EGI Financial 2008 Annual Report
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EGI Financial 2008 Annual Report

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2008 annual report for EGI Financial Holdings Inc. (TSX: EFH), a company that operates in the property and casualty insurance industry in Canada and the U.S.

2008 annual report for EGI Financial Holdings Inc. (TSX: EFH), a company that operates in the property and casualty insurance industry in Canada and the U.S.

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    EGI Financial 2008 Annual Report EGI Financial 2008 Annual Report Document Transcript

    • 1with brokers. Slow & steady wins the race. st “Echelon General Insurance Company backs up their commitment to top quality service by going above and beyond my expectations as a brokerage owner. Echelon’s top notch service philosophy allows my brokers to provide the level of service that fosters an environment of increased competitiveness and ultimately results in maximum client retention. In comparison to the other providers that we use both The tortoise and the hare – it’s a story we all know. And it’s a philosophy we embrace at EGI: slow and steady wins the race. We are in standard and non standard, Echelon continues to outperform them resulting focused on one overriding objective: delivering consistent profitability. We have a disciplined operating model designed to support you now being our first choice when we place business. The management and staff that objective. This is evident in all areas of business, including our pricing, our service and our claims handling. We know our niche at Echelon are to be commended for a job well done!” markets exceptionally well, and we have proved we can consistently generate superior returns on equity in these markets by sticking to our disciplined approach. Put simply, we will not chase new premiums at the expense of profit. And we believe this approach is the right one to build market share and increase value for shareholders over the long term. ~ Mario Galluzzo, President Causeway General Insurance Brokers EGI strives to provide optimum service to its policyholders and producers. We have created and implemented written service standards in all departments interfacing with policyholders or producers. Staff members in these departments are thoroughly trained in the delivery of quality service to achieve these standards. This service commitment ensures our policyholders and producers continue to be served by knowledgeable employees in a responsive manner. And it has paid off: we are consistently recognized by brokers as having superior service. We strongly believe service is a competitive advantage, and as we expand the company we will ensure these standards are consistently applied. This will help us achieve the best possible reputation among our peers and realize our vision to be the pre-eminent writer of specialized, niche products in the Canadian market.
    • 1 our core expertise 2009 growth strategies personal lines division The Personal Lines division continues �� Expand non-standard auto writings in to focus on the underwriting of Canadian jurisdictions where EGI earlier st non-standard automobile insurance withdrew or restricted its premium writing 63% and motorcycle business, but has expanded into other specialty products in underserved markets. �� (e.g. Prince Edward Island and Nova Scotia). Continue to monitor the impact of government reforms in Ontario aimed at reducing fraudulent claims, which may of premiums allow EGI to increase its business activities written in 2008 in additional urban markets. with brokers. �� �� Continue to build the Company’s profitable personal and commercial auto lines of business in the province of Quebec. Use EGI’s non-standard underwriting expertise “Echelon General Insurance Company backs add new specialty personal linesto top quality to up their commitment insurance products such as coverage for motorcycles service by going above and beyond my expectations as a brokerage owner. Echelon’s in Alberta, snowmobiles, all terrain vehicles, antique autos and recreational vehicles. top notch service philosophy allows my brokers to provide the level of service that �� Continue to expand our distribution networks fosters an environment of increased competitiveness and ultimately results in both by number of producers and share of maximum client retention. In comparison theirthe other providers that we use both to business. standard and its Niche Products division, continues to outperform them resulting in niche products division Through non standard, Echelon �� Continue to broaden market awareness you now being ourunderwrites specialized we place business. The division through and staff EGI designs and first choice when of EGI’s Niche Products management at Echelon are to be commended for a job proactive outreach to qualified brokers and non-auto insurance programs, such as well done!” 29% higher premium property, primary and and health insurance for a variety of businesses and consumers and extended other insurance product distributors. excess liability, legal expense and accident �� Ensure that the division grows organically by continuing to provide unique expertise andMario service in response to all ~ superior Galluzzo, President of premiums warranty coverage for homes and business inquiries. General Insurance written in 2008 consumer products. Causeway Brokers �� Seek opportunities to grow through select acquisitions of books of business, distributors, administrators or an insurance company. international division EGI formed the International division �� Exit the third-party reinsurance market. in 2008 to expand into the United States. �� Launch a new and/or acquire a suitable existing Currently, this division is focused on 8% non-standard automobile insurance company. personal lines business, predominantly non-standard automobile insurance. �� Focus on select states and markets. �� New company will serve as an entry point for of premiums EGI’s personal lines product offerings into the written in 2008 U.S. market. EGI strives to provide optimum service to its policyholders and producers. We have created and implemented written service standards in all departments interfacing with policyholders or producers. Staff members in these departments are thoroughly trained in the delivery of quality service to achieve these standards. This service commitment ensures our policyholders and producers continue to be served by knowledgeable employees in a responsive manner. And it has paid off: we are consistently recognized by brokers as having superior service. We strongly believe service is a competitive advantage, and as we expand the company we will ensure these standards are consistently applied. This will help us achieve the best possible reputation among our peers and realize our vision to be the pre-eminent writer of specialized, niche products in the Canadian market.
    • 1 EGI’swith brokers. st prudent approach brings steady, stable growth even in difficult markets. “Echelon General Insurance Company backs up their commitment to top quality service by going above and beyond my expectations as a brokerage owner. Echelon’s top notch service philosophy allows my brokers to provide the level of service that fosters an environment of increased competitiveness and ultimately results in maximum client retention. In comparison to the other providers that we use both standard and non standard, Echelon continues to outperform them resulting in We believe steady, stable growth works. We don’tour firsttaking imprudent risks, and this business. Thein the past – especially staff you now being believe in choice when we place has served us well management and in tough markets. So while we diversify ourare to be commended and by product line,done!” a very measured and pragmatic at Echelon business, both geographically for a job well we take approach. We start with niche insurance lines we know inside and out. We do thorough research and we enter a market slowly. When we see clear evidence that the business can produce sustainable profits, we invest further. And if something new doesn’t meet our expectations, we are quick to change course. In recent years, we have broadened well ~ Mario core product line, successfully beyond our Galluzzo, President expanding our Niche Products division. While our initial approach in the U.S. did not meet our expectations, we see significant Brokers Causeway General Insurance opportunity for our personal lines in this large and growing market. us$36.9B u.s. market for non-standard auto insurance, $800M with the five largest states being canadian market for non-standard california, texas, auto insurance florida, new york and georgia EGI strives to provide optimum service to its policyholders and producers. We have created and implemented $4B written service standards in all departments interfacing with policyholders or producers. Staff members in these departments are thoroughly trained in the delivery of quality service to achieve these standards. This service canadian market for niche products commitment ensures our policyholders and producers continue to be served by knowledgeable employees in a responsive manner. And it has paid off: we are consistently recognized by brokers as having superior service. We strongly believe service is a competitive advantage, and as we expand the company we will ensure these standards are consistently applied. This will help us achieve the best possible reputation among our peers and realize our vision to be the pre-eminent writer of specialized, niche products in the Canadian market.
    • 1 st st with brokers. with brokers. “Echelon General Insurance Company backs up their commitment to top quality service by going above and beyond my expectations as a brokerage owner. Echelon’s “Echelonservice philosophy allows my brokers to up theirthe level of service top quality top notch General Insurance Company backs provide commitment to that fosters an environment ofand beyond my expectations as a brokerage owner. Echelon’s service by going above increased competitiveness and ultimately results in maximum client retention. In comparison to the other providers the level of both that top notch service philosophy allows my brokers to provide that we use service standardan environment of increased competitiveness and ultimately results in fosters and non standard, Echelon continues to outperform them resulting in you now being our first choice when we place business. The management and staff both maximum client retention. In comparison to the other providers that we use at Echelon and to be standard, Echelon continues to outperform them resulting in standard are non commended for a job well done!” you now being our first choice when we place business. The management and staff at Echelon are to be commended for a ~ Mario Galluzzo, President job well done!” Causeway General Insurance Brokers ~ Mario Galluzzo, President Causeway General Insurance Brokers EGI strives to provide optimum service to its policyholders and producers. We have created and implemented written service standards in all departments interfacing with policyholders or producers. Staff members in these departments are thoroughly trained in the delivery of quality service to achieve these standards. This service commitment ensures our policyholders and producers continue to be served by knowledgeable employees in a EGI strives to provide optimum service to its policyholders and producers. Wehavingcreated and implemented responsive manner. And it has paid off: we are consistently recognized by brokers as have superior service. written service standards in allcompetitive advantage, andwith policyholders or producers. Staff members in these We strongly believe service is a departments interfacing as we expand the company we will ensure these departments are thoroughly trained in the delivery of quality service to reputation among our peers and service standards are consistently applied. This will help us achieve the best possible achieve these standards. This commitment ensures our pre-eminent writer of specialized, niche products in theby knowledgeable employees in a realize our vision to be the policyholders and producers continue to be served Canadian market. responsive manner. And it has paid off: we are consistently recognized by brokers as having superior service. We strongly believe service is a competitive advantage, and as we expand the company we will ensure these standards are consistently applied. This will help us achieve the best possible reputation among our peers and realize our vision to be the pre-eminent writer of specialized, niche products in the Canadian market.
    • LETTER TO SHAREHOLDERS In one of the most volatile and difficult years ever in global financial markets, our disciplined underwriting philosophy and conservative investment strategy enabled us to generate profits and year-over-year growth in 2008. This is in sharp contrast to many other North American insurers, and clearly highlights the value of our approach: slow and steady wins the race. We are focused on growth, but not at the expense of profitability. In 2008, direct written and assumed premiums increased 8.1% over the prior year to $170.7 million. Premium growth was achieved in both of the Canadian divisions in 2008. Despite difficult industry conditions, direct written premiums from Personal Lines increased 10.4% to $107.5 million, with non-standard auto growing 6.3% and the motorcycle line increasing by 20.1%. The Niche Products division generated written premiums of $49.3 million in 2008, compared to $48.1 million in 2007. These results were achieved despite a $7.6 million decrease in travel health premiums written as we focused on re-engineering this program during the year. These changes led to substantial year-over-year improvements in the latest travel season, and we continue to believe this program offers significant growth potential. The other Niche lines of business recorded significant growth in 2008 compared to 2007 and we continue to view this division as a primary source of growth for EGI. The combined ratio for the year ended December 31, 2008, was 99.9% compared with 91.4% for the previous year. The loss ratio in 2008 was 67.3% and the expense ratio was 32.6%, compared with 59.5% and 31.9%, respectively, in the same period last year. Underwriting income for 2008 decreased to $0.2 million, compared to $10.2 million for the previous year. Underwriting income from the Personal Lines division was $7.1 million, down from $10.6 million in 2007. The underwriting loss from the Niche Products division was $3.2 million, compared with a gain of $0.3 million in 2007, mainly reflecting the higher loss ratio caused by adverse claims experience in the travel health line of business from the 2007/2008 travel season. This resulted in an increase in the combined ratio to 106.9% in 2008, compared to 98.8% in 2007. Underwriting income for 2008 also includes an underwriting loss of $2.4 million from the International division. With our conservative investment strategy, EGI minimized the potential negative effect of the steep downturn in the financial markets that is hampering many North American P&C companies. Investment income from our portfolio was $10.0 million in 2008, compared with $12.9 million in 2007. The decline reflects $4.7 million of investment impairments recorded at year end, as a result of the significant decline in Canadian equity markets and evidence of other-than-temporary fair value deficiencies in certain investments. While profitability was affected by the increased loss ratio and investment losses in 2008, the Company generated net income of $6.0 million, compared to $15.1 million in 2007. Fully diluted net income per share was $0.53 in 2008, compared to $1.45 last year. As we look ahead, we anticipate the Company will produce improving financial results in 2009 while focusing on profitable diversification and expansion initiatives. We remain intensely focused on diversifying our business beyond the Ontario non-standard automobile market through three main strategies: profitably growing our Niche Products division; pursuing opportunities in new geographic markets and new vehicle types such as motorcycles, antique autos, other recreational vehicles; and expanding our underwriting business in the United States. 5
    • Letter to Shareholders 2008 While underwriting results in the Canadian P&C industry trend downward toward historic norms, EGI’s new business initiatives continue to provide shareholders with significant growth opportunities. We strongly believe large insurers will further retrench back into their core, standard risk markets as we move deeper into 2009, as evidenced by an overall tightening bias in underwriting rules among the standard line insurers. With Echelon now very clearly seen by brokers as the gold standard within the Canadian non-standard auto marketplace, we are favourably positioned to increase our market share without sacrificing our strict underwriting or pricing discipline. Our Niche Products division continues to demonstrate its outstanding growth potential and we continue to build on it with a number of strategies, including ongoing development of new programs, diversification by line and continued expansion of our distribution base. Our International division has stepped up efforts in reviewing and assessing opportunities in the United States aimed at establishing a more meaningful platform for future growth. With an experienced senior management team already in place, we have reduced the risk associated with acquiring and effectively integrating future acquisition targets. As the cornerstone of our U.S. strategy to transition to an insurer, we are establishing Echelon Insurance Company of America. Upon receiving regulatory approval, this new insurance company will ultimately service selected states in the large southeast non-standard auto market. This platform will enable EGI Financial to enter the market in a highly controlled way, with approval and start-up expected by the second quarter of 2009. In conjunction with planned organic growth from this platform, we are actively reviewing potential acquisitions to accelerate our entry into this market. With a strong balance sheet, EGI remains favourably positioned relative to its competitors, which provides us with the ability to exploit growth opportunities as they arise. Our experienced senior management team has proven ability to surface value in challenging markets, and I am more confident than ever that the elements are in place to enable EGI to profitably evolve into a much larger organization. I would like to thank both our Board of Directors for their continued counsel and oversight and our dedicated employees for their hard work in a challenging year. Their continued commitment and dedication will contribute to our growth and success in 2009 and beyond. In closing, I would also like to thank you, our shareholders, for your continued support. Sincerely, Douglas E. McIntyre, Chief Executive Officer EGI Financial Holdings Annual Report 2008
    • MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS For the period ending December 31, 2008 References to “EGI” in this Management’s Discussion and Analysis of Financial Condition and Results of Operations refer to EGI Financial Holdings Inc. on a consolidated basis, both now and in its predecessor forms. The following discussion should be read in conjunction with EGI’s audited consolidated financial statements and the related notes. The following commentary is current as of March 13, 2009. Additional information relating to EGI is available on SEDAR at www.sedar.com. Certain totals, subtotals and percentages may not reconcile due to rounding. EGI uses both Canadian generally accepted accounting principles (GAAP) and certain non-GAAP measures to assess performance. Securities regulators require that companies caution readers about non-GAAP measures that do not have a standardized meaning under GAAP and are unlikely to be comparable to similar measures used by other companies. EGI analyzes performance based on operating income and underwriting ratios such as combined, expense and loss ratios. The following discussion contains forward-looking information that involves risk and uncertainties based on current expectations. This information includes, but is not limited to, statements about the operations, business, financial condition, priorities, targets, ongoing objectives, strategies and outlook for EGI in 2009 and subsequent periods. This information is based upon certain material factors or assumptions that were applied in drawing a conclusion or making a projection as reflected in the forward-looking information. By its nature, this information is subject to inherent risks and uncertainties that may be general or specific. A variety of material factors, many of which are beyond EGI’s control, affect the operations, performance and results of EGI and its business and could cause actual results to differ materially from the expectations expressed in any of this forward-looking information (see “Risk Factors”). EGI’s actual results could differ materially from those anticipated in this forward-looking information as a result of various factors, including those discussed in this Management’s Discussion and Analysis. Forward- looking information is provided for the purpose of providing information about management’s current expectations and plans relating to the future. Readers are cautioned that such information may not be appropriate for other purposes. Additional information about the risks and uncertainties about EGI’s business is provided in its disclosure materials, including its annual information form, filed with the securities regulatory authorities in Canada, available at www.sedar.com. EGI does not undertake to update any forward-looking information. Underwriting income and interest expense for 2007 in the following table has been restated to reflect the re- allocation of interest expense, related to corporate indebtedness, as a separate line item after investment income in 2008. The restatement was made for comparative purposes only and does not affect net income after taxes. 7
    • Management’s Discussion and Analysis 2008 Financial Highlights Year ended December 31 Pro Forma ($ THOUSANDS EXCEPT PER SHARE AMOUNTS) 2008 2007 2006 2005 2004 2004 Revenue Direct written and assumed premiums Personal Lines/Auto $121,410 $109,870 $ 97,932 $105,567 $109,251 $54,626 Niche Products 49,320 48,065 19,902 11,439 3,765 2,614 Total direct written premiums 170,730 157,935 117,834 117,006 113,016 57,240 Net written premiums 158,107 146,511 106,047 91,783 69,230 35,217 Net earned premiums 157,255 119,606 103,942 76,344 65,890 33,615 Other revenue – – 1 227 298 298 Total underwriting revenue 157,255 119,606 103,943 76,571 66,188 33,913 Underwriting expenses Incurred claims 105,837 71,179 59,503 45,997 44,075 22,400 Acquisition costs 37,026 26,143 19,499 12,073 10,832 5,638 Operating expenses 14,229 12,043 10,431 9,083 7,762 4,506 Total underwriting expense 157,092 109, 365 89,433 67,153 62,669 32,544 Underwriting income (loss) 163 10,241 14,510 9,418 3,519 1,369 Investment income 10,009 12,954 11,033 7,527 6,591 3,419 Interest expense 1,216 259 – – – – Income before income taxes 8,956 22,936 25,543 16,945 10,110 4,788 Income tax expense (recovery) Current 3,453 7,839 9,832 7,505 2,310 1,155 Future (476) 32 (1,270) (1,768) (1,143) (1,085) 2,977 7,871 8,562 5,737 1,167 70 Income from continuing operations 5,979 15,065 16,981 11,208 8,943 4,718 Income from discontinued operations, net of income taxes – – – – 1,308 1,308 Extraordinary gain – – – 5,669 – – Net income $ 5,979 $ 15,065 $16,981 $ 16,877 $ 10,251 $ 6,026 Net income per share basic $ 0.57 $ 1.56 $ 1.76 $ 2.09 $ 1.29 $ 1.31 diluted $ 0.53 $ 1.45 $ 1.67 $ 1.96 $ 1.28 $ 1.30 Net operating income (1) $ 9,083 $ 12,957 $15,302 $ 10,440 $ 7,767 $ 4,130 Net operating income per share - diluted $ 0.80 $ 1.24 $ 1.50 $ 1.23 $ 0.97 $ 0.52 (1) Net operating income is defined as net income plus or minus after-tax realized losses or gains on sale of investments as shown below: Net income from continuing operations $5,979 $15,065 $16,981 $11,208 $8,943 $4,718 Add losses (deduct gains) from sales of investments 4,833 (3,350) (2,623) (1,221) (1,837) (919) Tax impact (1,729) 1,242 944 453 661 331 Net operating income $9,083 $12,957 $15,302 $10,440 $7,767 $4,130 EGI Financial Holdings Annual Report 2008
    • Management’s Discussion and Analysis 2008 As at December 31 ($ THOUSANDS) 2008 2007 2006 2005 2004 Balance Sheet Data Cash and short-term deposits $ 29,111 $ 22,785 $ 17,153 $ 15,899 $ 7,327 Investments 259,774 238,310 179,383 152,736 57,098 Total assets 402,780 370,084 288,439 260,731 110,737 Provision for unpaid claims 185,255 169,091 146,101 129,173 54,149 Unearned premiums 71,154 69,190 43,154 39,973 17,933 Bank indebtedness 19,550 19,550 – – 1,590 Total shareholders’ equity 118,604 101,671 86,041 72,585 25,309 The following table shows the Company’s selected financial ratios and return on equity (ROE) data. These ratios are defined in the “Glossary of Selected Insurance Terms”. Selected Financial Ratios (1) and ROE Data (%) 2008 2007 2006 2005 2004 Loss ratio 67.3 59.5 57.2 60.3 66.6 Expense ratio 32.6 31.9 28.8 27.7 30.2 Combined ratio 99.9 91.4 86.0 88.0 96.8 ROE 5.4 16.1 21.4 30.1 27.0 Adjusted ROE (2) 5.4 16.1 21.4 25.9 23.0 (1) The underwriting ratios (the loss and expense ratios and the combined ratio) are all non-GAAP measures which are common insurance industry measures of performance. (2) Excludes the after-tax effects resulting from acquisitions and divestitures including the corresponding adjustments to shareholders’ equity (see “Significant Transactions”). 2008 Financial Overview Net income after taxes for 2008 was $6.0 million, a decrease of $9.1 million, or 60%, compared to net income of $15.1 million in 2007. Underwriting income declined to $0.2 million in 2008 compared to $10.2 million for the full year 2007 and investment income (including realized gains (losses)) declined to $10.0 million from $12.9 million in 2007. The significant decline in underwriting income was primarily attributable to adverse loss experience related to the Emergency Travel Health (ETH) business for the 2007–2008 travel season. Investment income in 2008 included investment impairments of $4.7 million recorded as at December 31, 2008, primarily related to EGI’s common equity portfolio. Management has recorded these impairments as a result of the significant decline in Canadian equity markets and evidence of other-than-temporary fair value deficiencies in certain investments. Net operating income, defined as net income excluding after-tax realized losses/gains, including impairments on the sale of investments, was $9.1 million for the year ended December 31, 2008 compared to $13.0 million in 2007. The decrease of $3.9 million, or 29%, is much lower than the decline in net income primarily due to the investment impairments of $4.7 million recorded at year-end 2008. 9
    • Management’s Discussion and Analysis 2008 Overview of EGI EGI operates in the property and casualty (P&C) insurance industry in Canada and, commencing in 2007, in the United States, primarily focusing on non-standard automobile insurance and other niche and specialty general insurance products. Founded in 1997 as an insurance and reinsurance broker and marketer, EGI has since developed its business to focus on underwriting opportunities not served by many of the larger, standard insurers. EGI operates through two Strategic Business Units (SBUs) in Canada, the Personal Lines division and the Niche Products division. The Personal Lines division was created in 2006 to transition the Automobile division into a multi-product, multi-line SBU. Currently, the Personal Lines division continues to focus on the underwriting of non-standard automobile insurance and motorcycle business but has expanded into other non- standard products and specialty lines of business. Through its Niche Products division, EGI designs and underwrites specialized non-auto insurance programs, such as higher premium property, primary and excess liability, legal expense and accident and health insurance for a variety of businesses and consumers and extended warranty coverage for homes and consumer products. In addition to the two SBUs in Canada, EGI also formed the International division in 2008 to leverage its strategy to expand into the United States. Currently, this division is focused on personal lines business, predominantly non-standard automobile insurance. As an interim step to execute this strategy, EGI entered the U.S. non-standard auto insurance market under reinsurance agreements with three arms-length insurance companies. These companies provide property and casualty insurance to the non-standard private passenger automobile segment of the industry and operate in several states in the southeastern U.S. Being dissatisfied with the results of these arrangements, EGI terminated the reinsurance agreements. EGI now intends to pursue its U.S. expansion exclusively as an insurer in its own right, where the Company can exercise greater underwriting control. By pursuing its focused niche strategy, EGI’s objective is to produce an ROE superior to the Canadian P&C insurance industry average. A key factor for EGI’s ROE to outperform the industry is for its loss ratio to be below the industry average. EGI Financial Holdings Annual Report 2008
    • Management’s Discussion and Analysis 2008 The charts below illustrate EGI’s and the P&C insurance industry’s automobile loss ratios and return on equity. Loss Ratio (%) ROE (%) (2) 90.0% 82.7% E (Auto) GI P& C Industry 35.0% 80.0% 76.0% 77.3% EGI 70.5% 71.3% 71.8% 70.0% 67.4% 68.9% 30.0% 30.1% P& C Industry 65.6% 27.0% 61.6% 59.1% 25.0% 60.0% 57.9% 21.4% 19.1% 50.0% 20.0% 19.1% 18.9% 16.1% 40.0% 15.0% 17.5% 14.9% 30.0% 10.0% 11.2% 5.4% 20.0% 5.0% 5.3% 10.0% 0.0% 2003 2004 2005 2006 2007 2008 0.0% (1) 2003 2004 2005 2006 2007 2008 (1) Source for P&C industry data: MSA Research Inc. (data represents over 92% of Canadian primary writers when measured on a premium volume basis). (2) EGI results for 2003 and 2004 include net income from discontinued operations. 2005 results include extraordinary gain. Approximately 71% of EGI’s written premium revenue in 2008 was from its Personal Lines business in Canada with approximately 62% of total premiums underwritten in Ontario. A further 8% of premiums were written in the U.S. pursuant to assumed reinsurance arrangements. The breakdown of direct written premiums by category of business and by region during 2008 is illustrated below. 2008 Gross Written Premiums by Category 2008 Gross Written Premiums by Region BC Other Alberta Niche 5.2% 4.5% Quebec 5.6% 28.9% 15.1% Ontario 61.5% Auto USA 71.1% 8.2% Net earned premiums from the sale of Personal Lines policies (Canada and United States combined) account for 71% of net earned premiums. One of EGI’s diversification strategies is the growth of the non-auto business in the Niche Products division, currently accounting for approximately 29% of net earned premiums, and the growth of the newly created International division. 11
    • Management’s Discussion and Analysis 2008 The financial performance of EGI is determined by two main factors: (i) the level of premiums earned in relation to claims and operating costs incurred; and (ii) the returns generated from the investment portfolio. Premiums collected are ultimately used to pay claims and operating expenses. There is, however, a time lapse between the collection of premiums and the payment of claims and certain operating expenses. This allows EGI to invest premiums collected and earn an investment return until claims and operating expenses are paid. EGI also earns an investment return on invested capital. EGI’s results also include fees for consulting, and income from one-time gains from acquisitions and divestitures and from corporate and other activities. The income from the non-operating transactions is discussed in the “Significant Transactions” section. Outlook In 2008, the impact of past actions taken by the standard insurers began to surface in the form of escalating industry auto loss ratios, partly because of inadequate pricing that the standard writers were offering for the non- standard auto business. The erosion of underwriting margins in the P&C industry in 2008 and potentially in 2009 will likely cause the standard insurers to reverse their actions taken earlier to gain market share. Many of the auto insurers have filed for rate increases in 2008 to improve their margin and this trend is expected to continue in 2009. Additionally, the current economic and financial crisis will negatively impact the investment income of most insurance companies, if not all, and therefore the industry as a whole will be focusing to a greater degree on the underwriting income element of their earnings. EGI’s management feels that these changes will create opportunities for non-standard insurers as standard insurers’ margins erode on this higher risk business, leading them to return to their traditional standard risk markets. Through the contracting market phase, EGI has preserved its capital and focused on profitable lines of business and thus is well positioned to take advantage of the opportunities that the changing market cycle may offer. In addition to the attractive opportunities that EGI management expects for the non-standard auto business, it also sees similar opportunities to grow the Niche Products business and to continue to pursue its diversification strategy. EGI has laid the groundwork in the past few years to aggressively expand the Niche line of business. As part of that expansion process the Company started to underwrite ETH insurance in 2007. ETH is a multi- billion dollar segment of the Accident and Sickness insurance industry that is growing due to the aging of the Canadian population. The Company will continue to pursue opportunities to grow its U.S. business, in a tax effective manner, by creating and/or acquiring its own U.S.-domiciled insurer and by continuing to utilize its wholly owned subsidiaries, CIM Reinsurance Company Ltd. (CIM Re), which is domiciled in Barbados and EGI Insurance Services, Inc. (EGIS), based in Atlanta, Georgia. EGIS is staffed with a small team of experts in U.S. niche and specialty lines of business that has performed the initial due diligence and ongoing monitoring of CIM Re’s existing and potential reinsurance clients. Our U.S. staff has now turned its attention to establishing EGI’s presence as an insurer in the U.S. market. EGI will also continue to seek out opportunities for profitable growth either through expansion of its existing business or by select acquisitions in Canada and the United States. EGI Financial Holdings Annual Report 2008
    • Management’s Discussion and Analysis 2008 Strategy EGI’s business strategies and actions are guided by its vision: “Strives to be the pre-eminent writer of specialized, niche insurance products”. EGI’s objective is to deliver an ROE superior to the average of the Canadian P&C insurance industry through a comprehensive specialized insurance offering. EGI’s focus is on non-standard auto and targeted niches that are currently underserved by the market and which require the high level of underwriting and claims expertise of EGI’s management team and staff. For 2009, EGI’s strategic goals remain focused on driving profitable business growth by leveraging and building on its strengths. In order to achieve this objective, EGI intends to: Maintain and grow its core non-standard auto insurance offering. EGI concentrates on what it considers to be the best accounts from the non-standard segment, which has resulted in above-average underwriting margins. The Company will continue to provide superior policy issuance and underwriting capabilities to its brokers and agents to support and expand its offering in this market segment. In addition, focusing primarily on return on equity, EGI will consider returning to markets from which the Company previously exited if long-term profitable opportunities arise. Introduce new and innovative niche insurance products and programs. Working closely with Managing General Agents (MGAs) and other producers, EGI will continue to design niche and specialty programs that are not offered by traditional insurers. As many brokers need specialty insurers to cover all of their customers’ insurance requirements, EGI’s Niche Products division continues to respond to this market opportunity. Provide industry-leading service. EGI strives to provide optimum service to its policyholders and producers. EGI has created and implemented written service standards in all departments interfacing with policyholders or producers. Staff members in these departments are thoroughly trained in the delivery of quality service to achieve these standards at a minimum. This service commitment ensures its policyholders and producers continue to be served by knowledgeable employees in a responsive manner. Continue to invest in technology. EGI invests in technology where opportunities exist to enhance the producers’ ease of doing business, create operating efficiencies and improve EGI’s data analysis capabilities. EGI developed and introduced its proprietary ADAPT® policy and claims management data processing system to streamline the management of its niche programs and will continue to employ leading technology solutions to serve its customers. With recent technological advancements, EGI has implemented a program to internalize its claims administration processes to enhance customer service and decrease administration costs. Claim forms are available to claimants immediately over the Internet from a computerized forms library that allows greater efficiencies in dealing with claimants directly. Much of the historical duplication of process and expense has been eliminated. Pursue acquisitions. EGI intends to continue to grow its business by seeking attractively priced acquisitions of insurers or books of business in markets and business lines that are compatible with EGI’s strategic objectives. With the current financial crisis, EGI anticipates that there will be further consolidation of insurance companies on both sides of the border and there will be continued downward pressure on the asking price of companies that become available for sale. As a result, EGI sees a tremendous opportunity to execute its growth strategy by seeking out attractively priced acquisitions. 13
    • Management’s Discussion and Analysis 2008 Competitive Strengths EGI believes that it is uniquely positioned to compete in the P&C insurance industry for the following reasons: Comprehensive specialized insurance offering. EGI offers its producers, both agents and brokers and through MGAs, a comprehensive line of insurance products comprised of non-standard automobile insurance and specialized non-auto insurance products and programs. Responding to a market need, EGI thoroughly researches a product opportunity and develops underwriting procedures and ratings that will both meet the customers’ requirements and earn an attractive ROE for EGI. The Company then arranges for distribution through its selected distribution channels. Entrepreneurial culture. EGI fosters an entrepreneurial environment which encourages innovation in the development of new niche programs and the flexibility to allow for unique, tailor-made solutions to meet market demand. Strong customer service focus. EGI believes that it has a strong reputation for customer service with its producers and policyholders from both an underwriting and a claims standpoint. Automobile policies are typically issued in five business days or less from receipt of the completed application. In the last published Automobile Claims Satisfaction Survey (2005) of insurers, EGI ranked highest among its non-standard auto competitors. Also in a recent survey of brokers by the Insurance Brokers Association of Ontario, EGI ranked the highest among non-standard auto writers. Because of limited competition in niche markets, EGI believes that its strong customer service focus provides stability to the existing business and future growth opportunities with existing and new producers. Financial strength. EGI has a strong capital base relative to its current underwriting commitments, as evidenced by the strong Minimum Capital Test ratio of its main insurance subsidiary. Echelon’s Minimum Capital Test ratio as at December 31, 2008 was 268% compared to the P&C insurance industry average Minimum Capital Test ratio of 224% (as per OSFI’s third-quarter 2008 information). EGI intends to preserve and grow its underwriting capital through appropriate pricing, underwriting discipline and conservative loss reserving practices. Experienced management team. EGI has a seasoned group of owner-managers who have worked together successfully for years. With an average of over 20 years of experience in senior positions within the insurance industry, the executive management team has extensive knowledge in non-standard and niche insurance products together with an entrepreneurial thrust and a decisive, collegial management style. Personal Lines Division As part of its strategic planning and analysis process, EGI has moved to diversify its writings, both geographically and by product line, including the creation, development, marketing and processing of new personal lines product offerings. These new offerings, in conjunction with the Company’s core, non-standard automobile product, will provide distributors with a wider array of personal lines products (which have historically been underserved by the standard market). This will be accomplished by utilizing the same “niche underwriting philosophy and discipline” that has been the hallmark of EGI’s activities. Although the non-standard automobile segment remains as the largest, single component of EGI’s activities, the additional personal lines products will facilitate additional production and diversification, making the Company an even more important partner for its distributors. In this manner, the non-standard automobile segment will continue to form the critical, though not sole, component of the Personal Lines division. EGI Financial Holdings Annual Report 2008
    • Management’s Discussion and Analysis 2008 The non-standard automobile segment currently targeted by EGI’s Personal Lines division is high premium insurance for drivers who, because of inexperience or a poor driving record, are not able to obtain insurance from standard insurers. EGI provides coverage for private passenger vehicles as well as single commercial vehicles and small commercial and farm fleets. Management believes that EGI’s underwriting discipline and claims expertise, strict controls and an experienced management team (who are well versed in the nuances of non- standard auto) enable the Company to select those drivers in the higher premium categories who have a proportionally lower potential claims risk. For applicants paying the higher premiums for non-standard automobile insurance, price is the single most important consideration. EGI provides selected drivers with a lower premium option than the higher premium coverage offered by the Facility Association (or the Groupement in Quebec), the industry-operated pools that serve as the “market of last resort.” EGI targets drivers most likely to be “reformers” not “repeaters”. These non- standard auto risks fall between Facility and the applicants normally targeted by standard market insurers. The likely reformer expresses concern with respect to his or her poor driving record and exhibits a sincere desire to improve (so as to re-enter the standard market at standard rates). EGI trains its brokers and agents to select qualifying risks. EGI then employs the experience of its underwriting personnel to ensure that complete and accurate underwriting and rating information has been developed. In recent years, EGI focused on appointing brokers and agents in “rural” and “smaller urban” centres in its markets due to concerns regarding growth in the number of fraudulent claims in the largest urban centres. This strategy has resulted in enhanced underwriting margins that, on average, exceed the industry average. In July 2005, EGI withdrew from the Alberta personal lines automobile insurance market. The Alberta government’s auto insurance reform package (introduced in October 2004) imposed a capping of insurance premiums, particularly for inexperienced and other higher risk drivers, through the implementation of a mandated rating grid and clearly defined risk selection rules. The grid subsidizes the premiums of higher-risk drivers which resulted in the overcharging of lower-risk drivers in Alberta. The size of this subsidy remains large. Recently, approved grid rate changes have made re-entry into the Alberta private passenger market a viable option, one that EGI is currently evaluating. EGI presently underwrites motorcycle, commercial, small fleet and farm vehicle insurance in Alberta. In September 2005, EGI also withdrew from the Newfoundland and Labrador private passenger automobile insurance market. This decision was made as a result of the introduction of Bill 26, which eliminated an insurer’s ability to use statistically valid rating factors (such as number of years licensed) which are essential to the proper underwriting of non-standard risks. The regulatory changes made it, in the opinion of management, uneconomical for a non-standard automobile insurer to underwrite the higher risk, private-passenger business for its own account in Newfoundland and Labrador. As part of the strategy to develop business in other vehicle types, in the first quarter of 2006 EGI entered into an exclusive arrangement with a specialist broker to write motorcycle business in Ontario. Direct written premiums from this arrangement, along with producers of motorcycle business in other jurisdictions, totaled $16.7 million in 2008 and $13.9 million in 2007. EGI will maintain and grow its personal lines business by employing the following strategies: • Expand non-standard auto writings in jurisdictions where EGI earlier withdrew or restricted its premium writing – such as Prince Edward Island, Nova Scotia and New Brunswick – via new rates filed in 2007. 15
    • Management’s Discussion and Analysis 2008 • Continue to monitor and participate in the review of Alberta’s grid rating system by the Alberta Automobile Insurance Rate Board, with a view to reactivating distribution of EGI’s private passenger automobile insurance coverages in that province (should a viable opportunity be proven). • Monitor the impact of recent government reforms in Ontario aimed at further reducing fraudulent claims, which may allow EGI to increase its business activities in additional urban markets. • Continue to build the Company’s profitable personal and commercial auto lines of business in the province of Quebec. Personal lines production in Quebec (in 2008) totaled $10.6 million (a 16.5% increase compared to 2007). Quebec remains a critical territory in EGI’s efforts to diversify geographically. • Use EGI’s non-standard underwriting expertise to add other lines of specialty personal lines insurance products such as coverage for motorcycles (Alberta), snowmobiles, all terrain vehicles, antique autos and recreational vehicles. Niche Products Division EGI’s Niche Products division, established in 2003, provides specialized commercial and personal insurance products and programs covering areas of the market that are considered underserved. This division works with property and casualty insurance brokers, MGAs, benefit consultants, warranty-product distributors and third party administrators (TPAs) to design insurance and warranty product solutions that respond to gaps in the insurance market created by traditional insurers’ focus on standardized coverage. The division is focused on satisfying its distributors’ need for customized consumer-oriented solutions that differentiate them from the product offerings provided by standard market insurers. Staffed with highly knowledgeable and experienced insurance professionals, the division researches and designs specialty insurance programs in response to market demand. These programs are then distributed and administered by the initiating broker, MGA, TPA or other intermediary who has worked closely with the division to design the insurance solution. EGI believes that the direct written premiums for its target specialized niche product insurance segment are approximately 8% to 10% of the non-auto P&C insurance market and 5% of the accident and health insurance market. EGI has identified niche market segments within five product areas that offer opportunities for profitable growth: property insurance; commercial general liability and professional liability insurance; casualty insurance; accident and health insurance; and warranty products. Within each of these areas, EGI concentrates its underwriting within the sub-segments where the risk characteristics of the business offer an opportunity to obtain a higher rate relative to the specific exposure than would be available within the broader segment of that niche market. This focus allows EGI to seek a per-risk margin that exceeds what is available in the standard market. An important component of the niche products market is the degree to which significant expertise often resides at the broker and distributor level. The distribution partners we select have highly specialized knowledge of the product and the market as well as administration systems to service the customer before and after the sale. They provide highly effective distribution capability for EGI’s programs. Their market knowledge and technical design capability are used in product design and, combined with EGI’s expertise in pricing, underwriting structures and financial management, create a sustainable product offering. Many of our distribution partners are interested in sharing in future underwriting profits through retention of risk. Accordingly, in certain circumstances, EGI will enter into a risk-sharing agreement with a distribution partner. In response to the growth experienced in the Niche Products division, the ADAPT® system was developed to enable the administrator of each program to provide customer information to EGI in an electronic format on contracts and policies sold by the distributor. The ADAPT® system software uploads customer data provided by EGI Financial Holdings Annual Report 2008
    • Management’s Discussion and Analysis 2008 the administrator of the program in preset formats supplied by EGI. The ability to export data avoids costly duplication and allows the distributors to use their own internal systems to supply the required information to EGI rather than being forced to re-enter data on EGI’s systems. Once the data transfer is received, EGI is able to immediately create customer policy records on the ADAPT® system and can use the claims portion of the ADAPT® system to manage claims and provide customer service. EGI intends to maintain and grow the niche programs business by employing the following strategies: • Continue to broaden market awareness of the existence and capabilities of EGI’s Niche Products division (including EGI’s risk retention structuring capabilities) by directly contacting and making presentations to qualified brokers and other insurance product distributors. • Ensure that the Niche Products division grows organically by continuing to provide unique expertise and superior service in response to all business inquiries. • Seek opportunities for the Niche Products division to grow through select acquisitions of books of business, distributors, administrators or an insurance company. • Attract high quality profitable program business by offering a unique opportunity for distribution partners to enter into risk-sharing arrangements with EGI. International Division In January 2008, EGI formed the International division to focus on its strategy to expand into the US. As an interim step to execute this strategy, EGI entered the U.S. non-standard auto market under reinsurance agreements with three arms’-length insurance companies. EGI has terminated the reinsurance agreements, being dissatisfied with the results. With the termination of the assumption of business from selected U.S. insurers, the Company is now undertaking to launch a new and/or acquire a suitable existing non-standard automobile insurance company. The new, or acquired company, will be domiciled in the United States and licensed in one or more states which EGI believes constitute attractive markets, to contribute to EGI’s goal of earning superior returns. EGI’s management team has past experience with the acquisition and operation of U.S., non-standard auto carriers. Any such acquisitions could also serve as an entry point, for the personal lines product offerings (noted above) into the U.S. market. Segmented Financial Information The International division’s 2008 results include all premiums assumed pursuant to reinsurance arrangements with U.S.-based, non-standard automobile insurers. This business was previously included in the Personal Lines division (U.S.) in 2007, and these figures have been re-stated for comparative purposes in the table below. The segmented information for the final quarter of 2008 and full year show significant growth in underwriting revenue for each of the business segments of EGI. The growth in Personal Lines premiums resulted from increases in both the non-standard automobile and motorcycle lines of business. The growth in Niche Products premiums resulted from continued growth in this part of our business, which is maturing into a significant portion of EGI’s book of business. Premium growth in the International division is related to assumed reinsurance premiums from quota share arrangements with three non-standard automobile reinsurers based in south-eastern United States. 17
    • Management’s Discussion and Analysis 2008 For the three months ended For the three months ended December 31, 2008 December 31, 2007 Canada International Canada International Personal Niche Personal Niche ($THOUSANDS) Lines Products Total Lines Products Total Underwriting revenue 25,500 10,235 35,735 3,811 22,536 9,192 31,728 2,432 Underwriting income (loss) 466 186 652 (999) 2,054 (966) 1,088 (73) Loss ratio 70.4% 56.5% 66.4% 90.3% 61.0% 73.4% 64.6% 72.0% Expense ratio 27.8% 41.7% 31.8% 35.9% 29.9% 37.1% 32.0% 31.0% Combined ratio 98.2% 98.2% 98.2% 126.2% 90.9% 110.5% 96.6% 103.0% The segmented information for the fourth quarter of 2008 shows that both the Personal Lines and Niche Products divisions contributed underwriting income of $0.5 million and $0.2 million, respectively. The International division recorded an underwriting loss of $1.0 million in the period. The fourth quarter 2008 Personal Lines results represent a decrease in underwriting income of $1.5 million compared to the underwriting income of $2.0 million in the fourth quarter of 2007. This was primarily due to an increase in the loss ratio to 70.4% in the 2008 period compared to 61.0% for the final quarter of 2007. The fourth quarter 2008 loss ratio was negatively impacted by a market yield adjustment due to the decline in the actuarial discount rate used in 2007 of 2.8%, to 2.5% in 2008. Underwriting income in the quarter of $0.2 million for the Niche Products division represents a significant improvement compared to the underwriting loss of $1.0 million recorded in the final quarter of 2007. A decline in the loss ratio to 56.5% in 2008, compared to 73.4% for the same period in 2007, was the primary factor in this improved result. As also noted in the segmented information year-over-year comparison, the improvement in the ETH line of business loss ratio contributed to this positive result. The underwriting loss of $1.0 million recorded in the International division was the result of adverse claims experience during the quarter, resulting in a loss ratio of 90.3% for the period compared to 72.0% in the final quarter of 2007. 2008 2007 Canada International Canada International Personal Niche Personal Niche ($THOUSANDS) Lines Products Total Lines Products Total Underwriting revenue 98,665 46,009 144,674 12,581 87,700 23,900 111,600 8,006 Underwriting income (loss) 7,058 (3,183) 3,875 (2,404) 10,664 297 10,962 (17) Loss ratio 65.6% 66.0% 65.7% 85.7% 59.1% 56.1% 58.5% 73.9% Expense ratio 27.3% 40.9% 31.6% 33.4% 28.7% 42.7% 31.7% 26.3% Combined ratio 92.9% 106.9% 97.3% 119.1% 87.8% 98.8% 90.2% 100.2% The segmented information on a year-to-date basis shows that the Personal Lines division contributed $7.1 million of underwriting income while the Niche Products division recorded an underwriting loss of $3.2 million and the International division recorded an underwriting loss of $2.4 million. EGI Financial Holdings Annual Report 2008
    • Management’s Discussion and Analysis 2008 The Personal Lines business segment recorded an increase in its loss ratio partially offset by a decreased expense ratio in 2008. Although favourable claims development was lower than in 2007, this line continued to experience favourable loss development of claims related to prior years, with total net positive development of prior year claims of $5.1 million in 2008 compared to $11.8 million in 2007. The Personal Lines division expense ratio decreased slightly to 27.3% compared to 28.7% in 2007 as a result of operating expense controls. The Niche Products loss ratio increased to 66.0% in 2008 primarily due to a higher-than-expected loss ratio incurred in the Emergency Travel Health (ETH) insurance business. The loss ratio on this line of business was 94.6% while the loss ratio from all other Niche programs was 45.2% in 2008. This reflects an improvement of 48% (excluding the ETH results) from this business segment compared to the 2007 loss ratio. ETH results primarily reflect performance related to the 2007–2008 travel season, which for the most part ended June 30, 2008. Management has undertaken a number of initiatives, including premium rate increases, implementing caps on premiums written by distributors, and stricter underwriting criteria intended to significantly improve the financial results in the 2008–2009 travel season. As a result, the loss ratio for the 2008–2009 travel season as at December 31, 2008, was 58.8%, representing a significant improvement over the loss ratio for the 2007–2008 travel season of 91.9% as at December 31, 2007. The Niche Products division expense ratio decreased to 40.9% in 2008, compared to 42.7% in 2007, primarily due to the increase in earned premiums year over year and the resulting improved economies of scale related to operating expenses. The International division incurred adverse claims experience in 2008 resulting in an increase in the loss ratio to 85.7% compared to 73.9% in 2007. In 2007 and 2008, premiums generated from the International division were derived from assumed reinsurance contracts with U.S.-based non-standard automobile insurers. The largest of these contracts was cancelled effective December 31, 2008, with the remaining contracts to be cancelled effective March 31, 2009. Revenue Revenue reflected in the consolidated financial statements includes net earned premiums, investment income, realized gains and losses on the sale of investments, and other revenue. ($ THOUSANDS) 2008 2007 Gross premiums written 170,730 157,935 Net premiums written 158,107 146,511 Net premiums earned 157,255 119,606 Net interest and dividends 12,136 9,759 Net realized gains (losses) on investments (4,833) 3,350 Foreign exchange gains (losses) 2,706 (155) Total revenue 167,264 132,560 The main source of revenue was earned premiums from the sale of insurance policies. Gross written premiums totaled $170.7 million, 8.1% above the $157.9 million level last year. This significant increase was attributable to premium growth in each of EGI’s business segments. Net earned premiums rose $37.6 million, or 31.4% in 2008, to $157.2 million from $119.6 million last year. This increase was higher than the percentage increase in written premiums, primarily due to the significant amount of ETH insurance premiums written in the last quarter of 2007 (compared to the last quarter of 2008) and earned in the first half of 2008. 19
    • Management’s Discussion and Analysis 2008 The second largest source of revenue was investment income, which constituted approximately 6% of EGI’s total revenue in 2008. EGI recognizes revenue from interest, dividends, realized capital gains and losses on the invested assets and foreign exchange gains and losses. Market fluctuations in interest rates affect EGI’s returns on, and the market value of, fixed income and short-term investments. The fair market value of EGI’s exposure to preferred and common shares and other equity investments fluctuates as a result of changes in the overall level of the equity markets. Net losses on invested assets totaled $4.8 million compared to realized gains of $3.4 million last year. The losses in 2008 include an investment impairment of $4.7 million recorded in the last quarter of the year due to evidence of other-than-temporary fair value deficiencies on specific investments. Impairment losses recognized in net income do not have an impact on total shareholders’ equity since the fair values of available-for-sale investments are recorded on the balance sheet. Foreign exchange gains of $2.7 million recorded in 2008, due to the weakened Canadian dollar, arise primarily from cash balances held in U.S. dollars used to fund claims liabilities, also denominated in U.S. dollars, related to the ETH line of business. Expenses EGI’s expenses consist of incurred claims, acquisition costs and operating expenses, including interest on borrowed funds. ($ THOUSANDS) 2008 2007 Expenses Incurred claims 105,837 71,179 Acquisition expense 37,026 26,143 Operating expense 14,229 12,043 157,092 109,365 Selected Underwriting Ratios 2008 2007 Incurred claims ratio 67.3% 59.5% Acquisition expense ratio 23.5% 21.9% Operating expense ratio 9.1% 10.0% Combined ratio 99.9% 91.4% The combined ratio for EGI increased in 2008 to 99.9% from 91.4% in 2007. As noted in the table above, the primary reason for the increase was the higher loss and acquisition expense ratios in 2008 compared to 2007. The increased loss ratio was primarily due to adverse experience in ETH claims and assumed reinsurance arrangements in the International division. The increase in the acquisition expense ratio was primarily due to the change in the mix of EGI business, with a greater emphasis on Niche Products lines, which attract a larger commission rate compared to Personal Lines products. The decrease in the operating expense ratio was primarily due to the growth in earned premiums and the resulting improved economies of scale along with expense controls. Incurred claims, also referred to as losses, are the amounts payable under insurance policies relating to insured events. Loss adjustment expenses, also referred to as claim expenses, are the expenses of settling claims, including allocated (i.e. external) loss adjustment expenses and unallocated (i.e. internal) loss adjustment expenses (together, LAE). Achieving profitable results depends on EGI’s ability to manage future claims and other costs through innovative product design, strict underwriting criteria and efficient claims management. EGI Financial Holdings Annual Report 2008
    • Management’s Discussion and Analysis 2008 Acquisition costs consist mainly of commissions and premium taxes which are directly related to the acquisition of premiums. Commissions are the amounts paid to producers for selling insurance policies. The amount of commission is generally a percentage of the premium of the insurance policy sold. Contingent commissions are paid to brokers and MGAs on an annual basis if they meet certain targets. In general, these producers have to meet or exceed certain criteria, including written premium targets and profitability, on average over three years, to qualify for this compensation. Premium taxes are taxes paid by EGI to provincial governments, calculated as a percentage of direct written premiums. Operating expenses are the non-commission selling, underwriting, administrative and interest expenses incurred to support EGI’s business. A significant portion of these expenses is related to employee compensation and benefits. The effective control and management of these expenses can enhance the underwriting results from the operation. Significant Transactions Normal Course Issuer Bid In December 2008, EGI announced its intention to make a normal course issuer bid. Pursuant to the bid, the Company proposes to purchase, over the next 12 months, up to an aggregate of 629,030 common shares of EGI, representing approximately 10% of the public float as of December 31, 2008. As of December 31, 2008, the Company had not settled the purchase of any shares. Rights Offering In July 2008, EGI issued rights to eligible holders of outstanding common shares of record on July 4, 2008, to subscribe for and purchase an aggregate of 1,943,630 common shares, at a price of $10.75 per share. Completion of the rights offering on July 31, 2008, resulted in the issuance of 1,943,630 common shares for $20.773 million in net proceeds to be used for general corporate purposes. Credit Facility to fund U.S. Expansion In October 2007, EGI entered into a non-revolving term credit facility with a major Canadian bank in the amount of US$20 million, converted to CDN$19.55 million, the equivalent Canadian dollar amount as of the closing date. The facility bears interest of 6.2% which is payable monthly over the three-year term of the agreement. After three years, EGI is obligated to repay the amounts drawn as at the termination of the agreement. Pursuant to the credit facility agreement, EGI is required to comply with various financial covenants and financial information reporting requirements. The initial drawdown of US$20 million or CDN$19.55 million was used to increase the capital of CIM Reinsurance Company Ltd., EGI’s Barbados-based subsidiary reinsurance company, which has been used to reinsure selected niche and specialty line insurers, underwriting business in the United States. Regulation The industry in which EGI operates is regulated for the sale of P&C insurance. Changes in these regulations may significantly affect the operations and financial results of EGI. 21
    • Management’s Discussion and Analysis 2008 Significant Accounting Changes Capital Disclosures and Financial Instruments – Disclosures and Presentation On January 1, 2008, the Company adopted three new accounting standards issued by the Canadian Institute of Charted Accountants (CICA): Handbook Section 1535 – Capital Disclosures Handbook Section 3862 – Financial Instruments – Disclosure Handbook Section 3863 – Financial Instruments – Presentation Section 1535 specifies the disclosure of (i) an entity’s objectives, policies and processes for managing capital; (ii) quantitative data about what the entity regards as capital; (iii) whether the entity has complied with any capital requirements; and (iv) if it has not complied, the consequences of such non-compliance. Sections 3862 and 3863 replaced Handbook Section 3861, Financial Instruments – Disclosure and Presentation, revised and enhanced its disclosure requirements, and continued its presentation requirements. These new standards place increased emphasis on disclosures about the nature and extent of risks arising from financial instruments and the management of those risks. The new standards did not have an impact on the financial position or earnings of the Company. Future Changes in Accounting Policies and Disclosure Transition to International Financial Reporting Standards (IFRS) The CICA has announced that Canadian GAAP for publicly accountable enterprise companies will be replaced with IFRS over a transition period expected to end in 2011. EGI will begin reporting its financial statements in accordance with IFRS on January 1, 2011. EGI has begun planning its transition to IFRS. The impact on its consolidated financial position and results of operations has not yet been determined. Critical Accounting Estimates and Assumptions EGI’s significant accounting policies are disclosed in note 3 to the consolidated financial statements for the financial year ended December 31, 2008. The preparation of EGI’s financial statements in accordance with Canadian GAAP requires EGI to make estimates and assumptions that affect the amounts reported in the financial statements. These estimates and assumptions principally relate to the establishment of reserves for claims and expenses, impairments of investment securities, amounts recoverable from reinsurers and certain other assets. As more information becomes known, these estimates and assumptions could change and impact future results. The most significant estimates and assumptions made in preparing the financial statements are in respect of policy liabilities, investments, reinsurance and income taxes. Policy Liabilities Policy liabilities consist of provisions for claim liabilities and premium liabilities. Claim liability reserves are maintained to cover EGI’s estimated ultimate liability for unpaid losses and loss adjustment expenses with respect to reported and unreported claims incurred as of the end of each accounting period. The provision for unpaid claims and adjustment expenses is first determined on a case-by-case basis as claims are reported and then reassessed as additional information becomes known. The provision also accounts for the future development of these claims, including claims incurred but not reported (IBNR). Reserves do not represent an exact calculation of liability, but instead represent estimates developed using projection techniques in accordance with Canadian accepted actuarial practice. These reserve estimates are expectations of the ultimate cost of settlement and administration of claims based on EGI’s assessment of facts and circumstances then EGI Financial Holdings Annual Report 2008
    • Management’s Discussion and Analysis 2008 known, its review of historical settlement patterns, estimates of trends in claims severity and frequency, legal theories of liability and other factors. Variables in the reserve estimation process can be affected by both internal and external events, such as changes in claims handling procedures, economic inflation, legal trends and legislative changes. Many of these items are not directly quantifiable, particularly on a prospective basis. Additionally, there may be significant reporting lags between the occurrence of the insured event and the time it is actually reported to the insurer. Reserve estimates are refined in a systematic ongoing process as historical loss experience develops and additional claims are reported and settled. Because the establishment of reserves is an inherently uncertain process involving estimates, current reserves may not be sufficient. Adjustments to reserves, both positive and negative, are reflected in the statement of income for the period in which such estimates are updated. The provision for unpaid claims and adjustment expenses is discounted to take into account the time value of money. It also includes a provision for adverse deviation, as required by Canadian accepted actuarial practice. The appointed actuary of EGI’s subsidiaries, using appropriate actuarial techniques, evaluates the adequacy of the policy liabilities. Premium liabilities are considered adequate when the unearned premium reserve (after deducting any deferred acquisition cost assets) is at least equal to the present value, at the balance sheet date, of the cash flow of claims, expenses and taxes to be incurred after that date on account of the policies in force at that date or at an earlier date. Deferred acquisition costs are comprised of commissions, premium taxes and expenses directly related to the acquisition of premiums. These costs are deferred to the extent that they are recoverable from unearned premiums, after considering the related anticipated claims, expenses and investment income in respect of these premiums. Deferred acquisition costs are amortized on the same basis as the premiums are recognized in income. A premium deficiency would be recognized immediately by a charge to the statement of income as a reduction of deferred acquisition costs to the extent that the unearned premium reserve, plus anticipated investment income, is not adequate to recover all deferred acquisition costs and related claims and expenses. If the premium deficiency was greater than unamortized deferred acquisition costs, a liability would be accrued for the excess deficiency. Investments EGI obtains values for all publicly traded securities in its investment portfolio from external pricing services. Impairment of investment securities results in a charge to earnings when a market decline in the value of an investment to below cost is considered to be other-than-temporary. EGI’s methodology to identify potential impairments requires professional judgment and places particular emphasis on those securities with unrealized losses of 20% or greater of the book value where the unrealized loss has been outstanding for more than six months. Assessment factors include, but are not limited to, the financial condition and rating of the issuer of the security, any collateral held and the length of time the market value of the security has been below cost. An impairment loss is recognized when the assessment concludes that there is objective evidence of impairment and the decline in fair value is other-than-temporary. Once a security with an unrealized loss is determined to be other than temporarily impaired, an impairment loss is recorded in the income statement with an offset to Accumulated Other Comprehensive Income. Previously impaired securities continue to be monitored quarterly. In 2008, other-than-temporary investment impairments of $4.7 million were recorded in the statement of income. There are inherent risks and uncertainties involved in making these judgments. Changes in circumstances and critical assumptions such as a weak economy, a pronounced economic downturn or unforeseen events which affect one or more companies or industry sectors could result in additional write-downs in future periods for 23
    • Management’s Discussion and Analysis 2008 impairments that are deemed to be other-than-temporary. See also note 4 to the consolidated annual financial statements for a description of EGI’s impairment policies. Reinsurance Reinsurance recoverables include amounts for expected recoveries related to claims liabilities as well as the portion of the reinsured premiums which has not yet been earned by the reinsurer. The cost of reinsurance is accounted for over the terms of the underlying reinsured policies, using assumptions consistent with those used to account for the policies. Amounts recoverable from reinsurers are estimated in a manner consistent with claim and claim adjustment expense reserves and are reported in the consolidated balance sheet. The ceding of insurance liability to a reinsurer does not discharge EGI’s primary liability to the policyholders. The Company’s policy is to record an estimated allowance for doubtful accounts on the basis of periodic evaluations of balances due from reinsurers, reinsurer solvency, management’s experience and current economic conditions. Income Taxes EGI uses the asset and liability method whereby income taxes reflect the expected future tax consequences of temporary differences between the carrying amounts of financial statement assets and liabilities compared with their respective tax bases. Accordingly, a future tax asset or liability is determined for each temporary difference, based on the income tax rates that are expected to be in effect when the underlying items of revenue and expenses are expected to be realized. Future income taxes, accumulated as a result of temporary differences, are included in the consolidated balance sheet. In addition, the consolidated statement of income contains items that are non-taxable or non- deductible for income tax purposes, which cause the income tax provision to differ from what it would be if based on statutory rates. SUMMARY OF QUARTERLY RESULTS 2008 2007 ($ THOUSANDS EXCEPT PER SHARE DATA) Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Direct written and assumed premiums 39,948 46,067 49,779 34,936 43,098 42,343 42,299 30,196 Total revenues (excluding investment income) 39,547 36,150 35,999 45,559 34,161 30,847 29,808 24,790 Underwriting income (489) 1,514 (465) (397) 868 3,536 4,533 1,304 Income (loss) before income (3,272) 4,394 3,947 3,888 5,658 6,772 6,601 3,905 taxes Net income (loss) (2,322) 3,026 2,690 2,586 3,727 4,462 4,349 2,527 Earnings per adjusted share - Basic $(0.20) $0.28 $0.27 $0.27 $0.39 $0.46 $0.45 $0.26 - Diluted $(0.19) $0.26 $0.25 $0.25 $0.35 $0.44 $0.42 $0.24 Selected financial ratios (%) Loss ratio 68.7 64.0 67.7 68.4 65.1 58.2 53.2 61.0 Expense ratio 32.5 31.7 33.6 32.4 32.3 30.3 31.6 33.7 Combined 101.2 95.7 101.3 100.8 97.4 88.5 84.8 94.7 EGI Financial Holdings Annual Report 2008
    • Management’s Discussion and Analysis 2008 QUARTER ENDED DECEMBER 31, 2008 COMPARED TO QUARTER ENDED DECEMBER 31, 2007 The following financial information compares the results for the fourth quarter 2008 with the fourth quarter 2007. Q4 Q4 Variance Variance ($ THOUSANDS) 2008 2007 $ % Direct written premiums 39,948 43,098 (3,150) (7.3) Net written premiums 36,644 39,257 (2,613) (6.7) Net earned premiums 39,547 34,161 5,386 15.8 Claims incurred 27,169 22,253 4,916 22.1 Acquisition costs 8,980 7,483 1,497 20.0 Operating expenses 3,886 3,557 329 9.2 Underwriting income (loss) (489) 868 (1,357) (156.3) Investment income (loss) (2,481) 5,049 (7,530) (149.1) Interest expense 302 259 43 16.6 Net income (loss) before income taxes (3,272) 5,658 (8,930) (157.8) Income taxes (950) 1,931 (2,881) (149.2) Net income (loss) (2,322) 3,727 (6,050) (162.3) Net operating income 3,037 2,256 781 34.6 Insurance Operation Written Premiums In the fourth quarter of 2008, direct written premiums decreased $3.1 million, or 7.3%, to $40 million compared to $43.1 million in the same period last year. The decrease was the result of a decrease in premiums generated by the Niche Products division’s ETH line of business. This line of business generated $3.5 million of premiums, a decrease of $8.0 million, compared to $11.5 million in the final quarter of 2007. The decrease in premiums in this line of business is due to stricter underwriting restrictions put in place for the 2008–2009 travel season intended to return this line of business to profitability. Excluding the decline in business in ETH, the Niche Products division continued to generate premium growth in the last quarter of 2008, with written premiums of $10.1 million, an increase of $2.4 million, or 31.2% over the same period last year. In our Personal Lines division, direct written and assumed premiums increased $0.5 million or 2.3% to $22.2 million compared to $21.7 million in the fourth quarter of 2007. Assumed premiums in the International division increased $1.4 million, or 11.2%, to $13.9 million compared to $12.5 million in the last quarter of 2007. For the three months ended December 31, 2008, net written premiums decreased $2.6 million or 6.6% to $36.6 million compared to $39.2 million for the last quarter of 2007. This decrease was consistent with the decrease in direct written and assumed premiums noted above. Earned Premiums Net earned premiums for the three months ended December 31, 2008 were $39.5 million, an increase of $5.3 million, or 15.5%, compared to the fourth quarter of 2007. Growth in net earned premiums was achieved despite the decrease in net premiums written in the final quarter of 2008. This is the result of growth in our other lines of business (excluding ETH). Since ETH premiums are earned primarily during the winter months (December to March) the decline in written premiums in this line of business will not fully impact net earned premiums until 25
    • Management’s Discussion and Analysis 2008 the first quarter of 2009. As noted above, the decline in written premiums in ETH is the result of actions taken by EGI designed to return this line to profitability for the 2008–2009 travel season. Incurred Claims Expense For the quarter ended December 31, 2008, net claims expense increased $4.9 million or 22% to $27.2 million compared to $22.3 million for the fourth quarter of 2007. This resulted in a loss ratio of 68.7% for the three months ended December 31, 2008 compared to 65.1% for the same period in 2007. The increase was attributable to increases in the loss ratios in the quarter for the Personal Lines and International divisions. The loss ratio of the Personal Lines division was 70.4% in the three month period ended December 31, 2008 compared to 61.0% in the same period of 2007. The increase in the loss ratio was due to a decline in favourable loss development of prior-year claims for the Personal Lines business segment compared to the final quarter of 2007. Favourable development of $0.1 million was recorded in the fourth quarter of 2008, for this business segment, compared to favourable development of $2.0 million in the same period in 2007. The International division had a loss ratio of 90.3% in the fourth quarter of 2008 compared to 72.0% experienced in the final quarter of 2007. The increase in 2008 was primarily due to adverse claims experience resulting from unfavourable loss development of 2007 accident year claims of $0.2 million from assumed reinsurance business written in this division. The Niche Products division loss ratio was 56.5% in the last three months of 2008 compared to 73.4% in the same period last year. This significant improvement is primarily due to the improvement in the ETH loss ratio in 2008. The loss ratio for the ETH line of business was 58.8% in the final quarter of 2008, compared to 91.9% in the final three months of 2007, reflecting the initiatives taken by management to return this line to profitability for the 2008–2009 travel season. On a company-wide consolidated basis, net unfavourable development of prior year claims of $0.2 million was recorded in the fourth quarter of 2008 compared to favourable development of $2.0 million in the same period in 2007. Acquisition Costs Net acquisition costs, which consist mainly of commissions and premium taxes, increased $1.5 million or 20% to $9.0 million in the quarter ended December 31, 2008, compared to $7.5 million in the same period in 2007. The increase is slightly higher than the increase in net earned premiums of 15.5% due to the higher proportion of Niche business compared to Personal Lines in 2008, which attracts higher acquisition expenses. Operating Expenses For the fourth quarter of 2008, operating expenses were $3.9 million compared to $3.6 million (excluding interest expense) in the same period in 2007 or an increase of 8.3%. This increase was lower than the 15.5% increase in net earned premiums in the quarter compared to 2007. As noted above, this is partially the result of an improvement in economies of scale caused by an increase in ETH net earned premiums relative to written premiums in 2008. Underwriting Income Underwriting results reflect the revenues from net earned premiums less claims, acquisition and operating expenses. The quarter ended December 31, 2008, had an underwriting loss of $0.5 million, compared to underwriting income of $0.9 million in the same quarter of 2007. The decline was attributable to the increase in the loss ratio, primarily from the Personal Lines and International divisions as noted above. EGI Financial Holdings Annual Report 2008
    • Management’s Discussion and Analysis 2008 Investment Income In the final quarter of 2008, income from investments decreased significantly to a net loss on investments of $2.5 million compared to investment income of $5.1 million in the final quarter of 2007. The result was due to the realization of losses of $3.3 million on the sale of investments during the quarter, and the recording of other- than-temporary investment impairments of $4.7 million in the period. As noted earlier, as a result of a detailed assessment of our investment portfolio, EGI has identified specific other-than-temporary investment impairments, primarily caused by the significant decline in equity markets during the final quarter of 2008 and evidence of other-than-temporary fair value deficiencies related to specific holdings. Partially offsetting the realized losses on sale of investments and impairments recorded in the quarter were foreign exchange gains of $2.3 million. The gain resulted from weakening of the Canadian dollar in the period, which increased the value of bank balances held in U.S. dollars. As at December 31, 2008, EGI held US$7.7 which was used to fund claims liabilities, also denominated in U.S. dollars, related to the ETH line of business. Income from interest and dividends totaled $3.2 million in the fourth quarter of 2008 compared to $2.7 million in the same period in 2007, reflecting the increase in the total investment portfolio during the year. Interest Expense During the final quarter of 2008, interest expense related to bank indebtedness of $0.3 million was incurred. In October 2007, EGI entered into a non-revolving term loan facility with a major Canadian bank in the amount of $19.55 million. During the three-year term of the facility, interest of 6.2% is paid quarterly. Net Income before Income Taxes For the quarter ended December 31, 2008, the net loss before income taxes was $3.3 million compared to net income of $5.7 million for the final quarter of 2007, as the result of a higher 2008 combined ratio of 101.2%, compared to 97.4% for the same period in 2007, and an aggregate investment loss of $2.5 million incurred in the period compared to investment income of $5.1 million in the same period of 2007. Income Taxes For the quarter ended December 31, 2008, the provision for income taxes reflected a recovery of $0.9 million compared to an expense of $1.9 million for the same period last year. The 2008 recovery is the result of the net loss before income taxes incurred in the period. The approximate effective tax rate was 33% for the last quarter of 2008 and 34% for the same period last year. Net Operating Income Net operating income, defined as net income plus or minus after-tax realized losses or gains on the sale of investments, increased $0.8 million to $3.0 million in the final quarter of 2008 compared to $2.2 million in the same period in 2007. Net operating income, in the last three months of 2008, consisted of a net loss of $2.3 million plus after-tax realized losses on the sale of investments of $5.3 million, compared to net income of $3.7 million less after-tax gains on the sale of investments of $1.5 million in 2007. The significant improvement in net operating income in the fourth quarter of 2008, compared to 2007, is primarily related to the improved results from the ETH line of business as noted above. 27
    • Management’s Discussion and Analysis 2008 YEAR ENDED DECEMBER 31, 2008 COMPARED TO 2007 The following financial information compares results for the full year 2008 and 2007. Variance Variance ($ THOUSANDS) 2008 2007 $ % Direct written premiums 170,730 157,935 12,795 8.1 Net written premiums 158,107 146,511 11,596 7.9 Net earned premiums 157,255 119,606 37,649 31.5 Claims incurred 105,837 71,179 34,658 48.7 Acquisition costs 37,026 26,143 10,883 41.6 Operating expenses 14,229 12,043 2,186 18.2 Underwriting income (loss) 163 10,241 (10,078) (98.4) Investment income (loss) 10,009 12,954 (2,945) (22.7) Interest expense 1,216 259 957 369.5 Net income (loss) before income taxes 8,956 22,936 (13,980) (60.9) Income taxes 2,977 7,871 (4,894) (62.2) Net income (loss) 5,979 15,065 (9,086) (60.3) Net operating income 9,083 12,957 (3,874) (29.9) Insurance Operation Written Premiums Direct written and assumed premiums increased $12.8 million or 8.1% to $170.7 million for the year ended December 31, 2008 compared to $157.9 million for 2007. Premium growth was achieved in both Canadian business segments. The increase in Personal Lines premiums, despite difficult market conditions in the P&C industry, was the result of premium growth in non-standard automobile and motorcycle business. Total Personal Lines division gross written premiums were $107.5 million in 2008 compared to $97.4 million in 2007, reflecting a growth rate of 10.4%. Non-standard automobile premiums in 2008 totaled $88.4 million compared to $83.2 million in the prior year, with motorcycle premiums of $16.7 million in 2008 compared to $13.9 million in 2007. The remaining premiums for the Personal Lines division are from other vehicles. Regionally, Quebec automobile insurance premiums grew 16.5% to $10.6 million for 2008, compared to $9.1 million in 2007. Direct written premiums for Niche Products increased 2.5% to $49.3 million for 2008, compared to $48.1 million in 2007. This increase was achieved despite a significant decrease of $7.6 million in the ETH written premiums to $11.5 million from $19.1 million in 2007. As noted earlier, the premium decrease in the ETH line of business was the result of stricter underwriting criteria implemented for the 2008–2009 travel season designed to improve the financial performance of this line of business. All other Niche Products’ lines of business recorded significant growth in 2008 compared to 2007 and management continues to view this division as a primary source of growth for EGI. Net written premiums increased $11.6 million or 7.9% to $158.1 million for the year ended December 31, 2008, compared to $146.5 million for the same period last year. The increase in net written premiums was consistent with the percentage increase in gross written premiums noted above. EGI Financial Holdings Annual Report 2008
    • Management’s Discussion and Analysis 2008 Earned Premiums Net earned premiums for 2008, were $157.3 million, an increase of $37.7 million or 31.5% from 2007. This increase was higher than the increase in net written premiums of 7.9%, primarily due to the decline of written premiums from the ETH line of business in 2008 compared to 2007. Since ETH premiums are mainly earned during the winter months (December to March), relatively high written premiums from the 2007–2008 travel season recorded in 2007, were earned in the first quarter of 2008. The decline in written premiums from this line of business will not fully impact net earned premiums until the first half of 2009. Incurred Claims Expense Net incurred claims expense increased $34.6 million or 48.6% to $105.8 million for 2008, compared to $71.2 million for 2007. The resulting loss ratio of 67.3% for 2008, represents an increase of 7.8% over the 2007 loss ratio of 59.5%. The loss ratio for each business segment increased in 2008, compared to 2007 for several reasons. The Niche Products division’s loss ratio increased to 66% for the year compared to 56.1% in 2007. This result was caused primarily by adverse claims experience in the ETH line of business for the 2007–2008 travel season. The loss ratio reflected in the 2008 results for this travel season was 99.2% on net earned premiums of $17.2 million. Partially offsetting this result was the loss ratio from all other Niche Products programs of 45.1% which slightly exceeded EGI’s expectations The Personal Lines division incurred a loss ratio of 65.6% in 2008 compared to 59.1% in 2007. This increase was primarily attributable to a decrease in the favourable development of prior year claims recorded for this business segment in 2008 compared to 2007. Positive development continued in 2008, resulting in the release of $4.7 million of net reserves, compared to $10.7 million for 2007. Excluding the decrease in favourable development in 2008, the net loss ratio of 70% compares favourably to 72.1% in 2007. The 2008 loss ratio for the International division was 85.7% compared to the 2007 loss ratio of 73.9%. The 2008 result was adversely impacted by unfavourable development of 2007 accident year claims of $1.0 million and a 2008 current year loss ratio of 77.0%. As previously noted, the reinsurance arrangements in place in the International division have either been cancelled effective December 31, 2008, or are in the process of being cancelled in 2009. On a Company-wide consolidated basis, net favourable development of prior year claims of $5.1 million was recorded in 2008 compared to favourable development of $11.8 million in 2007. Acquisition Costs Net acquisition costs, consisting mainly of commissions and premium taxes, increased $10.9 million or 41.8% to $37.0 million for 2008, compared to $26.1 million in 2007. This increase, compared to 2007 and in relation to the increase in net earned premiums of 31.5%, was due to the higher proportion of Niche business compared to Personal Lines business in 2008, attracting higher acquisition expenses. Operating Expenses Operating expenses, excluding interest expense in 2008, increased $2.2 million or 18.3% to $14.2 million for 2008, compared to $12.0 million for 2007. This increase was lower than the 31.5% increase in net earned premiums noted above, which is partially the result of an improvement in economies of scale caused by an increase in 2008 in ETH net earned premiums relative to written premiums. 29
    • Management’s Discussion and Analysis 2008 Underwriting Income Underwriting results reflect the revenues from net earned premiums less claims, acquisition and operating expenses. The overall underwriting income decreased $10 million to $0.2 million for the year ended December 31, 2008 compared to $10.2 million for 2007. The underwriting income for 2008 and 2007 was net of $1.3 million and $0.9 million of corporate and other expenses, respectively. The increase in corporate and other expenses in 2008 was due to expenses associated with potential acquisition reviews during the year. Underwriting income from the Personal Lines division for the year ended December 31, 2008 was $7.1 million, representing a decline of $3.5 million compared to an income of $10.6 million for 2007. This result was due to an increase in the combined ratio to 92.9% in 2008 compared to 87.8% in 2007. The underwriting loss from the Niche Products division for the year ended December 31, 2008 was $3.2 million, compared to an income of $0.3 million in 2007. This result was primarily due to the increase in the loss ratio caused by adverse claims experience in the ETH line of business which resulted in an increase in the combined ratio to 106.9% in 2008 compared to 98.8% in 2007. The International division incurred an underwriting loss of $2.4 million, which includes expenses from EGI Insurance Services, Inc., compared to a breakeven in 2007. As noted earlier, this result was caused by adverse claims experience from assumed premium reinsurance contracts. The combined ratio for this business segment increased to 119.1% in 2008 compared to 100.2% in 2007. Investment Income Investment income decreased $3.0 million, or 23.0%, to $10.0 million in 2008 compared to $13.0 million in 2007. The decrease in investment income compared to 2007 resulted from net losses recorded in 2008 on the sale of investments and recording of investment impairments as at December 31, 2008. Net losses on investments totaled $4.8 million in 2008, consisting of $0.1 million in net realized losses on the sale of investments and $4.7 million of investment impairments recorded at year-end, due to evidence of other-than-temporary fair value deficiencies on specific investments. This result compares to net realized gains on disposal of investments of $3.4 million earned in 2007. Partially offsetting the net losses on investments in 2008 were foreign exchange gains of $2.7 million derived from funds held in U.S. currency and the impact of the weakened Canadian dollar. Income from interest and dividends increased to $12.1 million in 2008 compared to $9.8 million in 2007. The increase resulted from an increase in total invested assets to $259.8 million, on a fair value basis, as at December 31, 2008 compared to $238.3 million as at year end 2007. A significant portion of the increase in invested assets was related to funds raised of $20.8 million pursuant to completion of EGI’s rights offering in July 2008. Interest Expense During 2008, interest expense related to bank indebtedness of $1.2 million was incurred compared to $0.3 million in 2007. In October 2007, EGI entered into a non-revolving term loan facility with a major Canadian bank in the amount of $19.5 million. During the three-year term of the facility, interest of 6.2% was paid quarterly. Net Income before Income Taxes Net income before income taxes decreased $13.9 million, or 60.7%, to $9.0 million for 2008 compared to $22.9 million for 2007 as the result of a higher combined ratio and the decline in investment income. For the year ended December 31, 2008, underwriting income of $0.2 million plus investment income of $10.0 million, reduced by interest expenses on bank indebtedness of $1.2 million, comprised net income before income EGI Financial Holdings Annual Report 2008
    • Management’s Discussion and Analysis 2008 taxes of $9.0 million. This is compared to an underwriting income of $10.2 million plus investment income of $13.0 million, reduced by interest expense of $0.3 million in 2007. Income Taxes The provision for income taxes for the year ended December 31, 2008 was $3.0 million compared to $7.9 million for 2007. This reflected lower pre-tax income as a result of lower underwriting profits and lower investment income year over year. The approximate effective tax rate decreased to 33% for 2008 compared to 34% for the previous year, primarily due to the decline in the federal corporate income tax rate to 19.5% in 2008 from 22.1% in 2007. Net Operating Income Net operating income decreased $3.7 million to $9.1 million in 2008 from $13.0 million in 2007. Net operating income excludes the after-tax impact of net realized losses and impairments on investments totaling $3.2 million from net income in 2008. In 2007, net income was reduced by $2.2 million, the after-tax realized gains recorded in the year. YEAR ENDED DECEMBER 31, 2007 COMPARED TO 2006 The following financial information compares results for the full year 2007 and 2006. Variance Variance ($ THOUSANDS) 2007 2006 $ % Direct written premiums 157,935 117,834 40,101 34.0 Net written premiums 146,511 106,047 40,464 38.2 Net earned premiums 119,606 103,942 15,664 15.1 Claims incurred 71,179 59,503 11,676 19.6 Acquisition costs 26,143 19,499 6,644 34.1 Operating expenses 12,043 10,431 1,612 15.5 Underwriting income (loss) 10,241 14,510 (4,268) (29.4) Investment income (loss) 12,954 11,033 1,920 17.4 Interest expense 259 – 259 – Net income (loss) before income taxes 22,936 25,543 (2,607) (10.2) Income taxes 7,871 8,562 (691) (8.1) Net income (loss) 15,065 16,981 (1,916) (11.3) Net operating income 12,957 15,302 (2,345) (15.3) Insurance Operation Written Premiums Direct written and assumed premiums increased $40.1 million or 34.0% to $157.9 million in 2007 compared to $117.8 million for 2006. A significant increase was achieved in both business segments. The increase in Personal Lines premiums was primarily the result of EGI’s entry into the U.S. non-standard auto insurance market, effective January 1, 2007 through a reinsurance arrangement with AssuranceAmerica. The Company’s Niche Products division continued to record significant premium growth in 2007, maintaining our track record of steady growth in this business segment. The increase in premiums generated by the Personal Lines division was achieved despite continued competitive pressures from standard auto insurers continuing to pursue what had been 31
    • Management’s Discussion and Analysis 2008 traditionally perceived as non-standard risks. Offsetting the shrinkage in the Ontario non-standard auto business was the premium growth achieved in assumed business from the U.S.-based quota share treaty participation, an increase in Ontario motorcycle premiums and increases in Quebec’s automobile business. Automobile insurance premiums in Quebec grew 42.1% to $9.1 million in 2007, compared to $6.4 million in 2006. Quebec is viewed as a strategic growth area for geographic diversification with a focus on contracting new brokers and introducing new products such as the motorcycle program. Under an exclusive arrangement with a specialist broker, EGI began writing motorcycle business in Ontario during the first quarter of 2006. During 2007, direct premiums from this jurisdiction totaled $13.9 million compared to $7.6 million in 2006. Direct written premiums for the Niche Products division increased 142% to $48.1 million for in 2007, compared to $19.9 million in 2006. Formed in 2003, the Niche Products division experienced significant growth in the prior three years due to continued marketing efforts. Net written premiums increased $40.5 million, or 38.2% to $146.5 million in 2007, compared to $106 million for the prior year. The increase in net written premiums was consistent with the percentage increase in gross written premiums noted above. Earned Premiums Net earned premiums for 2007, were $119.6 million, an increase of $15.7 million or 15.1% from 2006. This increase was significantly lower than the net written premiums increase due to the impact of significant ETH premiums, written primarily in the fourth quarter of 2007, the majority of which was not earned until the first half of 2008. Incurred Claims Expense Net incurred claims expense increased $11.7 million or 19.7% to $71.2 million in 2007, compared to $59.5 million in 2006. The resulting 2007 loss ratio of 59.5% represented an increase of 2.3% over the 2006 year loss ratio of 57.2%. As noted in the analysis above for the fourth quarter of 2007, the primary reason for the increase in the 2007 loss ratio was an increase in the Niche Products division’s loss ratio to 56.1% for the year. ETH recorded a loss ratio of 94% while all other Niche Products programs recorded an excellent 48% loss ratio in 2007. The Personal Lines division incurred a loss ratio of 60.4% in 2007 compared to 57.9% in 2006. This increase was attributed to a higher than expected loss ratio in the motorcycle line of business of 76.6%. EGI entered the Ontario motorcycle insurance market in 2006, and as this relatively new line of business grows and matures, loss ratios are expected to decline. Positive development of prior year claims continued in 2007, resulting in a release of $11.8 million of net reserves that were accrued for the prior accident years. The favourable development can be distributed as $6.7 million for liability claims, $3.2 million for accident benefits claims, and $1.9 million for all other lines of business. In 2006, favourable prior year claims development of $12.0 million was recorded. Acquisition Costs Net acquisition costs, which consist mainly of commissions and premium taxes, increased $6.6 million or 33.8% to $26.1 million in 2007, compared to $19.5 million in 2006. This increase, in relation to the increase in net earned premiums of 15.1% compared to 2006, was the result of the reduction in the sliding scale reinsurance commission adjustments recorded in 2007 compared to the prior year. Additional reinsurance commission of $0.6 million was recorded in 2007 related to the 2005 policy year, compared to $2.7 million in 2006. EGI Financial Holdings Annual Report 2008
    • Management’s Discussion and Analysis 2008 Operating Expenses Operating expenses, which include interest expense, increased $1.6 million or 13.3% to $12.0 million for 2007 compared to $10.4 million for 2006. The increase was primarily due to (1) an increase in employee salaries and benefits of $1.37 million due to head count growth; (2) an accrual of rent and operating costs of $280,000 associated with EGI’s intention to relocate in 2008; and (3) expenses of $165,000 incurred in our new U.S. subsidiary, EGI Insurance Services, Inc. Underwriting Income Underwriting results reflect the revenues from net earned premiums less claims, acquisition and operating expenses. The overall underwriting income decreased $4.3 million to $10.2 million for 2007 compared to $14.5 million for 2006. The underwriting income for 2007 and 2006 was net of $0.9 million and $0.9 million of corporate and other expenses, respectively. Underwriting income from the Personal Lines division in 2007 was $10.8 million, representing a decline of $4.3 million compared to an income of $15.1 million for 2006. This result was due to an increase in the combined ratio to 87.8% in 2007 compared to 83.4% in 2006. The 2007 results include the release of actuarial reserves for prior accident years’ claims of $11.8 million compared to a release of $12.0 million in 2006, both the result of positive claims development related to prior year reserves. Underwriting income from the Niche Products division for 2007 was $0.3 million, a slight increase of $0.1 million compared to an income of $0.2 million in 2006. This result was achieved despite the adverse loss ratio experienced in the ETH business and allocation of shared services expenses to this division in 2007 of $0.7 million. Allocation of shared expenses commenced in 2007. Investment Income Investment income increased $1.9 million, or 17.2%, to $12.9 million for 2007 compared to $11.0 million for 2006. The significant increase in investment income compared to 2006 resulted from two primary factors. EGI’s investment portfolio reflected a $57.3 million or 25.6% increase in fair value as at December 31, 2007 compared to 2006, due to positive cash flows from operations during the period. There was also an increase in realized gains recorded in 2007 to $3.4 million, compared to $2.6 million of realized gains in 2006. The gains were derived from the sale of investments totaling $204.1 million in 2007 and $169.7 million in 2006. Note that a significant portion of the increase in the investment portfolio in 2007, compared to 2006, resulted from the additional funds drawn from the credit facility of $19.6 million, established in October 2007, arranged to fund U.S. business expansion. Net Income before Income Taxes Net income before income taxes decreased $2.6 million, or 10.2%, to $22.9 million for 2007, compared to $25.5 million for 2006, as a result of a higher combined ratio partially offset by the increase in investment income. For 2007, underwriting income of $10.2 million plus investment income of $12.9 million minus interest expense of $0.2 million, comprised net income before income taxes of $22.9 million. This compared to an underwriting income of $14.5 million plus investment income of $11.0 million in 2006. 33
    • Management’s Discussion and Analysis 2008 Income Taxes The provision for income taxes for the year ended December 31, 2007 was $7.9 million compared to $8.6 million for 2006. This reflected lower pre-tax income as a result of lower underwriting profits and increased investment income year over year. The approximate effective tax rate was 34% for 2007 and 2006. BALANCE SHEET ANALYSIS Investments EGI has an investment policy that seeks to provide a stable income base to support EGI’s liabilities without incurring an undue level of investment risk. All investment decisions are made with this risk-return trade off in mind. The two most important methods used to reduce the level of risk without reducing the rate of return in EGI’s portfolio are diversification and the use of proven investment professionals. EGI’s Board of Directors has established an Investment Committee to develop and implement detailed strategies consistent with EGI’s objectives and to report regularly to the Board of Directors on its activities. EGI has outsourced all buy/sell decisions on individual securities to a small number of reputable professional investment managers. Using the “prudent person” approach, the Investment Committee monitors the performance of each manager, measuring his or her performance against an appropriate market index benchmark. Each of EGI’s investment managers operates under an investment management agreement which provides the investment manager with a discretionary mandate to hold one or more types of securities and/or cash. The investment manager receives an annual fee (payable quarterly) based on a negotiated percentage of the market value of the portfolio being managed. The investment manager’s engagement is subject to immediate cancellation by EGI, without penalty, upon giving written notice. EGI’s investment portfolio is invested in well-established, active and liquid markets in Canada and the United States. Fair value for most investments is determined by reference to quoted market prices. The external investment managers invest on a total return basis, viewing realized gains and losses as important and recurring components of the return on investments and, consequently, of income. The timing of the realization of gains and losses may be unpredictable, and changes in the overall levels of fixed income or equity markets generally result in corresponding changes in realized gains and losses. To assess impairments, the Investment Committee and management review all holdings with a fair value below their carrying values and, in consultation with the appropriate investment manager, ascertain whether the carrying amounts are expected to be recovered. EGI’s investment managers provide advice as to whether the fair value of these securities is adversely affected on an other than temporary basis. Based on this advice and other factors, including the significant equity market decline in the last half of 2008 and uncertainty regarding its recovery, EGI recorded investment impairments of $4.7 million as at December 31, 2008. EGI Financial Holdings Annual Report 2008
    • Management’s Discussion and Analysis 2008 Fair Value of Investments The following table provides a comparison as at December 31, 2008 and December 31, 2007: As at December 31 2008 2007 ($ THOUSANDS) Fair value Fair value Bonds Canadian Federal $ 82,078 $ 80,378 Provincial 45,162 30,948 Municipal 6,935 3,908 Corporate 86,570 67,864 220,745 183,098 United States Federal – 2,288 Corporate 2,717 666 2,717 2,954 Total Bonds 223,462 186,052 Preferred shares 4,042 6,106 Common shares Canadian 29,049 42,150 United States 1,178 2,244 30,227 44,394 Investment income due and accrued 2,043 1,758 $259,774 $238,310 EGI’s portfolio is constructed in a manner that seeks to ensure that its objectives of producing a competitive rate of return are met, while at the same time protecting and enhancing statutory underwriting capital on a long- term basis. This is achieved through diversification principles that ensure each asset class has limited exposure by region, industry, issuer and type of underlying security. Target ranges are set for each asset class and economic sector and are monitored by the Investment Committee to ensure that EGI’s investment managers comply with these guidelines. All regulatory requirements and liquidity needs are adhered to by each manager. Impaired Assets and Provisions for Losses The Board of Directors has established a policy to write down or make a provision for any investment with other-than-temporary impairment. Management has reviewed currently available information regarding those investments whose estimated fair values are less than carrying values. For those securities whose decline in fair value was considered to be other- than-temporary, the Company has recorded the difference between the cost of the investment and its fair value as an impairment which reduces investment income in the year recorded. The Company considers an impairment to be other-than-temporary if it is unlikely the Company will recover an investment’s amortized cost in a reasonable period of time. Factors considered by the Company include but are not limited to the impact of issuer and industry specific events, current and expected future market and economic conditions, the nature of the investment, and the severity and duration of the fair value deficiency. 35
    • Management’s Discussion and Analysis 2008 An impairment loss of $4,713, comprised of $4,326 of common shares and $387 of Canadian corporate bonds, has been recognized in net income during 2008. No provisions were recorded in 2007. A remaining gross unrealized loss of $14,757 on investments held as at December 31, 2008, is recorded, net of tax, in the amount of $9,887 in Accumulated Other Comprehensive Loss. The Company has concluded, based on its review, that these fair value deficiencies are considered temporary in nature and they will be monitored on an ongoing basis. Fixed Income Securities EGI holds fixed income securities to provide a steady, predictable level of income and reasonable liquidity with minimum risk of loss and a fixed sum at maturity. EGI’s portfolio is diversified by selecting various types of government and corporate bonds. Constraints on types of issuers take liquidity, diversification and risk into account by limiting the portfolio mix by issuer. EGI maintains a high overall credit quality level as measured by Dominion Bond Rating Service (DBRS). Constraints are placed on the percentage of bonds which can be held in the rating classes as follows: Class A or better – no maximum; Class BBB or lower – maximum 10%. EGI’s policy is to purchase only corporate bond issues which are rated BBB or better at the time of purchase. In the event of subsequent downgrades, the Investment Committee will consider whether to continue to hold the bonds. The following table sets forth EGI’s fixed income portfolio by credit quality according to DBRS as at December 31, 2008 and 2007. Fixed Income Portfolio As at December 31 2008 2007 % of % of ($ THOUSANDS) Fair value Fair value Fair value Fair value AAA $107,830 48 $100,388 54 AA 60,713 27 43,015 23 A 48,080 22 37,631 20 BBB 6,765 3 5,018 3 CCC 74 – – – Total $223,462 100 $186,052 100 Common Shares Common shares are a key component of EGI’s portfolio to enhance the capital appreciation opportunities of EGI’s invested assets. Using a conservative approach to equity selection, EGI’s investment managers ensure that equities of companies with a reputation for strong management and a proven track record of success are selected for EGI’s portfolio. Diversification by country and industry sector also reduces the overall risk level inherent in EGI’s common share portfolio. EGI generally limits its total exposure to common shares at any one time to a maximum of 16% of the total of its invested assets and premium financing receivables, which is slightly below the average exposure to equities for Canadian-owned P&C insurers. EGI Financial Holdings Annual Report 2008
    • Management’s Discussion and Analysis 2008 Canadian Common Share Portfolio Included in the common shares held by the Company, as at December 31, 2007, was an investment in Gladiator LP, managed by Savoy Capital, with a fair value of $1.2 million. In August 2006, as noted in our 2007 annual report, subsequent to a notice provided by Savoy to terminate the investment management services agreement with the Gladiator fund, Savoy ceased actively investing in the fund and immediately began to employ a defensive position. Equity exposures were reduced significantly and the cash position increased. Since that time, the process to wind up the fund has been completed resulting in total cash redemptions received by EGI of $8.2 million, of which $1.4 million was received in 2008, resulting in a small realized gain recorded in 2008 related to the final wind up of the fund. EGI had no further exposure related to this fund as at December 31, 2008. Restrictions as to the amount of common shares held in any industry sector are also part of EGI’s risk diversification methodology. The following table outlines EGI’s Canadian common share exposure to industry sectors as at December 31, 2008 and 2007. As at December 31 2008 2007 Fair value and % of Fair value and % of carrying fair carrying fair ($ THOUSANDS) amount value amount value Energy 5,513 19 7,736 18 Financial services 9,173 32 14,275 34 Materials 4,105 14 4,852 11 Gladiator LP – – 1,238 3 Other 10,258 35 14,049 34 Total 29,049 100 42,150 100 Recoverable from Reinsurers As at December 31 ($ THOUSANDS) 2008 2007 Reinsurers’ share of unpaid claims $41,901 $48,461 Reinsurers’ share of unearned premiums 3,712 3,602 Total $45,613 $52,063 As at December 31, 2008, the amount recoverable from reinsurers decreased by $6.4 million, or 12.3%, to $45.6 million from $52.0 million at December 31, 2007. The decrease was due to reduced reliance on reinsurance particularly for the 2007 and 2008 policy years. All reinsurers, with balances due, have a rating of B++ or above as determined by Standard &Poor’s and A.M. Best. Accounts Receivable As at December 31 ($ THOUSANDS) 2008 2007 Premium financing receivables 20,615 19,569 Facility Association (87) (90) Agents and brokers 6,949 5,807 Other 88 96 Total 27,565 25,382 37
    • Management’s Discussion and Analysis 2008 Premium financing receivables was the largest component of this asset as at December 31, 2008 and represents approximately 75.0% or $20.6 million of total receivables. Premium financing receivables increased to $20.6 million at December 31, 2008, from $19.6 million at December 31, 2007. The majority of the automobile business is billed directly to policyholders and remitted on a monthly basis. Agent and broker receivables grew by 19% in 2008 compared to 2007, largely due to the significant growth in the Niche business segment. EGI also experienced significant growth in business in Quebec where broker billing is offered as a mode of payment. Provision for Unpaid Claims EGI establishes loss reserves to provide for future amounts required to pay claims related to insured events that have occurred and been reported but have not yet been settled, as well as for those related to events that have occurred but have not yet been reported to the insurer. Claims provisions (i.e. reserves for claims liability) are established at the individual file level by the “case method” as claims are reported. The provisions are subsequently adjusted as additional information affecting the estimated amount of a claim becomes known during the course of its settlement. With the assistance of EGI’s consulting actuary, a reserve provision is also made for management’s calculation of factors affecting the future development of claims, including a provision for IBNR claims, based on the volume of business currently in force and the historical experience on claims. Reserves are also established for the estimated internal and external loss adjustment expenses which will be incurred during the claims settlement process. The provision for unpaid claims and adjustment expenses is discounted to take into account the time value of money as required by EGI’s primary insurance regulator. It also includes a provision for adverse deviation as required by accepted Canadian actuarial practice. EGI’s consulting actuary reports on the adequacy of EGI’s claims reserves on a quarterly basis. As time passes, more information about the claims becomes known and provisional estimates are appropriately adjusted upward or downward. Adjustments to reserves are reflected in the results of operations in the periods in which the estimates are changed. The development of the provision for claims is shown by the difference between estimates of reserves as of the initial year-end and the re-estimated liability at each subsequent year-end. This is based on actual payments in full or partial settlement of claims, plus re-estimates of the reserves required for claims still open or claims still unreported. Favourable development means that the original reserve estimates were higher than subsequently indicated. Unfavourable development means that the original reserve estimates were lower than subsequently indicated. For further discussion of EGI’s reserving methods and underlying assumptions, see “Critical Accounting Estimates and Assumptions – Policy Liabilities”. Provision for unpaid claims consists of the gross amount of individual case reserves established and management’s estimate of claims incurred, but not reported, based on the volume of business currently in force and historical claims experience. In order to ensure that EGI’s provision for unpaid claims (often called “reserves”) is adequate, management has retained the services of an independent consulting actuary. EGI strives to establish adequate provisions at each quarter-end. EGI estimates its reserves on a quarterly basis and this is supported by quarterly assessments by the independent consulting actuary. Every quarter, for each line of business, EGI compares actual and expected claims development. To the extent that actual results differ from expected development, assumptions are re- evaluated and new estimates are derived. Although EGI believes its overall provision levels to be adequate to satisfy its obligations under existing policies, actual losses may deviate, perhaps substantially, from the amounts EGI Financial Holdings Annual Report 2008
    • Management’s Discussion and Analysis 2008 reflected in EGI’s financial statements. To the extent provisions prove to be inadequate, EGI would have to increase such provisions and incur a charge to earnings in the future. The table below shows the development of the provision for claims reserves including loss adjustment expenses as at December 31 in each year of the five-year period and for the year ended December 31, 2008, for Echelon (on a 100% basis). Year ended December 31 ($ THOUSANDS) 2007 2006 2005 2004 2003 Reserve carried (actuarial present value basis) (1) 168,257 145,691 129,041 107,196 79,191 Reserve at December 31, 2003 Cumulative paid to December 31, 2003 Cumulative redundancy (deficiency) Reserve at December 31, 2004 56,226 Cumulative paid to December 31, 2004 24,184 Cumulative redundancy (deficiency) (1,219) Reserve at December 31, 2005 70,620 37,802 Cumulative paid to December 31, 2005 24,922 38,802 Cumulative redundancy (deficiency) 11,654 2,587 Reserve at December 31, 2006 88,029 49,557 25,214 Cumulative paid to December 31, 2006 25,817 41,158 49,592 Cumulative redundancy (deficiency) 15,195 16,481 4,385 Reserve at December 31, 2007 107,992 67,408 36,129 17,569 Cumulative paid to December 31, 2007 30,432 46,413 55,306 28,217 Cumulative redundancy (deficiency) 7,267 15,220 15,761 3,405 Reserve at December 31, 2008 117,541 81,172 50,013 25,237 12,112 Cumulative paid to December 31, 2008 44,265 53,325 62,210 66,181 64,392 Cumulative redundancy (deficiency) 6,450 11,194 16,818 15,778 2,687 (1) Amounts include provision for adverse deviation (PFAD) of $17,401 for 2007; $14,756 for 2006; $12,473 for 2005; $8,613 for 2004; and $6,137 for 2003. The uncertainties regarding EGI’s reserves could result in a liability exceeding the reserves by an amount that would be material to EGI’s financial condition or results of operations in a future period. Future development could be significantly different from the past, due to many unknown factors (see “Risk Factors”). Reinsurance EGI has reinsurance treaties with several unaffiliated reinsurers, all of whom are selected on the basis of their creditworthiness. EGI purchases reinsurance to reduce its exposure to the insurance risks that it assumes in writing business. For 2008, the maximum net retention on a single risk was $1.5 million (2007 – $1.15 million). In accordance with industry practice, EGI’s reinsurance recoverables with licensed Canadian reinsurers are generally unsecured because Canadian regulations require these reinsurers to maintain minimum asset and capital balances in Canada to meet their Canadian obligations. However, policy liabilities rank in priority to any subordinate creditors a reinsurer may have. For reinsurance recoverables with non-licensed reinsurers, EGI maintains security against reinsurance recoverables in the form of cash, letters of credit and/or assets held in trust accounts. At December 31, 2008, EGI was the assigned beneficiary of such trust accounts totaling $2.3 million (December 31, 2007 – $2.4 million) in guarantees from unlicensed reinsurers. 39
    • Management’s Discussion and Analysis 2008 Excess of loss and catastrophe reinsurance is used to limit an insurer’s exposure to a maximum dollar value per claim and per occurrence. Quota share is a form of proportional reinsurance often used by an insurer to build a book of business larger than can be supported by the insurer’s own capital. When used on established, profitable lines of business, quota share is an expensive substitute for equity capital. The insurer is essentially borrowing capital from the reinsurer by transferring unearned premium and claims liabilities from its books to the books of the reinsurer. Within the range of expected loss ratios, this transfer is done at a direct cost to the insurer, which happens through the ceding commission (expense allowance) paid by the reinsurer. The ceding commission paid to the insurer by the reinsurer varies depending on the gross loss ratio. As the gross loss ratio increases, the amount of ceding commission decreases, subject to agreed upon limits. Above the maximum loss ratio on the ceding commission scale, there is full risk transfer (i.e. the potential to lose money) to the reinsurer. Below the minimum loss ratio on the ceding commission scale, the reinsurer’s profit increases. The reinsurer also retains the investment income on the cash balances that develop between the dates premiums are received and the dates claims are paid. EGI purchases renewable excess of loss and catastrophe reinsurance from third-party reinsurers, covering its automobile and general liability business. In 2008, such coverage was for a total of $18.0 million, and $13.9 million in 2007. Other than general liability, coverages for the programs of the Niche Products division are reinsured on a program-by-program basis. For 2008, EGI’s liability after all reinsurance recoveries was limited to a maximum of $1.5 million, and in 2007, $1.15 million on any one claim. Using reinsurance, EGI’s policy is to limit its loss exposure in any one claim to not more than 2% of its shareholders’ equity. EGI depends upon the financial stability of its reinsurers in the same way that EGI’s insureds rely upon EGI. Accordingly, EGI carefully selects its reinsurers and only deals with creditworthy reinsurers. EGI’s Reinsurance Committee is responsible for evaluating and approving companies to which EGI cedes reinsurance. The committee consults with AON Re Canada Inc. regarding the financial ratings of EGI’s reinsurers. Reinsurers are selected based on their financial strength ratings, services, reputation and prices offered on the required reinsurance. As reported to EGI by AON Re Canada Inc., EGI’s reinsurance broker, at December, 2008, all reinsurers providing coverage under EGI’s treaties were rated B++ or better by A.M. Best. As EGI’s insurance and reinsurance company subsidiaries increase their equity (and therefore regulatory capital), they can retain more insurance business for their own account and therefore purchase less reinsurance. The marginal return on this new capital can be very substantial. Each dollar of new equity allows EGI to retain up to two and one- half dollars of additional premium (and the potential downside risk thereon) each year for its own account. EGI believes that there is currently adequate reinsurance capacity in the marketplace for those classes of business which EGI underwrites, and management is not aware of any developments that might cause a serious shortage of capacity in the future. EGI believes that, through its reinsurance program, it is adequately protected against major underwriting losses arising from a large claim under a single policy or claims under a group of policies arising from a single event. Share Capital As of March 13, 2009, there were 11,687,582 common shares issued and outstanding. See also note 10 to the consolidated financial statements. EGI Financial Holdings Annual Report 2008
    • Management’s Discussion and Analysis 2008 Liquidity and Capital Resources The purpose of liquidity management is to ensure there is sufficient cash to meet all of EGI’s financial commitments and obligations as they come due. The Company pays quarterly dividends to its common shareholders. The dividend payment for the fourth quarter was made on December 29, 2008, to common shareholders of record on December 12, 2008, in the amount of $0.7 million. EGI believes that it has the flexibility to obtain, from internal sources, the funds needed to fulfill its cash requirements, including quarterly dividend payment commitments to shareholders, during the following financial year and to satisfy regulatory capital requirements. Despite recent global market events, including a material reduction in liquidity, EGI believes that its liquidity and funding position remains adequate to execute its strategy. Additionally EGI has been able to raise $20.8 million in net proceeds from a Rights Offering in July 2008 to supplement current resources and further strengthen its liquidity position. EGI’s principal sources of funds are premiums collected, investment income and proceeds from investments that have been sold or have matured. However, such funds may not provide sufficient capital to enable EGI to pursue additional market opportunities. In October 2007, EGI entered into a non-revolving term credit facility with a major Canadian bank in the amount of US$20 million, converted to CDN$19.55 million, the equivalent Canadian dollar amount as of the closing date. The facility bears interest of 6.2% which is payable monthly over the three-year term of the agreement. After three years, EGI is obligated to repay the amounts drawn as at the termination of the agreement. Pursuant to the credit facility agreement, EGI is required to comply with various financial covenants and financial information reporting requirements. During the three-year term, EGI has agreed to various financial covenants, of which the key ones require EGI to maintain a minimum tangible net worth of $80.0 million and a maximum debt-to-capital ratio of 0.30:1.00. The initial drawdown of US$20 million, or CDN$19.55 million, was used to increase the capital of CIM Reinsurance Company Ltd., EGI’s Barbados-based reinsurance company, which has been used to reinsure selected niche and specialty line insurers which underwrite business in the United States. Contractual obligations include operating leases, for which $1.1 million was due in less than a year and $8.2 million is due over the next nine years. In addition, EGI has commitments under a contractual agreement with a third party computer software provider totaling $4.4 million over the next three years. Under this agreement EGI has retained the right to use an integrated insurance policy administration system which is expected to improve operating efficiencies related to the administration of Personal Lines products. EGI is primarily a holding company and, as such, has limited direct operations of its own. EGI’s principal assets are the shares of its insurance, reinsurance and insurance management subsidiaries. Accordingly, its future cash flows depend in part upon the availability of dividends and other statutorily permissible distributions from the insurance subsidiaries. The ability to pay such dividends and to make such other distributions is limited by applicable laws and regulations of the jurisdictions in which the insurance subsidiaries are domiciled, which subject the insurance subsidiaries to significant regulatory restrictions. These laws and regulations require, among other things, that the insurance subsidiaries maintain minimum solvency requirements and may also limit the amount of dividends that the insurance subsidiaries can pay to EGI. Transactions with Related Parties EGI has entered into transactions with two related parties, The Co-operators Group Limited (Co-operators) and Purves Redmond Limited (Purves Redmond). These transactions are carried out in the normal course of operations and are measured at cost which approximates fair value. The transactions involving Co-operators, 41
    • Management’s Discussion and Analysis 2008 which is a significant shareholder of EGI, principally consist of an agent distribution channel, support services and investment management. Purves Redmond is involved in arranging insurance coverage for the companies within the EGI group. Robert Purves, a shareholder and director of EGI, is also a shareholder and the chairman of Purves Redmond. Risk Management EGI has developed a comprehensive process of risk management and internal control which emphasizes the proactive identification of risks facing the organization and the effective management and control of these risks. The foundation of the process is the ongoing thorough operational analysis by senior management committees and a structured oversight process undertaken by the Board of Directors and appointed committees. Underlying this structure are strong internal control procedures which are designed to safeguard EGI’s assets and protect the organization and its stakeholders from risk. As a provider of insurance products, effective risk management is fundamental to EGI’s ability to protect the interests of EGI’s customers and shareholders. EGI is exposed to potential loss from various market risks, including interest rate and equity market fluctuation risk, credit risk, liquidity risk and, to a lesser extent, foreign currency risk. Market Risk Market risk is the risk of loss arising from adverse changes in market rates and prices, such as interest rates, foreign currency exchange rates, and other relevant market rate or price changes. Market risk is directly influenced by the volatility and liquidity in the markets in which the related underlying assets are traded. The primary market risk to the investment portfolio is the interest rate risk associated with investments in fixed income securities. EGI’s exposure to unhedged foreign exchange risk is not significant and is limited to the common equity portfolio. For EGI’s investment portfolio, there were no significant changes in 2008 in the primary market risk exposures or in how those exposures are managed compared to the year ended December 31, 2007. Management does not currently anticipate significant changes in EGI’s primary market risk exposures or in how those exposures are managed in future reporting periods based upon what is known or expected to be in effect in future reporting periods. Interest Rate and Equity Market Fluctuation Movements in short and long-term interest rates, as well as fluctuations in the value of equity securities, affect the level and timing of recognition of gains and losses on securities EGI holds, and cause changes in realized and unrealized gains and losses. Generally, EGI investment income will be reduced during sustained periods of lower interest rates as higher yielding fixed income securities are called, mature, or are sold and the proceeds are reinvested at lower rates. During periods of rising interest rates, the market value of EGI’s existing fixed income securities will generally decrease and the realized gains on fixed income securities will likely be reduced. Realized losses will be incurred following significant increases in interest rates. Generally, declining interest rates result in unrealized gains in the value of the fixed income securities EGI continues to hold, as well as realized gains to the extent the relevant securities are sold. General economic conditions, political conditions and many other factors can also adversely affect the stock markets and, consequently, the value of the equity securities EGI owns. EGI Financial Holdings Annual Report 2008
    • Management’s Discussion and Analysis 2008 Credit Risk Credit risk is the possibility that counterparties may not be able to meet payment obligations when they become due. EGI assumes counterparty credit risk in many forms. A counter-party is any person or entity from which cash or other forms of consideration are expected to extinguish a liability or obligation to EGI. The credit risk exposure is concentrated primarily in the fixed income and preferred share investment portfolios and, to a lesser extent, in reinsurance recoverables. EGI’s risk management strategy and investment policy is to invest in debt instruments of high credit quality issuers and to limit the amount of credit exposure with respect to any one issuer. EGI attempts to limit its credit exposure by imposing fixed income portfolio limits on individual corporate issuers based upon credit quality (see “Investments” – “Fixed Income Securities” and “Reinsurance” sections. Foreign Exchange Risk Foreign exchange risk is the possibility that changes in exchange rates may produce an unintended effect on earnings and equity when measured in domestic currency. This risk is largest when asset backing liabilities are payable in one currency and are invested in financial instruments of another currency. EGI is exposed to some foreign exchange risk arising from claims on the ETH insurance business, the investment in U.S. dollar denominated investments and business assumed from U.S.-domiciled insurers. Total invested assets denominated in U.S. dollars were less than 3% of the total invested assets at December 31, 2008. EGI’s general policy is to minimize foreign currency exposure by maintaining investments in the same currency as the offsetting liabilities. Risk Factors Careful consideration should be given to the following factors, which must be read in conjunction with the detailed information appearing elsewhere in this report. Any of the matters highlighted in these risk factors could have a material adverse effect on EGI’s results of operations, business prospects or financial condition. Nature of the Industry The P&C insurance business in Canada is affected by many factors which can cause fluctuations in the results of operations of EGI. Many of these factors are beyond EGI’s control. An economic downturn in those jurisdictions in which EGI writes business could result in less demand for insurance and lower policy amounts. As a property and casualty insurer, EGI is subject to claims arising out of catastrophes, which may have a significant impact on its results of operations and financial condition. These factors, together with the industry’s historically cyclical competitive pricing, could result in fluctuations in the underwriting results and net income of EGI. A significant portion of the earnings of insurance companies is derived from the income from their investment portfolios. EGI’s investment income will fluctuate depending on the returns and values of securities in its investment portfolio. Regulation EGI is subject to the laws and regulations of the jurisdictions in which it carries on business. These laws and regulations cover many aspects of its business, including premium rates for automobile insurance; the assets in which it may invest; the levels of capital and surplus and the standards of solvency that it must maintain; and the amount of dividends which it may declare and pay. Changes to laws or regulations are impossible to predict and could materially adversely affect EGI’s business, results of operations and financial condition. Where the Office of the Superintendent of Financial Institutions (OSFI) is concerned about an unsafe course of conduct or an unsound practice in conducting the business of a 43
    • Management’s Discussion and Analysis 2008 federally regulated insurance company, OSFI may direct the insurance company to refrain from a course of action or to perform acts necessary to remedy the situation. In certain circumstances, OSFI may take control of the assets of an insurance company or take control of the company itself. More restrictive laws, rules or regulations may be adopted in the future that could make compliance more difficult and/or expensive. Specifically, recently adopted legislation addressing privacy issues, among other matters, is expected to lead to additional regulation of the insurance industry in the coming years, which could result in increased expenses or restrictions on EGI’s operations. Industry Growth EGI is subject to and dependent on fluctuations within the P&C insurance industry. According to Canadian Underwriter, from 2001 to 2004, direct written premiums in the P&C insurance industry in Ontario, Alberta and Quebec grew at an abnormally high compound annual growth rate of 12.3%. However, in 2005 and 2006, the growth in direct written premiums slowed significantly to approximately 1%. EGI believes that soft market conditions will continue in the short term and that the performance of the P&C insurance industry will trend toward the industry’s historic norms. Competition The P&C insurance business is highly competitive with pricing being a primary means of competition. Other elements of competition include availability and quality of products, quality and speed of service, financial strength, distribution systems and technical expertise. EGI competes with many other insurance companies. Certain of these competitors are larger and have greater financial resources than EGI has. In addition, certain competitors have from time to time decreased their prices in an apparent attempt to gain market share. As competitors introduce new products and as new competitors enter the market, the Company and its insurance subsidiaries may encounter additional and more intense competition. There can be no assurance that EGI will continue to increase revenues or be profitable. To a large degree, future revenues of EGI are dependent upon its ability to continue to develop and market its products and to enhance the capabilities of its products to meet changes in customer needs. EGI expects to encounter competition from other entities having a business objective similar to that of EGI. Many of these entities are well established and have extensive experience in connection with identifying and effecting business acquisitions directly or through affiliates. Many of these competitors possess greater financial resources, technical personnel and other resources than EGI and there can be no assurance that EGI will have the ability to compete successfully. EGI’s financial resources will be relatively limited when contrasted with those of many of its competitors. Although EGI’s business strategy assumes that the industry will generate competition, there can be no assurance on how any level of competition may impact the future revenues of EGI. Cyclicality Historically, the results of companies in the P&C insurance industry have been subject to significant fluctuations and uncertainties. The profitability of P&C insurers can be affected significantly by many factors, including regulatory regimes, developing trends in tort and class action litigation, adoption of consumer initiatives regarding rates or claims handling procedures, and privacy and consumer protection laws that prevent insurers from assessing risk, or factors that have a high correlation with risks considered, such as credit scoring. The financial performance of the P&C insurance industry has historically tended to fluctuate in cyclical patterns of “soft” markets characterized generally by increased competition, resulting in lower premium rates and EGI Financial Holdings Annual Report 2008
    • Management’s Discussion and Analysis 2008 underwriting standards, followed by “hard” markets characterized generally by lessening competition, stricter underwriting standards and increasing premium rates. EGI’s profitability tends to follow this cyclical market pattern with profitability generally increasing in hard markets and decreasing in soft markets. These fluctuations in demand and competition could produce underwriting results that would have a negative impact on EGI’s results of operations and financial condition. Unpredictable Catastrophic Events Catastrophes can be caused by various natural and unnatural events. Natural catastrophic events include hurricanes, windstorms, earthquakes, hailstorms, explosions, severe winter weather and fires. Unnatural catastrophic events include hostilities, terrorist acts, riots, crashes and derailments. The incidence and severity of catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Most catastrophes are restricted to small geographic areas; however, hurricanes, windstorms and earthquakes may produce significant damage in large, heavily populated areas. Catastrophes can cause losses in a variety of P&C insurance lines. For example, the ice storm in eastern Canada in 1998 caused P&C insurance losses in several lines of business, including business interruption, personal property, automobile and commercial property. Claims resulting from natural or unnatural catastrophic events could cause substantial volatility in EGI’s financial results for any fiscal quarter or year and could materially reduce EGI’s profitability or harm EGI’s financial condition. EGI’s ability to write new business also could be affected. EGI may experience an abrupt interruption of activities caused by unforeseeable and/or catastrophic events. EGI’s operations may be subject to losses resulting from such disruptions. Losses can relate to property, financial assets, trading positions and also to key personnel. If EGI’s business continuity plans cannot be put into action or do not take such events into account, losses may further increase. Interest Rates An increase in interest rates may result in lower values for EGI’s bond portfolio and increased costs of borrowing for EGI on future debt instruments or credit facilities. Such increased costs would negatively affect EGI’s operating results. Negative Publicity in the Industry EGI’s products and services are ultimately distributed to individual consumers. From time to time, consumer advocacy groups or the media may focus attention on EGI’s products and services, thereby subjecting its industry to periodic negative publicity. EGI also may be negatively impacted if its industry engages in practices resulting in increased public attention to its business. Negative publicity may also result in increased regulation and legislative scrutiny of practices in the P&C insurance industry as well as increased litigation. Such consequences may increase EGI’s costs of doing business and adversely affect EGI’s profitability by impeding its ability to market its products and services or increasing the regulatory burdens under which EGI operates. Reliance on Brokers EGI distributes its products primarily through a network of brokers. These brokers sell EGI’s competitors’ products and may stop selling EGI products altogether. Strong competition exists among insurers for brokers with demonstrated ability to sell insurance products. Premium volume and profitability could be materially adversely affected if there is a material decrease in the number of brokers that choose to sell EGI products. In addition, some P&C insurance companies offer their products through dedicated, captive sales organizations. If the number of such P&C insurance companies increases, EGI’s revenues may decrease, which could have a material adverse effect on EGI’s business, financial condition and results of operations. EGI’s strategy of distributing through Co-operators’ agent channel may also adversely impact its relationship with brokers who distribute EGI products. 45
    • Management’s Discussion and Analysis 2008 Product and Pricing EGI prices its products taking into account numerous factors, including claims frequency and severity trends, product line expense ratios, special risk factors, the capital required to support the product line, and the investment income earned on that capital. EGI’s pricing process is designed to ensure an appropriate return on capital and long-term rate stability, avoiding wide fluctuations in rate unless necessary. These factors are reviewed and adjusted periodically to ensure they reflect the current environment. However, pricing for automobile insurance must be submitted to each provincial government regulator and in certain provinces pre-approved by the regulator. It is possible that, in spite of EGI’s best efforts, regulator decisions may impede automobile rate increases or other actions that EGI may wish to take. Also, during periods of intense competition for any product line to gain market share, EGI’s competitors may price their products below the rates EGI considers acceptable. Although EGI may adjust its pricing up or down to maintain EGI’s competitive position, EGI strives to ensure its pricing will produce an appropriate return on invested capital. There is no assurance that EGI will not lose market share during periods of intense pricing competition. Underwriting and Claims EGI is exposed to losses resulting from the underwriting of risks being insured and the exposure to financial loss resulting from greater than anticipated adjudication, settlement and claims costs. EGI’s success depends upon its ability to accurately assess the risks associated with the insurance policies that EGI writes. EGI’s underwriting objectives are to develop business within EGI’s target markets on a prudent and diversified basis and to achieve profitable underwriting results (i.e. a combined ratio below 100%). EGI underwrites automobile business after a review of the applicant’s driving record reports and claims experience. There can be no assurances that EGI will properly assess the risks associated with the insurance policies that it writes and may, therefore, experience increased adjudication, settlement and claims costs. Loss Reserves and Claims Management The amounts established and to be established by EGI for loss and loss adjustment expense reserves are estimates of future costs based on various assumptions, including actuarial projections of the cost of settlement and the administration of claims, estimates of future trends in claims severity and frequency, and the level of insurance fraud. Most or all of these factors are not directly quantifiable, particularly on a prospective basis, and the effects of these and unforeseen factors could negatively impact EGI’s ability to accurately assess the risks of the policies that it writes. In addition, future adjustments to loss reserves and loss adjustment expenses that are unanticipated by management could have an adverse impact upon the financial condition and results of operations of EGI. Although EGI’s management believes its overall reserve levels as at December 31, 2008 are adequate to meet its obligations under existing policies, actual losses may deviate, perhaps substantially, from the reserves reflected in EGI’s financial statements. To the extent reserves prove to be inadequate, EGI would have to increase such reserves and incur a charge to earnings. Errors and Omissions Claims Where EGI acts as a licensed insurance agency, it is subject to claims and litigation in the ordinary course of business resulting from alleged errors and omissions in placing insurance and handling claims. The placement of insurance and the handling of claims involve substantial amounts of money. Since errors and omissions claims against EGI may allege EGI’s potential liability for all or part of the amounts in question, claimants may seek large damage awards and these claims can involve significant defense costs. Errors and omissions could include, for example, EGI’s employees or sub-agents failing, whether negligently or intentionally, to place coverage or file claims on behalf of customers, to appropriately and adequately disclose insurer fee arrangements to its customers, EGI Financial Holdings Annual Report 2008
    • Management’s Discussion and Analysis 2008 to provide insurance providers with complete and accurate information relating to the risks being insured or to appropriately apply funds that it holds for its customers on a fiduciary basis. It is not always possible to prevent or detect errors and omissions, and the precautions EGI takes may not be effective in all cases. EGI’s business, financial condition and/or results may be negatively affected if in the future its errors and omissions insurance proves to be inadequate or unavailable. In addition, errors and omissions claims may harm EGI’s reputation or divert management resources away from operating the business. Investments EGI’s investment assets are exposed to any combination of risks related to interest rates, foreign exchange rates and changing market values. EGI’s investment portfolio consists of diversified investments in fixed-income securities and preferred and common stocks. Investment returns and market values of investments fluctuate from time to time. A decline in returns could reduce the overall profitability of EGI. A change in interest rates, market values or foreign exchange rates may affect Echelon’s regulatory strength tests. Reinsurance Consistent with industry practice, EGI utilizes reinsurance to manage its claims exposure and diversifies its business by types of insurance and geographic area. The availability and cost of reinsurance are subject to prevailing market conditions that are generally beyond the control of EGI and may affect EGI’s level of business and profitability. There can be no assurance that developments may not occur in the future which might cause a shortage of reinsurance capacity in those classes of business which EGI underwrites, which could result in the curtailment of issuing of policies in a certain line of business or containing limits above a certain size. Reinsurer Credit Risk EGI’s reinsurance arrangements are with a limited number of reinsurers. This reinsurance may cause an adverse effect on EGI’s results of operations if one or more of its reinsurers are unable to meet its financial obligations. Although all of its reinsurers were rated B++ or higher by A.M. Best at the time of entering into the reinsurance arrangements, these ratings are subject to change and may be lowered. Although reinsurance makes the assuming reinsurers liable to EGI to the extent of the risk each reinsurer assumes, EGI is not relieved of its primary liability to its insureds as the direct insurer. As a result, EGI bears credit risk with respect to its reinsurers. EGI cannot ensure that its reinsurers will pay all reinsurance claims on a timely basis or at all. EGI evaluates each reinsurance claim based on the facts of the case, historical experience with the reinsurer on similar claims, and existing law and includes in its reserve for uncollectible reinsurance any amounts deemed uncollectible. The inability to collect amounts due to EGI under reinsurance arrangements would reduce EGI’s net income and cash flow. Technology EGI is heavily dependent on systems technology to process large volumes of transactions and there would be a risk if the technology employed is inadequate or inappropriate to support current and future business needs and objectives. EGI continues to implement new computer applications as part of a comprehensive approach to improve systems technology. EGI regularly tests and improves its Business Recovery Emergency Plan to protect itself, its producers and policyholders in the event of a technology failure; however, there is no assurance that EGI will be able to respond to technology failures effectively and with minimal disruption. 47
    • Management’s Discussion and Analysis 2008 Liquidity EGI manages its cash and liquid assets in an effort to ensure there is sufficient cash to meet all of EGI’s financial obligations as they fall due. As a federally regulated insurance company, Echelon is required to maintain an asset base comprised of liquid securities that can be used to satisfy its ongoing commitments. EGI believes that internally generated funds provide the financial flexibility needed to fulfill cash commitments on an ongoing basis. EGI has no material commitments for capital expenditures. However, there can be no assurances that EGI’s cash on hand and liquid assets will be sufficient to meet any future obligations that may come due. Future Capital Requirements EGI’s future capital requirements will depend upon many factors, including the expansion of EGI’s sales and marketing efforts and the status of competition. There can be no assurance that any additional financing will be available to EGI on acceptable terms, or at all. If additional funds are raised by issuing equity securities, further dilution to the existing stockholders will result. If adequate funds are not available, EGI may be required to delay, scale back or eliminate its programs. Accordingly, the inability to obtain such financing could have a material adverse effect on EGI’s business, financial condition and results of operations. Corporate Governance Active oversight remains a priority for the Board of Directors. The board is directly involved, through its committees, in overseeing all aspects of EGI’s operation. The objective of the board is to meet or exceed best practices in corporate governance. There is independent oversight from the board and the respective committees to key corporate functions such as financial reporting, compliance, risk assessment and management, as well as human resources and succession planning. EGI’s Board of Directors has established the following committees to ensure that risks are effectively identified, monitored, controlled and reported on: Audit and Risk Committee: This committee of directors of the Company reviews all financial information, monitors internal controls and provides oversight of management’s risk control processes, specifically focusing on financial related risks. Echelon also has an audit and risk committee of its directors in accordance with the requirements of the Insurance Companies Act (Canada). Conduct Review & Compensation Committee: The Conduct Review & Compensation Committee of directors of the Company monitors related party transactions affecting EGI and reviews and approves officer compensation and benefit plans. The Conduct Review Committee of directors of Echelon is responsible for the identification and reporting of related party transactions to Echelon’s board of directors and the monitoring of regulatory compliance and market conduct programs put in place by management to ensure their effectiveness. Investment Committee: This committee, composed of directors and supported by senior executives, ensures that risks associated with the investment of corporate and policyholder funds are effectively managed to accomplish EGI’s investment objectives of prudent, conservative management of funds and compliance with regulatory restrictions while achieving competitive rates of return. Reinsurance Committee: This committee of senior executives works closely with AON Re Canada Inc., EGI’s reinsurance brokers, to ensure that effective reinsurance programs are in place, which facilitate the desired growth of EGI’s business and provide EGI with protection against the occurrence of significant and unusual claims risk and development. EGI Financial Holdings Annual Report 2008
    • Management’s Discussion and Analysis 2008 In addition to these committees, management has formed a number of working committees which have been assigned the responsibility of identifying and managing specific corporate risks, including (i) a strategic initiatives committee to consider the strategic risks faced by EGI; (ii) underwriting and claims committees to manage the risks associated with the development and pricing of EGI’s products, claims adjudication and reserving; (iii) a technology committee and a system prioritization committee to implement effective technology solutions; and (iv) a compliance committee to ensure that the appropriate processes and procedures are in place to ensure compliance with all applicable regulatory requirements. EGI has also established a Business Recovery Emergency Plan with the objectives of protecting life, securing critical infrastructure and facilities from a catastrophic event and resuming business operations in a timely effective manner thus minimizing loss to the organization. EGI maintains liability insurance covering errors or omissions that may occur while acting in its role as an insurance consultant. The annual premium for this coverage during fiscal 2008 was $5,031. This coverage has an aggregate limit of liability of $2,000,000. Controls and Procedures Disclosure Controls and Procedures Our disclosure controls and procedures are designed to provide reasonable assurance that information required to be disclosed by EGI is recorded, processed, summarized and reported in a timely manner. This includes controls and procedures that are designed to ensure that information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. As of December 31, 2008 an evaluation was carried out, under the supervision of the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures as defined under Multilateral Instrument 52-109. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the design of these disclosure controls and procedures was effective. Internal Controls over Financial Reporting As at the financial year ended December 31, 2008, the Chief Executive Officer and the Chief Financial Officer evaluated the effectiveness of the Company’s internal control over financial reporting. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the internal control over financial reporting was effective as at December 31, 2008, and provided reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with Canadian GAAP. There have been no changes in the Company’s internal control over financial reporting during the year ended December 31, 2008 that have materially affected or are reasonably likely to materially affect our internal control over financial reporting. Capital Resources The total capitalization of EGI at December 31, 2008 was $118.6 million compared to $101.7 million at December 31, 2007. The elements that increased shareholders’ equity consist of net income of $6.0 million, the issuance of common shares for proceeds of $21.0 million and the cost of granting employee stock options of $0.2 million. These increases were offset by other comprehensive loss of $7.7 million in 2008, reflecting (i) a decline in fair value of investments designated as available-for-sale investments of $10.6 million, net of income tax; (ii) a reclassification for losses realized in 2008 of $3.1 million, net of income tax, and included in net income in the year; and (iii) unrealized losses on translation of financial statements of self-sustaining foreign operations of $0.2 million and the payment of common share dividends of $2.6 million in 2008. 49
    • Management’s Discussion and Analysis 2008 The continued growth in capitalization reflects the strengthening of EGI’s balance sheet and provides for better capital adequacy as a property and casualty insurance underwriter. A common measure of capital adequacy is the net written premium ratio to surplus (or common shareholders’ equity). This ratio was 1.33 as at December 31, 2008, compared to 1.44 in 2007. This level of leverage continues to be well below the 2.5:1 ratio which management feels is fully leveraged capital. Therefore, EGI’s current capitalization provides it with adequate financial resources for planned growth. Shareholders’ Equity As at December 31 ($ THOUSANDS) 2008 2007 Common shares 67,056 46,040 (11,676,282 shares) (9,682,152 shares) Retained earnings 56,605 53,193 Contributed surplus 403 247 Accumulated other comprehensive income (loss) (5,460) 2,191 Total capitalization 118,604 101,671 Future Accounting Changes International Financial Reporting Standards (IFRS) During 2008, the Canadian Accounting Standards Board confirmed that publicly accountable enterprises will be required to adopt International Financial Reporting Standards (IFRS) in place of Canadian GAAP for interim and annual reporting purposes. The required changeover date is for fiscal years beginning on or after January 1, 2011. The Company began its IFRS conversion process in 2008 and has established a project plan and governance structure. The plan includes regular reporting to the Audit and Risk Committee of the Company’s Board of Directors from the Project Management Committee which consists of members of Finance and IT, headed by the Chief Financial Officer. The Company will be using an external advisor to assist in the conversion project, in addition to receiving guidance from our external auditors. The Company is currently engaged in the assessment and design phase of the project. This phase will involve completion of a detailed diagnostic review to identify and assess the impact of IFRS differences in relation to Canadian GAAP. In addition, an initial evaluation of IFRS 1 transition exemptions and an analysis of financial systems will be performed. On completion of the assessment and design phase, the Company will address the extent of financial and operation system modifications required, plan the execution of further phases of the project, and develop solutions to successfully complete implementation. At this time, the impact, of the implementation of IFRS on the financial statements of the Company is not reasonably determinable. The Company will continue to report on the key elements and timing of our IFRS implementation plan in our interim MD&As throughout 2009. EGI Financial Holdings Annual Report 2008
    • Management’s Discussion and Analysis 2008 GLOSSARY OF SELECTED INSURANCE TERMS “Case method” means establishing a reserve liability equal to the most probable expected outcome for an individual claim. “Cede” means the act of an insurer transferring or assigning part or all of the risk on an insurance policy written by it to a reinsurer by purchasing insurance from such reinsurer to cover the risk or part thereof. “Combined ratio” of an insurer for any period means the sum of the loss ratio and the expense ratio of the insurer for such period. “Direct written premiums” of an insurer for any period means the total premiums on insurance, including assumed reinsurance, written by the insurer during such period. “Expense ratio” for any period means the sum of expenses, including commissions, premium taxes and operating expenses incurred, expressed as a percentage of net earned premiums. “Facility Association” or “Facility” refers to an organization of the Canadian automobile insurance industry which exists to ensure that all drivers can obtain basic insurance, even if their application fails to meet the criteria of individual insurance companies. “Groupement” refers to a Quebec organization of the automobile insurance industry which exists to ensure that all drivers in Quebec can obtain basic insurance, even if their application fails to meet the criteria of individual insurance companies. “Loss adjustment expenses” or “LAE” means the expense of settling claims, including certain legal and other fees and the expense of administering the claims adjustment process. “Loss ratio” for any period means the sum of claims and claims adjustment expenses incurred, net of reinsurance, expressed as a percentage of net earned premiums. “Minimum Capital Test” means the OSFI’s Minimum Capital Test Guideline under which a federally regulated insurer is measured for the adequacy of its capital. “Net earned premiums” of an insurer means the portion of the written premium equal to the expired portion of the time for which insurance or reinsurance was in effect. “Net written premiums” of an insurer means direct written premiums less amounts ceded to reinsurers. “Producers” refers to, collectively, insurance brokers, agents and managing general agencies. “Quota share” means a type of reinsurance where the reinsurer agrees to assume the risk on a fixed portion of a specified line of business in return for the same portion of the ceding company’s premium for that line of business. “Reinsurance” means an arrangement in which an insurance company, the reinsurer, agrees to indemnify another insurance or reinsurance company, the ceding company, against all or a portion of the insurance or reinsurance risks underwritten by the ceding company under one or more policies. “Retention” means the amount of liability for which an insurance company will be responsible after it has completed its reinsurance arrangements. “Return on equity” or “ROE” for a period means net income expressed as a percentage of the average shareholders’ equity in that period. “Risk” means a person or thing insured on an insurance policy. “Underwriting” means the assumption of risk for designated loss or damage by issuing a policy of insurance in respect thereof. “Unearned premiums” means the portion of premiums received relating to the period of risk in subsequent accounting periods and which is deferred to such subsequent accounting periods. 51
    • Management’s Responsibility for Financial Reporting Roles of Management, Board of Directors and Audit Committee Management is responsible for the preparation and fair presentation of the consolidated financial statements, management’s discussion and analysis and other information in the annual report. The consolidated financial statements of EGI Financial Holdings Inc. (the Company) were prepared in accordance with Canadian generally accepted accounting principles. Where necessary, these consolidated financial statements reflect amounts based on the best estimates and judgment of management. In meeting its responsibility for the reliability of the consolidated financial statements, management maintains the necessary system of internal controls. These controls are designed to provide management with reasonable assurance that the financial records are reliable for preparing consolidated financial statements and other financial information, assets are safeguarded against unauthorized use or disposition and liabilities are recognized. The Audit Committee, comprised of directors who are not officers or employees of the Company, meets, as required, with management, the Appointed Actuary and the external auditors to review actuarial, accounting, reporting and internal control matters. The Audit Committee is responsible for reviewing the consolidated financial statements and management’s discussion and analysis and recommending them to the Board of Directors for approval. Role of Appointed Actuary The actuary is appointed by the Board of Directors, pursuant to the Insurance Companies Act. The Appointed Actuary is responsible for ensuring that the assumptions and methods used in the valuation of policy liabilities are in accordance with accepted actuarial practice, applicable legislation and associated regulations or directives. The Appointed Actuary is also required to provide an opinion regarding the appropriateness of the policy liabilities at the consolidated balance sheet dates to meet all policyholder obligations of the Company. Examination of supporting data for accuracy and completeness and consideration of the Company’s assets are important elements of the work required to form this opinion. The Appointed Actuary uses the work of the external auditors in verifying data used for valuation purposes. Policy liabilities include unearned premiums, provision for unpaid claims, reinsurers’ share of unearned premiums and provision for unpaid claims and deferred policy acquisition costs. Role of External Auditors PricewaterhouseCoopers LLP, external auditors, have been appointed by the shareholders to conduct an independent audit of the consolidated financial statements of the Company in accordance with Canadian generally accepted auditing standards and report to the shareholders regarding the fairness of the annual consolidated financial statements. The external auditors consider the work of the Appointed Actuary in respect of policy liabilities included in the consolidated financial statements, on which the Appointed Actuary has rendered an opinion. Toronto, Ontario February 23, 2009 Douglas E. McIntyre, Hemraj Singh, Chief Executive Officer Chief Financial Officer EGI Financial Holdings Annual Report 2008
    • APPOINTED ACTUARY'S REPORT To the Shareholders of EGI Financial Holdings Inc. I have valued the policy liabilities of the subsidiary insurance operations of EGI Financial Holdings Inc. in its consolidated balance sheets as at December 31, 2008 and 2007 in accordance with accepted actuarial practice, including the selection of appropriate assumptions and methods. In my opinion, the amount of policy liabilities makes appropriate provision for all policyholder obligations and the consolidated balance sheets fairly present the results of the valuation. __ _________ Toronto, Ontario Joe S. Cheng, FCIA February 23, 2009 J. S. Cheng & Partners Inc. February 23, 2009 Auditors’ Report To the Shareholders of EGI Financial Holdings Inc. We have audited the consolidated balance sheets of EGI Financial Holdings Inc. as at December 31, 2008 and 2007 and the consolidated statements of income, changes in shareholders’ equity and comprehensive income and cash flows for the years then ended. These consolidated financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with Canadian generally accepted auditing standards. Those standards require that we plan and perform an audit to obtain reasonable assurance whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. In our opinion, these consolidated financial statements present fairly, in all material respects, the financial position of the company as at December 31, 2008 and 2007 and the results of its operations and its cash flows for the years then ended in accordance with Canadian generally accepted accounting principles. Chartered Accountants, Licensed Public Accountants Toronto, Ontario 53
    • EGI FINANCIAL HOLDINGS INC. Consolidated Balance Sheets (in $ thousands) December 31 December 31 Assets 2008 2007 Cash and short-term deposits $ 29,111 $ 22,785 Investments (note 4) 259,774 238,310 Reinsurers’ share - unearned premiums (note 5) 3,712 3,602 - provision for unpaid claims (note 6) 41,901 48,461 Accounts receivable 27,565 25,382 Income taxes recoverable 7,202 3,278 Due from insurance companies 9,063 6,199 Deferred policy acquisition costs 14,703 15,530 Fixed assets (note 9) 2,372 1,250 Future income taxes (note 13) 3,172 2,674 Prepaid expenses and other assets 4,205 2,613 $402,780 $370,084 Liabilities Bank indebtedness (note 14) $ 19,550 $ 19,550 Provision for unpaid claims (note 6) 185,255 169,091 Unearned premiums (note 5) 71,154 69,190 Unearned commission 363 291 Income taxes payable 429 – Accounts payable and accrued liabilities 4,291 5,444 Payable to insurance companies 2,460 3,894 Other liabilities 674 953 284,176 268,413 Shareholders’ Equity Share capital (note 10) 67,056 46,040 Contributed surplus (note 11) 403 247 Retained earnings 56,605 53,193 Accumulated other comprehensive (loss) income (5,460) 2,191 118,604 101,671 $402,780 $370,084 On Behalf of the Board of Directors: Director Director EGI Financial Holdings Annual Report 2008
    • EGI FINANCIAL HOLDINGS INC. Consolidated Statements of Income for the years ended December 31 (in $ thousands) 2008 2007 Revenue Direct written and assumed premiums $170,730 $157,935 Net written and assumed premiums 158,107 146,511 Net earned premiums 157,255 119,606 Investment income (note 4) 10,009 12,954 167,264 132,560 Expenses Incurred claims 105,837 71,179 Acquisition costs 37,026 26,143 Operating costs 14,229 12,043 Interest 1,216 259 158,308 109,624 Income before income taxes 8,956 22,936 Income tax expense (note 13) 2,977 7,871 Net income $ 5,979 $ 15,065 Earnings per share (note 19) Net income per share - basic $ 0.57 $ 1.56 Net income per share - diluted $ 0.53 $ 1.45 55
    • EGI FINANCIAL HOLDINGS INC. Consolidated Statements of Changes in Shareholders’ Equity and Comprehensive (Loss) Income for the years ended December 31 (in $ thousands) 2008 2007 Share capital Balance, beginning of year $ 46,040 $ 45,833 Common shares issued 21,016 207 Balance, end of year 67,056 46,040 Contributed surplus Balance, beginning of year 247 149 Stock options - granted 186 123 - exercised (30) (25) Balance, end of year 403 247 Retained earnings Balance, beginning of year 53,193 40,059 Net income 5,979 15,065 Dividends - Common shares (2,567) (1,931) Balance, end of year 56,605 53,193 Accumulated other comprehensive (loss) income Balance beginning of year 2,191 – Transition adjustment - financial instruments – 5,301 Other comprehensive (loss) (7,651) (3,110) Balance, end of year (5,460) 2,191 Shareholders’ equity, end of year $118,604 $101,671 Comprehensive income Net income $ 5,979 $ 15,065 Other comprehensive loss, net of taxes Change in unrealized gains on available-for-sale securities: Net unrealized gains (losses) on (10,618) (957) available-for-sale securities Reclassification of net realized (gains) losses to net income 3,120 (2,153) Unrealized losses on translation of financial statements of self-sustaining foreign operations (153) – Other comprehensive (loss) (7,651) (3,110) Total comprehensive (loss) income $ (1,672) $ 11,955 EGI Financial Holdings Annual Report 2008
    • EGI FINANCIAL HOLDINGS INC. Consolidated Statements of Cash Flows for the years ended December 31 (in $ thousands) 2008 2007 Cash provided by (used in): Operating activities Net income $ 5,979 $15,065 Items not involving cash Amortization of fixed assets 674 406 Amortization of premiums on bonds 501 368 Realized losses (gains) on investments 4,833 (3,350) Increase in accrued investment income (285) (426) Other 186 123 11,888 12,186 Cash flow from changes in Reinsurers’ share of unearned premiums (110) 229 Reinsurers’ share of unpaid claims 6,560 (76) Accounts receivable (2,183) (3,200) Income taxes recoverable (3,495) (2,706) Due from insurance companies (2,864) (2,203) Accounts payable and accrued liabilities (2,794) 590 Provision for unpaid claims 16,164 22,990 Unearned premiums 1,964 26,036 Income taxes payable - (3,151) Future income taxes 2,988 547 Prepaid expenses and other assets (1,592) (2,343) Deferred policy acquisition costs 827 (8,065) 27,353 40,834 Financing activities Increase in bank indebtedness – 19,550 Issue of common shares 20,986 182 Common share dividends (2,567) (1,931) 18,419 17,801 Investing activities Purchase of fixed assets (1,796) (857) Purchase of investments (249,873) (256,245) Sale/maturity of investments 212,223 204,099 (39,446) (53,003) Increase in cash and short-term deposits $ 6,326 $ 5,632 Cash and short-term deposits, beginning of year 22,785 17,153 Cash and short-term deposits, end of year $29,111 $22,785 Supplementary information Income taxes paid $ 9,021 $13,095 Interest paid $ 1,209 $ 196 57
    • EGI FINANCIAL HOLDINGS INC. Notes to Consolidated Financial Statements (in $ thousands, except per share amounts) 1 Organization and Basis of Presentation EGI Financial Holdings Inc. (the Company or EGI) was incorporated on August 18, 1997 under the Business Corporations Act (Ontario). The Company is principally engaged, through its subsidiaries, in property and casualty insurance in Canada and the U.S. The Company’s wholly-owned subsidiaries are EGI Insurance Managers Inc., Echelon General Insurance Company (Echelon), EGI Insurance Services, Inc., and CIM Reinsurance Company Ltd. (CIM Re). The Company’s Barbados based subsidiary, CIM Re changed its functional currency to U.S. dollars effective January 1, 2008. CIM Re is operating as a self-sustaining foreign subsidiary and is therefore subject to foreign currency translation adjustments upon consolidation. These consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated upon consolidation. 2 Significant accounting changes Capital Disclosures and Financial Instruments- Disclosures and Presentation On January 1, 2008, the Company adopted three new accounting standards that were issued by The Canadian Institute of Charted Accountants (CICA): Handbook Section 1535, Capital Disclosures Handbook Section 3862, Financial Instruments – Disclosure Handbook Section 3863, Financial Instruments – Presentation Section 1535 specifies the disclosure of (i) an entity’s objectives, policies and processes for managing capital; (ii) quantitative data about what the entity regards as capital; (iii) whether the entity has complied with any capital requirements; and (iv) if it has not complied, the consequences of such non-compliance. Sections 3862 and 3863 replaced Handbook Section 3861, Financial Instruments – Disclosure and Presentation, revised and enhanced its disclosure requirements, and continued its presentation requirements. These new sections place increased emphasis on disclosures about the nature and extent of risks arising from financial instruments and how the entity manages those risks. EGI Financial Holdings Annual Report 2008
    • EGI FINANCIAL HOLDINGS INC. Notes to Consolidated Financial Statements (continued) (in $ thousands, except per share amounts) 3 Summary of significant accounting policies These consolidated financial statements have been prepared in accordance with Canadian generally accepted accounting principles. The preparation of consolidated financial statements in accordance with Canadian generally accepted accounting principles requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the reporting date of the consolidated financial statements. Estimates also affect the reported amounts of revenue and expenses for the reporting period of the consolidated statements of income. Actual results could differ from those estimates. Cash and short-term deposits Cash and short-term deposits include cash-on-hand, cash balances with banks and short term investments maturing in 90 days or less from the date of acquisition. These financial assets are classified as held-to-maturity assets and are recorded at an amortized cost which approximates fair value. Investments Investments are carried at fair value, which is the amount of consideration that would be agreed upon in an arm’s-length transaction between knowledgeable, willing parties who are under no compulsion to act. Fair values are determined by reference to quoted bid or asking prices, as appropriate, in the most advantageous active market available. All investments are non- derivatives and as such have all been classified as available-for-sale (AFS) investments. Any change during the year in the fair values of investments classified as AFS are recognized in Other Comprehensive Income (loss) (OCI). The cumulative change in the fair values of investments previously recognized in Accumulated Other Comprehensive Income (loss) (AOCI) are reclassified to Net Income when they are realized or the decline in value is considered to be other than temporary. Transaction costs related to AFS investments are capitalized on initial recognition and, where applicable, are amortized to interest income using the effective yield method. Investment income is recorded as it accrues. Dividend income on shares is accrued on the ex- dividend date. Gains and losses on disposal of investments are determined and recorded as at the transaction date and are calculated on the basis of the average cost of the investments held. Provision for unpaid claims Provision for unpaid claims includes adjustment expenses, which represent the estimated amounts required to settle all outstanding and unreported claims incurred to the end of the year. Unpaid claims liabilities are carried on an actuarial present value (APV) basis (discounted claims plus provisions for adverse deviations). Expected reinsurance recoveries on unpaid claims and adjustment expenses, net of any required provision for doubtful amounts, are 59
    • EGI FINANCIAL HOLDINGS INC. Notes to Consolidated Financial Statements (continued) (in $ thousands, except per share amounts) recognized as assets at the same time, using principles consistent with the Company’s method for establishing the related liability. Reinsurance The Company reflects third party reinsurance balances on the consolidated balance sheets on a gross basis to indicate the extent of credit risk related to third party reinsurance and its obligations to policyholders and on a net basis in the consolidated statements of income to indicate the results of the retention of premiums written. Revenue recognition Insurance premiums written are deferred as unearned premiums and taken into income pro rata primarily over the terms of the underlying policies. The portion of the premium related to the unexpired term of the policy at the end of the fiscal year is reflected in unearned premiums. Deferred policy acquisition costs Commissions and premium taxes incurred in the writing of premiums are deferred only to the extent that they are expected to be recovered from unearned premiums and are amortized to income over the terms of the related insurance policies. If unearned premiums are not sufficient to pay expected claims and expenses, including policy maintenance expenses and unamortized policy acquisition costs, a premium deficiency is said to exist. Premium deficiencies are recognized initially by writing down deferred policy acquisition costs. Fixed assets Fixed assets are recorded at cost less accumulated amortization. Amortization is provided over the estimated useful lives of the assets using the straight-line method over the following terms: Furniture and equipment 3 years Computer hardware 3 years Computer software 2 years Employee benefits The Company contributes to a group registered savings plan for employees as services are incurred. There are no other post-employment benefits. Income taxes The Company follows the asset and liability method of accounting for income taxes, whereby future income tax assets and liabilities are recognized for the future income tax consequences attributable to differences between the carrying amounts of existing assets and liabilities and their respective income tax bases and taxable losses and tax credit carry-forwards. Future income tax assets and liabilities are measured using enacted or substantively enacted income tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on future income tax assets and liabilities of a change in income tax rates is recognized in income in the year that includes the date of EGI Financial Holdings Annual Report 2008
    • EGI FINANCIAL HOLDINGS INC. Notes to Consolidated Financial Statements (continued) (in $ thousands, except per share amounts) enactment or substantive enactment. Future tax assets are recognized to the extent the realization of such assets is more likely than not. Foreign currency translation Foreign currency transactions are translated into Canadian dollars using the exchange rates in effect at the date the transactions occurred. Monetary assets and liabilities are translated into Canadian dollars using the exchange rates in effect at the consolidated balance sheet dates. Exchange gains and losses are included in income, except unrealized gains or losses related to investments designated as AFS, which are recorded in AOCI. Stock-based compensation The Company has a stock option plan that is described in note 11. Stock options granted under the plan are accounted for using the fair value method. Under this method, the compensation cost of stock options granted is measured at estimated fair value at the grant date and recognized over the vesting period. 4 Investments The Company utilizes the prudent person approach to asset management, as required by the Insurance Companies Act (the Act). An investment policy is in place and its application is monitored by the Board of Directors. Diversification techniques are employed to minimize risk. Policies limit investments in any entity or group of related entities to a maximum of 5% of the Company’s assets. Limitations are also placed on the quality of investments, particularly relating to investment grade bonds. Fair value The fair value of the investments is considered to be the quoted value, less transaction costs, based on bid prices determined by external pricing services. The majority of the investment portfolio is fully invested in well-established, active, liquid markets. 61
    • EGI FINANCIAL HOLDINGS INC. Notes to Consolidated Financial Statements (continued) (in $ thousands, except per share amounts) Fair value of investments The following table provides a comparison as at December 31: Available for sale 2008 2007 Carrying and Carrying and fair value fair value Bonds Canadian Federal $ 82,078 $ 80,378 Provincial 45,162 30,948 Municipal 6,935 3,908 Corporate 86,570 67,864 220,745 183,098 United States Federal – 2,288 Corporate 2,717 666 2,717 2,954 Total bonds 223,462 186,052 Preferred shares 4,042 6,106 Common shares Canadian 29,049 42,150 United States 1,178 2,244 30,227 44,394 Investment income due and accrued 2,043 1,758 $259,774 $238,310 Impaired assets and provisions for losses The Board of Directors has established a policy to write down or make a provision for any investment with other than temporary impairment. Management has reviewed currently available information regarding those investments whose estimated fair values are less than carrying values. For those securities whose decline in fair value was other than temporary, the Company has recorded the difference between the cost of the investment and its fair value as an impairment which reduces investment income in the year recorded. The Company considers an impairment as other than temporary if it is unlikely the Company will recover an investment’s amortized cost in a reasonable period of time. Factors considered by the Company include but are not limited to the impact of issuer specific events, industry specific events, current and expected future market and economic conditions, the nature of the investment and the severity and duration of the fair value deficiency. EGI Financial Holdings Annual Report 2008
    • EGI FINANCIAL HOLDINGS INC. Notes to Consolidated Financial Statements (continued) (in $ thousands, except per share amounts) An impairment loss of $4,713, comprised of $4,326 of common shares and $387 of Canadian corporate bonds, has been recognized in net income during 2008. No provisions were recorded in 2007. A remaining gross unrealized loss of $14,757 on investments held as at December 31, 2008, is recorded, net of tax, in the amount of $9,887 as Accumulated Other Comprehensive Loss. The Company has concluded during its review, that these fair value deficiencies are considered temporary in nature. Investment income Investment income was derived from the following: 2008 2007 Interest income $11,596 $ 9,653 Dividend income 1,664 1,102 (1) Net realized (losses) gains and impairments (4,833) 3,350 (2) Foreign exchange gain (loss) 2,706 (155) Investment expenses (1,124) (996) $10,009 $12,954 (1) Net realized (losses) gains and impairments include realized losses of $121 (2007 – gain of $3,350) and impairments of $4,712 (2007 – NIL). (2) The foreign exchange gain of $2,706 (2007 loss of $155) arises primarily from cash balances held during the year, denominated in U.S. dollars, used to fund claims liabilities, denominated in U.S. dollars. 5 Unearned premiums 2008 2007 Gross Ceded Gross Ceded Personal Lines: Automobile - accident benefits $15,592 $ 821 $16,435 $ 892 - liability 23,803 1,051 18,512 1,031 - other 11,746 112 9,836 185 Total Personal Lines 51,141 1,984 44,783 2,108 Niche: Property - commercial 5,743 666 5,341 576 - personal 1,284 141 311 41 Liability 4,526 795 2,963 646 Accident and sickness 6,941 94 14,939 220 Other 1,519 32 853 11 Total Niche 20,013 1,728 $24,407 1,494 $71,154 $3,712 $69,190 $3,602 63
    • EGI FINANCIAL HOLDINGS INC. Notes to Consolidated Financial Statements (continued) (in $ thousands, except per share amounts) 6 Provision for unpaid claims The determination of the provision for unpaid claims and adjustment expenses and the related reinsurers’ share requires the estimation of three major variables or quanta, being development of claims, reinsurance recoveries and the effects of discounting, to establish a best estimate of the value of the respective liability or asset. The provision for unpaid claims and adjustment expenses is an estimate subject to variability and the variability could be material in the near term. The variability arises because all events affecting the ultimate settlement of claims have not taken place and may not take place for some time. Variability can be caused by receipt of additional claim information, changes in judicial interpretation of contracts, significant changes in the severity or frequency of claims for historical trends, the timing of claim payments, recoverability of reinsurance and future rates of investment return. The estimates are principally based on the Company’s historical experience. Methods of estimation have been used, which the Company believes produce reasonable results given current information. All provisions are periodically reviewed and evaluated considering emerging claims experience and changing circumstances. The process of determining the provisions necessarily involves risks that actual results may differ, perhaps materially, from the best estimates made. The resulting changes in estimates of the ultimate liability are recorded as incurred claims in the current year. The fair value of the provision for unpaid claims approximates carrying value determined in accordance with generally accepted actuarial methods in Canada, which discount estimated future cash flows and include a margin for adverse deviation. The Company discounts its best estimate of claim provisions at a rate of interest of 2.45% for 2008 (2007 – 2.8%) for all lines of business. The Company determines the discount rate based on the expected return on its investment portfolio of assets with appropriate assumptions for interest rates relating to reinvestment of maturing investments. The Company has recorded a $5,097 (2007 – $11,807) reduction to the net provision for unpaid claims relating to redundancies in prior year estimates. To recognize the uncertainty in establishing these best estimates, to allow for possible deterioration in experience, and to provide greater comfort that the actuarial liabilities are adequate to pay future claims, the Company includes provisions for adverse deviations (PFADs) in some assumptions relating to claim development, reinsurance recoveries and future investment income. The PFADs selected are in the mid-range of those recommended by the Canadian Institute of Actuaries. The aggregate impact of the provision for adverse deviation is to increase the provision for unpaid claims on a gross basis by $20,102 as at December 31, 2008 (2007 – $17,487). EGI Financial Holdings Annual Report 2008
    • EGI FINANCIAL HOLDINGS INC. Notes to Consolidated Financial Statements (continued) (in $ thousands, except per share amounts) The following table shows the effects of discounting on unpaid claims and adjustment expenses. Effect of present Undiscounted value PFADs APV 2008 Provision for unpaid claims and adjustment expenses $179,426 $(14,273) $20,102 $185,255 Reinsurers’ share of unpaid claims 39,411 (1,423) 3,913 41,901 $140,015 $(12,850) $16,189 $143,354 2007 Provision for unpaid claims and adjustment expenses $164,267 $(12,663) $17,487 $169,091 Reinsurers’ share of unpaid claims 47,115 (3,083) 4,429 48,461 $117,152 $ (9,580) $13,058 $120,630 The provision for unpaid claims on an APV gross and ceded basis by line of business is as follows: APV basis 2008 2007 Gross Ceded Gross Ceded Personal lines: Accident benefits $ 72,008 $21,396 $ 64,794 $23,526 Liability 91,555 17,218 86,919 22,509 Other 4,336 656 3,607 663 Total Personal lines $167,899 $39,270 $155,320 $46,698 Niche: Property Commercial $ 3,273 $ 247 $ 4,371 $ 520 Personal 332 20 101 50 Liability 8,377 1,960 3,967 1,180 Accident and sickness 4,728 404 4,940 13 Other 646 – 392 – Total Niche $ 17,356 $ 2,631 $ 13,771 $ 1,763 $185,255 $41,901 $169,091 $48,461 7 Underwriting policy and reinsurance ceded In the normal course of business, the Company seeks to reduce the loss that may arise from catastrophes or other events that cause unfavourable underwriting results by purchasing reinsurance to share all or part of the insurance risks originally accepted by the Company in 65
    • EGI FINANCIAL HOLDINGS INC. Notes to Consolidated Financial Statements (continued) (in $ thousands, except per share amounts) writing premiums. This reinsurance does not relieve the Company of its primary obligation to policyholders. During 2008, the Company followed the policy of underwriting and reinsuring contracts of insurance, which limits the net exposure of the Company to a maximum amount on any one loss to $1,500 (2007 - $1,150). In addition, the Company obtained catastrophe reinsurance which limits the loss from a series of claims arising from a single occurrence to $2,000 (2007 - $1,150), to a maximum coverage of $18,000 (2007 - $13,850). The Company places all its automobile reinsurance with Canadian registered reinsurers. There are non-registered reinsurers participating on the specialty property and casualty program business. The Company has access to trust funds that, in the Company’s judgment, are adequate to secure the liabilities that the Company has ceded to non-registered reinsurers. Failure of reinsurers to honour their obligations could result in losses to the Company. Consequently, the Company continually evaluates the financial condition of its reinsurers and monitors concentrations of credit risk to minimize its exposure to significant losses. There have been no defaults and no provision made in the accounts for defaults based on management’s review of the creditworthiness of its reinsurers. Reinsurance recoverables The following table summarizes the balances outstanding from reinsurers as at December 31, 2008 by risk rating: Gross Less: Provisions reinsurance and securities Credit rating recoverable held Net exposure A $47,860 $ – $47,860 Not rated 613 2,133 – $48,473 $2,133 $47,860 Included in gross reinsurance recoverable is reinsurers’ share of unearned premiums of $3,712 reinsurers’ share of provision for unpaid claims of $41,901 and receivables from reinsurers presented as due from insurance companies of $2,860. No balances due from reinsurers are considered past due as at December 31, 2008. 8 Risk management As a provider of insurance products, effective risk management is fundamental to EGI’s ability to protect the interests of EGI’s customers and shareholders. EGI is exposed to risks of loss pertaining to insurance products. These include risks surrounding product and pricing, underwriting and claims, catastrophic exposure, and matching of assets and liabilities. EGI is also exposed to potential loss from various risks, including interest rate risk and equity market fluctuation risk, credit risk, liquidity risk, and to a lesser extent foreign exchange risk. The Company has written principles for overall risk management, as well as written policies covering specific areas such as underwriting, reinsurance, foreign exchange risk, interest rate risk, credit risk, use of derivative financial instruments and non-derivative financial instruments and investment of excess liquidity. EGI Financial Holdings Annual Report 2008
    • EGI FINANCIAL HOLDINGS INC. Notes to Consolidated Financial Statements (continued) (in $ thousands, except per share amounts) Product and pricing EGI prices its products taking into account numerous factors, including claims frequency and severity trends, product line expense ratios, special risk factors, the capital required to support the product line, and the investment income earned on that capital. EGI’s pricing process is designed to ensure an appropriate return on capital and long-term rate stability avoiding wide fluctuations in rates, unless necessary. These factors are reviewed and adjusted periodically to ensure they reflect the current environment. Pricing for automobile insurance must be submitted to each provincial government regulator and, in certain provinces, pre-approved by the regulator. Regulatory decisions may impede automobile rate increases or other actions that EGI may wish to take. Also, during periods of intense competition for any product line, to gain market share, EGI’s competitors may price their products below the rates EGI considers acceptable. Although EGI may adjust its pricing up or down to maintain EGI’s competitive position, EGI strives to ensure its pricing will produce an appropriate return on invested capital. There is no assurance that EGI will not lose market share during periods of pricing competition. Underwriting and claims EGI is exposed to loss resulting from the underwriting of risks being insured and the exposure to financial loss resulting from greater than anticipated adjudication, settlement and claims costs. EGI’s underwriting objectives are to develop business within EGI’s target markets on a prudent and diversified basis and to achieve profitable underwriting results. EGI underwrites automobile business after a review of the applicant’s driving record reports and claims experience. Specialty commercial and personal risks are selected by EGI, working with its external brokers, after consideration of various risk factors associated with these lines of business. Despite its best efforts, and consideration of all known risk factors, there can be no assurance that all risks associated with the insurance policies that it writes can be identified and assessed, and EGI may, therefore, experience increased adjudication, settlement and claims costs. EGI estimates its claims reserves on a quarterly basis and this is supported by quarterly assessments by the independent consulting actuary. Every quarter, for each line of business, EGI compares actual and expected claims development. To the extent that actual results differ from expected development, assumptions are re-evaluated and new estimates are derived. Although EGI believes its overall provision levels to be adequate to satisfy its obligations under existing policies, actual losses may deviate, perhaps substantially, from the amounts reflected in EGI’s consolidated financial statements. To the extent provisions prove to be inadequate, EGI would have to re-evaluate such provisions and may incur a charge to earnings in the future. Unpredictable catastrophic events Catastrophes can be caused by various natural and unnatural events. Natural catastrophic events include hurricanes, windstorms, earthquakes, hailstorms, explosions, severe winter weather and fires. Unnatural catastrophic events include hostilities, terrorist acts, riots, crashes and derailments. The incidence and severity of catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Most catastrophes are restricted to 67
    • EGI FINANCIAL HOLDINGS INC. Notes to Consolidated Financial Statements (continued) (in $ thousands, except per share amounts) small geographic areas; however, hurricanes, windstorms and earthquakes may produce significant damage in large, heavily populated areas. Catastrophes can cause losses in a variety of business lines. Claims resulting from natural or unnatural catastrophic events could cause substantial volatility in EGI’s financial results and could materially reduce EGI’s profitability or harm EGI’s financial condition. The Company manages the impact of losses which may result from catastrophic events by purchasing excess of loss and catastrophe reinsurance to share all or part of the insurance risks originally accepted by the Company (note 7). EGI’s ability to write new business also could be affected. EGI may experience an abrupt interruption of activities caused by unforeseeable and/or catastrophic events. EGI’s operations may be subject to losses resulting from such disruptions. Losses can relate to property, financial assets, trading positions and to key personnel. EGI has developed business continuity plans designed to allow the Company to continue operations in case of a catastrophic event; however, if these plans cannot be put into action or do not take such events into account, losses may further increase. Financial asset and liability matching The Company is exposed to: • changes in the value of its fixed income securities and policy liabilities to the extent that market interest rates change; • equity price fluctuations, which affect the fair values of equities held by the Company; • the risk of losses to the extent that the sale of a security prior to its maturity is required to provide liquidity to satisfy policyholder and other cash outflows; • the risk that future inflation of policyholder cash flows exceed returns on long- term investment securities; and • foreign exchange risks with respect to investments, receivables and policy liabilities denominated in foreign currencies. To mitigate these risks, the Company has policies to ensure that assets and liabilities are broadly matched in terms of their duration and currency. The Company's exposures are monitored on a regular basis and actions are taken to balance investment positions when approved risk tolerance limits are exceeded. Risk management is carried out by the Investment Committee under policies approved by the Board of Directors. Market risk Market risk is the risk of loss arising from adverse changes in market rates and prices, such as interest rates, equity market fluctuations, foreign exchange rates, and other relevant market rate or price changes. Market risk is directly influenced by the volatility and liquidity in the markets in which the related underlying financial assets are traded. Below is a discussion of the Company’s primary market risk exposures and how these exposures are currently managed. EGI Financial Holdings Annual Report 2008
    • EGI FINANCIAL HOLDINGS INC. Notes to Consolidated Financial Statements (continued) (in $ thousands, except per share amounts) Interest rate risk Fluctuations in interest rates have a direct impact on the fair valuation and future cash flows of the Company’s fixed income securities portfolio. Generally, the Company’s investment income will be reduced during sustained periods of lower interest rates as higher yielding fixed income securities mature or are sold and the proceeds are reinvested at lower rates. During periods of rising interest rates, the fair value of the Company’s existing fixed income securities will generally decrease and gains on fixed income securities will likely be reduced. The sensitivity analysis for interest rate risk as set out in the table below illustrates the impact of changes in interest rates on OCI relating to the fixed income securities portfolio as at December 31, based on parallel 200 basis point shifts in interest rates up and down in 100 basis point increments. As at December 31, 2008 As at December 31, 2007 Fair value of Hypothetical Fair value of Hypothetical fixed income change on Effect on fixed income change on fair Effect on Change in interest rates portfolio fair value OCI portfolio value OCI 200 basis point rise $202,324 (9%) $(14,162) $166,475 (11%) $(12,921) 100 basis point rise 212,438 (5%) (7,386) 175,763 (6%) (6,790) No change 223,462 – – 186,052 – – 100 basis point decline 235,533 5% 8,087 197,536 6% 7,579 200 basis point decline 248,463 11% 16,751 210,482 13% 16,124 Liquidity risk Liquidity risk is the risk that an entity will encounter difficulty in raising funds to meet cash flow requirements associated with financial instruments. The purpose of liquidity management is to ensure that there is sufficient cash to meet all financial commitments and obligations as they fall due. To manage cash flow requirements, the Company maintains a portion of invested assets in liquid securities. The maturity profile of bonds as at December 31, 2008 is as follows: Greater Less than than 1 year 1 – 3 years 3 – 5 years 5 years Total Bonds $10,187 $46,959 $57,135 $109,181 $223,462 Percentage of total 4.6% 21.0% 25.6% 48.8% 100% 69
    • EGI FINANCIAL HOLDINGS INC. Notes to Consolidated Financial Statements (continued) (in $ thousands, except per share amounts) Future cash flows The following table summarizes the expected timing of cash flows arising from insurance obligations, on an undiscounted basis (note 6), as at December 31, 2008: Greater Less than than 1 year 1 – 3 years 3 – 5 years 5 years Total Actuarial liabilities (undiscounted) $59,526 $63,161 $34,627 $22,112 $179,426 Less: Reinsurance recoverable 14,499 14,812 6,615 3,485 39,411 Net actuarial liabilities $45,027 $48,349 $28,012 $18,627 $140,015 All other financial liabilities with the exception of bank indebtedness (note 14) and lease commitments (note 15) are for a duration of one year or less. Equity price risk Fluctuations in the value of equity securities affect the level and timing of recognition of gains and losses on securities held, and causes changes in realized and unrealized gains and losses. General economic conditions, political conditions and many other factors can also adversely affect the stock and bond markets and, consequently, the value of the equity and fixed income securities held. The Company has policies to limit and monitor its exposure to individual issuers and classes of issuers of equity securities. The table below summarizes the potential impact of a 20% change in the value of the equity securities (common and preferred shares) on OCI for the year ended December 31, 2008. Certain shortcomings are inherent in the method of analysis presented, as the analysis is based on the assumptions that all equity holdings increased/decreased by 20% with all other variables held constant. Change in Effect on equity holdings OCI 20% rise $ 4,592 20% decline ($4,592) Credit risk The Company is exposed to credit risk principally through its investment securities and balances receivable from policyholders and reinsurers. The Company has policies to limit and monitor its exposure to individual issuers and classes of issuers of investment securities which do not carry the guarantee of a national or Canadian provincial government. EGI's credit exposure to any one individual policyholder is not material. The Company has policies which limit its exposure to individual reinsurers and regular review processes to assess the creditworthiness of reinsurers with whom it transacts business. EGI Financial Holdings Annual Report 2008
    • EGI FINANCIAL HOLDINGS INC. Notes to Consolidated Financial Statements (continued) (in $ thousands, except per share amounts) The Company’s maximum exposure to credit risk, without taking into account amounts held as collateral is $288,062, comprised of $223,462 of bonds $47,860 of gross reinsurance recoverables, $9,063 of amounts due from insurance companies and $7,677 in structured settlements. The following table sets forth EGI’s fixed income securities portfolio by credit quality according to DBRS as at December 31. Fixed income portfolio As at As at December 31, 2008 December 31, 2007 Fair value Fair value Fair value Fair value AAA $107,830 48% $100,388 54% AA 60,713 27% 43,015 23% A 48,080 22% 37,631 20% BBB 6,765 3% 5,018 3% CCC 74 – – – Total $223,462 100% $186,052 100% Foreign exchange risk Foreign exchange risk is the possibility that changes in foreign exchange rates produce an unintended effect on earnings and equity when measured in domestic currency. A portion of the Company’s premiums are written in US dollars and a portion of loss reserves are also in US dollars. In addition, premiums relating to the Emergency Travel Health line of business are remitted in Canadian dollars but a significant portion of the claims incurred for this line of business are in US dollars. A portion of the Company’s cash and investments are also held in US dollars. In general, the Company attempts to manage foreign exchange risk on liabilities by investing in financial instruments denominated in the same currency as the financial liabilities which they back. The Company may, nevertheless, from time to time experience losses resulting from fluctuations in the value of the US dollar, which could adversely affect operating results. The table below illustrates the expected impact on net income and OCI of a 10% change in the Canadian dollar (“CAD”) compared to the US dollar (“USD”) as at December 31, 2008. Computations of the prospective effects of hypothetical foreign exchange changes are based on numerous assumptions, including the maintenance of the existing level and composition of financial assets and financial liabilities, and should not be relied on as indicative of actual or future results. Change in Effect on Net CAD / USD rate Income Effect on OCI* 10% rise ($665) $100 10% decline 665 (108) 71
    • EGI FINANCIAL HOLDINGS INC. Notes to Consolidated Financial Statements (continued) (in $ thousands, except per share amounts) Capital management Capital is comprised of the Company’s shareholders’ equity and bank indebtedness. As at December 31, 2008, the Company’s shareholders’ equity was $118,604 and bank indebtedness was $19,550. The Company’s objectives when managing capital are to maintain financial strength and protect its claims paying abilities, to maintain creditworthiness and to maximize returns to shareholders over the long term. A common measure of capital adequacy in the property and casualty industry used by management is the ratio of premiums to surplus (or shareholders’ equity). A lower ratio implies a higher measure of capital adequacy. The Company’s ratio as at December 31, 2008 is 1.3:1. This level is well below the 2.5:1 ratio considered by management to be the maximum acceptable ratio. The Company’s Canadian insurance subsidiary, Echelon, is required to maintain minimum capital levels as required by the Office of the Superintendent of Financial Institutions. As at December 31, 2008 and 2007, the Company exceeded the minimum regulatory capital requirement. Legislation applicable to insurance companies imposes certain restrictions on the Company’s ability to pay dividends. 9 Fixed assets 2008 2007 Accumulated Accumulated Cost amortization Net Cost amortization Net $ Furniture and equipment $1,577 $ 663 $ 914 533 $ 459 $ 74 Computer hardware 293 211 82 253 153 100 Computer software 3,029 1,653 1,376 2,318 1,242 1,076 $3,10 $4,899 $2,527 $2,372 4 $1,854 $1,250 10 Share capital 2008 2007 Authorized Unlimited common shares Unlimited special shares issuable in Series Issued 11,676,282 common shares $67,056 $46,040 (2007 - 9,682,152 common shares) In July 2008, the Company issued rights to eligible holders of outstanding common shares of the Company of record on July 4, 2008, to subscribe for and purchase from the Company an aggregate of 1,943,630 common shares, at a price of $10.75 per share. EGI Financial Holdings Annual Report 2008
    • EGI FINANCIAL HOLDINGS INC. Notes to Consolidated Financial Statements (continued) (in $ thousands, except per share amounts) Completion of the rights offering on July 31, 2008, resulted in issuance of 1,943,630 common shares for $20,773 in net proceeds. The Company intends to use the proceeds for general corporate purposes. During 2008, 50,500 (2007 – 43,000) common shares were issued pursuant to the exercise of employee stock options, with an issue cost of $4.82 (2007 – $4.82) per share. 11 Employee stock option plan The Company sponsors a stock option plan. The stock option plan provides for the issuance of shares of the Company’s common stock not exceeding 10% of the total issued and outstanding shares (on a non-diluted basis) and shares reserved for issuance under employee stock option plans, options for services and employee stock purchase plans. The Board of Directors determines the terms and conditions of the awards under the stock option plan as well as any award allocations. For the year ended December 31, 2008, the Company recorded a compensation expense of $186 (2007 – $123), with an offsetting credit to contributed surplus. During 2008, 50,500 (2007 – 43,000) stock options were exercised. All stock options granted are for a term of five years with varying vesting periods. The following is a continuity schedule of stock options outstanding as at December 31, 2008 and 2007: Weighted average Number of shares exercise price per share 2008 2007 2008 2007 Outstanding, beginning of year 825,500 681,750 $ 7.79 $ 6.07 Granted during year 127,750 186,750 9.11 13.26 Exercised during year (50,500) (43,000) 4.23 4.23 Outstanding, end of year 902,750 825,500 $ 8.18 $ 7.79 73
    • EGI FINANCIAL HOLDINGS INC. Notes to Consolidated Financial Statements (continued) (in $ thousands, except per share amounts) As at December 31, 2008, the outstanding stock options consist of the following: Remaining Number of options Stock Option price per share Number contractual life exercisable $4.23 330,500 0.8 years 236,500 $5.09 45,000 1.3 years 27,000 $10.61 90,500 1.8 years – $10.31 6,750 2.3 years – $9.26 70,500 2.8 years – $9.65 45,000 3.0 years 18,000 $11.03 3,000 3.3 years – $11.68 20,000 3.6 years – $12.80 26,750 3.6 years 4,000 $11.68 10,000 3.6 years 6,000 $12.34 45,000 3.7 years – $14.26 92,000 3.8 years – $13.89 6,750 4.0 years – $13.20 3,000 4.3 years – $11.80 6,750 4.4 years – $10.65 6,000 4.6 years – $10.47 6,750 4.7 years – $8.03 81,750 4.8 years – $6.35 6,750 5.0 years – The fair values of the stock options issued in 2008 were determined using the Black-Scholes option pricing model with the following assumptions: (i) risk-free rate of 2.0%; (ii) life expectancy of four years; (iii) estimated volatility of 30%; and (iv) dividend yield of 1.7%. The grant-date fair value of total options granted is estimated at $1,085. The weighted average grant-date fair value of stock options granted to date is $1.04. 12 Related party transactions The Co-operators Group Limited and Co-operators General Insurance Company (collectively Co-operators), significant shareholders of the Company, provide services to the Company, including but not limited to product distribution and investment management services. Direct written premiums derived from Co-operators’ agents was $12,564 (2007 – $15,180), commissions paid were $1,493 (2007 – $1,744) and investment management fees were $200 (2007 – $175). The Company holds deposits of $1,421 (2007 – $2,781) under the terms of a 2001 100% Quota Share reinsurance treaty with Co-operators General Insurance Company, with income resulting from the investment of these deposits for their account. Reinsurers’ share of unpaid claims includes a recoverable of $1,714 (2007 – $2,058) from Co-operators General Insurance Company. The payable to insurance companies balance includes amounts due to Co-operators General Insurance Company of $1,426 (2007 – $2,790). EGI Financial Holdings Annual Report 2008
    • EGI FINANCIAL HOLDINGS INC. Notes to Consolidated Financial Statements (continued) (in $ thousands, except per share amounts) 13 Income taxes The income tax expense (recovery) is as follows: 2008 2007 Current $3,453 $7,839 Future (476) 32 $2,977 $7,871 The provision for income taxes reflects an effective rate, which differs from the corporate tax rate as follows: 2008 2007 Combined basic Canadian federal and provincial income tax rate 33.5% 36% Income tax expense at statutory rates $2,998 $8,257 Permanent differences (16) (226) Future income tax rate changes 212 (2) Other (217) (158) $2,977 $7,871 Future income taxes are comprised of the following: 2008 2007 Losses carried forward $ 273 $ 26 Provision for unpaid claims 2,896 2,774 Investments (326) (520) Deferred costs 152 329 Fixed assets 177 65 $3,172 $2,674 75
    • EGI FINANCIAL HOLDINGS INC. Notes to Consolidated Financial Statements (continued) (in $ thousands except per share amounts) Income taxes included in OCI The amounts included in the consolidated statements of changes in shareholders’ equity and comprehensive (loss) income for the years ended December 31 are shown net of the following tax benefit: Tax impact on: 2008 2007 Change in unrealized gains and losses $(5,215) $ (299) Reclassification to net income of (gains) and losses 1,729 (1,242) Total income tax benefit included in OCI $(3,486) $(1,541) 14 Bank indebtedness On October 11, 2007, the Company entered into a non-revolving term loan facility with a major Canadian bank in the amount of $19,550. The facility has a term of three years, bearing an interest rate of 6.20%. During the term of the loan, monthly payments will include interest only and on maturity a balloon payment of $19,550 will be made to settle the principal amount. 15 Lease commitments The Company is committed under lease agreements for office premises and computer equipment with minimum lease payments of $9,245 as follows: 2009 $1,090 2010 954 2011 926 2012 904 2013 936 2014 and thereafter 4,435 $9,245 16 Structured settlements In the normal course of claims adjudication, the Company may settle certain long-term losses through the purchase of annuities (structured settlements) from life insurance companies. The fair value of these annuity contracts amounts to $7,677 (2007 – $4,105) using a discount rate of 3.45% (2007 – 5.00%). It is the policy of the Company to purchase annuities from life insurers with proven financial stability. The net risk to the Company is the credit risk related to the life insurance companies and this risk is reduced to the extent of coverage provided by Assuris, the life insurance compensation insurance plan. The Company has determined that no credit risk provision is required. EGI Financial Holdings Annual Report 2008
    • EGI FINANCIAL HOLDINGS INC. Notes to Consolidated Financial Statements (continued) (in $ thousands except per share amounts) 17 Contingencies From time to time, in connection with its insurance operations, the Company is named as a defendant in actions for damages and costs allegedly sustained by the plaintiffs. While it is not possible to estimate the outcome, such actions have generally been resolved with minimal damage or expense in excess of amounts provided as policy liabilities. The Company does not believe that it will incur any significant additional loss or expense in connection with such actions. 18 Rate regulations The Company writes business subject to rate regulation, including non-standard automobile and motorcycle insurance, which comprises approximately 65% of net premiums written. The Company’s automobile insurance premiums can be impacted by mandatory rate rollbacks and mandatory rate assessments as legislated by provincial law and by regulation in certain provinces. This could result in lower future premium rates or reductions to premium rates charged by the Company in prior years. In addition, the Company is required, under certain provincial legislation, to participate in risk sharing pools, which may impact positively or negatively on underwriting results. Certain benefit payments are also subject to provincial government regulation, including automobile accident benefits. The Company is not aware of any proposed or pending rate rollbacks related to prior years. 19 Earnings per share 2008 2007 Basic earnings per share: Net income available to shareholders $ 5,979 $15,065 Average number of common shares (in thousands) 10,532 9,655 Basic earnings per share $ 0.57 $ 1.56 Diluted earnings per share: Average number of common shares (in thousands) 10,532 9,655 Average number of common shares obligation under employee stock option plan (in thousands) 814 761 Average number of diluted common shares (in thousands) 11,346 10,416 Diluted earnings per share $ 0.53 $ 1.45 20 Segmented information The Company operates through three segments. The Personal Lines and Niche Products divisions operate in Canada while the International division assumes premiums from U.S. resident companies that specialize in the non-standard automobile market. Through its Personal Lines division, the Company is engaged primarily in the underwriting of high premium, non- standard automobile insurance. Through its Niche Products division, the Company designs and underwrites specialized non-auto insurance programs, such as higher premium property, 77
    • EGI FINANCIAL HOLDINGS INC. Notes to Consolidated Financial Statements (continued) (in $ thousands except per share amounts) primary and excess liability, legal expense, accident and health insurance and warranty coverage. The effect of reinsurance is reflected in the revenue and results of the three divisions. The investment activities consist of managing the investment portfolio for the Company as a whole. Investment income is shown net of investment expenses. The corporate and other activities include holding company expenses not attributable to a division. Interest expense represents interest on bank indebtedness. Year ended December 31 2008 2007 Revenue Earned premiums and other revenue Property and casualty insurance Canada - Personal Lines $ 98,665 $ 87,700 - Niche Products 46,009 23,900 144,674 111,600 International (United States) 12,581 8,006 157,255 119,606 Interest and dividends, net of investment expense 12,136 9,759 Realized investment (losses) gains (4,833) 3,350 Foreign exchange gains (losses) 2,706 (155) Total revenue $167,264 $132,560 Income (loss) before income taxes Property and casualty insurance Canada - Personal Lines $ 7,058 $ 10,664 - Niche Products (3,183) 297 3,875 10,961 International (United States) (2,404) (17) Corporate and other (1,308) (703) Underwriting income 163 10,241 Interest and dividends, net of investment expense 12,136 9,759 Realized investment (losses) gains (4,833) 3,350 Foreign exchange gains (losses) 2,706 (155) Interest expense (1,216) (259) Total income before income taxes $ 8,956 $ 22,936 21 Comparative figures Certain comparative figures have been reclassified to conform with the current consolidated financial statement presentation. EGI Financial Holdings Annual Report 2008