UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

 

Commission file number:  001-32883

DARWIN PROFESSIONAL UNDERWRITERS, INC.

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code:

  860-284-1300

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

Not applicable

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.

Large accelerated filer o     Accelerated filer o     Non-accelerated filer þ

 

Indicate by check mark whether the registrant is a shell company.  Yes o     No þ

 

As of February 23, 2007, 17,048,022 shares, par value $0.01 per share, of Common Stock of the registrant were outstanding, and the aggregate market value (based upon the closing price of these shares on the NYSE Arca Inc. of the shares of Common Stock of registrant held by non-affiliates was $163,189,243.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Proxy Statement relating to Annual Meeting of Stockholders of Darwin Professional Underwriters, Inc. to be held on May 4, 2007 are incorporated into Part III of this Form 10-K Report.

 

 

SELECTED HISTORICAL CONSOLIDATED FINANCIAL DATA
Darwin Professional Underwriters, Inc.

 

Annual Report on Form 10-K

 

For Fiscal Year Ended December 31, 2006

 

TABLE OF CONTENT

 

 

Unless the context requires otherwise, references in this Annual Report to “Darwin,” the “company,” “we,” “our” and “us” are to Darwin Professional Underwriters, Inc. and its subsidiaries, taken as a whole, unless the context otherwise requires. We sometimes refer to Darwin Professional Underwriters, Inc., excluding its subsidiaries, as “DPUI.” References to “Alleghany” are to Alleghany Corporation, our ultimate parent company, which is a holding company primarily engaged, through its subsidiaries, in the property and casualty insurance business. References to “Darwin Group” are to our subsidiary Darwin Group, Inc. References to “DNA” are to our subsidiary Darwin National Assurance Company and references to “Darwin Select” are to our subsidiary Darwin Select Insurance Company. Whenever in this Annual Report we refer to business generated, written or produced by Darwin, we include business produced by DPUI and written on policies of certain insurance company subsidiaries of Alleghany (which we refer to as the “Capitol Companies”), whether before or after the acquisitions of DNA and Darwin Select, all of which policies are now fully reinsured by DNA. This Annual Report gives effect to certain reorganization and reinsurance transactions that were implemented prior to the date of our initial public offering as though the structure of our business resulting therefrom had been in effect since our inception in March 2003. See “Business and Properties” for a description of these transactions.

 

Overview

 

We are an insurance holding company, and our subsidiaries are engaged in writing policies across a spectrum of the specialty commercial insurance market, principally within the executive and professional liability classes, including ancillary coverages. We currently write the bulk of our business in three broad professional liability lines of business: Directors and Officers Liability (“D&O”); Errors and Omissions Liability (“E&O”); and Medical Malpractice Liability.

 

Our principal objective is to create and sustain superior returns for stockholders by generating consistent underwriting profits across our product lines and through all market cycles. We believe that this can be best accomplished by directing our efforts toward consistent growth of our small and middle market business, while taking advantage of opportunities when they are presented by larger accounts in the professional liability insurance market.

 

Since our formation almost four years ago, we have grown our business to produce $246.3 million of gross premiums written in calendar year 2006, which was up 49% from the $165.8 million of gross premiums written in calendar year 2005. Despite the Company’s significant premium growth since our inception, we believe that we continue to have a substantial opportunity to penetrate the markets for our target lines of business, which we estimate exceed $20 billion in annual premium volume. Although, at any given time, our focus will be on those portions of this estimated $20 billion market that then represent the greatest opportunities, we believe our existing market share (currently approximately 1%) allows for significant future growth.

 

Stephen Sills, our President and Chief Executive Officer, and Alleghany formed DPUI in March 2003. The Company was initially created as an underwriting manager for the Capitol Companies, pending the establishment or acquisition of a separate insurance carrier for our business (see “Management’s Discussion and Analysis of Financial Condition and Results of Operations”). We wrote our first policy in the spring of 2003. We believe that the timing of our market entry was favorable, and allowed us to quickly establish a presence in our target markets, particularly D&O for public companies, Medical Malpractice Liability, managed care E&O and insurance agents E&O. When we entered the market, many of our target classes of business were attractively priced as a result of prior industry losses and the corresponding price increases that resulted. At that time, we were able to realize benefits from a corrective phase in the cycle of pricing and policy terms, without having sustained the losses that produced these market corrections. We also took advantage of the opportunity to develop insurance systems using current technology. We believe these systems provide us with a competitive advantage compared to insurance companies that are encumbered by older systems and processes.

 

Since Darwin’s formation in March 2003, we have gradually increased the number and variety of coverages offered by our subsidiaries, most recently adding E&O liability products which address insurance company and technology provider exposures and developing an offering for clinical trials professionals. We value diversification

in our portfolio of product offerings and anticipate that additional products and product lines will continue to be introduced from time to time. While our underwriting activities are likely to remain predominantly oriented toward professional liability coverages in the D&O, E&O and Medical Malpractice Liability lines, other specialty property-casualty businesses will also be explored. Our insurance company subsidiaries are currently rated “A−” (Excellent) by A.M. Best.

 

The executives who founded and continue to lead our Company have significant experience in the insurance industry in general, and particularly in the specialty lines of business that we write. Five of the seven executives who constitute our management team, including Mr. Sills, worked together at Executive Risk Inc., a specialty insurance company that was acquired by The Chubb Corporation in 1999. Company management and other employees currently own approximately 10.6% of the Company’s issued and outstanding shares (includes ownership in the form of shares awarded under the Company’s restricted stock plan). Alleghany owns approximately 54.9% of the Company’s issued and outstanding common stock.

 

Our insurance group includes both an admitted company (DNA) and a surplus lines company (Darwin Select) (see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Our History”). These companies provide us with the ability to write business both on an admitted basis and on a surplus lines basis throughout much of the United States. Surplus lines insurance covers risks that do not fit the underwriting criteria of standard, admitted carriers, usually because of the perceived risk associated with aspects of the insured’s business. In contrast to an admitted insurance company, which is required to be licensed in each state where it writes insurance, a surplus lines insurance company does not have to apply for and maintain a license in each state where it writes insurance. It is, however, either required to meet suitability standards or else be subject to approval under each particular state’s surplus lines laws in order to be an eligible surplus lines insurance company. Because insureds in the surplus lines market are generally considered higher risk, surplus lines carriers generally offer more restrictive coverage at higher prices than would be offered by the standard market. Because of their greater flexibility, we usually prefer to use surplus lines policies where they are legally authorized and accepted by the market.

 

In November 2005, Alleghany contributed $135 million to Darwin Group, which was subsequently contributed by Darwin Group to its wholly-owned subsidiary DNA (see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Our History”). This capital infusion resulted in total GAAP equity for Darwin of approximately $200 million. It also enabled DNA, which previously had been rated on a “reinsured” basis (based upon its relationship with the Capitol Companies), to obtain an independent “A−” (Excellent) rating from A.M. Best, and it enabled Darwin Select to obtain an “A−” (Excellent) rating on a reinsured basis (based on DNA’s relationship with Darwin Select). As of December 31, 2006, we had stockholders equity of $217.9 million. We believe that this level of capital provides us with a conservative balance sheet relative to our net premiums written of $157.0 million in 2006, particularly when taking into consideration the fact that we did not write any insurance business prior to 2003.

 

Our Competitive Strengths

 

We believe that our competitive strengths include:

 

Proven Leadership and Experienced Management.  Our executive officers have significant experience in the insurance industry in general, and particularly in the specialty lines of business that we write. Our President and Chief Executive Officer, Stephen Sills, has more than 30 years of insurance industry experience and is the former Chief Executive Officer of Executive Risk Inc. (now a subsidiary of The Chubb Corporation). Under his leadership, Executive Risk Inc. grew from a small, private D&O facility into a leading, publicly-traded specialty lines insurance carrier. Five of the seven executives who constitute our management team, including Mr. Sills, worked together at Executive Risk Inc. The seven members of our senior management team average well over 20 years of experience in the insurance industry. We believe that we have attracted superior management and a talented workforce, creating an environment that is innovative, disciplined, energetic and team-oriented.

 

Specialized Product Offerings and Underwriting Expertise.  We focus on specialty professional liability products. We believe our targeted focus allows us to understand the unique needs of our customers and to tailor

products and services to meet their needs. It also allows us to identify opportunities, such as underserved markets, where, in our judgment, the perception of risk is greater than the actual risk. We believe that this focus and specialization also allows us to recognize problems quickly so that we are able to address them promptly. Although we concentrate on specialty markets, we have diverse products and customers within our product lines. We believe that our specialty focus, disciplined underwriting, collaborative processes and entrepreneurial culture facilitate our ability to bring new product offerings to market quickly and that, taken together, these factors position us to write profitable business through all market cycles.

 

Our Knowledge of the Healthcare Industry.  We have a team of professionals dedicated to the specialty insurance needs of the healthcare industry, one of the largest and fastest growing industries in the country. The expertise of these professionals extends across all three of our major lines of business and includes professionals with underwriting, claims, risk management and actuarial backgrounds. We believe that our dedicated team of experienced professionals and our track record in developing insurance solutions for the healthcare industry provide us with a competitive advantage.

 

Focused Distribution.  We are selective when choosing our distribution partners. We have developed a network of approximately 180 distribution partners that focuses on the lines and classes of business in the professional liability insurance market that we find attractive. Four of these distribution partners are known as program administrators, third-party entities authorized to bind business for us subject to underwriting guidelines that we prescribe. In choosing our distribution partners, we look for technical expertise; a shared commitment to excellent service (including value-added elements like risk management and loss control); an ability to significantly penetrate the portion of the distributor’s business that is of greatest interest to us; and a willingness to innovate with us in new technologies, processes and products.

 

Innovative Use of Technology.  We have developed our systems platform using current technology that we believe maximizes the effectiveness and flexibility of our key functions, including underwriting, claims, finance and accounting. This technology platform facilitates significant “real-time” management reporting capability and allows us to interact efficiently with our distribution partners. We have developed and rolled out i-bind, our web-based underwriting system, to selected distribution partners. i-bind is an underwriting system that allows on-line policy submission, rating, quoting, proposal and binder issuance. i-bind is a dynamic application that only asks for relevant information based on prior answers and provides intelligent underwriting through thousands of rules embedded in the system.

 

Strong Ratings.  Our insurance company subsidiaries are rated “A−” (Excellent) by A.M. Best. “A−” (Excellent) is the fourth highest rating of A.M. Best’s 16 rating categories. A.M. Best assigns ratings that are intended to provide an independent opinion of an insurance company’s ability to meet its obligations to policyholders; therefore, our subsidiaries’ ratings are not evaluations directed to the protection of investors. A.M. Best’s opinions are derived from an evaluation of a company’s balance sheet strength, operating performance and business profile. We believe that our ratings provide us with a competitive advantage over lower-rated or unrated insurance companies in establishing lasting relationships with our distribution partners and in marketing to insureds. While our current ratings are strong, there are business risks associated with a decline in our ratings in the future (see “Risks Related to Our Business” on page 29).

 

Conservative Balance Sheet.  As of December 31, 2006, we had stockholders’ equity of $217.9 million, with $157.0 million of net premiums written in 2006. We believe that our capital base is currently unleveraged and we believe it is sufficient to support a significantly greater volume of net premiums than we currently write. Additionally, we believe that our investment portfolio is conservative. As of December 31, 2006, our investment portfolio was entirely invested in cash and fixed-income securities that had an average duration of 3.99 years, and 93.1% of the fixed-income securities had a quality rating of A or higher from Standard & Poor’s. We are currently investigating the feasibility of diversifying our portfolio to include some classes of equity for a small minority of the Company’s total portfolio holdings.

 

Our Strategy

 

We have developed strategies that we believe assist us in pursuing our objective of creating and sustaining superior returns for our stockholders by generating consistent underwriting profits across our product lines and through all market cycles. These strategies include:

 

Manage a Balanced Book of Business.  We strive to balance our three broad lines of business (D&O, E&O and Medical Malpractice Liability), with the goal of having each line constitute between 30% — 40% of our total business, subject to market conditions in any particular segment. We also continue our focus on growing our small and mid-sized account business, which we believe will maintain more consistent profitability through market cycles and over sustained periods. Smaller businesses represent a significant market opportunity for Darwin, and we believe that i-bind will assist us and our distribution partners in producing and managing small account business in a cost-effective manner. However, when market conditions warrant, we plan also to selectively write profitable larger accounts.

 

Focus on Underwriting Profitability.  Sustained profitability requires careful class of business and individual risk selection, as well as the consistent monitoring of underwriting results, identification of trends and implementation of corrective action when necessary. We believe our management reporting capability enhances our ability to monitor results and make timely, accurate decisions to manage our business profitably. As part of the monitoring process, we hold regular “roundtable” reviews of underwriting risks; we engage in price monitoring discussions among underwriting, claims and actuarial personnel, as well as senior management; we conduct claim reviews, including quarterly meetings of claims, actuarial and underwriting personnel and senior management to review serious and potentially serious claims; and we perform periodic audits of the claims and underwriting functions. We believe these processes are enhanced by our collaborative culture and by the substantial centralization of core functions at our headquarters in Farmington, CT. In addition, our commitment to underwriting profitability is augmented by management’s equity ownership interest in the Company and by the incentive compensation structure for our key employees, which ties bonus compensation to long-term underwriting results.

 

Limit Commodity Business.  We seek to avoid business where our products and services are seen as being interchangeable with those of our competitors. Such commodity relationships are difficult to sustain and, generally, are profitable only during the most favorable market conditions. We limit commodity business by:

 

 

Utilize Technology to Efficiently Operate our Business.  As we have built our business, we have used current technology to automate operational functions and processes, and to automatically feed transactional data between systems. Presently, our underwriting, claims, financial reporting and accounts payable systems and processes benefit from these integrated transactional data transfers. We believe that our technology design and the absence of any legacy systems enable us to transact business more efficiently, and to maintain high quality service levels with fewer employees than would be needed if these processes and systems were not in place.

 

Expand Use of i-bind Technology.  We believe our proprietary i-bind methodology has the potential to significantly assist us in the cost-effective production and underwriting of small account, small premium professional liability business. Historically, on-line systems have been limited in their use and functionality

with regard to the professional liability lines, and the production of this business has been relatively expensive. The complexity of these coverages frequently requires a retail agent to seek the assistance of a wholesale broker, and is thus relatively expensive to produce. Because we believe that insurance purchasers want to have an agent or broker to advise them in the purchase of professional liability products, we designed i-bind so that, rather than displacing the intermediary, it enables the agent or broker to operate more efficiently.

 

i-bind enhances relationships with our distribution partners by efficiently providing real time quoting and binding capability for the producer, seamless interaction between wholesaler, retailer and insurance carrier, flexible coverage options and intelligent underwriting software. i-bind is a dynamic on-line application that asks for only the relevant information (based on prior answers) and provides intelligent underwriting through the several thousand rules embedded in the system. As of December 31, 2006, i-bind had been introduced on a limited basis to nineteen producers for our private and non-profit D&O products. During 2007, we plan to expand the number of distribution partners who can access the system, as well as the products available on it.

 

Grow Responsibly into Our Capital Base.  We believe our capital base is sufficient to support a significantly greater volume of net premiums than we currently write. In 2006, we had net premiums written of $157.0 million, an increase of 56% over 2005. The ratio of net premiums written to statutory surplus is a common industry measure for capital utilization. Our ratio for 2006 was 0.85, which compares favorably to the 1.1 ratio reported in a study by A.M. Best of 214 insurers focused on commercial casualty lines, for net premiums written for 2005 to statutory surplus as of December 31, 2005 (the most recent year for which data is available). Based upon current market conditions, we believe there are opportunities to produce significant premium growth over the next three to five years. Over time, we will seek to deploy our capital more fully, while maintaining our focus on underwriting profitability. We also intend to maintain reinsurance buying and investment practices that will protect our balance sheet strength as we increase our volume of net premiums written relative to our capital base.

 

Selective Acquisitions.  We believe attractive acquisition possibilities may arise from time to time, presenting the opportunity to diversify our business profitably. Acquisition opportunities, which may include risk-bearing entities or distribution firms (e.g. program administrators) will be considered if they meet our criteria, which include: enhancing our portfolio of product offerings for our current distribution base, expanding our distribution capabilities for specialty liability insurance and/or increasing our geographic spread of business.

 

Industry Dynamics

 

The property and casualty insurance business has historically been subject to cyclical fluctuation in pricing and availability. “Soft” markets are characterized by an excess of capital and underwriting capacity, and by pricing and policy terms that are relatively less favorable to insurers. Soft markets generally result in intense premium rate competition, an erosion of underwriting discipline and poor operating performance. Quite often, a “soft” market will be followed by a period of diminishing capacity and increased underwriting discipline; companies may exit unprofitable areas of business and/or increase premiums in order to improve operating performance. This phase of the cycle is generally referred to as a “hard” market.

 

Although the professional liability businesses on which we focus are subject to “soft” and “hard” market cycles, the individual lines of business generally have separate dynamics and rarely move in lock step with one another. For example, the public D&O market recently has been impacted by options backdating and similar corporate scandals. On the other hand, the market for insurance agents’ E&O has been impacted by natural disasters and the managed care E&O market has been impacted by certain class-action litigation. In addition, compared to the smaller and mid-sized accounts that we focus on, large commercial insureds tend to be more impacted by market cycles, are more volatile, and generally more difficult to write profitably over long periods of time. Conversely, small and mid-sized accounts, even with their loss patterns that are relatively stable, do experience rate increases in hard markets, while their rate decreases are more modest during softer periods.

 

A survey sponsored by The Council of Insurance Agents & Brokers reported that, in the soft commercial property and casualty market through the fourth quarter of 2006, rates for the average small account (defined as accounts with less than $25,000 in commission and fees) decreased by only 6.3%, while rates for the average mid-

sized account (commissions and fees ranging from $25,000 to $100,000) decreased by 10.5% and rates for the average large account (more than $100,000 in commissions and fees) decreased by 12.1%. Our belief that losses are generally more stable in small and mid-sized risks is also supported by the 2005 Directors and Officers Liability Survey Report by Towers Perrin. According to that study both claims frequency (the average number of claims per participant) and claims susceptibility (the likelihood of incurring a claim) correlate to asset size. Entities with smaller asset sizes had significantly less loss frequency and susceptibility than the larger asset size companies. The report noted a particularly strong correlation between entities with asset sizes below $100 million and a reduced susceptibility to and frequency of claims.

 

Admitted Business and Surplus Lines Business

 

Our admitted company, DNA, is required to be licensed in each state where it operates. In general, an admitted carrier must file premium and rate schedules and policy or coverage forms for review and approval by the insurance regulators. In many states, an admitted carrier’s rates and policy forms must be approved prior to use, and insurance regulators have broad discretion in judging whether an insurer’s rates are adequate, not excessive and not unfairly discriminatory. In some states, commercial lines have been deregulated so that admitted insurers are able to write certain commercial risks without obtaining prior review or approval of rates and/or forms, although the content of the policy is still regulated.

 

Our surplus lines carrier, Darwin Select, is not subject to rate and form requirements and does not participate in the various states’ guaranty fund programs. Darwin Select can implement changes in policy terms and underwriting guidelines or rates more quickly than DNA. Because of the greater ability to respond to market changes, we use Darwin Select’s surplus lines policies where acceptable to the market. However, as described in the discussion of specific classes below, in states where forms and rates have been deregulated for larger commercial insureds, we will write some classes on an admitted basis. If surplus lines are not authorized by regulators for certain business, or if market conditions make surplus lines unacceptable, then we issue policies on an admitted basis.

 

Our Products and Markets

 

We group our products into the following lines of business: Directors and Officers liability (“D&O”), Errors and Omissions liability (“E&O”), and Medical Malpractice (also known as Medical Professional Liability). Within each of these lines of business we target specific classes that we believe exhibit adequate pricing and favorable terms and conditions. We have gradually expanded the number of classes in which we do business. For example, we added the Psychiatrist class to our Medical Malpractice Liability line in 2004, the Municipal Entity and Public Officials class to our E&O line of business in 2005 and the Psychologist class to our E&O line in 2006. In each case, we expanded because we were able to add expertise by hiring key employees or contracting with program administrators who have experience in these classes. Additionally, we added the Miscellaneous Medical Facilities class to our Medical Malpractice Liability line in 2004, the Technology class to our E&O line in 2005 and the Insurance Company class to our E&O line in 2006, in each case by hiring professionals with expertise in those areas to take advantage of opportunities that we believed were emerging in those markets.

The following table lists each class that we currently write and when we began to write it.

 

 

The following table sets forth gross premiums written by line of business during each of the past three years:

 

 

Each of these businesses has underwriting and service needs that are unique to its operations and, therefore, we believe that each provides a distinct underwriting opportunity for us.

 

Although we generally seek to build a balanced book of business with each of our three lines constituting 30-40% of our total business, we will write more business in one line or in one industry concentration than another when we see favorable market opportunities. For example, in 2006 our E&O Liability line, where we observed favorable market conditions, totaled 45.1% of gross premiums written.

 

Both D&O and E&O are designed to protect insureds against lawsuits and associated legal defense expenses. In connection with D&O coverage of for-profit corporations, such liabilities arise from claims by customers, vendors, competitors and former employees, although the most severe liabilities have historically arisen from lawsuits by stockholders alleging director or officer failure to discharge duties to the corporation or violations of federal securities laws (which are frequently asserted as class actions). In the case of non-profit organizations, our coverage often involves employment practices litigation. E&O is most often sold to professionals, where the principal sources of potential claims are dissatisfied clients alleging breaches of professional standards or ethical violations. Fiduciary liability coverage is intended primarily to protect those who invest and administer benefit plan trusts, and we generally sell this coverage along with, or as an adjunct to, D&O. Employment practices liability

insurance, which is available to cover both the employing organization and its supervisors, insures against losses associated with employee claims such as sexual harassment, wrongful termination and discriminatory treatment. Employment practices liability coverage is included in such products as Healthcare Management Liability and Private and Non-profit D&O, and is also offered as a stand-alone product.

 

Medical Malpractice Liability is designed to protect insureds against lawsuits and associated legal defense expenses. In connection with Medical Malpractice Liability coverage for Hospital Professional Liability, Miscellaneous Medical Facilities, Physicians & Physicians Groups and Psychiatrists, the most frequent and severe claims have historically arisen from patients who allege physician and/or organizational negligence.

 

We occasionally write small amounts of non-specialty business as an adjunct to specialty coverage. For example, we may include general liability coverage as part of a hospital professional liability coverage. When we do write such general liability insurance as an adjunct to specialty coverage, the limits offered are not affected. The non-specialty coverage is included in the overall policy limit.

 

The overwhelming number of our policies are “claims-made,” although we do write a small amount of “occurrence” coverage. Claims-made policies cover only those lawsuits or other claims that are asserted during the policy period. Occurrence policies cover claims no matter when they are asserted, so long as they are based on incidents that took place during the policy period. Claims-made policies are generally considered to have a shorter “tail,” meaning that the insurer can recognize its ultimate liabilities, if any, more quickly than under longer-tailed occurrence policies, where the claim may not be asserted until years after the policy period.

 

D&O.  Under various state laws, a corporation is authorized to indemnify its directors and officers against legal claims arising in connection with their work on behalf of the corporation. In order to attract and retain qualified directors and officers, corporations purchase D&O insurance. D&O insurance for public corporations covers directors and officers when the corporation is not legally permitted, or is financially unable, to indemnify them. It also covers the corporation to the extent that the corporation has indemnified directors and officers, and also frequently covers the corporation directly for claims relating to violations of the securities laws. D&O insurance for private or non-profit accounts generally provides broader coverage for the entity, but has little or no exposure to securities claims.

 

Public Accounts.  There are currently well over 10,000 publicly-listed businesses in the U.S. We focus on providing either the primary layer or low layer excess coverage for companies with smaller market capitalizations (under $2 billion). We have written some higher policies where coverage is limited only to the Directors of the Corporation (“A-side only”) on some larger market capitalization companies. We write policies providing up to $15 million of coverage in this class of our business, a significant portion of which has resulted from strong service relationships we’ve established with a small number of wholesale brokers. Pricing in the public D&O market was hard when we began our business in 2003, but it has since softened. As a result, we have limited our writings in this line of business, and public D&O has declined as a percentage of our total gross premiums written (17.1% in 2004, 15.1% in 2005 and 11.8% in 2006).

 

Private Accounts; Non-Profit Accounts; Employment Practices Liability (“EPL”).  This business focuses on small private businesses and non-profit organizations. The U.S. Small Business Administration has estimated that there are over twenty million for-profit, non-farm small businesses in the U.S. We believe that this class has had favorable loss experience in recent years, and we expect this class to represent an increasing part of our D&O business in the near term. We generally write business in this class on an admitted basis and generally issue primary policies. We currently offer limits of up to $15 million in this class, but most of our issued policies have limits of $2 million or less. Average policy premium in this class is relatively low (for calendar year 2006, approximately $4 thousand), and we believe that the introduction of our i-bind system presents an opportunity for us to expand our writings in this class.

 

We did not market to non-profit accounts until late 2005, when we added a D&O product for non-profit organizations to i-bind. One national information source on U.S. non-profits lists over 1.5 million IRS-recognized organizations in its database, which represents a significant market. Private and non-profit D&O coverage is frequently sold with both management liability and employment practices coverage. Through i-bind, we also offer a stand-alone EPL product for those purchasers who are only interested in the EPL coverage.

 

Healthcare Management Liability.  Our target buyers in this class are non-profit health systems and hospitals and managed care organizations. As we are one of the few insurers that writes both managed care E&O and D&O, the two products are frequently marketed together to managed care organizations. Most of our D&O for managed care organizations is written on a surplus lines basis, while the majority of our business for hospitals is on an admitted basis. We currently offer policies with limits of up to $15 million in this class.

 

Financial Institutions D&O/E&O:  In the 3rd quarter of 2006, Darwin began to actively underwrite risks in the Financial Institutions sector. This segment includes a variety of financial institutions including banks, insurance companies, investment advisors and mutual funds. These products provide D&O and E&O on a stand-alone and blended basis, and currently offer policy limits of up to $15 million. The majority of business in this class will be written on a surplus lines basis, with admitted policies available in select states.

 

E&O.  This coverage protects insureds, generally business owners and professional service providers, against claims by clients, customers and other parties that services rendered by the insured were executed negligently or outside of professional standards . We provide insurance against underlying liability claims as well as the legal fees in connection with defending such claims. Managed Care E&O provides protection for some business activities of managed care organizations such as evaluating the appropriateness of medical services provided for purposes of coverage under a health care plan (utilization review), and selecting, evaluating or contracting with providers of medical services (provider selection). Our E&O policies specifically exclude coverage for any medical professional service (except for vicarious liability claims).

 

Some types of organizations or professionals receive a specialized form of policy that is highly customized for their needs and risks (e.g., insurance agents, law firms). Miscellaneous E&O refers to those coverages that can be written on a more generic, less customized form of policy. Although relatively new additions to our E&O product capabilities, we believe that Technology E&O, Municipal Entity and Public Officials E&O and Insurance Company E&O have the potential to be significant contributors to our future growth.

 

E&O tends to be a more fragmented and regionalized marketplace than D&O, since the risks vary significantly depending on the nature of the profession and the geographic area in which it is practiced. Despite this fragmentation and diversity, the E&O business is generally competitive. Despite the competitive market conditions, we believe that certain classes remain adequately priced and that, with knowledgeable underwriting and well-conceived distribution and claims handling systems, we can be successful in these lines.

 

Managed Care E&O.  The Economic Census conducted by the U.S. Census Bureau for 2002 (latest year for which data is available) reported that there are more than 4,000 direct health and medical insurance carriers in the U.S. We believe that the Managed Care E&O market has comparatively few competitors for the primary and first excess layer business that we target. Therefore, we believe we have become a significant supplier in this class of business, particularly in view of the market dislocations caused when Chubb & Son, a major managed care E&O provider, exited this market in 2005. We now see opportunities in this class with respect to larger risks, and we will seek to compete effectively for such larger risks. For example, several Blue Cross organizations left the captive insurer that had previously insured them, and sought coverage in the commercial market. We issue Managed Care E&O policies with limits of up to $20 million. We are most interested in primary and first excess layer placements in this class. The business we have written to date is either on a surplus lines basis or, in states where there has been deregulation which allows us to write business without regulatory review or approval of rates and forms, on an admitted basis.

 

Lawyers Professional E&O.  According to the U.S. Department of Labor, Bureau of Labor Statistics, there were more than half a million lawyers working in private law firms in the U.S. in 2004. In this class, we have historically targeted small to mid-sized firms (generally with fewer than 50 attorneys) which the market considers “non-standard.” Non-standard generally refers to legal specialties that are considered to be more complicated and to carry the potential for greater exposure. We typically write this business on a surplus lines basis, offering liability limits up to $10 million, although actual policy limits are typically between $1 million and $2 million. We believe that with careful underwriting and appropriate pricing, non-standard risks in the lawyers E&O class can produce attractive profits. During the first half of 2006, we observed an emerging opportunity in the standard small and mid-size markets, and we have now commenced an effort to enter these markets as well. We expect that a significant portion of the business that we write in this class will be written on an admitted basis and will be produced via one or

more program administration arrangements with leading agencies in selected geographic areas. Currently, we have entered into a program administration arrangement with Professional Coverage Managers (“PCM”), which will solicit and accept applications, underwrite and bind coverage (in accordance with guidelines we provide) and issue policies. We will retain full responsibility for claims handling and for any reinsurance.

 

We also offer limits of up to $5 million to large law firm risks under appropriate circumstances, although the market in this segment is quite competitive, and opportunities that offer attractive pricing are increasingly rare. In general, we believe that, compared to small and mid-sized law firms, large law firm business is more volatile and more difficult to write profitably over long periods. Our current overall market share in Lawyers Professional E&O is very small. However, we believe that the pricing for the law firm risks in our targeted segments remains attractive and that there are significant opportunities to expand this book of business.

 

Insurance Agents E&O.  The U.S. Department of Labor has estimated that in 2004 the total number of insurance agents in the U.S. is approximately 400,000. Claims against insurance agents tend to increase in frequency and severity following large systemic losses. As a result of the significant catastrophe and liability losses that occurred in the U.S. in recent years, the insurance agents’ E&O marketplace, with the exception of smaller “Main Street” agencies, has been in a “hard market” cycle although pricing has become more competitive recently. We focus primarily on the mid-sized wholesale agents. However, we will also write more complex business in this class (such as third party administrators and managing general agents) where we see favorable opportunities. We currently offer policies with limits of up to $10 million, and nearly all of our business in this class is being written on a surplus lines basis.

 

Insurer E&O.  In August 2006, we announced the commencement of our initiative to write management and professional liability coverage for alternative risk transfer (A.R.T.) facilities, including captives, risk retention groups, reciprocals, and exchanges, as well as privately held non-rated insurance companies (i.e., insurance companies without an A.M. Best Company financial strength rating). Concurrently, we partnered with an experienced A.R.T. specialist, Ohio-based Quadrant Insurance Managers, as our underwriting partner for this product. The product is a combined management and professional liability coverage, and it is geared towards A.R.T. facilities that offer property and casualty, workers’ compensation, and life, accident, and health insurance, so long as they write $250 million or less in annual gross written premium. The coverages include D&O, E&O and employment practices liability (EPL) components. Coverage is also available for subsidiary operations, including claims administrators, captive managers, and managing general agents/underwriters. A proprietary loss control program is provided. The business flows in from both retail and wholesale producers, and is written on a surplus lines basis.

 

Technology E&O.  Technology E&O is one of our newer classes of business. While technology producing businesses comprise a significant part of this market, the widespread use of technology in virtually every American industry creates opportunities to provide this form of coverage to companies beyond typical technology firms. In addition to defective technology products and services, a Technology E&O policy may cover risks relating to network security, on-line media, privacy and intellectual property. Based on the 2005 Betterley Report, “Technology Errors and Omissions Market Survey,” we estimate that the current market for Technology E&O coverage is in the range of $650 million to $750 million in gross premiums annually. Our strategy has been to identify niches where we can develop a depth of knowledge that will allow us to quantify the technology exposures. In addition to technology users, our Technology E&O business focuses on application service providers, storage providers and consultants. We currently offer policies with limits of up to $10 million in this class. A significant portion of this business that we write is produced through wholesale brokers and written on a surplus lines basis.

 

Municipal Entity and Public Officials E&O.  In the fourth quarter of 2005, we entered into an agreement with Professional Government Underwriters, Inc. (“PGU”), a program administrator that specializes in Municipal Entity and Public Officials E&O. PGU’s Municipal Entity and Public Officials E&O business consists of three distinct subclasses: Educators Liability; Police Professionals Liability; and Public Officials Liability. PGU’s business focuses on smaller jurisdictions rather than on major metropolitan areas. Its customers typically are municipalities that seek to purchase professional liability coverages separately from standard property and casualty coverages. Our policies cover the municipality and/or municipal employee for claims such as employment discrimination, mismanagement or improper use of funds, and failure to or improper discharge of official duties. We currently

offer policy limits up to $5 million in this class. Most of the business is written on a surplus lines basis, but in a small number of states it is offered on an admitted basis. Under this program, PGU markets the program, receives applications and binds the coverage, subject to our underwriting guidelines. We retain responsibility for administration of claims and for any reinsurance.

 

Psychologists E&O.  In October 2006, we announced a new program administration agreement with American Professional Agency (“APA”) to provide Psychologist’s E&O Insurance to its nationwide group of mental health professionals. The APA program coverage offers individual limits of up to $2.0 million, and is available in all states on an admitted basis. A wide range of mental health professionals, including psychologists, marriage and family counselors, school counselors, employed counselors, bachelor’s-level employed counselors, clergy and pastoral counselors, certified hypnotists, sex counselors, psychoanalysts, and employed marriage and family therapists, are eligible for coverage. Policies are available nationwide on an admitted basis. They are marketed by APA, which also accepts applications, underwrites and binds coverage, in accordance with underwriting guidelines prepared and maintained by our in-house experts. We are solely responsible for all claims administration and reinsurance matters. APA, which also administers our Psychiatrist’s Program (see below under Medical Malpractice Liability) is a New York-based risk purchasing group with long experience in insuring mental health professionals.

 

Miscellaneous Professional E&O.  Miscellaneous Professional E&O refers to coverages that are written on a more generic, less customized form of policy. Claims are usually made by clients alleging errors and omissions in the performance of professional services. The insurance industry typically recognizes more than fifty sub-classes within this class, such as travel agents, notary publics, title agents and abstractors. We have written a small amount of Miscellaneous Professional E&O to date, but believe that there is potential to grow this business over the long term as we expand the use of i-bind.  We are currently nearing completion of a project to revise our Miscellaneous Professional E&O policy wording, which we hope will assist us in growing this segment of our E&O book.

 

Medical Malpractice Liability.  We are currently engaged in four distinct classes within our Medical Malpractice Liability line of business: Hospital Professional Liability; Miscellaneous Medical Facilities; Physicians and Physician Groups; and Psychiatrists. In this line of business, we provide coverage to physicians and other healthcare providers as individual practitioners or as members of practice groups. Our insurance protects policyholders against losses arising from professional liability claims and the related defense costs for injuries in which the patient alleges that medical error or malpractice has occurred. Optional coverage is available for the professional corporations in which some physicians practice. According to reports by A.M. Best, total gross premiums written for Medical Malpractice Liability insurance by U.S. insurance companies in 2004 (most recent year for which data is available) was approximately $11.4 billion. This line of business had until recently been experiencing a relatively “hard” market, spurred in part by the exit of a number of carriers, including The St. Paul Travelers Companies, Inc., PHICO Insurance Company and Farmers Group, Inc. The depleted capacity supported higher pricing and, consistent with our strategy, we seized upon that opportunity to increase writings in Medical Malpractice Liability. Most of our Medical Malpractice Liability line is produced by large retailers, regional specialty retailers and wholesalers. In the Medical Malpractice Liability line, we generally write primary and first excess layer placements.

 

Hospital Professional Liability.  Our hospital professional liability book is the largest class within our Medical Malpractice Liability line of business and consists of a portfolio of community hospitals, typically with 300 or fewer licensed beds, located throughout the country. In this class, we currently offer limits of up to $11 million, generally written on a surplus lines basis (except for a small number of states where we write this business on an admitted basis).

 

Miscellaneous Medical Facilities.  This class consists of surgical centers, out-patient clinics and other specialty medical facilities. Most of the business is written on a surplus lines basis with policy limits in the range of $1 million to $5 million, with maximum limits of $11 million.

 

Physicians and Physician Groups.  Our business in this class falls into two categories: small to mid-sized physician group (generally, groups with fewer than 50 physicians) policies, such groups where a fraction of the physicians who are in the group have raised an underwriting complexity, and individual physicians who are in the non-standard marketplace, such as physicians with prior claims experience or physicians performing particularly

high-risk procedures (for example, bariatric surgery). Most of this business is written on a surplus lines basis with policy limits in the range of $1 million to $2 million, with maximum policy limits of $11 million on larger physician groups.

 

Psychiatrists.  This class of business is written through APA, which as noted above (see Psychologists E&O) is a program administrator that specializes in this class. These policies are written on an admitted basis with policy limits of up to $1 million, except that, in certain jurisdictions where we are required to do so, we offer policy limits of $2 million. Under this program, APA has authority to bind policies, subject to our underwriting guidelines. We retain responsibility for administration of claims and any reinsurance.

 

Clinical Trial Professionals.  This class of business is being researched and developed as of the date of this Annual Report, with the limits profile and distribution methodology being finalized for roll out in early spring 2007.

 

We believe that our development and successful marketing of Hospital Professional Liability, Miscellaneous Medical Facility, Physician and Physician Group, and Psychiatrist products demonstrates our commitment to, and expertise in, the healthcare market. We believe that if current market conditions continue, our Medical Malpractice Liability line should continue to present an opportunity for profitable growth.

 

Geographic Concentration

 

The following table sets forth the geographic distribution of our gross premiums written for the years ended December 31, 2006, 2005, and 2004:

 

 

 

 

Concentration by Statutory Line

 

The following table sets forth our gross premiums written by statutory line for the years ended December 31, 2006, 2005, and 2004:

 

 

 

 

Underwriting

 

Our principal objective is to create and sustain superior returns for stockholders by earning underwriting profits across our business and through all market cycles. Our underwriting approach focuses on disciplined analysis, pricing appropriate to risk assumed and prudent coverage terms, accompanied by multi-level underwriting and actuarial reviews. Formal rating strategies and plans have been adopted for each line of business. Underwriting acceptability depends on business class, claims history, experience of the insured’s management team, financial stability and other relevant factors. The information is obtained from, among other sources, application forms, underlying insurance coverage (if any), the applicant’s policies and procedures, financial condition, public disclosures and interviews with the management team. If an account does not meet acceptability parameters, coverage is declined. In connection with renewal, claims activity is reviewed to test the accuracy of our original profitability assessments and the information obtained during the prior underwriting of the insured is updated.

 

Darwin’s operations are organized so as to maintain underwriting discipline. We have a technical group of underwriters and actuaries, which sets our underwriting policies and guidelines, and separate groups of underwriters who maintain relationships with distribution partners. The technical underwriting group consists of approximately ten members, headed up by our chief underwriting officer and our chief actuary. In consultation with all relevant disciplines, this group is responsible for product design, rating, underwriting guidelines, testing and overall quality control. Daily underwriting business, including reviews of individual submissions, is conducted by separate groups, comprising approximately thirty underwriters (as of December 31, 2006), six of whom are product managers. The underwriting authority for each underwriter, who typically specializes in a specific line or class of business, is determined on an individual basis. Except for program administrators (third-party entities authorized to bind business for us, subject to underwriting guidelines that we prescribe), our in-house underwriters make all underwriting decisions.

 

Underwriting efforts are supported by account coordinators and by a separate staff of business development personnel, who attend to the Company’s relationships with producers. This system allows our underwriters to rely on account coordinators for administrative tasks like file organization, pre-underwriting, endorsement review and policy issuance. We believe it contributes to underwriting profitability by reducing the number of employees who exercise underwriting authority and by allowing underwriters to focus on underwriting decisions, rather than on marketing or administration.

 

We actively monitor the growth and profitability of our business, with the goal of ensuring continued profitability. Included within this monitoring process are: “roundtable” reviews of underwriting risks; price and trend monitoring discussions among our underwriting, claims and actuarial groups, as well as senior management; quarterly meetings of claims, actuarial, and underwriting personnel (including senior management) to review

serious and potentially serious claims; and periodic audits of the claims and underwriting functions. We believe that disciplined monitoring of the business we’re writing is a key to continued underwriting success, as it provides us with the ability to react quickly to changing market conditions.

 

Our commitment to sustaining underwriting profitability is reflected in and augmented by the incentive structure for senior management, which ties bonus compensation to long-term underwriting results. Darwin has a Long-Term Incentive Plan (“LTIP”) under which a profit pool is established for each year. Management personnel selected by the Compensation Committee of Darwin’s Board of Directors are assigned percentage participations in the profit pool established for each year. The profit pool established for each of calendar years 2003 through 2005 consists of an amount equal to 20% of the underwriting profit produced by the business written in the subject year plus 20% of the investment income earned during the subject year (at a deemed interest rate equal to the 10-year U.S. Treasury note rate). Beginning with and including calendar year 2006, the yearly profit pool consists of an amount equal to 20% of the underwriting profit produced by the business written in the subject year less an amount equal to 5% of the net premiums earned for the subject year. In order to encourage management retention, participants vest in each calendar year’s profit pool over a four-year period, with payouts generally made over the fourth, fifth and sixth years following the end of the subject profit pool year. The payout schedule is intended to hold management accountable for loss development over a six-year period. In addition, the plan provides for loss carryforwards and loss carrybacks, so that amounts under profit pools for different years are offset against one another and any loss arising in one profit pool needs to be “made whole” by offset from available credit under another profit pool. As a result, no payments can be made unless at the time of determination there is net profitability, taking into account the experience under all existing profit pools. We believe that the structure of this plan aligns management’s interests with the primary objective of creating and sustaining superior returns by generating consistent underwriting profits across product lines and through all market cycles.

 

Marketing and Distribution

 

We distribute our products through a select group of approximately 180 distribution partners, including brokers, agents and four program administrators. Our business development staff is responsible for selecting the brokers and agents we do business with, as well as training them to market and sell our products and monitoring to ensure compliance with our production and profitability standards. For calendar years 2006 and 2005, we generated quote ratios (business quoted to applications submitted) of 46.7% and 30.4%, respectively. Among the total policies quoted, we bound 27.3% in 2006, compared with 31.7% in 2005. Distribution of our products is somewhat concentrated, with approximately 39.7% of our gross premiums written for calendar year 2006 being distributed through four of our distribution partners: Marsh Inc., American Professional Agency, Inc. (program administrator), Professional Government Underwriters (program administrator) and Arc Excess & Surplus, LLC. For calendar year 2005, approximately 42.7% was distributed through four of our distribution partners: Marsh Inc., American Professional Agency, Inc., Arthur J. Gallagher & Co. and Arc Excess & Surplus, LLC.

 

In choosing distribution partners, we look for technical expertise; a shared commitment to excellent service (including value-added elements like risk management and loss control); ability to significantly penetrate the portion of the distributor’s business that is of greatest interest to us; and willingness to innovate with us in new technologies, processes and products. We have developed a rating scale to assess new potential partners, which is based on the factors listed above. Approvals for new brokers are limited, and are often granted by line and class of business, rather than on a blanket basis. Since we have used the application process and rating scale, we have reached what we believe to be an optimally sized distribution force based upon the business segments at this time.

 

During calendar year 2006, we received approximately 21,000 submissions from our producers, exclusive of business submitted to our program administrators. Of these submissions, approximately half of the risks satisfied our underwriting guidelines and were quoted, and we ultimately bound 2,700 of these risks (a 12.8% “hit ratio” on total submissions). These 2006 statistics compare with a 9.9% hit ratio (15,100 submissions and 1,450 risks bound) in 2005. We believe that these relatively low hit ratios indicate a continuing commitment to careful underwriting.

 

As discussed above, we currently use program administrators in a number of lines (see the E&O Liability sections discussing Lawyers Professional Liability, Municipal Entity and Public Officials E&O and Psychologists’ E&O; and Medical Malpractice Liability — Psychiatrists). In our program business, we authorize program

administrators to solicit and accept applications for insurance and to issue policies on our behalf within underwriting guidelines that we prescribe. We retain responsibility for administration of claims and for any reinsurance on the program business. Before we enter into a program administration relationship, we analyze historical loss data associated with the program business and do a diligence review of the administrator’s underwriting, financial condition and information technology. In selecting program administrators, we consider the integrity, experience and reputation of the program administrator, the availability of reinsurance, and the potential profitability of the business. In order to assure the continuing integrity of the underwriting and related business operations in our program business, we conduct additional reviews and audits on an ongoing basis. To help align our interests with those of our program administrators, profit incentives based on long-term underwriting results are a significant component of their fees.

 

Our distribution partners produce business through traditional channels as well as through i-bind, our web-based underwriting system. As of year-end 2006, i-bind has been introduced on a limited basis to nineteen (19) producers for our private and non-profit D&O products. We believe that i-bind has the potential to significantly contribute to the growth of the small account business that we target. We intend to both expand the number of distributors using i-bind and add new products to the system. Our i-bind distribution strategy currently focuses primarily on admitted company products, although non-admitted options are under development. We believe that our ability to implement and offer the most efficient distribution strategies to market our products will enhance our ability to deliver a diversified product mix to the markets we serve.

 

The i-bind model recognizes our brokers’ need for underwriting speed, the automated offerings by our competitors, and the operational efficiencies required to handle high volume, low exposure business. Our goal is to have a high percentage of this business flow straight through our systems without human intervention, as described below. Since small business accounts may still have unique features, in some situations we will need some underwriter involvement to appropriately assess risk. Accordingly, the i-bind workflow is defined by two separate processes:

 

 

Under either workflow process, the rating, binding, billing, and policy issuance will be integrated into our policy administration technology. We believe that certain of our Private and Non-profit Accounts D&O, Municipal Entity and Public Officials E&O, Miscellaneous Medical Facilities and Miscellaneous Professional E&O classes of business can be effectively distributed using the i-bind platform.

 

While currently a small part of our business, we anticipate that business processed through i-bind will increase and will become a significant portion of Darwin’s writings over time.

 

Arrangements with the Capitol Companies

 

As described elsewhere in this Annual Report (see “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Certain Arrangements and Relationships Between Darwin and Alleghany”), we were initially formed in March 2003 as a non risk-bearing underwriting manager for the Capitol Companies, pending the establishment or acquisition of a separate insurance carrier for Darwin business. Effective

as of June 1, 2003, DPUI entered into an underwriting management agreement with each of the Capitol Companies pursuant to which DPUI was appointed by each of the Capitol Companies to underwrite and administer specialty liability insurance business. These policies are written by the Capitol Companies pursuant to the underwriting management agreements currently in effect and are fully reinsured by DNA. During the third quarter of 2006, DNA collateralized reinsurance payables to the Capitol Companies with the establishment of reinsurance trusts which are and are required in the future to be funded at 100% of the reinsurance payables outstanding from time to time.

 

Since November 2005, when our insurance company subsidiaries obtained their own A.M. Best ratings of “A−” (Excellent), DPUI has written coverage on policies issued by DNA or Darwin Select whenever possible. However, DNA is not yet admitted, and Darwin Select not yet eligible to write on a surplus lines basis, in some states. Also, DNA does not yet have in place all rate and form filings required to write business in every jurisdiction where it is licensed. In addition, the Capitol Companies have A.M. Best ratings of “A” (Excellent), and insureds in certain classes (primarily public company D&O) require policies issued by an “A” rated insurer. Consequently, although we expect to write the majority of our business on DNA or Darwin Select policies, we continue to depend upon the Capitol Companies to write policies for a portion of the business produced by DPUI. These policies are written by the Capitol Companies pursuant to the underwriting management agreements currently in effect and are fully reinsured by DNA.

 

For the year ended December 31, 2006, we wrote gross premiums of $65.8 million (26.7% of our total gross premium written) through the Capitol Companies arrangement. Of this amount, $32.8 million (49.8% of the total) related to business written through the Capitol Companies because the business was in a state where our insurance company subsidiaries were not then licensed or eligible to write business, and $33.0 million (50.2%) related to business where our insured required a policy from an A.M. Best “A” rated carrier. By comparison, during 2005 the business placed through the Capitol Companies arrangement totaled $142.5 million, or almost 86% of Darwin’s total gross premium written for the year. We do not expect that our issuance of policies written on the Capitol Companies for the insureds who require an A.M. Best rating of “A” (Excellent) will decline so long as our rating is “A−” (Excellent). Most of the insureds in this category are public companies purchasing D&O insurance.

 

The following table indicates the amount of public D&O gross premiums written in each of the periods presented as a percentage of total gross premiums written for such period. Management believes that public D&O is the most rating sensitive class of business we write and, accordingly, that it provides the best available indicator of our level of rating sensitive business.

 

 

While our public D&O writings are declining as a percentage of our total writings, public D&O writings have generally increased in absolute terms as our business has grown. We believe these trends are likely to continue.

 

We expect that our issuance of policies written on the Capitol Companies in jurisdictions where our insurance companies are not currently licensed or eligible to write business will decrease as we continue to obtain required licenses or approvals in various jurisdictions. The following table shows the status of applications in these jurisdictions by insurance company subsidiary and state:

 

DNA

 

Darwin Select

 

 

 

 

The timing of the approval of these applications is within the discretion of the various state insurance authorities, and we can provide no assurance as to when, or if, these approvals will be obtained.

 

Darwin and the Capitol Companies have received regulatory approval from the insurance departments of the relevant states for certain changes to the fee arrangements between Darwin and the Capitol Companies. The fees charged to Darwin for the issuance of Capitol Companies’ policies in respect of business produced by DPUI during 2006 were 0.5% of gross premiums written. Under the underwriting management agreements, as amended, such fees automatically increased as of January 1, 2007 to 3.0% of gross premium. If fees on the business written through the Capitol Companies had been payable at 3.0%, as provided for under the amended fee arrangement, the total fees would have been approximately $2.0 million during 2006. In addition, under the fee arrangements, Darwin is required to reimburse the Capitol Companies for direct expenses that they incur in connection with the issuance of Darwin-produced policies (such as premium taxes and guaranty association assessments). Pursuant to the fee arrangements, Darwin incurred fees payable to the Capitol Companies of $0.3 million in 2006, and reimbursed the Capitol Companies an additional $0.7 million during 2006 for direct expenses incurred, in connection with the business written on policies of the Capitol Companies.

 

The initial term of the underwriting management agreements between DPUI and the Capitol Companies extends until May 31, 2007 and thereafter renews on an annual basis. However, either party may terminate effective upon an expiration date (whether May 31, 2007 or a subsequent May 31), provided that the terminating party provides 60 days prior notice of termination. In addition, a Capitol Company may terminate at any time, by written notice, when Alleghany does not own at least 51% of the outstanding equity interests in DPUI or upon a sale of all or substantially all of the assets of DPUI to a person other than Alleghany or an affiliate of Alleghany. DPUI may terminate its underwriting management agreement with a Capitol Company at any time, by written notice, when Alleghany does not own at least 51% of the outstanding equity interests in the subject Capitol Company or upon a sale of all or substantially all of the assets of the subject Capitol Company to any person other than Alleghany or an affiliate of Alleghany.

 

Reinsurance

 

Ceded Reinsurance

 

Like other insurers, we reinsure a portion of our business with other insurance companies. Ceding reinsurance permits us to diversify risk and limit our exposure to loss arising from large or unusually hazardous risks or catastrophic events in addition to frequency risks. We are subject to credit risk with respect to our reinsurers, as

ceding risk to reinsurers does not relieve us of liability to our insureds. To mitigate reinsurer credit risk, we cede business to reinsurers only if they meet our requirement of an A.M. Best rating of “A−” (Excellent). If a reinsurer’s A.M. Best rating falls below “A−” (Excellent), our contract with the reinsurer generally provides that we may prospectively terminate the reinsurer’s participation in our reinsurance program upon 30 days’ notice.

 

For our D&O and the majority of our E&O liability lines of business, we generally retain $3.5 million of loss per occurrence on policies written at our maximum offered limit of $15 million. For our managed care E&O line, we have written limits up to $20 million, whereby we generally retain $2.75 million of loss per occurrence on the first $10 million of loss and $1 million per occurrence of the next $10 million of loss. For certain of our classes of E&O business (primarily public entities and psychologists professional liability), we generally retain $0.25 to $0.85 million of loss per occurrence. For our Medical Malpractice Liability line of business, we generally retain $0.5 million of loss per occurrence for psychiatrists’ professional liability, $1.9 million of loss per occurrence for physicians’ professional liability, and $2.15 million of loss per occurrence for hospital and other medical facilities professional liability at our maximum offered limit of $11 million.

 

Generally, there are two types of traditional reinsurance, treaty reinsurance and facultative (individual risk) reinsurance. We currently purchase treaty reinsurance and, as described below, in certain cases we purchase facultative reinsurance.

 

Treaty Reinsurance.  Our treaty reinsurance program consists of primarily excess of loss and, to a lesser extent, pro rata reinsurance. Pro rata reinsurance is a type of reinsurance whereby the reinsurer, in return for a predetermined portion or share of the insurance premium charged by the ceding company, indemnifies the ceding company against a predetermined portion of the losses and loss adjustment expenses of the ceding company under the covered policy or policies.

 

The following is a summary of our major reinsurance coverages effective for policies written at December 31, 2006:

 

 

 

 

We purchase excess of loss reinsurance to mitigate the volatility of our book of business by limiting exposure to frequency and severity losses. We purchase both fixed rate and variable rate excess of loss reinsurance.

 

 

We also purchase pro rata reinsurance for certain portions of our book of business. Pro rata reinsurance allows us to grow our book of business cautiously by managing our loss exposure and net premiums written position. Furthermore, pro rata reinsurance allows us to collect a ceding commission equal to a percentage of ceded premium. We typically use such ceding commission on pro rata reinsurance to offset product development expenses and policy acquisition costs.

 

The principal reinsurance intermediary used by Darwin, R.K. Carvill & Co., Ltd., employs the brother of our Senior Vice President — Underwriting, David Newman, who is a member of Darwin management’s reinsurance purchasing committee. Mr. Newman’s brother, who resides in the United Kingdom, is compensated with respect to reinsurance transactions in which the Company engages, but Mr. Newman receives no personal benefit from such compensation. The Company’s reinsurance committee also consists of the Company’s Chief Executive Officer, Chief Financial Officer and Chief Actuary.

 

Facultative Reinsurance.  If a particular risk that we would like to write falls outside of the underwriting parameters of our treaty reinsurance, we utilize the facultative reinsurance market. Generally, facultative

reinsurance enables us to take advantage of opportunities that arise from time to time to write specific, one-off risks on terms that we believe to be favorable.

 

Risk Transfer Requirements.  Reinsurance contracts that do not result in a reasonable possibility that the reinsurer may realize a significant loss from the insurance risk assumed and that do not provide for the transfer of significant insurance risk generally do not meet the requirements for reinsurance accounting and are accounted for as deposits. Darwin has no contracts with third party reinsurers that do not meet the risk transfer provisions of Financial Accounting Standards Board (FASB) Statement No. 113, Accounting for Reinsurance (SFAS No. 113).

 

Darwin Select Reinsurance Recoverable.  In connection with the acquisition of Darwin Select in May 2005 from Ulico Casualty Company, a subsidiary of ULLICO Inc., the entity that became Darwin Select ceded all liabilities on insurance business it had written or assumed prior to the acquisition to Ulico Casualty Company. Darwin Select and Ulico Casualty Company also entered into a trust agreement under which Ulico Casualty Company established a trust account for the benefit of Darwin Select. Under the trust agreement, the obligations of Ulico Casualty Company to Darwin Select are collateralized by a deposit of trust assets, which are limited to cash and investment securities permitted by Arkansas insurance laws. At December 31, 2006, the aggregate amount of gross reserves in respect of the liabilities reinsured under the reinsurance agreement carried on the balance sheet of Darwin Select was $1.5 million. In addition, Ulico Casualty Company has agreed to indemnify both DNA (the purchaser) and Darwin Select against liabilities arising out of the operations prior to the closing. ULLICO Inc. has guaranteed the performance by Ulico Casualty Company of its indemnification obligations and of its obligations under the reinsurance agreement and the trust agreement. The trust fund balance was approximately $3.0 million as of December 31, 2006.

 

Principal Reinsurers

 

The following table sets forth our ten largest reinsurers in terms of amounts recoverable as of December 31, 2006. Also shown are the amounts of ceded unearned reinsurance premiums for each reinsurer less net ceded premiums payable and amounts in trust accounts or secured by letters of credit to determine the net credit exposure by reinsurer as of December 31, 2006.

 

 

 

 

Reinsurance Assumed from the Capitol Companies.  As described above ( See “Arrangements with the Capitol Companies”), all of the obligations of the Capitol Companies relating to business produced by DPUI and written on policies of the Capitol Companies are fully reinsured by DNA. In September 2006 DNA fully collateralized its obligations (both loss reserves and unearned premiums) to the Capitol Companies with respect to these reinsurance arrangements. The balances are collateralized by a reinsurance trust and at December 31, 2006, the market value of trust assets was $217.2 million. Darwin retains ownership rights to the investments held in the trust and the investment income continues to accrue to the Company. In addition, Darwin has authority to substitute similar assets without prior notification to the Capitol Companies.

 

Claims Management and Administration

 

Our claims department, which is organized by product, manages all claims arising under insurance policies we have underwritten. The policies we write may be either “duty to defend” or “indemnity” coverages. With duty to defend policies, we are obliged to appoint counsel to defend our insured. In connection with this, we have developed lists of counsel who have the expertise to defend claims professionally and in a cost-effective manner. With indemnity policies, the insured selects the defense counsel, subject to our approval. In either case, our claims department is actively involved in the evaluation, strategy and resolution of any case. With regard to our most severe claims, or claims which may involve coverage disputes, we retain monitoring counsel. These lawyers represent our interests, but may also add value to the defense team’s ability to resolve a claim.

 

Setting accurate and timely case reserves is an important function of the claims department. We use a severity code system to help assure that claims are being properly monitored and reserved, with more severe claims receiving the most attention but with all claims monitored through a diary system. Each claims handler is assigned the reserving and settlement authority that we believe is appropriate for his or her experience and the nature of the claims they handle.

 

All claims professionals are located at our Farmington, CT headquarters and have regular interaction with underwriters, actuaries and the finance and accounting department. We also have quarterly claims meetings of claims and underwriting personnel and senior management to review serious claims and claims with the potential to become serious claims. We believe that this regular interaction provides us with the ability to efficiently monitor results.

 

Reserves for Unpaid Losses and LAE

 

We establish reserves on our balance sheet for unpaid losses and LAE related to our insurance contracts. As of any particular balance sheet date, there are claims that have not yet been reported. Although most of our insurance policies are issued on a claims-made basis, we do have some occurrence- based policies. In the case of occurrence policies, there may be claims that are not reported for years after the date that a loss event occurs. As a result, the liability for unpaid losses and LAE at any given date includes significant estimates for claims incurred but not reported (known in the industry as “IBNR”). Additionally, many of the claims that have been reported will be in various stages of resolution. Each claim is resolved individually based upon its merits, and some may take years to resolve, especially if litigated. As a result, the liability for unpaid losses and LAE at any given date reflects significant judgments, assumptions and estimates made by management relating to the ultimate losses that will arise from the claims. Due to the inherent uncertainties in the process of establishing these liabilities, the actual ultimate loss from a claim is likely to differ, perhaps materially, from the liability initially recorded, and the amount of the difference between the actual ultimate loss and the recorded amount could be material to the results of our operations.

 

As with any insurance company’s balance sheet date, some of the claims that have occurred under in-force policies will have not yet been reported; some that have been reported will not have been resolved. The time period between occurrence of a loss and its resolution by the insurer is referred to as the claims “tail,” and insurers generally consider a shorter claim tail to be preferable. Although Darwin’s predominance of claims-made policies has a positive impact in terms of reducing claim tails, most of our coverages are nonetheless regarded as having moderate or longer tails. This is because our lines of business frequently involve litigation by third parties against insureds, and the litigation may take years before resolution by judgment or settlement. Our reference to moderate and longer tail business generally refers to claim tails of between three and seven years.

 

We use a variety of techniques that employ significant judgments and assumptions to establish the liabilities for unpaid losses and LAE recorded on the balance sheet date. These techniques include statistical analyses and standard actuarial methodologies applied to our claim history supplemented with loss experience for the insurance industry overall (through use of publicly-available data). The techniques may consider open and closed claims counts, settlement activity, claim frequency, internal loss experience, loss reporting and payout patterns, reported and projected ultimate loss ratios, changes in pricing or coverages, and severity data, depending upon the statistical credibility of the available information. Subjective techniques are used to complement actuarial analyses, especially when statistical data is insufficient or unavailable.

These liabilities also reflect implicit or explicit assumptions regarding the potential effects of future inflation, changes in price levels, judicial decisions, changes in laws and recent trends in such factors, as well as a number of actuarial assumptions that vary across our lines of business. This data is analyzed by line of business and accident/report year, as appropriate.

 

Our loss reserve review process uses actuarial methods and underlying assumptions from which we select the carried reserve for each class of business. The estimates underlying the liabilities for loss reserves are derived from generally accepted actuarial techniques, applied to our actual experience, though limited to our approximate four years of operating history, and take into account insurance industry data to the extent judged relevant to our operations.

 

While not necessarily indicative of future results, in the years since our inception, reported losses have been below expectations. The relatively low volume of losses to date limits the applicability of many standard actuarial analysis methods (which require a significantly higher volume of losses). The actuarial methods used by Darwin include the Bornhuetter-Ferguson method for incurred losses. We continually evaluate the potential for changes, both positive and negative, in our estimates of such liabilities and use the results of these evaluations to adjust both recorded liabilities and underwriting criteria. With respect to liabilities for unpaid losses and LAE established in prior years, such liabilities are periodically analyzed and their expected ultimate cost adjusted, where necessary, to reflect positive or negative development in loss experience and new information. Adjustments to previously recorded liabilities for unpaid losses and LAE, both positive and negative, are reflected in our financial results for the periods in which such adjustments are made and are referred to as prior year reserve development.

 

Changes in Historical Net Loss and LAE Reserves

 

The following table shows changes in our historical net loss and LAE reserves for years 2003 through 2006. Reported reserve development is derived primarily from information included in statutory financial statements of the Capitol Companies and of our insurance company subsidiaries DNA and Darwin Select. The “Net liability as of the end of the period” line of the table shows the net reserves at December 31 of each of years 2003, 2004, 2005 and 2006, representing the estimated amounts of net outstanding losses and LAE for claims arising during the period and in all prior periods that are unpaid, including losses that have been incurred but not yet reported. The “Cumulative amount of net liability paid as of” line of the table shows the cumulative net amounts paid with respect to the net reserve liability for each period. The “Net liability re-estimated as of” line of the table shows the re-estimated amount of the previously recorded net reserves for each period based on experience as of the end of each succeeding period. The estimate changes as more information becomes known about claims for individual periods. The “Gross cumulative redundancy (deficiency)” represents, as of December 31, 2006, the difference between the latest re-estimated liability and the reserves as originally estimated. A redundancy means the original estimate was higher than the current estimate; and a deficiency means that the current estimate is higher than the original estimate.

 

Conditions and trends that have affected the development of the net reserve liability in the past may not necessarily occur in the future. Accordingly, you should not extrapolate future redundancies or deficiencies based on this table.

 

 

Net Loss and LAE Reserves

 

The reconciliation between our aggregate net loss and LAE reserves reported in the annual statements filed with state insurance departments prepared in accordance with statutory accounting practices (“SAP”) and those reported in our historical consolidated financial statements prepared in accordance with GAAP is shown below:

 

Reconciliation of Reserves for Losses and LAE from SAP Basis to GAAP Basis

 

The reconciliation of beginning and ending aggregate reserves for unpaid losses and LAE is shown below:

 

Reconciliation of Reserves for Losses and LAE

 

 

Asbestos, Environmental Impairment and Mold Claims Reserves

 

We believe that we have not provided insurance coverage that could reasonably be expected to produce material levels of asbestos, environmental or mold claims activity.

 

Competition

 

The insurance industry is highly competitive. We compete with domestic and foreign insurers and reinsurers, some of which have greater financial, marketing and management resources than we do. We may also be subject to additional future competition from new market entrants. Competition is based on many factors, including the perceived financial strength of the insurer, pricing and other terms and conditions, services provided, ratings assigned by independent rating organizations (including A.M. Best), the speed of claims payment and the reputation and experience of the insurer. Our competitors vary by line and class of business. Collectively, however, we consider our major competitors to include American International Group, Inc., The Chubb Corporation, XL Capital Ltd., The St. Paul Travelers Companies, Inc., Lloyd’s of London, ACE Limited, Liberty Mutual Group Inc., The Hartford Financial Services Group, Inc., The Navigators Group, Inc., HCC Insurance Holdings, Inc., United States Liability Insurance Group, OneBeacon Insurance Group LLC, RSUI, Odyssey, W.R. Berkley, Markel Corporation, Philadelphia Consolidated Insurance Companies. Re Holdings Corp., CNA Financial Corporation, Arch Insurance Group, Inc., AXIS Capital Holdings Limited and Zurich Financial Services.

 

Ratings

 

A.M. Best Company is the leading provider of ratings, news, data and financial information for the global insurance industry. A.M. Best ratings currently range from “A++” (Superior) to “F” (Liquidation), with a total of 16 separate ratings categories. The objective of A.M. Best’s rating system is to provide an independent opinion as to an insurer’s financial strength and ability to meet obligations to policyholders. A.M. Best’s opinions are derived from

an evaluation of a company’s balance sheet strength, operating performance and business profile. Particularly for companies that have limited operating histories like us, A.M. Best’s rating methodology incorporates a conservative view of business risks and balance sheet position. As a result, in order to optimize our Best’s rating we currently hold capital that we believe is significantly in excess of the level required to support our current premium volume. We expect that this additional capital will be available to support our future growth.

 

In November 2005, A.M. Best assigned DNA an independent “A−” (Excellent) rating and assigned Darwin Select an “A−” (Excellent) rating on a reinsured basis. According to A Guide to Best’s Financial Strength Ratings, which is available on A.M. Best’s website, “A”/“A−” (Excellent) ratings are assigned to insurers that have, in A.M. Best’s opinion, an excellent ability to meet their ongoing obligations to policyholders. A.M. Best bases its ratings on factors that concern policyholders and not upon factors concerning investor protection. Accordingly, such ratings are subject to change and are not recommendations to buy, sell or hold securities.

 

Our insurance ratings are subject to periodic review by, and may be revised or revoked at any time at the sole discretion of, A.M. Best. A downgrade of our ratings could cause our current and future distribution partners and insureds to choose higher-rated competitors and could also increase the cost or reduce the availability of reinsurance to us. As a result, a downgrade in our ratings could cause a substantial reduction in the number of policies we write, which would have a material adverse effect on our financial condition and results of operations.

 

Legal Proceedings

 

We are subject to routine legal proceedings in the normal course of operating our business, including litigation regarding claims. We are not involved in any legal proceeding which we believe could reasonably be expected to have a material adverse effect on our business, results of operations or financial condition. We anticipate that, like other insurers, we will continue to be subject to legal proceedings in the ordinary course of our business.

 

Employees

 

At January 31, 2007 we employed 111 full-time and 5 part-time employees. None of our employees is subject to collective bargaining agreements and we know of no current efforts to implement such agreements. We believe that we have an excellent relationship with our employees.

 

Facilities

 

Substantially all of our employees work out of our offices located in approximately 25,000 square feet of leased office space in Farmington, Connecticut. For calendar year 2006, we paid rent for this space of approximately $0.6 million. The term of our lease extends through 2011. Under the lease, we are required, over time, to take on additional space up to a total of 36,000 square feet by 2008. We believe that the space available to us under this lease will be sufficient to meet our needs for the near term future. In addition to our Farmington headquarters, we rent a small office in New York City.

 

Available Information on the Internet

 

This report and all other filings made by the Company with the Securities and Exchange Commission (“SEC”) pursuant to Section 13(a) or 15(d) of the Exchange Act are made available to the public by the SEC. All filings can be read and copied at the SEC Public Reference Room, located at 100 F Street, NE, Washington, DC 20549. Information pertaining to the operation of the Public Reference Room can be obtained by calling 1-800-SEC-0330. Further, the Company is an electronic filer, so all reports, proxy and information statements, and other information can be found at the SEC website, www.sec.gov. The Company’s website address is http://www.darwinpro.com. Through its website, the Company makes available, free of charge, its Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC. The Annual Report to stockholders, press releases and recordings of our earnings release conference calls are also provided on our website.

REGULATION

 

State Regulation

 

General

 

We are regulated by insurance regulatory agencies in the states in which we conduct business. State insurance laws and regulations generally are designed to protect the interests of policyholders, consumers or claimants rather than stockholders or other investors. The nature and extent of state regulation varies by jurisdiction, and state insurance regulators generally have broad administrative power relating to, among other matters, setting capital and surplus requirements, licensing of insurers and agents, establishing standards for reserve adequacy, prescribing statutory accounting methods and the form and content of statutory financial reports, regulating certain transactions with affiliates, prescribing the types and amounts of investments, payments of dividends and of distributions and proposed acquisitions of control of domestic or licensed insurers.

 

Regulation of insurance companies constantly changes as governmental agencies and legislatures react to real or perceived issues. In recent years, the state insurance regulatory framework has come under increased federal scrutiny, and some state legislatures have considered or enacted laws that alter and, in many cases, increase state authority to regulate insurance companies and insurance holding company systems. Further, the National Association of Insurance Commissioners (NAIC) and some state insurance regulators are re-examining existing laws and regulations specifically focusing on issues relating to the solvency of insurance companies, interpretations of existing laws and the development of new laws. Although the federal government does not directly regulate the business of insurance, federal initiatives often affect the insurance industry in a variety of ways.

 

Certain types of state insurance regulation applicable to us are described more fully below.

 

Required Licensing

 

DNA is organized under the laws of Delaware and is authorized (licensed) in Delaware to transact certain lines of property and casualty insurance. As of year-end 2006, DNA was licensed in 48 jurisdictions (including the District of Columbia) and was eligible to write on a surplus lines basis in one other state. Insurance licenses are issued by state insurance regulators and may be of perpetual duration or may require periodic renewal. We must obtain appropriate new licenses before we can expand into a new state on an admitted basis or offer new lines of insurance that require separate or additional licensing.

 

As an admitted insurer DNA must usually file its premium rates and policy forms for review and approval by each state’s insurance regulators. In many states, rates and forms must be approved prior to use, and insurance regulators have broad discretion in judging whether an insurer’s rates are adequate, not excessive and not unfairly discriminatory. In some states, there has been deregulation for large commercial risks, which may reduce or eliminate form and rate approval requirements in certain circumstances.

 

Darwin Select is organized under the laws of Arkansas and is authorized (licensed) in Arkansas to transact certain lines of property and casualty insurance. In certain other states, Darwin Select policies may be placed on a surplus lines basis. As of year-end 2006, Darwin Select was eligible to have its policies placed on a surplus lines basis in 45 jurisdictions (including the District of Columbia). Darwin Select is not required to apply for or maintain a license in those states. However, in order to remain an eligible surplus lines insurer in a particular jurisdiction, Darwin Select must either meet suitability standards or obtain approval under such jurisdiction’s surplus lines laws. Except for Arkansas (where it is licensed) Darwin Select maintains surplus lines eligibility in all of the states where it operates. As a surplus lines writer, Darwin Select does not file rates or policy forms, and it can therefore adjust its pricing and coverage terms more quickly than an admitted insurer can.

 

All of the business of Darwin Select is written through licensed surplus lines agents and brokers who must comply with specific rules and regulations concerning surplus lines placements. For example, surplus lines agents and brokers are often required to certify that a certain number of licensed admitted insurers had been offered and declined to write a particular risk prior to placing that risk with Darwin Select.

 

Insurance holding company laws

 

We operate as an insurance holding company system and are subject to regulation in the states in which our insurance company subsidiaries are domiciled. These laws require that each of our insurance company subsidiaries register with the insurance department of its state of domicile and furnish information about the operations of the companies within the insurance holding company system that may materially affect the operations, management or financial condition of the insurers within the system. These laws also provide that all transactions between the insurer domiciled in that jurisdiction and any member of its holding company system must be fair and reasonable. Transactions between insurance company subsidiaries and their parents and affiliates generally must be disclosed to the state regulators, and notice and prior approval of the state insurance regulator is required for material or extraordinary transactions. Transactions between DNA or Darwin Select, on the one hand, and Alleghany or any other member of the Alleghany holding company system (including the subsidiaries we refer to as the Capitol Companies), on the other hand, are subject to these regulatory requirements of notice and prior approval.

 

Payment of dividends

 

General.  DPUI does not have significant operations other than our underwriting manager business. Currently, the payments we receive from our insurance subsidiaries under our underwriting management and tax sharing agreements and investment income earned on excess cash balances are our sole sources of funds to pay holding company expenses. We anticipate that subsidiary payments, including any dividends paid by our subsidiaries, will be our primary source of funds for the foreseeable future. To protect insurer solvency, state insurance laws restrict insurance subsidiaries’ ability to pay dividends or to make other payments to holding companies. Regulators require insurance companies to maintain specified levels of statutory capital and surplus. Generally, dividends may only be paid out of earned surplus, and the insurer’s surplus following payment of any dividends must be both reasonable in relation to its outstanding liabilities and adequate to meet its financial needs. Also, prior approval of the insurance department of its state of domicile is required before either of our insurance company subsidiaries can declare and pay an “extraordinary dividend” to us.

 

Delaware.  Under Delaware law, DNA may not pay an “extraordinary” dividend, which includes a dividend or distribution paid at a time when the Company does not have a positive earned surplus balance, or a dividend the fair market value of which, together with that of other dividends or distributions made within the preceding 12 months, exceeds the greater of (i) 10% of statutory surplus as of the prior year-end or (ii) statutory net income less realized capital gains for such prior year, until thirty days after the Insurance Commissioner of the State of Delaware (“Delaware Commissioner”) has received notice of such dividend and has either (i) not disapproved such dividend within such thirty day period or (ii) approved such dividends within such thirty day period. In addition, DNA must provide notice to the Delaware Commissioner of all dividends and other distributions to stockholders within five business days after declaration and at least ten days prior to payment.

 

Arkansas.  Darwin Select is domiciled in Arkansas, and under that State’s Arkansas law it may not pay an “extraordinary” dividend, defined as any dividend or distribution, the fair market value of which, together with that of other dividends or distributions made within the preceding 12 months, exceeds the greater of (i) 10% of statutory surplus as of the prior year-end or (ii) statutory net income less realized capital gains for such prior year, until thirty days after the Insurance Commissioner of the State of Arkansas (“Arkansas Commissioner”) has received notice of such dividend and has either (i) not disapproved such dividend within such thirty day period or (ii) approved such dividends within such thirty day period. In addition, Darwin Select must provide notice to the Arkansas Commissioner of all dividends and other distributions to stockholders within fifteen business days after the declaration thereof.

 

The dividend and distribution limitations imposed by the state insurance laws described above are based on the statutory financial results of the respective insurance company subsidiaries as determined by statutory accounting principles, which differ from GAAP in various ways. Key differences relate to, among other things, deferred policy acquisition costs, limitations on deferred income taxes and required investment reserves. See “Statutory Accounting Principles” below. Insurance regulators can block payments to us from our insurance company subsidiaries that would otherwise be permitted without prior approval if the regulators determine that the payments (such as

payments under our underwriting management agreements or tax sharing agreements or payments for employee or other services) would be adverse to the interests of policyholders or creditors.

 

Based on the dividend restrictions under applicable laws and regulations described above, no amount of regular dividends were or could have been paid to us by DNA in 2006. Business and regulatory considerations will also affect the ability of DNA to pay dividends to us in future periods. In 2005 and 2006, Darwin Select did not pay any dividends to DNA, and DNA did not pay any dividends to us.

 

On January 30, 2007, the Company’s insurance subsidiary DNA applied to the Delaware Insurance Commissioner for approval of an extraordinary dividend of $3.5 million. DNA anticipates a final determination on the payment of the extraordinary dividend from the Delaware Insurance Commissioner during the first quarter of 2007.

 

Change of control

 

Many state insurance laws contain provisions for advance approval by the insurance commissioner of any change of control of an insurer domiciled (or, in some cases, has such substantial business that it is deemed to be commercially domiciled) in that state. Before approving an application to acquire control of an insurer, a commissioner will typically consider such factors as the acquirer’s financial strength, the integrity of its directors and executive officers, its plans for future operations of the insurer and any anti- competitive result that may arise from the change of control. Generally, state statutes provide that control of an insurer is presumed to exist if any person, directly or indirectly, owns, controls, holds with the power to vote, or holds proxies representing, 10% or more of the voting shares of the insurer or of any company that controls the insurer, although this presumption of control may be rebutted. Therefore, if any person were to acquire 10% or more of DPUI’s voting shares without prior approval of the Delaware and the Arkansas Commissioners there would be a violation of those states’ laws, subjecting such acquirer to injunctive action as the relevant regulator may determine appropriate, such as, for example, required disposition of the common stock or prohibition against voting such stock.

 

In addition, the laws of many states contain provisions requiring pre-notification to a regulatory agency prior to any change of control of a non-domestic insurance company admitted to transact business in that jurisdiction. While these pre-notification statutes do not authorize the regulatory agency to disapprove the change of control, they do authorize issuance of cease and desist orders with respect to the non-domestic insurer if it is determined that some conditions, such as undue market concentration, would result from the change of control.

 

These requirements may discourage acquisition proposals and may delay or prevent transactions affecting the control of our common stock, including transactions, and in particular unsolicited transactions, that some or all of our stockholders may consider desirable.

 

Privacy regulations

 

In 1999, Congress enacted the Gramm-Leach-Bliley Act, which, among other things, protects consumers from the unauthorized dissemination of certain personal information. Subsequently, a majority of states have implemented additional regulations to address privacy. These laws apply to all financial institutions, including insurance companies, and require them to maintain procedures to manage and protect certain personal information of customers and fully disclose privacy practices to our customers. We may also be exposed to future privacy laws and regulations, which could impose additional costs and impact our results of operations or financial condition. The NAIC has adopted the Privacy of Consumer Financial and Health Information Model Regulation, which assisted states in promulgating regulations to comply with the Gramm-Leach-Bliley Act. Although we are a “financial institution” for these purposes, we do not believe we are subject to the privacy requirements of the Gramm-Leach-Bliley Act because we do not underwrite consumer-oriented insurance for individuals who are purchasing coverage primarily for personal, family, or household purposes, but rather engage only in commercial insurance for businesses or professionals. However, since the Gramm-Leach-Bliley Act does not preempt state laws which afford greater benefits than the Federal Act, we may be subject to financial privacy laws of certain states where we transact business.

 

Statutory accounting principles

 

Statutory accounting principles (or SAP) is a basis of accounting developed to assist insurance regulators in monitoring and regulating the solvency of insurance companies. SAP were developed primarily to measure the ability to pay all current and future obligations to policyholders and creditors. As a result, statutory accounting focuses on valuing an insurer’s assets and liabilities in accordance with standards specified by the domiciliary jurisdiction. Regulators in the domiciliary states of our insurance company subsidiaries, Delaware and Arkansas, have adopted the NAIC’s statutory principles, with certain modifications. SAP and related regulations determine, among other things, the amount of statutory surplus and statutory net income of our insurance company subsidiaries and thus determine, in part, the amount of funds these subsidiaries have available to pay to us as dividends.

 

The values for assets, liabilities and equity reflected in financial statements prepared in accordance with GAAP may be different from those reflected in financial statements prepared under SAP. GAAP is designed to measure a business on a going-concern basis. It gives more consideration to the matching of revenue and expenses than SAP does and, as a result, certain expenses are capitalized when incurred and then amortized over the life of the associated policies. The valuation of assets and liabilities under GAAP is based in part upon best estimates made by the insurer. Stockholder’s equity represents both amounts currently available and amounts expected to become available over the life of the business.

 

Guaranty association assessments

 

Most of the states require property and casualty insurers writing business on an admitted basis in that state to participate in guaranty associations. These associates are organized to pay benefits owed to policyholders and claimants pursuant to insurance policies issued by insurers which have become impaired or insolvent. Typically, a state assesses each licensed insurer an amount related to the licensed insurer’s proportionate share of premiums written by all licensed insurers in the state in the line of business in which the impaired or insolvent insurer was engaged. Some states permit licensed insurers to recover a portion of these payments through full or partial premium tax credits or, in limited circumstances, by surcharging policyholders. In some states where full and partial premium tax credits are allowed, there have been legislative efforts to limit or repeal the tax offset provisions.

 

For the year ended December 31, 2006, $0.1 million of assessment were levied against either DNA or Darwin Select. Aggregate assessments levied against DNA were $0.2 million for the year ended December 31, 2005. Although the amount and timing of future assessments are not predictable, we have established liabilities for guaranty fund assessments that we consider adequate for assessments with respect to insurers that currently are subject to insolvency proceedings in states where our insurance company subsidiaries are licensed to transact business.

 

Insurance Regulatory Information System

 

The NAIC Insurance Regulatory Information System, or IRIS, was developed to help state regulators identify companies that may require special attention. IRIS identifies twelve key financial ratios and specifies “usual ranges” for each ratio. Insurers typically submit financial information about themselves to the NAIC annually, which in turn analyzes the data using the prescribed ratios. These ratios assist state insurance departments in executing their statutory mandates to oversee the financial condition of insurance companies operating in their respective states.

 

Departures from the usual ranges of ratios may lead to inquiries from the insurance departments. Generally, regulators will begin to investigate or monitor an insurance company if four or more of its ratios fall outside the usual ranges. Due to the significant direct premiums written growth, assumption of 100% of Capitol Companies’ premiums written, assumption of 90% of Darwin Select’s premiums written by DNA during 2006, and the 2005 assumption of the outstanding loss and LAE reserves from the Capitol Companies, DNA had two unusual values for the IRIS tests for the year ended December 31, 2006. They were “Change in Net Writings” and “Estimated Current Reserve Deficiency to Policyholders’ Surplus.” For Darwin Select, due to the significant increase in net premiums written for its first full year of operations and ceding commissions for ceding 90% of premiums written after ceding to unaffiliated reinsurers, Darwin Select had three unusual values for the year ended December 31, 2006. They were “Change in Net Premiums Written,” “Surplus Aid to Policyholders’ Surplus,” and “Gross Agents’ Balances to

Policyholders’ Surplus.” We are not aware of either DNA or Darwin Select being subject to regulatory scrutiny because of these ratios.

 

Risk-based capital

 

In order to enhance the regulation of insurer solvency, the NAIC has adopted a formula and a model law to implement risk-based capital, or RBC, requirements to assess the minimum amount of capital that an insurance company needs to support its overall business operations and to assure that it has an acceptably low likelihood of becoming financially impaired. The RBC formula takes into account various risk factors including asset risk, credit risk, underwriting risk and interest rate risk. As the ratio of an insurer’s total adjusted capital and surplus decreases relative to its risk-based capital, the RBC laws provide for increasing levels of regulatory intervention such as supervision and rehabilitation, and culminating with mandatory control of the operations of the insurer by the domiciliary insurance department at the so-called mandatory control level. As of December 31, 2006, the RBC ratios of DNA and Darwin Select are above the range that would trigger any regulatory or corrective action.

 

Market condition examinations

 

The laws and regulations of the states where DNA and Darwin Select operate include numerous provisions governing the marketplace activities of admitted insurers, including provisions governing the form and content of disclosure to consumers, product illustrations, advertising, sales and underwriting practices, complaint handling and claims handling. These provisions are enforced by the state insurance regulatory agencies through periodic market conduct examinations.

 

Financial examinations

 

As part of the regulatory oversight process, state insurance departments conduct periodic detailed examinations of the books, records, accounts, policy filings and business practices of insurers domiciled in their state, generally once every three to five years. These examinations generally are conducted in cooperation with the insurance departments of two or three other states or jurisdictions, representing each of the NAIC zones, under guidelines promulgated by the NAIC. As of the date of this Annual Report on Form 10-K, the Delaware Department of Insurance is conducting a regular triennial financial examination of DNA, the results of which we expect to receive later this year.

 

Insurance reserves

 

Under the laws and regulations of their respective states of domicile, our insurance company subsidiaries are required to conduct annual analyses of the sufficiency of their reserves. In addition, other states in which DNA is licensed and in which Darwin Select is an eligible surplus lines carrier may have certain reserve requirements that differ from those of their domiciliary states. In each case, a qualified actuary must submit an opinion that states that the aggregate statutory reserves, when considered in light of the assets held with respect to those reserves, make adequate provisions for the associated contractual obligations and related expenses of the insurer.

 

Regulation of investments

 

Our insurance company subsidiaries are subject to laws and regulations that require diversification of their investment portfolios and limit the amount of investments in certain asset categories, such as below investment grade fixed-income securities, equity real estate, other equity investments and derivatives. Failure to comply with these laws and regulations would cause investments exceeding regulatory limitations to be treated as non-admitted assets (which are assets or portions thereof that are not permitted to be reported as admitted assets in an insurer’s annual statement prepared in accordance with SAP) for purposes of measuring surplus, and, in some instances, would require divestiture of such non-complying investments. We believe that the investments made by our insurance company subsidiaries comply with these laws and regulations.

 

Broker compensation

 

The recent investigations and legal actions brought by the various state attorneys general relating to broker compensation practices, as well as other measures (such as proposed legislation) that have been taken to address some of the practices at issue in those investigations and actions, are likely to result in potentially far-reaching changes in industry broker compensation practices. Market practices are still evolving in response to these developments, and we cannot predict what practices the market will ultimately adopt or how these changes will affect our competitive standing with brokers and agents or on the commission rates that we pay to our brokers, agents and program administrators.

 

Prior to September 30, 2004, we had contingent commission fee arrangements in effect with two of our brokers. Since September 30, 2004, we have not incurred any contingent commissions payable to any of our brokers or agents (although, in order to encourage our program administrators to focus on profitability of business produced as well as volume of business produced, we do include a contingent profit component as part of their compensation). Beginning in November 2004, we received subpoenas, inquiries and document requests from the insurance departments of the States of Delaware and North Carolina with regard to broker compensation matters. The subpoenas, inquiries and document requests we received, and subsequently responded to, did not allege any wrongdoing. We believe that these subpoenas, inquiries and document requests were issued by the Delaware and North Carolina insurance departments to most, if not all, property and casualty insurers domiciled and/or licensed in those jurisdictions. We have heard nothing further regarding these subpoenas during the approximately two years since our response, and on the basis of that interval, we believe Darwin will not have any further involvement in this matter.

 

Federal Regulation

 

General

 

The federal government generally does not directly regulate the insurance business. However, various federal legislation and administrative policies in several areas, including terrorism and financial transparency, do affect the insurance business. One proposal which could impact federal regulation of insurance — the State Modernization and Regulatory Transparency (“SMART”) Act — would use federal preemption and/or revenue penalties to induce uniform regulatory standards among the states. Congress has also considered and discussed so-called optional federal charter proposals, which would afford insurers the option to be regulated at the state level or at the federal level. We are not able to predict the effect of these federal legislative initiatives on the level of competition we may face or on our results of operations.

 

Terrorism Risk Insurance Act

 

The Terrorism Risk Insurance Act of 2002 (“TRIA”) generally requires primary commercial property and casualty insurers to make insurance coverage for certified acts of terrorism available to their policyholders at the same limits and terms as are available for other coverages. TRIA, which was set to expire on December 31, 2005, has been extended through December 31, 2007 by the Terrorism Risk Insurance Extension Act (the “Extension Act”). Previously, we were required by TRIA to offer terrorism coverage on all quotes in all of the lines of business that we write other than our Medical Malpractice Liability line. Under the Extension Act, we believe that we are required to offer terrorism coverage only on our D&O line. Subject to applicable deductibles, insurance losses on our D&O policies attributable to certified acts of terrorism are reinsured by the federal government. Because the Extension Act increased deductibles, and because our deductible is based upon the aggregate amount of premiums written by all insurance company subsidiaries of Alleghany, it is possible that we could receive little or no benefit from the federal reinsurance program.

 

The federal reinsurance program under TRIA and the Extension Act is scheduled to expire at the end of 2007 unless Congress further extends it. We cannot predict whether or when any such extension may be enacted or what the final terms of such legislation would be. In addition, with regard to our lines of business not subject to the Extension Act (E&O and Medical Malpractice Liability), we may still be required to offer terrorism coverage as a result of state regulation or market demand. The federal reinsurance program would not apply to these lines of business.

 

USA PATRIOT Act and OFAC

 

The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, (or “Patriot Act”) contains anti-money laundering and financial transparency laws and mandates the implementation of various new regulations applicable to financial services companies including insurance companies. The Treasury Department’s Office of Foreign Assets Control (OFAC) maintains various economic sanctions regulations against certain foreign countries and groups and prohibits “U.S. Persons” from engaging in certain transactions with certain persons or entities in or associated with those countries or groups. Together, the Patriot Act and OFAC increase obligations of financial institutions to identify their customers, watch for and report suspicious transactions, respond to requests for information by regulatory authorities and law enforcement agencies, and share information with other financial institutions. To satisfy these obligations, financial institutions are required to implement and maintain internal practices, procedures and controls. We believe that we have appropriate internal practices, procedures and controls to enable us to comply with the provisions of these federal regulations.

 

Risks Related to Our Business

 

In addition to the risks referenced in “Note on Forward Looking Statements” included in “Management’s Discussion and Analysis of Financial Conditions and Results of Operations” herein and elsewhere in this Annual Report on Form 10-K, there are a number of risk factors which could impact our performance, including those listed below.

 

We have a limited operating and financial history, and if we are unable to implement our business strategy or operate our business as we currently expect, our financial condition and results of operations may be adversely affected.

 

We were formed in March 2003 as an underwriting manager for the Capitol Companies pending the establishment or acquisition of a separate insurance carrier for Darwin business. In May 2004, we acquired DNA, an admitted insurance company. In May 2005, we acquired Darwin Select, a surplus lines insurance company. We therefore have limited operating and financial history available upon which to evaluate our past performance or to make a decision about an investment in our securities. In addition, because we focus our efforts on certain specialized sectors of the insurance market, and because we do not have an extensive claims history to date, our historical financial results may not accurately predict our future performance. Moreover, companies in their initial stages of development present substantial business and financial risks and may suffer significant losses. Because of the risks specific to our business and those associated with early stage companies in general, we may not be successful in implementing our business strategy. If unable to implement our strategy or to operate our business as we currently expect, our results of operations may be adversely affected.

 

A decline in our financial strength ratings could cause us to lose substantially all of our business.

 

A.M. Best currently rates DNA at “A−” (Excellent) and Darwin Select at “A−” (Excellent) (reinsured rating). A rating of “A−” (Excellent) is the fourth highest of 16 separate A.M. Best rating categories that currently range from “A++” (Superior) to “S” (Suspended). Our insurance company subsidiaries’ ratings are subject to periodic review by, and may be revised downward or revoked at any time at the sole discretion of, A.M. Best. A downgrade could cause our current and future distribution partners (brokers, agents and licensed insurance agents who are delegated authority to manage part of our insurance business, whom we refer to as “program administrators”) and insureds to choose other, more highly rated competitors and could also increase the cost or reduce the availability of reinsurance to us. As a result, a downgrade in our ratings could cause us to lose substantially all of our business, which would have a material adverse effect on our financial condition and results of operations. Further, a downgrade of our ratings could adversely impact our ability to attract investment capital on favorable terms.

 

We do not have employment agreements or non-competition agreements with most of our key management personnel, and if we lose key personnel or are unable to recruit qualified personnel, our ability to implement our business strategies could be delayed or hindered.

 

Our future success will depend, in part, upon the efforts of our executive officers and other key personnel, including Stephen Sills, our President and Chief Executive Officer. The loss of Mr. Sills or any of our other key personnel could prevent us from fully implementing our business strategies and could materially and adversely affect our business, financial condition and results of operations. We have not entered into employment agreements with any of our key management personnel other than Mr. Sills and Mark I. Rosen, our Senior Vice President and General Counsel. Our executive officers and key personnel, other than Mr. Sills and Mr. Rosen, are not subject to non-competition agreements.

 

Our employment agreement with Mr. Sills provides that he has the right to terminate his agreement for any reason. Mr. Sills’ agreement provides that he can terminate for “good reason” under certain circumstances, including the termination by the Capitol Companies of the underwriting management agreement with DPUI prior to December 31, 2007, and for which he would be entitled to receive certain payments and benefits upon termination. We could be materially adversely affected by the termination of Mr. Sills’ employment as our President and Chief Executive Officer.

 

We do not have key person insurance on the life of Mr. Sills or on the lives of any of our other key management personnel. As we continue to grow, we will need to recruit and retain additional qualified management personnel, but our ability to recruit and retain such personnel will depend upon a number of factors, such as our results of operations, prospects and the level of competition then prevailing in the market for qualified personnel.

 

If we are unable to underwrite risks accurately and to charge adequate rates to policyholders, our financial condition and results of operations could be adversely affected.

 

In the insurance business the product is priced and sold before the underlying costs are known. This requires significant reliance on estimates and assumptions in setting prices. Rate adequacy is necessary, together with investment income, to generate sufficient revenue to offset losses, LAE and other underwriting expenses (which include the aggregate of policy acquisition costs, including commissions, and the portion of administrative, general and other expenses attributable to underwriting operations) and to earn a profit. If we fail to assess accurately the risks we assume, we may fail to charge adequate premium rates, which could reduce income and have a material adverse effect on our financial condition and results of operations.

 

In order to price accurately, we must collect and analyze a substantial volume of data; test and apply appropriate rating formulae; monitor and timely recognize changes in trends; and project both severity and frequency of losses with reasonable accuracy. We must also implement our pricing accurately in accordance with our assumptions. Our ability to undertake these efforts successfully, and as a result price accurately, is subject to risks and uncertainties, including, but not limited to: availability of sufficient reliable data; incorrect or incomplete analysis of available data; uncertainties inherent in estimates and assumptions, generally; selection and implementation of appropriate rating formulae or other pricing methodologies; ability to predict investment yields and the duration of our liability for losses and LAE accurately; and unanticipated court decisions, legislation or regulatory action.

 

Our actual incurred losses and LAE may be greater than our loss and LAE reserves, which could have a material adverse effect on our financial condition and results of operations.

 

We are liable for incurred losses and LAE under the terms of the insurance policies we underwrite. In many cases, several years may elapse between the occurrence of an insured loss event, the making of a claim, and our resolution of that claim. We establish loss and LAE reserves for the estimated ultimate payment of all losses and LAE incurred. We estimate loss and LAE reserves using individual case-basis valuations of reported claims. We also use statistical analyses to estimate the cost of losses that have been incurred but not reported to us. These estimates are based on historical information and on estimates of future trends that may affect the frequency of claims and changes in the average cost of claims that may arise in the future. They are by their nature imprecise, and our ultimate losses and LAE may vary from established reserves. Because of our short operating history, we have a

limited claims experience on which to base our reserves. Consequently, the techniques that we currently utilize to establish our loss and LAE reserves primarily take into account relevant insurance industry data. If our loss and LAE reserves should prove to be inadequate, we will be required to increase reserves, thereby reducing net earnings and stockholders’ equity in the period in which the deficiency is identified. Future loss experience which is substantially in excess of established reserves could also have a material adverse effect on future earnings and liquidity and our financial position. Furthermore, factors that are difficult to predict may impact future loss and LAE, such as claims inflation, claims development patterns, legislative activity, social and economic patterns and litigation and regulatory trends.

 

We currently rely on certain Alleghany subsidiaries to write some of the insurance policies that we produce, and a termination of our arrangements with them could have an adverse effect on our business, financial condition and results of operations.

 

We have underwriting management agreements with each of the Capitol Companies to write policies produced by DPUI. Initially, all business produced by DPUI was written on policies of the Capitol Companies. Since each of our insurance company subsidiaries obtained its own A.M. Best rating of “A−” (Excellent) in November 2005, whenever possible, DPUI has written coverage on policies issued by DNA or Darwin Select. However, our insurance company subsidiaries are not currently licensed (in the case of our admitted carrier DNA) or eligible to write business on a surplus lines basis (in the case of Darwin Select) in all U.S. jurisdictions, and DNA does not yet have in place all rate and form filings required to write insurance business in every jurisdiction where it is licensed. In addition, the Capitol Companies have A.M. Best ratings of “A” (Excellent), and we believe that insureds in certain classes of our business (primarily public D&O) require policies issued by an insurer with an A.M. Best rating of “A” (Excellent). Consequently, although we expect to write an increasing percentage of our future business on policies of our own subsidiaries, we continue to depend upon the Capitol Companies to write policies for a portion of the business produced by DPUI. (For the year ended December 31, 2006, see “Business — Arrangements with the Capitol Companies” above.)

 

We do not expect that our issuance of policies written on the Capitol Companies for the insureds who require an A.M. Best rating of “A” (Excellent) will decline so long as our rating is “A−” (Excellent). To date, most of the insureds in this category are public companies purchasing D&O insurance. While our public D&O writings have declined as a percentage of our total writings, public D&O writings have generally increased in absolute terms as our business has grown. We believe these trends are likely to continue. We do expect that our issuance of policies written on the Capitol Companies in jurisdictions where our insurance companies are not currently licensed or eligible to write business will decrease as we obtain required licenses or approvals in the various jurisdictions.

 

The initial term of the underwriting management agreements between DPUI and the Capitol Companies extends until May 31, 2007 and thereafter renews on an annual basis. However, either party may terminate effective upon an expiration date (whether May 31, 2007 or a subsequent May 31), provided that the terminating party provides 60 days prior notice of termination. In addition, a Capitol Company may terminate at any time, by written notice, at any time when Alleghany does not own at least 51% of the outstanding equity interests in DPUI or upon a sale of all or substantially all of the assets of DPUI to a person other than Alleghany or an affiliate of Alleghany. DPUI may terminate its underwriting management agreement with a Capitol Company at any time, by written notice, when Alleghany does not own at least 51% of the outstanding equity interests in the subject Capitol Company or upon a sale of all or substantially all of the assets of the subject Capitol Company to any person other than Alleghany or an affiliate of Alleghany.

 

If the underwriting management agreements between DPUI and the Capitol Companies were terminated at a time when we still depended on the Capitol Companies to write a material portion of the business produced by DPUI, or if the Capitol Companies were downgraded from their current A.M. Best ratings of “A” (Excellent) at a time when a material portion of the business produced by DPUI was in a class where there is rating sensitivity, then, unless we were able to locate other entities to write such business and to negotiate new agreements with such other entities (which new agreements might involve additional expense to us), we could be materially adversely affected. In addition, the employment agreement between DPUI and Stephen Sills provides that termination prior to December 31, 2007 by any of the Capitol Companies of its underwriting management agreement with DPUI will permit Mr. Sills to terminate his employment with DPUI and that such termination will be deemed to be a

termination by Mr. Sills “for good reason,” which will entitle him to receive certain payments and benefits. We could be materially adversely affected by the termination of Mr. Sills’ employment as President and Chief Executive Officer of DPUI.

 

If we are not able to renew our existing reinsurance or obtain new reinsurance or if we were to increase our retention levels in premiums written, either our net exposures would increase or we would have to reduce the level of our underwriting commitment, both of which could negatively affect our revenues and results of operations.

 

We purchase reinsurance to spread our risk on substantially all of our lines of business. We currently purchase primarily excess of loss reinsurance to stop our loss from a single occurrence on any one coverage part from any one policy. Excess of loss reinsurance is reinsurance that indemnifies the insured against all or a specified portion of losses on underlying insurance policies in excess of a specified amount, which is called an “attachment level” or “retention.” In addition, we currently purchase quota share reinsurance on certain classes of our business to provide additional reinsurance protection. Quota share reinsurance is a type of reinsurance whereby the reinsurer, in return for a predetermined portion or share of the insurance premium charged by the ceding company, indemnifies the ceding company against a predetermined portion of the losses and LAE of the ceding company under the covered policy or policies. Total ceded premiums amounted to 36.2% of our gross premiums written in 2006.

 

We may choose in the future to re-evaluate the use of reinsurance to increase, decrease or eliminate the amount of liability we cede to reinsurers, depending upon the cost and availability of reinsurance. If we were to increase the levels of risk we retain, our net exposures would increase and this could cause our earnings and results of operations to be more volatile. See “Business — Reinsurance.” Market conditions beyond our control determine the availability and cost of the reinsurance protection that we purchase. The reinsurance market has changed dramatically over the past few years as a result of inadequate pricing, poor underwriting and significant losses incurred. As a result, some reinsurers have exited certain lines of business, reduced available capacity and implemented provisions in their contracts designed to reduce their exposure to loss. In addition, the availability of capital affects the availability of reinsurance.

 

Our reinsurance facilities generally are subject to annual renewal. We cannot provide any assurance that we will be able to maintain our current reinsurance facilities or that we will be able to obtain other reinsurance facilities in adequate amounts and at favorable rates. If we are unable to renew our expiring contracts or to make new arrangements or if the cost of reinsurance increased to an amount we were unwilling to pay, our net exposure would increase, which would cause our earnings and results of operations to be more volatile. If we were unwilling to bear an increase in net exposures, we would have to reduce the level of our underwriting commitments, which would reduce our revenues.

 

If our reinsurers do not pay claims made by us in a timely fashion, our business, financial condition and results of operations could be materially adversely affected.

 

Although reinsurance makes the reinsurer liable to us to the extent the risk is transferred or ceded to the reinsurer, it does not relieve us (the reinsured) of our liability to our policyholders. Accordingly, we are subject to credit risk with respect to our reinsurers. Our reinsurers may not pay claims made by us on a timely basis, or they may not pay some or all of our claims. Either event would increase our costs and could have a material adverse effect on our business, financial condition and results of operations.

 

If our relationships with certain of our distribution partners, four of which account for a significant part of our business, were terminated, our financial condition and results of operations could be materially adversely affected.

 

We distribute our products through a select group of approximately 180 distribution partners, including brokers, agents and four program administrators. For the year ended December 31, 2006, approximately 39.7% of our gross premiums written was produced by four of our distribution partners: Marsh Inc., American Professional Agency (a program administrator), Professional Government Underwriters (a program administrator) and Arc Excess & Surplus, LLC. Our program administration agreements are terminable upon 180 days notice. We do not have exclusive

arrangements with our brokers and agents, and they can terminate our relationship at any time. Thus, we cannot be sure that relationships with our distribution partners will continue. The termination of a relationship with one or more of these producers could result in lower gross premiums written and have a material adverse effect on our financial condition and results of operations.

 

We rely on our brokers, agents and program administrators to collect premiums on our behalf, and their failure to remit premiums to us could cause our underwriting profits to decline.

 

Premiums produced by our brokers, agents and program administrators are collected directly by our distribution partners and forwarded to us. In certain jurisdictions, when the insured pays premiums for these policies to brokers, agents or program administrators for payment over to us, the premiums might be considered to have been paid to us, whether or not we have actually received the premiums from our distribution partners. Consequently, we assume a degree of credit risk associated with our distribution partners. Although failure by our distribution partners to remit premiums to us has not had a material adverse effect on us to date, there may be instances where our distribution partners collect premium but do not remit it to us and we may be nonetheless required under applicable law to provide the coverage set forth in the policy despite the absence of premium. Because the possibility of these events is dependent in large part upon the financial condition and internal operations of our distribution partners, which in most cases is not public information, we are not able to quantify the exposure presented by this risk. If we are unable to collect premiums from our distribution partners in the future, our underwriting profits may decline and our financial condition and results of operations could be materially adversely affected.

 

If a program administrator were to exceed its underwriting authority or otherwise breach obligations owed to us, we could be materially adversely affected.

 

In the programs currently in place, we authorize the program administrators to write business on our behalf within underwriting guidelines that we prescribe. In this structure, we rely on the underwriting controls of our program administrators to write business within the underwriting guidelines that we prescribe. Although we monitor our programs on an ongoing basis, our monitoring efforts may not be adequate or our program administrators may exceed their underwriting authorities or otherwise breach obligations owed to us. We are liable to policyholders under the terms of policies underwritten by our program administrators and, to the extent that our program administrators exceed underwriting authorities or otherwise breach obligations owed to us, our financial condition and results of operations could be materially adversely affected.

 

We rely heavily on our information technology and telecommunication systems, and the failure of these systems could materially and adversely affect our business.

 

Our business is more highly dependent than many others on successful, uninterrupted functioning of our information technology and telecommunications systems. We rely on these systems to process new and renewal business, provide customer service, make claims payments and facilitate collections and cancellations. These systems also enable us to perform actuarial and other modeling functions necessary for underwriting and rate development. A failure of these systems or the termination of a third-party software license upon which any of these systems are based could materially impact our ability to evaluate and write new business. Because our information technology and telecommunications systems interface with and depend on third-party systems, we could experience service denials if demand for such services exceeds capacity or such third-party systems fail or experience interruptions. If sustained or repeated, a system failure could result in a deterioration of our ability to write and process new and renewal business and provide customer service or compromise our ability to pay claims in a timely manner.

 

If we do not maintain adequate systems, we could experience adverse consequences, including: inadequate information on which to base critical decisions; loss of existing customers; difficulty in attracting new distribution partners or disputes with our present distribution partners; regulatory problems, such as failure to meet prompt payment obligations; litigation exposure; and increased administrative expenses. Thus, our failure to update our systems to reflect technological advancements or to protect our systems could have a material adverse effect on our business, financial condition and results of operations.

 

If i-bind, our web-based underwriting system, has technical problems, or if it is accepted by the marketplace more slowly than anticipated, we may not be able to grow the small account business that we target as quickly or as cost-effectively as we would like.

 

i-bind is our web-based underwriting system that allows on-line policy submission, rating, quoting, proposal and binder issuance. We believe i-bind will assist us and our distribution partners in producing and managing small account business in a cost-effective manner. i-bind is still being rolled out to certain of our distribution partners, and we cannot be sure if, or how quickly, it will be accepted by the marketplace. Also, although we have experienced no material technical problems related to the i-bind program to date, to the extent that i-bind were to have problems in the future or is not accepted by the marketplace, we may not be able to grow the small account business that we target as quickly or as cost-effectively as we would like, which could result in lower gross premiums written and higher costs.

 

Our investment results and, therefore, financial condition and results of operations, may be materially adversely impacted by changes in the business, financial condition or operating results of the entities in which we invest, as well as changes in interest rates, government monetary policies, general economic conditions and overall capital market conditions.

 

Our results of operations depend, in part, on the performance of our invested assets. Fluctuations in interest rates affect our returns on, and the fair value of, our investments in fixed-income securities. The fair market value of our fixed-income securities generally increases or decreases in an inverse relationship with fluctuations in interest rates, while net investment income realized by us from future investments in fixed-income securities will generally increase or decrease with interest rates. As a result, interest rate fluctuations could impact our net income. Substantially all of our fixed-income securities are classified as available for sale, and unrealized gains and losses on such securities are recognized in accumulated other comprehensive income (loss), net of taxes, and increase or decrease our stockholders’ equity. In addition, issuers of the fixed-income securities that we own may default on principal and interest payments, as a result of economic downturn, events of corporate malfeasance or other factors which would cause a decline in the value of our fixed-income portfolio and cause our net earnings to decline.

 

Our fixed-income investment portfolio includes mortgage-backed securities. The fair value of these securities fluctuates with the market, and in addition changes in interest rates expose these securities to prepayment risk. That is, in periods of declining interest rates, mortgage prepayments (generally from refinancings) increase and the securities are paid down more quickly, requiring us, as the investor, to reinvest repayments at the then lower market rates. Conversely, during periods of rising interest rates, prepayments generally slow. Mortgage/asset-backed securities that have an amortized cost that is less than par (i.e. purchased at a discount) may incur a decrease in yield as a result of a slower rate of prepayment.

 

Although we have not historically invested in equity securities, we may decide to do so in the future. The performance of an equity portfolio depends on a number of factors, including many of the same that affect the performance of fixed-income securities (although those factors can have the opposite effect on the market prices of equity securities.) The equity markets as a whole have been relatively volatile in recent years, and we will need to exercise care in selecting equity securities for investment, and our equity investments may be negatively affected by market conditions outside our control.

 

If we do not structure our investment portfolio so that it appropriately matches our insurance liabilities, we may be forced to liquidate investments prior to maturity at a significant loss to cover such liabilities. In addition, if we do not succeed in targeting an appropriate overall risk level for our investment portfolio, the return on our investments may be insufficient to meet our long-term profit targets.

 

As a holding company and underwriting manager, we are dependent on the results of operations of our insurance company subsidiaries, and we rely upon the regulatory and financial capacity of our subsidiaries to pay dividends to us. The inability of our subsidiaries to pay dividends to us in sufficient amounts could harm our ability to meet our obligations.

 

As an insurance holding company without significant operations of our own (other than our underwriting manager business), payments from our subsidiaries under our underwriting management and tax sharing

agreements are currently our sole sources of funds to pay holding company expenses. We anticipate that such payments, together with dividends paid by subsidiaries, will be the primary source of funds for our holding company.

 

With respect to payments under the underwriting management and tax sharing agreements, if a subsidiary should become insolvent, our creditors and stockholders will have no right to proceed against the assets of that subsidiary or to cause the liquidation, bankruptcy or winding-up of the subsidiary under applicable liquidation, bankruptcy or winding-up laws. Insurance laws of the jurisdiction in which such subsidiary is domiciled would govern any proceedings relating to the subsidiary. The insurance authority designated by these laws would act as a liquidator for that subsidiary and creditors and policyholders of the subsidiary would be entitled to payment in full from the subsidiary’s assets before we would be entitled to receive any distribution from the subsidiary.

 

State insurance laws restrict the ability of our insurance company subsidiaries to declare stockholder dividends. State insurance regulators require insurance companies to maintain specified levels of statutory capital and surplus. Generally, dividends may only be paid out of earned surplus, and the amount of an insurer’s surplus following payment of any dividends must be reasonable in relation to the insurer’s outstanding liabilities and adequate to meet its financial needs. Under the insurance laws of Delaware and Arkansas, the states of domicile of DNA and Darwin Select, respectively, neither of our subsidiaries may pay an “extraordinary” dividend, which is defined as any dividend or distribution, the fair market value of which, together with that of other dividends or distributions made within the preceding 12 months, exceeds the greater of (i) 10% of statutory surplus as of the prior year-end or (ii) statutory net income less realized capital gains for such prior year, until thirty days after the Insurance Commissioner has received notice of such dividends and has either approved or not disapproved such dividends within the thirty day period. In addition, insurance regulators can block payments to us from our insurance company subsidiaries that would otherwise be permitted without prior approval if the regulators determine that the payments (such as payments under tax sharing agreements or payments for employee or other services) would be adverse to the interests of policyholders or creditors. As a result, we may not be able to receive dividends or other payments from our subsidiaries at times and in amounts necessary to pay corporate expenses or meet other obligations. If the ability of our insurance company subsidiaries to pay dividends or make other payments to us is materially restricted by regulatory requirements, it could adversely affect our ability to pay our corporate expenses.

 

If we are unable to raise additional capital in the future, whether on favorable terms or at all, we may not have sufficient funds to implement our operating plans, and our business, financial condition or results of operations could be materially adversely affected.

 

Based on our current operating plan, we believe that payments under our underwriting management and tax sharing agreements and such dividends as are permitted by regulators to receive from our subsidiaries will support operations for the foreseeable future without the need for additional capital. However, we cannot provide any assurance in that regard, since many factors will affect our capital needs and their amount and timing. Such factors include: our growth and profitability; claims experience and the availability of reinsurance; and possible acquisition opportunities, market disruptions and other unforeseeable developments. If we have to raise additional capital, equity or debt financing may not be available at all or may be available only on unfavorable terms and may, in an equity financing, dilute our stockholders’ interests. In any case, such securities may confer rights, preferences and privileges that are senior to those of the common stock shares or may impose covenants that impair our operations.

 

Litigation and legal proceedings against our insurance company subsidiaries could have an adverse effect on our financial condition and results of operations.

 

We are subject to routine legal proceedings in the normal course of operating our business, including litigation regarding claims, and we expect to continue to be subject to legal proceedings in the ordinary course of our business. We are not currently involved in any legal proceeding that we believe could reasonably be expected to have a material adverse effect on our business, financial condition or results of operations. However, if such litigation were to develop, adverse judgments in one or more of such lawsuits could require us to pay significant damage amounts or to change aspects of our operations, which could have a material adverse effect on our business, financial condition and results of operations.

 

If we acquire other insurance businesses and are unable to integrate them successfully with our business, our financial condition and results of operations could be materially adversely affected.

 

We do not currently have plans to acquire any specific insurance business. However, we believe we will be presented from time to time with acquisition opportunities which would allow us to grow our business while achieving our profitability goals. Therefore, if we are presented with an appropriate opportunity, we may pursue acquisition of one or more specialty insurance businesses or books of business. Some of these acquisitions could be material in size and scope. If a potential acquisition opportunity is identified, there can be no assurance that we will consummate such acquisition. If any such acquisition does occur it may not be successful in enhancing our business, may not be accretive to earnings or book value or may not generate an underwriting profit. In addition, to the extent that we do acquire new businesses, such acquisitions could pose a number of special risks, including the diversion of management’s attention, the unsuccessful integration of the acquired operations and personnel, adverse short-term effects on reported operating results, impairment of acquired intangible assets and the loss of key employees.

 

We may, in the future, issue additional common stock in connection with one or more acquisitions, which may dilute our stockholders. Alternatively, we may issue debt, which could limit our future financial flexibility. Additionally, with respect to future acquisitions, our stockholders may not have an opportunity to review the financial statements of the entity being acquired or to vote on such acquisitions.

 

Our capital adequacy requirements could negatively affect our return on equity for a long time. In addition, if we are unable to grow into our capital base as quickly as we anticipate, our return on equity could be negatively affected.

 

We need to satisfy certain capital requirements in order to maintain our A.M. Best ratings. We are also subject to capital adequacy requirements imposed by insurance regulators. These requirements may lead us to maintain a higher level of capital in our insurance company subsidiaries than we otherwise would, which could hold down our return on equity. In addition, while we believe that the amount of capital we currently hold is capable of supporting a significantly higher volume of net premiums than we currently write, our return on equity could be negatively affected if we are unable to grow into our capital base as quickly as we anticipate. Either circumstance could persist for a relatively long period, meaning that our return on equity would be decreased for a number of years into the future.

 

Our insurance company subsidiaries are subject to assessments in the states in which they are licensed, and these assessments could significantly affect our financial condition.

 

We are obligated to pay guaranty fund assessments in the various states in which DNA is licensed and in the State of Arkansas, where Darwin Select is licensed. Generally, our assessment depends upon our proportionate share of all premiums written by licensed insurers in the state on a particular line of insurance. Such assessments assist in the payment of claims and related costs of insolvent insurance companies in those states. Through year-end 2006, guaranty fund assessments have not represented a material expense, but as we grow, our share of premiums and our exposure to assessments may increase. The number and magnitude of future insurance company failures cannot be predicted, but resulting assessments could significantly affect our business, financial condition and results of operations.

 

Risks Related to Our Industry

 

Our business is cyclical in nature, which may affect our financial performance.

 

The insurance business historically has been a cyclical industry, with periods of intense price competition and broad coverage terms (referred to as “soft market” conditions), and other periods when insuring capacity is tight, resulting in high premium levels and restrictive coverage terms (“hard markets”). An increase in the supply of risk-bearing capacity, due either to new entrants’ bringing in new capital or to additional capital being contributed by existing insurers, causes less favorable pricing and policy terms and may decrease demand for our underwriting services. Additionally, periodic changes in loss frequency and severity within a particular insurance line will impact the cycle of the insurance business significantly.

 

While we believe our specialty insurance business may experience less volatility through market cycles than standard lines, our returns will generally be impacted by the cyclical nature of the industry. Though each of our lines and classes is cyclical, each is subject to its own insurance cycle. For example, we believe that the D&O market, particularly for public companies, was at its hardest sometime in 2002, that it softened significantly thereafter, and that it has now stabilized at a relatively soft level. Market conditions for E&O and Medical Malpractice Liability vary by class and geography. While difficult to generalize, we believe markets for the E&O and Medical Malpractice Liability lines are becoming more competitive (i.e. moving toward a softer market). We endeavor to target market segments where conditions are favorable to insurers, but downturns in market conditions could affect our ability to write insurance at rates that we consider appropriate relative to the risk assumed. If we were unable to write our specialty lines of insurance at appropriate rates, we would have to reduce the level of our underwriting commitments, which would reduce our revenues.

 

Some of our competitors have greater financial resources than we have, or have more market recognition than we do, and, we may not be successful in competing effectively with them.

 

We compete with a large number of other companies in our selected lines of business. See “Business — Competition.” Many of our competitors, such as American International Group, Inc., The Chubb Corporation, The St. Paul Travelers Companies, Inc., are more established and have significantly greater financial resources than we have. Some competitors also have significantly longer histories in the market and greater market recognition than we do. Larger carriers may have lower total expense ratios, allowing them to price their products more competitively than we can. In addition, some of our competitors operate from tax-advantaged jurisdictions and have the ability to offer lower rates due to such tax advantages.

 

If we are unable to compete effectively in the markets in which we operate or to expand our operations into new markets, our underwriting revenues and net income may decline. Competition is based on many factors, including: perceived market strength of the insurer; pricing and other terms and conditions; services provided; speed of claims payment; reputation and experience of the key management and underwriting staff; and ratings assigned by independent rating organizations such as A.M. Best.

 

A number of potential new developments could further increase competition in our industry. These developments could include, for example, an increase in capital-raising by companies in our lines of business, which could result in new entrants to our markets and an excess of capital in the industry. Competition from new entrants or increased competition from our existing competitors could affect our ability to price our products at rates that are likely to generate underwriting profits.

 

We are subject to extensive regulation, which may adversely affect our ability to achieve our business objectives. In addition, if we fail to comply with regulations, we may be subject to penalties, including fines and suspensions, which may adversely affect our results of operations.

 

Our insurance company subsidiaries are subject to extensive regulation, primarily by DNA’s state of domicile Delaware, and Darwin Select’s state of domicile Arkansas. To a lesser extent, our insurance company subsidiaries are also subject to regulation in the other states where they operate. Significant changes the laws and regulations of these States could further limit our discretion or make it more expensive to conduct our business. State insurance departments also conduct periodic examinations of the affairs of insurance companies and require the filing of annual and other reports relating to financial condition, holding company issues and other matters. These regulatory requirements may impose timing and expense constraints that could adversely affect our ability to achieve some or all of our business objectives.

 

In addition, regulatory authorities have broad discretion to deny or revoke licenses for various reasons, including the violation of regulations. In some instances, where there is uncertainty as to applicability, we follow practices based on our interpretations of regulations or practices that we believe to be generally followed by the industry. These practices may turn out to be different from the interpretations of regulatory authorities. If we do not have the requisite licenses and approvals or do not comply with applicable regulatory requirements, insurance regulatory authorities could preclude or temporarily suspend us from carrying on some or all of our activities or otherwise penalize us. This could adversely affect our ability to operate our business. Further, changes in the level of

regulation of the insurance industry or changes in laws or regulations themselves or interpretations by regulatory authorities could interfere with our operations and require us to bear additional costs of compliance, which could adversely affect our ability to operate our business.

 

The National Association of Insurance Commissioners, or “NAIC,” is a voluntary organization of state insurance officials that promulgates model laws regulating the insurance industry, values securities owned by insurers, develops and modifies insurer financial reporting statements and insurer performance criteria and performs other services with respect to the insurance industry. The NAIC has adopted a system to test the adequacy of statutory capital, known as “risk-based capital.” This system establishes the minimum amount of risk-based capital necessary for a company to support its overall business operations and to assure that it has an acceptably low likelihood of becoming financially impaired. It identifies property and casualty insurers that may be inadequately capitalized by taking into account various risk factors, including asset risk, credit risk, underwriting risk and interest rate risk. As the ratio of an insurer’s total adjusted capital and surplus to its risk-based capital falls below specified thresholds, it will become subject to varying degrees of regulatory intervention, such as supervision and rehabilitation, and culminating with mandatory control of the operations of the insurer by the domiciliary insurance department at the so-called mandatory control level. Failure to maintain our risk-based capital at the NAIC’s required levels could adversely affect the ability of our subsidiaries to maintain regulatory authority to conduct our business.

 

The NAIC Insurance Regulatory Information System, or IRIS, was developed to help state regulators identify companies that may require special attention. IRIS identifies thirteen key financial ratios and specifies “usual ranges” for each ratio. Insurers typically submit financial information about themselves to the NAIC annually, which in turn analyzes the data using the prescribed ratios. These ratios assist state insurance departments in executing their statutory mandates to oversee the financial condition of insurance companies operating in their respective states. Failure to maintain our risk-based capital at the NAIC’s required levels could adversely affect the ability of our subsidiaries to maintain regulatory authority to conduct our business.

 

Federal legislation may also negatively affect the business opportunities we perceive are available to us in the market. The Terrorism Risk Insurance Act of 2002 (“TRIA”) was enacted in response to the tightening of supply in some insurance markets resulting from, among other things, the terrorist attacks of September 11, 2001. TRIA generally requires primary commercial property and casualty insurers to make insurance coverage for certified acts of terrorism available to their policyholders at the same limits and terms as are available for other coverages. TRIA provides for federal reinsurance of terrorism-related loss, but as currently structured, such reinsurance would be unlikely to benefit our subsidiaries. The federal reinsurance program under TRIA and its Extension Act is scheduled to expire at the end of 2007. In addition, with regard to those of our lines of business not subject to TRIA (E&O and Medical Malpractice Liability), we may still be required to offer terrorism coverage as a result of state regulation or market demand. The federal reinsurance program would not apply to these lines of business.

 

The effects of emerging claim and coverage issues on our business are uncertain and could materially adversely affect our business, financial condition and results of operations.

 

As industry practices and legal, judicial, social and other environmental conditions change, unexpected issues related to claims and coverage may emerge. These issues may adversely affect our business by either extending coverage beyond our underwriting intent or by increasing the number or size of claims. In some instances, these changes may not become apparent until some time after we have issued the insurance affected by the changes. As a result, the full extent of our liability may not be known for years after a contract is issued. A recent example of an emerging claims and coverage trend is the larger amount of settlements and jury awards against professionals and corporate directors and officers covered by professional liability and directors and officers liability insurance. The effects of claims and coverage trends are extremely hard to quantify or predict and could harm our results of operations.

 

The passage of tort reform and the subsequent review of such laws by the courts could have a material impact on our operations.

 

“Tort reform” generally refers to laws restricting a plaintiff’s ability to recover damages by imposing one or more limitations, including: eliminating certain claims that can be heard in a court, limiting the amounts or types of damages; reducing statutes of limitation; or limiting venue or court selection. Certain states in which we do business have enacted, or are considering, tort reform legislation. However, many reform laws are being challenged in state courts, and there is no assurance that they will ultimately be upheld. While the effects of tort reform would appear beneficial to our business generally, there can be no assurance that such reforms will be effective. If tort reforms are effective, providing professional and other liability insurance may become more attractive, thereby causing an increase in competition for our business. In addition, there is no assurance that the benefits of tort reform will not be accompanied by regulatory actions that may be detrimental to our business such as expanded coverage requirements and premium rate limitations or rollback of premiums charged.

 

Risks Related to Our Corporate Structure

 

We are a majority-owned subsidiary of Alleghany and the ownership of our shares is highly concentrated. A future sale of all or a substantial portion of Alleghany’s shares of our common stock, or the possibility of such future sales, could adversely affect the market price of our common stock.

 

Alleghany and our management stockholders beneficially own approximately 65% of our outstanding common stock. For the greater part of 2006, substantially all of these shares were subject to lock-up agreements that prohibited the owners from disposing of their shares, generally for a period of 180 days after the date of our initial public offering effective May 18, 2006. Additionally, Alleghany was granted the right to require us to register some or all of the Alleghany shares for sale under the U.S. securities laws, which rights remain in effect. The exercise of these registration rights, or similar registration rights for securities we may issue in the future, could result in additional sales of our common stock in the market, which may have an adverse effect on our stock price. We cannot predict what effect, if any, future sales of shares by these persons, their affiliates or our other stockholders, or the availability of shares for future sale, may have on the prevailing market price of our common stock. Sales of substantial amounts of our common stock in the public market by these persons, their affiliates or our other stockholders, or the possibility that such sales could occur, could adversely affect prevailing market prices for our common stock. If such sales reduce the market price of our common stock, our ability to raise additional capital in the equity markets may be adversely affected.

 

Alleghany has significant control over us and may not always exercise its control in a way that benefits the other securityholders. Also, conflicts of interest that may arise between us and Alleghany could be resolved in a manner unfavorable to us.

 

As our majority stockholder, Alleghany has the ability to exert significant influence over our policies and affairs, including the power to affect the election of our directors, appointment of our management and the approval of any action requiring a stockholder vote, such as amendments to our certificate of incorporation, transactions with affiliates, mergers or sales of substantially all of our assets. Because Alleghany’s interests may differ from the interests of our other security holders, actions Alleghany takes with respect to us, as our controlling stockholder, may not be favorable to such other investors.

 

Additionally, questions relating to conflicts of interest may arise between us and Alleghany from time to time. One of our directors is an officer and director of Alleghany, and two other of our directors are also officers of Alleghany. Ownership interests of our directors in Alleghany shares, or service as a director or officer of both our company and Alleghany, could give rise to potential conflicts of interest when a director or officer is faced with a decision that could have different implications for the two companies. These potential conflicts could arise, for example, over matters such as the desirability of an acquisition opportunity, employee retention or recruiting, or our dividend policy.

 

The corporate opportunity policy set forth in our certificate of incorporation addresses potential conflicts of interest between Darwin, on the one hand, and Alleghany and its officers and directors who are directors of the

Company, on the other hand. It provides that, subject to any written agreement to the contrary, Alleghany has no legal duty to refrain from engaging in the same or similar business activities or lines of business as we do, or from doing business with any of our clients, customers or vendors. The policy also provides that if Alleghany acquires knowledge of a potential transaction or matter which may be a corporate opportunity for both us and Alleghany, or a person who is an affiliate of Alleghany, then unless the corporate opportunity was expressly offered to Alleghany in its capacity as a stockholder of Darwin, the corporate opportunity will be deemed to be renounced by us such that we waive any claim that the corporate opportunity should have been presented to us, and Alleghany will have no duty to communicate or present that corporate opportunity to us. The policy further provides that if one of our directors or officers who is also a director, officer, employee or agent of Alleghany learns of a potential transaction or matter that may be a corporate opportunity for both us and Alleghany, or a person who is an affiliate of Alleghany, then unless the corporate opportunity is expressly offered to such person solely in his or her capacity as our director or officer, the corporate opportunity will be deemed to be renounced by us such that we waive any claim that the corporate opportunity should have been presented to us, and such director or officer will have no duty to communicate or present that corporate opportunity to us.

 

If a conflict of interest arises between us and Alleghany, the corporate opportunity policy set forth in our certificate of incorporation may result in a conflict resolution that would be unfavorable to us.

 

Because Alleghany, through certain of its insurance company subsidiaries, engages in some of the same lines of specialty insurance that we write, our ability to successfully operate and expand our business may be adversely affected.

 

Alleghany has no obligation to refrain from engaging in the same or similar business activities or lines of business as us, or doing business with, or in competition with, any of our clients, customers or vendors. Some of Alleghany’s insurance company subsidiaries compete with us in some of the same lines of specialty insurance that we write. Because of Alleghany’s significant financial resources, Alleghany could have a significant competitive advantage over us should it decide to expand its business in any of the specialty insurance lines that we write.

 

We are a “controlled company” within the meaning of the NYSE Arca exchange rules and qualify for exemptions from certain corporate governance requirements. As a result, our stockholders are not afforded all of the same protections as stockholders of companies that are subject to all of the corporate governance requirements of the exchange.

 

A company of which more than 50% of the voting power is held by an individual, a group or another company is a “controlled company” and may elect not to comply with certain corporate governance requirements of the NYSE Arca exchange. As a “controlled company” (because Alleghany holds more than 50% of the voting power of DPUI), we rely upon the “controlled company” exemptions of the NYSE Arca exchange corporate governance standards. These exemptions free us from the obligation to comply with certain NYSE Arca exchange corporate governance requirements, including the requirements that a majority of our board of directors consist of independent directors; that we have a nominating/corporate governance committee consisting entirely of independent directors with a written charter addressing the committee’s purpose and responsibilities; and that we have a compensation committee consisting entirely of independent directors with a written charter addressing the committee’s purpose and responsibilities. Accordingly, our stockholders do not have the same protections afforded to stockholders of companies that are subject to all of the corporate governance requirements of the NYSE Arca exchange.

 

We have not received any written comments from the SEC staff regarding our periodic or current reports filed during 2006.

 

We are subject to routine legal proceedings in the normal course of operating our business, including litigation regarding claims. We are not involved in any legal proceeding which we believe could reasonably be expected to

have a material adverse effect on our business, results of operations or financial condition. We anticipate that, like other insurers, we will continue to be subject to legal proceedings in the ordinary course of our business.

 

There were no matters submitted to a vote of security holders during the fourth quarter of 2006.

 

Shares and Stockholders

 

Our common stock is traded on the NYSE Arca under the ticker symbol “DR”. We have two classes of authorized capital stock: 50,000,000 shares of common stock, par value $0.01 per share (the “Common Stock”), and 10,000,000 shares of preferred stock, par value $0.10 per share (the “Preferred Stock”).

 

As of February 23, 2007, there were 17,048,022 shares of Common Stock issued and outstanding, and we estimate that there are approximately 2,800 beneficial owners of our shares. As of that date, there were no shares of Preferred Stock issued and outstanding. We did not issue any shares of Common Stock that were not registered under the Securities Act on 1933, and no repurchases of the Company’s shares of Common Stock were made during the year ended December 31, 2006.

 

Price Range of Common Stock

 

The high and low sales prices for the period from our initial public offering on May 19, 2006 to June 30, 2006, and for the quarters ended September 30, 2006 and December 31, 2006, and the closing prices as of each period’s end, were as follows:

 

Performance Graph

 

The following graph compares, for the period from our initial public offering price of $16.00 per share on May 19, 2006 to December 31, 2006, the cumulative total stockholder return on each of Darwin’s Common Stock, the Standard & Poor’s 500 Stock Index (the “S&P 500”) and the Standard & Poor’s Property and Casualty Insurance Index (the “P&C Index”). The graph shows the value at the end of such period of $100 invested as of May 19, 2006 in the Common Stock, the S&P 500 and the P&C Index.

 

COMPARISON OF CUMULATIVE TOTAL RETURN

 

 

INDEXED RETURNS

 

 

The foregoing graph is based on the assumptions that any cash dividends are reinvested on the ex-dividend date in respect of such dividend.

Dividend Policy

 

In connection with the initial public offering our Board approved a 33 for two stock split on our Common Stock, which was effective in May 2006. There are no current plans for any additional stock split or stock dividend.

 

We have not paid or declared a cash dividend on our Common Stock. While there is presently no intention to pay cash dividends on the common stock, future declarations, if any, are at the discretion of our Board of Directors, and the amounts of such dividends will be dependent on, among other things, Company earnings, our financial condition and business needs, any restrictive covenant under a credit facility, the capital and surplus requirements of our subsidiaries and applicable government regulations.

 

Initial Public Offering and Repurchase of Preferred Stock

 

On March 10, 2006, we filed a registration statement on Form S-1 with the SEC for the purpose of making an initial public offering of Common Stock. The registration statement was declared effective on May 18, 2006 for the issuance of 5,217,391 shares of common stock at an initial offering price of $16.00 per share. Subsequently, the underwriters of the initial public offering exercised their over-allotment option in which an additional 782,609 shares of Common Stock were issued at the $16.00 initial public offering price. Gross proceeds from the sale of the 6,000,000 shares of Common Stock were $96.0 million. Total costs associated with the initial public offering included $6.7 million of underwriting costs and $3.0 million of offering expenses. Net proceeds from the offering, including the over-allotment option, after deducting underwriting costs and offering expenses were $86.3 million.

 

The net proceeds from the offering were used to redeem all of the then-outstanding shares of Series A Preferred Stock at the aggregate liquidation preference of $2.3 million and all then-outstanding shares of the Series C Convertible Preferred Stock with an aggregate liquidation preference of $2.5 million. The remaining proceeds of $81.5 million were used to redeem a portion of the outstanding Series B Convertible Preferred Stock at a redemption price per share, on an as-converted basis, equal to the public offering price less underwriting costs or 5,478,904 shares of common stock on an as-converted basis. The remaining outstanding shares of the Series B Convertible Preferred Stock were converted into 9,371,096 shares of Common Stock. As a result of the foregoing, the net proceeds of the offering were used to reduce Alleghany’s ownership in the Company to approximately 55%.

 

Equity Compensation Plan Information

 

Information concerning the Company’s equity compensation plans is incorporated herein by reference to the Proxy Statement.

 

The selected historical consolidated financial data set forth below for the years ended December 31, 2006, 2005 and 2004 been derived from the historical consolidated financial statements, which have been audited by KPMG LLP, Independent Registered Public Accounting firm, and should be read in conjunction with the audited consolidated financial statements and accompanying notes, and within “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

The selected historical consolidated financial statements for the years ended December 31, 2006, 2005, 2004 and 2003 give retroactive effect to Darwin’s reorganization. See “Management’s Discussion and Analysis of Financial Condition and Results of Operation — Our History” and Note 1(b) to the audited consolidated financial statements.