Final Results - Part 2

Catlin Group Limited 09 March 2007 PART 2 Catlin Group Limited Consolidated Balance Sheets As at 31 December 2006 and 2005 (US dollars in thousands, except share amounts) 2006 2005 -------- --------- Assets Investments Fixed maturities, available-for-sale, at fair value (amortised cost 2006: $2,685,960; 2005: $1,761,968) $2,669,437 $1,744,043 Short-term investments, at fair value 27,565 14,666 Investment in funds 326,208 - Investment in associate 2,617 2,794 -------- --------- Total investments 3,025,827 1,761,503 -------- --------- Cash and cash equivalents 1,987,882 609,857 Securities lending collateral 130,854 - Accrued investment income 32,136 17,227 Premiums and other receivables 987,768 565,500 Reinsurance recoverable (net of allowance of 2006: $46,791; 2005: $24,511) 1,237,531 607,446 Deposit with reinsurer 1,321 21,823 Reinsurers' share of unearned premiums 104,731 37,222 Deferred policy acquisition costs 144,063 126,738 Value of in-force business acquired 118,384 - Intangible assets and goodwill (accumulated amortisation 2006: 868,026 63,639 $29,789; 2005: $26,181) Derivatives, at fair value 46,037 - Other assets 121,758 49,028 -------- --------- Total assets $8,806,318 $3,859,983 -------- --------- Liabilities, Minority Interest and Stockholders' Equity Liabilities: Reserves for losses and loss expenses $4,005,133 $1,995,485 Unearned premiums 1,290,379 663,659 Deferred gain - 8,078 Reinsurance payable 192,958 137,313 Accounts payable and other liabilities 363,399 70,186 Notes payable 550,290 50,000 Subordinated debt 99,936 - Derivatives, at fair value 619 - Securities lending payable 130,854 - Deferred taxes 153,721 4,181 -------- --------- Total liabilities $6,787,289 $2,928,902 -------- --------- Minority interest 749 - 2006 2005 -------- -------- Stockholders' equity: Ordinary common shares, par value $0.01 $2,383 $1,559 Authorised 400,000,000; issued and outstanding 2006: 238,283,281; 2005: 155,914,616) Additional paid-in capital 1,610,725 721,935 Treasury stock (6,600) - Accumulated other comprehensive loss (26,090) (21,399) Retained earnings 437,862 228,986 -------- -------- Total stockholders' equity 2,018,280 931,081 -------- -------- Total liabilities, minority interest and stockholders' equity $8,806,318 $3,859,983 -------- -------- Approved by the Board of Directors on 8 March 2007 Stephen Catlin, Director Christopher Stooke, Director Catlin Group Limited Consolidated Statements of Operations For the years ended 31 December 2006 and 2005 (US dollars in thousands, except share amounts) 2006 2005 ---------- ---------- Revenues Gross premiums written $1,605,019 $1,386,600 Reinsurance premiums ceded (194,896) (197,501) ---------- ---------- Net premiums written 1,410,123 1,189,099 Change in net unearned premiums (84,262) 27,343 ---------- ---------- Net premiums earned 1,325,861 1,216,442 ---------- ---------- Net investment income 105,287 82,147 Net realised losses on investments (17,041) (1,520) Change in fair value of derivatives (619) Net realised gains/(losses) on foreign currency exchange 38,746 (13,791) Other income 3,528 741 ---------- ---------- Total revenues 1,455,762 1,284,019 ---------- ---------- Expenses Losses and loss expenses 681,549 865,285 Policy acquisition costs 341,531 305,539 Administrative expenses 130,703 61,865 Other expenses 26,562 23,665 ---------- ---------- Total expenses 1,180,345 1,256,354 ---------- ---------- Income before minority interest and income tax expense 275,417 27,665 Minority interest (22) - Income tax expense (16,606) (8,003) ---------- ---------- Net income $258,789 $19,662 ---------- ---------- Earnings per common share Basic $1.59 $0.13 Diluted $1.47 $0.12 Catlin Group Limited Consolidated Statements of Changes in Stockholders' Equity and Accumulated Other Comprehensive Income For the years ended 31 December 2006 and 2005 (US dollars in thousands, except share amounts) Accumulated Additional other Total Common paid-in Treasury Retained comprehensive stockholders' stock capital stock earnings income (loss) equity ------- -------- -------- -------- --------- --------- Balance 1 January 2005 $1,541 $716,649 - $248,841 $4,156 $971,187 Comprehensive income: Net income - - - 19,662 - 19,662 Other comprehensive loss - - - - (25,555) (25,555) ------- -------- -------- -------- --------- --------- Total comprehensive income/(loss) - - - 19,662 (25,555) (5,893) ------- -------- -------- -------- --------- --------- Stock compensation expense - 4,246 - - - 4,246 Dividends declared - - - (38,950) - (38,950) Deferred compensation obligation - 567 - (567) - - Adjustment to Global Offer expenses ------- -------- -------- -------- --------- --------- - 491 - - - 491 ------- -------- -------- -------- --------- --------- Balance 31 December 2005 $1,559 $721,935 - $228,986 $(21,399) $931,081 ------- -------- -------- -------- --------- --------- Comprehensive income: Net income - - - 258,789 - 258,789 Other comprehensive loss - - - - (4,691) (4,691) ------- -------- -------- -------- --------- --------- Total comprehensive income/(loss) - - - 258,789 (4,691) 254,098 ------- -------- -------- -------- --------- --------- Issuance of common shares in connection with acquisition of Wellington 744 811,683 - - - 812,427 Equity raise 77 64,804 - - - 64,881 Stock compensation expense - 11,000 - - - 11,000 Stock options and warrants exercised 3 (3) - - - - Dividends declared - - - (48,607) - (48,607) Deferred compensation obligation - 1,306 - (1,306) - - Treasury stock purchase - - (6,600) - - (6,600) ------- -------- -------- -------- --------- --------- Balance 31 December 2006 $2,383 $1,610,725 $(6,600) $437,862 $(26,090) $2,018,280 ------- -------- -------- -------- --------- --------- Catlin Group Limited Consolidated Statements of Cash Flows For the years ended 31 December 2006 and 2005 (US dollars in thousands, except share amounts) 2006 2005 --------- --------- Cash flows provided by operating activities Net income $258,789 $19,662 Adjustments to reconcile net income to net cash provided by operations: Amortisation and depreciation 11,379 9,631 Amortisation of premiums/discounts of fixed maturities (6,185) (12,371) Net realised losses on investments 17,040 1,520 Changes in operating assets and liabilities, net of effect of business combination Reserves for losses and loss expenses (258,017) 700,895 Unearned premiums 52,587 7,810 Premiums and other receivables (7,346) (10,087) Deferred policy acquisition costs (1,639) 2,577 Reinsurance payable (175,687) 166,576 Reinsurance recoverable 292,176 (305,930) Reinsurers' share of unearned premiums 4,016 (14,334) Deposit with reinsurer 21,823 36,007 Deferred gain (8,078) (11,470) Accounts payable and other liabilities 60,894 (2,174) Investment in funds (89,925) - Deferred tax - 6,855 Other (50,635) (129,933) --------- --------- Net cash flows provided by operating activities 121,192 465,234 --------- --------- Cash flows provided by/(used in) investing activities Purchases of fixed maturities (2,138,862) (1,817,889) Purchases of short-term investments (97,088) (258,048) Proceeds from sales of fixed maturities 2,104,900 1,445,990 Proceeds from maturities of fixed maturities 17,397 77,864 Proceeds from sales of short-term investments 102,219 429,616 Cash flows arising from investment in associate 1,452 - Purchases of subsidiaries, net of cash acquired 933,042 - Purchase of intangible assets (223,257) (51) Purchases of property and equipment (16,484) (11,174) Proceeds from sales of property and equipment 340 21 Investment of securities lending collateral (130,854) - --------- --------- Net cash flows provided by/(used in) investing activities $552,805 $(133,671) --------- --------- 2006 2005 --------- --------- Cash flows provided by/(used in) financing activities Net proceeds from issue of common shares $65,436 - Dividends paid on common shares (48,751) (38,291) Proceeds from notes payable 500,000 250,000 Repayment of notes payable - (250,000) Securities lending collateral received 130,854 - Purchase of treasury stock (1,352) - --------- --------- Net cash flows provided by/(used in) financing activities 646,187 (38,291) --------- --------- Net increase in cash and cash equivalents 1,320,184 293,272 Cash and cash equivalents - beginning of year 609,857 354,608 Effect of exchange rate changes 57,841 (38,023) --------- --------- Cash and cash equivalents - end of year $1,987,882 $609,857 --------- --------- Supplemental cash flow information Taxes paid $16,135 $223 Interest paid $2,655 $2,113 Cash and cash equivalents comprise the following: Cash at bank and in hand $1,040,079 $480,014 Cash equivalents $947,803 $129,843 --------- --------- The accompanying notes are an integral part of the consolidated financial statements Catlin Group Limited Notes to the Consolidated Financial Statements For the years ended 31 December 2006 and 2005 (US dollars in thousands, except share amounts) 1 Nature of operations Catlin Group Limited ('Catlin' or the 'Company') is a holding company incorporated on 25 June 1999 under the laws of Bermuda. Through intermediate holding companies in the United Kingdom ('UK'), the Company is the sole shareholder of Catlin Underwriting Agencies Limited ('CUAL'), a Lloyd's managing agent, and Catlin Syndicate Limited ('CSL'), a member of Lloyd's Syndicate 2003 and Syndicate 2600. As well as Syndicates 2003 and 2600, CUAL also managed Syndicate 1003, the capital of which was provided by third parties for 2002 and prior years. With effect from the 2003 underwriting year through 31 December 2006, CSL was the sole capital provider to all CUAL-managed syndicates; with effect from the 2007 underwriting year, certain Wellington companies also provide capital to support Syndicate 2003's underwriting. In December 2000, the Company established Catlin Insurance Company Ltd. ('Catlin Bermuda') as a Bermuda licensed insurer. Catlin Bermuda remained dormant until July 2002 when, in conjunction with a private equity capital raise, Catlin Bermuda was capitalised, activated and licensed as a Class 4 insurer under the laws and regulations of Bermuda. In December 2003, Catlin Bermuda received authorisation from the Financial Services Authority ('FSA') to commence underwriting in the UK through its UK Branch operations. In March 2005, Catlin Insurance Company (UK) Limited ('Catlin UK') was authorised by the FSA and in June 2005, all of the business written by the UK Branch of Catlin Bermuda was novated into this new company, Catlin UK, a subsidiary of Catlin Bermuda. In May 2006, the Group, through its wholly owned subsidiary Catlin Inc., acquired 100 per cent of the outstanding common shares of American Indemnity Company. That company, now renamed Catlin Insurance Company Inc. ('Catlin US'), is expected to become a key part of the Company's US operations. On 18 December 2006, the Group declared unconditional its offer to acquire all of the issued and to be issued share capital of Wellington Underwriting plc (' Wellington'). The core of Wellington's business was in the Lloyd's insurance market. Wellington also owned a managing general agent in the United States, Wellington Underwriting Inc. ('WU Inc.') and a US-based specialist insurance company, Wellington Specialty Insurance Company ('WSIC'). This acquisition is described in Note 3. At 31 December 2006, the Company was also the sole shareholder (directly or through intermediate holding companies) of companies in Canada (Toronto and Calgary), Australia (Sydney), Singapore, Malaysia (Kuala Lumpur), Hong Kong, Germany (Cologne), Belgium (Antwerp) and Guernsey. Catlin UK operates regional offices in Glasgow, Leeds, Derby, Birmingham, Watford and Tonbridge. These companies all act as underwriting agents for Catlin underwriting platforms. During early 2007, the Company established (directly or through intermediate holding companies) companies in France (Paris), Spain (Barcelona), Austria ( Innsbruck) and Switzerland (Zurich). Through its subsidiaries, the Company writes a broad range of products, including property, casualty, energy, marine and aerospace insurance products and property, catastrophe and per-risk excess, non-proportional treaty, aviation, marine, casualty and motor reinsurance business. Business is written from many countries, although business from the United States predominates. The Company and its subsidiaries are together referred to as the 'Group'. 2 Significant accounting policies Basis of presentation The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America ('US GAAP'). The preparation of financial statements in conformity with US GAAP requires management to make estimates when recording transactions resulting from business operations based on information currently available. The most significant items on the Group's balance sheet that involve accounting estimates and actuarial determinations are reserves for losses and loss expenses, deferred policy acquisition costs, reinsurance recoverables, valuation of investments, intangible assets and goodwill. The accounting estimates and actuarial determinations are sensitive to market conditions, investment yields, commissions and other policy acquisition costs. As additional information becomes available, or actual amounts are determinable, the recorded estimates will be revised and reflected in operating results. Although some variability is inherent in these estimates and actual results may differ from the estimates used in preparing the consolidated financial statements, management believes the amounts recorded are reasonable. Principles of consolidation The consolidated financial statements include the accounts of the Company and all of its wholly owned subsidiaries. All significant inter-company transactions and balances are eliminated on consolidation. Reporting currency The financial information is reported in US dollars ('US dollars' or '$'). Investment in fixed maturities The Group's investments in fixed maturities are considered to be available-for-sale and are carried at fair value. The fair value is based on the quoted market price of these securities provided by either independent pricing services, or, when such prices are not available, by reference to broker or underwriter bid indications. Net investment income includes interest income together with amortisation of market premiums and discounts and is net of investment management and custody fees. Interest income is recognised when earned. Premiums and discounts are amortised or accreted over the lives of the related fixed maturities as an adjustment to yield using the effective-interest method and is recorded in current period income. 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 recognised prospectively. Realised gains or losses are included in earnings and are derived using the specific-identification method. Net unrealised gains or losses on investments, net of deferred income taxes, are included in accumulated other comprehensive income in stockholders' equity. Other than temporary impairments The Group regularly monitors its investment portfolio to ensure that investments that may be other than temporarily impaired are identified in a timely fashion and properly valued, and that any impairments are charged against earnings in the proper period. The Group's decision to make an impairment provision is based on regular objective reviews of the issuer's current financial position and future prospects, its financial strength rating and an assessment of the probability that the current market value will recover to former levels and requires the judgment of management. In assessing the recovery of market value for debt securities, the Group also takes into account the timing of such recovery by considering whether it has the ability and intent to hold the investment to the earlier of (a) settlement or (b) market price recovery. Any security whose price decrease is deemed other-than-temporary is written down to its then current market level and the cumulative net loss previously recognised in stockholders' equity is removed and charged to earnings. Inherently, there are risks and uncertainties involved in making these judgments. Changes in circumstances and critical assumptions such as a continued weak economy, a more pronounced economic downturn or unforeseen events which affect one or more companies, industry sectors or countries could result in additional writedowns in future periods for impairments that are deemed to be other-than-temporary. Additionally, unforeseen catastrophic events may require us to sell investments prior to the forecast market price recovery. Short-term investments Short-term investments are carried at amortised cost, which approximates fair value, and are composed of securities due to mature between 90 days and one year from the date of purchase. Investment in funds The Group's investment in funds is considered to be trading and is carried at fair value. The fair value is based on the quoted market price of these funds provided by independent pricing services. Realised and unrealised gains and losses are included in earnings and are derived using the specific-identification method. Investment in associate Investment in associate comprises an investment in a limited liability corporation. This investment is accounted for using the equity method. Derivatives In accordance with FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities (FAS 133), the Group recognises derivative financial instruments as either assets or liabilities measured at fair value. Gains and losses resulting from changes in fair value are included in earnings. The fair value of the catastrophe swap agreement described in Note 9 is determined by management using internal models based on the valuation of the underlying notes issued by the counterparty, which are publicly quoted. The fair value model takes into account changes in the market for catastrophe reinsurance contracts with similar economic characteristics and the potential for recoveries from events preceding the valuation date. The fair value of the Aspen share options is estimated using the Black-Scholes valuation model. The fair value of all other derivative financial instruments is obtained from independent valuation sources. Cash and cash equivalents Cash equivalents are carried at cost, which approximates fair value, and include all investments with original maturities of 90 days or less. Securities lending Certain entities within the Group participate in securities lending arrangements whereby specific securities are loaned to other institutions, primarily banks and brokerage firms, for short periods of time. Under the terms of the securities lending agreements, the loaned securities remain under the Group's control and therefore remain on the Group's balance sheet. Collateral in the form of cash, government securities and letters of credit is required and is monitored and maintained by the lending agent. The Group receives interest income on the invested collateral, which is included in net investment income. Premiums Premiums written are primarily earned on a daily pro rata basis over the terms of the policies to which they relate. Accordingly, unearned premiums represent the portion of premiums written which is applicable to the unexpired risk portion of the policies in force. Reinsurance premiums assumed are recorded at the inception of the policy and are estimated based on information provided by ceding companies. The information used in establishing these estimates is reviewed and subsequent adjustments are recorded in the period in which they are determined. These premiums are earned over the terms of the related reinsurance contracts. For multi-year policies written which are payable in annual instalments, due to the ability of the insured or reinsured to commute or cancel coverage within the term of the policy, only the annual premium is included as written premium at policy inception. Annual instalments are included as written premium at each successive anniversary date within the multi-year term. Reinstatement premiums are recognised and fully earned as they fall due. Deferred policy acquisition costs Certain policy acquisition costs, consisting primarily of commissions and premium taxes, that vary with and are primarily related to the production of premium, are deferred and amortised over the period in which the related premiums are earned. A premium deficiency is recognised immediately by a charge to earnings to the extent that future policy premiums, including anticipation of interest income, are not adequate to recover all deferred policy acquisition costs ('DPAC') and related losses and loss expenses. If the premium deficiency is greater than unamortised DPAC, a liability will be accrued for the excess deficiency. Value of in-force business acquired Upon the Group's acquisition of Wellington, an asset representing the present value of future profits associated with unearned premiums was recorded. The value of in-force insurance contracts is amortised over the period in which the related premiums are earned, and is expected to be fully amortised approximately two years from the date of acquisition. Reserves for losses and loss expenses A liability is established for unpaid losses and loss expenses when insured events occur. The liability is based on the expected ultimate cost of settling the claims. The reserve for losses and loss expenses includes: (1) case reserves for known but unpaid claims as at the balance sheet date; (2) incurred but not reported ('IBNR') reserves for claims where the insured event has occurred but has not been reported to the Group as at the balance sheet date; and (3) loss adjustment expense reserves for the expected handling costs of settling the claims. Reserves for losses and loss expenses are established based on amounts reported from insureds or ceding companies and according to generally accepted actuarial principles. Reserves are based on a number of factors, including experience derived from historical claim payments and actuarial assumptions to arrive at loss development factors. Such assumptions and other factors include trends, the incidence of incurred claims, the extent to which all claims have been reported, and internal claims processing charges. The process used in establishing reserves cannot be exact, particularly for liability coverages, since actual claim costs are dependent upon such complex factors as inflation, changes in doctrines of legal liability and damage awards. The methods of making such estimates and establishing the related liabilities are periodically reviewed and updated. Reinsurance In the ordinary course of business, the Company's insurance subsidiaries cede reinsurance to other insurance companies. These arrangements allow for greater diversification of business and minimise the net loss potential arising from large risks. Ceded reinsurance contracts do not relieve the Group of its obligation to its insureds. Reinsurance premiums ceded are recognised and commissions thereon are earned over the period that the reinsurance coverage is provided. Reinstatement premiums are recorded and fully expensed as they fall due. Return premiums due from reinsurers are included in premiums and other receivables. Reinsurers' share of unearned premiums represent the portion of premiums ceded to reinsurers applicable to the unexpired terms of the reinsurance contracts in force. Reinsurance recoverable includes the balances due from reinsurance companies for paid and unpaid losses and loss expenses that will be recovered from reinsurers, based on contracts in force. A reserve for uncollectible reinsurance has been determined based upon a review of the financial condition of the reinsurers and an assessment of other available information. Deferred gain The Group may enter into retroactive reinsurance contracts, which are contracts where an assuming company agrees to reimburse a ceding company for liabilities incurred as a result of past insurable events. Any initial gain and any benefit due from a reinsurer as a result of subsequent covered adverse development is deferred and amortised into income over the settlement period of the recoveries under the relevant contract. Contract deposits Contracts written by the Group which are not deemed to transfer significant underwriting and/or timing risk are accounted for as contract deposits and are included in premiums and other receivables. Liabilities are initially recorded at an amount equal to the assets received and are included in accounts payable and other liabilities. The Group uses the risk-free rate of return of equivalent duration to the liabilities in determining risk transfer and records the transactions using the interest method. The Group periodically reassesses the estimated ultimate liability. Any changes to this liability are reflected as an adjustment to interest expense to reflect the cumulative effect of the period the contract has been in force, and by an adjustment to the future internal rate of return of the liability over the remaining estimated contract term. Goodwill and intangible assets Goodwill represents the excess of acquisition costs over the net fair values of identifiable assets acquired and liabilities assumed in a business combination. Pursuant to Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets ('FAS 142'), goodwill is deemed to have an indefinite life and is not amortised, but rather tested at least annually for impairment. The goodwill impairment test has two steps. The first step identifies potential impairments by comparing the fair value of a reporting unit with its book value, including goodwill. If the fair value of the reporting unit exceeds the carrying amount, goodwill is not impaired and the second step is not required. If the carrying value exceeds the fair value, the second step calculates the possible impairment loss by comparing the implied fair value of goodwill with the carrying amount. If the implied goodwill is less than the carrying amount, a writedown would be recorded. The measurement of fair value of the reporting unit was determined based on an evaluation of ranges of future discounted earnings. Certain key assumptions considered include forecasted trends in revenues, operating expenses and effective tax rates. Intangible assets are valued at their fair value at the time of acquisition. The Group's intangibles relate to the purchase of syndicate capacity, the distribution network and admitted as well as surplus lines licenses. During 2005, the Group reassessed its estimate of the useful life of syndicate capacity purchased during 2002 and determined that it was indefinite. As a result, the Group has ceased amortising this intangible asset and instead assesses its recoverability at least annually. Admitted licenses are considered to have an indefinite life and as such are subject to annual impairment testing. Surplus lines authorisations are considered to have a finite life and are amortised over their estimated useful lives of five years. Distribution channels are amortised over their useful lives of five years. The Group evaluates the recoverability of its intangible assets whenever changes in circumstances indicate that an intangible asset may not be recoverable. If it is determined that an impairment exists, the excess of the unamortised balance over the fair value of the intangible asset is charged to earnings. Other assets Other assets are principally composed of prepaid items and property and equipment. Property and equipment are stated at cost less accumulated depreciation. Depreciation of property and equipment is calculated using the straight-line method over the estimated useful lives of four to ten years for fixtures and fittings, four years for automobiles and two years for computer equipment. Leasehold improvements are amortised over the life of the lease or the life of the improvement, whichever is shorter. Computer software development costs are capitalised when incurred and depreciated over their estimated useful lives of five years. Comprehensive income/(loss) Comprehensive income/(loss) represents all changes in equity that result from recognised transactions and other economic events during the period. Other comprehensive income/(loss) refers to revenues, expenses, gains and losses that are included in comprehensive income/(loss) but excluded from net income/(loss), such as unrealised gains or losses on available for sale investments and foreign currency translation adjustments. Foreign currency translation and transactions Foreign currency translation The Group has more than one functional currency, generally the currency of the local operating environments, consistent with its operating environment and underlying cash flows. The presentation currency of the Group has been determined to be US dollars. For subsidiaries with a functional currency other than US dollars, foreign currency assets and liabilities are translated into US dollars using period end rates of exchange, while statements of operations are translated at average rates of exchange for the period. The resulting translation differences are recorded as a separate component of accumulated other comprehensive income/(loss) within stockholders' equity. Foreign currency transactions Monetary assets and liabilities denominated in currencies other than the functional currency are revalued at period end rates of exchange, with the resulting gains and losses included in income. Revenues and expenses denominated in foreign currencies are translated at average rates of exchange for the period. Income taxes Income taxes have been provided for those operations that are subject to income taxes. Deferred tax assets and liabilities result from temporary differences between the amounts recorded in the consolidated financial statements and the tax basis of the Group's assets and liabilities. Such temporary differences are primarily due to the tax basis discount on unpaid losses, adjustment for unearned premiums, the accounting treatment of reinsurance contracts, and tax benefits of net operating loss carry-forwards. The effect on deferred tax assets and liabilities of a change in tax rates is recognised in income in the period that includes the enactment date. A valuation allowance against deferred tax assets is recorded if it is more likely than not that all or some portion of the benefits related to deferred tax assets will not be realised. Stock compensation The Group accounts for stock-based compensation arrangements under the provisions of Statement of Financial Accounting Standards No. 123 (Revised 2004), Accounting for Stock-Based Compensation ('FAS 123R'). The fair value of options is calculated at the date of grant based on the Black-Scholes Option Pricing Model. The corresponding compensation charge is recognised on a straight-line basis over the requisite service period. The fair value of non-vested shares is calculated on the grant date based on the share price and the exchange rate in effect on that date and is recognised on a straight-line basis over the vesting period. This calculation is updated on a regular basis to reflect revised expectations and/or actual experience. Warrants For convertible preference shares issued with detachable stock purchase warrants, the portion of the proceeds that is allocable to the warrants is accounted for as additional paid-in capital. This allocation is based on the relative fair values of the two securities at the time of issuance. Warrant contracts are classified as equity so long as they meet all the conditions of equity outlined in EITF 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company's Own Stock. Subsequent changes in fair value are not recognised in the Statement of Operations as long as the warrant contracts continue to be classified as equity. Pensions The Group operates defined contribution pension schemes for eligible employees, the costs of which are expensed as incurred. The Group also sponsors a defined benefit pension scheme which was closed to new members in 1993. In accordance with Statement of Financial Accounting Standard No 87, Employers' Accounting for Pensions, the recorded asset related to the plan was set equal to the value of plan assets in excess of the defined benefit obligation at the date of the business combination. Risks and uncertainties In addition to the risks and uncertainties associated with unpaid losses and loss expenses described above and in Note 7, cash balances, investment securities and reinsurance recoveries are exposed to various risks, such as interest rate, market, foreign exchange and credit risks. Due to the level of risk associated with investment securities and the level of uncertainty related to changes in the value of investment securities, it is at least reasonably possible that changes in risks in the near term would materially affect the amounts reported in the financial statements. The cash balances and investment portfolio are managed following prudent standards of diversification. Specific provisions limit the allowable holdings of a single institution issue and issuers. Similar diversification provisions are in place governing the Group's reinsurance programme. Management believes that there are no significant concentrations of credit risk associated with its investments and its reinsurance programme. New accounting pronouncements In April 2005, the Financial Accounting Standards Board ('FASB') issued FAS 123R, which is a revision of FAS 123, 'Accounting for Stock-based Compensation.' FAS 123R focuses primarily on accounting for transactions in which an entity obtains employee services for share-based payment transactions, and requires that all share-based payment transactions are recorded at fair value. FAS 123R is effective for reporting periods beginning after 15 December 2005, but early adoption is permitted. The Group adopted the provisions of FAS 123R in the 2005 consolidated financial statements using modified prospective application, such that the new Performance Share Plan described in Note 14 has been accounted for in accordance with FAS 123R. The Group's existing stock option plan was historically accounted for at fair value and therefore the adoption of FAS 123R had no impact on the Group's financial position or results of operations. In June 2005, the FASB issued Financial Accounting Standard 154, ('FAS 154') Accounting Changes and Error Corrections, a replacement of APB No. 20 and FAS No 3. FAS 154 changes the requirements for the accounting and reporting of a change in accounting principle. FAS 154 requires retrospective application to prior periods' financial statements of changes in accounting principle and requires that a change in depreciation, amortisation, or depletion method for long-lived, non-financial assets be accounted for as a change in accounting estimate effected by a change in accounting principle. The provisions of FAS 154 are effective for accounting changes made in fiscal years beginning after 15 December 2005, but early adoption is permitted. The adoption of FAS 154 did not have an impact on the Group's financial position or results of operations. In February 2006, the FASB issued Financial Accounting Standard 155, ('FAS 155') Accounting for Certain Financial Instruments, an amendment Financial Accounting Standard 133 ('FAS 133'), Accounting for Derivative Instruments and Hedging Activities, and Financial Accounting Standard 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. This Statement resolves issues addressed in FAS 133 Implementation Issue No. D1,'Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.' FAS 155 is effective for reporting periods beginning after 15 September 2006, although early adoption is permitted. The adoption of FAS 155 is not expected to have a material effect on the Group's financial position or results of operations. In July 2006, the FASB issued FIN 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 ('FIN 48'). FIN 48 clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before recognition in the financial statements. It also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after 15 December 2006. Management has reviewed its tax positions and does not anticipate that the adoption of FIN 48 will have a significant impact on the reporting of those positions. In September 2006, the FASB issued Financial Accounting Standard 157 ('FAS 157'), Fair Value Measurements. FAS 157 provides a common definition of fair value and establishes a framework to make the measurement of fair value in generally accepted accounting principles more consistent and comparable. FAS 157 also requires expanded disclosures to provide information about the extent to which fair value is used to measure assets and liabilities, the methods and assumptions used to measure fair value, and the effect of fair value measures on earnings. FAS 157 is effective for reporting periods beginning after 15 November 2007, although early adoption is permitted. The adoption of FAS 157 is not expected to have a material effect on the Company's financial position or results of operations. In September 2006, the FASB issued Financial Accounting Standard No. 158, Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R) ('FAS 158'). This statement requires recognition of the overfunded or underfunded status of defined benefit pension and other postretirement plans as an asset or liability in the balance sheet and changes in that funded status to be recognised in comprehensive income in the year in which the changes occur. FAS 158 also requires measurement of the funded status of a plan as at the balance sheet date. The recognition provisions of FAS 158 are effective for reporting periods ending after 15 December 2006, while the measurement date provisions are effective for reporting periods ending after 15 December 2008. The adoption of FAS 158 will not have a material effect on the Company's financial position or results of operations. 3 Business Combination On 18 December 2006, the Group declared unconditional its offer to acquire Wellington, which was announced on 30 October 2006 (the 'Offer'). The business combination was deemed effective 31 December 2006 for accounting purposes; accordingly the net assets acquired are valued as at that date and the operating results of Wellington will be included in the Group's consolidated financial statements in periods following 31 December 2006. Prior to the acquisition, Wellington managed and underwrote a diversified book of insurance and reinsurance business at Lloyd's and in the US. As a result of the acquisition, the enlarged Group will be a major international specialty insurance and reinsurance business with well established underwriting platforms in the United Kingdom and Bermuda and a significantly enhanced underwriting and distribution platform in the United States. Under the terms of the Offer, Wellington shareholders received 0.17 shares of the Company's common stock and 35 pence in cash for each Wellington share surrendered. Total consideration paid by the Group was $1,184,934, including $ 347,431 of cash and 86,094,294 shares of the Company's common stock valued at $ 812,427. The value of the common shares issued was determined based on the average market price of the Company's common shares for the period from 20 October to 2 November 2006, inclusive, which commenced two business days before the announcement that the Company and Wellington were in discussions regarding a possible combination and ended two business days after the terms of the Offer were announced. As at 31 December 2006, acceptances representing 93 per cent of Wellington's issued share capital had been received, and acceptances representing 88 per cent of Wellington's issued share capital had been settled in the form of $300,286 of cash and 74,414,657 shares. The remaining 12 per cent has been accrued in the year end balance sheet as a liability for the cash consideration and within additional paid-in capital for the equity consideration, and has been acquired in early 2007 as described in Note 21. The following table summarises the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition. The fair values will continue to be refined as further relevant information is obtained. Investments and cash $2,288,886 Premiums and other receivables 339,366 Reinsurance recoverable 804,787 Value of in-force business acquired 118,384 Intangible assets and goodwill 472,556 Other assets 119,676 -------------- Total assets acquired 4,143,655 -------------- Reserves for losses and loss expenses 2,026,268 Unearned premiums 491,756 Reinsurance payable 65,306 Subordinated debt 99,936 Deferred tax 134,739 Other liabilities 217,176 -------------- Total liabilities assumed 3,035,181 -------------- Net assets acquired $1,108,474 -------------- The table below summarises the calculation of goodwill arising on the acquisition. Cash consideration $347,431 Catlin share consideration 812,427 Acquisition expenses 25,076 -------------- Total consideration $1,184,934 -------------- Net assets acquired 1,108,474 Treasury shares acquired 7,490 -------------- Goodwill $68,970 -------------- Of the $472,556 of acquired intangible assets, $461,580 was assigned to purchased syndicate capacity, which is not subject to amortisation as it is deemed to have an indefinite life. The remaining acquired intangible assets consist of $4,900 of distribution network with an average life of five years and $6,076 of licenses with an average life of five years. The values assigned to goodwill and intangible assets with finite and indefinite lives were determined based on independent third-party valuations. The value of in-force business acquired of $118,384 represents the estimated present value of future profits associated with the unearned premium acquired, and replaces the deferred policy acquisition costs that were carried on Wellington's historical balance sheet. Its value was determined based on an independent third-party valuation. Given the timing of the acquisition of Wellington, the goodwill arising has not yet been allocated to a segment. This allocation will take place in early 2007. The goodwill is not expected to be deductible for income tax purposes. The unaudited pro forma financial information presented below assumes the acquisition occurred as at 1 January 2005. The following unaudited pro forma results have been prepared for comparative purposes only and do not purport to be indicative of the actual results of operations that would have occurred had the acquisition been consummated at the beginning of the periods presented. 2006 2005 --------- --------- Gross premiums written $2,721,800 $2,360,770 Total revenues 2,488,451 2,152,266 Net income 408,635 (53,813) Earnings per share: Basic $1.73 $(0.23) Diluted $1.63 $(0.23) Shares outstanding: Basic 236,601,569 229,398,754 Diluted 250,078,528 237,443,942 Restructuring costs In December 2006, the Group's management approved and committed to plans to terminate the employment of certain employees of Wellington. A liability of $5,565 representing the cost of these actions has been included in the allocation of the purchase price of the Wellington acquisition. No payments were made against these liabilities during 2006. Termination costs with respect to identified employees employed by the Group prior to the acquisition were recorded as part of other expenses. 4 Segmental information At 31 December 2006, there were four intra-Group reinsurance contracts in place: a 10 per cent Qualifying Quota Share ('QQS') contract on the 2004 Year of Account; a Long Tail Stop Loss ('LTSL'); and a 50 per cent Corporate Quota Share ('CQS'), all of which cede Catlin Syndicate risk to Catlin Bermuda, as well as the 60 per cent Quota Share contract that cedes Catlin UK risk to Catlin Bermuda ('CUK QS'). The effects of each of these reinsurance contracts are included within each of the operating segments, as this is the basis upon which the performance of each segment is assessed, and are then eliminated to reconcile to the Group position. For the years ended 31 December 2006 and 2005, these segments correspond to the location of where the business was written, with Catlin Syndicate Direct, Catlin Syndicate Reinsurance and Catlin UK business being written in the UK and Catlin Bermuda business being written in Bermuda. Net income before tax by operating segment for the year ended 31 December 2006 is as follows: Catlin Catlin Syndicate Syndicate Catlin Catlin Intra- Direct Reinsurance Bermuda UK Group Total Gross premiums written $836,312 $270,308 $728,755 $299,255 $(529,611) $1,605,019 Reinsurance premiums ceded (420,875) (138,084) (6,235) (159,313) 529,611 (194,896) -------- -------- -------- -------- -------- -------- Net premiums written 415,437 132,224 722,520 139,942 - 1,410,123 -------- -------- -------- -------- -------- -------- Net premiums earned 402,701 138,616 652,025 132,519 - 1,325,861 Losses and loss expenses (156,777) (89,038) (368,368) (67,366) - (681,549) Policy acquisition costs (191,587) (51,777) (97,641) (58,307) 57,781 (341,531) Administrative and other expenses (23,914) (5,852) (64,654) (5,064) (57,781) (157,265) -------- -------- -------- -------- -------- -------- Net underwriting result 30,423 (8,051) 121,362 1,782 - 145,516 -------- -------- -------- -------- -------- -------- Net investment income, net realised losses on investments and change in fair value of derivatives 26,615 9,161 43,093 8,758 - 87,627 Net realised gains on foreign currency exchange 11,768 4,051 19,054 3,873 - 38,746 Other income 1,071 369 1,735 353 - 3,528 -------- -------- -------- -------- -------- -------- Income before income tax expense $69,877 $5,530 $185,244 $14,766 - $275,417 -------- -------- -------- -------- -------- -------- Total revenue $442,155 $152,197 $715,907 $145,503 - $1,455,762 -------- -------- -------- -------- -------- -------- Net income before tax by operating segment for the year ended 31 December 2005 is as follows: Catlin Catlin Syndicate Syndicate Catlin Catlin Intra- Direct Reinsurance Bermuda UK Group Total -------- -------- -------- -------- -------- -------- Gross premiums written $698,841 $278,450 $566,805 $232,129 $(389,625) $1,386,600 Reinsurance premiums ceded (360,037) (122,814) (8,341) (95,934) 389,625 (197,501) -------- -------- -------- -------- -------- -------- Net premiums written 338,804 155,636 558,464 136,195 - 1,189,099 -------- -------- -------- -------- -------- -------- Net premiums earned 478,670 186,191 395,727 155,854 - 1,216,442 Losses and loss expenses (205,042) (184,556) (382,577) (93,110) - (865,285) Policy acquisition costs (176,886) (58,495) (45,513) (36,203) 11,558 (305,539) Administrative and other expenses (29,109) (11,322) (24,064) (9,477) (11,558) (85,530) -------- -------- -------- -------- -------- -------- Net underwriting result 67,633 (68,182) (56,427) 17,064 - (39,912) -------- -------- -------- -------- -------- -------- Net investment income and net realised losses on investments 31,727 12,341 26,229 10,330 - 80,627 Net realised losses on foreign currency exchange (5,426) (2,111) (4,487) (1,767) - (13,791) Other income 291 113 242 95 - 741 -------- -------- -------- -------- -------- -------- Income/(loss) before income tax expense $94,225 $(57,839) $(34,443) $25,722 $27,665 -------- -------- -------- -------- -------- -------- Total revenue $505,262 $196,534 $417,711 $164,512 - $1,284,019 -------- -------- -------- -------- -------- -------- Total revenue is the total of net premiums earned, net investment income and net realised gain/(loss) on investments, net realised gain/(loss) on foreign currency exchange, and other income. Total assets by segment at 31 December 2006 and 2005 are as follows: 2006 2005 --------- --------- Catlin Syndicate Direct $1,953,095 $2,190,303 Catlin Syndicate Reinsurance 835,510 749,162 Catlin Bermuda 2,932,168 1,913,467 Catlin UK 708,546 509,869 Other 2,438,957 860,990 Assets acquired from Wellington 4,214,867 - Consolidation adjustments (4,276,825) (2,363,808) --------- --------- Total assets $8,806,318 $3,859,983 --------- --------- 'Other' in the table above includes assets such as investments in Group companies which are not allocated to individual segments. Net assets acquired from Wellington have not as yet been allocated to segments. As noted above, goodwill associated with the acquisition of Wellington has not yet been allocated to segments. Previously recognised goodwill has been allocated to the relevant segments, being Catlin Syndicate Direct and Catlin Syndicate Reinsurance. The amount of goodwill allocated as at 31 December 2006 was $10,179 (2005: $11,740) for Catlin Syndicate Direct and $3,504 (2005: $3,173) for Catlin Syndicate Reinsurance. 5 Investments Fixed maturities The fair values and amortised costs of fixed maturities at 31 December 2006 and 2005 are as follows: 2006 2005 Fair Amortised Fair Amortised Value Cost Value Cost ---------- ---------- ---------- ---------- US government and agencies $733,861 $744,753 $860,839 $869,655 Non-US governments 338,525 342,150 378,339 381,449 Corporate securities 424,901 426,167 277,575 281,500 Asset-backed securities 535,718 535,974 208,141 209,949 Mortgage-backed securities 636,432 636,916 19,149 19,415 ---------- ---------- ---------- ---------- Total fixed maturities $2,669,437 $2,685,960 $1,744,043 $1,761,968 ---------- ---------- ---------- ---------- The composition of the amortised cost of fixed maturities by ratings assigned by ratings agencies is as follows: 2006 2005 ----------------- ---------------- Amortised Amortised Cost % Cost % --------- ---------- --------- --------- US government and agencies $744,753 28% $869,655 49% Non-US governments 342,150 13% 381,449 22% AAA 1,156,200 43% 337,923 19% AA 165,875 6% 74,210 4% A 263,875 10% 98,731 6% BBB 12,513 -% - -% Other 594 -% - -% --------- ---------- --------- --------- Total fixed maturities $2,685,960 100% $1,761,968 100% --------- ---------- --------- --------- The gross unrealised gains and losses related to fixed maturities at 31 December 2006 and 2005 are as follows: 2006 2005 ----------------- ----------------- Gross Gross Gross Gross unrealised unrealised unrealised unrealised gains losses gains losses ---------- ---------- ---------- ---------- US government and agencies $540 $11,432 $925 $9,742 Non-US governments 261 3,886 315 3,425 Corporate securities 486 1,752 33 3,958 Asset-backed securities 240 495 101 1,908 Mortgage-backed securities 756 1,241 - 266 ---------- ---------- ---------- ---------- Total fixed maturities $2,283 $18,806 $1,374 $19,299 ---------- ---------- ---------- ---------- There were no other than temporary declines in the value of investments in the year to 31 December 2006 or 2005. The net realised losses on fixed maturities for the year ended 31 December 2006 were $17,236 (2005: $1,314). The following is an analysis of how long each of the fixed maturities that were in an unrealised loss position as at 31 December 2006 had been in a continual loss position. This information concerns the potential effect upon future earnings and financial position should management later conclude that some of these current unrealised losses represent other than temporary declines in the value of the securities. Equal to or Less than 12 greater than 12 months months ----------------- ----------------- Gross Gross Fair unrealised Fair unrealised value losses value losses ---------- ---------- ---------- ---------- US government and agencies $323,295 $6,104 $176,196 $5,328 Non-US governments 227,473 2,231 65,251 1,655 Corporate securities 186,233 1,106 33,676 646 Asset-backed securities 121,402 428 5,375 67 Mortgage-backed securities 188,623 961 18,932 280 ---------- ---------- ---------- ---------- Total fixed maturities $1,047,026 $10,830 $299,430 $7,976 ---------- ---------- ---------- ---------- Over 80 per cent of the unrealised losses at 31 December 2006 related to 40 securities. The securities in an unrealised loss position as at 31 December 2006 have been reviewed by the Group with regard to the severity and duration of the losses, and to the nature of the investments and of the issuers. On this basis, the Group has determined that the unrealised losses are temporary. Proceeds from the sales and maturities of fixed maturities during 2006 were $2,122,297 (2005: $1,523,854). Proceeds from the sales and maturities of short-term investments during 2006 were $102,219 (2005: $429,616). Gross gains of $1,705 (2005: $5,962) and gross losses of $18,896 (2005: $7,469) were realised on sales of fixed maturities and short-term investments in 2006. Mortgage-backed securities issued by US government agencies are combined with all other asset-backed securities and are included in the category 'asset-backed securities'. Approximately 15 per cent (2005: 8 per cent) of the total asset-backed holdings at 31 December 2006 are represented by investments in SallieMae, Government National Mortgage Association, Federal National Mortgage Association, Federal Home Loan Bank and Federal Home Loan Mortgage Corporation bonds. The remainder of the asset-backed exposure consists of non-government asset-backed securities, the majority of which provide a planned structure for principal and interest payments and carry a 'AAA' rating by the major credit rating agencies. The Group did not have an aggregate investment in a single entity, other than the US government securities, in excess of 10 per cent of total investments at 31 December 2006 and 2005. Fixed maturities at 31 December 2006, by contractual maturity, are shown below. Expected maturities could differ from contractual maturities because borrowers may have the right to call or prepay obligations, with or without call or prepayment penalties. Fair Amortised value cost --------- --------- Due in one year or less $153,195 $153,814 Due after one through five years 878,786 884,981 Due after five years through ten years 451,594 460,352 Due after ten years 13,712 13,923 --------- --------- 1,497,287 1,513,070 Asset-backed securities 535,718 535,974 Mortgage-backed securities 636,432 636,916 --------- --------- Total $2,669,437 $2,685,960 --------- --------- Investment in funds The Group has classified its investment in funds as a trading security and accordingly, all realised and unrealised gains and losses on this investment are recorded in net income. This investment comprises investments in a fixed maturities fund, an equity fund and a fund of hedge funds. The change in fair value of the investment in funds is recorded in as net investment income. The amount of net investment income for the year to 31 December 2006 that relates to investment in funds still held at the year end was $2,960 (2005: $nil). Net investment income The components of net investment income for the years ended 31 December 2006 and 2005 are as follows: 2006 2005 --------- --------- Interest income $102,438 $71,153 Amortisation of premium/discount 6,185 12,371 Equity in income of associate 1,275 1,343 Change in fair value of investment in funds 2,960 - --------- --------- Gross investment income 112,858 84,867 Investment expenses (7,571) (2,720) --------- --------- Net investment income $105,287 $82,147 --------- --------- Restricted assets The Group is required to maintain assets on deposit with various regulatory authorities to support its insurance and reinsurance operations. These requirements are generally promulgated in the statutory regulations of the individual jurisdictions. These funds on deposit are available to settle insurance and reinsurance liabilities. The Group also has investments in segregated portfolios primarily to provide collateral or guarantees for Letters of Credit ('LOC'), as described in Note 10. Finally, the Group also utilises trust funds where the trust funds are set up for the benefit of the ceding companies, and generally take the place of LOC requirements. The total value of these restricted assets by category at 31 December 2006 and 2005 are as follows: 2006 2005 --------- --------- Fixed maturities, available for sale $1,666,967 $741,281 Short term investments 10,951 6,957 Cash and cash equivalents 751,908 98,873 --------- --------- Total restricted assets $2,429,826 $847,111 --------- --------- Securities lending The Group participates in a securities lending program under which certain of its fixed maturity investments are loaned to third parties through a lending agent. Collateral in the form of cash, government securities and letters of credit is required at a minimum rate of 102 per cent of the market value of the loaned securities and is monitored and maintained by the lending agent. The Group had $124,486 (2005: $nil) of securities on loan at 31 December 2006. 6 Investment in associate The Group, through Catlin Inc., one of its US subsidiaries, has a 25 per cent membership interest in Southern Risk Operations, L.L.C. ('SRO') which is accounted for using the equity method. The Group received cash distributions from SRO during the year ended 31 December 2006 of $1,452 (2005: $1,418). The share of SRO's profit included within the Consolidated Statement of Operations during 2006 was $1,275 (2005: $1,343). In management's opinion, the fair value of SRO is not less than its carrying value. 7 Reserves for losses and loss expenses The Group establishes reserves for losses and loss expenses, which are estimates of future payments of reported and unreported claims for losses and related expenses, with respect to insured events that have occurred. The process of establishing reserves is complex and imprecise, requiring the use of informed estimates and judgments. The Group's estimates and judgments may be revised as additional experience and other data become available and are reviewed, as new or improved methodologies are developed or as current laws change. Any such revisions could result in future changes in estimates of losses or reinsurance recoverable, and would be reflected in earnings in the period in which the estimates are changed. Management believes they have made a reasonable estimate of the level of reserves at 31 December 2006 and 2005. The reconciliation of unpaid losses and loss expenses for the years ended 31 December 2006 and 2005 is as follows: 2006 2005 --------- --------- Gross unpaid losses and loss expenses, beginning of year $1,995,485 $1,472,819 Reinsurance recoverable on unpaid loss and loss expenses (575,522) (359,154) --------- --------- Net unpaid losses and loss expenses, beginning of year 1,419,963 1,113,665 --------- --------- Net incurred losses and loss expenses for claims related to: Current year 679,115 959,492 Prior years 2,434 (94,207) --------- --------- Total net incurred losses and loss expenses 681,549 865,285 --------- --------- Net paid losses and loss expenses for claims related to: Current year (64,247) (115,128) Prior year (528,661) (363,449) --------- --------- Total net paid losses and loss expenses (592,908) (478,577) --------- --------- Foreign exchange and other 86,607 (80,410) Business combinations (1) 1,413,026 - --------- --------- Net unpaid losses and loss expenses, end of year 3,008,237 1,419,963 Reinsurance recoverable on unpaid loss and loss expenses 996,896 575,522 --------- --------- Gross unpaid losses and loss expenses, end of year $4,005,133 $1,995,485 --------- --------- (1) Wellington net unpaid losses and loss expenses at 31 December 2006. Wellington gross unpaid losses and loss expenses at 31 December 2006 were $2,026,268. As a result of the changes in estimates of insured events in prior years, the 2006 reserve for losses and loss expenses net of reinsurance recoveries increased by $2,434 (2005: decrease of $94,207). In 2006 the increase was due to a deterioration of $52,454 in respect of the 2005 hurricanes and $29,400 in respect of a South African motor loss, offset by positive development in respect of recent underwriting years over a number of business classes. In 2005, the decrease was due to changes in estimates of insured events in previous years resulting from reductions of expected ultimate loss costs, settlement of losses at amounts below previously estimated loss costs and reduction in uncertainty surrounding the quantification of the net cost of claim events. 2005 hurricanes The table below shows the Group's estimated ultimate loss as at 31 December 2006, showing separately the amounts assumed in 2006 as part of the acquisition of Wellington described in Note 3. Legacy Legacy 2006 2005 Wellington Catlin Total --------- --------- --------- -------- Gross losses $987,017 $674,881 $1,661,898 $615,097 Reinsurance recoveries (654,076) (288,921) (942,997) (281,591) --------- --------- --------- -------- Net loss prior to reinsurance costs 332,941 385,960 718,901 333,506 Net reinstatements due on ceded business 69,674 51,040 120,714 48,258 Reinsurance restatements on assumed business (24,087) (38,087) (62,174) (31,540) --------- --------- --------- -------- Net loss $378,528 $398,913 $777,441 $350,224 --------- --------- --------- -------- The figures above represent management's best estimate of the likely final losses to the Group from the three hurricanes: Katrina, Rita and Wilma. In making this estimate, management has used the best information available, including estimates performed by the Group's underwriters, actuarial and claims staff, retained external actuaries, outside agencies and market studies. Allowance is made in the overall management best estimate of net unpaid losses for an appropriate level of sensitivity, for both individual large losses and the overall portfolio of business. In respect of the 2005 hurricanes, management have particularly considered sensitivities relating to gross losses on direct and reinsurance accounts, underlying loss experience of cedants and reinsurance coverage and security issues. 8 Reinsurance The Group purchases reinsurance to limit various exposures including catastrophe risks. Although reinsurance agreements contractually obligate the Group's reinsurers to reimburse it for the agreed upon portion of its gross paid losses, they do not discharge the primary liability of the Group. The effect of reinsurance and retrocessional activity on premiums written and earned is as follows: 2006 2005 Premiums Premiums Premiums Premiums written earned written earned ---------- ---------- ---------- ---------- Direct $1,154,851 $1,070,621 $953,172 $992,181 Assumed 450,168 434,417 433,428 427,515 Ceded (194,896) (179,177) (197,501) (203,254) ---------- ---------- ---------- ---------- Net premiums $ 1,410,123 $1,325,861 $1,189,099 $1,216,442 ---------- ---------- ---------- ---------- The Group's provision for reinsurance recoverable as at 31 December 2006 and 2005 is as follows: 2006 2005 --------- --------- Gross reinsurance recoverable $1,284,322 $631,957 Provision for uncollectible balances (46,791) (24,511) --------- --------- Net reinsurance recoverable $1,237,531 $607,446 --------- --------- The Group evaluates the financial condition of its reinsurers and potential reinsurers on a regular basis and also monitors concentrations of credit risk with reinsurers. All current reinsurers have a financial strength rating of at least 'A' from Standard & Poor's or 'A-' from A M Best, or provide appropriate collateral. However, certain reinsurers from prior years have experienced reduced ratings which has led to the need for the provision. At 31 December 2006, there were five reinsurers which accounted for 5 per cent or more of the total reinsurance recoverable. % of AM Best reinsurance recoverable Rating ---------- --------- Hannover Ruck AG 11% A Munich Re 11% A+ National Indemnity Company 7% A++ GE Frankona Ruck AG 7% A Allianz Global Corporate & Specialty AG 5% A ---------- --------- At 31 December 2006, the Group had a deposit with reinsurer of $nil (2005: $ 21,823) with Max Re, which is rated 'A-' by A M Best. This relates to a whole account stop loss contract that covers the Group's underwriting at Lloyd's for the 2001 and prior underwriting years. The reinsurance contract is retroactive in nature and as a result, premiums paid are accounted as a deposit. The deferred gain under the contract of $nil (2005: $6,898) is recognised in income as recoveries are made. During 2006, $6,898 of the deferred gain was recognised in income (2005: $11,380). Assets equivalent in value to the amount accounted as a deposit were held by an independent trustee for the benefit of the reinsured syndicates. 9 Derivative financial instruments Catastrophe swap agreement On 17 November 2006, Catlin Bermuda entered into a catastrophe swap agreement ('Cat Swap') that provides up to $200.25 million in coverage in the event of a series of natural catastrophes. Catlin Bermuda's counterparty in the Cat Swap is a special purpose vehicle, Bay Haven Limited ('Bay Haven'). Bay Haven has issued to investors $200.25 million in three-year floating rate notes, divided into Class A and Class B notes. The proceeds of those notes provide the collateral for Bay Haven's potential obligations to Catlin Bermuda under the Cat Swap. The Cat Swap responds to certain covered risk events occurring during a three year period. No payment will be made for the first three such risk events. Bay Haven will pay Catlin Bermuda $33.375 million per covered risk event thereafter, up to a maximum of six events. The aggregate limit potentially payable to Catlin Bermuda is $200.25 million. The categories of risk events covered by the transaction are: US hurricanes ( Florida, Gulf States and East Coast), California earthquakes, US Midwest earthquakes, UK windstorms, European (excluding UK) windstorms, Japanese typhoons and Japanese earthquakes. Only one payment will be made for each covered risk event, but the Cat Swap will respond to multiple occurrences of a given category of risk event, such as if more than one qualifying US hurricane occurs during the period. The catastrophe swap will be triggered for US risk events if aggregate insurance industry losses, as estimated by Property Claims Services, meet or exceed defined threshold amounts. Coverage for non-US risk events will be triggered if specific parametric criteria, such as wind speeds or ground motions, are met or exceeded. The first two events paid under the catastrophe swap would impact the Class B notes; subsequent events, up to the limit of six events over the three year period, would impact the Class A notes. In addition, on 17 November 2006 Catlin Bermuda entered into a further catastrophe swap agreement with ABN AMRO Bank N.V. London Branch which will respond to the third covered risk event (that is, the covered risk event before the Class B notes are triggered). The terms are otherwise as described for the Class A and Class B notes, except that the limit payable is $46,500. The Cat Swap falls within the scope of SFAS 133 ('Accounting for Derivative Instruments and Hedging Activities' as amended ('SFAS 133') and is therefore measured in the balance sheet at fair value with any changes in the fair value included in earnings. As at 31 December 2006, the fair value of the Cat Swap is a liability of $619. As there is no quoted market value available for this derivative, the fair value is determined by management using internal models based on the valuation of the Class A and Class B notes issued by Bay Haven, which are publicly quoted. The fair value model takes into account changes in the market for catastrophe reinsurance contracts with similar economic characteristics and the potential for recoveries from events preceding the valuation date. Other derivative instruments On acquisition of Wellington, the Group acquired various foreign currency derivatives (forward contracts, caps and collars) and options to purchase shares in Aspen Insurance Holdings Ltd. As at 31 December 2006, the fair value of the foreign currency derivatives was $24,847, of which $18,324 had a remaining term of less than 12 months, and the fair value of the Aspen options was $21,190. 10 Notes payable, debt and financing arrangements The Group's outstanding debt as at 31 December 2006 and 2005 consisted of the following: 2006 2005 -------- ------- Notes payable Revolving bank facility, due 22 January 2007 $50,000 $50,000 -------- ------- Total notes payable 50,000 50,000 -------- ------- Subordinated debt (1) Variable rate, face amount €7,000, due 15 March 2035 10,032 - Variable rate, face amount $27,000, due 15 March 2036 29,274 - Variable rate, face amount $31,300, due 15 September 2036 34,103 - Variable rate, face amount $9,800, due 15 September 2036 10,677 - Variable rate, face amount €11,000, due 15 September 2036 15,850 - -------- ------- Total subordinated debt 99,936 - -------- ------- Bridge financing 500,290 - -------- ------- Total debt $650,226 $50,000 -------- ------- (1) Debt instruments acquired in business combination Future interest payments on notes payable and bridge financing as at 31 December 2006 are $3,185, due in 2007. Future annual interest payments on subordinated debt, estimated at interest rates in effect at 31 December 2006, are $7,345. The Group paid $2,655 in interest during the year ended 31 December 2006 (2005: $2,113). Subordinated debt On 12 May 2006 Wellington issued $27,000 and €7,000 of variable rate unsecured subordinated notes. The notes are subordinated to the claims of all Senior Creditors, as defined in the agreement. The notes pay interest based on the rate on three-month deposits in US Dollars plus a margin of 317 basis points for the Dollar note and 295 basis points for the Euro note. Interest is payable quarterly in arrears. The notes are redeemable at the discretion of the issuer beginning on 15 March 2011 with respect to the Dollar notes and 22 May 2011 with respect to the Euro notes. On 20 July 2006 Wellington issued $31,300, $9,800 and €11,000 of variable rate unsecured subordinated notes. The notes are subordinated to the claims of all Senior Creditors, as defined in the agreement. The notes pay interest based on the rate on three-month deposits in US Dollars plus a margin of 310 basis points for the $31,300 notes and 300 basis points for the other two notes. Interest is payable quarterly in arrears. The notes are each redeemable at the discretion of the issuer on 15 September 2011. Bridge financing On 30 October 2006 Catlin entered into a bridge financing arrangement with JP Morgan Cazenove under which it could borrow up to $500 million. On 27 and 28 December 2006 Catlin borrowed $325 and $175 million, respectively, under this bridge facility to partially finance the Wellington acquisition. The interest rate on this bridge loan is based on three-month Libor plus 45 basis points. The weighted average interest rate on the bridge loan at 31 December 2006 is 5.8 per cent. As at 31 December 2006 the Group had a balance of $500.3 million outstanding on this facility. The bridge financing was repaid with the proceeds of the non-cumulative perpetual preferred shares in January 2007, described in Note 21. Bank facilities Since November 2003, the Group has participated in a Letter of Credit/ Revolving Loan Facility (the 'Club Facility') with three, and since 15 December 2006, four banks. Each bank participates equally in the Club Facility. The Club Facility is comprised of three tranches as detailed below. The Club Facility has been varied, amended and restated since it was originally entered into, most recently on 15 December 2006 when the credit available under the Club Facility increased from $250,000 and £150,000 to $400,000 and £275,000 respectively. The following amounts were outstanding under the Club Facility as at 31 December 2006: • Debt outstanding was $50,000, in the form of a 364-day $50,000 revolving facility with a one year term-out option ('Facility A'). Facility A, while not directly collateralised, is secured by floating charges on Group assets and cross guarantees from material subsidiaries. This debt bears interest at three-month Libor plus 65 basis points, and the Group is required to maintain free and unencumbered assets consisting of OECD Government Bonds, US Agencies and Corporate Bonds, discounted by 10 per cent, sufficient to repay the loan at any time. The undrawn portion of Facility A costs 25 basis points per annum. This loan, which is available under one-, two- or three-month renewal periods, can be repaid at any time at the discretion of the Group in increments of $10 million. The Group has the option to extend the revolving facility for 364 days, or to convert all cash advances into a term loan. This loan was repaid including interest on 22 January 2007. • A clean, irrevocable standby LOC of $294,000 (£150,000) is provided to support CSL's underwriting at Lloyd's ('Facility B'). As at 31 December 2006, CSL has utilised Facility B and deposited with Lloyd's an LOC in the amount of $294,000 (£150,000). In the event that CSL failed to meet its obligations under policies of insurance written on its behalf, Lloyd's could draw down this letter of credit. This LOC has an initial expiry date of 27 November 2010. Collateral of $78,400 (£40,000) was provided in 2006. • A two-year $350 million standby LOC facility is available for utilisation by Catlin Bermuda and Catlin UK ('Facility C'). It is split into two equal tranches of $175 million with the first being fully secured by OECD Government Bonds, US Agencies and or cash discounted at varying rates. The second tranche is unsecured. At 31 December 2006, $106,922 in LOC's were outstanding, of which $103,639 are issued for the benefit of Catlin Bermuda, with a single LOC of $3,283 (£1,675) being for the benefit of Catlin UK. The terms of the Club Facility require that certain financial covenants be met on a quarterly basis through the filing of Compliance Certificates. These include maximum levels of possible exposures to realistic disaster scenarios for the Group, as well as requirements to maintain minimum Tangible Net Worth and Adjusted Tangible Net Worth levels, the calculations of which are based upon fixed amounts in 2006 and increase over time, for items such as consolidated net income in future accounting periods. The Group was in compliance with all covenants during 2006. At 31 December 2006 a Wellington bank facility was still in existence. Wellington had deposited with Lloyd's unsecured LOCs totalling $147,000 (£75,000). In February 2007, these unsecured letters of credit were cancelled and replaced with letters of credit issued under the Group's Facility B described above. 11 Intangible assets and goodwill Net intangible assets and goodwill as at 31 December 2006 and 2005 consist of the following: Indefinite Finite life life Goodwill intangibles intangibles Total --------- --------- --------- --------- Gross value at 1 January 2005 $36,099 - $64,302 $100,401 Accumulated amortisation (19,869) - (9,294) (29,163) --------- --------- --------- --------- Net value at 1 January 2005 16,230 - 55,008 71,238 --------- --------- --------- --------- Movements during 2005: Reclassification of intangible asset - 54,337 (54,337) - Additions - - 51 51 Foreign exchange adjustment (1,317) (5,660) (2) (6,979) Write off - - (671) (671) --------- --------- --------- --------- Total movements during 2005 (1,317) 48,677 (54,959) (7,599) --------- --------- --------- --------- Gross value at 31 December 2005 32,805 56,966 49 89,820 Accumulated amortisation (17,892) (8,289) - (26,181) --------- --------- --------- --------- Net value at 31 December 2005 $14,913 $48,677 $49 $63,639 --------- --------- --------- --------- Movements during 2006: Business combination 68,970 461,580 10,976 541,526 Additions 704 253,446 325 254,475 Foreign exchange revaluation 1,648 6,792 21 8,461 Amortisation charge - - (75) (75) --------- --------- --------- --------- Total movements during 2006 71,322 721,818 11,247 804,387 --------- --------- --------- --------- Gross value at 31 December 2006 106,498 779,941 11,376 897,815 Accumulated amortisation (20,263) (9,446) (80) (29,789) --------- --------- --------- --------- Net value at 31 December 2006 $86,235 $770,495 $11,296 $868,026 --------- --------- --------- --------- Neither goodwill nor intangibles were impaired in 2006 or 2005. Goodwill, purchased syndicate capacity and admitted licenses are considered to have an indefinite life and as such are subject to annual impairment testing. The Group's intangibles relate to the purchase of syndicate capacity, customer relationships, distribution channels and admitted as well as surplus lines licenses. Distribution channels and surplus lines licenses are considered to have a finite life and are amortised over their estimated useful lives of five years. Amortisation of intangible assets for the next five years at current exchange rates will amount to approximately $2,275 per annum. Purchased syndicate capacity Lloyd's syndicate capacity purchased in 2002 amounted to $50,959. The acquisition of the syndicate capacity gives the Group benefits that relate to the value of future income streams estimated to arise from business originally underwritten by members of Syndicate 1003, which was assumed by Syndicate 2003, and which was capitalised by CSL in the 2003 Lloyd's underwriting year. The acquisition also gives the Group a valuable ability to generate additional profits as a consequence of the underwriting capital and management flexibility, which results from the acquisition of the third party capacity. The whole of the consideration has been allocated to these intangible assets. In connection with the Wellington acquisition, the Group purchased Wellington's 67 per cent share of the underwriting capacity of Syndicate 2020. A portion of the purchase price of Wellington has been allocated to this capacity (see Note 3 for further details). In a separate transaction executed simultaneously with the Wellington acquisition, the Group, by way of cessation of Syndicate 2020, in effect acquired the remaining 33 per cent of Syndicate 2020's capacity from the unaligned members. As compensation for the cessation (and, in effect, for surrendering the capacity), unaligned members were given the option of i) 50 pence per £1.00 of capacity; or ii) 40 pence per £1.00 of capacity and the ability to participate in a new reinsurance syndicate that will write a whole account quota share reinsurance of Syndicate 2003 for the 2007 and 2008 years of account. Approximately one-third of unaligned members elected to take option i), with the balance taking option ii). This asset has been valued at $250,071, or 50 pence per £1.00 of capacity acquired. This represents the cash paid plus an amount representing the participation in a new reinsurance syndicate, a non-monetary asset, which has been valued at 10 pence per £1.00 of capacity acquired. This non-monetary amount, $30,514, has been accounted for as a reinsurance creditor and will be amortised over the two years of participation in the new reinsurance syndicate. Effective 1 January 2007, Syndicate 2020 ceased underwriting and the purchased capacity (and that falling to the Group by way of cessation of Syndicate 2020) has been re-deployed to increase the capacity of Syndicate 2003. 12 Taxation Bermuda Under current Bermuda law neither the Company nor its Bermuda subsidiary, Catlin Bermuda, are required to pay any taxes in Bermuda on their income or capital gains. Both the Company and Catlin Bermuda have received undertakings from the Minister of Finance in Bermuda that, in the event of any taxes being imposed, they will be exempt from taxation in Bermuda until March 2016. United Kingdom The Group also operates in the UK through its UK subsidiaries and the income of the UK companies is subject to UK corporation taxes. Income from the Group's operations at Lloyd's is also subject to US income taxes. Under a Closing Agreement between Lloyd's and the Internal Revenue Service (IRS), Lloyd's Members pay US income tax on US connected income written by Lloyd's Syndicates. US income tax due on this US connected income is calculated by Lloyd's and remitted directly to the Internal Revenue Service and is charged by Lloyd's to Members in proportion to their participation on the relevant Syndicates. The Group's Corporate Members are all subject to this arrangement but, as UK tax residents, will receive UK corporation tax credits for any US income tax incurred up to the value of the equivalent UK corporation income tax charge on the US income. United States The Group also operates in the US through its US subsidiaries and their income is subject to both US State and US Federal income taxes. Other international income taxes The Group has a network of international operations and they also are subject to income taxes imposed by the jurisdictions in which they operate but they do not constitute a material component element of the Group's tax charge. The Group is 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 the Group to change the way it operates or become subject to taxation. The income tax expense for the years ended 31 December 2006 and 2005 is as follows: 2006 2005 --------- --------- Current tax (benefit)/expense $(5,438) $6,477 Deferred tax expense 22,044 1,526 --------- --------- Expense for income taxes $16,606 $8,003 --------- --------- The weighted average expected tax expense has been calculated using pre-tax accounting income/(loss) in each jurisdiction multiplied by that jurisdiction's applicable statutory tax rate. The weighted average tax rate for the Group is 6.0 per cent (2005: 29.9 per cent). A reconciliation of the difference between the expense for income taxes and the expected tax expense at the weighted average tax rate for the years ended 31 December 2006 and 2005 is provided below. 2006 2005 --------- --------- Expected tax expense at weighted average rate $1,889 $8,307 Permanent differences: Disallowed expenses 474 1,149 (Over)/under accrual of tax in prior periods (1,297) 262 Items taxed in previous years - (1,212) Specific contingency provision 15,540 - Other - (503) --------- --------- Expense for income taxes $16,606 $8,003 --------- --------- The components of the Group's net deferred tax liability as at 31 December 2006 and 2005 are as follows: 2006 2005 --------- --------- Deferred tax assets: Net operating loss carryforwards $73,346 $7,462 Future UK double tax relief 7,953 7,507 Whole account stop loss - 2,069 Deep discount security unwind 770 1,201 Accelerated capital allowances 1,137 488 Compensation accruals 5,080 Cumulative translation adjustment - 4,447 Syndicate capacity amortisation and other 156 2,022 --------- --------- Total deferred tax assets $88,442 $25,196 --------- --------- Deferred tax liabilities: Intragroup financing charges (8,932) - Untaxed profits (104,030) (29,377) Intangible assets arising on business combination (127,017) - --------- --------- Net deferred tax liability $(151,537) $(4,181) --------- --------- As at 31 December 2006, a deferred tax asset of $2,184 (2005: $nil) and a deferred tax liability of $153,721 (2005: $4,181) are recognised in the balance sheet. No valuation allowance was necessary as at 31 December 2006 and 2005. As at 31 December 2006, the Group has net operating loss carryforwards of approximately $243,401, which are available to offset future taxable income (2005: $24,873). The net operating loss carry forwards primarily arise in the UK subsidiaries where they are expected to be fully utilised. There are no time restrictions on the utilisation of these losses. 13 Stockholders' equity The following is a detail of the number and par value of common shares authorised, issued and outstanding as at 31 December 2006 and 2005: Issued and Authorised outstanding ----------------- ----------------- Par Par Number value Number value of shares $000 of shares $000 ---------- ---------- ---------- ---------- Ordinary common shares, par value $0.01 per share As at 31 December 2006 400,000,000 $4,000 238,283,281 $2,383 ---------- ---------- ---------- ---------- As at 31 December 2005 250,000,000 $2,500 155,914,616 $1,559 ---------- ---------- ---------- ---------- The following table outlines the changes in common shares issued and outstanding during 2006 and 2005: 2006 2005 ---------- ---------- Balance, 1 January 155,914,616 154,097,989 Exercise of stock options and warrants 249,108 1,816,627 Equity raise 7,704,900 - Business combination 74,414,657 - ---------- ---------- Balance, 31 December 238,283,281 155,914,616 ---------- ---------- Equity raise On 14 March 2006, the Group placed 7,704,900 new common shares with par value of $0.01 each at $8.68 (£5.00) per share, raising $65,231 net of expenses. Business Combination As described more fully in Note 3, the Group has issued 74,414,657 common shares as at 31 December 2006 to former holders of Wellington shares in connection with the acquisition of Wellington. Treasury stock In connection with the Performance Share Plan ('PSP'), at each dividend date, an amount equal to the dividend that would be payable in respect of the shares to be issued under the PSP (assuming full vesting), is paid into an Employee Benefit Trust ('EBT'). The EBT uses these funds to purchase Group shares on the open market. These shares will ultimately be distributed to PSP holders to the extent that the PSP awards vest. During 2006, the Group, through the EBT, purchased 155,155 of the Group's shares, at an average price of $8.72 (£4.65) per share. The total amount paid of $1,352 is shown as a deduction to stockholders' equity. Wellington also had an EBT which held shares in Wellington. The EBT accepted the Offer and therefore at year end, it held 555,768 of the Group's shares at a price of $9.44 (£4.99) per share. Dividends On 12 June 2006, the Group paid a final dividend relating to the 2005 financial year of $0.176 (£0.101) per share to shareholders of record at the close of business on 12 May 2006. The total dividend paid for the 2005 financial year was $0.275 (£0.155) per share. On 10 November 2006, the Group paid an interim dividend relating to the 2006 financial year of $0.113 per share (£0.060 per share) to shareholders of record as at 13 October 2006. 14 Employee stock compensation schemes The Group has two stock compensation schemes in place under which awards are outstanding: a Performance Share Plan, which was adopted in 2004, and a Long Term Incentive Plan, adopted in 2002. These financial statements include the total cost of stock compensation for both plans, calculated using the fair value method of accounting for stock-based employee compensation. The total cost of the plans expensed in the year ended 31 December 2006 was $11,000 (2005: $4,246 ). Remaining stock compensation to be expensed in future periods relating to these plans is $20,913. Performance Share Plan ('PSP') On 9 March 2006, a total of 2,020,301 options with $nil exercise price and 275,296 non-vested shares (total of 2,295,597 securities) were granted to Group employees under the PSP. Up to half of the securities will vest on 9 March 2009 and up to half will vest on 9 March 2010, subject to certain performance conditions. These securities have been treated as non-vested shares and as such have been measured at their fair value as if they were vested and issued on the grant date, excluding the impact of performance vesting conditions. Performance vesting conditions are included in assumptions about the number of non-vested shares that employees will ultimately receive. This estimate is revised at each balance sheet date and the difference is charged or credited to the income statement, with a corresponding adjustment to equity. The current vesting conditions assume that employees will ultimately receive 100% of granted securities and that the annual attrition rate is 3%. The total number of PSP securities outstanding at 31 December 2006 was 4,429,075 and the total compensation expense relating to the PSP for the year ended 31 December 2006 was $9,669. None of the PSP securities have vested. The table below shows the unvested PSP securities as at 31 December: 2006 2005 ------------ ------------ Outstanding, beginning of period 2,203,786 - Granted during year 2,295,597 2,223,959 Forfeited during year (72,497) (20,173) ------------ ------------ Outstanding, end of period 4,426,886 2,203,786 ------------ ------------ Fair value per PSP security as at date of grant $8.71 $7.13 ------------ ------------ In addition, at each dividend payment date, an amount equal to the dividend that would be payable in respect of the shares to be issued under the PSP (assuming full vesting), is paid into an Employee Benefit Trust. This amount, totalling $1,306 in 2006, is treated as a deferred compensation obligation and as such is taken directly to retained earnings and capitalised in stockholders' equity within additional paid-in capital. Long Term Incentive Plan ('LTIP') Interests in a total of 16,051,613 ordinary common shares were granted to eligible employees. The individual awards were divided into options with an exercise price of $5.00 and exercisable in four equal annual tranches, and options with exercise prices of $10.00, $12.50 and $15.00, exercisable on 1 July 2007. The total compensation expense relating to the LTIP for the year ended 31 December 2006 was $1,331. The options vest on various dates as prescribed under LTIP plan documentation, but in any event all will have vested and will expire by 4 July 2012. The table below shows the vesting dates and the number of options that have vested on those dates: Number of options Date vesting ----------- 4 July 2003 1,576,110 6 April 2004 (IPO date) 4,815,484 4 July 2004 1,668,261 4 July 2005 1,655,158 4 July 2006 1,647,564 ----------- Total 11,362,577 ----------- The table below shows the status of the interests in shares as at 31 December: 2006 2005 ---------- ---------- Weighted Weighted average average exercise exercise Number price ($) Number price ($) ---------- --------- ---------- --------- Outstanding, beginning of period 15,979,915 9.68 16,440,660 9.60 Exercised during year (544,500) 4.97 (322,877) 5.05 Forfeited during year (164,736) 11.94 (137,868) 11.27 --------- ---------- --------- ---------- Outstanding, end of period 15,270,679 9.76 15,979,915 9.68 --------- ---------- --------- ---------- Exercisable, end of period 10,084,791 8.45 9,005,511 8.94 --------- ---------- --------- ---------- Average Number of remaining Exercise price options contractual outstanding life (years) ------------ ------------- $5.00 5,197,217 5.5 £3.50 322,155 5.5 $10.00 3,250,427 1.0 $12.50 3,250,427 1.0 $15.00 3,250,453 1.0 ------------ ------------- Total 15,270,679 2.5 ------------ ------------- As at year end, there was no amount receivable from shareholders on the exercise of interests in shares. The fair value of the options granted during 2004 was calculated using the Black-Scholes valuation model and is being amortised over the expected vesting period of the options, being four years for the £3.50 tranche, 1.875 years for the performance based tranche that vested on admission and 3.625 for the performance based tranche that vests on 4 July 2007. The valuation has assumed an average volatility of 40 per cent, no expected dividends and a risk free rate using US dollar swap rates appropriate for the expected life assumptions: 2.8 per cent for four years; 1.79 per cent for 1.875 years; and 2.64 per cent for 3.625 years. The fair value of the options granted prior to 2004 was calculated using the Black-Scholes valuation model and is being amortised over the expected vesting period of the options, being 4.5 years from the date of the subscription agreement. The valuation has assumed a risk free rate of return at the average of the four- and five-year US dollar swap rates of 3.39 per cent and no expected volatility (as the minimum value method was utilised because the Company was not listed on the date the options were issued). Warrants In 2002, the Company issued warrants to shareholders to purchase 20,064,516 common shares. Warrants may be exercised in whole or in part, at any time, until 4 July 2012 and are exercisable at a price per share of $5.00. No warrants were exercised during 2006. During 2005, warrants to purchase 5,120,465 common shares were exercised and settled net for 1,703,386 common shares, leaving warrants entitling the purchase of 14,944,051 common shares outstanding. 15 Earnings per share Basic earnings per share is calculated by dividing the earnings attributable to common shareholders by the weighted average number of common shares in issue during the year. Diluted earnings per share is calculated by dividing the earnings attributable to all shareholders by the weighted average number of common shares in issue adjusted to assume conversion of all dilutive potential common shares. The company has the following potentially dilutive instruments outstanding during the periods presented: (i) PSP; (ii) LTIP; and (iii) Warrants There is no difference between net income attributable to ordinary stockholders and net income attributable to all stockholders for the years ended 31 December 2006 and 2005. Reconciliations of the number of shares used in the calculations are set out below. 31 December 31 December 2006 2005 ---------- ---------- Weighted average number of shares 162,598,043 154,984,097 Dilution effect of warrants 6,492,633 5,101,067 Dilution effect of stock options and non-vested shares 6,771,102 2,013,603 Dilution effect of stock options and warrants exercised in the period 213,223 930,519 ---------- ---------- Weighted average number of shares on a diluted basis 176,075,001 163,029,285 ---------- ---------- Earnings per common share Basic $1.59 $0.13 Diluted $1.47 $0.12 Options to purchase 9,751,307 shares (2005: 9,903,849) under the LTIP were outstanding during the year but were not included in the computation of diluted earnings per share because the options' exercise price was greater than the average market price of the common shares. All securities awarded under the PSP were included in the computation of diluted earnings per share because the performance conditions necessary for these securities to vest were met as at 31 December 2006 (2005: 2,203,786 securities were excluded). Finally, the issuance of new shares in connection with the acquisition of Wellington had a minimal dilutive effect on earnings per common share because it happened very late in the year. 16 Other comprehensive loss The following table details the tax effect of the individual components of other comprehensive loss for 2006 and 2005: Amount before Tax benefit Amount 2006 tax /(expense) after tax --------- --------- --------- Unrealised gains arising during year $18,684 $(5,750) $12,934 Less reclassification for losses realised in income (17,041) 3,564 (13,476) --------- --------- --------- Net unrealised gains on investments 1,643 (2,186) (542) Cumulative translation adjustments (9,055) 4,907 (4,149) --------- --------- --------- Change in accumulated other comprehensive loss $(7,412) $2,721 $(4,691) --------- --------- --------- Amount before Tax benefit/ Amount 2005 tax (expense) after tax --------- --------- --------- Unrealised losses arising during year $(27,495) $2,400 $(25,095) Less reclassification for losses realised in income (1,520) 582 (938) --------- --------- --------- Net unrealised losses on investments (29,015) 2,982 (26,033) Cumulative translation adjustments 1,361 (883) 478 --------- --------- --------- Change in accumulated other comprehensive loss $(27,654) $2,099 $(25,555) --------- --------- --------- 17 Pension commitments The Group operates various pension schemes for the different countries of operation. In addition, the Group acquired a defined benefit pension plan and defined contribution plans as part of the Wellington acquisition. In the UK, the Group operates defined contribution schemes for certain directors and employees, which are administered by third party insurance companies. The pension cost for the UK scheme was $4,184 for the year ended 31 December 2006 (2005: $3,265). In Bermuda, the Group operates a defined contribution scheme, under which the Group contributes a specified percentage of each employee's earnings. The pension cost for the Bermuda scheme was $683 for the year ended 31 December 2006 (2005: $470). In the US, Catlin Inc. has adopted a Profit Sharing Plan ('the Plan') qualified under the Internal Revenue Code in which all employees meeting specified minimum age and service requirements are eligible to participate. Contributions are made to the Plan as determined by the Board of Directors of Catlin Inc. on an annual basis and are allocated on a pro rata basis to individual employees based upon eligible compensation. The pension cost for the Plan was $567 for the year ended 31 December 2006 (2005: $303). In connection with the acquisition of Wellington, the Group assumed liabilities associated with a defined benefit pension scheme which Wellington sponsored. The scheme has been closed to new members since 1993. The current membership consists only of pensioners and deferred members. The movements in the period are shown in the table below. 2006 ------------ Change in projected benefit obligation: - Projected Benefit obligation, beginning of year - Business combination 32,720 ------------ Projected benefit obligation, end of year $32,720 ------------ Change in plan assets: - Fair value of plan assets, beginning of year - Business combination 34,429 ------------ Fair value of plan assets, end of year $34,429 ------------ Reconciliation of funded status: Funded status $1,709 ------------ Net pension asset recognised at year end $1,709 ------------ The actuarial assumptions used to value the benefit obligation at 31 December 2006 were as follows: Discount rate 5.1% Price inflation 5.1% Pension increases to pensions in payment 3.2% ------------ As the plan was assumed from Wellington at 31 December 2006, there are no income statement effects in 2006. The objectives in managing the scheme's investments are to ensure that sufficient assets are available to pay members' benefits as they arise, with due regard to minimum regulatory requirements and the employer's ability to meet contribution payments. It is believed that, in relation to membership consisting only of pensioners and deferred members, these objectives are best met by investment in fixed income securities. The investments are in a pooled, non-government bond fund which is diversified across a large number of securities in order to reduce specific risk. As at 31 December 2006, 97 per cent of plan assets were held in debt securities, with the remaining 3 per cent held as cash. No plan assets are expected to be returned to the Group in the year ending 31 December 2007. The overall expected return on assets is calculated as the weighted average of the expected returns on each individual asset class. The return on debt securities is the current market yield on debt securities. The expected return on other assets is derived from the prevailing interest rate set by the Bank of England as at the measurement date. Estimated future benefit payments for the defined benefit pension plan, are as follows: 2007 $1,862 2008 $1,960 2009 $2,058 2010 $2,156 2011 $2,254 2012 to 2016 inclusive $12,740 -------- No contributions are expected to be paid to the defined benefit plan during 2007. 18 Statutory financial data The Group's statutory capital and surplus was $1,459,950 at 31 December 2006 (2005: $909,134). The statutory surplus of each of its principal operating subsidiaries is far in excess of regulatory requirements. The Group's ability to pay dividends is subject to certain regulatory restrictions on the payment of dividends by its subsidiaries. The payment of such dividends is limited by applicable laws and statutory requirements of the jurisdictions in which the Group operates. The Group is also subject to restrictions on some of its assets to support its insurance and reinsurance operations, as described in Note 5. 19 Commitments and contingencies Legal proceedings The Group is party to a number of legal proceedings arising in the ordinary course of the Group's business which have not been finally adjudicated. While the results of the litigation cannot be predicted with certainty, management believes that the outcome of these matters will not have a material impact on the results of operations or financial condition of the Group. Concentrations of credit risk Areas where significant concentration of risk may exist include investments, reinsurance recoverable and cash and cash equivalent balances. The cash balances and investment portfolio are managed following prudent standards of diversification. Specific provisions limit the allowable holdings of a single institution issue and issuers. Similar principles are followed for the purchase of reinsurance. The Group believes that there are no significant concentrations of credit risk associated with its investments or its reinsurers. Note 8 describes concentrations of more than 5 per cent of the Group's total reinsurance recoverable asset. Letters of credit The Group provides finance under its Club Facility to enable its subsidiaries to continue trading and to meet its liabilities as they fall due, as described in Note 10. The Group has given guarantees to the providers under the previous Wellington credit facility described in Note 10. Future lease commitments The Group leases office space and equipment under non-cancellable operating lease agreements, which expire at various times. Future minimum annual lease commitments for non-cancellable operating leases as at 31 December 2006 are as follows: 2007 $9,784 2008 8,445 2009 5,693 2010 5,614 2011 and thereafter 33,978 -------- Total $63,514 -------- Under non-cancellable sub-lease agreements, the Group is entitled to receive future minimum sub-lease payments of $869 (2005: $nil). 20 Related parties The Group purchased services from Catlin Estates Limited and Burnhope Lodge, both of which are controlled by a Director of the Group. All transactions were entered into on normal commercial terms. The cost of services purchased from Catlin Estates Limited during 2006 was $nil (2005: $201) and from Burnhope Lodge was $nil (2005: $23). There were no material transactions between Catlin and Wellington prior to the business combination in December 2006. Club Facility During 2005 and until 4 October 2006, Barclays plc held interests in more than 10per cent of the issued share capital of the Company. An affiliate of Barclays plc, Barclays Bank plc ('Barclays'), is one of the banks participating in the Club Facility, described in Note 10. Barclays participates equally with the other two banks in the Club Facility and, while Barclays plc held interests in more than 10 per cent of the issued share capital, Barclays received fees as follows: • A participation fee of one third of 0.085per cent on the total amount of the Club Facility; • A fronting fee of 0.125per cent per annum on the maximum actual and contingent liabilities of the other two banks under Facility C; • A fronting agent/security trustee fee of $75 per annum plus $0.5 for each LOC issued, payable on a quarterly basis, once more than 75 LOCs are issued; • A commitment fee of one third of 0.25 per cent per annum on Facility A, one third of 0.25 per cent per annum on Facility B and one third of 0.135 per cent per annum on Facility C, in each case payable on the undrawn portion of the relevant Facility; • Interest of one third of LIBOR plus 0.65 per cent per annum plus mandatory costs on Facility A; • Commission of one third of 1.2 per cent per annum, reducing to 0.3 per cent per annum in respect of securitised outstandings, on Facility B; and • Commission of one third of 0.6 per cent per annum, reducing to 0.3 per cent per annum in respect of securitised outstandings, on Facility C. In addition, Barclays was the Arranger for the Club Facility, and was paid a coordination fee of $150 for acting in that capacity. Various subsidiaries of the Group also hold bank accounts with Barclays and its affilitiates, in the normal course of business. Management believes that all transactions with Barclays were conducted under normal commercial terms. 21 Subsequent events Proposed dividend On 8 March 2007, the Board approved a proposed final dividend of $0.328 per share (£0.17 per share), payable on 8 June 2007 to shareholders of record at the close of business on 11 May 2007. The final dividend is determined in US dollars but partially payable in sterling based on the exchange rate of £1=$1.93 on 7 March 2007. Issuance of preferred shares On 18 January 2007, the Group, through Catlin Bermuda, issued $600,000 of non-cumulative perpetual preferred shares at a dividend rate of 7.249 per cent. The proceeds were used to repay the $500,000 bridge facility as well as Facility A described in Note 10, and for general corporate purposes. Issuance of common shares As described in Note 3, at 31 December 2006, acceptances representing 88 per cent of Wellington's share capital subject to the Offer had been settled. The remaining Wellington shares subject to the Offer were settled in 2007, resulting in a further issuance of 11,679,637 shares. Payment to Lloyd's Wellington has agreed, without admission of wrongdoing or liability, to pay Lloyd's £16,071 to resolve an inquiry commenced by Lloyd's into the conduct of Wellington Underwriting Agencies Limited and Wellington (Five) Limited in the Lloyd's capacity auctions held during September 2006. The amount equates approximately to the difference, in aggregate, between the price received by sellers of Syndicate 2020 capacity in the auctions and the amount they would have received if they had not sold in the auction but had accepted the Syndicate cessation compensation offer of 50 pence per £1.00 of capacity. It is anticipated that the payment will be made before the end of the first quarter 2007. Cat Swap On 13 February 2007, Catlin Bermuda entered into a further $10,000 Cat Swap with ABN AMRO Bank N.V. London Branch which will respond to the third covered risk event (that is, the covered risk event before the Class B notes are triggered). The terms are otherwise as described for the third covered event entered into during 2006 as described in Note 9, except that the limit payable is $10,000. This information is provided by RNS The company news service from the London Stock Exchange

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