Statement of operations data and balance sheet data of the Company for the years ended December 31, 2007 and 2006 and for the period October 4, 2005 through December 31, 2005 are derived from our audited consolidated financial statements included in Item 8 of this Form 10-K, which have been prepared in accordance with U.S. GAAP.
(1) Earnings (loss) per common share is a measure based on our net income (loss) divided by our weighted average common shares outstanding. Basic earnings (loss) per common share is defined as net income (loss) divided by the weighted average common shares outstanding and weighted average vested RSUs for the period, giving no effect to dilutive securities. Diluted earnings (loss) per common share is defined as net income (loss) divided by the weighted average common shares and common share equivalents outstanding calculated using the treasury stock method for all potentially dilutive securities, including the Warrant, PSUs, and RSUs. The issuance of shares with respect to the PSUs is contingent upon the attainment of certain levels of diluted return-on-equity (“DROE”). Because the number of common shares contingently issuable under the PSU Plan depends on the average DROE over a three year period, the PSUs are excluded from the calculation of diluted earnings per share until the end of the performance period, when the number of shares issuable under the PSU Plan will be known. When the effect of securities would be anti-dilutive, these securities are excluded from the calculation of diluted earnings (loss) per common share. The warrant was anti-dilutive and was excluded from the calculation of diluted earnings per common share for the years ended December 31, 2007 and 2006 and the period from October 4, 2005 through December 31, 2005.
(2) The loss ratio is calculated by dividing loss and loss adjustment expenses by net premiums earned.
(5) The combined ratio is the sum of the loss ratio, the acquisition cost ratio and the general administrative expense ratio.
(7) Diluted book value per common share is defined as total shareholders’ equity divided by the number of common shares and common share equivalents outstanding at the end of the period, including the Warrant, PSUs, and RSUs. When the effect of securities would be anti-dilutive, these securities are excluded from the calculation of diluted book value per common share. The warrant was anti-dilutive and was excluded from the calculation of diluted book value per common share for the years ended December 31, 2007 and 2006 and for the period ended December 31, 2005.
As of January 1, 2007, we adopted SFAS 157 and SFAS 159. As a result, substantially all of our investments are now carried at fair value with changes in fair value being reported as net realized and unrealized gains (losses) in our statement of operations. Prior to the adoption of SFAS 157 and SFAS 159, our available for sale investments were carried at fair value with changes in fair value with changes therein reported as a component of other comprehensive income
The various components of our operating model are unified through our centralized management in Hamilton, Bermuda, and integrated through our use of advanced technology. Our Bermuda-based underwriters are complemented with a separately licensed and staffed European underwriting platform, Flagstone Suisse, based in Martigny, Switzerland. We recently established a Middle East and North Africa presence with the establishment of an office in Dubai in addition to an office in Puerto Rico focused on sourcing Caribbean and Latin American risks. Our research and development efforts and part of our catastrophe modeling and risk analysis team is based in Hyderabad, India, and our international reinsurance marketing operations are conducted from London, England. Our computer data center is in our Halifax, Canada office, where we also run support services such as accounting, claims, application support administration and software development. The result is an operating platform which provides significant efficiencies in our operations and access to a large and highly qualified staff at a relatively low cost.
Management views the operations and management of the Company as one operating segment and does not differentiate its lines of business into separate reporting segments. We regularly review our financial results and assess our performance on the basis of our single operating segment.
We measure our financial success through long term growth in diluted book value per share plus accumulated dividends, which we believe is the most appropriate measure of the performance of the Company, a measure that focuses on the return provided to the Company’s common shareholders. Diluted book value per share is obtained by dividing shareholders equity by the number of common shares and common share equivalents outstanding.
Interest expense consists primarily of the interest expense related to the Deferrable Interest Debentures and the Junior Subordinated Deferrable Interest Notes that were issued by the Company in 2006 and 2007.
Minority interest consists of the minority interest relating to Mont Fort and Island Heritage. The portions of Mont Fort’s net income and shareholders’ equity attributable to holders of the preferred shares for the year ended December 31, 2007 and the portions of Island Heritage’s net income and shareholders’ equity attributable to minority shareholders’ for the year ended December 31, 2007 are recorded in the consolidated financial statements of the Company as minority interest.
It is important to understand our accounting policies in order to understand our financial position and results of operations. Our consolidated financial statements contain certain amounts that are inherently subjective in nature and have required management to make assumptions and best estimates to determine the reported values. If events or other factors, including those described in Item 1A, “Risk Factors,” cause actual events or results to differ materially from management’s underlying assumptions or estimates, there could be a material adverse effect on our results of operations, financial condition and liquidity.
For our property catastrophe policies which comprise 71.3% and 72.4% of our gross premiums written for the years ended December 31, 2007 and 2006, respectively, and other catastrophe policies, we initially establish our loss reserves based on loss payments and case reserves reported by ceding companies. We then add to these case reserves our estimates for IBNR. To establish our IBNR estimates, in addition to the loss information and estimates communicated by cedents, we use industry information, knowledge of the business written by us, management’s judgment and general market trends observed from our underwriting activities.
Expected Loss Ratio Method. To estimate ultimate losses under the expected loss ratio method, we multiply earned premiums by an expected loss ratio. The expected loss ratio is selected utilizing industry data, historical company data and professional judgment. The Company uses this method for lines of business and contracts where there are no historical losses or where past loss experience is not credible.
Initially selected expected loss ratios are used while the exposure is earning. We assign payment and reporting patterns for attritional business to use with paid development, incurred development, and paid and incurred Bornheutter-Ferguson methods. We maintain an expected loss ratio through the exposure earning period followed by selections of Bornheutter-Ferguson paid and reported during intermediate reporting periods. Later, through the development, we revert from Bornheutter-Ferguson paid and reported to paid and reported development methods to fully reflect account exeperience. This entails a reasonable evolution from initial expected loss ratios to full account experience through a tempering phase of Bornheutter-Ferguson weightings. We maintain a conservative bias toward the selection of Bornheutter-Ferguson paid and reported methods on accounts with losses paid or reported earlier while holding expected loss ratios on loss free accounts where no paid or reported losses have yet occurred early in the account's maturation.
For our non-catastrophe business, the key factors used to arrive at our best estimate of loss and loss adjustment expense reserves are the expected loss ratios, rate of loss cost inflation, selection of benchmarks and reported and paid loss emergence patterns. Our reporting patterns and expected loss ratios were based on either benchmarks or historical reporting patterns. The benchmarks selected are those that we believe are most similar to our underwriting business. There were no material changes in any of these key factors during the year ended December 31, 2007.
We recognize premiums as revenue ratably over the terms of the related contracts and policies. Our gross premiums written are based on policy and contract terms and include estimates based on information received from both insured and ceding companies. The information received is typically in the form of bordereaux, broker notifications and/or discussions with ceding companies or their brokers. This information can be received on a monthly, quarterly or transactional basis and normally includes estimates of gross premiums written (including adjustment premiums and reinstatement premiums), net premiums earned, acquisition costs and ceding commissions. Adjustment premiums are premiums due to either party when the contract's subject premium is adjusted at expiration and is recorded in subsequent periods. Reinstatement premiums are premiums charged for the restoration of a reinsurance limit of an excess of loss contract to its full amount after payment of losses as a result of an occurrence.
Prior to January 1, 2007, investments were considered available-for-sale in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS 115”), and were carried at fair value with unrealized gains and losses recorded in accumulated other comprehensive income. Following the issuance by the FASB of SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115” (“SFAS 159”), the Company elected to early adopt the fair value option for all fixed maturity investments, equity investments (excluding investments accounted for under the equity method of accounting), real estate investment trusts (“REITs”), investment funds, catastrophe bonds, and fixed income funds commencing January 1, 2007. This election requires the Company to adopt SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), regarding fair value measurements. The valuation technique used to fair value the financial instruments is the market approach which uses prices and other relevant information generated by market transactions involving identical or comparable assets.
The table above does not include an equity investment of $0.1 million in which the Company is deemed to have a significant influence and is accounted for under the equity method, and as such, is not accounted at fair value under SFAS 159.
The PSU Plan is the Company’s shareholder-approved primary executive long-term incentive scheme. Pursuant to the terms of the PSU Plan, at the discretion of the Compensation Committee of the Board of the Directors, PSUs may be granted to executive officers and certain other key employees. The current series of PSUs vests over a period of approximately three years and vesting is contingent upon the Company meeting certain diluted return-on-equity goals. Future series of PSUs may be granted with different terms and measures of performance.
Upon vesting, the existing PSU holders will be entitled to receive a number of common shares of the Company (or the cash equivalent, at the election of the Company) equal to the product of the number of PSUs granted multiplied by a factor. The factor will range between zero and 200%, depending on the diluted return-on-equity achieved during the vesting period.
344,000 PSUs granted between April 1, 2006 and May 22, 2006 valued at $10.07. The fair value was determined by using the price to book value multiple of a group of comparable publicly traded reinsurers and adjusting it downward. In adjusting the price to book value multiple, we took into account that our common shares were relatively illiquid at the time of these PSU grants and the fact that these comparable reinsurers have longer track records, more mature infrastructures and more established franchises than us.
672,000 PSUs granted between January 1, 2007 and March 31, 2007 valued at $13.50. The fair value was determined by using the stock price of the IPO that occurred on March 30, 2007.
As highlighted in the table below, the three most significant items impacting our 2007 financial performance compared to 2006 and 2005 include: (1) an increase in our net premiums earned, principally resulting from the growth in business by increased participation on programs from our existing clients and the addition of new clients due to our increased capital base and growth in our franchise; (2) an increase in loss and loss adjustment expenses in 2007 impacted by Windstorm Kyrill, U.K. floods and New South Wales storms versus light catastrophe activity in 2006; and (3) a significant increase in investment income due to higher average invested assets from the generation of cash flows from operations and financing activities.
Details of gross premiums written by line of business and by geographic area of risk insured are provided below:
Our property catastrophe reinsurance contracts provide protection for most catastrophic losses that are covered in the underlying insurance policies written by our ceding company clients. Property catastrophe reinsurance contracts are typically “all risk” in nature, meaning that they protect against losses from earthquakes and hurricanes, as well as other natural and man-made catastrophes such as tornados, fires, winter storms, and floods (where the contract specifically provides for coverage). Losses on these contracts typically stem from direct property damage and business interruption.
For the years ended December 31, 2007 and 2006, gross property catastrophe premiums written were $411.6 million and $219.1 million, respectively, comprising business written on the key renewal dates of January 1, April 1, June 1 and July 1. The $192.5 million (87.8%) increase in property catastrophe premiums written during 2007 was primarily due to the increased participation on programs from our existing clients, the addition of new clients due to our increased capital base, growth in our franchise and the acquisition of the controlling interest in Island Heritage in July 2007 which resulted in the inclusion of $32.9 million in gross premiums for the year ended December 31, 2007.
Reinsurance premiums ceded for the years ended December 31, 2007 and 2006 were $50.1 million (8.7% of gross written premiums) and $20.0 million (6.6% of gross written premiums), respectively.
For the year ended December 31, 2007, the Company purchased common account reinsurance of $3.5 million and purchased $27.1 million of opportunistic and core reinsurance protection to optimize our overall risk profile. In addition, the acquisition of the controlling interest in Island Heritage resulted in the inclusion of $19.5 million in our ceded premiums for the year.
As the Company grows its book of business, the need for additional retrocessional coverage will also grow. We will continue to assess the need for retrocessional coverage and may purchase additional coverage in future periods.
We write the majority of our business on a losses occurring basis. A “losses occurring” contract covers claims arising from loss events that occur during the term of the reinsurance contract, although not necessarily reported during the term of the contract. The premium from a losses occurring contract is earned over the term of the contract, usually twelve months. In contrast, a “risks attaching” contract covers claims arising on underlying insurance policies that incept during the term of the reinsurance contract. The premium from a risks attaching contract generally is earned over a period longer than twelve months.
Net premiums earned for the years ended December 31, 2007 and 2006 were $477.1 million and $192.1 million, respectively. The increase of $285.0 million, during 2007, or 148.4%, is primarily due to the increased levels of net premiums written over the last twelve months, and the acquisition of the controlling interest in Island Heritage in July 2007 which resulted in the inclusion of $12.9 million in net premiums earned for the year ended December 31, 2007. The large difference between net premiums written and net premiums earned during the years ended December 31, 2007 and 2006 reflects the fact that most of our contracts are written on an annual basis, with the premiums earned over the course of the contract period. The majority of our business is written at the January 1, April 1, June 1 and July 1 renewal periods and therefore it is reasonable to anticipate that the earned premiums would generally increase over the course of the fiscal year as premiums written in earlier months are increasingly earned.
The increase in the loss ratio of 26.5% in 2007 is as a result of the catastrophe events that occurred in 2007 (described below) compared to the light insured catastrophe activity experienced in 2006.
Loss and loss adjustment expenses for the years ended December 31, 2007 and 2006 were $192.9 million and $26.7 million, respectively. The components of loss and loss adjustment expenses of $192.9 million for the year ended December 31, 2007 include $39.6 million paid losses and our actuaries’ estimate of case reserves and IBNR on premiums earned to date of $153.3 million. The change in the case reserves and IBNR of $153.3 million includes the following key loss events: $32.4 million for losses from Windstorm Kyrill in January 2007; $38.0 million for United Kingdom flood losses in June and July 2007; $18.5 million for New South Wales (Australia) flood losses in June 2007; $13.8 million for three satellite losses during 2007; and $11.4 million for the Sydney (Australia) hailstorm in December 2007.
Because of our short operating history, our loss experience is limited and reliable evidence of changes in trends of numbers of claims incurred, average settlement amounts, numbers of claims outstanding and average losses per claim will necessarily take years to develop. A significant portion of our business is property catastrophe reinsurance and other classes of reinsurance with high attachment points of coverage. Attachment points refer to the dollar amount of loss above which excess of loss reinsurance becomes operative. Reserving for losses in such programs is inherently complicated in that losses in excess of the attachment level of our policies are characterized by high severity and low frequency. In addition, as a broker market reinsurer, we must rely on loss information reported to such brokers by primary insurers who must estimate their own losses at the policy level, often based on incomplete and changing information. See “-Critical Accounting Policies-Loss and Loss Adjustment Expense Reserves” and Item 1A, “Risk Factors-Risks Related to the Company.” If we underestimate our loss reserves, so that they are inadequate to cover our ultimate liability for losses, the underestimation could materially adversely affect our financial condition and results of operations.
For the years ended December 31, 2007 and 2006, acquisition costs were $82.3 million and $29.9 million, respectively, representing an increase of 174.9%. Acquisition costs consist principally of ceding commissions, brokerage, premium taxes, profit commissions and other expenses that relate directly to the writing of reinsurance contracts. Acquisition costs are driven by contract terms and are generally determined based upon a set percentage of premiums. Acquisition costs are expensed over the period of their related contracts. The acquisition cost ratio has increased 1.6% from 2006 due to increased levels of proportional contracts written in 2007 which typically have higher levels of acquisition costs.
Interest expense was $18.7 million for the year ended December 31, 2007 compared to $4.6 million for the year ended December 31, 2006. Interest expense primarily consists of interest due on our subordinated debt securities and the amortization of debt offering expenses. The primary reason for the increase is that the first debt issuances of $120.0 million and €13.0 million occurred in August 2006, resulting in only five months of interest expense in 2006. During 2007, the Company incurred twelve months of interest expense on the debt contracted in 2006 and interest expense on the additional debt offerings of $100.0 million and $25.0 million which occurred in June and September 2007, respectively.
For the year ended December 31, 2007, we experienced net foreign exchange gains of $5.3 million compared to net foreign exchange gains of $2.1 million for the year ended December 31, 2006. For both years, the net gains were principally a result of gains on net monetary assets denominated in foreign currencies which generally appreciated against the Company’s functional currency. The Company’s policy is to hedge the majority of its foreign currency exposures with derivative instruments such as foreign currency swaps and forward contracts.
Net investment income for the year ended December 31, 2007 was $73.8 million, compared to $34.2 million for the year ended December 31, 2006, an increase of 115.7% from the prior year. Investment income is principally derived from interest and dividends earned on investments, partially offset by investment management fees and fees paid to our custodian bank. The components of net investment income are set forth below:
Net investment income increased by $39.6 million in 2007 compared to 2006 principally due to an increase in interest and dividend income due to the growth on our cash and fixed maturities portfolio, dividends from other investments and the increase in amortization income on our TIPS due to the significant increase in the inflation index during the year. The increase in invested assets is due to positive cash flows from our operating and financing activities (receipt of net proceeds in April 2007 of $168.7 million from our IPO and $123.6 million of net debenture proceeds) which we deployed into our invested assets.
Our investment portfolio is structured to preserve capital and provide us with a high level of liquidity and is managed to produce a total return. In assessing returns under this approach, we include investment income and realized and unrealized gains and losses generated by the investment portfolio. As a result, there can be significant changes in the levels of our net realized and unrealized gains and losses from year to year.
Effective January 1, 2007, we early adopted SFAS 159 with respect to our investment portfolio. The impact is that all subsequent changes in the fair value of our investment portfolio have been recorded as net realized and unrealized gains and losses in our statement of operations.
Net realized and unrealized gains and losses on our investment portfolio amounted to a $17.2 million gain for the year ended December 31, 2007 compared to a $10.3 million gain for the year ended December 31, 2006. These amounts comprise net realized and unrealized gains and losses on our fixed maturities and equities portfolios, on our investment portfolio of derivatives including global equity, global bond, commodity and real estate futures, TBA securities, interest rate swaps and total return swaps.
The following table is the breakdown of net realized and unrealized gains and losses - investments in the consolidated statements of operations into its various components:
Net realized and unrealized gains on equities of $9.7 million for the year ended December 31, 2007 were due primarily to an $8.7 million gain on the disposal of an exchange traded fund during the year.
The following table is a breakdown of the realized and unrealized gains and losses on derivatives:
The Company also enters into derivative instruments such as foreign currency forward contracts, interest rate and currency swaps on our subordinated debt in order to manage its foreign currency exposure and interest rate risk. In addition, the Company enters into reinsurance transactions that are structured as derivatives.
During the year ended December 31, 2007, other income was $5.8 million, compared to $6.1 million during the year ended December 31, 2006. Other income for 2007 includes earned revenue relating to upfront commitment fees on reinsurance contracts, ceding commissions earned by Island Heritage, which was consolidated from July 1, 2007 onwards, and other fee income. Other income for 2006 primarily consisted of fees from Mont Fort (management, performance fees and ceding commissions). With effect from January 12, 2007, the results of Mont Fort were consolidated in the Company’s consolidated financial statements, and therefore fee income of $8.5 million relating to Mont Fort during 2007 has been eliminated with the consolidation of Mont Fort’s results into the Company’s consolidated financial statements.
From January 12, 2007, the Company consolidated Mont Fort, in accordance with the provisions of FIN 46(R). As such, the results of Mont Fort are included in the Company’s consolidated financial statements and the portions of Mont Fort’s net income and shareholders’ equity attributable to the preferred shareholders are recorded in the consolidated financial statements of the Company as minority interest. In relation to Mont Fort, the Company recorded a minority interest expense of $33.6 million for the year ended December 31, 2007.
Comparison of the Year Ended December 31, 2006 and the Period October 4, 2005 through December 31, 2005
Because the Company began operations on December 20, 2005, and as the principal renewal periods for our ceding company clients commenced January 1, 2006, the Company did not write any policies in the period from October 4, 2005 through December 31, 2005. Net investment income resulting from the investment of the proceeds of our private placement contributed $0.6 million to our net income. This was offset, however by general and administrative expenses of $0.8 million and the compensation expense based on the fair value of the Warrant of $12.2 million. As a result we do not believe a comparison of the results of operations for the year ended December 31, 2006 with the period from October 4, 2005 through December 31, 2005 is meaningful.
the addition of $167.3 million of invested assets and cash equivalents resulting from the consolidation of Mont Fort in 2007;
increase in net payable for securities purchased during the year of $26.0 million.
When the Company was formed, the Finance Committee decided to invest initially in a conventional portfolio consisting of mainly high grade bonds and a 10% component of passive U.S. equities. Subsequently, the Finance Committee conducted a comprehensive asset allocation study, consistent with modern practice in portfolio optimization, and developed a sophisticated optimization model using asset classes the Company is allowed to invest in from fiscal, regulatory, and liquidity aspects. The model aims at achieving higher expected total returns while maintaining adequate liquidity to pay potential claims and preserving our financial strength rating. The asset class composition of the model output includes a significant allocation to high grade fixed maturity securities, with the balance invested between other asset classes, such as U.S. equities, developed and emerging market equities, commodities, and cash equivalents. A smaller portion of our investments is allocated to private equity, real estate (see “-Sub-prime Exposure”) and hedge funds. The Company has a strong bias against active management in favor of indexing and passive securities that are generally the most liquid. A number of our equity and other exposure implementations use futures contracts and swaps, whereas the assets in a short term portfolio, managed by external managers, support the futures contracts as if those assets were pledged and not available for liquidity purposes. The portfolio managers are required to adhere to investment guidelines as to minimum ratings and issuer and sector concentration limitations. This implementation strategy gives us a low cost and efficient way, using a mixture of passive assets and outside managers, to complement our in-house capability for overall portfolio management, liquidity management and hedging. The Company believes that an allocation of a portion of its investments to asset classes other than high grade fixed income is both prudent and desirable, as it helps to achieve broader asset diversification (lower risk) and maximizes the portfolio’s total return over time.
As noted above, the Company’s investment strategy allows the use of derivative instruments such as futures contracts, total return swaps, foreign exchange forward contracts, and currency swaps, subject to strict limitations. Derivative instruments may be used to replicate investment positions or to manage currency and market exposures and duration risk that would be allowed under the Company’s investment policy if implemented in other ways.
Our investment portfolio on a risk basis, at December 31, 2007 comprised 66.6% fixed maturities and short-term investments, 22.9% equities and the balance in other investments. Our desired portfolio mix will comprise 50% high grade short term fixed maturities and the balance a highly diversified global asset mix. We believe our fixed maturity securities, short term investments, equity investments, fixed income fund, REITs and derivatives held for investments can be liquidated and converted into cash within a very short period of time. However, our investments in investment funds and catastrophe bonds, which represent 3.6% of our total investments and cash and cash equivalents at December 31, 2007, do not trade on liquid markets or are subject to redemption provisions that prevent us from converting them into cash immediately.
At December 31, 2007 and 2006, 100% of our fixed maturity securities were rated investment-grade (BBB- or higher) by Standard & Poor’s (or estimated equivalent).
Prior to January 1, 2007, investments were considered available-for-sale in accordance with SFAS 115 and were carried at fair value with unrealized gains and losses recorded in accumulated other comprehensive income. Following the issuance by the FASB of SFAS 159, the Company elected to early adopt the fair value option for all fixed maturity investments, equity investments (excluding investments accounted for under the equity method of accounting), REITs, investment funds, catastrophe bonds, and fixed income funds commencing January 1, 2007. This election requires the Company to adopt SFAS 157 regarding fair value measurements. The valuation technique used to fair value the financial instruments is the market approach which uses prices and other relevant information generated by market transactions involving identical or comparable assets.
The Company has elected the fair value option to simplify the accounting, as this election will reduce the burden of the monitoring of differences between the cost and fair value of our investments, including the assessment as to whether declines in value are temporary in nature and, therefore, further removes an element of management's judgment.
Based in part on published news and research reports, further deterioration in the performance of the sub-prime mortgage sector appears to be generally expected; however, the extent and duration of the current deterioration in the credit markets more broadly is unknown. It is possible that the continued deterioration in the credit markets noted above would significantly adversely impact the overall economy, which could directly or indirectly give rise to adverse effects on us, potentially including effects we can not currently reasonably foresee. In addition, there can be no assurance that any of the governmental or private sector initiatives designed to address such credit deterioration in the markets will be implemented, or that if implemented would be successful.
The following table represents an analysis of paid and incurred losses and a reconciliation of the beginning and ending loss and loss adjustment expense reserves for the years ended December 31, 2007 and 2006:
The significant increase in the reserves in 2007 is primarily attributable to light insured catastrophe activity in 2006 coupled with significant losses in 2007 from Windstorm Kyrill ($32.4 million), June and July U.K. Floods ($38.0 million), New South Wales Floods ($18.5 million), three satellite losses ($13.8 million) and the Sydney Hailstorm ($11.4 million).
As at December 31, 2007, total shareholders’ equity was $1.2 billion, a 40.0% increase compared to $864.5 million at December 31, 2006. The increase in shareholders’ equity is principally due to the completion of our IPO and the exercise of the underwriters’ overallotment option in the amount of $168.7 million, net income for the year ended December 31, 2007 of $167.9 million, share based compensation of $8.3 million, accumulated other comprehensive income of $7.9 million offset by dividends declared of $7.0 million. Other comprehensive income consists of the change in currency translation adjustment arising from the translation of the Company’s foreign subsidiaries into U.S. dollars.
Management uses growth in diluted book value per share as a prime measure of the value the Company is generating for its common shareholders. Diluted book value per share is calculated using the common shareholders’ equity divided by the number of common share and share equivalents outstanding. In 2007, the Company’s diluted book value per share plus accumulated dividends increased by 16.8% from $11.94 at December 31, 2006 to $13.95 at December 31, 2007.
Through the acquisition of IAL King Air on July 22, 2007, the company acquired debt of $0.9 million. The loan has a floating rate of interest equal to 30-day LIBOR plus 195 basis points per annum, reset monthly. The debt matures March 15, 2009.
The table below sets forth the capital structure of the Company at December 31, 2007 and 2006:
We are a holding company that conducts no operations of our own. We rely primarily on cash dividends and return of capital from our subsidiaries to pay our operating expenses and make principal and interest payments on our long term debt. There are restrictions on the payment of dividends from Flagstone and Flagstone Suisse to the Company, which are described in more detail below. Following the completion of our IPO, we have paid a quarterly cash dividend of $0.04 per common share in both the third and fourth quarters of 2007. Our subsidiaries’ sources of funds primarily consist of premium receipts net of commissions, investment income, capital raising activities including the issuance of common shares, long term debt and proceeds from sales and maturities of investments. Cash is used primarily to pay losses and loss adjustment expenses, reinsurance purchased, brokerage, general and administrative expenses and dividends, with the remainder made available to our investment manager for investment in accordance with our investment policy. In the future, we may use cash to fund any authorized share repurchases and acquisitions.
Cash flows relating to financing activities include the payment of dividends, share related transactions and the issue or repayment of debt. During 2007, we generated $336.2 million from financing activities compared to $296.4 million in 2006. During 2007 we received net proceeds of $168.7 million from the issuance of our common shares through our IPO in April 2007 and net proceeds of $123.7 million from the issuance of junior subordinated deferrable interest notes, offset by a $17.1 million repayment of a loan under a sale lease-back transaction. In 2006 we raised $162.8 million from the issuance of common shares and net proceeds of $132.8 million from the issuance of deferrable interest debentures.
In August 2006, the Company entered into a $200.0 million uncommitted letter of credit facility agreement with Citibank N.A. In April 2007, the Company increased its uncommitted letter of credit facility agreement with Citibank N.A. from $200.0 million to $400.0 million. As at March 17, 2008, $73.7 million has been drawn under this facility and the drawn amount of the facility is secured by $82.0 million of fixed maturity securities from our investment portfolio.
The cash generated from the three closings of our private placement, the issuance of our Deferrable Interest Debentures, the completion of our IPO and operating cash flows has provided us with sufficient liquidity to enable Flagstone to meet its Bermuda statutory requirements under the Insurance Act, as described below.
Bermuda law limits the maximum amount of annual dividends or distributions payable by Flagstone to the Company and in certain cases requires the prior notification to, or the approval of, the BMA. As a Bermuda Class 4 reinsurer, Flagstone may not pay dividends in any financial year which would exceed 25% of its total statutory capital and surplus unless at least seven days before payment of those dividends it files an affidavit with the BMA signed by at least two directors and Flagstone’s principal representative, which states that in their opinion, declaration of those dividends will not cause Flagstone to fail to meet its prescribed solvency margin and liquidity ratio. Further, Flagstone may not reduce by 15% or more its total statutory capital as set out in its previous year’s statements, without the prior approval of the BMA. Flagstone must also maintain, as a Class 4 Bermuda reinsurer, paid-up share capital of $1 million.
Flagstone Suisse is licensed to operate as a reinsurer in Switzerland. Swiss law permits dividends to be declared only after profits have been allocated to the reserves required by law and to any reserves required by the articles of incorporation. The articles of incorporation of Flagstone Suisse do not require any specific reserves. Therefore, Flagstone Suisse must allocate any profits first to the reserve required by Swiss law generally, and may pay as dividends only the balance of the profits remaining after that allocation. In the case of Flagstone Suisse, Swiss law requires that 5% of the company’s profits be allocated to a “general reserve” until the reserve reaches 20% of its paid-in share capital. In addition, a Swiss reinsurance company may pay a dividend only if, after payment of the dividend, it will continue to comply with regulatory requirements regarding minimum capital, special reserves and solvency margin requirements. See Item 1, “Business-Regulation-Other Jurisdictions-Switzerland.”
We have no obligations, assets or liabilities other than those disclosed in the financial statements; no trading activities involving non-exchange traded contracts accounted for at fair value; and except as disclosed in this document no relationships and transactions with persons or entities that derive benefits from their non-independent relationship with us or our related parties.
(2) The Company has based its estimate of future claim payments upon benchmark payment patterns constructed internally, drawing upon available relevant industry sources of loss and allocated loss adjustment expense development data which may include both internal and external data sources. We also supplement these benchmark payment patterns with information received from treaty submissions and periodically update them. We believe that it is likely that this benchmark data will not be predictive of our future claim payments and that material fluctuations can occur due to the nature of the losses which we insure and the coverages which we provide. Because of the nature of the coverages that we provide, the amount and timing of the cash flows associated with our policy liabilities will fluctuate, perhaps significantly, and therefore are highly uncertain. See “-Critical Accounting Policies-Loss and Loss Adjustment Expense Reserves.”
(3) Effective November 20, 2007, Island Heritage entered into a share repurchase agreement with one of its minority shareholders. Under this agreement, Island Heritage will buy back 16,919 shares (representing 5% of its common shares) on June 30, 2008 at a price of 1.78 times the fully diluted book value as at December 31, 2007. The amount will be settled with fifty percent cash on or before June 30, 2008 and fifty percent cash on or before December 31, 2008.
Prior to December 2007, gains and losses on foreign currency forward contracts and on foreign currency swaps used to hedge the foreign currency exposure of the Company’s debt, investments in and loan to various subsidiaries, and operational balances (premiums and reserves) of our investments in foreign subsidiaries were recorded with realized gains and losses - other on the income statement, while gains and losses on the translation of foreign subsidiaries’ assets and liabilities were recorded in accordance with SFAS No. 52 “Foreign Currency Translation” (“SFAS 52”) as a change in currency translation adjustment, a component of comprehensive income. Since the change in currency translation adjustment is not a component of net income, there was volatility created in our reported earnings from the translation of our foreign subsidiaries. Prior to renewing our forward contracts in December 2007, we considered the guidance under SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) which outlines the designated hedge accounting method, which permits the offset of gains and losses on the hedged instruments (i.e. the forward contracts) against the gains and losses recorded for the hedged items (i.e. foreign subsidiaries). As a result, $3.5 million of unrealized losses on forward contracts was accounted for as an offset against the currency translation adjustment gain in the fourth quarter 2007, thus reducing the income statement volatility. The losses on forward contracts resulted from the continued weakening of the U.S. dollar against other major currencies, mainly the Swiss franc.
At December 31, 2007, the value of the U.S. dollar weakened approximately 1.6% against the British pound, 10.8% against the Euro, 15.1% against the Canadian dollar, and 7.1% against the Swiss franc, compared to December 31, 2006. Since a large proportion of the Company’s assets and liabilities are expressed in these currencies, there was a net increase in the U.S. dollar value of the assets and liabilities denominated in these currencies in 2007.
We do not believe that inflation has had a material effect on our consolidated results of operations, except insofar as inflation may affect interest rates. The potential exists, after a catastrophe loss, for the development of inflationary pressures in a local economy. The effects of inflation are considered implicitly in pricing through the modeled components such as demand surge. Loss reserves are established to recognize likely loss settlements at the date payment is made. Those reserves inherently recognize the effects of inflation. The actual effects of inflation on our results cannot be accurately known, however, until claims are ultimately resolved.
We have audited the accompanying consolidated balance sheets of Flagstone Reinsurance Holdings Limited and subsidiaries (the “Company”) as of December 31, 2007 and 2006, and the related consolidated statements of operations and comprehensive income (loss), shareholders' equity, and cash flows for the years ended December 31, 2007 and 2006, and the period from October 4, 2005 (date of incorporation) to December 31, 2005. Our audits also included the financial statement schedules listed in the Index at Item 15. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.
For the Years Ended December 31, 2007, 2006, and the Period from October 4, 2005 through December 31, 2005
On March 31, 2006, Flagstone acquired an equity interest in Island Heritage Holdings Limited (“Island Heritage”), a Caribbean property insurer based in the Cayman Islands. With subsequent purchases in October 2006 and May 2007, Flagstone increased its equity interest in Island Heritage to 33.2%. On July 3, 2007, Flagstone took a controlling interest in Island Heritage by increasing its ownership to 54.6% of Island Heritage’s voting shares.
On March 31, 2006, the Company acquired Flagstone Capital Management (Bermuda) Limited and its subsidiaries (formerly known as West End Capital Management (Bermuda) Limited and referred to herein as “West End”), a company engaged in the business of investment and insurance management in Bermuda. West End subsidiaries include (a) Flagstone Management Services (Halifax) Limited which provides accounting, claims, information technology support, risk modeling, actuarial and legal services and (b) West End Capital Management BPO Services (India) Private Limited which provides back office information technology support services.
These consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. The Company’s policy is to consolidate all entities in which it has a controlling financial interest. In accordance with FIN 46(R), entities that are deemed to be VIEs are consolidated by the Company if it is determined that the Company is the primary beneficiary. Under FIN 46(R) the primary beneficiary of a VIE is the party that absorbs a majority of the entity’s expected losses, receives a majority of its expected returns, or both, as a result of holding variable interests. For entities that are not deemed to be VIEs under FIN 46(R), the Company consolidates those in which it owns more than 50% of the outstanding voting stock unless it does not control the entity. Investments in preferred or voting common shares relating to unconsolidated entities that provide the Company with significant influence over the operating and financial policies of the investee are accounted for under the equity method of accounting.
As discussed in Note 1 above, the results of Mont Fort are included in the Company’s consolidated financial statements with effect from January 12, 2007. The portions of Mont Fort’s net income and shareholder’s equity attributable to holders of the preferred shares for the year ended December 31, 2007 are recorded in the consolidated financial statements of the Company as minority interest. (See Note 4 for further details)
Loss and loss adjustment expense reserves, including losses incurred but not reported (“IBNR”) and provisions for settlement expenses, include amounts determined from loss reports on individual cases, independent actuarial determinations and based on the Company’s own historical experience. To the extent that the Company’s own historical experience is inadequate for estimating reserves, such estimates may be determined based upon industry data and management estimates.
Loss and loss adjustment expense reserves include a component for outstanding case reserves for which claims have been reported and a component for IBNR. Case reserve estimates are initially set on the basis of loss reports received from ceding companies. Estimated IBNR reserves consist of a provision for additional development in excess of the case reserves reported by ceding companies as well as a provision for claims which have occurred but which have not yet been reported to the Company by ceding companies. IBNR reserves are estimated by management using various actuarial methods as well as a combination of the Company’s loss experience, insurance industry loss experience, underwriters’ experience, general market trends, and management’s judgment. The Company’s internal actuaries review the reserving assumptions and methodologies on a quarterly basis.
Premiums are first recognized as written as at the date that the contract is bound. The Company writes both excess of loss and pro rata reinsurance contracts, and also writes a select property insurance portfolio in the Caribbean region through its subsidiary Island Heritage.
The Company has entered into industry loss warranty transactions that are structured as reinsurance or derivatives. The Company evaluates each contract in accordance with Derivatives Implementation Group B26, “Dual Trigger Property and Casualty Contracts,” to determine if the amounts received from these contracts should be recorded as reinsurance transactions or as derivatives. When the transactions are determined to be reinsurance, the consideration received is recorded as premiums written and earned over the contract period.
In the normal course of its operations, the Company has received commitment fees to provide future reinsurance capacity. These contracts are accounted for as deferred revenue as they relate to upfront commitment fees and are included in other liabilities. The commitment fees are recognized ratably over the commitment period and are non-refundable in the event that the counterparty does not utilize the reinsurance capacity.
The election of SFAS 159 will not change the carrying value of our fixed maturity investments, equity investments, REITs, investment funds, catastrophe bonds, fixed income fund and derivative instruments as they were previously carried at fair value. The Company’s U.S. government securities, equity securities and fixed income fund are stated at fair value as determined by the quoted market price of these securities as provided either by independent pricing services or exchange market prices or, when such prices are not available, by reference to broker or underwriter quotes. When the market for a security is considered active and multiple quotes are obtained with identical prices, the quote is considered to be binding. The fair value of the corporate bonds, mortgage-backed securities, asset-backed securities and REITs are derived from broker quotes based on inputs that are observable for the asset, either directly or indirectly, such as yield curves and transactional history. Investment funds and other investments are stated at fair value as determined by either the most recently published net asset value -- being the fund’s holdings in quoted securities adjusted for administrative expenses -- or the most recently advised net asset value as advised by the fund adjusted for cash flows -- where the fund’s holdings are in private equity investments. The private equity investments are valued by the investment funds using the valuations and financial statements provided by the general partners on a quarterly basis. These valuations are then adjusted by the investment funds for the cash flows since the most recent valuation. The valuation methodology used for the investment funds are consistent with the investment industry.
The Company’s share based compensation plans consists of performance share units (“PSUs”) and restricted share units (“RSUs”). The PSUs are designed to maximize shareholder value over long periods of time by aligning the financial interests of the Company’s management with those of its shareholders. The Company estimates the fair value of PSUs granted under the PSU Plan on the date of grant using the grant date fair value and the most probable performance factor for the three-year performance period and records the compensation expense in its consolidated statements of operations over the course of such period. At the end of each quarter, the Company reassesses the projected results for each three-year performance period as its financial results evolve. The Company recalculates the compensation expense under the PSU Plan and reflects any adjustments in the consolidated statements of operations in the period in which they are determined.
Equity method investments will be reviewed annually, at a minimum, for potential impairment in accordance with Accounting Policies Board Opinion 18 (“APB 18”), “The Equity Method of Accounting for Investments in Common Stock”. If it is determined the Company would be unable to recover the carrying amount of its equity investment or if its equity investment would be unable to sustain an earning capacity to justify its carrying amount, the Company would record an impairment charge in the period the determination is made by lowering the goodwill recorded on the equity method investment.
The Company conducted its annual reviews as at December 31, 2007 and determined that the recorded goodwill was not impaired.
Funds held by reinsured companies represent insurance balances retained by ceding companies for a period in accordance with contractual terms. The company generally earns investment income on these balances during the period funds are held.
The issuance of shares with respect to the PSUs is contingent upon the attainment of certain levels of diluted return-on-equity (“DROE”). Because the number of common shares contingently issuable under the PSU Plan depends on the average DROE over a three year period, the PSUs are excluded from the calculation of diluted earnings per share until the end of the performance period, when the number of shares issuable under the PSU Plan will be known.
Certain subsidiaries of the Company operate in jurisdictions where they are subject to taxation. Current and deferred income taxes are charged or credited to net income based upon enacted tax laws and rates applicable in the relevant jurisdiction in the period in which the tax becomes realizable. Deferred income taxes are provided for all temporary differences between the bases of assets and liabilities used in the consolidated balance sheets and those used in the various jurisdictional tax returns. When management’s assessment indicates that it is more likely than not that deferred income tax assets will not be realized, a valuation allowance is recorded against the deferred tax assets. We adopted the provisions of FASB Interpretation No. 48, "According for Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109" ("FIN 48") on January 1, 2007. Under FIN 48, the tax benefits of uncertain tax positions may only be recognized when the position is more-likely-than-not to be sustained upon audit by the relevant taxing authorities.
On March 31, 2006, the Company purchased all of the common shares of West End for a purchase price of $16.1 million. The Company purchased 12,000 West End shares (representing a 70.6% interest) from the Company’s Executive Chairman and 2,829 West End shares (representing a 16.6% interest) from the Company’s Chief Executive Officer. The results of operations of West End are included in the consolidated statement of operations from April 1, 2006.
The primary reason for the transaction was for the Company to be self-supporting and not reliant on outsourcing for its administrative functions and investment activities.
The Company paid an amount of $15.4 million on March 31, 2006 and the final settlement was made on August 16, 2006 in the amount of $0.7 million. Goodwill of $2.0 million was recognized on the acquisition date. The fair value of the net assets acquired is summarized as follows:
Rockridge, a company incorporated under the laws of the Cayman Islands, was established to assume high-layer, short-tail risks principally from Montpelier Reinsurance Ltd. West End held 11.6% of the common share equity interests, which represented 29.6% of the total voting rights of all shares. West End was deemed to have significant influence over Rockridge due to its 29.6% voting interest and board representation. As such, the Rockridge investment was recorded as an equity method investment. On December 20, 2006, the board of directors of Rockridge decided that it was in the best interest of Rockridge to redeem all its common shares. Redemption proceeds of $10.7 million were received by West End on December 29, 2006 and the Company recorded an amount of $0.2 million as receivable from Rockridge as of December 31, 2006. Further proceeds of $0.2 million were received during 2007 resulting in a $nil receivable at December 31, 2007.
On July 3, 2007, Flagstone purchased 73,110 shares (representing a 21.4% interest) in Island Heritage for a purchase price of $12.6 million. With this acquisition, Flagstone took a controlling interest in Island Heritage by increasing its interest to 54.6% of the voting shares. Flagstone had previously acquired 33.2% of the shares through three purchases in March 2006 ($7.3 million, 18.7% interest), October 2006 ($4.2 million, 9.8% interest) and May 2007 ($2.5 million, 4.7% interest). At December 31, 2007, the Company had recorded goodwill and intangible assets not subject to amortization in the amount of $8.8 million and $0.8 million, respectively, and $3.6 million and $nil, respectively, at December 31, 2006. Following the acquisition, the Company’s representation on Island Heritage’s board and the close working relationship with its management allows Flagstone to promote and support best practices in the underwriting of Island Heritage’s underlying business and to consequently enhance the quality of data available to Flagstone to underwrite the reinsurance of such business. The Company recorded goodwill in excess of the fair value of the acquired net assets to increase its participation in Island Heritage’s reinsurance program and to expand its book of business into the developing Caribbean markets.
Flagstone’s share of Island Heritage’s results from operations was recorded in the Company’s consolidated financial statements under the equity method of accounting through June 30, 2007. As a result of the acquisition of the controlling interest, the results of operations of Island Heritage have been included in the Company’s consolidated financial statements from July 1, 2007, with the portions of Island Heritage’s net income and shareholders’ equity attributable to minority shareholders recorded as minority interest in the Company’s consolidated financial statements.
On January 12, 2007, Mont Fort closed an offering of preferred shares relating to a third cell, Mont Fort HL which yielded gross proceeds of $28.1 million. The investor in Mont Fort HL is Newcastle Special Opportunity Fund V, L.P., an entity with no previous investments or affiliations with the Company or with Mont Fort. Mont Fort, in respect of Mont Fort HL, entered into a quota share reinsurance contract with Flagstone under which Flagstone assumes 9.0% of the business written by Mont Fort HL.
In accordance with a reinsurance agreement entered into between Flagstone and Mont Fort on behalf on its cells, Flagstone earns a ceding commission from the cells based on the level of premiums ceded to the cells. During the year ended December 31, 2007, transactions between Flagstone and Mont Fort were eliminated upon consolidation. During the year ended December 31, 2006, when Mont Fort was not consolidated, Flagstone earned $0.4 million from Mont Fort ILW under this arrangement. West End also entered into an investment management agreement with Mont Fort in respect to each cell. Under the agreement, West End earns an investment management fee based on the current size of the cells and a performance-based fee of 15% of the increase, if any, in the net asset value of each cell over the course of each year. During the year ended December 31, 2006, West End earned $1.3 million from Mont Fort ILW under this arrangement. On August 28, 2006, Mont Fort repurchased the preferred shares held by Flagstone for $5.1 million, and Mont Fort in respect of Mont Fort ILW entered into a quota share reinsurance contract with Flagstone under which Flagstone assumes 8.3% of the business written by Mont Fort ILW.
Included in the Company’s assets as at December 31, 2007 were cash, cash equivalents and fixed maturity investments of $177.0 million held for the sole benefit of preferred shareholders of each specific Mont Fort cell and available to settle the specific current and future liabilities of each cell.
Flagstone’s share of Island Heritage’s results from operations was recorded in the Company’s consolidated financial statements under the equity method of accounting from April 1, 2006 (date of initial investment) through June 30, 2007. As a result of the acquisition of the controlling interest in July 2007, the results of operations of Island Heritage have been included in the Company’s consolidated financial statements from July 1, 2007, with the portions of Island Heritage’s net income and shareholders’ equity attributable to minority shareholders recorded as minority interest in the Company’s consolidated financial statements. (See Note 3 for additional discussion on Island Heritage)
Catastrophe bonds held pay a variable interest coupon and their return, from interest and return of principal, is contingent upon climatological and geological events. The catastrophe bonds are recorded at fair value and as at December 31, 2007 and December 31, 2006 they had net realized gains of $0.8 and $0.9 million for the years then ended, respectively.
Prior to January 1, 2007, investments were considered available-for-sale in accordance with SFAS 115, and were carried at fair value with unrealized gains and losses recorded in accumulated other comprehensive income. Following the issuance by the FASB of SFAS 159, the Company elected to early adopt the fair value option for all fixed maturity investments, equity investments (excluding investments accounted for under the equity method of accounting), REITs, investment funds, catastrophe bonds, and fixed income funds commencing January 1, 2007. This election requires the Company to adopt SFAS 157 regarding fair value measurements. The valuation technique used to fair value the financial instruments is the market approach which uses prices and other relevant information generated by market transactions involving identical or comparable assets.
Realized investment gains and losses on the sale of fixed maturity, short term and equity investments for the years ended December 31, 2007 and 2006 and the period from October 4, 2005 through December 31, 2005 are as follows:
The following table is a breakdown of the net realized and unrealized gains recorded in the consolidated statements of operations:
The Company was incorporated on October 4, 2005, commenced operations on December 20, 2005 and did not write any reinsurance contracts during the period ended December 31, 2005.
The Company purchases reinsurance to reduce its net exposure to losses. Reinsurance provides for recovery by the Company of a portion of gross losses and loss adjustment expenses from its reinsurers. The Company remains liable to the extent that its reinsurers do not meet their obligations under these agreements and the Company therefore regularly evaluates the financial condition of its reinsurers and monitors concentration of credit risk. The reinsurance claims recoverable as at December 31, 2007 and 2006 was $nil for both years.
Assumed and ceded net premiums written and earned and loss and loss adjustment expenses for the years ended December 31, 2007 and 2006 are as follows:
The Company has entered into certain foreign currency forward contracts that it has designated as hedges in order to hedge its net investments in foreign subsidiaries. The accounting for the gains and losses associated with changes in fair value of the designated hedge instruments will be recorded in other comprehensive income as part of the cumulative translation adjustment, to the extent that it is effective as a hedge. All other derivatives are not designated as hedges, and accordingly, these instruments are carried at fair value, with the fair value recorded in other assets or liabilities with the corresponding realized and unrealized gains and losses included in net realized and unrealized gains and losses in the consolidated financial statements. There were no derivatives designated as hedges as of December 31, 2006.
The Company uses total return equity swaps to gain exposure to the equity markets. The total return swaps allow the company to earn the return of the underlying index while paying floating interest plus a spread to the counterparty. As of December 31, 2007 the notional amount of the total return swaps were $14.2 million and had a fair value of $(4.9) million. During the year ended December 31, 2007, the Company recorded $4.7 million of realized and unrealized losses on total return swaps. As of December 31, 2006, there were no total returns swaps in the portfolio.
The Company has entered into index and interest rate futures. At December 31, 2007 and 2006, the notional amount of index and interest rate futures were $421.0 million and $178.5 million respectively. The net fair value of futures contracts was ($2.2) million and $1.9 million as at December 31, 2007 and 2006, respectively. During the years ended December 31, 2007 and 2006, the Company recorded $4.4 million and $8.3 million, respectively, of realized and unrealized gains on futures.
The Company has subsidiaries that operate in various other jurisdictions around the world that are subject to tax and examination by taxing authorities in the jurisdictions in which they operate. The significant jurisdictions in which the Company’s subsidiaries are subject to tax are Canada, India, Switzerland, U.S. Virgin Islands and the United Kingdom. Income tax returns are open for examination for the tax years 2004-2006 in Canada, 2004-2006 in the U.S. Virgin Islands and 2006-2007 in India. Due to its limited history, the Company’s subsidiaries in Switzerland and the United Kingdom have not yet filed income tax returns and therefore do not yet have any tax years open for examination.
Income tax expense for the years ended December 31, 2007 and 2006 was as follows:
For the period from October 4, 2005 to December 31, 2005, the Company did not have operations in taxable jurisdictions.
The following table is a reconciliation of the actual income tax rate for to the amount computed by applying the effective rate of 0% under Bermuda law to income before income taxes:
SFAS No. 107, “Disclosure about Fair Value of Financial Instruments” (“SFAS 107”), requires disclosure of fair value information of financial instruments. For financial instruments where quoted market prices are not available, the fair value of these financial instruments is estimated by discounting future cash flows or by using similar recent transactions. Because considerable judgment is used, these estimates are not necessarily indicative of amounts that could be realized in a current market exchange. The Company does not carry its long term debt at fair value on its consolidated balance sheets. As at December 31, 2007 and 2006, the Company estimated the fair value of its long term debt to be approximately equal to its carrying value as they were recently issued and pay a floating interest rate.
At December 31, 2007 and 2006, the total authorized common voting shares of the Company were 150,000,000 with a par value of $0.01 per common share.
On April 4, 2007, the Company completed an initial public offering of 13,000,000 of its common shares for gross proceeds of $175.5 million and incurred issuance costs of $16.2 million. On April 30, 2007, the underwriters of the initial public offering exercised their option to purchase an additional 750,000 common shares of the Company at the public offering price less underwriting discounts and commissions. Gross proceeds of $10.1 million were received by the Company and $0.7 million issuance costs were incurred. The Company has contributed the proceeds from this offering to Flagstone to increase its underwriting capacity and Flagstone has invested the proceeds according to its investment strategy.
Subsequently, in connection with the February 1 and February 23, 2006 additional closings of the private placement of 1,957,008 common shares, the Warrant was amended such that the number of common shares that could be issuable upon exercise of the Warrant would be 8,585,747, being 12.0% of the issued share capital as at February 23, 2006. The additional compensation expense based on the fair value on the date of grant was $3.4 million and is included in general and administrative expenses and in additional paid-in capital in the consolidated financial statements for the year ended December 31, 2006. This value has been calculated using the Black-Scholes option pricing model. The assumptions used were: risk-free interest rate 4.6%, expected life 4.8 years, volatility 25.0%, dividend yield nil. The volatility assumption was based on the average historical volatility of a group of comparable companies over a period equal to the expected life of the Warrant. With the completion of the Company’s private placement in February 2006, there have been and will be no further additions to the number of common shares underlying the Warrant other than due to stock splits or otherwise in accordance with the terms of the Warrant.
No PSUs have vested or been cancelled since the inception of the Plan.
Beginning July 1, 2006, the Company granted RSUs to certain employees and directors of the Company. The RSU grants to employees vest over a period of approximately two years while RSUs granted to directors vest on the grant date.
The computation of basic and diluted earnings per common share for the year ended December 31, 2007 and 2006, and the period from October 4, 2005 through December 31, 2005 is as follows:
As at December 31, 2007, 2006, and 2005, there were securities which would result in the issuance of common shares that were excluded in the computation of diluted earnings (loss) per common share because the effect would be anti-dilutive. These securities were as follows:
In addition, because the number of shares contingently issuable under the PSU Plan depends on the average DROE over a three year period, commencing in 2007, the PSUs are excluded from the calculation of diluted earnings (loss) per common share until the end of the performance period, at which time the number of shares issuable under the PSU Plan will be known.
At December 31, 2007, the Company’s consolidated results include the results of Mont Fort from January 12, 2007 onwards (see Note 4). The portions of Mont Fort’s net income and shareholders’ equity attributable to holders of the preferred shares for the year ended December 31, 2007 are recorded in the consolidated financial statements of the Company as minority interest. In relation to Mont Fort, the Company recorded a minority interest expense of $33.6 million for the year ended December 31, 2007 and $165.2 million was included in minority interest on the consolidated balance sheet as at December 31, 2007.
At December 31, 2007, the Company’s consolidated results include the results of Island Heritage from July 1, 2007 onwards (see Note 3). The portions of Island Heritage’s net income and shareholders’ equity attributable to the minority shareholders for the year ended December 31, 2007 are recorded in the consolidated financial statements of the Company as minority interest. In relation to Island Heritage, the Company recorded a minority interest expense of $2.2 million for the year ended December 31, 2007 and $19.6 million was included in minority interest on the consolidated balance sheet as at December 31, 2007.
During the period ended December 31, 2005, the Company paid $0.2 million to HCP in relation to services performed in respect of the initial capital subscription. The Company entered into a consultancy arrangement with Meetinghouse LLC, a company controlled by the Chief Executive Officer of HCP. The consultancy arrangement provided for 150 hours of actuarial services at a rate of $500 per hour, for the period from December 2005 through March 2006. During the period from October 4, 2005 through December 31, 2005, the Company incurred $21,000 for services relating to the development of financial and business models. During the year ended December 31, 2006, additional expenses of $54,000 were incurred for services relating to business model development. These expenses have been recorded in general and administrative expenses.
On March 31, 2006, the Company purchased all of the common shares of West End for a purchase price of $16.1 million. The Company purchased 12,000 shares (representing a 70.6% interest) from Mr. Byrne and 2,829 shares (representing a 16.6% interest) from Mr. Brown.
Flagstone entered into an excess of loss reinsurance agreement with Island Heritage during 2007 and 2006 under which Flagstone assumed a share of Island Heritage’s residential and commercial property risks. Premiums written under the agreement included in the Company’s consolidated financial statements during the year ended December 31, 2007 and 2006 amounted to $1.7 million and $1.4 million, respectively and $0.4 million was due from Island Heritage at December 31, 2006. Employees of the Company serve as directors of Island Heritage. As a result of the acquisition of the controlling interest in July 2007, the results of operations of Island Heritage have been included in the Company’s consolidated financial statements from July 1, 2007, and therefore, the results of the excess of loss reinsurance agreement from July 2007 onwards have been eliminated with the consolidation of Island Heritage’s results into the Company’s consolidated financial statements.
On March 31, 2006, the Company purchased all of the common shares of Mont Fort from Haverford for a purchase price of $0.1 million (see note 4).
On June 5, 2006, West End entered into an investment management agreement with Mont Fort in respect of Mont Fort ILW under which West End earns an investment management fee of 0.5% per year based on the current size of Mont Fort ILW and a performance-based fee of 15.0% of the increase, if any, in the net asset value of Mont Fort ILW over the course of each year. During the year ended December 31, 2006, West End earned $1.3 million from Mont Fort ILW under this arrangement. With effect from January 12, 2007, the results of Mont Fort are consolidated in the Company’s consolidated financial statements, and therefore, Mont Fort’s results during year ended December 31, 2007 have been eliminated.
Effective, August 29, 2007 Longtail Aviation Limited (“Longtail”), an entity controlled by Mr. Byrne, entered into an Amalgamation Agreement (“Agreement”) with a wholly owned subsidiary of the Company, Longtail Aviation International Limited (“Longtail International”) . Longtail provides support, maintenance and pilot services for the aircraft utilized by the Company in its worldwide operations. Pursuant to the terms of the Agreement, Longtail was, subject to certain regulatory approvals required by the Bermuda Registrar of Companies, amalgamated (merged) into Longtail International in consideration of payment for agreed net assets in Longtail as of July 31, 2007 and forgiveness of debt owed to Mr. Byrne by Longtail. Mr. Byrne, as Longtail’s principal shareholder received $1.9 million from Longtail International. The consideration paid to Mr. Byrne was equal to the net assets received by Longtail International.
During the years ended December 31, 2007 and 2006 and the period from October 4, 2005 through December 31, 2005, the Company made lease payments of $0.3 million, $0.4 million, and $nil, respectively to Eye Patch Holdings Limited, a company in which Haverford has a 40.0% stake and from which the Company leases office space.
On September 5, 2006, the Company entered into a foreign currency swap agreement with Lehman Brothers Inc. in relation to the issuance of the Deferrable Interest Debentures. Under the terms of the agreement, the Company exchanged €13.0 million for $16.7 million, will receive Euribor plus 354 basis points and will pay LIBOR plus 371 basis points. The agreement will terminate on September 15, 2011 and had a fair value of $2.5 million and $0.4 million as at December 31, 2007 and 2006, respectively. Affiliates of Lehman Brothers Inc. are shareholders of the Company and preferred shareholders of Mont Fort. Lehman Brothers Inc. provided additional investment banking services to the Company in connection with the initial private placement of the Company, for which it received fees of $2.0 million. Lehman Brothers Inc. acted as an underwriter of the Company's initial public offering, for which it received fees of $3.4 million.
On December 7, 2007, the Company entered into an interest rate swap agreement with Lehman Brothers Special Financing Inc. Under the terms of the agreement, the Company exchanged interest on a notional amount of $25.0 million, will receive interest at three month LIBOR and will pay 4.096% interest. The agreement will terminate on September 15, 2012. On December 7, 2007, the Company entered into an interest rate swap agreement with Lehman Brothers Special Financing Inc. Under the terms of the agreement, the Company exchanged interest on a notional amount of $120.0 million, will receive interest at three month LIBOR and will pay 3.962% interest. The agreement will terminate on September 15, 2011. The fair value of the two swaps was $0.2 million as at December 31, 2007.
Credit risk arises out of the failure of a counter-party to perform according to the terms of the contract. The Company is exposed to credit risk in the event of non-performance by the counterparties to the Company’s foreign exchange forward contracts, currency swaps and interest rate swaps. However, because the counterparties to these agreements are high credit quality international banks, the Company does not anticipate any non-performance. The difference between the contract amounts and the related fair market values in excess of the contract amount is the Company’s maximum credit exposure.
The Company’s investment portfolio is managed by external advisors in accordance with prudent standards of diversification. Specific provisions limit the allowable holdings of a single issue or issuer. The Company believes that there are no significant concentrations of credit risk associated with its investments.
The Company and its subsidiaries lease office space and guest accommodations in the countries in which they operate under operating leases which expire at various dates. The Company renews and enters into new leases in the ordinary course of business as required. Total rent expense with respect to these operating leases for the years ended December 31, 2007 and 2006 was approximately $1.2 million and $0.6 million.
Future minimum lease payments under the leases regarding the aircraft are expected to be as follows:
In the normal course of business, the Company may become involved in various claims litigation and legal proceedings. As at December 31, 2007 and 2006, the Company was not a party to any litigation or arbitration proceedings.
During 2006, the Company made certain commitments with respect to an investment in a private equity fund. As at December 31, 2007 and 2006, the total outstanding investment commitment was $6.4 million and $8.4 million, respectively.
The Insurance Act 1978 and Related Regulations (“the Act”) requires Flagstone to maintain minimum levels of solvency and liquidity. The Act requires Flagstone to maintain a minimum statutory capital and surplus equal to the greater of $100.0 million, 50% of net premiums written (being gross premiums written less ceded premiums, with a maximum of 25% of gross premiums considered as ceded premiums for the purpose of this calculation) or 15% of the loss and loss adjustment expense reserves. To satisfy these requirements, Flagstone was required to maintain a minimum level of statutory capital and surplus of $228.0 million and $141.2 million, as at December 31, 2007 and 2006, respectively. Actual statutory capital and surplus as at December 31, 2007 and 2006 was $1.4 billion and $969.9 million, respectively. In addition, Flagstone is required to maintain a minimum liquidity ratio and is required to prepare annual statutory financial statements and to file a statutory financial return. As at December 31, 2007 and 2006, Flagstone was in compliance with all of the requirements of the Act.
Flagstone Suisse is licensed to operate as a reinsurer in Switzerland. Swiss law permits dividends to be declared only after profits have been allocated to the reserves required by law and to any reserves required by the articles of incorporation. The articles of incorporation of Flagstone Suisse do not require any specific reserves. Therefore, Flagstone Suisse must allocate any profits first to the reserve required by Swiss law generally, and may pay as dividends only the balance of the profits remaining after that allocation. In the case of Flagstone Suisse, Swiss law requires that 5% of the company’s profits be allocated to a “general reserve” until the reserve reaches 20% of its paid-in share capital.
For the years ended December 31, 2007 and 2006, premiums produced by brokers were as follows:
On February 29, 2008, a quarterly dividend of $0.04 per common share was declared. The dividend was payable on March 12, 2008 to shareholders of record at the close of business on March 6, 2008.
On March 6, 2008 the Company signed an agreement to subscribe to a majority stake (65%) in Imperial Reinsurance Company Limited (“Imperial Re”). The transaction is subject to regulatory approvals and closing conditions and is expected to close in the second quarter of 2008. The subscription amount, to be determined upon completion of Imperial Re’s audited financial statements, will be approximately $20.8 million.
Imperial Re is domiciled in South Africa and writes multiple lines of reinsurance in sub-Saharan Africa. The Company believes that its capital and technical support will enhance Imperial Re’s services, increase its market penetration and broaden its product distribution within Africa.
SFAS No. 107, “Disclosure about Fair Value of Financial Instruments” (“SFAS 107”), requires disclosure of fair value information of financial instruments. For financial instruments where quoted market prices are not available, the fair value of these financial instruments is estimated by discounting future cash flows or by using similar recent transactions. Because considerable judgment is used, these estimates are not necessarily indicative of amounts that could be realized in a current market exchange. The Company does not carry its long term debt at fair value on its consolidated balance sheets. As at December 31, 2007 and 2006, the Company estimated the fair value of its long term debt to be equal to its carrying value.
The Notes indentures contain various covenants, including limitations on liens on the stock restricted subsidiaries, restrictions as to the disposition of the stock of restricted subsidiaries and limitations on mergers and consolidations. The Company was in compliance with all the covenants contained in the Notes indentures at December 31, 2007.
Interest expense includes interest payable and amortization of debt offering expenses. The debt offering expenses are amortized over the period from the issuance of the Notes to the earliest they may be called by the Company. For the years ended December 31, 2007 and 2006, the Company incurred interest expense and amortization of debt offering expenses of $13.7 million, and $4.5 million on the Notes. For the period October 4, 2005 through December 31, 2005 the Company did not incur any interest expense. Also, at December 31, 2007 and 2006, the Company had $0.5 million and $0.5 million, respectively, of interest payable included in other liabilities in the consolidated balance sheets.
As at and for the Periods Ended December 31, 2007, 2006, and 2005