The following table sets forth our selected historical statement of income data for the fiscal years ended December 31, 2007, 2006 and 2005 and the period from inception on July 13, 2004 to December 31, 2004, as well as our selected balance sheet data as of December 31, 2007, 2006, 2005 and 2004 which are derived from our audited consolidated financial statements also included as part of this filing. The audited consolidated financial statements are prepared in accordance with U.S. GAAP and have been audited by BDO Seidman, LLP, an independent registered public accounting firm. Since we commenced underwriting business in April 2006 and did not write any reinsurance contracts in 2005 and 2004, comparisons to prior periods may not be meaningful.
Severity business is typically characterized by contracts with the potential for significant losses emanating from one event or multiple events. Clients generally buy this protection to remove volatility from their balance sheets and, accordingly, we expect the results of severity business to be volatile from period to period. However, over the long term, we also expect that our severity business will generate higher profit margins and return on equity than those of our frequency business.
• premiums from reinsurance on property and casualty business assumed; and
Income from our investments is primarily comprised of interest income, dividends, net realized and unrealized gains and losses on investment securities. We also derive interest income from money market funds.
Acquisition costs consist primarily of brokerage fees, ceding commissions, premium taxes, profit commissions and other direct expenses that relate to our writing reinsurance contracts. We amortize deferred acquisition costs over the related contract term.
Our consolidated financial statements contain certain amounts that are inherently subjective in nature and have required management to make assumptions and best estimates to determine reported values. If certain factors, including those described in ‘‘Risk Factors,’’ cause actual events or results to differ materially from our underlying assumptions or estimates, there could be a material adverse effect on our results of operations, financial condition or liquidity. We believe that the following accounting policies affect the more significant estimates used in the preparation of our consolidated financial statements. The descriptions below are summarized and have been simplified for clarity. A more detailed description of our critical accounting policies is included in the notes to the consolidated financial statements.
Investments. We classify all exchange traded investments as trading securities and record their values based on the last reported price on the balance sheet date as reported by a recognized exchange. If no such sale of such security was reported on that date, the market value will be the last reported bid price (in the case of securities held long), or last reported ask price (in the case of securities sold short). Securities for which recognized exchange quotations are not readily available are valued at management’s best estimate (utilizing the services of DME Advisors) of fair value, on the basis of the specific identification method (by reference to cost or amortized cost, as appropriate) based on prices received from market makers. Any realized gains or losses are determined and included in investment income in the statement of income. Unrealized gains and losses, if any, on unlisted securities are included in accumulated other comprehensive income as a separate component of shareholders’ equity. A decline in market value of a security below cost that is deemed other than temporary, is charged to earnings and results in the establishment of a new cost basis of the security.
For natural catastrophe exposed business we establish loss reserves based on loss payments and case reserves reported by our clients, when and if received. We then add to these case reserves our estimates for IBNR. To establish our IBNR loss estimates, in addition to the loss information and estimates communicated by ceding companies, we use industry information, knowledge of the business written by us and management’s judgment.
For most of the contracts we write, our risk exposure is limited by the fact that the contracts have defined limits of liability. Once the loss limit for a contract has been reached, we have no further exposure to additional losses from that contract. However, certain contracts, particularly quota share contracts which relate to first dollar exposure, may not contain aggregate limits.
For all non-natural catastrophe business, we initially reserve every individual contract to the expected loss and loss expense ratio in the pricing analysis. In our pricing analyses, we typically utilize a significant amount of information both from the individual client and from industry data. Where practical, we compare reserving data that we receive from our client, if any, to publicly-available financial statements of the client in an effort to identify, confirm and monitor the accuracy and completeness of the received data. If we do not receive reserving data from a client, we rely on industry data, as well as the judgment and experience of our underwriters and actuaries. We complete our analyses for all contracts for all lines of business. The information may include many years of history. Depending on the type of business underwritten, we are entitled to receive client and industry information on historical paid losses, incurred losses, number of open claims, number of closed claims, number of total claims, listings of individual large losses, earned premiums, policy count, policy limits underwritten, exposure information and rate change information. We also may receive information by class or subclass of business. As we are a new company, we currently rely more on client and industry data than our own to identify unusual trends in the data requiring changes in reserve estimates. Where available, we receive relevant actuarial reports from the client. We supplement this information with subjective information on each client, which may include management biographies, competitor information, meetings with the client, and supplementary industry research and data. Generally, we obtain regular updates of premium and loss related information for the current period and historical periods, which we utilize to update our initial expected loss and loss expense ratio. There may be a time lag from when claims are reported to our client and when our client reports the claims to us. This time lag may impact our loss reserve estimates from period to period. Once we receive this updated information we use a variety of standard actuarial methods in our analysis each quarter. Such methods may include:
• Reported Loss Development Method. We estimate ultimate losses by calculating past reported loss development factors and applying them to exposure periods with further expected reported loss development. Since reported losses include payments and case reserves, changes in both of these amounts are incorporated in this method. This approach provides a larger volume of data to estimate ultimate losses than paid loss methods. Thus, reported loss patterns may be less varied than paid loss patterns, especially for coverage that have historically been paid out over a long period of time but for which claims are reported relatively early and case loss reserve estimates established.
• Bornheutter-Ferguson Paid Loss Method. We estimate ultimate losses by modifying expected loss ratios to the extent paid losses experienced to date differ from what would have been expected to have been paid based upon the selected paid loss development pattern. This method avoids some of the distortions that could result from a large development factor being applied to a small base of paid losses to calculate ultimate losses. We use this method for lines of business and contracts where there are limited historical paid losses.
For each contract, we utilize each reserving methodology that our actuaries deem appropriate in order to calculate a best estimate, or point estimate, of reserves. In setting our reserves, we do not use a range of estimates that may be subject to adjustment. Accordingly, at the end of each period, we will establish reserves at a point estimate based upon all information then available. Whether we use one methodology, a combination of methodologies or all methodologies depends upon the contract and the judgment of the actuaries responsible for the contract.
industry volatility and uses the full life of the option, ten years, as the estimated term of the option. Additionally, we have assumed that dividends will not be paid. If actual results differ significantly from these estimates and assumptions, particularly in relation to our estimation of volatility which requires the most judgment due to our limited operating history, share-based compensation expense, primarily with respect to future share-based awards, could be materially impacted.
Although current general market conditions in the reinsurance business may not be favourable we continue to believe that specific sectors within the reinsurance marketplace may provide attractive opportunities. In particular, we anticipate that we will see attractive opportunities during 2008 in casualty and property lines, including certain property catastrophe coverages and professional liability risks. We believe that these lines of business will present us with opportunities for the following reasons:
• legislation in certain states, including tort reform and workers’ compensation regulation, has resulted in attractive opportunities for professional liability reinsurance; and
We expect to see increased claim activity in the Directors and Officers, or D&O, and Errors and Omissions, or E&O, insurance markets as a result of increased litigation involving public companies due to market losses and share price declines associated with the current global credit crisis. We will continue to actively review our exposure to such events and believe that loss and loss expense reserves established as of December 31, 2007 include and fairly reflect any liability exposure to the credit crisis.
For the year ended December 31, 2006, our net income increased 117.0% to $57.0 million from $26.3 million for the year ended December 31, 2005. The increase in net income of $30.7 million was due to the positive impact of underwriting activities and an increase in investment returns experienced during 2006.
We expect our annual reporting of premiums written to be volatile as our underwriting portfolio continues to develop. Additionally, the composition of premiums written between frequency and severity business will vary from year to year depending on the specific market opportunities that we pursue. Given that we only commenced underwriting operations in April 2006 and we continue to develop our underwriting portfolio, direct comparisons between years may not be meaningful.
Our severity business includes contracts that contain or may contain natural peril loss exposure. As of December 31, 2007, our maximum aggregate loss exposure to any series of natural peril events was $75.7 million. For purposes of the preceding sentence, aggregate loss exposure is equal to the difference between the aggregate limits available in the contracts that contain natural peril exposure minus reinstatement premiums for the same contracts. We categorize peak zones as: United States, Europe, Japan and the rest of the world. The following table provides single event loss exposure and aggregate loss exposure information for the peak zones of our natural peril coverage as of the date of this filing:
We expect losses incurred on our severity business to be volatile from period to period. Losses incurred on the natural peril exposed portion of our severity business have benefited from benign natural peril loss experiences during all years reported. Additionally, given the seasonality of wind
exposure, we expect that the first six months of a calendar year will generally report lower losses incurred on natural peril business than the last six months of a calendar year. The loss ratios for our severity business were 19.9% and 8.5% for the years ended December 31, 2007 and 2006, respectively. The increase in the loss ratio during 2007 is primarily due to the different composition of the severity underwriting portfolio. During the year ended December 31, 2006, the severity underwriting portfolio was composed entirely of natural peril business. Because of benign natural peril loss experience, we incurred a very low loss ratio. This contrasts with the current severity underwriting portfolio which also includes casualty and liability exposures in addition to natural peril risks, which account for the increase in the reported loss ratio.
Our general and administrative expenses for the years ended December 31, 2007, 2006 and 2005 were $11.9 million, $9.1 million and $3.0 million, respectively. The increase in general and administrative expenses of $2.8 million in 2007 from 2006 reflects the continued expansion of our underwriting operations, as well as increased expenses incurred as a publicly-traded company, including hiring additional financial and accounting staff and other related expenses. The large increase in general and administrative expenses of $6.1 million in 2006 from 2005 reflects the initial expansion of our underwriting operations as we commenced underwriting operations in April 2006. These expenses for the years ended December 31, 2007, 2006 and 2005 include $2.9 million, $2.9 million and $0.7 million, respectively, for the expensing of the fair value of stock options and restricted stock granted to employees and directors.
The internal expense ratio is the ratio of all general and administrative expenses to net premiums earned. We expect our internal expense ratio to decrease as we continue to expand our underwriting operations. The high internal expense ratio of 34.1% reported for the year ended December 31, 2006 reflected that underwriting operations only commenced in April 2006 and as such start up costs were high relative to the initial premiums earned.
The combined ratio is the sum of the composite ratio and the internal expense ratio. The combined ratio measures the total profitability of our underwriting operations and does not take net investment income or loss into account. The reported combined ratio for the year ended December 31, 2007 was 92.2%. Given the nature of our opportunistic underwriting strategy, we expect that our combined ratio may also be volatile from period to period.
Total investments in securities reported as of December 31, 2007 were $590.5 million compared to $243.5 million as of December 31, 2006, an increase of 142.5%. The increase in investments was principally due to the net proceeds of $255.7 million from our public and private offering in May 2007 as well as cash flows from reinsurance operations and investment gains.
Loss reserves totaled $42.4 million as of December 31, 2007 compared to $5.0 million as of December 31, 2006. The increase is principally attributable to estimated losses associated with premiums earned during the year ended December 31, 2007 resulting from our increased underwriting activities.
Our shareholders’ equity increased to $605.6 million as of December 31, 2007 from $312.2 million as of December 31, 2006, an increase of 94.0%. The increase is principally attributable to the net proceeds of $255.7 million from our public and private offerings in May 2007 and net income of $35.3 million for the year ended December 31, 2007.
For the year ended December 31, 2007, we used $273.7 million in net cash flow from operations. Since we classify our investments in securities as trading, U.S. GAAP requires that all cash flows relating to our investment portfolio be classified as an operating activity. As such, the proceeds from our initial public offering which were invested result in a significant cash outflow being reported for operating activities. For the year ended December 31, 2007, the proceeds from the initial public offering generated net proceeds of $255.7 million. There were no cash flows reported for investing activities during the year ended December 31, 2006.
Although Greenlight Capital Re is not subject to any significant legal prohibitions on the payment of dividends, Greenlight Re is subject to Cayman Islands regulatory constraints that affect its ability to pay dividends to us and include a minimum net worth requirement. Currently the minimum net worth requirement for Greenlight Re is $120,000. As of December 31, 2007 Greenlight Re exceeded the minimum required by $605.5 million. By law, Greenlight Re is restricted from paying a dividend if such a dividend would cause its net worth to drop to less than the required minimum.
Greenlight Re is not licensed or admitted as a reinsurer in any jurisdiction other than the Cayman Islands. Because many jurisdictions do not permit domestic insurance companies to take credit on their statutory financial statements unless appropriate measures are in place from reinsurance obtained from unlicensed or non-admitted insurers we anticipate that all of our
Our capital structure currently consists entirely of equity issued in two separate classes of ordinary shares. We expect that current level of capital and internally generated funds, will be sufficient to implement our business strategy. Consequently, we do not presently anticipate that we will incur any material indebtedness in the ordinary course of our business. However, we cannot provide assurances, that in the future we will not be required to incur indebtedness to implement our business strategy, pay claims or make acquisitions. We have not made any significant capital expenditures during the period from inception to December 31, 2007.
The following table shows our aggregate contractual obligations by time period remaining to due date as of December 31, 2007:
(2) Due to the nature of our reinsurance operations, the amount and timing of the cash flows associated with our reinsurance contractual liabilities will fluctuate, perhaps materially, and, therefore, are highly uncertain.
On January 1, 2008, we entered into an agreement wherein the Company and DME Advisors agreed to create a joint venture for the purposes of managing certain jointly held assets. The term of the investment agreement is January 1, 2008 through December 31, 2010, with automatic three-year renewals unless either Greenlight Re or DME Advisors terminate the agreement by giving 90 days notice prior to the end of the three year term. Concurrent with the execution of the investment agreement, we terminated the advisory agreement with DME Advisors.