Bank of N.T. Butterfield & Son Ltd
Annual Report 2006

Plain-text annual report

The Bank of N.T. Butterfield & Son Limited | 65 Front Street, Hamilton, Bermuda | www.butterfieldbank.com Contents 2 3 4 5 6 8 14 15 Financial & Statistical Summary Corporate Profile Messages from the Board President & Chief Executive Officer’s Report Management’s Discussion & Analysis of Results of Operations & Financial Condition Jurisdictional Overview Group Business Lines Support Divisions Financials 17 22 23 24 25 26 27 28 29 Directory 61 61 61 62 62 64 Financial Overview Financial Summary Management’s Financial Reporting Responsibility Independent Auditors’ Report to the Shareholders Consolidated Balance Sheet Consolidated Statement of Income Consolidated Statement of Cash Flows Notes to Consolidated Financial Statements Consolidated Statement of Changes in Shareholders’ Equity and Comprehensive Income Board of Directors & Principal Board Committees Directors’ Code of Practice & Group Code of Conduct Directors’ & Executive Officers’ Share Interests & Directors’ Service Contracts Management Shareholders’ Information Principal Offices & Subsidiaries Awards Financial & Statistical Summary Corporate Profile (In $ thousands except per share data) 31 December 2006 31 December 2005 31 December 2004 31 December 2003 Year ended Net income Diluted earnings per share At year end Total assets Cash and deposits with banks Investments Loans Deposits from customers Deposits from banks Subordinated capital and senior debt Shareholders’ equity Net book value per share Market value per share Number of shares (in thousands)* Number of shareholders Number of employees Financial ratios Return on assets** Return on shareholders’ equity** Total capital ratio 134,083 4.60 109,351 3.85 90,466 3.19 70,838 2.54 11,132,802 3,151,191 3,786,793 3,760,745 9,755,659 287,173 280,168 549,553 19.37 56.25 28,375 3,915 1,730 1.3% 24.6% 13.5% 9,197,566 2,849,920 2,916,399 3,085,594 7,948,966 291,143 278,679 495,226 17.71 42.36 25,429 3,878 1,597 1.2% 23.6% 13.1% 8,630,383 2,396,724 3,266,400 2,645,331 7,404,855 502,595 142,333 428,030 15.57 33.47 22,745 3,778 1,552 1.1% 21.2% 10.7% 7,733,806 2,912,383 2,638,253 1,954,716 6,612,303 510,274 122,871 382,095 13.91 33.05 20,643 3,581 1,381 1.0% 17.9% 13.0% Comparative per share data has been restated to reflect the 1 for 10 stock dividends in August 2006, 2005, 2004 and 2003. All percentages here and in the report that follows are based on actual rather than rounded numbers. * Actual outstanding; excludes shares held by the Bank’s Stock Option Trust. ** Excludes gain on sale of subsidiaries. Net Income ($ millions)** Earnings Per Share ($) (Diluted)** Return on Equity (%)** Return on Assets (%)** 134.1 109.3 90.5 70.8 4.60 3.85 3.19 2.54 23.6 24.6 21.2 17.9 1.3 1.2 1.1 1.0 Dec 03 Dec 04 Dec 05 Dec 06 Dec 03 Dec 04 Dec 05 Dec 06 Dec 03 Dec 04 Dec 05 Dec 06 Dec 03 Dec 04 Dec 05 Dec 06 Butterfield Bank Group is a publicly held, diversified provider of financial services with operations in seven jurisdictions. In addition to assets of $11 billion, we have $10 billion of assets under management, and over $123 billion of client assets under administration. The Group is headquartered in Bermuda, where we were established as the Island’s first bank in 1858. We have Our success is built on a set of fundamental strengths: sound corporate values, a motivated and capable workforce, a stable customer base, strong liquidity and capital positions, and a focus on the ongoing development of our core businesses. We believe that a positive, rewarding work environment that offers employees security and opportunities benefits our customers through quality service, and our shareholders through long-term improvement in results. At 31 December 2006, Butterfield Bank Group had 1,730 employees around the world. Good corporate citizenship and community involvement are additional operations in The Bahamas, Barbados, the Cayman part of our culture. We support a variety of local projects Islands, Guernsey, Switzerland and the United Kingdom. Our home country regulator is the Bermuda Monetary Authority, which operates in accordance with Basel principles and maintains close contacts with regulators in other jurisdictions. Our common stock is listed on the Bermuda Stock Exchange and the Cayman Islands Stock Exchange. We have over 3,900 shareholders and 29.9 million shares outstanding. We provide community banking services in Barbados, Bermuda and the Cayman Islands, encompassing retail banking, corporate banking and treasury activities. In the wealth management area, private banking, asset management and personal trust services are provided from the Group’s headquarters in Bermuda and subsidiary offices in The Bahamas, the Cayman Islands, Guernsey, Switzerland and the United Kingdom. For corporate and institutional clients, investment and pension fund administration services, asset management and corporate trust services are offered in Bermuda, The Bahamas, the Cayman Islands and Guernsey. and organisations that invest in areas such as youth development, healthcare, social causes, heritage and the arts. Our educational scholarships and bursaries help young people fulfil their potential and achieve their dreams. We take an active role in community events and encourage and recognise employees who volunteer their time and energy to charitable causes. Our business strategy involves judiciously expanding our core businesses – community banking, private banking and wealth management, and fund services. For Butterfield Bank Group, these areas represent our strongest competencies and greatest opportunities. We seek to increase profitability by widening our client base and deepening our customer relationships in these business lines, offering the right products at fair prices, with excellent service. This strategy is the basis of our success to date and the key to future growth. 2 2006 | Annual Report 3 Messages From The Board Chairman’s Letter to the Shareholders On behalf of the Board of Directors, I am pleased to report that Butterfield Bank Group enjoyed another year of growth and profitability in 2006. Although, as an increasingly international organisation, we faced varied challenges in each of our jurisdictions, through astute management and an ongoing commitment to strengthening our core businesses, the Group generated a record profit of $134.1 million. The Board approved cash dividends of $0.44 for each of the first three quarters of 2006 and a cash dividend of $0.48 for the fourth quarter, bringing the 12-month dividend to $1.80, which when taking account of the ‘one for ten’ stock dividend in August, equates to a 20% increase in the dividend and provided shareholders with an impressive return on their investments. In 2006, we bade farewell to our colleague, Sheila Manderson, who retired from the Board of Directors on 31 July. I thank Mrs. Manderson, who was a valued member of the Board for ten years, for her significant contributions and the good counsel she provided to the management team. The vacancy created by Mrs. Manderson’s retirement was filled by Pauline Richards, whom we are delighted to welcome to the Board. On a personal note, I recently advised the Board that I will retire as Chairman and Director following the Annual General Meeting to be held on 18 April 2007. Brian Duperreault, who was elected to the Board in 1996 and appointed to the position of Co-Vice Chairman in 2006, has been elected by the Board to take over as Chairman upon my retirement. It has been my honour to be part of the Board of Directors and the Butterfield Bank family for 29 years. Although the Bank has changed over the years – growing substantially and expanding internationally – what has not changed is the unwavering commitment of management and employees to our customers and to the communities in which we operate. I would like to express my sincere thanks to them, and to our shareholders and customers, whose ongoing support and loyalty are the bedrock upon which Butterfield Bank Group will continue to build and prosper. In closing, I extend sincere best wishes to Mr. Duperreault. I am confident that, under his direction, the Board will continue to provide effective guidance and leadership to the Group, and build sustainable value for our shareholders. James A.C. King, JP Chairman of the Board Message from the Incoming Chairman On behalf of the Board of Directors, I would like to thank Dr. James King for his many contributions to Butterfield Bank Group. As a member of the Board for 29 years and as Chairman for close to ten years, Dr. King has provided strong governance oversight to the Bank and exemplary leadership to the Board. I have had the pleasure of working with Dr. King for over ten years, and I know him to be a compassionate advocate for the Group’s stakeholders – employees, shareholders, customers and the public. The Board and the management team have benefited greatly from Dr. King’s experience and constructive guidance. Over his term as Chairman, shareholders enjoyed a total return (including dividends) of over 800%. Although I will miss Dr. King’s presence on the Board following his retirement in April, I am looking forward to taking on the role of Chairman and continuing to work with the Directors to help Butterfield Bank Group realise strategic and financial growth and create value for our fellow shareholders. Brian Duperreault Incoming Chairman President & Chief Executive Officer’s Report Butterfield Bank Group’s strategy of growth through investment in our core competencies – community banking, private banking and wealth management, and fund administration – yielded strong results in 2006. On revenues of $415.1 million, we earned a record net income of $134.1 million, an increase of 22.6% over last year, leading to a return of 24.6% on shareholders’ equity. We are particularly pleased with our results this year, as the growth we enjoyed is based purely on the solid performance of our existing operations. There were no acquisitions during 2006 that contributed to the bottom line. Our achievements are the result of the commitment of our employees to strengthening our quality of service and deepening relationships with our customers. Solidifying customer relationships and growing market share in each of our jurisdictions means being attuned to local market developments and responding with products and services that meet local needs. From the introduction of unique home equity lending products in Bermuda, to the expansion of Lifestyle Mortgage options in the Cayman Islands, to the introduction of Art Advisory services for private banking clients in the United Kingdom, Butterfield Bank Group continues to earn market share through innovation in each of our jurisdictions and lines of business. At the same time, the Group continues to work at developing our global brand. This year, we introduced a new Group website, www.butterfieldbank.com, which showcases the scope of our worldwide operations, but also provides user-friendly information and tools for customers in each market. This successful project, which is destined to be among the first of many international marketing collaborations, highlighted the synergies we now enjoy, along with the customer benefits we can deliver, as an increasingly multinational bank. Although we did not make any acquisitions in 2006, we did announce plans for the expansion of two of our core businesses. In November, we broadened our European asset management presence with the establishment of an office in Zurich, Switzerland. In the same month we also announced the planned extension of our fund administration services to North American providers of alternative investments with the establishment of Butterfield Fund Services (Canada) Limited to be based in Halifax, Nova Scotia. As we continue to expand internationally, we will ensure that community involvement remains a priority for each of our offices. In 2006, with our financial donations, and through the efforts of employees who lent their time, expertise and talent, we supported causes that fund the arts, help to preserve and celebrate local culture, and provide assistance and care to those in need. In recognition of our financial strength, service excellence, product innovation, and philanthropic efforts, Butterfield Bank received awards from three prestigious international financial publications during the year: the Euromoney Award for Excellence, the Global Finance award for Best Bank in Bermuda, and The Banker awards for Bank of the Year in Bermuda and the Cayman Islands. These awards reflect the dedication of our employees, to whom I express my sincere thanks. On behalf of the management team, I would also like to express appreciation to the Board of Directors for their ongoing advice and oversight, and to our customers and shareholders, whose continuing support inspires us to succeed. Alan R. Thompson President & Chief Executive Officer Left: James A.C. King JP Chairman of the Board Centre: Brian Duperreault Incoming Chairman Right: Alan R. Thompson President & Chief Executive Officer 4 2006 | Annual Report 5 Management’s Discussion & Analysis of Results of Operations & Financial Condition1 Results of operations for the 12-month 109.9%, the United Kingdom up 35.1%, Barbados up 14.9% and period ended 31 December 2006 compared Bermuda’s community banking business up 11.4%. with the 12-month period ended 31 December 2005. Butterfield Bank Group2 achieved net income of $134.1 million for the 12-month period ending 31 December 2006, representing a 22.6% increase over the same period last year. Net interest income was a record at $218.2 million before credit related provisions. Up year on year by 17.7%, the increase reflects balance sheet growth, a 21.9% increase in the loan portfolio and a benefit from the rise in both U.S. and U.K. interest rates. Non-interest income also increased year on year by $21.6 million, or 12.5%, to $193.7 million reflecting strong growth in revenues from investment and pension fund administration, trust and investment services and banking. Non-performing loans totalled $29.1 million at year-end 2006, representing 0.8% of total loans, compared to 0.9% a year ago. As at 31 December 2006 the general provision for credit losses of $22.1 million was equivalent to 0.6% of total loans. In addition, there is a specific provision of $3.6 million held for possible shortfalls in the security for non-performing loans. In total, therefore, the allowance for credit losses is $25.7 million, or 0.7% of the loan portfolio. Delinquency and charge-off ratios continued to be well below industry average. Shareholder Value Sustained strong performances have enabled the Group to continue building shareholder value and, for the fourth consecutive year, a ‘one for ten’ bonus share issue was made in August 2006. Additionally, for the fourth quarter the Board The Group’s balance sheet remains highly liquid with a loan approved a dividend increase of 4 cents, resulting in a total to customer deposits ratio of 38.6%. Customer deposits dividend for 2006 of $1.80 per share, an increase of 13 cents, increased significantly by 22.7% year on year to $9.8 billion, or 7.8%, over last year. The dividend paid to shareholders in reflecting growth in the United Kingdom, up $701 million, 2006 was $46.5 million, up 20.8% on the previous year, and Bermuda, up $619 million, Guernsey, up $234 million and represents a 34.7% payout on net income for the period. The the Cayman Islands, up $188 million. Loan portfolio growth increase in shareholder value for the year, defined as the of 21.9% across the Group’s operations reflects our ability to increase in share price plus dividends reinvested, was 36.8%, meet new demand for lending products, with Guernsey up compared to 31.4% the previous year. Share Purchase Activity Under the Share Buy-back Plan, during the year 47,659 shares were repurchased and cancelled at an average cost of $55.82 1 Management’s discussion and analysis of results of operations and financial condition should be read in conjunction with the Group’s Consolidated Financial Statements, beginning on page 25, and the notes to those financial statements, which begin on page 29. These statements and notes have been prepared in accordance with generally accepted accounting principles in the United States per share. The Stock Option Trust bought 431,132 shares of America (US GAAP). 2 All references to Butterfield Bank Group or “the Group” refer to The Bank of N.T. Butterfield & Son Limited and its subsidiaries on a consolidated basis. at an average cost of $58.11 per share to satisfy the Bank’s obligations with respect to the Stock Option Plan. The Bank’s Charitable Foundation bought 192,899 shares at an average cost of $56.71 per share. Performance Indicators The Group’s overall strength and performance are indicated by certain key measures. Return on shareholders’ equity was 24.6% for the period, up from 23.6% in 2005. Diluted earnings per share were $4.60, up 75 cents, or 19.5% compared with $3.85 last year. The Group’s efficiency ratio, which is operating expenses (excluding corporation tax and amortisation of intangible assets) expressed as a percentage of operating income (excluding credit provisions and gain on sale of subsidiaries and affiliates) saw a year on year improvement, from 66.4% the previous year to 64.8% in 2006. (from left to right) Graham M. Jack Managing Director, Butterfield Trust (Bermuda) Limited Michael O’Mahoney Senior Vice President, Treasury Donna E. Harvey Maybury Senior Vice President, Human Resources (from left to right) Richard J. Ferrett Executive Vice President, Chief Financial Officer Graham C. Brooks Executive Vice President, International Peter J.M. Rodger Senior Vice President & Group Legal Adviser, Secretary to the Board Curtis Dickinson Senior Vice President, Corporate Management 6 2006 | Annual Report 7 Jurisdictional Overview Bermuda pushed Bermuda’s per capita Gross Domestic Product to the top of world rankings, and the thriving economy has led to increased competition among financial services providers on the Island for community banking, wealth management and corporate business. Community Banking To help solidify our position as a leading premier community bank, we invested in initiatives designed to enhance our $ millions (noted percentage changes reflect year on year variances) customers’ banking experiences and build market share. We Net Income: Revenue: Customer Deposits: Loans: Total Assets*: 65.3 227.3 3,833 2,265 4,974 (s 23.5%) (s 13.6%) (s 19.2%) (s 11.4%) (s 8.9%) Assets Under Administration: 50,276 (s 11.3%) Assets Under Management: 7,487 (s 11.8%) *Before inter-segment eliminations Major Business Lines: Community Banking, Private Banking, Treasury Services, Asset Management, Personal Trust, Corporate Trust, Investment & Pension Fund Administration Number of Employees: 845 2006 was our 148th year of business in Bermuda, which is home to Butterfield Bank Group headquarters. As the largest independent bank on the Island, we play an important role in the daily functioning of Bermuda’s economy. The major pillar of the economy is international business, followed by sizeable tourism and hospitality industries and a large number of locally based retail and service organisations. Combined, these industries have completed renovations to public spaces at a number of our locations and extended the range of products offered in our branches. Mortgages and loans, which were previously available only from our Consumer Credit office in the City of Hamilton, are now offered at Rosebank, St. George’s and Somerset branches, creating a network of full-service community banking locations across the Island. Further service enhancements included the introduction of a centralised Call Centre that is able to handle virtually all client enquiries. We continued to leverage our relationship with insurance provider Freisenbruch-Meyer Group. In keeping with our efforts to improve convenience, Butterfield Bank customers can now obtain home, yacht and vehicle ownership and protection solutions by speaking with a Personal Banking Representative at any of our branches. Notable among new retail offerings introduced in 2006 was Butterfield Line, an innovative, revolving home equity line of credit product that allows customers to access the equity in their homes using a special Butterfield Bank MasterCard® credit card. ATM features were also enhanced during the year with the addition of iTop Up services that allow local Digicel prepaid cellular phone customers to easily top up their cell phone accounts from their Butterfield Bank accounts. (from left to right) Bob W. Wilson Senior Vice President, Corporate and Private Banking Sheila M. Brown Senior Vice President, Investment Services Ian M. Coulman Managing Director, Butterfield Asset Management From left to right: Lorem ipsum dolor sit amet, quis dictum lacus amet fermentum porttitor, elementum vel We ran a highly successful credit card promotion during the first quarter – the Butterfield Bank MasterCard FIFA World CupTM 2006 Contest – which helped increase consumer card usage and our share of the Bermuda merchant market. We are also pleased with the recent announcement that our USD Money Market Fund Portfolio Manager received a top manager award for 2006 from iMoneyNet. Fund Services Private Banking Working cooperatively with Butterfield fund administration We continue to expand our private client business in Bermuda offices in other jurisdictions, the Bermuda Fund Services (BFS) by following a proven strategy that utilises a comprehensive team significantly increased Assets Under Administration approach to addressing the wealth management needs of high during the past year by participating in the burgeoning and net worth clients. Our Private Banking Relationship Managers act increasingly complex global hedge fund market. BFS offers as a gateway for clients, enabling them to access the full range of highly rated administration services to a diverse group of Butterfield Bank products and services through a single point of alternative investment and fund of hedge fund managers based contact. Strong growth in our private client loan and investment in Bermuda and abroad. These clients count on BFS to provide businesses has resulted from the success of this service model, them with consistently accurate and timely fund pricing, financial which helps us broaden our relationships with existing clients statements and shareholder reporting to meet the sophisticated and from our efforts to attract new clients to the Bank. needs of wealthy individual and institutional investors. Trust Community Involvement Butterfield Trust (Bermuda) provides a comprehensive range of We are well known in Bermuda for our support of local charities trust, estate and company administration, company management and cultural events, and for providing a range of bursaries and custody services, focusing on local and international clients, and scholarships to assist young Bermudians pursuing higher both corporate and individual. Asset Management Butterfield Asset Management continued to experience growth during 2006. Assets Under Management increased to education. Notable among our community-focused activities this year were our sponsorship of the Bermuda International Film Festival’s “BIFF Kids” film series and the Masterworks Museum of Bermuda Art which, when completed in 2007, will be the Island’s first purpose-built art museum, designed to permanently house $7.5 billion, up 11.8% year on year. Growth was particularly strong the Bermudiana Collection. in mutual funds, where assets increased 16.8% to $5.8 billion. The Butterfield Money Market Fund and our fund of funds product, Butterfield Select, saw strong asset growth. The Butterfield Select Funds passed the $400 million mark and ended 2006 valued at $406 million. Bermuda (from left to right) Lloyd O. Wiggan Senior Vice President, Retail Banking W. Aaron M. Spencer Senior Vice President, Operations Douglas Lang Managing Director, Butterfield Fund Services (Bermuda) Limited 8 2006 | Annual Report 9 Jurisdictional Overview Funds, which are regulated vehicles for investment funds, and new business was attracted by The Bahamas’ progressive investment fund legislation, offset by a number of redemptions from existing administered funds. The Bahamas Barbados $ millions (noted percentage changes reflect year on year variances) $ millions (noted percentage changes reflect year on year variances) Net Income: Revenue: Customer Deposits: Loans: Total Assets: 2.2 9.1 140 14 (s 33.4%) (s 33.7%) (s 66.4%) (s 164.1%) 155.4 (s 60.4%) Net Income: Revenue: 1.0 (t 32.4%) 12.3 (s 10.0%) Customer Deposits: 170.0 (s 6.3%) Loans: Total Assets: 124.0 (s 14.9%) 213 (s 9.8%) Assets Under Administration: 3,890 (t 1.8%) Cayman Islands $ millions (noted percentage changes reflect year on year variances) Net Income: Revenue: 53.4 99.1 (s 16.5%) (s 20.6%) Customer Deposits: 2,374 (s 7.3%) Loans: Total Assets: 340 (s 11.7%) 2,793 (s 8.3%) Assets Under Administration: 40,152 (s 26.8%) Assets Under Management: 1,110 (t 4.1%) Major Business Lines: Community Banking, Private Banking, Treasury Services, Asset Management, Personal Trust, Corporate Trust, Investment & Pension Fund Administration Major Business Lines: Community Banking Number of Employees: 351 Major Business Lines: Private Banking, Personal Trust, Corporate Trust, Investment & Pension Fund Administration Number of Employees: 123 Number of Employees: 63 During the year, the Bahamas office generated strong growth, as well as local and international recognition, through focused business development and targeted marketing of bespoke financial and fund administration services. Our long-term objective is to increase our share of the Barbados community banking market. Toward that end, significant investment was made in the development of our technical and service-related infrastructure during 2006. These projects will help establish a foundation for new services that will be introduced during 2007 to meet the evolving financial The increase in the loan book of over 160% was a notable success, services needs of Barbadians. reflecting growth in our international mortgage products. The fund administration business is focused on providing administration services to investment and pension funds. The year saw growth in innovative products like SMART Community involvement was a major focus for the Barbados team in 2006. Highlights included our sponsorship of the Barbados International Jazz Festival as “Official Bank” and title sponsorship of Butterfield Empire Hockey Club. The Cayman Islands’ economy continued to grow in 2006, fuelled in part by the construction that commenced following 2004’s Hurricane Ivan. Representative of our commitment to Cayman, we are currently constructing a new 60,000 square foot office building in George Town. The completion of structural work (at seven storeys) was celebrated in November with a topping out ceremony. The building is expected to be complete and ready for occupancy in the third quarter of 2007. Butterfield Bank is the largest private sector employer in the Cayman Islands’ financial services industry. As an employer of choice, we focus on providing quality educational and career opportunities for employees. This year, we introduced a comprehensive e-learning system to enhance our existing Left: Bahamas Management Team (from left to right) Heather M. Bellot Managing Director Fund Services Ian D. Fair Deputy Chairman Julien D. Martel Vice President, Private Banking Robert V. Lotmore Managing Director Right: Barbados Management Team (from left to right) Mariano Browne Managing Director Cheryll-Ann Wilson-Drakes Vice President, Investment Banking Caroline Prow Vice President, Butterfield Asset Management (Barbados) Limited Arlene Miller Senior Manager, Credit 10 2006 | Annual Report training and development programmes. The Bank also committed to assisting the Government with a project to provide funding, management training, and staff and student mentoring to local high schools. We see these developments as key to our ability to continue to attract high-potential candidates and build organisational strength. Currently 86% of our employees are Cayman nationals, which is significant in an environment where expatriates comprise more than half of the workforce. We continue to respond to the changing needs of customers with new products and services. In 2006, we introduced a suite of “Lifestyle Mortgage” products, which contributed to good growth in the loan book. We strive to be a model corporate citizen and took the lead in several community projects during the year that focused on the arts, health and sports. We were pleased to present the Grand Finale of the 2006 Cayman Arts Festival and continue to support Little League and Junior Squash programmes. The Bahamas & Caribbean Left: Cayman Management Team (from left to right) Erwin Dikau Senior Manager, CFO Barry Yetton Director and Head of Banking Sheree Ebanks Director and Head of Wealth Management Conor O’Dea Managing Director Right: Cayman Management Team (from left to right) Simon Cawdery Manager, Discretionary Management Services David Titcombe Senior Manager and Head of Trust Adrian Watkin Head of Credit Services Antonette Alexander Manager, Branch Banking 11 Jurisdictional Overview Guernsey $ millions (noted percentage changes reflect year on year variances) Net Income: Revenue: 10.7 50.4 (s 47.9%) (s 25.5%) during the year, with good growth both in property-related lending and in facilities collateralised by securities portfolios. We continued to be a market leader for administered banking – providing outsourcing solutions, such as operational, accounting, compliance and corporate secretarial services – for Guernsey branches and subsidiaries of leading Customer Deposits: 1,610 (s 19.2%) international banks and other financial institutions. This Loans: Total Assets: 451 (s 109.9%) 1,810 (s 21.0%) business line saw further growth in 2006, with assets under administration increasing by 21.9%. Assets Under Administration: 28,090 (s 39.3%) Custody Services also registered strong business growth. Assets Under Management: 1,120 (s 28.9%) Major Business Lines: Private Banking, Treasury Services, Personal Trust, Corporate Trust, Investment & Pension Fund Administration, Administered Banking, Custody and Custodian Trustee Services Number of Employees: 223 Institutional custody clients, including sponsors of both Guernsey and non-Guernsey regulated investment funds, continue to be attracted by the combination of technical expertise and high quality service we offer. Switzerland The positive international economic environment seen in 2005 carried on into 2006 and again provided a supportive backdrop for the Guernsey operations. Institutional client business registered high growth levels on all fronts, including fund Butterfield Bank Group’s Swiss subsidiary was established in November 2006 and focused on office set-up and recruitment for the balance of the year. Butterfield Asset Management (Switzerland) Limited opened Butterfield Bank (UK) Limited operates under the trade for business in November 2006, with the establishment of name Butterfield Private Bank. During the year, we continued an office in Zurich. We offer independent and global wealth to strengthen our private banking offer, working together management services to private clients and their families. We with clients’ professional advisers (especially Solicitors, work closely with Butterfield Bank Group’s other international Accountants and specialist IFAs) and with other Group offices. offices to provide multi-jurisdictional services and with Notable among the service enhancements introduced in selected banks in Switzerland to provide other key services. 2006 was the fee-based Family Office service, which provides United Kingdom $ millions (noted percentage changes reflect year on year variances) Net Income: Revenue: 0.7 25.4 (s 390.3%) (s 12.5%) Customer Deposits: 1,630 (s 75.4%) Loans: Total Assets: Assets Under Administration: 566.5 (s 35.1%) 1,986 1,198 (s 64.7%) (t 18.9%) Assets Under Management: 263 (t 62.8%) Major Business Lines: Private Banking, Treasury Services bespoke solutions to the often complex financial and lifestyle requirements of clients and their families. The reduction in Assets Under Management was caused by the departure of some members of the Asset Management team. We have recruited a strong new team and, with improved coordination among Group offices, we believe a strong building block for future growth is now in place. With the advent of A-day affecting pensions in April 2006, and recent changes to financial services regulations, Butterfield Private Bank has seen continued growth as a major provider of full Self-Invested Personal Pensions. This has been achieved through a special partnership with independent trustees and our unique offering of pension banking, pension lending and pension investment management options in one package. Major Business Lines: Asset Management Number of Employees: 123 administration, custody services and administered banking Number of Employees: 2 services. Loan volumes registered particularly strong increases Left: Guernsey Management Team (from left to right) Robert S. Moore Managing Director Neil Farrand Director Ivor Bisson Director John Robinson Deputy Managing Director Right: Guernsey Management Team (from left to right) Paul Hodgson Managing Director - Butterfield Trust (Guernsey) Limited Richard Saunders Senior Manager - Investments Patrick Firth Managing Director - Butterfield Fund Services (Guernsey) Limited 12 2006 | Annual Report Europe Left: Iain Little Managing Director, Switzerland Right: U.K. Office (from left to right) Joan Mason Manager Property Finance George Bogucki Managing Director Kathryn Field Portfolio Manager Simon Brooks Head of Banking 13 Group Business Lines Support Divisions Group Asset Management Group Fund Services Human Resources Marketing & Communications The Group’s Asset Management businesses provide investment Significant progress was made during the year in the coordination Human Resources provides oversight and management of Marketing and Communications teams in each jurisdiction provide management, advisory and brokerage services to institutional of the activities of Butterfield Fund Services’ (BFS) various compensation, benefits, recruiting, employee relations and direction and support for the Group’s corporate and departmental and private clients from offices in Bermuda, the Cayman Islands, operating units in Bermuda, The Bahamas, the Cayman Islands organisational development in each jurisdiction. The Group marketing activities and overall image. Responsibilities include Guernsey, Switzerland and the United Kingdom. and Guernsey. This process was initiated with the hiring of an operates under human resources policies and standards that internal and external communication activities, including executive to oversee the Group’s business and the appointment of require adherence to the highest ethical standards and all sponsorships and events, promotions and advertising, newsletters, regional business heads for Europe and the Americas. applicable regulations and employment laws. and public and media relations. The Group’s Corporate Standards A full spectrum of asset classes are handled for clients, from money market funds to hedge funds. We respond to clients’ needs with services ranging from wealth management advice including BFS provides a range of essential administration services to hedge portfolio structuring to niche funds for existing structures. fund and other alternative investment managers as well as to During 2006, Group Asset Management continued to meet clients’ needs through solid investment performance, timely reporting and analysis. Additional portfolio managers and analysts were added in various jurisdictions to increase market coverage and client growth. During the year, we installed new, more advanced portfolio analytics tools to produce comprehensive reports and to assist with improved internal research. Our Swiss asset management pension plan and mutual fund sponsors. In the past year, Assets Under Administration grew from $61 billion to over $75 billion, making BFS the 12th and 14th largest administrator of fund of hedge funds and single hedge funds, respectively, worldwide, according to industry publication HFM Week. The Group’s current staff of 210 specialists administers over 800 diverse funds for many of the Our overriding objective is to become the employer of choice in each of our jurisdictions and lines of business. We strive to attract and retain knowledgeable, service-oriented, high potential employees by creating and maintaining a motivating work environment. Recognising that our organisation’s people are our strongest competitive advantage, we offer employees fair and equitable compensation, personal development and career advancement opportunities, as well as recognition world’s leading investment organisations. for good performance. office was opened in November, expanding our ability to service BFS looks to participate in the continuing growth of the global clients in Europe and adding investment input to our global investment industry in the years ahead and, in this regard, has process. We introduced new investment funds in the Butterfield announced the opening in 2007 of a new administration centre stable, enriching our offerings to help meet ever-more demanding to be located in Halifax, Canada. The new facility will provide the client needs. Group with the significant additional servicing capacity required In 2006, our continued focus was on employee training and improvement of the physical working environment. These priorities were reflected in a host of service training and development opportunities provided to employees in multiple jurisdictions, and in the ongoing renovation and improvement of premises in Assets Under Management continued to grow, reaching $10 billion by year end, through both the addition of new clients and existing clients entrusting us with the management of greater portions of their wealth, offset by the loss of business in the United Kingdom. to support their growth strategy. many areas. (from left to right) Frank J. Sebestyen, III Senior Vice President, Group Head of Fund Services Bruce Albrecht Senior Vice President, Group Head of Asset Management provide consistency in brand messages and advertising across all jurisdictions and lines of business. We also conduct market research to measure the success of new product launches and advertising campaigns, customer service levels, market demographics and opinions, and obtain employee feedback through internal workplace surveys. Technology Much of the Group’s project activity this year focused on upgrading infrastructure items – ranging from desktops to networks, telephony to data centres. This modernisation effort will continue through 2007. A major upgrade of the Bank’s general ledger system commenced in 2006, with the first project completed successfully at the end of December. Activities for 2007 include a new Bermuda banking system implementation. The new Butterfield Bank Group website went live in November, and has enhanced customers’ online experiences. Additional Internet banking capabilities are planned, building on the progress we made with the new website. (from left to right) Pete D. Ramsdale Senior Vice President, Chief Information Officer Dianne M. Brewer Vice President, Head of Marketing and Communications 14 2006 | Annual Report 15 As the Group continues to grow, Information Technology must In addition, the Group Credit Committee, chaired by the President provide expanded support for new buildings, staff, tools and & Chief Executive Officer, provides a forum to review credit products. Along with increased regulatory and compliance exposures, establish and review credit strategy and policy, and obligations, this makes for an ever-more challenging business approve selected credit transactions for the Group. The Group has environment. In 2006, the Information Technology team rose to an independent loan review program, which provides Management that challenge, and we will strive to continue to deliver value to and the Board of Directors with an assessment of overall loan our internal and external customers going forward. quality and soundness of credit management practices. The Risk Policy Committee of the Board of Directors plays an integral role in reviewing the Group’s credit risk framework and profile. Market risk and liquidity risk are managed through appropriate controls and reporting systems. The Asset and Liability Management Committee (ALCO), chaired by the Chief Financial Officer, and the Risk Policy Committee of the Board of Directors play an integral role in identifying, reviewing and managing financial risk. The Risk Review Committee, chaired by the Head of Enterprise Risk Management, reviews and monitors business/event risks, transactions and operational controls, operating losses and frauds, business continuity, potential regulatory changes, legal risks and compliance with financial and business conduct regulations. The Compliance function seeks to ensure the Group is adequately safeguarded from criminals and fraud. Undertaking Know Your Customer research, monitoring of account activity, working with regulators and assisting with criminal investigations, Compliance is an integrated part of the Group’s business processes. Risk Management Risk is inherent in all of the Group’s businesses and support activities. Our goal is to limit risks to appropriate levels in light of the Group’s financial strength, the characteristics of our businesses, the markets in which we operate, and the competitive and regulatory environment to which we are subject. The Risk Policy Committee of the Board of Directors reviews the risks impacting our businesses and establishes Risk Management Policies that are to be consistently applied across all jurisdictions. The Enterprise Risk Management Division (Group ERM) is responsible for developing and maintaining a framework for the application of those Policies and related Standards that establish both accountability and approval authorities, and a comprehensive set of control objectives against which we benchmark product/process controls. Credit risk is the risk of loss associated with the failure of a borrower or counterparty to fulfill its financial or contractual obligation to the Bank. The Group Credit Risk Management Division (Group CRM), which is independent of the Bank’s business units, is responsible for identifying, monitoring and reporting on credit risks affecting the Group’s business activities, including connected lending, large exposures and sector concentrations. All significant credit proposals are processed through Group CRM for adjudication. (from left to right) Fred H. Tesch Senior Vice President, Group Internal Audit Michael A. McWatt Senior Vice President, Credit Risk Management James R. Stewart Senior Vice President, Enterprise Risk Management Financials 16 2006 | Annual Report 17 Financial Overview Income Total income for the Group after provisions was $415.1 million for the year ended 31 December 2006, up $59.9 million, or 16.9%, from $355.1 million for the same period a year ago. Net interest income before provisions for credit losses increased by 17.7% to $218.2 million. The increase reflects growth in average interest earning assets, up 13.5% to $10.0 billion, and the Group’s continually successful asset/liability management strategies. As a result the net interest margin widened by 0.09% to 2.15%. We continue to be appropriately reserved with total provisions of $25.7 million. Non-performing loans totalled $29.1 million as at 31 December 2006, up from $27.0 million a year ago, reflecting loan growth. They represent 0.8% of the total loan portfolio, in line with that a year ago. Provisions in respect of credit losses charged to income were $3.0 million, compared to $3.2 million last year. Non-interest income grew by 12.5% to $193.7 million, reflecting business growth, notably from investment & pension fund administration (+15.6%), banking services (+13.4%), trust and investment services (+11.4%), and foreign exchange (+10.6%). Other revenues during the year totalled $6.2 million, up from $0.9 million the previous year, reflecting realised gains on the sale of affiliates and an equity investment, the final settlement of an insurance claim, and unrealised gains on trading securities. Changes in Net Interest Income (In $ thousands) For the year ended 31 December 2006 2005 Average balance Interest Rate Average balance Interest Rate Assets Cash and deposits with banks Investments Loans Interest earning assets Other assets Total assets Liabilities Deposits Subordinated capital Interest bearing liabilities Non-interest bearing current accounts Other liabilities Total liabilities Shareholders’ equity Total liabilities and shareholders’ equity Spread Net interest margin 3,308,586 3,317,309 3,384,718 10,010,613 129,908 163,348 234,772 528,028 3.93% 4.92% 6.94% 5.27% 2,660,107 3,307,160 2,855,086 8,822,353 69,346 129,092 180,743 379,181 389,083 10,399,696 - 528,028 - 5.08% 333,286 9,155,639 - 379,181 8,415,621 278,963 8,694,584 298,254 14,553 312,807 3.54% 5.22% 3.60% 7,345,378 223,335 7,568,713 188,493 8,514 197,007 964,496 195,115 9,854,195 545,501 10,399,696 - - - - 312,807 - - - 963,599 157,380 8,689,692 - - - - 3.60% 465,947 9,155,639 - 197,007 1.67% 2.15% Note: Underlying assets and liabilities are comprised of various currencies. 2.61% 3.90% 6.33% 4.30% - 4.14% 2.57% 3.81% 2.60% - - - - 2.60% 1.70% 2.06% 17 The Bank of N.T. Butterfield & Son Limited | 65 Front Street, Hamilton, Bermuda | www.butterfieldbank.com Expenses Balance Sheet The Group remains committed to the prudent management of the expense base and continually seeks opportunities to improve efficiency. The efficiency ratio improved from 66.4% in 2005 to 64.8%, reflecting the fact that growth in the Group’s operating revenue, up 16.9%, was higher than the 13.5% increase for operating expenses. The increase in the operating expense primarily reflected the expanding size of the Group, with salaries and employee benefits up 12.6% to $162.5 million, and accounting for 58.6% of total Group operating expenses, compared with 59.1% last year. Increases of 16.3% and 18.0% respectively were seen in technology and communication and property costs, reflecting continued investment in these areas. As at 31 December 2006 there were 845 employees in Bermuda, up from 789 a year ago, and overseas the headcount rose by 77 to 885, the increases primarily to support continued business growth. Total assets increased by 21.0% to $11.1 billion, up from $9.2 billion a year ago. This increase reflects the rise in the customer deposit base, up year on year by $1.8 billion, or 22.7%, to $9.8 billion. The increase in the customer deposit base was primarily employed in deposits with banks, up 10.6% to $3.2 billion, and in funding our investment and loan portfolios, up year on year by 29.8% and 21.9% to $3.8 billion for both portfolios respectively. The Balance sheet remains highly liquid with a loans to customer deposits ratio of 38.6% and loans to total assets ratio of 33.8%. Investment Portfolio by Long Term Debt Rating Other 1.9% Taxes BBB 0.6% For the period under review the corporation tax of the Group was $3.8 million compared to $1.6 million for the same period a year ago, reflecting increased taxable earnings in Guernsey and the United Kingdom. Corporation taxes of $3.6 million in Guernsey, $0.1 million in Barbados and $0.1 million in the United Kingdom were incurred for the year. Non-income taxes of $13.0 million were also paid across the Group, up from $11.9 million the previous year, primarily reflecting an increase in employee-related ‘payroll tax’ paid in Bermuda. AAA 34.6% A 22.5% AA 40.4% Distribution of 2006 Total Expense Distribution of 2006 Expenses by Location The Bahamas 2.4% Barbados 3.9% UK 8.7% Salaries and other employee benefits 57.8% Guernsey 14.1% Bermuda 54.9% Cayman 16.0% Other expenses 9.2% Marketing 2.5% Amortisation of intangible assets 2.3% Non-income taxes 4.6% Professional and outside services 5.4% Property 8.8% Technology and Communications 9.4% Investment Portfolio by Long Term Debt Rating Lending by Location Other 1.9% BBB 0.6% A 22.5% AA 40.4% AAA 34.6% Barbados 3.3% UK 15.1% Guernsey 12.0% Cayman 9.0% The Bahamas 0.4% Bermuda 60.2% Distribution of 2006 Total Revenue Distribution of 2006 Total Revenue by Location Other Income 3.0% Trust & Investment Services 7.9% Asset Management 8.3% The Bahamas 1.6% Barbados 2.9% UK 7.0% Net Interest Income 51.9% Investment & Pension Fund Administration 11% Guernsey 11.6% Hong Kong 0.2% Bermuda 53.7% Banking Services 9.9% Cayman 23.0% Foreign Exchange Revenue 8.0% Lending by Location Group Loans by Type Barbados 3.3% Other Consumer Loans 15.7% The Bahamas 0.4% Commercial and Industrial 17.2% UK 15.1% Guernsey 12.0% Residential Mortgages 33.2% Bermuda 60.2% Commercial Real Estate 19.9% Cayman 9.0% Credit Card 1.6% Financial Institutions and Government 12.4% 18 2006 | Annual Report 19 Capital The Group continues to maintain a strong capital base that ensures stability and allows us to take advantage of opportunities for growth. At 31 December 2006 the risk weighted total capital ratio was 13.5%, compared to the 10.0% minimum requirement of the Bermuda Monetary Authority and up from 13.1% a year ago. Of the total, the Tier 1 ratio was 8.9%, compared to a 5% minimum requirement and 8.6% at year-end 2005. Shareholders’ equity increased by $54.3 million, or 11.0%, over a year ago, reflecting the increase in retained earnings less share buy-backs offset by the adoption of the Financial Accounting Standards Board new accounting standard – FAS 158 ‘Employers’ accounting for Defined Benefit Pension and Other Postretirement Plans’. This standard is effective for years ending after 15 December 2006 with no retrospective application. Its impact was to reduce shareholders’ equity by $41.3 million. Weighted risk assets rose year on year by 16.6% to $5.5 billion, primarily due to growth in loans and investments. The loan to the Stock Option Trust of $37.0 million is in respect of potential obligations under the Bank’s Stock Option Plan and is deducted from shareholders’ equity as treasury stock. The increase in the loan from $25.5 million the previous year reflects the purchase by the Trust of 431,132 shares at a total cost of $25.1 million during the year, offset by repayments from cash received on the exercise of stock options by Directors and employees. During the period under review, the Bank issued 263,435 shares under the Dividend Re-investment Programme, which represents a cash savings of $10.6 million, or 32.3% of the total dividend paid. As a result of the one-for-ten stock dividend in August 2006, 2,706,063 new shares were also issued. Under the Share Repurchase Programme, the Bank purchased and cancelled 47,659 shares, at a cost of $2.7 million. Capital Composition (In $ thousands) For the year ended 31 December 2006 2005 Tier 1 capital Tier 2 capital Deductions * Total capital Weighted Risk Assets (In $ thousands) Cash and inter-bank placements Investments Loans Other assets Off-balance sheet items Total weighted risk assets Capital Ratios (%) Tier 1 Tier 2 Deductions * Total * Deductions from capital comprise investments in affiliates. 488,131 266,185 (18,722 ) 735,594 402,766 222,012 (13,351 ) 611,427 623,260 1,091,422 2,867,821 285,450 600,715 5,468,668 569,030 874,306 2,407,471 218,971 611,571 4,681,349 8.9% 4.9% (0.3% ) 13.5% 8.6% 4.7% (0.2% ) 13.1% Financial Overview Selected Quarterly Results of Operations (Unaudited, in $ thousands except per share data and ratios) Quarter ended 31 December 30 September 30 June 31 March 2006 Net interest income after provision for credit losses Total fees and other income Total revenue Total non-interest expense Net income for the quarter Earnings per share ($) * Basic Diluted Return on shareholders’ equity (%) 57,688 49,581 107,269 74,786 32,483 1.15 1.11 22.7 55,058 51,018 106,076 71,424 34,652 1.22 1.18 24.5 53,573 51,078 104,651 70,794 33,857 1.19 1.16 25.0 48,902 48,154 97,056 63,965 33,091 1.18 1.15 26.3 Quarter ended 31 December 30 September 30 June 31 March 2005 Net interest income after provision for credit losses Total fees and other income Total revenue Total non-interest expense Net income for the quarter Earnings per share ($) * Basic Diluted Return on shareholders’ equity (%) 47,918 42,638 90,556 66,218 24,338 0.88 0.85 19.7 47,602 43,919 91,521 60,893 30,628 1.10 1.07 25.7 45,760 44,564 90,324 60,274 30,050 1.09 1.07 27.3 40,894 41,834 82,728 58,393 24,335 0.88 0.86 22.7 * Comparative per share data has been restated to reflect the 1 for 10 stock dividends in August 2006 and 2005. 20 2006 | Annual Report 21 Financial Summary (In $ thousands, except per share data) Year ended 31 December 2006 2005 2004 2003 2002 At year end Cash and deposits with banks Investments Loans, net of allowance for credit losses Premises, equipment and computer software Total assets Total deposits Subordinated capital and senior debt Shareholders’ equity 3,151,191 3,786,793 3,760,745 171,326 11,132,802 10,042,832 280,168 549,553 2,849,920 2,916,399 3,085,594 141,708 9,197,566 8,240,109 278,679 495,226 2,396,724 3,266,400 2,645,331 126,031 8,630,383 7,907,450 142,333 428,030 2,912,383 2,638,253 1,954,716 99,979 7,733,806 7,122,577 122,871 382,095 1,989,159 2,073,112 1,767,088 96,419 6,007,874 5,516,216 75,000 338,799 (unaudited) 97,503 114,832 17,013 88,612 56,993 83,927 25,432 1.2% 20.5% 30.3% 6.9% 13.1% 66.4% 2.69 1.37 12.44 724 476 1,200 215,221 199,831 - 162,504 118,465 134,083 46,496 182,174 172,955 - 144,331 101,447 109,351 38,504 148,075 163,090 - 127,459 93,240 90,466 32,217 115,066 118,985 - 100,104 63,109 70,838 26,809 1.3% 24.6% 34.7% 7.5% 13.5% 64.8% 4.60 1.80 19.37 845 885 1,730 1.2% 23.6% 35.2% 8.4% 13.1% 66.4% 3.85 1.67 17.71 789 808 1,597 1.1% 21.2% 35.6% 6.6% 10.7% 69.1% 3.19 1.55 15.57 786 766 1,552 1.0% 17.9% 37.8% 6.5% 13.0% 67.7% 2.54 1.43 13.91 734 647 1,381 3,915 28,375 3,878 25,429 3,778 22,745 3,581 20,643 3,322 18,603 For the year Net interest income after provision for credit losses Fee and other income Gain on sale of subsidiaries Salaries and other employee benefits Other non-interest expenses Net income Dividends paid Financial ratios Return on assets * Return on shareholders’ equity * Dividend payout ratio Total capital funds to total assets ratio Risk weighted capital ratio Efficiency ratio Per share ($) **† Net income (diluted) Dividends declared Net book value Number of employees Bermuda Overseas Total Shareholder data Number of shareholders Number of shares (in thousands)** Management’s Financial Reporting Responsibility The Management of The Bank of N.T. Butterfield & Son Limited is responsible for the preparation of the consolidated financial statements contained in this Report, which covers all of the interests of the Bank. Management has fully disclosed its income, assets, liabilities and off balance sheet commitments. These financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and, where appropriate, are based on the best estimates and judgement of Management. Management has established and maintains a system of financial reporting and internal controls to provide reasonable assurance that transactions are properly authorised and recorded, assets are protected against unauthorised use or disposition and liabilities are recognised. These procedures include the careful selection and training of qualified staff, the establishment of organisational structures providing an appropriate and well-defined division of responsibilities, and the communication of policies and standards of business conduct throughout the Bank. The system of internal controls is further supported by a professional staff of internal auditors who conduct periodic inspections of all aspects of the Bank’s operations. In addition, the Bank’s Head of Group Internal Audit has full and free access to the Audit & Compliance Committee of the Board of Directors. The Audit & Compliance Committee, composed entirely of directors who are not employees of the Bank, reviews the financial statements before such statements are approved by the Board of Directors and submitted to the Bank’s shareholders. The Committee meets and consults regularly with Management, the internal auditors and our external independent auditors to review the scope and results of their work. Under the provisions of the Bermuda Monetary Authority Act 1969, the Bermuda Monetary Authority is charged with the supervision of the Bank. Such supervision is in line with international practices and combines a comprehensive system of statistical returns, providing a detailed breakdown of the balance sheet and statement of income accounts of the Bank, and regular meetings with the senior management of the Bank. Such regular reviews are intended to satisfy the Authority that the safety and interests of the depositors, creditors and shareholders of the Bank are being duly observed and that the Bank is in a sound financial condition. The accounting firm of PricewaterhouseCoopers, the shareholders’ independent auditors, has examined the consolidated financial statements of the Bank in accordance with auditing standards generally accepted in the United States of America and have expressed their opinion in their report to the shareholders. The auditors have unrestricted access to, and meet periodically with, the Audit & Compliance Committee to review their findings regarding internal controls over the financial reporting process, auditing matters and financial reporting issues. Management has made available to PricewaterhouseCoopers all of the Bank’s financial records and related data as well as the minutes of shareholders’ and directors’ meetings. Alan R. Thompson President & Chief Executive Officer 2 March 2007 Richard J. Ferrett Executive Vice President & Chief Financial Officer 2 March 2007 * Excludes gain on sale of subsidiaries. ** Excludes shares held by the Bank’s Stock Option Trust. † Inclusive of gain on sale of subsidiaries. Comparative per share data, with the exception of dividends, has been restated to reflect the 1 for 10 stock dividends in August 2006, 2005, 2004 and 2003. The number of shares in 2006, 2005, 2004, and 2003 increased primarily due to the issue of the stock dividends. Data for 2006, 2005, 2004 and 2003 is shown under US GAAP and for 2002 under Canadian GAAP. 22 2006 | Annual Report 23 Independent Auditors’ Report to the Shareholders PricewaterhouseCoopers Chartered Accountants Dorchester House 7 Church Street Hamilton HM 11 Bermuda Telephone +1 (441) 295 2000 Facsimile +1 (441) 295 1242 www.pwc.com/bermuda Independent Auditors’ Report To the Shareholders of The Bank of N.T. Butterfield & Son Limited In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, changes in shareholders’ equity and comprehensive income and of cash flows present fairly, in all material respects, the financial position of The Bank of N.T. Butterfield & Son Limited and its subsidiaries at 31 December 2006 and 2005 and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Bank’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. Chartered Accountants 2 March 2007 Consolidated Balance Sheet As at 31 December (In $ thousands) Assets Cash and demand deposits with banks Term deposits with banks Total cash and deposits with banks Investments Trading Available for sale Held to maturity Total investments Loans, net of allowance for credit losses Premises, equipment and computer software Accrued interest Goodwill Other intangible assets Other assets Total assets Liabilities Deposits Non-interest bearing Interest bearing Customers Banks Total deposits Employee future benefits Accrued interest Dividend payable Other liabilities Total other liabilities Subordinated capital Total liabilities Shareholders’ equity Share capital ($1.00 par: Authorised shares 100,000,000 (2005: 70,000,000)) Additional paid in capital Retained earnings Less: treasury stock Accumulated other comprehensive income Total shareholders’ equity Total liabilities and shareholders’ equity The accompanying notes are an integral part of these consolidated financial statements. 2006 2005 341,582 2,809,609 3,151,191 154,698 2,695,222 2,849,920 56,471 963,355 2,766,967 3,786,793 3,760,745 171,326 64,163 25,018 69,685 103,881 11,132,802 136,520 546,302 2,233,577 2,916,399 3,085,594 141,708 44,648 22,840 69,622 66,835 9,197,566 964,496 858,358 8,791,163 287,173 10,042,832 107,191 33,409 13,178 106,471 260,249 280,168 10,583,249 29,870 514,872 76,881 (37,039 ) (35,031 ) 549,553 11,132,802 7,090,608 291,143 8,240,109 61,573 19,093 11,049 91,837 183,552 278,679 8,702,340 26,948 341,647 152,501 (25,548 ) (322 ) 495,225 9,197,566 A list of partners can be obtained from the above address PricewaterhouseCoopers refers to the members of the worldwide PricewaterhouseCoopers organisation James A. C. King, JP Chairman of the Board Robert J. Stewart, JP Co-Vice Chairman Alan R. Thompson President & Chief Executive Officer 24 2006 | Annual Report 25 Consolidated Statement of Income For the year ended 31 December (In $ thousands, except per share data) Consolidated Statement of Changes in Shareholders’ Equity and Comprehensive Income For the year ended 31 December (In $ thousands) Non-interest income Investment and pension fund administration Banking services Asset management Foreign exchange revenue Trust and investment services Other non-interest income Total non-interest income Interest income Loans Investments Deposits with banks Total interest income Interest expense Deposits Subordinated capital and senior debt Total interest expense Net interest income before provision for credit losses Provision for credit losses Net interest income after provision for credit losses Realised / unrealised gains on trading securities Realised gains on available for sale securities Gain on sale of affiliates Other gains / (losses) Total revenue Non-interest expense Salaries and other employee benefits Technology and communications Property Professional and outside services Non-income taxes Amortisation of intangible assets Marketing Other expenses Total non-interest expense Net income before income taxes Income taxes Net income Earnings per share Basic Diluted The accompanying notes are an integral part of these consolidated financial statements. Earnings per share comparative figures have been restated for the 1 for 10 stock dividend in August 2006. 26 2006 | Annual Report 2006 2005 45,798 41,289 34,492 33,053 32,650 6,372 193,654 237,769 163,348 129,908 531,025 298,254 14,553 312,807 218,218 (2,997 ) 215,221 1,608 - 2,144 2,425 415,052 162,504 26,531 24,770 15,071 13,045 6,352 6,932 21,972 277,177 137,875 (3,792 ) 134,083 39,617 36,404 34,687 29,894 29,309 2,188 172,099 183,915 129,092 69,346 382,353 188,493 8,514 197,007 185,346 (3,172 ) 182,174 895 90 - (129 ) 355,129 144,331 22,813 20,993 14,352 11,886 6,308 5,658 17,809 244,150 110,979 (1,628 ) 109,351 Share capital Authorised: 100,000,000 shares (2005: 70,000,000) of par value $1 each Issued Issued and outstanding at beginning of year (January 2006: 26,947,915 shares; January 2005: 24,301,337 shares) Dividend reinvestment (December 2006: 263,435 shares; December 2005: 242,738 shares) Stock dividend (December 2006: 2,706,063 shares; December 2005: 2,436,730 shares) Shares repurchased and cancelled (December 2006: 47,659 shares; December 2005: 32,890 shares) Issued and outstanding at end of year (December 2006: 29,869,754; December 2005: 26,947,915 shares) Additional paid in capital Balance at beginning of year Dividend reinvestment Stock dividend Issued under directors’ and executive officers’ and employees’ stock option plans Shares repurchased and cancelled Balance at end of year Retained earnings Appropriated - general reserve Unappropriated at beginning of year Net income for year Cash dividends declared Stock dividend Balance at end of year Accumulated other comprehensive (loss) income Balance at beginning of year Net change in unrealised gains and losses on translation of net investment in foreign operations Net change in unrealised gains and losses on available for sale securities Net change in unrealised gains and losses on cash flow hedges Net change in employee future benefits Net change in minimum pension liability Balance at end of year Treasury stock Balance at beginning of year (January 2006: 1,519,203 shares; January 2005: 1,556,476 shares) Net purchases Balance at end of year (December 2006: 1,494,584 shares; December 2005: 1,519,203 shares) Total shareholders’ equity 4.74 4.60 3.95 3.85 Comprehensive income Net income Other comprehensive loss Total comprehensive income The accompanying notes are an integral part of these consolidated financial statements. 2006 2005 26,948 24,301 264 243 2,706 2,437 (48 ) (33 ) 29,870 26,948 341,647 14,804 158,371 2,666 (2,616 ) 514,872 100,000 52,501 134,083 (48,626 ) (161,077 ) 76,881 (322 ) 5,465 (446 ) 1,134 (41,266 ) 404 (35,031 ) (25,548 ) (11,491 ) (37,039 ) 229,495 10,395 102,769 321 (1,333 ) 341,647 100,000 88,674 109,351 (40,318 ) (105,206 ) 152,501 11,031 (7,752 ) (328 ) (2,869 ) - (404 ) (322 ) (25,471 ) (77 ) (25,548 ) 549,553 495,226 134,083 (34,709 ) 99,374 109,351 (11,353 ) 97,998 27 Consolidated Statement of Cash Flows For the year ended 31 December (In $ thousands) Cash flows from operating activities Net income Adjustments to reconcile net income to cash provided by operating activities Depreciation and amortisation Write down of equipment and computer software (Increase) decrease in carrying value of investments in affiliates Share-based compensation Gain on sale of affiliate Gain on sale of premises and equipment Gain on sale of private equity investment Realised gain on sale of available for sale securities Provision for credit losses Increase in accrued interest receivable Increase in other assets Increase in accrued interest payable (Decrease) increase in other liabilities Net change in trading account securities Cash provided by operating activities Cash flows from investing activities Net decrease (increase) in term deposits with banks Additions to premises, equipment and computer software Net increase in loans Held to maturity securities: proceeds from maturities Held to maturity securities: purchases Available for sale securities: proceeds from sale and maturities Available for sale securities: purchases Net proceeds on sale of private equity investment Net proceeds on sale of affiliate Cash used in investing activities Cash flows from financing activities Net increase in demand and term deposit liabilities Issuance of subordinated capital Repayment of senior debt Proceeds from dividend re-investment plan Shares repurchased and cancelled Treasury stock Cash dividends paid Cash used in financing activities Effect of exchange rates on cash and demand deposits with banks Net increase (decrease) in cash and demand deposits with banks Cash and demand deposits with banks: beginning of year Cash and demand deposits with banks: end of year Supplemental disclosure of cash flow information Cash interest paid Cash income tax paid The accompanying notes are an integral part of these consolidated financial statements. 28 2006 | Annual Report 2006 2005 134,083 109,351 21,009 - (4,204 ) 2,328 (635 ) (1,509 ) (1,501 ) - 2,997 (16,708 ) (27,521 ) 12,724 (344 ) 120,719 86,758 207,477 21,486 (42,621 ) (575,187 ) 734,672 (1,240,278 ) 2,685,099 (3,030,445 ) 1,501 635 (1,445,138 ) 1,470,924 - - 15,066 (2,664 ) (11,491 ) (46,496 ) 1,425,339 20,822 1,100 833 - - - - (90 ) 3,172 (15,237 ) (10,359 ) 10,743 30,280 150,615 487,611 638,226 (555,669 ) (35,569 ) (504,151 ) 1,168,313 (883,195 ) 731,186 (1,263,259 ) - - (1,342,344 ) 583,108 150,000 (9,666 ) 10,638 (1,366 ) (77 ) (38,504 ) 694,133 (794 ) 252 186,884 (9,733 ) 154,698 341,582 164,431 154,698 300,956 2,741 187,429 322 Notes to Consolidated Financial Statements For the year ended 31 December 2006 (All amounts are expressed in thousands of Bermuda dollars unless otherwise stated) Note 1: Significant Accounting Policies (a) Basis of Presentation The accounting and financial reporting policies of The Bank of N.T. Butterfield & Son Limited (the Bank) and its subsidiaries conform to Generally Accepted Accounting Principles in the United States of America (GAAP). The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the period. Such estimates are subject to change in the future as additional information becomes available or previously existing circumstances are modified. (b) Basis of Consolidation The Bank consolidates subsidiaries where it holds, directly or indirectly, more than 50% of the voting rights or where it exercises control. Entities where the Bank holds 20% to 50% of the voting rights and/or has the ability to exercise significant influence, other than investments in designated variable interest entities (VIEs), are accounted for under the equity method, and the pro rata share of their income (loss) is included in other income. The Bank consolidates entities deemed to be VIEs when the Bank is determined to be the primary beneficiary under the Financial Accounting Standards Board (FASB) Interpretation No. 46 (Revised 2003) Consolidation of Variable Interest Entities (FIN 46R). (c) Foreign Currency Translation Assets, liabilities, revenues and expenses denominated in US dollars are translated to Bermuda dollars at par. Assets and liabilities arising from other foreign currency transactions are translated into Bermuda dollars at the rates of exchange prevailing at the balance sheet date. The resulting gains or losses are included in foreign exchange revenue in the Consolidated Statement of Income. The assets and liabilities of foreign currency based subsidiaries are translated at the rate of exchange prevailing at the balance sheet date while associated revenues and expenses are translated to Bermuda dollars at the average rates of exchange prevailing throughout the period. Unrealised translation gains or losses on investments in foreign currency based subsidiaries are recorded as a separate component of shareholders’ equity within accumulated other comprehensive income. Such gains and losses are recorded in the Consolidated Statement of Income only when realised. (d) Assets Held in Trust or Custody Securities and properties (other than cash and deposits held with the Bank and its subsidiaries) held in trust, custody, agency or fiduciary capacity for customers are not included in the Consolidated Balance Sheet because the Bank is not the beneficiary of these assets. (e) Investments Investments include debt and equity securities. Debt securities include bonds, notes, certificates of deposit, redeemable preferred stock, as well as certain loan or asset backed and structured securities subject to prepayment risk. Equity securities include common and non-redeemable preferred stocks. Debt securities classified as “held to maturity” represent securities that the Bank has both the ability and the intent to hold until maturity and are carried at amortised cost adjusted to recognise other than temporary impairment, except for money market mutual funds which are carried at market value, which approximates cost plus accrued and reinvested interest since acquisition. Debt securities and marketable equity securities classified as “available for sale” are carried at fair value, with unrealised gains and losses reported in Other Comprehensive Income, with the exception of other than temporary impairments which are included in net income. Debt and equity securities classified as “trading” securities are carried at fair value, with the unrealised gains and losses included in the Consolidated Statement of Income as gains and losses on trading securities. Fair value is determined based on the quoted market price when available or, if quoted market prices are not available, discounted expected cash flows using market rates commensurate with the credit quality and maturity of the investment. In respect of held to maturity or available for sale securities, declines in fair value that are determined to be other than temporary are charged to earnings. Accrual of income is suspended in respect of debt securities that are in default, or from which it is unlikely that future interest payments will be received as scheduled. Realised gains and losses on sales of investments are included in earnings on a specific identified cost basis. Venture capital investments are recorded at fair value with adjustments to fair value being recognised in investment income. In assessing fair value, management reviews meaningful third party transactions in the private market and the results of applying acceptable valuation methodologies to current and projected cash flows. In the absence of persuasive evidence to the contrary, management generally considers cost to be the best indicator of fair value. Due to the dynamic nature of assumptions used in establishing fair values, the values reflected in the consolidated financial statements may differ materially from the values that would be determined by negotiations held between parties in a sale transaction. (f) Loans Loans are reported at the principal amount outstanding, net of allowance for credit losses, unearned income and net deferred loan fees. Interest income is recognised over the term of the loan using the interest method, or on a basis approximating a level rate of return over the term of the loan, except for loans classified as non-accrual. Non-accrual loans are those on which the accrual of interest is discontinued. Loans are placed on non-accrual status immediately if, in the opinion of management, full payment of principal or interest is in doubt or when principal or interest is 90 days past due, unless the loan is fully secured and any collection efforts are reasonably expected to result in repayment of all amounts due under the contractual terms of the loan. 29 Interest accrued but not collected at the date a loan is placed on non-accrual status is reversed against interest income. In addition, the amortisation of net deferred loan fees is suspended. Interest income on non-accrual loans is recognised only to the extent it is received in cash. However, where there is doubt regarding the ultimate collectivity of the loan principal, all cash thereafter received is applied to reduce the carrying value of the loan. Loans are restored to accrual status only when interest and principal payments are brought current and future payments are reasonably assured. Credit card loans that are contractually 180 days past due and consumer loans with an outstanding balance under $100,000 that are contractually 180 days past due are automatically written off. The Bank accounts for and discloses non-accrual commercial loans as impaired loans, and recognises interest income as previously discussed for non-accrual loans. Accordingly, interest income on these loans is recognised after the entire recorded investment is recovered, and interest is actually received. In addition, the amortisation of net deferred loan fees is suspended. (g) Allowance for Credit Losses The Bank maintains an allowance for credit losses, which in management’s opinion is adequate to absorb all incurred credit related losses in its portfolio relating to on and off balance sheet financial instruments. The allowance for credit losses consists of specific allowances and a general allowance, each of which is reviewed on a regular basis. The allowance for credit losses is included as a reduction of the related asset category. (h) Specific Allowances Specific allowances are determined on an item by item basis and reflect the associated estimated credit loss. The specific allowance for credit loss is computed as the difference between the recorded investment in the loan and present value of expected future cash flows from the loan. The effective rate of return on the loan is used for discounting the cash flows. However, when foreclosure of a collateral-dependent loan is probable, the Bank measures impairment based on the fair value of the collateral. The Bank considers estimated costs to sell, on a discounted basis, in the measurement of impairment if those costs are expected to reduce the cash flows available to repay or otherwise satisfy the loan. If the measurement of an impaired loan is less than the recorded investment in the loan, then the Bank recognises impairment by creating a valuation allowance with a corresponding charge to bad debt expense. (i) General Allowance The allowance for credit losses attributed to the remaining portfolio is established through a process that estimates the probable loss inherent in the portfolio based upon various analyses. These analyses consider historical default rates and loss severities, internal risk ratings, and geographic, industry, and other environmental factors. Management also considers overall portfolio indicators including trends in internally risk rated exposures, cash-basis loans, historical and forecasted write-offs, and a review of industry, geographic and portfolio concentrations, including current developments within those segments. In addition, management considers the current business strategy and credit process, including limit setting and compliance, credit approvals, loan underwriting criteria and loan workout procedures. Each portfolio of smaller balance, homogeneous loans, including consumer mortgage, instalment, revolving credit, and most other consumer loans, is collectively evaluated for impairment. The allowance for credit losses attributed to these loans is established via a process that estimates the probable losses inherent in the portfolio, based upon various analyses. Management considers overall portfolio indicators including historical credit losses; delinquent (defined as loans with payments contractually over 30 days past due), non-performing, and classified loans; trends in volumes and terms of loans; an evaluation of overall credit quality; the credit process, including lending policies and procedures; and economic, geographical, product, and other environmental factors. (j) Business Combinations, Goodwill and Intangible Assets All business combinations are accounted for using the purchase method. Identifiable intangible assets (mostly customer relationships) are recognised separately from goodwill and are initially valued using discounted cash flow calculations and other recognised valuation techniques. Goodwill represents the excess of the price paid for the acquisition of a business over the fair value of the net assets acquired. Goodwill is tested annually for impairment at the reporting unit level, or more frequently if events or circumstances such as adverse changes in the business climate indicate there may be impairment. If the carrying amount of a reporting unit, including the allocated goodwill, exceeds its fair value, goodwill impairment is measured as the excess of the carrying amount of the reporting unit’s allocated goodwill over the implied fair value of the goodwill. Other acquired intangible assets with finite lives are amortised on a straight-line basis over their estimated useful lives, not exceeding 15 years. Intangible assets’ estimated lives are re-evaluated annually and an impairment test is carried out if certain indicators of impairment exist. (k) Premises, Equipment and Computer Software Land, building, equipment and computer software, including leasehold improvements, are carried at cost less accumulated depreciation. The Bank generally computes depreciation using the straight-line method over the estimated useful life of an asset, which is 50 years for buildings, and 3 to 10 years for other equipment. For leasehold improvements the Bank uses the straight-line method over the lesser of the remaining term of the leased facility or the estimated economic life of the improvement. The Bank capitalises certain costs associated with the acquisition or development of internal use software. Once the software is ready for its intended use, these costs are amortised on a straight-line basis over the software’s expected useful life, which is between 5 and 7 years. If deemed significant the Bank will capitalise interest cost in accordance with FAS No. 34 Capitalisation of Interest Cost (FAS 34). (l) Derivatives In accordance with FAS No. 133 Accounting for Derivative Instruments and Hedging Activities (FAS 133), all derivatives are recognised on the Consolidated Balance Sheet at their fair value. FAS 133, as amended by FAS No. 138 Accounting for Certain Derivative Instruments and Certain Hedging Activities (FAS 138) and FAS No. 149 Amendment of Statement 133 on Derivative Instruments and Hedging Activities (FAS 149), establishes accounting and reporting standards for financial derivatives, including certain financial derivatives embedded in other contracts and hedging activities. On the date that the Bank enters into a derivative contract, it designates the derivative as either: a hedge of the fair value of a recognised asset or liability (a fair value hedge); a hedge of a forecasted transaction or the variability of cash flows that are to be received or paid in connection with a recognised asset or liability (a cash flow hedge), or an instrument that is held for trading or non-hedging purposes (a trading or non-hedging instrument). Changes in the fair value of a derivative that is highly effective, and that is designated and qualifies as a fair value hedge, along with changes in the fair value of the hedged asset or liability that are attributable to the hedged risk, are recorded in current period earnings. Changes in the fair value of a derivative that is highly effective and that is designated and qualifies as a cash flow hedge, to the extent that the hedge is effective, are recorded in other comprehensive income, until earnings are affected by the variability of cash flows of the hedged transaction. Any hedge ineffectiveness is recorded in current period earnings. Changes in the fair value of a derivative that is highly effective as and that is designated and qualifies as a foreign currency hedge is recorded in either current period earnings or other comprehensive income, depending on whether the hedging relationship satisfies the criteria for a fair value or cash flow hedge. If, however, a derivative is used as a hedge of a net investment in a foreign operation, the changes in the derivative’s fair value, to the extent that the derivative is effective as a hedge, are recorded in the cumulative translation adjustment account within other comprehensive income. Changes in the fair value of derivative trading and non-hedging instruments are reported in current period earnings. The Bank formally documents all relationships between hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives that are designated as fair value, cash flow, or foreign currency hedges to specific assets and liabilities on the consolidated balance sheet or specific firm commitments or forecasted transactions. The Bank also formally assesses whether the derivatives that are used in hedging transactions have been highly effective in offsetting changes in the fair value or cash flows of hedged items and whether those derivatives may be expected to remain highly effective in future periods. When it is determined that a derivative has ceased to be highly effective as a hedge, the Bank discontinues hedge accounting prospectively. For those hedge relationships that are terminated, hedge designations that are removed, or forecasted transactions that are no longer expected to occur, the hedge accounting treatment described in the paragraphs above is no longer applied and the end-user derivative is terminated or transferred to the trading account. For fair value hedges, any changes to the hedged item remain as part of the basis of the asset or liability and are ultimately reflected as an element of the yield. For cash flow hedges, any changes in fair value of the end-user derivative remain in other comprehensive income and are included in retained earnings of future periods when earnings are also affected by the variability of the hedged cash flows. If the forecasted transaction is no longer likely to occur, any changes in fair value of the end-user derivatives are immediately reflected in other income. (m) Employee Future Benefits The Bank maintains trusteed pension plans for substantially all employees including non-contributory defined benefit plans and a number of defined contribution plans. Benefits under the defined benefit plans are primarily based on the employee’s years of credited service and average annual salary during the final years of employment as defined in the plans. The Bank also provides post-retirement medical benefits for substantially all retired Bermuda-based employees. The Bank’s defined benefit pension plans are accounted for in accordance with FAS No. 87 Employers’ Accounting for Pensions (FAS 87) and FAS No. 88 Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits (FAS 88). Its post-retirement medical and life insurance plans are accounted for in accordance with FAS No. 106 Employers’ Accounting for Post-retirement Benefits Other Than Pensions (FAS 106). Starting 31 December 2006, both plans are also accounted for in accordance with FAS No. 158 (FAS 158), Employers’ Accounting for Defined Benefit Pension and Other Post-retirement Plans, an amendment of FASB Statements No. 87, 88, 106 and 132(R). Expense for the defined benefit pension plans and the post-retirement medical benefits plan is comprised of (a) the actuarially determined benefits for the current year’s service, (b) imputed interest on the actuarially determined liability of the plan, (c) in the case of the defined benefit pension plans, the expected investment return on the market value of plan assets and (d) amortisation of certain items over the expected average remaining service life of employees in the case of the defined benefit pension plans, and the expected average remaining service life to full eligibility age of employees covered by the plan in the case of the post-retirement medical benefits plan. The items amortised are amounts arising as a result of experience gains and losses, changes in assumptions, plan amendments and the change in the net pension asset or post-retirement medical benefits liability arising on adoption of revised accounting standards. For each of the defined benefit pension plans and for the post-retirement medical benefits plan, the asset (liability) recognised for accounting purposes is reported in other assets and employee future benefits. 30 2006 | Annual Report 31 For the defined contribution pension plans the Bank and participating employees provide an annual contribution based on each participating employee’s pensionable earnings. Amounts paid are expensed in the period. (n) Share-Based Compensation The Bank has a stock option plan for all eligible employees. In accordance with FAS No. 123R Share-Based Payment (FAS 123R), starting on 1 January 2006 the Bank follows the fair value method of accounting for stock options. The fair value of options that eventually vest is amortised over the vesting period of the options. (o) Revenue Recognition Trust and investment services fees include fees for private and institutional trust, executorship, and custody services. These fees are recognised as revenue when the Bank has rendered all services to the clients and is entitled to collect the fee from the client, as long as there are no other contingencies associated with the fee. Asset management fees include fees for investment management, investment advice and brokerage services. Investment management fees are recognised over the period in which the related service is provided, on a net asset value basis. Investment advice and brokerage services fees are recognised in the period in which the related service is provided. Investment and pension fund administration fees include fees for pension fund administration, institutional fund administration, registration and transfer agent and corporate services. Pension and institutional fund administration fees are recognised as revenue when the Bank has rendered all services to the clients and is entitled to collect the fee from the client, as long as there are no other contingencies associated with the fee. All other fees are recognised as revenue over the period of the relationship. Banking services fees primarily include fees for certain loan origination, letters of credit, other financial guarantees, compensating balances and other financial services related products. Certain loan origination fees are primarily overdraft and other revolving lines of credit fees. These fees are recognised as revenue over the period of the underlying facilities. Letters of credit fees are recognised as revenue over the period in which the related service is provided. All other fees are recognised as revenue in the period in which the service is provided. Loan interest income includes the amortisation of non-refundable loan origination and commitment fees. These fees are deferred (except for certain retrospectively determined fees meeting specified criteria) and recognised as an adjustment of yield over the life of the related loan. In accordance with FAS No. 91 Accounting for Non-refundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases (FAS 91), these loan origination and commitment fees are offset by their related direct cost and only the net amounts are deferred and amortised into interest income. Dividend and interest income on all securities, including amortisation of premiums and discounts on debt securities held for investment, are included in investment income in the Consolidated Statement of Income. (p) Fair Value of Financial Instruments The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The accounting for an asset or liability may differ based on the type of instrument and / or its use in a trading or investing strategy. Generally, the measurement framework recorded in financial statements is based on one of the following: – At fair value on the Consolidated Balance Sheet, with changes in fair value recorded each period in the Consolidated Statement of Income. – At fair value on the Consolidated Balance Sheet, with changes in fair value recorded each period as a separate component of shareholders’ equity and as part of other comprehensive income. – At cost (less other than temporary impairments), with changes in fair value not recorded in the financial statements but disclosed in the notes. – At the lower of cost or fair value. Fair value amounts represent estimates of the consideration that would currently be agreed upon between knowledgeable, willing parties who are under no compulsion to act and is best evidenced by a quoted market price, if one exists. Some of the Bank’s financial instruments lack an available trading market. Therefore, these instruments have been valued using present value or other valuation techniques and may not necessarily be indicative of the amounts realisable in an immediate settlement of the instruments. In addition, the calculation of estimated fair value is based on market conditions at a specific point in time and may not be reflective of future fair values. The book value of financial assets and financial liabilities held for purposes other than trading may exceed their fair value due primarily to changes in interest rates. In such instances, the Bank does not reduce the book value of these financial assets and financial liabilities to their fair values as it is the Bank’s intention to hold them until maturity. The fair values disclosed exclude premises and equipment and certain other assets and liabilities as these are not financial instruments. The following methods and assumptions were used in the determination of the fair value of financial instruments: i) Cash and deposits with banks: The fair value of cash and deposits with banks, being short term in nature, is deemed to equate to the carrying value. ii) Investments: The fair values of investments are based upon quoted market prices where available. iii) Loans: The majority of loans are variable rate and re-price in response to changes in market rates and hence the fair value has been estimated as the carrying value. For fixed-rate loans, the fair value has been estimated by performing a discounted cash flow calculation using market rates for similar loans made at the balance sheet date. iv) Accrued interest: The carrying values of accrued interest receivable and payable are assumed to approximate their fair values given their short-term nature. v) Deposits: The fair value of fixed-rate deposits has been estimated by discounting the contractual cash flows, using market interest rates offered at the balance sheet date for deposits of similar terms. The fair value of deposits with no stated maturity date is deemed to equate to the carrying value. vi) Subordinated capital and senior debt: The fair value of the subordinated capital and senior debt is based on current market pricing. vii) Derivatives: Fair value of exchange traded derivatives is based on quoted market prices. Fair value of over the counter derivatives is calculated as the net present value of contractual cash flows using prevailing market rates. The aggregate of the estimated fair value of amounts presented does not represent management’s estimate of the underlying value to the Bank. (q) Credit Related Arrangements In the normal course of business, the Bank enters into various commitments to meet the credit requirements of its customers. Such commitments, which are not included in the Consolidated Balance Sheet, include: i) Commitments to extend credit which represent undertakings to make credit available in the form of loans or other financing for specific amounts and maturities, subject to certain conditions. ii) Standby letters of credit, which represent irrevocable obligations to make payments to third parties in the event that the customer is unable to meet its financial obligations. iii) Documentary and commercial letters of credit, primarily related to the import of goods by customers, which represent agreements to honour drafts presented by third parties upon completion of specific activities. These credit arrangements are subject to the Bank’s normal credit standards and collateral is obtained where appropriate. The contractual amounts for these commitments set out in the table in Note 10 represent the maximum payments the Bank would have to make should the contracts be fully drawn, the counterparty default, and any collateral held prove to be of no value. As many of these arrangements will expire or terminate without being drawn upon or fully collateralised, the contractual amounts do not necessarily represent future cash requirements. The Bank does not carry any liability for these obligations. (r) Income Taxes The Bank uses the asset and liability method whereby income taxes reflect the expected future tax consequences of temporary differences between the financial statements’ carrying amounts of assets and liabilities and their respective tax bases. Accordingly, a deferred income tax asset or liability is determined for each temporary difference based on the enacted tax rates to be in effect on the expected reversal date of the temporary difference. Income taxes on the Consolidated Statement of Income include the current and deferred portions of the income taxes. Income taxes applicable to items charged or credited directly to shareholders’ equity are included in such items. Net deferred income tax assets or liabilities accumulated as a result of temporary differences are included in other assets or other liabilities, respectively. A valuation allowance is established to reduce deferred income tax assets to the amount more likely than not to be realised. (s) Consolidated Statement of Cash Flows For the purposes of the Consolidated Statement of Cash Flows, cash and demand deposits with banks include cash and demand deposits; vault cash and cash in transit where the Bank holds the related assets. (t) Earnings Per Share Earnings per share has been calculated using the weighted average number of shares outstanding during the year and adjusted for the stock dividends declared during the years ended 31 December 2006 and 2005 (see also Notes 17 and 21). The dilutive effect of stock options was calculated using the treasury stock method, whereby the proceeds received from the exercise of stock options are assumed to be used to repurchase outstanding shares, using the quarterly average market price of the Bank’s shares for the period. 32 2006 | Annual Report 33 (u) Consolidation of Variable Interest Entities FIN 46R requires beneficiaries of variable interests to consolidate the VIE if that party will absorb a majority of the expected losses of the VIE, receive a majority of residual returns of the VIE, or both. This party is considered the primary beneficiary of the entity. The determination of whether an entity meets the criteria to be considered the primary beneficiary of a VIE requires an evaluation of all transactions (such as investments, loans and fee arrangements) with the entity. (v) Impairment or Disposal of Long-Lived Assets An impairment loss is recognised when the carrying amount of a long-lived asset to be held and used exceeds the sum of the undiscounted cash flows expected from its use and disposal. The impairment recognised is measured as the amount by which the carrying amount of the asset exceeds its fair value. Long-lived assets that are to be disposed of other than by sale are classified and accounted for as held for use until the date of disposal or abandonment. Assets that meet certain criteria are classified as held for sale and are measured at the lower of their carrying amounts or fair value, less costs of sale. Note 2: Cash and Deposits with Banks 31 December Unrestricted Non-interest earning 2006 2005 Bermuda Non-Bermuda Total Bermuda Non-Bermuda Total Cash and demand deposits 27,062 22,955 50,017 22,962 16,200 39,162 Interest earning Deposits maturing within three months and on demand Deposits maturing between three to six months Deposits maturing between six to twelve months Sub-total - Interest earning 183,815 - - 183,815 2,745,502 77,458 78,719 2,901,679 2,929,317 77,458 78,719 3,085,494 307,898 - - 307,898 1,628,157 810,453 58,235 2,496,845 1,936,055 810,453 58,235 2,804,743 Total unrestricted cash and deposits 210,877 2,924,634 3,135,511 330,860 2,513,045 2,843,905 Affected by drawing restrictions related to minimum reserve and derivative margin requirements Non-interest earning Demand deposits - 12,795 12,795 - - - Interest earning Deposits maturing within three months 2,885 - 2,885 1,586 4,429 Total restricted deposits 2,885 12,795 15,680 1,586 4,429 6,015 6,015 Total cash and deposits with banks 213,762 2,937,429 3,151,191 332,446 2,517,474 2,849,920 Note 3: Investments The following table presents securities by remaining term to maturity: 31 December 2006 Trading Debt securities issued by non-US governments Corporate securities and other Total trading Available for sale Debt securities issued by non-US governments Corporate debt securities Equity securities Other, primarily asset-backed securities Total available for sale Held to maturity US government and federal agencies / corporations Collateralised mortgage obligations Debt securities issued by non-US governments Corporate debt securities Other, primarily asset-backed securities Total held to maturity Total investments Total by currency Bermuda dollars US dollars Other Total investments Remaining term to maturity Within 3 months 3 to 12 months 1 to 5 years Over No specific maturity 5 years Carrying value - - - 559 3 562 3,847 - 3,847 6,351 - 6,351 - 45,711 45,711 10,757 45,714 56,471 27,265 464,226 - 97,932 589,423 - 372,059 - - 372,059 - - - - - - 1,650 - - 1,650 - - 223 - 223 27,265 837,935 223 97,932 963,355 - - - 319,165 - 319,165 - - 5,458 397,402 19,524 422,384 64,645 - 60,396 1,130,477 44,413 1,299,931 158,977 279,393 14,407 113,568 159,142 725,487 - - - - - - 223,622 279,393 80,261 1,960,612 223,079 2,766,967 908,588 795,005 1,303,778 733,488 45,934 3,786,793 - 364,042 544,546 - 393,328 401,677 - 1,138,242 165,536 - 573,015 160,473 2,787 40,925 2,222 2,787 2,509,552 1,274,454 908,588 795,005 1,303,778 733,488 45,934 3,786,793 34 2006 | Annual Report 35 31 December 2005 Trading Certificates of deposit, bankers acceptances and commercial paper Debt securities issued by non-US governments Corporate securities and other Total trading Available for sale Debt securities issued by non-US governments Corporate debt securities Equity securities Other, primarily asset-backed securities Total available for sale Held to maturity US government and federal agencies / corporations Collateralised mortgage obligations Debt securities issued by non-US governments Corporate debt securities Other, primarily asset-backed securities Total held to maturity Total investments Total by currency Bermuda dollars US dollars Other Total investments Within 3 months 3 to 12 months Remaining term to maturity Over 5 years 1 to 5 years No specific maturity Carrying value 73,285 - 219 73,504 33,226 207,094 - - 240,320 - - 5,003 161,603 - 166,606 12,901 828 - 13,729 - 260,185 - 34,403 294,588 - - 3,178 266,427 - 269,605 - 2,126 692 2,818 9,443 - - - 9,443 - 7,677 - 7,677 - 1,650 - - 1,650 - - 38,792 38,792 - - 301 - 301 86,186 10,631 39,703 136,520 42,669 468,929 301 34,403 546,302 59,950 - 71,761 1,229,485 48,888 1,410,084 36,678 151,135 13,575 5,000 180,894 387,282 - - - - - - 96,628 151,135 93,517 1,662,515 229,782 2,233,577 480,430 577,922 1,422,345 396,609 39,093 2,916,399 61 217,295 263,074 480,430 - 194,576 383,346 577,922 - 1,350,436 71,909 1,422,345 - 370,949 25,660 396,609 800 28,536 9,757 39,093 861 2,161,792 753,746 2,916,399 Investments at carrying value includes $2,159 million (2005: $1,738 million) of floating-rate instruments and $1,582 million (2005: $1,144 million) of fixed-rate instruments. The approximate yield on floating-rate securities at 31 December 2006 was 5.61% (2005: 4.36%), while the approximate yield on fixed-rate securities was 5.39% (2005: 4.46%). The cost of available for sale securities, the amortised cost of held to maturity securities and their estimated fair values were as follows: 31 December 2006 Gross Gross unrealised unrealised losses gains Cost Fair value 2005 Gross Gross unrealised unrealised losses gains Cost Fair value Available for sale US government and federal agencies / corporations Collateralised mortgage obligations Debt securities issued by non-US governments Corporate debt securities Equity securities Other, primarily asset-backed securities Total available for sale - - 27,265 838,476 223 97,931 963,895 - - - - - 1 1 2006 31 December Gross Gross Amortised unrealised unrealised losses gains cost - - - (541 ) - - (541 ) - - 27,265 837,935 223 97,932 963,355 - - 42,669 468,996 301 34,400 546,366 - - - 67 - 3 70 - - - (134 ) - - (134 ) - - 42,669 468,929 301 34,403 546,302 2005 Gross Gross Fair Amortised unrealised unrealised losses gains cost value Fair value Held to maturity US government and federal agencies / corporations 223,623 Collateralised mortgage obligations 279,393 Debt securities issued by non-US governments 80,261 Corporate debt securities 1,960,611 Other, primarily asset-backed securities 223,079 2,766,967 Total held to maturity 397 61 125 1,495 337 2,415 (849 ) (128 ) (543 ) 96,628 223,171 151,135 279,326 93,517 79,843 (2,080 ) 1,960,026 1,662,515 229,782 214,226 (9,190 ) (12,790 ) 2,756,592 2,233,577 99 106 177 1,315 124 1,821 (716 ) (157 ) (703 ) (2,662 ) (11,117 ) (15,355 ) 96,011 151,084 92,991 1,661,168 218,789 2,220,043 The following table shows the fair value and gross unrealised losses of the Bank’s investments with unrealised losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealised loss position: Less than 12 months 12 months or more Gross Fair unrealised losses value Gross Fair unrealised losses value Total Total gross fair unrealised losses value 31 December 2006 Available for sale Corporate debt securities Total available for sale securities with unrealised losses 831,839 (541 ) 831,839 (541 ) - - - - 831,839 (541 ) 831,839 (541 ) 36 2006 | Annual Report 37 Held to maturity US government and federal agencies / corporations Collateralised mortgage obligations Debt securities issued by non-US governments Corporate debt securities Other, primarily asset-backed securities Total held to maturities securities with unrealised losses 35,162 113,455 - 313,482 39,117 (89 ) (78 ) - (270 ) (53 ) 63,885 35,218 39,399 277,480 64,076 (760 ) (50 ) (543 ) (1,810 ) (9,137 ) 99,047 148,673 39,399 590,962 103,193 (849 ) (128 ) (543 ) (2,080 ) (9,190 ) 501,216 (490 ) 480,058 (12,300 ) 981,274 (12,790 ) Total securities with unrealised losses 1,333,055 (1,031 ) 480,058 (12,300 ) 1,813,113 (13,331 ) Less than 12 months 12 months or more Gross unrealised losses Fair value Gross unrealised losses Fair value Total gross unrealised losses Total fair value 31 December 2005 Available for sale Corporate debt securities Total available for sale securities with unrealised losses 302,040 (134 ) 302,040 (134 ) - - - - 302,040 (134 ) 302,040 (134 ) Held to maturity US government and federal agencies / corporations Collateralised mortgage obligations Debt securities issued by non-US governments Corporate debt securities Other, primarily asset-backed securities Total held to maturities securities with unrealised losses 64,186 26,118 54,038 310,912 45,265 (716 ) (19 ) (703 ) (1,594 ) (749 ) - 46,009 - 447,381 63,046 - (137 ) - (1,067 ) (10,370 ) 64,186 72,127 54,038 758,293 108,311 (716 ) (156 ) (703 ) (2,661 ) (11,119 ) 500,519 (3,781 ) 556,436 (11,574 ) 1,056,955 (15,355 ) Total securities with unrealised losses 802,559 (3,915 ) 556,436 (11,574 ) 1,358,995 (15,489 ) In respect of the following categories, the Bank does not consider those investments to be other-than-temporarily impaired at 31 December 2006: US Government and federal agencies / corporations The unrealised losses on the Bank’s investments in US Treasury obligations and direct obligations of US government agencies were caused by interest rate increases and not credit quality decreases. The Bank has the ability and intent to hold those investments until a recovery of fair value, which may be maturity. Collateralised mortgage obligations The unrealised losses on the Bank’s investment in collateralised mortgage obligations were caused by interest rate increases and not credit quality decreases. It is expected that the securities would not be settled at a price less than the amortised cost of the Bank’s investment. The Bank has the ability and intent to hold those investments until a recovery of fair value, which may be maturity. Debt securities issued by non-US governments The unrealised losses on the Bank’s investments in non-US government debt securities obligations and direct obligations of non-US government agencies were caused by interest rate increases and not credit quality decreases. The Bank has the ability and intent to hold those investments until a recovery of fair value, which may be maturity. Corporate debt securities The unrealised losses on the Bank’s investments in corporate bonds were caused by interest rate increases and not credit quality decreases. The Bank currently does not believe it is probable that it will be unable to collect all amounts due according to the contractual terms of the investments. Therefore, it is expected that the debentures would not be settled at a price less than the amortised cost of the investments. The Bank has the ability and intent to hold those investments until a recovery of fair value, which may be maturity. Other, primarily asset-backed securities The unrealised losses on the Bank’s other investments, primarily asset-backed securities, were caused by credit rating decreases and interest rate increases. The Bank currently does not believe it is probable that it will be unable to collect all amounts due according to the contractual terms of the investments. Therefore, it is expected that the securities would not be settled at a price less than the amortised cost of the investments. The Bank has the ability and intent to hold those investments until a recovery of fair value, which may be maturity. The following table presents realised and unrealised gains and losses on trading securities: 31 December Realised / unrealised gains (losses) on trading securities Equities (a) Fixed income and other (b) Total (a) Includes equity securities and equity derivatives. (b) Includes bonds, commercial paper, interest rate and foreign exchange derivatives. The following table presents realised gains and losses from available for sale securities: 31 December Realised gains on available for sale securities Realised gains Net realised gains Note 4: Loans The composition of the loan portfolio at each of the indicated dates was as follows: 2006 2005 2,103 (495 ) 1,608 1,084 (189 ) 895 2006 2005 - - 90 90 2006 Non- Bermuda Total Bermuda Non- Bermuda 2005 Total 183,749 650,971 445,970 87,386 533,356 31 December Bermuda 467,222 Commercial loans Commercial and industrial Commercial real estate Commercial mortgage 123,123 138,055 Construction Financial institutions 422,528 Government 21,600 Overdrafts 24,995 1,197,523 Total commercial loans Less allowance for credit losses on commercial loans (12,734 ) Total commercial loans after allowance for credit losses 1,184,789 485,179 7,920 26,392 - 214,627 917,867 (1,763 ) 916,104 608,302 145,975 448,920 21,600 239,622 2,115,390 (14,497 ) 2,100,893 133,626 140,101 313,980 15,600 33,939 1,083,216 (13,765 ) 1,069,451 Consumer loans Automobile financing 60,068 Credit card 42,385 Mortgages 904,339 Overdrafts 4,514 Other consumer 76,787 Total consumer loans 1,088,093 Less allowance for credit losses on consumer loans (7,628 ) Total consumer loans after allowance for credit losses 1,080,465 7,419 18,879 352,906 16,254 187,537 582,995 (3,608 ) 579,387 67,487 61,264 1,257,245 20,768 264,324 1,671,088 (11,236 ) 1,659,852 52,919 38,990 799,922 6,345 72,033 970,209 (5,978 ) 964,231 Total loans Less allowance for credit losses Net loans 2,285,616 (20,362 ) 2,265,254 1,500,862 (5,371 ) 1,495,491 3,786,478 (25,733 ) 3,760,745 2,053,425 (19,743 ) 2,033,682 1,056,903 (4,991 ) 1,051,912 427,765 8,980 10,615 - 51,548 586,294 (2,158 ) 584,136 8,948 18,254 252,498 22,090 168,819 470,609 (2,833 ) 467,776 561,391 149,081 324,595 15,600 85,487 1,669,510 (15,923 ) 1,653,587 61,867 57,244 1,052,420 28,435 240,852 1,440,818 (8,811 ) 1,432,007 3,110,328 (24,734 ) 3,085,594 38 2006 | Annual Report 39 The principal means of securing residential mortgages, personal, credit card and business loans are charges over assets and guarantees. Mortgage loans are generally repayable over periods of up to thirty years and personal, credit card, business and government loans are generally repayable over terms not exceeding five years. The effective yield on total loans as at 31 December 2006 is 6.94% (2005: 6.37%). The table below sets forth information about the Bank’s non-accrual loans: Note 5: Credit Risk Concentrations 31 December Commercial loans - Bermuda Commercial loans - Non-Bermuda Consumer loans - Bermuda Consumer loans - Non-Bermuda Mortgages - Bermuda Mortgages - Non-Bermuda Total Gross 5,082 7,201 1,524 1,053 7,714 6,514 29,088 2006 Allowance Total Gross 2005 Allowance (2,484 ) (226 ) (51 ) (610 ) (165 ) (79 ) (3,615 ) 2,598 6,975 1,473 443 7,549 6,435 25,473 6,293 7,791 900 2,700 4,597 4,681 26,962 (2,625 ) (729 ) (165 ) (358 ) (165 ) (62 ) (4,104 ) Total 3,668 7,062 735 2,342 4,432 4,619 22,858 For the year ended 31 December 2006, the amount of gross interest income that would have been recorded had impaired loans been current was $2,808 (2005: $2,711). For the year ended 31 December 2006, the Bank recovered overdue interest of $192 (2005: $529) on impaired loans that were repaid in the year. The average balance of impaired loans during the year ended 31 December 2006 was $28,521 (2005: $24,705). The table below summarises the changes in the allowances for credit losses: Year ended 31 December Allowance for credit losses at beginning of year Provision this year Recoveries Charge-offs Other Allowance for credit losses at end of year Specific allowances 2006 General allowance Total Specific allowances 4,104 1,871 400 (2,760 ) - 3,615 20,630 1,126 996 (634 ) - 22,118 24,734 2,997 1,396 (3,394 ) - 25,733 1,918 4,464 255 (2,528 ) (5 ) 4,104 2005 General allowance 21,903 (1,292 ) 1,195 (1,176 ) - 20,630 Total 23,821 3,172 1,450 (3,704 ) (5 ) 24,734 The table below presents information about the loan delinquencies, and charge-offs: 31 December loans past due Charge-offs 2006 Loans 90 delinquent days or more Total Total 2005 Loans 90 delinquent days or more past due loans Credit card Automobile financing Other consumer and mortgages Consumer loans Commercial loans Total loans reported 4,770 2,513 30,409 37,692 12,165 49,857 502 441 20,001 20,944 8,967 29,911 1,204 27 188 1,419 310 1,729 4,198 765 22,637 27,600 6,433 34,033 845 369 11,798 13,012 5,127 18,139 31 December Bermuda Barbados Cayman Guernsey The Bahamas United Kingdom Sub-total General allowance Total Charge-offs 897 42 2,431 3,370 334 3,704 Concentrations of credit risk arise when a number of customers are engaged in similar business activities, are in the same geographic region, or when they have similar economic features that would cause their ability to meet contractual obligations to be similarly affected by changes in economic conditions. The Bank regularly monitors various segments of its credit risk portfolio to assess potential concentrations of risks and to obtain collateral when deemed necessary. In the Bank’s commercial portfolio, risk concentrations are primarily evaluated by industry and also by geographic region. In the consumer portfolio, concentrations are primarily evaluated by products. Credit exposures include loans, guarantees and acceptances, letters of credit and commitments for undrawn lines of credit. The following table summarises the credit exposure of the Bank by business sector: 31 December Banks and financial services Commercial and merchandising Governments Individuals Primary industry and manufacturing Real estate Transport and communication Sub-total General allowance Total 2006 On-balance Off-balance Total credit exposure sheet sheet 2005 On-balance Off-balance sheet sheet Total credit exposure 851,643 444,696 21,600 1,659,580 28,731 755,089 21,524 3,782,863 (22,118 ) 3,760,745 818,742 252,723 2,400 156,834 36,476 156,169 11,731 1,435,075 - 1,435,075 1,670,385 697,419 24,000 1,816,414 65,207 911,258 33,255 5,217,938 (22,118 ) 5,195,820 446,481 558,895 9,421 1,219,941 41,400 803,530 26,556 3,106,224 (20,630 ) 3,085,594 815,745 166,979 9,882 158,254 14,279 164,151 4,438 1,333,728 - 1,333,728 1,262,226 725,874 19,303 1,378,195 55,679 967,681 30,994 4,439,952 (20,630 ) 4,419,322 The following table summarises the credit exposure of the Bank by region: 2006 On-balance Off-balance Total credit exposure sheet sheet 2005 On-balance Off-balance sheet sheet Total credit exposure 2,282,917 125,044 343,710 451,046 13,598 566,548 3,782,863 (22,118 ) 3,760,745 1,016,157 29,467 110,242 163,940 - 115,269 1,435,075 - 1,435,075 3,299,074 154,511 453,952 614,986 13,598 681,817 5,217,938 (22,118 ) 5,195,820 2,050,470 108,710 307,604 214,898 5,182 419,360 3,106,224 (20,630 ) 3,085,594 979,214 10,910 136,672 109,298 - 97,634 1,333,728 - 1,333,728 3,029,684 119,620 444,276 324,196 5,182 516,994 4,439,952 (20,630 ) 4,419,322 40 2006 | Annual Report 41 Note 6: Premises, Equipment and Computer Software The following table summarises land, buildings, equipment and computer software: 2006 Accumulated Net carrying value Cost depreciation 2005 Accumulated Cos t depreciation Net carrying value 13,571 126,218 50,366 66,055 256,210 - (29,757 ) (30,907 ) (24,220 ) (84,884 ) 11,997 109,742 42,925 49,848 214,512 - (28,403 ) (25,229 ) (19,172 ) (72,804 ) 13,571 96,461 19,459 41,835 171,326 2006 3,755 3,549 6,552 13,856 31 December Land Buildings Equipment Computer software Total 31 December Depreciation Buildings (included in property expense) Equipment (included in property expense) Computer hardware and software (included in technology expense) Total depreciation charged to operating expenses Note 7: Goodwill and Other Intangible Assets The following table presents goodwill and other intangible assets by business segment: Goodwill Business segment Balance as at 31 December 2004 Foreign exchange translation adjustment Balance as at 31 December 2005 Foreign exchange translation adjustment Balance as at 31 December 2006 Other intangible assets 31 December Bermuda Barbados Cayman Guernsey The Bahamas United Kingdom Customer relationships Barbados Guernsey The Bahamas United Kingdom 8,191 (848 ) 7,343 1,020 8,363 1,923 - 1,923 - 1,923 5,220 - 5,220 - 5,220 2006 9,304 (950 ) 8,354 1,158 9,512 2005 Gross carrying Accumulated amount amortisation 8,337 6,681 1,211 51,801 7,790 20,219 96,039 (1,250 ) (1,371 ) (188 ) (17,381 ) (2,142 ) (4,022 ) (26,354 ) Net carrying amount 7,087 5,310 1,023 34,420 5,648 16,197 69,685 Gross carrying Accumulated amount amortisation 8,337 6,681 1,211 45,491 7,790 17,905 87,415 (695 ) (926 ) (108 ) (12,205 ) (1,465 ) (2,394 ) (17,793 ) 11,997 81,339 17,696 30,676 141,708 2005 2,839 3,794 7,698 14,331 Total 24,638 (1,798 ) 22,840 2,178 25,018 Net carrying amount 7,642 5,755 1,103 33,286 6,325 15,511 69,622 Note 8: Customer Deposits and Deposits from Banks (a) By maturity 31 December Demand deposits Demand deposits - Non-interest bearing Demand deposits - Interest bearing Sub-total - demand deposits 2006 Customers Banks Total Customers 2005 Banks Total 964,496 4,779,115 5,743,611 - 49,248 49,248 964,496 4,828,363 5,792,859 858,358 3,891,545 4,749,903 - 72,472 72,472 858,358 3,964,017 4,822,375 Term deposits Term deposits maturing within six months Term deposits maturing between six to twelve months Term deposits maturing after twelve months Sub-total - term deposits 3,594,235 200,471 217,342 4,012,048 233,097 2,995 1,833 237,925 3,827,332 203,466 219,175 4,249,973 2,869,968 148,667 180,428 3,199,063 216,543 - 2,128 218,671 3,086,510 148,667 182,557 3,417,734 Total 9,755,659 287,173 10,042,832 7,948,966 291,143 8,240,109 (b) By type and location 31 December Bermuda Customers Banks Barbados Customers Banks Cayman Customers Banks Guernsey Customers Banks The Bahamas Customers Banks United Kingdom Customers Banks Total Customers Total Banks Total 2006 2005 Payable Payable on a fixed date on demand Total Payable Payable on a fixed date on demand Total 2,273,826 - 1,558,952 - 3,832,778 - 1,970,607 8,069 1,243,597 24,831 3,214,204 32,900 123,621 - 45,886 16,156 169,507 16,156 117,272 7,710 42,168 - 159,440 7,710 1,646,663 38,198 727,156 78,782 2,373,819 116,980 1,522,129 55,185 689,696 75,994 2,211,825 131,179 717,452 8,346 892,275 10,037 1,609,727 18,383 654,654 5,681 695,709 2,005 1,350,363 7,686 61,444 - 78,454 1,558 139,898 1,558 57,537 - 26,531 - 84,068 - 920,605 2,704 5,743,611 49,248 5,792,859 709,325 131,392 4,012,048 237,925 1,629,930 134,096 9,755,659 287,173 4,249,973 10,042,832 419,994 3,537 4,742,193 80,182 4,822,375 509,072 108,131 3,206,773 210,961 3,417,734 929,066 111,668 7,948,966 291,143 8,240,109 There have been no impairment losses for the years ended 31 December 2006 and 2005. The estimated aggregate amortisation expense for each of the succeeding years until 31 December 2011 is $6.6 million. Customer relationships are initially valued based on the present value of net cash flows expected to be derived solely from the recurring customer base existing as at the date of acquisition. Customer relationship intangible assets may or may not arise from contracts. During 2006, the Bank did not purchase new customer relationships (2005: nil), the amortisation expense amounted to $6.3 million (2005: $6.3 million) and the foreign exchange translation adjustment increased the net carrying amount by $6.4 million (2005: decreased by $5.5 million). 42 2006 | Annual Report 43 Note 9: Employee Future Benefits Balance sheet effect of recognising the funded status of the plans at 31 December 2006 The Bank maintains trusteed pension plans including non-contributory defined benefit plans and a number of defined contribution plans, and provides post-retirement medical benefits to its qualifying retirees. The defined benefit provisions under the pension plans are generally based upon years of service and average salary during the final years of employment. The defined benefit plans are non-contributory and the funding required is provided by the Bank, based upon the advice of an independent actuary. Substantially all of the pension assets are invested in equity, fixed income and other marketable securities. The following table presents the financial position of the Bank’s defined benefit pension plans and the Bank’s post-retirement medical benefit plan. The benefit obligations and plan assets are measured as at 30 November. 2006 Post-retirement medical benefit plan Pension plans Pension plans Accumulated benefit obligation at end of year 112,720 - 103,713 Change in projected benefit obligation Opening projected benefit obligation Service cost Employee contributions Interest cost Benefits paid Actuarial (gain) loss Foreign exchange translation adjustment Closing projected benefit obligation Change in plan assets Opening fair value of plan assets Actual return on plan assets Employer contribution Employee contributions Benefits paid Foreign exchange translation adjustment Closing fair value of plan assets Funded status Deficit of plan assets over projected benefit obligation at measurement date Employer contribution during the period from measurement date to fiscal year end Unamortised net actuarial loss Unamortised past service cost Net amount recognised before 2006 adjustments 112,228 3,634 386 6,293 (5,079 ) (1,586 ) 6,502 122,378 97,260 9,853 14,623 386 (5,079 ) 5,686 122,729 351 161 161 127 800 Amounts recognised in balance sheet before 2006 adjustments consist of: Prepaid benefit cost included in other assets Accrued pension benefit cost included in employee future benefits liability Accumulated other comprehensive income Net amount recognised before 2006 adjustments (1,780 ) - 797 2,577 97,245 2,358 - 5,893 (1,569 ) 2,729 - 106,656 - - 1,569 - (1,569 ) - - 105,515 3,748 272 5,729 (3,650 ) 5,342 (4,728 ) 112,228 86,448 8,461 9,348 272 (3,650 ) (3,619 ) 97,260 (106,656 ) (14,968 ) 83 40,409 - (66,164 ) - (66,164 ) - (66,164 ) 5,176 4,854 146 (4,792 ) 180 (5,376 ) 404 (4,792 ) 2005 Post-retirement medical benefit plan - 82,524 2,256 - 5,572 (1,257 ) 8,150 - 97,245 - - 1,257 - (1,257 ) - - (97,245 ) - 41,048 - (56,197 ) - (56,197 ) - (56,197 ) Other assets Other liabilities Employee future benefits liability Accumulated other comprehensive income (loss) Total shareholders’ equity Total liabilities and shareholders’ equity Before Recognition Adjustments After Recognition 105,330 105,901 67,944 6,235 590,819 11,134,251 (1,449 ) 570 39,247 (41,266 ) (41,266 ) (1,449 ) 103,881 106,471 107,191 (35,031 ) 549,553 11,132,802 Before-tax amounts recognised in accumulated other comprehensive loss after adjustments consist of: 31 December 2006 Net actuarial loss Past service cost Accumulated other comprehensive loss after adjustments Annual benefit expense Service cost Interest cost Expected return on plan assets Amortisation of past service cost Amortisation of actuarial (gain) loss Defined benefit expense Defined contribution expense Total benefit expense 2006 Post-retirement medical benefit plan Pension plans 3,634 6,293 (6,746 ) 37 (52 ) 3,166 4,589 7,755 2,358 5,893 N/A - 3,368 11,619 - 11,619 (40,570 ) (127 ) (40,697 ) 2005 Post-retirement medical benefit plan 2,256 5,572 - - 3,976 11,804 - 11,804 Pension plans 3,748 5,729 (5,733 ) 36 (71 ) 3,709 3,378 7,087 The estimated portions of the net actuarial loss and past service cost for the pension plans that will be amortised from accumulated other comprehensive income into benefit expense over the next fiscal year are nil. The estimated portion of the net actuarial loss for the post-retirement medical benefit plan that will be amortised from accumulated other comprehensive income into benefit expense over the next fiscal year is $3.2 million. 44 2006 | Annual Report 45 31 December Actuarial assumptions used to determine annual benefit expense Weighted average discount rate Weighted average rate of compensation increases Weighted average expected long-term rate of return on plan assets Weighted average annual medical cost increase rate Actuarial assumptions used to determine benefit obligations at end of year Weighted average discount rate Weighted average rate of compensation increases Weighted average annual medical cost increase rate 2006 Post-retirement medical benefit plan Pension plans 2005 Post-retirement medical benefit plan Pension plans 5.45% 3.80% 6.45% N/A 5.35% 3.65% N/A 6.00% N/A N/A 11% to 5% in 2013 5.75% N/A 10% to 5% in 2013 5.60% 3.70% 6.50% N/A 5.45% 3.80% N/A 6.00% N/A N/A 12% to 5% in 2013 6.00% N/A 11% to 5% in 2013 For 2006, the effect of a one percentage point increase or decrease in the assumed medical cost increase rate on the aggregate of service and interest costs is a $1.7 million increase (2005: $1.6 million increase) and a $1.3 million decrease (2005: $1.2 million decrease), respectively, and on the benefit obligation a $19.5 million increase (2005: $16.8 million increase) and a $15.7 million decrease (2005: $13.6 million decrease), respectively. To develop the expected long-term rate of return on the plan assets assumption for each plan, the Bank considered the historical returns and the future expectations for returns for each asset class, as well as the target asset allocations of the funds. The weighted average discount rate used to determine benefit obligations at the end of the year is derived from interest rates on high quality corporate bonds with maturities that match the expected benefit payments. The weighted average actual and target asset allocations of the pension plans by asset category, are as follows: 31 December Actual allocation Target allocation Actual allocation Target allocation 2006 2005 Asset category Equity securities (including equity mutual funds) Debt securities (including debt mutual funds) Other Total 49% 32% 19% 100% 46% 43% 11% 100% 55% 40% 5% 100% 50% 50% - 100% At 31 December 2006, 34.8% (2005: 52.6%) of the assets of the pension plans were mutual funds and alternative investments managed or administered by wholly-owned subsidiaries of the Bank. At 31 December 2006, 3.3% (2005: 2.0%) of the plans’ assets were invested in common shares of the Bank. The investments of the pension funds are diversified across a range of asset classes and are diversified within each asset class. The assets are generally actively managed with the goal of adding some incremental value through security selection and asset allocation. Estimated 2007 Bank contribution to, and estimated benefit payments for the next ten years under, the pension and post-retirement medical benefit plans are as follows: Estimated Bank contributions for 2007 5,200 3,087 Pension plans Post-retirement medical benefit plan Estimated benefit payments by year: 2007 2008 2009 2010 2011 2012-2016 3,500 3,900 4,000 4,400 4,700 28,700 3,087 3,510 3,925 4,363 4,773 29,497 The projected benefit obligation and fair value of plan assets for pension plans with projected benefit obligations in excess of plan assets were $93 million and $93 million respectively, as at 31 December 2006 ($110 million and $94 million respectively, as at 31 December 2005). The projected benefit obligation, accumulated benefit obligation and fair value of plan assets for pension plans with accumulated benefit obligations in excess of plan assets were nil as at 31 December 2006 ($43 million, $41 million and $32 million respectively, as at 31 December 2005). Note 10: Commitments, Credit Related Arrangements and Contingencies Commitments The Bank was committed to expenditures under contract for software development and construction of $3.3 million and $23 million respectively, as at 31 December 2006 (2005: $5.4 million and $29.5 million). Rental expense for premises leased on a long-term basis for the year ended 31 December 2006 amounted to $5.7 million (2005: $5.1 million). The following table summarises the Bank’s commitments for construction, software development and long-term leases: Year 2007 2008 2009 2010 2011 2012 & thereafter 9,425 5,338 5,150 4,773 4,596 5,936 Credit Related Arrangements Standby letters of credit and letters of guarantee are issued at the request of a Bank customer in order to secure the customer’s payment or performance obligations to a third party. These guarantees represent an irrevocable obligation of the Bank to pay the third party beneficiary upon presentation of the guarantee and satisfaction of the documentary requirements stipulated therein, without investigation as to the validity of the beneficiary’s claim against the customer. Generally, the term of the standby letters of credit does not exceed one year, while the term of the guarantees does not exceed four years. The types and amounts of collateral security held by the Bank for these standby letters of credit and guarantees is generally represented by deposits with the Bank or a charge over assets held in mutual funds. 46 2006 | Annual Report 47 The Bank considers the fees collected in connection with the issuance of standby letters of credit to be representative of the fair value of its obligation undertaken in issuing the guarantee. In accordance with applicable accounting standards related to guarantees, the Bank defers fees collected in connection with the issuance of standby letters of credit. The fees are then recognised in income proportionately over the life of standby letters of credit agreements. The Bank enters into contractual commitments to extend credit, normally with fixed expiration dates or termination clauses, at specified rates and for specific purposes. Substantially all of the Bank’s commitments to extend credit are contingent upon customers maintaining specific credit standards at the time of loan funding. Management assesses the credit risk associated with certain commitments to extend credit in determining the level of the allowance for possible loan losses. The following table presents the credit related arrangements with contractual amounts representing credit risk as follows: 31 December Gross 2006 Collateral Net Gross 2005 Collateral Net Commitments to extend credit 959,495 182,514 776,981 775,689 245,875 529,814 Letters of credit Standby Documentary and commercial Guarantees Forward guarantees Total 492,220 2,422 15,667 1,741 1,471,545 443,098 2,422 9,164 1,741 638,939 49,122 - 6,503 - 832,606 560,419 2,324 37,441 2,846 1,378,719 529,593 2,324 32,347 2,846 812,985 30,826 - 5,094 - 565,734 Collateral is shown at estimated market value less selling cost. Where cash is the collateral, this is shown gross including interest income. The Bank has a facility by one of its custodians, whereby the Bank may offer up to US$150 million of standby letters of credit to its customers on a fully secured basis. Under the standard terms of the facility, the custodian has the right to set-off against securities held of 110% of the utilised facility. At 31 December 2006, $27.8 million (2005: $20.4 million) of standby letters of credit were issued under this facility. Legal Proceedings There are a number of actions and legal proceedings pending against the Bank and its subsidiaries which arose in the normal course of its business. Management, after reviewing all actions and proceedings, pending against or involving the Bank and its subsidiaries, considers that the resolution of these matters would not be material to the consolidated financial position of the Bank. Note 11: Interest Income Loans The following table presents the components of loan interest income: Year ended 31 December Mortgages Other loans Amortisation of loan origination fees (net of amortised costs) Total loan interest income 2006 111,783 120,893 232,676 5,093 237,769 Balance of unamortised loan fees as at 31 December 12,528 2005 85,134 95,201 180,335 3,580 183,915 10,843 Note 12: Segmented Information (a) Operating Segments For management reporting purposes, the operations of the Bank are grouped into the following nine business segments based upon the geographic location of the Bank’s operations: Bermuda (which is further sub-divided based on products and services into Community Banking, Wealth Management & Fiduciary Services and Investment & Pension Fund Administration, and Real Estate), Barbados, Cayman, Guernsey, The Bahamas, the United Kingdom, and Hong Kong. Accounting policies of the reportable segments are the same as those described in Note 1. The Bermuda Community Banking segment provides a full range of community, commercial and private banking services. Retail services are offered to individuals and small to medium sized businesses through five branch locations and through telephone banking, internet banking, Automated Teller Machines (ATMs) and debit cards. Retail services include deposit services, consumer and mortgage lending, credit cards and personal insurance products. Corporate services include commercial lending and mortgages, cash management, payroll services, remote banking, and letters of credit. Treasury services include money market and foreign exchange activities. The Bermuda Wealth Management & Fiduciary Services and Investment & Pension Fund Administration segment consists of Butterfield Asset Management Limited, which provides investment management, advisory and brokerage services, Butterfield Fund Services Limited, which provides valuation, accounting, corporate and shareholder services, and Butterfield Trust (Bermuda) Limited which provides trust, estate, company management and custody services. The Real Estate segment consists of the Bank’s investments in real estate and all related costs. This segment also includes rental revenues from third parties. The Barbados segment provides a range of community and commercial banking services through four branch locations, ATMs and debit cards. Services include deposit services, commercial banking, consumer and mortgage lending, credit cards. The Cayman segment provides a comprehensive range of community and commercial banking services to private and corporate customers through five locations and through internet banking, ATMs and debit cards. Wealth management and fiduciary services and investment and pension fund administration services are also provided. The Guernsey segment provides a broad range of services to private clients and financial institutions including, private banking and treasury services, internet banking, administered bank services, investment and pension fund administration services and offers wealth management and fiduciary services from both Guernsey and Switzerland. The Bahamas segment provides institutional, corporate and private clients with a range of wealth management & fiduciary services and investment fund administration services. The United Kingdom segment provides a broad range of services including private banking and treasury services, internet banking and wealth management and fiduciary services to high net worth individuals and privately owned businesses. The Hong Kong segment represents the Bank’s 20% investment in RBC Dexia Investor Services Limited (formerly Dexia Holdings (Hong Kong) Limited), which provides investment and pension fund administration and custody services. 48 2006 | Annual Report 49 Operating segment information follows: 31 December 2006 2005 4,853,686 4,459,464 37,532 82,735 4,973,953 213,449 2,792,777 1,809,878 155,398 1,985,942 3,439 6,960,883 (802,034 ) 11,132,802 32,432 76,265 4,568,161 194,433 2,579,080 1,495,284 96,903 1,206,154 233 5,572,087 (942,682 ) 9,197,566 Total Assets Bermuda Community Banking Wealth Management & Fiduciary Services and Investment & Pension Fund Administration Real Estate Total Bermuda Barbados Cayman Guernsey The Bahamas United Kingdom Hong Kong Total overseas Less: inter-segment eliminations Total Business Area Analysis Year ended 31 December 2006 Bermuda Community Banking Wealth Management & Fiduciary Services and Investment & Pension Fund Administration Real Estate Sub-total Bermuda Barbados Cayman Guernsey The Bahamas United Kingdom Hong Kong Sub-total overseas Net interest income Customer Intersegment Allowance for credit losses Fees and other income Total Total revenue expenses amortisation expenses Other Depreciation & 119,740 (2,931 ) (1,902 ) 33,867 148,774 106,437 4,223 110,660 38,114 - - 119,740 688 (1,235 ) (3,478 ) - - (1,902 ) 8,785 53,133 15,395 (360) 21,525 - 98,478 144 2,955 1,728 2,535 (3,884 ) - 3,478 (479 ) (615 ) - (1 ) - - (1,095 ) 75,244 3,811 75,932 41,172 6,705 112,922 227,282 154,314 2,576 12,295 99,116 50,373 9,081 3,845 43,643 33,250 6,907 7,726 845 9,594 42,508 35,521 6,026 25,367 22,103 - 96,216 197,077 115,752 845 33,614 1,146 42,318 2,345 (6,474 ) 9,050 7,714 162,028 65,254 1,726 11,320 975 3,216 45,724 53,392 4,191 39,712 10,661 2,207 749 845 12,496 128,248 68,829 848 6,874 2,515 24,618 - - Total income 218,218 - (2,997 ) 209,138 424,359 270,066 20,210 290,276 134,083 Less: inter-segment eliminations (principally rent and management fees) Total - 218,218 - - - (2,997 ) (9,307 ) (9,307 ) (9,307 ) 199,831 415,052 260,759 - - (9,307 ) 20,210 280,969 134,083 Year ended 31 December 2005 Bermuda Community Banking Wealth Management & Fiduciary Services and Investment & Pension Fund Administration Real Estate Sub-total Bermuda Barbados Cayman Guernsey The Bahamas United Kingdom Hong Kong Sub-total overseas Net interest income Customer Intersegment Allowance for credit losses Fees and other income Total Total revenue expenses amortisation expenses Other Depreciation & Net income 112,658 (5,730 ) (4,513 ) 28,285 130,700 96,893 5,709 102,602 28,098 - - 112,658 7,934 37,345 10,993 (301 ) 16,717 - 72,688 342 (1,115 ) (6,503 ) - 6,717 1,652 1,354 (3,220 ) - 6,503 - - (4,513 ) 67,692 2,518 98,495 68,034 1,403 200,137 35,907 5,692 138,492 37,067 1,160 1,925 7,617 8,794 147,286 30,967 (6,214 ) 52,851 (255 ) 1,622 - (26 ) - - 1,341 3,495 36,520 27,493 5,763 9,058 639 82,968 11,174 82,204 40,138 6,790 22,555 639 163,500 8,136 33,454 28,622 4,476 20,284 - 94,972 1,595 2,935 4,310 659 2,529 - 9,731 36,389 32,932 5,135 22,813 - 12,028 107,000 1,443 45,815 7,206 1,655 (258 ) 639 56,500 Total income 185,346 - (3,172 ) 181,463 363,637 233,464 20,822 254,286 109,351 Less: inter-segment eliminations (principally rent and management fees) Total - 185,346 - - - (3,172 ) (8,508 ) 172,955 (8,508 ) 355,129 (8,508 ) 224,956 - - (8,508 ) 20,822 245,778 109,351 Net income For the year ended 31 December 2006, included within other expenses are the following income tax expense amounts: Guernsey $3.5 million (2005: $1.0 million), United Kingdom $0.1 million (2005: $0.1 million) and Barbados $0.1 million (2005: $0.6 million). Transactions between operating segments principally include interbank deposits and rent which are recorded based upon market rates, and management fees, which are recorded based on the cost of the services provided. (b) Revenues by Products and Services The principal sources of revenues by products and services are disclosed separately in the Consolidated Statement of Income. Note 13: Accounting for Derivative Instruments and Risk Management The Bank uses derivatives in the asset and liability management (ALM) of positions and to assist customers with their risk management objectives. The Bank primarily enters into derivative contracts as part of its overall interest rate risk management strategy to minimise significant unplanned fluctuations in earnings that are caused by interest rate volatility. The Bank’s goal is to manage interest rate sensitivity by modifying the repricing or maturity characteristics of certain consolidated balance sheet assets and liabilities so that movements in interest rates do not adversely affect the net interest margin. The Bank’s derivative contracts principally involve over the counter transactions that are privately negotiated between the Bank and the counterparty to the contract. Derivative instruments that are used as part of the Bank’s interest rate risk management strategy include interest rate swaps and option contracts that have indices related to the pricing of specific consolidated balance sheet assets and liabilities. Interest rate swaps generally involve the exchange of fixed and variable-rate interest payments between two parties, based on a common notional principal amount and maturity date. Interest rate options represent contracts that allow the holder of the option to receive cash or purchase, sell, or enter into a financial instrument at a specified price within a specified period. The Bank pursues opportunities to reduce its exposure to credit losses on derivatives by entering into International Swaps and Derivatives Association Master Agreements (ISDAs). Depending on the nature of the derivative transaction, bilateral collateral arrangements may be used as well. When the Bank is engaged in more than one outstanding derivative transaction with the same counterparty, and also has a legally enforceable master netting agreement with that counterparty, the ”net” marked to market exposure represents the netting of the positive and negative exposures with that counterparty. When there is a net negative exposure, the Bank regards its credit exposure to the counterparty as being zero. The net marked to market position with a particular counterparty represents a reasonable measure of credit risk when there is a legally enforceable master netting agreement between the Bank and that counterparty. Included in other assets (other liabilities) are the reported receivables and unrealised gains (payables and unrealised losses) related to derivatives. These amounts include the effect of netting as permitted under FASB Interpretation No. 39 Offsetting Amounts Related to Certain Contracts (FIN 39). 50 2006 | Annual Report 51 (a) Fair Value Hedges The Bank enters into interest rate swaps to convert its fixed-rate long-term debt to floating-rate debt, and convert fixed-rate deposits to floating-rate deposits. For the year ended 31 December 2006 the Bank recognised a net loss of $0.1 million (2005: $0.4 million) reported as other income in the Consolidated Statement of Income, which represented the ineffective portion of all fair value hedges. As of 31 December 2006 the Bank has recorded the fair value of derivative instrument assets of $1.5 million (2005: $1.3 million) in other assets and derivative instrument liabilities of $6.2 million (2005: $7.2 million) in other liabilities. (b) Cash Flow Hedges The Bank uses interest rate swaps to convert floating-rate notes to fixed-rate instruments. These swaps, which qualify for hedge accounting, have the pay rate indexed to the rates received on the Bank’s variable-rate assets and the receive rate indexed to rates paid on the Bank’s various deposit liabilities. For cash flow hedges, gains and losses on derivative contracts that are reclassified from accumulated other comprehensive income to current period earnings are included in the line item in which the hedged item is recorded in the same period the forecasted transaction affects earnings. As at 31 December 2006 and 2005, there was no hedge ineffectiveness related to cash flow hedges. As of 31 December 2006, nil (2005: ($0.5) million) of the deferred net gains on derivative instruments accumulated in other comprehensive income are expected to be reclassified as earnings during the next twelve months. The maximum term over which the Bank is hedging its exposure to the variability of future cash flows is 2 months (2005: 2 years). As of 31 December 2006, the Bank has recorded the fair value of derivative instrument assets of nil (2005: $0.2 million) in other assets and nil (2005: $1.5 million) in other liabilities. Notional amounts: The following table provides the aggregate notional amounts of derivative contracts outstanding listed by type and divided between those used for trading (non-hedging) and those used in hedging activities. The notional amounts are not recorded as assets or liabilities on the Consolidated Balance Sheet as they represent the face amount of the contract to which a rate or price is applied to determine the amount of cash flows to be exchanged. Notional amounts represent the volume of outstanding transactions and do not represent the potential gain or loss associated with market risk or credit risk of such instruments. 31 December Trading ALM Total value Trading ALM Total value 2006 2005 Interest rate contracts Interest rate swaps Interest rate caps Sub-total Foreign exchange contracts Spot and forwards Total notional amount of financial derivatives outstanding 2,763 43,810 46,573 476,332 - 476,332 479,095 43,810 522,905 26,748 52,332 79,080 444,204 - 444,204 470,952 52,332 523,284 7,369,599 - 7,369,599 5,604,472 - 5,604,472 7,416,172 476,332 7,892,504 5,683,552 444,204 6,127,756 Included in the notional amounts for cash flow hedges using interest rate swaps for 31 December 2006, are $25.0 million (2005: $225.2 million), pertaining to specific floating-rate notes included in the investment portfolio which were classified as held to maturity, and nil (2005: $12.9 million) pertaining to floating-rate deposits. Included in the notional amounts for fair value hedges using interest rate swaps for 2006, are $86.4 million (2005: $51.2 million). pertaining to specific loans, $125.0 million (2005: $125.0 million) pertaining to subordinated debt, and $245.6 million (2005: $42.8 million) pertaining to fixed-rate deposits. (c) Fair Value Derivative instruments, in the absence of any compensating up-front cash payments, generally have no market value at inception. They obtain value, positive or negative, as relevant interest rates, exchange rates, equity or commodity prices or indices change, such that previously contracted derivative transactions have become more or less favourable than what can be negotiated under current market conditions for contracts with the same remaining period to maturity. The potential for derivatives to increase or decrease in value as a result of the foregoing factors is generally referred to as market risk. Market risk is managed within clearly defined parameters as prescribed by senior management of the Bank. The following table shows the marked to market fair value of all derivative contracts outstanding. This is defined as the profit (loss) associated with replacing the derivative contracts at prevailing market prices. 31 December Derivative financial instruments Interest rate swaps Spot and forward foreign exchange Interest rate caps and currency options Total fair value Positive 2006 Negative Net Positive 2005 Negative 1,485 25,410 1,286 28,181 6,891 27,095 1,233 35,219 (5,406 ) (1,685 ) 53 (7,038 ) 1,519 26,318 1,136 28,973 8,740 24,613 1,070 34,423 Net (7,221 ) 1,705 66 (5,450 ) (d) Remaining Maturity The following table summarises the remaining term to maturity of the notional amounts of the Bank’s derivative instruments by type: 31 December 2006 Interest rate contracts Interest rate swaps Interest rate caps Sub-total Foreign exchange contracts Spot and forwards Within 6 months 6 to 12 months 1 to 3 years 3 to 5 years After 5 years Total 196,182 16,750 212,932 47,223 12,250 59,473 102,305 3,917 106,222 58,344 10,893 69,237 75,041 - 75,041 479,095 43,810 522,905 7,325,246 38,760 110 5,483 - 7,369,599 Total notional amount by remaining maturity 7,538,178 98,233 106,332 74,720 75,041 7,892,504 31 December 2005 Interest rate contracts Interest rate swaps Interest rate caps Sub-total Foreign exchange contracts Spot and forwards Within 6 months 6 to 12 months 1 to 3 years 3 to 5 years After 5 years Total 158,310 - 158,310 78,380 24,000 102,380 130,663 17,440 148,103 22,157 10,892 33,049 81,442 - 81,442 470,952 52,332 523,284 5,560,957 39,891 3,624 - - 5,604,472 Total notional amount by remaining maturity 5,719,267 142,271 151,727 33,049 81,442 6,127,756 52 2006 | Annual Report 53 (e) Replacement Cost The following table reflects the replacement cost of all derivative contracts outstanding. This is defined as the cost of replacing, at current market rates, all contracts that have a positive fair value before factoring in the impact of master netting agreements. The replacement cost of an instrument is dependent upon its terms relative to prevailing market prices and will fluctuate as market prices change and as the derivative approaches its scheduled maturity. 31 December Interest rate contracts Interest rate swaps Interest rate caps Sub-total Foreign exchange contracts Spot and forwards Trading 5 1,286 1,291 2006 ALM 1,480 - 1,480 Total value Trading 1,485 1,286 2,771 156 1,136 1,292 2005 ALM 1,363 - 1,363 Total value 1,519 1,136 2,655 25,410 - 25,410 26,318 - 26,318 Total replacement cost 26,701 1,480 28,181 27,610 1,363 28,973 Note 14: Fair Value of Financial Instruments The following table presents the carrying value and fair value of financial assets and liabilities under FAS No. 107 Disclosures About Fair Value of Financial Instruments (FAS 107). Accordingly, certain amounts which are not considered financial instruments are excluded from the table. For investments with an indicator of impairment, management has considered the available evidence, including discussions with rating agencies. Based on this and because the Bank has the ability and the intent to hold such securities to maturity, the Bank believes it will recover the full carrying value of the security. Should specific circumstances dictate that the Bank may not be able to hold such securities to maturity, such as a significant deterioration of credit worthiness of the issuer, the Bank may reassess whether a market value below carrying value represents an other than temporary impairment. 31 December Carrying value Fair value (depreciation ) Carrying value 2006 Appreciation / 2005 Appreciation / (depreciation) Fair value Financial assets Cash and deposits with banks Investments Trading Available for sale Held to maturity Loans Commercial, net of allowance for credit losses Consumer, net of allowance for credit losses Other assets Total financial assets Financial liabilities Customer deposits Demand deposits Term deposits Deposits, financial institutions Other liabilities Subordinated capital Total financial liabilities 3,151,191 3,151,191 - 2,849,920 2,849,920 - 56,471 963,355 2,766,967 56,471 963,355 2,756,592 2,100,893 1,659,852 434,073 11,132,802 2,097,201 1,660,992 434,073 11,119,875 - - (10,375 ) (3,692 ) 1,140 - (12,927 ) 136,520 546,302 2,233,577 136,520 546,302 2,220,043 1,653,587 1,432,007 345,653 9,197,566 1,653,265 1,432,443 345,653 9,184,146 5,743,611 4,012,048 287,173 260,249 280,168 10,583,249 5,743,611 4,015,231 287,173 260,249 274,836 10,580,100 - (3,183 ) - - 5,332 2,149 4,742,193 3,206,773 291,143 183,552 278,679 8,702,340 4,742,193 3,209,043 291,143 183,552 275,408 8,701,339 - - (13,534 ) (322 ) 436 - (13,420 ) - (2,270 ) - - 3,271 1,001 Note 15: Interest Rate Risk The following table sets out the assets, liabilities and off-balance sheet instruments on the date of the earlier of contractual maturity or repricing date. Use of this table to derive information about the Bank’s interest rate risk position is limited by the fact that customers may choose to terminate their financial instruments at a date earlier than the contractual maturity or repricing date. Examples of this include fixed-rate mortgages, which are shown at contractual maturity but which may pre-pay earlier, and certain term deposits, which are shown at contractual maturity but which may be withdrawn before their contractual maturity, and certain investments which have call or pre-payment features. 31 December 2006 (in $ millions) Within 3 months 3 to 6 months 6 to 12 months 1 to 5 years After Non-interest 5 years bearing funds Total Earlier of contractual maturity or repricing date Assets Cash and deposits with banks Investments Loans Premises, equipment and computer software Other assets Total assets Liabilities Shareholders’ equity Deposits Other liabilities Subordinated capital (a) Total liabilities 2,932 2,886 3,430 - - 9,248 - 8,384 - 125 8,509 77 318 150 - - 545 - 272 - - 272 79 252 28 - - 359 - 203 - - 203 - 216 141 - - 357 - 212 - 90 302 - 69 50 - - 119 - 8 - 70 78 63 46 (38 ) 171 263 505 550 964 260 (5 ) 1,769 Interest rate sensitivity gap 739 273 156 55 41 (1,264 ) Cumulative interest rate sensitivity gap 739 1,012 1,168 1,223 1,264 - 31 December 2005 (in $ millions) Assets Cash and deposits with banks Investments Loans Premises, equipment and computer software Other assets Total assets Liabilities Shareholders’ equity Deposits Other liabilities Subordinated capital (a) Total liabilities Interest rate sensitivity gap Cumulative interest rate sensitivity gap Earlier of contractual maturity or repricing date Within 3 months 3 to 6 months 6 to 12 months 1 to 5 years After Non-interest 5 years bearing funds 1,943 1,745 2,948 - - 6,636 - 6,183 - 125 6,308 328 328 810 353 26 - - 1,189 - 913 - - 913 276 604 58 355 9 - - 422 - 103 - - 103 319 - 368 118 - - 486 - 144 - 90 234 252 - 56 21 - - 77 - 39 - 69 108 39 39 (36 ) 142 204 388 495 858 184 (5 ) 1,532 (31 ) (1,144 ) 923 1,175 1,144 - 3,151 3,787 3,761 171 263 11,133 550 10,043 260 280 11,133 - - Total 2,850 2,916 3,086 142 204 9,198 495 8,240 184 279 9,198 - - (a) Includes interest rate swaps with fair value of $4.6 million (2005: ($4.9 million)), that are highly effective, designated and qualify as fair value hedges. 54 2006 | Annual Report 55 Note 16: Subordinated Capital On 28 May 2003, the Bank issued US $125 million of Subordinated Lower Tier II capital notes. The notes were issued at par and in two tranches, namely US $78 million in Series A notes due 2013 and US $47 million in Series B notes due 2018. The issuance was by way of private placement with US institutional investors. The notes are listed on the Bermuda Stock Exchange (BSX) in the specialist debt securities category. Part proceeds of the issue were used to repay the entire amount of the US $75 million outstanding subordinated notes redeemed in July 2003. The notes issued under Series A pays a fixed coupon of 3.94% until 27 May 2008 when they become redeemable in whole at the option of the Bank. The Series B notes pays a fixed coupon of 5.15% until 27 May 2013 when they also become redeemable in whole at the Bank’s option. The Series A notes were priced at a spread of 1.25% over the 5-year US Treasury yield and the Series B notes were priced at a spread of 1.35% over the 10-year US Treasury yield. On 2 April 2004, in conjunction with the acquisition of Leopold Joseph, the Bank assumed a subordinated debt of £5 million which is included in the balance sheet in the amount of $9.8 million. The issuance was by way of private placement in the United Kingdom and pays a fixed coupon of 9.29% until April 2012 when it becomes redeemable in whole at the option of the Bank and 10.29% thereafter until August 2017. On 27 June 2005, the Bank issued US $150 million of Subordinated Lower Tier II capital notes. The notes were issued at par in two tranches, namely US $90 million in Series A notes due 2015 and US $60 million in Series B notes due 2020. The issuance was by way of private placement with US institutional investors. The notes are listed on the BSX in the specialist debt securities category. The notes issued under Series A pays a fixed coupon of 4.81% until 2 July 2010, when they will become redeemable in whole at the Bank’s option. The Series B notes pays a fixed coupon of 5.11% until 2 July 2015 when they also become redeemable in whole at the Bank’s option. The Series A notes were priced at a spread of 1.00% over the 5-year US Treasury yield and the Series B notes were priced at a spread of 1.10% over the 10-year US Treasury yield. Interest capitalised in accordance with FAS 34 during the year amounted to $1.5 million (2005: $1.2 million) and is included in interest expense - subordinated capital in the Consolidated Statement of Income. The following table presents the contractual maturity and interest payments for subordinated capital issued by the Bank as at 31 December 2006: Within 1 year 1 to 5 years After 5 years Carrying value Subordinated capital Bermuda 2003 issuance - Series A 2003 issuance - Series B 2005 issuance - Series A 2005 issuance - Series B Subsidiary Other (a) Total Fixed rate Fixed rate Fixed rate Fixed rate Fixed rate 3,073 2,421 4,329 3,066 - - 12,889 12,293 9,682 17,316 12,264 - - 51,555 82,610 62,733 107,316 87,594 9,793 - 350,046 78,000 47,000 90,000 60,000 9,793 (4,625 ) 280,168 (a) Other includes interest rate swaps with notional amount of $125 million, that are highly effective, designated and qualify as fair value hedges. Note 17: Earnings per Share Earnings per share has been calculated using the weighted average number of shares outstanding during the year after deduction of the shares held as treasury stock and adjusted for the stock dividends declared during the year ended 31 December 2006 and 2005 (see also Note 21). The dilutive effect of stock options was calculated using the treasury stock method, whereby the proceeds received from the exercise of stock options are assumed to be used to repurchase outstanding shares, using the average market price of the Bank’s shares for the period. 31 December Basic earnings per share Net income for the year Weighted average number of common shares issued (in thousands) Weighted average number of common shares held as treasury stock (in thousands) Adjusted weighted average number of common shares (in thousands) 2006 2005 134,083 29,769 (1,480 ) 28,289 4.74 109,351 29,513 (1,795 ) 27,718 3.95 56 2006 | Annual Report 31 December Diluted earnings per share Net income for the year Weighted average number of common shares issued (in thousands) Weighted average number of common shares held as treasury stock (in thousands) Stock options (in thousands) Adjusted weighted average number of diluted common shares (in thousands) 2006 2005 134,083 109,351 29,769 (1,480 ) 840 29,129 4.60 29,513 (1,795 ) 721 28,439 3.85 Note 18: Share-Based Payment As at 31 December 2006, the Bank has two share-based compensation plans, which are described below. The compensation cost that has been charged against net income for those plans for the year ended 31 December 2006 was $3.7 million (2005: $1.9 million). The total income tax benefit recognised in the income statement for share-based compensation arrangements for the year ended 31 December 2006 was $0.1 million (2005: nil). Stock Option Plan At the Annual General Meeting of Shareholders held on 29 October 1997, the Directors were granted authority to implement a Stock Option Plan for Directors and employees. Under the Bank’s 1997 Stock Option Plan (the 1997 Plan), options to purchase common shares of the Bank may be granted to employees and directors of the Bank that entitle the holder to purchase one common share at a subscription price equal to the market price on the effective date of the grant. Option exercise prices are stated and payable in Bermuda dollars. Generally, grants vest 25 percent at the end of each year for four years. The committee that administers the 1997 Plan has the discretion to vary the period during which the holder has the right to exercise options and, in certain circumstances, may accelerate the right of the holder to exercise options, but in no case shall the exercise period exceed ten years. The Board of Directors of the Bank has established at 3,000,000 the current maximum number of common shares which may be issued or transferred by the Stock Option Trust pursuant to exercise of options. On 12 December 2005, the Board of Directors of the Bank approved the acceleration of the vesting of all outstanding unvested stock options (the Acceleration) for non-managerial employees. The Acceleration was effective for all such options outstanding on 25 November 2005, all of which were granted by the Bank when the accounting rules permitted use of the intrinsic value method of accounting for stock options. All of the other terms and conditions applicable to such outstanding stock option grants still apply. Under Accounting Principles Board Opinion No. 25 Accounting for Stock Issued to Employees (APB 25), the Acceleration resulted in recognition of stock-based compensation expense of $0.3 million which was determined by measuring the intrinsic value on the date of the modification of the options that otherwise would have expired unexercised. The Company’s decision to accelerate the vesting of these options was made to reduce administrative burden and in anticipation of compensation expense to be recorded in connection with outstanding unvested stock options issued to employees subsequent to the effective date of FAS No. 123 (Revised 2004) Share Based Payment (FAS 123R). The compensation expense that would have been recognised in the income statements for the years 2006 to 2009 as a result of the adoption of FAS 123R had the Acceleration not taken place is $0.7 million. As a result of the Acceleration, options to purchase 206,588 shares of the Bank’s common stock became immediately exercisable. At 31 December 2006, the Bank held as treasury stock 1,494,584 shares (2005: 1,519,203) that will be used to satisfy the Bank’s obligations with respect to the Stock Option Plan. 57 Directors’ and Executive Officers’ Stock Option Plan 2006 2005 31 December Outstanding at beginning of year Granted Stock dividend granted Exercised Outstanding at end of year Vested and exercisable at end of year Employees’ Stock Option Plan 31 December Outstanding at beginning of year Granted Stock dividend granted Exercised Forfeited / cancelled Outstanding at end of year Vested and exercisable at end of year Number of stock options 614,698 100,000 55,718 (228,517 ) 541,899 334,303 Number of stock options 1,407,065 489,471 189,793 (345,914 ) (34,894 ) 1,705,521 686,223 Weighted Weighted average average life exercise price ($) (years) Aggregate remaining Intrinsic Value Number of ($) stock options 27.82 50.00 29.22 23.63 30.96 25.44 6.68 5.74 13,706 10,301 520,229 129,425 60,937 (95,893 ) 614,698 311,265 2005 2006 Weighted Weighted average average life exercise price ($) (years) Aggregate remaining Intrinsic Value Number of ($) stock options 30.00 50.12 34.16 24.55 37.81 34.87 24.57 1,217,466 495,309 159,708 (350,820 ) (114,598 ) 1,407,065 708,588 7.39 5.86 36,460 21,739 Weighted average exercise price ($) 25.47 38.48 26.42 15.98 27.82 20.81 Weighted average exercise price ($) 28.72 37.53 29.65 25.65 34.07 30.00 24.87 Deferred Incentive Plan Under its Deferred Incentive Plan as approved by the Board of Directors, the Bank grants restricted shares to selected members of the management team. Shares are granted fully vested and are affected by transfer restrictions which are lifted at a rate of 33 percent at the end of each year for three years. The fair value of each restricted share granted under the Deferred Incentive Plan was estimated based on the grant date market price of the Bank’s shares discounted by 25% for their transfer restrictions. The discount for transfer restrictions was based, among other factors, on published restricted stock studies. During the year ended 31 December 2006, 32,569 restricted shares were granted (2005: 38,025). The fair value of shares granted during the year was $1.3 million (2005: $1.2 million). Note 19: Share Buy-Back Plans During the year under review, 47,659 shares (2005: 32,890) were purchased and cancelled at a cost of $2.7 million (2005: $1.4 million). During the same period, the Bank’s Stock Option Trust bought 431,132 shares at a cost of $25.1 million (2005: 285,854 shares at a cost of $12.6 million) and the Bank’s Charitable Foundation bought 192,899 shares at a cost of $11.0 million (2005: nil). The Bank has the present intention to repurchase and cancel over the twelve month period commencing 1 January 2007, up to 2 million of its ordinary shares of par value $1 each, pursuant to its share repurchase programme authorised by the shareholders on 29 October 1997. This intention is subject to appropriate market conditions and repurchases will only be made in the best interest of the Bank. From time to time the Bank’s associates, insiders and insiders’ associates as defined by the BSX regulations may sell shares which may result in such shares being repurchased pursuant to the programme, but under BSX regulations such trades must not be pre-arranged and all repurchases must be made in the open market. Prices paid by the Bank must not, according to BSX regulations, be higher than the last independent trade for a ‘round lot’, defined as 100 shares or more. The BSX is advised monthly of shares repurchased and cancelled by the Bank and shares purchased by both the Stock Option Trust and the Charitable Foundation. Note 20: Dividend Re-Investment and Employee Common Stock Purchase Plans The weighted average fair value of stock options granted in the year ended 31 December 2006 was $6.53 per stock option (2005: $5.18), calculated using the Black-Scholes-Merton option-pricing model with the following weighted average assumptions: The Bank’s dividend re-investment and employee common stock direct purchase plans permit participants to purchase, at market value, shares of the Bank’s common stock by re-investment of dividends and/or optional cash payments, subject to the terms of each plan. Year Ended 31 December Projected dividend yield Risk-free interest rate Projected volatility Expected life (years) 2006 4.00 % 4.60 % 16 % 5.0 2005 4.00 % 3.71 % 19 % 5.0 The projected dividend yield and volatility are based on the historical dividends paid and trading prices of the Bank’s shares. The risk-free interest rate for periods within the expected life of the option is based on the US Treasuries yield curve in effect at the time of grant. The Bank uses historical data to estimate expected option life and employee termination rates; separate groups of employees that have similar historical exercise behaviour are considered separately for valuation purposes. The compensation cost related to the Plan that has been charged against the income for the year ended 31 December 2006 was $2.4 million (2005: $0.3 million). The total intrinsic value of options exercised during the year ended 31 December 2006 was $13.1 million (2005: $9.0 million). As at 31 December 2006, there was $2.9 million of total unrecognised compensation cost related to non-vested options granted under the Plan. That cost is expected to be recognised over a weighted average period of 2.4 years. Had compensation cost been determined based on the fair value of the stock option awards at the date of grant, net income and earnings per share would have been reduced to the pro-forma amounts shown below: Year Ended 31 December Net income as reported Net income – pro-forma Earnings per share – as reported (basic) Earnings per share – pro-forma (basic) 2006 N/A N/A N/A N/A 2005 109,351 107,560 3.95 3.88 Note 21: Stock Dividend In August 2006 and August 2005, the Bank distributed a 10% stock dividend to shareholders of record on 7 August 2006 and 5 August 2005 respectively. All prior period per share amounts have been restated to reflect the stock dividend. Note 22: Variable Interest Entities The effect of FIN 46R was an increase in the Bank’s net assets of approximately $1.4 million for the year ended 31 December 2006 (2005: decrease of $0.6 million). The increase (decrease) primarily relates to the Bank’s venture capital investment subsidiary (Butterfield Vencap Limited). Butterfield Vencap Limited holds investments in private and listed companies where the nature of the investment relationship is such that the Bank, through Butterfield Vencap Limited, may absorb a majority of the expected losses or receive a majority of the residual returns of these companies. As at 31 December 2006 the total assets of variable interest entities consolidated in the balance sheet is $40.2 million (2005: $17.7 million). 58 2006 | Annual Report 59 Note 23: Income Taxes The Bank is not subject to any taxes in Bermuda, The Bahamas and Cayman on either income or capital gains under current laws in those jurisdictions. The Bank’s income tax expense for all periods presented relates to income from operations and is attributable to subsidiaries and offices in various other jurisdictions that are subject to the relevant taxes in those jurisdictions. 31 December 2006 2005 Income taxes in Consolidated Statement of Income Current Deferred Total tax expense Deferred income tax asset Tax loss carried forward General bad debt allowance Pension liability Allowance for compensated absence Onerous leases Other Total asset Deferred income tax liability Other Total liability 3,061 731 3,792 3,953 20 912 34 145 704 5,768 266 266 1,358 270 1,628 3,229 33 2,230 14 190 495 6,191 3 3 Net deferred income tax asset 5,502 6,188 Note 24: Future Accounting Developments a) In July 2006, the Financial Accounting Standards Board released FIN 48, Accounting for Uncertainty in Income Taxes, which addresses how companies should recognise and measure uncertain tax positions under US generally accepted accounting principles. FIN 48 will be effective for fiscal years beginning after 15 December 2006 and, therefore, effective from the Bank’s first quarter in 2007. Management is currently evaluating the effect of adoption. b) In September 2006, the Financial Accounting Standards Board issued FAS 157, Fair Value Measurement, which addresses how companies should measure fair value when required for recognition or disclosure purposes under US generally accepted accounting principles. Specifically, FAS 157 creates a common definition of fair value and will require expanded disclosures about fair value measurements. FAS 157 will be effective for fiscal years beginning after 15 November 2007 and, therefore, effective from the Bank’s first quarter in 2008. Management is currently evaluating the effect of adoption. Directory The Bank of N.T. Butterfield & Son Limited | 65 Front Street, Hamilton, Bermuda | www.butterfieldbank.com 60 2006 | Annual Report 61 Board of Directors and Principal Board Committees Committees indicated by numbers 2 James A.C. King, JP, Chairman Chairman, KeyTech Ltd. Chairman, Argus Group Holdings Ltd. 2 Brian Duperreault, Co-Vice Chairman Chairman, ACE Limited Director, Tyco International Ltd. 1 Robert J. Stewart, JP, Co-Vice Chairman Chairman, Island Circle Limited, Bermuda Director, Shell Trust (Bermuda) Limited 1 Roderick A. Ferguson III, JP Chairman, Gorham’s Ltd. Chairman, Purvis Ltd. Director, KeyTech Ltd. 4 A.L. Vincent Ingham, JP Executive Vice President & Chief Operating Officer, BELCO Holdings Limited Director, BELCO Holdings Limited Sheila G. Manderson (retired 31 July 2006) Former Chief Executive Officer, KeyTech Ltd. 1, 3 Robert A. Mulderig Retired Chairman & Chief Executive Officer, Mutual Risk Management Ltd. Chairman, Woodmont Trust Co. Ltd. 3, 4 Pauline Richards (appointed 1 August 2006) Director, Wyndham Worldwide Inc Director of Development, Saltus Grammar School 1, 2 Robert Steinhoff Retired Partner, KPMG Director, Argus Group Holdings Ltd. 3, 4 Glenn M. Titterton Chairman, BF&M Insurance Group Retired President & Chief Executive Officer, BF&M Insurance Group Chairman, Insurance Corporation of Barbados Limited 1, 2 Harry Wilken* President, Jardine Matheson International Services Limited 4 John R. Wright* Retired Bank Chief Executive Principal Board Committees: 1 Audit & Compliance Committee 2 Risk Policy Committee 3 Corporate Governance Committee 4 Human Resources Committee Alan R. Thompson* President & Chief Executive Officer, The Bank of N.T. Butterfield & Son Limited *Non-Bermudian Directors’ Code of Practice and Group Code of Conduct The Directors have adopted a Code of Best Practice based upon recommended principles of corporate governance. In implementing the Code, the Board meets regularly, retains full effective control over the Bank, and monitors executive management. A Group Code of Conduct applies to Directors and employees and imposes the Bank’s principles of business, including ethics and conflicts of interest. Copies of the Codes can be accessed on www.butterfieldbank.com/About/corporate_governance. Directors’ and Executive Officers’ Share Interests and Directors’ Service Contracts Pursuant to Regulation 6.8(3) of section IIA of the Bermuda Stock Exchange Listing Regulations, the total interests of all Directors and Executive Officers of the Bank in the shares of the Bank as at 31 December 2006 were 942,749 shares. With the exception of those participating in the Shareholders’ Dividend Reinvestment Plan or the Stock Option Plan, no rights to subscribe for shares in the Bank have been granted to or exercised by any Director or Officer. None of the Directors or Executive Officers had any interest in any debt securities issued by the Bank or its subsidiaries. There are no service contracts with Directors, except for Alan R. Thompson, President & Chief Executive Officer, whose contract expires on 30 June 2008. Non-Bermudian 31.2% Bermudian 68.8% 10,000 – 49,000 Shares 22.6% 100,000 and above Shares 50.9% 1 – 999 Shares 2.3% 1,000 – 4,999 Shares 8.1% 5,000 – 9,999 Shares 5.3% Split of Share Ownership: Bermudian / Non-Bermudian Distribution of Shares by Number Held 50,000 – 99,999 Shares 11.8% The Bank of N.T. Butterfield & Son Limited | 65 Front Street, Hamilton, Bermuda | www.butterfieldbank.com 61 Management Alan R. Thompson President & Chief Executive Officer Graham C. Brooks Executive Vice President International Richard J. Ferrett Executive Vice President Chief Financial Officer Bruce Albrecht Senior Vice President Group Head of Asset Management George Bogucki Managing Director Butterfield Bank (UK) Limited Dianne M. Brewer Vice President Marketing & Communications Sheila M. Brown Senior Vice President Investment Services Mariano R. Browne Managing Director Butterfield Bank (Barbados) Limited Ian M. Coulman Managing Director Butterfield Asset Management Limited Michael O’Mahoney Senior Vice President Treasury Curtis Dickinson Senior Vice President Corporate Management Donna E. Harvey Maybury Senior Vice President Human Resources Pete D. Ramsdale Senior Vice President Chief Information Officer Peter J.M. Rodger Senior Vice President & Group Legal Adviser Secretary to the Board Graham M. Jack Managing Director Butterfield Trust (Bermuda) Limited Frank J. Sebestyen, III Senior Vice President Group Head of Fund Services Douglas Lang Managing Director Butterfield Fund Services (Bermuda) Limited W. Aaron M. Spencer Senior Vice President Operations Robert V. Lotmore Managing Director Butterfield Bank (Bahamas) Limited James R. Stewart Senior Vice President Enterprise Risk Management Michael A. McWatt Senior Vice President Credit Risk Management Robert S. Moore Managing Director Butterfield Bank (Guernsey) Limited Fred H. Tesch Senior Vice President Group Internal Audit Lloyd O. Wiggan Senior Vice President Retail Banking Andrew R. Collins Managing Director Butterfield Fund Services (Bermuda) Limited Conor O’Dea Managing Director Butterfield Bank (Cayman) Limited Bob W. Wilson Senior Vice President Corporate and Private Banking Shareholders’ Information Dividend Payment Dividends approved by the Board are paid quarterly, occurring normally in November, March, May and August. Exchange Listing The Bank’s shares are listed on the Bermuda Stock Exchange (BSX) and the Cayman Islands Stock Exchange (CSX), located at: Bermuda Stock Exchange (Primary Listing) Phase 1 – 3rd Floor Washington Mall Church Street Hamilton, HM 11 Bermuda Tel: (441) 292 7212 or (441) 292 7213 Fax: (441) 292 7619 www.bsx.com Cayman Islands Stock Exchange (Secondary Listing) Elizabethan Square, 4th Floor GT, Grand Cayman Cayman Islands Tel: (345) 945 6060 Fax: (345) 945 6061 www.csx.com.ky Share Dealing Service Butterfield Securities (Bermuda) Limited 65 Front Street Hamilton, HM 12 Bermuda Tel: (441) 299 3972 Fax: (441) 296 8867 Share Price Published daily in The Royal Gazette in Bermuda and available on Bloomberg Financial Markets (symbol: NTB BH). Also available on the BSX and CSX websites. Dividend Reinvestment Plan Details are available from Butterfield Fund Services (Bermuda) Limited E-mail: contact@bntb.bm Certain restrictions apply. Registrar and Transfer Agent Butterfield Fund Services (Bermuda) Limited Rosebank Centre 11 Bermudiana Road Pembroke, HM 11 Bermuda Tel: (441) 298 6464 Fax: (441) 295 6759 E-mail: contact@bntb.bm Head Office The Bank of N.T. Butterfield & Son Limited 65 Front Street Hamilton, HM 12 Bermuda Tel: (441) 295 1111 Fax: (441) 292 4365 E-mail: contact@bntb.bm Media Relations / Publication Requests Marketing & Communications Tel: (441) 299 1624 or (441) 298 4610 E-mail: markjohnson@bntb.bm or stuartroberts@bntb.bm Investor Relations Chief Financial Officer Tel: (441) 299 1643 E-mail: richardferrett@bntb.bm Market Value & Net Book Value per Share ($) 60 50 40 30 20 10 0 Written Notice of Share Repurchase Programme — BSX Regulation 6.38 The Board of Directors of the Bank announced the intention to repurchase over the 12 month period commencing 1 January 2007, up to 2,000,000 of its ordinary shares of par value $1 each pursuant to its share repurchase programme authorised by shareholders on 29 October 1997. As at 31 December 2006, 2,000,000 shares represented 6.7% of total issued shares of the Bank. This intention is subject to appropriate market conditions and repurchases will only be made in the best interests of the Bank. The Directors consider that share repurchase is an excellent means of enhancing shareholder value while increasing earnings per share. Shares repurchased and cancelled in the 12 months to 31 December 2006 totalled 47,659 at an average price of $55.82 and aggregate cost of $2,663,389. From time to time the Bank’s associates, insiders, and insiders’ associates as defined in the BSX Regulations may sell shares which may result in being repurchased pursuant to the programme, but under BSX Regulations such trades must not be prearranged and all repurchases must be made in the open market. Prices paid by the Bank must not, according to BSX Regulations, be higher than the last independent trade. The Bank will continue to advise the BSX monthly of shares repurchased and cancelled. In addition and separate to the above, the Bank’s Stock Option Trust may from time to time purchase shares of the Bank through the BSX to satisfy the Bank’s obligations with respect to the Stock Option Plan, and such purchases will likewise be advised to the BSX monthly. Shares purchased in this way in the 12 months to 31 December 2006 totalled 431,132 shares at an average price of $58.11 and aggregate cost of $25,080,967. In addition and separate to the above, the Bank’s Charitable Foundation bought 192,899 shares at an average price of $56.71 and aggregate cost of $10,951,119. Such purchases by the Foundation are advised to the BSX on a monthly basis. Large Shareholders The following professional nominees at 31 December 2006 were registered holders of 5% or more of the issued share capital: Harcourt & Co. (14.84%), Palmar Limited (5.83%) and Murdoch & Co. (5.10%). Known beneficial holdings of 5% or more of issued share capital, at that date, were: Bermuda Life Insurance Company Limited (6.98%); Jardine Strategic Holdings Limited (6.73%); and the Bank’s Stock Option Trust (5.28%). Annual Dividend Declared ($) 1.80 1.67 1.55 1.37 1.43 Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 Market Value Book Value Dec 02 Dec 03 Dec 04 Dec 05 Dec 06 62 2006 | Annual Report 63 Principal Offices and Subsidiaries This list does not include all companies in the Group. It includes all companies that materially contribute to the profit or loss or assets of the Group. The Bank of N.T. Butterfield & Son Limited Holding Company, Community Banking, Credit and Treasury Services Head Office 65 Front Street Hamilton, HM 12 Bermuda Tel: (441) 295 1111 Fax: (441) 292 4365 S.W.I.F.T. BNTB BM HM E-mail: contact@bntb.bm BERMUDA Butterfield Asset Management Limited Investment Management and Brokerage Services Managing Director: Ian M. Coulman 65 Front Street Hamilton, HM 12 Bermuda Tel: (441) 299 3817 Fax: (441) 292 9947 E-mail: contact@bntb.bm Butterfield Fund Services (Bermuda) Limited Investment and Pension Fund Administration, Corporate Trust Managing Director: Douglas Lang Rosebank Centre 11 Bermudiana Road Pembroke, HM 11 Bermuda Tel: (441) 299 3933 Fax: (441) 295 6759 E-mail: contact@bntb.bm Butterfield Trust (Bermuda) Limited Grosvenor Trust Company Limited Private Banking, Personal Trust Managing Director: Graham M. Jack 65 Front Street Hamilton, HM 12 Bermuda Tel: (441) 299 3980 Fax: (441) 292 1258 E-mail: contact@bntb.bm THE BAHAMAS GUERnSEy Butterfield Bank (Bahamas) Limited Private Banking, Personal Trust, Corporate Trust Butterfield Bank (Guernsey) Limited Private Banking, Administered Banking, Custody Managing Director: Robert S. Moore Regency Court Glategny Esplanade St Peter Port, Guernsey, GY1 3AP Channel Islands Tel: (44) 1481 711 521 Fax: (44) 1481 714 533 E-mail: info@butterfield.gg Butterfield Trust (Guernsey) Limited Personal Trust, Corporate Trust, Custodian Trustee Services Managing Director: Paul D.H. Hodgson Regency Court Glategny Esplanade St Peter Port, Guernsey, GY1 3AP Channel Islands Tel: (44) 1481 711 521 Fax: (44) 1481 714 533 E-mail: info@butterfield.gg Butterfield Fund Services (Guernsey) Limited Investment and Pension Fund Administration Managing Director: Patrick A.S. Firth Regency Court Glategny Esplanade St Peter Port, Guernsey, GY1 3AP Channel Islands Tel: (44) 1481 720 321 Fax: (44) 1481 716 117 E-mail: info@butterfield.gg SwITzERlAnD Butterfield Asset Management (Switzerland) Limited Asset Management Managing Director: Iain Little Talstrasse 37 CH-8022 Zurich Switzerland Telephone: (41) 43 888 6488 Facsimile: (41) 43 888 6489 E-mail: info@butterfield.ch UnITED KInGDOM Butterfield Bank (UK) Limited Private Banking, Treasury Services Managing Director: George Bogucki 99 Gresham Street London, EC2V 7NG United Kingdom Tel: (44) 207 776 6700 Fax: (44) 207 776 6701 E-mail: info@butterfieldprivatebank.co.uk Managing Director: Robert V. Lotmore Montague Sterling Centre, East Bay Street Nassau, N.P. Bahamas Tel: (242) 393 8622 Fax: (242) 393 3772 E-mail: info@butterfieldbank.bs Butterfield Fund Services (Bahamas) Limited Investment and Pension Fund Administration Managing Director: Heather Bellot Montague Sterling Centre, East Bay Street Nassau, N.P. Bahamas Tel: (242) 393 8622 Fax: (242) 393 3772 E-mail: info@butterfieldbank.bs BARBADOS Butterfield Bank (Barbados) Limited Community Banking Managing Director: Mariano R. Browne 1st Floor, Carlisle House Hincks Street, Bridgetown Barbados Tel: (246) 431 4500 Fax: (246) 430 0221 E-mail: contact@butterfieldbank.bb Vice President, Butterfield Asset Management (Barbados) Limited: Caroline J. Prow Belleville Corporate Centre 38 Pine Road Belleville, St. Michael Barbados Tel: (246) 430-1650 Fax: (246) 436-7999 E-mail: carolineprow@butterfield.bb CAyMAn ISlAnDS Butterfield Bank (Cayman) Limited Community Banking, Private Banking, Asset Management, Personal Trust, Corporate Trust Managing Director: Conor O’Dea Butterfield House 68 Fort Street Grand Cayman, KY1-1107 Cayman Islands Tel: (345) 949 7055 Fax: (345) 949 7004 E-mail: info@butterfieldbank.ky Butterfield Fund Services (Cayman) Limited Investment and Pension Fund Administration Managing Director: John Lewis Butterfield House 68 Fort Street Grand Cayman, KY1-1107 Cayman Islands Tel: (345) 949 7055 Fax: (345) 949 7004 E-mail: fund.admin@butterfieldbank.ky 64 2006 | Annual Report 

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