(g) During 2007, we repurchased 939,039 common shares and 7,172,375.5 warrants to acquire common shares from White Mountains Insurance Group, Ltd. (“White Mountains”), a former affiliate, for $65.0 million. We also repurchased 3,780,305 common shares for $63.7 million from shareholders other than White Mountains.
(i) During 2005, we publicly sold 25,850,926 common shares for $600.0 million.
We ended 2007 with a fully converted tangible book value per share of $17.82, an increase of 17.2% for the year inclusive of dividends. The increase was largely the result of favorable underwriting conditions resulting from satisfactory pricing and a low level of catastrophes experienced throughout the year, as well as solid investment results. Our comprehensive income for 2007 was $314.0 million and our GAAP combined ratio was 61.3%.
(3) Computed as the change in fully converted tangible book value per share, as adjusted for dividends declared.
Pricing in most insurance and reinsurance markets is generally cyclical in nature. We assign a price index percentage to business which we renew. This index represents an internal subjective measure which takes into account both changes in pricing and terms and conditions which we observe. This index does not reflect deteriorating pricing or terms of business we decline to renew.
Outside of property business in U.S. peak zones, pricing during 2006 was mixed and we observed instances of both upward price movement and, more frequently, price decreases.
Despite witnessing broad-based rate strengthening in our Property Catastrophe line we took deliberate steps to reduce our gross exposures at January 1, 2009, in anticipation of continued market tightening for U.S. property business for the remainder of the year. Additionally, we were mindful of the widening disparity between pricing for inwards reinsurance and outwards retrocession, which renders certain protections typically purchased in prior years uneconomical.
Looking ahead to future periods, it is difficult to predict the amount of annual premiums we will write and how attractive pricing will be. However, we believe that the recent widespread investment and catastrophe losses have weakened the balance sheets of many insurance and reinsurance companies and have reduced the reinsurance capacity provided by the capital markets. We see all of these factors as directly reducing the supply of capital which should, in turn, result in higher return hurdles. Based on discussions with a variety of ceding companies, we also expect to see increased demand for reinsurance driven by several sources, including weaker capital adequacy positions and shrinking risk tolerances.
During the fourth quarter of 2008, we announced that we had received approval from Lloyd’s for the establishment of our own wholly-owned Managing Agent, MUA. MUA has assumed the management of Montpelier Syndicate 5151 for the 2009 underwriting year of account, with effect from January 1, 2009.
Our three-tiered risk management approach focuses on tracking exposed contract limits, estimating the potential impact of a single natural catastrophe event, and simulating our yearly net operating result to reflect certain modellable underwriting and investment risks we face on an aggregate basis. We seek to refine and improve our risk management process over time. Our catastrophe and enterprise-wide risk management metrics entail significant estimates, judgments and uncertainties. As such, the following discussion should be read in conjunction with our “Risk Factors” contained in Item 1A herein, in particular the specific risk factor entitled “Our stated catastrophe and enterprise-wide risk management exposures are based on estimates and judgments which are subject to significant uncertainties.”
We track gross reinsurance treaty contract limits which we deem exposed to a single natural perils occurrence within certain broadly defined major catastrophe zones. The resulting measure represents the sum of all contract limits assumed through property reinsurance treaties, other specialty reinsurance treaties and event-linked insurance derivatives, but excludes limits relating to individual risk insurance business and the benefit of any reinsurance protections we have purchased. As of December 31, 2008, our largest single zonal concentration was Northern European windstorm (the zone consisting of the U.K., Ireland, Germany, France, the Benelux countries, Switzerland, Denmark, Norway and Sweden). For individual risk business, including both direct insurance and facultative reinsurance accounts, we supplement our treaty approach by tracking contract limits to a finer geographic resolution.
Our consolidated financial results for years ended December 31, 2008, 2007 and 2006 follow:
The Company operates through four operating segments, Montpelier Bermuda, Montpelier Syndicate 5151, MUSIC and Blue Ocean. Each operating segment is a separate underwriting platform through which the Company writes reinsurance and insurance business. The activities of the Company, certain of its intermediate holding and service companies and intercompany eliminations relating to inter-segment reinsurance and service charges, collectively referred to as “Corporate and Other,” are also presented.
The following table summarizes Montpelier Bermuda’s gross premiums, by line of business, for the years ended December 31, 2008, 2007 and 2006:
Our gross premiums written within our Montpelier Bermuda segment decreased by approximately 6% in 2007, as compared to 2006. In addition, our mix of premiums written also changed significantly during the period. The premium decrease and change in mix resulted from the following:
During 2008, net premiums written within our Montpelier Bermuda segment decreased by approximately 13% and 12% as compared to 2007 and 2006, respectively. Various factors will continue to affect Montpelier Bermuda’s appetite and capacity to write and retain risk. These include the impact of changes in frequency and severity assumptions used in our models and the corresponding pricing required to meet our return targets, evolving industry-wide capital requirements, increased competition, and other considerations. The level of reinstatement premiums received in future periods is also dependent upon the occurrence of catastrophic losses.
The following tables present Montpelier Bermuda’s gross unpaid loss and LAE reserves, by line of business, as of and for the years ended December 31, 2008, 2007 and 2006:
The following tables present Montpelier Bermuda’s net unpaid loss and LAE reserves, by line of business, as of and for the years ended December 31, 2008, 2007 and 2006:
Our best estimate for Montpelier Bermuda’s ending gross loss and LAE reserves at December 31, 2008 and 2007 was $750.0 million and $839.8 million, respectively. Our best estimate for Montpelier Bermuda’s ending net loss and LAE reserves at December 31, 2008 and 2007 was $635.9 million and $704.0 million, respectively.
The following tables present Montpelier Bermuda’s net loss and LAE and net loss and LAE ratios for the years ended December 31, 2008, 2007 and 2006:
During 2007, Montpelier Bermuda incurred significant losses from European windstorms Kyrill and Gonu, California wildfires and floods in the U.K. and Australia. These events generated combined net losses of $88.6 million.
During 2006, Montpelier Bermuda’s single largest catastrophe loss, a series of U.S. tornadoes and hailstorms, amounted to less than $10.0 million.
· Net estimated ultimate Property Specialty losses for prior years decreased by $26.6 million due primarily to claims emergence on Montpelier Bermuda’s direct and facultative book of business being lower than expected and lower than expected ultimate losses on proportional business.
Profit commissions totaled $5.9 million, $6.8 million and $3.8 million for 2008, 2007 and 2006, respectively. Profit commissions, which are paid by assuming companies to ceding companies in the event of favorable loss experience, change as our estimates of loss and LAE fluctuate. Relatively few of our assumed reinsurance contracts contain profit commission clauses. The terms of these commissions are specific to the individual contracts and vary as a percentage of the contract results. Profit commission is expensed based on the estimated results of the subject contract.
The significant decrease in incentive compensation during 2008, as compared to 2007, is due to a sharp reduction in incentive accruals resulting from the significant storm losses incurred during 2008. Additional reasons for the decreases are: (i) a decrease in performance share expense due to a lower share price in the 2008 periods versus 2007; and (ii) lower overall RSU expense in 2008 due to the timing of Montpelier Bermuda’s outstanding awards (RSU awards are more heavily amortized in the early stages of the award). The significant increase in our incentive compensation from 2006 to 2007 was the mainly result of: (i) having two cycles of performance shares outstanding versus only one cycle during 2006 (all performance shares issued for the 2005 - 2007 performance period were cancelled without payment as there was no payout related to this tranche due to the adverse financial effects of the 2005 hurricanes); and (ii) having two cycles of RSUs outstanding versus only one cycle outstanding during 2006.
The following table summarizes Montpelier Syndicate 5151’s gross premiums, by line of business, for the years ended December 31, 2008 and 2007:
Syndicate 5151’s current focus is primarily on short tail business that does not contain catastrophe exposure. Virtually all of Syndicate 5151’s Property Catastrophe premium represents business transferred from the Montpelier Bermuda and Blue Ocean segments, bringing Montpelier’s underwriting function closer to the local market generating the business.
To date, most of Montpelier’s outward reinsurance has been purchased by the Montpelier Bermuda segment, which in turn provides inter-segment reinsurance to Montpelier Syndicate 5151. However, from time to time, Montpelier Syndicate 5151 purchases a limited amount of reinsurance cover that protects exposures unique to that segment.
Various factors will continue to affect this segment’s appetite and capacity to write and retain risk. These include the impact of changes in frequency and severity assumptions used in our models and the corresponding pricing required to meet our return targets, evolving industry-wide capital requirements, increased competition, and other considerations.
Net premiums earned at Montpelier Syndicate 5151 during years ended December 31, 2008 and 2007 were $63.6 million and $4.2 million, respectively. Net premiums earned are a function of the timing of net premiums written.
The following tables present Montpelier Syndicate 5151’s loss and LAE and net loss and LAE ratios for the years ended December 31, 2008 and 2007:
Loss and LAE relating to current year losses amounted to $46.7 million in 2008 and related to several individual risk losses, as well as $6.8 million of losses relating to hurricanes Gustav and Ike. Of the total current year loss and LAE recorded by Montpelier Syndicate 5151 during 2008, $23.7 million related to business underwritten by our U.S. underwriters and $23.0 million related to business underwritten by our U.K. underwriters.
Montpelier Syndicate 5151 experienced $0.7 million in adverse development on its loss and LAE reserves relating to prior year losses during 2008.
The following table presents Montpelier Syndicate 5151’s underwriting expenses for the years ended December 31, 2008 and 2007:
Acquisition costs (which include brokerage costs, commissions and excise taxes, when applicable) are generally driven by contract terms and are normally a set percentage of gross premiums written. Acquisition costs consist of the net of commission expenses incurred on assumed business and commission revenue earned on purchased reinsurance covers. Commission revenue on purchased reinsurance covers is earned over the same period over which the corresponding premiums are expensed. Montpelier Syndicate 5151’s acquisition costs for 2008 and 2007 included premium deficiency charges of $0.1 million and $0.9 million, respectively, with the 2007 charge representing 21 points to that year’s acquisition costs ratio.
The following table summarizes Montpelier Syndicate 5151’s general and administrative expenses during the years ended December 31, 2008 and 2007:
Share based and other incentive compensation represents annual and long-term incentives for Montpelier Syndicate 5151 employees. The increase in such incentive compensation costs from 2007 to 2008 was mainly due to staff increases within the U.S. and U.K. operations. This increase was partially offset by a decrease in incentive accruals made during the third quarter of 2008 resulting from the significant storm losses incurred during that period.
The following table summarizes MUSIC’s general and administrative expenses during the years ended December 31, 2008 and 2007:
MUSIC’s fixed expenses of $4.5 million for 2008 represent recurring expenses associated with its operations whereas its fixed expenses of $1.1 million for 2007 primarily represent costs associated with establishing its operating platform. MUSIC’s variable expenses of $0.5 million and $0.1 million for 2008 and 2007, respectively, consisted of annual and long-term incentive accruals.
Underwriting results for Blue Ocean for the years ended December 31, 2008, 2007 and 2006 were as follows. Blue Ocean was formed in December 2005 and ceased writing new business in June 2007.
Corporate and Other, which collectively represents the Company, certain intermediate holding and service companies and intercompany eliminations relating to inter-segment reinsurance and service charges, is not considered to be an operating segment of our business. The results of Corporate and Other principally reflect general and administrative expenses in support of its various operating companies.
Our Corporate and Other results for the years ended December 31, 2008, 2007 and 2006 were as follows:
The following table summarizes the general and administrative expenses of Corporate and Other during the years ended December 31, 2008, 2007 and 2006:
Management services principally represent underwriting, risk management, claims management, ceded retrocession agreement management, actuarial and accounting service fees provided to Blue Ocean. The decrease in fees earned from 2006 to 2008 is due to the timing and extent of Blue Ocean’s underwriting activities.
Our total investment return for 2008 was significantly lower than that of 2007 and 2006, due to sizable net realized and unrealized investment losses and reductions in net investment income experienced during the year.
During 2008, we experienced $73.6 million of net realized investment losses. The net realized investment losses recorded during the year principally resulted from a $17.5 million loss within our fixed maturity portfolio resulting from the bankruptcy of Lehman Brothers and $43.6 million in losses within our other investment portfolio attributable to two leveraged limited partnership funds which specialized in distressed loans. During 2007 we experienced $6.0 million in realized gains within our fixed maturity portfolio and $20.6 million in realized gains from our equity securities. During 2006 we experienced $7.9 million in realized losses within our fixed maturity portfolio and $12.3 million in realized gains from our equity securities.
As of December 31, 2008, our fixed maturity portfolio contained certain securities with exposure to the sub-prime mortgage market and the Alternative-A mortgage market which had a fair value of $25.4 million. Of these securities, 88% were currently rated “AAA” (Extremely Strong) and 12% were rated “BB” (Marginal) by Standard & Poor’s. These securities had an amortized cost of $27.0 million as of December 31, 2008.
During 2008, 2007 and 2006, we recorded unrealized gains (losses) from our private placement investment in Symetra Financial Corporation (“Symetra”) of $0.9 million, $(1.6) million and $2.4 million respectively. Symetra provides retirement plans, employee benefits, life insurance and annuities through a national network of independent advisors and agents.
As of December 31, 2008, 9.3% of our total invested assets measured at fair value were considered to be Level 3 assets as defined in FAS 157. As of December 31, 2007, 12.6% of our total invested assets measured at fair value were considered to be Level 3 assets. Our investments classified as Level 3 at December 31, 2008 and 2007, primarily consisted of the following: (i) with respect to fixed maturity investments, certain corporate bonds, convertible debt and asset-backed securities, many of which are not publicly traded or are not actively traded; (ii) with respect to equity securities, warrants to acquire equity securities and certain non-U.S. equity securities; and (iii) with respect to other investments, our investment in Symetra.
The following table summarizes the components of our consolidated net foreign exchange gains (losses) for years ended December 31, 2008, 2007 and 2006:
In 2008, we entered into an Industry Loss Warranty (“ILW”) swap contract (the “ILW Swap”) with a third-party in order to provide protection against our U.S. hurricane exposure. In return for a fixed-rate payment of $0.7 million, we are entitled to receive a floating-rate payment triggered on the basis of losses incurred by the insurance industry as a whole through April 30, 2009. The maximum recovery to us under the ILW Swap is $5.0 million.
Annual contract payments expensed in connection with the CAT Bond Protection, calculated at 12.83% per annum on the first tranche and 13.58% per annum on the second tranche, total $11.9 million. In addition, during 2006 we incurred $1.9 million in one-time setup costs associated with the CAT Bond Protection.
The fair value of the CAT Bond Protection was zero at December 31, 2008.
We recorded a net revenues associated with our Investment Options and Futures of $1.8 million during 2008.
The following table summarizes our consolidated interest and other financing expenses for the years ended December 31, 2008, 2007 and 2006:
Interest and other financing expenses decreased significantly during 2008, as compared to 2007, due primarily to the repayment of the Blue Ocean Debt and the cancellation of Blue Ocean’s credit facilities, each of which occurred in January 2008. Interest and other financing expenses increased significantly during 2007, as compared to 2006, due to addition of MCL’s Lloyd’s standby letter of credit facility in July 2007 and the issuance of the Blue Ocean debt in November 2006.
In January 2006 we, through Montpelier Capital Trust III, participated in a private placement of $103.1 million of floating rate capital securities (the “Trust Preferred Securities”). The Trust Preferred Securities mature on March 30, 2036, are redeemable at Montpelier Capital Trust III’s option at par beginning March 30, 2011, and require quarterly distributions of interest to the holders of the Trust Preferred Securities. The Trust Preferred Securities bear interest at 8.55% per annum through March 30, 2011, and thereafter at a floating rate of 3-month LIBOR plus 380 basis points, reset quarterly. Montpelier Capital Trust III simultaneously issued all of its issued and outstanding share capital to us for a purchase price of $3.1 million which is carried in other investments.
Our newly-established U.S. subsidiaries have not yet generated U.S. Federal taxable income. Our non-U.S. subsidiaries generated Non-U.S. taxable income of $2.9 million, $(3.0) million and $0.2 million for the years ended December 31, 2008, 2007 and 2006, respectively.
Our minority interest expense for 2008, 2007 and 2006 of $1.9 million, $31.9 million and $39.3 million, respectively, represents the portion of Blue Ocean’s net income attributable to its minority shareholders.
In 2008, we acquired all the outstanding share capital of Blue Ocean from its minority shareholders for $30.5 million in cash. This transaction resulted in an extraordinary gain of $1.0 million representing the excess of fair value of acquired net assets over our cost.
The following table summarizes our capital structure as of December 31, 2008 and 2007:
Montpelier Re amended its $225.0 million syndicated secured facility in August 2005. The amendment served to revise this facility from a $250.0 million three-year facility to a $225.0 million five-year facility with a revised expiry date of August 2010. This facility is subject to an annual commitment fee of 0.275% on drawn balances and 0.075% on undrawn balances.
Montpelier Re entered into a five-year syndicated secured $250.0 million letter of credit facility in June 2007. During 2008, this facility was reduced to $215.0 million. This facility is subject to an annual commitment fee of 0.275% on drawn balances and 0.08% on undrawn balances.
Montpelier Re entered into a $100.0 million secured letter of credit facility in November 2005. This facility has no stated expiration date. This facility is subject to an annual commitment fee of 0.20% on drawn balances only.
In the normal course of business, Blue Ocean Re established trust funds for the benefit of ceding companies. As of December 31, 2008, Blue Ocean Re had no in force reinsurance contracts and no longer required any of its assets to be held in trust. As of December 31, 2007, Blue Ocean Re’s restricted assets held in trust funds consisted of cash and cash equivalents of $35.5 million and fixed maturity investments of $153.7 million.
In May 2006, we entered into two equity forward sale agreements (the “Forward Sale Agreements”), one expiring in March 2007 and one expiring in March 2008, under which we agreed to sell (subject to our right to cash settle or net share settle such agreements) an aggregate of between 9,796,388 and 15,694,800 common shares to a third-party (the “forward counterparty”) in exchange for proceeds of approximately $180 million (subject to prior prepayment and assuming no subsequent repayment pursuant to the terms of such agreements). The forward counterparty subsequently sold a total of 15,694,800 common shares in order to hedge its position under the Forward Sale Agreements.
In March 2007, we notified the forward counterparty of our election to settle the entire first Forward Sale Agreement which related to up to 7,774,800 common shares. In the course of that settlement, as the valuation price per common share for each component was greater than the $11.75 forward floor price and less than the $18.465 forward cap price, no payments or deliveries of common shares were required to be made by us or the forward counterparty.
Pursuant to the terms of the amendment, the remaining Forward Sale Agreement was divided into two tranches, each relating to 3,960,000 common shares. Each tranche is comprised of twenty separate components, each relating to 198,000 common shares. Subject to our right to elect cash or net share settlement with respect to all of or a portion of the components of either tranche, or to terminate early or otherwise accelerate settlement of any component of either tranche, we will issue common shares to the forward counterparty: (i) in the case of the first tranche, over a twenty business day period beginning on October 8, 2009 based upon the price of common shares over a twenty trading-day period beginning on October 5, 2009; and (ii) in the case of the second tranche, over a twenty business day period beginning on November 11, 2009 based upon the price of common shares over a twenty trading-day period beginning on November 6, 2009.
Also pursuant to the terms of the amendment, the forward cap price of the remaining Forward Sale Agreement was increased from $18.375 to $22.00 per common share in the case of the first tranche, and from $18.375 to $23.00 per common share in the case of the second tranche. The amendment did not change the forward floor price which remains at $11.25 per common share. As a result, upon full physical settlement of any component of the Forward Sale Agreement, if the relevant volume-weighted average per share price of common shares on the valuation date for such component is greater than the increased forward cap price, we will issue to the forward counterparty a number of common shares equal to 51.1364% of the number of common shares underlying such component in the case of the first tranche, and 61.2245% of the number of common shares underlying such component in the case of the second tranche.
We made a $3.9 million cash payment to the forward counterparty for the amendment of the Forward Sale Agreement, which we recorded as a reduction of our additional paid-in capital.
In connection with the Forward Sale Agreements described above, in May 2006 we entered into a Share Issuance Agreement with the forward counterparty. Under the terms of the Share Issuance Agreement, we issued 15,694,800 common shares during 2006 to the forward counterparty for payment equal to the par value of such common shares. As a result of the settlement of the first Forward Sale Agreement, in May 2007 we repurchased and retired 7,774,800 of these common shares for payment of the par value of such common shares. As a result, we continue to have 7,920,000 common shares issued and outstanding under the Share Issuance Agreement at December 31, 2008.
We may terminate the Share Issuance Agreement at any time. Upon any termination of the Share Issuance Agreement, the common shares issued to the forward counterparty thereunder (or other common shares) must, subject to compliance with Bermuda law, be repurchased for cancellation for nominal consideration by us. The forward counterparty has agreed to post and maintain collateral with a third-party as security for certain of its obligations as required under the terms of the Share Issuance Agreement.
Any common shares issued to the forward counterparty will be issued and outstanding for company law purposes, and accordingly, the holders of such shares will have all of the rights of a holder of our issued and outstanding common shares, including the right to vote the shares on all matters submitted to a vote of our shareholders and the right to receive any dividends or other distributions that we may pay or make on our issued and outstanding common shares. However, under the Share Issuance Agreement, the forward counterparty has agreed to pay to us an amount equal to any cash dividends or distributions that are paid on the issued shares and to pay or deliver to the us any other distribution, in liquidation or otherwise, on the issued common shares.
During periods in which our average share price exceeds the forward cap price, the Forward Sale Agreement will have a dilutive impact on diluted earnings per share and, during periods in which our fully converted tangible book value per share exceeds the forward cap price, the Forward Sale Agreement will have a dilutive impact on fully converted book value per share.
Our cash flows provided from investing activities totaled $221.0 million, resulting from the following:
· we made $254.8 of net purchases of equity securities and other investments, of which $71.6 million represented the purchase of CAT Bonds from our former CAT Bond Facility,
· we had a $27.2 million reduction in our restricted cash,
· we repaid the $75.0 million Blue Ocean Debt, made $38.1 million in cash distributions to Blue Ocean’s minority common shareholders and paid $21.0 million in dividends and redemptions to Blue Ocean’s minority preferred shareholders,
Our cash flows provided from operations totaled $100.1 million which resulted primarily from premiums received, net of acquisition costs, exceeding net paid losses of $361.2 million.
Our cash flows provided from investing activities totaled $500.6 million resulting from the following:
· we received $451.3 million from net sales and maturities of fixed maturities,
· we made $59.4 million of net purchases of equity securities and other investments,
· we had a $122.3 million net dispositions of securities lending collateral,
· we paid $29.9 million in cash dividends to our common shareholders and warrant holders and repurchased $124.7 million of our common shares and warrants,
· we made $135.2 million in cash distributions to Blue Ocean’s minority common shareholders and paid $46.4 million in dividends and redemptions to Blue Ocean’s minority preferred shareholders,
Our cash flows used for investing activities totaled $263.1 million (including net purchases of trading securities) resulting from the following:
· we made $178.7 million of net purchases of fixed maturities,
Our cash flows provided from financing activities totaled $309.4 million resulting from the following:
· we received $66.5 million in cash proceeds from issuances of Blue Ocean’s preferred and common shares to minority holders,
· we had a $0.1 million net increase in securities lending payable.
Our consolidated financial statements have been prepared in accordance with GAAP. The preparation of financial statements in accordance with GAAP requires us to make estimates and assumptions that affect the reported and disclosed amounts of our assets and liabilities as of the balance sheet dates (including disclosures of our contingent assets and liabilities) and the reported amounts of our revenues and expenses during the reporting periods. We believe the items that require the most subjective and complex estimates are:
We utilize a reserving methodology that calculates a point estimate for our ultimate losses. The point estimate represents management’s best estimate of ultimate loss and LAE. We review our reserving assumptions and our methodologies on a quarterly basis. Our third quarter and year-end loss estimates are subject to a corroborative review by independent actuaries using generally accepted actuarial principles. The Audit Committee of our Board of Directors also reviews our quarterly and annual reserve analysis.
Most of our treaty reinsurance contracts comprise business which has both a low frequency of claims occurrence and a high potential severity of loss, such as claims arising from natural catastrophes, terrorism, large individual property risks, and aviation risks. Given the high-severity, low-frequency nature of these events, the losses typically generated do not lend themselves to traditional actuarial reserving methods. Therefore, our reserving approach for these types of coverages is generally to estimate the ultimate cost associated with a single loss event rather than analyzing the
historical development patterns of past losses as a means of estimating ultimate losses for an entire accident year. We generally estimate our reserves for these large events on a contract-by-contract basis by means of a review of policies with known or potential exposure to a particular loss event.
While the approach we use in reserving for large events is generally consistent for large events, at any point in time the particular reserving assumptions applied to an individual contract may vary. The assumptions for a specific contract may depend upon the class of business, historical reporting patterns of the cedant, whether or not the cedant provides an IBNR estimate, how much of the loss has been paid, the number of underlying claims still open and other factors. For example, the expected loss development for a contract with 1% of claims still outstanding would likely be less than for a contract with 50% of claims still open.
To the extent we rely on industry data to aid us in our reserve estimates there is a risk that the data may not match our risk profile or that the industry’s reserving practices overall differ from our own and those of our cedants. In addition, reserving can prove especially difficult should a significant loss take place near the end of a reporting period, particularly if the loss involves a catastrophic event. These factors further contribute to the degree of uncertainty in our reserving process.
As a predominantly broker market reinsurer for both excess-of-loss and proportional contracts, we must rely on loss information reported to brokers by primary insurers who, in turn, must estimate their own losses at the policy level, often based on incomplete and changing information. The information we receive varies by cedant and may include paid losses, estimated case reserves, and, infrequently, an estimated provision for IBNR reserves. Reserving practices and the quality of data reporting varies among ceding companies, which adds further uncertainty to the estimation of our ultimate losses. The nature and extent of information received from ceding companies also varies widely depending on the type of coverage, the contractual reporting terms (which are affected by market conditions and practices) and other factors. Due to the lack of standardization of the terms and conditions of reinsurance contracts, the wide variability of coverage provided to individual clients and the tendency of those coverages to change rapidly in response to market conditions, the ongoing economic impact of such uncertainties and inconsistencies cannot be reliably measured. Additional risks to us involved in the reporting of retrocessional contracts include varying reserving methodologies used by the original cedants and an additional reporting lag due to the time required for the retrocedant to aggregate its assumed losses before reporting them to us. Furthermore, the number of contractual intermediaries is generally greater for retrocessional business than for direct business, thereby increasing the time lag and imprecision associated with loss reporting.
The nature and extent of loss information provided under many facultative and per occurrence excess contracts, where company personnel work closely with the ceding company in settling individual claims, may not differ significantly from the information received under a primary insurance contract. Loss information from aggregate excess-of-loss contracts, including catastrophe losses and proportional share treaties, will often be less detailed. Occasionally, such information is reported in summary format rather than on an individual claim basis.
Estimating loss reserves for our small book of longer-tail casualty reinsurance business, which can be either on an excess-of-loss or proportional basis, involves further uncertainties. In addition to the uncertainties inherent in the reserving process described above, casualty business can be subject to longer reporting lags than property business, and claims often take many years to settle. During this period, additional factors and trends will be revealed and as these factors become apparent we will adjust our reserves. There is also the potential for the emergence of new types of losses within our casualty book. Any factors that extend the time until claims are settled add uncertainty to the reserving process. At December 31, 2008 and 2007, we recorded gross loss and LAE reserves related to our casualty business of $182.5 million and $191.9 million, respectively.
The uncertainties inherent in the reserving process, together with the potential for unforeseen developments, including changes in laws and the prevailing interpretation of policy terms, may result in loss and LAE significantly greater or less than the reserves initially established. Changes to our prior year loss reserves will impact our current underwriting results by improving our results if the prior year reserves prove to be redundant or reducing our results if the prior year reserves prove to be insufficient. We expect volatility in our results in periods that significant loss events occur because U.S. GAAP does not permit insurers or reinsurers to reserve for loss events until they have occurred and are expected to give rise to a claim. As a result, we are not allowed to record contingency reserves to account for expected future losses. We anticipate that claims arising from future events will require the establishment of substantial reserves from time to time.
The following tables provide the details of our gross case reserves and IBNR, by line of business, at December 31, 2008 and 2007:
We have determined that our best estimates for gross loss and LAE reserves at December 31, 2008 and 2007 were $808.9 million and $860.7 million, respectively. Of this estimate, at December 31, 2008 and 2007, $51.6 million and $66.6 million related to our insurance business, respectively, and $757.3 and $794.1 million related to our reinsurance business, respectively.
Our reserving methodology does not lend itself well to a statistical calculation of a range of estimates surrounding the best point estimate of our loss and LAE reserves. As discussed above, due to the low frequency and high severity nature of our business, our reserving methodology involves arriving at a point estimate for the ultimate expected loss on a contract by contract basis with our aggregate loss reserves being the sum of the individual reserves established per contract.
Though we are principally a provider of reinsurance, we write both reinsurance and insurance contracts. Insurance and facultative reinsurance contracts are written based on agreed upon terms and conditions which include a stated premium for coverages provided. The stated premium within the underlying contract is then recorded as written premium at the effective date of the policy. In general, if the terms and conditions change during the policy period, either through policyholder request or underwriting audit, the policy would be endorsed to reflect the change in coverage. This endorsement usually generates a change to the policy premium which is then recorded as an adjustment to written premium for the policy term.
Management includes an assessment of the creditworthiness of cedants in the review process above, primarily based on market knowledge, the timeliness of cedants’ past payments and the status of current balances owing. In addition, management may also review the financial statements of ceding companies. Based on this assessment, management established an allowance of $0.8 million for uncollectible premiums receivable as of December 31, 2008 and 2007.
The cost of reinsurance purchased is subject to variability based on a number of factors. Excess-of-loss reinsurance contracts are generally purchased prior to the time our assumed risks are written and accordingly we must estimate our premiums when purchasing reinsurance coverage. For these contracts, the deposit or minimum premium is defined in the contract wording which is based on our estimated assumed premiums and this is the amount we record as ceded premium in the period the coverage incepts. In the majority of cases, the deposit or minimum premium paid under these contracts is adjusted at the end of the contract period in order to reflect any change in the premium actually payable in respect of the underlying risks assumed during the contract period. Subsequent adjustments, based on the calculation of our gross premiums written, are recorded in the period they are determined. To date these adjustments have not been significant. In addition, a loss which pierces the reinsurance cover may generate reinstatement premium ceded, depending on the terms of the contract. This reinstatement premium ceded is recognized at the time the reinsurance recovery is estimated and recorded.
Reinsurance recoverable on paid and unpaid loss and LAE represents amounts due to us from reinsurance companies for paid and unpaid loss and LAE. For excess-of-loss reinsurance, the attachment point and limit of these contracts are based on the amount of our actual losses incurred from an event or events. In some cases, our recovery is also contingent upon the associated industry loss reaching a sufficient level.
At target payout, each performance share represents the fair value of a common share. At the end of a performance period, which is generally the three-year period following the date of grant, the value of each performance share is adjusted to represent a harvest of between zero and 200% of target depending on the achievement of specific performance criteria relating to our operating and financial performance over the period. At the discretion of the CN Committee, any final payment in respect of such performance shares may take the form of cash, common shares or a combination of both.
Since performance shares are contingently payable, we initially accrue the projected performance share expense based on: (i) the number of performance shares granted; (ii) the closing price of our common shares at the date of grant; and (iii) an assumed 100% harvest ratio. Beginning at the mid-point of the performance cycle, and every subsequent quarter thereafter, we re-assess the projected results for each outstanding performance share cycle and adjust our performance share accrual as necessary based on: (i) the number of performance shares granted; (ii) the current price of our common shares as of the balance sheet date; and (iii) our current estimate of the ultimate harvest ratio. As a result, in the latter half of any performance share period, our performance share expense may fluctuate significantly as the harvest ratio and the market price of our common shares is adjusted.
The primary performance target (that resulting in a 100% harvest) for all participants with respect to performance shares granted for the 2005-2007, 2006-2008 and 2007-2009 performance periods is the achievement of an underwriting return on an internally generated risk-based capital measure of 16% over the period. Additionally, at the sole discretion of the CN Committee, the performance of certain members of senior management may be further measured by reference to the ratio of the actual return on equity to the return on risk-based capital and may result in an adjustment to the harvest of + / - 25%.
With respect to the 2005-2007 performance period, 400,000 performance shares were granted to employees. Due to the impact of severe hurricane losses on our 2005 results, the estimated harvest ratio for this performance period was reduced to 0% during the 2005 third quarter. This action resulted in an immediate performance share liability reversal of $2.8 million during 2005. We also reversed other pre-existing long-term incentive liabilities of $18.8 million at that time.
Since performance share grants were made to relatively few employees, we do not adjust our performance share accruals for assumed forfeitures.
RSUs are phantom restricted shares which, depending on the individual award, vest in equal tranches over three, four or five year periods, subject to the recipient maintaining a continuous relationship with us (either as an employee, a director or a consultant) through the applicable vesting date. Holders of RSUs are not entitled to voting rights but are entitled to receive cash dividends and distributions.
Throughout 2006 and 2007, RSU awards consisted solely of: (i) grants made to induce individuals to join us; (ii) grants made to retain certain of our key employees; (iii) grants made to reward those employees exhibiting outstanding individual performance; and (iv) grants made to non-management members of our Board of Directors as part of their total remuneration. In each of these cases, the number of RSUs granted to recipients were fixed and determinable on the grant date (“Fixed RSUs”).
During 2008 we also began using a new form of RSU award, in addition to Fixed RSUs, as the principal component of our ongoing long-term incentive compensation for employees (“Variable RSUs”). Variable RSUs are contingent awards in which the actual number of RSUs to be awarded is dependent on Company performance during the initial year (the “Initial RSU Period”) of the four year award cycle. The actual number of Variable RSUs is not fixed and determinable until the completion of the Initial RSU Period and, during that period, the number of RSUs expected to be awarded for that cycle may fluctuate, perhaps significantly. For the RSU award cycle from 2008 to 2011, the actual number of Variable RSUs projected to be awarded has been determined based on a 2008 target ROE of 11.2%, assuming a standardized investment return. With respect to the 2008 to 2011 award cycle, at an achieved ROE of 11.2% we projected a grant of approximately 600,000 Variable RSUs to participants, at an ROE of 5.2% we would not expect to grant any Variable RSUs to participants and at an ROE of 21.2% we projected a grant of approximately 1,200,000 Variable RSUs to participants. Based on an estimated ROE achieved for 2008 of 8.2%, we projected the number of Variable RSUs to be granted for the 2008-2011 award cycle to be 316,036.
The unamortized grant date fair value of the 316,036 Variable RSUs outstanding as of December 31, 2008 was $2.4 million. The fair value of these Variable RSUs was $5.1 million on the date of grant.
For the years ended December 31, 2008, 2007 and 2006, we recognized $8.3 million, $8.2 million and $4.8 million of RSU expense.
As of December 31, 2008, 457,288 of our total outstanding RSUs were vested and are payable during the first quarter of 2009.