As of January 1, 2007, we adopted SFAS No. 157, “Fair Value Measurements” and SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115” (currently FASB Accounting Standards Codification Topics on Fair Value Measurements and Disclosures and on Financial Instruments (see Item 8, Note 1 “Significant Accounting Policies” for additional details regarding the adoption of the FASB Accounting Standards Codification)). 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 these Topics, 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.
On July 1, 2008, we began to consolidate the operations of Flagstone Africa, on October 1, 2008, we began to consolidate the operations of Flagstone Alliance and on November 18, 2008, we began to consolidate the operations of Marlborough in accordance with the FASB ASC Topic on Consolidation.
The following is a discussion and analysis of our financial condition as at December 31, 2009 and 2008 and our results of operations for the years ended December 31, 2009, 2008 and 2007. All amounts in the following tables are expressed in thousands of U.S. dollars, except share amounts, per share amounts and percentages. This discussion should be read in conjunction with our audited consolidated financial statements and related notes included in Item 8 of this Form 10-K. Some of the information contained in this discussion and analysis is included elsewhere in this document, including information with respect to our plans and strategy for our business, and includes forward-looking statements that involve risks and uncertainties. Please see the “Cautionary Statement Regarding Forward-Looking Statements” for more information. You should review Item 1A, “Risk Factors” for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements.
We are a global reinsurance and insurance company. Effective January 1, 2009, as a result of our acquisition of Marlborough Underwriting Agency Limited (“Marlborough”), the managing agency for Lloyd’s Syndicate 1861, management views the Company as being organized into three business segments: Reinsurance, Lloyd’s and Insurance. Through our Reinsurance segment, we write primarily property, property catastrophe and short-tail specialty and casualty insurance and reinsurance. Through our Lloyd’s segment, we write primarily property and short-tail specialty and casualty reinsurance focused on the energy, hull, cargo, marine liability, engineering, and aviation business sectors. Through our Insurance segment, comprised of Island Heritage, we primarily write property insurance for homes, condominiums and office buildings in the Caribbean region.
We derive our revenues primarily from net premiums earned from the reinsurance and insurance policies we write, net of any retrocessional or reinsurance coverage purchased, net investment income from our investment portfolio, and fees for services provided. Premiums are generally a function of the number and type of contracts we write, as well as prevailing market prices. Premiums are normally due in installments and earned over the contract term, which ordinarily is twelve or twenty four months.
As a result of the acquisition of Marlborough, the managing agency for Lloyd’s Syndicate 1861, in November 2008, the Company established a new reporting segment which took effect January 1, 2009, when Syndicate 1861 began writing business for the benefit of the Company. The Company reports its results to the chief operating decision maker based on three reporting segments: Reinsurance, Lloyd’s and Insurance. The Company regularly reviews its financial results and assesses performance on the basis of these three operating segments.
Our Lloyd’s segment includes the business generated through the Lloyd’s Syndicate 1861 and Marlborough. Syndicate 1861 primarily provides property and short-tail specialty and casualty insurance and reinsurance for risks such as energy, hull and cargo, marine liability, engineering and aviation. Marlborough generates fee income for the provision of services to Syndicates and third parties.
Under U.S. GAAP, we are not permitted to establish loss reserves, which include case and Incurred But Not Reported (“IBNR”) reserves, until the occurrence of an event which may give rise to a claim. As a result, only loss reserves applicable to losses incurred up to the reporting date are established, with no allowance for the establishment of loss reserves to account for expected future losses. Claims arising from future catastrophic events can be expected to require the establishment of substantial loss reserves from time to time.
For our property catastrophe policies which comprise 47.4%, 58.5% and 65.6% of our total gross premiums written for the years ended December 31, 2009, 2008 and 2007, 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.
When a catastrophic event occurs, we first determine which treaties may be affected using our zonal monitoring of exposures. We contact the respective brokers and ceding companies involved with those treaties, to determine their estimate of involvement and the extent to which the reinsurance program is affected. We may also use our computer-based vendor and proprietary modeling systems to measure and estimate loss exposure under the actual event scenario, if available. Although the loss modeling systems assist with the analysis of the underlying loss, and provide us with information and the ability to perform an enhanced analysis, the estimation of claims resulting from catastrophic events is inherently difficult because of the variability and uncertainty of property and other catastrophe claims and the unique characteristics of each loss.
For non-catastrophe business, we utilize a variety of standard actuarial methods in our analysis. The selections from these various methods are based on the loss development characteristics of the specific line of business and specific contracts. The actuarial methods we use to perform our quarterly contract by contract loss reserve analysis include:
the cedent’s business practices will proceed as in the past with no material changes either in submission of accounts or cash flow receipts;
case reserve reporting practices, particularly the methodologies used to establish and report case reserves, are unchanged from historical practices;
Our reserving methodology, as discussed above, uses a loss reserving model that calculates a point estimate for the Company’s ultimate losses, as opposed to a methodology that develops a range of estimates. The Company then uses this point estimate, deducting cumulative paid claims and current case reserves, to record its estimate of IBNR. The Company employs sensitivity analysis in selecting our point estimate, which involves varying industry loss estimates for catastrophe events and estimated loss ratio for non-catastrophe business.
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 was no material change in any of these key factors during the year ended December 31, 2009.
During the year ended December 31, 2009, the losses on our catastrophe business were primarily from a series of small catastrophe events and one significant event, floods in Ireland ($13.6 million). During the year ended December 31, 2008, the significant losses on our catastrophe business were as follows: Hurricane Ike ($158.4 million), Hurricane Gustav ($14.5 million), Chinese winter storms ($18.2 million) and the U.S. Memorial Day Weekend storms ($11.1 million). During the year ended December 31, 2007, the significant losses on our catastrophe business were as follows: United Kingdom floods in June and July ($38.0 million); European Windstorm Kyrill ($32.4 million); New South Wales (Australia) floods ($18.5 million); three satellite losses during 2007 ($13.8 million); and the Sydney Hailstorm ($11.4 million). Because we expect a small volume of large claims, we believe the variance of our catastrophe related loss ratio could be relatively wide. Claims from catastrophic events could reduce our earnings and cause substantial volatility in our results of operations for any fiscal quarter or year which could adversely affect our financial condition and liquidity position.
In accordance with the Financial Instruments Topic of the Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”), the Company elects 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. The Company also applies the Fair Value Measurements and Disclosures Topic of the FASB ASC. The valuation technique used to 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 elects the fair value option to simplify the accounting, as this election reduces the burden of monitoring 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 judgment. Any movement in unrealized gains and losses is recorded within net realized and unrealized gains (losses) on investments within the consolidated statements of operations and comprehensive income (loss).
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 following is a summary of valuation methodologies we used to measure our financial instruments:
The Company’s U.S. government securities are stated at fair value as determined by the quoted market price of these securities as provided by exchange market prices, which represented 39.5% of our total fixed maturities portfolio. These securities are classified within Level 1.
The fair value of the corporate bonds, mortgage-backed securities, foreign government bonds, and asset-backed securities are provided by independent pricing services or by broker quotes based on inputs that are observable for the asset, either directly or indirectly. These securities are classified within Level 2 and Level 3, and the specific details of the sources are described below.
Upon vesting, the PSU holder shall 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 50% and 150%, depending on the DROE achieved during the vesting period.
In December 2009, the FASB issued ASC Topic 860, “Transfers and Servicing,” (“ASC 860”) which codifies FASB Statement No. 166, “Accounting for Transfers of Financial Assets” which was issued on June 12, 2009. ASC 860 requires that a transferor recognize and initially measure at fair value all assets obtained (including a transferor’s beneficial interest) and liabilities incurred as a result of financial assets accounted for as a sale. It is a revision to FASB Statement No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” and requires more information about transfers of financial assets, including securitization transactions, and where entities have continuing exposure to the risks related to transferred financial assets. ASC 860 is effective on a prospective basis in fiscal years beginning on or after November 15, 2009 and interim periods within those fiscal years, and will be adopted by the Company in the first quarter of fiscal year 2010. The Company does not expect the adoption of ASC 860 to have a material impact on its consolidated results of operations and financial condition.
Both events are expected to cause sizeable losses to the insurance industry. The Company has commenced the estimation process for expected claims relating to its exposures from these events but believes it is too early to issue an estimate of claims given the significant unknowns and early stages of the claims reporting process.
The Company’s reporting currency is the U.S. dollar. The Company’s subsidiaries have one of the following functional currencies: U.S. dollar, Euro, Swiss franc, Indian rupee, British pound, Canadian dollar or South African rand. As a significant portion of the Company’s operations are transacted in foreign currencies, fluctuations in foreign exchange rates may affect period-to-period comparisons. To the extent that fluctuations in foreign currency exchange rates affect comparisons, their impact has been quantified, when possible, and discussed in each of the relevant sections. See Note 2 “Significant Accounting Policies” to the consolidated financial statements in Item 8, “Financial Statements and Supplementary Data”, for a discussion on translation of foreign currencies.
We generated $242.2 million of net income in 2009, compared to a net loss of $187.3 million and net income of $167.9 million in 2008 and 2007, respectively. As highlighted in the table below, the two most significant items impacting our 2009 financial performance compared to 2008 and 2007 include: (1) An increase in underwriting income due to an increase in our net premiums earned, principally resulting from the growth in business by increased participation in programs from our existing clients, the addition of new clients, contribution from our 2008 acquisitions, growth in our franchise and due to the absence in 2009 of significant loss and loss adjustment expenses as incurred in 2008 from significant catastrophic events, such as Hurricanes Ike and Gustav and 2007 from Windstorm Kyrill and U.K. floods; and (2) A significant increase in 2009 in net realized and unrealized gains (losses) - investments primarily due to the significant declines in the global equity, bond and commodities markets in 2008, attributable to the broader deterioration and volatility in the credit markets and financial markets and the lingering impact of the sub-prime crisis, partially offset by a decrease in net investment income in 2009 resulting from lower interest rates.
Effective January 1, 2009, as a result of the acquisition of Marlborough, the managing agency for Lloyd’s Syndicate 1861 and Syndicate 1969, management views the Company as being organized into three reporting segments: Reinsurance, Lloyd’s, and Insurance. The Lloyd’s segment includes the business generated for Lloyd’s Syndicate 1861 by Marlborough. Syndicate 1861 began writing business for the benefit of Flagstone effective January 1, 2009. As such, there are no comparative numbers for the prior years.
Our Reinsurance segment provides reinsurance through our property, property catastrophe and short-tail specialty and casualty reinsurance business units. Our Lloyd’s segment primarily provides property and short-tail specialty and casualty insurance and reinsurance for risks such as energy, hull and cargo, marine liability, engineering and aviation. Our Insurance segment provides insurance through Island Heritage
Our property catastrophe business is primarily on an excess of loss basis. Our property business and our short-tail specialty and casualty business are on both an excess of loss and a pro rata basis. See Item 1, “Business-Reinsurance Products and Operations-Reinsurance Products”.
On June 26, 2008 and October 1, 2008, the Company acquired a controlling interest in Flagstone Africa and Flagstone Alliance, respectively. As a result, the year over year results are not directly comparable. Where appropriate, the impact of the acquisitions has been quantified in the results of operations for our reinsurance segment.
Gross property catastrophe premiums written for the year ended December 31, 2009 were $503.0 million compared to $492.7 million for the year ended December 31, 2008. The increase in property catastrophe premiums written of $10.3 million, excluding the impact of acquisitions, or 2.0%, is primarily due to hardening of prices in the property catastrophe market partially offset by the Company’s non-renewal of certain treaties that no longer met the Company’s profitability objectives.
During the year ended December 31, 2009, we recorded $11.4 million of gross reinstatement premiums compared to $28.2 million recorded for the year ended December 31, 2008, which was primarily related to Hurricanes Gustav and Ike.
During the year ended December 31, 2009, we recorded $1.3 million gross reinstatement premiums compared to $4.6 million for the year ended December 31, 2008.
Gross property premiums written for the year ended December 31, 2008 were $94.7 million ($89.6 million excluding acquisitions in 2008), compared to $94.5 million for the year ended December 31, 2007, a decrease of $4.9 million, excluding the impact of acquisitions. There was a decrease in proportional property premiums of $25.0 million which was mostly offset by an increase in non-proportional premiums of $20.1 million, excluding the impact of acquisitions, for the year ended December 31, 2008, compared to the same period in 2007. The decline in proportional premiums was due to the non-renewal of contracts during 2008 as well as decreased revenues on existing contracts partially offset by the impact of new contracts signed in 2008. The increase in non-proportional premiums was due to the addition of new clients as well as increased business with existing clients.
Various factors will continue to affect our 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.
As the levels of net premiums written increase, the levels of net premiums earned also increase. Reinsurance net premiums earned were $689.5 million for the year ended December 31, 2009, compared to $641.5 million for the year ended December 31, 2008, representing an increase of $48.0 million, or 7.5%. The increase is primarily due to ongoing growth in premium writings, partially offset by the increase in premiums ceded.
Our combined ratio and components thereof related to the Reinsurance segment are set out below for the years ended December 31, 2009, 2008 and 2007:
See the discussion below for an explanation of the fluctuations in these ratios.
Acquisition costs for the year ended December 31, 2009 were $121.8 million compared to $101.5 million for the year ended December 31, 2008. The increase in acquisition costs for the year ended December 31, 2009 is primarily related to higher levels of premium writings and also includes $14.3 million of acquisition costs in relation to the quota share arrangement with Island Heritage.
General and administrative expenses for the year ended December 31, 2008, were $90.0 million ($86.8 million excluding acquisitions) compared to $68.9 million in the year ended December 31, 2007. The increase of $17.9 million, excluding the impact of acquisitions, in 2008 as compared to 2007 was primarily due to the cost of additional staff and infrastructure as we built our global operations and enhanced our technology platform, partially offset by a decrease in stock compensation expenses. Considering the net loss incurred in the year ended December 31, 2008, the Company reviewed its DROE estimates for the performance periods and revised accordingly the number of PSUs expected to vest. As a result of the revised DROE estimates, the Company reversed previously expensed stock compensation related to the PSU Plan of $8.1 million. At the Company’s board meeting held on November 14, 2008, the Warrant was amended. As a result of the amendments, additional compensation expense of $3.6 million was recognized in the year ended December 31, 2008.
As a result of the benign hurricane loss activity in 2009 coupled with the recovering global financial markets, capital and surplus levels have rapidly been restored for many insurers and reinsurers. Therefore we anticipate any new demand for US catastrophe reinsurance will be met by an increasingly available over-supply, particularly as the mid-year approaches. This softening US catastrophe market is expected to continue upon the January 1 trend and may build toward 10% rate decreases or more as we approach the June and July 1 renewals. Some new demand will arise from the Florida Hurricane Cat Fund’s further $2 billion TICL layer reduction as well as new interest in frequency loss driven coverage such as proportional cover, mainly for surplus relief.
Specialty lines around the world were mixed, presenting select opportunities for us to grow overall in on-shore energy and some tailored programs. Commercial aviation and workers compensation catastrophe business presented less opportunity to grow as we believe rates need to improve. We expect specialty lines will grow overall, allowing us to continue to diversify our portfolio from the core property catastrophe lines.
As a result of the acquisition of Marlborough, the managing agency for Lloyd’s Syndicate 1861, in November 2008, the Company established a new reporting segment. Syndicate 1861 began writing business for the benefit of Flagstone effective January 1, 2009. As such there are no comparative numbers for the prior year. The net underwriting loss for the Lloyd’s segment for the year ended December 31, 2009 amounted to $0.5 million. Due to the startup nature of the 2009 year of account for Syndicate 1861, the level of earned premium income is slowly ramping up with new business writings, placing strain on the underwriting results as we have incurred expenses for the full periods. In addition, due to the start up nature of the operations, there is a very limited level of funds available to invest and therefore minimal investment income has been earned to date.
Gross premiums written were $145.9 million for the year ended December 31, 2009, and consist primarily of property and specialty lines. For the year ended December 31, 2009, the property line gross premiums written were $60.2 million and the specialty lines were $85.7 million.
Net premiums earned totaled $62.1 million for the year ended December 31, 2009. The net premiums earned are a function of the timing and amount of premiums written and given the start up nature of the syndicate’s writings, premiums earned are small relative to the writings.
Loss and loss adjustment expenses amounted to $40.8 million for the year ended December 31, 2009. There were no significant loss events recorded during the year ended December 31, 2009.
Acquisition costs totaled $14.6 million for the year ended December 31, 2009. The acquisition ratio, which is equal to acquisition cost expenses over net premiums earned, for the year ended December 31, 2009, was 23.5%. Acquisition costs include brokerage, gross commission costs, profit commission and premium taxes.
The existing major business lines written in London through Syndicate 1861, including marine and energy excess of loss, offshore energy, marine, technical property risk and engineering insurance, are expected to show modest growth overall through 2010. However, during 2009, Marlborough also implemented a number of business initiatives designed to increase the flow of new business to the Syndicate including the establishment of a property division in London, a representative office in Rio de Janeiro, and an underwriting agency in New York. These initiatives began developing business flow towards the end of 2009 and it is expected that they will each contribute significantly to the overall portfolio of risks for 2010, in particular, US and International direct and facultative property risks, US marine liability and associated vessel risks and, from Brazil, non-marine and specialty lines treaty and facultative reinsurance.
Gross premiums written were $76.9 million for the year ended December 31, 2008, compared to $33.0 million for the six months ended December 31, 2007.
Insurance premiums ceded for the year ended December 31, 2008 were $75.8 million (98.5% of gross insurance premiums written) which amounted to $40.6 million net of premiums ceded to Flagstone Suisse through the quota share arrangement, compared to $20.4 million (61.7% of gross insurance premiums written) for the six months ended December 31, 2007. As described above, Island Heritage’s reinsurance program was significantly changed on April 1, 2008 compared to prior years, resulting in a significant net quota share reinsurance portfolio transfer. The change in the reinsurance program enabled Island Heritage to enter into new markets as well as increase penetration in existing markets.
Loss and loss adjustment expenses amounted to $2.7 million for the year ended December 31, 2008, compared to $1.6 million for the six months ended December 31, 2007. The increase in loss and loss adjustment expense in the year ended December 31, 2008 was primarily related to the claims incurred in respect of Hurricanes Gustav, Hanna, Ike, Omar and Paloma.
General and administrative expenses for the year ended December 31, 2009 were $11.7 million compared to $9.0 million for the year ended December 31, 2008, as Island Heritage continues to grow its operations including its Puerto Rico office and enhance its underwriting and claims operating platform.
General and administrative expenses for the year ended December 31, 2008 were $9.0 million compared to $3.5 million for the six months ended December 31, 2007. During 2008, Island Heritage expanded its operations into the Latin America market with the opening of an office in Puerto Rico. The increase in general and administrative expenses for 2008 was primarily related to increased costs associated with expanding into this market and the fact that 2008 included a full year of expenses.
The general economic outlook for the Caribbean is expected to be neutral with little or no economic growth in 2010. Despite this the market outlook for Island Heritage for 2010 is positive as measured organic volume growth is planned throughout existing markets in the Caribbean. It is expected that whilst there will be softening pressure on primary insurance rates as a result of market pressures this should be offset by expected decreases in reinsurance costs.
Our investment portfolio on a risk basis, as at December 31, 2009, comprised 89.7% fixed maturities, short-term investments and cash and cash equivalents, 4.0% equities and the balance in other investments.
For the year ended December 31, 2008, the total return was (13.9) % compared to 7.0% for the year ended December 31, 2007. The change in the return on invested assets of (20.9)% during the year ended December 31, 2008, compared to the same period in 2007 is primarily due to the 2008 return being negatively impacted by the global financial crisis.
Investment income is principally derived from interest and dividends earned on investments and amortization income, partially offset by investment management and custody fees. The components are set forth in the table below:
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.
The following table is the breakdown of net realized and unrealized gains (losses) - investments in the audited consolidated statements of operations into its various components:
Net realized and unrealized gains on fixed maturities of $55.6 million for the year ended December 31, 2009, were due to the tightening of the credit spreads during 2009 and also to the realized and unrealized gains on the foreign currency portfolios caused by the weakening of the U.S. dollar. Foreign exchange gains were offset by losses on derivatives used for hedging, as described in the note below.
Net realized and unrealized gains on futures contracts of $12.5 million for the year ended December 31, 2009 were primarily due to $3.7 million of gains on U.S. and global equity index futures, $8.9 million of gains on commodity index futures and $0.2 million of losses on global bond futures.
Net realized and unrealized losses and gains on our investment portfolio amounted to a $272.2 million loss for the year ended December 31, 2008, compared to a $17.2 million gain for the year ended December 31, 2007. These amounts comprised net realized and unrealized gains and losses on our fixed maturities, equities, and other investments and on our investment portfolio of derivatives which includes global equity, global bond, commodity and real estate futures, TBA securities, interest rate swaps and total return swaps. The decrease during the year ended December 31, 2008 compared to the same period in 2007, was primarily due to our allocation to equities and commodities in 2008 being negatively impacted by the global financial crisis.
Net realized and unrealized losses on fixed maturities of $23.3 million for the year ended December 31, 2008, were primarily due to the widening of the credit spreads during 2008 and the losses incurred in relation to Alt-A securities of $5.5 million.
Net realized and unrealized losses on futures contracts of $147.5 million during the year ended December 31, 2008 were primarily due to $96.5 million of losses on U.S. and global equity index futures, $52.8 million of losses on commodity index futures and $1.8 million of gains on global bond futures.
The Company’s policy is to hedge the majority of its non-investment currency exposure with derivative instruments such as foreign currency swaps and foreign currency forward contracts.
Currency swaps and foreign currency forward contacts are used to hedge the economic currency exposure of the Company’s investment in foreign subsidiaries, primarily our Swiss subsidiary, and to hedge operational balances such as premiums receivable, loss reserves and the portion of our long term debt issued in Euros.
Reinsurance derivatives relate to industry loss warranty contracts (“ILWs”) that are structured as derivative transactions and exchange traded futures options contracts on major hurricane indexes. The Company recorded unrealized gains on ILWs determined to be derivatives of $2.4 million in 2009, versus $4.1 million in 2008. The decrease was due to the decreased number of ILWs determined to be derivatives written during 2009. The realized and unrealized gains recorded on the futures options contracts were $nil for 2009 compared to $2.5 million for 2008.
The Company recorded unrealized gains on ILW’s determined to be derivatives of $4.1 million in 2008, versus $1.7 million in 2007. The increase was due to the increased number of ILW’s determined to be derivatives written during 2008. The realized and unrealized gains recorded on futures options contracts were $2.5 million for 2008. The Company did not enter into futures options contracts in 2007.
For the year ended December 31, 2009, we experienced net foreign exchange losses of $3.2 million compared to net foreign exchange losses of $21.5 million for the year ended December 31, 2008. For the year ended December 31, 2009, the net foreign exchange losses were principally experienced on the net monetary asset and liability balances denominated in foreign currencies which generally weakened against the U.S. dollar, especially during the third and fourth quarters of 2009. 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 realized and unrealized gains and losses on derivatives used to hedge those balances are included in “Net realized and unrealized gains and losses - other” in the consolidated financial statements.
The Company has subsidiaries that operate in various other jurisdictions around the world that are subject to tax in the jurisdictions in which they operate. The significant jurisdictions in which the Company’s subsidiaries are subject to tax are Canada, Cyprus, India, Luxembourg, South Africa, Switzerland, U.S. Virgin Islands (“USVI”) and the United Kingdom. However since the majority of our income to date has been earned in Bermuda where we are exempt from income tax, the Company’s tax impact to date has been minimal.
During the year ended December 31, 2009, income tax expense was $5.4 million compared to $1.2 million for the year ended December 31, 2008. The increase for the year ended December 31, 2009, compared to the same period in 2008, is primarily attributable to higher taxable income in jurisdictions around the world that are subject to tax as well as the acquisition of Flagstone Africa in June 2008, which resulted in taxable income being earned in Africa. As a result of the merger between Flagstone Reinsurance Limited and Flagstone Suisse, we expect our tax expense to increase to approximate our effective Swiss Federal tax rate of approximately 8% on the portion of underwriting profits, if any, generated by Flagstone Suisse, excluding the underwriting profits generated in Bermuda through the Flagstone Suisse branch office.
The results of operations of Flagstone Africa have been included in the Company’s audited consolidated financial statements from June 26, 2008, onwards, with the portions of Flagstone Africa’s net income and shareholders’ equity attributable to minority shareholders recorded as noncontrolling interest. On November 10, 2009, Flagstone Suisse became the sole shareholder of Flagstone Africa by acquiring the remaining 35% of shares owned by Imperial Holdings Limited for a purchase price of $11.4 million. The Company recorded a noncontrolling interest charge of $0.1 million for the year ending December 31, 2008.
On February 8, 2008, Mont Fort repurchased 5.0 million preferred shares relating to its second cell, Mont Fort ILW 2 for $6.6 million. In relation to Mont Fort, the Company recorded income (loss) attributable to noncontrolling interest of $14.2 million for the year ended December 31, 2008, compared to $33.6 million for the year ended December 31, 2007. The 2008 results of Mont Fort were impacted by the negative investment returns and Hurricane Ike losses.
The Company recorded income (loss) attributable to noncontrolling interest of $(0.6) million for the year ended December 31, 2008, compared to $2.2 million for the year ended December 31, 2007 with respect to its controlling interest in Island Heritage. On July 1, 2008, Island Heritage issued 1,789 shares to certain of its employees under a performance share unit plan. Prior to this transaction, the Company held an ownership interest in Island Heritage of 59.6% and as of December 31, 2008, held an interest of 59.2%. The Company elected to record gains and losses resulting from the issuance of subsidiary’s stock as an equity transaction. Accordingly, the Company recorded a noncontrolling interest charge of $0.1 million as a decrease to additional paid-in capital.
On June 26, 2008, Flagstone Suisse purchased 3,714,286 shares (representing a 65% interest) in Flagstone Africa (previously known as Imperial Reinsurance Company Limited) for a purchase price of $18.6 million. The results of operations of Flagstone Africa were included in the Company’s consolidated financial statements from June 26, 2008, onwards, with the portions of Flagstone Africa’s net income and shareholders’ equity attributable to minority shareholders recorded as noncontrolling interest. The Company recorded a noncontrolling interest charge of $0.1 million for the year ended December 31, 2008.
Comprehensive (loss) income attributable to Flagstone for the year ended December 31, 2008, was $(203.0) million compared to $175.9 million for the same period in 2007. For the year ended December 31, 2008, comprehensive (loss) income included $(173.7) million of net loss, $(16.3) million for the change in the currency translation adjustment, and $(0.9) million for the change in the defined benefit pension plan transitional obligation compared to $167.9 million of net income and $7.9 million for the change in the currency translation adjustment for the year ended December 31, 2007.
The Company designated $337.7 million and $264.4 million of foreign currency forwards contractual value as hedge instruments, which had a fair value of $(5.7) million and $(3.4) million, at December 31, 2008 and 2007, respectively. The Company recorded $17.0 million and $3.5 million of realized and unrealized foreign exchange losses on these hedges during the years ended December 31, 2008 and 2007, respectively.
The total of investments, cash and cash equivalents, and restricted cash was $1.9 billion at December 31, 2009, compared to $1.7 billion at December 31, 2008.
At December 31, 2009, all of our fixed maturity securities, with the exception of three bonds with a fair value of $0.5 million, were rated investment-grade (BBB- or higher) by Standard & Poor’s (or estimated equivalent) with an average rating of AA+. At December 31, 2008, all of our fixed maturity securities, with the exception of $0.3 million were rated investment-grade (BBB- or higher) by Standard & Poor’s (or estimated equivalent) with an average rating of AA+.
At December 31, 2009 and 2008, the average duration of the Company’s investment portfolio was 2.3 years and 2.9 years, respectively. The duration decreased mostly due to the change in asset allocation during the year.
At December 31, 2009 and 2008, we had no exposure to sub-prime backed investments or collateralized debt obligations (“CDOs”) of sub-prime backed investments. At December 31, 2009 and 2008, our holdings of Alt-A securities were $0.8 million with an average rating of AAA and $3.0 million with an average rating of AA+, respectively. Alt-A securities are defined as a classification of mortgages where the risk profile falls between prime and sub-prime. The borrowers behind these mortgages will typically have clean credit histories, but the mortgage itself will generally have some features that increase its risk profile compared to prime securities, but less risky than sub-prime backed investments. These features include higher loan-to-value and debt-to-income ratios or inadequate documentation of the borrower’s income. The Company’s exposure to traditional monoline insurers emanates from our non subprime asset-backed holdings. We did not hold securities with credit enhancement from the traditional monoline insurers at December 31, 2009 and we had $1.2 million at December 31, 2008. We do not have any collateralized loan obligations or CDO exposures in our portfolio.
Other investments as at December 31, 2009 amounted to $45.9 million compared to $54.7 million at December 31, 2008. The December 31, 2009 investments are comprised mainly of our investment in catastrophe bonds of $36.1 million, in private equity and hedge funds of $5.5 million and the Company’s $4.3 million equity investment. The Company’s other investments as of December 31, 2009 and 2008 are as follows:
The significant increase in the reserves in 2008 is primarily attributable to more severe catastrophe losses in 2008 than in 2007 resulting from Hurricane Ike ($158.4 million), Hurricane Gustav ($14.5 million), Chinese winter storms ($18.2 million) and the U.S. Memorial Day weekend storms ($11.1 million).
As at December 31, 2009, total shareholders’ equity was $1.2 billion, a 22.8% increase compared to $986.0 million at December 31, 2008. The increase in shareholders’ equity is principally due to net income for the year ended December 31, 2009 of $242.2 million, accumulated other comprehensive income of $1.3 million, partially offset by dividends declared of $13.9 million and repurchase of Mont Fort preferred shares of $63.1 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 and the change in the defined benefit pension plan obligation.
On August 23, 2006, the Company raised gross and net proceeds of $136.7 million and $132.8 million, respectively, of Deferrable Interest Debentures. The Deferrable Interest Debentures have a floating rate of interest equal to (i) LIBOR plus 354 basis points per annum, reset quarterly for the dollar-denominated principal amount and (ii) Euro Interbank Offered Rated (“Euribor”) plus 354 basis points per annum, reset quarterly for the Euro-denominated principal amount. The Deferrable Interest Debentures mature on September 15, 2036, and may be called at par by the Company at any time after September 15, 2011. The Company may defer payment of the interest for up to 20 consecutive quarterly periods, but no later than September 15, 2011. Any deferred interest payments would accrue interest quarterly on a compounded basis.
The indenture governing our Deferrable Interest Debentures would restrict us from declaring or paying dividends on our common shares if the Company:
is downgraded by A.M. Best to a financial strength rating below A- and sells more than 51% of its rights to renew net premiums written over the course of a twelve-month period;
Through the acquisition of IAL King Air on July 22, 2007, the company acquired debt of $0.9 million. At December 31, 2008 there was $0.8 million outstanding. The loan had a floating rate of interest equal to 30-day LIBOR plus 195 basis points per annum, reset monthly. The debt matured and was repaid on March 15, 2009.
In May 2008, the Company repurchased, in a privately negotiated transaction, $11.25 million of principal amount of its outstanding $100.0 million notes. The purchase price paid for the notes was 81% of face value, representing a discount of 19%. The repurchase resulted in a gain of $1.8 million, net of unamortized debt issuance costs of $0.1 million that were written off. As a result, the gain has been included as a gain on early extinguishment of debt under other income.
At December 31, 2009 and 2008, the Company was in compliance with all required covenants,, and no conditions of default existed related to the Company’s long term debt. We may incur additional indebtedness in the future if we determine that it would be an efficient component of our capital structure.
Cash flows relating to financing activities include the payment of dividends, share related transactions and the issuance or repayment of debt. During the year ended December 31, 2009, net cash of $110.8 million was used in financing activities, compared to $40.6 million provided by financing activities for the year ended December 31, 2008. In 2009, the net cash used in financing activities related principally to the payment of dividends, the redemption of preferred shares in Mont Fort ILW 1, the repurchase of common shares held in treasury and the repayment of principal on long term debt. In 2008, the net cash used in financing activities related principally to the payment of dividends, the redemption of preferred shares in Mont Fort ILW 2, the repurchase of common shares and the repayment of principal on long term debt.
We may incur additional indebtedness in the future if we determine that it would be an efficient part of our capital structure.
On June 5, 2009, Flagstone Suisse entered into a secured $50.0 million standby letter of credit facility with BNP Paribas (the “BNP Facility”). The BNP Facility will be used to support the reinsurance obligations of the Company and its subsidiaries. As at December 31, 2009, no letters of credit have been issued under the BNP Facility.
Flagstone Suisse is licensed to operate as a reinsurer in Switzerland and is also licensed in Bermuda through the Flagstone Suisse branch office and is not licensed in any other jurisdictions. Because many jurisdictions do not permit insurance companies to take credit for reinsurance obtained from unlicensed or non-admitted insurers on their statutory financial statements unless appropriate security mechanisms are in place, we anticipate that our reinsurance clients will typically require Flagstone Suisse to post a letter of credit or other collateral.
The Bermuda Insurance Act requires Flagstone Suisse to maintain a minimum solvency margin (being the minimum amount that the statutory assets must exceed the statutory liabilities as required by the Bermuda Insurance Act) equal to the greatest of (i) $100 million, (ii) 50% of net premiums written or (iii) 15% of the reserve for losses and loss adjustment expenses. To satisfy these requirements, Flagstone Suisse was required to maintain a minimum level of statutory capital and surplus of $316.6 million as at December 31, 2009. In addition, Flagstone Suisse is required to maintain a minimum liquidity ratio. As at December 31, 2009, 2008, and 2007, Flagstone Suisse was in compliance with all of the requirements of the Bermuda Insurance Act.
Island Heritage is domiciled in the Cayman Islands and maintains a Class A Domestic Insurance License issued in accordance with the terms of the Insurance Law (as revised) of the Cayman Islands, or the Law, and is subject to regulation by the Cayman Islands Monetary Authority, or CIMA, in terms of the Law. Island Heritage is required to maintain a net worth (defined in the Law as the excess of assets, including any contingent or reserve fund secured to the satisfaction of CIMA, over liabilities other than liabilities to partners or shareholders) of at least 100,000 Cayman Islands dollars (which is equal to approximately US$120,000), subject to increase by CIMA depending on the type of business undertaken. In addition Island Heritage may not issue any dividends without prior approval from the Cayman Islands Monetary Authority. In order to obtain approval Island Heritage must demonstrate that the issuing of dividends would not render Island Heritage insolvent or affect its ability to pay any future claims.
Marlborough and Syndicate 1861 are regulated by the Financial Services Authority (“FSA”) in the United Kingdom. The FSA is an independent non-governmental body, given statutory powers by the Financial Services and Markets Act 2000. Although accountable to treasury ministers and through them to Parliament, it is funded entirely by the firms it regulates. The FSA has wide ranging powers in relation to rule-making, investigation and enforcement to enable it to meet its four statutory objectives, which are summarized as one overall aim: “to promote efficient, orderly and fair markets and to help retail consumers achieve a fair deal”.
The Company has determined that Valais Re has the characteristics of a variable interest entity that are addressed by the Consolidation Topic of the FASB ASC. In accordance with the Consolidation Topic, Valais Re is not consolidated because the Company does not hold a variable interest and as such is not the primary beneficiary.
The Company has determined that Montana Re has the characteristics of a variable interest entity that are addressed by the Consolidation Topic of the FASB ASC. In accordance with the Consolidation Topic, Montana Re is not consolidated because the Company does not absorb any other economic risks and therefore has no variable interest and as such is not the primary beneficiary.
The following table shows our aggregate contractual obligations by time period remaining to due date as at December 31, 2009:
(1) The interest on the long term debt is based on a spread above LIBOR and Euribor. We have reflected interest due in the table based on the current interest rates on the facility. See “Long Term Debt” above for further details.
(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 Estimates-Loss and Loss Adjustment Expense Reserves.”
(3) The Company has entered into commitment for the construction of office buildings located in Luxembourg and Martigny.
The Company’s reporting currency is the U.S. dollar. The Company has exposure to foreign currency risk due to the following: its investments in foreign subsidiaries whose functional currencies are typically their national currencies; its underwriting reinsurance exposures; the collection of premiums and payment of claims and other general operating expenses denominated in currencies other than the U.S. dollar; and holding certain net assets in foreign currencies. The Company’s most significant foreign currency exposures are to the Swiss franc, the Euro and the British pound.
At December 31, 2009, the value of the U.S. dollar weakened approximately 12.3% against the British pound, 3.2% against the Euro and 3.0% against the Swiss franc, compared to December 31, 2008. Since a large proportion of the Company’s assets and liabilities are expressed in these currencies, there was a net decrease in the U.S. dollar value of the assets and liabilities denominated in these currencies in 2009.
Net foreign exchange (losses) gains amounted to ($3.2) million, ($21.5) million and $5.3 million for the years ended December 31, 2009, 2008 and 2007, respectively (See “Results of Operations” above).
Consolidated Statements of Operations and Comprehensive Income (Loss) for the Years Ended December 31, 2009, 2008, and 2007
The accompanying notes to the consolidated financial statements are an integral part of the consolidated financial statements.
On March 31, 2006, the Company 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, the Company increased its equity interest in Island Heritage to 33.2%. On July 3, 2007, the Company took a controlling interest in Island Heritage by increasing its ownership to 54.6% of Island Heritage’s voting shares. On June 30, 2008, the Company acquired an additional 16,919 shares in Island Heritage (representing 5% of its common shares) for total consideration of $3.3 million, taking its total shareholding in Island Heritage to 203,129 shares (representing a 59.6% interest). In July 2008 and June 2009, Island Heritage issued common shares to certain employees under a stock based compensation plan which resulted in a small dilution of the Company’s ownership to 59.2% and 58.8%, respectively. Through Island Heritage, the Company primarily writes property insurance.
The accompanying financial statements as at December 31, 2009, include all adjustments (consisting of normal recurring accruals) considered necessary to present fairly the financial position as at December 31, 2009 and 2008 and the results of operations and cash flows for the years ended December 31, 2009, 2008 and 2007.
On September 15, 2009, the Company adopted FASB ASC Topic 105, “Generally Accepted Accounting Principles” (“ASC 105” or “The Codification”). ASC 105 is a replacement to FASB Statement No. 162, “The Hierarchy of Generally Accepted Accounting Principles,” (“SFAS 162”) which became effective on November 13, 2008, and identified the sources of accounting principles and the framework for selecting the principles used in preparing financial statements in conformity with U.S. GAAP. It also arranged these sources of U.S. GAAP in a hierarchy for users to apply. ASC 105 provides for a single source of authoritative U.S. GAAP recognized by the FASB to be applied to nongovernmental entities in the preparation of financial statements. The Codification carries the same level of authority and supersedes SFAS 162 and all other accounting and reporting standards. The U.S. GAAP hierarchy has been modified to include two levels of U.S. GAAP: authoritative and non-authoritative.
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 insureds and ceding companies. Estimated IBNR reserves consist of a provision for additional development in excess of the case reserves reported by insureds and ceding companies as well as a provision for claims which have occurred but which have not yet been reported to the Company’s insureds and 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.
Net investment income is stated net of investment management and custody fees. Investment income is recognized when earned and includes interest and dividend income together with the amortization of premiums and the accretion of discounts calculated under the interest method on fixed maturity investments purchased at amounts different from their par value.
The Company accounts for the warrant granted to Haverford (Bermuda) Ltd. (“Haverford”), a related party due to common ownership, as stock compensation in accordance with the Compensation - Stock Compensation Topic of the FASB ASC. Compensation expense for the warrant was measured at fair value at the date of issuance of the warrant and recorded as compensation expense in the issuance period as there was no required service period. Additional compensation expense was recorded as a result of amendments to the warrant on November 14, 2008. (See Note 13 “Shareholders’ Equity” for additional details).
The Company accounts for its derivative instruments using the Derivatives and Hedging Topic of the FASB ASC which requires an entity to recognize all derivative instruments as either assets or liabilities in the balance sheet and measure those instruments at fair value, with the fair value recorded in other assets or liabilities. The accounting for realized and unrealized gains and losses associated with changes in the fair value of derivatives depends on its hedge designation and if designated as a hedging instrument whether the hedge is effective in achieving offsetting changes in the fair value of the asset or liability being hedged. The realized and unrealized gains and losses on derivatives not designated as hedging instruments are included in net realized and unrealized gains and losses in the consolidated financial statements. Gains and losses associated with changes in fair value of the designated hedge instruments are recorded with the gains and losses on the hedged items, to the extent that the hedge is effective. Derivative instruments are stated at fair value in accordance with the Fair Value Measurements and Disclosures Topic of the FASB ASC based on a quoted market price for futures contracts and based on observable market inputs (such as currency spot and forward rates, underlying exchange traded securities yield curves and transactional history) for foreign currency forwards, total return swaps, currency swaps, interest rates swaps and “to be announced” mortgage-backed securities (“TBAs”). The Company fair values reinsurance derivative contracts using internal valuation models, with the significant inputs to the valuation models being the underlying risk exposure and the time left to the end of the contract.
Business combinations are accounted for under the purchase method in accordance with the Business Combinations Topic of the FASB ASC. See Note 3 “Acquisitions and Dispositions” for further details.
The Company accounts for intangible assets that arise from business combinations in accordance with the Business Combinations Topic of the FASB ASC. Intangible assets with a finite life are amortized over the estimated useful life of the asset. Intangible assets with an indefinite useful life are not amortized.
In December 2009, the FASB amended ASC Topic 860, “Transfers and Servicing,” (“ASC 860”) which codifies FASB Statement No. 166, “Accounting for Transfers of Financial Assets” which was issued on June 12, 2009. ASC 860 requires that a transferor recognize and initially measure at fair value all assets obtained (including a transferor’s beneficial interest) and liabilities incurred as a result of financial assets accounted for as a sale. It is a revision to FASB Statement No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” and requires more information about transfers of financial assets, including securitization transactions, and where entities have continuing exposure to the risks related to transferred financial assets. ASC 860 is effective on a prospective basis in fiscal years beginning on or after November 15, 2009 and interim periods within those fiscal years, and will be adopted by the Company in the first quarter of fiscal year 2010. The Company does not expect the adoption of ASC 860 to have a material impact on its consolidated results of operations and financial condition.
On November 10, 2009, Flagstone Suisse purchased 1,999,998 shares (representing the remaining 35% noncontrolling interest) in Flagstone Africa for a purchase price of $11.4 million. The acquisition of the noncontrolling interest did not result in a change of control of Flagstone Africa. As a result, the transaction was accounted for as an equity transaction using the Consolidation Topic of the FASB ASC, resulting in the elimination of the related minority interest and $0.8 million recorded to additional paid-in capital.
During 2008, the Company acquired 100% of Alliance Re (renamed Flagstone Alliance) for total consideration of $45.3 million. In June 2008, the Company purchased 9,977,664 shares (representing 14.6% of Flagstone Alliance’s common shares) for $6.8 million and on August 12, 2008, purchased 10,498,164 shares (representing 15.4% of Flagstone Alliance’s common shares) for $6.8 million, from current shareholders. During September 2008, the Company acquired a further 4,427,189 shares on the open market for total consideration of $3.0 million. The remainder of the 43,444,198 shares were acquired during the fourth quarter of 2008 for total consideration of $28.7 million. Flagstone Alliance, domiciled in the Republic of Cyprus is a specialist property and casualty reinsurer writing multiple lines of business in Europe, Asia, and the Middle East and North Africa region.
During the first quarter of 2009, the Company finalized the allocation of the purchase price for the acquisition of Flagstone Alliance. At December 31, 2008, the estimated purchase price allocation included $1.1 million of goodwill, which was reduced to $nil at March 31, 2009.
The fair value of the net assets acquired and allocation of the purchase price is summarized as follows:
On June 30, 2009, Flagstone Alliance disposed of 100% of the share capital in Uni-Alliance Holdings Limited, a subsidiary of Flagstone Alliance since January 1, 2007. The transaction was completed with Mr. Khader Hemsi, Chief Executive Officer of Flagstone Alliance, who retired from Flagstone Alliance during the third quarter of 2009. The sale was completed to eliminate conflict with existing broker relationships and resulted in a net loss of $1.2 million, which has been recorded in other income.
The following tables detail goodwill and intangible assets at December 31, 2009 and 2008:
On March 6, 2006, the Company entered into a share purchase agreement to purchase 370,000 common shares, representing 100% of the outstanding common shares of Mont Fort, a segregated accounts or “cell” company registered under the Bermuda Segregated Accounts Companies Act 2000 (as amended), for consideration of $0.1 million. The assets and liabilities acquired at the date of purchase were $0.1 million and $nil, respectively. In May 2006, the Company invested an additional $1.3 million in Mont Fort.
The Company determined that the establishment of these cells was a reconsideration event under the provisions of FIN 46(R). Consequently, the Company assessed whether or not Mont Fort continued to be a VIE and, if so, whether the Company or another party was Mont Fort’s primary beneficiary. The Company assessed the impact of these reconsideration events on its results and financial position, and concluded that the establishment of the Mont Fort HL cell on January 12, 2007 was the reconsideration event that resulted in the Company being the primary beneficiary of Mont Fort. As such, 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 years ended December 31, 2009, 2008 and 2007 are recorded in the consolidated financial statements of the Company as minority interest.
Further, with the addition of any new contracts that the Company enters into with each of the new cells, the Company will evaluate whether the contracts with Mont Fort continue to meet the risk transfer parameters of the FASB ASC Topic on Financial Services - Insurance considered individually and, where appropriate, in the aggregate. In the event that these cells caused any contract or group of contracts to fail to meet the risk transfer parameters, the Company’s future financial statements would account for these reinsurance transactions in accordance with the provisions of the FASB ASC Subtopic on Other Assets and Deferred Costs - Insurance Contracts that Do Not Transfer Insurance Risk.
In accordance with a reinsurance agreement entered into between the Company and Mont Fort on behalf on its cells, the Company earns a ceding commission from the cells based on the level of premiums ceded to the cells. During the years ended December 31, 2009 and 2008 and 2007, transactions between the Company and Mont Fort were eliminated upon consolidation. 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.
On August 10, 2009, Mont Fort repurchased 43.6 million preferred shares relating to its first cell, Mont Fort ILW for $63.1 million. The Company has considered the implication of this share repurchase as it relates to FASB ASC Topic on Consolidations, specifically relating to variable interest entities, and has concluded that the Company remains the primary beneficiary and should continue to consolidate Mont Fort.
The cost or amortized cost, gross unrealized gains and losses, and carrying values of the Company’s fixed maturity, short term and equity investments as at December 31, 2009 and 2008 are as follows:
(Amounts in tables expressed in thousands of U.S. dollars, except for ratios, share and per share amounts)
Proceeds from the sale of fixed maturity, short term and equity investments during the year ended December 31, 2009 and 2008 amounted to $1.9 billion and $1.8 billion, respectively.
Actual maturities may differ from contractual maturities because certain borrowers have the right to prepay certain obligations with or without prepayment penalties.
The 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, 2009 and 2008 they had net realized gains of $2.0 and $0.3 million for the years then ended, respectively.
The investment funds consist of investments in private equity funds. The Company accounts for its other investments at fair value based on the most recent financial information available from fund managers and third party administrators, plus fair value adjustments where it is deemed appropriate based on analysis and discussions with the fund managers.
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. In accordance with the Fair Value Measurements and Disclosures Topic of the FASB ASC, the Company determined that its investments in U.S. government treasury securities, listed equity securities and exchange traded funds are stated at Level 1 fair value as determined by the quoted market price of these securities, as provided either by independent pricing services or exchange market prices. Investments in U.S. government agency securities, corporate bonds, mortgage-backed securities, foreign government bonds and asset backed securities are stated at Level 2 fair value derived from broker quotes based on inputs that are observable for the asset, either directly or indirectly, such as yield curves and transactional history. Catastrophe bonds are stated at fair value as determined by reference to broker indications. Those indications are based on current market conditions, including liquidity and transactional history, recent issue price of similar catastrophe bonds and seasonality of the underlying risks. The catastrophe bonds held prior to September 30, 2009, and still held at December 31, 2009, were transferred from Level 3 to Level 2 due to the increase in pricing sources obtained and the increased activity within the market.
For reconciliation purposes, the table above does not include an equity investment of $5.7 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 for at fair value under the FASB ASC guidance for financial instruments.
The reconciliation of the fair value for the Level 3 investments for the years ended December 31, 2009 and 2008, including net purchases and sales and change in unrealized gains, is set out below:
Net investment income for the years ended December 31, 2009, 2008, and 2007 was $28.5 million, $51.4 million, and $73.8 million, respectively. The components are set out below:
Realized investment gains (losses) on the sale of fixed maturity, short term and equity investments for the years ended December 31, 2009, 2008 and 2007 are as follows:
As at December 31, 2009 and 2008, approximately $85.9 million and $42.4 million, respectively, of cash and cash equivalents and approximately $425.1 million and $327.2 million, respectively of fixed maturity securities were deposited or pledged in favor of ceding companies and other counterparties or government authorities to comply with reinsurance contract provisions and insurance laws.
During the year ended December 31, 2009, the Company had total net positive development of $6.6 million; $(7.6) million relating to the 2008 loss year and $14.2 million relating to the 2007 loss year and prior. The favorable development was primarily due to actual loss emergence in the property catastrophe, property, and the short-tail specialty and casualty lines of business being lower than the initial expected loss emergence.
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, 2009 and 2008 was $19.3 million and $16.4 million, respectively, against which the Company has determined that no provision for doubtful debt is required.
The Company accounts for its derivative instruments using the Derivatives and Hedging Topic of the FASB ASC, which requires an entity to recognize all derivative instruments as either assets or liabilities in the balance sheet and measure those instruments at fair value, with the fair value recorded in other assets or liabilities. The accounting for realized and unrealized gains and losses associated with changes in the fair value of derivatives depends on the hedge designation, and if designated as a hedging instrument, whether the hedge is effective in achieving offsetting changes in the fair value of the asset or liability being hedged. The realized and unrealized gains and losses on derivatives not designated as hedging instruments are included in net realized and unrealized gains and losses in the consolidated financial statements. Gains and losses associated with changes in fair value of the designated hedge instruments are recorded with the gains and losses on the hedged items, to the extent that the hedge is effective.
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. These foreign currency forward contracts are carried at fair value and the gains and losses associated with changes in fair value of the designated hedge instruments are recorded in other comprehensive income as part of the cumulative translation adjustment, to the extent that these are effective as hedges. 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.
The non-designated derivatives are carried at fair value, with the fair value recorded in other assets and liabilities and the corresponding realized and unrealized gains and losses included in net realized and unrealized gains and losses.
The Company has used interest rate swap contracts in the portfolio as protection against unexpected shifts in interest rates, which would affect the fair value of the fixed maturity portfolio. By using interest rate swaps, the overall duration or interest rate sensitivity of the portfolio can be altered. The Company has also used interest rate swaps to manage its borrowing costs on its long term debt.
The Company has entered into foreign currency forward contracts that it has designated as hedges in order to hedge its net investments in foreign subsidiaries. These foreign currency forward contracts are carried at fair value and the gains and losses associated with changes in fair value of the designated hedge instruments are recorded in other comprehensive income as part of the cumulative translation adjustment, to the extent that these are effective as hedges, with the ineffective portion recorded in realized and unrealized gains and losses included in the income statement. All other foreign currency forward contracts are not designated as hedges, and are also 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.
The Company uses currency swaps to minimize the effect of fluctuating foreign currencies. The currency swaps relate to the Company’s Euro denominated debentures.
In accordance with Fair Value Measurements and Disclosures Topic of the FASB ASC, the fair value of derivative instruments held as of December 31, 2009 and December 31, 2008 is allocated between levels as follows:
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 South Africa, Canada, Cyprus, India, Mauritius, Switzerland, U.S. Virgin Islands, United Kingdom and the United States. Income tax returns are open for examination for the tax years 2006-2008 in Canada, 2003-2008 in Cyprus, 2006-2008 in India 2006-2008 in the U.S. Virgin Islands and 2007-2008 in the UK.
The valuation allowance relates to operating and capital losses of the Company’s foreign subsidiaries in Switzerland, Luxembourg, Cyprus and the United States. Local tax laws allow tax losses to be carried forward and offset against future taxable income. However, the Company believes it is necessary to establish a valuation allowance against these operating loss and capital loss deferred tax assets due to the Company’s short operating history and uncertainty regarding its ability to generate sufficient future taxable income to utilize the loss carried forward and realize the deferred tax asset.
The Company incurred expenses for these defined contribution arrangements of $2.0 million, $0.9 million and $0.7 million for the years ended December 31, 2009, 2008 and 2007, respectively.
The incremental effect of adopting the accounting requirements for defined benefit plans in 2008, was to increase total liabilities by $0.5 million and decrease total shareholders’ equity (accumulated other comprehensive income) by $0.5 million. Of the $0.5 million transition adjustment recorded in 2008, $0.4 million remains in accumulated other comprehensive income at December 31, 2009. Of this transition adjustment, approximately $50,000 is expected to be recognized in net periodic benefit cost in 2010.
At December 31, 2009 and 2008, the Swiss Plan’s asset allocation was as follows:
The assumptions used to determine the pension obligation and net periodic benefit cost for the years ended December 31, 2009 and 2008 were as follows:
The Company’s debt outstanding as at December 31, 2009 and 2008 is as follows:
The Note 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 Note Indentures at December 31, 2009 and 2008.
On March 5, 2009, Flagstone Suisse entered into a secured $200.0 million secured committed letter of credit facility with Barclays Bank Plc (the “Barclays Facility”). The Barclays Facility will be used to support the reinsurance obligations of the Company and its subsidiaries. As at December 31, 2009, $32.3 million had been drawn under the Barclays Facility, and the drawn amount was secured by $35.9 million of fixed maturity securities from the Company’s investment portfolio.
These facilities are used to provide security to reinsureds and are collateralized by the Company, at least to the extent of the letters of credit outstanding at any given time.
The following table is a summary of common shares issued and outstanding:
The Company accounts for share based compensation in accordance with the Compensation - Stock Compensation Topic of the FASB ASC which requires entities to measure the cost of services received from employees and directors in exchange for an award of equity instruments based on the grant date fair value of the award. The cost of such services will be recognized as compensation expense over the period during which an employee or director is required to provide service in exchange for the award. The Company’s share based compensation plans consists of performance share units (“PSUs”) and restricted share units (“RSUs”).
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 Directors, PSUs may be granted to executive officers and certain other key employees and vesting is contingent upon the Company meeting certain diluted return on equity (“DROE”) goals.
Beginning July 1, 2006, the Company granted RSUs to certain employees and directors of the Company. The purpose of the RSU Plan is to encourage employees and directors of the Company to further the development of the Company and to attract and retain key employees for the Company’s long-term success. The RSUs granted to employees vest over a period of approximately two years while RSUs granted to directors vest on the grant date.
The Company uses a nil forfeiture assumption for its PSUs and RSUs. The intrinsic value of the PSUs and RSUs outstanding as of December 31, 2009 was $36.2 million and $4.1 million, respectively.
Also at December 31, 2009, 2008, and 2007, there was a warrant outstanding which would result in the issuance of common shares that were excluded from the computation of diluted earnings per common share because the effect would be anti-dilutive. These securities were as follows:
At December 31, 2009, the Company’s consolidated results include the results of Mont Fort from January 12, 2007 onwards (see Note 5). The portions of Mont Fort’s net income and shareholders’ equity attributable to holders of the preferred shares for the year ended December 31, 2009, 2008 and 2007 are recorded in the consolidated financial statements of the Company as noncontrolling interest. On August 10, 2009, Mont Fort repurchased 43.6 million preferred shares relating to its first cell, Mont Fort ILW for $63.1 million. On February 8, 2008, Mont Fort repurchased 5.0 million preferred shares relating to its second cell, Mont Fort ILW 2 for $6.6 million. In relation to Mont Fort, the Company recorded income attributable to noncontrolling interest of $26.3 million, $14.2 million and $33.6 million, respectively, for the years ended December 31, 2009, 2008 and 2007 and $135.9 million and $172.8 million, respectively, was included in noncontrolling interest on the consolidated balance sheets as at December 31, 2009 and 2008.
On October 1, 2009, the Company sold 25% of the common shares of IAL King Air Limited for proceeds of $0.8 million, maintaining a controlling interest. As a result, $0.4 million recorded as noncontrolling interest on the consolidated balance sheet as at December 31, 2009.
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.
On March 6, 2009, the Company entered into a Share Purchase Agreement (“IAL 7X Agreement”) with the Company’s Executive Chairman, Mark Byrne (“Mr. Byrne”) to acquire 100% of the issued and outstanding common voting shares of IAL 7X Leasing Limited (“IAL 7X”) for a cash purchase price of $10,000. IAL 7X owned, as its principal asset, a delivery slot for a Dassault Falcon 7X aircraft (“7X Purchase Agreement”). Mr. Byrne and the Company agreed that upon delivery of the aircraft, the Company would either sell the aircraft or retain it as determined by the Board of Directors according to the Company’s needs at that time. The parties further agreed that any gain on disposition or delivery would be split 85% to Mr. Byrne and 15% to the Company, and any loss would be borne 100% by Mr. Byrne.
On November 24, 2009, Flagstone Suisse entered into a senior unsecured loan agreement with Star and Shield Holdings LLC (“Star and Shield”), a member owned insurance company in which the Company holds a 43.3% equity investment interest. Under the terms of the agreement, the Company agreed to a revolving basis commitment of $2.5 million with an interest rate of LIBOR plus 8.5% per annum, adjusted and compounded quarterly on any unpaid balance of principal and interest until the maturity of the loan which is no later than November 24, 2012. As at December 31, 2009, the Company had advanced $0.4 million as a loan receivable from Star and Shield on its Consolidated Balance Sheet.
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 Company also holds counterparty collateral or posts collateral with the derivative counterparties, as allowed for in the International Swaps and Derivatives Association (“ISDA”) agreements, in order to mitigate the counterparty exposure risk related to the fair value of the derivatives. The difference between the contract amounts and collateral held or posted is the Company’s credit exposure with these counterparties.
The Company’s investment portfolio is managed in accordance with the diversification strategy outlined in the Company’s investment policy guidelines. 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.
For the year ended December 31, 2009, two brokers accounted for approximately 61% of gross premiums written and for the year ended December 31, 2008, two brokers accounted for approximately 68% of gross premiums written.
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, 2009, 2008, and 2007 was approximately $4.2 million, $2.6 million, and $1.2 million.
During 2008, the Company entered into an agreement to acquire an office building in Luxembourg. The building is currently under construction and is expected to be completed in 2010. During 2009, the Company, entered into an agreement to acquire an office building in Martigny. The building is currently under construction and is expected to be completed in 2012. The remaining balance of $3.5 million and $15.9 million, respectively, for Luxemburg and Martigny is to be paid as specific milestones are reached in the construction. Also during 2009, the Company entered into an agreement to acquire two apartments in London. The purchases are expected to be completed in 2010 for a total cost of $1.3 million.
During 2006, the Company made certain commitments with respect to an investment in a private equity fund. As at December 31, 2009 and 2008, the total outstanding investment commitment was $3.4 million and $4.2 million, respectively.
Bermuda law limits the maximum amount of annual dividends or distributions that can be paid by Flagstone Suisse to the Company and in certain cases requires the prior notification to, or the approval of, the Bermuda Monetary Authority (the “BMA”). As a Bermuda Class 4 reinsurer, Flagstone Suisse may not pay dividends in any financial year which would exceed 25% of its total statutory capital and surplus, as shown on its statutory balance sheet in relation to the previous financial year, 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 Suisse’s principal representative, which states that in their opinion, declaration of those dividends will not cause Flagstone Suisse to fail to meet its prescribed solvency margin and liquidity ratio. Further, Flagstone Suisse may not reduce by 15% or more its total statutory capital as set out in its previous year’s financial statements, without the prior approval of the BMA. This may limit the amount of funds available for distribution to the Company, restricting the Company’s ability to pay dividends, make distributions and repurchase any of its common shares. Flagstone Suisse was required to maintain a minimum level of statutory capital and surplus of $316.6 million (unaudited) and $326.8 million (unaudited), as at December 31, 2009 and 2008, respectively. Actual statutory capital and surplus as at December 31, 2009 and 2008 was $1.6 billion (unaudited) and $1.3 billion, respectively.
UK company law prohibits Marlborough and Flagstone Corporate Name Limited from declaring a dividend to its shareholders unless it has “profits available for distribution”. The determination of whether a company has profits available for distribution is based on its accumulated realized profits less its accumulated realized losses. While the UK insurance regulatory laws impose no statutory restrictions on a Lloyd’s managing agent’s ability to declare a dividend, the FSA’s rules require maintenance of adequate resources, including each company’s solvency margin within its jurisdiction. In addition, under Lloyd’s rules, a managing agent must maintain a minimum level of capital based, among other things, on the amount of capacity it manages subject to a minimum of £400,000.
As a result of the acquisition of Marlborough, the managing agency for Lloyd’s Syndicate 1861, the Company revised its segment structure, effective January 1, 2009, to include a new Lloyd’s segment. As a result of this process, the Company is now reporting its results to the chief operating decision maker based on three reporting segments: Reinsurance, Lloyd’s and Insurance. The Company regularly reviews its financial results and assesses performance on the basis of these three reporting segments.
The Lloyd’s segment includes the business generated for Lloyd’s Syndicate 1861 by Marlborough. Syndicate 1861, based in London, primarily provides property and short-tail specialty and insurance and casualty reinsurance for risks such as energy, hull and cargo, marine liability, engineering and aviation. Syndicate 1861 began writing business for the benefit of Flagstone effective January 1, 2009. As such, there are no comparative numbers for the Lloyd’s segment for the prior years. Marlborough generates fee income for the provision of services to Syndicates and third parties.
The Company’s Lloyd’s segment includes the business generated through the Lloyd’s Syndicate 1861 and Marlborough. Syndicate 1861 primarily provides property and short-tail specialty and casualty insurance and reinsurance for risks such as energy, hull and cargo, marine liability, engineering and aviation. Marlborough generates fee income for the provision of services to Syndicates and third parties.
The Company has evaluated subsequent events thru to the date the financial statements were available to be issued. The following events have occurred subsequent to December 31, 2009 thru to the financial statements becoming available to be issued.
On February 27, 2010, a powerful 8.8 magnitude earthquake struck the southwest coast of Chile, causing widespread damage, business interruption, and tsunami warnings across the Pacific.
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, 2009.