Preliminary Results

7th Mar 2007 07:04

Lancashire Holdings Limited07 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 • Fully converted book value per share grows 17.4% • Operating income of $180.5 million1 or $0.892 per common share • Profit after tax of $159.3 million or $0.793 per common share • Gross written premiums of $626.0 million • Loss ratio of 16.1% • Combined ratio of 44.3% • Capital retained for 2007 opportunities Operating highlights • Successful transition from start-up to fully established major underwriter • Excellent response to launch of UK underwriting platform • Provisional authorisation received for Middle East marketing operation • Highly experienced team of 57 people across the Group Positive outlook for 2007 • Capital expected to be fully utilised in 2007 • Overall trading conditions very healthy and business flow accelerating • 1 January 2007 net unearned premium reserve of $306.6 million • Projected 2007 gross written premium growth of at least 20% • 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 andlosses, foreign exchange and warrants issued at IPO, but inclusive of optionsissued thereafter 2 Net operating income per common share of £0.48, using an average 2006 exchangerate 3 Profit after tax per common share of £0.42, using an average 2006 exchangerate Richard Brindle, Chief Executive Officer and Chief Underwriting Officer,commented: "I am delighted to report that 2006, our first full year of business, was asuccess both financially and operationally. Financially, we increased fullyconverted book value per share by 17.4% from a standing start. We achieved a lowcombined ratio of 44.3% and generated net income of $159.3 million. Netoperating income was $180.5 million and shareholders' equity grew by $190.5million to a year end total of $1,137.6 million. Operationally, we have gonefrom being a start-up company to an established major underwriter in the marketwith sophisticated technical capabilities, a highly experienced underwritingteam and 57 people across Bermuda, London and Dubai. In 2007, broker and clientsupport remains extremely strong and the acceleration in business flow has beenremarkable." Bob Spass, Chairman, commented: "After its first year, Lancashire has emerged as a highly focused and successfulbusiness. Market expectations for the 'Class of 2005' were for Bermuda reinsurers writingpredominantly cat cover. Lancashire is somewhat different. We write adiversified mix of insurance and reinsurance, both cat and non-cat, across manyspecialty lines, from twin underwriting platforms in Bermuda and London.Underwriting teams in both locations are experienced and operate under the samemandate - risk selection is key. As a result, we can boast not only today'sexcellent results, but also a wealth of business relationships with brokers andclients that will give us strength to grow over the years ahead." Financial Summary ($ millions) Property Energy Marine Aviation TotalGross premium written 254.5 253.9 53.1 64.5 626.0Net premium written 214.7 215.2 53.1 64.5 547.5Net premium earned 98.5 107.6 24.3 13.1 243.5Losses 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 10.5 169.5Investment income 56.0Share of profit of associate 3.2Operating expenses (33.9)Options (2.0)Financing costs (12.3)Operating income 180.5Profit 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, successfullyexecuted, will deliver our overriding aim of creating attractive long-termgrowth in book value per share for our shareholders. Lancashire primarily writes insurance with a focus on short-tail, specialtyrisks, mostly written on a direct basis. All things equal, we prefer writingdirect risks as opposed to reinsuring someone else's book as we believe thisapproach can create a durable competitive advantage. Insurance involves thecreation of direct sustainable relationships with our insured clients and afocus on specific risk selection which should improve the probability of successthrough hard and soft cycles. Reinsurance can however offer compelling opportunities from time to time. Forexample, in 2006 we enthusiastically capitalized on such opportunities inproperty retrocession, and this will continue in 2007. However, reinsurancetends to be more of a commodity business where achieving a meaningfulcompetitive advantage is difficult. With insurance underwriting, the criticalsuccess factor is risk selection. Skills in risk selection take experience, andour underwriting team is highly experienced. In our major lines of business, theteam leaders have, on average, almost twenty years of experience. Byconsistently being smart about risk selection - through hard and soft cycles -Lancashire can sustain a competitive advantage. This competitive advantageshould produce a better than expected loss ratio, and thus strong growth in bookvalue 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 arenot exposed to natural catastrophes. We have deliberately built a diversifiedbook of non correlating risks. This has been enhanced by our presence in threestrategic locations - Bermuda, London and Dubai - giving us access to thebusiness flow that is generated in each of these markets. The benefit of ourdiversified book is that in the future we can direct our capital to the bestunderwriting opportunities. This flexibility - combined with underwritingdiscipline - will allow us to trade successfully through all stages of thecycle. It also sets us apart from many more concentrated (re)insurers in Bermudaand elsewhere. We like the book of business created in 2006. At the start of the year pricingwas good in many areas and, as we anticipated, pricing and terms steadilyimproved through the year. Our enthusiasm increased correspondingly, as did ourbook. This rosy picture was not uniform though. In certain areas, most notablymarine, pricing failed to reach expectations and we declined deals in largenumbers. This reduced our top line premium but, crucially, resulted in astronger portfolio of risks as we ended the year. We wrote $626.0 million of gross premium in 2006. With the wealth of experienceof our underwriting team, significant increases in policy submission count, andvery good trading conditions, we expect to increase gross written premiums by atleast 20% in 2007. This is based on current expectations for pricing and termsin lines that we target. 2007 has begun well. Loss experience to date has been lower than expected. Themost significant industry loss has been the Kyrill wind storm which hit Europein January. While we have received only a de minimis amount of advices, becauseof the inherent uncertainties surrounding such events we are currentlyestimating an impact to Lancashire of between zero and ten million dollars. Capital Management To generate attractive long term returns for shareholders, we seek to coupleexcellent underwriting with conservative, active capital management. First, weintend 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 ourunderwriting. In 2006, we grew capital by $190.5 million and, by the end of the year, ourcapital was fully deployed. Looking ahead, we are encouraged by the tradingconditions 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 of2007. We are currently projecting book value per share growth in 2007 in the lowto mid twenties percent range, assuming a normal level of losses and premiumgrowth in line with expectations. Following the end of the 2007 hurricane season, we will re-evaluate our capitalrequirements, giving careful consideration to balance sheet strength, ratingagencies and other stakeholders. We expect that our combination of underwritingdiscipline and careful trading through the cycle will result in significantreturns 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 FinancialSupplement. This can be accessed via our website www.lancashire.bm. Gross written premiums for the twelve month period were $626.0 million. Overalltrading conditions in the classes written by Lancashire have been very good.This, combined with the lack of any significant loss events in 2006, hasresulted in a healthy operating income of $180.5 million and an overall combinedratio of 44.3%. We move into 2007 well placed to build on our existing book andrelationships, and the increases in deal flow compared to a year ago have beensignificant. Our presence in the London market, through our FSA authorisedinsurer, has been well received. To date, 2007 renewals have been at encouragingprices and terms. Overall trading conditions are excellent. We are experiencinga gradual softening in certain areas from the peaks of summer 2006, but overallcat-pricing remains ahead of a year ago. We believe rates and conditions willhold strong in our major lines for the majority of 2007. Underwriting Lancashire writes a highly diversified book of business, mostly on a directbasis, in four lines: property, energy, marine and aviation. In 2007, we expectour overall portfolio to grow but remain broadly similar in composition to thatof 2006. In 2006, premium for risks exposed to natural catastrophes representedapproximately 58% of our total written premium. For 2007, we expect thiselemental proportion to reduce below 50%. Property This segment includes direct commercial property insurance and terrorism, allwritten on a facultative basis, as well as property cat retrocession. We havealso written a handful of political risk contracts. Pricing overall has beenrobust, as have terms and conditions, particularly in the retrocession anddirect commercial property classes. Trading conditions in these classes steadilyimproved through 2006. While demand for our retrocession product may reduce as aresult of the Florida State backed reinsurance facility, 2007 trading conditionsfor retrocession and direct and facultative property are generally expected toremain 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 worldwidebasis. The Gulf of Mexico offshore energy class represented approximately 68% ofenergy premium written through 31 December 2006. Trading conditions in thisclass have been unprecedented. Pricing was consistently up several hundredpercent 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 themajority of energy renewals take place in the second quarter, we currently seelittle change in supply or demand for Gulf of Mexico wind exposed deals. Pricingis expected to decrease only marginally, remaining at excellent levels. Outsidethe Gulf of Mexico, we continue to expand our book, with further opportunitiesexpected to arise following the establishment of our Middle East marketingpresence. Marine This segment includes marine excess of loss and a number of marine hull, marinewar, marine P&I and other miscellaneous marine classes. As reported in earliertrading statements, marine excess of loss renewal prices were disappointing in2006 and conditions meant that marine represented a smaller proportion of ouroverall book than initially anticipated. However, with the addition of a marineteam in mid-2006, we were able to gradually build a good quality book. Whileconditions in general remain depressed for 2007, by entering the year with afull team we are in a good position to trade carefully but successfully in thissegment. Aviation To date, our aviation focus has been centered on AV52 war carve-out business. Wedo not write general aviation business at this time, as we believe pricing isinadequate. AV52 pricing has been excellent on a risk adjusted basis although wepredict some softening during 2007. We may also write a small number of aviationindustry loss warranty contracts and satellite programs. Outwards reinsurance Outwards reinsurance premiums ceded in the twelve month period were $78.5million, including $29.9 million of Gulf of Mexico offshore energy premiumsceded to Sirocco Reinsurance Limited, a Bermuda reinsurer in which Lancashireinvested $20.0 million in June 2006. We expect that the ratio of ceded premiumsto gross written premiums will remain relatively similar in 2007 compared to2006. ***** Net premiums earned were $243.5 million for the year. As a newly formed group ofcompanies with no existing book of unearned policies, there was a substantialdifference between the relative size of premiums written and premiums earnedbecause policies written generally earn over a twelve month period. Grosspremiums earned as a proportion of gross premiums written was a modest 48.4% in2006, but this ratio will increase substantially in 2007. The loss ratio for the twelve months to 31 December 2006 was 16.1%, driven bythe relative absence of large loss events in the major classes written byLancashire. All but a de minimis amount of the loss expense recorded is inrespect of losses incurred but not reported. We do not expect the unusual lossconditions of 2006 to be repeated in 2007. The acquisition cost ratio for the period was 14.3% and the underwritingoperating expense ratio was 13.9%. The acquisition cost ratio is expected toincrease only marginally in 2007. The underwriting operating expense ratio for2006 is significantly higher than the expected long term ratio due to the lag innet premiums earned in the first year of operations. In 2007, the operatingexpense ratio should be well below 10%. Net investment income for 2006 was $56.0 million. The fixed income portfolio iscurrently 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 31December 2006 was fixed income 65%, cash 29% and equities 6%. The weightedaverage duration and credit quality of our fixed income portfolio was 2.3 yearsand AA+, respectively. Employee warrants and option expense is the accrual of the fair value ofwarrants and options granted to employees. The fair value is calculated on thegrant date and will be expensed over the vesting period of each security, whichis between three and four years. The fair value is expensed in the incomestatement and there is a corresponding credit to share premium in the balancesheet resulting in a net zero impact on total shareholders' equity. The warrantswere a one-off creation at the time of the IPO in late 2005. Due to theirnon-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 millionof common equity and $128.6 million of long-term debt. Leverage is 10.2%. Fullyconverted book value per share at 31 December 2006 was $5.68 compared to $4.84at 31 December 2005, representing growth of 17.4% in the twelve months to 31December 2006. Based on projected opportunities for 2007, we believe the leveland mix of capital is appropriate. This will be reassessed by management as thetrading 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 SouthamptonBuildings, London WC2A 1PB. This presentation will be hosted by Richard Brindle,Chief Executive Officer and Chief Underwriting Officer; Neil McConachie, ChiefFinancial Officer; and Simon Burton, Deputy Chief Underwriting Officer and ChiefOperating Officer. Those wishing to attend are asked to contact Rob Bailhache orNick Henderson at Financial Dynamics on +44 (0) 207 269 7200 /[email protected] or +44 (0) 207 269 7114 / [email protected]. The presentation will also be accessible via a conference call for those unableto 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. Areplay facility can also be accessed at www.lancashire.bm. For further information, please contact: Lancashire Holdings +1 441 278 8950Neil McConachie Financial DynamicsRob Bailhache +44 20 7269 7200Nick Henderson +44 20 7269 7114 Investor enquiries and questions can also be directed to [email protected] by accessing the Company's website www.lancashire.bm. About Lancashire Lancashire, through its UK and Bermuda-based insurance subsidiaries, is a globalprovider of specialty insurance products. Its insurance subsidiaries carry theLancashire group rating of A minus (Excellent) from A.M. Best with a stableoutlook. Lancashire has capital in excess of $1 billion and its Common Sharestrade on AIM under the ticker symbol LRE. Lancashire is headquartered atMintflower Place, 8 Par-La-Ville Road, Hamilton HM 08, Bermuda. The mailingaddress is Lancashire Holdings Limited, P.O. Box HM 2358, Hamilton HM HX,Bermuda. For more information on Lancashire, visit the company's website atwww.lancashire.bm Consolidated income statement for the year ended December 31, 2006 notes 2006 2005 $m $mgross premiums written 626.0 2.6outwards reinsurance premiums 25 (78.5) -net premiums written 547.5 2.6change 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 2.1net 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) 0.3total net revenue 302.2 2.4insurance 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 10.0total expenses 130.4 10.0 results of operating activities 171.8 (7.6)finance costs 20 12.3 4.0profit (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 sharebasic 24 $0.81 $(0.24)diluted 24 $0.79 $(0.24) Consolidated balance sheet as at December 31, 2006 notes 2006 2005 $m $massetscash and cash equivalents 10 400.1 1,072.4accrued interest receivable 14 7.5 2.0investments- 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 0.5other receivables 14 6.3 0.3inwards premium receivable from insureds and cedants 14 173.7 2.1deferred tax asset 8, 9 0.8 -investment in associate 12 23.2 -property, plant and equipment 18 2.4 0.4total assets 1,662.7 1,077.7 liabilitiesinsurance 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 2.2corporation tax payable 9 1.0 -interest rate swap 20 0.9 -accrued interest payable 19 0.5 0.4long-term debt 19 128.6 125.4total liabilities 525.1 130.6 shareholders' equityshare capital 21 97.9 97.9share premium 21, 26 33.6 860.8contributed 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 1,137.6 947.1total 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 $mbalance 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 - - - 978.6equity offering expenses - (58.6) - - - (58.6)formation expenses 26 - (36.1) - - - (36.1)warrant issues - founders & sponsor 22 - 66.4 - - - 66.4warrant issues - management 6 - 8.4 - - - 8.4balance as at december 31, 2005 97.9 860.8 - - (11.6) 947.1 profit for the period - - - - 159.3 159.3change in investment unrealised gains (losses) 3, 11 - - - 8.7 - 8.7total recognised income for the period - - - 8.7 159.3 168.0issue of share capital 21 - 0.3 (0.3) - - -transfer from share premium to contributed 26 - (850.0) 850.0 - - -surpluswarrant issues - management and performance 6, 22 - 20.5 - - - 20.5options issues - management 6, 22 - 2.0 - - - 2.0balance 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 $mcash flows from operating activitiesprofit (loss) before interest and tax 116.4 (13.3)interest income 3 53.6 2.1interest 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 8.4foreign 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 1.3corporation tax payable 1.0 -accrued interest payable - 0.4net cash flows from (used in) operating activities 314.5 (4.1) cash flows from investing activitiespurchase 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 activitiesproceeds from issue of share capital - 978.6transaction costs from issue of share capital - (12.2)formation expenses - (15.2)proceeds from issue of long-term debt - 125.7net cash flows from financing activities - 1,076.9 net (decrease) increase in cash and cash equivalents (673.5) 1,072.4cash 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 accountingpolicies adopted in the preparation of Lancashire Holdings Limited ("LHL") andits subsidiaries' (collectively "the Group") consolidated financial statementsare set out below. basis of preparation The Group's consolidated financial statements are prepared in accordance withaccounting principles generally accepted under International Financial ReportingStandards ("IFRS") endorsed by the European Commission. Where IFRS is silent, as it is in respect of the measurement of insuranceproducts, the IFRS framework allows reference to another comprehensive body ofaccounting principles. In such instances, management determines appropriatemeasurement bases, to provide the most useful information to users of theconsolidated financial statements, using their judgment and considering theaccounting 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 sharedata 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 yeteffective, have not been early adopted by the Group: • IFRS 7, Financial Instruments Disclosure; • IFRS 8, Operating Segments; • IAS 1, Presentation of Financial Statements. These standards are not expected to have a material impact on the results anddisclosures reported in the consolidated financial statements. InternationalFinancial Reporting Interpretations Committee ("IFRIC") standards issued but notyet effective are similarly not expected to have a material impact on theresults and disclosures of the Group. The consolidated balance sheet of the Group is presented in order of decreasingliquidity. use of estimates The preparation of financial statements in conformity with IFRS requiresmanagement to make estimates and assumptions that affect the reported anddisclosed amounts at the balance sheet date and the reported and disclosedamounts of revenues and expenses during the reporting period. Actual resultsmay 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. Asubsidiary is an entity in which the Group owns, directly or indirectly, morethan 50% of the voting power of the entity or otherwise has the power to governits operating and financial policies. The results of subsidiaries acquired areincluded in the consolidated financial statements from the date on which controlis transferred to the Group. Intercompany balances, profits and transactionsare eliminated. Subsidiaries' accounting policies are consistent with the Group's accountingpolicies. ii. associates Investments in which the Group has significant influence over the operationaland financial policies of the investee, are initially recognised at cost andthereafter accounted for using the equity method. Under this method, the Grouprecords its proportionate share of income or loss from such investments in itsresults of operations for the period. Adjustments are made to associates'accounting policies, where necessary, in order to be consistent with the Group'saccounting policies. foreign currency translation The functional currency for all Group entities is U.S. dollars. Theconsolidated financial statements are presented in U.S. dollars. Items includedin the financial statements of each of the Group's entities are measured usingthe functional currency, which is the currency of the primary economicenvironment in which operations are conducted. Foreign currency transactions are recorded in the functional currency for eachentity using the exchange rates prevailing at the dates of the transactions, orat the average rate for the period when this is a reasonable approximation.Monetary assets and liabilities denominated in foreign currencies are translatedat period end exchange rates. The resulting exchange differences on translationare recorded in the consolidated income statement. Non-monetary assets andliabilities carried at historical cost denominated in a foreign currency aretranslated at historic rates. Non-monetary assets and liabilities carried atfair value denominated in a foreign currency are translated at the exchange rateat the date the fair value was determined, with resulting exchange differencesrecorded in the fair value reserves in shareholders' equity. insurance contracts i. classification Insurance contracts are those contracts that transfer significant insurance riskat the inception of the contract. Contracts that do not transfer significantinsurance risk are accounted for as investment contracts. Insurance risk istransferred when an insurer agrees to compensate a policyholder if a specifieduncertain 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 basedon the minimum and deposit or flat premium, as defined in the contract.Subsequent adjustments to the minimum and deposit premium are recognised in theperiod in which they are determined. For pro-rata contracts and excess of losscontracts where no deposit is specified in the contract, written premium isrecognised based on estimates of ultimate premiums provided by the insureds orceding companies. Initial estimates of written premium are recognised in theperiod in which the underlying risks incept. Subsequent adjustments, based onreports of actual premium by the insureds or ceding companies, or revisions inestimates, are recorded in the period in which they are determined. Premiums are earned ratably over the term of the underlying risk period of thereinsurance contract, except where the period of risk differs significantly fromthe contract period. In these circumstances, premiums are recognised over theperiod of risk in proportion to the amount of insurance protection provided.The portion of the premium related to the unexpired portion of the risk periodis reflected in unearned premium. Where contract terms require the reinstatement of coverage after a cedingcompany's loss, the mandatory reinstatement premiums are recorded as writtenpremium when the loss event occurs. Inwards premiums receivable from insureds and cedants are recorded net ofcommissions, brokerage, premium taxes and other levies on premiums. Thesebalances are reviewed for impairment, with any impairment loss recognised inincome in the period in which they are determined. Acquisition costs represent commissions, brokerage, profit commissions and othervariable costs that relate directly to the securing of new contracts and therenewing of existing contracts. They are deferred over the period in which therelated premiums are earned, to the extent they are recoverable out of expectedfuture revenue margins. All other acquisition costs are recognised as anexpense when incurred. iii. outwards reinsurance Outwards reinsurance premiums comprise the cost of reinsurance contracts enteredinto. Outwards reinsurance premiums are accounted for in the period in whichthe underlying risks incept. The provision for reinsurers' share of unearnedpremiums represents that part of reinsurance premiums written which is estimatedto be earned in future financial periods. Unearned reinsurance commissions arerecognised as a liability using the same principles. Any amounts recoverablefrom reinsurers are estimated using the same methodology as the underlyinglosses. The Group monitors the credit worthiness of its reinsurers on an ongoing basisand assesses any reinsurance assets for impairment, with any impairment lossrecognised in income in the period in which it is determined. iv. losses Losses comprise losses and loss adjustment expenses paid in the period andchanges in the provision for outstanding losses, including the provision forlosses incurred but not reported ("IBNR") and related expenses. Losses and lossadjustment expenses are charged to income as they are incurred. A significant portion of the Group's business is classes with high attachmentpoints of coverage, including property catastrophe. Reserving for losses insuch programs is inherently complicated in that losses in excess of theattachment level of the Group's policies are characterised by high severity andlow frequency and other factors which could vary significantly as losses aresettled. This limits the volume of industry loss experience available fromwhich 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 ofsettling all losses and loss adjustment expenses arising from events which haveoccurred up to the balance sheet date, including a provision for IBNR. TheGroup does not discount its liabilities for unpaid losses. Outstanding lossesare initially set on the basis of reports of losses received from third parties.Estimated IBNR reserves consist of a provision for additional development inexcess of case reserves reported by ceding companies or insureds, as well as aprovision for losses which have occurred but which have not yet been reported tous by ceding companies or insureds. IBNR reserves are estimated by managementusing various actuarial methods as well as a combination of our own lossexperience, historical insurance industry loss experience, our underwriters'experience, estimates of pricing adequacy trends, and management's professionaljudgment. The estimation of the ultimate liability arising is a complex and judgmentalprocess. It is reasonably possible that uncertainties inherent in the reservingprocess, delays in insureds or ceding companies reporting losses to the Group,together with the potential for unforeseen adverse developments, could lead to amaterial change in losses and loss adjustment expenses. v. liability adequacy tests At each balance sheet date, the Group performs a liability adequacy test usingcurrent best estimates of future cash flows generated by its insurancecontracts, plus any investment income thereon. If, as a result of these tests,the carrying amount of the Group's insurance liabilities is found to beinadequate, the deficiency is charged to the consolidated income statement forthe period initially by writing off deferred acquisition costs and subsequentlyby establishing a provision. cash and cash equivalents Cash and cash equivalents are carried in the consolidated balance sheet at costand includes cash in hand, deposits held on call with banks and other short termhighly liquid investments with a maturity of three months or less at the date ofpurchase. Carrying amounts approximate fair value due to the short term natureof the instruments. Interest income earned on cash and cash equivalents is recognised on theeffective interest rate method. The carrying value of accrued interest incomeapproximates fair value due to its short term nature. investments The Group's fixed income and equity investments are classified as available forsale and are carried at fair value. Other investments classified as availablefor sale are recorded at estimated fair value based on financial informationreceived and other information available to management, including factorsrestricting the liquidity of the investments. Regular way purchases and salesof investments are recognised at fair value less transaction costs on the tradedate and are subsequently carried at fair value. Estimated fair value of quotedinvestments is determined based on bid prices from recognised exchanges.Investments are derecognised when the Group has transferred substantially all ofthe risks and rewards of ownership. Realised gains and losses are included inincome in the period in which they arise. Unrealised gains and losses fromchanges in fair value are included in the fair value reserve in shareholders'equity. On derecognition of an investment, previously recorded unrealised gainsand losses are removed from shareholders' equity and included in current periodincome. Amortisation and accretion of premiums and discounts are calculated using theeffective interest rate method and are recognised in current period netinvestment income. Dividends on equity securities are recorded as revenue onthe date the dividends become payable to the holders of record. The carryingvalue of accrued interest income approximates fair value due to its short termnature. The Group reviews the carrying value of its investments for evidence ofimpairment. An investment is impaired if its carrying value exceeds theestimated recoverable amount and there is objective evidence of impairment tothe asset. Such evidence would include a prolonged decline in fair value belowcost or amortised cost, where other factors do not support a recovery in value.If an impairment is deemed appropriate, the difference between cost or amortisedcost 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 theincome statement. Impairment losses on debt securities may be subsequentlyreversed 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. Derivativeinstruments with a positive value are recorded as derivative financial assetsand those with a negative value are recorded as derivative financialliabilities. Embedded derivatives that are not closely related to their hostcontract 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 underlyinginstrument and are subject to the same risks as that underlying instrument,including liquidity, credit and market risk. Fair values are based on exchangequotations and discounted cash flow models, which incorporate pricing of theunderlying instrument, yield curves and other factors, with changes in the fairvalue of instruments that do not qualify for hedge accounting recognised incurrent period income. Derivative financial assets and liabilities are offset and the net amountreported in the consolidated balance sheet only to the extent there is a legallyenforceable 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 accumulateddepreciation and any impairment in value. Depreciation is calculated towrite-off the cost over the estimated useful economic life on a straight-linebasis as follows: IT equipment 33% per annumOffice furniture and equipment 33% per annumLeasehold improvements 20% per annum The assets' residual values, useful lives and depreciation methods are reviewedand adjusted if appropriate, at each balance sheet date. An item of property, plant or equipment is derecognised on disposal or when nofuture economic benefits are expected to arise from the continued use of theasset. Gains and losses on the disposal of property, plant and equipment are determinedby comparing proceeds with the carrying amount of the asset, and are included inthe income statement. Costs for repairs and maintenance are charged to theconsolidated income statement as incurred. long term debt Long-term debt is recognised initially at fair value, net of transaction costsincurred. Thereafter it is held at amortised cost, with the amortisationcalculated using the effective interest rate method. leases Rentals payable under operating leases are charged to income on a straight-linebasis over the lease term. employee benefits i. equity compensation plans The Group operates a management warrant plan and an option plan. The fair valueof the equity instrument granted is estimated on the date of grant. The fairvalue is recognised as an expense pro-rata over the vesting period of theinstrument. The total amount to be expensed is determined by reference to thefair value of the awards estimated at the grant date, excluding the impact ofany non-market vesting conditions. At each balance sheet date, the Group revises its estimate of the number ofwarrants and options that are expected to become exercisable. It recognises theimpact of the revision of original estimates, if any, in the consolidated incomestatement, and a corresponding adjustment is made to shareholders' equity overthe remaining vesting period. On vesting or exercise, the differences between the expense charged to theconsolidated income statement and the actual cost to the Group is transferred toretained earnings. Where new shares are issued, the proceeds received arecredited to share capital and share premium. ii. pensions The Group operates a defined contribution plan. On payment of contributions tothe plan there is no further obligation to the Group. Contributions arerecognised as employee benefits in the consolidated income statement in theperiod to which they relate. founder and sponsor warrants The Group issued warrants to certain founding shareholders and a sponsor onlisting. The fair value of the equity instruments granted were estimated on thedate of grant. Warrants issued to founding shareholders were treated as a capital transactionand the associated fair value was credited to the share premium account. Thefair value of warrants issued to the sponsor for assistance with incorporationand other start-up services was credited to the share premium account. Thetotal amount to be credited was determined by reference to the fair value of theawards estimated at the grant date, excluding the impact of any non-marketvesting conditions. tax Income tax expense represents the sum of the tax currently payable and anydeferred tax. The tax payable is calculated based on taxable profit for theperiod. Taxable profit for the period can differ from that reported in theconsolidated income statement due to certain items which are not tax deductibleor which are deferred to subsequent periods. Deferred tax is recognised on temporary differences between the assets andliabilities in the consolidated balance sheet and their tax base. Deferred taxassets or liabilities are accounted for using the balance sheet liabilitymethod. Risk disclosures for the year ended December 31, 2006 risk disclosures: introduction The Group enters into contracts that directly accept and transfer insurancerisk. This in turn creates exposure for the Group to insurance risk andfinancial risk. The Group's appetite for accepting risk is established by the Board ofDirectors. The management of risks is described below. A. insurance risk The Group underwrites contracts that transfer insurance risk. The Group'sunderwriters assess the likely losses using their experience and knowledge ofpast loss experience and current circumstances. This allows them to estimatethe premium sufficient to meet likely losses and expenses. The Group considersinsurance risk at an individual contract level and at an aggregate portfoliolevel. The Group's exposure in connection with such contracts is, in the eventof insured losses, whether premium will be sufficient to cover the loss paymentsand expenses. The Group underwrites worldwide short tail insurance and reinsurance propertyrisks, including risks exposed to natural catastrophes. The four principalclasses, or lines, are property, energy, marine and aviation. The Group doesnot currently underwrite a significant amount of casualty business. The levelof risk tolerance per class is set by the Board of Directors, who delegate dayto day responsibility to senior management. A number of controls are deployed to limit the amount of insurance exposureunderwritten: • A business plan is produced annually which includes target premium by class • The business plan is monitored and reviewed on an on-going basis • Each authorised class has a pre-determined normal maximum line structure proposed by management and agreed by the Board • The Group has a pre-determined target limit on probabilistic loss of capital for certain catastrophic events • A daily underwriting meeting is held to peer review risks • Sophisticated pricing models are utilised in the underwriting process, and are updated frequently to latest versions • Computer modeling tools are deployed to simulate catastrophes and resultant losses to the portfolio • Reinsurance is purchased to mitigate losses in peak areas of exposure The Group has established an internal audit function which is independent of theunderwriting process. The head of internal audit reports directly to the AuditCommittee. The internal audit function is required to perform risk reviews onthe underwriting function to ensure compliance with Group policies and requiredprocedures. The Group establishes targets for the maximum proportion of capital, includinglong 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% ofcapital, after collection of reinsurance and after payment and collection ofreinstatement premiums. There can be no guarantee that the assumptions and techniques deployed incalculating this figure are accurate. There could also be an unmodeled losswhich exceeds these figures. In addition, a California Quake loss event with anoccurrence probability of greater than 1 in 250 years could cause a larger lossto capital, as could a different type of loss event with an occurrenceprobability of less than 1 in 250 years. The Group commenced underwriting in December 2005, but wrote an insignificantamount of business for the period from incorporation to December 31, 2005.Comparatives have therefore not been presented in the analysis provided insection A: insurance risk. Details of gross premiums written by line of business are provided below for theyear ending December 31, 2006: $m % property 254.5 40.6energy 253.9 40.6marine 53.1 8.5aviation 64.5 10.3 total 626.0 100.0 Details of gross premiums written by geographic area of risks insured areprovided below for the year ending December 31, 2006: $m % worldwide offshore 209.4 33.5worldwide, including the US (1) 168.2 26.9USA and Canada 143.5 22.9worldwide, excluding the US (2) 32.6 5.2far east 19.9 3.2rest of world 18.3 2.9middle east 17.1 2.7europe 17.0 2.7total 626.0 100.0 (1) Worldwide comprises insurance and reinsurance contracts that insure orreinsure risks in more than one geographic area. (2) Worldwide, excluding the U.S., comprises insurance and reinsurance contractsthat insure or reinsure risks in more than one geographic area, but thatspecifically exclude the United States of America and Canada. Sections a to d below describe the risks in each of the four principal lines ofbusiness written by the Group. a. property Gross premium written, for the year ending December 31, 2006: $m property retrocession 112.8property direct and facultative 111.4terrorism 18.9property political risk 9.4property cat excess of loss 0.6other property 1.4 total 254.5 Property retrocession is written on an excess of loss basis through treatyarrangements. Programs are generally written on a pillared basis, with separategeographic zonal limits for risks in the U.S. and Canada and for risks outsidethe U.S. and Canada. Property cat excess of loss may be written in a similarmanner to property retrocession but is not written on a pillared basis. TheGroup is exposed to large catastrophic losses such as wind and earthquake lossfrom assuming property retrocession and property cat excess of loss risks.Exposure to such events is controlled and measured through loss modeling but theaccuracy of this exposure analysis is limited by the quality of data andeffectiveness of the modeling. It is possible that a catastrophic event exceedsthe expected event loss. The Group's appetite and exposure guidelines to largelosses are set out in the risk disclosure section under the sub-headinginsurance risk. Reinsurance has also been purchased to mitigate gross losses inthe U.S. and Canada. Property direct and facultative is written for the full value of the risk, on anet excess of loss basis. Cover is generally provided to large commercialenterprises with high value locations. Coverage is for non-elemental perilsincluding fire and explosion and elemental (natural catastrophe) perilsincluding flood, windstorm, earthquake and tornado. Coverage generally includesindemnification for both property damage and business interruption. Terrorism cover is provided for U.S. and worldwide property risks, but excludesnuclear, chemical and biological coverage in most territories. Political risk cover is written on an individual case by case basis and coveragevaries significantly between policies. b. energy Gross premium written, for the year ending December 31, 2006: $m gulf of mexico offshore energy 171.8worldwide offshore energy 42.3construction energy 24.5onshore energy 13.5other energy 1.8 total 253.9 Energy risks are mostly written on a direct basis. Gulf of Mexico energyprograms cover elemental and non-elemental risks. The largest exposure is fromhurricanes in the Gulf of Mexico. Exposure to such events is controlled andmeasured through loss modeling but the accuracy of this exposure analysis islimited by the quality of data and effectiveness of the modeling. It ispossible that a catastrophic event exceeds the expected event loss. The Group'sappetite and exposure guidelines to large losses are set out in the riskdisclosure statement (A. insurance risk). Policies have sub-limits on coveragefor elemental losses, and significant policy restrictions on other areas ofcover such as business interruption and control of well. Non-elemental energyrisks include fire and explosion. Reinsurance protection has been purchased toprotect 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 energyinstallations and are largely subject to the same loss events as describedabove. Energy construction contracts generally cover all risks of platform anddrilling units under construction. c. marine Gross premium written, for the year ending December 31, 2006: $m marine hull and total loss 26.1marine builders risk 10.5marine P&I clubs 6.4marine excess of loss 4.3marine hull war 4.1other marine 1.7 total 53.1 Marine hull and total loss is generally written on a direct basis and coversmarine risks on a worldwide basis primarily for physical damage and loss.Marine P&I is the reinsurance of The International Group of Protection andIndemnity Clubs. Marine excess of loss is generally written on a treaty basis.Marine builders risk is insurance for the building of ocean going vessels inspecialised yards worldwide, from keel laying to delivery to owner. Marine hull war is direct insurance of loss of vessels from war or terroristattack. Marine cargo programs are not normally written. The largest exposureis from physical loss rather than from elemental loss events. d. aviation Gross premium written, for the year ending December 31, 2006: $m AV 52 56.2other aviation 8.3 total 64.5 Aviation AV52 provides coverage for third party liability resulting from acts ofwar or hijack against aircraft. Other aviation business includes aviation hull war risks and industry losswarranty programs. reinsurance The Group, in the normal course of business and in accordance with its riskmanagement practices, seeks to reduce the loss that may arise from events thatcould cause unfavourable underwriting results by entering into reinsurancearrangements. Reinsurance does not relieve the Group of its obligations topolicyholders. Under the Group's reinsurance security policy, reinsurers aregenerally 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 theabove rating category on a case by case basis, and may therefore requirecollateral to be posted to support obligations. The Group monitors the creditworthiness of its reinsurers on an ongoing basis. In 2006 the Group purchased excess of loss reinsurance, including industry losswarranty covers, and proportional reinsurance. The reinsurance purchasedreduced 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 notcurrently purchased reinsurance for risks outside the U.S. There is no guarantee that reinsurance coverage will be available to meet allpotential loss circumstances, as it is possible that the cover purchased is notsufficient. Any loss amount which exceeds the program would be retained by theGroup. Some parts of the reinsurance program have limited reinstatementstherefore the number of claims which may be recovered from second or subsequentlosses is limited. insurance liabilities For most insurance and reinsurance companies, the most significant judgment madeby management is the estimation of loss and loss adjustment expense reserves.The estimation of the ultimate liability arising from claims made underinsurance and reinsurance contracts is a critical estimate for the Group. Under generally accepted accounting principles, loss reserves are not permitteduntil 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 areestablished, with no allowance for the provision of a contingency reserve toaccount for expected future losses. Claims arising from future catastrophicevents can be expected to require the establishment of substantial reserves fromtime to time. Loss and loss adjustment expense reserves are however maintained to cover theGroup's estimated liability for both reported and unreported claims. Reservingmethodologies that calculate a point estimate for the ultimate losses areutilised, and then a range is developed around the point estimate. The pointestimate represents management's best estimate of ultimate loss and lossadjustment expenses. The Group's internal actuaries review the reservingassumptions and methodologies on a quarterly basis with loss estimates beinggenerally 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 differsas to whether the business is insurance or reinsurance, whether it is short-tailor long-tail and whether the business is written on an excess of loss or on apro-rata basis. Over a typical annual period, the Group expects to write themajority of programs on a direct basis. Typically, over 80% of programs areexpected to be written on an excess of loss basis. The Group does not currentlywrite a significant amount of long-tail business. a. insurance versus reinsurance Loss reserve calculations for direct insurance business are not precise in thatthey deal with the inherent uncertainty of future contingent events. Estimatingloss reserves requires management to make assumptions regarding future reportingand development patterns, frequency and severity trends, claims settlementpractices, potential changes in the legal environment and other factors such asinflation. These estimates and judgments are based on numerous factors, and maybe revised as additional experience or other data becomes available or reviewedas new or improved methodologies are developed or as current laws change. Furthermore, as a broker market reinsurer for both excess of loss andproportional contracts, management must rely on loss information reported tobrokers by primary insurers who must estimate their own losses at the policylevel, often based on incomplete and changing information. The informationmanagement receives varies by cedant and may include paid losses, estimated casereserves, and an estimated provision for IBNR reserves. Additionally, reservingpractices and the quality of data reporting may vary among ceding companieswhich 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 thoseunderwritten by the Group, are reported more promptly by third parties thanthose relating to long-tail risks, including the majority of casualty risks.However, the timeliness of reporting can be affected by such factors as thenature of the event causing the loss, the location of the loss, and whether thelosses 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 treatyhas a defined limit of liability arising from one event. Once that limit hasbeen reached, there is no further exposure to additional losses from that treatyfor the same event. For proportional treaties, generally an initial estimatedloss and loss expense ratio (the ratio of losses and loss adjustment expensesincurred to premiums earned) is used, based upon information provided by theinsured or ceding company and/or their broker and management's historicalexperience of that treaty, if any, and the estimate is adjusted as actualexperience becomes known. d. time lags There is a time lag inherent in reporting from the original claimant to theprimary insurer to the broker and then to the reinsurer, especially in the caseof excess of loss reinsurance contracts. Also, the combination of low claimfrequency and high severity make the available data more volatile and lessuseful 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 inestimating reserves for these contracts. In addition, if available, reliance isplaced partially on ultimate loss ratio forecasts as reported by cedants, whichare 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 IBNRreserves, which consist of a provision for additional development in excess ofthe case reserves reported by ceding companies, as well as a provision forclaims which have occurred but which have not yet been reported by cedingcompanies. Because of the degree of reliance that is necessarily placed onceding companies for claims reporting, the associated time lag, the lowfrequency/high severity nature of much of the business that the Groupunderwrites, and the varying reserving practices among ceding companies, reserveestimates are highly dependent on management judgment and therefore uncertain.During the loss settlement period, which may be years in duration, additionalfacts regarding individual claims and trends often will become known, andcurrent laws and case law may change, with a consequent impact on reserving. The claims count on the types of insurance and reinsurance that the Groupwrites, which are low frequency and high severity in nature, is generally low. For certain catastrophic events there is greater uncertainty underlying theassumptions and associated estimated reserves for losses and loss adjustmentexpenses. Complexity resulting from problems such as policy coverage issues,multiple events affecting one geographic area and the resulting impact on claimsadjusting (including allocation of claims to event and the effect of demandsurge on the cost of building materials and labour) by, and communications from,ceding companies, can cause delays to the timing with which the Group isnotified of changes to loss estimates. In the year to December 31, 2006, management were not notified or made aware ofany losses of a material size. As such, at December 31, 2006 management'sestimates for IBNR represented approximately 97% of total loss reserves. The majority of the estimate relates to potential claims on non-elemental riskswhere timing delays in cedant reporting may mean losses have occurred whichmanagement 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 tofund obligations arising from its insurance contracts. The Group segments its investment portfolio into two main components: Acategory to at least meet expected insurance liabilities ("core portfolio") anda 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 coreportfolio 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 cashequivalents and a modest amount of equity securities. Currently, the Group doesnot hold any alternative investments such as hedge funds. The surplus portfoliohas a modest holding of convertible debt securities. These instruments havebeen bifurcated into their component parts with the embedded option fair valuedthrough the income statement. Investment guidelines are established by the Investment Committee of the Boardof Directors. Separate investment guidelines exist for the core portfolio, thesurplus portfolio and the Group's consolidated portfolio. Investment guidelinesset parameters within which investment managers must operate. Importantparameters include guidelines on permissible assets, duration ranges, creditquality 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 totalfixed 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 - 1,072.4total 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 - 100.0total 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 totalshort 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 externalinvestment managers with identical mandates. The equity portfolio is managed byone investment manager. The equity portfolio is invested predominantly in U.S.and Canadian securities in a diversified range of sectors. The performance ofthe managers is monitored on an on-going basis. An analysis of the most important components of financial risk is detailed in ato e below. a. valuation risk The Group's net asset value is directly impacted by movements in the value ofinvestments held. Values can be impacted by movements in interest rates, creditratings, economic environment and outlook, and exchange rates. The impact of a 10% fall in the value of the Group's equity portfolio atDecember 31, 2006 would be $7.0 million. Valuation risk in the equity portfoliois mitigated by adopting a value strategic approach and by diversifying theportfolio across sectors. b. interest rate risk The majority of the Group's investments comprise fixed income securities. Thefair value of the Group's fixed income portfolio is inversely correlated tomovements in market interest rates. If market interest rates fall, the fairvalue 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 itsduration(1). The greater a security's duration, the greater its percentageprice volatility. The sensitivity of the Group's fixed income portfolio at December 31, 2006 tointerest 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 establishingand monitoring duration ranges within investment guidelines. The duration ofthe fixed income portfolios at December 31, 2006 was 1.5 years for the coreportfolio and 3.2 years for the surplus portfolio. Insurance contract liabilities are not directly sensitive to the level of marketinterest 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 notesbear interest at a floating rate plus a fixed margin of 3.7%. The Group issubject to interest rate risk on the coupon payments of the long-term debt. TheGroup has mitigated the interest rate risk by entering into swap contracts asfollows: maturity prepayment interest date date(1) hedged(2)subordinated loan notes €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 slidingscale 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 theprincipal through the prepayment dates specified above. The current Euribor interest rate on 50% of the subordinated loan notes has beenfixed at 3.67%. The current LIBOR interest rate on 50% of the subordinated loannotes has been fixed at 5.36%. The Group retains exposure to interest risk onthe 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 notbe available to pay obligations when they are due without incurring anunreasonable cost. The maturity dates of the Group's fixed income portfolio at December 31, 2006were as follows: $m $m $m core surplus totalless than one year 21.3 - 21.3between one year and two years 117.8 28.9 146.7between two and three years 79.0 21.7 100.7between three and four years 56.5 42.0 98.5between four and five years 16.7 35.2 51.9over five years 174.7 302.5 477.2total 466.0 430.3 896.3 Actual maturities may differ from contractual maturities because certainborrowers have the right to call or pre-pay certain obligations with or withoutcall or prepayment penalties. The Board limits liquidity risk in several ways. First, a portion of theinvestment portfolio is segregated for the short term liquidity requirementsarising from insurance obligations. The core portfolio is highly liquid withshort maturity. All core portfolio securities are quoted on major exchanges.Secondly, the Board has established asset allocation and maturity parameterswithin investment guidelines such that the majority of the Group's investmentsare in high quality assets which could be converted into cash promptly and atminimal 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 arepredominantly denominated in U.S. dollars. The Group is exposed to currencyrisk to the extent its assets are denominated in different currencies to itsliabilities. The Group is also exposed to non-retranslation risk onnon-monetary assets such as unearned premiums. At each balance sheet dateexchange gains and losses can impact the consolidated income statement. The Group has hedged the large majority of currency risk by closely matching thenon U.S. dollar liabilities with non U.S. dollar assets. The Group's mainforeign currency exposure relates to its insurance obligations and the €24million subordinated notes long-term debt liability. While the unhedgedbalances are not large, the Group has more closely hedged these currencyexposures by holding larger balances of non U.S. dollar cash. The Group's assets and liabilities, categorised by currency at their translatedcarrying amount was as follows: assets $m $m $m $m $m U.S. $ sterling euro other totalcash and cash equivalents 359.0 1.3 37.1 2.7 400.1accrued interest receivable 7.5 - - - 7.5investments 978.1 - - - 978.1unearned premium on premium ceded 19.1 - - - 19.1deferred acquisition costs 48.5 0.2 1.6 1.2 51.5other receivables 5.1 1.2 - - 6.3inwards premium receivable from insureds 161.6 0.7 5.6 5.8 173.7deferred tax asset - 0.8 - - 0.8investment in associate 23.2 - - - 23.2property, plant and equipment 1.4 1.0 - - 2.4total assets as at december 31, 2006 1,603.5 5.2 44.3 9.7 1,662.7 $m $m $m $m $mliabilities U.S. $ sterling euro other totallosses and loss adjustment expenses 38.0 0.2 0.9 - 39.1unearned premiums 304.9 2.0 10.4 8.4 325.7insurance contracts - other payables 3.6 - - - 3.6amounts payable to reinsurers 2.4 - - - 2.4deferred acquisition costs ceded 2.5 - - - 2.5other payables 19.8 1.0 - - 20.8corporation tax payable - 1.0 - - 1.0interest rate swap 1.0 - (0.1) - 0.9accrued interest payable 0.4 - 0.1 - 0.5long-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 totalcash and cash equivalents 1,072.4 - - - 1,072.4accrued interest receivable 2.0 - - - 2.0deferred acquisition costs 0.5 - - - 0.5other receivables 0.3 - - - 0.3inwards premium receivable from insureds 2.1 - - - 2.1property, 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 totalunearned premiums 2.6 - - - 2.6other payables 2.2 - - - 2.2accrued interest payable 0.4 - - - 0.4long-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 orobligation. The Group is exposed to credit risk on its fixed income investmentportfolio, its inwards premium receivable from insureds and cedants, and on anyamounts recoverable from reinsurers. Credit risk on the fixed income portfolio is managed by establishing investmentguidelines that set parameters on the absolute credit ratings of holdings andthe concentration of holdings within credit rating bands. The guidelines alsoplace 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 andapproval of reinsurer security by the Group's reinsurance security committee asdiscussed in the risk disclosure section under sub-heading reinsurance. The table below presents an analysis of the Group's major exposures tocounterparty credit risk, based on Standard & Poor's or equivalent rating. Thetable includes amounts due from policyholders and unsettled investment trades.The quality of these receivables is not graded, but based on managementshistorical experience there is limited default risk associated with theseamounts. Outstanding claims, including IBNR, recoverable from reinsurers wasnil at December 31, 2006 and December 31, 2005, and therefore has not beenincluded. 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 islisted on the Alternative Investment Market ("AIM"), a subsidiary market of theLondon Stock Exchange. The registered office of LHL is Clarendon House, 2Church 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 isauthorized by the Bermuda Monetary Authority (the "BMA") as a Class 4 generalinsurer. 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 andis authorised by the United Kingdom Financial Services Authority (the "FSA") toconduct general insurance business. The products provided are the same as thoseprovided by LICL. LICUKL is also registered as a Class 3 general insurer inBermuda and has a permit issued under the Bermuda Companies Act to enablecertain activities related to its insurance business to be performed fromBermuda. LIMSL is authorised by the FSA to undertake insurance mediation activities.LIMSL provides business introduction and other support services to LICL in theUnited Kingdom, and was incorporated under the laws of England & Wales onOctober 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 fourprincipal classes: property, energy, marine and aviation. Management hastherefore deemed these classes to be its business and primary segments for thepurposes of segmental reporting. Further sub classes of business areunderwritten within each primary segment. The Group commenced underwriting inDecember 2005, but wrote an insignificant amount of business in the period fromincorporation to December 31, 2005. Comparatives have therefore not beenpresented 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 - 209.4worldwide including the U.S. 71.5 26.2 7.4 63.1 168.2U.S. and Canada 111.7 1.4 0.4 - 143.5worldwide excluding the U.S. 31.4 0.5 0.6 0.1 32.6far east 10.6 2.6 6.7 - 19.9rest of world 10.3 6.8 - 1.2 18.3middle east 6.7 9.0 1.3 0.1 17.1europe 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 54.2other investment income 1.8net realised gains (losses) and impairments 0.8share of profit of associate 3.2net 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 totalattributable to business segments 82.2 82.7 29.3 57.0 251.2other assets 1,411.5 total assets 1,662.7 liabilities $m $m $m $m $m property energy marine aviation totalattributable to business segments 128.8 154.6 38.2 51.7 373.3other liabilities 151.8 total liabilities 525.1total net assets 1,137.6 The Group's net assets are located primarily in Bermuda. Less than 10% of totalnet assets are currently attributable to the UK operations. 3. investment return The total investment return for the Group is as follows: 2006 2005 $m $minvestment 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 Groupat December 31, 2006. 4. net insurance acquisition expenses 2006 2005 $m $minsurance acquisition expenses 91.0 0.5changes 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 1.6equity based compensation 22.5 8.4total 56.4 10.0 6. employee benefits 2006 2005 $m $mwages and salaries 5.4 0.2pension costs 0.6 -other benefits 7.5 -equity based compensation 22.5 8.4total 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 termincentive plan. On admission to AIM, warrants to purchase common shares were issued forimmediate allocation to certain members of management or reserved for laterallocation 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 beexercisable at an initial price per share of US$5.00 equal to the price pershare paid by investors in the initial public offering. Settlement is at thediscretion 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 suchwarrants vested immediately upon issuance. Thereafter, 25% of such warrantswill vest on the first, second and third anniversary of the grant date. On December 16, 2005, the board approved the issue of ordinary warrants topurchase 12,708,695 common shares, representing the full allocation ofmanagement team ordinary warrants. Warrants from this amount were subsequentlyawarded 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 certainperformance criteria with specific measurement dates of December 31, 2007,December 31, 2008 and December 31, 2009. Half of these warrants will vest onlyon achievement of a fully diluted book value per share in comparison to aplanned appreciation threshold of between 70% and 100% at certain dates. Theremaining half of these warrants will vest only on achievement of an internalrate of return ("IRR") in comparison to a planned IRR of between 70% and 100% atcertain dates. On December 31, 2005, the board approved the issue of performance warrants topurchase 7,625,218 common shares, representing the full allocation of managementteam performance warrants. Warrants from this amount were subsequently awardedto individual members of management. The fair value of each warrant was estimated on the date of grant using theBlack-Scholes option-pricing model. Assumptions used for valuation of thesegrants were as follows: risk free interest rate of 4.93%; an expected life often years; volatility of 30% being the maximum contractual rate; performancetargets will be fully met; dividend yield of nil due to contractual dividendprotection; the Group will settle in shares; no dilutive events, and noforfeitures, other than leavers which are assumed to be 10% of total employeesfor management performance warrants during all vesting periods and 10% of the2007 and 2008 vesting periods relating to ordinary warrants expensed in 2006.For the ordinary warrants that vested in 2006, there was no leaver's adjustmentas 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 $5.00allocated during the period 4,834 $5.00allocated as at december 31, 2006 19,297 $5.00exercisable 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 paymentexpense of $20.5 million (2005 - $8.4 million) is included in other operatingexpenses in the consolidated income statement. long term incentive plan ("LTIP") Options may be granted under the LTIP at the discretion of the RemunerationCommittee. Options granted under the LTIP are limited to 5% of the fully dilutedcommon share capital in issue at the date of grant. All options issued willexpire ten years from date of issue and the exercise price is equal to orgreater than the average market value of the shares on the twenty previoustrading days prior to grant. The range of exercise prices for options at December 31, 2006 was £3.25 ($6.37)to £3.55 ($6.95) per share. 25% of options vest on each of the first, second,third and fourth anniversary of the grant date. There are no associatedperformance criteria. Settlement is at the discretion of the Group and may bein cash or shares. In 2006, certain members of staff were issued options to purchase 2,503,613common shares. Options to purchase 101,670 common shares were forfeited duringthe period (see note 22). The fair value of each option was estimated on the date of grant using theBlack-Scholes option-pricing model. Assumptions used for valuation of thesegrants were as follows: risk free interest rate of 5.125%; an expected life ofsix years; volatility of 30% being the maximum contractual rate; dividend yieldof nil due to contractual dividend protection; the Group will settle in shares;no forfeitures, other than leavers which are assumed to be 10% of totalemployees, and no dilutive events. options weighted average number exercise price thousands US$granted during the period and outstanding as at december 31, 2,402 $5.772006exercisable 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 incomestatement. 7. results of operating activities Results of operating activities are stated after charging the following amounts: 2006 2005 $m $mdepreciation on owned assets 0.6 -operating lease charges 1.1 -auditors remuneration- group audit fees 0.7 0.1- other services 0.3 0.6total 2.7 0.7 Fees paid to the Group's auditors for other services are approved by the Group'sAudit Committee. Such fees comprise the following amounts: 2006 2005 $m $mtax advice 0.1 -FSA regulatory advice 0.2 -other - 0.6total 0.3 0.6 8. tax Bermuda LHL, LICL and LICUKL have received an undertaking from the Bermuda governmentexempting them from all Bermuda local income, withholding and capital gainstaxes until March 28, 2016. At the present time no such taxes are levied inBermuda. United States The Group does not consider itself to be engaged in trade or business in theUnited States and, accordingly, does not expect to be subject to United Statestaxation. United Kingdom The UK subsidiaries are subject to normal UK corporation tax on all theirprofits. 2006 2005 $m $mcurrent 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 taxliability. The standard rate of corporation tax in the UK is 30% (2005 - 30%). The currenttax 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 $mdeferred tax assets 0.8 -deferred tax liabilities - -net deferred tax asset 0.8 - Deferred tax is calculated in full on temporary differences under the balancesheet liability method using a tax rate of 30%. Deferred tax assets arerecognised to the extent that realisation of the related tax benefit throughfuture taxable profits is likely. Deferred tax assets and liabilities areoffset when there is a legally enforceable right to offset current tax assetsagainst current tax liabilities and when the deferred income taxes relate to thesame 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 $mas 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 $mshare 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 $mcash at bank and in hand 50.0 12.2cash equivalents 350.1 1,060.2total 400.1 1,072.4 Cash equivalents have an original maturity of three months or less. Thecarrying amount of these assets approximates their fair value. Cash and cash equivalents totaling $10.9 million (2005 - $5.4 million) were ondeposit in various trust accounts for the benefit of policyholders orcounterparties to agreements to cover their credit risk. Cash and cash equivalents totaling $25.1 million (2005 - $nil) were on depositas collateral in favour of letters of credit issued for the benefit ofpolicyholders 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) 896.3equity securities 64.2 7.0 (0.9) 70.3other investments 9.7 1.9 (0.1) 11.5total 967.6 12.4 (1.9) 978.1 Equity securities and other investments are generally deemed non-current. Fixedincome maturities are presented in the risk disclosures section. In 2005 the Group's invested assets were held entirely in cash and cashequivalents. Comparatives for the above table have therefore not beenpresented. 12. investment in associate On June 15, 2006 the Group made an investment of $20.0 million which representsa 21% interest in Sirocco Holdings Limited ("Sirocco"), a company incorporatedin Bermuda. Sirocco's operating subsidiary, Sirocco Reinsurance Limited ("Sirocco Re"), is authorised as a Class 3 insurer by the Bermuda MonetaryAuthority. Sirocco Re was established to assume Gulf of Mexico energy risks fromthe Group. Sirocco is an unquoted investment and its shares do not trade on anyactive market. Sirocco is carried at $23.2 million, representing management'sbest estimate of fair value at December 31, 2006, based on the July 15, 2006audited financial statements and subsequent management information. 2006 $m as at january 1, 2006 -acquisition 20.0share of profit of associate 3.2 as at december 31, 2006 23.2 Investments in associates are generally deemed non-current. Key financialinformation for Sirocco for the period from May 22, 2006 (date of incorporation)to December 31, 2006 is as follows: $massets 124.6liabilities 14.3revenues 18.6profit 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 - 2.6exchange adjustments - - - -as at december 31, 2005 - 2.6 - 2.6movement in period 39.1 323.1 3.6 365.8exchange 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) 16.7exchange adjustments - - -as at december 31, 2006 19.1 (2.4) 16.7 Further information on the calculation of loss reserves and the risks associatedwith them is provided in the risk disclosures section. The risks associatedwith general insurance contracts are complex and do not readily lend themselvesto meaningful sensitivity analysis. The impact of an unreported event couldlead to a significant increase in our loss reserves. Management believe thatthe loss reserves established as at December 31, 2006 are adequate, however a20% increase in estimated losses would lead to a $7.8m (2005 - $nil) increase inloss reserves. The split of losses and loss adjustments expenses between notified outstandinglosses and losses incurred but not reported is shown below: 2006 2005 $m $moutstanding 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 hasan approximate duration of one year. claims development The development of insurance liabilities is indicative of the Group's ability toestimate the ultimate value of its insurance liabilities. The Group beganwriting insurance and reinsurance business in December 2005. Due to theunderlying risks and lack of known loss events occurring during the period toDecember 31, 2005, the Group does not expect to incur any losses from coverageprovided in 2005. Accordingly, a loss development table has not been included. 14. insurance and other receivables 2006 2005 $m $minwards premium receivable from insureds and cedants 173.7 2.1accrued interest receivable 7.5 2.0other receivables 6.3 0.3total receivables 187.5 4.4 Other receivables consist primarily of unsettled investment trades. Allreceivables are considered current other than $8.9 million (2005 - $nil) ofinwards premium receivable related to multi-year contracts. The carrying valueapproximates fair value due to the short term nature of the receivables. Thereare no provisions in place for impairment or irrecoverable balances. There isno significant concentration of credit risk within the Group's receivables. 15. deferred acquisition costs The reconciliation between opening and closing deferred acquisition costs isshown below: $mbalance as at october 12, 2005 (date of incorporation) -movement in period 0.5balance as at december 31, 2005 0.5movement in period 51.0balance as at december 31, 2006 51.5 16. reinsurance and other payables 2006 2005 $m $mother payables 20.8 2.2insurance 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. Allpayables are considered current. The carrying value approximates fair value dueto the short-term value of the payables. 17. deferred acquisition costs ceded The reconciliation between opening and closing deferred acquisition costs cededis shown below: $m balance as at october 12, 2005 (date of incorporation) -movement in period -balance as at december 31, 2005 -movement in period 2.5balance 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 costas at october 12, 2005 (date ofincorporation) - - - -additions - - 0.4 0.4as at december 31, 2005 - - 0.4 0.4accumulated depreciationas at october 12, 2005 (date ofincorporation) - - - -charge for the period - - - -as at december, 31 2005 - - - -net book valueas at october 12, 2005 (date of - - - -incorporation) - - 0.4 0.4as at december 31, 2005 - - 0.4 0.4costas at january 1, 2006 - - 0.4 0.4additions 1.0 0.6 1.0 2.6as at december 31, 2006 1.0 0.6 1.4 3.0accumulated depreciationas at january 1, 2006 - - - -charge for the period 0.2 0.1 0.3 0.6as at december 31, 2006 0.2 0.1 0.3 0.6net book valueas at january 1, 2006 - - 0.4 0.4as at december 31, 2006 0.8 0.5 1.1 2.4 19. long term debt and financing arrangements 2006 2005 $m $msubordinated loan note of €12.0 million 15.8 14.2subordinated loan note of €12.0 million 15.8 14.2subordinated loan note of $97.0 million 97.0 97.0carrying value and fair value 128.6 125.4 On December 15, 2005 the Group issued $97 million in aggregate principal amountof subordinated loan notes and €24 million in aggregate principal amount ofsubordinated loan notes ("long-term debt") at an issue price of $1,000 and€1,000 of their principal amounts respectively. The Euro subordinated loan notes are repayable on June 15, 2035 with aprepayment option available from March 15, 2011. Interest on the principal isbased 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 aprepayment 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 ispayable quarterly. The Group is exposed to cash flow interest rate risk and currency risk. Furtherinformation 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 theU.S., the terms of certain contracts require them to provide letters of creditto policyholders as collateral. On May 17, 2006, LHL and LICL entered into asyndicated collateralised three year credit facility in the amount of $350million. 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 toLICUKL to collateralise certain insurance balances. It contains a $75m loansub-limit available for general corporate purposes. As at December 31, 2006,LICUKL had no such obligations. Letters of credit totalling $25.1 million hadbeen issued to third parties by LICL and there was no outstanding debt underthis facility. 20. derivative financial instruments The Group hedges a portion of its floating rate borrowings using interest rateswaps to transfer floating to fixed rate. These instruments are held at fairvalue through the consolidated income statement. During the period, $1.0million (2005 - $nil) was charged to financing costs in respect of the interestrate 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 cashsettlement due on this instrument is negligible (2005 - $nil) and is due onMarch 15, 2007. The Group invests a small portion of its investment portfolio in convertibledebt securities. The option to convert is an embedded derivative, which isrequired to be separated from the host contract and fair valued through theconsolidated income statement. As at December 31, 2006 the derivativeinstrument was valued at $11.5 million, with net unrealised gains of $1.8million reflected in the consolidated income statement in other investmentincome. 21. share capital authorised ordinary shares of $0.50 each number $mas at december 31, 2005 and december 31, 2006 3,000,000,000 1,500allocated, called up and fully paid number $mas at october 12, 2005 (date of incorporation) - -shares issued 195,713,902 97.9as at december 31, 2005 195,713,902 97.9shares 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 initialcapitalisation and launch. On December 9, 2005, LHL's outstanding shares wereconsolidated on a 5:1 basis into 3,200,000 shares. On December 16, 2005, anaggregate of 192,513,902 new shares were issued as part of LHL's privateplacement in the U.S. and initial public offering in the U.K., which includedshares issued on the exercise of an over-allotment option. As a result of allthe shares issued, a total of $978.6 million was raised, $97.9 million of whichis included in share capital and $880.7 million of which was included in sharepremium, net of $19.9 million of offering expenses, formation expenses andwarrants 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 exerciseof 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 ofincorporation) - - - - 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 aninitial price per share of US$5.00 equal to the price per share paid byinvestors in the initial public offering. The warrant holder may request acashless exercise. The method of settlement is at the discretion of the Groupand may be in cash or shares. founders The Group's founders provided industry expertise, resources and relationshipsduring the fourth quarter of 2005. For the founders position and consideration,the Group issued warrants to certain founding shareholders to purchase in theaggregate, up to 17,791,919 common shares. These warrants were approved onDecember 9, 2005, dated December 16, 2005 and were fully vested and exercisableupon issuance. On December 28, 2006 a founding investor exercised 113,219 warrants at a strikeprice of $5.00 per share. This was a cashless exercise and resulted in the Groupissuing a further 29,444 common shares at $0.50 per share. sponsor In consideration for incorporation services received, warrants were issued toBenfield Advisory Limited to purchase 7,625,217 common shares. These warrantswere granted on December 16, 2005 and were fully vested and exercisable uponissuance. On November 30, 2006 Benfield sold its entire holding of warrants toan 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 certainitems of office equipment and office space. Operating lease expenses for theperiod were $1.1 million (2005 - $nil). Lease payments under non-cancellableoperating leases are as follows: 2006 2005 $m $mdue 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 profitor loss for the period attributable to shareholders by the weighted averagenumber of common shares outstanding during the year. Diluted earnings or loss per share amounts are calculated by dividing the netprofit or loss attributable to shareholders by the weighted average number ofcommon shares outstanding during the year plus the weighted average number ofcommon shares that would be issued on the conversion of all dilutive potentialcommon shares into common shares. The following reflects the profit (loss) and share data used in the basic anddiluted 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 thousandsbasic weighted average number of shares 195,714 48,320potentially 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 tocommon shares would decrease earnings per share or increase loss per share fromcontinuing operations. In the current period, incremental shares from theassumed exercising of management performance warrants are not included incalculating dilutive shares as the relevant criteria have not been met. Inaddition, the options are antidilutive and are therefore not included in thenumber of potentially dilutive shares. In the prior period, incremental shares from the assumed exercising of warrantsare not included in calculating the diluted earnings or loss per share as theyare antidilutive. 25. related party disclosures The consolidated financial statements include Lancashire Holdings Limited andthe subsidiaries listed below: name domicileLancashire Insurance Company Limited BermudaLancashire Insurance Marketing Services Limited United KingdomLancashire Holdings Financing Trust I United StatesLancashire Insurance Holdings (UK) Limited United KingdomLancashire Insurance Company (UK) Limited (previously "Lancashire Insurance United KingdomServices (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 HoldingsFinancing 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 propertytrustee's obligations to seek approval of the holders of the Trust's preferredsecurities in case of default and other limited circumstances where the propertytrustee would enforce its rights. While the ability of the Group to influencethe actions of the Trust is limited by the Trust Agreement, the Trust was set upby the Group with the sole purpose of issuing the loan notes and is in essencecontrolled by the Group, and is therefore consolidated. key management compensation Remuneration for key management for the period ending December 31, 2006 was asfollows: 2006 2005 $m $mshort-term compensation 4.5 -share based compensation 12.1 5.2total 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' feesand expenses, including $0.4 million to significant shareholders. A further$0.3 million (2005 - $nil) was paid in respect of monitoring fees forsignificant shareholders pursuant to Monitoring Agreements, the terms of whichare as disclosed in the AIM admission document. transactions with associate During the period the Group ceded $29.9 million (2005 - $nil) of premium toSirocco and received $5.4 million (2005 - $nil) of commission income. As atDecember 31, 2006 the following amounts with Sirocco were included in ourconsolidated 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 Siroccoover the period January 1, 2006 to July 15, 2008. The contingent profitcommission 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 $11.8million with Benfield Group. 26. non-cash transactions Accrued formation expenses of $nil (2005 - $0.9 million) have been recordeddirectly in shareholders' equity. This amount represents a non-cash transactionand therefore is not included within the change in operational assets andliabilities in the consolidated cashflow statement. On November 2, 2006, following shareholder approval, LHL transferred $850.0million (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 providecash flow required for debt service and dividends to shareholders. Thesubsidiaries' ability to pay dividends and make capital distributions is subjectto the legal and regulatory restrictions of the jurisdiction in which theyoperate. For the primary operating subsidiaries these are based principally onthe amount of premiums written and reserves for losses and loss expenses,subject to overall minimum solvency requirements. Statutory capital and surplusis different from shareholders' equity due to certain items that are capitalisedunder IFRS but expensed, have a different valuation basis, or are not admittedunder insurance regulations. Statutory capital and surplus reported to regulatory authorities by the primaryoperating subsidiaries is as follows: as at december 31, 2006 $m £m LICL LICUKLstatutory capital and surplus 1,079.2 56.3minimum required statutory capital and surplus 271.1 7.4 as at december 31, 2005 $m £m LICL LICUKLstatutory capital and surplus 1,069.6 n/aminimum required statutory capital and surplus 100.0 n/a 28. presentation Certain amounts in the December 31, 2005 consolidated financial statements havebeen re-presented to conform with the current year's presentation and format.These changes in presentation have no effect on the previously reported netloss. 29. subsequent events On February 25, 2007, LHL received notification from the Dubai FinancialServices Authority that its application to operate an authorised insuranceintermediation firm in Dubai had been approved in principle. The authorisationwill be exercised via a wholly-owned subsidiary incorporated and operatingwithin the Dubai International Financial Centre. The new subsidiary, calledLancashire Marketing Services (Middle East) Limited, will allow the Group tomarket its UK and Bermuda - based insurance subsidiaries more effectively andefficiently in the region. NOTE REGARDING FORWARD-LOOKING STATEMENTS CERTAIN STATEMENTS MADE IN THIS ANNOUNCEMENT OR ON THE CONFERENCE CALL THAT ARENOT BASED ON CURRENT OR HISTORICAL FACTS ARE FORWARD-LOOKING IN NATUREINCLUDING, WITHOUT LIMITATION, STATEMENTS CONTAINING WORDS "BELIEVES","ANTICIPATES", "PLANS", "PROJECTS", "INTENDS", "EXPECTS", "ESTIMATES","PREDICTS", "MAY", "WILL", "SEEKS", "SHOULD" OR, IN EACH CASE, THEIR NEGATIVE ORCOMPARABLE TERMINOLOGY. ALL STATEMENTS OTHER THAN STATEMENTS OF HISTORICALFACTS INCLUDING, WITHOUT LIMITATION, THOSE REGARDING THE GROUP'S FINANCIALPOSITION, RESULTS OF OPERATIONS, LIQUIDITY, PROSPECTS, GROWTH, BUSINESSSTRATEGY, PLANS AND OBJECTIVES OF MANAGEMENT FOR FUTURE OPERATIONS (INCLUDINGDEVELOPMENT PLANS AND OBJECTIVES RELATING TO THE GROUP'S INSURANCE BUSINESS) AREFORWARD-LOOKING STATEMENTS. SUCH FORWARD-LOOKING STATEMENTS INVOLVE KNOWN ANDUNKNOWN RISKS, UNCERTAINTIES AND OTHER IMPORTANT FACTORS THAT COULD CAUSE THEACTUAL RESULTS, PERFORMANCE OR ACHIEVEMENTS OF THE GROUP TO BE MATERIALLYDIFFERENT FROM FUTURE RESULTS, PERFORMANCE OR ACHIEVEMENTS EXPRESSED OR IMPLIEDBY SUCH FORWARD-LOOKING STATEMENTS. THESE FORWARD-LOOKING STATEMENTS SPEAK ONLYAS AT THE DATE OF THIS ANNOUNCEMENT OR OTHER INFORMATION CONCERNED. LANCASHIREHOLDINGS LIMITED EXPRESSLY DISCLAIMS ANY OBLIGATION OR UNDERTAKING (SAVE ASREQUIRED TO COMPLY WITH ANY LEGAL OR REGULATORY OBLIGATIONS (INCLUDING THE AIMRULES)) TO DISSEMINATE ANY UPDATES OR REVISIONS TO ANY FORWARD-LOOKINGSTATEMENTS CONTAINED HEREIN TO REFLECT ANY CHANGES IN THE GROUP'S EXPECTATIONSWITH REGARD THERETO OR ANY CHANGE IN EVENTS, CONDITIONS OR CIRCUMSTANCES ONWHICH ANY SUCH STATEMENT IS BASED. NO OFFER, INVITATION OR INDUCEMENT TO ACQUIRESHARES OR OTHER SECURITIES OF LANCASHIRE IN ANY JURISDICTION IS BEING MADE BYTHIS 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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Related Shares:

Lancashire Holdings