We lease and/or sublease office space in (i) Hamilton, Bermuda, (ii) New York, New York and (iii) Lisle, Illinois. CastlePoint Re subleases premises in Hamilton, Bermuda, used for the operations of our reinsurance segment. CastlePoint also leased three residential premises (on behalf of certain of its employees located in Bermuda) on varying terms. CastlePoint Management and CastlePoint Insurance Company currently sublease office space in New York, New York from Tower Insurance Company of New York, at its cost, pursuant to an arrangement covered by the service and expense sharing agreement between these parties. This space is used for the operations of our insurance and insurance services segments. CastlePoint Management currently leases office space in Lisle, Illinois which is used for the operations of our insurance services segment.
Tower. In April 2006 we entered into a master agreement, certain reinsurance agreements, a program management agreement and a service and expense sharing agreement with Tower and/or its subsidiaries. We and Tower have subsequently modified certain of these arrangements. Our relationship with Tower and its subsidiaries, including the master agreement and other agreements we entered into with such companies, is described under “Item 1: Business-Description of Our Business Relationships with Tower.”
All of our agreements with Tower, including the alternative insurance risk-sharing agreements, are generally subject to review, approval and requests for modification by the New York State Insurance Department and may be subject to review by the insurance departments of the other domiciliary states of Tower’s domestic insurance companies. All of our agreements with Tower are also subject to the review and approval of the domiciliary states of the U.S. licensed insurance companies we own, to the extent such companies participate in these agreements.
Our consolidated financial statements and the related disclosures included in this report have been prepared in accordance with U.S. GAAP. The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect reported and disclosed amounts of assets and liabilities, as well as disclosure of contingent assets and liabilities at the balance sheet date and the reported amounts of revenues and expenses during the reporting period. Our consolidated financial statements contain certain amounts that are inherently subjective and require management to make assumptions and estimates to determine the reported values. If factors, including those described in “Item 1A: Risk Factors” in this report, cause actual events or results to differ materially from management’s underlying assumptions or estimates, actual results may differ, perhaps substantially, from the estimates.
Estimates are made primarily for unreported written premiums and losses. Differences between estimated and actual unreported written premiums generally do not have a material impact on our financial results, because the unreported written premiums are usually estimated for only the most recent month(s), and the amount of written premiums for the most recent month that is earned as of the end of a given calendar quarter is approximately 1/24 of the written premiums for that month. However, these differences in the estimation of unreported and unpaid losses can have a material impact on our financial results, since the loss reserves accumulate for many years until all losses are paid.
Assumed premiums written and ceded may include estimates based on information received from brokers and ceding companies, and any subsequent differences arising on such estimates are recorded in the periods in which they are determined. Our management estimates premiums on our excess of loss reinsurance contracts when the business is underwritten. For such contracts, the deposit premium, as defined in the contract, is generally considered to be the best estimate of the contract’s written premium at inception. This amount is determined by the underwriters based upon analysis of the prior written premium experience of the ceding companies, plans for growth in the current year as stated by the ceding companies, and our proportion of the ceding companies’ written premiums based upon the terms of the reinsurance contracts. Accordingly, we generally record this amount as written premium in the period in which the underlying risks begin. As actual premiums are reported by brokers or ceding companies, management evaluates the appropriateness of the premium estimate and any adjustment to this estimate is recorded in the period in which it becomes known, which, in some cases, involves reducing premiums to the minimum specified in the contract. In addition, if estimates of unreported written premiums are required for a particular ceding company at the end of an accounting period, the monthly trend in written premiums and historical seasonality of written premiums for these ceding companies are analyzed to determine a best estimate of the unreported written premiums. See Note 2 “Summary of Significant Accounting Policies-Premiums Earned” and “Summary of Significant Accounting Policies-Reinsurance Accounting” to the audited financial statements included elsewhere in this report for a discussion of related accounting policies.
Deposit premiums are generally not changed throughout the term of a reinsurance contract, although this has no impact on final booked net written premiums since the deposit premiums only affect cash receipts.
Reinstatement premiums are written at the time a loss event occurs where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms. Depending on the terms of the reinstatement premiums, they are earned over the remaining risk period or
immediately. Reinstatement premiums are not expected to be a significant portion of our net written premiums, since we do not write significant amounts of property catastrophe excess of loss treaties where reinstatement premiums are common, and in cases where we write such reinsurance, we do not underwrite it in property catastrophe prone areas where reinstatement premiums are more common.
Losses and Loss Adjustment Expense Reserves. Our losses and loss adjustment expense reserves, for both reported and unreported claims obligations, are maintained to cover the estimated ultimate liability for all of our insurance and reinsurance obligations. Losses and loss adjustment expense reserves are categorized in one of two ways: (i) case reserves, which represent unpaid losses and loss adjustment expenses as reported by cedents to us or as estimated by our claims adjusters retained by us, and (ii) incurred but not reported reserves, or IBNR reserves, which are reserves for losses and loss adjustment expenses that have been incurred, but have not yet been reported to us, as well as additional amounts relating to losses already reported, that are in excess of case reserves. IBNR reserves are estimates based on all information currently available to us and are reevaluated on a quarterly basis utilizing the most recent information supplied by our cedents and by our own claims adjusters.
We rely on initial and subsequent claims reports received from the program underwriting agencies administering our programs or risk sharing in our insurance segment or from the ceding companies for whom we provide reinsurance in our reinsurance segment to establish our estimate of losses and loss adjustment expenses. For direct policies generated from our insurance programs, we rely on initial and subsequent claims reports as estimated by claims adjusters retained by us or by the program underwriting managers. For insurance risk sharing, we rely on initial and subsequent claims reports received from the insurance companies with which we do business. For reinsurance we rely on initial and subsequent claims reports received from the companies with which we do business.
Reported claims are in various stages of the settlement process. Each claim is settled individually based on its merits, and certain claims may take several years to settle, particularly where legal action is involved. During this period, additional facts may be revealed, and as these factors become apparent, case reserves will be adjusted, sometimes requiring an increase in our overall reserves, including our IBNR reserves.
adjustment expenses resulting from catastrophic events is inherently difficult because of the possible severity of catastrophe claims, difficulties physically inspecting catastrophe hit areas to estimate claim amounts, and delays in receiving information about claims from program administrators or ceding companies. Therefore, we supplement the methods described above by utilizing commercially available models for purposes of evaluating and providing an estimate of ultimate claims costs.
This information is used to develop point estimates of carried reserves for each business segment and line of business. These individual point estimates, when aggregated, represent the total carried losses and loss adjustment expense reserves reflected in our consolidated financial statements. While we analyze our reserves estimates utilizing different methods, we do not attempt to produce a range around our point estimate of loss. Also, we do not include a specific provision in our loss reserves for adverse deviation. See Note 2 “Summary of Significant Accounting Policies-Liability for Loss and Loss Adjustment Expenses” to our audited financial statements included elsewhere in this report for a discussion of related accounting policies.
The adequacy of our booked loss reserves at CastlePoint Re and CastlePoint Insurance Company are opined upon annually by an independent actuary pursuant to Bermuda and U.S. statutory regulations.
Any future impact to income as a result of changes in losses and loss adjustment expense estimates may vary considerably from historical experience. Our estimates of ultimate loss exposures are based upon the information we have available at any given point in time and our assumptions based upon that information. Changes in estimates of losses and loss adjustment expenses are reflected as adjustments to income in the period in which the estimate is revised. Under U.S. GAAP, we are not permitted to establish loss reserves until the occurrence of an actual loss event, whether reported or unreported. As a result, only loss reserves applicable to losses incurred up to the reporting date may be recorded, with no allowance for the provision of a contingency reserve to account for expected future losses. Losses arising from future events, which could be substantial, are estimated and recognized at the time the loss is incurred.
Estimates of reserves for unpaid losses and loss adjustment expenses also may be impacted by legislative, regulatory, social, economic and legal events and trends that may or may not occur or develop in the future, thereby affecting assumptions in the actuarial projections.
Changes in loss reserves estimates may result from (1) variability in the estimation process itself, and (2) the fact that external factors may cause changes in the future that are not reflected in historical patterns. With respect to the former source of variability, i.e. estimation process variation, we believe that a reasonably likely range for the loss reserves can be represented by a standard utilized by some professional, independent actuaries as part of their certification of an insurer’s reserves. That standard contemplates the number of years of the expected loss payout period (i.e., the longer expected payout period, the more variability inherent in the estimation process and the larger the reasonable range). In considering the business mix between property and casualty lines of business that we write, we believe that a reasonable range surrounding our actuary’s best estimate of loss reserves is from minus 5% to plus 10%. Utilizing this standard as a guide, we believe that most professional actuaries, assuming they are presented with the same information, would determine that the loss reserves can be certified if they fall within a range of minus 5% to plus 10%. Therefore, it is reasonably likely that some professional actuaries, assuming they are presented with the same information relating to our company, would determine a best estimate of our loss reserves to be between $115.4 million and $133.6 million as of December 31, 2007, as compared to our own best estimate of the loss reserves, which is $121.4 million as of that date. If we were to book loss reserves at minus 5% of our actuary’s best estimate, the impact would be an increase of income before income taxes of $6.0 million. Conversely, if we were to book loss reserves at plus 10% of our actuary’s best estimate, the impact would be a reduction of income before taxes of $12.2 million. No assurance can be given that outcomes outside of the above range cannot occur, as outcomes outside of such range are possible. In addition, the above range assumes that future patterns are similar to historical patterns, as to which there can be no assurance. With regard to the potential variability in loss reserves estimates due to the fact that future patterns may differ from historical patterns, we believe there is additional potential variability that cannot be estimated.
Deferred acquisition costs. We defer certain expenses that vary with and are primarily related to the acquisition of new and renewal insurance and reinsurance business, including commission expense on net premiums written, premium taxes, brokerage and certain other costs related to the acquisition of insurance and reinsurance contracts. These costs are capitalized and the resulting asset, deferred acquisition costs, is amortized and charged to expense in future periods as net premiums written are earned. The method followed in computing deferred acquisition costs limits the amount of such deferral to its estimated realizable value. The ultimate recoverability of deferred acquisition costs is dependent on the continued profitability of our insurance and reinsurance underwriting. A probable loss on insurance contracts exists if there is a premium deficiency relating to the policies we write. A premium deficiency is recognized if the sum of expected claim costs and claim adjustment expenses, unamortized acquisition costs and maintenance costs exceeds related unearned premiums. If a premium deficiency exists, it is first recognized by charging any unamortized deferred acquisition costs to expense to the extent required to eliminate the deficiency. If the premium deficiency is greater than unamortized deferred acquisition costs, a liability is accrued for the excess deficiency. In determining whether or not a premium deficiency exists, we group our insurance contracts consistent with the manner of acquiring, servicing and measuring the profitability of our business. See Note 2 “Summary of Significant Accounting Policies-Deferred Acquisition Costs” to our audited financial statements included elsewhere in this report for a discussion of related accounting policies.
The balance in deferred acquisitions cost was $73.1 million as of December 31, 2007. In determining recoverability of deferred acquisition costs, future profitability of our insurance and reinsurance underwriting is considered, including investment income. At each of December 31, 2007, 2006 and 2005, we determined that no premium deficiency existed and that deferred acquisition costs were recoverable.
After recording an other-than-temporary impairment charge of $9.0 million at December 31, 2007, the net unrealized loss for the year ended December 31, 2007 was $1.1 million, including gross unrealized gains of $4.8 million and gross unrealized losses of $5.9 million. Securities in an unrealized loss position are reviewed for impairment on a regular and case-by-case basis, during which we look for deterioration of credit quality and other factors that would adversely affect the price of the security. There could be an instance where a security was in an unrealized loss position and not considered impaired by our management; however, due to changes in our liquidity requirements, a future decision may be made to sell the security at a loss. At the time such a decision is made, if the security were still in an unrealized loss position, we would recognize a charge against net income.
Although we do not anticipate offering reinsurance contracts that do not meet risk transfer requirements, any reinsurance contracts that do not transfer significant insurance risk will be accounted for as deposits. These deposits are accounted for as financing transactions, with interest expense credited to the contract deposit.
We plan to purchase ceded reinsurance, known as reinsurance on primary business and retrocession reinsurance on reinsurance business, to protect our reinsurance subsidiary, CastlePoint Re, as well as CastlePoint Insurance Company, and plan to purchase reinsurance for any other U.S. licensed insurance companies that we may acquire. The reinsurance and retrocession reinsurance we purchase and plan to purchase is intended to bring our aggregate property excess of loss exposure on all of our business on a net basis to less than 10% of our equity. Also, we monitor and may purchase reinsurance and retrocession reinsurance for our primary or reinsurance companies depending upon their risk profile and level of surplus. We may also purchase reinsurance and retrocession protection in situations where we desire to limit our net loss for any single underlying policy to lower amounts, generally to less than 1% of our equity. The costs to obtain reinsurance and retrocession reinsurance are built into the pricing of our programs and reinsurance treaties and, therefore, we do not expect that such costs will materially affect our future results of operations or cash flow.
We use various measures to analyze the growth and profitability of business operations. For insurance and reinsurance business, we measure growth in terms of gross and net premiums written and we measure underwriting profitability by examining our loss, expense and combined ratios. A combined ratio is the sum of the loss ratio and the underwriting expense ratio calculated as described below. We also measure our gross and net written premiums to surplus ratios to measure the adequacy of capital in relation to premiums written. For insurance services, we measure growth in terms of fee income produced for insurance company services provided. We analyze profitability by evaluating income before taxes, generally as a percentage of premium and fee income produced. On a consolidated basis, we measure profitability in terms of net income margins and return on average equity.
Premiums written. We use gross premiums written to measure our sales of insurance and reinsurance products. Gross premiums written also correlate to our ability to generate net premiums earned and, for certain products, fee income.
Realized and unrealized gains and losses from our investment in a limited partnership were recorded as a component of net investment income
The following table summarizes our results of operations for the years ended December 31, 2007 and 2006. Except for a minimal amount of expenses in 2005, there was no activity reported in 2005.
Summary. Despite softening market conditions in the property and casualty industry, we have not experienced significant weakening in pricing or a softening in demand for our products. Management believes that this is in large part due to our emphasis on providing solutions to small insurance companies and program underwriting managers, which results in the transfer by such companies and program underwriting managers to us of large blocks of business composed of small policies. We believe there is a growing industry awareness of our capabilities to provide primary insurance company capacity combined with reinsurance capacity and customized insurance services. We believe this segment of the market is generally underserved by the larger insurers. We target existing profitable, measurable books of business with an actuarial track record. Our senior management is involved in the underwriting assessment of our business.
Net income increased 210.5% to $32.7 million for the year ended December 31, 2007, compared to $10.5 million for the year ended December 31, 2006. Net earned premiums increased 214.5% to $248.4 million, based upon growth from Tower, CastlePoint’s largest client, as well as growth from other clients. CastlePoint Insurance Company implemented its alternative insurance risk-sharing solutions with Tower during 2007, and as a result, wrote $84.2 million in direct premiums from Tower which contributed to $14.4 million of earned premium.
Net income was adversely impacted by an other-than-temporary impairment charge at December 31, 2007 in the amount of $9.0 million included in net realized (loss) gain on investments. See discussion below under “Net investment income and realized gains/(losses).” Operating net income, a non-GAAP measure, increased 296.2% to $41.6 million for the year ended December 31, 2007, compared to $10.5 million for the year ended December 31, 2006.
Total revenues. Total revenues increased by 199.5% to $277.1 million for the year ended December 31, 2007, compared to $92.5 million for the year ended December 31, 2006. The increase is primarily due to the increase in net premiums earned and net investment income.
Revenues for the year ended December 31, 2007 consisted of net premiums earned (89.6% of the total revenues), commission income (2.7% of the total revenues) and net investment income and realized losses (7.7% of the total revenues) compared to net premiums earned (85.4% of the total revenues), commission income (2.5% of the total revenues) and net investment income (12.1% of the total revenues) for the year ended December 31, 2006.
Premiums earned. Net premiums earned increased by 214.5% to $248.4 million for the year ended December 31, 2007 compared to $79.0 million for the year ended December 31, 2006. The increase is due to higher premiums written in 2007 due to our start up in April 2006 and the normal lag between written and earned premiums. The chart shows the percentage of earned premiums related to written premiums.
preferred securities issued in September 2007. The book yield on our invested assets was 5.3% for the year ended December 31, 2007 compared to 5.3% for the year ended December 31, 2006. Our book yield in 2007 was negatively impacted by the recording of an unrealized loss of $2.2 million as a component of net investment income on our investment in a limited partnership. Excluding the unrealized loss, the increase in yield during a generally declining interest rate environment in 2007 is primarily due to an extension in the average duration of our fixed maturity portfolio from 1.97 years at December 2006 to 2.24 years at December 2007, to take advantage of a more normalized yield curve compared with a relatively flat yield curve throughout December 2006 and a slight decrease in the average credit quality of our portfolio from AA+ at December 31, 2006 to AA at December 31, 2007.
Net realized investment losses were $8.2 million for the year ended December 31, 2007, compared with a small gain of $35,000 for the year ended December 31, 2006. We recorded an other-than-temporary impairment charge at December 31, 2007 in the amount of $9.0 million recorded in realized losses. This charge primarily relates to an investment in a fund which was subsequently sold in February 2007 and investments in four mortgage real estate investment trust (“REIT”) equity securities.
Interest Expense. Our interest expense was $9.4 million for the year ended December 31, 2007 compared to $0.6 for the year ended December 31, 2006. Interest expense resulted primarily from the $100 million of subordinated debentures issued by us in December 2006 at an average fixed interest rate of 8.6%, and $30 million of subordinated debentures issued by us in September 2007 at a fixed interest rate of 8.39%.
partnership which was included in net investment income, accounted for negative 9.5 percentage points of the negative 21.8% effective tax rate in 2007, compared with the effective rate of negative 11.6% for 2006. The negative effective rates in both years are due to the losses generated in our U.S. operations, which we believe are recoverable from future taxable income.
Net income and return on average equity. Our net income was $32.7 million for the year ended December 31, 2007 compared to $10.5 million for the year ended December 31, 2006. 2007 operating net income, a non-GAAP measure, was $41.6 million. Our return on average equity was 8.6% for the year ended December 31, 2007 compared to 5.1% for the year ended December 31, 2006. The 2007 operating return on average equity was 10.9%. The return for the year ended December 31, 2007 was calculated by dividing net income of $32.7 million by weighted average shareholders’ equity of $382.1 million. The return for the year ended December 31, 2006 was calculated by dividing net income of $10.5 million by weighted average shareholders’ equity of $207.3 million. The increase in the return on average equity resulted primarily from improved underwriting results. Our consolidated combined ratio improved to 93.9% in 2007 from 101.5% on 2006 primarily from an improvement in the underwriting expense ratio component (see below).
Summary. The Insurance segment had an underwriting loss for the year ended December 31, 2007 in large part due to the cost of purchasing property catastrophe reinsurance. The cost of property catastrophe reinsurance is expensed in the year incurred, and in the first year of operations is therefore high relative to the amount of net premiums earned of $19.1 million, which was only 21% of net premiums written in this first year of operations for this segment. On a gross of reinsurance basis, the combined ratio was 94.3% which reflects solid underlying profitability, and when the premiums earned increase relative to premiums written the net combined ratio is expected to decrease and be closer to the gross combined ratio. Premiums written in the year ended December 31, 2007 increased significantly based upon implementation of the alternative insurance risk-sharing solutions with Tower which generated $84.2 million in premiums written during the period, as well as premiums written of $11.1 million on a risk-sharing arrangement with another client.
Gross premiums and net premiums. Gross and net premiums written were $111.0 million and $91.4 million, respectively, for the year ended December 31, 2007. Gross and net premium earned were $25.1 million and $19.1million, respectively, for the year ended December 31, 2007. CastlePoint Insurance Company’s gross premiums written are primarily comprised of $13.6 million through programs managed by CastlePoint Management, approximately $84.2 million of direct business that was produced by Tower Risk Management Corp., a subsidiary of Tower and $12.5 million assumed from Tower under the brokerage quota share agreement. The ceded premium consisted of excess of loss and catastrophe premium of which approximately 37.9% was ceded to third-party reinsurers and 62.1% to CastlePoint Re.
Underwriting expenses and underwriting expense ratio. Underwriting expenses for the year ended December 31, 2007 for the insurance segment were $8.4 million, comprised primarily of commission and other underwriting expenses. Commission expense was $7.8 million and other underwriting expenses included $0.4 million in boards, bureaus and taxes, and a minimal amount for other operating expenses for the year ended December 31, 2007. The gross underwriting expense ratio was 33.6% and the net underwriting expense ratio was 44.1% for the year ended December 31, 2007.
Underwriting loss and net combined ratio. The underwriting loss and net combined ratio from the insurance segment was $1.1 million and 105.8%, respectively, for the year ended December 31, 2007.
The following table summarizes the results of operations for our reinsurance segment for the years ended December 31, 2007 and 2006.
Gross premiums and net premiums. Gross and net written premiums increased 72.5% to $284.8 million for the year ended December 31, 2007 from $165.2 million for the year ended December 31, 2006. Business not originated from Tower and CastlePoint Insurance Company represents 26% or $73.2 million of the total written premiums compared to 5% or $7.5 million during the year ended December 31, 2006. Gross and net premiums earned increased by 190.4% to $229.3 million for the year ended December 31, 2007 from $79.0 million for the year ended December 31, 2006. The increase is attributable to the fact we have a full year of written premium included in our earned premium for the year ended December 31, 2007 compared to only three quarters of written premium included for the same period in 2006 and the time lag between writing and earning premiums in a start up company. During the year ended December 31, 2007, CastlePoint Re added 13 new quota share reinsurance agreements (resulting in earned premium of $24.0 million) and 11 new excess of loss reinsurance agreements / property catastrophe treaties (resulting in earned premium of $4.2 million). Of the $24.0 million of earned premium resulting from the 13 new quota share reinsurance agreements, approximately 79% pertains to non-standard auto business and approximately 10% pertains to workers’ compensation business. CastlePoint Re’s new nonstandard auto clients range from mid-size
Loss and loss adjustment expenses and loss ratio. Loss and loss adjustment expenses increased by 191.9% to $119.6 million, which produced a 52.1% loss ratio for the year ended December 31, 2007 compared to $41.0 million, which produced a 51.9% loss ratio, for the year ended December 31, 2006. Of this $78.6 million increase, $51.6 million was due to new contracts, $31.1 million was due to additional earned premium on contracts written in 2006 and $(4.1) million was due to change in reserve estimates on contracts written in 2006. The 13 new quota share reinsurance agreements written in 2007 had an aggregate loss ratio of 67.1% for the year ended December 31, 2007 and the 11 new excess of loss reinsurance agreements had an aggregate loss ratio of 44.3% for the year ended December 31, 2007. The loss ratios on most of the treaties were approximately equal to our pricing expectations, except for Tower business which had a better than expected loss ratio.
Underwriting expenses and underwriting expense ratio. Underwriting expenses for the reinsurance segment are comprised of ceding commission paid to insurance companies, which cede business to CastlePoint Re, and other underwriting expenses. Ceding commission expense was $77.6 million and other underwriting expenses were $3.5 million for the year ended December 31, 2007 compared to $27.2 million and $1.4 million, respectively, for the year ended December 31, 2006. The gross underwriting expense ratio and the net underwriting expense ratio were 35.3% and 35.4%, respectively, for the year ended December 31, 2007 compared to 36.2% for both for the year ended December 31, 2006. The lower underwriting expense ratio is due to spreading certain fixed costs over a larger earned premium base.
The following table summarizes the results of operations for our insurance services segment for the years ended December 31, 2007 and 2006.
Insurance services loss. Insurance services loss was $5.5 million for the year ended December 31, 2007 compared to $3.0 million for the year ended December 31, 2006 due to CastlePoint Management’s current incurrence of costs to produce programs that are expected to generate commission revenue in future periods due in part to the lag time associated with launching new programs that require rates and forms to be filed and approved, as well as systems to be implemented.
CastlePoint Holdings is a holding company, and as such, has no direct operations of its own. We expect substantially all of our operations to be conducted by our insurance, reinsurance, and management company subsidiaries. Accordingly, we expect to have continuing cash needs for administrative expenses, dividends and the payment of principal and interest on any current and future borrowings and any future taxes and to make strategic investments. Funds to meet
In our operating subsidiaries, we try to maintain sufficient liquidity to pay claims, operating expenses and meet our other obligations. On a consolidated basis, we held $153.6 million and $34.8 million of cash and cash equivalents at December 31, 2007 and 2006, respectively, all of which had maturities of 90 days or less rated A-1/P-1 or above. We monitor our expected claim payment needs and try to maintain a sufficient portion of our invested assets in cash and cash equivalents to enable us to fund our claim payments without having to sell longer-duration investments prior to maturity. As of December 31, 2007, cash and cash equivalents exceeded the booked reserves of $121.4 million, of which $33.6 million is expected to be paid within the next year. The $118.8 million increase in cash and cash equivalents as of December 31, 2007 compared to December 31, 2006 was due to management’s decision to invest funds short term and not take on additional interest rate risk associated with longer-term investments as well as the receipt of $30.0 million of new cash from the trust preferred offering in September 2007 that had not yet been invested. The average weighted yield on cash and cash equivalents at December 31, 2007 was 3.5%. We expect that the majority of these cash funds will be reinvested in longer term investments over the next few months to take advantage of the recent steepening of the yield curve. We expect our portfolio duration to increase from 2.24 years at December 31, 2007 to approximately 3.0 years within the next several months. We believe a target of 3.0 years provides adequate matching of our portfolio assets with expected claim payouts. We also expect our cash flow from operations to continue to be strong throughout 2008 as we expect our premiums written to continue to increase.
Bermuda. Bermuda legislation imposes limitations on the dividends that CastlePoint Re may pay. We are subject to Bermuda regulatory constraints that affect our ability to pay dividends on our shares and make other payments. Under the Companies Act 1981 of Bermuda, as amended (the “Companies Act”), we may declare or pay a dividend out of distributable reserves only if we have reasonable grounds for believing that we are, or would after the payment, be able to pay our liabilities as they become due and if the realizable value of our assets would thereby not be less than the aggregate of our liabilities and issued share capital and share premium accounts.
Additional U.S. licensed insurance companies we may acquire or form and capitalize will be subject to regulation by their respective states of domicile. Under most U.S. state insurance laws, prior regulatory approval is generally required for the payment of dividends or distributions which, together with any other dividends and distributions paid during the immediately preceding twelve month period exceed the greater of 10% of statutory capital and surplus or the prior calendar year’s net income or net investment income. Additionally, dividends generally may only be paid out of an insurer’s earned surplus.
For the year ended December 31, 2007, net cash provided by operating activities was approximately $140.7 million compared to $62.6 million for the year ended December 31, 2006. The increase in net cash provided by operations resulted primarily from the increase in collected premiums as a result of the growth in premiums written. For the year ended December 31, 2007 net cash flows used in investing activities was approximately $162.8 million compared to $385.8 million for the year ended December 31, 2006, which consisted of purchases and sales of investments.
In 2007 we received cash, and in 2008 we expect to receive cash, from direct and assumed premiums collected, net cash settlements under our insurance risk sharing and reinsurance agreements, fee income for services provided, investment income and proceeds from sales and redemptions of investments. We also expect that we will raise additional funds in the future through additional equity and/or additional debt financings.
We constantly monitor and review our internal capital allocation, the performance of our investment portfolio, the need for new debt and or new capital raises and potential acquisitions.
We are subject to U.S. federal, state and local income tax requirements in the states in which we operate. We are not subject to income tax in Bermuda. Actual tax expense is based on taxable earnings reported by our U.S. operations arising from underwriting results, investment income and other income less expense items. Our effective tax rate reflects the proportion of taxable income recognized by our operating subsidiaries, including CastlePoint Management Company and CastlePoint Insurance Company and any U.S. based subsidiaries we expect to acquire or form and capitalize in the future, subject to receipt of regulatory approvals, that generally will be taxed at the U.S. corporate income rate (35%), and CastlePoint Re, which is exempt from corporate tax. CastlePoint Management is taxed by New York State at the rate of 7.5%, net of the federal tax benefit. There is also a 30% withholding tax imposed on dividends, if any, paid to us by our U.S.-based subsidiaries.
Property and casualty insurance and reinsurance premiums are established based upon our estimates at the time of the amount of losses and loss adjustment expenses that have been incurred in the past for similar types of business. We attempt to estimate the potential impact of inflation on losses and loss adjustment expenses in establishing our premiums, but we cannot be certain about the extent to which inflation may affect such amounts. Inflation in excess of the levels we have assumed could cause losses and losses adjustment expenses to be higher than we anticipated and therefore insurance and reinsurance premiums to be inadequate.
The Company has developed specific investment objectives and guidelines for the management of its investment portfolio. These investment guidelines stress capital preservation and maximization of after tax investment income through the maintenance of liquidity, risk diversification and credit quality. Generally, we invest our assets in relatively liquid, high-grade fixed maturity securities of relatively short duration. We seek to manage our credit risk through issuer and industry diversification and interest rate risk by monitoring the duration and structure of the portfolio. Despite the prudent focus of these objectives and guidelines, the Company’s investments are subject to general market risk, as well as to risks inherent to particular securities.
The aggregate fair market value of our available-for-sale investments as of December 31, 2007 was $527.4 million, which excludes our investment in common trust securities of the three statutory business trusts described under “-Off-Balance Sheet Transactions” below and excludes our investment in a limited partnership. Our fixed maturity securities as of this date had a fair market value of $485.0 million and an amortized cost of $484.5 million. Short-term investments were carried at fair value of $0 as of December 31, 2007 compared to $51.6 million as of December 31, 2006.
At December 31, 2007 we held $153.6 million of cash and cash equivalents, which include all securities that, at their purchase date, have a maturity of 90 days or less, of which $30 million was uninvested cash resulting from the proceeds from the offering by CastlePoint Bermuda Holdings of trust preferred securities, which we received at the end of September 2007. The average yield on cash and cash equivalents held at December 31, 2007 was approximately 3.5%. During 2007, our investment manager recommended overweight positions in mortgages, favoring pass-through instruments and high quality collateralized mortgage obligations and
commercial mortgage backed securities. Our investment manager recommended underweight positions in virtually all other sectors. However, since we did not wish to materially increase our exposure to mortgages at this time, we decided to maintain a relatively high amount of cash and cash equivalent balances.
The portfolio duration of the fixed maturity securities at December 31, 2007 was approximately 2.24 years (1.97 years at December 31, 2006) and the average credit rating was AA (AA+ at December 31, 2006).
Included in “Equity securities” on the balance sheet at December 31, 2007, the Company held an investment in the amount of $13.9 million in a fund that invests in primarily floating rate mortgage and asset backed securities with 40% of the funds assets invested in home equity loans backed by subprime mortgages at December 31,2007. As further described below, we recorded an other-than-temporary impairment charge at December 31, 2007 in the amount of $7.1 million on this investment and then subsequently sold this investment on February 1, 2008 for an additional loss of $0.2 million. Additionally, we have no Alternative A (defined as risks falling between prime and subprime) mortgage exposure in our portfolio or in any of the funds in which we have invested. Also in this category we have an investment of $9.9 million in a fund comprised of primarily investment grade securities with a focus on the financial institutions segment of the credit markets (i.e., primarily trust preferred, subordinated debt and preferred securities). We also hold a $2.3 million investment in a fund investing primarily in securitized bank loans and we hold $2.1 million of publicly traded common stocks whose purpose is to own various mortgage backed securities, including CMBS, non-agency RMBS, and RMBS backed by
U.S. government or government chartered agencies. We recorded an other-than-temporary impairment charge on these common stock securities at December 31, 2007 in the amount of $1.8 million because we do not necessarily have the intent to hold these securities until full recovery. The remaining investments in this category are preferred stocks in the finance and banking industries in the amount of $14.2 million with an average rating of A+.
We constantly monitor our exposure to “real estate” related securities (i.e., commercial and residential mortgage backed securities, asset backed securities backed by home equity loans and mortgage real estate investment trust (“REIT”) securities, whether directly held or held in a fund). Our total exposure to real estate related securities at December 31, 2007 of $306.0 million represented 44.1% of cash and invested assets. At December 31, 2007, of the total $306.0 million exposure to real estate related securities, $284.0 million was rated AAA, of which $154.9 million were U.S. obligations backed by U.S. government or government chartered agencies. Of the remaining $22.0 million, $20.2 million was rated BBB (including the average BBB rating of the underlying securities of an investment in a fund in the amount of $13.9 million) and $1.8 million was rated BB. The $13.9 million represents an investment in a fund (included in equity securities, see above and below) with 40% subprime exposure that was subsequently sold in 2008. We recorded an other-than-temporary impairment charge at December 31, 2007 in the amount of $7.1 million and recorded a loss on the sale in 2008 of $0.2 million. The $2.5 million of assets backed by home equity loans represents subprime exposure and is rated AAA. We recorded an other-than-temporary impairment loss on these securities at December 31, 2007 in the amount of $33,000, since we did not have the intent to hold these securities until a full recovery. We subsequently sold these securities in February 2008 for a loss of $65,000. Therefore, as of the date of this annual report, we have no subprime or Alternative A exposure.
Corporate Fixed Maturities. The unrealized loss position of $1.4 million in corporate fixed maturities relates to 17 securities all rated BBB or above and all of which have been in an unrealized loss position for less than 12 months as of December 31, 2007. The security with the largest unrealized loss in this group of $0.6 million is Lehman Brothers Holdings, Inc., issued May 17, 2007, with a coupon of 5.86% and a book yield of 6.04%, rated A-. The brokerage sector has been negatively impacted by the general market disruptions caused by the significant decline in market liquidity. The remaining corporate securities are distributed over the following industries - banks, brokerage, insurance, other finance, media, pipelines and utilities. The impairment on all fixed corporate maturities is considered temporary at December 31, 2007 and is generally the result of widening spreads during the fourth quarter. The Company has both the ability and intent to hold these securities until a full recovery of fair value, which may not be until maturity.
Mortgage and Asset Backed Securities. The unrealized loss in mortgage and asset backed securities of $2.9 million relates to 23 issues, with 18 issues rated AAA ($0.2 million), 4 issues rated BBB ($2.0 million) and 1 issue rated BB ($0.7 million). All of these securities, except for certain positions with unrealized losses amounting to $11,000, had been in an unrealized loss position for less than 12 months as of December 31, 2007. The five securities rated BBB and BB are CMBS and were purchased after June 30, 2007. Since all five securities are rated less than AA, a cash flow analysis was performed pursuant to Emerging Issues Task Force (“EITF”) 99-20. None of these securities indicated a reduction in cash flow on a present value basis from what was originally expected at the date of purchase. The impairment on all mortgage and asset backed securities, except as discussed below, is considered temporary at December 31, 2007 and is due to the market disruptions caused by the significant decline in market liquidity affecting this sector. The Company has both the ability and intent to hold these securities until a full recovery of fair value, which may not be until maturity.
Equity Securities. The unrealized loss in equity securities of $1.7 million relates to 9 issues. These securities had been in an unrealized loss position for less than 12 months as of December 31, 2007. The largest single equity security in an unrealized loss position at December 31, 2007 was an investment in a fund comprised primarily of collateralized bank loans with an unrealized loss of $0.7 million. The loans have floating rates. The collateralization makes the loans structurally senior in priority to corporate bonds from the same issuers, providing additional credit protection. This security had been in an unrealized loss position for less than 6 months as of December 31, 2007. The unrealized loss is due to market disruptions caused by the significant decline in market liquidity and the general spread widening during the fourth quarter. The remaining unrealized loss of $1.0 million is comprised of 8 preferred stock issues with no individual unrealized loss at December 31, 2007 exceeding $0.2 million. The Company has both the ability and intent to hold all equity securities that were in a loss position at the end of 2007, other than the securities discussed below, until a full recovery of fair value.
The unrealized loss on the four equity securities, all of which are mortgage real estate investment trusts (“REITs”), was $1.8 million and these securities were in an unrealized loss position for less than twelve months. The market values at December 31, 2007 were 54% of cost. These four equity securities are all publicly traded mortgage REITs whose purpose is to own various mortgage backed securities, including CMBS, and agency and non-agency residential MBS. To date, these equity securities continue to generate the earnings necessary to continue the dividend payments. However, the biggest risk of not generating earnings and therefore discontinuing dividend payments is if the funds are forced to unwind holdings due to the inability to borrow against current holdings due to market prices that are based on distressed sale levels vs. actual value. Based on the magnitude of the unrealized loss and the time period it may take for full recovery, we do not necessarily have the intent to hold these securities until full recovery. Therefore, we considered them other-than-temporarily impaired at December 31, 2007.
The subordinated debentures are unsecured obligations of CastlePoint Management and CastlePoint Bermuda Holdings and are subordinated and junior in right of payment to all its present and future senior indebtedness. CastlePoint Management and CastlePoint Bermuda Holdings and CastlePoint Holdings issued guarantees in favor of the holders of the preferred securities of the trusts, all of which provide for full and unconditional guarantee of the guaranteed securities. All of these subordinated debentures have stated maturities of thirty years. CastlePoint Management and CastlePoint Bermuda Holdings have the option to redeem any or all of the subordinated debentures beginning five years from the date of issuance, at the principal amount plus accrued and unpaid interest. The interest rate on the subordinated debentures is a combination fixed and floating rate with a fixed rate equal to 8.66% per annum with respect to the subordinated debentures issued on December 1, 2006, 8.551% per annum with respect to the subordinated debentures issued on December 14, 2006, and equal to 8.39% per annum with respect to the subordinated debentures issued on September 27, 2007, all during the first five years, after which the interest rate will be equal to the three month London Interbank Offered Rate (“LIBOR”) plus 3.5% per annum (calculated quarterly). If CastlePoint Management or CastlePoint Bermuda Holdings chose to redeem the subordinated debentures, the trusts would then redeem the trust preferred securities at the same time.
We anticipate that CastlePoint Re will not be licensed, accredited or otherwise approved as a reinsurer anywhere in the United States. All U.S. jurisdictions prohibit insurance companies from taking credit for reinsurance obtained from unlicensed or non-admitted insurers on their U.S. statutory financial statements without appropriate security. Therefore, insurance companies in these jurisdictions will only receive credit for reinsurance purchased from CastlePoint Re to the extent that CastlePoint Re provides adequate security for the reinsurance obligations. This type of security is typically provided by posting a letter of credit for the benefit of the primary insurer or through the deposit of assets into a trust fund established for the benefit of the primary insurer in accordance with state regulation. The amount of the letter of credit or trust is generally required to be adjusted each calendar quarter. Under the terms of the quota share reinsurance agreements between CastlePoint Re and Tower’s insurance companies, CastlePoint Re is required to provide security to Tower’s insurance companies to support reinsurance recoverables owed to these reinsureds in a form acceptable to the insurance commissioners of the State of New York and Commonwealth of Massachusetts, the domiciliary states of Tower’s insurance companies. CastlePoint Re is also required by its reinsurance agreements with its other cedents to collateralize amounts through a letter of credit, cash advance, funds held or a trust account meeting the requirements of the applicable state insurance regulations. If we are unable to provide the necessary security, insurance companies may be prohibited from purchasing our reinsurance products, which could adversely affect us.
In connection with posting of security as described above, CastlePoint Re will file annual statements in the states of domicile of its reinsureds, to the extent required.
seeking to qualify as an eligible or approved excess or surplus lines insurer in certain U.S. jurisdictions.
In 2006, we formed two Delaware statutory business trusts of which CastlePoint Management owns all of the common trust securities, to facilitate the trust preferred financing completed in December 2006.
We lease and/or sublease office space in (i) Hamilton, Bermuda, (ii) New York, New York and (iii) Lisle, Illinois. CastlePoint Re executed a sublease agreement for premises in Hamilton, Bermuda, as of September 1, 2006, which is expected to expire on June 30, 2012. In December
The timing and amounts of actual claims payments related to loss reserves vary based on many factors, including large individual losses, changes in the legal environment, as well as general market conditions. The ultimate amount of the claims payments could differ materially from the amounts estimated by us. For more information regarding estimates for unpaid loss and loss adjustment expenses, as well as factors affecting potential payment patterns of reserves for actual and potential claims related to our lines of business, see “Critical Accounting Estimates-Losses and Loss Adjustment Expense Reserves” above. Certain of our lines of business may have loss experience characterized as low frequency and high severity. This may result in significant variability in loss payment patterns and, therefore, may impact the related asset/liability investment management process.
See our consolidated Financial statements and notes thereto and required Financial statement schedules on pages through and S-1 through S-7 below.