sole Lead Arranger and Sole Book Manager (incorporated herein by reference to Scottish Re Group
Limited's 2004 Annual Report on Form 10-K). (20)
10.45 Administrative Services Agreement, dated as of December 31, 2004, between Security Life of Denver Insurance Company and Security Life of Denver International Limited and Scottish Re (U.S.), Inc. (incorporated herein by reference to Scottish Re Group Limited's 2004 Annual Report on Form 10-K). (20)
10.46 Coinsurance Agreement dated December 31, 2004 between Security Life of Denver Insurance Company and Scottish Re (U.S.), Inc. (incorporated herein by reference to Scottish Re Group Limited's 2004 Annual Report on Form 10-K). (20)
10.47 Coinsurance/Modified Coinsurance Agreement, dated December 31, 2004, between Security Life of Denver Insurance Company and Scottish Re (U.S.), Inc. (incorporated herein by reference to Scottish Re Group Limited's 2004 Annual Report on Form 10-K). (20)
10.48 Retrocession Agreement, dated December 31, 2004, between Scottish Re (U.S.), Inc. and Security Life of Denver Insurance Company (incorporated herein by reference to Scottish Re Group Limited's 2004 Annual Report on Form 10-K). (20)
10.49 Retrocession Agreement, dated December 31, 2004, between Scottish Re Life (Bermuda) Limited and Security Life of Denver Insurance Company (incorporated herein by reference to Scottish Re Group Limited's 2004 Annual Report on Form 10-K). (20)
10.50 Reserve Trust Agreement, dated as of December 31, 2004, between Scottish Re (U.S.) Inc., as Grantor, and Security Life of Denver Insurance Company, as Beneficiary, and The Bank of New York, as Trustee, and The Bank of New York, as Securities Intermediary (incorporated herein by reference to Scottish Re Group Limited's 2004 Annual Report on Form 10-K). (20)
10.51 Security Trust Agreement, dated as of December 31, 2004, by and among Scottish Re (U.S.), Inc., as Grantor, Security Life of Denver Insurance Company, as Beneficiary, The Bank of New York, as Trustee, and The Bank of New York, as Securities Intermediary (incorporated herein by reference to Scottish Re Group Limited's 2004 Annual Report on Form 10-K). (20)
10.52 Coinsurance Agreement, dated December 31, 2004, between Security Life of Denver International Limited and Scottish Re Life (Bermuda) Limited (incorporated herein by reference to Scottish Re Group Limited's 2004 Annual Report on Form 10-K). (20)
10.53 Coinsurance/Modified Coinsurance Agreement, dated December 31, 2004, between Security Life of Denver International Limited and Scottish Re Life (Bermuda) Limited (incorporated herein by reference to Scottish Re Group Limited's 2004 Annual Report on Form 10-K). (20)
10.54 Coinsurance Funds Withheld Agreement, dated December 31, 2004, between Security Life of Denver International Limited and Scottish Re Life (Bermuda) Limited (incorporated herein by reference to Scottish Re Group Limited's 2004 Annual Report on Form 10-K). (20)
10.55 Reserve Trust Agreement, dated December 31, 2004, between Scottish Re Life (Bermuda) Limited, as Grantor, and Security Life of Denver International Limited, as Beneficiary. The Bank of New York, as Trustee, and The Bank of New York, as Securities Intermediary (incorporated herein by reference to Scottish Re Group Limited's 2004 Annual Report on Form 10-K). (20)
10.56 Security Trust Agreement, dated as of December 31, 2004, by and among Scottish Re Life (Bermuda) Limited, as Grantor, Security Life of Denver International Limited, as Beneficiary, The Bank of New York, as Trustee, and the Bank of New York, as Securities Intermediary (incorporated herein by reference to Scottish Re Group Limited's 2004 Annual Report on Form 10-K). (20)
10.57 Technology Transfer and License Agreement, dated as of December 31, 2004, between Security Life of Denver Insurance Company, ING North America Insurance Corporation and Scottish Re (U.S.), Inc. (incorporated herein by reference to Scottish Re Group Limited's 2004 Annual Report on Form 10-K). (20)
10.58 Transition and Integration Services Agreement, dated December 31, 2004, between Security Life of Denver Insurance Company and Scottish Re (U.S.), Inc. (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (19)
10.59 Form of Remarketing Agreement, between the Company and Lehman Brothers, Inc., as Remarketing Agent (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (16)
10.60 Amended and Restated Credit Agreement, dated as of July 14, 2005, among Scottish Annuity & Life Insurance Company (Cayman) Ltd., Scottish Re (Dublin) Limited, Scottish Re (U.S.), Inc., and Scottish Re Limited, as Borrowers, Bear Stearns Corporate Lending, Inc., HSBC Bank USA, National Association, and Wachovia Bank, National Association as Syndication Agents, Bank of America, N.A., as Administrative Agent and L/C Issuer, and the Other Lenders Party Hereto, Banc of America Securities LLC, as Sole Lead Arranger and Sole Book Manager (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (17)
10.61 Scottish Re Group Limited 2004 Equity Incentive Compensation Plan (incorporated herein by reference to Scottish Re Group Limited's Proxy Statement filed with the SEC on April 1, 2004).
10.62 Amendment No. 1 to Scottish Re Group Limited 2004 Equity Incentive Compensation Plan (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (18) (22)10.63 Amendment No. 2 to Scottish Re Group Limited 2004 Equity Incentive Compensation Plan (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (18) (22) 10.64 Form of Management Stock Option Agreement under the Scottish Re Group Limited 2004 Equity Incentive Compensation Plan (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (18) (22)
10.65 Form of Management Performance Share Unit Agreement under the Scottish Re Group Limited 2004 Equity Incentive Compensation Plan (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (18) (22)
10.66 Form of Management Restricted Share Unit Agreement under the Scottish Re Group Limited 2004 Equity Incentive Compensation Plan (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (18) (22)
10.67 Employment Agreement, dated as of July 18, 2005, between Scottish Re Group Limited and Dean Miller (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (19) (22)
10.68 Letter of Credit Agreement, dated as of August 18, 2005, among Scottish Re (Dublin) Limited, as Borrower, Scottish Annuity & Life Insurance Company (Cayman) Ltd., as Guarantor, Bank of America, N.A., as Administrative Agent and L/C Issuer, and the Other Lenders Party Hereto, and Bank of America Securities LLC, as Sole Lead Arranger and Sole Book Manager (incorporated herein by reference to Scottish Re Group Limited's Current Report on Form 8-K). (21)
21.1 List of Subsidiaries
23.1 Consent of Ernst & Young LLP
24.1 Power of Attorney
31.1 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
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(1) Scottish Re Group Limited's Registration Statement on Form S-1 was filed with the SEC on June 19, 1998, as amended. (2) Scottish Re Group Limited's 1999 Annual Report on Form 10-K was filed with the SEC on April 3, 2000. (3) Scottish Re Group Limited's 2000 Annual Report on Form 10-K was filed with the SEC on March 30, 2001. (4) Scottish Re Group Limited's 2001 Annual Report on Form 10-K was filed with the SEC on March 5, 2002. (5) Scottish Re Group Limited's Current Report on Form 8-K was filed with the SEC on December 31, 2001. (6) Scottish Re Group Limited's Current Report on Form 8-K was filed with the SEC on June 2, 2005. (7) Scottish Re Group Limited's Current Report on Form 8-K was filed with the SEC on August 9, 2001. (8) Scottish Re Group Limited's Amended Quarterly Report on Form 10-Q/A was filed with the SEC on August 8, 2002. (9) Scottish Re Group Limited's Registration Statement on Form S-3 was filed with the SEC on January 31, 2003, as amended. (10) Scottish Re Group Limited's Current Report on Form 8-K was filed with the SEC on December 17, 2003. (11) Scottish Re Group Limited's Current Report on Form 8-K was filed with the SEC on January 6, 2004. (12) Scottish Re Group Limited's 2002 Annual Report on Form 10-K was filed with the SEC on March 31, 2003. (13) Scottish Re Group Limited's Quarterly Report on Form 10-Q was filed with the SEC on August 12, 2003. (14) Scottish Re Group Limited's Quarterly Report on Form 10-Q was filed with the SEC on May 10, 2004. (15) Scottish Re Group Limited's Current Report on Form 8-K was filed with the SEC on October 21, 2004. (16) Scottish Re Group Limited's Current Report on Form 8-K was filed with the SEC on July 1, 2005. (17) Scottish Re Group Limited's Current Report on Form 8-K was filed with the SEC on July 18, 2005. (18) Scottish Re Group Limited's Current Report on Form 8-K was filed with the SEC on August 8, 2005.
(19) Scottish Re Group Limited's Current Report on Form 8-K was filed with the SEC on August 4, 2005. (20) Scottish Re Group Limited's 2004 Annual Report on Form 10-K was filed with the SEC on March 18, 2005. (21) Scottish Re Group Limited's Current Report on Form 8-K was filed with the SEC on August 22, 2005. (22) This exhibit is a management contract or compensatory plan or arrangement.
FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULES
Report of Independent Registered Public Accounting Firm................ 88 Consolidated Balance Sheets............................................ 89 Consolidated Statements of Income...................................... 90 Consolidated Statements of Comprehensive Income........................ 91 Consolidated Statements of Shareholders' Equity........................ 92 Consolidated Statements of Cash Flows.................................. 94 Notes to Consolidated Financial Statements............................. 95 Schedule I - Summary of Investments .................................. 146 Schedule II - Condensed Financial Information.......................... 147 Schedule III - Supplementary Insurance Information..................... 149 Schedule IV - Reinsurance.............................................. 150 Schedule V - Valuation and Qualifying Accounts......................... 152
All other schedules are omitted because they are either not applicable or the required information is included in the Management's Discussion and Analysis of Financial Condition and Results of Operations, Financial Statements or Notes thereto appearing elsewhere in this Form 10-K.
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of Scottish Re Group Limited
We have audited the accompanying consolidated balance sheets of Scottish Re Group Limited and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, comprehensive income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 2005. Our audit also included the financial statement schedules listed at Item 15(a)(2). These financial statements and schedules are the responsibility of Scottish Re Group Limited's management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Scottish Re Group Limited and subsidiaries at December 31, 2005 and 2004, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Scottish Re Group Limited's internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 13, 2006 expressed an unqualified opinion thereon.
As discussed in Note 2 to the financial statements, in 2003 the Company changed its accounting related to its funds withheld at interest.
/s/Ernst & Yount LLP - --------------------
Philadelphia, Pennsylvania March 13, 2006
(1) Reflects reduction for dividends declared on non-cumulative perpetual preferred shares
SCOTTISH RE GROUP LIMITED CONSOLIDATED STATEMENTS OF CASH FLOWS (Expressed in Thousands of United States Dollars)
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005
1. Organization and business
Organization
Scottish Re Group Limited is a holding company organized under the laws of the Cayman Islands with its principal executive office in Bermuda. Through our operating subsidiaries, we are a reinsurer of life insurance, annuities and annuity-type products. These products are written by life insurance companies and other financial institutions located principally in the United States, as well as around the world. We refer to this portion of our business as Life Reinsurance. To a lesser extent, we directly issue variable life insurance and variable annuities and similar products to high net worth individuals and families for insurance, investment and estate planning purposes. We refer to this portion of our business as Wealth Management. We have operating companies in Bermuda, the Cayman Islands, Guernsey, Ireland, the United Kingdom and the United States and a branch office in Singapore.
Business
In our Life Reinsurance North America Segment, we provide solutions to insurance companies seeking reinsurance of life insurance, annuities and annuity-type products. We reinsure lines of business that may be subject to significant reserve or capital requirements by regulatory and rating agencies. We assume risks associated with primary life insurance policies and annuities, both in-force and new business. We reinsure: (i) mortality, (ii) investment, (iii) persistency, and (iv) expense risks. We originate reinsurance business predominantly by marketing our products and services directly to U.S. life insurance and reinsurance companies.
Prior to 2005, our Life Reinsurance International Segment specialized in niche markets in developed countries and broader life insurance markets in the developing world and focused on the reinsurance of short-term group life policies and aircrew "loss of license" insurance. In 2005, the Life Reinsurance International Segment became actively engaged in the reinsurance of United Kingdom and Ireland traditional solutions business and annuity products. The life insurance and annuity products are similar to those offered in the Life Reinsurance North America Segment.
In our Wealth Management business, we directly issue variable life insurance and variable annuities and similar products to high net worth individuals and families, for insurance, investment and estate planning purposes. For us, high net worth generally means individuals and families with a liquid net worth in excess of $10.0 million. Variable life insurance and variable annuities have a cash value component that is placed in a separate account and invested by us on behalf of the policyholder with a money manager. Our Wealth Management business is included in the Corporate and Other segment.
2. Summary of significant accounting policies
Basis of presentation
Accounting Principles--Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America ("GAAP") and all tabular amounts are reported in thousands of United States dollars (except share and per share data). Certain items in the prior year financial statements have been reclassified to conform with the current year presentation.
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
2. Summary of significant accounting policies (continued)
Consolidation--The consolidated financial statements include the assets, liabilities and results of operations of Scottish Annuity & Life Insurance Company (Cayman) Ltd., Scottish Re (U.S.), Inc. and Scottish Re Limited, as well as other subsidiaries and all variable interest entities for which we are the primary beneficiary as defined in Financial Accounting Standards Board ("FASB") Interpretation No. 46R "Consolidation of Variable Interest Entities - An Interpretation of ARB No. 51." All significant intercompany transactions and balances have been eliminated on consolidation.
Estimates, Risks and Uncertainties--The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported on the consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates and assumptions used by management. Our most significant assumptions are for assumed reinsurance liabilities, premiums receivable, deferred acquisition costs and valuation of investment impairments. We review and revise these estimates as appropriate. Any adjustments made to these estimates are reflected in the period the estimates are revised.
Fixed maturity investments
Fixed maturity investments are classified as available for sale, and, accordingly, we carry these investments at fair values on our consolidated balance sheets. The fair value of fixed maturity investments is calculated using quoted market prices provided by independent pricing services. The cost of fixed maturity investments is adjusted for prepayments and the amortization of premiums and discounts. The unrealized appreciation (depreciation) is the difference between fair value and amortized cost and is recorded directly to equity with no impact to net income. The change in unrealized appreciation (depreciation) is included in accumulated other comprehensive income (loss) in shareholders' equity after deductions for adjustments for deferred acquisition costs and deferred income taxes. Investment transactions are recorded on the trade date with balances pending settlement reflected in the balance sheet as a component of other assets or other liabilities. Interest income is recorded on the accrual basis.
Realized gains (losses) on securities are determined on a specific identification method. Realized gains and losses are stated net of associated amortization of deferred acquisition costs. Management reviews securities with material unrealized losses and tests for other than temporary impairments on a quarterly basis. Factors involved in the determination of potential impairment include fair value as compared to cost, length of time the value has been below cost, credit worthiness of the issuer, forecasted financial performance of the issuer, position of the security in the issuer's capital structure, the presence and estimated value of collateral or other credit enhancement, length of time to maturity, interest rates and our intent and ability to hold the security until the market value recovers. When a decline is considered to be "other than temporary" the cost basis of the impaired asset is adjusted to its fair value and a corresponding realized investment loss is recognized in the consolidated statements of income. The actual value at which such financial instruments could actually be sold or settled with a willing buyer may differ from such estimated fair values.
Our review of fixed maturities for impairment also includes an analysis of the total gross unrealized losses. We review all investments with fair values less than amortized cost, and pay particular attention to those that have traded continuously at less than 80% of amortized cost for at least six months or 90% of amortized cost for at least twelve months and any other investments with material differences between amortized cost and fair value. Investments meeting those criteria are analyzed in detail for "other-than-temporary impairment".
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
2. Summary of significant accounting policies (continued)
Cash and cash equivalents
Cash and cash equivalents include cash and fixed deposits with an original maturity, when purchased, of three months or less. Cash and cash equivalents are recorded at face value, which approximates fair value.
Funds withheld at interest
Funds withheld at interest are funds held by ceding companies under modified coinsurance and coinsurance funds withheld agreements whereby we receive the interest income earned on the funds. The balance of funds held represents the statutory reserves of the ceding companies and are legally owned by the ceding company. Interest accrues to these assets at rates defined by the treaty terms. These agreements are considered to include embedded derivatives as further discussed in this Note.
Retrocession arrangements and amounts recoverable from reinsurers
In the ordinary course of business, our reinsurance subsidiaries cede reinsurance to other reinsurance companies. These agreements provide greater diversification of business and minimize the net loss potential arising from large risks. Ceded reinsurance contracts do not relieve us of our obligation to the direct writing companies. The cost of reinsurance related to long duration contracts is recognized over the terms of the reinsured policies on a basis consistent with the reporting of those policies.
In the normal course of business, we seek to limit our exposure to losses on any single insured and to recover a portion of benefits paid by ceding reinsurance to other insurance enterprises or reinsurers under excess coverage and coinsurance (quota share) contracts. Effective January 1, 2005, we raised our maximum per life retention on newly written business, excluding the in-force individual life reinsurance business, which we acquired (the "ING acquisition") from ING America Holdings, Inc. ("ING"), to $1.0 million from $0.5 million in our Life Reinsurance North America Segment. Our retention on business acquired in the ING acquisition is $2.0 million per life. Our targeted maximum corporate retention per life in our Life Reinsurance International Segment is $250,000. In addition, we maintain catastrophe cover on our retained life reinsurance business, which effective January 1, 2005, provides reinsurance for losses of $50.0 million in excess of $10.0 million for our North American risks and $57.5 million excess of $2.5 million for our International risks. The catastrophe covers include protection for terrorism, nuclear, biological and chemical risks.
Amounts recoverable from reinsurers includes the balances due from reinsurance companies for claims and policy benefits that will be recovered from reinsurers, based on contracts in force, and are presented net of a reserve for uncollectible reinsurance that has been determined based upon a review of the financial condition of the reinsurers and other factors. The method for determining the reinsurance recoverable involves actuarial estimates as well as a determination of our ability to cede claims and policy benefits under our existing reinsurance contracts. The reserve for uncollectible reinsurance is based on an estimate of the amount of the reinsurance recoverable balance that we will ultimately be unable to recover due to reinsurer insolvency, a contractual dispute or any other reason.
The methods used to determine the reinsurance recoverable balance, and related bad debt provision, are continually reviewed and updated and any resulting adjustments are reflected in earnings in the period identified. At December 31, 2005, we had a reserve for uncollectible reinsurance of $6.0 million.
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
2. Summary of significant accounting policies (continued)
Deferred acquisition costs
Costs of acquiring new business, which vary with and are primarily related to the production of new business, have been deferred to the extent that such costs are deemed recoverable from future premiums or gross profits. Such costs include commissions and allowances as well as certain costs of policy issuance and underwriting. We perform periodic tests to determine that the cost of business acquired remains recoverable, and if financial performance significantly deteriorates to the point where a premium deficiency exists, the cumulative amortization is re-estimated and adjusted by a cumulative charge or credit to current operations.
Deferred acquisition costs related to traditional life insurance contracts, substantially all of which relate to long-duration contracts, are amortized over the premium-paying period of the related policies in proportion to the ratio of individual period premium revenues to total anticipated premium revenues over the life of the policy. Such anticipated premium revenues are estimated using the same assumptions used for computing liabilities for future policy benefits.
Deferred acquisition costs related to interest-sensitive life and investment-type policies are amortized over the lives of the policies, in relation to the present value of estimated gross profits from mortality, investment income, less interest credited, and expense margins.
The development of and amortization of deferred acquisition costs for our products requires management to make estimates and assumptions. Actual results could differ materially from those estimates. Management monitors actual experience, and should circumstances warrant, will revise its assumptions and the related estimates.
Present value of in-force business
The present value of in-force business is established upon the acquisition of a book of business and is amortized over the expected life of the business as determined at acquisition. The amortization each year is a function of the ratio of annual gross profits or revenues to total anticipated gross profits or revenues expected over the life of the business, discounted at the assumed net credit rate. The carrying value is reviewed at least annually for indicators of impairment in value.
Goodwill
We account for goodwill pursuant to the provisions of Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets". Goodwill is established upon the acquisition of a subsidiary and is calculated as the difference between the price paid and the value of individual assets and liabilities on the date of acquisition. Goodwill is not amortized into results of operations, but instead is reviewed for impairment annually. Goodwill was tested for impairment in 2005, 2004 and 2003 and no impairment resulted.
During 2004, we received a payment of $1.7 million in respect of a post closing adjustment of the purchase price of Scottish Re Holdings Limited (formerly World-Wide Holdings Limited). This payment arose on the finalization of income taxes due for periods prior to the acquisition and resulted in a decrease in the goodwill arising on the acquisition.
Other assets
Other assets primarily include unamortized debt issuance costs, collateral finance facility costs and fixed assets, including capitalized software. Capitalized software is stated at cost, less accumulated amortization.
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
2. Summary of significant accounting policies (continued)
Other assets (continued)
Purchased software costs, as well as internal and external costs incurred to develop internal-use computer software during the application development stage, are capitalized. As of December 31, 2005 and 2004, we had unamortized computer software costs of approximately $9.3 million and $8.0 million, respectively. During 2005, 2004 and 2003, we amortized computer software costs of $3.5 million, $1.7 million and $0.0 million, respectively.
Segregated assets and liabilities
Separate account investments are in respect of wealth management clients and include the net asset values of the underlying funds plus separate cash and cash equivalent balances less separate account fees payable to us. The funds in the separate accounts are not part of our general funds and are not available to meet our general obligations. The assets and liabilities of these transactions move in tandem. The client bears the investment risk on the account and we receive an asset-based fee for providing this service that is recorded as fee income.
Separate account liabilities include amounts set aside to pay the deferred variable annuities and the cash values associated with life insurance policies. These balances consist of the initial premiums paid after consideration of the net investment gains/losses attributable to each separate account, less fees and withdrawals.
Foreign Currency Translation
The translation of the foreign currency amounts into United States dollars is performed for balance sheet accounts using current exchange rates in effect at the balance sheet date and for revenue and expense accounts using a weighted average exchange rate during each year. Gains or losses, net of applicable deferred income taxes, resulting from such translation are included in accumulated currency translation adjustments, in accumulated other comprehensive income (loss) on the consolidated balance sheets. Our material functional currencies are the British pound and the Euro for our United Kingdom operations.
Revenue recognition
(i) Reinsurance premiums from traditional life policies and annuity policies with life contingencies are generally recognized as revenue when due from policyholders and are reported net of amounts retroceded. Traditional life policies include those contracts with fixed and guaranteed premiums and benefits, and consist principally of whole life and term insurance policies. We estimate assumed premiums using actuarial model projections at the treaty level. Consistent with reinsurance industry practices, these models use the most recent policy level data available from our ceding companies and our estimate of new business for treaties still open to new business. The estimated premiums from the models are then compared to historical trends in reported assumed premiums by treaty and other information and adjusted if appropriate. Actual results could differ from these estimates. The adjustments in a given period have generally not been significant to the overall premiums or results of operations.
Based on historical experience, the creditworthiness of ceding companies and our contractual right of offset, uncollectible assumed premium amounts have been infrequent and not material. Any provision for doubtful accounts would be recorded on a specific case by case basis.
Benefits and expenses, net of amounts retroceded, are matched with net earned premiums so as to result in the recognition of profits over the life of the contracts. This is achieved by means of the provision for liabilities for future policy benefits and deferral and subsequent amortization of deferred acquisition costs.
From time to time, we acquire blocks of in-force business and account for these transactions as purchases. Results of operations only include the revenues and expenses from the respective dates of acquisition of these blocks of in-force business. The initial transfer of assets and liabilities is recorded on the balance sheet.
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
2. Summary of significant accounting policies (continued)
Revenue recognition (continued)
Reinsurance assumed for interest sensitive and investment type products does not generate premium but generates investment income on the assets we receive from ceding companies, policy charges for the cost of insurance, policy administration, and surrenders that have been assessed against policy account balances during the period.
(ii) Fee income is recorded on an accrual basis.
(iii) Net investment income includes interest and dividend income together with amortization of market premium and discounts and is net of investment management and custody fees. For mortgage backed securities, and any other holdings for which there is a prepayment risk, prepayment assumptions are evaluated and revised as necessary. Any adjustments required due to the resultant change in effective yields and maturities are recognized prospectively.
Reserves for future policy benefits
SFAS No. 60 "Accounting and Reporting by Insurance Enterprises" applies to our traditional life policies with continuing premiums. For these policies, reserves for future policy benefits are computed based upon expected mortality rates, lapse rates, investment yields, expenses and other assumptions established at policy issue, including a margin for adverse deviation. Once these assumptions are made for a given treaty or group of treaties, they will not be changed over the life of the treaty. We periodically review actual historical experience and relative anticipated experience compared to the assumptions used to establish reserves for future policy benefits. Further, we determine whether actual and anticipated experience indicates that existing policy reserves together with the present value of future gross premiums are sufficient to cover the present value of future benefits, settlement and maintenance costs and to recover unamortized acquisition costs. Significant changes in experience or assumptions may require us to provide for expected losses on a group of treaties by establishing additional net reserves. Because of the many assumptions and estimates used in establishing reserves and the long-term nature of the reinsurance contracts, the reserving process, while based on actuarial science, is inherently uncertain.
We primarily rely on our own valuation and administration systems to establish reserves for future policy benefits. The reserves for future policy benefits may differ from those established by ceding companies due to the use of different assumptions, based principally on actual and anticipated experience, including industry experience and standards. We rely on our ceding companies, however, to provide accurate policy level data, including face amount, age, duration and other characteristics as well as underlying premiums and claims. This data constitutes the primary information used to establish reserves for essentially all of our future policy benefits. The use of reinsurance intermediaries in our transactions with ceding companies has been infrequent. In the few instances in which intermediaries are involved, we receive data from the intermediary in a similar timeframe and fashion as if received directly from the ceding company.
Claims payable for incurred but not reported losses are determined using case basis estimates and lag studies of past experience. The time lag from the date of the claim or death to when the ceding company reports the claim to us can vary significantly by ceding company, but generally averages around two months. We update our analysis of incurred but not reported losses, including lag studies, on a quarterly basis and adjust our claim liabilities accordingly. The adjustments in a given period have generally not been significant relative to the overall reserves for future policy benefits or our results of operations.
In the underwriting process, we perform procedures to evaluate the ceding company's process for compiling and reporting data. After entering into a reinsurance contract, we work closely with our ceding
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
2. Summary of significant accounting policies (continued)
Reserves for future policy benefits (continued)
companies to help ensure information submitted by them is in accordance with the underlying reinsurance contracts. Additionally, we have a dedicated compliance team that performs extensive audits, including on-site audits and desk reviews, of the information provided by ceding companies. In addition to ceding company audits, we routinely perform analysis, at a treaty level, to compare the actual results of ceding companies against initial pricing and expected results. Generally, there have been few disputes or disagreements with ceding companies and most are resolved through normal administration procedures.
Occasionally, we experience processing backlogs and establish reserves for processing backlogs with a goal of clearing all backlogs as quickly as possible. There were no significant processing backlogs at December 31, 2005.
SFAS No. 97 "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments" applies to investment contracts, limited premium contracts, and universal life-type contracts. For investment and universal life-type contracts, future benefit liabilities are held using the retrospective deposit method, increased for amounts representing unearned revenue or refundable policy charges. Acquisition costs are deferred and recognized as expense as a constant percentage of gross margins using assumptions as to mortality, persistency, and expense established at policy issue without provision for adverse deviation and are revised periodically to reflect emerging actual experience and any material changes in expected future experience. Liabilities and the deferral of acquisition costs are established for limited premium policies under the same practices as used for traditional life policies with the exception that any gross premium in excess of the net premium is deferred and recognized into income as a constant percentage of insurance in force. Should the liabilities for future policy benefits plus the present value of expected future gross premiums for a product be insufficient to provide for expected future benefits and expenses for that product, deferred acquisition costs will be written off and thereafter, if required, a premium deficiency reserve will be established by a charge to income. Changes in the assumptions for mortality, persistency, maintenance expense and interest could result in material changes to the financial statements.
The development of policy reserves for our products requires management to make estimates and assumptions regarding mortality, lapse, expense and investment experience. Interest rate assumptions for individual life reinsurance reserves range from 2.5 to 7.0%. The interest assumptions for immediate and deferred annuities range from 4.0 to 6.5%.
Interest sensitive contract liabilities
The liabilities for interest sensitive contract liabilities equal the accumulated account values of the policies or contracts as of the valuation date and include funds received plus interest credited less funds withdrawn and interest paid. Benefit liabilities for fixed annuities during the accumulation period equal their account values; after annuitization, they equal the discounted present value of expected future payments.
Other liabilities
Other liabilities primarily relate to collateral facility accrued interest, the fair value of embedded derivative and employee benefits.
Income taxes
Income taxes are recorded in accordance with SFAS No. 109, "Accounting for Income Taxes". In accordance with this statement, for all years presented we use the asset and liability method to record deferred
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
2. Summary of significant accounting policies (continued)
Income taxes (continued)
income taxes. Accordingly, deferred income tax assets and liabilities are recognized that reflect the net tax effect of the temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes, using enacted tax rates. Such temporary differences are primarily due to tax basis of reserves for future policy benefits, deferred acquisition costs, present value of in-force and net operating loss carry forwards. A valuation allowance is applied to deferred tax assets if it is more likely than not that all, or some portion, of the benefits related to the deferred tax assets will not be realized.
Stock-based compensation
Prior to 2003, we adopted the provisions of APB Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations in accounting for employee stock options. Since the exercise price of the stock options equals or exceeds the market price of the underlying stock on the date of grant, no compensation expense was recognized.
Effective January 1, 2003, we prospectively adopted the fair value-based stock option expense provisions of SFAS No. 148. "Accounting for Stock-Based Compensation - Transition and Disclosure, an Amendment to FASB Statement No. 123" which is considered the preferable accounting method for stock based compensation. Compensation expense has been recognized for all equity based compensation granted since January 1, 2003. This has resulted in a charge to income of $5.4 million, $0.8 million and $0.2 million in the years ended December 31, 2005, 2004 and 2003, respectively.
In December 2004, the FASB revised SFAS No. 123, "Accounting for Stock-Based Compensation", by issuing "Share-Based Payment" ("SFAS No. 123(R)"). SFAS No. 123(R) requires us to recognize, in the determination of income, the grant date fair value of all stock options and other equity based compensation issued to employees. We will adopt the revised pronouncement during the first quarter of 2006. The effects of applying SFAS No. 123(R) will increase compensation cost in 2006 because we will expense the unvested portion of options granted in 2002 and prior, which were previously not expensed under APB Opinion No. 25. We expect SFAS No. 123(R) will increase compensation expense by approximately $0.7 million in 2006.
Note 14 contains a summary of the pro forma effects to reported net income and earnings per share for 2005, 2004 and 2003 had we elected to recognize compensation cost for all options based on the fair value of the options granted at grant date as prescribed by SFAS No. 123(R).
Earnings per share
In accordance with SFAS No. 128, "Earnings per Share", basic earnings per share is calculated based on the weighted average ordinary shares outstanding and excludes any dilutive effects of options, restricted stock and warrants. Diluted earnings per share assume the exercise of all dilutive stock options, restricted stock, warrants, convertible debt instruments and the Hybrid Capital Units ("HyCUs") using the treasury stock method. Basic and diluted earnings per share are calculated by dividing net income available to ordinary shareholders by the applicable weighted average number of shares outstanding during the year.
Fair value of financial instruments
The fair value of assets and liabilities included on the consolidated balance sheets, which qualify as financial instruments under SFAS No. 107, "Disclosure About Fair Value of Financial Instruments," approximate the carrying amount presented in the consolidated financial statements.
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
2. Summary of significant accounting policies (continued)
Derivatives
All derivative instruments are recognized as either assets or liabilities in the consolidated balance sheets at fair value as required by SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS No.133"). The accounting for changes in the fair value of derivatives that have not been designated as a hedge are included in realized gains and losses in the consolidated statements of income. The gain or loss on derivatives designated as a hedge of our interest expense on floating rate securities is included in interest expense.
Our funds withheld at interest arise on modified coinsurance and fund withheld coinsurance transactions. Derivatives Implementation Group Issue No. B36 "Embedded Derivatives: Bifurcation of a Debt Instrument that Incorporates Both Interest Rate and Credit Rate Risk Exposures that are Unrelated or Only Partially Related to the Creditworthiness of the Issuer of that Instrument" indicates that these transactions contain embedded derivatives. The embedded derivative feature in our funds withheld treaties is similar to a fixed-rate total return swap on the assets held by the ceding companies. The swap consists of two parts. The first is the market value of the underlying asset portfolio and the second is a hypothetical loan to the ceding company. The hypothetical loan is based on the expected cash flows of the underlying reinsurance liability. We have developed models to systematically estimate the value of the total return swap. The fair value of the embedded derivative is affected by changes in expected cash flows, credit spreads of the assets and changes in "risk-free" interest rates. The change in fair value is included in our calculation of estimated gross profits and, therefore, also affects the amortization of deferred acquisition costs. In addition to our quota share indemnity funds withheld contracts, we have entered into various financial reinsurance treaties that, although considered funds withheld, do not transfer significant insurance risk and are recorded on a deposit method of accounting. As a result of the experience refund provisions of these treaties, the value of the embedded derivative is currently considered immaterial.
We adopted DIG B36 on October 1, 2003. The initial adoption resulted in a loss, after tax and after related amortization of deferred acquisition costs, of $19.5 million which was recorded as a cumulative effect of change in accounting principle in our consolidated statements of income for the year ended December 31, 2003. The change in fair value of the derivative between October 1, 2003 and December 31, 2003 was a gain of $13.9 million, net of related amortization of deferred acquisition costs and taxes. The fair value of the derivative of $24.8 million and $5.2 million at December 31, 2005 and 2004, respectively, is included in other liabilities.
New Accounting Pronouncements
Statement of Financial Position 03-1, "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Insurance Contracts and for Separate Accounts" ("SOP 03-01")
In July 2003, the Accounting Standards Executive Committee issued SOP 03-01. This SOP provides guidance on accounting and reporting by insurance enterprises for certain nontraditional long-duration contracts and for separate accounts and is effective for financial statements for fiscal years beginning after December 15, 2003. In implementing the SOP, we have made various determinations, such as qualification for separate account treatment, classification of securities in separate account arrangements, significance of mortality and morbidity risk, adjustments to contract holder liabilities and adjustments to estimated gross profits as defined in SFAS No. 97, "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments". Implementation of this SOP did not have a material effect on our financial statements.
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
2. Summary of significant accounting policies (continued)
EITF 04-8, "The Effect of Contingently Convertible Debt on Diluted Earnings Per Share"("EITF 04-8")
In September 2004, EITF 04-8 was issued. EITF 04-8 requires that certain instruments with embedded conversion features that are contingent upon market price triggers be included in diluted earnings per share calculations regardless of whether the contingency has been met. Our 4.5% senior convertible notes are convertible on the basis of a market price trigger. On October 26, 2004, we amended the terms of these notes so that we are required to settle the principal amount of $115.0 million in cash on conversion or repurchase. As a result, we continue to apply the treasury stock method in calculating diluted earnings per share for amounts in excess of the principal of $115.0 million. Also see Note 10 in the Consolidated Financial Statements.
FASB Interpretation No. 46 and 46R, "Consolidation of Variable Interest Entities" ("FIN 46" and "FIN 46R")
In December 2003, the FASB revised FIN 46, which was originally issued in January 2003. FIN 46R addresses whether certain types of entities, referred to as variable interest entities ("VIEs"), should be consolidated in a company's financial statements. A company must consolidate a VIE in which it has an ownership, contractual or other financial interest if it is determined to be the primary beneficiary. A primary beneficiary has a variable interest that will absorb a majority of the expected losses if they occur, receive a majority of the entity's expected returns, or both. We are the primary beneficiary of the collateral finance facilities, except Stingray Investor Trust, discussed in Note 8 to the Consolidated Financial Statements, and have consolidated the variable interest entities in accordance with FIN 46R. The Stingray Investor Trust, discussed in Note 8 to the Consolidated Financial Statements, is a variable interest entity but we are not considered to be the primary beneficiary of the Investor Trust. Accordingly, it is not consolidated in accordance with FIN 46R.
SFAS No.154, "Accounting Changes and Error Corrections" ("SFAS No. 154")
In May 2005, the FASB issued SFAS No. 154, which replaces APB Opinion No. 20, "Accounting Changes", and SFAS No. 3, "Reporting Accounting Changes in Interim Financial Statements". SFAS No. 154 requires retrospective application to prior period financial statements for changes in accounting principle, unless determination of either the period specific effects or the cumulative effect of the change is impracticable or otherwise promulgated. SFAS No. 154 is effective for fiscal years beginning after December 15, 2005. SFAS No. 154, upon adoption, is not expected to have a material effect on our results of operations or financial position.
EITF Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" ("EITF 03-1") and FAS 115-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" ("FSP FAS 115-1")
In June 2005, the FASB completed its review of EITF Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments". EITF 03-1 provides accounting guidance regarding the determination of when an impairment of debt and marketable equity securities and investments accounted for under the cost method should be considered other-than-temporary and recognized in income. EITF 03-1 also requires certain quantitative and qualitative disclosures for debt and marketable equity securities classified as available-for-sale or held-to-maturity under SFAS No.115, Accounting for Certain Investments in Debt and Equity Securities", that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. The FASB decided not to provide additional guidance on the meaning of other-than-temporary impairment but issued in November 2005, FSP FAS 115 , which nullifies the guidance in paragraphs 10-18 of EITF 03-1, and references existing other than temporary impairment guidance. FSP FAS 115-1 clarifies that an investor should recognize an impairment loss no later than when the impairment is deemed other-than-temporary, even if a decision to sell the security has not been made, and also provides guidance on the subsequent accounting for an impaired debt security. We have provided the appropriate disclosures in accordance with EITF 03-1. FSP FAS 115-1 is effective for reporting periods beginning after December 15, 2005. The adoption of FSP FAS 115-1 is not expected to have a material effect on our results of operations or financial position.
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
2. Summary of significant accounting policies (continued)
SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments--an amendment of FASB Statements No. 133 and 140" ("SFAS No. 155")
In February 2006, the FASB issued SFAS No. 155, which resolves issues addressed in SFAS No. 133 Implementation Issue No. D1, "Application of Statement 133 to Beneficial Interests in Securitized Financial Assets." SFAS No. 155, among other things, permits the fair value remeasurement of any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS No. 133; and establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation. SFAS No. 155 is effective for all financial instruments acquired or issued in a fiscal year beginning after September 15, 2006. We are currently assessing the impact of SFAS No. 155 on our results of operations and financial position.
3. Business acquisitions
On December 31, 2004, we completed the 100% coinsurance of ING's individual life reinsurance business. The acquisition was accounted for as a purchase in accordance with SFAS No. 141 "Business Combinations". During the year ended December 31, 2005, we completed the analysis of purchase accounting for this acquisition and the final post closing adjustment of $47.9 million was paid to ING during the fourth quarter of 2005. The balance sheet as of the date of acquisition, as finalized in 2005, was as follows:
December 31, 2004 -------------------
Total investments..................... $ 1,529,190 Reinsurance balances receivable....... 201,019 Other assets.......................... 67,308 ------------------- Total assets.......................... $ 1,797,517 ===================
Reserves for future policy benefits... $ 1,669,090 Other liabilities..................... 128,427 ------------------- Total liabilities..................... $ 1,797,517 ===================
The acquired business represents the reinsurance division of ING's U.S. life insurance operations, which was written through Security Life of Denver Insurance Company and Security Life of Denver International Limited. The acquired business mainly consists of traditional mortality risk reinsurance written on an automatic basis with more than 100 different ceding insurers. Less than 10% of the acquired business was written on a facultative basis. Most of the business involves guaranteed level premium term life insurance that is subject to the statutory reserve requirements of NAIC Actuarial Regulation XXX as well as universal life insurance that is subject to a similar statutory reserve requirement known as Regulation AXXX.
The following pro-forma information related to our acquisition of the ING individual life reinsurance business for the years ended December 31, 2004 and 2003 illustrates the effects of the acquisition as if it had occurred at the beginning of the periods presented. The pro-forma information is not intended to be indicative of the consolidated results of operations that would have been reported if the acquisition had occurred at January 1, 2004 and 2003 nor does it purport to be indicative of combined results of operations which may be reported in the future. In the table below, dollars are in millions, except per share data.
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
3. Business acquisitions (continued)
On December 22, 2003, we completed the purchase of 95% of ERC Life Reinsurance Corporation for $169.9 million in cash. There was no goodwill arising on the acquisition. The present value of in-force business acquired was $56.3 million. On February 19, 2004, ERC Life Reinsurance Corporation's name was changed to Scottish Re Life Corporation. During the year ended December 31, 2004, we completed the analysis of purchase accounting for this acquisition. The balance sheet of Scottish Re Life Corporation at the date of acquisition, as finalized in 2004, was as follows:
December 22, ------------
Total investments ..................... $ 573,538 Reinsurance balances receivable ....... 51,457 Amounts recoverable from reinsurers ... 730,044 Other assets .......................... 60,644 ------------ Total assets .......................... $ 1,415,683 ============ Reserves for future policy benefits ... $ 933,090 Interest sensitive contract liabilities 177,486 Reinsurance balances payable .......... 109,050 Other liabilities ..................... 14,575 ------------ Total liabilities ..................... $ 1,234,201 ============ Acquired net assets ................... $ 181,482 ============
The following pro forma information related to our acquisition of Scottish Re Life Corporation for the years ended December 31, 2003 illustrates the effects of the acquisition as if it had occurred at the beginning of the period presented.
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
3. Business acquisitions (continued)
Year Ended December 31, ----------
Revenue ............................. $ 768,223 Net income .......................... $ 67,663 Earnings per ordinary share - Basic . $ 2.21 Earnings per ordinary share - Diluted $ 2.10
The pro-forma information is not intended to be indicative of the consolidated results of operations that would have been reported if the acquisition had occurred at the beginning of the period presented nor does it purport to be indicative of combined results of operations which may be reported in the future.
See Note 19 Commitments and Contingencies - Mediation, for additional detail on the Scottish Re Life Corporation acquisition.
The acquisitions described above were accounted for by the purchase method of accounting. In accordance with SFAS No. 141, the accompanying consolidated statements of income do not include any revenues or expenses related to these acquisitions prior to the closing dates.
4. Discontinued operations
During 2003, we discontinued our Wealth Management operations in Luxembourg. We transferred our Luxembourg Wealth Management business to third parties, closed the office and are in the process of liquidating our Luxembourg subsidiary. We reported the results of the Luxembourg Wealth Management activities as discontinued operations. Losses from these operations amounted to $0.2 million in 2004 and $2.0 million in 2003. There were no losses or income in 2005.
5. Investments
The amortized cost, gross unrealized appreciation and depreciation and estimated fair values of our fixed maturity investments and preferred stock at December 31, 2005 and 2004 are as follows:
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2003
5. Investments (continued)
The contractual maturities of the fixed maturities and preferred stock are as follows (actual maturities may differ as a result of calls and prepayments):
December 31, 2005 ----------------------------- Amortized Estimated Fair Cost or Cost Value ------------ --------------- Due in one year or less .............. $ 108,343 $ 108,012 Due in one year through five years ... 530,852 527,362 Due in five years through ten years... 839,195 832,831 Due after ten years .................. 813,007 808,130 ---------- ---------- 2,291,397 2,276,335 Mortgage and asset backed securities.. 3,169,362 3,150,064 ---------- ---------- Total ................................ $5,460,759 $5,426,399 ========== ==========
The following tables present the estimated fair values and gross unrealized losses for the fixed maturity investments and preferred stock that have estimated fair values below amortized cost as of December 31, 2005 and 2004. These investments are presented by class and grade of security, as well as the length of time the related market value has remained below amortized cost.
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
5. Investments (continued)
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
5. Investments (continued)
We believe that based on an analysis of each security whose price has been below market for greater than twelve months, that the financial strength, liquidity, leverage, future outlook, and our ability and intent to hold the security until recovery support the view that the security was not other-than-temporarily impaired as of December 31, 2005. The unrealized losses on fixed maturity securities are primarily a result of rising interest rates, changes in credit spreads and the long-dated maturities of the securities. Additionally, as at December 31, 2005, approximately 98% of the gross unrealized losses are associated with investment grade securities.
The analysis of realized gains (losses) and the change in net unrealized appreciation (depreciation) on investments for the years ended December 31, 2005, 2004 and 2003 is as follows:
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
5. Investments (continued)
The investment portfolio is managed following prudent standards of diversification. Specific provisions limit the allowable holdings of a single issuer and issuers. At December 31, 2005, 2004 and 2003, we did not have a material concentration of investments in fixed income securities in a single issuer or industry.
Net investment income for the years ended December 31, 2005, 2004 and 2003 was derived from the following sources:
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
5. Investments (continued)
We are required to maintain assets on deposit with various regulatory authorities to support our insurance and reinsurance operations. These requirements are generally promulgated in the statutory regulations of the individual jurisdictions. The assets on deposit are available to settle insurance and reinsurance liabilities. We also utilize trust funds in certain transactions where the trust funds are set up for the benefit of the ceding companies and generally take the place of Letter of Credit ("LOC") requirements. At December 31, 2005, restricted assets include fixed maturities of $4.9 billion and $2.8 billion, respectively, and cash and cash equivalents of $1.0 billion and $0.5 billion, respectively. The components of the fair value of the restricted assets at December 31, 2005 and 2004 are as follows:
6. Funds withheld at interest
For agreements written on a modified coinsurance basis and certain agreements written on a coinsurance funds withheld basis, assets equal to the net statutory reserves are withheld and legally agreed and managed by the ceding company and are reflected as funds withheld at interest on the consolidated balance sheets.
At December 31, 2005, funds withheld at interest were in respect of seven contracts with five ceding companies. At December 31, 2004, funds withheld at interest were in respect of seven contracts with four ceding companies. At December 31, 2005, we had three contracts with Lincoln National Life Insurance Company that accounted for $1.2 billion or 48% of the funds withheld balances. Additionally, we had one contract with Security Life of Denver International that accounted for $0.7 billion or 27% of the funds withheld balances and one contract with Fidelity & Guaranty Life that accounted for $0.6 billion or 23% of the funds withheld balances. The remaining contracts were with Illinois Mutual Insurance Company and American Founders Life Insurance Company. Lincoln
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2003
6. Funds withheld at interest (continued)
National Life Insurance Company, the largest exposure, has financial strength ratings of "A+" from A.M. Best Company ("A.M. Best"), "AA-" from Standard & Poor's Ratings Services, a division of the McGraw-Hill Companies, Inc ("Standard & Poors"), "Aa3" from Moody's Investor Services ("Moody's") and "AA" from Fitch Ratings Ltd. ("Fitch"). In the event of insolvency of the ceding companies on these arrangements we would need to exert a claim on the assets supporting the contract liabilities. However, the risk of loss is mitigated by our ability to offset amounts owed to the ceding company with the amounts owed to us by the ceding company. Interest accrues on these assets at rates defined by the treaty terms. In most cases, we are subject to the investment performance on the funds withheld assets, although we do not control them. To mitigate this risk, we help set the investment guidelines followed by the ceding company and monitor compliance with these guidelines. Reserves for future policy benefits and interest sensitive contract liabilities relating to these contracts amounted to $2.4 billion and $1.7 billion at December 31, 2005 and 2004, respectively.
According to data provided by our ceding companies, the amortized cost, gross unrealized appreciation and depreciation and estimated fair values of invested assets, excluding cash of $132.6 million (2004 - $472.4 million), backing our funds withheld at interest at December 31, 2005 and 2004 are as follows:
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
6. Funds withheld at interest (continued)
According to data provided by our ceding companies, the contractual maturities (excluding cash) of the assets backing our funds withheld fixed maturities are as follows (actual maturities may differ as a result of calls and prepayments):
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2005
7. Present value of in-force business
A reconciliation of the present value of in-force business is as follows:
Future estimated amortization of the present value of in-force business is as follows:
Year ending December 31 - ----------------------- 2006...................................................... $5,321 2007...................................................... 5,371 2008...................................................... 5,725 2009...................................................... 6,173 2010...................................................... 3,608 Thereafter................................................ $28,545
8. Collateral finance facilities
HSBC I
In 2004, we entered into a collateral finance facility with HSBC Bank USA, N.A. ("HSBC I"). This facility provides $200.0 million that can be used to collateralize reinsurance obligations under intercompany reinsurance agreements. Simultaneously, we entered into a total return swap with HSBC Bank USA, N.A. under which we are entitled to the total return of the investment portfolio of the trust established for this facility. In accordance with FIN 46R, the trust is considered to be a variable interest entity and we are deemed to hold the primary beneficial interest in the trust. As a result, the trust has been consolidated in these financial statements. The assets of the trust have been recorded as fixed maturity investments. Our consolidated statements of income show the investment return of the trust as investment income and the cost of the facility is reflected in collateral finance facilities expense. The creditors of the trust have no recourse against our general assets.
Stingray
On January 12, 2005, we entered into a put agreement with Stingray Investor Trust ("Investor Trust") for an aggregate value of $325.0 million. Under the terms of the put agreement, we acquired an irrevocable put option to issue funding agreements to Investor Trust in return for the assets in a portfolio of 30-day commercial paper. This put option may be exercised at any time. In addition, we may be required to issue funding agreements to Investor Trust under certain circumstances, including, but not limited to, the non-payment of the put option premium and a non-payment of interest under any outstanding funding agreements under the put agreement. The facility matures on January 12, 2015. This transaction may also provides collateral for Scottish Re (U.S.), Inc. for reinsurance obligations under intercompany quota share reinsurance agreements and at December 31, 2005, $50.0 million was in use for this purpose. The put premium incurred during the year ended
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
8. Collateral finance facilities (continued)
December 31, 2005 amounted to $4.7 million, and is included in collateral finance facilities expense in the consolidated statements of income. In accordance with FIN 46R, we are not considered to have the primary beneficial interest in Investor Trust and as a result we are not required to consolidate Investor Trust.
Orkney Re, Inc.
On February 11, 2005, Orkney Holdings, LLC, a Delaware limited liability company, issued and sold in a private offering an aggregate of $850.0 million Series A Floating Rate Insured Notes due February 11, 2035 (the "Orkney Notes"). Orkney Holdings, LLC is organized for the limited purpose of holding the stock of Orkney Re, Inc., a South Carolina special purpose captive insurance company, and issuing the Orkney Notes. All of the common shares of Orkney Holdings, LLC are owned by Scottish Re (U.S.), Inc. Proceeds from this offering were used to fund the Regulation XXX reserve requirements for a defined block of level premium term life insurance policies issued between January 1, 2000 and December 31, 2003 reinsured by Scottish Re (U.S.), Inc. to Orkney Re, Inc. Proceeds from the Orkney Notes have been deposited into a series of trusts that collateralize the notes.
The holders of the Orkney Notes cannot require repayment from us or any of our subsidiaries, other than Orkney Holdings, LLC. The timely payment of interest and ultimate payment of principal for the Orkney Notes are guaranteed by MBIA Insurance Corporation.
Interest on the principal amount of the Orkney Notes is payable quarterly at a rate equivalent to three month LIBOR plus 0.53%. At December 31, 2005, the interest rate was 5.07%. Any payment of principal, including by redemption, or interest on the Orkney Notes is sourced from dividends from Orkney Re, Inc. and the balances available in a series of trust accounts. Dividends may only be made with the prior approval of the Director of Insurance of the State of South Carolina in accordance with the terms of its licensing orders and in accordance with applicable law. The Orkney Notes also contain a customary limitation on lien provisions and customary events of default provisions, which, if breached, could result in the accelerated maturity of the Orkney Notes. Orkney Holdings, LLC has the option to redeem all or a portion of the Orkney Notes prior to and on or after February 11, 2010, subject to certain call premiums.
In accordance with FIN 46R, Orkney Holdings, LLC, is considered to be a variable interest entity and we are considered to hold the primary beneficial interest. As a result, Orkney Holdings, LLC has been consolidated in these financial statements. The assets of Orkney Holdings, LLC have been recorded as fixed maturity investments and cash and cash equivalents. Our consolidated statements of income show the investment return of Orkney Holdings, LLC as investment income and the cost of the facility is reflected in collateral finance facilities expense.
Orkney Re II plc
On December 21, 2005, Orkney Re II plc, an orphan special purpose vehicle incorporated under the laws of Ireland, whose issued ordinary shares are held by a share trustee and its nominees in trust for charitable purposes, issued in a private offering $450.0 million of debt to external investors. The debt consisted of $382.5 million Series A-1 Floating Rate Guaranteed Notes (the "Series A Notes"), $42.5 million in aggregate principal amount of Series A-2 Floating Rate Notes (the "Series B Notes"), and $25.0 million Series B Floating Rate Notes, all due December 31, 2035 (collectively, the "Orkney II Notes"). The Orkney II Notes are listed on the Irish Stock Exchange. Proceeds from this offering were used to fund the Regulation XXX reserve requirements for a defined block of level premium term life insurance policies issued between January 1, 2004 and December 31, 2004 reinsured by Scottish
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
8. Collateral finance facilities (continued)
Re (U.S.), Inc. to Orkney Re II plc. Proceeds from the Orkney II Notes have been deposited into a series of trusts that collateralize the notes.
The holders of the Orkney II Notes cannot require repayment from us or any of our subsidiaries, only from Orkney Re II plc. Assured Guaranty (UK) Ltd has guaranteed the timely payment of the scheduled interest payments and the principal on the maturity date, December 21, 2035 of the Series A-1 Notes.
Interest on the principal amount of the Orkney II Notes is payable quarterly at a rate equivalent to three month LIBOR plus 0.425% for the Series A-1 Notes, three month LIBOR plus 0.73% for the Series A-2 Notes, and three month LIBOR plus 3.0% for the Series B Notes. At December 31, 2005, the interest rate on the Series A-1 Notes was 4.96%, Series A-2 Notes was 5.27%, and Series B Notes was 7.50%. The Orkney II Notes also contain a customary limitation on lien provisions and customary events of default provisions, which, if breached, could result in the accelerated maturity of the Orkney II Notes. Orkney Re II plc has the option to redeem all or a portion of the Orkney II Notes prior to and on or after February 11, 2007, subject to certain call premiums.
In accordance with FIN 46R, Orkney Re II plc is considered to be a variable interest entity and we are considered to hold the primary beneficial interest. As a result, Orkney Re II plc has been consolidated in these financial statements. The assets of Orkney Re II plc have been recorded as fixed maturity investments and cash and cash equivalents. Our consolidated statements of income show the investment return of Orkney II Re plc as investment income and the cost of the facility is reflected in collateral finance facilities expense.
HSBC II
On December 22, 2005, we entered into a second collateral finance facility with HSBC Bank USA, N.A ("HSBC II"). This facility is a 20 year collateral finance facility that provides up to $1.0 billion of Regulation XXX collateral support for the business acquired from ING and can be used to collateralize reinsurance obligations under inter-company reinsurance agreements. Simultaneously, we entered into a total return swap with HSBC Bank USA, N.A. under which we are entitled to the total return of the investment portfolio of the trust established for this facility. In accordance with FIN 46R the trust is considered to be a variable interest entity and we are deemed to hold the primary beneficial interest in the trust. As a result, the trust has been consolidated in these financial statements. The assets of the trust have been recorded as fixed maturity investments and cash and cash equivalents. Our consolidated statements of income show the investment return of the trust as investment income and the cost of the facility is reflected in collateral finance facilities expense. The creditors of the trust have no recourse against our general assets.
Reinsurance Facility
On December 22, 2005, we entered into a long term reinsurance facility with a third party ("Reinsurance Facility"), Bermuda-domiciled reinsurer that provides up to $1.0 billion of Regulation XXX collateral support for the business acquired from ING. The Bermuda reinsurer provides security in the form of letters of credit in trust equal to the statutory reserves. All risks and returns arising out of the underlying book of business are retained by us.
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
8. Collateral finance facilities (continued)
At December 31, 2005, we had $1.986 billion of collateral finance facility obligations relating to the HSBC I, HSBC II, Orkney Re, Inc. and Orkney Re II plc transactions. In connection with these transactions we have assets in trust of approximately $2.705 billion which represent assets supporting both the economic and excess reserves and surplus in the transactions. The assets in trust are managed in accordance with predefined investment guidelines as to permitted investments, portfolio quality, diversification and duration.
9. 7.00% Convertible Junior Subordinated Notes
In order to provide additional capital to support the in-force individual life reinsurance business acquired from ING, we signed a Securities Purchase Agreement on October 17, 2004 with the Cypress Merchant B Partners II (Cayman) L.P., Cypress Merchant Banking II-A C.V., 55th Street Partners II (Cayman) L.P. and Cypress Side-by-Side (Cayman) L.P. (collectively, the "Cypress Entities"). Pursuant to the Securities Purchase Agreement, we issued to the Cypress Entities on December 31, 2004, $41.3 million aggregate principal amount of 7.00% Convertible Junior Subordinated Notes with a maturity date of December 31, 2034 (the "7.00% Convertible Junior Subordinated Notes").
On April 7, 2005, our shareholders approved the conversion of the 7.00% Convertible Junior Subordinated Notes and accrued interest thereon resulting in the issuance of 2,170,896 Class C warrants. Upon receipt of regulatory approval on May 4, 2005, the Class C Warrants were converted into ordinary shares. See Note 12 for additional details.
10. Debt obligations
Long-term debt consists of:
4.5% senior convertible notes
On November 22, 2002 and November 27, 2002, we issued $115.0 million (which included an over-allotment option of $15.0 million) of 4.5% senior convertible notes, which are due December 1, 2022. The notes are general unsecured obligations, ranking on parity in right of payment with all our existing and future unsecured senior indebtedness, and senior in right of payment with all our future subordinated indebtedness and do not have the benefit of any sinking fund. Interest on the notes is payable on June 1 and December 1 of each year. The notes are rated "Baa2" by Moody's and "BBB-" by Standard & Poor's.
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
10. Debt obligations (continued)
The notes are convertible into our ordinary shares initially at a conversion rate of 46.0617 ordinary shares per $1,000 principal amount of notes (equivalent to an initial conversion price of $21.71 per ordinary share). On conversion, we shall settle the principal amount of $115.0 million in cash. The notes are redeemable at our option in whole or in part beginning on December 6, 2006, at a redemption price equal to 100% of the principal amount of the notes plus accrued and unpaid interest. The notes are subject to repurchase by us upon a change of control of Scottish Re or at a holder's option on December 6, 2006, December 1, 2010, December 1, 2012 and December 1, 2017, at a repurchase price equal to 100% of the principal amount of the notes plus accrued and unpaid interest. The notes are due on December 1, 2022 unless earlier converted, redeemed by us at our option or repurchased by us at a holder's option.
A holder may surrender notes for conversion prior to the stated maturity only under the following circumstances:
o during any conversion period if the sale price of our ordinary shares for at least 20 trading days in the period of 30 consecutive trading days ending on the first day of the conversion period exceeds 120% of the conversion price in effect on that 30th trading day;
o during any period in which the notes are rated by either Moody's Investors Service, Inc. or Standard & Poor's Rating Group and the credit rating assigned to the notes by either rating agency is downgraded by two levels or more, suspended or withdrawn;
o if we have called those notes for redemption; or
o upon the occurrence of the certain specified corporate transactions.
Pursuant to a registration rights agreement, we filed a shelf registration statement with the Securities and Exchange Commission, for resale of the notes and our ordinary shares issuable upon conversion of the notes.
Capital securities due 2032
On December 4, 2002, Scottish Holdings Statutory Trust I, a Connecticut statutory business trust ("Capital Trust") issued and sold in a private offering an aggregate of $17.5 million Floating Rate Capital Securities (the "Capital Securities"). All of the common shares of the Capital Trust are owned by Scottish Holdings, Inc., our wholly owned subsidiary.
The Capital Securities mature on December 4, 2032. They are redeemable in whole or in part at any time after December 4, 2007. Interest is payable quarterly at a rate equivalent to 3 month LIBOR plus 4%. At December 31, 2005 and December 31, 2004, the interest rates were 8.54% and 6.44%, respectively. Prior to December 4, 2007, interest cannot exceed 12.5%. The Capital Trust may defer payment of the interest for up to 20 consecutive quarterly periods, but no later than December 4, 2032. Any deferred payments would accrue interest quarterly on a compounded basis if Scottish Holdings, Inc. defers interest on the Debentures due December 4, 2032 (as defined below).
The sole assets of the Capital Trust consist of $18.0 million principal amount of Floating Rate Debentures (the "Debentures") issued by Scottish Holdings, Inc. The Debentures mature on December 4, 2032 and interest is
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
10. Debt obligations (continued)
payable quarterly at a rate equivalent to 3 month LIBOR plus 4%. At December 31, 2005 and December 31, 2004, the interest rates were 8.54% and 6.44%, respectively. Prior to December 4, 2007, interest cannot exceed 12.5%. Scottish Holdings, Inc. may defer payment of the interest for up to 20 consecutive quarterly periods, but no later than December 4, 2032. Any deferred payments would accrue interest quarterly on a compounded basis. Scottish Holdings, Inc. may redeem the Debentures at any time after December 4, 2007 and in the event of certain changes in tax or investment company law.
Scottish Annuity & Life Insurance Company (Cayman) Ltd. has guaranteed Scottish Holdings, Inc.'s obligations under the Debentures and distributions and other payments due on the Capital Securities.
Preferred trust securities due 2033
On October 29, 2003, Scottish Holdings, Inc. Statutory Trust II, a Connecticut statutory business trust ("Capital Trust II") issued and sold in a private offering an aggregate of $20.0 million Preferred Trust Securities (the "Preferred Trust Securities"). All of the common shares of Capital Trust II are owned by Scottish Holdings, Inc.
The Preferred Trust Securities mature on October 29, 2033. They are redeemable in whole or in part at any time after October 29, 2008. Interest is payable quarterly at a rate equivalent to 3 month LIBOR plus 3.95%. At December 31, 2005 and December 31, 2004, the interest rates were 8.49% and 6.08%, respectively. Prior to October 29, 2008, interest cannot exceed 12.45%. Capital Trust II may defer payment of the interest for up to 20 consecutive quarterly periods, but no later than October 29, 2033. Any deferred payments would accrue interest quarterly on a compounded basis if Scottish Holdings, Inc. defers interest on the 2033 Floating Rate Debentures due October 29, 2033 (as described below).
The sole assets of Capital Trust II consist of $20.6 million principal amount of Floating Rate Debentures (the "2033 Floating Rate Debentures") issued by Scottish Holdings, Inc. The 2033 Floating Rate Debentures mature on October 29, 2033 and interest is payable quarterly at 3 month LIBOR plus 3.95%. At December 31, 2005 and December 31, 2004, the interest rates were 8.49% and 6.08%, respectively. Prior to October 29, 2008, interest cannot exceed 12.45%. Scottish Holdings, Inc. may defer payment of the interest for up to 20 consecutive quarterly periods, but no later than October 29, 2033. Any deferred payments would accrue interest quarterly on a compounded basis. Scottish Holdings, Inc. may redeem the 2033 Floating Rate Debentures at any time after October 29, 2008 and in the event of certain changes in tax or investment company law.
Scottish Annuity & Life Insurance Company (Cayman) Ltd. has guaranteed Scottish Holdings, Inc.'s obligations under the 2033 Floating Rate Debentures and distributions and other payments due on the Preferred Trust Securities.
Trust preferred securities due 2033
On November 14, 2003, GPIC Holdings Inc. Statutory Trust, a Delaware statutory business trust ("GPIC Trust") issued and sold in a private offering an aggregate of $10.0 million Trust Preferred Securities (the "2033 Trust Preferred Securities"). All of the common shares of GPIC Trust are owned by Scottish Holdings, Inc.
The 2033 Trust Preferred Securities mature on September 30, 2033. They are redeemable in whole or in part at any time after September 30, 2008. Interest is payable quarterly at a rate equivalent to 3 month LIBOR
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
10. Debt obligations (continued)
plus 3.90%. At December 31, 2005 and December 31, 2004, the interest rates were 8.44% and 6.46%, respectively. GPIC Trust may defer payment of the interest for up to 20 consecutive quarterly periods, but no later than September 30, 2033. Any deferred payments would accrue interest quarterly on a compounded basis if Scottish Holdings, Inc. defers interest on the Junior Subordinated Notes due September 30, 2033 (as described below).
The sole assets of GPIC Trust consist of $10.3 million principal amount of Junior Subordinated Notes (the "Junior Subordinated Notes") issued by Scottish Holdings, Inc. The Junior Subordinated Notes mature on September 30, 2033 and interest is payable quarterly at 3 month LIBOR plus 3.90%. At December 31, 2005 and December 31, 2004, the interest rates were 8.44% and 6.46%, respectively. Scottish Holdings, Inc. may defer payment of the interest for up to 20 consecutive quarterly periods, but no later than September 30, 2033. Any deferred payments would accrue interest quarterly on a compounded basis. Scottish Holdings, Inc. may redeem the Junior Subordinated Notes at any time after September 30, 2008 and in the event of certain changes in tax or investment company law.
Scottish Annuity & Life Insurance Company (Cayman) Ltd. has guaranteed Scottish Holdings, Inc.'s obligations under the Junior Subordinated Notes and distributions and other payments due on the trust preferred securities.
Trust preferred securities due 2034
On May 12, 2004, Scottish Holdings, Inc. Statutory Trust III, a Connecticut statutory business trust ("Capital Trust III") issued and sold in a private offering an aggregate of $32.0 million Trust Preferred Securities (the "2034 Trust Preferred Securities"). All of the common shares of Capital Trust III are owned by Scottish Holdings, Inc.
The 2034 Trust Preferred Securities mature on June 17, 2034. They are redeemable in whole or in part at any time after June 17, 2009. Interest is payable quarterly at a rate equivalent to 3 month LIBOR plus 3.80%. At December 31, 2005 and December 31, 2004, the interest rate was 8.34% and 6.30%, respectively. Prior to June 17, 2009, interest cannot exceed 12.50%. Capital Trust III may defer payment of the interest for up to 20 consecutive quarterly periods, but no later than June 17, 2034. Any deferred payments would accrue interest quarterly on a compounded basis if Scottish Holdings, Inc. defers interest on the 2034 Floating Rate Debentures due June 17, 2034 (as described below).
The sole assets of Capital Trust III consist of $33.0 million principal amount of Floating Rate Debentures (the "2034 Floating Rate Debentures") issued by Scottish Holdings, Inc. The 2034 Floating Rate Debentures mature on June 17, 2034 and interest is payable quarterly at 3 month LIBOR plus 3.80%. At December 31, 2005 and December 31, 2004 the interest rate was 8.34% and 6.30%, respectively. Prior to June 17, 2009, interest cannot exceed 12.50%. Scottish Holdings, Inc. may defer payment of the interest for up to 20 consecutive quarterly periods, but no later than June 17, 2034. Any deferred payments would accrue interest quarterly on a compounded basis. Scottish Holdings, Inc. may redeem the 2034 Floating Rate Debentures at any time after June 17, 2009 and in the event of certain changes in tax or investment company law.
Scottish Annuity & Life Insurance Company (Cayman) Ltd. has guaranteed Scottish Holdings, Inc.'s obligations under the 2034 Floating Rate Debentures and distributions and other payments due on the 2034 Trust Preferred Securities.
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
10. Debt obligations (continued)
Trust preferred securities due 2034
On December 18, 2004, SFL Statutory Trust I, a Delaware statutory business trust ("SFL Trust I") issued and sold in a private offering an aggregate of $50.0 million Trust Preferred Securities (the "December 2034 Trust Preferred Securities"). All of the common shares of SFL Trust I are owned by Scottish Financial (Luxembourg) S.a.r.l.
The December 2034 Trust Preferred Securities mature on December 15, 2034. They are redeemable in whole or in part at any time after December 15, 2009. Interest is payable quarterly at a rate equivalent to 3 month LIBOR plus 3.50%. At December 31, 2005, and December 31, 2004 the interest rate was 8.04.% and 5.95%, respectively. Prior to December 15, 2009, interest cannot exceed 12.50%. SFL Trust I may defer payment of the interest for up to 20 consecutive quarterly periods, but no later than December 15, 2034. Any deferred payments would accrue interest quarterly on a compounded basis.
The sole assets of SFL Trust I consist of $51.5 million principal amount of Floating Rate Debentures (the "December 2034 Floating Rate Debentures") issued by Scottish Financial (Luxembourg) S.a.r.l. The December 2034 Floating Rate Debentures mature on December 15, 2034 and interest is payable quarterly at 3 month LIBOR plus 3.50%. At December 31, 2005 and December 31, 2004 the interest rate was 8.04% and 5.95%, respectively. Prior to December 15, 2009, interest cannot exceed 12.50%. Scottish Financial (Luxembourg) S.a.r.l. may defer payment of the interest for up to 20 consecutive quarterly periods, but no later than December 15, 2034. Any deferred payments would accrue interest quarterly on a compounded basis. Scottish Financial (Luxemburg) S.a.r.l. may redeem the December 2034 Floating Rate Debentures at any time after December 15, 2009 and in the event of certain changes in tax or investment company law.
Scottish Annuity & Life Insurance Company (Cayman) Ltd. has guaranteed Scottish Financial (Luxembourg) S.a.r.l.'s obligations under the December 2034 Floating Rate Debentures and distributions and other payments due on the December 2034 Trust Preferred Securities.
Credit facilities
On July 14, 2005, Scottish Annuity & Life Insurance Company (Cayman) Ltd., Scottish Re (Dublin) Limited, Scottish Re (U.S.), Inc. and Scottish Re Limited entered into a $200.0 million, three-year revolving unsecured senior credit facility with a syndicate of banks. This facility replaced a 364-day facility which was due to mature in October 2005. The facility may be increased, at our option, to an aggregate principal amount of $300.0 million. The facility provides capacity for borrowing and extending letters of credit. The facility is a direct financial obligation of each of the borrowers; however, Scottish Annuity & Life Insurance Company (Cayman) Ltd. has guaranteed the payment of obligations of Scottish Re (Dublin) Limited, Scottish Re (U.S.), Inc. and Scottish Re Limited. There were no outstanding borrowings at December 31, 2005. Outstanding letters of credit under this facility amounted to $40.9 million at December 31, 2005.
On August 18, 2005, Scottish Re (Dublin) Limited entered into a $30.0 million three-year revolving, unsecured letter of credit facility with a syndicate of banks. The credit facility may be increased, at our option, to an aggregate principal amount of $50.0 million. The facility is a direct financial obligation of Scottish Re (Dublin) Limited, however, Scottish Annuity & Life Insurance Company (Cayman) Ltd. has guaranteed the payment
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
10. Debt obligations (continued)
obligations of Scottish Re (Dublin) Limited. There were no outstanding borrowings or letters of credit at December 31, 2005.
The financial covenants of these facilities require that Scottish Annuity & Life Insurance Company (Cayman) Ltd. maintain a minimum amount of consolidated shareholders' equity and maintain the ratio of unencumbered assets to aggregate borrowings under the facilities of 1.2 times borrowings. In addition, these facilities also require Scottish Re Group Limited to maintain a minimum amount of consolidated shareholders' equity and a debt to capitalization ratio of less than 30%. For the purposes of computing the financial covenants, the collateral facilities and their associated costs are excluded.
Failure to comply with the requirements of the credit facilities would, subject to grace periods, result in an event of default and we would be required to repay any outstanding borrowings. At December 31, 2005, Scottish Annuity & Life Insurance Company (Cayman) Ltd. and Scottish Re Group Limited were in compliance with the financial covenants noted in the preceding paragraphs.
ING is obligated to maintain collateral for the Regulation XXX and AXXX reserve requirements of the business we acquired from them for the duration of such requirements (which relate to state insurance law reserve requirements applying to reserves for level premium term life insurance policies and universal life policies). We pay ING a fee based on the face amount of the collateral provided until satisfactory alternative collateral arrangements are made. In the normal course of business and our capital planning we are always looking for opportunities to relieve capital strain relating to Regulation XXX reserve requirements for our previously existing business as well as the business acquired from ING. We completed two financing solutions relating to these requirements in December 2005 and received a $6.7 million rebate of fees incurred in 2005. See Note 8 for details on the financing solutions.
We also have a reverse repurchase agreement with a major broker/dealer. Under this agreement, we have the ability to sell agency mortgage backed securities with the agreement to repurchase them at a fixed price, providing the dealer with a spread that equates to an effective borrowing cost linked to one-month LIBOR. This agreement is renewable monthly at the discretion of the broker/dealer. At December 31, 2005 and 2004, respectively, there were no borrowings under this agreement.
11. Mezzanine equity
On December 17, 2003 and December 22, 2003, we issued in a public offering 5,750,000 Hybrid Capital Units or HyCUs. The aggregate net proceeds were $141.9 million. Each HyCU consists of (i) a purchase contract ("purchase contract") to which the holder is obligated to purchase from us, on February 15, 2007, an agreed upon number of ordinary shares for a price of $25.00 and (b) a convertible preferred share with a liquidation preference of $25.00, convertible into ordinary shares, which we will settle in cash and ordinary shares on May 21, 2007.
The agreed upon number of shares that the purchase contract will be settled for is called the "settlement rate". The settlement rate on each purchase contract is as follows:
(i) If the average closing price per ordinary share on each of the 20 consecutive trading days ending on the fourth trading day preceding February 15, 2007 (the "Applicable Market Value"), is less than or equal to $19.32, then each purchase contract will be settled for 1.294 ordinary shares; or
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
11. Mezzanine equity (continued)
(ii) If the Applicable Market Value is greater than $19.32, then each purchase contract will be settled for a number of ordinary shares by dividing $25.00 by the Applicable Market Value.
Each convertible preferred share is pledged to us to secure the holder's obligations under the purchase contract. A holder of the HyCU can obtain the release of the pledged convertible share by substituting zero-coupon treasury securities as security for the obligation under the purchase contract. The resulting unit is then known as a Treasury Unit. Holders of Treasury Units can recreate HyCUs by re-substituting the convertible preferred shares and withdrawing the treasury securities.
Holders of the convertible preferred shares have the option to allow the convertible preferred share to be included in the remarketing process and use the proceeds of the remarketing to settle the purchase contract or elect not to participate in the remarketing by delivering the requisite amount of cash to settle the purchase contract.
The convertible preferred shares will be initially convertible into 1.0607 ordinary shares per $25.00 liquidation preference (referred to as the "conversion rate"), subject to anti-dilution adjustments. This reflects an initial conversion price of $23.57. Upon conversion, we will deliver an amount of cash up to the liquidation preference, in lieu of the ordinary shares, and ordinary shares for the value of the excess, if any, of the conversion obligation minus the liquidation preference of the convertible preferred shares. The value of the excess of the conversion obligation is reflected in our diluted earnings per share computation. The convertible preferred shares are mandatorily redeemable on May 21, 2007, unless earlier converted.
Amounts accumulate under the HyCUs at a rate of 5.875% per year, payable quarterly beginning February 14, 2004. These amounts consist of quarterly contract adjustment payments at a rate of 4.875% per year and dividends at a rate of 1.00% per year on the convertible preferred shares, payable quarterly when declared by our board of directors. We may defer contract adjustment payments until no later than the purchase contract settlement date. The present value of the contract adjustment payments (discounted at a rate of 4.75%) is included in other liabilities and resulted in a decrease in additional paid-in capital at the date of issuance. Issue costs on the purchase contract have also been included in additional paid-in capital. The dividends on the convertible preferred shares are included in interest expense.
We have accounted for the HyCUs in accordance with SFAS No. 150 "Accounting for Certain Instruments with Characteristics of Debt and Equity" ("SFAS No. 150"). The convertible preferred shares that comprise the HyCUs are not mandatorily redeemable as defined by SFAS No. 150. On the redemption date of May 21, 2007, the convertible preferred shares are subject to optional conversion by the holder. SFAS No. 150 indicates that a conditionally redeemable preferred share, such as a convertible preferred share, should not be classified as a liability if it can be converted rather than redeemed. Because the convertible preferred shares are subject either to conversion or redemption on May 21, 2007, it is conditionally redeemable as defined by SFAS No. 150 for all periods preceding that date. Accordingly, the HyCUs have been recorded as mezzanine equity, which is net of issuance costs related to the convertible preferred shares.
12. Shareholders' equity
Ordinary shares
We are authorized to issue 100,000,000 ordinary shares of par value $0.01 each.
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
12. Shareholders' equity (continued)
On July 23, 2003, we completed a public offering of 9,200,000 ordinary shares (which included an over-allotment option of 1,200,000 ordinary shares) in which we raised aggregate net proceeds of $180.1 million. We used $30.0 million of these proceeds to repurchase 1,525,000 ordinary shares from Pacific Life at a purchase price of $19.66 per share. During 2003, we issued 200,000 ordinary shares upon the exercise of Class A Warrants.
During 2004, in order to provide additional capital to support the acquisition of the ING individual life reinsurance business, we signed a Securities Purchase Agreement on October 17, 2004 with the Cypress Entities. Pursuant to the Securities Purchase Agreement, we issued to the Cypress Entities on December 31, 2004:
(i) 3,953,183 ordinary shares, par value $0.01 per share (equal to 9.9% of the aggregate number of ordinary shares issued and outstanding on December 31, 2004, taking into account such issuance);
(ii) Class C Warrants to purchase 3,206,431 ordinary shares (equal to the difference between (A) 19.9% of the ordinary shares issued and outstanding on December 31, 2004 (without taking into account the issuance of ordinary shares pursuant to (i) above) and (B) the number of ordinary shares issued to the Cypress Entities as provided in (i) above); and
(iii) The 7.00% Convertible Junior Subordinated Notes discussed in Note 9.
The proceeds from the Cypress Entities net of a commitment fee and other expenses amounted to $126.9 million. The Class C Warrants were exercisable on receipt of shareholder and regulatory approvals. On April 7, 2005, our shareholders approved the conversion of the Cypress Notes into 2,170,896 Class C Warrants. All regulatory approvals were obtained on May 4, 2005 and all of the Class C Warrants were converted into 5,377,327 ordinary shares.
On December 23, 2005, we completed a public offering of 7,660,000 ordinary shares (which included an over-allotment option of 1,410,000 ordinary shares) in which we raised aggregate net proceeds of $174.1 million. We used the proceeds of the offering for general corporate purposes, which may include investments in or advances to subsidiaries, possible acquisitions, working capital and other corporate purposes.
In connection with the offering, we entered into forward sales agreements with affiliates of Bear, Stearns & Co. Inc and Lehman Brothers, Inc. (the "forward purchasers") and the forward purchasers borrowed and sold an aggregate of approximately 3,150,000 ordinary shares as their initial hedge of the forward sale agreements. Pursuant to the forward sale agreements, the forward purchasers agree to pay us an aggregate of approximately $75.0 million on September 29, 2006 and an aggregate of approximately $75.0 million on December 29, 2006, subject to our right to receive a portion of such payment prior to the settlement dates. In exchange, on each of such dates the we will deliver to the forward purchasers a variable number of ordinary shares based on the average market price of the ordinary shares, subject to a floor price of $22.80 and a cap price of $28.80. We also have the right to net share settle or cash settle the forward sale agreements. The fair value of the forward sales agreements at inception is reflected in shareholders' equity (as a reduction in additional paid-in capital) and the fair value is not adjusted till the settlement date of the forward. In addition, the underwriting costs of the forward sales agreements have been reflected in shareholders' equity (as a reduction in additional paid-in capital). We expect to use the proceeds from the forward sales agreements for general corporate purposes which may include investments in or advances to subsidiaries, possible acquisitions, working capital and other corporate purposes.
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
12. Shareholders' equity (continued)
During the years ended December 31, 2005, 2004 and 2003 we issued 423,467, 749,551 and 425,955 ordinary shares, respectively, to employees upon the exercise of stock options. At December 31, 2005, there were 53,391,939 outstanding ordinary shares.
Preferred shares
We are authorized to issue 50,000,000 preferred shares of par value $0.01 each.
On December 17, 2003 and December 22, 2003, in connection with our HyCU offering, we issued 5,750,000 convertible preferred shares. See Note 11 for additional description of the terms of the convertible preferred shares.
On June 28, 2005, we priced our offering of 5,000,000 non-cumulative perpetual preferred shares and entered into a purchase agreement relating to the shares pursuant to which the underwriters of the offering agreed to purchase the shares. Gross proceeds were $125.0 million and related expenses were $4.6 million. Settlement of the net proceeds occurred on July 6, 2005.
Dividends on the perpetual preferred shares are payable on a non-cumulative basis at a rate per annum of 7.25% until the dividend payment date in July 2010. Thereafter, the dividend rate may be at a fixed rate determined through remarketing of the perpetual preferred shares for specific periods of varying length not less than six months or may be at a floating rate reset quarterly based on a predefined set of interest rate benchmarks. During any dividend period, unless the full dividends for the current dividend period on all outstanding perpetual preferred shares have been declared or paid, no dividend shall be paid or declared on our ordinary shares and no ordinary shares or other junior shares shall be purchased, redeemed or otherwise acquired for consideration. Declaration of dividends on the perpetual preferred shares is prohibited if we fail to meet specified capital adequacy, net income or shareholders' equity levels.
The perpetual preferred shares do not have a maturity date and we are not required to redeem the shares. The perpetual preferred shares are not redeemable prior to July 2010. Subsequent to July 2010, the perpetual preferred shares will be redeemable at our option, in whole or in part, at a redemption price equal to $25.00 per share, plus any declared and unpaid dividends at the redemption date, without accumulation of any undeclared dividends.
The perpetual preferred shares are unsecured and subordinated to all indebtedness that does not by its terms rank pari passu or junior to the perpetual preferred shares. The holders of the perpetual preferred shares have no voting rights except with respect to certain fundamental changes in the terms of the perpetual preferred shares and in the case of certain dividend non-payments.
The perpetual preferred shares are rated "BB-" by Standard & Poor's, "Ba1" by Moody's, "BB+" by Fitch Ratings and "BB" by A.M. Best Company.
Warrants
In connection with our initial capitalization, we issued Class A Warrants to related parties to purchase an aggregate of 1,550,000 ordinary shares. The aggregate consideration of $0.1 million paid for these Class A Warrants is reflected as additional paid-in capital. In connection with our initial public offering, we issued an aggregate of 1,300,000 Class A Warrants. All Class A Warrants are exercisable at $15.00 per ordinary share, in equal amounts over a three-year period commencing November 1999 and expire in November 2008.
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
12. Shareholders' equity (continued)
During the year ended December 31, 2003, we issued 200,000 ordinary shares upon the exercise of Class A Warrants and we repurchased 200,000 Class B Warrants for $3.0 million.
On December 31, 2004, we issued Class C Warrants to the Cypress Entities as discussed above.
On April 7, 2005, we issued 3,206,431 and 2,170,896, respectively, of Class C Warrants to the Cypress Entities as discussed above. The Class C warrants were subsequently converted into ordinary shares.
As at December 31, 2005 and 2004, there were 2,650,000 Class A warrants outstanding.
General restrictions
The holders of the ordinary shares are entitled to receive dividends and are allowed one vote per share subject to certain restrictions in our Memorandum and Articles of Association.
Dividends declared
Dividends declared on ordinary shares amounted to $9.0 million, $7.1 million and $6.2 million per ordinary share for the years ended December 31, 2005, 2004 and 2003, respectively. Dividends declared on the non-cumulative perpetual preferred shares amounted to $4.8 million for the year ended December 31, 2005.
13. Taxation
There is presently no taxation imposed on income or capital gains by the Governments of the Cayman Islands ("domestic") and Bermuda. Our Bermuda companies have been granted an exemption from income, withholding or capital gains taxation in Bermuda until 2016. If any taxation on income or capital gains were enacted in the Cayman Islands, Scottish Re and Scottish Annuity & Life Insurance Company (Cayman) Ltd. have been granted an exemption until 2028; and The Scottish Annuity Company (Cayman) Ltd. has been granted an exemption until 2024. These companies operate in a manner such that they will owe no U.S. tax other than premium excise taxes and withholding taxes on certain investment income. Additionally, we have operations in various jurisdictions around the world including, but not limited to, the United States, the United Kingdom, Ireland and Luxembourg that are subject to relevant taxes in those jurisdictions. Domestic income before income tax for the years ended December 31, 2005, 2004 and 2003 is $173.3 million, $144.7 million and $57.6 million, respectively. Foreign losses before income tax for the years ended December 31, 2005, 2004 and 2003 are $59.6 million, $89.3 million and $19.8 million, respectively. Domestic income tax expense for the years ended December 31, 2005, 2004 and 2003 is $1.8 million, $3.4 million and $0, respectively. Foreign income tax benefit for the years ended December 31, 2005, 2004 and 2003 is $18.2 million, $20.1 million and $11.1 million, respectively. We are not subject to taxation other than as stated above. There can be no assurance that there will not be changes in applicable laws, regulations or treaties, which might require us to change the way we operate or become subject to taxes.
Undistributed earnings of our subsidiaries are considered indefinitely reinvested and, accordingly, no provision for U.S. federal withholding taxes has been provided thereon. Our U.S. subsidiaries are subject to federal, state and local corporate income taxes and other taxes applicable to U.S. corporations. Upon distribution of current
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
13. Taxation (continued)
or accumulated earnings and profits in the form of dividends or otherwise from our U.S. subsidiaries to us, we would be subject to U.S. withholding taxes at a 30% rate.
At December 31, 2005, we had net operating loss carry-forwards of approximately $615.5 million (2004 - $129.2 million). $603.1 million are for our U.S. entities that expire in years 2012 through 2025. $12.4 million of the operating loss carry-forward resulted from our U.K. operations and have an unlimited carry-forward period. These net operating loss carry-forwards resulted primarily from our 1999 acquisition of Scottish Re (U.S.), Inc. and from current operations of Scottish Re (U.S.), Inc., Scottish Re Life Corporation, Scottish Holdings, Inc., Orkney Re, Inc and Scottish Re Limited.
At December 31, 2005, we had an alternative minimum tax carry-forward of approximately $2.4 million. There are no foreign tax credit carry-forwards.
Significant components of our deferred tax assets and liabilities as of December 31, 2005 and 2004, all of which arise outside of our home country, were as follows:
At December 31, 2005, we believe that it is more likely than not that all gross deferred tax assets will reduce taxes payable in future years except for a valuation allowance of $18.5 million. This valuation allowance is in respect of negative proxy deferred acquisition costs and deferred acquisition costs arising
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
13. Taxation (continued)
in respect of the acquisition of the ING individual life reinsurance business. This was established as a result of the purchase accounting for the acquisition and therefore was not included in the determination of net income in 2004. We have also established reserves when we believe that certain tax positions are likely to be challenged and we may not fully prevail in overcoming these challenges.
For the years ended December 31, 2005, 2004 and 2003, we have income tax benefit from operations as follows:
Year Ended Year Ended Year Ended December 31, December 31, December 31, 2005 2004 2003 -------- -------- -------- Current tax expense ............. $ 3,168 $ 8,526 $ 1,075 Deferred tax benefit ............ (19,602) (25,205) (12,180) -------- -------- -------- Total tax benefit ............... $(16,434) $(16,679) $(11,105) ======== ======== ========
Included in the 2005 tax benefit is a $2.5 million expense related to a write-off of a deferred tax asset related to state income taxes.
The acquisition of the ING individual life reinsurance business was reflected under U.S. GAAP in accordance with purchase accounting requirements but for taxation was a currently taxable transaction. As a result, approximately $84.0 million of current tax expense in the year ended December 31, 2004 and a corresponding $84.0 million of deferred tax benefit are netted in the income statement and are not reflected in the table above.
The weighted average expected tax provision has been calculated using the pre-tax accounting income (loss) in each jurisdiction multiplied by that jurisdiction's applicable statutory tax rate. Reconciliation of the difference between the provision for income taxes and the expected tax provision at the weighted average tax rate for the years December 31, 2005, 2004 and 2003 is provided below:
14. Employee benefit plans
Pension plan
We provide retirement benefits to the majority of employees, under defined contribution plans. Defined contribution plan expenses totaled $2.5 million, $1.4 million and $1.1 million for the years ended December 31,
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
14. Employee benefit plans (continued)
2005, 2004 and 2003, respectively. In 2002, pension benefits were provided to Scottish Re Holdings Limited employees under a defined benefit pension plan. During 2003, we established a defined contribution plan for Scottish Re Holdings Limited. New employees in 2003 joined this plan and a number of employees transferred from the defined benefit scheme to the defined contribution scheme. A small number of employees remain in the defined benefit plan and, additionally, there are preserved benefits for some transferees and some ex-employees in the defined benefit plan. As at December 31, 2005, the fair value of the defined benefit pension plan assets were approximately $11.3 million and the benefit obligation was approximately $10.5 million.
401(k) plan
We sponsor a 401(k) plan in the U.S. in which employee contributions on a pre-tax basis are supplemented by matching contributions. These contributions are invested, at the election of the employee, in one or more investment portfolios. Expenses for the plan amounted to $1.2 million, $0.6 million and $0.5 million, in the years ended December 31, 2005, 2004 and 2003, respectively.
Stock based incentive compensation plans
We have four stock option plans (the "1998 Plan", the "1999 Plan", the "Harbourton Plan" and the "2001 Plan", collectively the "Option Plans"). The Option Plans allow us to grant non-statutory options, subject to certain restrictions, to certain eligible employees, non-employee directors, advisors and consultants. The minimum exercise price of the options will be equal to the fair market value, as defined in the Option Plans, of our ordinary shares at the date of grant. The term of the options is between seven and ten years from the date of grant. Unless otherwise provided in each option agreement, all granted options issued prior to December 31, 2001 become exercisable in three equal annual installments, except for grants to directors, which are fully exercisable on the date of grant. All options granted between January 1, 2002 and May 4, 2004, will become exercisable in five equal installments commencing on the first anniversary of the grant date, except for annual grants to each director, which are fully exercisable on the date of grant. All options issued after May 5, 2004, become exercisable in three equal annual installments commencing on the first anniversary of the grant date, except for grants to directors, which are fully exercisable on the date of grant. Total options authorized under the Plans are 3,750,000.
At our Annual General Meeting held on May 5, 2004, our shareholders approved the equity incentive compensation plan ("2004 ECP"). This plan allows us to grant non-statutory options and restricted share units, subject to certain restrictions, to certain eligible employees, non-employee directors, advisors and consultants. For the first year of the 2004 ECP or the first 250,000 options issued, the minimum exercise price of the options will be equal to 110% of fair market value. At the discretion of our Compensation Committee, option grants after the first year of the 2004 ECP or in excess of 250,000 options may have a minimum exercise price equal to the fair market value of our ordinary shares at the date of grant. The term of the options shall not be more than ten years from the date of grant. Options will become exercisable in three equal installments commencing on the first anniversary of the grant date., except for grants to directors, which are fully exercisable on the date of grant Total options authorized under the 2004 ECP are 750,000. In addition, 1,000,000 restricted shares units have been authorized under the 2004 ECP of which at least 750,000 will vest based on achievement of certain performance goals. The performance measures that must be met for vesting to occur are established at the beginning of each three year performance period. Depending on the performance, the actual amount of restricted share units could range from 0% to 100%. The remaining 250,000 restricted share units may be issued without performance goals.
During the year ended December 31, 2005 and 2004, we issued 589,000 units and 95,700 units, respectively, under the terms of the 2004 ECP. The issuance of these restricted share units resulted in a charge to income of $2.9 million and $0.3 million for the years ended December 31, 2005 and 2004, respectively.
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
14. Employee benefits plans (continued)
Option activity under all Option Plans and the 2004 ECP is as follows:
Summary of options outstanding at December 31, 2005:
The fair value for the options was estimated at the date of grant using the Black-Scholes option-pricing model with the following assumptions:
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
14. Employee benefits plans (continued)
The weighted average fair value of options granted in each year is as follows:
The weighted average fair value of restricted share units granted in each year is as follows:
Option plans approved by shareholders are as follows:
Pro forma information regarding net income and earnings per share is required by SFAS No. 148, and has been determined as if we accounted for all the employee stock options under the fair value method of that Statement.
For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period using the Black-Scholes model. The Black-Scholes and pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected price volatility, dividend yield, risk free interest rate and expected life (in years). Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the Black-Scholes model does not necessarily provide a reliable single measure of the fair value of our employee stock options.
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
14. Employee benefits plans (coninued)
Our pro forma information is as follows:
As of December 31, 2005, 63,334 options were outstanding in respect of non-employees (2004 - 133,334; 2003 - 160,501).
15. Statutory requirements and dividend restrictions
Our insurance and reinsurance subsidiaries are subject to insurance laws and regulations in the jurisdictions in which they operate, including Bermuda, the Cayman Islands, the United States and the United Kingdom. These regulations include restrictions that limit the amount of dividends or other distributions, such as loans or cash advances, available to shareholders without prior approval of the insurance regulatory authorities.
The difference between financial statements prepared for insurance regulatory authorities and statements prepared in accordance with GAAP vary by jurisdiction; however the primary difference is that financial statements prepared for insurance regulatory authorities do not reflect deferred acquisition costs, deferred income tax net assets, intangible assets and unrealized appreciation (depreciation) on investments.
Our Bermuda insurance companies are required to maintain a minimum capital of $0.25 million. There are no statutory restrictions on the payment of dividends from retained earnings by any of the Bermuda subsidiaries as the minimum statutory capital and surplus requirements are satisfied by the share capital and additional paid-in capital of each of the Bermuda subsidiaries.
Under The Insurance Law of the Cayman Islands, Scottish Annuity & Life Insurance Company (Cayman) Ltd. and The Scottish Annuity Company (Cayman) Ltd. must each maintain a minimum net capital worth of $0.24 million. There are no statutory restrictions on the payment of dividends from retained earnings by any of the
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
15. Statutory requirements and dividend restrictions (continued)
Cayman subsidiaries as the minimum statutory capital and surplus requirements are satisfied by the share capital and additional paid-in capital of each of the Cayman subsidiaries.
Our United States subsidiaries file financial statements prepared in accordance with statutory accounting practices prescribed or permitted by insurance regulators. The NAIC prescribes risk-based capital ("RBC") requirements for U.S. domiciled life and health insurance companies. As of December 31, 2005 and 2004, Scottish Re (U.S.), Inc., Scottish Re Life Corporation and Orkney Re, Inc. exceeded all minimum RBC requirements. The maximum amount of dividends that can be paid by Scottish Re (U.S.), Inc. and Scottish Re Life Corporation (Delaware domiciled insurance companies) and Orkney Re, Inc. (South Carolina domicile) without prior approval of the Insurance Commissioner is subject to restrictions relating to statutory surplus and operating earnings. The maximum dividend payment that may be made without prior approval is limited to the greater of the net gain from operations for the preceding year or 10% of statutory surplus as of December 31 of the preceding year not exceeding earned surplus. The applicable statutory provisions only permit an insurer to pay a shareholder dividend from unassigned surplus. As of January 1, 2006, Scottish Re (U.S.), Inc. and Orkney Re, Inc. could not pay dividends without prior approval of the Insurance Commissioner. As of January 1, 2006, Scottish Re Life Corporation could pay maximum dividends, without prior approval, of approximately $7.4 million.
The following table presents selected statutory financial information for our primary life reinsurance legal entities, as of or for the years ended December 31, 2005, 2004 and 2003:
In connection with the Insurance Companies Act 1982 of the United Kingdom, Scottish Re Limited is required to maintain statutory minimum net capital of approximately $48.0 million at December 31, 2005 (December 31, 2004 - $65.4 million).
Scottish Re (Dublin) Limited is required by the Irish Financial Services Regulatory Authority to maintain a minimum level of paid up share capital. There are currently no statutory or regulatory restrictions on the ability of Scottish Re (Dublin) Limited to make dividend payments from profits available for distribution within the meaning of the Companies (Amendment) Act, 1983.
16. Reinsurance
Premiums earned are analyzed as follows:
Claims and other policy benefits are net of reinsurance recoveries of $158.9 million, $144.5 million and $21.4 million during the years ended December 31, 2005, 2004 and 2003, respectively.
At December 31, 2005 and 2004, there were no reinsurance ceded receivables associated with a single reinsurer with a carrying value in excess of 1% of total assets.
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
17. Business segments
The accounting policies of our segments are the same as those described in the Summary of Significant Accounting Policies in Note 2. We measure segment performance primarily based on income or loss before income taxes. Our reportable segments are strategic business units that are primarily segregated by geographic region. We report segments in accordance with SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information". Our segments are Life Reinsurance North America, Life Reinsurance International and Corporate and Other. The segment reporting is as follows:
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
17. Business segments (continued)
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
17. Business segments (continued)
Capital expenditures of each reporting segment were not material in the periods noted.
Revenues from transactions with a single external customer did not amount to 10% or more of our revenues.
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
18. Earnings per ordinary share
The following table sets forth the computation of basic and diluted earnings per ordinary share:
(1) Reflects reduction for dividends declared on non-cumulative perpetual preferred shares.
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
19. Commitments and contingencies
Derivative instruments
We do not invest in derivatives for speculative purposes and our use of derivatives has not been significant to our financial position. We maintain investments in derivative instruments such as interest rate swaps and foreign currency forward contracts for which the primary purposes are to manage duration or interest rate sensitivity and foreign currency exposure. We currently record changes in market value of these instruments as realized gains (losses) in the consolidated statements of operations in accordance with SFAS No. 133.
By using derivative instruments, we are exposed to credit and market risk. If the counterparty fails to perform, credit risk is equal to the extent of the fair value gain in the derivative. When the fair value of a derivative contract is positive, this generally indicates that the counterparty owes us and, therefore, creates a payment risk to us. When the fair value of a derivative contract is negative, we owe the counterparty and therefore we have no payment risk. We minimize the credit (or payment) risk in derivative instruments by entering into transactions with high quality counterparties that are reviewed regularly by us.
During 2004, we entered into an interest rate swap contract in the amount of $100.0 million in relation to certain of our investment assets not supporting reinsurance liabilities. This derivative has not been designated as a hedge. The fair value of the swap at December 31, 2005 was a positive $1.3 million. The change in fair value was a gain of $2.2 million and has been included in realized gains (losses) in the consolidated statements of income.
During 2004, we entered into interest rate swaps with varying notional amounts and maturities, which have been designated as hedges of the variable interest cash flows of four of the trust preferred debt issuances described in Note 10. These interest rate swaps require us to pay fixed rate interest in exchange for variable rate interest, based on a fixed notional, until the maturity of the contract, and have been used to eliminate interest rate risk from the hedged portions of our long term debt. The notional amounts, reset periods, variable interest rates and maturities of the interest rate swaps match the terms of the cash flows of the debt they have been designated to hedge and therefore the interest rate swaps are considered to be fully effective as required by SFAS No. 133. The gain on the interest rate swaps for the year of $0.2 million has been included in interest expense for 2004.
Lease commitments
We lease office space in the countries in which we conduct business under operating leases that expire at various dates through 2023. Total rent expense with respect to these operating leases for the years ended December 31, 2005, 2004 and 2003 were approximately $3.2 million, $1.9 million and $1.7 million, respectively.
Future minimum lease payments under the leases are expected to be:
Year ending December 31 2006.................................................... $3,186 2007.................................................... 3,187 2008.................................................... 3,231 2009.................................................... 3,246 2010.................................................... 2,568 Thereafter.............................................. 22,657 ------- Total future lease commitments.......................... $38,075 =======
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
19. Commitments and contingencies (continued)
Concentrations of credit risk
The creditworthiness of a counterparty is evaluated by us, taking into account credit ratings assigned by rating agencies. The credit approval process involves an assessment of factors including, among others, the counterparty, country and industry credit exposure limits. Collateral may be required, at our discretion, on certain transactions based on the creditworthiness of the counterparty.
The areas where significant concentrations of credit risk may exist include amounts recoverable from reinsurers and reinsurance balances receivable (collectively "reinsurance assets"), investments and cash and cash equivalent balances. Our reinsurance assets at December 31, 2005 amounted to $0.9 billion and resulted from reinsurance arrangements in the normal course of our operations. A credit exposure exists with respect to reinsurance assets as they may become uncollectible. We manage our credit risk in our reinsurance relationships by transacting with reinsurers that we consider financially sound, and if necessary, we may hold collateral in the form of funds, trust accounts and/or irrevocable letters of credit. This collateral can be drawn on for amounts that remain unpaid beyond specified time periods on an individual reinsurer basis.
Legal proceedings
In the normal course of our business, we are occasionally involved in litigation. The ultimate disposition of such litigation is not expected to have a material adverse effect on our financial condition, liquidity or results of operations.
The attorneys general and the insurance departments of New York and numerous other states have announced investigations of insurance broker compensation arrangements, bid-rigging and other practices within the insurance industry, and may propose changes in the regulation of broker compensation arrangements and disclosure. Some regulators have also announced investigations into proper uses of finite reinsurance. We received a letter of inquiry from the Delaware Department of Insurance in November 2004 as part of its review of Delaware domestic insurance companies and their arrangements and dealings with producers acting as brokers to which we responded in November 2004. We have not been contacted by any other government agency (including through receipt of a subpoena) in connection with these investigations. It is impossible to predict the outcomes of these investigations, whether they will expand into other industry practices not yet contemplated, whether they will result in changes in insurance regulation or practices, or the impact, if any, of this increased regulatory scrutiny of the insurance industry on us or on the liquidity or trading prices of the ordinary shares.
Government subpoenas
We have received separate subpoenas from the staff of the SEC and the Permanent Subcommittee on Investigations of the United States Senate Committee on Homeland Security and Governmental Affairs ("PSI"). The SEC subpoena seeks documents and other information regarding transactions and trading involving our securities by certain former officers and directors of Scottish Re (each of whom left those positions by mid-year 2001), by certain of our original shareholders of Scottish Re, and by our current Chairman. The PSI subpoena is in connection with the PSI's general review of compliance with anti-money laundering, tax and securities laws and regulations related to financial transactions by individuals and domestic and offshore entities. The PSI subpoena seeks documents regarding our formation of Scottish Re, certain wealth management products and transactions
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
19. Commitments and contingencies (continued)
involving the individuals mentioned above. We are fully cooperating with these inquiries. While it is premature for us to assess the scope or any potential outcome to us of these inquiries, including any potential enforcement actions involving us, these inquiries may result in negative publicity and could have an adverse affect on us.
Mediation
On June 16, 2005, we requested mediation from Employers Reinsurance Corporation ("ERC") pursuant to the stock purchase agreement transferring a 95% interest in Scottish Re Life Corporation (formerly ERC Life Corporation) to Scottish Holdings, Inc. We assert that ERC breached certain representations and warranties under the agreement. Any negative outcome from this mediation will not have a material adverse impact on our financial position because the asserted breaches have already been fully reflected in our financial position at December 31, 2005. Mediation is tentatively scheduled to begin on March 30, 2006.
Tax matters
We are a Cayman Islands corporation and certain of our non-U.S.-based insurance and reinsurance subsidiaries (non-U.S. subsidiaries) have not paid or provided for U.S. corporate income taxes (except certain withholding taxes) on the basis that they are not engaged in a trade or business in the U.S. or otherwise subject to taxation in the U.S. However, because definitive identification of activities which constitute being engaged in a trade or business in the U.S. is not provided by the Internal Revenue Code of 1986, regulations or court decisions, there can be no assurance that the Internal Revenue Service ("IRS") will not contend that we or our non-U.S. subsidiaries are engaged in a U.S. trade or business or otherwise subject to taxation. If we and our non-U.S. subsidiaries were considered to be engaged in a trade or business in the U.S., we or such subsidiaries could be subject to U.S. tax at regular corporate tax rates on its taxable income, if any, that is effectively connected with such U.S. trade or business plus an additional 30 percent "branch profits" tax on such income remaining, if any, after the regular corporate taxes, in which case there could be a significant adverse effect on our results of operations and financial condition. We and our non-U.S. subsidiaries do not file U.S. income tax returns reporting income subject to U.S. income tax since we and they do not conduct business within the U.S. However, we and some of our non-U.S. subsidiaries have filed protective tax returns, reporting no U.S. income to preserve the ability to deduct our and their ordinary and necessary business expenses should the IRS successfully contend that a portion of their income is subject to a net income tax in the U.S.
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
19. Commitments and contingencies (continued)
Directors and Officers
We indemnify our directors and officers as provided in our charters and by-laws. Since this indemnity generally is not subject to limitation with respect to duration or amount, we do not believe that it is possible to determine the maximum potential amount due under this indemnity in the future.
20. Quarterly financial data (Unaudited)
Quarterly financial data for the year ended December 31, 2005 is as follows:
Revenues for the first, second and third quarters of 2005 differ from amounts included in our respective Quarterly Reports on Form 10-Q filed during 2005 due to a change in presentation of experience refunds. In 2005, $1.6 million, $1.7 million and ($2.2. million) of experience refunds were netted against "Acquisition costs and other insurance expenses" in the first, second and third quarters, respectively, but were reclassified to "Premiums earned" beginning in the fourth quarter of 2005. In 2004, revenues for the first, second, third and fourth quarters differ from amounts included in our respective Quarterly Reports on Form 10-Q filed during 2004. In 2004, ($0.3 million), ($1.5 million), ($0.3 million), and ($0.5 million) of experience refunds were
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
20. Quarterly financial data (Unaudited) (continued)
netted against "Acquisition costs and other insurance expenses" in the first, second, third and fourth quarters, respectively, but were reclassified to "Premiums earned".
Computations of results per share for each quarter are made independently of results per share for the year. Due to rounding and transactions affecting the weighted average number of shares outstanding in each quarter, the sum quarterly results per share does not equal results per share for the year.
Schedule Page I Summary of Investments......................................... 146 II Condensed Financial Information................................ 147 III Supplementary Insurance Information............................ 149 IV Reinsurance.................................................... 150 V Valuation and Qualifying Accounts.............................. 152
All other schedules specified in Regulation S-X are omitted for the reason that they are not required, are not applicable, or that equivalent information has been included in the consolidated financial statements, and notes thereto, appearing in Item 8.
SCOTTISH RE GROUP LIMITED SCHEDULE 1 - SUMMARY OF INVESTMENTS - OTHER THAN INVESTMENTS IN RELATED PARTIES December 31, 2005 (Expressed in Thousands of United States Dollars)
SCOTTISH RE GROUP LIMITED SCHEDULE II - CONDENSED FINANCIAL INFORMATION (Expressed in Thousands of United States Dollars)
SCOTTISH RE GROUP LIMITED SCHEDULE III - SUPPLEMENTARY INSURANCE INFORMATION (Expressed in Thousands of United States Dollars)
1) Certain reclassifications have been made to the 2004 and 2003 amounts to conform to the 2005 presentation.
* Inculdes claims and other policy benefits and interest credited on interest sensitive contract liabilities.
SCOTTISH RE GROUP LIMITED SCHEDULE IV - REINSURANCE (Expressed in thousands of United States Dollars)
SCOTTISH RE GROUP LIMITED SCHEDULE IV - REINSURANCE (continued) (Expressed in thousands of United Staes Dollars)
*Excludes business acquired from ING.
SCOTTISH RE GROUP LIMITED SCHEDULE V - Valuation and Qualifying Accounts (Expressed in thousands of United States Dollars)
* This valuation arose in respect of the acquistion of the ING individual life reinsurance business. This was established as a result of the purchase accounting for the acquisition and therefore has not been included in the determination of net income.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant, in the capacities and on the dates indicated.
* The undersigned, by signing his name hereto, does hereby sign this Annual Report on Form 10-K pursuant to the Powers of Attorney executed on behalf of the above named officers and directors of the Registrant and contemporaneously filed herewith with the Securities and Exchange Commission.
/s/ Michael C. French Michael C. French Attorney-in-Fact