Part II, Item 6. "Selected Financial Data", and our consolidated financial statements and the related notes contained elsewhere in this Annual Report on Form 10-K for the fiscal year ended December 31, 2013 ("Annual Report").
We are a Bermuda-based specialty property and casualty reinsurer with a reinsurance and investment strategy that we believe differentiates us from our competitors. Our objective is to deliver attractive equity returns to shareholders by combining profitable reinsurance underwriting with our investment manager Third Point LLC’s superior investment management.
In contrast to many reinsurers with whom we compete, we have elected to limit our underwriting of property catastrophe exposures. We write excess of loss catastrophe reinsurance exclusively through the Catastrophe Fund, which is a separately capitalized reinsurance fund vehicle. On June 15, 2012, we established the Catastrophe Fund, the Catastrophe Fund Manager and the Catastrophe Reinsurer, in partnership with Hiscox. Our partnership with Hiscox is governed by a shareholders’ agreement that provides for certain matters relating to governance of the Catastrophe Fund Manager and restrictions on the transfers of its shares. Our investment in and management of the Catastrophe Fund
The Catastrophe Fund Manager is a property catastrophe fund management company, which began writing catastrophe risk through the Catastrophe Fund and related Catastrophe Reinsurer on January 1, 2013. The Catastrophe Fund Manager receives fee income in the form of management fees and performance fees from the Catastrophe Fund. We own 85% of the Catastrophe Fund Manager and Hiscox owns the remaining 15%. We consolidate the Catastrophe Fund Manager’s results in our consolidated results with a non-controlling interest recorded for the 15% Hiscox ownership. The objective of the Catastrophe Fund is to achieve positive uncorrelated investment returns by transacting, through the Catastrophe Reinsurer, in a portfolio of collateralized reinsurance treaties and other insurance-linked securities, including catastrophe bonds and industry loss warranties. The Catastrophe Reinsurer is a Bermuda based special purpose insurer authorized to write collateralized property catastrophe reinsurance business. The Catastrophe Fund owns 100% of the voting, non-participating, common shares and 100% of the non-voting, participating, preferred shares of the Catastrophe Reinsurer.
We were incorporated on October 6, 2011 and completed our initial capitalization on December 22, 2011. We began underwriting business on January 1, 2012. We completed an initial public offering of common shares on August 20, 2013 (the "IPO"). As a result, we have a limited operating history and are exposed to volatility in our results of operations. Period to period comparisons of our results of operations may not be meaningful.
We have included financial measures that are not calculated under standards or rules that comprise accounting principles generally accepted in the United States (GAAP). Such measures, including net underwriting income (loss), combined ratio, book value per share, diluted book value per share and return on beginning shareholders' equity, are referred to as non-GAAP measures. These non-GAAP measures may be defined or calculated differently by other companies. We believe these measures allow for a more complete understanding of the underlying business. These measures are used to monitor our results and should not be viewed as a substitute for those determined in accordance with GAAP. Reconciliations of such measures to the most comparable GAAP figures are referenced below in accordance with Regulation G.
The table below shows the key performance indicators for our consolidated business for the years ended December 31, 2013 and 2012 and the period from October 6, 2011 (incorporation date) to December 31, 2011:
Net investment income is an important measure that affects overall profitability. Net investment income is affected by the performance of Third Point LLC as our exclusive investment manager and the amount of investable cash, or float, generated by our reinsurance operation. Pursuant to the investment management agreement, Third Point LLC is required to manage our investment portfolio on substantially the same basis as its main hedge funds, subject to certain conditions set forth in our investment guidelines. These conditions include limitations on investing in private securities, a limitation on portfolio leverage, and a limitation on portfolio concentration in individual securities. The investment management agreement allows us to withdraw cash from our investment account with Third Point LLC at any time with three days’ notice to pay claims and with five days’ notice to pay expenses.
We track excess cash flows generated by our property and casualty reinsurance operation, or float, in a separate account which allows us to also track the net investment income generated on the float. We believe that net investment income generated on float is an important consideration in evaluating the overall contribution of our property and casualty reinsurance operation to our consolidated results. It is also explicitly considered as part of the evaluation of management’s performance for purposes of incentive compensation.
For the year ended December 31, 2013, book value per share increased by $2.41 per share, or 21.8%, to $13.48 per share from $11.07 per share as of December 31, 2012. For the year ended December 31, 2013, diluted book value per share increased by $2.23 per share, or 20.5%, to $13.12 per share from $10.89 per share as of December 31, 2012.
The increase in basic and diluted book value per share for the year was driven primarily from net income partially offset by the offering costs incurred with our IPO. The growth in diluted book value per share was also impacted by warrants and share compensation issued to our Founders, employees, directors and an advisor, including the additional warrants and options that became exercisable as a result of meeting the performance condition after the IPO.
The following table sets forth the computation of basic and diluted book value per share as of December 31, 2013 and 2012:
Premiums from our property and casualty reinsurance business assumed are directly related to the number, type and pricing of contracts we write. Premiums are earned over the contract period in proportion to the period of risk covered which is typically 12 to 24 months.
See Note 2 of our notes to consolidated financial statements included elsewhere in this Annual Report on Form 10-K for a summary of our significant accounting and reporting policies.
Our consolidated financial statements are prepared in accordance with U.S. GAAP, which requires management to make estimates and assumptions. We believe that the accounting policies that require the most significant judgments and estimations by management are (1) premium revenue recognition including evaluation of risk transfer, (2) loss and loss adjustment expense reserves, and (3) fair value measurements related to our investments. If actual events
We estimate the ultimate premiums for the entire contract period and record this estimate at the inception of the contract, to the extent that the amount of written premium is estimable. For contracts where the full written premium is not estimable at inception, we record written premium for the portion of the contract period for which the amount is estimable. These estimates are based primarily on information in the underlying contracts as well as information provided by our clients and/or brokers.
Premiums written are earned over the contract period in proportion to the period of risk covered. Unearned premiums represent the portion of premiums written that relate to the unexpired term of the contracts in force.
During the year ended December 31, 2013, we recorded $(35.7) million of changes in premium estimates on prior years' contracts, primarily due to return premiums on certain contracts that expired during the period with a provision within the contract to return the unearned premiums at expiration. However, there was minimal impact on net income of these changes in premium estimates for the year ended December 31, 2013.
Determining whether or not a reinsurance contract meets the condition for risk transfer requires judgment. The determination of risk transfer is critical to reporting premiums written and is based, in part, on the use of actuarial and pricing models and assumptions and evaluating contractual features that could impact the determination of whether a contract meets risk transfer. If we determine that a reinsurance contract does not transfer sufficient risk, we use deposit accounting. See Note 12 of the notes to consolidated financial statements for additional information on deposit contracts entered into to date.
Our loss and loss adjustment expense reserves include case reserves and reserves for losses incurred but not yet reported (“IBNR reserves”). Case reserves are established for losses that have been reported, but not yet paid, based on loss reports from brokers and ceding companies. IBNR reserves represent the estimated loss and loss adjustment
expenses that have been incurred by insureds and reinsureds but not yet reported to the insurer or reinsurer, including unknown future developments on loss and loss adjustment expenses which are known to us. IBNR reserves are established by management based on actuarially determined estimates of ultimate loss and loss adjustment expenses.
Inherent in the estimate of ultimate loss and loss adjustment expenses are expected trends in claim severity and frequency and other factors that may vary significantly as claims are settled. Accordingly, ultimate loss and loss adjustment expenses may differ materially from the amounts recorded in the financial statements. These estimates are reviewed regularly and, as experience develops and new information becomes known, the reserves are adjusted as necessary. Such adjustments, if any, are recorded in the consolidated statement of income in the period in which they become known.
We initially reserve every individual contract to the expected loss and loss expense ratio in the pricing analysis. As loss information is received from the cedents, we incorporate other actuarial methods in our projection of ultimate losses and, hence, reserves. In our pricing analysis, we typically utilize a significant amount of information unique to the individual client and, when necessary, supplement the analysis with industry data. Industry data primarily takes the form of paid and incurred development patterns from statutory financial statements and statistical agencies. For our actuarial reserve projections, the relevant information we receive from our reinsurance clients include premium estimates, paid loss and loss adjustment expenses and case reserves. We review the data for reasonableness and research any anomalies. On each contract, we compare the expected paid and incurred amounts at each quarter-end with actual amounts reported. We also compare premiums received with projected premium receipts at each quarter end.
A Priori Loss Ratio Method. To estimate ultimate losses under the a priori loss ratio method, we multiply earned premiums by an expected loss ratio. The expected loss ratio is selected as part of the pricing and utilizes individual client data, supplemented by industry data where necessary. This method is often useful when there is limited historical data due to few losses being incurred.
Paid Loss Development Method. This method estimates ultimate losses by calculating past paid loss development factors and applying them to exposure periods with further expected paid loss development. The paid loss development method assumes that losses are paid at a rate consistent with the historical rate of payment. It provides an objective test of reported loss projections because paid losses contain no reserve estimates. For some lines of business, claim payments are made slowly and it may take many years for claims to be fully reported and settled.
Bornhuetter-Ferguson Paid and Incurred Loss Methods. These methods are a weighted average of the a priori loss ratio and the relevant development factor method. The weighting between the two methods depends on the maturity
of the business. This means that for the more recent years a greater weight is placed on the a priori loss ratio, while for the more mature years a greater weight is placed on the development factor methods. These methods avoid some of the distortions that could result from a large development factor being applied to a small base of paid or incurred losses to calculate ultimate losses. This method will react slowly if actual paid or incurred loss experience develops differently than historical paid or incurred loss experience because of major changes in rate levels, retentions or deductibles, the forms and conditions of coverage, the types of risks covered or a variety of other factors.
Our reserving methodologies use a loss reserving model that calculates a point estimate for our ultimate losses. Although we believe that our assumptions and methodologies are reasonable, we cannot be certain that our ultimate payments will not vary, potentially materially, from the estimates that we have made.
Private securities are not registered for public sale and are carried at an estimated fair value at the end of the period, as determined by Third Point LLC. Valuation techniques, using information obtained from Third Point LLC, may include market approach, last transaction analysis, liquidation analysis and/or using discounted cash flow models where the significant inputs could include but are not limited to additional rounds of equity financing, financial metrics such as revenue multiples or price-earnings ratio, discount rates and other factors. In addition, we or Third Point LLC may employ third party valuation firms to conduct separate valuations of such private securities. The third party valuation
firms provide us or Third Point LLC with a written report documenting their recommended valuation as of the determination date for the specified investments.
Due to the inherent uncertainty of valuation for private securities, the estimated fair value may differ materially from the values that would have been used had a ready market existed for these investments. The actual value at which these securities could actually be sold or settled with a willing buyer or seller may differ from our estimated fair values depending on a number of factors including, but not limited to, current and future economic conditions, the quantity sold or settled, the presence of an active market and the availability of a willing buyer or seller.
We value our investments in affiliated investment funds at fair value, which is an amount equal to the sum of the capital account in the limited partnership generally determined from financial information provided by the investment manager of the investment funds. The resulting net gains or net losses are reflected in the consolidated statement of income.
For the years ended December 31, 2013 and 2012, there were no changes in the valuation techniques as it relates to the above.
derivatives held. Periodic payments received or paid on swap agreements are recorded as realized gain or loss on investment transactions. Such fluctuations are included within net investment income in the consolidated statement of income.
U.S. GAAP disclosure requirements establish a framework for measuring fair value, including a three-level hierarchy for fair value measurements based upon the transparency of inputs to the valuation of an asset or liability. The three-level hierarchy of inputs is summarized below:
Level 1 - Quoted prices available in active markets/exchanges for identical investments as of the reporting date.
In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, an investment’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. Our assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the investment.
The key inputs for swap valuation will vary based on the type of underlying on which the contract was written. Generally, the key inputs for most swap contracts include notional, swap period, fixed rate, credit or interest rate curves, current market or spot price of the underlying and the volatility of the underlying.
While management believes pricing remains adequate for the types of business on which we focus, there is significant underwriting capacity currently available. As a result, we believe market conditions will remain challenging in the near term. The segment with the greatest pricing pressure is property catastrophe reinsurance due to an influx of capacity from collateralized reinsurance and other ILS vehicles and the absence of significant catastrophe events during 2013. We and most other market participants believe that pricing for property catastrophe reinsurance treaties that renewed on January 1, 2014 dropped by more than 10% on average. Pricing for other types of traditional reinsurance, which are less attractive to collateralized reinsurance vehicles due to their longer loss development and claims payment periods, is also under pressure but not to the same degree as property catastrophe reinsurance.
Our direct exposure to falling property catastrophe prices is contained within the Catastrophe Fund and limited to our $54.8 million investment in the Catastrophe Fund and the contingent profit commission we receive from managing the Catastrophe Fund which had assets under management of $104.0 million as of December 31, 2013. The expected overall impact on our results, however, is tempered by the Catastrophe Fund’s portfolio construction and focus on smaller, regional companies, which have experienced more modest price decreases. Given current market conditions, we expect to limit the size of the Catastrophe Fund to ensure we can continue to profitably deploy the funds under management until market conditions improve.
Despite the fact that market conditions have deteriorated over the past year, we believe that there are several market developments that indicate a potential for improving market conditions in the medium term. These include improving pricing in several primary insurance lines of business which historically have flowed through to the reinsurance market, decelerating reserve releases from prior underwriting years, and historically low yields from investment portfolios consisting mostly of long-only, investment grade, shorter-term, fixed income securities. Companies with historically low yields from their investment portfolios are now focused on the need for pricing increases to offset the continued drop in investment income or on increasing the risk profile of their investment portfolios, which consumes more of their risk capital.
Consolidated Results of Operations-Years ended December 31, 2013 and 2012 and Period from October 6, 2011 (date of incorporation) to December 31, 2011
The increase in net income for the year ended December 31, 2013 compared to the year ended December 31, 2012 was primarily due to the following:
Our catastrophe risk management segment contributed net income of $3.4 million for the year ended December 31, 2013 compared to a net loss of $1.5 million for the year ended December 31, 2012. The Catastrophe Reinsurer wrote no business before January 1, 2013. The year ended December 31, 2012 included certain start-up related expenses related to formation of this segment.
For the year ended December 31, 2013, we recorded net investment income of $253.2 million, compared to $136.4 million for the year ended December 31, 2012. The return on investments managed by Third Point LLC was 23.9% for the year ended December 31, 2013 compared to 17.7% for the year ended December 31, 2012.
We were formed on October 6, 2011 and received proceeds from our initial capitalization in December 2011. For the period from October 6, 2011 to December 31, 2011, we incurred $1.1m of general and administrative expenses related to initial start-up costs.
As a result of these factors, we may experience volatility in the amount of gross premiums written and earned and period to period comparisons may not be meaningful.
The following table provides a breakdown of our property and casualty reinsurance segment’s gross premiums written by line of business for the years ended December 31, 2013 and 2012:
Changes in renewal premiums during the year ended December 31, 2013 resulted in increased premiums of $21.7 million. Premiums can change on renewals of contracts for a number of factors including: changes in our line size or participation, changes in the underlying premium volume of the client's program, pricing trends as well as other contractual terms and conditions. The increase was primarily due to one contract that was written for one year in 2012 and renewed as a two year contract in 2013 with other generally offsetting changes on other renewal business.
We did not renew four reinsurance contracts accounting for $72.8 million of premiums for the year ended December 31, 2012, with three of the contracts not renewing as a result of pricing and other changes in reinsurance contract structure, terms and conditions. In addition, our crop contract which accounted for $42.5 million of premium for the year ended December 31, 2012 was written in 2013 with a new counterparty and is included as $35.0 million of new business above.
Net loss and loss adjustment expenses. Net loss and loss expenses for the year ended December 31, 2013 was $139.6 million, or 65.7% of net premiums earned, compared to $80.3 million, or 83.2% of net premiums earned, for the year ended December 31, 2012.
The reinsurance contracts that we write have a wide range of initial loss ratio estimates. As a result, our net loss and loss expense ratio can vary significantly from period to period depending on the mix of business. For example, property quota share contracts have a lower initial loss ratio compared to other casualty and specialty lines of business. In general, our contracts have similar expected composite ratios (combined ratio before general and administrative expenses) and; therefore, contracts with higher initial loss ratio estimates have lower acquisition cost ratios and contracts with lower initial loss ratios have higher acquisition cost ratios. Retroactive reinsurance contracts have a higher initial loss ratio since the premiums are generally based on the net loss and loss adjustment reserves and do not include acquisition related and other expenses. In addition, we record the gross premiums written and earned and the net losses as incurred for retroactive reinsurance contracts at the inception of the contract, which can also impact the mix of premiums earned in a particular period.
The decrease in the loss ratio for the year ended December 31, 2013 was primarily due to the crop losses that were recorded in the year ended December 31, 2012. During the year ended December 31, 2012, we increased our crop loss from our initial loss estimate by $13.4 million, or 21.3 percentage points. This crop reinsurance contract accounted for $10.0 million of net underwriting loss for the year ended December 31, 2012.
We recorded $1.3 million, or 0.6 percentage points, of net favorable prior years' reserve development for the year ended December 31, 2013. We commenced underwriting in 2012 and therefore did not have any prior years' reserve development for the 2012 year.
For the year ended December 31, 2013, we also recorded a decrease of $3.4 million in loss and loss adjustment expense reserves due to a decrease in our premium estimate related to our crop contract. The reserve and premium adjustments generally offset resulting in no net underwriting income or net loss ratio impact for the year ended December 31, 2013.
The reinsurance contracts that we write have a wide range of acquisition cost ratios. As a result, our acquisition cost ratio can vary significantly from period to period depending on the mix of business. For example, our property quota share contracts have a higher initial acquisition cost ratio compared to other casualty and specialty lines of business. Property quota share contracts have a higher expense component due to inuring catastrophe reinsurance which increases the acquisition cost ratio on those contracts. Our property quota share contracts are structured to limit the amount of property catastrophe exposure we assume. As a result, inuring catastrophe reinsurance for the property catastrophe exposure reduces the amount of premium we assume relative to the acquisition costs or is an additional component of the acquisition costs. In general, our contracts have similar expected composite ratios (combined ratio before general and administrative expenses) and therefore, contracts with higher initial loss ratio estimates have lower acquisition cost ratios and contracts with lower initial loss ratios have higher acquisition cost ratios. Retroactive reinsurance contracts generally have a low initial acquisition cost ratio. In addition, we record the gross premiums written and earned for retroactive reinsurance contracts at the inception of the contract, which can also impact the mix of premiums earned in a particular period. Furthermore, a number of our contracts have a sliding scale or profit commission feature that will vary depending on the expected loss expense for the contract. As a result, changes in estimates of loss and loss adjustment expenses on a contract can result in changes in the sliding scale commissions and a contract's overall acquisition cost ratio.
The increase in general and administrative expenses for the year ended December 31, 2013 compared to the prior year period was primarily due to additional share compensation expense as a result of the performance condition having been met as a result of the IPO. In addition, we have increased headcount and related staff costs as we continued to
build out our management team and infrastructure throughout 2012 and 2013. These increases were partially offset by employee signing bonuses included in the year ended December 31, 2012. Although the general and administrative expenses increased compared to the prior year period, the general and administrative expense ratio is lower due to proportionately higher net premiums earned compared to the prior year period.
Gross premiums written. Gross premiums written of $8.3 million for the year ended December 31, 2013 consisted of property catastrophe business written.
Net loss and loss adjustment expenses. Net loss and loss adjustment expenses was $0.2 million for the year ended December 31, 2013 relating to tornadoes, hail and severe thunderstorms that occurred in the United States of America in March 2013.
The primary driver of our net investment income is the returns generated by our investment portfolio managed by our investment manager, Third Point LLC. The return on investments managed by Third Point LLC was 23.9% for the year ended December 31, 2013 compared to 17.7% for the year ended December 31, 2012. The following is a summary of the net investment return on investments managed by Third Point LLC by investment strategy:
The returns for the year ended December 31, 2013 were driven primarily by equity positions and to a lesser extent by gains in structured credit, corporate credit and macro positions. Net investment income for the year ended December 31, 2013 also benefited from higher average investments managed by Third Point LLC compared to the prior year periods due to the net proceeds generated by our IPO and float contributed by our property and casualty reinsurance operations.
The Company is a holding company and has no substantial operations of its own. Its assets consist primarily of its investments in subsidiaries. The Company’s ability to pay dividends or return capital to shareholders will depend upon the availability of dividends or other statutorily permissible distributions from those subsidiaries.
In addition, Third Point Re, as a Class 4 insurer, is prohibited from declaring or paying in any financial year dividends of more than 25% of its total statutory capital and surplus (as shown on its previous financial year’s statutory balance sheet) unless it files (at least seven days before payment of such dividends) with the BMA an affidavit signed by at least 2 directors (one of whom must be a Bermuda resident director if any of the insurer’s directors are resident in Bermuda) and the principal representative stating that it will continue to meet its solvency margin and minimum liquidity ratio.
Our cash flows from operations generally represent the difference between: (l) premiums collected and investment earnings realized and (2) losses and loss expenses paid reinsurance purchased an underwriting and other expenses paid. Cash flows from operations may differ substantially from net income. The potential for a large claim under a reinsurance contract means that substantial and unpredictable payments may need to be made within relatively short periods of time.
Our sources of funds primarily consist of premiums written, reinsurance recoveries, investment income and proceeds from sales and redemptions of investments. Cash is used primarily to pay loss and loss adjustment expenses, reinsurance premiums, acquisition costs and general and administrative expenses and to purchase investments.
Cash flows provided by operating activities for the year ended December 31, 2013 were $9.2 million compared to cash flows used in operating activities of $32.6 million for the year ended December 31, 2012 and cash flows used in operating activities of $1.6 million for the period from October 6, 2011 (date of incorporation) to December 31, 2011. Cash flows from operating activities generally represent net premiums collected less loss and loss adjustment expenses, acquisition costs and general and administrative expenses paid.
Cash and cash equivalents consist of cash held in banks and other short-term, highly liquid investments with original maturity dates of ninety days or less.
Effective January 1, 2013, the Citibank facility was reduced from $250 million to $150 million.
As of December 31, 2013, total shareholders’ equity was $1,510.4 million compared to $928.3 million as of December 31, 2012. This increase was primarily due to net proceeds of $286.0 million generated in our IPO, net income of $227.3 million and contributions from non-controlling interests of $88.3 million consisting of $25.3 million related to additional capital called by the Catastrophe Fund and $62.3 million related to the investment joint venture, primarily as a result of performance fees earned for 2013. These increases were partially offset by distributions of non-controlling interests of $35.1 million related to the investment joint venture.
We lease office space at Chesney House in Bermuda. This two year lease is scheduled to expire on November 30, 2015, with an option to renew for an additional three years.
See Note 12 to consolidated financial statements for detailed information on deposit liability contracts. For purposes of this contractual obligations table, we have included estimates of future interest accruals and what we expect the deposit liability contracts would settle for at their probable commutation dates.
We have no obligations, assets or liabilities, other than those derivatives in our investment portfolio and disclosed in our notes to consolidated financial statements, which would be considered off-balance sheet arrangements. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements.