We currently lease office space in Grand Cayman, Cayman Islands under an operating lease that expires on August 31, 2010. On July 9, 2008, we entered into an additional operating lease agreement for new office space in the Cayman Islands which expires on June 30, 2018. Once we have occupied the new office space, we will no longer require the use of our current office space and we believe that for the foreseeable future the new office space will be sufficient for us to conduct our operations.
The following is a discussion and analysis of our results of operations for the years ended December 31, 2008, 2007 and 2006 and financial condition as of December 31, 2008 and 2007. The following discussion should be read in conjunction with the consolidated financial statements and accompanying notes, which appear elsewhere in this filing.
Because we have a limited operating history and employ an opportunistic underwriting philosophy, period-to-period comparisons of our underwriting results are not yet possible and may not be meaningful. In addition, our historical investment results may not necessarily be indicative of future performance. In addition, due to the nature of our reinsurance and investment strategies, our operating results will likely fluctuate from period to period.
General and administrative expenses consist primarily of salaries and benefits and related costs, including costs associated with our incentive compensation plan, stock compensation expenses, professional fees, travel and entertainment, information technology, rent and other general operating expenses.
We account for reinsurance contracts in accordance with Statement of Financial Accounting Standards (SFAS) No. 60, ‘‘Accounting and Reporting by Insurance Enterprises,’’ and SFAS No. 113, ‘‘Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts.’’ Assessing whether or not a reinsurance contract meets the conditions 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. If we determine that a reinsurance contract does not transfer sufficient risk, we account for the contract as a deposit liability.
Investments.  Effective January 1, 2008, we adopted SFAS No. 157, “Fair Value Measurements,” which resulted in no material changes in the valuation techniques we previously used for measuring fair values. Our investments in debt and equity securities that are classified as “trading securities” are carried at fair value. The fair values of the listed equity and debt investments are derived based on last reported price on the balance sheet date as reported by a recognized exchange. The fair values of private debt securities are generally derived based on the average of multiple market maker or broker quotes which are considered to be binding. Where quotes are not available, debt securities are valued using cash flow models using assumptions and estimates that may be subjective and non-observable.
Our other investments in private equity securities, limited partnerships, futures, exchange traded options and over-the-counter (“OTC”) options, are all carried at fair value, based on broker or market maker quotes, or based on management’s assumptions developed from available information, using the services of our investment advisor. Our exchange traded option contracts are recorded at fair market value based on quoted prices in active markets. For OTC options or exchange traded options where a quoted price in an active market is not available, we obtain multiple market maker quotes to determine the fair values.
Loss and Loss Adjustment Expense Reserves. We establish reserves for contracts based on estimates of the ultimate cost of all losses including losses incurred but not reported, or IBNR. These estimated ultimate reserves are based on reports received from ceding companies, historical experience and actuarial estimates. These estimates are periodically reviewed and adjusted when necessary. Since reserves are estimates, the setting of appropriate reserves is an inherently uncertain process. Our estimates are based upon actuarial and statistical projections and on our assessment of currently available data, predictions of future developments and estimates of future trends and other factors. The final settlement of losses may vary, perhaps materially, from the reserves initially established and any adjustments to the estimates are recorded in the period in which they are determined. Under generally accepted accounting principles in the United States (“U.S. GAAP”), we are not permitted to establish loss reserves, which include case reserves and IBNR, 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 loss events.
Reported Loss Development Method. We estimate ultimate losses by calculating past reported loss development factors and applying them to exposure periods with further expected reported loss development. Since reported losses include payments and case reserves, changes in both of these amounts are incorporated in this method. This approach provides a larger volume of data to estimate ultimate losses than paid loss methods. Thus, reported loss patterns may be less varied than paid loss patterns, especially for coverage that have historically been paid out over a long
period of time but for which claims are reported relatively early and case loss reserve estimates have been established.
Expected Loss Ratio Method. We estimate ultimate losses under the expected loss ratio method, by multiplying earned premiums by an expected loss ratio. We select the expected loss ratio using industry data, historical company data and our professional judgment. We use this method for lines of business and contracts where there are no historical losses or where past loss experience is not credible.
Bornheutter-Ferguson Paid Loss Method. We estimate ultimate losses by modifying expected loss ratios to the extent paid losses experienced to date differ from what would have been expected to have been paid based upon the selected paid loss development pattern. This method avoids some of the distortions that could result from a large development factor being applied to a small base of paid losses to calculate ultimate losses. We use this method for lines of business and contracts where there are limited historical paid losses.
Acquisition Costs. We capitalize brokerage fees, ceding commissions, premium taxes and other direct expenses that relate directly to and vary with the writing of reinsurance contracts. Acquisition costs are deferred subject to ultimate recoverability and amortized over the related contract term. Acquisition costs also include profit commissions. Certain contracts include provisions for profit commissions to be paid to the ceding insurer based upon the ultimate experience of the contracts. Profit commissions are calculated and accrued based on the expected loss experience for such contracts and recorded when the expected loss experience indicates that a profit commission is probable under the contract terms. Profit commission reserves, if any, are included in reinsurance balances payable on the consolidated balance sheets.
Share-Based Payments. We have established a Stock Incentive Plan for directors, employees and consultants which we account under SFAS 123R, ‘‘Share-Based Payments.’’ SFAS 123R requires us to recognize share-based compensation transactions using the fair value at the grant date of the award. We calculate the compensation for restricted stock awards based on the price of the Company’s common shares
Due to our increasing market recognition, and the development of strategic relationships in 2007 and 2008, we expect to see an increase in frequency business written in 2009 compared to 2008, and continued diversification of business by client, line of business, broker and geography. In the second quarter of 2008, we believed there was an excess of capacity in the property and casualty reinsurance business, primarily due to two consecutive years of below-average natural peril losses. During the third quarter of 2008, there were two hurricanes (Gustav and Ike) that made landfall in the United States; preliminary estimates indicate total industry-wide insured losses range from $20 to $25 billion. We do not expect to experience any losses from these hurricanes. In addition, there are a number of insurers and reinsurers that have had significant investment-related issues that have created uncertainty in their businesses. We expect write downs of certain asset classes in the fourth quarter of 2008 to continue to reduce the capital positions of a number of reinsurers. Finally, we believe that the financial and credit crisis currently underway in the U.S. and the rest of the world has the potential to cause significant losses in certain lines of business.
If the current challenges facing the insurance industry create significant dislocations, we believe we will be well positioned to capitalize on resulting opportunities. In early 2009, we have seen pricing of property catastrophe retrocession business increase substantially. While it is unclear what other businesses could be most affected by the current financial and credit issues, we believe that opportunities are likely to arise in two areas. The first area is lines of business that have experienced poor loss experience. The second area is lines of business where current market participants are experiencing financial distress or uncertainty. Lines of business that are likely to be affected by either of these areas include property catastrophe reinsurance, marine reinsurance, marine retrocession, general liability, surety, directors and officers liability and errors and omissions liability, among others. In addition, we believe that we can also continue to find attractive opportunities in motor liability, workers compensation, health and medical malpractice risks.
Any significant market dislocations that increase the pricing of certain insurance coverages could create the need for insureds to retain risks and thus fuel the opportunity for new captives to form. If this happens, a number of these captives could form in the Cayman Islands, enhancing our opportunity to provide additional reinsurance to the Cayman Islands' captive market.
For the year ended December 31, 2008, we reported a net loss of $120.9 million as compared to a net income of $35.3 million for the year ended December 31, 2007. The net loss principally related to a $126.1 million net investment loss. Our investment portfolio reported a loss of 17.6% for the year ended December 31, 2008 compared to a gain of 5.9% for the year ended December 31, 2007. The underwriting income for the year ended December 31, 2008 was $17.8 million compared to $19.6 million for the year ended December 31, 2007.
For the year ended December 31, 2007, fully diluted book value increased by $2.30 per share or 16.1% to $16.57 per share. This increase included the increase associated with our initial public offering in May 2007.
We expect our annual reporting of premiums written to be volatile as our underwriting portfolio continues to develop. Additionally, the composition of premiums written between frequency and severity business will vary from year to year depending on the specific market opportunities that we pursue. For the
For the year ended December 31, 2007, the increase in premiums written for frequency business compared to 2006 was due to the fact that no frequency contracts were written until the third quarter of 2006 while a number of frequency contracts were entered into throughout 2007. Similarly, premiums written for severity business in 2007 reflect our first full year of underwriting whereas the 2006 comparative results related to premiums written from April 2006 (commencement of our underwriting operations) to December 31, 2006.
We entered into retrocessional contracts with ceded premiums of $16.4 million and $26.1 million for the years ended December 31, 2008, and 2007 respectively, relating to risks assumed from certain frequency reinsurance contracts. The lower ceded premiums for the year ended December 31, 2008 were principally due to frequency contracts restructured on renewal during 2008 which resulted in lower subject premiums and where we retained certain additional risks which we had previously ceded.
Details of net premiums written for the years ended December 31, are provided in the following table:
Our severity business includes contracts that contain or may contain natural peril loss exposure. As of February 1, 2009, our maximum aggregate loss exposure to any series of natural peril events was $97.1 million. For purposes of the preceding sentence, aggregate loss exposure is equal to the difference between the aggregate limits available in the contracts that contain natural peril exposure minus reinstatement premiums for the same contracts. We categorize peak zones as: United States, Europe, Japan and the rest of the world. The following table provides single event loss exposure and aggregate loss exposure information for the peak zones of our natural peril coverage as of February 1, 2009:
We expect losses incurred on our severity business to be volatile from period to period. Losses incurred on the natural peril exposed portion of our severity business have benefited from no material natural peril losses during 2008, as well as benign natural peril loss experiences during 2007 and 2006. Additionally, given the seasonality of wind exposure, we expect that the first six months of a calendar year generally will report lower losses incurred on natural peril business than the last six months of a calendar year. The loss ratios for our severity business were 57.7%, 19.9%, and 8.5% for the years ended December 31, 2008, 2007 and 2006, respectively.
The increase in the loss ratio during 2007 primarily is due to the different composition of the severity underwriting portfolio. During the year ended December 31, 2006, the severity underwriting portfolio was composed entirely of natural peril business. Because of benign natural peril loss experience, we incurred a very low loss ratio. This contrasts with the severity underwriting portfolio for the year ended December 31, 2007 which included casualty and liability exposures in addition to natural peril risks, which accounted for the increase in the reported loss ratio for the year ended December 31, 2007. Unlike natural peril coverages in which zero losses are booked until a covered natural peril event occurs, casualty and liability severity coverages typically have the potential for an unreported event to occur during the term of the coverage and thus IBNR reserves are booked based on an expected loss ratio for the business underwritten, resulting in a higher initial loss ratio being reported.
Extinguishing $1.2 million of reserves, held on two frequency contracts covering excess of loss medical malpractice, due to commutation without any reported losses.
There were no significant developments of prior year reinsurance reserves during the year ended December 31, 2007.
For the year ended December 31, 2008, the decrease in severity acquisition cost ratio is the result of (a) lower profit commissions accrued and paid on severity contracts due to losses developing on non-natural peril contracts, and (b) the premiums earned on certain multi-year professional liability severity contracts which incepted in the later part of the second quarter of 2007, had no acquisition costs associated with them.
For the year ended December 31, 2007, the increase in general and administrative expenses of $2.8 million reflected the continued expansion of our underwriting operations, as well as increased expenses incurred as a publicly-traded company, including hiring additional staff and other related expenses. General and administrative expenses for the years ended December 31, 2008, 2007 and 2006 include $3.0 million, $2.9 million and $2.9 million, respectively, for the expensing of the fair value of stock options and restricted stock granted to employees and directors.
The loss ratio is calculated by dividing loss and loss adjustment expenses incurred by net premiums earned. We expect that the loss ratio will be volatile for our severity business and may exceed that of our frequency business in certain periods. Given that we opportunistically underwrite a concentrated portfolio across several lines of business that have varying expected loss ratios, we can expect there to be significant annual variations in the loss ratios reported from our frequency business. In addition, the loss ratios for both frequency and severity business can vary depending on the lines of business written.
Total investments in securities reported as of December 31, 2008 were $494.0 million compared to $590.5 million as of December 31, 2007, a decrease of 16.3%. The decrease in investments was principally due to an investment loss of $126.1 million for the year ended December 31, 2008. This decrease was partially offset by investments purchased from the net positive cash flows generated from underwriting operations.
Loss reserves totaled $81.4 million as of December 31, 2008 compared to $42.4 million as of December 31, 2007. The increase is principally attributable to estimated losses associated with premiums earned during the year ended December 31, 2008 resulting from our increased underwriting activities. Case reserves increased $5.0 million, while reserves for losses incurred but not reported increased by approximately $34.1 million as of December 31, 2008.
As of December 31, 2008, the financial strength of our reinsurance subsidiary was rated “A- (Excellent)” with a stable outlook by A.M. Best. This rating reflects the A.M. Best’s opinion of our financial strength, operating performance and ability to meet obligations and it is not an evaluation directed toward the protection of investors or a recommendation to buy, sell or hold our Class A ordinary shares.
For the year ended December 31, 2008, we generated $46.4 million in net cash flow from operations, used $14.1 million in investing activities, and used $2.3 million to repurchase ordinary shares. Effective January 1, 2008, we adopted SFAS No. 159 and as a result cash flows relating to our investment portfolio are no longer classified as an operating activity, and instead have been classified as an investing activity to reflect the underlying nature and purpose of our investing strategies.
For the year ended December 31, 2007, we used $273.7 million for operating activities. Included in operating activities were securities and restricted cash and cash equivalents purchased from the proceeds of our initial public offering. During the year ended December 31, 2007, substantially all our cash provided by financing activities related to the proceeds from our initial public offering and there were no cash flows reported from investing activities.
Greenlight Re has a letter of credit facility of $400.0 million as of December 31, 2008 with Citibank, N.A. with a termination date of October 11, 2009. The termination date is automatically extended for an additional year unless written notice of cancellation is delivered to the other party at least 120 days prior to the termination date.
As of December 31, 2008, $167.3 million in letters of credit were issued from the available $425.0 million facilities. Under the letter of credit facilities, we provide collateral that may consist of equity securities. As of December 31, 2008, we had pledged $220.2 million of equity securities and cash equivalents as collateral for the above letter of credit facilities. The letter of credit facilities agreements contain various covenants that, in part, restrict Greenlight Re’s ability to place a lien or charge on the pledged assets and further restricts Greenlight Re’s ability to issue any debt without the consent of the letter of credit provider. Additionally, if an event of default exists, as defined in the letter of credit agreements, Greenlight Re will be prohibited from paying dividends to us. For the year ended December 31, 2008, the Company was in compliance with all of the covenants under each of the letter of credit facility agreements.
As of December 31, 2008, total shareholders’ equity was $485.4 million compared to $605.6 million at December 31, 2007. This decrease in total shareholders’ equity principally is due to the net loss of $120.9 million reported during the year ended December 31, 2008.
Our capital structure currently consists entirely of equity issued in two separate classes of ordinary shares. We expect that existing capital base and internally generated funds will be sufficient to implement our business strategy. Consequently, we do not presently anticipate that we will incur any material indebtedness as part of our capital structure. However, we cannot provide assurances that in the future, we will not be required to raise additional equity or incur indebtedness to implement our business strategy, pay claims or make acquisitions. We have not made any significant capital expenditures during the period from inception to December 31, 2008. We anticipate incurring approximately $1.0 million in capital expenditures during 2009 primarily related to leasehold improvements. We anticipate funding these capital expenditures from existing operations and do not anticipate requiring additional equity or indebtedness relating to these expenditures.
The following table shows our aggregate contractual obligations by time period remaining to due date as of December 31, 2008:
Reflects our contractual obligations pursuant to the September 1, 2005 lease agreement and the July 9, 2008 lease agreement as described below.
On July 9, 2008, we signed a ten year lease agreement for new office space in the Cayman Islands with the option to renew for an additional five year term. The lease term is effective from July 1, 2008, and the rental payments commence from the earlier of December 1, 2008 or when we occupy the premises. As of December 31, 2008, we had not occupied the premises. Under the terms of the lease agreement, our minimum annual rent payments will be $253,539 for the first three years, increasing by 3% thereafter each year to reach $311,821 by the tenth year. The minimum lease payments are included in the above table under operating lease obligations and in the accompanying consolidated financial statements.