Preliminary Results

Lancashire Holdings Limited 07 March 2007 LANCASHIRE HOLDINGS LIMITED Hamilton, Bermuda, 7 March 2007 PRELIMINARY RESULTS FOR THE 12 MONTH PERIOD TO 31 DECEMBER 2006 Fully converted book value per share grows 17.4% in first year of operations Financial highlights â€¢ Fully converted book value per share grows 17.4% â€¢ Operating income of $180.5 million1 or $0.892 per common share â€¢ Profit after tax of $159.3 million or $0.793 per common share â€¢ Gross written premiums of $626.0 million â€¢ Loss ratio of 16.1% â€¢ Combined ratio of 44.3% â€¢ Capital retained for 2007 opportunities Operating highlights â€¢ Successful transition from start-up to fully established major underwriter â€¢ Excellent response to launch of UK underwriting platform â€¢ Provisional authorisation received for Middle East marketing operation â€¢ Highly experienced team of 57 people across the Group Positive outlook for 2007 â€¢ Capital expected to be fully utilised in 2007 â€¢ Overall trading conditions very healthy and business flow accelerating â€¢ 1 January 2007 net unearned premium reserve of $306.6 million â€¢ Projected 2007 gross written premium growth of at least 20% â€¢ Projected 2007 growth in book value of between 20% and 25%, assuming normal market loss experience 1 Operating income is profit before tax, excluding realized investment gains and losses, foreign exchange and warrants issued at IPO, but inclusive of options issued thereafter 2 Net operating income per common share of Â£0.48, using an average 2006 exchange rate 3 Profit after tax per common share of Â£0.42, using an average 2006 exchange rate Richard Brindle, Chief Executive Officer and Chief Underwriting Officer, commented: 'I am delighted to report that 2006, our first full year of business, was a success both financially and operationally. Financially, we increased fully converted book value per share by 17.4% from a standing start. We achieved a low combined ratio of 44.3% and generated net income of $159.3 million. Net operating income was $180.5 million and shareholders' equity grew by $190.5 million to a year end total of $1,137.6 million. Operationally, we have gone from being a start-up company to an established major underwriter in the market with sophisticated technical capabilities, a highly experienced underwriting team and 57 people across Bermuda, London and Dubai. In 2007, broker and client support remains extremely strong and the acceleration in business flow has been remarkable.' Bob Spass, Chairman, commented: 'After its first year, Lancashire has emerged as a highly focused and successful business. Market expectations for the 'Class of 2005' were for Bermuda reinsurers writing predominantly cat cover. Lancashire is somewhat different. We write a diversified mix of insurance and reinsurance, both cat and non-cat, across many specialty lines, from twin underwriting platforms in Bermuda and London. Underwriting teams in both locations are experienced and operate under the same mandate - risk selection is key. As a result, we can boast not only today's excellent results, but also a wealth of business relationships with brokers and clients that will give us strength to grow over the years ahead.' Financial Summary ($ millions) Property Energy Marine Aviation Total Gross premium written 254.5 253.9 53.1 64.5 626.0 Net premium written 214.7 215.2 53.1 64.5 547.5 Net premium earned 98.5 107.6 24.3 13.1 243.5 Losses and loss expenses (13.2) (17.2) (8.7) - (39.1) Acquisition costs (11.2) (16.5) (4.6) (2.6) (34.9) Underwriting income 74.1 73.9 11.0 10.5 169.5 Investment income 56.0 Share of profit of associate 3.2 Operating expenses (33.9) Options (2.0) Financing costs (12.3) Operating income 180.5 Profit after taxes 159.3 Loss ratio 4 13.4% 16.0% 35.8% 0.0% 16.1% Acquisition cost ratio 4 11.4% 15.3% 18.9% 19.8% 14.3% Expense ratio 4 13.9% Combined ratio 4 44.3% 4 based on net earned premium Chief Executive's Statement Our strategy is built on four cornerstones: (i) underwriting comes first; (ii) maintenance of a strong balance sheet; (iii) keep operations nimble; and (iv) management of capital through the cycle. We believe this strategy, successfully executed, will deliver our overriding aim of creating attractive long-term growth in book value per share for our shareholders. Lancashire primarily writes insurance with a focus on short-tail, specialty risks, mostly written on a direct basis. All things equal, we prefer writing direct risks as opposed to reinsuring someone else's book as we believe this approach can create a durable competitive advantage. Insurance involves the creation of direct sustainable relationships with our insured clients and a focus on specific risk selection which should improve the probability of success through hard and soft cycles. Reinsurance can however offer compelling opportunities from time to time. For example, in 2006 we enthusiastically capitalized on such opportunities in property retrocession, and this will continue in 2007. However, reinsurance tends to be more of a commodity business where achieving a meaningful competitive advantage is difficult. With insurance underwriting, the critical success factor is risk selection. Skills in risk selection take experience, and our underwriting team is highly experienced. In our major lines of business, the team leaders have, on average, almost twenty years of experience. By consistently being smart about risk selection - through hard and soft cycles - Lancashire can sustain a competitive advantage. This competitive advantage should produce a better than expected loss ratio, and thus strong growth in book value per share over time. We believe Lancashire can trade strongly in a hard market and a soft market. First, our book is mostly direct. Secondly, it is highly diversified. In 2007, we expect that over half of our premium will be generated from risks that are not exposed to natural catastrophes. We have deliberately built a diversified book of non correlating risks. This has been enhanced by our presence in three strategic locations - Bermuda, London and Dubai - giving us access to the business flow that is generated in each of these markets. The benefit of our diversified book is that in the future we can direct our capital to the best underwriting opportunities. This flexibility - combined with underwriting discipline - will allow us to trade successfully through all stages of the cycle. It also sets us apart from many more concentrated (re)insurers in Bermuda and elsewhere. We like the book of business created in 2006. At the start of the year pricing was good in many areas and, as we anticipated, pricing and terms steadily improved through the year. Our enthusiasm increased correspondingly, as did our book. This rosy picture was not uniform though. In certain areas, most notably marine, pricing failed to reach expectations and we declined deals in large numbers. This reduced our top line premium but, crucially, resulted in a stronger portfolio of risks as we ended the year. We wrote $626.0 million of gross premium in 2006. With the wealth of experience of our underwriting team, significant increases in policy submission count, and very good trading conditions, we expect to increase gross written premiums by at least 20% in 2007. This is based on current expectations for pricing and terms in lines that we target. 2007 has begun well. Loss experience to date has been lower than expected. The most significant industry loss has been the Kyrill wind storm which hit Europe in January. While we have received only a de minimis amount of advices, because of the inherent uncertainties surrounding such events we are currently estimating an impact to Lancashire of between zero and ten million dollars. Capital Management To generate attractive long term returns for shareholders, we seek to couple excellent underwriting with conservative, active capital management. First, we intend to maintain a strong balance sheet at all times no matter what. Secondly, we will aim to have both the right level and mix of capital to support our underwriting. In 2006, we grew capital by $190.5 million and, by the end of the year, our capital was fully deployed. Looking ahead, we are encouraged by the trading conditions in our markets. We believe we can deploy all of our capital and, absent major losses, do not anticipate any capital actions during the bulk of 2007. We are currently projecting book value per share growth in 2007 in the low to mid twenties percent range, assuming a normal level of losses and premium growth in line with expectations. Following the end of the 2007 hurricane season, we will re-evaluate our capital requirements, giving careful consideration to balance sheet strength, rating agencies and other stakeholders. We expect that our combination of underwriting discipline and careful trading through the cycle will result in significant returns of capital in the future, as and when appropriate. Comment on Results and Outlook Further detail of our FY 2006 results can be obtained from our Financial Supplement. This can be accessed via our website www.lancashire.bm. Gross written premiums for the twelve month period were $626.0 million. Overall trading conditions in the classes written by Lancashire have been very good. This, combined with the lack of any significant loss events in 2006, has resulted in a healthy operating income of $180.5 million and an overall combined ratio of 44.3%. We move into 2007 well placed to build on our existing book and relationships, and the increases in deal flow compared to a year ago have been significant. Our presence in the London market, through our FSA authorised insurer, has been well received. To date, 2007 renewals have been at encouraging prices and terms. Overall trading conditions are excellent. We are experiencing a gradual softening in certain areas from the peaks of summer 2006, but overall cat-pricing remains ahead of a year ago. We believe rates and conditions will hold strong in our major lines for the majority of 2007. Underwriting Lancashire writes a highly diversified book of business, mostly on a direct basis, in four lines: property, energy, marine and aviation. In 2007, we expect our overall portfolio to grow but remain broadly similar in composition to that of 2006. In 2006, premium for risks exposed to natural catastrophes represented approximately 58% of our total written premium. For 2007, we expect this elemental proportion to reduce below 50%. Property This segment includes direct commercial property insurance and terrorism, all written on a facultative basis, as well as property cat retrocession. We have also written a handful of political risk contracts. Pricing overall has been robust, as have terms and conditions, particularly in the retrocession and direct commercial property classes. Trading conditions in these classes steadily improved through 2006. While demand for our retrocession product may reduce as a result of the Florida State backed reinsurance facility, 2007 trading conditions for retrocession and direct and facultative property are generally expected to remain at levels close to those of 2006. Trading conditions in terrorism, although softening, remain reasonably good on a risk-adjusted basis. Energy The energy segment includes offshore and onshore energy written on a worldwide basis. The Gulf of Mexico offshore energy class represented approximately 68% of energy premium written through 31 December 2006. Trading conditions in this class have been unprecedented. Pricing was consistently up several hundred percent from 2005, accompanied by dramatic tightening in terms and conditions. Trading conditions elsewhere in the world also improved markedly over 2005, albeit not to the extreme extent seen in the U.S. Looking ahead, while the majority of energy renewals take place in the second quarter, we currently see little change in supply or demand for Gulf of Mexico wind exposed deals. Pricing is expected to decrease only marginally, remaining at excellent levels. Outside the Gulf of Mexico, we continue to expand our book, with further opportunities expected to arise following the establishment of our Middle East marketing presence. Marine This segment includes marine excess of loss and a number of marine hull, marine war, marine P&I and other miscellaneous marine classes. As reported in earlier trading statements, marine excess of loss renewal prices were disappointing in 2006 and conditions meant that marine represented a smaller proportion of our overall book than initially anticipated. However, with the addition of a marine team in mid-2006, we were able to gradually build a good quality book. While conditions in general remain depressed for 2007, by entering the year with a full team we are in a good position to trade carefully but successfully in this segment. Aviation To date, our aviation focus has been centered on AV52 war carve-out business. We do not write general aviation business at this time, as we believe pricing is inadequate. AV52 pricing has been excellent on a risk adjusted basis although we predict some softening during 2007. We may also write a small number of aviation industry loss warranty contracts and satellite programs. Outwards reinsurance Outwards reinsurance premiums ceded in the twelve month period were $78.5 million, including $29.9 million of Gulf of Mexico offshore energy premiums ceded to Sirocco Reinsurance Limited, a Bermuda reinsurer in which Lancashire invested $20.0 million in June 2006. We expect that the ratio of ceded premiums to gross written premiums will remain relatively similar in 2007 compared to 2006. ***** Net premiums earned were $243.5 million for the year. As a newly formed group of companies with no existing book of unearned policies, there was a substantial difference between the relative size of premiums written and premiums earned because policies written generally earn over a twelve month period. Gross premiums earned as a proportion of gross premiums written was a modest 48.4% in 2006, but this ratio will increase substantially in 2007. The loss ratio for the twelve months to 31 December 2006 was 16.1%, driven by the relative absence of large loss events in the major classes written by Lancashire. All but a de minimis amount of the loss expense recorded is in respect of losses incurred but not reported. We do not expect the unusual loss conditions of 2006 to be repeated in 2007. The acquisition cost ratio for the period was 14.3% and the underwriting operating expense ratio was 13.9%. The acquisition cost ratio is expected to increase only marginally in 2007. The underwriting operating expense ratio for 2006 is significantly higher than the expected long term ratio due to the lag in net premiums earned in the first year of operations. In 2007, the operating expense ratio should be well below 10%. Net investment income for 2006 was $56.0 million. The fixed income portfolio is currently yielding 5.3%. During the year, we realised $0.8 million of net gains, and generated an unrealised gain of $8.7 million. The split of assets at 31 December 2006 was fixed income 65%, cash 29% and equities 6%. The weighted average duration and credit quality of our fixed income portfolio was 2.3 years and AA+, respectively. Employee warrants and option expense is the accrual of the fair value of warrants and options granted to employees. The fair value is calculated on the grant date and will be expensed over the vesting period of each security, which is between three and four years. The fair value is expensed in the income statement and there is a corresponding credit to share premium in the balance sheet resulting in a net zero impact on total shareholders' equity. The warrants were a one-off creation at the time of the IPO in late 2005. Due to their non-recurring nature, they are not included in operating income as defined. Options are a recurring expense and are included within operating income. Total capital at 31 December 2006 was $1.3 billion, comprising $1,137.6 million of common equity and $128.6 million of long-term debt. Leverage is 10.2%. Fully converted book value per share at 31 December 2006 was $5.68 compared to $4.84 at 31 December 2005, representing growth of 17.4% in the twelve months to 31 December 2006. Based on projected opportunities for 2007, we believe the level and mix of capital is appropriate. This will be reassessed by management as the trading environment evolves. Investor Presentation There will be an investor presentation on the results at 1130 UK time (0630 EST) on Wednesday 7 March at Financial Dynamics, Holborn Gate, 26 Southampton Buildings, London WC2A 1PB. This presentation will be hosted by Richard Brindle, Chief Executive Officer and Chief Underwriting Officer; Neil McConachie, Chief Financial Officer; and Simon Burton, Deputy Chief Underwriting Officer and Chief Operating Officer. Those wishing to attend are asked to contact Rob Bailhache or Nick Henderson at Financial Dynamics on +44 (0) 207 269 7200 / robert.bailhache@fd.com or +44 (0) 207 269 7114 / nick.henderson@fd.com. The presentation will also be accessible via a conference call for those unable to attend in person. To dial-in please call +44 (0) 1452 562 716 / + 1 866 832 0717 (Conf ID: 6035147). There will also be a live webcast of the presentation at www.lancashire.bm. A replay facility can also be accessed at www.lancashire.bm. For further information, please contact: Lancashire Holdings +1 441 278 8950 Neil McConachie Financial Dynamics Rob Bailhache +44 20 7269 7200 Nick Henderson +44 20 7269 7114 Investor enquiries and questions can also be directed to investors@lancashire.bm or by accessing the Company's website www.lancashire.bm. About Lancashire Lancashire, through its UK and Bermuda-based insurance subsidiaries, is a global provider of specialty insurance products. Its insurance subsidiaries carry the Lancashire group rating of A minus (Excellent) from A.M. Best with a stable outlook. Lancashire has capital in excess of $1 billion and its Common Shares trade on AIM under the ticker symbol LRE. Lancashire is headquartered at Mintflower Place, 8 Par-La-Ville Road, Hamilton HM 08, Bermuda. The mailing address is Lancashire Holdings Limited, P.O. Box HM 2358, Hamilton HM HX, Bermuda. For more information on Lancashire, visit the company's website at www.lancashire.bm Consolidated income statement for the year ended December 31, 2006 notes 2006 2005 $m $m gross premiums written 626.0 2.6 outwards reinsurance premiums 25 (78.5) - net premiums written 547.5 2.6 change in unearned premiums 13 (323.1) (2.6) change in unearned premiums on premium ceded 13 19.1 - net premiums earned 243.5 - net investment income 3 54.2 2.1 net other investment income 3, 11, 20 1.8 - net realised gains (losses) and impairments 3 0.8 - share of profit of associate 12 3.2 - net foreign exchange gains (losses) (1.3) 0.3 total net revenue 302.2 2.4 insurance losses and loss adjustment expenses 39.1 - insurance losses and loss adjustment expenses recoverable - - net insurance losses 39.1 - net insurance acquisition expenses 4, 25 34.9 - other operating expenses 5, 6, 7 56.4 10.0 total expenses 130.4 10.0 results of operating activities 171.8 (7.6) finance costs 20 12.3 4.0 profit (loss) before tax 159.5 (11.6) tax 8, 9 0.2 - profit (loss) for the period attributable to equity shareholders 159.3 (11.6) earnings per share basic 24 $0.81 $(0.24) diluted 24 $0.79 $(0.24) Consolidated balance sheet as at December 31, 2006 notes 2006 2005 $m $m assets cash and cash equivalents 10 400.1 1,072.4 accrued interest receivable 14 7.5 2.0 investments - fixed income securities 11 896.3 - - equity securities 11 70.3 - - other investments 11, 20 11.5 - reinsurance assets - unearned premium on premium ceded 13, 25 19.1 - deferred acquisition costs 15 51.5 0.5 other receivables 14 6.3 0.3 inwards premium receivable from insureds and cedants 14 173.7 2.1 deferred tax asset 8, 9 0.8 - investment in associate 12 23.2 - property, plant and equipment 18 2.4 0.4 total assets 1,662.7 1,077.7 liabilities insurance contracts - losses and loss adjustment expenses 13 39.1 - - unearned premiums 13 325.7 2.6 - other payables 13, 16 3.6 - amounts payable to reinsurers 13, 16, 25 2.4 - deferred acquisition costs ceded 17, 25 2.5 - other payables 16 20.8 2.2 corporation tax payable 9 1.0 - interest rate swap 20 0.9 - accrued interest payable 19 0.5 0.4 long-term debt 19 128.6 125.4 total liabilities 525.1 130.6 shareholders' equity share capital 21 97.9 97.9 share premium 21, 26 33.6 860.8 contributed surplus 26 849.7 - fair value and other reserves 3, 11 8.7 - retained earnings (deficit) 147.7 (11.6) total shareholders' equity attributable to equity shareholders 1,137.6 947.1 total liabilities and shareholders' equity 1,662.7 1,077.7 Consolidated statement of changes in equity for the year ended December 31, 2006 fair value retained share share contributed and other (deficit) notes capital premium surplus reserves earnings total $m $m $m $m $m $m balance as at october 12, 2005 (date of - - - - - - incorporation) loss for the period - - - - (11.6) (11.6) total recognised loss for the period - - - - (11.6) (11.6) issue of share capital 21 97.9 880.7 - - - 978.6 equity offering expenses - (58.6) - - - (58.6) formation expenses 26 - (36.1) - - - (36.1) warrant issues - founders & sponsor 22 - 66.4 - - - 66.4 warrant issues - management 6 - 8.4 - - - 8.4 balance as at december 31, 2005 97.9 860.8 - - (11.6) 947.1 profit for the period - - - - 159.3 159.3 change in investment unrealised gains (losses) 3, 11 - - - 8.7 - 8.7 total recognised income for the period - - - 8.7 159.3 168.0 issue of share capital 21 - 0.3 (0.3) - - - transfer from share premium to contributed 26 - (850.0) 850.0 - - - surplus warrant issues - management and performance 6, 22 - 20.5 - - - 20.5 options issues - management 6, 22 - 2.0 - - - 2.0 balance as at december 31, 2006 97.9 33.6 849.7 8.7 147.7 1,137.6 Consolidated cash flow statement for the year ended December 31, 2006 2006 2005 notes $m $m cash flows from operating activities profit (loss) before interest and tax 116.4 (13.3) interest income 3 53.6 2.1 interest expense (10.6) (0.4) tax 8 (0.2) - depreciation 7 0.6 - amortisation of debt securities (1.2) - employee benefits expense 5, 6 22.5 8.4 foreign exchange 1.9 (0.3) share of profit of associate 12 (3.2) - net realised gains and impairments on investments 3 (0.8) - net unrealised gains on derivative financial instrument 3, 20 (1.8) - unrealised loss on swaps 20 0.9 - accrued interest receivable (5.6) (2.0) unearned premium on premium ceded (19.1) - deferred acquisition costs (51.0) (0.5) other receivables (6.0) (0.3) inwards premium receivable from insureds and cedants (171.4) (2.1) deferred tax asset (0.8) - insurance contracts - losses and loss adjustment expenses 39.1 - - unearned premiums 323.1 2.6 - other payables 3.6 - amounts payable to reinsurers 2.4 - deferred acquisition costs ceded 2.5 - other payables 18.6 1.3 corporation tax payable 1.0 - accrued interest payable - 0.4 net cash flows from (used in) operating activities 314.5 (4.1) cash flows from investing activities purchase of property, plant and equipment 18 (2.6) (0.4) investment in associate 12 (20.0) - purchase of debt securities (2,086.1) - purchase of equity securities (76.1) - proceeds on maturity and disposal of debt securities 1,185.6 - proceeds on disposal of equity securities 20.9 - net purchase of other investments (9.7) - net cash flows used in investing activities (988.0) (0.4) cash flows from financing activities proceeds from issue of share capital - 978.6 transaction costs from issue of share capital - (12.2) formation expenses - (15.2) proceeds from issue of long-term debt - 125.7 net cash flows from financing activities - 1,076.9 net (decrease) increase in cash and cash equivalents (673.5) 1,072.4 cash and cash equivalents at beginning of period 1,072.4 - effect of exchange rate fluctuations on cash and cash equivalents 1.2 - cash and cash equivalents at end of period 10, 26 400.1 1,072.4 Accounting policies for the year ended December 31, 2006 summary of significant accounting policies The basis of preparation, consolidation principles and significant accounting policies adopted in the preparation of Lancashire Holdings Limited ('LHL') and its subsidiaries' (collectively 'the Group') consolidated financial statements are set out below. basis of preparation The Group's consolidated financial statements are prepared in accordance with accounting principles generally accepted under International Financial Reporting Standards ('IFRS') endorsed by the European Commission. Where IFRS is silent, as it is in respect of the measurement of insurance products, the IFRS framework allows reference to another comprehensive body of accounting principles. In such instances, management determines appropriate measurement bases, to provide the most useful information to users of the consolidated financial statements, using their judgment and considering the accounting principles generally accepted in the United States ('US GAAP'). Comparative figures have been presented for the period from October 12, 2005, the date of incorporation, to December 31, 2005. All amounts, excluding share data or where otherwise stated, are in millions of United States ('U.S.') dollars. The following new or amended standards, which have been issued, but are not yet effective, have not been early adopted by the Group: â€¢ IFRS 7, Financial Instruments Disclosure; â€¢ IFRS 8, Operating Segments; â€¢ IAS 1, Presentation of Financial Statements. These standards are not expected to have a material impact on the results and disclosures reported in the consolidated financial statements. International Financial Reporting Interpretations Committee ('IFRIC') standards issued but not yet effective are similarly not expected to have a material impact on the results and disclosures of the Group. The consolidated balance sheet of the Group is presented in order of decreasing liquidity. use of estimates The preparation of financial statements in conformity with IFRS requires management to make estimates and assumptions that affect the reported and disclosed amounts at the balance sheet date and the reported and disclosed amounts of revenues and expenses during the reporting period. Actual results may differ materially from the estimates made. basis of consolidation i. subsidiaries The Group's consolidated financial statements include the assets, liabilities, equity, revenues, expenses and cash flows of LHL and its subsidiaries. A subsidiary is an entity in which the Group owns, directly or indirectly, more than 50% of the voting power of the entity or otherwise has the power to govern its operating and financial policies. The results of subsidiaries acquired are included in the consolidated financial statements from the date on which control is transferred to the Group. Intercompany balances, profits and transactions are eliminated. Subsidiaries' accounting policies are consistent with the Group's accounting policies. ii. associates Investments in which the Group has significant influence over the operational and financial policies of the investee, are initially recognised at cost and thereafter accounted for using the equity method. Under this method, the Group records its proportionate share of income or loss from such investments in its results of operations for the period. Adjustments are made to associates' accounting policies, where necessary, in order to be consistent with the Group's accounting policies. foreign currency translation The functional currency for all Group entities is U.S. dollars. The consolidated financial statements are presented in U.S. dollars. Items included in the financial statements of each of the Group's entities are measured using the functional currency, which is the currency of the primary economic environment in which operations are conducted. Foreign currency transactions are recorded in the functional currency for each entity using the exchange rates prevailing at the dates of the transactions, or at the average rate for the period when this is a reasonable approximation. Monetary assets and liabilities denominated in foreign currencies are translated at period end exchange rates. The resulting exchange differences on translation are recorded in the consolidated income statement. Non-monetary assets and liabilities carried at historical cost denominated in a foreign currency are translated at historic rates. Non-monetary assets and liabilities carried at fair value denominated in a foreign currency are translated at the exchange rate at the date the fair value was determined, with resulting exchange differences recorded in the fair value reserves in shareholders' equity. insurance contracts i. classification Insurance contracts are those contracts that transfer significant insurance risk at the inception of the contract. Contracts that do not transfer significant insurance risk are accounted for as investment contracts. Insurance risk is transferred when an insurer agrees to compensate a policyholder if a specified uncertain future event adversely affects the policyholder. ii. premiums and acquisitions costs Premiums are first recognised as written at the date that the contract is bound. The Group writes both excess of loss and pro-rata / proportional contracts. For the majority of excess of loss contracts, written premium is recorded based on the minimum and deposit or flat premium, as defined in the contract. Subsequent adjustments to the minimum and deposit premium are recognised in the period in which they are determined. For pro-rata contracts and excess of loss contracts where no deposit is specified in the contract, written premium is recognised based on estimates of ultimate premiums provided by the insureds or ceding companies. Initial estimates of written premium are recognised in the period in which the underlying risks incept. Subsequent adjustments, based on reports of actual premium by the insureds or ceding companies, or revisions in estimates, are recorded in the period in which they are determined. Premiums are earned ratably over the term of the underlying risk period of the reinsurance contract, except where the period of risk differs significantly from the contract period. In these circumstances, premiums are recognised over the period of risk in proportion to the amount of insurance protection provided. The portion of the premium related to the unexpired portion of the risk period is reflected in unearned premium. Where contract terms require the reinstatement of coverage after a ceding company's loss, the mandatory reinstatement premiums are recorded as written premium when the loss event occurs. Inwards premiums receivable from insureds and cedants are recorded net of commissions, brokerage, premium taxes and other levies on premiums. These balances are reviewed for impairment, with any impairment loss recognised in income in the period in which they are determined. Acquisition costs represent commissions, brokerage, profit commissions and other variable costs that relate directly to the securing of new contracts and the renewing of existing contracts. They are deferred over the period in which the related premiums are earned, to the extent they are recoverable out of expected future revenue margins. All other acquisition costs are recognised as an expense when incurred. iii. outwards reinsurance Outwards reinsurance premiums comprise the cost of reinsurance contracts entered into. Outwards reinsurance premiums are accounted for in the period in which the underlying risks incept. The provision for reinsurers' share of unearned premiums represents that part of reinsurance premiums written which is estimated to be earned in future financial periods. Unearned reinsurance commissions are recognised as a liability using the same principles. Any amounts recoverable from reinsurers are estimated using the same methodology as the underlying losses. The Group monitors the credit worthiness of its reinsurers on an ongoing basis and assesses any reinsurance assets for impairment, with any impairment loss recognised in income in the period in which it is determined. iv. losses Losses comprise losses and loss adjustment expenses paid in the period and changes in the provision for outstanding losses, including the provision for losses incurred but not reported ('IBNR') and related expenses. Losses and loss adjustment expenses are charged to income as they are incurred. A significant portion of the Group's business is classes with high attachment points of coverage, including property catastrophe. Reserving for losses in such programs is inherently complicated in that losses in excess of the attachment level of the Group's policies are characterised by high severity and low frequency and other factors which could vary significantly as losses are settled. This limits the volume of industry loss experience available from which to reliably predict ultimate losses following a loss event. In addition, the Group has limited past loss experience due to its short operating history, which increases the inherent uncertainty in estimating ultimate loss levels. Losses and loss adjustment expenses represent the estimated ultimate cost of settling all losses and loss adjustment expenses arising from events which have occurred up to the balance sheet date, including a provision for IBNR. The Group does not discount its liabilities for unpaid losses. Outstanding losses are initially set on the basis of reports of losses received from third parties. Estimated IBNR reserves consist of a provision for additional development in excess of case reserves reported by ceding companies or insureds, as well as a provision for losses which have occurred but which have not yet been reported to us by ceding companies or insureds. IBNR reserves are estimated by management using various actuarial methods as well as a combination of our own loss experience, historical insurance industry loss experience, our underwriters' experience, estimates of pricing adequacy trends, and management's professional judgment. The estimation of the ultimate liability arising is a complex and judgmental process. It is reasonably possible that uncertainties inherent in the reserving process, delays in insureds or ceding companies reporting losses to the Group, together with the potential for unforeseen adverse developments, could lead to a material change in losses and loss adjustment expenses. v. liability adequacy tests At each balance sheet date, the Group performs a liability adequacy test using current best estimates of future cash flows generated by its insurance contracts, plus any investment income thereon. If, as a result of these tests, the carrying amount of the Group's insurance liabilities is found to be inadequate, the deficiency is charged to the consolidated income statement for the period initially by writing off deferred acquisition costs and subsequently by establishing a provision. cash and cash equivalents Cash and cash equivalents are carried in the consolidated balance sheet at cost and includes cash in hand, deposits held on call with banks and other short term highly liquid investments with a maturity of three months or less at the date of purchase. Carrying amounts approximate fair value due to the short term nature of the instruments. Interest income earned on cash and cash equivalents is recognised on the effective interest rate method. The carrying value of accrued interest income approximates fair value due to its short term nature. investments The Group's fixed income and equity investments are classified as available for sale and are carried at fair value. Other investments classified as available for sale are recorded at estimated fair value based on financial information received and other information available to management, including factors restricting the liquidity of the investments. Regular way purchases and sales of investments are recognised at fair value less transaction costs on the trade date and are subsequently carried at fair value. Estimated fair value of quoted investments is determined based on bid prices from recognised exchanges. Investments are derecognised when the Group has transferred substantially all of the risks and rewards of ownership. Realised gains and losses are included in income in the period in which they arise. Unrealised gains and losses from changes in fair value are included in the fair value reserve in shareholders' equity. On derecognition of an investment, previously recorded unrealised gains and losses are removed from shareholders' equity and included in current period income. Amortisation and accretion of premiums and discounts are calculated using the effective interest rate method and are recognised in current period net investment income. Dividends on equity securities are recorded as revenue on the date the dividends become payable to the holders of record. The carrying value of accrued interest income approximates fair value due to its short term nature. The Group reviews the carrying value of its investments for evidence of impairment. An investment is impaired if its carrying value exceeds the estimated recoverable amount and there is objective evidence of impairment to the asset. Such evidence would include a prolonged decline in fair value below cost or amortised cost, where other factors do not support a recovery in value. If an impairment is deemed appropriate, the difference between cost or amortised cost and fair value is removed from the fair value reserve in shareholders' equity and charged to current period income. Impairment losses on equity securities are not subsequently reversed through the income statement. Impairment losses on debt securities may be subsequently reversed through the income statement. derivative financial instruments Derivatives are recognised at fair value on the date a contract is entered into, the trade date, and are subsequently carried at fair value. Derivative instruments with a positive value are recorded as derivative financial assets and those with a negative value are recorded as derivative financial liabilities. Embedded derivatives that are not closely related to their host contract are separated and fair valued through income. Derivative and embedded derivative financial instruments include swap, option, forward and future contracts. They derive their value from the underlying instrument and are subject to the same risks as that underlying instrument, including liquidity, credit and market risk. Fair values are based on exchange quotations and discounted cash flow models, which incorporate pricing of the underlying instrument, yield curves and other factors, with changes in the fair value of instruments that do not qualify for hedge accounting recognised in current period income. Derivative financial assets and liabilities are offset and the net amount reported in the consolidated balance sheet only to the extent there is a legally enforceable right of offset and there is an intention to settle on a net basis, or to realise the assets and liabilities simultaneously. property, plant and equipment Property, plant and equipment is carried at historical cost, less accumulated depreciation and any impairment in value. Depreciation is calculated to write-off the cost over the estimated useful economic life on a straight-line basis as follows: IT equipment 33% per annum Office furniture and equipment 33% per annum Leasehold improvements 20% per annum The assets' residual values, useful lives and depreciation methods are reviewed and adjusted if appropriate, at each balance sheet date. An item of property, plant or equipment is derecognised on disposal or when no future economic benefits are expected to arise from the continued use of the asset. Gains and losses on the disposal of property, plant and equipment are determined by comparing proceeds with the carrying amount of the asset, and are included in the income statement. Costs for repairs and maintenance are charged to the consolidated income statement as incurred. long term debt Long-term debt is recognised initially at fair value, net of transaction costs incurred. Thereafter it is held at amortised cost, with the amortisation calculated using the effective interest rate method. leases Rentals payable under operating leases are charged to income on a straight-line basis over the lease term. employee benefits i. equity compensation plans The Group operates a management warrant plan and an option plan. The fair value of the equity instrument granted is estimated on the date of grant. The fair value is recognised as an expense pro-rata over the vesting period of the instrument. The total amount to be expensed is determined by reference to the fair value of the awards estimated at the grant date, excluding the impact of any non-market vesting conditions. At each balance sheet date, the Group revises its estimate of the number of warrants and options that are expected to become exercisable. It recognises the impact of the revision of original estimates, if any, in the consolidated income statement, and a corresponding adjustment is made to shareholders' equity over the remaining vesting period. On vesting or exercise, the differences between the expense charged to the consolidated income statement and the actual cost to the Group is transferred to retained earnings. Where new shares are issued, the proceeds received are credited to share capital and share premium. ii. pensions The Group operates a defined contribution plan. On payment of contributions to the plan there is no further obligation to the Group. Contributions are recognised as employee benefits in the consolidated income statement in the period to which they relate. founder and sponsor warrants The Group issued warrants to certain founding shareholders and a sponsor on listing. The fair value of the equity instruments granted were estimated on the date of grant. Warrants issued to founding shareholders were treated as a capital transaction and the associated fair value was credited to the share premium account. The fair value of warrants issued to the sponsor for assistance with incorporation and other start-up services was credited to the share premium account. The total amount to be credited was determined by reference to the fair value of the awards estimated at the grant date, excluding the impact of any non-market vesting conditions. tax Income tax expense represents the sum of the tax currently payable and any deferred tax. The tax payable is calculated based on taxable profit for the period. Taxable profit for the period can differ from that reported in the consolidated income statement due to certain items which are not tax deductible or which are deferred to subsequent periods. Deferred tax is recognised on temporary differences between the assets and liabilities in the consolidated balance sheet and their tax base. Deferred tax assets or liabilities are accounted for using the balance sheet liability method. Risk disclosures for the year ended December 31, 2006 risk disclosures: introduction The Group enters into contracts that directly accept and transfer insurance risk. This in turn creates exposure for the Group to insurance risk and financial risk. The Group's appetite for accepting risk is established by the Board of Directors. The management of risks is described below. A. insurance risk The Group underwrites contracts that transfer insurance risk. The Group's underwriters assess the likely losses using their experience and knowledge of past loss experience and current circumstances. This allows them to estimate the premium sufficient to meet likely losses and expenses. The Group considers insurance risk at an individual contract level and at an aggregate portfolio level. The Group's exposure in connection with such contracts is, in the event of insured losses, whether premium will be sufficient to cover the loss payments and expenses. The Group underwrites worldwide short tail insurance and reinsurance property risks, including risks exposed to natural catastrophes. The four principal classes, or lines, are property, energy, marine and aviation. The Group does not currently underwrite a significant amount of casualty business. The level of risk tolerance per class is set by the Board of Directors, who delegate day to day responsibility to senior management. A number of controls are deployed to limit the amount of insurance exposure underwritten: â€¢ A business plan is produced annually which includes target premium by class â€¢ The business plan is monitored and reviewed on an on-going basis â€¢ Each authorised class has a pre-determined normal maximum line structure proposed by management and agreed by the Board â€¢ The Group has a pre-determined target limit on probabilistic loss of capital for certain catastrophic events â€¢ A daily underwriting meeting is held to peer review risks â€¢ Sophisticated pricing models are utilised in the underwriting process, and are updated frequently to latest versions â€¢ Computer modeling tools are deployed to simulate catastrophes and resultant losses to the portfolio â€¢ Reinsurance is purchased to mitigate losses in peak areas of exposure The Group has established an internal audit function which is independent of the underwriting process. The head of internal audit reports directly to the Audit Committee. The internal audit function is required to perform risk reviews on the underwriting function to ensure compliance with Group policies and required procedures. The Group establishes targets for the maximum proportion of capital, including long term debt, that can be lost in a single extreme event. As at December 31, 2006, the impact of an estimated 1 in 250 year California Quake event was 25% of capital, after collection of reinsurance and after payment and collection of reinstatement premiums. There can be no guarantee that the assumptions and techniques deployed in calculating this figure are accurate. There could also be an unmodeled loss which exceeds these figures. In addition, a California Quake loss event with an occurrence probability of greater than 1 in 250 years could cause a larger loss to capital, as could a different type of loss event with an occurrence probability of less than 1 in 250 years. The Group commenced underwriting in December 2005, but wrote an insignificant amount of business for the period from incorporation to December 31, 2005. Comparatives have therefore not been presented in the analysis provided in section A: insurance risk. Details of gross premiums written by line of business are provided below for the year ending December 31, 2006: $m % property 254.5 40.6 energy 253.9 40.6 marine 53.1 8.5 aviation 64.5 10.3 total 626.0 100.0 Details of gross premiums written by geographic area of risks insured are provided below for the year ending December 31, 2006: $m % worldwide offshore 209.4 33.5 worldwide, including the US (1) 168.2 26.9 USA and Canada 143.5 22.9 worldwide, excluding the US (2) 32.6 5.2 far east 19.9 3.2 rest of world 18.3 2.9 middle east 17.1 2.7 europe 17.0 2.7 total 626.0 100.0 (1) Worldwide comprises insurance and reinsurance contracts that insure or reinsure risks in more than one geographic area. (2) Worldwide, excluding the U.S., comprises insurance and reinsurance contracts that insure or reinsure risks in more than one geographic area, but that specifically exclude the United States of America and Canada. Sections a to d below describe the risks in each of the four principal lines of business written by the Group. a. property Gross premium written, for the year ending December 31, 2006: $m property retrocession 112.8 property direct and facultative 111.4 terrorism 18.9 property political risk 9.4 property cat excess of loss 0.6 other property 1.4 total 254.5 Property retrocession is written on an excess of loss basis through treaty arrangements. Programs are generally written on a pillared basis, with separate geographic zonal limits for risks in the U.S. and Canada and for risks outside the U.S. and Canada. Property cat excess of loss may be written in a similar manner to property retrocession but is not written on a pillared basis. The Group is exposed to large catastrophic losses such as wind and earthquake loss from assuming property retrocession and property cat excess of loss risks. Exposure to such events is controlled and measured through loss modeling but the accuracy of this exposure analysis is limited by the quality of data and effectiveness of the modeling. It is possible that a catastrophic event exceeds the expected event loss. The Group's appetite and exposure guidelines to large losses are set out in the risk disclosure section under the sub-heading insurance risk. Reinsurance has also been purchased to mitigate gross losses in the U.S. and Canada. Property direct and facultative is written for the full value of the risk, on a net excess of loss basis. Cover is generally provided to large commercial enterprises with high value locations. Coverage is for non-elemental perils including fire and explosion and elemental (natural catastrophe) perils including flood, windstorm, earthquake and tornado. Coverage generally includes indemnification for both property damage and business interruption. Terrorism cover is provided for U.S. and worldwide property risks, but excludes nuclear, chemical and biological coverage in most territories. Political risk cover is written on an individual case by case basis and coverage varies significantly between policies. b. energy Gross premium written, for the year ending December 31, 2006: $m gulf of mexico offshore energy 171.8 worldwide offshore energy 42.3 construction energy 24.5 onshore energy 13.5 other energy 1.8 total 253.9 Energy risks are mostly written on a direct basis. Gulf of Mexico energy programs cover elemental and non-elemental risks. The largest exposure is from hurricanes in the Gulf of Mexico. Exposure to such events is controlled and measured through loss modeling but the accuracy of this exposure analysis is limited by the quality of data and effectiveness of the modeling. It is possible that a catastrophic event exceeds the expected event loss. The Group's appetite and exposure guidelines to large losses are set out in the risk disclosure statement (A. insurance risk). Policies have sub-limits on coverage for elemental losses, and significant policy restrictions on other areas of cover such as business interruption and control of well. Non-elemental energy risks include fire and explosion. Reinsurance protection has been purchased to protect a portion of loss from elemental energy claims. Worldwide offshore energy programs are generally for non-elemental risks. Onshore energy risks can include onshore Gulf of Mexico and worldwide energy installations and are largely subject to the same loss events as described above. Energy construction contracts generally cover all risks of platform and drilling units under construction. c. marine Gross premium written, for the year ending December 31, 2006: $m marine hull and total loss 26.1 marine builders risk 10.5 marine P&I clubs 6.4 marine excess of loss 4.3 marine hull war 4.1 other marine 1.7 total 53.1 Marine hull and total loss is generally written on a direct basis and covers marine risks on a worldwide basis primarily for physical damage and loss. Marine P&I is the reinsurance of The International Group of Protection and Indemnity Clubs. Marine excess of loss is generally written on a treaty basis. Marine builders risk is insurance for the building of ocean going vessels in specialised yards worldwide, from keel laying to delivery to owner. Marine hull war is direct insurance of loss of vessels from war or terrorist attack. Marine cargo programs are not normally written. The largest exposure is from physical loss rather than from elemental loss events. d. aviation Gross premium written, for the year ending December 31, 2006: $m AV 52 56.2 other aviation 8.3 total 64.5 Aviation AV52 provides coverage for third party liability resulting from acts of war or hijack against aircraft. Other aviation business includes aviation hull war risks and industry loss warranty programs. reinsurance The Group, in the normal course of business and in accordance with its risk management practices, seeks to reduce the loss that may arise from events that could cause unfavourable underwriting results by entering into reinsurance arrangements. Reinsurance does not relieve the Group of its obligations to policyholders. Under the Group's reinsurance security policy, reinsurers are generally required to be rated A- or better by A.M. Best or equivalent rating. The Group considers reinsurers that are not rated or do not fall within the above rating category on a case by case basis, and may therefore require collateral to be posted to support obligations. The Group monitors the credit worthiness of its reinsurers on an ongoing basis. In 2006 the Group purchased excess of loss reinsurance, including industry loss warranty covers, and proportional reinsurance. The reinsurance purchased reduced the Group's net exposure to a large natural catastrophe loss in the U.S. which is the Group's largest gross exposure to loss. The Group has not currently purchased reinsurance for risks outside the U.S. There is no guarantee that reinsurance coverage will be available to meet all potential loss circumstances, as it is possible that the cover purchased is not sufficient. Any loss amount which exceeds the program would be retained by the Group. Some parts of the reinsurance program have limited reinstatements therefore the number of claims which may be recovered from second or subsequent losses is limited. insurance liabilities For most insurance and reinsurance companies, the most significant judgment made by management is the estimation of loss and loss adjustment expense reserves. The estimation of the ultimate liability arising from claims made under insurance and reinsurance contracts is a critical estimate for the Group. Under generally accepted accounting principles, loss reserves are not permitted until the occurrence of an event which may give rise to a claim. As a result, only loss reserves applicable to losses incurred up to the reporting date are established, with no allowance for the provision of a contingency reserve to account for expected future losses. Claims arising from future catastrophic events can be expected to require the establishment of substantial reserves from time to time. Loss and loss adjustment expense reserves are however maintained to cover the Group's estimated liability for both reported and unreported claims. Reserving methodologies that calculate a point estimate for the ultimate losses are utilised, and then a range is developed around the point estimate. The point estimate represents management's best estimate of ultimate loss and loss adjustment expenses. The Group's internal actuaries review the reserving assumptions and methodologies on a quarterly basis with loss estimates being generally subject to a quarterly corroborative review by independent actuaries, using generally accepted actuarial principles. The extent of reliance on management judgment in the reserving process differs as to whether the business is insurance or reinsurance, whether it is short-tail or long-tail and whether the business is written on an excess of loss or on a pro-rata basis. Over a typical annual period, the Group expects to write the majority of programs on a direct basis. Typically, over 80% of programs are expected to be written on an excess of loss basis. The Group does not currently write a significant amount of long-tail business. a. insurance versus reinsurance Loss reserve calculations for direct insurance business are not precise in that they deal with the inherent uncertainty of future contingent events. Estimating loss reserves requires management to make assumptions regarding future reporting and development patterns, frequency and severity trends, claims settlement practices, potential changes in the legal environment and other factors such as inflation. These estimates and judgments are based on numerous factors, and may be revised as additional experience or other data becomes available or reviewed as new or improved methodologies are developed or as current laws change. Furthermore, as a broker market reinsurer for both excess of loss and proportional contracts, management must rely on loss information reported to brokers by primary insurers who must estimate their own losses at the policy level, often based on incomplete and changing information. The information management receives varies by cedant and may include paid losses, estimated case reserves, and an estimated provision for IBNR reserves. Additionally, reserving practices and the quality of data reporting may vary among ceding companies which adds further uncertainty to the estimation of the ultimate losses. b. short-tail versus long-tail In general, claims relating to short-tail property risks, such as those underwritten by the Group, are reported more promptly by third parties than those relating to long-tail risks, including the majority of casualty risks. However, the timeliness of reporting can be affected by such factors as the nature of the event causing the loss, the location of the loss, and whether the losses are from policies in force with primary insurers or with reinsurers. c. excess of loss versus proportional For excess of loss business, management are aided by the fact that each treaty has a defined limit of liability arising from one event. Once that limit has been reached, there is no further exposure to additional losses from that treaty for the same event. For proportional treaties, generally an initial estimated loss and loss expense ratio (the ratio of losses and loss adjustment expenses incurred to premiums earned) is used, based upon information provided by the insured or ceding company and/or their broker and management's historical experience of that treaty, if any, and the estimate is adjusted as actual experience becomes known. d. time lags There is a time lag inherent in reporting from the original claimant to the primary insurer to the broker and then to the reinsurer, especially in the case of excess of loss reinsurance contracts. Also, the combination of low claim frequency and high severity make the available data more volatile and less useful for predicting ultimate losses. In the case of proportional contracts, reliance is placed on an analysis of a contract's historical experience, industry information, and the professional judgment of underwriters in estimating reserves for these contracts. In addition, if available, reliance is placed partially on ultimate loss ratio forecasts as reported by cedants, which are normally subject to a quarterly or six month lag. e. uncertainty As a result of the time lag described above, an estimation must be made of IBNR reserves, which consist of a provision for additional development in excess of the case reserves reported by ceding companies, as well as a provision for claims which have occurred but which have not yet been reported by ceding companies. Because of the degree of reliance that is necessarily placed on ceding companies for claims reporting, the associated time lag, the low frequency/high severity nature of much of the business that the Group underwrites, and the varying reserving practices among ceding companies, reserve estimates are highly dependent on management judgment and therefore uncertain. During the loss settlement period, which may be years in duration, additional facts regarding individual claims and trends often will become known, and current laws and case law may change, with a consequent impact on reserving. The claims count on the types of insurance and reinsurance that the Group writes, which are low frequency and high severity in nature, is generally low. For certain catastrophic events there is greater uncertainty underlying the assumptions and associated estimated reserves for losses and loss adjustment expenses. Complexity resulting from problems such as policy coverage issues, multiple events affecting one geographic area and the resulting impact on claims adjusting (including allocation of claims to event and the effect of demand surge on the cost of building materials and labour) by, and communications from, ceding companies, can cause delays to the timing with which the Group is notified of changes to loss estimates. In the year to December 31, 2006, management were not notified or made aware of any losses of a material size. As such, at December 31, 2006 management's estimates for IBNR represented approximately 97% of total loss reserves. The majority of the estimate relates to potential claims on non-elemental risks where timing delays in cedant reporting may mean losses have occurred which management were not made aware of by December 31, 2006. B. financial risk disclosures The Group is exposed if proceeds from financial assets are not sufficient to fund obligations arising from its insurance contracts. The Group segments its investment portfolio into two main components: A category to at least meet expected insurance liabilities ('core portfolio') and a balancing category which represents funds in excess of the core portfolio (' surplus portfolio'). The core portfolio needs to be sufficiently liquid to settle claims. The core portfolio is invested in fixed income securities and cash and cash equivalents, with a bias towards shorter durations and higher quality assets. The surplus portfolio is invested in fixed income securities, cash and cash equivalents and a modest amount of equity securities. Currently, the Group does not hold any alternative investments such as hedge funds. The surplus portfolio has a modest holding of convertible debt securities. These instruments have been bifurcated into their component parts with the embedded option fair valued through the income statement. Investment guidelines are established by the Investment Committee of the Board of Directors. Separate investment guidelines exist for the core portfolio, the surplus portfolio and the Group's consolidated portfolio. Investment guidelines set parameters within which investment managers must operate. Important parameters include guidelines on permissible assets, duration ranges, credit quality and maturity. Investment guidelines are monitored on a monthly basis. Asset allocation is as follows: december 31, 2006 december 31, 2005 $m $m $m $m $m $m core surplus total core surplus total fixed income securities 466.0 430.3 896.3 - - - equity securities 5.7 64.6 70.3 - - - other investments - 11.5 11.5 - - - cash 306.6 93.5 400.1 1,072.4 - 1,072.4 total 778.3 599.9 1,378.2 1,072.4 - 1,072.4 % % % % % % fixed income securities 33.8 31.2 65.0 - - - equity securities 0.4 4.7 5.1 - - - other investments - 0.8 0.8 - - - cash 22.3 6.8 29.1 100.0 - 100.0 total 56.5 43.5 100.0 100.0 - 100.0 The investment mix of the fixed income portfolio is as follows: december 31, 2006 december 31, 2005 $m $m $m $m $m $m core surplus total core surplus total short term investments 2.1 4.8 6.9 - - - U.S. treasuries 15.0 15.8 30.8 - - - U.S. government agencies 102.1 48.3 150.4 - - - asset backed securities 80.8 40.3 121.1 - - - mortgage backed securities 140.6 226.5 367.1 - - - corporate bonds 125.4 65.7 191.1 - - - convertible debt securities - 28.9 28.9 - - - total 466.0 430.3 896.3 - - - % % % % % % short term investments 0.2 0.5 0.7 - - - U.S. treasuries 1.7 1.8 3.5 - - - U.S. government agencies 11.4 5.4 16.8 - - - asset backed securities 9.0 4.5 13.5 - - - mortgage backed securities 15.7 25.3 41.0 - - - corporate bonds 14.0 7.3 21.3 - - - convertible debt securities - 3.2 3.2 - - - total 52.0 48.0 100.0 - - - Both the core and surplus fixed income portfolios are managed by two external investment managers with identical mandates. The equity portfolio is managed by one investment manager. The equity portfolio is invested predominantly in U.S. and Canadian securities in a diversified range of sectors. The performance of the managers is monitored on an on-going basis. An analysis of the most important components of financial risk is detailed in a to e below. a. valuation risk The Group's net asset value is directly impacted by movements in the value of investments held. Values can be impacted by movements in interest rates, credit ratings, economic environment and outlook, and exchange rates. The impact of a 10% fall in the value of the Group's equity portfolio at December 31, 2006 would be $7.0 million. Valuation risk in the equity portfolio is mitigated by adopting a value strategic approach and by diversifying the portfolio across sectors. b. interest rate risk The majority of the Group's investments comprise fixed income securities. The fair value of the Group's fixed income portfolio is inversely correlated to movements in market interest rates. If market interest rates fall, the fair value of the Group's fixed income investments would tend to rise and vice versa. The sensitivity of the price of fixed income securities is indicated by its duration(1). The greater a security's duration, the greater its percentage price volatility. The sensitivity of the Group's fixed income portfolio at December 31, 2006 to interest rate movements is as follows: immediate shift in yield (basis points) % $m 100 -2.3 (21.0) 75 -1.7 (15.8) 50 -1.2 (10.5) 25 -0.6 (5.3) -25 0.6 5.3 -50 1.2 10.5 -75 1.7 15.8 -100 2.3 21.0 The Board limits interest rate risk on its investment portfolio by establishing and monitoring duration ranges within investment guidelines. The duration of the fixed income portfolios at December 31, 2006 was 1.5 years for the core portfolio and 3.2 years for the surplus portfolio. Insurance contract liabilities are not directly sensitive to the level of market interest rates, as they are undiscounted and contractually non-interest bearing. ((1)) Duration is the weighted average maturity of a security's cash flows, where the present values of the cash flows serve as the weights. The Group has issued long-term debt as described in note 19. The loan notes bear interest at a floating rate plus a fixed margin of 3.7%. The Group is subject to interest rate risk on the coupon payments of the long-term debt. The Group has mitigated the interest rate risk by entering into swap contracts as follows: maturity prepayment interest date date(1) hedged(2) subordinated loan notes â‚¬24 million june 15, 2035 march 15, 2011 50% subordinated loan notes $97 million december 15, 2035 december 15, 2011 50% (1) The subordinated note can be prepaid from 16 December 2005, with a sliding scale redemption price penalty which reduces to zero by 15 December 2011. (2) The Group has entered into swaps to fix the interest rate on 50% of the principal through the prepayment dates specified above. The current Euribor interest rate on 50% of the subordinated loan notes has been fixed at 3.67%. The current LIBOR interest rate on 50% of the subordinated loan notes has been fixed at 5.36%. The Group retains exposure to interest risk on the remaining portion of the notes. c. liquidity risk The Group can be exposed to daily calls on its available investment assets, principally from insurance claims. Liquidity risk is the risk that cash may not be available to pay obligations when they are due without incurring an unreasonable cost. The maturity dates of the Group's fixed income portfolio at December 31, 2006 were as follows: $m $m $m core surplus total less than one year 21.3 - 21.3 between one year and two years 117.8 28.9 146.7 between two and three years 79.0 21.7 100.7 between three and four years 56.5 42.0 98.5 between four and five years 16.7 35.2 51.9 over five years 174.7 302.5 477.2 total 466.0 430.3 896.3 Actual maturities may differ from contractual maturities because certain borrowers have the right to call or pre-pay certain obligations with or without call or prepayment penalties. The Board limits liquidity risk in several ways. First, a portion of the investment portfolio is segregated for the short term liquidity requirements arising from insurance obligations. The core portfolio is highly liquid with short maturity. All core portfolio securities are quoted on major exchanges. Secondly, the Board has established asset allocation and maturity parameters within investment guidelines such that the majority of the Group's investments are in high quality assets which could be converted into cash promptly and at minimal expense. d. currency risk The Group currently underwrites out of two locations, Bermuda and London. However, risks are assumed on a worldwide basis. Risks assumed are predominantly denominated in U.S. dollars. The Group is exposed to currency risk to the extent its assets are denominated in different currencies to its liabilities. The Group is also exposed to non-retranslation risk on non-monetary assets such as unearned premiums. At each balance sheet date exchange gains and losses can impact the consolidated income statement. The Group has hedged the large majority of currency risk by closely matching the non U.S. dollar liabilities with non U.S. dollar assets. The Group's main foreign currency exposure relates to its insurance obligations and the â‚¬24 million subordinated notes long-term debt liability. While the unhedged balances are not large, the Group has more closely hedged these currency exposures by holding larger balances of non U.S. dollar cash. The Group's assets and liabilities, categorised by currency at their translated carrying amount was as follows: assets $m $m $m $m $m U.S. $ sterling euro other total cash and cash equivalents 359.0 1.3 37.1 2.7 400.1 accrued interest receivable 7.5 - - - 7.5 investments 978.1 - - - 978.1 unearned premium on premium ceded 19.1 - - - 19.1 deferred acquisition costs 48.5 0.2 1.6 1.2 51.5 other receivables 5.1 1.2 - - 6.3 inwards premium receivable from insureds 161.6 0.7 5.6 5.8 173.7 deferred tax asset - 0.8 - - 0.8 investment in associate 23.2 - - - 23.2 property, plant and equipment 1.4 1.0 - - 2.4 total assets as at december 31, 2006 1,603.5 5.2 44.3 9.7 1,662.7 $m $m $m $m $m liabilities U.S. $ sterling euro other total losses and loss adjustment expenses 38.0 0.2 0.9 - 39.1 unearned premiums 304.9 2.0 10.4 8.4 325.7 insurance contracts - other payables 3.6 - - - 3.6 amounts payable to reinsurers 2.4 - - - 2.4 deferred acquisition costs ceded 2.5 - - - 2.5 other payables 19.8 1.0 - - 20.8 corporation tax payable - 1.0 - - 1.0 interest rate swap 1.0 - (0.1) - 0.9 accrued interest payable 0.4 - 0.1 - 0.5 long-term debt 97.0 - 31.6 - 128.6 total liabilities as at december 31, 2006 469.6 4.2 42.9 8.4 525.1 assets $m $m $m $m $m U.S. $ sterling euro other total cash and cash equivalents 1,072.4 - - - 1,072.4 accrued interest receivable 2.0 - - - 2.0 deferred acquisition costs 0.5 - - - 0.5 other receivables 0.3 - - - 0.3 inwards premium receivable from insureds 2.1 - - - 2.1 property, plant and equipment 0.4 - - - 0.4 total assets as at december 31, 2005 1,077.7 - - - 1,077.7 liabilities $m $m $m $m $m U.S. $ sterling euro other total unearned premiums 2.6 - - - 2.6 other payables 2.2 - - - 2.2 accrued interest payable 0.4 - - - 0.4 long-term debt 97.0 - 28.4 - 125.4 total liabilities as at december 31, 2005 102.2 - 28.4 - 130.6 e. credit risk Credit risk is the risk that a counterparty may fail to pay, or repay, a debt or obligation. The Group is exposed to credit risk on its fixed income investment portfolio, its inwards premium receivable from insureds and cedants, and on any amounts recoverable from reinsurers. Credit risk on the fixed income portfolio is managed by establishing investment guidelines that set parameters on the absolute credit ratings of holdings and the concentration of holdings within credit rating bands. The guidelines also place limits on the size of investment in a single issuer or class of issuer. Compliance with guidelines is regularly monitored. Credit risk from reinsurance recoverables is primarily managed by review and approval of reinsurer security by the Group's reinsurance security committee as discussed in the risk disclosure section under sub-heading reinsurance. The table below presents an analysis of the Group's major exposures to counterparty credit risk, based on Standard & Poor's or equivalent rating. The table includes amounts due from policyholders and unsettled investment trades. The quality of these receivables is not graded, but based on managements historical experience there is limited default risk associated with these amounts. Outstanding claims, including IBNR, recoverable from reinsurers was nil at December 31, 2006 and December 31, 2005, and therefore has not been included. december 31, 2006 december 31, 2005 $m $m $m $m cash & fixed premium & other cash & fixed premium & other income receivables income receivables AAA 1,018.8 - 1,072.4 - AA+, AA, AA- 43.6 - - - A+, A, A- 173.8 - - - BBB+, BBB, BBB- 51.9 - - - other 8.3 180.0 - 2.4 1,296.4 180.0 1,072.4 2.4 Notes to the accounts for the year ended December 31, 2006 1. general information The Group is a provider of global property insurance and reinsurance products. LHL was incorporated under the laws of Bermuda on October 12, 2005. LHL is listed on the Alternative Investment Market ('AIM'), a subsidiary market of the London Stock Exchange. The registered office of LHL is Clarendon House, 2 Church Street, Hamilton HM 11, Bermuda. LHL has four wholly owned subsidiaries: Lancashire Insurance Company Limited ('LICL'), Lancashire Insurance Holdings (UK) Limited ('LIHUKL'), Lancashire Insurance Marketing Services Limited ('LIMSL') and Lancashire Insurance Services Limited ('LISL'). LIHUKL is a holding company for a wholly owned operating subsidiary, Lancashire Insurance Company (UK) Limited ('LICUKL'). LICL and LICUKL are currently the Group's principal operating subsidiaries. LICL was incorporated under the laws of Bermuda on October 28, 2005 and is authorized by the Bermuda Monetary Authority (the 'BMA') as a Class 4 general insurer. LICL provides insurance and reinsurance products to its customers, with an emphasis on property, energy, marine and aviation lines of business. LICUKL was incorporated under the laws of England & Wales on March 17, 2006 and is authorised by the United Kingdom Financial Services Authority (the 'FSA') to conduct general insurance business. The products provided are the same as those provided by LICL. LICUKL is also registered as a Class 3 general insurer in Bermuda and has a permit issued under the Bermuda Companies Act to enable certain activities related to its insurance business to be performed from Bermuda. LIMSL is authorised by the FSA to undertake insurance mediation activities. LIMSL provides business introduction and other support services to LICL in the United Kingdom, and was incorporated under the laws of England & Wales on October 7, 2005. LISL was incorporated under the laws of England & Wales on March 17th, 2006. LISL provides support services to LIMSL and LICUKL. 2. segmental reporting Management and the Board review the Group's business primarily by its four principal classes: property, energy, marine and aviation. Management has therefore deemed these classes to be its business and primary segments for the purposes of segmental reporting. Further sub classes of business are underwritten within each primary segment. The Group commenced underwriting in December 2005, but wrote an insignificant amount of business in the period from incorporation to December 31, 2005. Comparatives have therefore not been presented for segments. revenue and expense by business segment gross premiums written $m $m $m $m $m property energy marine aviation total analysed by geographical segment: worldwide offshore - 175.5 33.9 - 209.4 worldwide including the U.S. 71.5 26.2 7.4 63.1 168.2 U.S. and Canada 111.7 1.4 0.4 - 143.5 worldwide excluding the U.S. 31.4 0.5 0.6 0.1 32.6 far east 10.6 2.6 6.7 - 19.9 rest of world 10.3 6.8 - 1.2 18.3 middle east 6.7 9.0 1.3 0.1 17.1 europe 12.3 1.9 2.8 - 17.0 total 254.5 253.9 53.1 64.5 626.0 outwards reinsurance premiums (39.8) (38.7) - - (78.5) change in unearned premiums (123.5) (119.4) (28.8) (51.4) (323.1) change in unearned premiums ceded 7.3 11.8 - - 19.1 net premiums earned 98.5 107.6 24.3 13.1 243.5 insurance losses and loss adjustment expenses (13.2) (17.2) (8.7) - (39.1) insurance acquisition expenses (12.7) (20.1) (4.6) (2.6) (40.0) insurance acquisition expenses ceded 1.5 3.6 - - 5.1 net underwriting profit 74.1 73.9 11.0 10.5 169.5 net investment income 54.2 other investment income 1.8 net realised gains (losses) and impairments 0.8 share of profit of associate 3.2 net foreign exchange gains (losses) (1.3) operating expenses unrelated to underwriting (33.9) equity based compensation (22.5) finance costs (12.3) profit before tax 159.5 tax (0.2) profit for the period attributable to equity shareholders 159.3 property energy marine aviation total loss ratio 13.4% 16.0% 35.8% - 16.1% acquisition cost ratio 11.4% 15.3% 18.9% 19.8% 14.3% expense ratio - - - - 13.9% combined ratio 24.8% 31.3% 54.7% 19.8% 44.3% assets and liabilities by business segment assets $m $m $m $m $m property energy marine aviation total attributable to business segments 82.2 82.7 29.3 57.0 251.2 other assets 1,411.5 total assets 1,662.7 liabilities $m $m $m $m $m property energy marine aviation total attributable to business segments 128.8 154.6 38.2 51.7 373.3 other liabilities 151.8 total liabilities 525.1 total net assets 1,137.6 The Group's net assets are located primarily in Bermuda. Less than 10% of total net assets are currently attributable to the UK operations. 3. investment return The total investment return for the Group is as follows: 2006 2005 $m $m investment income - interest on fixed income securities 33.3 - - net amortisation of premium (discount) 3.2 - - interest income on cash and cash equivalents 19.2 2.1 - dividends from equity securities 0.8 - - investment management and custodian fees (2.3) - net investment income 54.2 2.1 - net realised and unrealised gains (losses) 1.8 - net other investment income 1.8 - net realised gains (losses) and impairments - fixed income securities (2.4) - - equity securities 3.2 - net realised gains (losses) and impairments 0.8 - net unrealised gains (losses) recognised in shareholders' equity - fixed income securities 2.6 - - equity securities 6.1 - net unrealised gains (losses) recognised in shareholders' equity 8.7 - total investment return 65.5 2.1 Net realised gains (losses) on equity securities includes an impairment loss of $0.4 million (2005 - $nil) recognised on one equity investment held by the Group at December 31, 2006. 4. net insurance acquisition expenses 2006 2005 $m $m insurance acquisition expenses 91.0 0.5 changes in deferred insurance acquisition expenses (51.0) (0.5) insurance acquisition expenses ceded (7.6) - changes in deferred insurance acquisition expenses ceded 2.5 - total 34.9 - 5. other operating expenses 2006 2005 $m $m operating expenses unrelated to underwriting 33.9 1.6 equity based compensation 22.5 8.4 total 56.4 10.0 6. employee benefits 2006 2005 $m $m wages and salaries 5.4 0.2 pension costs 0.6 - other benefits 7.5 - equity based compensation 22.5 8.4 total 36.0 8.6 As at December 31, 2006, the Group had 54 (2005 - 4) employees. equity based compensation There are two forms of equity based compensation: warrants and a long term incentive plan. On admission to AIM, warrants to purchase common shares were issued for immediate allocation to certain members of management or reserved for later allocation to employees of the Group. There are two forms of warrant: Management Team Ordinary Warrants and Management Team Performance Warrants. All warrants issued to management expire on December 16, 2015 and will be exercisable at an initial price per share of US$5.00 equal to the price per share paid by investors in the initial public offering. Settlement is at the discretion of the Group and may be in cash or shares. management team ordinary warrants ('ordinary warrants') Ordinary warrants do not have associated performance criteria. 25% of such warrants vested immediately upon issuance. Thereafter, 25% of such warrants will vest on the first, second and third anniversary of the grant date. On December 16, 2005, the board approved the issue of ordinary warrants to purchase 12,708,695 common shares, representing the full allocation of management team ordinary warrants. Warrants from this amount were subsequently awarded to individual members of management and staff. management team performance warrants ('performance warrants') Performance warrants vest over a four year period and are dependent on certain performance criteria with specific measurement dates of December 31, 2007, December 31, 2008 and December 31, 2009. Half of these warrants will vest only on achievement of a fully diluted book value per share in comparison to a planned appreciation threshold of between 70% and 100% at certain dates. The remaining half of these warrants will vest only on achievement of an internal rate of return ('IRR') in comparison to a planned IRR of between 70% and 100% at certain dates. On December 31, 2005, the board approved the issue of performance warrants to purchase 7,625,218 common shares, representing the full allocation of management team performance warrants. Warrants from this amount were subsequently awarded to individual members of management. The fair value of each warrant was estimated on the date of grant using the Black-Scholes option-pricing model. Assumptions used for valuation of these grants were as follows: risk free interest rate of 4.93%; an expected life of ten years; volatility of 30% being the maximum contractual rate; performance targets will be fully met; dividend yield of nil due to contractual dividend protection; the Group will settle in shares; no dilutive events, and no forfeitures, other than leavers which are assumed to be 10% of total employees for management performance warrants during all vesting periods and 10% of the 2007 and 2008 vesting periods relating to ordinary warrants expensed in 2006. For the ordinary warrants that vested in 2006, there was no leaver's adjustment as no holders of these warrants had left the Group. warrants weighted average number exercise price thousands US$ allocated as at december 31, 2005 14,463 $5.00 allocated during the period 4,834 $5.00 allocated as at december 31, 2006 19,297 $5.00 exercisable at december 31, 2006 6,030 $5.00 The fair value of warrants granted for the period ended December 31, 2005 was $2.62 per share. There were no further issues in 2006. A share-based payment expense of $20.5 million (2005 - $8.4 million) is included in other operating expenses in the consolidated income statement. long term incentive plan ('LTIP') Options may be granted under the LTIP at the discretion of the Remuneration Committee. Options granted under the LTIP are limited to 5% of the fully diluted common share capital in issue at the date of grant. All options issued will expire ten years from date of issue and the exercise price is equal to or greater than the average market value of the shares on the twenty previous trading days prior to grant. The range of exercise prices for options at December 31, 2006 was Â£3.25 ($6.37) to Â£3.55 ($6.95) per share. 25% of options vest on each of the first, second, third and fourth anniversary of the grant date. There are no associated performance criteria. Settlement is at the discretion of the Group and may be in cash or shares. In 2006, certain members of staff were issued options to purchase 2,503,613 common shares. Options to purchase 101,670 common shares were forfeited during the period (see note 22). The fair value of each option was estimated on the date of grant using the Black-Scholes option-pricing model. Assumptions used for valuation of these grants were as follows: risk free interest rate of 5.125%; an expected life of six years; volatility of 30% being the maximum contractual rate; dividend yield of nil due to contractual dividend protection; the Group will settle in shares; no forfeitures, other than leavers which are assumed to be 10% of total employees, and no dilutive events. options weighted average number exercise price thousands US$ granted during the period and outstanding as at december 31, 2,402 $5.77 2006 exercisable at december 31, 2006 - - The weighted fair value of options granted during the period ended December 31, 2006 was $2.32 per option. A share-based payment expense of $2.0 million (2005 - $nil) is included in other operating expenses in the consolidated income statement. 7. results of operating activities Results of operating activities are stated after charging the following amounts: 2006 2005 $m $m depreciation on owned assets 0.6 - operating lease charges 1.1 - auditors remuneration - group audit fees 0.7 0.1 - other services 0.3 0.6 total 2.7 0.7 Fees paid to the Group's auditors for other services are approved by the Group's Audit Committee. Such fees comprise the following amounts: 2006 2005 $m $m tax advice 0.1 - FSA regulatory advice 0.2 - other - 0.6 total 0.3 0.6 8. tax Bermuda LHL, LICL and LICUKL have received an undertaking from the Bermuda government exempting them from all Bermuda local income, withholding and capital gains taxes until March 28, 2016. At the present time no such taxes are levied in Bermuda. United States The Group does not consider itself to be engaged in trade or business in the United States and, accordingly, does not expect to be subject to United States taxation. United Kingdom The UK subsidiaries are subject to normal UK corporation tax on all their profits. 2006 2005 $m $m current tax expense 1.0 - deferred tax credit (note 9) (0.8) - total 0.2 - In the period to December 31, 2005 the Group did not incur a UK corporation tax liability. The standard rate of corporation tax in the UK is 30% (2005 - 30%). The current tax charge as a percentage of the Group's profit before tax is 0.1% (2005 - nil) due to the different tax paying jurisdictions throughout the Group. 9. deferred tax 2006 2005 $m $m deferred tax assets 0.8 - deferred tax liabilities - - net deferred tax asset 0.8 - Deferred tax is calculated in full on temporary differences under the balance sheet liability method using a tax rate of 30%. Deferred tax assets are recognised to the extent that realisation of the related tax benefit through future taxable profits is likely. Deferred tax assets and liabilities are offset when there is a legally enforceable right to offset current tax assets against current tax liabilities and when the deferred income taxes relate to the same fiscal authority. The deferred tax asset relates to the warrants and options benefit scheme. These temporary differences are unlikely to reverse in the foreseeable future. All deferred tax assets and liabilities are classified as non current. The movement on the total net deferred tax asset is as follows: 2006 2005 $m $m as at january 1, 2006 - - income statement credit 0.8 - as at december 31, 2006 0.8 - Deferred tax assets were comprised of the following: 2006 2005 $m $m share warrants and options 0.8 - as at december 31, 2006 0.8 - As at December 31, 2006, deferred tax liabilities were negligible (2005 - $nil). 10. cash and cash equivalents 2006 2005 $m $m cash at bank and in hand 50.0 12.2 cash equivalents 350.1 1,060.2 total 400.1 1,072.4 Cash equivalents have an original maturity of three months or less. The carrying amount of these assets approximates their fair value. Cash and cash equivalents totaling $10.9 million (2005 - $5.4 million) were on deposit in various trust accounts for the benefit of policyholders or counterparties to agreements to cover their credit risk. Cash and cash equivalents totaling $25.1 million (2005 - $nil) were on deposit as collateral in favour of letters of credit issued for the benefit of policyholders or counterparties to cover their credit risk. 11. investments as at december 31, 2006 $m $m $m $m cost or gross gross estimated amortised unrealised unrealised fair cost gain loss value fixed income securities - short term investments 6.9 - - 6.9 - U.S. treasuries 30.8 - - 30.8 - U.S. government agencies 150.3 0.2 (0.1) 150.4 - asset backed securities 121.0 0.2 (0.1) 121.1 - mortgage backed securities 365.6 2.0 (0.5) 367.1 - corporate bonds 190.2 1.1 (0.2) 191.1 - convertible debt securities 28.9 - - 28.9 total fixed income securities 893.7 3.5 (0.9) 896.3 equity securities 64.2 7.0 (0.9) 70.3 other investments 9.7 1.9 (0.1) 11.5 total 967.6 12.4 (1.9) 978.1 Equity securities and other investments are generally deemed non-current. Fixed income maturities are presented in the risk disclosures section. In 2005 the Group's invested assets were held entirely in cash and cash equivalents. Comparatives for the above table have therefore not been presented. 12. investment in associate On June 15, 2006 the Group made an investment of $20.0 million which represents a 21% interest in Sirocco Holdings Limited ('Sirocco'), a company incorporated in Bermuda. Sirocco's operating subsidiary, Sirocco Reinsurance Limited (' Sirocco Re'), is authorised as a Class 3 insurer by the Bermuda Monetary Authority. Sirocco Re was established to assume Gulf of Mexico energy risks from the Group. Sirocco is an unquoted investment and its shares do not trade on any active market. Sirocco is carried at $23.2 million, representing management's best estimate of fair value at December 31, 2006, based on the July 15, 2006 audited financial statements and subsequent management information. 2006 $m as at january 1, 2006 - acquisition 20.0 share of profit of associate 3.2 as at december 31, 2006 23.2 Investments in associates are generally deemed non-current. Key financial information for Sirocco for the period from May 22, 2006 (date of incorporation) to December 31, 2006 is as follows: $m assets 124.6 liabilities 14.3 revenues 18.6 profit 15.2 13. insurance and reinsurance contracts insurance liabilities $m $m $m $m losses & loss unearned other total adjustment premiums payables expenses as at october 12, 2005 (date of incorporation) - - - - movement in period - 2.6 - 2.6 exchange adjustments - - - - as at december 31, 2005 - 2.6 - 2.6 movement in period 39.1 323.1 3.6 365.8 exchange adjustments - - - - as at december 31, 2006 39.1 325.7 3.6 368.4 reinsurance assets and liabilities $m $m $m unearned amounts payable total premiums ceded to reinsurers as at october 12, 2005 (date of incorporation) - - - movement in period - - - exchange adjustments - - - as at december, 31 2005 - - - movement in period 19.1 (2.4) 16.7 exchange adjustments - - - as at december 31, 2006 19.1 (2.4) 16.7 Further information on the calculation of loss reserves and the risks associated with them is provided in the risk disclosures section. The risks associated with general insurance contracts are complex and do not readily lend themselves to meaningful sensitivity analysis. The impact of an unreported event could lead to a significant increase in our loss reserves. Management believe that the loss reserves established as at December 31, 2006 are adequate, however a 20% increase in estimated losses would lead to a $7.8m (2005 - $nil) increase in loss reserves. The split of losses and loss adjustments expenses between notified outstanding losses and losses incurred but not reported is shown below: 2006 2005 $m $m outstanding losses 1.2 - losses incurred but not reported 37.9 - losses and loss adjustment expenses reserves 39.1 - It is estimated that our reserve for unpaid claims and adjustment expenses has an approximate duration of one year. claims development The development of insurance liabilities is indicative of the Group's ability to estimate the ultimate value of its insurance liabilities. The Group began writing insurance and reinsurance business in December 2005. Due to the underlying risks and lack of known loss events occurring during the period to December 31, 2005, the Group does not expect to incur any losses from coverage provided in 2005. Accordingly, a loss development table has not been included. 14. insurance and other receivables 2006 2005 $m $m inwards premium receivable from insureds and cedants 173.7 2.1 accrued interest receivable 7.5 2.0 other receivables 6.3 0.3 total receivables 187.5 4.4 Other receivables consist primarily of unsettled investment trades. All receivables are considered current other than $8.9 million (2005 - $nil) of inwards premium receivable related to multi-year contracts. The carrying value approximates fair value due to the short term nature of the receivables. There are no provisions in place for impairment or irrecoverable balances. There is no significant concentration of credit risk within the Group's receivables. 15. deferred acquisition costs The reconciliation between opening and closing deferred acquisition costs is shown below: $m balance as at october 12, 2005 (date of incorporation) - movement in period 0.5 balance as at december 31, 2005 0.5 movement in period 51.0 balance as at december 31, 2006 51.5 16. reinsurance and other payables 2006 2005 $m $m other payables 20.8 2.2 insurance contracts - other payables 3.6 - amounts payable to reinsurers 2.4 - total payables 26.8 2.2 Other payables include unsettled investment trades and other accruals. All payables are considered current. The carrying value approximates fair value due to the short-term value of the payables. 17. deferred acquisition costs ceded The reconciliation between opening and closing deferred acquisition costs ceded is shown below: $m balance as at october 12, 2005 (date of incorporation) - movement in period - balance as at december 31, 2005 - movement in period 2.5 balance as at december 31, 2006 2.5 18. property, plant and equipment $m $m $m $m office furniture leasehold IT total and equipment improvements equipment cost as at october 12, 2005 (date of incorporation) - - - - additions - - 0.4 0.4 as at december 31, 2005 - - 0.4 0.4 accumulated depreciation as at october 12, 2005 (date of incorporation) - - - - charge for the period - - - - as at december, 31 2005 - - - - net book value as at october 12, 2005 (date of - - - - incorporation) - - 0.4 0.4 as at december 31, 2005 - - 0.4 0.4 cost as at january 1, 2006 - - 0.4 0.4 additions 1.0 0.6 1.0 2.6 as at december 31, 2006 1.0 0.6 1.4 3.0 accumulated depreciation as at january 1, 2006 - - - - charge for the period 0.2 0.1 0.3 0.6 as at december 31, 2006 0.2 0.1 0.3 0.6 net book value as at january 1, 2006 - - 0.4 0.4 as at december 31, 2006 0.8 0.5 1.1 2.4 19. long term debt and financing arrangements 2006 2005 $m $m subordinated loan note of â‚¬12.0 million 15.8 14.2 subordinated loan note of â‚¬12.0 million 15.8 14.2 subordinated loan note of $97.0 million 97.0 97.0 carrying value and fair value 128.6 125.4 On December 15, 2005 the Group issued $97 million in aggregate principal amount of subordinated loan notes and â‚¬24 million in aggregate principal amount of subordinated loan notes ('long-term debt') at an issue price of $1,000 and â‚¬1,000 of their principal amounts respectively. The Euro subordinated loan notes are repayable on June 15, 2035 with a prepayment option available from March 15, 2011. Interest on the principal is based on a set margin (3.7%) above Euribor and is payable quarterly. The US dollar subordinated loan notes are repayable on December 15, 2035 with a prepayment option available from March 15, 2011. This, like the Euro notes, only applies to a 'special event' issue as defined in the transaction documents. Interest on the principal is based on a set margin (3.7%) above Libor and is payable quarterly. The Group is exposed to cash flow interest rate risk and currency risk. Further information is provided in the risk disclosures section. The interest accrued on the loans payable was $0.5 million (2005 - $0.4 million) at the balance sheet date. Due to the floating interest rates, the carrying value approximates fair value. letters of credit As both LICL and LICUKL are not admitted insurers or reinsurers throughout the U.S., the terms of certain contracts require them to provide letters of credit to policyholders as collateral. On May 17, 2006, LHL and LICL entered into a syndicated collateralised three year credit facility in the amount of $350 million. This facility is available for the issue of letters of credit ('LOCs') to ceding companies. The facility is also available for LICL to issue LOCs to LICUKL to collateralise certain insurance balances. It contains a $75m loan sub-limit available for general corporate purposes. As at December 31, 2006, LICUKL had no such obligations. Letters of credit totalling $25.1 million had been issued to third parties by LICL and there was no outstanding debt under this facility. 20. derivative financial instruments The Group hedges a portion of its floating rate borrowings using interest rate swaps to transfer floating to fixed rate. These instruments are held at fair value through the consolidated income statement. During the period, $1.0 million (2005 - $nil) was charged to financing costs in respect of the interest rate swap. The net fair value position to the Group was $0.9 million (2005 - $nil). The Group has the right to net settle this instrument. The next cash settlement due on this instrument is negligible (2005 - $nil) and is due on March 15, 2007. The Group invests a small portion of its investment portfolio in convertible debt securities. The option to convert is an embedded derivative, which is required to be separated from the host contract and fair valued through the consolidated income statement. As at December 31, 2006 the derivative instrument was valued at $11.5 million, with net unrealised gains of $1.8 million reflected in the consolidated income statement in other investment income. 21. share capital authorised ordinary shares of $0.50 each number $m as at december 31, 2005 and december 31, 2006 3,000,000,000 1,500 allocated, called up and fully paid number $m as at october 12, 2005 (date of incorporation) - - shares issued 195,713,902 97.9 as at december 31, 2005 195,713,902 97.9 shares issued 113,219 - shares repurchased (83,775) - as at december 31, 2006 195,743,346 97.9 LHL issued 16,000,000 new shares on October 27, 2005 as part of its initial capitalisation and launch. On December 9, 2005, LHL's outstanding shares were consolidated on a 5:1 basis into 3,200,000 shares. On December 16, 2005, an aggregate of 192,513,902 new shares were issued as part of LHL's private placement in the U.S. and initial public offering in the U.K., which included shares issued on the exercise of an over-allotment option. As a result of all the shares issued, a total of $978.6 million was raised, $97.9 million of which is included in share capital and $880.7 million of which was included in share premium, net of $19.9 million of offering expenses, formation expenses and warrants issued to management, founders and a sponsor. On December 28, 2006, 113,219 shares were issued and 83,775 repurchased as part of a cashless exercise of warrants (see note 22). 22. warrants and options management management ordinary warrants performance other warrants number warrants options number number number as at october 12, 2005 (date of incorporation) - - - - issued 25,417,136 12,708,695 7,625,218 - exercised - - - - as at december 31, 2005 25,417,136 12,708,695 7,625,218 - issued - - - 2,503,613 forfeited - - - (101,670) exercised (113,219) - - - as at december 31, 2006 25,303,917 12,708,695 7,625,218 2,401,943 warrants All warrants issued will expire on December 16, 2015 and are exercisable at an initial price per share of US$5.00 equal to the price per share paid by investors in the initial public offering. The warrant holder may request a cashless exercise. The method of settlement is at the discretion of the Group and may be in cash or shares. founders The Group's founders provided industry expertise, resources and relationships during the fourth quarter of 2005. For the founders position and consideration, the Group issued warrants to certain founding shareholders to purchase in the aggregate, up to 17,791,919 common shares. These warrants were approved on December 9, 2005, dated December 16, 2005 and were fully vested and exercisable upon issuance. On December 28, 2006 a founding investor exercised 113,219 warrants at a strike price of $5.00 per share. This was a cashless exercise and resulted in the Group issuing a further 29,444 common shares at $0.50 per share. sponsor In consideration for incorporation services received, warrants were issued to Benfield Advisory Limited to purchase 7,625,217 common shares. These warrants were granted on December 16, 2005 and were fully vested and exercisable upon issuance. On November 30, 2006 Benfield sold its entire holding of warrants to an unrelated third party. Management warrants and options are discussed in note 6. 23. lease commitments The Group has payment obligations in respect of operating leases for certain items of office equipment and office space. Operating lease expenses for the period were $1.1 million (2005 - $nil). Lease payments under non-cancellable operating leases are as follows: 2006 2005 $m $m due in less than one year 1.2 - due between one and five years 4.5 - due in more than five years 0.3 - total 6.0 - 24. earnings per share Basic earnings or loss per share amounts are calculated by dividing net profit or loss for the period attributable to shareholders by the weighted average number of common shares outstanding during the year. Diluted earnings or loss per share amounts are calculated by dividing the net profit or loss attributable to shareholders by the weighted average number of common shares outstanding during the year plus the weighted average number of common shares that would be issued on the conversion of all dilutive potential common shares into common shares. The following reflects the profit (loss) and share data used in the basic and diluted loss per share computations: 2006 2005 $m $m profit (loss) for the period attributable to equity shareholders 159.3 (11.6) number of number of shares shares thousands thousands basic weighted average number of shares 195,714 48,320 potentially dilutive shares related to share-based compensation 6,325 5,733 diluted weighted average number of shares 202,039 54,053 Share based payments are only treated as dilutive when their conversion to common shares would decrease earnings per share or increase loss per share from continuing operations. In the current period, incremental shares from the assumed exercising of management performance warrants are not included in calculating dilutive shares as the relevant criteria have not been met. In addition, the options are antidilutive and are therefore not included in the number of potentially dilutive shares. In the prior period, incremental shares from the assumed exercising of warrants are not included in calculating the diluted earnings or loss per share as they are antidilutive. 25. related party disclosures The consolidated financial statements include Lancashire Holdings Limited and the subsidiaries listed below: name domicile Lancashire Insurance Company Limited Bermuda Lancashire Insurance Marketing Services Limited United Kingdom Lancashire Holdings Financing Trust I United States Lancashire Insurance Holdings (UK) Limited United Kingdom Lancashire Insurance Company (UK) Limited (previously 'Lancashire Insurance United Kingdom Services (UK) Limited') Lancashire Insurance Services Limited United Kingdom All subsidiaries are wholly owned, either directly or indirectly. The Group has issued loan notes via a trust vehicle - Lancashire Holdings Financing Trust I (the 'Trust') (see note 19). The Group effectively has 100% of the voting rights in the Trust. These rights are subject to the property trustee's obligations to seek approval of the holders of the Trust's preferred securities in case of default and other limited circumstances where the property trustee would enforce its rights. While the ability of the Group to influence the actions of the Trust is limited by the Trust Agreement, the Trust was set up by the Group with the sole purpose of issuing the loan notes and is in essence controlled by the Group, and is therefore consolidated. key management compensation Remuneration for key management for the period ending December 31, 2006 was as follows: 2006 2005 $m $m short-term compensation 4.5 - share based compensation 12.1 5.2 total 16.6 5.2 transactions with directors and shareholders Significant shareholders have a representation on the Board of Directors. During the period the Group paid $0.9 million (2005 - $nil) in directors' fees and expenses, including $0.4 million to significant shareholders. A further $0.3 million (2005 - $nil) was paid in respect of monitoring fees for significant shareholders pursuant to Monitoring Agreements, the terms of which are as disclosed in the AIM admission document. transactions with associate During the period the Group ceded $29.9 million (2005 - $nil) of premium to Sirocco and received $5.4 million (2005 - $nil) of commission income. As at December 31, 2006 the following amounts with Sirocco were included in our consolidated balance sheet: 2006 2005 $m $m unearned premium on premium ceded 11.8 - reinsurance payable 0.8 - deferred acquisition costs ceded 2.2 - Profit commission is payable to the Group based on the performance of Sirocco over the period January 1, 2006 to July 15, 2008. The contingent profit commission as at December 31, 2006 was $2.6m (2005 - $nil). transactions with sponsor During the period the Group incurred net brokerage and consulting costs of $11.8 million with Benfield Group. 26. non-cash transactions Accrued formation expenses of $nil (2005 - $0.9 million) have been recorded directly in shareholders' equity. This amount represents a non-cash transaction and therefore is not included within the change in operational assets and liabilities in the consolidated cashflow statement. On November 2, 2006, following shareholder approval, LHL transferred $850.0 million (2005 - $nil) from share premium to contributed surplus. 27. statutory requirements and dividend restrictions As a holding company, LHL relies on dividends from its subsidiaries to provide cash flow required for debt service and dividends to shareholders. The subsidiaries' ability to pay dividends and make capital distributions is subject to the legal and regulatory restrictions of the jurisdiction in which they operate. For the primary operating subsidiaries these are based principally on the amount of premiums written and reserves for losses and loss expenses, subject to overall minimum solvency requirements. Statutory capital and surplus is different from shareholders' equity due to certain items that are capitalised under IFRS but expensed, have a different valuation basis, or are not admitted under insurance regulations. Statutory capital and surplus reported to regulatory authorities by the primary operating subsidiaries is as follows: as at december 31, 2006 $m Â£m LICL LICUKL statutory capital and surplus 1,079.2 56.3 minimum required statutory capital and surplus 271.1 7.4 as at december 31, 2005 $m Â£m LICL LICUKL statutory capital and surplus 1,069.6 n/a minimum required statutory capital and surplus 100.0 n/a 28. presentation Certain amounts in the December 31, 2005 consolidated financial statements have been re-presented to conform with the current year's presentation and format. These changes in presentation have no effect on the previously reported net loss. 29. subsequent events On February 25, 2007, LHL received notification from the Dubai Financial Services Authority that its application to operate an authorised insurance intermediation firm in Dubai had been approved in principle. The authorisation will be exercised via a wholly-owned subsidiary incorporated and operating within the Dubai International Financial Centre. The new subsidiary, called Lancashire Marketing Services (Middle East) Limited, will allow the Group to market its UK and Bermuda - based insurance subsidiaries more effectively and efficiently in the region. NOTE REGARDING FORWARD-LOOKING STATEMENTS CERTAIN STATEMENTS MADE IN THIS ANNOUNCEMENT OR ON THE CONFERENCE CALL THAT ARE NOT BASED ON CURRENT OR HISTORICAL FACTS ARE FORWARD-LOOKING IN NATURE INCLUDING, WITHOUT LIMITATION, STATEMENTS CONTAINING WORDS 'BELIEVES', 'ANTICIPATES', 'PLANS', 'PROJECTS', 'INTENDS', 'EXPECTS', 'ESTIMATES', 'PREDICTS', 'MAY', 'WILL', 'SEEKS', 'SHOULD' OR, IN EACH CASE, THEIR NEGATIVE OR COMPARABLE TERMINOLOGY. ALL STATEMENTS OTHER THAN STATEMENTS OF HISTORICAL FACTS INCLUDING, WITHOUT LIMITATION, THOSE REGARDING THE GROUP'S FINANCIAL POSITION, RESULTS OF OPERATIONS, LIQUIDITY, PROSPECTS, GROWTH, BUSINESS STRATEGY, PLANS AND OBJECTIVES OF MANAGEMENT FOR FUTURE OPERATIONS (INCLUDING DEVELOPMENT PLANS AND OBJECTIVES RELATING TO THE GROUP'S INSURANCE BUSINESS) ARE FORWARD-LOOKING STATEMENTS. SUCH FORWARD-LOOKING STATEMENTS INVOLVE KNOWN AND UNKNOWN RISKS, UNCERTAINTIES AND OTHER IMPORTANT FACTORS THAT COULD CAUSE THE ACTUAL RESULTS, PERFORMANCE OR ACHIEVEMENTS OF THE GROUP TO BE MATERIALLY DIFFERENT FROM FUTURE RESULTS, PERFORMANCE OR ACHIEVEMENTS EXPRESSED OR IMPLIED BY SUCH FORWARD-LOOKING STATEMENTS. THESE FORWARD-LOOKING STATEMENTS SPEAK ONLY AS AT THE DATE OF THIS ANNOUNCEMENT OR OTHER INFORMATION CONCERNED. LANCASHIRE HOLDINGS LIMITED EXPRESSLY DISCLAIMS ANY OBLIGATION OR UNDERTAKING (SAVE AS REQUIRED TO COMPLY WITH ANY LEGAL OR REGULATORY OBLIGATIONS (INCLUDING THE AIM RULES)) TO DISSEMINATE ANY UPDATES OR REVISIONS TO ANY FORWARD-LOOKING STATEMENTS CONTAINED HEREIN TO REFLECT ANY CHANGES IN THE GROUP'S EXPECTATIONS WITH REGARD THERETO OR ANY CHANGE IN EVENTS, CONDITIONS OR CIRCUMSTANCES ON WHICH ANY SUCH STATEMENT IS BASED. NO OFFER, INVITATION OR INDUCEMENT TO ACQUIRE SHARES OR OTHER SECURITIES OF LANCASHIRE IN ANY JURISDICTION IS BEING MADE BY THIS ANNOUNCEMENT OR ON THE CONFERENCE CALL. This information is provided by RNS The company news service from the London Stock Exchange

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