The Company leases office spaces in Hamilton, Bermuda, where the Company’s principal executive offices are located. The Company also leases office space in London, United Kingdom, where the Company’s subsidiary, Montpelier Marketing Services (UK) Limited is located. We also lease office space in Canada where our disaster recovery center is located. We believe our facilities are adequate for our current needs.
The following is a discussion and analysis of our results of operations for the years ended December 31, 2006, 2005 and 2004 and financial condition as at December 31, 2006. This discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes thereto included in this filing.
This discussion contains forward-looking statements that are not historical facts, including statements about our beliefs and expectations. These statements are based upon current plans, estimates and projections. Our actual results may differ materially from those projected in these forward-looking statements as a result of various factors. See “Cautionary Statement under “Safe Harbor” Provision of the Private Securities Litigation Reform Act of 1995.” and Item 1A “Risk Factors” in this filing.
To a lesser extent, prior to 2006 we also wrote property catastrophe retrocessional contracts, which provide catastrophe protection to other reinsurers, also called retrocedants. Retrocessional contracts typically carry a higher degree of volatility in extreme events than reinsurance contracts as they protect against concentrations of exposures written by retrocedants, which in turn may experience an aggregation of losses from a single catastrophic event. Since 2006, property catastrophe retrocessional business has been written through Blue Ocean Re only. For additional discussion on gross premiums written see Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
incurred but not reported. The uncertainties inherent in the reserving process, together with the potential for unforeseen developments, may result in loss and loss adjustment expenses significantly greater or less than the reserve provided. Changes to our prior year loss reserves will impact our current underwriting results by improving our results if the prior year reserves prove to be redundant or reducing our results if the prior year reserves prove to be insufficient. As new information becomes known to us, any resulting adjustments will be reflected in income in the period in which they become known. Our ability to estimate loss and loss adjustment expenses accurately at the time of pricing our contracts is a critical factor in determining our profitability.
In general, claims relating to short tail property risks are reported and settled more promptly than those relating to long tail risks, including the majority of casualty risks. However, the timeliness of reporting can be affected by such factors as the nature of the event causing the loss, the location of the loss, and whether the losses are from policies in force with primary insurers or with reinsurers.
We maintain loss and loss adjustment expense reserves to cover our estimated liability for both reported and unreported claims. Our loss and loss adjustment expense reserves include both a component for outstanding case reserves for claims which have been reported and a component for incurred but not reported losses (“IBNR”). Our case reserve estimates are initially set on the basis of loss reports received from third parties. IBNR consists of a provision for additional development in excess of the case reserves reported by ceding companies, as well as a provision for claims which have occurred but which have not yet been reported to us by ceding companies.
IBNR reserves are estimated by management using various actuarial methods as well as a combination of our own historical loss experience, historical insurance industry loss experience, our underwriters’ experience, estimates of pricing adequacy trends, and management’s 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 used to estimate IBNR reserves involves projecting the estimated ultimate loss and loss adjustment expense amount and then subtracting paid claims and case reserves as notified by the ceding company, to arrive at the IBNR reserve.
are subject to a corroborative review by independent actuaries using generally accepted actuarial principles. The Audit Committee of our Board of Directors also reviews our quarterly and annual reserve analysis.
Loss reserve estimates for insurance and reinsurance business 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. 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.
Most of our reinsurance contracts comprise business which has both a low frequency of claims occurrence and a high potential severity of loss, such as claims arising from natural catastrophes, terrorism, large individual property risks, and aviation risks. Given the high-severity, low-frequency nature of these events, the losses generated by them do not lend themselves to traditional actuarial reserving methods. Therefore, our reserving approach for these types of coverages is generally to estimate the ultimate cost associated with a single loss event rather than analyzing the historical development patterns of past losses as a means of estimating ultimate losses for an entire accident year. We generally estimate our reserves for these large events on a contract-by-contract basis by means of a review of policies with known or potential exposure to a particular loss event.
Since our loss reserve estimate is based principally on assumptions made individually for each loss event and contract there is significant variability which cannot be quantified at any level of aggregation which is meaningful in the context of our financial reporting. Following a major catastrophic event the possibility of future litigation or legislative change that may impact interpretation of policy terms further increases the degree of uncertainty in the reserving process.
Since we rely on estimates of paid losses, case reserves, and IBNR reserves provided by ceding companies in order to assist us in estimating our own loss and loss adjustment expense reserves, we maintain certain procedures designed to mitigate the risk that such information is incomplete or inaccurate. These procedures include, for example, the comparison of expected premiums to reported premiums to help us identify delinquent client periodic reports, ceding company audits to facilitate loss reporting and identify inaccurate or incomplete claim reporting, and underwriting reviews to ascertain that the losses ceded are covered as provided under the contract terms. We also use catastrophe model output and industry market share information to evaluate the reasonableness of reported losses, which are also compared to loss reports received from other cedants. In addition, each subsequent year of loss experience with a given cedant provides additional insight into the accuracy and timeliness of previously reported information. These procedures are incorporated in our internal controls process on an ongoing basis, and are regularly evaluated and amended as market conditions, risk factors, and unanticipated areas of exposure develop. Since our follow up actions form part of our normal due diligence process in claims handling matters, we do not capture data which records the extent to which ceding company claims are subsequently adjusted as a result of these activities alone, nor is it possible to determine the extent to which our actions influence the accuracy of subsequent cedant reporting. However, unreliable reporting is a factor which influences our underwriters’
willingness to offer terms to potential cedants. We believe that our diligence in these matters promotes better reporting by brokers and cedants over the long term. In our relatively short history, disputes with ceding companies have been rare and those which have not been resolved in negotiation have been resolved through arbitration in accordance with contractual provisions.
The development of our prior-year losses is monitored during the course of subsequent calendar years by comparing the actual reported losses against expected losses. The analysis of this loss development is an important factor in our ongoing refinement of the assumptions underlying our reserving process. See “- Results of Operations - Loss and Loss Adjustment Expenses” below which contains a discussion of the effects of the significant changes in loss reserve estimates for prior years’ loss occurrences. Our internal analysis of changes in prior year reserve estimates is focused on changes in the estimated ultimate loss and therefore management believes that it is not meaningful to split the movement of prior year reserve estimates between case reserves and IBNR. With regards to our short-tail property book of business, we do not feel that we can estimate the expected breakdown of losses in the first year with a high level of accuracy. The percentage split between paid losses, case reserves, and IBNR would vary greatly depending on the number, nature and timing of losses throughout the year. However, we would expect that by the end of the year subsequent to the year in which the loss occurred, the majority of these short-tail property losses would be reported to us, and by the end of the following year the majority would be paid.
Management has determined that the best estimate for net loss and loss adjustment expense reserves at December 31, 2006 and 2005 was $891.9 million and $1,476.2 million, respectively.
low frequency and high severity nature of our business, our reserving methodology involves arriving at a point estimate for the ultimate expected loss on a contract by contract basis; and our aggregate loss reserves are the sum of the individual reserves established. Development of prior period net incurred losses as a percentage of net loss reserves across all underwriting years was (1.6%), (3.8%) and (40.3%) for the years ended December 31, 2006, 2005 and 2004, respectively. Based on our experience from 2006 and 2005, and the current makeup of our loss reserves, we believe it is reasonably likely our net loss and loss adjustment expense reserves could increase or decrease by up to 10% from current amounts. In view of the small base of our reserves at December 31, 2003 arising from our short period of operations of only two years, and the low number of catastrophes which occurred during 2003 and 2002, we do not believe that the 2004 experience is a reliable indicator of the potential variability in our current reserves. At that time, a relatively small dollar movement in loss and loss adjustment expense reserves resulted in a large percentage change for the 2004 year. By contrast, at December 31, 2006, we have a larger loss and loss adjustment expense reserve base and a more mature book of business, which provides us with a higher level of confidence in the level of percentage variability of loss and loss adjustment expense reserves.
As at December 31, 2006, we estimate that a 10% change in our net loss and loss adjustment expense reserves would result in an increase or decrease of our net income and shareholders’ equity by $89.2 million. The net income and shareholders’ equity impact of the change in net reserves may be partially offset by adjustments to items such as reinstatement premium, profit commission expense or other corporate expenses.
The following table sets forth a breakdown between case reserves and IBNR by line of business at December 31, 2006 ($ in millions):
premium estimates are recorded in the period in which they become known. Adjustments to original premium estimates could be material and may significantly impact earnings in the period they are determined.
Reinsurance receivable and recoverable on paid and unpaid loss and loss adjustment expenses includes amounts due to us from reinsurance companies for paid and unpaid loss and loss adjustment expenses based on contracts in force. For excess of loss reinsurance, in some cases the attachment point and exhaustion of these contracts are based on the amount of our actual losses incurred from an event or events. In other cases, our recovery is dependent on an amount of industry loss as well as our own incurred losses.
The recognition of reinsurance recoverable requires two key judgments. The first judgment 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 (see “- Loss and Loss Adjustment Expense Reserves” above). The second judgment 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. At December 31, 2006 we recorded $7.7 million in reinsurance receivable on paid claims and $197.3 million in reinsurance recoverable on unpaid claims. 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 loss adjustment expenses is not considered necessary as at December 31, 2006.
Under the LTIP for the 2006-2008 performance period, the Committee granted 172,000 Performance Shares (or up to 344,000 common shares should the maximum harvest of 200% of awards for the 2006-2008 apply). In addition, the Committee authorized a maximum of 456,000 RSUs related to this performance period.
We accrue the projected value of the Performance Shares and expense the value in the income statement over the course of each three-year performance period. The accrual is initially based on the number of Performance Shares granted, the share price at the grant date, and an assumed 100% harvest ratio. At the end of the sixth quarter, and every subsequent quarter, we reassess the projected results for each three year performance period and adjust the accrued LTIP liability as necessary. We recalculate the liability under the LTIP as our financial results evolve and the share price changes, and reflect such adjustments in income in the period in which they are determined. This may result in an adjustment to the harvest ratio used in the liability calculation which may increase or decrease the amount of liability and expense recorded during the period.
The increase in net income of $1,056.0 million for the year ended December 31, 2006 year compared to 2005 was principally driven by the following factors:
A reduction in net premiums written and earned from the purchase of additional retrocessional protection, particularly during the fourth quarter of 2005.
An increase in realized gains, principally due to gains on the sale of the remainder of our Aspen holdings.
The creation of Blue Ocean Re, as discussed above, gave rise to the Collateralized Property Catastrophe Retrocessional Business reporting segment in 2006. Accordingly, no comparative segment information has been provided for the years ended December 31, 2005 or 2004.
The conversion on renewal of certain Florida proportional quota share contracts into lower premium excess of loss contracts. Further, gross premiums written for proportional contracts is spread evenly over the contract period compared to gross premiums written for excess of loss contracts, which is recorded as written when the contract is bound. These factors have caused a decrease in gross premiums written for the Property Catastrophe line during 2006;
Effective January 1, 2006, Blue Ocean Re commenced writing collateralized property catastrophe retrocession business. Blue Ocean is presently consolidated into our consolidated financial statements and the portion of Blue Ocean’s earnings and shareholders equity held by third parties is recorded in the consolidated financial statements as minority interest. Under FIN 46R, Blue Ocean Re Holdings Ltd. is consolidated into our financial statements and
the portion of Blue Ocean’s earnings and shareholders equity held by third parties is recorded in the consolidated financial statements as minority interest.
For the year ended December 31, 2005, excluding the effects of reinstatement premiums, gross premiums written were higher in 2005 by $36.4 million, or by 4.5% as compared to 2004. The main driver of this increase was a strong U.S. windstorm renewal season in the second quarter of 2005. The largest growth in premium was seen in our Property Specialty business with more pro-rata business representing much of the increase. The Property Catastrophe and Other Specialty categories also saw slight growth from the prior year, which was driven by loss-impacted renewals mainly for Florida programs at higher prices and a small number of new contracts with relatively high premiums.
In 2005 our mix of business changed modestly as compared to 2004. While our focus was still predominately short-tail excess of loss business, we wrote an increased amount of property pro-rata business. Additionally, there was an increase in our writings of casualty business during 2005. For the years ended December 31, 2005 and 2004, casualty business represented approximately 9.0% and 8.5% of our gross premiums written, respectively. Excluding reinstatement premium, casualty business written increased by 23.8% during 2005 as compared to 2004.
We expect to reduce our writings of Other Specialty business during 2007, mainly in the casualty area, as we believe that for business that is not exposed to peak zone catastrophes, rates are declining and terms and conditions are weakening. In contrast, we believe rates for property business are still relatively strong, and will continue to write property business at similar levels as in 2006. Due to the increasing competition and weaker demand for retrocessional business, Blue Ocean Re expects to write a reduced amount of business in 2007 as compared to 2006.
During 2006 and 2005 we purchased retrocessional excess of loss protection against individual risk losses on our direct and facultative book and against catastrophes on our overall property writings. During the first quarter of 2006 we also purchased a greater amount of large event protection coverage, including Industry Loss Warranty (“ILW”) reinsurance protection. We also purchased quota share protection against our 2006 property business, specific protection for our direct and facultative business, and retrocessional stop-loss protection against losses on our casualty writings and against our sabotage and terrorism writings.
During the years ended December 31, 2006 and 2005, we ceded property catastrophe reinsurance to Rockridge of $7.5 million and $6.6 million, respectively.
In addition to the reinsurance protection described above effective December 30, 2005, we purchased fully-collateralized coverage for losses sustained from qualifying hurricane and earthquake loss events. We acquired this protection from Champlain Limited, a Cayman Islands special purpose vehicle, which financed this coverage through the issuance of $90 million in catastrophe bonds to investors under two separate bond tranches, each of which matures on January 7, 2009. The first $75 million tranche covers large earthquakes affecting Japan and/or the U.S. The remaining $15 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 this reason, this cover is accounted for as a weather derivative, rather than a reinsurance transaction. Paragraph 10 (e) of FAS 133 exempts weather derivatives from the fair value requirements of that Statement. For accounting guidance, we followed the provisions of EITF Abstract 99-2, “Accounting for Weather Derivatives,” which addresses non-exchange traded contracts indexed to climatic or geological variables. This abstract specifies that weather derivatives should be accounted for at fair value if these contracts are “entered into under trading or speculative activities.” As we entered into the transactions to mitigate our exposure to assumed reinsurance losses rather than for trading activity, the weather derivatives have been measured by applying the “intrinsic value method” as required by the Abstract. Our application of this method results in a $Nil value adjustment in the absence of an industry loss event triggering recovery. Should an industry loss event triggering a recovery occur, our application of the intrinsic value method results in the present value of the expected ultimate recovery being recorded. Contract payments in relation to the
catastrophe bond are calculated at 12.75% plus 8 basis points per annum on the coverage provided by the first tranche and 13.5% plus 8 basis points on the coverage provided by the second tranche. These costs are expensed as they are incurred and are included in other operating expenses.
Net premiums earned increased for the year ended December 31, 2005 as compared to 2004, mainly due to net earned reinstatement premium related to the 2005 hurricanes of $61.9 million compared to net earned reinstatement premium of $0.9 million for the year ended December 31, 2004 related to the 2004 catastrophes.
The nature of our business means that loss ratios can vary widely from period to period depending on the occurrence and severity of natural and man-made catastrophes. During the year ended December 31, 2006, we incurred below-average catastrophe losses, resulting in the low loss ratio for the year. The 2005 loss ratio was impacted by estimated net losses of $1,202.8 million from Hurricanes Katrina, Rita, Wilma and Dennis in the U.S and the European floods. 2004 was less severe than in 2005 in terms of catastrophe activity, but the loss ratio was impacted by the four Florida hurricanes and the two Japanese typhoons.
We commuted all three of the 2002 QQS contracts during the second quarter of 2005 and as expected we commuted the three 2003 contracts in 2006. The final commutation terms resulted in a benefit of $4.6 million to gross losses and $3.5 million on a net basis.
Favorable development during the year ended December 31, 2004 of losses incurred during the prior accident years amounted to $97.6 million, due mainly to the following:
In the Property Specialty and Other Specialty categories, the frequency and severity of reported losses were lower than the assumed reporting pattern of losses established for these classes at December 31, 2003. In 2004 we placed more weight in the loss reserving process on our actual loss experience compared with the initial loss ratio expectation, and this change generated a combined reduction of $69.4 million in the ultimate loss projection during 2004.
Property Catastrophe estimated ultimate losses associated with the European Floods of 2002, as well as Hurricane Isabel and the California wildfires, both of which occurred in 2003, decreased during 2004.
Management has determined that the best estimate for net loss and loss adjustment expense reserves at December 31, 2006, 2005 and 2004 was $891.9 million, $1,476.2 million and $454.8 million, respectively.
Net foreign exchange gains (losses) resulted from the effect of the fluctuation in foreign currency exchange rates on the translation of foreign currency assets and liabilities combined with realized losses resulting from the receipt of premium installments and payment of claims in foreign currencies. The foreign exchange gains (losses) during the years ended December 31, 2006 and 2005 are primarily due to the weakening (strengthening) of the U.S. dollar resulting in gains (losses) on translation arising out of receipts of non-U.S. dollar premium installments and payment of non-U.S. dollar claims. Certain of our investments, premiums receivable and liabilities for losses incurred in currencies other than the U.S. dollar are exposed to the risk of changes in value resulting from fluctuations in foreign exchange rates and may affect our financial results in the future. Also included are contract gains (losses) on foreign currency exchange agreements.
Acquisition costs on business that we write includes brokerage, commission and excise tax, which are generally driven by contract terms and are normally a set percentage of gross premiums written. Ceding commission related to our reinsurance premiums ceded are presented as a reduction of the ceding commissions payable by us to brokers and intermediaries and are recognized as earned over the same period as the corresponding premiums are expensed. To date we have earned ceding commission in respect of our purchased quota share reinsurance only. General and administrative expenses are comprised of fixed expenses, which include salaries and
benefits, share options, office and risk management expenses, and variable expenses, which include costs related to our performance unit plan, long-term incentive plan and bonuses.
The decrease in acquisition costs during 2006 as compared to 2005 is consistent with the decrease in gross premiums written and earned, which is discussed above. In addition, as discussed above, the conversion of proportional treaty premium into excess of loss premium has resulted in a lower level of acquisition costs. Acquisition costs increased in 2005 as compared to 2004 is consistent with the increase in gross premiums written from 2004 to 2005 as discussed above. The expense ratio has increased for 2006 as compared to 2005 mainly as a result of the increase in general and administrative expenses combined with the decrease in gross premiums written which decreases the denominator of the ratio.
Relatively few of our assumed reinsurance contracts contain profit commission clauses. The terms of these commissions are specific to the individual contracts and vary as a percentage of the contract results. Profit commission is expensed based on the estimated results of the subject contract. Profit commission expensed was $3.8 million, $6.8 million and $7.6 million, respectively, for the years ended December 31, 2006, 2005 and 2004. Profit commission has decreased for 2006 as compared to 2005 because, as discussed above, we have written less proportional business in 2006 as compared to 2005, which generally contain profit commission clauses. In addition, we have accrued profit commission due to us on some of our retrocession agreements which reduces the net amount of profit commission expensed in the income statement. The decrease in net earned premiums discussed above has also contributed to the decline in profit commission in 2006. The decline in profit commission in 2005 as compared to 2004 is mainly due to the increase in loss and loss adjustment expenses related to the 2005 and 2004 hurricanes. Profit commission will fluctuate as our estimate of loss and loss adjustment expense reserves fluctuates and as the level of our net premiums earned fluctuates.
The increase in current and deferred incentive compensation is due to the establishment of an accrual for a significantly higher amount of current incentive compensation as compared to 2005 due to the improvement in our results in 2006. In addition, expenses have increased in 2006 as compared to 2005 related to the issuance of Restricted Stock Units (“RSUs”) under the LTIP. Under the LTIP, certain eligible plan participants were granted RSUs related to the 2006-2008 performance period. The RSU share-based compensation cost was valued at $7.9 million at January 1, 2006 using the weighted average grant date fair value of $18.27. We expensed $4.8 million during 2006 with no comparable expense during 2005. The unrecognized share-based compensation cost of $3.1 million at December 31, 2006 will be recognized over the remaining vesting period. Vesting is dependent on continuous service by the employee through the vesting date for the respective tranche. All restrictions placed upon the common shares lapse at the end of the performance period, December 31, 2008. There was no such expense in 2005.
third quarter of 2005, accrued incentive compensation liabilities were reversed as a result of the effect that the 2005 catastrophes had on our results. We have accrued the estimated LTIP Performance Shares expense based on an estimated harvest ratio of 100%. Our 2006 results reflect an estimated 0% harvest ratio for the 2004-2006 and 2005-2007 performance periods.
Includes $16.6 million in interest income related to the collateralized property catastrophe retrocessional business for the year ended December 31, 2006.
Our total investment return increased in 2006 compared to 2005. This increase resulted primarily from two factors. First, in 2006 we held a greater proportion of equity and convertible bond investments compared with 2005, which generated a higher return. Second, in 2006, foreign denominated securities have experienced a favorable investment return due to the weakening of the U.S. dollar. The size of the investment portfolio and related investment income has and will continue to be affected by the payment of claims related to the 2005 hurricanes. We have paid out a substantial amount of claims to date and will continue to do so during 2007. This drawdown has to an extent been offset by additional capital raised by issuing junior subordinated debt securities during the first quarter of 2006, as well as the raising of $100.0 million of common equity during the second quarter of 2006 and net income. In addition, Blue Ocean raised $75.0 million in long-term debt during the fourth quarter of 2006, increasing the level of the investment portfolio.
We believe that the gross unrealized losses relating to our fixed maturity investments at December 31, 2006, 2005 and 2004 of $13.9 million, $33.3 million and $11.1 million, respectively, resulted primarily from increases in market interest rates from the dates that certain investments within that portfolio were acquired as opposed to fundamental changes in the credit quality of the issuers of such securities. Therefore, these decreases in value are viewed as being temporary because we have the intent and ability to retain such investments for a period of time sufficient to allow for any anticipated recovery in market value. We also believe that the gross unrealized losses relating to our equity portfolio of $0.6 million, $2.0 million and $0.1 million at December 31, 2006, 2005 and 2004, respectively, are temporary based on an analysis of various factors including the time period during which the individual investment has been in an unrealized loss position and the significance of the decline.
Fees for the letter of credit facilities relate to the Letters of Credit that we have in place as detailed in the Capital Resources section below.
Rockridge ceding commission and incentive fee income are recorded pursuant to our agreement with West End Capital Management (Bermuda) Ltd. related to our investment in Rockridge. As Rockridge has ceased operations we will not be receiving any ceding or incentive fees in 2007. Interest on funds advanced represents interest earned on funds advanced to ceding companies to cover losses in accordance with contract terms. Catastrophe Bond Total Rate of Return Swap Facility fees represent net contract payments on the swap facility and the unrealized gain (loss) on the outstanding facilities at December 31, 2006.
Minority interest represents the minority shareholders interest of Blue Ocean’s income (loss) for the years ended December 31, 2006 and 2005.
We are a holding company and conduct no operations of our own. We rely primarily on cash dividends and management fees from Montpelier Re to pay our operating expenses, interest on our debt and dividends to our shareholders and warrant holders. There are restrictions on the payment of dividends from Montpelier Re to the Company, which are described in more detail in Item 1, “Business” of this filing. We currently have in place a regular dividend of $0.075 per common voting share and warrant per quarter. However, the Companies Act limits our ability to pay dividends to shareholders. Any determination to pay future dividends will be at the discretion of our Board of Directors and will be dependent upon our results of operations and cash flows, our financial position and capital requirements, general business conditions, legal, tax, regulatory and any contractual restrictions on the payment of dividends, and any other factors our Board of Directors deems relevant.
Our shareholders’ equity at December 31, 2006 was $1,492.9 million, which is net of an accumulated deficit of $376.0 million. Our capital base has increased by $435.2 million since December 31, 2005, mainly as a result of retained earnings for period to date plus an increase in capital of $100.0 million from the issuance of common shares. In addition, we issued $103.0 million of subordinated debt in January 2006 and Blue Ocean issued
On August 4, 2003, we issued $250.0 million aggregate principal amount of senior unsecured debt (the “Senior Notes”) at an issue price of 99.517% of their principal amount. The net proceeds were used in part to repay a term loan facility with the remainder used for general corporate purposes. 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. Unless previously redeemed, the Senior Notes will mature on August 15, 2013. We may redeem the Senior Notes at any time and from time to time, in whole or in part, at a “make-whole” redemption price. We have no current intention of calling the Senior Notes. The Senior Notes do not contain any covenants regarding financial ratios or specified levels of net worth or liquidity.
Montpelier Capital Trust III used the proceeds from the sale of the Trust Preferred Securities and the issuance of its common securities to purchase junior subordinated debt securities, due March 30, 2036, in the principal amount of $103.1 million (the “Debentures”). Our net proceeds of $99.5 million from the sale of the Debentures to Montpelier Capital Trust III, after the deduction of approximately $0.5 million of commissions paid to the placement agents in the transaction and approximately $3.1 million representing our investment in Montpelier Capital Trust III, have been used to fund ongoing reinsurance operations and for general working capital purposes. We incurred interest expense related to the Debentures for the year ended December 31, 2006 of $8.6 million, none of which was payable at December 31, 2006.
The table above includes the estimated timing of the payment of estimated future cash flows for gross loss and loss adjustment expenses based on our best estimate of obligations to pay policyholders at December 31, 2006. The amount and timing of the cash flows are uncertain and do not have contractual payout terms. Due to the short-tail nature of our business, we expect that gross and net loss and loss adjustment expenses generally will be settled during the time period in which they are incurred. For a discussion of these uncertainties refer to the Loss and Loss Adjustment Expense Reserves section above. These estimated obligations will be funded through existing cash and investments.
Letter of credit fees relate to letters of credit issued to clients as described in Letter of Credit Facilities below.
On July 31, 2006 we filed a universal shelf registration statement on Form S-3 with the U.S. Securities and Exchange Commission for the potential future sale of an indeterminate amount of debt, trust preferred and/or equity securities. We cannot assure you that additional financing under the universal shelf registration statement or elsewhere will be available at terms acceptable to us.
(1) if the volume-weighted average price, calculated excluding some transactions on the relevant date that would not qualify for a regulatory safe harbor relating to issuer repurchase transactions, of the Company’s common shares on the valuation date for such component is less than or equal to $11.75, in the case of the first forward sale agreement, or $11.25, in the case of the second forward sale agreement (the “forward floor price” for that forward sale agreement), the number of shares underlying such component;
(2) if such volume-weighted average price is greater than the relevant forward floor price, but less than $18.465, in the case of the first forward sale agreement, or $18.375 in the case of the second forward sale agreement (the “forward cap price” for that forward sale agreement), the relevant forward floor price, divided by such volume-weighted average price, multiplied by the number of shares underlying such component; and
(3) if such volume-weighted average price is greater than or equal to the relevant forward cap price, (a) in the case of the first forward sale agreement, (x) the relevant forward floor price, plus such volume-weighted average price, minus the relevant forward cap price, divided by (y) such volume-weighted average price, multiplied by (z) the number of shares underlying such component; and (b) in the case of the second forward sale agreement, 61.2245% of the number of shares underlying such component,
if such volume-weighted average price is greater than or equal to the forward cap price, $7,178,084 (which is the forward cap price multiplied by the maximum number of shares underlying such component).
We may terminate the share issuance agreement at any time. The forward counterparty may also tender to us for repurchase for cancellation for nominal consideration by us, subject to applicable law, some or all of the shares issued to it under the share issuance agreement at any time. Upon the occurrence of a bankruptcy or similar event with respect to the forward counterparty, the share issuance agreement will automatically terminate, and the forward counterparty will be required to tender to us for repurchase for cancellation all of the shares issued. In addition, if, on any day, we are required to issue common shares to the forward counterparty pursuant to any of the forward sale agreements, then on the date of such issuance, we shall, subject to applicable law, repurchase for cancellation for nominal consideration from the forward counterparty, and the forward counterparty shall tender to us for repurchase for cancellation, a number of common shares equal to the number of common shares so issued pursuant to such forward sale agreement.
Upon any termination of the share issuance agreement, the common shares issued to the forward counterparty thereunder (or other common shares) must, subject to compliance with Bermuda law, be repurchased for cancellation for nominal consideration by us. Under the share issuance agreement, the forward counterparty has agreed to post and maintain with Credit Suisse Securities (USA) LLC, acting as collateral agent on our behalf, collateral as security for the certain obligations of the forward counterparty to tender the common shares to us for repurchase for cancellation for nominal consideration, subject to applicable law, when required under the terms of the share issuance agreement.
As at December 31, 2006, under the terms of the share issuance agreement, we had issued 15,694,800 common shares for their par value of 1/6 cent per share. In view of the contractual undertakings of the forward counterparty in the share issuance agreement, which have the effect of substantially eliminating the economic dilution that otherwise would result from the issuance of the shares under the share issuance agreement, we believe that under U.S. GAAP currently in effect, the share issuance agreement has no impact on basic earnings per share. However, as the Company’s share price exceeded the forward cap price at December 31, 2006, the forward sale agreements have an impact on diluted earnings per share. In order to incorporate the forward sale agreements into the calculation of fully converted book value per share, we assumed settlement at the market price at December 31, 2006. However, as the incorporation of the forward sale agreements in this manner would be accretive to fully converted book value per
On August 4, 2005, Montpelier Re amended and restated Tranche B of the syndicated collateralized 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.
All of the Company’s letter of credit facilities contain covenants that limit the Company’s and Montpelier Re’s ability, among other things, to grant liens on their assets, sell assets, merge or consolidate. The Letter of Credit Facility Agreement for the syndicated collateralized facility also requires the Company to maintain a 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 fails to comply with these covenants or meet these financial ratios, the lenders could declare a default and begin exercising remedies against the collateral, Montpelier Re would not be able to request the issuance of additional letters of credit. As at December 31, 2006 and 2005, the Company and Montpelier Re were in compliance with all covenants. Letters of credit issued under these facilities are secured by cash and investments.
In addition, effective November 29, 2006, Blue Ocean Re entered into a Letter of Credit Reimbursement agreement with Merrill Lynch International Bank Ltd. in an amount of $50 million. This facility is guaranteed by Blue Ocean Re Holdings Ltd. and is not secured by cash and investments. If Blue Ocean Re fails to maintain capital in a minimum specified amount relative to its insurance risks, and in certain other circumstances, the lender could declare a default and begin exercising remedies against the collateral and Blue Ocean Re would not be able to request the issuance of additional letters of credit under this facility. As at December 31, 2006 Blue Ocean Re was in compliance with all covenants under both facilities.
Montpelier Re is registered under The Insurance Act 1978 (Bermuda), Amendments Thereto and Related Regulations (the “Act”). Under the Act, Montpelier Re is required annually to prepare and file Statutory Financial Statements and a Statutory Financial Return. The Act also requires Montpelier Re to meet minimum solvency requirements. For the years ended December 31, 2006 and 2005, Montpelier Re satisfied these requirements.
As Blue Ocean Re writes business on a fully collateralized basis, trust funds are set up for the benefit of ceding companies and generally take the place of letter of credit requirements. As at December 31, 2006, restricted assets associated with the trust funds consisted of cash of $35.5 million and fixed maturities of $335.6 million.
These ratings are not evaluations directed to investors in our securities or a recommendation to buy, sell or hold our securities. Our ratings may be revised or revoked at the sole discretion of the rating agencies.
With the exception of the off-balance sheet arrangements which include the derivative catastrophe bond transaction with Champlain Limited, the Catastrophe Bond Total Rate of Return Swap Facility, the forward sale agreements, the foreign currency exchange contracts and the related share issuance agreement, all of which are
Because a significant portion of our contracts provide short-tail reinsurance coverage for losses resulting mainly from natural and man-made catastrophes, we could become liable for a significant amount of losses on short notice. Accordingly, we have structured our investment portfolio to preserve capital and provide us with significant liquidity, which means that our investment portfolio contains a significant amount of relatively short term fixed maturity investments, such as U.S. government securities, U.S. government-sponsored enterprises securities, corporate debt securities and mortgage-backed and asset-backed securities. Approximately $35.5 million of cash and cash equivalents and $340.4 million of fixed maturity investments relate to Blue Ocean, which Blue Ocean holds on a trading basis. In addition, we invest a portion of the portfolio in equities to enhance our expected returns.
The market value of our portfolio of fixed maturity investments, available for sale, is comprised of the following:
The market value of our portfolio of fixed maturity investments, trading, is comprised of the following:
On June 1, 2005, Montpelier Re invested $10.0 million in Rockridge as part of a total $90.9 million in common equity raised by Rockridge in conjunction with its formation. In return for Montpelier Re’s investment, Montpelier Re received 100,000 common shares, representing approximately an 11.0% ownership in Rockridge’s outstanding common shares. Rockridge, a Cayman formed reinsurance company, was established to invest its assets in a fixed income arbitrage strategy and to assume high-layer, short-tail risks principally from Montpelier Re. During December 2006, Rockridge ceased operations and returned 97% of capital to investors and the unearned premium to Montpelier. It is anticipated that the remaining capital will be returned to investors during the first six months of 2007 when Rockridge is formally dissolved.
Our sources of funds primarily consist of the receipt of premiums written, investment income and proceeds from sales and redemptions of investments. In addition, we will also receive cash as a result of capital raising efforts from time to time.