Our business consists of a single operating segment, financial guaranty reinsurance, the purpose of which is to indemnify a primary financial guarantor, against the portion of any loss it may sustain under financial guaranty policies it has ceded to us. We reinsure policies covering both U.S. and international exposures. We market our reinsurance directly through the execution of treaty and facultative contracts with primary insurers.
and, consequently, reinsurance declines. A deteriorating economic and credit environment, in contrast, is typically accompanied by widening credit spreads and improved pricing for financial guaranty products. However, a prolonged period of weak or deteriorating economic activity could stress in-force financial guaranty insured portfolios and could result in claims payments or could adversely impact capital adequacy due to deterioration in the credit quality of in-force insured portfolios. Other broad economic factors, such as the general level of interest rates, also have an effect on the business in that, for example, returns on our invested assets are largely determined by interest rates and premium rates may be substantially influenced by the level of interest rates.
The primary strengths of the Premium Method of fair valuing CDS based on our understanding of this model are:
The primary strengths of the Expected Loss Method of valuing CDS, which we believe is only used by one of the primaries, based on our understanding of this model are:
Subprime - First- or second-lien residential mortgage loans made to a borrower who has a history of delinquency or other credit problems.
NIMs - Net interest margin securities backed by the residual cash flow from residential mortgage securitizations.
3 RAM Re ratings are current as of February 27, 2009. These ratings are assigned by RAM Re based on management’s judgment and take into consideration the ratings assigned by the ceding companies and the rating agencies. RAM Re undertakes no obligation to update its ratings, and such ratings do not constitute investment advice.
The following table summarizes the estimated changes in fair value of our credit derivatives assuming immediate changes in the Company’s non performance credit risk at specified levels at December 31, 2008:
RAM Re and the Company must also comply with the provisions of the Bermuda Companies Act regulating the payment of dividends and making of distributions from contributed surplus. A company is prohibited from declaring or paying a dividend, or making a distribution out of contributed surplus, if there are reasonable grounds for believing that: (a) the company is, or would after the payment, be unable to pay its liabilities as they become due; or (b) the realizable value of the company’s assets would thereby be less than the aggregate of its liabilities and its issued share capital and share premium accounts. The Board of Directors of RAM Re and the Company will evaluate any dividends in accordance with this test at the time such dividends are declared.
Loss and loss expense reserve and credit impairments (a non-GAAP measure) represent estimated future payments relating to actual or probable reinsurance policy claims. We have estimated the timing of these payments and actual payments may vary significantly from these estimates. The discounted value of the claims are reported as losses and loss expense reserves on the consolidated balance sheets, and as credit impairments within derivative liabilities on the consolidated balance sheet. Of the net amount of $100.4 million due in more than 5 years, $104.2 million is not expected to be paid out for more than 20 years and net recoveries of $3.8 million are expected to be received between years 6 and 20, primarily attributable to RMBS. Approximately 44% of the unallocated reserve is in the 4-5 year category as it relates to further loss development on US RMBS exposures, which are expected to pay out in 4-5 years. The remaining 56% of the unallocated reserve is included in the more than 5 years category as it does not relate to any actual claims and cannot be scheduled; therefore, it is assumed to payout after more than 20 years.
Our underwriting procedures differed in 2008 and prior years, depending on whether we were conducting facultative or treaty-based reinsurance activities. We have not written any new financial guaranty reinsurance business to date in 2009 and do not expect to do so in the near term, but if we were to write new financial guaranty reinsurance business, we would adhere to the underwriting procedures followed in 2008 and prior years, as follows. Our facultative reinsurance activities are subject to a formal underwriting process on a transaction-by-transaction basis, whereas our treaty underwriting is based upon an evaluation of the portfolio of transactions ceded to us by a particular primary insurer as well as the history of each primary insurer’s own underwriting activities.
The Audit Committee meets with management, the independent registered public accounting firm and the outside firm engaged to perform internal audit functions for the Company; approves the overall scope of audit work and related fee arrangements; and reviews audit reports and findings. In addition, the independent registered public accounting firm and the outside firm engaged to perform internal audit functions for the Company meet separately with the Audit Committee, without management representatives present, to discuss the results of their audits; the adequacy of the Company’s internal control; the quality of its financial reporting; and the safeguarding of assets against unauthorized acquisition, use or disposition.
The unprecedented deterioration in the U.S. housing market since the latter half of 2007 and the resulting lack of liquidity in the capital markets has had a substantial adverse impact on the financial guaranty industry generally and the Company in particular. It is uncertain whether the primary financial guaranty market will return to the level of business volume of prior years. As a result of these adverse developments and the downgrades of the Company’s ratings from AAA to A+ by Standard & Poor’s Ratings Services (“S&P”) and from Aa3 to Baa3 by Moody’s Investors Service (“Moody’s”), we wrote only a modest amount of new financial guaranty reinsurance business in 2008 and have not renewed our reinsurance treaties with the primaries or written any new financial guaranty business to date in 2009.
Reducing our insured risk exposure: We commuted our entire insured portfolio assumed from Syncora Guaranty Re Ltd. and MBIA, effective July 25, 2008 and November 30, 2008, respectively. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations, “Results of operations: Net income - Commutations”. We commuted our entire insured portfolio assumed from Ambac Assurance Corporation effective April 8, 2009. See Note 27, “Subsequent Events.” We are pursuing further commutations in cases where they can be negotiated at acceptable prices. In addition, we are pursuing legal actions against our ceding companies in cases where we dispute the validity of cessions made under our treaties or ceded losses.
RAM Holdings is a holding company and therefore our liquidity, both on a short-term basis (for the next twelve months) and a long-term basis (beyond the next twelve months), is largely dependent upon (1) the ability of RAM Re to pay dividends or make other payments to us and (2) our ability to access the debt and equity markets, which is unlikely in the near term given current market conditions and the Company’s current share valuation. Our principal uses of liquidity are for payment of interest on our senior notes, non-mandatory dividends on our preference shares and capital investments in RAM Re. On March 19, 2009, RAM Re’s Board approved a dividend of $2.8 million from RAM Re to RAM Holdings’. Based on the amount of dividends that we received on March 19, 2009, we believe that we will have sufficient liquidity to pay interest on our senior notes over the next twelve months. RAM Re’s ability to declare and pay dividends to us may be influenced by a variety of factors such as adverse loss development, insurance regulatory changes and changes in general economic conditions, beyond the next twelve months, the amounts required to be held by us in trust for the benefit of our U.S. regulated customers and Bermuda law as described below. Consequently, although we believe that we will continue to have sufficient liquidity to meet our obligations over the long term, we cannot guarantee that RAM Re will be able to dividend amounts sufficient to satisfy all our obligations, and there can be no assurance that dividends will be declared or paid in the future.
Installment premiums are recorded as written at each installment due date and are earned over the respective installment period, which equates to the period of risk. All other premiums written are recorded as written at the inception of the policy and are earned ratably over the period of risk. When insured issues are refunded or called, the remaining unearned premiums are earned at that time, since there is no longer risk to the Company. Premiums are recorded on a one month lag due to the timing of receipt of the information from the ceding companies. Premiums earned for 2008, 2007, and 2006, respectively, includes $23.7 million, $5.7 million, and $6.3 million related to refundings.
extension of its financial guaranty reinsurance business and reinsurance in substance, under FASB Statement of Financial Accounting Standards No. 149 (“FAS 149”), the reinsurance the Company provides does not meet the scope exception that excludes most financial guaranty policies from the fair value provisions of FASB Statement of Financial Accounting Standards No. 133 “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”). The credit default swaps that the Company assumes from ceding companies do not meet the scope exception provided under FAS 149 because (a) the guaranteed party (i.e., the underlying insured) is entitled to recover amounts on occurrence of events other than failure to pay principal and interest when due; and (b) the guaranteed party is not exposed to the risk of non-payment at the inception of the contract and throughout the contract term as the guaranteed party does not have legal ownership of the guaranteed obligation. As the assumed policies do not qualify for the scope exception under FAS 149, the Company must account for these assumed credit default swaps under the provisions of FAS 133, and not as reinsurance under FASB Statement of Financial Accounting Standards No. 113, “Accounting and Reporting for Reinsurance under Short-Duration and Long-Duration Contracts.” FAS 133 establishes accounting and reporting standards for derivative instruments, and requires the Company to recognize the derivative instruments on the balance sheet at their fair value, with changes in fair value recognized in earnings. Changes in fair value are recorded in “Net change in fair value of credit derivatives” on the Consolidated Statement of Operations. The “Realized gains and losses and other settlements” component of this change in fair value includes, (i) net premiums earned on credit derivative policies, including current premiums receivable on assumed credit derivative polices, net of ceding commissions, and (ii) loss payments to the reinsured including losses payable upon the occurrence of a credit event. The “Unrealized gains and losses” component of the “Net change in fair value of credit derivatives” includes all other changes in fair value, including changes in instrument specific credit spreads and reduction in fair values due to commutation of credit derivative policies.
On January 1, 2008, the Company adopted Statement of Financial Accounting Standard No. 157 “Fair Value Measurement” (“FAS 157”). This statement provides guidance for fair value measurement of assets and liabilities and associated disclosures about fair value measurement. Under this standard, the definition of fair value focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price). FAS 157 clarifies that fair value is a market-based measurement, not an entity-specific measurement. FAS 157 establishes a fair value hierarchy of inputs in measuring fair value, with the highest level being observable inputs and the lowest being unobservable data as follows:
Certain reclassifications have been made to the prior period amounts to conform to the current period’s presentation.
As of December 31, 2008 and 2007, the Company had restricted cash of $8.3 million and $8.2 million, respectively, and investments at fair value of $370.6 million and $406.7 million, respectively, invested in trust accounts for the benefit of ceding companies. Pursuant to the terms of the reinsurance agreements with ceding companies regulated in the U.S., the Company is required to secure its obligations to these ceding companies in accordance with applicable state statutes governing credit for reinsurance, and may not withdraw funds from these trust accounts without their express permission. Subsequent to December 31, 2008, approximately $32.9 million was released from the trust accounts to the Company’s operating account.
(1) See Note 16 “Commutations” for details of the effect of the commutations with MBIA Insurance Corporation and its affiliates (“MBIA”) and Syncora Guaranty Re (formerly XL Financial Assurance Ltd) (“XLFA”) on the above balances.
Each ceding company uses its own internal valuation models where market prices are not available. Given the contractual terms of RAM’s reinsurance that limit its access to the terms of the underlying credit derivatives, which are highly individualized, and the underlying loan level data, RAM believes that an exit market participant would look to the information that is available from the ceding companies to determine the exit value of RAM’s reinsurance contract, as discussed above. Therefore, the Company, in determining the fair value of derivative instruments, uses credit derivative contract valuations from its ceding companies as a key input. Management then assesses the reasonableness of the ceding companies’ valuations on a quarterly basis by i) discussing with primary insurers their mark-to-market valuation methodology including the nature of changes in key assumptions, ii) reviewing the primaries’ publicly available information regarding their mark-to-market process, including methodology and key assumptions, and iii) analyzing the movement of each individual derivative policy compared to observable market data, including credit spread movements and collateral delinquency information. Spreads and the related movements quarter to quarter are identified from observable market information such as indices, including the CDX, ABX, CMBX and LCDX indices, as related to specific types of derivative contracts. Overall, the relationship between the widening of credit spreads and fair value is not a linear one due to the mix of policy types (duration, rating, and maturities) within the portfolio. Therefore it is difficult to calculate the actual magnitude of any increase/decrease in the unrealized gain/(loss) with the movement of spreads alone. Additionally, there are many other assumptions that drive the ceding companies’ ultimate fair value assessment namely, asset recovery assumptions, correlation across asset assumptions, discount rate used, time to maturity, timing of default assumptions, and collateral posting requirements, where applicable. So while spreads are a significant driving factor in models of fair value they are not the only ones. Changes in correlation and recovery assumptions can result in valuations moving more or less than the absolute movement of spreads. RAM’s reinsurance contracts do not provide rights to the detailed underlying data for each policy, or the inputs and assumptions used to obtain the fair valuations as calculated by the ceding companies, and therefore RAM can only generally analyze the fair valuations for consistency with market movements, in conformity with the manner in which RAM believes an exit market participant would analyze the fair valuations given the contractual terms of RAM’s reinsurance. If it appears that the marks are consistent with macro spread movements, and general market trends and RAM believes that the modeling and assumptions that drive the modeling are reasonable (based on RAM’s ceding company audits and review of publicly available information), RAM will use the mark provided by the ceding company as a key input in the determination of the fair value of its reinsurance contracts on credit derivatives.
Due to the non-standard terms under which each primary enters into derivative contracts, the fair value of their credit derivatives may not reflect the same prices observed in an actively traded market of credit derivatives that do not contain terms and conditions similar to those observed in the financial guaranty market.
Actual maturity of credit default swaps is generally expected to be significantly less than the legal term.
ended December 31, 2008, 2007 and 2006, $1.6 million, $0.8 million and $0.5 million, respectively, of expenses relating to the operation of this facility were paid. As of December 31, 2008, the put option had not been exercised. Subsequent to December 31, 2008, on February 17, 2009, RAM Re exercised the put option in the soft capital facility and issued 500.01 Class B preference shares to the trust in exchange for $50,001,000 of proceeds. On March 16, 2009, RAM Re elected to pay a fixed rate dividend on the Class B preference shares, as a result of which the Class B preference shares were distributed to the holders of the trust’s securities and the trust is now in the process of dissolution. As a result of the fixed rate election, dividends are payable on the Class B preference shares every 90 days at a rate of 6.276%. The Class B preference shares give investors the rights of an equity investor in RAM Re. Such rights are subordinate to insurance claims, as well as the general unsecured creditors of RAM Re. Dividends on the Class B preference shares are cumulative, only if RAM Re pays dividends on its common shares without paying accrued and unpaid dividends on the Class B preference shares. The Class B preference shares are rated ‘BBB’ by S&P. As of the date of filing of this Form 10-K, Moody’s has not assigned a rating to the Class B preference shares. RAM Re has the option to redeem the Class B preference shares, subject to certain specified terms and conditions. The fair value of the put option at the exercise date was $41.9 million and therefore the value of the preference shares will be $8.1 million, being the difference between the proceeds received and the fair value of the put option on the date of exercise.
The following table sets forth the general guidelines the Company uses for our remaining loss assumptions (expressed as a percent of the outstanding principal balance of loans less than 90 days delinquent) for 2005-2007 vintage US RMBS. Our exposures to US RMBS vintages from earlier vintages have minimal case reserves and are therefore analyzed using different assumptions applied on a case-by-case basis.
The Company renewed its Directors & Officers (“D&O”) insurance in February 2008. One of the policies forming part of the total coverage involved a premium of $5.0 million, $4.0 million of which is refundable to the Company if no claims are made under the policy by the end of the annual period of coverage. The Company believes that there has not been a transfer of significant insurance risk on this part of the coverage and accordingly has accounted for the policy as a non risk transferring contract. Of the $5.0 million paid for this part of the coverage, $4.0 million, representing the amount currently expected to be recovered from the insurers, has been accounted for as a receivable in other receivables on the balance sheet and the Company has expensed the $1.0 million premium which it does not expect to recover.
Reinsurance balances payable consist of the following balances at December 31, 2008 and 2007:
On August 7, 2008, Moody’s downgraded its financial strength rating on RAM Re from Aa3 to A3 and, on December 4, 2008, Moody’s further downgraded RAM Re to Baa3 with outlook developing. At this time, RAM is unable to conclude if there will be any further additional ceding commissions associated with Moody’s downgrade because Moody’s has not yet established the amount of reinsurance credit RAM Re will provide its ceding companies at the Baa3 level. Subsequent to December 31, 2008, RAM Re withdrew their rating from Moody’s. This is not expected to have an effect the amount additional ceding commissions accrued.
The effect of the MBIA commutation on the Company’s results of operations was to (i) reduce gross written premiums and unearned premiums by $36.4 million, resulting in no impact on earned premiums (ii) increase net change in fair value of credit derivatives by a gain of $110.7 million, and (iii) increase loss and loss adjustment expenses by a loss of $61.4 million, resulting in an overall gain to net income at the time of commutation of $49.3 million.
The effect of the XLFA commutation on the Company’s results of operations was to (i) reduce gross written premiums by $11.4 million, (ii) increase net earned premiums by $1.1 million, (iii) increase net change in fair value of credit derivatives by a gain of $26.0 million, (iv) reduce loss and loss adjustment expenses by a gain of $15.5 million and (v) increase acquisition expenses by $0.3 million, resulting in an overall gain to net income of $42.3 million.
As at December 31, 2008, outstanding awards under the Plan of 1,552,297 share options and 139,626 restricted share units had been granted to the Company’s officers and employees. Each of the options will vest in equal annual installments over a four-year period and will expire on the seventh anniversary of the date of grant. The grant price is the average of the highest and lowest quoted selling price on the grant date. The exercise price of the options at December 31, 2008 ranges from $1.45 to $16.20. Restricted share units will vest in equal annual installments over a four-year period.
During 2008, RAM Re renewed two treaties that were effective in the first quarter with AAA-rated ceding companies, both of which were subsequently downgraded by Moody’s (but not S&P) to the Aa-level. RAM Re has not renewed these treaties in 2009. This means that RAM Re does not expect to write any financial guaranty reinsurance business in the current year but this does not reduce our in-force business, unless the business is commuted or recaptured by the primaries. The remaining treaties that were in effect in 2007 were cancelled or expired in 2008. New business written in 2008 was minimal as a result of a number of factors arising out of the effect of the subprime and credit crisis on the financial guaranty industry, including the following:
On March 26, 2004, RAM Holdings Ltd. issued $40.0 million of unsecured senior notes (the “Notes”) to a qualified institutional buyer as defined in Rule 144A of the Securities Act. The term of the Notes is 20 years with the full principal amount due at maturity. The Notes rank pari passu in right of repayment with RAM Holding Ltd.’s other unsecured senior debt, of which there is currently none. The net proceeds from the Notes have been used to provide capital for RAM Reinsurance Company Ltd.