We lease office space in Hamilton, Bermuda, where our principal executive offices are located. We also lease office space in London, U.K., where MCL, MMSL and MUSL are located; in Zug, Switzerland, where MEAG is located; in Hartford, CT, Overland Park, KS, Stamford, CT and Shelton, CT where MUI is located; in Scottsdale, AZ where MUSIC is located; in Hanover, NH where MTR is located; and Toronto, Canada, where our disaster recovery center is located.
(c) During 2005, we incurred substantial losses associated with hurricanes Katrina, Wilma and Rita which resulted in a net loss for the year.
(d) During 2007, Blue Ocean paid a total of $249.0 million in dividends and distributions to its common and preferred shareholders (of which we received $103.9 million) and repurchased a total of $55.0 million of its preferred shares (of which we received $18.5 million).
(e) During 2007, we publicly repurchased 3,776,989 common shares for $63.7 million. In addition, we privately repurchased 939,039 common shares and 7,172,375.5 warrants from White Mountains Insurance Group, Ltd. (“White Mountains”), a former affiliate, for $65.0 million.
(f) During 2006, we privately sold 6,896,552 common shares for $100.0 million.
(g) During 2005, we publicly sold 25,850,926 common shares for $600.0 million.
(h) During 2004, we publicly repurchased 1,888,865 common shares for $65.5 million.
As of the date of the warrant repurchase, our fully converted book value per share was less than the $16.67 strike price of the warrants, meaning that the warrants were not dilutive to our book value at that time. As of December 31, 2007, our fully converted tangible book value per share of $17.82 exceeded the strike price of the warrants meaning that the warrants, had they continued to be outstanding, would have been dilutive to our book value at the end of 2007. We have determined that we have recouped approximately 20% of the cost of the warrants in the form of reduced dilution to shareholders in the eight month period since the date of the transaction.
We ended 2006 with a fully converted tangible book value per share of $15.46, an increase of 33.2% for the year inclusive of dividends. The increase was largely the result of favorable underwriting conditions resulting from attractive pricing and a low level of catastrophes experienced throughout the year, as well as strong investment results.
Our comprehensive income for 2007 was $314.0 million and our GAAP combined ratio was 61.3%, compared to $361.5 million and a GAAP combined ratio of 60.3% for 2006. The favorable results we achieved in 2007 and 2006 were largely a function of the low level of catastrophic losses that we experienced during those periods. In 2005, we had a comprehensive loss of $752.9 million with a GAAP combined ratio of 200.7%. The unfavorable results we achieved in 2005 were largely the result of substantial catastrophic losses we experienced during that year from hurricanes Katrina, Rita and Wilma.
As a predominantly short-tail property reinsurer, we have exposure to various natural catastrophes around the world. We manage our exposure to catastrophes using a combination of CATM, third party vendor models, underwriting judgment, and our own reinsurance purchases.
Our three-tiered risk management approach focuses on tracking exposed contract limits, estimating the potential impact of a single natural catastrophe event, and simulating our yearly net operating result to reflect certain modellable underwriting and investment risks we face on an aggregate basis. We seek to refine and improve our risk management process over time.
For certain defined natural catastrophe region and peril combinations, we assess the probability and likely magnitude of losses using a combination of industry third party vendor models, CATM and underwriting judgment. We attempt to model the projected net impact from a single event taking into account contributions from our inward portfolio of property, aviation, workers’ compensation, casualty, and personal accident insurance policies, reinsurance policies, and event-linked derivative securities offset by the net benefit of any reinsurance or derivative protections we purchase and the net benefit of reinstatement premiums. The table below details our estimated average net impact market share for selected natural catastrophe events of various industry loss magnitudes:
The market share estimates above represent an estimate of our average market share across our largest possible event scenarios corresponding to industry losses of a given size. However, it is important to note that our average market share may vary considerably within a particular territory depending on the specific characteristics of the event. This is particularly true for the direct insurance and facultative reinsurance portfolio we underwrite. Other factors contributing to such variation may include our decision to be overweight or underweight in certain regions within a territory. For example, our market share for a large European wind event may differ depending on whether the majority of loss comes from the U.K. or from Continental Europe. Additionally, our net market share may be impacted by the number and order of occurrence of catastrophic events during a year which could exhaust individual policy limits or trigger additional losses from certain policies offering second-event or aggregate protection. Further, certain reinsurance we purchase may have geographic restrictions or provide coverage for only a single occurrence within the policy period. Lastly, these estimates represent snapshots at a point in time. The composition of our in-force portfolio will fluctuate due to the acceptance of new policies, the expiration of existing policies, and changes in our reinsurance program.
Our catastrophe and enterprise-wide risk management metrics entail significant estimates, judgments and uncertainties. See “Risk Factors” contained in Item 1A herein.
We assign a price index percentage to business which we renew. This index represents an internal subjective measure which takes into account both changes in pricing and terms and conditions which we observe. This index does not reflect deteriorating pricing or terms in business we decline to renew. During the January 2008 renewal process we observed an average renewal price index across our portfolio of minus 10%, with the U.S. market being slightly more competitive than other regions at an average of minus 11% versus an average of minus 9% for international accounts. We also observed strong incumbent market retention within our existing positions on desirable programs, which means that our Bermuda operation was able to maintain and/or expand positions with its long-term target client base. We also observed that aggregate demand was static at best, but more likely decreasing in most catastrophe markets.
Looking ahead to future periods, it remains difficult to predict the amount of annual premiums we will write. However, gross written premium for January 2008 was flat to down 5% versus the comparable 2007 period. Increased signings within Bermuda and new business from our U.K. and U.S. platforms largely offset the impact of rate reductions, non-renewals for pricing reasons, and business attrition due to larger ceding company retentions and the run-off of Blue Ocean. Absent any major changes in market conditions, we would expect a similar pattern for the full year 2008.
In November 2007, we acquired MUSIC, an Oklahoma domiciled stock property and casualty insurance corporation. MUSIC is an admitted insurer in Oklahoma and is authorized as an excess and surplus lines insurer in 37 additional states. At the time the acquisition was completed, MUSIC had no employees or in force premium.
MUSIC aims to target smaller commercial property and casualty risks that do not conform to normal underwriting patterns for standard lines and are not subject to extreme competitive pressures. From the date of the MUSIC Acquisition to December 31, 2007, MUSIC wrote a de minimis amount of premium.
Due to the start-up nature and date of commencement of these new operations, they did not have a significant impact on our consolidated revenues for 2007. However, during 2007 we began, and during 2008 will continue, the process of building an infrastructure to support these activities. As a result, our general and administrative expenses have increased significantly, and are expected to further increase, over levels experienced prior to 2007.
Our consolidated financial results for years ended December 31, 2007, 2006 and 2005 follow:
We operate through two business segments, Rated Reinsurance and Insurance Business and Collateralized Property Catastrophe Retrocessional Business.
Our Rated Reinsurance and Insurance segment, which consists of the operations of the Company and its wholly-owned subsidiaries (including our operating subsidiaries Montpelier Re, Syndicate 5151 and MUSIC), relies on its financial strength ratings to provide assurance to customers that Montpelier will be able to honor its insurance and reinsurance obligations.
Underwriting results for our Rated Reinsurance and Insurance segment for the years ended December 31, 2007, 2006 and 2005 were as follows:
Year Ended December 31, 2007 as compared to Year Ended December 31, 2006
Gross premiums written during 2007 were $611.0 million, a decrease of 3% compared to 2006. Excluding reinstatement premiums, gross premiums written during 2007 were $602.6 million, a decrease of 2% compared to 2006. The decrease in premiums written from 2006 to 2007 is primarily the result of increased competition and the impact of recent changes in Florida legislation. Under the new legislation, state sponsored entities significantly increased their assumption of property catastrophe risk in Florida, a significant market to us. The 2007 decrease in gross premiums written was partially offset by $15.3 million in new premium writings through Syndicate 5151.
Loss and LAE incurred during 2007 was $177.5 million, an increase of 3% compared to 2006. Although both 2007 and 2006 were low catastrophe loss years, the primary increase in loss and LAE during 2007 was due to marginally higher catastrophe losses experienced in 2007 versus 2006, partially offset by a $12.6 million increase in favorable loss reserve development. During 2007 we recorded net losses of $88.6 million associated with six large catastrophe losses (as further described herein). During 2006 our single largest catastrophe loss, a series of U.S. tornadoes and hailstorms, amounted to less than $10 million.
General and administrative expenses incurred during 2007 were $84.6 million, an increase of 31% compared to 2006. This increase is largely due to $11.7 million of incremental general administrative expenses incurred in connection with our newly established U.S., U.K. and Swiss operations as well as an increase in incentive compensation accruals resulting from having multiple long-term incentive award cycles outstanding during 2007 versus only one cycle in 2006 (as further described herein).
Underwriting income was $158.9 million during 2007, resulting in a GAAP combined ratio of 67.9%. This compares to underwriting income of $165.2 million for 2006, which resulted in a GAAP combined ratio of 67.6%.
Gross premiums earned during 2006 were $698.4 million, a decrease of 30% compared to 2005. This decrease is the result of the aforementioned decrease in, as well as the timing of, gross premiums written in 2006.
Earned reinsurance premiums ceded were $188.3 million, an increase of 22% compared to 2005. This increase primarily resulted from the purchase of quota share reinsurance during the fourth quarter of 2005 to protect the 2005 underwriting year in-force book of business. This reinsurance transaction had a significant effect on our 2006 earned reinsurance premiums ceded.
Loss and LAE incurred during 2006 was $172.7 million, a decrease of $1,338.0 million from 2005. During 2005, we incurred net losses of $1,202.8 million from hurricanes Katrina, Rita, Wilma and Dennis and from European floods. As previously mentioned, 2006 was a year in which we incurred only a limited amount of catastrophic losses.
Acquisition costs incurred during 2006 were $107.4 million, a decrease of 35% compared to 2005. This decrease is primarily due to the significant reduction in premiums earned during 2006, versus that of 2005.
The following table summarizes our gross premiums, by line of business, within our Rated Reinsurance and Insurance segment for the years ended December 31, 2007, 2006 and 2005:
During 2006, our mix of premiums written changed modestly, as compared to 2005, mainly as a result of the following:
During 2005 and 2006 we commuted all of our outstanding Qualifying Quota Share contracts.
We purchase reinsurance to accomplish a number of objectives, including protecting our direct and assumed reinsurance portfolio against large risk losses, protecting us against certain catastrophes on our overall property writings and providing stop-loss protection against losses on our casualty, sabotage and terrorism writings.
As a result of the impact of catastrophes in 2005, the supply of reinsurance and retrocessional coverage contracted causing increases in the cost of traditional reinsurance. Certain non-traditional markets, such as hedge funds and investment banks, increasingly endeavored to provide reinsurance protection through Industry Loss Warranty (“ILW”) reinsurance protection. With ILWs, the cedant’s prospect of recovery is based on the size of the market loss, regardless of the cedant’s own ultimate net loss (“UNL”) which is protected in the case of a traditional reinsurance contract. ILWs require less underwriting due diligence and eliminate the risk of incurring a disproportionately large share of an industry loss from the cedant. For these reasons, ILWs may be seen as more attractively priced from the ceding company’s perspective than UNL covers. The availability of traditional reinsurance and ILW reinsurance is a function of market capacity, which is in turn a function of the perceived returns that retrocessional providers expect to earn, and their appetite and capacity for assuming risk.
In addition to the reinsurance described above, we also purchased fully-collateralized reinsurance-like coverage for losses sustained from qualifying hurricane and earthquake loss events as of December 31, 2005. We acquired this protection from Champlain Limited (“Champlain”), a Cayman Islands special purpose vehicle, which financed this coverage through the issuance of $90.0 million in catastrophe bonds to investors under two separate bond tranches, each of which matures on January 7, 2009. The first $75.0 million tranche covers large earthquakes affecting Japan and/or the U.S. The remaining $15.0 million coverage provides second event coverage for a U.S. hurricane or earthquake. Both tranches respond to parametric triggers, whereby payment amounts are determined on the basis of modeled losses incurred by a notional portfolio rather than by actual losses incurred by us. For that reason, this transaction is accounted for as a derivative, rather than a reinsurance transaction.
Net loss and LAE relating to current year losses were $213.9 million, $196.5 million and $1,527.8 million for the years ended December 31, 2007, 2006 and 2005, respectively.
During 2007 we recorded net losses of $88.6 million associated with windstorms Kyrill and Gonu, floods in Australia, floods in the U.K. (in June and July), and wildfires in California. During 2006 our single largest catastrophe loss, a series of U.S. tornadoes and hailstorms, amounted to less than $10 million. During 2005, we recorded net losses of $1,202.8 million from hurricanes Katrina, Rita, Wilma and Dennis and from European floods. The severity of these events served to increase our 2005 current year GAAP loss ratio by 141.8%.
The nature of our business means that losses, and the resulting loss ratios, can vary widely from period to period depending on the occurrence and severity of natural and man-made catastrophes.
Reinsurance recoveries netted against loss and LAE were $6.9 million, $31.2 million and $318.6 million for the years ended December 31, 2007, 2006 and 2005, respectively. The majority of the reinsurance recoveries in 2005 related to hurricanes Katrina, Rita and Wilma.
During the year ended December 31, 2007, we experienced $36.4 million in favorable development on net loss and LAE reserves relating to prior year losses within the following lines of our business:
· Net estimated ultimate Other Specialty losses for prior years decreased by $5.8 million due to the re-assessment of loss and LAE reserves relating to several classes of business within our Other Specialty lines.
During the year ended December 31, 2006, we experienced $23.8 million in favorable development on net loss and LAE reserves relating to prior year losses within the following lines of our business:
· Net estimated ultimate Other Specialty losses for prior years decreased by $19.9 million due primarily to a decrease in Marine losses relating to Hurricane Rita, decreases in expected losses on proportional contracts relating to the Aviation, Marine and Personal Accident classes of business and favorable commutations of a related group of Other Specialty contracts.
During the year ended December 31, 2005, we experienced $17.1 million in favorable development on net loss and LAE reserves relating to prior year losses within the following lines of our business:
· Net estimated ultimate Property Catastrophe losses for prior years increased by $20.5 million due primarily to an increase in expected ultimate losses associated with hurricanes occurring in 2004 and Typhoon Songda.
· Net estimated ultimate Property Specialty losses for prior years decreased by $24.3 million due primarily to an increase in ceded losses relating to hurricanes occurring in 2004.
· Net estimated ultimate Qualifying Quota Share losses for prior years increased by $4.4 million. The variability of ultimate premiums and limited availability of underlying loss information within this line of business resulted in the need to strengthen prior year reserves.
The following tables presents information with respect to our gross loss and LAE reserves, by line of business, within our Rated Reinsurance and Insurance segment as of December 31, 2007 and 2006 and for the years then ended:
The following tables present information with respect to our net loss and LAE reserves, by line of business, within our Rated Reinsurance and Insurance segment as of December 31, 2007 and 2006 and for the years then ended:
Underwriting results for our Collateralized Property Catastrophe Retrocessional segment for the years ended December 31, 2007 and 2006 were as follows:
Net premiums earned and acquisition costs decreased from 2006 to 2007 due to the sharp decline in gross premiums written during 2007 versus that of 2006. Net premiums earned also decreased from 2006 to 2007 due to the timing of premium writings. General and administrative expenses, consisting primarily of third party management fees, increased $0.1 million from 2006 to 2007 due to professional fees incurred in connection with the distributions made to Blue Ocean’s shareholders during 2007.
In January 2008, Blue Ocean repaid its $75.0 million secured loan from a syndicate of lenders, repurchased all its remaining preferred shares outstanding and cancelled its $250.0 million letter of credit facility.
The following table summarizes our consolidated net investment income and total investment return for the years ended December 31, 2007, 2006 and 2005:
Investment expenses were higher during 2007, as compared to 2006, due mainly to a change in investment managers during the period. Investment expenses were higher during 2006, as compared to 2005, due mainly to a significant increase in the weighted average size of the portfolio.
Our total investment return decreased in 2007 compared to 2006 as increases in net investment income and foreign exchange gains were offset by lower net realized and unrealized investment gains. During 2006, we experienced significant realized and unrealized gains on our equity securities and convertible bonds. Our total investment return increased significantly in 2006 compared to 2005 due to increases in net investment income resulting from the higher weighted average size of the portfolio and the aforementioned increase in realized and unrealized gains. During 2005, we experienced significant net realized and unrealized losses on our fixed maturity portfolio due to market movements affecting bond prices.
Because we provide short-tail reinsurance and insurance coverage for losses resulting mainly from natural and man-made catastrophes, we could become liable to pay substantial claims on short notice. Accordingly, we have structured our investment portfolio to preserve capital and to provide us with a high level of liquidity, which means that the large proportion of our investment portfolio comprises shorter-term fixed maturity investments, such as U.S. government and agency bonds, U.S. government-sponsored enterprises, corporate debt securities and mortgage-backed and asset-backed securities. We have also maintained investments in equity securities and other investments over the past few years and believe our returns will be higher over time as a result. During 2007, we began to modestly increase our exposure to equity securities and other investments in order to increase expected returns. We expect to continue this trend in future periods.
In December 2005, we purchased fully-collateralized coverage for losses sustained from qualifying hurricane and earthquake loss events from Champlain, as previously mentioned.
During 2003, we issued $250.0 million of senior unsecured debt. The Senior Notes bear interest at a rate of 6.125% per annum, payable semi-annually in arrears on February 15 and August 15 of each year. The Senior Notes are scheduled to mature on August 15, 2013. The unamortized carrying value of the Senior Notes at December 31, 2007 and December 31, 2006, was $249.3 million and $249.2 million, respectively.
In January 2006, through Montpelier Capital Trust III, we participated in a private placement of $103.1 million of floating rate capital securities (the “Trust Preferred Securities”). The Trust Preferred Securities mature on March 30, 2036, are redeemable at Montpelier Capital Trust III’s option at par beginning March 30, 2011, and require quarterly distributions of interest to the holders of the Trust Preferred Securities. The Trust Preferred Securities bear interest at 8.55% per annum through March 30, 2011, and thereafter at a floating rate of 3-month LIBOR plus 380 basis points, reset quarterly. Montpelier Capital Trust III simultaneously issued all of its issued and outstanding common securities to us for a purchase price of $3.1 million which is carried in other investments in our consolidated balance sheet and is valued on the equity method of accounting.
Montpelier Capital Trust III used the proceeds from the sale of the Trust Preferred Securities and the issuance of its common securities to purchase the Junior Notes, due March 30, 2036, in the principal amount of $100.0 million issued by the Company. The Junior Notes bear interest at the same rates as the Trust Preferred Securities discussed above.
In the normal course of business, Montpelier Re and MCL provide letters of credit for the benefit of their clients. In addition, the Company and Montpelier Re maintained a $50 million unsecured revolving credit facility at December 31, 2007. These arrangements are described in detail herein. See “Liquidity and Capital Resources” contained in Item 7 herein.
During each of the years ended December 31, 2007 and 2006, we recorded $0.1 million of U.K. income tax expense related to the operations of MMSL.
Our newly established U.K. domiciled subsidiaries are subject to U.K. income taxes. During the year ended December 31, 2007, these subsidiaries incurred a $3.0 million U.K. net operating loss. Due to the start-up nature of these operations, and the uncertainty at this time of whether such operations will generate sufficient taxable income in future periods, we established a $0.8 million U.K. deferred tax valuation allowance at December 31, 2007. This net operating loss may generally be carried forward to offset future U.K. income tax liabilities for an indefinite period of time.
MMSL is also subject to U.K. income taxes which, for each of the periods presented, were de minimis.
As a provider of short-tail insurance and reinsurance for losses resulting mainly from natural and man-made catastrophes, we could become liable for significant losses on short notice. As a result, we have structured our fixed maturity investment portfolio with high-quality securities with a short average duration to preserve capital and provide us with adequate liquidity for the settlement of our expected liabilities. As of December 31, 2007, our cash equivalents and fixed maturities had an average credit quality of AA+ and an average duration of 1.5 years. Nonetheless, if our calculations with respect to the timing of the payment of our liabilities are incorrect, or if we improperly structure our investments, we could be forced to liquidate investments prior to maturity, potentially at a significant loss.
During the years ended December 31, 2007, 2006 and 2005, we were able to meet all of our cash obligations. We anticipate that our current cash and cash equivalent balances, sales and maturities of investments and our projected future cash flows from operations should be sufficient to cover our cash obligations under most loss scenarios through the foreseeable future.
Our common shareholders’ equity at December 31, 2007 was $1,653.1 million, which is net of an accumulated retained deficit of $43.6 million. Our total capital increased by $10.6 million during 2007 as our comprehensive net income for the year exceeded our dividends and distributions to shareholders, our repurchases of common shares and warrants and Blue Ocean’s capital distributions to its minority shareholders.
In August 2005, Montpelier Re amended Tranche B of its syndicated facility. The amendment served to revise the facility from a $250.0 million three-year facility to a $225.0 million five-year facility with a revised expiry date of August 2010.
In June 2006, Montpelier Re amended its Letter of Credit Reimbursement and Pledge Agreement with Bank of America, N.A. and a syndicate of commercial banks. This amendment served to revise the facility from a one-year secured $1.0 billion facility to a secured $500.0 million facility, which expired in June 2007, and a five-year secured $500.0 million facility.
In June 2007, Montpelier Re entered into a new five-year secured $250.0 million letter of credit facility and the Company and Montpelier Re entered into a new one-year unsecured $50.0 million revolving loan and letter of credit facility.
In June 2007, the Company, Montpelier Re and MCL entered into a secured £74.0 million standby letter of credit facility through December 31, 2012, which will be used specifically as Funds at Lloyd’s to support business to be underwritten by Syndicate 5151.
The agreements governing these facilities contain covenants that limit our ability, among other things, to grant liens on our assets, sell assets, merge or consolidate, incur debt and enter into certain burdensome agreements. In addition, the syndicated secured facilities, the Lloyd’s standby facility and the syndicated unsecured revolving credit facility each require the Company to maintain debt leverage of no greater than 30% and Montpelier Re to maintain an A.M. Best financial strength rating of no less than B++. If the Company or Montpelier Re were to fail to comply with these covenants or fail to meet these financial ratios, the lenders could revoke the facilities and exercise remedies against the collateral. As of December 31, 2007 and 2006, the Company and Montpelier Re were in compliance with all covenants.
In the normal course of business, Blue Ocean Re establishes trust funds for the benefit of ceding companies. As of December 31, 2007 and 2006, Blue Ocean Re held restricted assets in trust consisting of cash and cash equivalents of $35.5 million and $35.5 million, respectively, and fixed maturity investments of $153.7 million and $335.6 million, respectively.
The number of common shares to be sold in return for these proceeds is a function of the share price as well as the terms of the contract. If the share price on a given settlement date falls within the contractual floor and cap prices, the number of common shares sold to the forward counterparty will equal the number that would need to be sold on a public exchange in order to generate the same proceeds, resulting in no economic benefit or cost to us. If the share price on a given settlement date is above the cap price, the number of common shares sold to the forward counterparty will be more than the number that would need to be sold on a public exchange in order to generate the same proceeds, resulting in an economic cost to us. If the share price on a given settlement date is below the floor price, the number of common shares sold to the forward counterparty will be less than the number that would need to be sold on a public exchange in order to generate the same proceeds, resulting in an economic benefit to us.
In March 2007, we notified the forward counterparty of our election to settle, in net common shares, the entire first Forward Sale Agreement which related to up to 7,774,800 common shares. In the course of that settlement, as the valuation price per common share for each component was greater than the $11.75 forward floor price and less than the $18.465 forward cap price, no payments or deliveries of common shares were required to be made by us or the forward counterparty.
We made a $3.9 million cash payment to the forward counterparty for the amendment of the Forward Sale Agreement, which we recorded as a reduction of additional paid-in capital.
In view of the contractual undertakings of the forward counterparty under the Share Issuance Agreement, which have the effect of substantially eliminating the economic dilution that otherwise would result from the issuance of the common shares, we believe that, under GAAP currently in effect, the common shares issued thereunder should not be considered outstanding for the purposes of computing and reporting earnings per share or fully converted book value per share.
We have entered into several derivative transactions as of December 31, 2007; the CAT Bond Protection; the ILW Contract; the CAT Bond Facility; the Foreign Exchange Contracts; and the Forward Sale Agreements and Share Issuance Agreement. Each of these transactions constitute an off-balance sheet arrangement.
Excluding the derivative transactions outlined above, we are not involved in any other off-balance sheet transaction, agreement or other contractual arrangement, to which an unconsolidated entity is a party, that is believed to have a material current or future effect on our financial condition, results of operations, liquidity, capital expenditures or capital resources.
During 2007, our cash flows provided from operations totaled $100.1 million which resulted primarily from premiums received, net of acquisition costs, exceeding net paid losses of $361.2 million.
In May 2007, we repurchased from White Mountains, through a private transaction, 939,039 common shares and 7,172,375.5 outstanding warrants to acquire common shares for a total purchase price of $65.0 million.
During 2007, we paid $29.9 million in cash dividends and distributions to our common shareholders and warrant holders.
In June 2007, Blue Ocean paid $72.0 million in cash dividends and paid $162.0 million in cash distributions to holders of its common shares, of which $41.6 million and $93.6 million, respectively, were paid to minority holders.
During 2007, we experienced a $122.3 million net reduction in securities lending payable.
In May 2006, we entered into a purchase agreement with WLR Recovery Fund, II, L.P. and WLR Recovery Fund III, L.P. for a private sale of 6,896,552 common shares and received net cash proceeds of $99.5 million.
During 2005, our cash flows provided from investing activities totaled $103.7 million resulting primarily from a $105.3 million net disposition of securities lending collateral.
In September 2005, we publicly sold 25,850,926 common shares and received net cash proceeds of $602.0 million.
In December 2005, Blue Ocean received $133.9 million in cash proceeds from issuances of preferred and common shares to minority holders.
Our primary focus is on short-tail property treaty reinsurance, written on both an excess of loss and proportional basis. We also underwrite certain direct insurance and casualty specialty risks.
Our IBNR reserves are determined using various actuarial methods as well as a combination of our own historical loss experience, historical insurance industry loss experience, estimates of pricing adequacy trends, and our professional judgment. In the case of our reinsurance business, we also take into account ceding company reports on IBNR reserves in making our estimates, however, these are rarely provided. The process we use to estimate our IBNR reserves involves projecting our estimated ultimate loss and LAE reserves and then subtracting paid claims and case reserves as notified by the ceding company, to arrive at our IBNR reserve.
Loss reserve estimates are not precise in that they deal with the inherent uncertainty of future contingent events. Estimating loss reserves requires us to make assumptions regarding reporting and development patterns, frequency and severity trends, claims settlement practices, potential changes in the legal environment and other factors such as inflation and demand surge. These estimates and judgments are based on numerous factors, and may be revised as additional experience or other data becomes available and is reviewed, as new or improved methodologies are developed, or as current laws change.
Estimating loss reserves for our small book of longer-tail casualty reinsurance business, which can be either on an excess of loss or proportional basis, involves further uncertainties. In addition to the uncertainties inherent in the reserving process described above, casualty business can be subject to longer reporting lags than property business, and claims often take many years to settle. During this period, additional factors and trends will be revealed and as these factors become apparent we will adjust our reserves. There is also the potential for the emergence of new types of losses within our casualty book. Any factors that extend the time until claims are settled add uncertainty to the reserving process. At December 31, 2007 and 2006, we recorded gross loss and LAE reserves related to our casualty business of $191.9 million and $156.6 million, respectively.
We believe that our reserves for loss and LAE are sufficient to cover losses that fall within the terms of our policies and agreements with our insured and reinsured customers on the basis of the methodologies used to estimate those reserves. However, there can be no assurance that our actual losses will not exceed our total reserves. Any adjustments for reserves are reflected in our loss and LAE during the period in which they become known.
The following tables provide the details of our gross case reserves and IBNR, by line of business, at December 31, 2007 and 2006:
We have determined that our best estimate for loss and LAE reserves net of reinsurance ceded (as discussed below) at December 31, 2007 and 2006 was $708.2 million and $891.9 million, respectively.
Though we are principally a provider of reinsurance, we write both insurance and reinsurance contracts. Insurance policies are written based on agreed upon terms and conditions which includes a stated premium for coverages provided. The stated premium within the underlying contract is then recorded as written premium at the effective date of the policy. In general, if the terms and conditions subsequently change during the policy period, either through policyholder request or underwriting audit, the policy would be endorsed to reflect the change in coverage. This endorsement usually generates a change to the policy premium which is then recorded as an adjustment to written premium for the policy term.
Generally, on pro-rata contracts and certain excess of loss contracts in which the deposit premium is not specified in the contract, an estimate of written premium is recorded in the period in which the underlying risks incept. The premium estimate is based on information provided by ceding companies. At the inception of the contract the ceding company estimates how much premium it expects to write during the year, and this estimate serves as the basis of our gross written premium. When the actual premium is reported by the ceding company, which may be on a quarterly or six month lag, it may be significantly higher or lower than the estimate.
Excess of loss contracts can include contract terms that require the mandatory reinstatement of coverage. Generally, reinstatement premiums assumed and ceded by us are triggered by losses. The reinstatement premium is generally calculated on the basis of (a) a fixed percentage (normally 100%) of the deposit premium and (b) the proportion of the original limit exhausted. In a year of large individual losses, reinstatement premiums will be higher than in a year in which there are no such large loss events. Reinstatement premiums are fully earned or expensed as applicable when a triggering loss event occurs and losses are recorded. We accrue reinstatement premiums based on case reserves reported by ceding companies and on management’s best estimate of IBNR reserves. Generally pro-rata contracts do not contain provisions for the reinstatement of coverage.
Management includes an assessment of the creditworthiness of cedants in the review process above, primarily based on market knowledge, the timeliness of cedants’ past payments and the status of current balances owing. In addition, management may also review the financial statements of ceding companies. Based on this assessment, management established an allowance of $0.8 million as of December 31, 2007. As of December 31, 2006, no provision for doubtful accounts was necessary.
In the normal course of our business, we purchase reinsurance from third parties in order to manage our exposures. All of our reinsurance purchases to date have represented prospective cover; meaning that the coverage has been purchased to protect us against the risk of future losses as opposed to covering losses that we have already incurred but have not yet paid. The majority of our reinsurance contracts are excess of loss contracts covering one or more lines of business. To a lesser extent, we have also purchased quota share reinsurance with respect to specific lines of our business. We also purchase ILW policies which provide us with coverage for certain losses we incur provided they are triggered by events exceeding a specified industry loss size.
In addition to the reinsurance described above, we also purchased fully-collateralized reinsurance-like coverage for losses sustained from qualifying hurricane and earthquake event loss events as of December 31, 2005. We acquired this protection from Champlain, a Cayman Islands special purpose vehicle, which financed this coverage through the issuance of $90.0 million in catastrophe bonds to investors under two separate bond tranches, each of which matures on January 7, 2009. The first $75.0 million tranche covers large earthquakes affecting Japan and/or the U.S. The remaining $15.0 million coverage provides second event coverage for a U.S. hurricane or earthquake. Both tranches respond to parametric triggers, whereby payment amounts are determined on the basis of modeled losses incurred by a notional portfolio rather than by actual losses incurred by us. For that reason, this transaction is accounted for as a derivative, rather than a reinsurance transaction.
The recognition of reinsurance recoverable requires two key judgments. The first involves our estimation of the amount of gross IBNR to be ceded to reinsurers. Ceded IBNR is generally developed as part of our loss reserving process and consequently, its estimation is subject to similar risks and uncertainties as the estimation of gross IBNR. The second relates to the amount of the reinsurance recoverable balance that we will ultimately be unable to recover from reinsurers due to insolvency, contractual dispute, or other reasons. As of December 31, 2007 and 2006, we recorded $16.8 and $7.8 million in reinsurance recoverable on paid losses, respectively, and $152.5 and $197.3 million in reinsurance recoverable on unpaid losses, respectively. Based on a review of the financial condition of the reinsurers and other factors, we have determined that a reserve for uncollectible reinsurance recoverable on paid and unpaid loss and LAE was not considered necessary as of December 31, 2007 and 2006.
The LTIP is our primary long-term incentive plan and was approved by our shareholders in May 2007. Incentive awards that may be granted under the LTIP consist of share appreciation rights, RSUs and performance shares. There are currently no grants of share appreciation rights outstanding under the LTIP.
Since performance shares are contingently payable, we initially accrue the projected performance share expense based on: (i) the number of performance shares granted; (ii) the closing price of our common shares at the date of grant; and (iii) an assumed 100% harvest ratio. Beginning at the mid-point of the performance cycle, and every subsequent quarter thereafter, we re-assess the projected results for each outstanding performance share cycle and adjust our performance share accrual as necessary based on: (i) the number of performance shares granted; (ii) the current price of our common shares as of the balance sheet date; and (iii) our current estimate of the ultimate harvest ratio. As a result, in the latter half of any performance share period, we may experience significant volatility in our performance share expense as the harvest ratio and the market price of our common shares fluctuate.
The unamortized grant date fair value of 219,750 RSUs outstanding as of December 31, 2007, which were granted with respect to the 2007-2012 period, was $2.8 million. The fair value of these RSUs was $3.6 million on the date of grant.
For the years ended December 31, 2007 and 2006, we recognized $8.2 million and $3.1 million of RSU expense.
As of December 31, 2007, 407,166 of the total outstanding RSUs were vested.
The financial statements and supplementary data have been filed as a part of this Annual Report on Form 10-K as indicated in the Index to Consolidated Financial Statements and Financial Statement Schedules appearing on page 79 of this report.