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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
For Annual and Transition Reports Pursuant
to Sections 13 or 15(d) of the Securities Exchange Act of 1934
|X| Annual Report Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
For the fiscal year ended December 31, 2005
|_| Transition Report Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
For the Transition period from to
Commission File Number 0-29788
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SCOTTISH RE GROUP LIMITED
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
Cayman Islands 98-0362785
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
Crown House, Third Floor
4 Par-la-Ville Road
Hamilton HMO8, Bermuda Not Applicable
(Address of Principal Executive Office) (Zip Code)
Registrant's telephone number, including area code: (441) 295-4451
Securities Registered Pursuant to Section 12(b) of the Act:
Title of Each Class Name of Each Exchange on Which Registered
------------------- -----------------------------------------
Ordinary Shares, par value $0.01 per share New York Stock Exchange
Hybrid Capital Units New York Stock Exchange
Non-Cumulative Perpetual Preferred New York Stock Exchange
Shares, par value $0.01 per share
Securities Registered Pursuant to Section 12(g) of the Act:
None
Indicate by checkmark if the registrant is a well-known seasoned
issuer, as defined in Rule 405 of the Securities Act. Yes|X| No |_|
Indicate by checkmark if the registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act. Yes |_| No |X|
Indicate by check mark whether the Registrant: (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes|X| No |_|
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. |_|
Indicate by checkmark whether the registrant is a large accelerated
filer, as defined in Rule 12b-2 of the Exchange Act. Large accelerated filer |X|
Accelerated filer |_| Non-accelerated filer |_|
Indicate by checkmark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act). Yes|_| No |X|
The aggregate market value of the voting stock held by non-affiliates
of the Registrant as of June 30, 2005 was $793,126,667. As of March 9, 2006,
Registrant had 53,486,106 ordinary shares outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Certain information required by Items 10, 11, 12, 13 and 14 of Form
10-K is incorporated by reference into Part III hereof from the registrant's
proxy statement for its 2006 Annual Meeting of Shareholders, which is expected
to be filed with the Securities and Exchange Commission (the "SEC") within 120
days of the close of the registrant's fiscal year ended December 31, 2005.
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SCOTTTTISH RE GROUP LIMITED
FORM 10-K
YEAR ENDED DECEMBER 31, 2005
TABLE OF CONTENTS
Page
PART I............................................................................................................1
Item 1: BUSINESS...............................................................................................1
Item 1A RISK FACTORS..........................................................................................21
Item 1B UNRESOLVED STAFF COMMENTS.............................................................................34
Item 2: PROPERTIES............................................................................................34
Item 3: LEGAL PROCEEDINGS.....................................................................................34
Item 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...................................................35
PART II..........................................................................................................36
Item 5: MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF
EQUITY SECURITIES....................................................................................36
Item 6: SELECTED FINANCIAL DATA...............................................................................37
Item 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.................39
Item 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK............................................72
Item 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA...........................................................75
Item 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE..................75
Item 9A: CONTROLS AND PROCEDURES...............................................................................75
Item 9B: OTHER INFORMATION.....................................................................................78
PART III.........................................................................................................78
Item 10: DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT........................................................78
Item 11: EXECUTIVE COMPENSATION................................................................................78
Item 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS........78
Item 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS........................................................78
Item 14: PRINCIPAL ACCOUNTANT FEES AND SERVICES................................................................78
PART IV..........................................................................................................78
Item 15: EXHIBITS, FINANCIAL STATEMENT SCHEDULES...............................................................78
i
PART I
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
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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
2
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:
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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
4
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
5
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.
6
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.
7
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
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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
9
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.
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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.
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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.
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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:
A.M. Best Fitch Moody's Investors Standard &
Company Ratings Service Poor's
------- ------- ------- ------
Insurer Financial Stength Ratings:
Scottish Annuity and Life
Insurance Company (Cayman) Ltd. A- A A3* A-
Scottish Re (U.S.), Inc. A- A A3* A-
Scottish Re Ltd. A- A - A-
Scottish Re Life Corporation A- - - A-
* 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.
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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.
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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.
15
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.
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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,
17
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.
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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
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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
20
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. 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.
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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
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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
23
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.
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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
25
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.
26
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.
27
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.
28
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.
29
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.
30
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
31
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
32
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.
33
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: UNRESOLVED STAFF COMMENTS
None.
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: 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.
34
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.
35
PART II
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".
36
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)
Year Ended Year Ended Year Ended Year Ended Year Ended
December 31, December 31, December 31, December 31, December 31,
2005 2004 2003 2002 2001
----------- ----------- ----------- ---------- ----------
Income Statement data:(1)
Total revenues ................................. $ 2,297,329 $ 814,387 $ 556,045 $ 306,212 $ 120,962
Total benefits and expenses .................... 2,183,705 758,936 518,299 274,871 103,729
Income before income taxes and
minority interest............................. 113,624 55,451 37,746 31,341 17,233
Income from continuing operations
before cumulative effect of change
in accounting principle....................... 130,197 71,599 48,789 33,235 17,245
Net income ..................................... 130,197 71,391 27,281 32,524 16,839
Dividend declared on non-cumulative
perpetual preferred shares ................... (4,758) - - - -
----------- ----------- ----------- ---------- ---------
Net income available to ordinary
shareholders ................................. $ 125,439 $ 71,391 $ 27,281 $ 32,524 $ 16,839
=========== =========== ========== ========== =========
Per share data: (1)
Basic earnings per share:
Income from continuing
operations before cumulative
effect of change in accounting
principle and discontinued
operations (2)......................... $ 2.86 $ 2.00 $ 1.59 $ 1.32 $ 1.10
Cumulative effect of change in
accounting principle................... - - (0.64) - (0.02)
Discontinued operations.................. - (0.01) (0.06) (0.03) -
----------- ----------- ----------- ---------- ---------
Net income available to
ordinary shareholders................. $ 2.86 $ 1.99 $ 0.89 $ 1.29 $ 1.08
=========== =========== =========== ========== =========
37
Year Ended Year Ended Year Ended Year Ended Year Ended
December 31, December 31, December 31, December 31, December 31,
2005 2004 2003 2002 2001
------------ ------------ ------------ ------------ ------------
Diluted earnings per share:
Income from continuing
operations before cumulative
effect of change in accounting
principle and discontinued
operations(2).......................... $ 2.64 $ 1.91 $ 1.51 $ 1.25 $ 1.05
Cumulative effect of change in
accounting principle .................. - - (0.60) - (0.03)
Discontinued operations ................. - (0.01) (0.06) (0.02) -
------------ ------------ ------------ ------------ ------------
Net income available to
ordinary shareholders.................. $ 2.64 $ 1.90 $ 0.85 $ 1.23 $ 1.02
============ ============ ============ ============ ============
Book value per share(3)...................... $ 21.48 $ 21.60 $ 18.73 $ 18.24 $ 16.44
Market value per share ...................... $ 24.55 $ 25.90 $ 20.78 $ 17.45 $ 19.35
Cash dividends per ordinary share ........... $ 0.20 $ 0.20 $ 0.20 $ 0.20 $ 0.20
Weighted average number of shares
outstanding:
Basic.................................... 43,838,261 35,732,522 30,652,719 25,190,283 15,646,106
Diluted.................................. 47,531,116 37,508,292 32,228,001 26,505,612 16,485,338
Balance sheet data (at end of year): (1)
Total fixed maturity investments ............ $ 5,292,595 $ 3,392,463 $ 2,014,719 $ 1,003,946 $ 583,890
Total assets ................................ 12,006,120 8,952,237 6,053,517 3,291,226 2,141,566
Long-term debt .............................. 244,500 244,500 162,500 132,500 -
Total liabilities ........................... 10,582,046 7,937,417 5,242,450 2,800,134 1,810,284
Minority interest ........................... 9,305 9,697 9,295 - -
Mezzanine equity ............................ 143,057 142,449 141,928 - -
Total shareholders' equity .................. $ 1,271,712 $ 862,674 $ 659,844 $ 491,092 $ 331,282
Actual number of ordinary shares
outstanding .................................... 53,391,939 39,931,145 35,228,411 26,927,456 20,144,956
- --------------
(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.
38
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;
39
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
40
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.
41
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
42
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
43
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
44
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.
45
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2005 2004 2003
------------ ------------- ------------
Premiums earned, net.................................. $1,933,930 $ 589,445 $ 390,654
Investment income, net................................ 355,837 217,138 148,028
Fee income............................................ 12,316 11,547 7,907
Net realized gains (losses)........................... 3,738 (8,304) (4,448)
Change in value of embedded derivatives, net.......... (8,492) 4,561 13,904
---------- ---------- ----------
Total revenues........................................ 2,297,329 814,387 556,045
---------- ---------- ----------
Claims and other policy benefits...................... 1,442,505 425,965 275,887
Interest credited to interest sensitive
contract liabilities............................... 132,968 106,525 89,156
Acquisition costs and other insurance expenses, net... 423,775 151,405 114,678
Operating expenses.................................... 115,573 54,658 31,021
Due diligence costs................................... - 4,643 -
Collateral finance facilities expense................. 48,146 2,724 -
Interest expense...................................... 20,738 13,016 7,557
---------- ---------- ----------
Total benefits and expenses........................... 2,183,705 758,936 518,299
---------- ---------- ----------
Income before income taxes and minority interest...... 113,624 55,451 37,746
Income tax benefit .................................. 16,434 16,679 11,105
---------- ---------- ----------
Income from continuing operations before minority
interest........................................... 130,058 72,130 48,851
Minority interest..................................... 139 (531) (62)
---------- ---------- ----------
Income before cumulative effect of change in
accounting principle and discontinued operations.... 130,197 71,599 48,789
Cumulative effect of change in accounting principle... - - (19,537)
Loss from discontinued operations..................... - (208) (1,971)
---------- ---------- ----------
Net income............................................ 130,197 71,391 27,281
Dividend declared on non-cumulative perpetual
preferred shares................................... (4,758) - -
---------- ---------- ----------
Net income available to ordinary shareholders......... $ 125,439 $ 71,391 $ 27,281
========== ========== ==========
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
46
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
47
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.
48
Segment Operating Results
Life Reinsurance North America
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2005 2004 2003
------------ ------------- -------------
Revenues
Premiums earned, net..................................... $ 1,814,875 $ 466,927 $ 229,796
Investment income, net................................... 341,539 206,009 135,731
Fee income............................................... 9,233 7,867 4,067
Net realized gains (losses).............................. 1,121 (7,974) (6,124)
Change in value of embedded derivatives, net............. (8,492) 4,561 13,904
------------ ------------ -------------
Total revenues........................................ 2,158,276 677,390 377,374
------------ ------------ -------------
Benefits and expenses
Claims and other policy benefits......................... 1,365,599 344,319 171,711
Interest credited to interest sensitive
contract liabilities.................................. 132,968 106,525 89,156
Acquisition costs and other insurance expenses, net...... 400,992 131,658 82,682
Operating expenses....................................... 48,849 18,408 8,646
Collateral finance facilities expense ................... 43,113 2,724 -
Interest expense......................................... 10,823 4,605 1,109
------------ ------------ -------------
Total benefits and expenses........................... 2,002,344 608,239 353,304
------------ ------------ -------------
Income before income taxes and minority interest......... $ 155,932 $ 69,151 $ 24,070
============ ============ =============
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.
49
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
50
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.
51
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
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2005 2004 2003
------------ ------------- ------------
Revenues
Premiums earned, net..................................... $ 119,055 $ 122,518 $ 160,858
Investment income, net................................... 11,488 10,023 7,537
Net realized gains ...................................... 1,263 1,685 548
------------ ------------- ------------
Total revenues........................................ 131,806 134,226 168,943
------------ ------------- ------------
Benefits and expenses
Claims and other policy benefits......................... 76,906 81,646 104,176
Acquisition costs and other insurance expenses, net...... 20,722 17,634 29,733
Operating expenses....................................... 25,276 18,798 11,518
------------ ------------- ------------
Total benefits and expenses........................... 122,904 118,078 145,427
------------ ------------- ------------
Income before income taxes............................... $ 8,902 $ 16,148 $ 23,516
============ ============= ============
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
52
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
53
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
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2005 2004 2003
------------ ------------ ------------
Revenues
Investment income, net...................... $ 2,810 $ 1,106 $ 4,760
Fee income.................................. 3,083 3,680 3,840
Net realized gains (losses)................. 1,354 (2,015) 1,128
------------ ------------ ------------
Total revenues.............................. 7,247 2,771 9,728
------------ ------------ ------------
Benefits and expenses
Acquisition costs and other insurance
expenses, net............................ 2,061 2,113 2,263
Operating expenses.......................... 41,448 17,452 10,857
Interest expense............................ 9,915 8,411 6,448
Collateral finance facilities expense....... 5,033 - -
Due diligence costs......................... - 4,643 -
------------ ------------ ------------
Total benefits and expenses.............. 58,457 32,619 19,568
------------ ------------ ------------
Loss before income taxes.................... $ (51,210) $ (29,848) $ (9,840)
============ ============ ============
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
54
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.
55
Year Ended
December 31, 2005
------------------------------------
Portfolio performance....................................................... 3.22%
Customized index............................................................ 2.53%
Lehman Brothers Global Bond Index........................................... 1.22%
S&P 500..................................................................... 4.91%
The following table presents the fixed income investment portfolio
(market value) credit exposure by category as assigned by Standard & Poor's.
December 31, 2005 December 31, 2004
------------------------- ------------------------
Ratings $ in millions % $ in millions %
------------- ----- ------------- -----
AAA.................................................... $ 3,017.4 44.8% $ 1,754.2 41.1%
AA..................................................... 1,069.1 15.9 451.1 10.5
A...................................................... 1,646.9 24.4 1,284.0 30.1
BBB.................................................... 977.7 14.5 750.5 17.6
BB or below............................................ 28.0 0.4 30.3 0.7
------------ ----- ------------ -----
Total.................................................. $ 6,739.1 100.0% $ 4,270.1 100.0%
============ ===== ============ =====
The following table illustrates the fixed income investment portfolio
(market value) sector exposure.
December 31, 2005 December 31, 2004
------------------------- ------------------------
Sector $ in millions % $ in millions %
------------- ----- ------------- -----
U.S. Treasury securities and U.S. government agency
obligations......................................... $ 47.9 0.7% $ 89.5 2.1%
Corporate securities................................... 2,057.0 30.5 1,618.3 37.9
Municipal bonds........................................ 37.6 0.6 20.8 0.5
Mortgage and asset backed securities................... 3,150.1 46.7 1,663.8 39.0
Preferred stock........................................ 133.8 2.0 125.2 2.9
----------- ----- ------------ -----
5,426.4 80.5 3,517.6 82.4
Cash................................................... 1,312.7 19.5 752.5 17.6
----------- ----- ------------ -----
Total.................................................. $ 6,739.1 100.0% $ 4,270.1 100.0%
=========== ===== ============ =====
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.
56
December 31, 2005
----------------------------------------------------------------------------------------
Equal to or greater than
Less than 12 months 12 months Total
------------------------- ------------------------- --------------------------
Estimated Unrealized Estimated Unrealized Estimated Unrealized
fair value loss fair value loss fair value loss
----------- --------- ---------- ---------- ----------- ----------
Investment Grade
Securities:
CMO...................... $ 467,314 $ (4,865) $ 85,305 $ (1,688) $ 552,619 $ (6,553)
Corporates............... 1,132,840 (23,950) 94,218 (2,545) 1,227,058 (26,495)
Governments.............. 36,297 (774) 1,999 (71) 38,296 (845)
MBS...................... 143,956 (3,383) 42,682 (1,611) 186,638 (4,994)
Municipal................ 17,738 (330) 1,621 (68) 19,359 (398)
Other structured
securities............. 1,028,657 (11,882) 135,341 (3,113) 1,163,998 (14,995)
Preferred stocks......... 98,263 (2,287) 24,106 (1,295) 122,369 (3,582)
----------- --------- ---------- ---------- ----------- ----------
Total investment grade
securities............. $ 2,925,065 $ (47,471) $ 385,272 $ (10,391) $ 3,310,337 $ (57,862)
----------- --------- ---------- ---------- ----------- ----------
Below investment grade
securities:
Corporates............... $ 10,676 $ (655) $ 1,841 $ (59) $ 12,517 $ (714)
Other structured
securities............. 3,552 (555) 7,260 (29) 10,812 (584)
Preferred stock.......... 392 (12) 340 (19) 732 (31)
----------- --------- ---------- ---------- ----------- ----------
Total below investment
grade securities....... 14,620 (1,222) 9,441 (107) 24,061 (1,329)
----------- --------- ---------- ---------- ----------- ----------
Total ................... $ 2,939,685 $ (48,693) $ 394,713 $ (10,498) $ 3,334,398 $ (59,191)
=========== ========= ========== ========== =========== ==========
57
December 31, 2004
----------------------------------------------------------------------------------------
Equal to or greater than
Less than 12 months 12 months Total
------------------------- ------------------------- --------------------------
Estimated Unrealized Estimated Unrealized Estimated Unrealized
fair value loss fair value loss fair value loss
----------- ---------- ---------- ---------- ----------- --------
Investment Grade
Securities:
CMO...................... $ 225,068 $ (1,830) $ 4,100 $ (96) $ 229,168 $ (1,926)
Corporates............... 241,030 (2,139) 49,445 (660) 290,475 (2,799)
Governments.............. 51,123 (139) - - 51,123 (139)
MBS...................... 49,085 (627) 9,585 (199) 58,670 (826)
Municipal................ 12,130 (158) - - 12,130 (158)
Other structured
securities............. 311,733 (2,375) 17,227 (1,125) 328,960 (3,500)
Preferred stocks......... 35,152 (628) 257 (12) 35,409 (640)
----------- ---------- ---------- --------- ----------- ----------
Total investment grade
securities............. $ 925,321 $ (7,896) $ 80,614 $ (2,092) $ 1,005,935 $ (9,988)
----------- ---------- ---------- --------- ----------- ----------
Below investment grade
securities:
Corporates............... $ 1,966 $ (35) $ - $ - $ 1,966 $ (35)
Other structured
securities............. 7,988 (977) 2,492 (1,047) 10,480 (2,024)
Preferred stock.......... 54 (1) - - 54 (1)
----------- ---------- ---------- --------- ----------- ----------
Total below investment
grade securities....... 10,008 (1,013) 2,492 (1,047) 12,500 (2,060)
----------- ---------- ---------- --------- ----------- ----------
Total ................... $ 935,329 $ (8,909) $ 83,106 $ (3,139) $ 1,018,435 $ (12,048)
=========== ========== ========== ========= =========== ==========
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
58
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:
December 31, 2005
------------------------------------------------------------------------------
Amortized Estimated Unrealized
Cost % Fair Value % Loss %
---------- ----- ---------- ----- ----------- -----
Industry
--------
Mortgage and asset backed
securities............. $1,941,193 57.2% $1,914,068 57.4% $ (27,125) 45.8%
Banking................... 210,360 6.2 206,189 6.2 (4,171) 7.1
Communications............ 192,282 5.7 186,480 5.6 (5,802) 9.8
Consumer cyclical......... 114,199 3.4 111,488 3.3 (2,711) 4.6
Consumer non-cyclical..... 124,998 3.7 122,134 3.7 (2,864) 4.8
Financial companies....... 103,455 3.0 101,663 3.0 (1,792) 3.0
Financial other........... 117,803 3.5 115,767 3.5 (2,036) 3.4
Other*.................... 589,299 17.3 576,609 17.3 (12,690) 21.5
---------- ----- ---------- ----- ----------- -----
Total..................... $3,393,589 100.0% $3,334,398 100.0% $ (59,191) 100.0%
========== ===== ========== ===== =========== =====
December 31, 2004
------------------------------------------------------------------------------
Amortized Estimated Unrealized
Cost % Fair Value % Loss %
---------- ----- ---------- ----- ----------- -----
Industry
--------
Mortgage and asset backed
securities............. $ 635,556 61.7% $ 627,279 61.6% $ (8,277) 68.7%
Banking................... 89,131 8.7 88,371 8.7 (760) 6.3
Insurance................. 30,229 2.9 29,831 2.9 (398) 3.3
Financial other........... 30,081 2.9 29,645 2.9 (436) 3.6
Brokerage................. 25,071 2.4 24,893 2.4 (178) 1.5
Financial companies....... 24,293 2.4 24,080 2.4 (213) 1.8
Communications............ 16,734 1.6 16,503 1.6 (231) 1.9
Other*.................... 179,388 17.4 177,833 17.5 (1,555) 12.9
---------- ----- ---------- ----- ---------- -----
Total..................... $1,030,483 100.0% $1,018,435 100.0% $ (12,048) 100.0%
========== ===== ========== ===== ========== =====
*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.
December 31, 2005
----------------------------------------------------------------------------------
Estimated Unrealized
Maturity Book Value % Fair Value % Loss %
- -------- ----------- ----- ----------- ----- ----------- -----
Due in one year or less........ $ 269,410 7.9% $ 267,712 8.0% $ (1,698) 2.9%
Due in one through five years.. 1,659,946 48.9 1,636,102 49.1 (23,844) 40.3
Due in five through ten years.. 925,650 27.3 905,973 27.2 (19,677) 33.2
Due after ten years............ 538,583 15.9 524,611 15.7 (13,972) 23.6
----------- ----- ----------- ----- ----------- -----
Total.......................... $ 3,393,589 100.0% $ 3,334,398 100.0% $ (59,191) 100.0%
=========== ===== =========== ===== =========== =====
59
December 31, 2004
----------------------------------------------------------------------------------
Estimated Unrealized
Maturity Book Value % Fair Value % Loss %
- -------- ----------- ----- ----------- ----- ----------- -----
Due in one year or less........ $ 162,787 15.8% $ 160,087 15.7% $ (2,700) 22.4%
Due in one through five years.. 532,436 51.7 527,660 51.8 (4,776) 39.6
Due in five through ten years.. 256,319 24.9 252,939 24.9 (3,380) 28.1
Due after ten years............ 78,941 7.6 77,749 7.6 (1,192) 9.9
----------- ----- ----------- ----- ----------- -----
Total.......................... $ 1,030,483 100.0% $ 1,018,435 100.0% $ (12,048) 100.0%
=========== ===== =========== ===== =========== =====
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.
Year ended December 31, 2005
---------------------------------------------------------------------------------------
Credit Concern Relative Value Other Total
------------------- ------------------- ------------------- -------------------
Days Proceeds Loss Proceeds Loss Proceeds Loss Proceeds Loss
- ---- -------- -------- -------- -------- -------- -------- -------- --------
0-90 ....... $ 43,223 $ (1,703) $ 44,230 $ (356) $471,886 $ (1,440) $559,339 $ (3,499)
91-180 ..... 355 (83) 12,456 (59) 6,499 (48) 19,310 (190)
181-270 .... 5,869 (1,246) 2,240 (7) 6,361 (88) 14,470 (1,341)
271-360 .... 2,581 (255) 2,045 (70) 4,881 (29) 9,507 (354)
Greater than
360........ 2,670 (330) 7 - 2,453 (64) 5,130 (394)
-------- -------- -------- -------- -------- -------- -------- --------
Total ...... $ 54,698 $ (3,617) $ 60,978 $ (492) $492,080 $ (1,669) $607,756 $ (5,778)
======== ======== ======== ======== ======== ======== ======== ========
Year ended December 31, 2004
---------------------------------------------------------------------------------------
Credit Concern Relative Value Other Total
------------------- ------------------- ------------------- -------------------
Days Proceeds Loss Proceeds Loss Proceeds Loss Proceeds Loss
- ---- -------- -------- -------- -------- -------- -------- -------- --------
0-90 ....... $ 7,528 $ (474) $ 54,772 $ (1,284) $ 77,107 $ (1,859) $139,407 $ (3,617)
91-180 ..... 1,909 (136) 22,884 (266) 6,543 (46) 31,336 (448)
181-270 .... 10,483 (159) 3,904 (23) 127 (1) 14,514 (183)
271-360 .... - - 488 (10) 1,886 (31) 2,374 (41)
Greater than
360........ 8,011 (710) 306 (11) 321 (33) 8,638 (754)
-------- -------- -------- -------- -------- -------- -------- --------
Total ...... $ 27,931 $ (1,479) $ 82,354 $ (1,594) $ 85,984 $ (1,970) $196,269 $ (5,043)
======== ======== ======== ======== ======== ======== ======== ========
60
Year ended December 31, 2003
---------------------------------------------------------------------------------------
Credit Concern Relative Value Other Total
------------------- ------------------- ------------------- -------------------
Days Proceeds Loss Proceeds Loss Proceeds Loss Proceeds Loss
- ---- -------- -------- -------- ------- -------- -------- -------- --------
0-90 ....... $ 924 $ (5) $ 15,389 $ (166) $ 20,686 $ (191) $ 36,999 $ (362)
91-180 ..... 3,529 (295) 3,693 (35) 1,720 (15) 8,942 (345)
181-270 .... 3,300 (251) 776 (29) 656 (4) 4,732 (284)
271-360..... - - 545 (12) 479 (55) 1,024 (67)
Greater than
360........ 6,008 (951) 1,380 (116) - - 7,388 (1,067)
-------- -------- -------- -------- -------- -------- -------- --------
Total....... $ 13,761 $ (1,502) $ 21,783 $ (358) $ 23,541 $ (265) $ 59,085 $ (2,125)
======== ======== ======== ======== ======== ======== ======== ========
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
61
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.
Ratings December 31, 2005 December 31, 2004
- ------- ---------------------- ----------------------
millions % millions %
---------- ----- ---------- -----
AAA.................................................... $ 705.9 27.4% $ 692.6 33.3%
AA..................................................... 146.0 5.7 85.0 4.1
A...................................................... 741.6 28.9 527.7 25.4
BBB.................................................... 785.8 30.6 579.7 27.9
BB or below............................................ 78.0 3.0 63.3 3.1
---------- ----- ---------- -----
2,457.3 95.6 1,948.3 93.8
Commercial mortgage loans.............................. 112.6 4.4 129.9 6.2
---------- ----- ---------- -----
Total.................................................. $ 2,569.9 100.0% $ 2,078.2 100.0%
========== ===== ========== =====
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.
Sector December 31, 2005 December 31, 2004
- ------- ---------------------- ----------------------
millions % millions %
---------- ----- ---------- -----
U.S. Treasury securities and U.S. government agency
obligations .................................... $ 62.3 2.4% $ 39.7 1.9%
Corporate securities .............................. 1,634.4 63.6 1,096.3 52.8
Municipal bonds ................................... 33.0 1.3 25.2 1.2
Mortgage and asset backed securities .............. 595.1 23.1 314.7 15.1
Commercial mortgage loans ......................... 112.5 4.4 129.9 6.3
Cash .............................................. 132.6 5.2 472.4 22.7
---------- ----- ---------- -----
Total ............................................. $ 2,569.9 100.0% $ 2,078.2 100.0%
========== ===== ========== =====
62
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.
63
Capital
Total capitalization is analyzed as follows:
December 31, December 31, December 31,
2005 2004 2003
---------- ---------- ----------
Shareholders' equity ...................... $1,271,712 $ 862,674 $ 659,844
Mezzanine equity .......................... 143,057 142,449 141,928
Long-term debt ............................ 244,500 244,500 162,500
7.00% Convertible Junior Subordinated Notes - 41,282 -
---------- ---------- ----------
$1,659,269 $1,290,905 $ 964,272
========== ========== ==========
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
64
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,
65
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.
66
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
67
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.
68
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:
Less Than 1 More Than
Year 1-3 Years 4-5 Years 5 Years Total
-------- ---------- ---------- -------- ----------
Long-term debt..................... $115,000 $47,500 $82,000 $ - $ 244,500
Mezzanine equity................... 8,445 145,686 - - 154,131
Operating leases................... 3,186 6,418 5,814 22,657 38,075
Funding agreements................. 120,000 380,000 100,000 - 600,000
Collateral financing facility
liabilities....................... - 450,000 1,535,681 - 1,985,681
Life claims payable................ 560,798 - - - 560,798
-------- ---------- ---------- -------- ----------
$807,429 $1,029,604 $1,723,495 $ 22,657 $3,583,185
======== ========== ========== ======== ==========
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
69
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
70
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;
71
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: 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.
72
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
73
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.
74
Expected Maturity Date
------------------------------------------------------------------------------------------------------------
Total Fair
Total 2006 2007 2008 2009 2010 Thereafter Total Value
- ----- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Principal amount .... $ 403,018 $ 771,146 $1,091,652 $ 793,735 $ 636,763 $2,315,299 $6,011,613 $5,426,399
Book value .......... 464,440 769,064 757,676 710,213 425,748 2,333,618 5,460,759
Weighted average
book yield......... 4.9% 4.8% 4.9% 4.8% 4.9% 5.4% 5.1%
- --------------------
Expected Maturity Date
------------------------------------------------------------------------------------------------------------
Total Fair
Fixed Rate Only 2006 2007 2008 2009 2010 Thereafter Total Value
- --------------- ---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Principal amount .... $ 110,680 $ 284,531 $ 674,446 $ 369,399 $ 517,344 $2,054,403 $4,010,803 $3,438,520
Book value .......... 172,003 281,274 339,483 285,785 305,958 2,086,911 3,471,414 -
Weighted average
book yield......... 4.6% 4.5% 4.6% 4.8% 4.9% 5.5% 5.2% -
- --------------------
Expected Maturity Date
------------------------------------------------------------------------------------------------------------
Total Fair
Floating Rate Only 2006 2007 2008 2009 2010 Thereafter Total Value
- ------------------ ---------- ---------- ---------- ---------- ---------- ---------- ---------- ----------
Principal amount ..... $ 292,338 $ 486,615 $ 417,206 $ 424,336 $ 119,419 $ 260,896 $2,000,810 $1,987,879
Book value ........... 292,437 487,790 418,193 424,428 119,790 246,707 1,989,345
Weighted average
book yield.......... 5.1% 5.0% 5.1% 4.8% 4.9% 4.7% 5.0%
- --------------------
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: 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: 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
75
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.
76
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
77
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: OTHER INFORMATION
None.
PART III
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: 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: 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: 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: 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: 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
78
(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)
79
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)
80
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
81
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
82
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)
83
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)
84
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.
- --------------------
(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.
85
(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.
86
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.
87
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
88
SCOTTISH RE GROUP LIMITED
CONSOLIDATED BALANCE SHEETS
(Expressed in Thousands of United States Dollars, except share data)
December 31, December 31,
2005 2004
------------ ------------
Assets
Fixed maturity investments, available for sale, at fair value
(Amortized cost $5,323,488; 2004 - $3,362,929) ....................................... $ 5,292,595 $ 3,392,463
Preferred stock available for sale, at fair value (Cost $137,271; 2004 -
$124,629) ............................................................................ 133,804 125,204
Cash and cash equivalents ............................................................... 1,420,205 794,639
Other investments ....................................................................... 54,619 16,250
Funds withheld at interest .............................................................. 2,597,416 2,056,280
------------ ------------
Total investments .................................................................... 9,498,639 6,384,836
Accrued interest receivable ............................................................. 44,012 32,092
Reinsurance balances and risk fees receivable ........................................... 325,372 495,517
Deferred acquisition costs .............................................................. 594,583 417,306
Amounts recoverable from reinsurers ..................................................... 551,288 680,956
Present value of in-force business ...................................................... 54,743 62,164
Goodwill ................................................................................ 34,125 34,125
Other assets ............................................................................ 87,198 38,926
Current income tax receivable ........................................................... - 7,712
Deferred tax benefit .................................................................... 55,453 15,030
Segregated assets ....................................................................... 760,707 783,573
------------ ------------
Total assets ......................................................................... $ 12,006,120 $ 8,952,237
============ ============
Liabilities
Reserves for future policy benefits ..................................................... $ 3,477,222 $ 3,301,715
Interest sensitive contract liabilities ................................................. 3,907,573 3,181,447
Collateral finance facilities ........................................................... 1,985,681 200,000
Accounts payable and other liabilities .................................................. 83,130 68,311
Reinsurance balances payable ............................................................ 114,078 116,589
Current income tax payable .............................................................. 9,155 -
7.00% Convertible Junior Subordinated Notes ............................................. - 41,282
Long-term debt .......................................................................... 244,500 244,500
Segregated liabilities .................................................................. 760,707 783,573
------------ ------------
Total liabilities .................................................................... 10,582,046 7,937,417
------------ ------------
Commitments and contingencies (See Note 19)
Minority Interest ....................................................................... 9,305 9,697
Mezzanine Equity ........................................................................ 143,057 142,449
Shareholders' Equity
Share capital, par value $0.01 per share:
Issued and outstanding: 53,391,939 ordinary shares (2004-39,931,145) ................ 534 399
Preferred shares, par value $0.01 per share:
Issued: 5,000,000 shares ............................................................ 125,000 -
Additional paid-in capital .............................................................. 893,767 684,719
Accumulated other comprehensive income (loss) ........................................... (9,991) 31,604
Retained earnings ....................................................................... 262,402 145,952
------------ ------------
Total shareholders' equity ........................................................... 1,271,712 862,674
------------ ------------
Total liabilities, minority interest, mezzanine equity and shareholders' equity ......... $ 12,006,120 $ 8,952,237
============ ============
See Accompanying Notes to Consolidated Financial Statements
89
SCOTTISH RE GROUP LIMITED
CONSOLIDATED STATEMENT OF INCOME
(Expressed in Thousands of United States Dollars, except share data)
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2005 2004 2003
---------- ---------- ----------
Revenues
Premiums earned, net ............................................................ $ 1,933,930 $ 589,445 $ 390,654
Investment income, net .......................................................... 355,837 217,138 148,028
Fee income ...................................................................... 12,316 11,547 7,907
Net realized gains (losses) ..................................................... 3,738 (8,304) (4,448)
Change in value of embedded derivatives, net .................................... (8,492) 4,561 13,904
---------- ---------- ----------
Total revenues ................................................................ 2,297,329 814,387 556,045
---------- ---------- ----------
Benefits and expenses
Claims and other policy benefits ................................................ 1,442,505 425,965 275,887
Interest credited to interest sensitive contract liabilities .................... 132,968 106,525 89,156
Acquisition costs and other insurance expenses, net ............................. 423,775 151,405 114,678
Operating expenses .............................................................. 115,573 54,658 31,021
Collateral finance facilities expense ........................................... 48,146 2,724 -
Interest expense ................................................................ 20,738 13,016 7,557
Due diligence costs ............................................................. - 4,643 -
---------- ---------- ----------
Total benefits and expenses ................................................... 2,183,705 758,936 518,299
---------- ---------- ----------
Income before income taxes and minority interest ................................ 113,624 55,451 37,746
Income tax benefit .............................................................. 16,434 16,679 11,105
---------- ---------- ----------
Income before minority interest ................................................. 130,058 72,130 48,851
Minority interest ............................................................... 139 (531) (62)
---------- ---------- ----------
Income from continuing operations before cumulative effect
of change in accounting principle and discontinued
operations .................................................................... 130,197 71,599 48,789
Cumulative effect of change in accounting principle (net of
taxation of $3,415)............................................................ - - (19,537)
Loss from discontinued operations ............................................... - (208) (1,971)
---------- ---------- ----------
Net income ...................................................................... 130,197 71,391 27,281
Dividend declared on non-cumulative perpetual preferred shares .................. (4,758) - -
---------- ---------- ----------
Net income available to ordinary shareholders ................................... $ 125,439 $ 71,391 $ 27,281
========== ========== ==========
Basic earnings per share:
Income from continuing operations before cumulative
effect of change in accounting principle (1) ................................ $ 2.86 $ 2.00 $ 1.59
Cumulative effect of change in accounting principle ........................... - - (0.64)
Discontinued operations ....................................................... - (0.01) (0.06)
---------- ---------- ----------
Net income available to ordinary shareholders.................................. $ 2.86 $ 1.99 $ 0.89
========== ========== ==========
Diluted earnings per share:
Income from continuing operations before cumulative
effect of change in accounting principle (1) ................................ $ 2.64 $ 1.91 $ 1.51
Cumulative effect of change in accounting principle ........................... - - (0.60)
Discontinued operations ....................................................... - (0.01) (0.06)
---------- ---------- ----------
Net income available to ordinary shareholders.................................. $ 2.64 $ 1.90 $ 0.85
========== ========== ==========
Weighted average number of ordinary shares outstanding
Basic ......................................................................... 43,838,261 35,732,522 30,652,719
========== ========== ==========
Diluted ....................................................................... 47,531,116 37,508,292 32,228,001
========== ========== ==========
See Accompanying Notes to Consolidated Financial Statements
(1) Reflects reduction for dividends declared on non-cumulative perpetual
preferred shares
90
SCOTTISH RE GROUP LIMITED
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Expressed in Thousands of United States Dollars)
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2005 2004 2003
--------- --------- ---------
Net income ................................................................ $ 130,197 $ 71,391 $ 27,281
--------- --------- ---------
Other comprehensive income (loss), net of tax:
Unrealized appreciation (depreciation) on investments ................. (30,750) 3,644 10,270
Add: reclassification adjustment for net realized gains
included in net income .............................................. (790) (6,831) (2,352)
--------- --------- ---------
Net unrealized appreciation (depreciation) on
investments, net of income taxes and deferred
acquisition costs of $(32,039), $11,366 and $2,222 .................. (31,540) (3,187) 7,918
Cumulative translation adjustment ..................................... (10,055) 5,757 6,278
Minimum pension liability adjustment, net of income
taxes of $(588) ..................................................... - - 1,371
--------- --------- ---------
Other comprehensive income (loss) ......................................... (41,595) 2,570 15,567
--------- --------- ---------
Comprehensive income ...................................................... $ 88,602 $ 73,961 $ 42,848
========= ========= =========
See Accompanying Notes to Consolidated Financial Statements
91
SCOTTISH RE GROUP LIMITED
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(Expressed in Thousands of United States Dollars, except share data)
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2005 2004 2003
----------- ------------- -------------
Ordinary shares:
Beginning of year ................................................ 39,931,145 35,228,411 26,927,456
Ordinary shares issued ........................................... 7,660,000 3,953,183 9,200,000
Ordinary shares repurchased ...................................... - - (1,525,000)
Exercise of options .............................................. 423,467 749,551 425,955
Exercise of warrants ............................................. 5,377,327 - 200,000
----------- ------------- -------------
End of year ...................................................... 53,391,939 39,931,145 35,228,411
=========== ============= =============
Preferred shares:
Beginning of year ............................................... - - -
Non-cumulative perpetual preferred shares issued ................ 5,000,000 - -
----------- ------------- -------------
End of year ..................................................... 5,000,000 - -
=========== ============= =============
Share capital:
Ordinary shares:
Beginning of year ................................................ $ 399 $ 352 $ 269
Ordinary shares issued ........................................... 77 40 92
Ordinary shares repurchased ...................................... - - (15)
Exercise of options .............................................. 4 7 4
Exercise of warrants ............................................. 54 - 2
----------- ------------- -------------
End of year ...................................................... 534 399 352
----------- ------------- -------------
Preferred shares:
Beginning of year ................................................ - - -
Non-cumulative perpetual preferred shares issued ................. 125,000 - -
----------- ------------- -------------
End of year ...................................................... 125,000 - -
----------- ------------- -------------
Additional paid-in capital:
Beginning of year ................................................ 684,719 548,750 416,712
Conversion of 7% Convertible Junior Subordinated Notes ........... 42,061 - -
Ordinary shares issued, net of issuance costs .................... 174,031 64,824 179,995
Costs of forward sale agreements ................................. (13,893) - -
Ordinary shares repurchased ...................................... - - (29,966)
Exercise of options .............................................. 5,358 8,339 4,575
Option and restricted stock unit expense ......................... 5,377 843 207
Issuance of HyCUs ................................................ - - (24,171)
Costs of issue of non-cumulative perpetual preferred shares ...... (4,563) - -
Warrants issued .................................................. - 62,125 2,998
Warrants repurchased ............................................. - - (1,600)
Other ............................................................ 677 (162) -
----------- ------------- -------------
End of year ...................................................... 893,767 684,719 548,750
----------- ------------- -------------
Accumulated other comprehensive income (loss):
Unrealized appreciation (depreciation) on investments
Beginning of year ............................................ 13,661 16,848 8,930
Change in period (net of income taxes and deferred
acquisition costs) ......................................... (31,540) (3,187) 7,918
----------- ------------- -------------
End of year ................................................. (17,879) 13,661 16,848
----------- ------------- -------------
Cumulative translation adjustment
Beginning of year ............................................ 17,943 12,186 5,908
Change in period (net of tax) ................................ (10,055) 5,757 6,278
----------- ------------- -------------
End of year .................................................. 7,888 17,943 12,186
----------- ------------- -------------
Minimum pension liability
Beginning of year ............................................ - - (1,371)
Change in period (net of tax) ................................ - - 1,371
----------- ------------- -------------
End of year .................................................. - - -
----------- ------------- -------------
Total accumulated other comprehensive income (loss) ................... $ (9,991) $ 31,604 $ 29,034
=========== ============= =============
92
SCOTTISH RE GROUP LIMITED
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (continued)
(Expressed in Thousands of United States Dollars, except share data)
December 31, December 31, December 31,
2005 2004 2003
----------- ------------- -------------
Retained earnings:
Beginning of year .......................................... $ 145,952 $ 81,708 $ 60,644
Net income ................................................. 130,197 71,391 27,281
Dividends declared on non-cumulative perpetual
preferred shares ........................................ (4,758) - -
Dividends declared on ordinary shares ...................... (8,989) (7,147) (6,217)
----------- ------------- -------------
End of year ................................................ 262,402 145,952 81,708
----------- ------------- -------------
Total shareholders' equity .................................... $ 1,271,712 $ 862,674 $ 659,844
=========== ============= =============
See Accompanying Notes to Consolidated Financial Statements
93
SCOTTISH RE GROUP LIMITED
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Expressed in Thousands of United States Dollars)
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2005 2004 2003
----------- ------------- -------------
Operating activities
Income before cumulative effect of change in accounting principle
income ...................................................................... $ 130,197 $ 71,391 $ 46,818
Adjustments to reconcile net income before cumulative effect of change
in accounting principle to net cash provided by operating activities:
Net realized losses (gains) ................................................. (3,738) 8,306 4,448
Changes in value of embedded derivatives, net ............................... 8,492 (4,561) 13,904
Amortization discount on investments......................................... 18,253 11,140 5,619
Amortization of deferred acquisition costs .................................. 68,906 80,235 74,239
Amortization of present value of in-force business .......................... 7,373 7,689 4,926
Changes in assets and liabilities:
Accrued interest receivable ............................................. (12,317) (894) (6,731)
Reinsurance balances and risk fees receivable ........................... (162,358) (136,792) (54,689)
Deferred acquisition costs .............................................. (232,971) (180,908) (167,281)
Deferred tax liability .................................................. (19,246) 68,807 (17,350)
Other assets and liabilities ............................................ (73,723) (24,807) (25,561)
Current income tax receivable and payable ............................... 17,193 (95,631) (1,459)
Reserves for future policy benefits, net of amounts
recoverable from reinsurers........................................... 434,063 211,901 159,242
Interest sensitive contract liabilities, net of funds
withheld at interest ................................................. 168,188 34,550 25,546
Accounts payable and other liabilities .................................. 17,328 (5,443) 11,989
Other ................................................................... 93 (6,131) 14,844
----------- ----------- -----------
Net cash provided by operating activities .................................. 365,733 38,852 88,504
----------- ----------- -----------
Investing activities
Purchase of fixed maturity investments ......................................... (3,008,823) (1,832,494) (1,254,226)
Proceeds from sales of fixed maturity investments .............................. 690,533 595,059 288,611
Proceeds from maturity of fixed maturity investments ........................... 517,775 345,778 216,617
Purchase of preferred stock investments ........................................ (17,028) (26,186) (82,717)
Proceeds from sale of preferred stock investments .............................. 4,174 19,620 18,530
Proceeds from maturity of preferred stock investments .......................... - 6,257 5,137
Cash received on ING acquisition ............................................... - 414,008 -
Acquisition of subsidiary net of cash acquired ................................. - - (140,228)
Purchase of other investments .................................................. (37,737) - (4,984)
Other .......................................................................... (6,843) (1,898) -
----------- ----------- -----------
Net cash used in investing activities ....................................... (1,857,949) (479,856) (953,260)
----------- ----------- -----------
Financing activities
Proceeds from collateral finance facilities .................................... 1,785,681 200,000 -
Deposits to interest sensitive contract liabilities ............................ 312,956 571,843 736,884
Withdrawals from interest sensitive contract liabilities ....................... (255,515) (83,319) (40,783)
Net proceeds from issuance of ordinary shares .................................. 179,466 73,210 187,666
Net proceeds from issuance of non-cumulative perpetual preferred shares ........ 120,436 - -
Costs of variable share forward contracts ...................................... (13,815) - -
Net proceeds from issuance of warrants ......................................... - 62,125 -
Repurchase of ordinary shares .................................................. - - (29,981)
Repurchase of warrants ......................................................... - - (1,600)
Net proceeds from issuance of long-term debt ................................... - 79,500 29,047
Net proceeds from issuance of notes payable to buy Cypress Entities ............ - 41,282 -
Net funds received on issuance of HyCUs ........................................ - - 138,223
Net proceeds from exercise of Class C warrants ................................. 54 - -
Dividends paid on ordinary shares .............................................. (8,989) (7,147) (6,217)
Dividend paid on non-cumulative perpetual preferred shares ..................... (2,492) - -
----------- ----------- -----------
Net cash provided by financing activities ................................... 2,117,782 937,494 1,013,239
----------- ----------- -----------
Net change in cash and cash equivalents ........................................ 625,566 496,490 148,483
Cash and cash equivalents, beginning of year ................................... 794,639 298,149 149,666
----------- ----------- -----------
Cash and cash equivalents, end of year ......................................... $ 1,420,205 $ 794,639 $ 298,149
=========== =========== ===========
Interest paid .................................................................. $ 18,232 $ 16,418 $ 6,195
=========== =========== ===========
Taxes paid (refunded) .......................................................... $ (1,041) $ 28,726 $ 1,156
=========== =========== ===========
See Accompanying Notes to Consolidated Financial Statements
94
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.
96
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".
97
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.
98
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.
99
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.
100
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
101
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
102
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.
103
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.
104
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.
105
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.
106
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
3. Business acquisitions (continued)
Year Ended Year Ended
December 31, December 31,
2004 2003
------------ ------------
Revenue.................................... $ 2,115.7 $ 1,547.5
Net income................................. $ 132.0 $ 73.3
Earnings per ordinary share - Basic........ $ 3.08 $ 1.81
Earnings per ordinary share - Diluted...... $ 2.96 $ 1.75
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,
2003
------------
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.
107
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
3. Business acquisitions (continued)
Year Ended
December 31,
2003
----------
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:
December 31, 2005
---------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Estimated
Cost or Cost Appreciation Depreciation Fair Value
---------- ----------- ----------- -----------
U.S. Treasury securities and U.S. government agency $ 48,519 $ 244 $ (846) $ 47,917
obligations.....................................
Corporate securities................................. 2,205,052 16,548 (30,821) 2,190,779
Municipal bonds...................................... 37,826 211 (398) 37,639
Mortgage and asset backed securities................. 3,169,362 7,828 (27,126) 3,150,064
---------- ----------- ----------- -----------
Total................................................ $5,460,759 $ 24,831 $ (59,191) $ 5,426,399
========== =========== =========== ===========
108
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2003
5. Investments (continued)
December 31, 2004
---------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Estimated
Cost or Cost Appreciation Depreciation Fair Value
---------- ----------- ----------- -----------
U.S. Treasury securities and U.S. government agency
obligations .......................................... $ 89,418 $ 200 $ (139) $ 89,479
Corporate securities ...................................... 1,719,502 27,542 (3,474) 1,743,570
Municipal bonds ........................................... 20,712 261 (158) 20,815
Mortgage and asset backed securities ...................... 1,657,926 14,154 (8,277) 1,663,803
---------- ---------- ---------- ----------
Total ..................................................... $3,487,558 $ 42,157 $ (12,048) $3,517,667
========== ========== ========== ==========
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.
109
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
5. Investments (continued)
December 31, 2005
------------------------------------------------------------------------------------------
Equal to or greater than
Less than 12 months 12 months Total
-------------------------- -------------------------- ------------------------
Estimated Unrealized Estimated Unrealized Estimated Unrealized
fair value loss fair value loss fair value loss
---------- ---------- ---------- ---------- ---------- ----------
Investment Grade
Securities:
CMO .............................. $ 467,314 $ (4,865) $ 85,305 $ (1,688) $ 552,619 $ (6,553)
Corporates ....................... 1,132,840 (23,950) 94,218 (2,545) 1,227,058 (26,495)
Governments ...................... 36,297 (774) 1,999 (71) 38,296 (845)
MBS .............................. 143,956 (3,383) 42,682 (1,611) 186,638 (4,994)
Municipal ........................ 17,738 (330) 1,621 (68) 19,359 (398)
Other structured securities ...... 1,028,657 (11,882) 135,341 (3,113) 1,163,998 (14,995)
Preferred stocks ................. 98,263 (2,287) 24,106 (1,295) 122,369 (3,582)
---------- ---------- ---------- ---------- ---------- ----------
Total investment grade
securities ....................... 2,925,065 (47,471) 385,272 (10,391) 3,310,337 (57,862)
---------- ---------- ---------- ---------- ---------- ----------
Below investment grade securities:
Corporates ....................... 10,676 (655) 1,841 (59) 12,517 (714)
Other structured securities ...... 3,552 (555) 7,260 (29) 10,812 (584)
Preferred stock .................. 392 (12) 340 (19) 732 (31)
Total below investment grade ---------- ---------- ---------- ---------- ---------- ----------
securities ....................... 14,620 (1,222) 9,441 (107) 24,061 (1,329)
---------- ---------- ---------- ---------- ---------- ----------
Total ............................ $2,939,685 $ (48,693) $ 394,713 $ (10,498) $3,334,398 $ (59,191)
========== ========== ========== ========== ========== ==========
110
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
5. Investments (continued)
December 31, 2004
---------------------------------------------------------------------------------------------
Equal to or greater than
Less than 12 months 12 months Total
-------------------------- -------------------------- ---------------------------
Estimated Unrealized Estimated Unrealized Estimated Unrealized
fair value loss fair value loss fair value loss
---------- ---------- ---------- ---------- ---------- -----------
Investment Grade Securities:
CMO ........................ $ 225,068 $ (1,830) $ 4,100 $ (96) $ 229,168 $ (1,926)
Corporates ................. 241,030 (2,139) 49,445 (660) 290,475 (2,799)
Governments ................ 51,123 (139) - - 51,123 (139)
MBS ........................ 49,085 (627) 9,585 (199) 58,670 (826)
Municipal .................. 12,130 (158) - - 12,130 (158)
Other structured
securities ............... 311,733 (2,375) 17,227 (1,125) 328,960 (3,500)
Preferred stocks ........... 35,152 (628) 257 (12) 35,409 (640)
---------- ---------- ---------- ---------- ---------- ----------
Total investment grade .... 925,321 (7,896) 80,614 (2,092) 1,005,935 (9,988)
---------- ---------- ---------- ---------- ---------- ----------
Below investment grade
securities:
Corporates ................. 1,966 (35) - - 1,966 (35)
Other structured
securities ............... 7,988 (977) 2,492 (1,047) 10,480 (2,024)
Preferred stock ............ 54 (1) - - 54 (1)
Total below investment ---------- ---------- ---------- ---------- ---------- ----------
grade securities ......... 10,008 (1,013) 2,492 (1,047) 12,500 (2,060)
---------- ---------- ---------- ---------- ---------- ----------
Total ...................... $ 935,329 $ (8,909) $ 83,106 $ (3,139) $1,018,435 $ (12,048)
========== ========== ========== ========== ========== ==========
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:
111
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
5. Investments (continued)
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2005 2004 2003
-------- -------- --------
Gross realized gains (losses)
Fixed maturities:
Gross realized gains ..................................... $ 8,867 $ 10,169 $ 7,830
Gross realized losses .................................... (6,561) (3,140) (3,409)
Other than temporary impairments ......................... (2,437) (9,870) (6,259)
-------- -------- --------
(131) (2,841) (1,838)
Preferred stock:
Gross realized gains ..................................... 23 82 (34)
Gross realized losses .................................... (238) (3,151) (92)
-------- -------- --------
(215) (3,069) (126)
Other investments ........................................ - (636) (802)
Foreign currency gains ................................... 402 1,690 1,270
Change in fair value interest rate swaps ................. 2,228 (2,232) -
Change in fair value on derivatives ...................... 1,454 (1,216) (2,952)
-------- -------- --------
Net realized gains (losses) .......................... 3,738 (8,304) (4,448)
-------- -------- --------
Change in net unrealized appreciation (depreciation) on
investments
Fixed maturities ......................................... (60,426) 8,623 9,152
Preferred stock .......................................... (4,041) (414) 988
Other investments ........................................ 888 - -
Change in deferred acquisition costs ..................... 13,127 (8,653) -
Change in deferred income taxes .......................... 18,912 (2,743) (2,222)
-------- -------- --------
Change in net unrealized appreciation (depreciation) on
investments .............................................. (31,540) (3,187) 7,918
-------- -------- --------
Total net realized gains (losses) and change in net
unrealized appreciation (depreciation) on investments..... $(27,802) $(11,491) $ 3,470
======== ======== ========
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:
112
SCOTTISH RE GROUP LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
5. Investments (continued)
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2005 2004 2003
--------- --------- ---------
Fixed maturities available for sale.. $ 225,216 $ 113,763 $ 68,579
Preferred stock ..................... 8,107 6,245 3,018
Funds withheld at interest .......... 110,523 96,637 76,654
Other investments ................... 21,259 4,176 1,286
Investment expenses ................. (9,268) (3,683) (1,509)
--------- --------- ---------
Net investment income ............... $ 355,837 $ 217,138 $ 148,028
========= ========= =========
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:
Year Ended Year Ended
December 31, 2005 December 31, 2004
----------------- -----------------
Deposits with U.S. regulatory authorities................ $ 7,615 $ 5,297
Trust funds.............................................. 5,941,669 3,303,463
---------- ----------
$ 5,949,284 $ 3,308,760
========== ==========
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
113
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:
December 31, 2005
-----------------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Estimated
Cost Appreciation Depreciation Fair Value
----------- ----------- ----------- -----------
U.S. Treasury securities and U.S. government
agency obligations ........................ $ 62,564 $ 64 $ (375) $ 62,253
Corporate securities ........................ 1,599,376 48,805 (13,749) 1,634,432
Municipal bonds.............................. 33,333 206 (581) 32,958
Mortgage and asset backed securities ........ 597,437 8,213 (10,540) 595,110
----------- ----------- ----------- -----------
2,292,710 57,288 (25,245) 2,324,753
Commercial mortgage loans ................... 106,954 6,047 (444) 112,557
----------- ----------- ----------- -----------
Total ....................................... $ 2,399,664 $ 63,335 $ (25,689) $ 2,437,310
=========== =========== =========== ===========
December 31, 2004
-----------------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Estimated
Cost Appreciation Depreciation Fair Value
----------- ----------- ----------- -----------
U.S. Treasury securities and U.S. government
agency obligations......................... $ 39,423 $ 458 $ (143) $ 39,738
Corporate securities......................... 1,027,809 70,336 (1,896) 1,096,249
Municipal bonds.............................. 24,728 738 (228) 25,238
Mortgage and asset backed securities ........ 303,833 11,969 (1,088) 314,714
----------- ----------- ----------- -----------
1,395,793 83,501 (3,355) 1,475,939
Commercial mortgage loans.................... 121,468 9,212 (832) 129,848
----------- ----------- ----------- -----------
Total ....................................... $ 1,517,261 $ 92,713 $ (4,187) $ 1,605,787
=========== =========== =========== ===========
114
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):
December 31, 2005
--------------------------------
Amortized Estimated Fair
Cost Value
---------- ----------
Due in one year or less ............................ $ 37,881 $ 38,100
Due in one year through five years ................. 503,014 509,119
Due in five years through ten years ................ 842,379 861,911
Due after ten years ................................ 311,999 320,513
---------- ----------
1,695,273 1,729,643
Mortgage and asset backed securities ............... 597,437 595,110
Commercial mortgage loans .......................... 106,954 112,557
---------- ----------
Total .............................................. $2,399,664 $2,437,310
========== ==========
115
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:
December 31, December 31, December 31,
2005 2004 2003
-------- -------- --------
Balance at beginning of year .................................. $ 62,164 $ 44,985 $ 18,181
Acquisition of Scottish Re Life Corporation ................... - 24,766 31,506
Amortization .................................................. (7,373) (7,689) (4,926)
Other ......................................................... (48) 102 224
-------- -------- --------
Balance at end of year ........................................ $ 54,743 $ 62,164 $ 44,985
======== ======== ========
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
116
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
117
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.
118
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:
December 31, December 31,
2005 2004
-------- --------
4.5% senior convertible notes due 2022 ........ $115,000 $115,000
Capital securities due 2032 ................... 17,500 17,500
Preferred trust securities due 2033 ........... 20,000 20,000
Trust preferred securities due 2033 ........... 10,000 10,000
Trust preferred securities due 2034 ........... 32,000 32,000
Trust preferred securities due 2034 ........... 50,000 50,000
-------- --------
$244,500 $244,500
======== ========
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.
119
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
120
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
121
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.
122
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
123
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
124
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.
125
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.
126
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.
127
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
128
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:
December 31, 2005 December 31, 2004
----------------- -----------------
Deferred tax asset:
Net operating losses ......................... $ 209,520 $ 46,268
Reserves for future policy benefits .......... 60,226 29,029
Unrealized depreciation on investments ....... 12,212 793
Intangible assets ............................ 8,234 8,933
Negative proxy deferred acquisition costs .... 10,196 14,025
Alternative minimum tax credit ............... 2,442 2,318
Other ........................................ 11,667 6,783
-------- --------
Total deferred tax asset ........................ 314,497 108,149
-------- --------
Deferred tax liability:
Unrealized appreciation on investments ....... - (7,478)
Undistributed earnings of U.K. subsidiaries . (3,155) (4,959)
Deferred acquisition costs ................... (52,503) (9,415)
Pension liability ............................ (1,134) (1,068)
Reserves for future policy benefits .......... (166,255) (24,433)
Present value of in-force .................... (13,884) (18,153)
Other ........................................ (3,662) (5,465)
-------- --------
Total deferred tax liability .................... (240,593) (70,971)
-------- --------
Net deferred tax asset before valuation
allowance..................................... 73,904 37,178
Valuation allowance ............................. (18,451) (22,148)
-------- --------
Net deferred tax asset .......................... $ 55,453 $ 15,030
======== ========
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
129
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:
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2005 2004 2003
============ ============= ============
Expected tax provision at weighted average rate ........ $(20,290) $(18,313) $ (8,287)
Negative deferred acquisition costs .................... - (934) (1,427)
Other and state taxes .................................. 3,856 2,568 (1,391)
------------ ------------- ------------
Total tax benefit ...................................... $(16,434) $(16,679) $(11,105)
============ ============= ============
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,
130
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.
131
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:
Year Ended Year Ended Year Ended
December 31, 2005 December 31, 2004 December 31, 2003
------------------- ------------------- -------------------
Outstanding, beginning of year............ 2,491,236 3,086,651 3,398,103
Granted................................... 631,001 253,000 180,000
Exercised................................. (422,867) (749,551) (425,955)
Cancelled................................. (113,133) (98,864) (65,497)
------------------- ------------------- -------------------
Outstanding, end of year.................. 2,586,237 2,491,236 3,086,651
=================== =================== ===================
Options exercisable....................... 1,589,703 1,798,936 2,232,170
=================== =================== ===================
Weighted average exercise price per share:
Granted................................... $ 25.5068 $ 23.5164 $ 18.2515
Exercised................................. $ 12.6811 $ 11.1209 $ 10.7494
Cancelled................................. $ 21.6711 $ 17.9752 $ 18.2339
Outstanding, end of year.................. $ 17.5411 $ 14.8860 $ 13.3634
Options exercisable....................... $ 14.0025 $ 12.9632 $ 11.7862
Summary of options outstanding at December 31, 2005:
Options Options
Outstanding Exercisable
------------------------------------------ -----------------------------------------
Weighted Weighted
Weighted Average Weighted Average
Number of Average Remaining Number of Average Remaining
Year of Range of Shares Exercise Contractual Shares Exercise Contractual
Grant Exercise Prices Outstanding Price Life Exercisable Price Life
- --------- ------------------- ------------- ---------- ------------ ----------- ---------- ------------
1998 $15.0000 353,336 $15.0000 2.92 353,336 $15.0000 2.92
1999 $8.0625-$15.0000 172,100 $11.8183 2.33 172,100 $11.8183 2.33
2000 $7.7500-$ 9.0000 385,000 $8.1792 4.25 385,000 $8.1792 4.25
2001 $7.0000-$18.7600 277,500 $14.6419 4.47 277,500 $14.6419 4.47
2002 $15.5000-$21.5100 490,300 $17.9820 6.18 295,500 $18.0973 6.17
2003 $17.4700-$17.7500 94,000 $17.6830 6.81 22,000 $17.6164 6.45
2004 $21.7000-$23.8700 198,000 $23.4199 8.35 74,267 $23.2059 8.40
2005 $22.5000-$26.1030 616,001 $25.4923 9.30 10,000 $25.5000 9.01
------------------- ------------- ---------- ------------ ----------- ---------- ------------
$7.0000-$26.1030 2,586,237 $17.5411 5.94 1,589,703 $14.0025 5.94
=================== ============= ========== ============ =========== ========== ============
The fair value for the options was estimated at the date of grant using
the Black-Scholes option-pricing model with the following assumptions:
2005 2004 2003
------------- -------------- ---------------
Expected dividend yield........................................ 0.77% 0.77% - 0.82% 1.00% - 0.82%
Risk free interest rate........................................ 3.43% - 4.59% 1.06% - 4.77% 1.06% - 4.44%
Expected life of options....................................... 7 years 7 years 7 years
Expected volatility............................................ 0.4 0.4 0.4
132
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:
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2005 2004 2003
------------- -------------- ---------------
Weighted average exercise price for all options $ 17.5411 $ 14.8860 $ 13.3634
Discounted exercise price...................................... $ - $ - $ -
Market price exercise price.................................... $ 11.7960 $ 7.6581 $ 6.8170
Premium exercise price......................................... $ 25.9541 $ 23.8700 $ -
The weighted average fair value of restricted share units granted in
each year is as follows:
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2005 2004 2003
------------- -------------- ---------------
Restricted share units (number of shares)...................... 589,000 95,700 -
Weighted average market price at time of grant................. $ 24.2270 $ 21.7572 $ -
Option plans approved by shareholders are as follows:
Option Plans Option Plans not
Approved by Approved by Total Option
Shareholders Shareholders Plans
------------- ---------------- ------------
Outstanding.................................................. 2,088,737 497,500 2,586,237
Weighted average exercise price.............................. $18.1977 $14.7841 $17.5411
Available for future issuance................................ 440,029 59,225 499,254
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.
133
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:
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2005 2004 2003
------------- -------------- ---------------
Net income available to ordinary shareholders as reported............ $ 125,439 $ 71,391 $ 27,281
Stock-based employee compensation cost, net of related tax effects,
included in the determination of net income as reported........... 5,377 843 207
Stock-based employee compensation cost, net of related tax effects,
that would have been included in the determination of net income
if the fair value based method had been applied to all awards..... (6,010) (1,448) (2,384)
------------- -------------- ---------------
Net income available to ordinary shareholders - pro forma............ $ 124,806 $ 70,786 $ 25,104
============= ============== ===============
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2005 2004 2003
------------- -------------- ---------------
Basic net income per share - as reported............................. $ 2.86 $ 1.99 $ 0.89
Basic net income per share - pro forma............................... $ 2.85 $ 1.98 $ 0.82
Diluted net income per share - as reported........................... $ 2.64 $ 1.90 $ 0.85
Diluted net income per share - pro forma............................. $ 2.63 $ 1.89 $ 0.78
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
134
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:
Statutory capital & Statutory net
surplus earned income (loss)
-------------------------------- ---------------------------------------
2005 2004 2005 2004 2003
------------ -------------- ----------- ----------- ------------
Scottish Re (U.S.), Inc. ........... $ 229,839 $ 227,864 $ (207,001) $ (25,573) $ (110,163)
Scottish Re Life Corporation ....... 74,332 68,587 8,757 (68,517) -
Scottish Re Limited ................ 67,600 78,700 (15,747) $(6,597) 407
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:
Year ended Year ended Year ended
December 31, 2005 December 31, 2004 December 31, 2003
------------------- ------------------- -------------------
Premiums assumed......................... $ 2,155,279 $ 827,082 $ 426,106
Premiums ceded............................ (221,349) (237,637) (35,452)
------------------- ------------------- -------------------
Premiums earned........................... $ 1,933,930 $ 589,445 $ 390,654
=================== =================== ===================
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.
135
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:
Year Ended December 31, 2005
--------------------------------------------------------------
Life
Reinsurance Life
North Reinsurance Corporate
America International and Other Total
------------- --------------- ------------- ------------
Premiums earned, net..................... $ 1,814,875 $ 119,055 $ - $1,933,930
Investment income, net................... 341,539 11,488 2,810 355,837
Fee income............................... 9,233 - 3,083 12,316
Realized gains .......................... 1,121 1,263 1,354 3,738
Change in value of embedded derivative,
net................................... (8,492) - - (8,492)
------------- --------------- ------------- ------------
Total revenues........................ 2,158,276 131,806 7,247 2,297,329
------------- --------------- ------------- ------------
Claims and other policy benefits......... 1,365,599 76,906 - 1,442,505
Interest credited to interest sensitive
contract liabilities.................. 132,968 - - 132,968
Acquisition costs and other insurance
expenses, net......................... 400,992 20,722 2,061 423,775
Operating expenses....................... 48,849 25,276 41,448 115,573
Collateral finance facilities expense 43,113 - 5,033 48,146
Interest expense......................... 10,823 - 9,915 20,738
------------- --------------- ------------- ------------
Total benefits and expenses........... 2,002,344 122,904 58,457 2,183,705
------------- --------------- ------------- ------------
Income (loss) before income taxes and
minority interest..................... $ 155,932 $ 8,902 $ (51,210) $ 113,624
============= =============== ============= ============
136
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
17. Business segments (continued)
Year Ended December 31, 2004
--------------------------------------------------------------
Life
Reinsurance Life
North Reinsurance Corporate
America International and Other Total
------------- --------------- ------------- ------------
Premiums earned, net..................... $ 466,927 $ 122,518 $ - $ 589,445
Investment income, net................... 206,009 10,023 1,106 217,138
Fee income............................... 7,867 - 3,680 11,547
Realized gains (losses) ................. (7,974) 1,685 (2,015) (8,304)
Change in value of embedded derivative,
net................................... 4,561 - - 4,561
------------- ------------- ------------- ------------
Total revenues........................ 677,390 134,226 2,771 814,387
------------- ------------- ------------- ------------
Claims and other policy benefits......... 344,319 81,646 - 425,965
Interest credited to interest sensitive
contract liabilities.................. 106,525 - - 106,525
Acquisition costs and other insurance
expenses, net......................... 131,658 17,634 2,113 151,405
Operating expenses....................... 18,408 18,798 17,452 54,658
Collateral finance facilities expense 2,724 - - 2,724
Interest expense......................... 4,605 - 8,411 13,016
Due diligence costs...................... - - 4,643 4,643
------------- ------------- ------------- ------------
Total benefits and expenses........... 608,239 118,078 32,619 758,936
------------- ------------- ------------- ------------
Income (loss) before income taxes and
minority interest..................... $ 69,151 $ 16,148 $ (29,848) $ 55,451
============= ============= ============= ============
137
SCOTTISH RE GROUP LIMITED
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
December 31, 2005
17. Business segments (continued)
Year Ended December 31, 2003
--------------------------------------------------------------
Life
Reinsurance Life
North Reinsurance Corporate
America International and Other Total
-------------- --------------- ------------- ------------
Premiums earned, net..................... $ 229,796 $ 160,858 $ - $ 390,654
Investment income, net................... 135,731 7,537 4,760 148,028
Fee income............................... 4,067 - 3,840 7,907
Realized gains (losses).................. (6,124) 548 1,128 (4,448)
Change in value of embedded
derivative, net....................... 13,904 - - 13,904
-------------- --------------- ------------- ------------
Total revenues........................ 377,374 168,943 9,728 556,045
-------------- --------------- ------------- ------------
Claims and other policy benefits......... 171,711 104,176 - 275,887
Interest credited to interest sensitive
contract liabilities.................. 89,156 - - 89,156
Acquisition costs and other insurance
expenses, net......................... 82,682 29,733 2,263 114,678
Operating expenses....................... 8,646 11,518 10,857 31,021
Interest expense......................... 1,109 - 6,448 7,557
-------------- --------------- ------------- ------------
Total benefits and expenses........... 353,304 145,427 19,568 518,299
-------------- --------------- ------------- ------------
Income (loss) before income taxes and
minority interest..................... $ 24,070 $ 23,516 $ (9,840) $ 37,746
============== =============== ============= ============
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.
Assets December 31, 2005 December 31, 2004
------------------ -------------------
Life Reinsurance:
North America.......................... $ 10,472,863 $ 7,560,937
International.......................... 460,888 396,219
------------------ -------------------
Total Life Reinsurance.......................... 10,933,751 7,957,156
Corporate and Other............................. 1,072,369 995,081
------------------ -------------------
Total........................................... $ 12,006,120 $ 8,952,237
================== ===================
138
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:
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2005 2004 2003
------------- -------------- ---------------
Numerator:
Net income.................................. $ 130,197 $ 71,391 $ 27,281
Dividend declared on non-cumulative
perpetual preferred shares............... (4,758) - -
------------- -------------- ---------------
Net income available to ordinary
shareholders............................. $ 125,439 $ 71,391 $ 27,281
============= ============== ===============
Denominator:
Denominatorfor basic earnings per ordinary
share
Weighted average number of ordinary shares.. 43,838,261 35,732,522 30,652,719
Effect of dilutive securities
- Stock options and restricted stock..... 661,693 634,562 885,552
- Warrants............................... 2,237,663 885,363 689,730
- 4.5% Convertible Notes and Hybrid
Capital Units........................ 793,499 255,845 -
------------- -------------- ---------------
Denominator for dilutive earnings per
ordinary share........................... 47,531,116 37,508,292 32,228,001
============= ============== ===============
Basic earnings per ordinary share:
Income from continuing operations (1)....... $ 2.86 $ 2.00 $ 1.59
Cumulative effect of change in accounting
principle................................. - - (0.64)
Discontinued operations..................... - (0.01) (0.06)
------------- -------------- ---------------
Net income available to ordinary
shareholders............................. $ 2.86 $ 1.99 $ 0.89
============= ============== ===============
Diluted earnings per ordinary share:
Income from continuing operations (1)....... $ 2.64 $ 1.91 $ 1.51
Cumulative effect of change in accounting
principle................................. - - (0.60)
Discontinued operations..................... - (0.01) (0.06)
------------- -------------- ---------------
Net income available to ordinary
shareholders............................. $ 2.64 $ 1.90 $ 0.85
============= ============== ===============
(1) Reflects reduction for dividends declared on non-cumulative perpetual
preferred shares.
139
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
=======
140
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
141
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.
142
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:
Quarter Ended
--------------------------------------------------------------
December 31 September 30 June 30 March 31
--------------- -------------- ---------- -----------
Total revenue.......................................... $ 674,980 $ 563,741 $ 502,046 $ 556,562
Income (loss) from continuing operations before income
taxes and minority interest........................ 59,153 27,846 (6,798) 33,423
Net income............................................. 60,776 34,410 1,591 33,420
Dividend declared on non-cumulative perpetual preferred
shares............................................. (2,266) (2,492) - -
----------- ----------- ----------- ----------
Net income available to ordinary shareholders.......... $ 58,510 $ 31,918 $ 1,591 $ 33,420
Basic earnings per ordinary share...................... $ 1.26 $ 0.70 $ 0.04 $ 0.84
Diluted earnings per ordinary share.................... $ 1.18 $ 0.66 $ 0.03 $ 0.74
Quarterly financial data for the year ended December 31, 2004 is as
follows:
Quarter Ended
--------------------------------------------------------------
December 31 September 30 June 30 March 31
--------------- -------------- ---------- ---------
Total revenue.......................................... $ 211,113 $ 195,421 $ 228,421 $ 179,432
Income from continuing operations before income taxes and 10,968 6,194 26,970 11,319
minority interest..................................
Income from continuing operations...................... 21,254 11,578 28,671 10,096
Net income............................................. 21,046 11,578 28,671 10,096
Basic earnings per ordinary share...................... $ 0.58 $ 0.32 $ 0.80 $ 0.29
Diluted earnings per ordinary share.................... $ 0.56 $ 0.31 $ 0.77 $ 0.27
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
143
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.
144
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.
145
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)
Year Ended
December 31, 2005 Amount at
---------------------------- which shown
Amortized Market in the
Cost Value Balance Sheet
------------- ------------- -------------
Type of investment:
Fixed maturities
U.S. Treasury securities and U.S. government agency
obligations.......................................... $ 48,519 $ 47,918 $ 47,918
Corporate securities .................................. 2,067,781 2,056,974 2,056,974
Municipal bonds........................................ 37,826 37,639 37,639
Mortgage or asset backed securities ................... 3,169,362 3,150,064 3,150,064
------------- ------------- ------------
Total fixed maturities................................. 5,323,488 5,292,595 5,292,595
------------- ------------- ------------
Preferred stock........................................ 137,271 133,804 133,804
Cash and cash equivalents.............................. 1,420,205 1,420,205 1,420,205
Other investments...................................... 54,619 54,619 54,619
Funds withheld at interest............................. 2,399,664 2,437,310 2,597,416
------------- ------------- ------------
Total investments, cash and cash equivalents........... $ 9,335,247 $ 9,338,533 $ 9,498,639
============= ============= ============
146
SCOTTISH RE GROUP LIMITED
SCHEDULE II - CONDENSED FINANCIAL INFORMATION
(Expressed in Thousands of United States Dollars)
UNCONSOLIDATED CONDENSED BALANCE SHEETS
December 31, December 31,
Assets 2005 2004
--------------- --------------
Investment in subsidiaries on equity basis................................. $ 1,534,544 $ 1,144,035
Cash and cash equivalents.................................................. 52,859 2,358
Other assets............................................................... 14,155 35,882
--------------- --------------
Total assets............................................................... $ 1,601,558 $ 1,182,275
=============== ==============
Liabilities
Accounts payable and other liabilities..................................... $ 71,789 $ 20,870
7.00% Convertible Junior Subordinated Notes................................ - 41,282
Long term debt............................................................. 115,000 115,000
Mezzanine equity........................................................... 143,057 142,449
Total shareholders' equity................................................. 1,271,712 862,674
--------------- --------------
Total liabilities, minority interest, mezzanine equity and shareholders'
equity.................................................................... $ 1,601,558 $ 1,182,275
=============== ==============
UNCONSOLIDATED CONDENSED STATEMENTS OF INCOME
Year Ended Year Ended Year Ended
December 31, 2005 December 31, 2004 December 31, 2003
----------------- ----------------- -----------------
Revenues.................................................
Investment income, net................................... $ 12,562 $ 4,453 $ 3,160
Net realized gains (losses).............................. (16) 58 (22)
Other income (loss), net of operating expenses .......... (1,155) 5,356 22,519
Interest expense......................................... (9,728) (8,198) (6,074)
Income tax expense....................................... (9) (119) -
----------------- ----------------- -----------------
Income before undistributed earnings of subsidiaries..... 1,654 1,550 19,583
Equity in earnings of subsidiaries.......................
128,543 69,841 7,698
----------------- ----------------- -----------------
Net income............................................... $ 130,197 $ 71,391 $ 27,281
================= ================= =================
UNCONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
Year Ended Year Ended Year Ended
December 31, 2005 December 31, 2004 December 31, 2003
----------------- ----------------- -----------------
Operating activities
Net income................................................ $ 130,197 $ 71,391 $ 27,281
Equity in earnings of subsidiaries........................ (128,543) (69,841) (7,698)
Other .................................................... 77,748 (10,622) 10,872
----------------- ----------------- -----------------
Net cash provided by (used in) operating activities.. 79,402 (9,072) 30,455
----------------- ----------------- -----------------
Investing activities
Proceeds from sales of fixed maturity investments......... - 1,546 4642
Capital contributions to subsidiaries..................... (303,559) (170,624) (313,833)
----------------- ----------------- -----------------
Net cash used in investing activities................ (303,559) (169,078) (309,191)
----------------- ----------------- -----------------
Financing activities
Net proceeds from issuance of ordinary shares and warrants 165,704 135,335 187,666
Repurchase of ordinary shares and warrants................ - - (31,581)
Net proceeds from issuance of perpetual preferred shares.. 120,436 - -
Net proceeds from issuance of notes payable to buy Cypress
Entities............................................. - 41,282 -
Net funds received on issuance of HyCUs................... - - 138,223
Dividends paid on non-cumulative perpetual preferred shares (2,492) - -
Dividends paid on ordinary shares......................... (8,989) (7,147) (6,217)
----------------- ----------------- -----------------
Net cash provided by financing activities........... 274,659 169,470 288,091
----------------- ----------------- -----------------
147
SCOTTISH RE GROUP LIMITED
SCHEDULE II - CONDENSED FINANCIAL INFORMATION (CONTINUED)
(Expressed in Thousands of United States Dollars)
Net change in cash and cash equivalents................... 50,502 (8,680) 9,355
Cash and cash equivalents, beginning of year.............. 2,358 11,038 1,683
----------------- ----------------- -----------------
Cash and cash equivalents, end of year.................... $ 52,860 $ 2,358 $ 11,038
================= ================= =================
148
SCOTTISH RE GROUP LIMITED
SCHEDULE III - SUPPLEMENTARY INSURANCE INFORMATION
(Expressed in Thousands of United States Dollars)
Year Ended December 31, 2005
--------------------------------------------------------------------------------------------------------
Benefits,
Future policy claims, Amortization
Deferred benefits, and Interest Net losses and of deferred Other
acquisition sensitive contract Premium investment settlement acquisition operating
Segment costs liabilities revenue (1) income expenses* costs costs
------------ ------------------ ------------ ------------ ------------ ------------- ----------
Life Reinsurance North
America................. $ 575,124 $ 7,168,143 $ 1,814,875 $ 341,539 $ 1,498,567 $ 50,847 $ 452,930
Life Reinsurance
International.......... 8,147 216,652 119,055 11,488 76,906 17,232 28,766
Corporate and Other....... 11,312 - - 2,810 - 827 57,630
------------ -------------- ------------ ---------- ------------ ----------- ----------
Total..................... $ 594,583 $ 7,384,795 $ 1,933,930 $ 355,837 $ 1,575,473 $ 68,906 $ 539,326
============ ============== ============ ========== ============ =========== ==========
Year Ended December 31, 2004
--------------------------------------------------------------------------------------------------------
Benefits,
Future policy claims, Amortization
Deferred benefits and Interest Net losses and of deferred Other
acquisition sensitive contract Premium investment settlement acquisition operating
Segment costs liabilities revenue (1) income expenses* costs costs
------------ ------------------ ------------ ------------ ------------ ------------- ----------
Life Reinsurance North
America............... $ 399,056 $ 6,260,282 $ 466,927 $ 206,009 $ 450,844 $ 66,864 $ 90,531
Life Reinsurance
International......... 6,077 222,880 122,518 10,023 81,646 12,577 23,855
Corporate and Other...... 12,173 - - 1,106 - 794 31,825
--------- --------------- ------------ ---------- ---------- ----------- ----------
Total.................... $ 417,306 $ 6,483,162 $ 589,445 $ 217,138 $ 532,490 $ 80,235 $ 146,211
========= =============== ============ ========== ========== =========== ==========
Year Ended December 31, 2003
----------------------------------------------------------------------------
Benefits,
claims, Amortization
Net losses and of deferred Other
Premium investment settlement acquisition operating
Segment revenue (1) income expenses costs costs
----------- ---------- ----------- ------------- -----------
Life Reinsurance North
America................... $ 229,796 $135,731 $ 260,867 $51,461 $ 40,976
Life Reinsurance
International............. 160,858 7,537 104,176 22,074 19,177
Corporate and Other............ - 4,760 - 704 18,864
----------- ---------- ----------- ------------- -----------
Total.......................... $ 390,654 $148,028 $ 365,043 $74,239 $79,017
=========== ========== =========== ============= ===========
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.
149
SCOTTISH RE GROUP LIMITED
SCHEDULE IV - REINSURANCE
(Expressed in thousands of United States Dollars)
Year Ended December 31, 2005
--------------------------------------------------------------------------------
Percentage
Ceded to Assumed from of amount
other other assumed to
Gross Amount companies companies Net Amount net
-------------- --------------- ----------------- -------------- ------------
Life insurance in force
Premiums............................. $ - $(139,517,423) $1,024,250,510 $884,733,088 116%
Life Reinsurance North America....... - (204,119) 2,018,994 1,814,875 111%
Life Reinsurance International....... - (17,230) 136,285 119,055 114%
Corporate and Other.................. - - - - -
-------------- --------------- ----------------- -------------- ------------
Total................................ $ - $ (221,349) $ 2,155,279 $ 1,933,930 111%
============== =============== ================= ============== ============
Year Ended December 31, 2004
--------------------------------------------------------------------------------
Percentage
Ceded to Assumed from of amount
other other assumed to
Gross Amount companies companies Net Amount net
-------------- --------------- ----------------- -------------- ------------
Life insurance in force*
Premiums............................. $ - $ (84,925,322) $ 306,408,016 $221,482,694 138%
Life Reinsurance North America....... - (226,099) 693,024 466,925 148%
Life Reinsurance International....... - (11,538) 134,058 122,520 109%
Corporate and Other.................. - - - - -
-------------- --------------- ----------------- -------------- ------------
Total................................ $ - $ (237,637) $ 827,082 $ 589,445 140%
============== =============== ================= ============== ============
150
SCOTTISH RE GROUP LIMITED
SCHEDULE IV - REINSURANCE (continued)
(Expressed in thousands of United Staes Dollars)
Year Ended December 31, 2003
--------------------------------------------------------------------------------
Percentage
Ceded to Assumed of amount
other from other assumed to
Gross Amount companies companies Net Amount net
-------------- --------------- ----------------- -------------- ------------
Life insurance in force
Premiums............................. $ - $(93,853,099) $ 271,176,974 $177,323,875 153%
Life Reinsurance North America....... - (25,593) 255,389 229,796 111%
Life Reinsurance International....... - (9,860) 170,717 160,857 106%
Corporate and Other.................. - - - - -
-------------- --------------- ----------------- -------------- ------------
Total................................ $ - $ (35,453) $ 426,106 $ 390,653 109%
============== =============== ================= ============== ============
*Excludes business acquired from ING.
151
SCOTTISH RE GROUP LIMITED
SCHEDULE V - Valuation and Qualifying Accounts
(Expressed in thousands of United States Dollars)
Year Ended December 31, 2005
-----------------------------------------------------------
Balance at Charges to Balance at
Beginning of Costs and Charges to end of
Period Expenses Other Accounts Period
-------------- ------------ ---------------- -------------
Description
Allowance on income taxes.............. $ (22,148) $ - $ 3,697* $ (18,541)
Reserve for uncollectible reinsurance.. $ - $ 6,000 $ - $ (6,000)
Year Ended December 31, 2004
-----------------------------------------------------------
Balance at Charges to Balance at
Beginning of Costs and Charges to end of
Period Expenses Other Accounts Period
-------------- ------------ ---------------- -------------
Description
Allowance on income taxes.............. $ - $ - $ 22,148* $ (22,148)
Year Ended December 31, 2003
-----------------------------------------------------------
Balance at Charges to Balance at
Beginning of Costs and Charges to end of
Period Expenses Other Accounts Period
-------------- ------------ ---------------- -------------
Description
Allowance on income taxes.............. $ - $ - $ - $ -
* 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.
152
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.
Signature Title Date
/s/ Michael C. French
- -----------------------------------------
Michael C. French Chairman and Director March 15, 2006
/s/ Michael Austin
- -----------------------------------------
Michael Austin Director March 15, 2006
/s/ G. William Caulfeild-Browne
- -----------------------------------------
G. William Caulfeild-Browne Director March 15, 2006
/s/ Robert M. Chmely
- -----------------------------------------
Robert M. Chmely Director March 15, 2006
/s/ Jean Claude Damerval
- -----------------------------------------
Jean Claude Damerval Director March 15, 2006
/s/ Lord Norman Lamont
- -----------------------------------------
Lord Norman Lamont Director March 15, 2006
/s/ Hazel O'Leary
- -----------------------------------------
Hazel O'Leary Director March 15, 2006
/s/Glenn Schafer
- -----------------------------------------
Glenn Schafer Director March 15, 2006
/s/ William Spiegel
- -----------------------------------------
William Spiegel Director March 15, 2006
/s/ Scott E. Willkomm
- -----------------------------------------
Scott E. Willkomm CEO, President and Director March 15, 2006
* 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
153