Our loss reserve estimates do not represent an exact calculation of liability. Rather, they represent estimates of our expectations of the ultimate settlement and administration costs of claims incurred. These estimates are based upon actuarial and statistical projections and on our assessment of currently available data, predictions of future developments and estimates of future trends in claims severity and frequency and other variable factors such as inflation. Establishing an appropriate level of our loss reserve estimates is an inherently uncertain process. It is likely that the ultimate liability will be greater or less than these estimates and that, at times, this variance will be material.
The Company accounts for share based compensation in accordance with SFAS No. 123(R), “Share-Based Payment” (“SFAS 123(R)”). The Company’s share based compensation plans consists of performance share units (“PSUs”) and restricted share units (“RSUs”). SFAS 123(R) requires entities to measure the cost of services received from employees and directors in exchange for an award of equity instruments based on the grant date fair value of the award. The cost of such services will be recognized as compensation expense over the period during which an employee or director is required to provide service in exchange for the award.
The grant date fair value of the common shares underlying the RSUs granted during 2008 and 2007 was determined by reference to the closing share price effective at the date of grant. The grant date fair value of the common shares underlying the RSUs granted during 2006 was determined by reference to the price to book value multiple of a group of comparable publicly traded reinsurers with a longer track record, more mature infrastructure and a more established franchise.
Premiums written during the years ended December 31, 2007 and 2006 were $71.1 million and $27.0 million, respectively. The increase of $44.1 million during 2007, or 163.6%, was primarily driven by increased participation on existing accounts and expansion of our client base, mainly in the marine and aviation programs.
Reinsurance premiums ceded for the years ended December 31, 2008 and 2007, were $46.6 million ($38.2 million excluding the impact of acquisitions made in 2008) and $30.6 million (5.2% and 5.6% of gross reinsurance premiums written, net of the impact of acquisitions), respectively, representing an increase of $7.6 million excluding the impact of acquisitions in 2008. The increase in premiums ceded for the year ended December 31, 2008 is primarily related to new premiums ceded partially offset by the non-renewal of certain covers.
Loss and loss adjustment expenses are comprised of three main components:
Loss and loss adjustment expenses for the year ended December 31, 2008 were $377.2 million, or 58.8% of net premiums earned, ($370.7 million, or 58.8% of net premiums earned, excluding the impact of acquisitions) compared to $191.3 million, or 41.2% of net premiums earned, for the year ended December 31, 2007. The components of loss and loss adjustment expenses of $377.2 million for the year ended December 31, 2008 include $200.5 million paid losses and our actuaries’ estimate of case reserves and IBNR of $176.7 million on premiums earned to date. The increase in the loss ratio was primarily due to more severe catastrophic events during 2008 than during 2007. Significant loss events for 2008 included Hurricane Ike ($158.4 million), Hurricane Gustav ($14.5 million), Chinese winter storms ($18.2 million) and the U.S. Memorial Day weekend storms ($11.1 million). During the year ended December 31, 2008 we also revisited our loss estimates for previous loss events. Based on updated estimates provided by clients and brokers, we have recorded net favorable developments for prior loss events of $15.7 million. The reserve changes primarily arose from better than expected emergence of actual claims relative to our prior year estimates. During 2007, the significant loss events included the European Windstorm Kyrill ($32.4 million), United Kingdom floods ($38.0 million), and New South Wales (Australia) floods ($18.5 million), three satellite losses during 2007 ($13.8 million), and the Sydney (Australia) hailstorm in December 2007 ($11.4 million).
Acquisition costs for the year ended December 31, 2008 were $101.5 million ($97.7 million excluding acquisitions) compared to $75.9 million for the year ended December 31, 2007. The increase in acquisition costs for the year ended December 31, 2008 is primarily related to higher levels of premium writings and also includes $9.7 million of acquisition costs in relation to the quota share arrangement with Island Heritage. The acquisition cost ratio, which is equal to acquisition cost expenses over net premiums earned, for the year ended December 31, 2008 was 15.5% (excluding acquisitions) compared to 16.3% for the year ended December 31, 2007.
The Company enters into investment portfolio derivatives including global equity, global bond, commodity and real estate futures, TBAs, total return swaps and interest rate swaps. The Company enters into index futures contracts and total return swaps to gain or reduce its exposure to an underlying asset or index. The Company also purchases TBAs as part of its investing activities. The Company enters into interest rate swaps in order to manage portfolio duration and interest rate risk. The Company manages the exposure to these instruments based on guidelines established by management and approved by the Board of Directors.
The decrease in net realized and unrealized losses and gains on derivatives in 2007 was due to the negative performance of our swap contracts which had exposure to the real estate market and to the lower performance in 2007 of equity markets compared to 2006 which affected our net gains on futures contracts.
The total of investments, cash and cash equivalents, and restricted cash was $1.7 billion at December 31, 2008, compared to $1.9 billion at December 31, 2007.
As noted above, the Company’s investment strategy allows the use of derivative instruments such as futures contracts, total return swaps, foreign exchange forward contracts, and currency swaps, subject to strict limitations. Derivative instruments may be used to replicate investment positions or to manage currency and market exposures and duration risk that would be allowed under the Company’s investment policy if implemented in other ways. These derivatives seek investment results that generally correspond to the price and yield performance of the underlying markets. The fair value of these derivatives held by the Company at December 31, 2008 was $(5.3) million, compared to $(9.3) million at December 31, 2007.
In relation to insurance business, the FSA regulates insurers, insurance intermediaries and Lloyd’s itself. The FSA and Lloyd’s have common objectives in ensuring that Lloyd’s market is appropriately regulated and, to minimize duplication, the FSA has agreed arrangements with Lloyd’s for co-operation on supervision and enforcement.
We are not party to any transaction, agreement or other contractual arrangement to which an affiliated entity unconsolidated with us is a party, other than that noted above with Valais Re, that management believes is reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.
These financial statements contain certain reclassifications of prior period amounts to be consistent with the current period presentation with no effect on net income or loss including the reclassification of restricted cash from cash and cash equivalents and other assets and the reclassification of reinsurance recoverable from other assets.
Premiums are earned over a period that is consistent with the risks covered under the terms of the contract, which is generally one to two years. The portion of the premium related to the unexpired portion of the risk period is reflected in unearned premiums. Where contract terms require the reinstatement of coverage after a ceding company’s loss, the mandatory reinstatement premiums are recorded as written and are recognized as premiums earned when the loss event occurs.
In accordance with SFAS 157, the Company determined that its investments in U.S. government securities, listed equity securities and fixed income fund are stated at Level 1 fair value as determined by the quoted market price of these securities as provided either by independent pricing services or exchange market prices or, when such prices are not available, by reference to broker or underwriter quotes. When the market for a security is considered active and multiple quotes are obtained with identical prices, the quote is considered to be binding. Investments in corporate bonds, mortgage-backed securities, asset-backed securities, exchange traded funds, investment funds that are hedge funds, REITs and REIT funds are stated at Level 2 fair value derived from broker quotes based on inputs that are observable for the asset, either directly or indirectly, such as yield curves and transactional history. There are two mortgage-backed securities that were classified as Level 3 due to the limited availability of the pricing sources. Investment funds and other investments are stated at Level 3 fair value as determined by either the most recently published net asset value, being the fund’s holdings in quoted securities adjusted for administrative expenses, or the most recently advised net asset value as advised by the fund adjusted for cash flows, where the fund’s holdings are in private equity investments. The private equity investments are valued by the investment fund managers using the valuations and financial statements provided by the general partners of the funds on a quarterly basis. These valuations are then adjusted by the investment fund managers for cash flows since the most recent valuation. The valuation methodology used for the investment funds is consistent with the methodology that is generally employed in the investment industry.
The Company has entered into industry loss warranty transactions that are structured as reinsurance or derivatives. When those transactions are determined to be derivatives, they are recorded at fair value in other assets or liabilities with the changes in fair value reported in realized gains and losses in the consolidated financial statements.
On March 6, 2009, Flagstone Leasing entered into a Share Purchase Agreement (“IAL 7X Agreement”) with Mr. Byrne to acquire 100% of the issued and outstanding common voting shares of IAL 7X Leasing Limited (“IAL 7X”). Please refer to Note 22 Subsequent Events for further details.