We currently occupy office space in Hamilton, Bermuda. In addition, we own office space in Hyderabad, India and lease office space in Halifax, Canada; Mumbai, India; London, England; Martigny, Switzerland; Zurich, Switzerland; San Juan, Puerto Rico; Dubai, UAE; Johannesburg, South Africa; Limassol, Republic of Cyprus; George Town, Grand Cayman, Cayman Islands; Luxembourg, Luxembourg; and Douglas, Isle of Man. We are constructing new office buildings in Martigny and Luxembourg. While we believe that for the foreseeable future our current office spaces combined with the projects in Switzerland and Luxembourg will be sufficient for us to conduct our operations, we anticipate future growth and we will likely need to expand into additional facilities to accommodate this growth.
Statement of operations data and balance sheet data of the Company for the years ended December 31, 2008, 2007 and 2006 are derived from our audited consolidated financial statements included in Item 8, “Financial Statements and Supplementary Data” in this Form 10-K, which have been prepared in accordance with U.S. GAAP.
On July 1, 2007 we began to consolidate the operations of Island Heritage in accordance with Accounting Research Bulletin No. 51 - Consolidated Financial Statements.
The following is a discussion and analysis of our financial condition as at December 31, 2008 and 2007 and our results of operations for the years ended December 31, 2008, 2007 and 2006. All amounts in the following tables are expressed in thousands of U.S. dollars, except share amounts, per share amounts and percentages. This discussion should be read in conjunction with our audited consolidated financial statements and related notes included in Item 8 of this Form 10-K. Some of the information contained in this discussion and analysis is included elsewhere in this document, including information with respect to our plans and strategy for our business, and includes forward-looking statements that involve risks and uncertainties. Please see the “Cautionary Statement Regarding Forward-Looking Statements” for more information. You should review Item 1A, “Risk Factors” for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements.
We are a global reinsurance and insurance company. The Company is currently organized into two business segments: Reinsurance and Insurance. Through our Reinsurance segment, we write primarily property, property catastrophe and short-tail specialty and casualty reinsurance. Through our Insurance segment, we primarily write property insurance for homes, condominiums and office buildings in the Caribbean region. In addition, beginning in 2009 as a result of our recent acquisition of Marlborough, the managing agency for Lloyd's Syndicate 1861, the majority of the business written through Lloyd’s Syndicate 1861 will also be included in the Insurance segment.
The Company holds a controlling interest in Island Heritage, whose primary business is insurance. As a result of the strategic significance of the insurance business to the Company, and given the relative size of revenues generated by the insurance business, the Company modified its internal reporting process and the manner in which the business is managed and as a result the Company revised its segment structure, effective January 1, 2008, to include a new Insurance segment. As a result of this process the Company is now reporting its results to the chief operating decision maker based on two reporting segments: Reinsurance and Insurance. The 2007 comparative information below reflects our current segment structure. As the Company did not undertake any insurance business prior to its acquisition of Island Heritage in the third quarter of 2007, there is no 2006 comparative information for the Insurance segment. The Company regularly reviews its financial results and assesses performance on the basis of these two operating segments.
Short-tail Specialty and Casualty Reinsurance. We also provide short-tail specialty and casualty reinsurance for risks such as aviation, energy, accident and health, satellite, marine and workers’ compensation catastrophe. Most short-tail specialty and casualty reinsurance is written with loss limitation provisions. During 2009, we expect to continue increasing our specialty writings based on our assessment of the market environment.
On September 30, 2008, the Company completed the restructuring of its global reinsurance operations by merging its two wholly-owned subsidiaries, Flagstone Reinsurance Limited and Flagstone Suisse into one succeeding entity, Flagstone Suisse with its existing Bermuda branch. The merger consolidated the Company’s underwriting capital into one main operating entity, maximizing capital efficiency and creditworthiness, while still offering a choice of either Bermuda or Swiss underwriting access. Because both companies were wholly-owned subsidiaries of the Company, the merger did not result in any changes to prior periods. The change in corporate structure does not result in any change of management or corporate control, or any changes to the Board of Directors.
The Company has established a new Insurance segment during the year ended December 31, 2008, which included insurance business generated through Island Heritage, a property insurer based in the Cayman Islands which is primarily in the business of insuring homes, condominiums and office buildings in the Caribbean region. The Company gained controlling interest in Island Heritage on July 3, 2007, and as a result, the comparatives for the year ended December 31, 2007 include the results of Island Heritage for the six months ended December 31, 2007 only. The Company did not undertake any insurance business prior to its acquisition of Island Heritage in the third quarter of 2007, and therefore there are no comparatives for the year ended December 31, 2006.
The Company’s actuarial group performs a quarterly loss reserve analysis. This analysis incorporates specific exposures, loss payment and reporting patterns and other relevant factors. This process involves the segregation of risks between catastrophic and non-catastrophic risks to ensure appropriate treatment.
historical levels of claim inflation can be projected into the future;
For our non-catastrophe business, the key factors used to arrive at our best estimate of loss and loss adjustment expense reserves are the expected loss ratios, rate of loss cost inflation, selection of benchmarks and reported and paid loss emergence patterns. Our reporting patterns and expected loss ratios were based on either benchmarks or historical reporting patterns. The benchmarks selected are those that we believe are most similar to our underwriting business. There were no material changes in any of these key factors during the year ended December 31, 2008.
During the year ended December 31, 2008, the significant losses on our catastrophe business were as follows: Hurricane Ike ($158.4 million), Hurricane Gustav ($14.5 million), Chinese winter storms ($18.2 million) and the U.S. Memorial Day Weekend storms ($11.1 million). During the year ended December 31, 2007, the significant losses on our catastrophe business were as follows: United Kingdom floods in June and July ($38.0 million); European Windstorm Kyrill ($32.4 million); New South Wales (Australia) floods ($18.5 million); three satellite losses during 2007 ($13.8 million); and the Sydney Hailstorm ($11.4 million). Given the benign catastrophe activity during the year ended December 31, 2006, the losses incurred on catastrophe business were approximately $12.4 million. Because we expect a small volume of large claims, we believe the variance of our catastrophe related loss ratio could be relatively wide. Claims from catastrophic events could reduce our earnings and cause substantial volatility in our results of operations for any fiscal quarter or year which could adversely affect our financial condition and liquidity position.
Commencing January 1, 2007, following the issuance by the FASB of SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115” (“SFAS 159”), the Company elected to early adopt the fair value option for all fixed maturity investments, equity investments (excluding investments accounted for under the equity method of accounting), real estate investment trusts (“REITs”), investment funds, catastrophe bonds, and fixed income funds. This election required the Company to adopt SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), regarding fair value measurements. The valuation technique used to value the financial instruments is the market approach which uses prices and other relevant information generated by market transactions involving identical or comparable assets.
The valuation technique used to fair value the financial instruments is the market approach which uses prices and other relevant information generated by market transactions involving identical or comparable assets. The following is a summary of valuation methodologies we used to measure our financial instruments.
The Company’s U.S. government securities are stated at fair value as determined by the quoted market price of these securities as provided by exchange market prices, which represented 59.7% of our total fixed maturities portfolio. These securities are classified within Level 1.
At December 31, 2008, pricing for approximately 38.3% of our total fixed maturities, excluding U.S. government securities, was based on prices provided by nationally recognized independent pricing services. Generally, pricing services provide pricing for less-complex, liquid securities based on market quotations in active markets. For fixed maturities that do not trade on a listed exchange, these pricing services may use a matrix pricing consisting of observable market inputs to estimate the fair value of a security. These observable market inputs include: reported trades, benchmark yields, broker/dealer quotes, issuer spreads, two-side markets, benchmark securities, bids, offers, reference data, and industry and economic factors. Additionally, pricing services may use a valuation model such as an option adjusted spread model commonly used for estimating fair values of mortgage-backed and asset-backed securities. At December 31, 2008, we have not adjusted any pricing provided by independent pricing services.
The Company’s listed equity securities are stated at fair value as determined by the quoted market price of these securities. These investments are classified in Level 1.
The Company’s fixed income funds are stated at fair value as determined by the quoted market price of these securities. These securities are classified within Level 1. The Company held no fixed income funds as at December 31, 2008
At December 31, 2008, the fair value of the securities classified as Level 3 under SFAS 157 was $49.3 million, or approximately 5.7% of total investment assets measured at fair value. The Company does not carry equity method investments at fair value. Refer to Note 6 “Investments” in Item 8, “Financial Statements and Supplementary Data” of this Annual Report on Form 10-K for a breakdown of the fair value measurements.
The Performance Share Unit Plan (“PSU Plan”) is the Company’s shareholder-approved primary executive long-term incentive scheme. Pursuant to the terms of the PSU Plan, at the discretion of the Compensation Committee of the Board of the Directors, PSUs may be granted to executive officers and certain other key employees. The current series of PSUs vests over a period of approximately two or three years and vesting is contingent upon the Company meeting certain diluted return-on-equity (“DROE”) goals and service period. Future series of PSUs may be granted with different terms and measures of performance.
Upon vesting, the PSU holders shall be entitled to receive a number of common shares of the Company (or the cash equivalent, at the election of the Company) equal to the product of the number of PSUs granted multiplied by a factor. The factor will range between 50% and 150%, depending on the DROE achieved during the vesting period.
The grant date fair value of the common shares underlying the PSUs were valued on the closing price of our common shares on the grant date.
We estimate the fair value of PSUs granted under the PSU Plan on the date of grant using the grant date fair value and the most probable DROE outcome and record the compensation expense in our consolidated statement of operations over the course of each two-year or three-year performance period. At the end of each quarter, we reassess the projected results for each two-year or three-year performance period as our financial results evolve. If we determine that a change in estimate is required, we recalculate the compensation expense under the PSU Plan and reflect any adjustments in the consolidated statements of operations in the period in which they are determined.
The Restricted Share Unit Plan (“RSU Plan”) is the Company’s incentive scheme for officers, employees and non-management directors. The Compensation Committee has the authority to grant RSUs. Upon vesting, the value of an RSU grant may be paid in common shares, in cash, or partly in cash and partly in common shares at the discretion of the Compensation Committee. RSUs granted to employees generally vest two years after the date of grant and RSUs granted to directors vest on the date of grant. The Company estimates the fair value of RSUs on the date of grant and records the compensation expense in its consolidated statements of operations over the vesting period.
The total number of RSUs outstanding under the RSU Plan as at December 31, 2008, 2007 and 2006 were 282,876, 326,610 and 117,727, respectively. As at December 31, 2008, 2007 and 2006, there was a total of $1.0 million, $1.3 million and $0.5 million, respectively, of unrecognized compensation cost related to non-vested RSUs, the cost of which is expected to be recognized over a period of approximately 1.0 year, 0.9 years and 1.5 years, respectively.
On January 22, 2009, Flagstone Suisse entered into a secured $450.0 million standby letter of credit facility with Citibank Europe Plc (the “Facility”). The Facility comprises a $300.0 million facility for letters of credit with a maximum tenor of 15 months and a $150.0 million facility for letters of credit issued in respect of Funds at Lloyds with a maximum tenor of 60 months, in each case subject to automatic extension for successive periods, but in no event longer than one year. The Facility will be used to support the reinsurance obligations of the Company and its subsidiaries. This Facility replaces the existing $400.0 million uncommitted letter of credit facility agreement with Citibank N.A. discussed in Note 12 to the consolidated financial statements “Debt and Financing Arrangement”.
The Company holds a controlling interest in Island Heritage, whose primary business is insurance. As a result of the strategic significance of the insurance business to the Company, and given the relative size of revenues generated by the insurance business, we modified our internal reporting process and the manner in which the business is managed and as a result we revised our segment structure, effective January 1, 2008. As a result of this process the company is now reporting its results to the chief operating decision maker based on two reporting segments: Reinsurance and Insurance.
The net underwriting income for the Reinsurance segment for the years ended December 31, 2007 and 2006 amounted to $129.3 million and $101.7 million, respectively. The increase in net underwriting results is primarily related to higher levels of earned premiums due to increased premium writings partially offset by a higher loss ratio due to the catastrophe losses incurred in 2007.
For the years ended December 31, 2007 and 2006, gross property catastrophe premiums written were $378.7 million and $219.1 million, respectively. The $159.6 million (72.8%) increase in property catastrophe premiums written during 2007 was primarily due to the increased participation on programs from our existing clients, the addition of new clients due to our increased capital base, and growth in our franchise.
Gross property premiums written for the year ended December 31, 2008 were $94.7 million ($89.6 million excluding acquisitions in 2008), compared to $94.5 million for the year ended December 31, 2007, a decrease of $4.9 million, excluding the impact of acquisitions. There was a decrease in proportional property premiums of $25.0 million which was mostly offset by an increase in non-proportional premiums of $20.1 million, excluding the impact of acquisitions, for the year ended December 31, 2008, compared to the same period in 2007. The decline in proportional premiums is due to the non-renewal of contracts during 2008 as well as decreased revenues on existing contracts partially offset by the impact of new contracts signed in 2008. The increase in non-proportional premiums is due to the addition of new clients as well as increased business with existing clients.
Premiums written during the years ended December 31, 2007 and 2006 were $94.5 million and $56.4 million, respectively, which was primarily driven by pro rata contracts in the amount of $83.8 million and $41.9 million, respectively. This increase of $38.1 million during 2007, or 67.5%, was primarily driven by an increased participation on existing accounts as well as new proportional accounts.
During the year ended December 31, 2007, the Company recorded $0.9 million of gross reinstatement premiums compared to $nil recorded for the year ended December 31, 2006. In 2006, the lack of gross reinstatement premiums was due to low catastrophe activity during the period.
Short-tail specialty and casualty reinsurance premiums were $152.7 million ($150.1 million excluding the impact of acquisitions made in 2008) for the year ended December 31, 2008, compared to $71.1 million for the year ended December 31, 2007, representing an increase of $79.0 million excluding the impact of acquisitions, or 111.2% primarily driven by increased participation on existing accounts and expansion of our client base, mainly in the energy, marine, space and aviation programs. Proportional premiums increased $57.4 million and non-proportional premiums increased $21.6 million, excluding the impact of acquisitions, for the year ended December 31, 2008, compared to the same period in 2007. The increase in proportional premiums is principally due to the addition of new clients in 2008, and the addition of new contracts and increasing lines from existing clients. The increase in non-proportional premiums is primarily due to the addition of new specialty covers that originated from Flagstone Suisse during 2008.
Due to the potential volatility of our reinsurance contracts, especially our property catastrophe reinsurance contracts which we sell, we purchase reinsurance to reduce our exposure to large losses and as part of our overall risk management process. To the extent that appropriately priced coverage is available, we anticipate use of reinsurance to reduce the financial impact of large losses on our results and to optimize our overall risk profile. We segment our reinsurance purchases into the following areas - common account reinsurance purchased mutually on behalf of our needs and the client’s needs on specific treaties, business written with the intent to cede directly to our sidecar facility, and opportunistic and core purchases. As the Company grows its book of business, the need for additional retrocessional coverage will also grow. We will continue to assess the need for retrocessional coverage and may purchase additional coverage in future periods.
Reinsurance premiums ceded for the years ended December 31, 2007 and 2006 were $30.6 million (5.6% of gross reinsurance premiums written) and $20.0 million (6.6% of gross reinsurance written premiums), respectively.
For the year ended December 31, 2007, the Company purchased common account reinsurance of $3.5 million and purchased $27.1 million of opportunistic and core reinsurance protection to optimize our overall risk profile.
movement in IBNR reserves, which are reserves established by us for claims that are not yet reported but can reasonably be expected to have occurred based on industry information, management’s experience and actuarial evaluation, less expected recoveries from reinsurers, if any.
The increase in the loss ratio of 27.3% in 2007 is as a result of the catastrophe events that occurred in 2007 (described below) compared to the light insured catastrophe activity experienced in 2006.
General and administrative expenses consist primarily of salaries, benefits, and related costs, including costs associated with our PSU and RSU Plans and other general operating expenses.
General and administrative expenses for the years ended December 31, 2007 and 2006 were $68.9 million and $34.7 million, respectively. The increase of $34.2 million during 2007, or 98.6%, is principally due to expenses related to the increase in staffing levels as we continue to build our global platform and associated general operating expenses. Because the growth in our net premiums earned has outpaced the growth in our general and administrative expenses, the general and administrative expense ratio has decreased 3.2% from 2006.
During 2008, the Company completed three acquisitions; Flagstone Africa, Flagstone Alliance and Marlborough. Flagstone Africa is a South African reinsurer who primarily writes multiple lines of reinsurance in sub-Saharan Africa. Flagstone Alliance is a Cypriot reinsurer writing multiple lines of business in Europe, Asia, and the Middle East & North Africa region. Marlborough is the managing agency for Lloyd’s Syndicate 1861 - a Lloyd’s syndicate underwriting a specialist portfolio of short-tail insurance and reinsurance. The acquisition of Marlborough did not include the existing corporate Lloyd’s member or any liability for business written during or prior to 2008. The Company licensed its own corporate capital vehicle to be the capital provider for Lloyd’s Syndicate 1861 for fiscal year 2009 onwards. The acquisition of Marlborough provides the Company with a Lloyd’s platform with access to both London business and that sourced globally from our network of offices. The Company expects to see an increase in revenues for the Reinsurance segment as a result of these acquisitions.
The Company has established a new Insurance segment for the year ended December 31, 2008, which included insurance business generated through Island Heritage, a property insurer based in the Cayman Islands which is primarily in the business of insuring homes, condominiums and office buildings in the Caribbean region. The Company gained controlling interest of Island Heritage on July 3, 2007, and as a result, the comparatives for the year ended December 31, 2007 include the results of Island Heritage for the six months ended December 31, 2007 only. There is no comparative information for the year ended December 31, 2006, as the Company did not undertake any insurance business prior to its acquisition of Island Heritage in 2007.
Net premiums earned totaled $12.7 million for the year ended December 31, 2008, compared to $13.0 million for the six months ended December 31, 2007. Net premiums earned for 2008 are lower due to the changes in the reinsurance program referred to above.
Acquisition costs totaled $13.9 million for the year ended December 31, 2008, compared to $6.5 million for the six months ended December 31, 2007. The acquisition cost ratio, which is equal to acquisition cost expenses over net premiums earned plus other reinsurance and insurance income, for the year ended December 31, 2008 was 53.6% compared to 40.0% for the six months ended December 31, 2007. Acquisition costs include gross commission costs, profit commission, premium taxes, and the change in deferred acquisition costs. The increase in the acquisition cost ratio for the year ended December 31, 2008 reflects the lower net premiums earned for the same period.
During late 2008, Island Heritage opened an office in Puerto Rico and future growth is planned via expansion into the Puerto Rico market, along with additional organic expansion in existing markets. During November 2008, the Company completed the acquisition of Marlborough, the managing agency for Lloyd’s Syndicate 1861 - a Lloyd’s syndicate underwriting a specialist portfolio of short-tail insurance and reinsurance. The acquisition did not include the existing corporate Lloyd’s member or any liability for business written during or prior to 2008. The Company licensed its own corporate capital vehicle to be the capital provider for Lloyd’s Syndicate 1861 for fiscal year 2009 onwards. The acquisition provides the Company with a Lloyd’s platform with access to both London business and that sourced globally from our network of offices. The Company expects to see an increase in the underwriting revenues for the Insurance segment as a result of this acquisition.
The total return on our investment portfolio, excluding minority interests in the investment portfolio, comprises investment income and realized and unrealized gains and losses on investments. For the year ended December 31, 2008, the total return on invested assets was (13.9)% compared to 7.0% for the year ended December 31, 2007. The change in the return on invested assets of (20.9)% during the year ended December 31, 2008, compared to the same period in 2007 is primarily due to the significant declines in the global equity, bond and commodities markets in 2008. Such declines in the equity, bond and commodities markets are attributable to the broader deterioration and volatility in the credit markets, the widening of credit spreads in fixed income sectors, significant failures of large financial institutions, uncertainty regarding the effectiveness of governmental solutions and the lingering impact of the sub-prime residential mortgage crisis.
Net investment income increased by $39.6 million in 2007 compared to 2006 principally due to an increase in interest and dividend income due to the growth on our cash and fixed maturities portfolio, dividends from other investments and the increase in amortization income on our TIPS due to the significant increase in the inflation index during the year. The increase in invested assets is due to positive cash flows from our operating and financing activities (receipt of net proceeds in April 2007 of $168.7 million from our IPO and $123.6 million of net debenture proceeds) which we deployed into our invested assets
The following table is a breakdown of the net realized and unrealized (losses) gains on derivatives included in the table above:
Net realized and unrealized losses on other investments of $30.1 million during the year ended December 31, 2008, were primarily due to the negative performance of the real estate markets and our increased position in REIT funds during the year.
Net realized and unrealized losses on swap contracts of $18.7 million during the year ended December 31, 2008 were primarily due to $20.3 million of losses on index total return swaps offset by $1.6 million of gains on interest rate swaps within our fixed maturities portfolios.
The Company’s policy is to hedge the majority of its non-investment currency exposure with derivative instruments such as foreign currency swaps and forward currency contracts.
The following table is the breakdown of net realized and unrealized gains (losses) - other in the consolidated statements of operations into its various components:
We use currency swaps and foreign currency forwards to hedge the economic currency exposure of the Company’s investment in foreign subsidiaries, primarily our Swiss subsidiary, and to hedge operational balances such as premiums receivable, loss reserves and the portion of our long term debt issued in Euros. We recorded $(0.8) million of net realized and unrealized gains (losses) on foreign currency swaps on our subordinated debt in 2008 versus $2.0 million in 2007 and $(1.4) million on interest rate swaps on our subordinated debt in 2008 versus $0.5 million in 2007. In 2008 we recorded a $7.1 million gain on foreign currency forwards on Flagstone Suisse’s net assets (undesignated hedge) and operational hedges on reinsurance balances and a portion of long term debt incurred versus $(14.0) million in 2007.
Reinsurance derivatives relate to industry loss warranty contracts (“ILWs”) that are structured as derivative transactions and exchange traded futures options contracts on major hurricane indexes. The Company recorded unrealized gains on ILWs determined to be derivatives of $4.1 million in 2008, versus $1.7 million in 2007. The increase was due to the increased number of ILWs determined to be derivatives written during 2008. The realized and unrealized gains recorded on the futures options contracts were $2.5 million for 2008. The Company did not enter into futures options contracts in 2007.
We entered into interest rate swaps during 2007 to convert the interest on our long term debt from floating to fixed. Reinsurance derivatives relate to reinsurance arrangements that are structured as derivative transactions and the movement for the year ended December 31, 2007 is due to new contracts being entered into during 2007 offset by the earning of the 2006 contracts.
The Company has subsidiaries that operate in various other jurisdictions around the world that are subject to tax in the jurisdictions in which they operate. The significant jurisdictions in which the Company’s subsidiaries are subject to tax are Canada, India, South Africa, Switzerland, Cyprus, U.S. Virgin Islands (“USVI”) and the United Kingdom. However since the majority of our income to date has been earned in Bermuda where we are exempt from income tax, the Company’s tax impact to date has been minimal.
During the year ended December 31, 2007, income tax expense was $0.8 million compared to $0.1 million for the year ended December 31, 2006. The increase of $0.7 million is primarily attributable to higher taxable income in jurisdictions around the world that are subject to tax as well as the acquisition of Island Heritage in July 2007, which resulted in taxable income being earned in the USVI.
From January 12, 2007, the Company consolidated Mont Fort, in accordance with the provisions of FIN 46(R). As such, the results of Mont Fort have been included in the Company’s consolidated financial statements, with the portions of Mont Fort’s net income and shareholders’ equity attributable to the preferred shareholders recorded as minority interest. On February 8, 2008, Mont Fort repurchased 5 million preferred shares relating to its second cell, Mont Fort ILW 2 for $6.6 million. In relation to Mont Fort, the Company recorded a minority interest expense of $14.2 million for the year ended December 31, 2008, compared to $33.6 million for the year ended December 31, 2007. The 2008 results of Mont Fort were impacted by the negative investment returns and Hurricane Ike losses.
The results of operations of Island Heritage have been included in the Company’s unaudited condensed consolidated financial statements from July 1, 2007 onwards, with the portions of Island Heritage’s net income and shareholders’ equity attributable to minority shareholders recorded as minority interest. The Company recorded a minority interest charge (credit) of $(0.6) million for the year ended December 31, 2008, compared to $2.2 million for the year ended December 31, 2007.
On July 3, 2007, the Company purchased 73,110 shares (representing a 21.4% interest) in Island Heritage for a purchase price of $12.6 million. Island Heritage is a property insurer based in the Cayman Islands which primarily is in the business of insuring homes, condominiums and office buildings in the Caribbean region. With this acquisition, the Company took a controlling interest in Island Heritage by increasing its interest to 54.6% of the voting shares. The Company’s share of Island Heritage’s results from operations was recorded in the Company’s consolidated financial statements under the equity method of accounting through June 30, 2007. As a result of the acquisition of this controlling interest, the results of operations of Island Heritage have been included in the Company’s consolidated financial statements from July 1, 2007, with the portions of Island Heritage’s net income and shareholders’ equity attributable to minority shareholders recorded as minority interest in the Company’s consolidated financial statements. In relation to Island Heritage, the Company recorded a minority interest charge of $2.2 million for the year ended December 31, 2007.
The currency translation adjustment is as a result of the translation of our foreign subsidiaries into U.S. dollars, net of transactions designated as hedges of net foreign investments. The Company has entered into certain foreign currency forward contracts that it has designated as hedges in order to hedge its net investment in foreign subsidiaries. To the extent that the contract is effective as a hedge, both the realized and unrealized gains and losses associated with the designated hedge instruments are recorded in other comprehensive income as part of the cumulative translation adjustment. The Company designated $337.7 million and $264.4 million of foreign currency forwards contractual value as hedge instruments, which had a fair value of $(5.7) million and $(3.4) million, at December 31, 2008 and 2007, respectively. The Company recorded $17.0 million and $3.5 million of realized and unrealized foreign exchange losses on these hedges during the years ended December 31, 2008 and 2007, respectively.
Net cash provided by operating activities of $228.4 million, including net investment income of $51.4 million;
The addition of $32.4 million of invested assets and cash equivalents resulting from the consolidation of Flagstone Africa in 2008;
The addition of $62.5 million of invested assets and cash equivalents resulting from the consolidation of Flagstone Alliance in 2008;
The addition of $13.6 million of invested assets and cash equivalents resulting from the consolidation of Marlborough in 2008;
Total net realized and unrealized (losses) gains - investments and net realized and unrealized (losses) gains - other of $(260.6) million;
Decrease in payable for investments purchased of $34.0 million and an increase in receivable for investments sold of $9.6 million; and
Net realized and unrealized losses on designated hedges recorded directly into the currency translation adjustment of $17.0 million.
The investment management guidelines of the Company are set by the Finance Committee of our Board of Directors. The Finance Committee establishes investment policies and guidelines for both internal and external investment managers. The Company employs a prudent investment philosophy. It maintains a high-quality, well-balanced and liquid portfolio having the dual objectives of optimizing current investment income and achieving capital appreciation.
The Company has a strong bias against active management in favor of indexing and passive securities that are generally the most liquid. When they are part of the asset allocation, a number of our equity and other exposure implementations use futures contracts and swaps, whereas the assets in a short term portfolio, managed by external managers, support the futures contracts as if those assets were pledged and not available for liquidity purposes. The portfolio managers are required to adhere to investment guidelines as to minimum ratings and issuer and sector concentration limitations. This implementation strategy gives us a low cost and efficient way, using a mixture of passive assets and outside managers, to complement our in-house capability for overall portfolio management, liquidity management and hedging.
At December 31, 2008 and 2007, we had no exposure to sub-prime backed investments or collateralized debt obligations (“CDOs”) of sub-prime backed investments. At December 31, 2008 and 2007, our holdings of Alt -A securities were $3.0 million with an average rating of AA+ and $14.7 million with an average rating of AAA, respectively. Alt - A securities are defined as a classification of mortgages where the risk profile falls between prime and sub-prime. The borrowers behind these mortgages will typically have clean credit histories, but the mortgage itself will generally have some features that increase its risk profile compared to prime securities, but less risky than sub-prime backed investments. These features include higher loan-to-value and debt-to-income ratios or inadequate documentation of the borrower’s income. Our exposure to traditional monoline insurers emanates from our non subprime asset-backed holdings. We have securities with credit enhancement from the traditional monoline insurers that amount to $1.2 million and $9.9 million at December 31, 2008 and 2007, respectively. We do not have any collateralized loan obligations or CDO exposures in our portfolio.
The following table provides a breakdown of the credit quality of the Company’s fixed maturity investments at December 31, 2008 and 2007:
The contractual maturity dates of fixed maturity and short term investments as at December 31, 2008 and 2007 is shown below. Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
The following table represents an analysis of paid and incurred losses and a reconciliation of the beginning and ending loss and loss adjustment expense reserves for the years ended December 31, 2008 and 2007:
The prior year reduction in the net incurred losses arose from the revision of our loss estimates upon receipt of updated information from our clients and brokers. During the year ended December 31, 2008, we had total net positive development of $15.7 million; $10.5 million relating to the 2007 year and $5.2 million relating to the 2006 year. The favorable development was primarily due to actual loss emergence in the property catastrophe, property, and the short-tail specialty and casualty lines of business being lower than the initial expected loss emergence.
The significant increase in the reserves in 2008 is primarily attributable to more severe catastrophe losses in 2008 than in 2007 resulting from Hurricane Ike ($158.4million), Hurricane Gustav ($14.5million), Chinese winter storms ($18.2million) and the U.S. Memorial Day weekend storms ($11.1 million).
The Company actively manages its capital to support its underwriting operations and for the benefit of its shareholders, subject to the ability to maintain strong ratings from the agencies and maintain its ability to pay claims as they arise. Generally, the Company will seek to raise additional capital when its current capital position is not sufficient to support attractive business opportunities available. Conversely, the Company will seek to reduce its capital, through dividends or stock repurchases when the opportunity set is insufficient to utilize our capital to earn our long term return targets. On September 22, 2008, the Company announced that its Board of Directors had approved the potential repurchase of company stock. The buyback program allows the Company to purchase, from time to time, its outstanding stock up to a value $60.0 million. Purchases under the buyback program are made with cash, at market prices, through a brokerage firm. During the period from October 2, 2008 to December 31, 2008 the Company purchased 697,599 shares for total consideration of $6.6 million.
Management uses growth in diluted book value per share as a prime measure of the value the Company is generating for its common shareholders. Diluted book value per share is calculated using the common shareholders’ equity divided by the number of common share and share equivalents outstanding. In 2008, the Company’s diluted book value per share plus accumulated dividends decreased by 17.3% from $13.95 at December 31, 2007 to $11.53 at December 31, 2008.
At December 31, 2008 and 2007, the Company was in compliance with all required covenants, and no conditions of default existed related to the Company’s long term debt. We may incur additional indebtedness in the future if we determine that it would be an efficient part of our capital structure.
We are a holding company that conducts no operations of our own. We rely primarily on cash dividends and return of capital from our subsidiaries to pay our operating expenses and make principal and interest payments on our long term debt. There are restrictions on the payment of dividends from Flagstone Suisse to the Company, which are described in more detail below. We have paid a quarterly cash dividend of $0.04 per common share beginning in the third quarter of 2007 and for each quarter thereafter. Our subsidiaries’ sources of funds primarily consist of premium receipts net of commissions, investment income, capital raising activities including the issuance of common shares, long term debt and proceeds from sales and maturities of investments. Cash is used primarily to pay losses and loss adjustment expenses, reinsurance purchased, brokerage, general and administrative expenses and dividends, with the remainder made available to our investment manager for investment in accordance with our investment policy. In the future, we may use cash to fund any authorized share repurchases and acquisitions.
Cash flows from operations for the year ended December 31, 2008 decreased to $228.4 million from $335.4 million as compared to the same period in 2007. This decrease in cash flows from operations was primarily related to the net loss for 2008 compared to the net income in 2007. The changes in assets and liabilities were due primarily to reinsurance premiums receivable, unearned premiums ceded, loss and loss adjustment expense reserves, unearned premiums and other changes in assets and liabilities. The increase in reinsurance balances receivable resulted primarily from an increase in gross premiums written. The increase in unearned premiums ceded resulted primarily from an increase in premiums ceded. The increase in loss and loss adjustment expense reserves resulted primarily from a higher level of loss activity in 2008 over 2007, from catastrophic activity. The increase in unearned premiums resulted primarily from higher gross premiums written in 2008. The increase in other assets, net of an increase in other liabilities, resulted primarily from an increase in prepaid expenses related to a retrocessional premium for 2009 prepaid in late 2008. Because a large portion of the coverages we provide typically can produce losses of high severity and low frequency, it is not possible to accurately predict our future cash flows from operating activities. As a consequence, cash flows from operating activities may fluctuate, perhaps significantly, between individual quarters and years.
On June 30, 2008 the Company acquired an additional 16,919 shares in Island Heritage (representing 5% of its common shares) for total cash consideration of $3.3 million. On June 26, 2008, the Company acquired a 65% interest in Flagstone Africa for $(6.0) million in cash (net of cash acquired). Also during 2008, the Company acquired 100% of the outstanding common shares of Flagstone Alliance for $5.2 million in cash (net of cash acquired). On November 18, 2008, the Company acquired 100% of the common shares of Marlborough for $34.8 million in cash (net of cash acquired).
We monitor our long term liquidity needs with regard to our annual aggregate PML. Our annual aggregate PML for a given number of years is our estimate of the maximum aggregate loss and loss adjustment expenses that we are likely to incur in any one year during that number of years.
In 2009, we anticipate capital expenditures of approximately $2.5 million for our information technology infrastructure and systems enhancements, including proprietary software expenditures, $4.1 million primarily for the purchase and retrofit of an airplane and $10.6 million building costs primarily associated with the construction of our office buildings in Luxembourg and Martigny and leasehold improvements for other offices. We expect our operating cash flows, together with our existing capital base, to be sufficient to meet these requirements and to operate our business.
Under the terms of certain reinsurance contracts, our reinsurance subsidiaries may be required to provide letters of credit to reinsureds in respect of reported claims and/or unearned premiums. In August 2006, the Company entered into a $200.0 million uncommitted letter of credit facility agreement with Citibank N.A. In April 2007, the Company increased its uncommitted letter of credit facility agreement from $200.0 million to $400.0 million. As at December 31, 2008, $285.7 million had been drawn under this facility, and the drawn amount of the facility was secured by $327.2 million of fixed maturity securities from the Company’s investment portfolio. As at December 31, 2007, $73.8 million had been drawn under this facility, and the drawn amount of the facility was secured by $82.0 million of fixed maturity securities from the Company’s investment portfolio.
On December 24, 2008, the Company filed an unallocated universal shelf registration statement with the SEC that was declared effective on January 8, 2009. Under the shelf registration statement, the Company may issue up to $200 million of equity, debt, preferred shares or a combination of these securities. In addition, up to 71,547,891 Common Shares may be sold from time to time pursuant to this Registration Statement by the selling shareholders.
Swiss law permits dividends to be declared only after profits have been allocated to the reserves required by law and to any reserves required by the articles of incorporation. The articles of incorporation of Flagstone Suisse do not require any specific reserves. Therefore, Flagstone Suisse must allocate any profits first to the reserve required by Swiss law generally, and may pay as dividends only the balance of the profits remaining after that allocation. In the case of Flagstone Suisse, Swiss law requires that 20% of the company’s profits be allocated to a “general reserve” until the reserve reaches 50% of its paid-in share capital.
Bermuda law limits the maximum amount of annual dividends or distributions payable by Flagstone Suisse to the Company and in certain cases requires the prior notification to, or the approval of, the BMA. As a Bermuda Class 4 reinsurer, Flagstone Suisse may not pay dividends in any financial year which would exceed 25% of its total statutory capital and surplus unless at least seven days before payment of those dividends it files an affidavit with the BMA signed by at least two directors and Flagstone Suisse’s principal representative, which states that in their opinion, declaration of those dividends will not cause Flagstone Suisse to fail to meet its prescribed solvency margin and liquidity ratio. Further, Flagstone Suisse may not reduce by 15% or more its total statutory capital as set out in its previous year’s statements, without the prior approval of the BMA. Flagstone Suisse must also maintain, as a Class 4 Bermuda reinsurer, paid-up share capital of $1 million.
Flagstone Alliance operates under license issued by the Cyprus Insurance Superintendent to conduct general reinsurance and insurance business. Cyprus Companies Law permits dividends to be declared only if there are available sufficient distributable reserves after profits have been allocated to the reserves required by law and to any reserves required by the articles of incorporation. The articles of incorporation of Flagstone Alliance do not require any specific reserves. Irrespective of the Cyprus Companies Law, Cap 113 requirements and the Flagstone Alliance’s articles of association, Flagstone Alliance should maintain at any time, reserves and assets that meet the Solvency criteria and Orders of the Cyprus Insurance Superintendent. Flagstone Alliance complies and reports to the Superintendent of Insurance under Solvency I requirements and the Solvency II requirements will be adopted in 2012. Revenue reserves are distributable to the extent permitted by the Companies Law, and Flagstone Alliance’s Articles of Association. The share premium account cannot be used for the distribution of dividends but can be used to issue bonus shares. The reserve arising on the conversion of share capital to Euro may be capitalized by way of a future capital increase; alternatively, Flagstone Alliance may decide at a shareholders’ general meeting to distribute the decrease by way of a dividend.
Mont Gele is a special purpose Cayman Islands exempted company licensed as a restricted Class B reinsurer in the Cayman Islands and formed solely for the purpose of entering into certain reinsurance agreements and other risk transfer agreements with Flagstone Suisse. We have entered into an excess of loss reinsurance agreement with Mont Gele that provides us with a $60 million limit.
We are not party to any transaction, agreement or other contractual arrangement to which an affiliated entity unconsolidated with us is a party, other than that noted above with Mont Gele, that management believes is reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.
Valais Re is a special purpose Cayman Islands exempted company licensed as a restricted Class B reinsurer in the Cayman Islands and formed solely for the purpose of entering into certain reinsurance agreements and other risk transfer agreements with subsidiaries of Flagstone Suisse. We have entered into a reinsurance agreement with Valais Re that provides us with $104 million of aggregate indemnity protection for certain losses from global catastrophe events.
The following table shows our aggregate contractual obligations by time period remaining to due date as at December 31, 2008:
(3) The Company has entered into commitment for the construction of office buildings located in Luxembourg and Martingy as well as the acquisition and upgrade of an aircraft.
(4) The Company has made certain commitments with respect to an investment in a private equity fund and may receive capital call requests in 2009.
Net foreign exchange (losses) gains amounted to a loss of $(21.5) million, a gain of $5.3 million and a gain of $2.1 million for the years ended December 31, 2008, 2007 and 2006, respectively (See “Results of Operations” above).
The effects of inflation are considered implicitly in pricing and estimating reserves for unpaid losses and loss expenses. The actual effects of inflation on the results of operations of the Company cannot be accurately known until claims are ultimately settled.
Consolidated Statements of Operations and Comprehensive (Loss) Income for the Years Ended December 31, 2008, 2007, and 2006
Consolidated Statements of Changes in Shareholders’ Equity for the Years Ended December 31, 2008, 2007 and 2006
We have audited the accompanying consolidated balance sheets of Flagstone Reinsurance Holdings Limited and subsidiaries (the "Company") as of December 31, 2008 and 2007, and the related consolidated statements of operations and comprehensive (loss) income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2008. Our audits also included the financial statement schedules listed in the Index at Item 15. These financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Flagstone Reinsurance Holdings Limited and subsidiaries as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2008, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of December 31, 2008, based on identified control criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 13, 2009 expressed an unqualified opinion on the Company's internal control over financial reporting.
On March 6, 2006, the Company entered into a share purchase agreement to purchase 370,000 common shares, representing 100% of the outstanding common shares of Mont Fort Re Limited (“Mont Fort”), a segregated accounts or “cell” company registered under the Bermuda Segregated Accounts Companies Act 2000 (as amended). For further details relating to Mont Fort see Note 5 “Mont Fort Re Limited”.
On March 31, 2006, the Company acquired Flagstone Capital Management (Bermuda) Limited and its subsidiaries (formerly known as West End Capital Management (Bermuda) Limited and referred to herein as “West End”), a company engaged in the business of investment and insurance management in Bermuda. West End subsidiaries include (a) Flagstone Management Services (Halifax) Limited which provides accounting, claims, information technology support, risk modeling, proprietary systems development and high performance computing and (b) Flagstone Underwriting Support Services (India) Private Limited which provides underwriting risk modeling & analysis, underwriting operations support, financial research & accounting, actuarial support, catastrophe model research, proprietary systems development, legal services and information technology support.
On June 26, 2008, the Company acquired a 65% interest in Flagstone Reinsurance Africa Limited (“Flagstone Africa”), formerly known as Imperial Reinsurance Company Limited (“Imperial Re”), a South African reinsurer who primarily writes multiple lines of reinsurance in sub-Saharan Africa. On October 6, 2008, the Company acquired a controlling interest in Flagstone Alliance Insurance and Reinsurance Plc (“Flagstone Alliance”), formerly known as Alliance International Reinsurance Public Company Limited (“Alliance Re”) a Cypriot reinsurer writing multiple lines of business in Europe, Asia, and the Middle East and North Africa region. The Company acquired the remaining outstanding common shares of Alliance so that as of December 10, 2008, the Company owned 100% of the outstanding common shares of Flagstone Alliance. On November 18, 2008, the Company acquired 100% of the common shares of Marlborough Underwriting Agency Limited, (“Marlborough”) the managing agency for Lloyd’s Syndicate 1861 - a Lloyd’s syndicate underwriting a specialist portfolio of short-tail insurance and reinsurance. For further information on these acquisitions refer to Note 3 “Acquisitions”.
The accompanying financial statements as at December 31, 2008 include all adjustments (consisting of normal recurring accruals) considered necessary to present fairly the financial position as at December 31, 2008 and 2007 and the results of operations and cash flows for the years ended December 31, 2008, 2007 and 2006.
For excess of loss contracts, premiums written are based on the deposit premium as defined in the contract, which is generally based on an estimate at the inception of the contract of the underlying exposure (e.g., values of properties insured) during the contract period. At the end of the policy term, a final premium is calculated based on the actual underlying exposure during the contract period and an adjustment to the deposit premium, if any, is recognized in the period in which it is determined. For pro rata contracts where no deposit premium is specified in the contract, premiums written are based on estimates of ultimate premiums provided by the ceding companies. Initial estimates of premiums written are reflected quarterly from the period in which the underlying risks incept. Subsequent adjustments, based on reports of actual premiums written by the ceding companies, or revisions in estimates, are recorded in the period in which they are determined.
Reinsurance and insurance premiums ceded are expensed over the period the reinsurance coverage is provided. Unearned ceded premiums represent the portion of premiums ceded related to the unexpired portion of the risk period.
Prior to January 1, 2007, investments were considered available-for-sale in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS 115”), and were carried at fair value with unrealized gains and losses recorded in accumulated other comprehensive (loss) income. Following the issuance by the FASB of SFAS 159, “The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115” (“SFAS 159”), the Company elected to early adopt the fair value option for all fixed maturity investments, equity investments (excluding investments accounted for under the equity method of accounting), real estate investment trusts (“REITs”), investment funds, catastrophe bonds, and fixed income funds commencing January 1, 2007. This election required the Company to adopt SFAS No. 157, “Fair Value Measurements” (“SFAS 157”) regarding fair value measurements. The valuation technique used to fair value the financial instruments is the market approach which uses prices and other relevant information generated by market transactions involving identical or comparable assets.
The difference as a result of the election of the fair value option is in respect to the treatment of unrealized gains and losses. Prior to January 1, 2007, unrealized gains and losses on fixed maturity investments and equities were included within accumulated other comprehensive (loss) income as a separate component of shareholders’ equity. On January 1, 2007, a cumulative-effect adjustment was made to reclassify the net unrealized losses, which represented the difference between the cost or amortized cost of investments
and the fair value of those investments at December 31, 2006, from accumulated other comprehensive loss as at December 31, 2006 into retained earnings in the amount of $4.0 million. Subsequent to January 1, 2007, any movement in unrealized gains and losses has been recorded within net realized and unrealized gains (losses) on investments within the audited consolidated statements of operations and comprehensive (loss) income. Investments are recorded on a trade date basis and realized gains and losses on sales of investments are determined on a first-in, first-out basis. Net investment income includes interest income on fixed maturity investments, recorded when earned, dividend income on equity investments, recorded when declared, and the amortization of premiums and discounts on investments, using effective interest rate method.
The Company accounts for share based compensation in accordance with SFAS No. 123(R), “Share-Based Payment”, (“SFAS 123(R)”). SFAS 123(R) requires entities to measure the cost of services received from employees and directors in exchange for an award of equity instruments based on the grant date fair value of the award. The cost of such services will be recognized as compensation expense over the period during which an employee or director is required to provide service in exchange for the award.
The Company accounts for the warrant granted to Haverford (Bermuda) Ltd. (“Haverford”), a related party due to common ownership, as stock compensation in accordance with SFAS No. 123(R). Compensation expense for the warrant was measured at fair value at the date of issuance of the warrant and recorded as compensation expense in the issuance period as there was no required service period. Additional compensation expense was recorded as a result of amendments to the warrant on November 14, 2008. (See Note 13 “Shareholders’ Equity” for additional details).
The Company accounts for its derivative instruments using SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). SFAS 133 requires an entity to recognize all derivative instruments as either assets or liabilities in the balance sheet and measure those instruments at fair value, with the fair value recorded in other assets or liabilities. The accounting for realized and unrealized gains and losses associated with changes in the fair value of derivatives depends on its hedge designation and whether the hedge is highly effective in achieving offsetting changes in the fair value of the asset or liability being hedged. The realized and unrealized gains and losses on derivatives not designated as hedging instruments are included in net realized and unrealized gains and losses in the consolidated financial statements. Gains and losses associated with changes in fair value of the designated hedge instruments are recorded with the gains and losses on the hedged items, to the extent that the hedge is effective. Derivative instruments are stated at fair value in accordance with SFAS 157 based on a quoted market price for futures contracts and based on observable market inputs (such as currency spot and forward rates, underlying exchange traded securities yield curves and transactional history) for foreign currency forwards, total return swaps, currency swaps, interest rates swaps and “to be announced” mortgage-backed securities (“TBAs”). The Company fair values reinsurance derivative contracts using internal valuation models, with the significant inputs to the valuation models being the underlying risk exposure and the time left to the end of the contract.
The Company accounts for intangible assets that arise from business combinations in accordance with SFAS No. 141. Intangible assets with a finite life are amortized over the estimated useful life of the asset. Intangible assets with an indefinite useful life are not amortized.
The Company conducted its annual reviews as at December 31, 2008 and determined that the recorded goodwill and intangible assets were not impaired.
Funds held by reinsured companies represent insurance balances retained by ceding companies for a period in accordance with contractual terms. The Company generally earns investment income on these balances during the period funds are held.
The calculation of basic earnings (loss) per common share is based on weighted average common shares and weighted average vested RSUs outstanding and excludes any dilutive effects of warrants and share equivalents. Diluted earnings (loss) per common share assume the exercise of all dilutive warrant and share equivalents.
The issuance of shares with respect to the PSUs is contingent upon the attainment of certain levels of diluted return-on-equity (“DROE”). Because the number of common shares contingently issuable under the PSU Plan depends on the average DROE over a two-year or three year period, the PSUs are excluded from the calculation of diluted earnings per share until the end of the performance period, when the number of shares issuable under the PSU Plan will be known.
While the Company does not consider any of the acquisitions during 2008 to be material (including the acquisition of Flagstone Alliance), the following unaudited financial information related to the Company’s acquisition of Flagstone Alliance for the years ended December 31, 2008, 2007 and 2006 illustrates the results of the acquired entity for each of the periods presented.
The Company recorded $3.1 million of goodwill on the acquisition including the value of the workforce and recorded intangible assets of $23.5 million related to syndicate capacity, $3.4 million related to the distribution network, $1.4 million related to the trade name and $4.0 million related to software. Syndicate capacity represents Marlborough’s authorized premium income limit to write insurance business in the Lloyd’s market. The capacity is renewed annually at no cost to Marlborough, but may be freely purchased or sold, subject to Lloyd’s approval. The ability to write insurance business under the syndicate capacity is indefinite with the premium income limit being set yearly by Marlborough, subject to Lloyd’s approval. The trade name and distribution network are estimated to have finite useful lives of 10 years and 20 years, respectively, and the software is estimated to have a finite useful life of 10 years. The trade name and software are amortized on a straight line basis over the periods indicated and the distribution network is amortized on an accelerated method basis. Syndicate capacity and goodwill are estimated to have indefinite useful lives.
On June 30, 2008, the Company acquired an additional 16,919 shares in Island Heritage (representing 5% of its common shares) for total consideration of $3.3 million. The Company recorded $1.3 million of goodwill on the acquisition.
The following table details goodwill and intangible assets at December 31, 2008 and 2007:
On January 12, 2007, Mont Fort closed an offering of preferred shares relating to a third cell, Mont Fort HL which yielded gross proceeds of $28.1 million. The investor in Mont Fort HL is Newcastle Special Opportunity Fund V, L.P., an entity with no previous investments or affiliations with the Company or with Mont Fort. Mont Fort, in respect of Mont Fort HL, entered into a quota share reinsurance contract with the Company under which the Company assumes 9.0% of the business written by Mont Fort HL.
The Company determined that the establishment of these cells was a reconsideration event under the provisions of paragraph 7 and paragraph 15 of FIN 46(R). Consequently, the Company assessed whether or not Mont Fort continued to be a VIE and, if so, whether the Company or another party was Mont Fort’s primary beneficiary. The Company assessed the impact of these reconsideration events on its results and financial position, and concluded that the establishment of the Mont Fort HL cell on January 12, 2007 was the reconsideration event that resulted in the Company being the primary beneficiary of Mont Fort. As such, the results of Mont Fort are included in the Company’s consolidated financial statements with effect from January 12, 2007. The portions of Mont Fort’s net income and shareholder’s equity attributable to holders of the preferred shares for the year ended December 31, 2007 are recorded in the consolidated financial statements of the Company as minority interest.
Further, with the addition of any new contracts that the Company enters into with each of the new cells, the Company will evaluate whether the contracts with Mont Fort continue to meet the risk transfer parameters of SFAS No. 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts” (“SFAS 113”) considered individually and, where appropriate, in the aggregate. In the event that these cells caused any contract or group of contracts to fail to meet the risk transfer parameters, the Company’s future financial statements would account for these reinsurance transactions in accordance with the provisions of Statement of Position 98-7 “Deposit Accounting: Accounting for Insurance and Reinsurance Contracts that do not Transfer Insurance Risk.”
In accordance with a reinsurance agreement entered into between the Company and Mont Fort on behalf on its cells, the Company earns a ceding commission from the cells based on the level of premiums ceded to the cells. During the years ended December 31, 2008 and 2007, transactions between the Company and Mont Fort were eliminated upon consolidation. During the year ended December 31, 2006, when Mont Fort was not consolidated, the Company earned $0.4 million from Mont Fort ILW under this arrangement. West End also entered into an investment management agreement with Mont Fort in respect to each cell. Under the agreement, West End earns an investment management fee based on the current size of the cells and a performance-based fee of 15% of the increase, if any, in the net asset value of each cell over the course of each year. During the year ended December 31, 2006, West End earned $1.3 million from Mont Fort ILW under this arrangement. On August 28, 2006, Mont Fort repurchased the preferred shares held by the Company for $5.1 million, and Mont Fort in respect of Mont Fort ILW entered into a quota share reinsurance contract with the Company under which the Company assumes 8.3% of the business written by Mont Fort ILW.
On February 8, 2008, Mont Fort repurchased 5 million preferred shares relating to its second cell, Mont Fort ILW 2 for $6.6 million.
Included in the Company’s assets as at December 31, 2008 and 2007 were cash, cash equivalents and fixed maturity investments of $184.3 million and $177.0 million, respectively, held for the sole benefit of preferred shareholders of each specific Mont Fort cell and available to settle the specific current and future liabilities of each cell.
Proceeds from the sale of fixed maturity, short term and equity investments during the year ended December 31, 2008 and 2007 amounted to $1.8 billion and $1.4 billion, respectively.
Catastrophe bonds held pay a variable interest coupon and their return, from interest and return of principal, is contingent upon climatological and geological events. The catastrophe bonds are recorded at fair value and as at December 31, 2008 and 2007 they had net realized gains of $0.3 and $0.8 million for the years then ended, respectively.
Realized investment (losses) gains on the sale of fixed maturity, short term and equity investments for the years ended December 31, 2008, 2007 and 2006 are as follows:
The following table is a breakdown of the net realized and unrealized (losses) gains recorded in the consolidated statements of operations:
For the year ended December 31, 2007, the favorable reserve development in net losses incurred related to prior years was primarily due to actual loss emergence in the property catastrophe and property lines of business being lower than the initial expected loss emergence for the 2006 loss year. The favorable loss development was partially offset by unfavorable reserve development in the short-tail specialty and casualty line of business due to higher than anticipated loss emergence for the 2006 loss year.
As at December 31, 2008, 2007 and 2006, the provision for doubtful accounts was $2.1 million, $1.0 million and $0.1 million, respectively, which has been recorded in premiums receivable on the balance sheet.
The company periodically uses foreign currency swaps to minimize the effect of fluctuating foreign currencies. The swaps had a fair value of $(0.3) million and $2.5 million as at December 31, 2008 and December 31, 2007, respectively. During the year ended December 31, 2008 and 2007, the Company recorded realized and unrealized losses of $0.8 million and realized and unrealized gains of $2.0 million, respectively on foreign currency swaps.
The Company uses total return swaps to gain exposure to the U.S. real estate market. The total return swaps allow the Company to earn the return of the underlying index while paying floating interest plus a spread to the counterparty. As of December 31, 2008, there were total return swaps with a notional amount of $70.9 million and a fair value of $3.7 million in the portfolio and as of December 31, 2007, the notional amount of the total return swaps was $14.2 million with a fair value of $(4.9) million. During the years ended December 31, 2008 and 2007, the Company recorded $20.3 million and $4.7 million of realized and unrealized losses, respectively, on total return swaps.
By acquiring a TBA, the Company makes a commitment to purchase a future issuance of mortgage-backed securities. For the period between purchase of the TBA and issuance of the underlying security, the Company’s position is accounted for as a derivative in the consolidated financial statements. At December 31, 2008 and 2007, the notional principal amount of TBAs was $63.9 million and $18.2 million and the fair value was $0.6 million and $0.2 million, respectively. During the year ended December 31, 2008, the Company recorded $2.2 million of realized and unrealized gains on TBAs and for the year ended December 31, 2007, the Company recorded $0.8 million of realized and unrealized losses on TBAs.
The Company has entered into equity index, commodity index, bond index and interest rate futures. At December 31, 2008 and 2007, the notional amount of these futures was $61.9 million and $421.0 million, respectively. The net fair value of futures contracts was $0.1 million and $(2.2) million as at December 31, 2008 and 2007, respectively. During the years ended December 31, 2008 and 2007, the Company recorded $147.5 million of realized and unrealized losses and $4.4 million of realized and unrealized gains, respectively, on futures.
The Company has entered into industry loss warranty (“ILW”) transactions that may be structured as reinsurance or derivatives. For those transactions determined to be derivatives, the fair value was $(0.5) million and $(1.3) million at December 31, 2008 and 2007, respectively. During the years ended December 31, 2008 and 2007, the Company recorded $4.1 million and $1.7 million, respectively, of realized and unrealized gains on ILWs determined to be derivatives.
Beginning in 2008, the Company entered into futures options contracts, both purchased and written, on major hurricane indexes that are traded on the Chicago Mercantile Exchange. The net notional exposure is determined based on the futures exchange futures specifications. The Company did not hold futures option contacts as of December 31, 2008. The realized and unrealized gains recorded on the hurricane indexes were $2.5 million during the year ended December 31, 2008.
In accordance with SFAS 157, the fair value of derivative instruments held as of December 31, 2008 and December 31, 2007 is allocated between levels as follows:
The total change in fair value of the Level 3 items still held as of December 31, 2008 is $(0.5) million.
As at December 31, 2008 derivatives of $9.4 million are recorded in other assets and $15.3 million are recorded in other liabilities.
Management has deemed all material tax positions to have a greater than 50% likelihood of being sustained on technical merits if challenged. The Company does not expect any material unrecognized tax benefits within 12 months of December 31, 2008.
Income tax expense for the years ended December 31, 2008, 2007 and 2006 was as follows:
Contributions are made by the Company, and these contributions are supplemented by the local plan participants. Contributions are based on a percentage of the participant’s base salary depending upon competitive local market practice. Vesting provisions meet legal compliance standards and market trends; the accumulated benefits for the majority of these plans vest immediately or over a two-year period.
The incremental effect of adopting SFAS 158 in 2008 was to increase total liabilities by $0.5 million and decrease total shareholders’ equity (accumulated other comprehensive income) by $0.5 million. Of the $0.5 million transition adjustment recorded under SFAS 158 in 2008, $0.4 million remains in accumulated other comprehensive income at December 31, 2008. Of this transition adjustment, approximately $50,000 is expected to be recognized in net periodic benefit cost in 2009.
At December 31, 2008, the projected pension obligation was $5.6 million, the accumulated pension obligation was $5.3 million, and the fair value of plan assets was $4.4 million. At December 31, 2008, the Swiss Plan’s asset allocation was as follows:
The Company does not believe that any plan assets will be returned to the Company during 2009.
The Company’s debt outstanding as at December 31, 2008 and 2007 is as follows:
SFAS No. 107, “Disclosure about Fair Value of Financial Instruments” (“SFAS 107”), requires disclosure of fair value information of financial instruments. For financial instruments where quoted market prices are not available, the fair value of these financial instruments is estimated by discounting future cash flows or by using similar recent transactions. Because considerable judgment is used, these estimates are not necessarily indicative of amounts that could be realized in a current market exchange. The Company does not carry its long term debt at fair value on its consolidated balance sheets. As at December 31, 2008, the Company estimated the fair value of its long term debt to be approximately $151.2 million and as at December 31, 2007, the Company estimated the fair value of its long term debt to be approximately equal to its carrying value as the debt was recently issued and pays a floating interest rate.
The Note indentures contain various covenants, including limitations on liens on the stock restricted subsidiaries, restrictions as to the disposition of the stock of restricted subsidiaries and limitations on mergers and consolidations. The Company was in compliance with all the covenants contained in the Note indentures at December 31, 2008 and 2007.
Interest expense includes interest payable and amortization of debt offering expenses. The debt offering expenses are amortized over the period from the issuance of the Deferrable Interest Debentures to the earliest date that they may be called by the Company. For the years ended December 31, 2008, 2007 and 2006, the Company incurred interest expense of $18.3 million, $18.7 million and $4.6 million, respectively, on the Deferrable Interest Debentures. Also, at December 31, 2008, 2007 and 2006, the Company had $1.4 million, $1.9 million and $0.5 million, respectively, of interest payable included in other liabilities.
(1) Conversion of restricted share units are net of shares withheld for the payment of tax on the employees’ behalf.
On September 22, 2008, the Company announced that its Board of Directors had approved the potential repurchase of company stock. The buyback program allows the Company to purchase, from time to time, its outstanding stock up to a value $60.0 million. Purchases under the buyback program are made with cash, at market prices, through a brokerage firm. During the period from October 2, 2008 to December 31, 2008 the Company purchased 697,599 shares for total consideration of $6.6 million. The timing and amount of repurchase transactions will be determined by the Company’s management, based on its evaluation of a number of factors, including share price and market conditions. The Company may decide at any time to suspend or discontinue the program.
In connection with the initial closing of the private placement for the Company’s common shares in December 2005, the Company issued a warrant to Haverford for its role in these capital raising activities (the “Warrant”). The Warrant has been classified as an equity instrument, in accordance with Emerging Issues Task Force Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock”. The Company has determined the Warrant to be compensatory and has recorded its fair value as compensation in the issuance period as there is no required service period. The Warrant granted the holder the right, at any time during the period commencing on December 1, 2010 and ending December 31, 2010, to purchase from the Company up to 12.0% of the issued share capital of the Company at the consummation of the initial private placements of the Company at an exercise price of $14.00 per common share.
Subsequently, in connection with the February 1 and February 23, 2006 additional closings of the private placement of 1,957,008 common shares, the Warrant was amended such that the number of common shares that could be issuable upon exercise of the Warrant would be 8,585,747, being 12.0% of the issued share capital as at February 23, 2006. The additional compensation expense based on the fair value on the date of grant was $3.4 million and is included in general and administrative expenses and in additional paid-in capital in the consolidated financial statements for the year ended December 31, 2006. This value has been calculated using the Black-Scholes option pricing model. The assumptions used were: risk-free interest rate 4.6%, expected life 4.8 years, volatility 25.0%, dividend yield nil. The volatility assumption was based on the average historical volatility of a group of comparable companies over a period equal to the expected life of the Warrant.
On July 1, 2008, Island Heritage Holdings Company (“Island Heritage”), in which the Company holds a controlling interest, issued 1,789 shares to certain of its employees under a performance share unit plan. Prior to this transaction, the Company held an ownership interest in Island Heritage of 59.6% and now holds an interest of 59.2%.
The Company accounts for share based compensation in accordance with SFAS 123(R), which requires entities to measure the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award. The cost of such services will be recognized over the period during which an employee is required to provide service in exchange for the award.
Since the inception of the PSU Plan no PSUs have vested and 2,368,658 PSUs have been cancelled.
A summary of the activity under the RSU Plan as at December 31, 2008, 2007 and 2006, and changes during the years ended December 31, 2008, 2007 and 2006 is as follows:
Since the inception of the RSU Plan in July 2006, 230,296 RSUs granted to employees have vested and no RSUs granted to employees have been cancelled. During the years ended December 31, 2008, 2007 and 2006, 55,715, 62,449 and 53,827 RSUs, respectively, were granted to the directors. During the years ended December 31, 2008, 2007 and 2006, 25,299, 11,216 and nil RSUs, respectively, granted to directors were converted into common shares of the Company as elected by the directors.
The Company uses a nil forfeiture assumption for its PSUs and RSUs. The intrinsic value of the PSUs and RSUs outstanding as of December 31, 2008 was $21.4 million and $2.8 million, respectively.
The computation of basic and diluted earnings per common share for the years ended December 31, 2008, 2007 and 2006 is as follows:
Also at December 31, 2008, 2007, and 2006, there was a warrant outstanding which would result in the issuance of common shares that were excluded from the computation of diluted earnings per common share because the effect would be anti-dilutive. These securities were as follows:
At December 31, 2008, the Company’s consolidated results include the results of Island Heritage from July 1, 2007 onwards. The portions of Island Heritage’s net income and shareholders’ equity attributable to the minority shareholders for the years ended December 31, 2008 and 2007 are recorded in the consolidated financial statements of the Company as minority interest. In relation to Island Heritage, the Company recorded a minority interest expense of $(0.6) million and $2.2 million for the years ended December 31, 2008 and 2007, respectively, and $16.5 million and $19.6 million, respectively, was included in minority interest on the consolidated balance sheets as at December 31, 2008 and 2007.
At December 31, 2008, the Company’s consolidated results include the results of Flagstone Africa from June 30, 2008 onwards (see Note 3). The portions of Flagstone Africa’s net income and shareholders’ equity attributable to minority shareholders for the year ended December 31, 2008 is recorded in the consolidated financial statements of the Company as minority interest. In relation to Flagstone Africa, the Company recorded a minority interest expense of $0.1 million for the year ended December 31, 2008 and $8.1 million was included in minority interest on the consolidated balance sheet as at December 31, 2008.
For 2008, the Company’s consolidated results include the results of Flagstone Alliance from October 1, 2008 onwards (see Note 3). The portions of Flagstone Alliance’s net income and shareholders’ equity attributable to minority shareholders of their subsidiaries for the period from October 1, 2008 to December 31, 2008 is recorded in the consolidated financial statements of the Company as minority interest.
Haverford sponsored the Company’s formation in October 2005 and invested $100.0 million in its initial private placement. The Company’s Executive Chairman, Mark Byrne (“Mr. Byrne”), and the Company’s Chief Executive Officer, David Brown (“Mr. Brown”), serve as directors of Haverford.
As at December 31, 2008 and 2007, Haverford directly owns 10.0 million common shares, or 11.8% and 11.7% respectively, of the Company’s outstanding common shares and is the holder of the Warrant which will entitle it to purchase up to an additional 8,585,747 common shares of the Company in December 2013. The impact of the conversion of the Warrant would increase Haverford’s ownership interest to 19.9% and 19.8% of the outstanding voting common shares at December 31, 2008 and 2007, respectively. The Company paid $1.0 million to Haverford in relation to services performed in respect of the initial private placement.
The Company entered into a consultancy arrangement with Meetinghouse LLC, a company controlled by the Chief Executive Officer of HCP. The consultancy arrangement provided for 150 hours of actuarial services at a rate of $500 per hour, for the period from December 2005 through March 2006. During the year ended December 31, 2006, expenses of $54,000 were incurred for services relating to business model development. These expenses have been recorded in general and administrative expenses.
On December 20, 2005 Flagstone entered into a 24-month Operational Support Agreement (“OSA”) with West End. Mr. Byrne and Mr. Brown had ownership interests in West End, of 70.6% and 16.6%, respectively. West End provided Flagstone with certain insurance management and related support services for a fee pursuant to an OSA. Flagstone incurred $nil and $1.0 million in expenses under the OSA for the years ended December 31, 2007 and 2006, respectively. Fees charged under the OSA were based on an hourly fee rate for certain individuals.
The Company entered into an excess of loss reinsurance agreement with Island Heritage under which the Company assumed a share of Island Heritage’s residential and commercial property risks. Premiums written under the agreement included in the Company’s consolidated financial statements during the years ended December 31, 2007 and 2006 amounted to $1.7 million and $1.4 million, respectively. Employees of the Company serve as directors of Island Heritage. As a result of the acquisition of the controlling interest in July 2007, the results of operations of Island Heritage have been included in the Company’s consolidated financial statements from July 1, 2007, and therefore, the results of the excess of loss reinsurance agreement from July 2007 onwards have been eliminated with the consolidation of Island Heritage’s results into the Company’s consolidated financial statements.
On March 31, 2006, the Company purchased all of the common shares of Mont Fort from Haverford for a purchase price of $0.1 million (see Note 5 “Mont Fort Re Limited”).
On June 6, 2006, the Company entered into a reinsurance agreement with Mont Fort in respect of Mont Fort ILW under which Mont Fort ILW assumed a share of the Company’s Industry Loss Warranty exposure. Premiums ceded to Mont Fort ILW during the year ended December 31, 2006 amounted to $15.1 million and $0.6 million was included in amounts due from related parties as at December 31, 2006. In accordance with the reinsurance agreement, the Company earned a ceding commission of $0.4 million from Mont Fort ILW during the year ended December 31, 2006. On August 28, 2006, Mont Fort repurchased the preferred shares held by the Company for $5.1 million, and Mont Fort in respect of Mont Fort ILW entered into a quota share reinsurance contract with the Company under which the Company assumes 8.3% of the business written by Mont Fort ILW.
On August 22, 2007, the Company, through its wholly owned subsidiary, Flagstone Leasing Services Limited (“Flagstone Leasing”) entered into a Share Purchase Agreement (“King Air Agreement”) with Mr. Byrne, owner of 100% of the issued and outstanding common voting shares of IAL King Air Limited (“IAL King Air”). Pursuant to the terms of the King Air Agreement, Flagstone Leasing, on August 28, 2007, acquired all of the issued and outstanding common voting shares of IAL King Air for a cash purchase price of $1.6 million. The purchase price equaled the value of the net assets acquired, inclusive of debt of $0.9 million. IAL King Air owned, as its principal asset, a King Air B-200 aircraft. The value attributed to the aircraft for the purpose of this transaction was determined by the average of two independent appraisals.
Effective, August 29, 2007 Longtail Aviation Limited (“Longtail”), an entity controlled by Mr. Byrne, entered into an Amalgamation Agreement (“Agreement”) with a wholly owned subsidiary of the Company, Longtail Aviation International Limited (“Longtail International”). Longtail provides support, maintenance and pilot services for the aircraft utilized by the Company in its worldwide operations. Pursuant to the terms of the Agreement, Longtail was, subject to certain regulatory approvals required by the Bermuda Registrar of Companies, amalgamated (merged) into Longtail International in consideration of payment for agreed net assets in Longtail as of July 31, 2007 and forgiveness of debt owed to Mr. Byrne by Longtail. Mr. Byrne, as Longtail’s principal shareholder received $1.9 million from Longtail International. The consideration paid to Mr. Byrne was equal to the net assets received by Longtail International.
In July 2006, the Company entered into a sale agreement with IAL for the purchase of a Westwind 1124A aircraft. The Company paid IAL $1.8 million for the private aircraft. The value for the transaction was determined by the average of two independent appraisals from qualified aircraft valuation experts. The transaction closed on July 31, 2006. Prior to the acquisition of Longtail in August 2007, Flagstone Westwind Holdings Limited (“Flagstone Westwind”), a wholly owned subsidiary of the Company, had entered into a 24-month management and joint use agreement on August 1, 2006 with Longtail for the management and charter of its Westwind 1124A aircraft. Pursuant to the agreement, Flagstone Westwind paid Longtail a management fee of $6,000 per month and received a fee from Longtail of $2,000 per charter hour flown. Flagstone Westwind bore the costs of maintaining the aircraft. As at December 31, 2006, Flagstone Westwind had an amount of $0.1 million due to Longtail which was included in amounts due to related parties.
During the year ended December 31, 2006, West End earned advisory and performance fees from Rockridge, Mont Fort and Island Heritage of $1.8 million, $1.3 million, and $39,044, respectively. As a result of the acquisition of the controlling interest in Island Heritage by the Company, the results of operations of Island Heritage have been included in the Company’s consolidated financial statements from July 1, 2007, and therefore, the investment advisory fees from July 1, 2007 onwards have been eliminated with the consolidation of Island Heritage’s results into the Company’s consolidated financial statements. Investment advisory fees earned from Island Heritage from January 1, 2007 through June 30, 2007 were $nil. With effect from January 12, 2007, the results of Mont Fort are consolidated in the Company’s consolidated financial statements, and therefore, Mont Fort’s investment advisory fees have been eliminated. During the year ended December 31, 2006, the Company earned investment advisory fees of $1.4 million from Value Capital L.P. A subsidiary of the Company was the General Partner of Value Capital L.P. On June 30, 2006, the Company terminated its investment advisory agreement with Value Capital L.P.
Affiliates of Lehman Brothers Inc. are shareholders of the Company and preferred shareholders of Mont Fort. Lehman Brothers Inc. provided additional investment banking services to the Company in connection with the initial private placement of the Company, for which it received fees of $2.0 million. Lehman Brothers Inc. acted as an underwriter of the Company’s initial public offering, for which it received fees of $3.4 million.
As at December 31, 2008 and 2007, substantially all of the Company’s cash and investments were held with 3 custodian banks.
For the year ended December 31, 2008, two brokers accounted for approximately 68% of gross premiums written and for the year ended December 31, 2007, three brokers accounted for approximately 83% of gross premiums written, each of which individually accounted for 10% or more of the total gross premiums written.
The Company and its subsidiaries lease office space and guest accommodations in the countries in which they operate under operating leases which expire at various dates. The Company renews and enters into new leases in the ordinary course of business as required. Total rent expense with respect to these operating leases for the years ended December 31, 2008, 2007 and 2006 was approximately $2.6 million, $1.2 million and $0.6 million.
During 2008, the company entered into an agreement to acquire an office building in Luxembourg. The building is currently under construction and is expected to be completed in 2009. The remaining balance of $4.3 million is to be paid as specific milestones are reached in the construction. Also during late 2008, the company signed agreements, totaling $4.1 million, for the purchase and modification of an aircraft.
Flagstone Suisse is licensed to operate as a reinsurer in Switzerland and is also licensed in Bermuda through the Flagstone Suisse Branch office and is not licensed in any other jurisdictions. Because many jurisdictions do not permit insurance companies to take credit for reinsurance obtained from unlicensed or non-admitted insurers on their statutory financial statements unless appropriate security mechanisms are in place, we anticipate that our reinsurance clients will typically require Flagstone Suisse to post a letter of credit or other collateral.
While each of Mont Fort and Haute Route are registered as Class 3 insurers in Bermuda the following disclosure focuses on Flagstone Suisse operating through its Bermuda branch as it is subject to the most onerous regulation and supervision.
In 2008, new statutory legislation was enacted in Bermuda, which included, among other things, the Bermuda Solvency Capital Requirement (“BSCR”) which is a standard mathematical model designed to give the BMA more advanced methods for determining an insurer’s capital adequacy. Underlying the BSCR is the belief that all insurers should operate on an ongoing basis with a view to maintaining their capital at a prudent level in excess of the minimum solvency margin otherwise prescribed under the Bermuda Insurance Act. Effective December 31 2008, the BMA requires all Class 4 insurers to maintain their capital at a target level which is set at 120% of the minimum amount calculated in accordance with the BSCR or an approved in-house model. The Company is currently completing the 2008 BSCR for its Class 4 insurers and at this time believes that Flagstone Suisse will exceed the target level of capital.
In respect of the Lloyd’s market , while the FSA regulates all insurers, insurance intermediaries and Lloyd’s itself, the FSA and Lloyd’s have common objectives in ensuring that the Lloyd’s market is appropriately regulated. To minimize duplication, the FSA has agreed arrangements with Lloyd’s by which the Council of Lloyd’s undertakes primary supervision of Lloyd’s managing agents in relation to certain aspects of the FSA’s regulatory regime.
Flagstone Alliance operates under license issued by the Cyprus Insurance Superintendent to conduct general reinsurance and insurance business. Cyprus law permits dividends to be declared only after profits have been allocated to the reserves required by law and to any reserves required by the articles of incorporation. The articles of incorporation of Flagstone Alliance do not require any specific reserves. Irrespective of the Cyprus Companies Law, Cap 113 requirements and the Company’s articles of association, the Company should maintain at any time reserves and assets that meet the Solvency criteria and Orders of the Cyprus Insurance Superintendent. The Company complies and reports to the Superintendent of Insurance under Solvency I requirements and the Solvency II requirements will be adopted in 2012. Share Premium Reserve and the reserve arising on the conversion of Share Capital to Euro are not distributable.
Short-tail Specialty and Casualty Reinsurance. We also provide short-tail specialty and casualty reinsurance for risks such as aviation, energy, accident and health, satellite, marine and workers’ compensation catastrophe. Most short-tail specialty and casualty reinsurance is written with loss limitation provisions.
This geographic area includes contracts that cover risks in two or more geographic zones.
All other schedules specified in Regulation S-X are omitted for the reason that they are not required, are not applicable, or that equivalent information has been included in the consolidated financial statements, and notes thereto.
SUMMARY OF INVESTMENTS-OTHER THAN INVESTMENTS IN RELATED PARTIES AS AT DECEMBER 31,
SFAS No. 107, “Disclosure about Fair Value of Financial Instruments” (“SFAS 107”), requires disclosure of fair value information of financial instruments. For financial instruments where quoted market prices are not available, the fair value of these financial instruments is estimated by discounting future cash flows or by using similar recent transactions. Because considerable judgment is used, these estimates are not necessarily indicative of amounts that could be realized in a current market exchange. The Company does not carry its long term debt at fair value on its consolidated balance sheets. As at December 31, 2008, the Company estimated the fair value of its long term debt to be approximately $97.5 million and as at December 31, 2007, the Company estimated the fair value of its long term debt to be approximately equal to its carrying value as the debt was recently issued and pays a floating interest rate.
Interest expense includes interest payable and amortization of debt offering expenses. The debt offering expenses are amortized over the period from the issuance of the Notes to the earliest they may be called by the Company. For the years ended December 31, 2008, 2007 and 2006, the Company incurred interest expense and amortization of debt offering expenses of $11.5 million, $13.7 million and $4.5 million on the Notes. Also, at December 31, 2008 and 2007, the Company had $0.8 million and $0.5 million, respectively, of interest payable included in other liabilities in the consolidated balance sheets.
As at and for the Periods Ended December 31, 2008, 2007, and 2006