The following financial information for the five years ended December 31, 2007, has been derived from RAM’s Financial Statements. This information should be read in conjunction with the Financial Statements and related notes located in Part II, Item 8.
Calculated by dividing loss and loss adjustment expenses plus credit impairments by net earned premiums
Loss, acquisition and operating expense ratio may not total combined ratio due to rounding
Our estimate of the sum of U.S. basis policyholder surplus and contingency reserve, as RAM Re files Bermuda statutory financial statements.
We are a Bermuda-based provider of financial guaranty reinsurance, conducting substantially all of our operations through our wholly owned subsidiary, RAM Re. Our financial strength ratings from the rating agencies affect our ability to compete in the market of providing reinsurance to the primary financial guaranty insurers. On February 1, 2008, Moody’s announced that it had placed the Aa3 rating of RAM Re on review for possible downgrade, reflecting Moody’s revised expected loss projections for residential mortgage backed securities and related collateralized debt obligations risk, and the corresponding implications for RAM Re’s capital adequacy. On February 14, 2008, Standard & Poor’s placed the AAA rating on RAM Re on CreditWatch with negative implications. Standard & Poor’s stated that under its guidelines, CreditWatch with negative implications means that there is a one-in-two chance of a ratings change within the short term, typically within 90 days. On March 7, 2008, Moody’s confirmed the Aa3 insurance financial strength rating of RAM Re and changed the outlook to negative. Moody’s stated that RAM Re remains adequately capitalized for its Aa3 rating, although it has a capital cushion of only $10 million for this rating. Moody’s stated that the negative outlook assigned reflects continued uncertainty regarding both the ultimate performance of mortgage and mortgage-related collateralized debt obligation exposures, as well as RAM Re’s future underwriting prospects given its reliance on the primaries for business. We do not believe that the CreditWatch with negative implications status of our S&P rating or the change in outlook by Moody’s has had or will have an adverse impact on our business, although an actual reduction in or loss of rating could have a material adverse affect on our ability to compete, on the terms of our reinsurance and on our financial results, particularly if the downgrade results in a substantial loss of rating agency capital credit for our customers. RAM is pursuing a number of alternatives to improve its capital position, including but not limited to commutations and reassumption of selected exposures with our customers, seeking reinsurance and reducing our growth. Accessing the capital markets may not be a cost-effective option unless RAM’s quoted stock price improves in the future.
gains (losses) in our credit derivatives portfolio and on other financial instruments.
Losses and loss adjustment expenses are a function of the amount and types of business we write and are based in part upon estimates of the case basis and unallocated reserves as determined by the primary insurers, which are reviewed and revised by us as deemed appropriate, and related estimates by RAM Re management (See “Critical Accounting Policies - Losses and Loss Expense Reserves”). Acquisition costs are costs that vary with and are directly related to the production of new business. Certain acquisition costs are deferred and recognized over the period in which the related premiums are earned. Operating costs consist of general and administrative costs, which are primarily salaries and other employee-related costs. Operating costs do not generally vary with premium production. Interest expense is a function of outstanding debt and the contractual interest rate related to that debt, while dividends are a function of the amount of outstanding preference shares and the dividend rate on those preferred shares.
We believe that financial guaranty business is significantly affected by economic cycles. For example, a robust economy featuring a good or improving credit environment is beneficial to the in-force insured portfolios of financial guaranty insurers and reinsurers. If such conditions persist for an extended period, however, credit spreads tend to narrow and pricing and/or demand for financial guaranty insurance 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. During the past several years, interest rates have been relatively stable at low historical levels and credit spreads have generally remained historically “tight” or narrow and new aggregate business production of primary insurers has been about flat through mid-2007, although varying considerably by primary insurer. In particular during the last six months of 2007,a global credit crisis occurred, precipitated by heightened delinquencies and defaults in subprime mortgages. This has resulted in dramatic widening of credit spreads, ratings downgrades of policies, a lack of price transparency, less liquidity and increased capital requirements for financial guarantors and other participants in the financial markets. As a result of these market conditions, pricing for the products we reinsure has improved (See “Business - Pricing”) and the demand for reinsurance has increased as a result of the capital constrained positions of the primaries. However, the difficult market conditions and recent rating agency actions have resulted in some of our customers reporting limited new business production. (See “Business- Customers”) In addition, we are in a capital constrained position and may not be able to take advantage of the current reinsurance opportunities, such as opportunities to reinsure large portfolios of business from the primaries. If these market conditions continue or worsen during the remainder of 2008, we will continue to face a very challenging business environment.
On April 18, 2007, the Financial Accounting Standards Board (“FASB”) issued the Exposure Draft “Accounting for Financial Guarantee Insurance Contracts - an interpretation of FASB Statement No. 60” (“Exposure Draft”). The Exposure Draft among other things, would change current industry practices with respect to the recognition of premium revenue and claim liabilities. In addition, the Exposure Draft would require that the measurement of the initial deferred premium revenue (liability) be the present value of the contractual premium due pursuant to the terms of the financial guarantee insurance contract, thereby changing current industry accounting practice with respect to insurance policies with installments by requiring that the present value of contractual premiums due under such contracts, currently or in the future, be recorded on the company’s balance sheet as premiums receivable and unearned premiums. Under current industry practice such premiums are not reflected on the balance sheet. When the FASB issues authoritative guidance the Company and the rest of the financial guaranty industry may be required to change some aspects of their accounting for loss reserves, premium recognition and acquisition cost recognition, and these changes could have a material effect on our financial statements. The comment period for the Exposure Draft closed on June 15, 2007. A FASB Round Table discussion was held in early September 2007 with another FASB meeting held on January 30, 2008. The FASB has indicated that the final FASB Statement is expected to be issued in the first or second quarter of 2008 with an anticipated effective date of January 1, 2009. The Company is assessing the potential impact and at this time is unable to quantify the effect of the adoption of the proposed interpretation. Until the authoritative guidance is issued, the Company intends to continue to apply its existing policies with respect to its accounting for the establishment of both case and unallocated reserves as well as for premium recognition and deferred acquisition costs.
Losses and Loss Expense Reserves. The estimated liability for losses and loss adjustment expenses consists of case reserves and unallocated reserves. Case reserves are established by the primary insurer and our proportionate share of these reserves is reported to us at least quarterly. Case reserves are established in an amount that is estimated to be sufficient to cover the present value of the anticipated defaulted debt service payments over the expected period of default and estimated expenses associated with settling the claims, less estimated recoveries under collateral and subrogation rights. Case reserves are discounted by the ceding companies in accordance with discount rates prescribed or permitted by state regulatory authorities. We review and assess the ceded case reserves and our evaluation may result in the case reserve recorded by RAM Re differing from the amount reported to us by the primary insurer. We also establish an unallocated reserve because we believe that additional losses are inherent in our portfolio of reinsured risks although we cannot currently specify which risks. At December 31, 2007, and December 31, 2006, our balance sheet included reserves as follows:
Over the past several months, there has been considerable stress in the U.S. residential mortgage market, particularly related to mortgage loans originated during 2005, 2006 and 2007. The Company is exposed to U.S. residential mortgages through our reinsurance of residential mortgage-backed securities, or “RMBS”, and indirectly through our guarantees of collateralized debt obligations or “CDOs”. CDOs are securities backed by portfolios of assets that may include a combination of bonds, loans, asset-backed securities, tranches of other collateralized debt obligations or credit derivatives representing any of the former. As of December 31, 2007, we have established $26.4 million of case reserves relating to the 2005-2007 RMBS and an additional increase of $15.6 million to our unallocated loss reserve relating to RMBS losses that are probable to occur but cannot be specifically identified. This addition to unallocated loss reserves is an extension of our reserving methodology based on increases of unallocated reserves for RMBS by our primary insurers. Additionally, the Company has been ceded credit impairments relating to CDOs amounting to $44.4 million that is reported separately in the valuation of credit derivatives below.
Valuation of Derivative Financial Instruments. Certain transactions reinsured by the Company have been deemed to meet the definition of a derivative under FAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”), and FAS No. 149,”Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“FAS 149”), and require that an entity recognize all derivatives as either assets or liabilities in the consolidated balance sheets and measure those instruments at fair value. RAM’s exposure to derivative instruments is through reinsurance of credit default swap “CDS” contracts issued by ceding companies. These CDS contracts are held to maturity by the ceding companies, are generally highly rated tranches of structured credit default swap obligations, and because the primary insurer generally structures its credit default swap contracts with first loss protection from various financial institutions our risk of loss is mitigated. Management considers these agreements to be a normal extension of RAM’s financial guaranty reinsurance business and reinsurance in substance but they do not meet the scope exception that excludes most financial guaranty policies from the fair value provisions of FAS 149. Therefore, we are required to account for these assumed credit default swaps on the balance sheet at fair value and changes in fair value due to market conditions are reported as unrealized gains and losses on derivative financial instruments in our income statement. Credit impairments on credit default swaps relate to losses that are probable and estimable and will remain in place until the loss is paid or the policy matures.
As part of our financial guaranty reinsurance business, we reinsure guarantees of credit derivative transactions issued by primary insurers. These contracts are held to maturity and have been reinsured by RAM with initial underlying ratings of triple-A before they are insured. Such transactions may experience defaults that exceed expectations based on historical data, particularly in the case of residential mortgage collateral. We do not reinsure guarantees of single name corporate credit derivative transactions. We report revenues arising from such reinsurance as earned premiums; we record paid losses in losses and loss adjustment expenses as incurred, and we record changes in fair value including credit impairments in net losses on credit derivatives in our statement of operations. Credit derivative transactions require primary insurers to make payments upon the occurrence of certain defined credit events relating to underlying obligations (generally a fixed-income obligation). If credit spreads or collateral performance of the underlying obligations change, the market value of the related credit derivative transaction generally changes accordingly. Changes in credit spreads are typically caused by changes in the market’s perception of the credit quality of the underlying obligations.
Through June 30, 2007 the Company valued its credit default swap portfolio using an internally-developed model. While the model estimated an appropriate fair value during normal market conditions, the internal model output at September 30, 2007 and December 31, 2007 would not have fully reflected the effect of the present market conditions and the large changes in credit spreads and collateral deterioration currently being experienced. Management therefore determined that a more appropriate basis for our estimate of fair value was to use the valuation information provided to us by our ceding companies as they have access to each underlying risk and their internal models are able to reflect more detailed market data for each of those underlying risks. Accordingly, commencing September 30, 2007, our change in fair value estimate is based upon the information provided to us by our ceding companies, and our evaluation thereof.
Management assess the reasonableness of the ceding companies’ valuations by i) discussions with primary insurers on 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) assessing the reasonableness of the valuations, including changes in the reported valuations against current observable market data including credit spread movements and collateral delinquency information.
The fair value unrealized loss recognized in our statement of operations for the year ended December 31, 2007, was $177.8 million, compared with an immaterial loss for the year ended December 31, 2006, and a $2.5 million loss for the year ended December 31, 2005. The 2007 loss of $177.8 million primarily related to spreads widening and included $44.4 million of credit losses, compared to no credit impairments in prior years. It is expected that with the continued widening of credit spreads, the fair value amount will fluctuate significantly in the future periods.
Year Ended December 31, 2007 Compared to December 31, 2006 and Year Ended December 31, 2006 Compared to December 31, 2005
Gross Written Premiums. Gross written premiums were $108.7 million in 2007, a 40.1% increase compared to 2006. Gross written premiums were $77.6 million in 2006, an increase of 14.0% from $68.1 million of gross written premiums in 2005. The increase in gross written premiums in 2007 relative to 2006 is the combined result of two new treaties with two of our primaries, which contributed $28.4 million for the year ended December 31, 2007, along with an overall increase in market volume in 2007 over prior year. The increase in gross
Structured finance gross written premiums were $34.7 million in 2007, an increase of 19.7% from $29.0 million in 2006. Structured finance gross written premiums in 2006 increased by 19.8% from $24.2 million in 2005. Structured finance written premiums grew in 2007 over 2006 as a result of the new treaties along with increased cessions from our other primaries for 2007 over prior years. The increase in structured finance written premiums in 2006 versus 2005 results primarily from increased facultative business and a new treaty offset by lower premium rates compared to 2005.
Net Earned Premiums. Net earned premiums were $60.1 million in 2007, 23.2% above 2006 earned premiums of $48.8 million. In 2006, earned premiums increased by 14.6% from $42.6 million of earned premiums in 2005. The significant increases in upfront written premiums from the public finance business in past years, as indicated by growth in unearned premiums on the balance sheet, and growth in installment premiums from the structured finance business assumed in both the current and prior years contributed to this increase, as did an increase in accelerated earnings from refundings during 2007 and 2006 compared to prior years. Earned premiums resulting from refundings totaled $5.7 million in 2007 compared to $6.3 million in 2006 and $3.3 million in 2005.
Net Investment Income. Net investment income of $33.1 million in 2007 was 36.8% above the $24.2 million recorded in 2006, while the 2006 level represented a 33.0% increase from the $18.2 million recorded in 2005. During 2007, net investment income increased relative to 2006 primarily as a result of growth in the portfolio due to our issuance of $75 million of preferred shares on December 14, 2006 and net cash flows from operations. A secondary element of investment income growth was our ability to invest at higher yields than were available in 2006. The increase in investment income in 2006 was primarily attributable to the growth in the portfolio due to net cash flow from operations and investment proceeds from the IPO of $16.4 million and secondarily due to our ability to invest at higher yields that were available in 2005. Our portfolio is comprised predominantly of taxable securities, and had an average yield of 5.0% at December 31, 2007, compared with 4.9% and 4.6% at December 31, 2006 and 2005, respectively.
Net Losses on Credit Derivatives. Net losses on credit derivative contracts were $177.8 million in 2007, compared to immaterial unrealized losses in 2006 and unrealized losses of $2.5 million in 2005. The net loss on derivative financial instruments reported during the year primarily related to AAA-rated credit default swaps on approximately $11.9 billion of par exposure. The significant unrealized loss for the year was primarily due to the continuing deterioration in subprime mortgage assets and the corresponding widening credit spreads in the market. Of the $177.8 million unrealized loss for 2007, $44.4 million related to credit impairments which are expected to be paid out over the term of the contracts. At September 30, 2007, the credit derivative valuations were changed to reporting our share of the primaries’ valuations from using our own fair value model which would not have reflected the volatility in the market. The unrealized losses in 2005 were largely due to a change in fair value estimates associated with refinements to our fair value model. Changes in the fair value of our derivative contracts do not reflect actual claims or credit losses, unless otherwise identified as impairments, and have no impact on the Company’s claims-paying resources, rating agency capital or regulatory capital positions. As of December 31, 2007, no claims had been paid by us on credit derivatives contracts.
The unrealized gain or loss on credit derivatives will change based on the underlying assumptions and information used in the models and may not be indicative of ultimate claims. Fair value is defined as the amount at which an asset or liability could be bought or sold in a current transaction between willing parties. The credit derivative contracts we reinsure require us to make payments upon the occurrence of certain defined credit events relating to an underlying obligation. Credit derivative exposures are substantially similar to financial guaranty insurance contracts and provide for credit protection against payment default, are generally held to maturity, and the unrealized gains and losses on derivative financial instruments will amortize to zero as the exposure approaches its maturity date, unless there is a credit impairment.
Net Unrealized Gains(Losses) on Other Financial Instruments. Net unrealized gains on other financial instruments were $35.3 million in 2007 compared to $nil in 2006 and 2005. The unrealized gain on other financial instruments relates to a $50.0 million put option the Company has in place with respect to its preferred share soft capital facility. The put option allows the Company to issues preferred shares to a trust that holds the $50.0 million in exchange for the investments held in the trust. The unrealized gain of $35.3 million in 2007 relates to the increased value of the soft capital facility to the Company compared to the cost of similar capital that can be obtained in the current market.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses in 2007 were $48.0 million compared to $(2.8) million in 2006. Losses and loss adjustment expenses were $(2.8) million in 2006 compared to $7.2 million incurred in 2005. The loss ratio (incurred losses and loss adjustment expenses plus credit impairments (see “net losses on credit derivatives” analysis above), divided by earned premium) was 153.9% in 2007, (5.7)% in 2006, and 16.9% in 2005. The increase in loss and loss adjustment expense for 2007 is mainly driven by the establishment of reserves relating to the RMBS deals, primarily those underwritten with vintages between 2005-2007. Case basis loss reserves directly relating to subprime mortgages, Alt-A, Closed-end seconds and Home Equity Lines of Credit (HELOCs) account for $26.4 million of the increase in loss and loss adjustment expenses. Additionally, the unallocated loss reserve increased by $21.9 million, of which $15.6 million relates to future RMBS losses that are probable to default but cannot be allocated directly to a specific policy. The remaining increase in unallocated loss reserves was directly related to the increase in business written in the current year. The reduction in loss and loss adjustment expense for 2006 was mainly driven by a net $3.2 million reduction of previously established reserves, the majority of which was associated with an airline industry related obligation for which recoveries were reported to us and a manufactured housing credit which was successfully restructured, as well as loss recoveries received of $1.1 million for the year ended December 31, 2006. Loss activity that results in net negative incurred losses during a full year period, as occurred during 2006, is atypical although recoveries on previously paid losses are a normal part of our business. Loss and loss adjustment expenses are generally affected by changes in the mix, size, and credit quality of our portfolio, as well as specific credit events within reinsured obligations and trends in the reserving practices of our ceding insurers. At December
The residential mortgage markets in the United States are experiencing significant financial stress. The decline in home sales that began in the second half of 2006 and continued into 2007 led to the first year-over-year decline in nationwide house prices since 1991. The subprime mortgage industry began to deteriorate in early 2007 as borrowers became unable or unwilling to make mortgage payments. The significant increase in foreclosure activity and rising interest rates in mid-2007 depressed housing prices further as problems in the subprime markets spread to the prime mortgage markets. The widespread dispersion of credit risk related to mortgage delinquencies through the securitization of mortgage-backed securities, sales of CDOs and other structured products and the adverse impact on the banking industry caused banks to reduce lending activity. In addition, many lenders stopped offering home equity loans and “stated income” loans. As prices declined and delinquencies increased, rating agencies moved to downgrade CDOs and other mortgage-related investment products.
The following discussion summarizes the Company’s exposure to RMBS and CDOs as of December 31, 2007.The Company generally follows the classifications for RMBS and CDO securities used by the primary insurers and reported to the Company.
The following table summarizes RAM Re’s RMBS outstanding par exposure as of December 31, 2007 by loan type and vintage.
There has been a notable increase in mortgage loan delinquencies and foreclosures and this situation resulted in significant losses for mortgage lenders and investors in mortgage related products.
As a result of higher losses and declining home prices, traditional mortgage lenders have significantly curtailed lending to subprime borrowers for both new mortgages and refinancing existing mortgages. Additionally, investors in traditional mortgage products have curtailed their purchases of such investments. This environment significantly reduces the borrowers’ ability to refinance their mortgages and will increase their financial stress in the event they have an adjustable rate mortgage which resets to a higher interest rate. The reduced liquidity also contributes to the lack of availability of credit to purchase new homes, thus contributing to home price depreciation.
As noted above, RAM Re generally follows the classifications for RMBS securities used by the primary insurers and reported to RAM Re. In general, the primary insurers define the various residential mortgage product types as follows:
Closed-end Seconds (CES) - Second lien mortgage loans similar to HELOCs except that they have a fixed amount disbursed at closing and no additional borrowing allowed over the life of the loan and are typically fixed rate.
Alt-A - First-lien mortgage loan that generally conforms to traditional prime credit guidelines, although the loan-to-value ratio (“LTV”), loan documentation, occupancy status, or property type, etc., may cause the loan not to qualify under standard underwriting programs. Alt-A loans may include reduced or limited documentation, including no verification of the borrower’s assets, employment or income.
NIMs - Net interest margin securities backed by the residual cashflow from residential mortgage securitizations.
RAM Re has exposure to RMBS, including transactions that contain risk to the above types of mortgages and risk classifications. In the direct RMBS sector, RAM Re generally reinsures the most senior tranche of the RMBS, from a given loss attachment point to the top of the capital structure. The RMBS in the BBB portion of the table below are generally all relatively large senior tranches that reside at the top of the capital structure. Because of their size and position in the capital structure, these tranches generally produce lower levels of loss severity, upon collateral default, than BBB-rated mezzanine tranches with similar collateral.
The following table provides the break-down of RAM Re’s mortgage exposure outstanding as of December 31, 2007 for deals closed since January 1, 2005 by product type and RAM Re Rating.1 In the fourth quarter RAM Re downgraded internal RAM Re Ratings on a large
1 RAM Re ratings are current as of RAM Re’s credit review on January 19, 2008. These ratings are assigned by RAM Re based on management’s judgment and taking into consideration the ratings assigned by the primaries and the rating agencies. RAM Re undertakes no obligation to update its ratings, and such ratings do not constitute investment advice.
RAM Re also has exposure to residential mortgage loan collateral in CDOs. RAM Re’s exposure to residential mortgage loans is a sub-set of our CDOs backed by multi-sector (“MS”) collateral (see definition below). The following table sets forth the RAM Re Rating of the MS CDOs in our portfolio as of December 31, 2007.
HG - which are high grade securities (rated single-A or higher, primarily AA),
Mez - which are mezzanine securities (rated below single-A, primarily BBB) and
The vintage distribution, based on closing date of CDO issuance, of RAM Re’s MS CDOs is broken out by CDO Type in the table below:
The table below provides a listing of RAM Re’s multi-sector CDOs containing significant residential mortgage exposure and closed since January 1, 2005. The table lists each CDO transaction by vintage year and multi-sector type and provides the proportion of the collateral that is RMBS. The table also provides a break-down of the collateral into subprime RMBS, Alt A, CES, HELOCs, ABS CDOs, Non-ABS CDOs and Other. Also shown is the current subordination level below RAM Re and RAM Re’s current internal rating:
In the table above, all CDOs for which we have established credit impairments are rated below investment grade (“BIG”) by RAM Re.
As shown in the following table, RAM Re’s total CDO par exposure was $9.7 billion as of December 31, 2007. The following table breaks down RAM Re’s total CDO exposure by type of CDO:
The distribution of RAM Re’s total outstanding CDO portfolio by RAM Re rating is as follows:
General Expenses. General or operating expenses were $13.4 million in both 2007 and 2006, operating expenses in 2006 were $1.9 million or 16.5% higher than the $11.5 million of operating expenses in 2005. Operating expenses in 2007 included $0.5 million of non recurring secondary offering costs, and 2006 included $2.3 million in non-recurring costs related to the IPO. Expenses connected to the IPO have been expensed as incurred in proportion to the shares sold in the IPO by the selling shareholders, with $0.3 million of IPO expenses relating to the issuance of new shares allocated against the proceeds, while 2005 operating costs included $2.5 million of non-recurring compensation expense associated with a termination feature of a stock option plan. Without these non recurring costs, operating expenses increased by 16.2% in 2007 over 2006, and by 23.3% in 2006 as compared to 2005, primarily reflecting the ongoing costs of being a public company. Operating expenses as a percentage of earned premiums were 22.3% in 2007, 27.4% in 2006, and 27.1% in 2005.
The principal sources of RAM Re’s liquidity are gross written premiums, scheduled investment maturities, capital contributions from RAM Holdings, existing soft capital facilities and net investment income. The principal uses of RAM Re’s liquidity are for the payment of operating expenses, claims, ceding commissions, dividends to RAM Holdings and for purchases of new investments. We believe that RAM Re’s expected operating liquidity needs can be funded exclusively from its operating cash flow.
Cash Flows. During 2007, net operating cash flows were $84.5 million compared to $57.1 million and $45.0 million for 2006 and 2005, respectively. Our operating cash flows are primarily the result of the excess of net premiums received and investment income over operating expenses, claims payments and interest expenses. Net cash flows from financing activities were $Nil, $90.0 million, and ($1.0) million for 2007, 2006, and 2005, respectively. In 2006 net financing cash flows related primarily to the issuance of preferred shares amounting to $75.0 million, preferred share issuance costs of $1.1 million, additional common share issuance and the committed preferred securities expenses, and in 2005 to committed preferred securities expenses. Net cash used in investment activities amounted to $106.0 million, $111.1 million, and $74.1 million for the periods ending December 31, 2007, 2006 and 2005, respectively, and related to the purchase of investments, offset by sales and maturities of investments.
On May 2, 2006, the Company completed an initial public offering (“IPO”) of 10,820,816 common shares (including 1,411,411 over-allotment option shares). The offering raised approximately $131.2 million of proceeds, net of underwriters’ discount and commission, of which the Company received $16.4 million and the selling shareholders received $114.8 million. The Company contributed substantially all of the net proceeds of the offering to RAM Re to increase its capital and surplus in order to increase its underwriting capacity. In June 2007, the Company completed a secondary offering of 5,347,179 common shares. The Company did not receive any proceeds from the secondary offering.
From time to time, RAM may access the capital markets to increase its capital and support the growth of its business. As such, RAM filed a registration statement on Form S-3 with the SEC in December 2007 covering one or more offerings of $350 million of securities which has not yet been declared effective. This shelf registration statement permits RAM to issue various debt and equity securities described in the prospectus filed as part of the registration statement. Under current market conditions we do not expect to be raising any additional debt, hybrid or equity capital.
Our finance personnel monitor the portfolio for performance and adherence to policies, including market valuation, credit quality, portfolio duration and liquidity. We have a formal review process for all securities in our investment portfolio, including a review for impairment losses based on the factors described above under “Critical Accounting Policies - Valuation of Investment Portfolio.” We have recognized an other than temporary impairment of $3.6 million relating to an investment with subprime exposure at December 31, 2007. We had two other investments with subprime exposure amounting to fair value of $2.3 million, with unrealized losses of $0.02 million. We do not believe these two subprime investments to be other than temporarily impaired. No impairments were recognized as at December 31, 2006.
The amortized cost and estimated fair value of fixed income securities available for sale as of December 31, 2007 and December 31, 2006 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations.
The following table provides the ratings distribution of our investment portfolio at each of December 31, 2007 and December 31, 2006:
We have various contractual obligations as of December 31, 2007 that are summarized in the following table:
Losses and loss expense reserves and credit impairment reserves 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 $209.2 million due in more than 5 years, $196.4 million is not expected to be paid out for more than 20 years. 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, the majority of this is therefore expected to pay out after more than 20 years.
As of December 31, 2007, we did not have off-balance sheet arrangements that were not accounted for or disclosed in the consolidated financial statements.
Our underwriting procedures differ, depending on whether we are conducting facultative or treaty-based reinsurance activities. 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.
For facultative transactions, various factors affecting the credit worthiness of the underlying obligations are evaluated during the underwriting process. Our Credit Committee, comprised of our CEO, CFO, Chief Risk Manager and General Counsel, approves all treaties and facultative transactions prior to committing any of our reinsurance capacity.
We, like other reinsurers, rely in both our facultative and treaty-based business on the surveillance and remediation activities of the primary insurers that provide us with updated information on the performance of the transactions in our reinsured portfolio. The surveillance information provided to us by the primary insurers is supplemented by our own independent evaluations of the analysis and underlying performance data provided by the ceding primary with regard to watch list transactions and verification (where possible) of ratings information provided by the primary insurers on large exposures and on transactions where significant discrepancies are evident between a ceding primary insurer’s internal rating and the reported ratings of Standard & Poor’s or Moody’s. These results are reviewed periodically by senior finance and risk management personnel. Our management committee determines the adequacy of our loss reserves and makes any necessary adjustments following such assessment.
discussions with underwriting and risk management personnel to determine if there have been any changes in underwriting approach or emphasis;
Quantitative and Qualitative Information about Market Risk. Market risk represents the potential for losses that may result from changes in the value of a financial instrument as a result of changes in market conditions. The primary market risks that would impact the value of our financial instruments are interest rate risk and credit spread risk. An estimation of potential losses arising from adverse changes in market conditions is a key element in managing market risk. Senior finance personnel are responsible for risk measurement and monitoring procedures which include periodic analyses of shifts in the yield curve and changes in credit spreads. The valuation results from these analyses could differ materially from amounts that would actually be realized in the market.
and the following table summarizes the estimated changes in the fair value of our portfolio assuming immediate changes in credit spreads at specified levels at December 31, 2007:
Liquidity Risk. Liquidity risk relates to the possible inability to satisfy contractual obligations when due. This risk is most present in financial guarantee contracts reinsured by us in that we are required to make loss payments to primary insurers in the event they pay losses as a result of defaults in their ceded insured obligations. We manage our liquidity risk by analysis of projected cash flows and by maintaining a minimum level of cash and short-term investments which we anticipate to be sufficient to fulfill our contractual obligations, and by maintaining a highly liquid investment portfolio.
In February 2006, FASB issued FAS No. 155, “Accounting for Certain Hybrid Financial Instruments” (“FAS 155”). FAS 155 amends FAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”) and FAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“FAS 140”), and resolves issues addressed in FAS 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” The primary objectives of FAS 155 are, with respect to FAS 133, to address the accounting for beneficial interests in securitized financial assets and, as respects FAS 140, to eliminate a restriction on the passive derivative instruments that a qualifying special-purpose entity may hold. FAS 155 is effective for the Company for all financial instruments acquired or issued after January 1, 2007. The adoption of FAS 155 did not have any impact on the Company’s operating results or financial condition.
In February 2007, the FASB issued FAS No. 159 (“FAS 159”), Fair Value Option for Financial Assets and Financial Liabilities . This statement provides companies with an option to report selected financial assets and liabilities at fair value. The statement requires the fair value of the assets and liabilities that the company has chosen to fair value be shown on the face of the balance sheet. The standard also requires companies to provide additional information to enable users of the financial statements to understand the company’s reasons for electing the fair value option and how changes in the fair values affect earnings for the period. FAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. This statement is effective for fiscal years beginning on or before November 15, 2007. We adopted FAS 159 effective January 1, 2008. We did not apply the fair value option to any eligible items on our adoption date.
The consolidated financial statements have been audited by an independent registered public accounting firm, PricewaterhouseCoopers, who were given unrestricted access to all financial records and related data, including minutes of all meetings of the Board of Directors and committees of the Board. The Company believes that all representations made to our independent registered public accounting firm during their audits were valid and appropriate.
The management of RAM Holdings Ltd. is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is a process designed by, or under the supervision of our Chief Executive Officer and Chief Financial Officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of our consolidated financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.
The Company has classified its fixed-maturity investments as available for sale as defined by Statement of Financial Accounting Standards No. 115 (“SFAS 115”). Available for sale investments are carried at fair value, with unrealized appreciation or depreciation reported as a separate component of accumulated other comprehensive income. All investment transactions are recorded on a trade date basis. Realized gains and losses on sales of fixed maturity investments are determined on the basis of amortized cost. Gains and losses on sale of investments are included in investment income when realized. The cost of securities sold is determined using the specific identification method. Short-term investments are carried at amortized cost, which approximates fair value, and include all securities with maturities greater than 90 days but less than one year at time of purchase. All declines in fair value below cost that are considered other than temporary are recognized in income. Factors considered when assessing impairment include: (i) securities whose market values have declined by 20% or more below amortized cost for a continuous period of at least six months; (ii)
Deferred policy acquisition costs comprise those expenses that vary with and are primarily related to the production of business, including ceding commissions paid on reinsurance assumed, a portion of salaries and related costs of underwriting personnel, rating agency fees, and certain other underwriting expenses. Policy acquisition costs are deferred and amortized over the period in which the related premiums are earned. Policy acquisition costs related to insured derivative transactions are expensed as incurred. When assessing the recoverability of deferred policy acquisition costs, the Company considers the future earnings of premiums paid upfront and the estimated present value of net installment premiums to be received by underwriting year and by risk type. The Company will recognize a premium deficiency if the sum of expected losses and loss adjustment expenses, maintenance costs and unamortized policy acquisition costs exceed the related unearned premiums, the anticipated present value of future premiums for installment contracts written, and anticipated investment income. If a premium deficiency were calculated that was greater than unamortized acquisition costs, the unamortized acquisition costs would be reduced by a charge to expense, and a liability would be established for any remaining deficiency. There have been no premium deficiencies recorded by the Company since its inception.
commonly recognized measure of credit risk promulgated by Standard & Poor’s). RAM Re’s insured portfolio is segregated by primary insurer, and the above ratios are calculated individually by primary insurer. Therefore, changes in the following factors would result in changes in our unallocated reserves under our current practices:
Developments that could result in a change in the relativities between the weighted average capital charge for our portfolio exposures versus those of the primary insurers (such as could occur if modifications of capital charges by Standard & Poor’s were to differentially impact RAM Re and the primaries); or
Developments in the credit quality of our portfolio relative to our primaries.
Additionally, there are internal guidelines in place which address the procedures followed to determine that the total best estimate continues to be based upon expected loss experience over the long term and is not overly influenced by one short term development on one loss. Specifically, the Management Committee has two guidelines with respect to the interaction of unallocated and case reserves. No more than 20% of the unallocated reserve balance at quarter end can be reduced to offset a case reserve associated with a single default. No more than 50% of the unallocated reserve balance at year end can be reduced to offset aggregate case reserve activity during the following year.
The Company recognizes that there is diversity in practice among financial guaranty insurers and reinsurers with respect to their accounting policies for unallocated loss reserves. Current accounting literature, specifically FASB Statement of Financial Accounting Standards No. 60 “Accounting and Reporting by Insurance Enterprises” (FAS 60) and FASB Statement of Financial Accounting Standards No. 97 “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments” (“FAS 97”), do not specifically address the unique characteristics of financial guarantee insurance contracts. Consequently, the accounting principles applied by the industry, as well as the Company, have evolved over time and incorporate the concepts of both short-duration contracts, accounted for under the provisions of FAS 60 and long duration accounting under FAS 97, as well as other accounting literature, such as FASB No. 5 “Accounting for Contingencies” and Emerging Issues Task Force (“EITF”) Issue No. 85-20 “Recognition of Fees for Guaranteeing a Loan”. The Company will continue its loss reserving methodology as noted above until further guidance is provided by the FASB. See recent accounting pronouncements (part 2(k) of this note) for further discussion of this issue.
In the ordinary course of business, the Company cedes business to other insurance and reinsurance companies. These agreements enable the Company to manage its risk concentration limits thereby providing greater risk diversification and may minimize the net potential loss from large risks. Retrocessional contracts do not relieve the Company of its obligation to the reinsured. Prepaid reinsurance premiums represent the portion of premiums ceded to reinsurers relating to the unexpired terms of the reinsurance contracts in force. The Company currently has one retrocessional agreement in place which required a minimum cession that was complied with at December 31, 2007 and 2006.
The Company has entered into agreements to reinsure derivative instruments, consisting of credit default swaps that it intends to reinsure for the full term of the contract. While management considers these agreements to be a normal 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 swap risks that the Company assume 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. Because management considers the Company’s reinsurance of credit default swaps to be a normal extension of its financial guaranty reinsurance business and reinsurance in substance, management believes the most meaningful presentation of these derivatives is to reflect in the Statements of Operations (i) premiums that the Company receives from the reinsurance of such contracts in the line items entitled (i) gross written premium, ceded premium and change in unearned premiums, (ii) loss payments to the reinsured in “loss and loss adjustment expenses, and (iii) change in fair value, including credit impairments, in the caption “net unrealized losses on credit derivatives”.
In February 2006, the Financial Accounting Standards Board (“FASB”) issued FAS No. 155, “Accounting for Certain Hybrid Financial Instruments” (“FAS 155”). FAS 155 amends FAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”) and FAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“FAS 140”), and resolves issues addressed in FAS 133 Implementation Issue No. D1, “Application of Statement 133 to Beneficial Interests in Securitized Financial Assets.” The primary objectives of FAS 155 are, with respect to FAS 133, to address the accounting for beneficial interests in securitized financial assets and, as respects FAS 140, to eliminate a restriction on the passive derivative instruments that a qualifying special-purpose entity may hold. FAS 155 is effective for the Company for all financial instruments acquired or issued after January 1, 2007. The adoption of FAS 155 did not have any impact on the Company’s operating results or financial condition.
As of December 31, 2007 and 2006, the Company had cash and cash equivalents of $8.2 million and $6.3 million, respectively, and investments at fair value of $406.7 million and $323.6 million, respectively, invested in trust accounts for the benefit of ceding companies. Pursuant to the terms of the reinsurance agreements with ceding companies, the Company is required to secure its obligations with ceding companies and may not withdraw funds from these trust accounts without their express permission.
Valuation models include the use of estimates and current market information, including assumptions on how the fair value of derivative instruments is affected by current market conditions. The primaries consider factors such as current prices charged for similar agreements, performance of underlying assets, life of the instrument, and the nature and extent of activity in the financial guaranty credit derivative marketplace. The assumptions used to determine fair value may change in the future due to market conditions. Due to the inherent uncertainties of the assumptions used in the valuation models to determine the fair value of these derivative products, actual experience may differ from the estimates and the differences may be material.
The fair value loss recognized in our statement of operations for the year ended December 31, 2007, was $177.8 million, compared with an immaterial loss for the year ended December 31, 2006, and a $2.5 million loss for the year ended December 31, 2005. The 2007 loss of $177.8 million primarily related to spreads widening and underlying collateral deterioration and included $44.4 million of credit impairments, compared to no credit impairments in prior years. It is expected that with the continued widening of credit spreads, the fair value amount will fluctuate significantly in future periods.
The Company derives the majority of its business from four United States based primary financial guaranty insurance companies namely Ambac Assurance Corp., Financial Guaranty Insurance Co. (“FGIC”), Financial Security Assurance Inc., and MBIA Insurance Corp. The four primary insurers accounted for 20%, 26%, 22%, and 17% in 2007, for 25%, 12%, 30%, and 22% in 2006, and for 27%, 7%, 31%, and 31% in 2005 of gross premiums written. This customer concentration results from the small number of primary insurance companies that are licensed to write financial guaranty insurance. The majority of the Company’s gross premiums written are derived from treaty agreements that are renewed on an annual basis. One of the four United States based primary financial guaranty insurance companies identified above is also a related party. Description of the relationship is discussed in Note 19 “Related party transactions”.
The Company did not have an aggregate investment in a single entity, other than the U.S. Treasury securities, in excess of 10% of total investments at December 31, 2007 and 2006.
As of December 31, 2007, 71 out of 168 securities were in unrealized loss positions. As of December 31, 2007, 6 securities with total unrealized losses of $113,724 had continued losses for 6 months or less, 2 securities with total unrealized losses of $21,820 had continued losses for 7 months to 12 months and 63 securities with an unrealized loss of $3,932,892 had a continued loss for more than 12 months. The unrealized losses as of December 31, 2007 are attributed to the current interest rate environment and the Company believes the impairments to be temporary. The Company has the ability and intends to hold these investments until recovery.
Proceeds from maturities and sales of investments in fixed interest securities available for sale during 2007, 2006, and 2005 were $128,096,094, $118,996,819, and $144,659,043 respectively. Gross gains of $6,007, $nil and $144,908 in 2007, 2006, and 2005, respectively, and gross losses of $10,227, $1,002,055, and $1,728,448 in 2007, 2006, and 2005, respectively, were realized on those sales. As at December 31, 2007, the Company has recognized an other than temporary impairment of $3.6 million relating to an investment with subprime exposure, the fair value of this investment is $2.4 million. The Company had two other investments with subprime exposure with a fair value of $2.3, million, and unrealized losses were immaterial. The Company does not believe these two subprime investments to be impaired. No impairments were recognized as at December 31, 2006.
RAM Re has contingent capital and credit facilities totaling $180 million, the details of which are discussed in the following:
As of December 31, 2007 and 2006, the Company maintained a $90.0 million credit facility with major commercial banks. The facility may be drawn upon by the Company if cumulative losses exceed certain minimum thresholds in respect of cumulative losses on public finance bonds and, in a limited capacity, asset-backed securities reinsured by the Company. Loan obligations under this facility have limited recourse and would be repayable from, and collateralized by, a pledge of recoveries realized on defaulted reinsured obligations covered by the facility, including certain installment premiums and other collateral. The facility, which contains an annual renewal provision subject to approval by the banks, has a nine-year term ending on May 11, 2015. As of December 31, 2007 and 2006, no amounts were outstanding nor have there been any borrowings under this facility.
On February 3, 2006, RAM Re closed a $40.0 million contingent capital facility with two highly rated commercial banks. This facility is essentially the same as the $90.0 million contingent capital facility described above although it may be drawn upon only to cover catastrophic losses, exceeding the minimum threshold, from municipal obligations reinsured by RAM Re. Loan obligations under this facility also have limited recourse and are repayable from, and collateralized by, a pledge of recoveries realized on defaulted reinsured obligations covered by this facility, including certain installment premiums and other collateral, on a subordinate basis to the pledge made to secure the $90.0 million facility described above. The $40.0 million facility has a seven-year term ending on February 3, 2014, and had an annual extension feature, subject to approval of the lenders. This facility was not extended for an additional year on February 3, 2008. As of December 31, 2007 and 2006, no amounts were outstanding nor have there been any borrowings under this facility.
On December 23, 2003, RAM Re entered into a contingent capital facility whereby it was granted the right to exercise perpetual put options in respect of its Class B preference shares against the counterparty to the option agreement, in return for which it pays the counterparty a monthly floating put option fee. The counterparty is a trust established by an investment bank. The trust was created as a vehicle for providing capital support to RAM Re by allowing it to obtain, at its discretion and subject to the terms of the option agreement, access to new capital through the exercise of a put option and the subsequent purchase by the trust of RAM Re preference shares. The rights of the holders of the preference shares are subordinate to those of ceding companies under reinsurance contracts. The put agreement has no scheduled termination date or maturity, but will be terminated if RAM Re takes certain actions as specified in the operative facility documents. RAM Re has the option to redeem the Class B preference shares issued upon exercise of its put option, subject to certain specified terms and conditions. If the put option is exercised in full, RAM Re would receive up to $50.0 million in connection with the issuance of the preference shares, the proceeds of which may be used for any purpose including the payment of claims. To fund the purchase of preference shares upon exercise of the put option by RAM Re, the trust issued $50.0 million of its own auction market perpetual preferred securities which are rated “A+” and on CreditWatch for a downgrade by Standard & Poor’s and “A2” on negative outlook by Moody’s. The proceeds of this issuance are held by the trust in certain high quality, short-term commercial paper investments. As of December 31, 2007, the perpetual put options have not been exercised. During the years ended December 31, 2007, 2006 and 2005, expenses of $0.8 million, $0.5 million and $0.6 million, respectively, were paid, relating to the operation of the facility.
The fair values of investments are based on quoted market prices from nationally recognized pricing services, dealer quotes, or matrix pricing all of which are based on observable market inputs where available. The carrying amounts of cash and cash equivalents, interest and premiums receivable, other assets, accounts payable and accrued liabilities and other liabilities are considered reasonable estimates of their fair values.
consolidated balance sheet and as an unrealized gain on other financial instruments in the statement of operations, the unrealized gain at December 31, 2006 and 2005 was $Nil.
The carrying amount of unearned premiums represents the Company’s future earned premium revenue on policies where the premium was received at the inception of the policy and the risk is not yet expired. The fair value of the unearned premiums is the value the Company would receive as the Company’s market would be the ceding company from which we originally assumed the business; we perceive the market value to approximate the carrying value. For installment premiums, consistent with industry practice, there is no carrying amount since the Company will receive premiums on an installment basis over the term of the reinsurance contract. Similar to the treatment of unearned premiums, the fair value of installment premiums is estimated as the present value of the future contractual premiums that are expected to be received under a reinsurance agreement. The present value of future installment premiums, discounted at a rate of 4.26% and 4.56%, was $234.2 million and $161.4 million at December 31, 2007 and 2006, respectively.
The effect of the credit and mortgage markets, as a consequence of the subprime crisis, has resulted in the establishment of a significant amount of case basis loss reserves being recorded on the policies that have defaulted or have a high probability of defaulting. Additions to case basis reserves of $26.2 million in 2007, ($3.9 million) in 2006, and $7.5 million in 2005 represent the Company’s proportionate share of loss reserves established by ceding companies and are based on notification by ceding companies and the judgment of management. The net unallocated reserve increase of $21.9 in 2007 is partially due to the increase in exposure reinsured by the Company as well as an additional calculated amount of $15.6 million relating to residential mortgage-backed securities (“RMBS”) exposure where the development of a default is probable but the actual loss has not been specifically identified. The company insures par relating to RMBS exposure of $2.5 billion, of which $352.6 million has case reserves amounting to $27.5 million at December 31, 2007. RMBS exposure includes obligations backed by subprime, closed-end second mortgage loans and home equity lines of credit. The Company’s estimate of loss reserves related to RMBS exposure represent management’s best estimate of total losses for these exposures but actual losses may differ materially from these estimates. The Company continues to monitor the performance of these exposures and will update estimates of loss as new information reflecting future performance is available. The increase of the unallocated reserve of $1.2 million in 2006, and the immaterial decrease in 2005 are due primarily to the combination of increased exposures reinsured by the Company in the ordinary course of business and changes in unallocated reserve factors applied in estimating the unallocated loss reserve.
As of December 31, 2007, 2006, and 2005, recoverables on paid losses included $0.5 million, $0.9 million, and $0.7 million, respectively, in collateral certificates purchased by one of our ceding companies, MBIA (see Note 19 “Related party transactions”) in a foreclosure on assets underlying certain insured equipment trust lease obligations reinsured by the Company. The recoverable is recorded at its estimated fair value based on the estimated present value of lease payments over an average of 92 months, 92 months, and 15 months as of December 31, 2007,
2006, and 2005, respectively, and the estimated present value of the recovery value of the underlying assets. There are no assurances that the ultimate value received or recovered will not be materially different than the estimated fair value. As of December 31, 2007, the difference between the paid loss less lease payments received to date of $0.6 million and the estimated fair value of $0.5 million was $0.1 million. As of December 31, 2006, the difference between the paid loss less lease payments received to date of $1.0 million and the estimated fair value of $0.9 million was $0.1 million. As of December 31, 2005, the difference between the paid loss of $1.2 million and the estimated fair value of $0.7 million was $0.5 million. This change in fair value for the year ended December 31, 2007, 2006, and 2005, respectively, has been recorded as part of losses and loss adjustment expenses on the income statement. Subsequent to year end, the Company has received additional reimbursements totaling $0.1 million.
Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised), “Share-Based Payment” (“FAS 123R”), utilizing the prospective transition method. Under the prospective transition method, compensation costs recognized relate to the estimated fair value at the grant date of stock options granted subsequent to January 1, 2006 in accordance with FAS 123R. The Company continues to account for stock options issued under APB 25, where no compensation expense is recognized in net income for stock options granted under the plan as the exercise price is equal to the fair value of the underlying common stock at the date of grant. In accordance with the provisions of FAS 123R, options granted prior to January 1, 2006 using APB 25, have not been restated to reflect the adoption of FAS 123R. For the periods ended December 31, 2007, 2006, and 2005, the Company recognized $0.1 million, $0.1 million and $0.2 million, respectively, of compensation expense in the period for stock options with an exercise price less than the market value of the underlying common stock on the date of the grant.
As of April 26, 2006, the Company adopted the RAM Holdings Ltd. 2006 Equity Plan (the “Plan”). The number of common shares that may be delivered under the Plan may not exceed 2,470,000. In the event of certain transactions affecting the common shares of RAM Holdings Ltd., the number or type of shares subject to the Plan, the number and type of shares subject to outstanding awards under the Plan, and the exercise price of awards under the Plan, may be adjusted. The Plan authorizes the grant of share options, share appreciation rights, share awards, restricted share units, performance units, or other awards that are based on the Company’s common shares. The awards granted are contingent on the achievement of service conditions during a specified period, and may be subject to a risk of forfeiture or other restrictions that will lapse upon the achievement of one or more goals relating to completion of service by the participant. Awards under the Plan may accelerate and become vested upon a change in control of the Company. The Plan is administered by the compensation committee of the board of directors. The plan is subject to amendment or termination by the board.
The Company has used the Black-Scholes option pricing model to estimate the fair value of stock options using the following weighted average assumptions as at December 31, 2007:
As at December 31, 2007, there was $0.1 million of unrecognized compensation expense related to the stock options granted under FAS 123R which is expected to be recognized over the remaining service period of 2.72 years.
(1) The aggregate intrinsic value was calculated based on the market value of $4.94 as at December 31, 2007, and is calculated as the difference between the market value and the exercise price of the underlying options.
On July 1, 2005, the Company entered into a retrocession agreement with a “AA” rated financial guaranty company to retrocede business that exceeds its single risk limits on a facultative basis. As at December 31, 2007, the Company had met the requirements under the agreement.
A downgrade of RAM Re’s ratings could have a material adverse affect on RAM Re’s ability to compete in the financial guaranty reinsurance industry and significantly decrease the value of the reinsurance provided. In some cases upon a downgrade of our financial strength ratings by Standard & Poor’s, and in all cases upon a downgrade of our rating by Moody’s, the primaries would have the right, after a cure period, to increase the ceding commission, as stipulated in the treaties, or terminate the treaties and either leave their existing business with RAM Re or recapture it. In the case of a downgrade by S&P from AAA to AA, the primaries may generally increase the ceding commission but not all of the primaries have the right to terminate their treaties with RAM Re. RAM Re’s treaty contracts allow a cure period, generally between 30 to 90 days, in which RAM Re may restore its ratings or restore the reinsurance credit received by the primaries to the level associated with RAM Re’s rating prior to downgrade by providing additional collateral, which may be in the form of additions to the trust accounts maintained by RAM Re for the benefit of its U.S. based customers. To the extent policies are recaptured, RAM must forfeit to the primary an amount determined by formula under each treaty contract which generally consists of RAM’s allocated share of the statutory unearned premium, net of the ceding commission paid by RAM to the primary (subject to a penalty amount in some cases), and loss reserves established with respect to the policies ceded, as applicable. In some cases, the primaries may have the right to select specific years of business written to recapture, and a decision by a primary to recapture, for example, all business written prior to 2006, could have a material adverse effect on us because of the projected losses associated with the business written in the last two years.
An actual reduction in or loss of rating could have a material adverse affect on our ability to compete, on the terms of our reinsurance and on our financial results, particularly if the downgrade is below the AA-level. RAM is pursuing a number of alternatives to improve its capital position, including but not limited to: commutations and reassumption of selected exposures with our customers, seeking reinsurance and reducing its growth.
As at December 31, 2005, MBIA, one of the four major primary insurers, owned 11.4% of our aggregate issued and outstanding common shares. MBIA sold all of its RAM Holdings shares in our initial public offering, which closed on May 2, 2006, and is no longer a “related party.” Prior to the initial public offering, we engaged MBIA Capital, a wholly-owned subsidiary of the parent company to MBIA, to provide us with investment advisory and management services. We have agreed to pay an annual investment management fee payable quarterly in arrears based on the average market value of the assets under management for each quarter. In addition, we have agreed to reimburse custodian fees, transfer agent fees and brokerage costs, fees and commissions and certain other out-of -pocket expenses. An immaterial amount and $0.2 million were payable as of December 31, 2007 and December 31, 2006, respectively, to MBIA Capital for these services.
Shares issued and outstanding as at December 31, 2007 and December 31, 2006 were 27,238,976 and 27,234,755, respectively.
The Act limits the maximum amount of the annual distributions paid by RAM Reinsurance without the approval of the Bermuda Monetary Authority of such payment. The maximum amount of dividends that could be paid by RAM Reinsurance as a reduction of statutory capital, without such notification, was $51.3 million and $51.2 million as at December 31, 2007 and 2006, respectively without consideration of GAAP retained earnings.
The net unrealized investment gains (losses) and losses on credit derivatives and other financial instruments in the fourth quarter of 2007 resulted from the significant widening of credit spreads and the underlying collateral deterioration observed in the fourth quarter of 2007. The effect of the credit and mortgage markets, as a consequence of the subprime crisis, has resulted in the establishment of a significant amount of Loss and loss adjustment expenses in the fourth quarter of 2007. Investments are discussed further in note 7, Derivatives in note 4 and Losses and loss expense reserves in note 11 to these financial statements.