We maintain our executive office at RAM Re House, 46 Reid Street, Hamilton HM 12 Bermuda. We lease two floors of these premises, occupying approximately 4,590 square feet of space. We believe that our current facilities are adequate to meet our needs for the foreseeable future.
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and accompanying notes which are presented under Item 8. It contains forward-looking statements that involve risks and uncertainties. Please see “Forward-Looking Statements” for more information. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this Form 10-K, particularly under the headings “Risk Factors” and “Forward-Looking Statements.”
In response to the economic and rating events referenced above, we are continuing efforts that we began in 2008 to reduce the volatility of our insured portfolio and evaluate our business model:
Capital preservation and evaluation: We reduced our new business growth in 2008 and have not written any business to date in 2009. We are evaluating our capital position in light of the ongoing deterioration in the credit markets to determine whether we have sufficient capital in excess of that required to pay claims and other obligations under various stress scenarios to pursue opportunities to deleverage our capital structure by repurchasing our outstanding securities and, in the longer term, new business opportunities.
Reducing expenses: In order to reduce expenses we are actively considering whether to de-list our common shares from trading on NASDAQ and de-register our securities under the Securities Exchange Act of 1934 as promptly as possible after the filing of this annual report on Form 10-K. If we de-list and de-register, we would no longer file annual, quarterly and current reports or proxy statements with the U.S. Securities and Exchange Commission. We estimate that these actions will reduce our expenses by at least $2 million per year, although the full effect of this cost savings is not expected until 2010. We also requested on March 17, 2009 that Moody’s withdraw our financial strength rating on March 17, 2009, which will result in us no longer paying an annual fee to Moody’s. We are also evaluating other measures to reduce expenses.
During 2008, we wrote only a modest amount of new financial guaranty business as compared to prior periods. We have not written any financial guaranty reinsurance to date in 2009. The following discussion concerns our business operations during 2008 and prior.
We provide reinsurance in two product lines: public finance and structured finance. Public finance obligations consist primarily of debt obligations issued by or on behalf of states or other governmental entities or their political subdivisions (counties, cities, towns and villages, utility districts, public housing and transportation authorities), other public and quasi-public entities (including public universities and not-for-profit hospitals, and non-U.S. sovereigns and their political subdivisions), private universities and hospitals and investor-owned utilities. Structured finance obligations are generally securities backed by pools of assets such as residential mortgage loans, consumer or trade receivables, securities, short-term bank deposits or other assets having a specified cash flow or market value which are generally held by a special purpose issuing entity.
RAM Re has been downgraded and was in a rating agency capital-constrained position
We have not renewed our reinsurance treaties with any of the primaries or otherwise written any new business in 2009.
The written premiums we receive are directly related to the amount and type of business assumed from primary insurers under treaty and facultative reinsurance contracts as well as to prevailing premium rates at the time of reinsurance cessions. Written premiums are usually received on an upfront basis for public finance transactions and earned over the life of a policy, while premiums for structured finance transactions are typically written on an installment basis and earned ratably over the installment period. Investment income is primarily a function of invested assets and the market interest rates prevailing at the time of investing money, as well as the type, credit quality and maturity of the securities purchased. Unrealized gains (losses) on credit derivatives are a function of changes in estimated fair value of our assumed credit derivative transactions (primarily credit default swaps). U.S. GAAP requires us to recognize unrealized gains and losses on credit derivative contracts to the extent that the estimated fair value of these contracts change from the beginning to the end of each reporting period, which is referred to as “mark-to-market” accounting. We expect these unrealized gains or losses to fluctuate primarily based on changes in credit spreads and underlying collateral performance of the contracts reinsured by us except for unrealized losses associated with credit impairments. Because such contracts are typically held to maturity, unless actual losses are incurred due to defaults, the cumulative unrealized gains and losses will net to zero at the end of the contract. Unrealized gains (losses) on other financial instruments reflect estimated fair values of instruments required to be measured at fair value on the balance sheet. These gains or losses are expected to fluctuate based on current market trends and the financial strength of the Company, among other factors.
Losses and loss adjustment expenses are a function of the amount and types of business we write and are based in part upon estimates of the case-basis and unallocated reserves as determined by the primary insurers, which are reviewed and revised by us as deemed appropriate, and related estimates by RAM Re management (See “Critical Accounting Policies - Losses and Loss Expense Reserves”). Acquisition costs are costs that vary with and are directly related to the production of new business. Certain acquisition costs are deferred and recognized over the period in which the related premiums are earned. Operating costs consist of general and administrative costs, which are primarily salaries and other employee-related costs. Operating costs do not generally vary with premium production. Interest expense is a function of outstanding debt and the contractual interest rate related to that debt, while dividends are a function of the amount of outstanding preference shares and the dividend rate on those preference shares.
For several years prior to 2007, interest rates were relatively stable at low historical levels and credit spreads were generally historically “tight” or narrow and new aggregate business production of primary insurers was about flat through mid-2007, although varying considerably by primary insurer.
In contrast, beginning in late 2007 through the present, a global credit crisis occurred, precipitated by heightened delinquencies and defaults in subprime mortgages which has spread to other types of mortgages and asset classes. This has resulted in dramatic widening of credit spreads, ratings downgrades of policies, a lack of price transparency, less liquidity and increased capital requirements for financial guarantors and other participants in the financial markets. As a result of these market conditions, pricing for the products we reinsure has improved (See Item 1. Business -” Pricing”). However, the difficult market conditions and recent rating agency actions have resulted in the reduction in our customer base and limited new business production from our existing customers (See Item 1. Business - “Customers”). We have suspended writing new business in 2009 and therefore will not benefit from the improved pricing in the market. If the adverse market conditions continue or worsen during 2009, we may incur greater losses, which would have an adverse effect on our business, financial condition, liquidity and results of operations. See Item I A. Risk Factors “Continuing adverse developments in the global economy and credit markets and their negative impact on RAM’s insured portfolio may continue to materially and adversely affect our financial condition, results of operations and future business.”
Our consolidated financial statements include amounts that, either by their nature or due to requirements of U.S. GAAP, are determined using estimates and assumptions. The actual amounts realized could ultimately be materially different from the amounts currently provided for in our consolidated financial statements. Critical accounting policies are those that management believes to be inherently complex and subjective. We believe loss and loss adjustment expense reserves, valuation of derivative financial instruments, valuation of the investment portfolio including other than temporary impairments of investments, determination of deferred acquisition costs and premium revenue recognition to be inherently complex and subjective, and therefore an understanding of the accounting policies pertaining to these items is critically important. These policies are summarized below, and described in further detail in the notes to our consolidated financial statements contained elsewhere in this Form 10-K filing, and the discussion that follows should be read in conjunction with our consolidated financial statements and the related notes.
If the Company’s remaining loss assumption is increased by 25% over our current assumptions (which approximates the effect of estimated peak monthly default rates continuing for an additional six months beyond the Company’s current nine-month assumption for second liens and 24-month assumption for first liens), we estimate the addition to our total loss and LAE reserve for 2005-2007 vintage US RMBS would be approximately $31.9 million.Management believes extending the peak default rate by 6 months is representative of a typical stress scenario and a prolonged recession period. Such estimated increase assumes our current remediation recovery estimates remain constant; however, our actual remediation recoveries could be lower than our current estimates if the sponsors of these transactions either: i) fail to honor their obligations to repurchase the mortgage loans; ii) successfully dispute the primaries’ breach findings; or iii) no longer have the financial means to fully satisfy their obligations under the transaction documents. In addition, such estimated increase does not include the effect of the stress scenario on approximately $89.1 million par outstanding of 2005-2007 vintage RMBS for which the Company has insufficient data to perform this analysis.
The Company believes that its methodology for determining total loss and LAE reserves is appropriate based on the methodologies explained to the Company by the ceding companies used to determine ceding company reserves and the analysis performed by the Company, which validates or results in adjustments to the ceding company reserves. Although the Company believes its methodology for determining loss reserves is appropriate, there can be no assurance that actual, ultimate losses will not be higher or lower than the Company’s reserves. The ultimate performance of the Company’s RMBS transactions remains highly uncertain and may be subject to considerable volatility due to the influence of many factors, including the level and timing of loan defaults, changes in housing prices and other variables.
Beginning in the fourth quarter of 2008, we reduced our case-basis loss reserves with respect to RMBS by the amount of expected recoveries from originators of the related RMBS transactions. Expected recoveries derive from contractual provisions in the related transaction documents which require that the originator repurchase securitized mortgage loans which do not conform to representations and warranties given by the originator at the time that the mortgage-backed securities were issued. The primaries are engaging in various forensic exercises in which they examine loan files to ascertain whether the loans conformed to the representations and warranties. The primaries then submit nonconforming loans to the originator for repurchases and in some cases, pursue legal actions against originators in cases where they refuse to repurchase the loans. Individual primaries began recording these remediation benefits in their case reserves in mid-2008, with all of our ceding companies recording remediation benefits at year end. Prior to the fourth quarter we did not have access to sufficient information to assess the reliability of the remediation benefits ceded by the primaries. In the fourth quarter, we began to record our pro rata share of the remediation benefits in the ceded case reserves as a result of additional supporting information received from the primaries,
Estimates of our reserves for loss and loss adjustment expenses are substantially dependent on the surveillance activities and reserving policies of the primary insurers and our estimates are subjective and are based on the judgment of both the primary insurer and our senior risk and finance personnel and, therefore, the final liability may materially differ from amounts estimated and reserved.
If we assume (i) the ratio of a ceding company’s unallocated reserves to its outstanding par was .05% (or .0005) and (ii) the ratio of our weighted average capital charge to that of the ceding company was 125% (or 1.25), then our unallocated reserve factor would be .000625, calculated as the product of the two ratios, (i) .0005 multiplied by (ii) 1.25, and the resultant factor of .000625 would be applied to the outstanding par ceded to us by that particular primary insurer, such that for each $1 billion of outstanding par ceded to RAM Re we would have an unallocated reserve of $625,000. The calculation described is performed individually for each of RAM Re’s major ceding companies and the resulting reserve factor is applied to our outstanding par ceded by that ceding company. Therefore, under our reserving practices, our unallocated reserves would be affected by occurrences such as changes in the reserving practices of the primary insurers (which could occur if estimates of default frequency or severities of loss were to change), changes in the weighted average capital charge for our portfolio exposures versus those of ceding companies (which could occur if modifications of capital charges by S&P were to impact RAM Re and the primary insurers differently) or developments in the credit quality of our portfolio relative to primary insurers. For example, if the reserve factors applied at December 31, 2008 were calculated as the product of (1) the highest ratio of unallocated reserves to outstanding par that we have calculated for each ceding company during the years 2006, 2007 or 2008 and (2) the highest ratio of our weighted average capital charge to the weighted average capital charge of each ceding company that we have calculated during the years 2006, 2007 and 2008, the calculation of unallocated reserves would have resulted in a value that was $5.0 million, or 35%, greater than that recorded at December 31, 2008. We believe that developments resulting in a change in unallocated reserve of this magnitude are reasonably possible in that the values employed in the above calculation, although they did not occur simultaneously, are based on actual past experience. We can provide no assurance that conditions resulting in a material increase in reserves of that amount or greater amounts will not develop or that final claim liabilities will not materially differ from amounts estimated and reserved. An increase in unallocated reserves, in the absence of any offsetting claims related activity, would directly impact reported financial results by increasing incurred losses and would also affect financial position by increasing the unallocated reserve balance, although an increase would not by itself impact liquidity in that the unallocated reserve does not affect cash flows.
RAM Re’s unallocated reserve is reviewed periodically by the Management Committee and the estimate may be modified if industry experience or company specific-developments are judged to warrant such an adjustment. For example, as at December 31, 2008, some of the primaries increased the unallocated reserves for residential mortgage-backed securities, which has been reflected in our unallocated loss reserve calculation, as discussed in the following paragraph.
Since mid-2007, there has been considerable stress in the U.S. residential mortgage market, particularly related to mortgage loans originated during 2005, 2006 and 2007. The Company is exposed to U.S. residential mortgages through our reinsurance of residential mortgage-backed securities, or “RMBS”, and indirectly through our guarantees of collateralized debt obligations or “CDOs”. CDOs are securities backed by portfolios of assets that may include a combination of bonds, loans, asset-backed securities, tranches of other collateralized debt obligations or credit derivatives representing any of the former. As of December 31, 2008 and 2007, we established $48.2 million and $26.4 million, respectively, of case reserves relating to 2005-2007 RMBS and $8.9 million and $15.6 million, respectively, of unallocated loss reserve relating to RMBS losses that are probable. The December 31, 2008 unallocated reserves for 2005-2007 RMBS is made up of $26.5 million unallocated loss reserves offset by $17.6 million transferred to case reserves in 2008. This addition to unallocated loss reserves is an
Through June 30, 2007, RAM valued its credit default swap portfolio using an internally developed model. While the model estimated an appropriate fair value during normal market conditions, the internal model output would not fully reflect the effect of market conditions and the large changes in credit spreads being experienced. Management therefore determined that a more appropriate basis for our estimate of fair value was to use as a key input, from September 30, 2007 onward, the valuation information provided to us by our ceding companies. RAM participates in credit default swaps through a reinsurance treaty with a ceding company and therefore the contract to be valued is a reinsurance contract on a derivative. This contract is not identical to the underlying credit default swaps. In particular, although RAM’s contract allows it to share in the economic results of the underlying contracts, it does not provide rights to the same information that the ceding companies have access to. Under FAS 157, the fair value of RAM’s contract represents the exit price that would be paid to a market participant to assume the reinsurance contract as written; that is, the amount the market participant would require to assume RAM’s potential obligations under the contract with the same contractual rights and obligations, including those which limit the information about the ceding companies’ underlying contracts that are being reinsured. Given the contractual terms that exist, RAM believes that an exit market participant would look to the information that is available from the ceding companies to determine the exit value of RAM’s reinsurance contract. The primary insurers underwrite each of the transactions underlying the reinsurance contract and they have access to all the underlying data related to the transactions. The ceding companies use their own internal valuation models where market prices are not available. RAM employs procedures to test the reasonableness of the mark both in process and absolute terms because we believe that an exit market participant would perform similar procedures when determining an exit price for our reinsurance contract. If it appears that the fair values generated by the ceding companies internal models and reported to RAM are consistent with macro spread movements and general market trends, and RAM believes that the modeling and assumptions that drive the modeling are reasonable (based on RAM’s ceding company audits and review of publicly available information), RAM will use the mark provided by the ceding company as a key input in the determination of the fair value of reinsurance contract. There is no single accepted model for fair valuing credit default swaps and there is generally not an active market for the type of credit default swaps insured by ceding companies and reinsured by us. Therefore, due to the limited availability of quoted market prices for these derivative contracts and the inherent uncertainties in the assumptions used in models, different valuation models may produce materially different results and be materially different from actual experience. In addition, due to the complexity of fair value accounting and the application of FAS 133 and FAS 157, future amendments or interpretations of FAS 133 and FAS 157 may cause us to modify our accounting methodology in a manner which may have an adverse impact on our financial results.
Valuation models used by our ceding companies generally come in two forms, based on our understanding of the models as described to us by our ceding companies:
The model takes account of transaction structure and the key drivers of market value. The transaction structure includes par insured, weighted average life, level of subordination and composition of collateral.
The model maximizes the use of market-driven inputs whenever they are available. The key inputs to the model are market-based spreads for the collateral, and the credit rating of referenced entities. These are viewed by us to be the key parameters that affect fair value of the transaction.
The primaries are able to use actual transactions to validate their model results and to explain the correlation between various market indices and indicative CDS market prices.
There is no exit market or actual exit transactions. Thus the exit market is a hypothetical one based on each primary’s entry market.
The averaging of spreads in the model and use of a single diversity factor rather than using specific spreads for each piece of underlying collateral and collateral-specific correlation assumptions may distort results.
As noted above, this calculation is based on estimates, involves a significant degree of management judgment and is sensitive to selected assumptions. Changes to the assumptions used in this valuation could lead to materially different results. For example, a change in RAM’s estimated spread would have a significant impact on the amount of the adjustment for RAM’s own non-performance risk. Adjustments to RAM’s non-performance risk will be recorded in the periods in which they become known or estimable by the Company.
We have provided tables to summarize unrealized losses in our investment portfolio in our financial statements provided in Item 8 - “Financial Statements and Supplementary Data” in this annual Form 10-K filing.
For policies retroceded, the Company receives ceding commissions to compensate for acquisition costs incurred. The Company nets ceding commissions received against deferred acquisition costs and earns these ceding commissions over the period in which the related premiums are earned.
Premium Revenue Recognition. Written premiums are received either as upfront premiums or in installments. Under our reinsurance agreements, whether treaty or facultative, we reinsure policies that will be in force over extended time periods corresponding to the life of the insured obligations, so although our reinsurance treaties are generally renewable annually, our reinsurance obligations are for the life of the policies.
Loss and loss adjustment expenses of $214.8 million during 2008, an increase of $166.8 million over the $48.0 million for the comparable 2007 period primarily associated with the continued deterioration in the performance of reinsured RMBS. Included in the loss and loss adjustment expenses is a net loss on commutations of $45.9 million (see “Commutations” below).
The transaction reduced the par amount of RAM’s insured portfolio by $3.5 billion of which $711 million related to 2005 - 2007 vintage ABS CDOs (all structured as credit derivatives) and $280 million of 2005 - 2007 vintage RMBS.
In December 2008 RAM Re commuted a further $158.3 million in par outstanding on two policies with another primary insurer. One policy was a partial commutation of $41.8 million par outstanding on a 2007 subprime RMBS whereas RAM Re’s total obligations on the second policy were terminated fully. The Commutation payment of $3.1 million reduced the total loss reserve accordingly.
Public finance gross written premiums, excluding the premiums returned on commutations, were $24.0 million in 2008, 67.2% less than in 2007 when public finance written premiums were $73.1 million. Public finance gross written premiums increased by 51.0% in 2007, from $48.4 million in 2006. The decrease in public finance gross premiums written in 2008 is a result of a reduction in the number of ceding companies we assume business from, a decline in the cessions from our ceding companies due to lower insured penetration of the public finance market and ceding companies ceding minimum amounts under the treaties. The increase in public finance gross premiums written in 2007 as compared to 2006 is largely due to the new treaties in 2007, along with increases within our existing treaties.
The following table sets forth the amounts of gross written premiums by product line:
not S&P) to the Aa-level. The remaining treaties that were in effect in 2007 were cancelled or expired in 2008. New business written for 2008 was minimal as a result of a number of factors arising out of the effect of the subprime and credit crisis on the financial guaranty industry as discussed in the “Overview” above. During 2007, the aggregate gross premiums written ceded by our three largest customers was slightly below the level of premiums written in 2006. While these customers ceded premiums written slightly below prior years, our other primaries with new treaties ceded the remaining increase in premiums written in 2007 over 2006. The average premium rates for public finance business assumed by RAM Re in 2008 were above the average rates of 2007, and the average premium rates for public finance business assumed by RAM Re in 2007 had been comparable to those of 2006. Structured finance business assumed by RAM Re in 2008 had average premium rates above those of 2007, while 2007 average premium rates for structured finance business assumed by RAM Re were lower than those of 2006. Premium rates reflect market conditions, the type and mix of business ceded by RAM Re’s customers and the credit quality of such business so that an increase or decrease in average premium rates is the result of a several factors.
Net Earned Premiums. Net earned premiums were $68.6 million in 2008, 34.5% above 2007 earned premiums of $51.0 million. In 2007, earned premiums increased by 15.1% from $44.3 million of earned premiums in 2006. The increase in 2008 as compared to 2007 is primarily due to a significant increase in refundings in 2008. Refundings for the year ended December 31, 2008 were $23.7 million, compared to $5.7 million for the comparable 2007 period. Accelerated earnings from refundings were $6.3 million in 2006. The refundings primarily resulted from issuers terminating certain variable rate demand bonds and auction rate securities and issuing fixed rate bonds as interest rates on insured bonds increased due to deteriorating credit of the insurers. Refundings represent an acceleration of earned premiums that occurs when an obligation that we have reinsured is retired or defeased prior to its scheduled maturity which, in turn, results in the recognition of any remaining unearned premiums and deferred policy acquisition costs associated with the obligation. The significant increases in upfront written premiums from the public finance business in past years, and growth in installment premiums from the structured finance business assumed in prior years contributed to the increase in 2007 as compared to 2006.
Realized (losses) gains and other settlements consists of credit derivative premiums received and receivable, which represents premium income relating to credit default swap policies (net of acquisition expenses) and loss and loss adjustment expenses on those policies. Included within realized gains and other settlements were premiums received and receivable of $12.4 million in 2008, an increase of 36.3% above 2007 premiums of $9.1 million. In 2007, premiums received and receivable increased by 102.2% from the $4.5 million in 2006. The growth in premiums received and receivable in 2008 over 2007 and 2007 over 2006 is due to the new treaties written in 2007 along with increased cessions from our primaries for 2007.
The net unrealized gains for the year ended December 31, 2008 were $94.3 million, a change of $272.1 million over the unrealized losses of $177.8 million in 2007. The unrealized gains in 2008 include reduction of previously recorded unrealized losses of $136.1 million and $95.9 million on commutations with MBIA and XLFA, respectively, as discussed above, offset by increased unrealized losses on credit derivative policies during the period. This increase in unrealized losses is primarily due to the continuing deterioration of underlying collateral on these policies and the corresponding widening credit spreads in the market, offset by the adjustment for RAM’s own non-performance risk in accordance with FAS 157 which was adopted at January 1, 2008. RAM is required to comply with FAS 157, which requires the Company to adjust for its own non-performance risk when measuring the fair value of its derivative liabilities. The effect of the change in RAM Re’s risk of non-performance can result in large variations in the credit derivative liability quarter- on-quarter, which is based on how the market perceives RAM Re’s creditworthiness. The effect of the FAS 157 adjustment for RAM’s creditworthiness resulted in a gain of $203.3 million to the net mark-to-market charge during the year ended December 31, 2008.
The unrealized gain or loss on credit derivatives will change based on the underlying assumptions and information used in the models and may not be indicative of ultimate claims. The credit derivative contracts we reinsure require us to make payments upon the occurrence of certain defined credit events relating to an underlying obligation. Credit derivative exposures are substantially similar to financial guaranty insurance contracts and provide for credit protection against payment default. We view our assumed reinsurance of credit derivative policies to be an extension of normal financial guaranty business and typically intend to hold derivative financial instruments to maturity, so that in the absence of an actual loss, the changes in fair value estimates will net to zero over the term of the assumed business. Changes in the fair value of
our derivative contracts do not reflect expected or actual claims or credit losses, unless otherwise identified as impairments, and have no impact on the Company’s claims-paying resources, rating agency capital or regulatory capital positions.
Net Realized Investment Losses. Net realized investment losses were $2.4 million in 2008, $3.6 million in 2007 and $1.0 million in 2006. During 2008, other than temporary impairments of $10.5 million were recognized. The Company recognized an additional $2.2 million during 2008, $3.6 million during 2007 and $Nil in 2006, relating to an investment with subprime exposure. The fair value of this investment was $0.2 million at December 31, 2008. The Company had a second investment with subprime exposure on which it realized a $0.1 million loss in 2008 and the fair value of this investment at December 31, 2008 was $0.2 million. Two other securities have been other than temporarily impaired during 2008. These were corporate bonds that realized a total of $8.2 million of losses and the combined fair value of these investments at December 31, 2008 was $0.9 million. These impairments were offset by net gains in 2008 of $8.1 million primarily a result of gains realized on sales of securities for commutation payments. The balance of the net losses realized in 2007 and 2006 were generally the result of modest repositioning within the portfolio achieved by selling certain securities and purchasing others believed to provide improved investment characteristics.
The continued deterioration of and the establishment of reserves relating to the RMBS deals, primarily those underwritten with vintages between 2005-2007. Case-basis loss reserves directly relating to subprime mortgages, Alt-A, Closed-End Seconds and Home Equity Lines of Credit (HELOCs) account for $26.4 million of the increase in loss and loss adjustment expenses.
We established a case reserve of $25.0 million for a life insurance reserve securitization transaction, which we refer to as a pooled actuarial insurance policy securitization - Reg XXX. Our total par outstanding exposure on this transaction is $108 million. Monies raised through the issuance of the insured notes were used to support present and future U.S. statutory reserve requirements related to the life insurance contracts. The monies raised were invested at inception of the transaction in certain investment accounts, which have incurred substantial mark-to-market losses since mid-year 2007, principally as a result of their exposure to subprime and Alt-A RMBS transactions. Credit losses have been realized on the securities in the investment accounts and significant additional credit losses are expected to occur. Performance of the underlying block of life insurance business thus far generally has been in accordance with expectations, and cash flows from the investment accounts and the life insurance contracts is currently sufficient to cover interest payments due on the notes we reinsure. Based on the analysis performed by the primary of estimates of future investment performance, projected credit impairments on the invested assets and performance of the block of life insurance contracts, we established a case reserve of $25.0 million for this transaction representing our proportionate share of the case reserve established by the primary.
sampled RMBS loan files to determine whether the loans conformed to the representation and warranties made by the originators. The sampled loans were either in later stages of delinquency or had been charged off. Those loans that showed a material breach of representations and warranties are in the process of being put-back to the originator for repurchase. All of the primaries have stated that they intend to vigorously pursue enforcement of the contractual repurchase obligations of the originators. We view the obligation to repurchase as a standard provision of RMBS securitizations that has been enforced for many years. Thus we view the inclusion of remediation credit taken by the primaries in our reserves to be probable and estimable and have assumed our proportionate share of the credit given by the primaries when establishing our case reserves.
(1) Includes $121.8 million paid in 2008 towards commutations with XLFA and MBIA (see “Commutations” above).
As a reinsurer we report outstanding exposure on a one-quarter lag, which is consistent with the reinsurance industry practice. However, we closely monitor any credit changes on an ongoing basis through discussions with the ceding companies and rating agencies and our loss and loss expense reserves are current as of the end of the applicable quarter reported. Accordingly, the tables below present the outstanding par balances of our RMBS and CDO exposures as reported by the primaries on September 30, 2008, except that we exclude amounts commuted back to MBIA per the Commutation Agreement dated November 30, 2008. However, we closely monitor any credit changes on an ongoing basis through discussions with the ceding companies and rating agencies and our loss and loss expense reserves are current as of the end of the applicable quarter reported. The RAM Re ratings shown in the tables below are based on the current ratings of the ceding companies and the rating agencies as of our review on February 27, 2009. See Note 16 in our December 31, 2008 financial statements contained elsewhere herein for information on the Commutation Agreements entered into during the year, whereby RAM Re commuted business previously ceded to RAM Re back to certain ceding companies and each of the RAM Re and the respective ceding companies released each other from all claims under the reinsurance agreements. Outstanding exposures in the tables below exclude exposure commuted back to these ceding companies per the Commutation Agreements.
As noted above, RAM Re generally follows the classifications for RMBS securities used by the ceding companies and reported to RAM Re. In general, the ceding companies define the various residential mortgage product types as follows:
Prime Firsts - First lien, predominantly single-family residential mortgage loans to prime borrowers. Prime borrowers typically have credit scores above 660, on average better than 680.
HELOCs - Revolving home equity lines of credit, typically second lien and floating rate. These loans are typically made to prime quality borrowers.
Alt-A - First-lien mortgage loans that generally conform to traditional prime credit guidelines, although the loan-to-value ratio (“LTV”), loan documentation, occupancy status, or property type, etc., may cause the loan not to qualify under standard underwriting programs. Alt-A loans may include reduced or limited documentation, including no verification of the borrower’s assets, employment or income.
The following table provides the break-down of RAM Re’s mortgage exposure outstanding as of December 31, 2008 for deals closed since January 1, 2005, by product type and RAM Re Rating3:
The typical RMBS securitization originally rated “A” or “BBB” by RAM Re is structured such that RAM Re’s exposure is to the senior-most risk layer. Accordingly, our outstanding par exposure represents a layer of risk starting from the rating shown in the table, up to and including the AAA risk layer. For example, $50 million of outstanding par exposure originally reported as BBB represents the senior-most risk ranging from BBB to AAA. By far the largest of the risk layers, and therefore most of the $50 million, is considered to be of AAA credit quality.
RAM Re also has exposure to mortgage collateral in CDOs. RAM Re’s exposure to significant mortgage collateral in CDOs is a subset of our CDOs backed by multi-sector (“MS”) collateral (see definition below).
The following table sets forth the RAM Re Rating of the MS CDOs in our portfolio as of December 31, 2008:
RAM Re’s MS CDO exposure can be seen in more detail in our multi-sector CDO table below.
HG - which are high-grade securities (rated single-A or higher, primarily AA),
The table below provides a listing of RAM Re’s multi-sector CDOs containing significant residential mortgage exposure and closed since January 1, 2005. The table lists each CDO transaction by vintage year and multi-sector type and provides the proportion of the collateral that is RMBS. The table also provides a break-down of the collateral into Subprime RMBS, Alt A, HELOCs, ABS CDOs, Non-ABS CDOs and
Transactions on the Watch List are divided into four categories generally based upon the following definitions. Category 1 includes transactions for which performance of the issue or that of an issuance participant is sufficiently below expectations where increased monitoring is required; however, the risk of loss remains remote. Category 2 transactions include those for which performance of an issue or that of an issuance participant is sufficiently below expectations where increased monitoring is required and remedial intervention by the ceding company is either planned or already in progress. Performance issues occur when the performance of an issue does not stabilize or improve over the intermediate term and concerns about the transaction’s ability to meet its debt service obligations may arise. If performance has deteriorated to the point where concerns about the issuer’s continued ability to meet debt service requirements on a timely basis are substantial, such transaction would be classified as a Category 3 transaction. Category 3 includes transactions where claims have been paid but recoveries are forecast for the claims. Category 4 transactions include those for which claims or loss adjustment expense payments are likely. Designation of a transaction as Category 4 generally coincides with the establishment of a case-basis loss reserve. Each transaction in Category 3 or 4 of the Watch List is generally reviewed quarterly to determine whether material changes are noted by the ceding company or by the Risk Management staff. If material adverse changes are identified, surveillance reports are requested from the ceding company and discussions are held to assess the deterioration and outlook for the credit.
RAM’s Management Committee establishes reserves that it believes are adequate to cover the present value of ultimate liability for losses and loss adjustment expenses. These reserves are based on estimates and may vary materially from actual results. Adjustments based on actual loss experience are recorded in the periods in which they become known.
Operating Expenses. General or operating expenses were $16.9 million in 2008, 26.1% higher than the $13.4 million in 2007. Operating expenses in 2007 were comparable to the $13.4 million in 2006. The increase in operating expenses for 2008 as compared to 2007 was due to increased costs associated with the renewal of our Directors and Officers (“D&O”) insurance coverage, a reduction in the amount of expenses deferred corresponding to the decline in new business written, along with an increase in audit fees in the current year. These increases are offset partially by the reduction in staff costs due to a decline in bonuses in 2008. Operating expenses in 2007 included $0.5 million of non-recurring secondary offering costs, and 2006 included $2.3 million in non-recurring costs related to the IPO. Without these non-recurring costs, operating expenses increased by 16.2% in 2007 over 2006, primarily reflecting the ongoing costs of being a public company.
Interest Expense. Interest expense was $8.4 million in both 2008 and 2007 and $2.8 million in 2006. Preference share dividends, classified as interest expense, of $5.6 million were paid during both 2008 and 2007. The preference shares were issued on December 14, 2006 and therefore no dividends were paid in 2006. Dividends on the preference shares are payable semi-annually on June 15 and December 15 each year if declared by the Board of Directors. Interest expense also includes interest expense on the Company’s long term debt. Interest on long term debt was $2.8 million for all years reported.
At December 31, 2008, all but one of the Company’s investments were valued using the independent pricing services. One security, which had a fair value of $0.2 million, has no active market and includes subprime exposure, was valued using a non-binding broker quote. This security is included within level 3 in the fair value hierarchy.
As management is ultimately responsible for determining the fair value measurements for all securities, the Company assesses the reasonableness of the fair values received by comparing them to other pricing information readily available and management’s knowledge of the current markets. The Company also assesses the pricing methodologies and related inputs used by the pricing services to estimate fair value. Any prices that, in managements’ opinion, may not be representative of fair value are challenged with the pricing service. Based on the information obtained from the above reviews, the Company evaluated the fixed income securities in the investment portfolio to determine the appropriate FAS 157 fair value hierarchy level based on trading activity and observability of inputs. Based on the Company’s evaluation, each security was classified as Level 1, 2, or 3. Prices with observable market inputs were classified as Level 2, prices on money market funds and US treasuries were classified as Level 1, and valuations with no significant observable inputs were classified as Level 3 as of December 31, 2008.
The following table presents changes in the net credit derivative liabilities balance for which fair value was measured under Level 3 for the year ended December 31, 2008:
The Company’s fair value on Other Financial Instruments relates to the put option on the Company’s preference share soft capital facility, which represents the value to the Company in the current market environment. The put option is a financial instrument and is required to be fair valued. As at December 31, 2008, the unrealized gain on this put option was $43.1 million and is included in other financial instruments on the consolidated balance sheet. The movement in fair value of $7.8 million for the year ended December 31, 2008 is included as an unrealized gain on other financial instruments in the statement of operations. Valuations are based on unobservable inputs including assumptions over the Company’s performance and future outlook, the facility, the current market conditions, and other similar instruments in the market. Assumptions include the current rate paid for the facility (LIBOR plus 300 bps at December 31, 2008), the term of the facility and the Company’s rating, along with judgmental factors such as the market perception of the facility and the Company.
The following table presents the Other Financial Instruments for which fair value was measured under Level 3 for the year ended December 31, 2008:
Credit impairments on our credit default swaps are a non GAAP metric which management believes is useful to analysts, rating agencies and investors to review the results of our entire portfolio of policies. Management considers our credit derivative policies as a normal extension of our financial guarantee business and reinsurance in substance. The Company measures and monitors credit impairments which are expected to be paid out over the term of the credit derivative policies. As at December 31, 2008 and December 31, 2007, the Company estimates credit impairment reserves amounting to $6.0 million and $44.4 million, respectively. The decline in the credit impairments is primarily due to the commutation of ABS CDO’s with credit impairments during the year.
Liquidity. RAM Holdings is a holding company and therefore our liquidity, both on a short-term basis (for the next twelve months) and a long-term basis (beyond the next twelve months), is largely dependent upon (1) the ability of RAM Re to pay dividends or make other payments to us and (2) our ability to access the debt and equity markets, which is unlikely in the near term given current market conditions and the Company’s current share valuation. Our principal uses of liquidity are for payment of interest on our senior notes, non-mandatory dividends on our preference shares and capital investments in RAM Re. On March 19, 2009, RAM Re’s Board approved a dividend of $2.8 million from RAM Re to RAM Holdings’. Based on the amount of dividends that we received on March 19, 2009, we believe that we will have sufficient liquidity to pay interest on our senior notes over the next twelve months. RAM Re’s ability to declare and pay dividends to us may be influenced by a variety of factors such as adverse loss development, insurance regulatory changes and changes in general economic conditions, beyond the next twelve months, the amounts required to be held by us in trust for the benefit of our U.S. regulated customers and Bermuda law as described below. Consequently, although we believe that we will continue to have sufficient liquidity to meet our obligations over the long term, we cannot guarantee that RAM Re will be able to dividend amounts sufficient to satisfy all our obligations, and there can be no assurance that dividends will be declared or paid in the future.
RAM Re may declare dividends, provided that, after giving effect to the distribution, it would not violate certain statutory equity, solvency and asset tests. The Bermuda Insurance Act requires RAM Re to meet a minimum solvency margin equal to the greater of (i) $1.0
million, (ii) 20% of net premiums written up to $6.0 million plus 15% of net premiums written over $6.0 million, and (iii) 15% of loss and other insurance reserves. To satisfy these requirements, RAM Re was required to maintain a minimum level of statutory capital and surplus of $15.3 million at December 31, 2008. RAM Re’s statutory capital and surplus was $158.4 million at December 31, 2008. In addition to the solvency margin, the Bermuda Insurance Act requires RAM Re to comply with a liquidity ratio whereby the value of its relevant assets must be not less than 75% of the amount of its relevant liabilities. In the event RAM Re fails to meet its Relevant Margins on the last day of any financial year, it shall not without the approval of the Bermuda Monetary Authority (the “BMA”), declare or pay any dividend during the next financial year. In addition, under the Bermuda Insurance Act, Class 3B insurers are prohibited from declaring or paying any dividends of more than 25% of its total statutory capital and surplus, as shown on its previous financial year statutory balance sheet, unless at least seven days before payment of the dividends it files with the BMA an affidavit that it will continue to meet its required solvency margins. Based upon these tests, without filing an affidavit with the BMA, the maximum amount that will be available during 2009 for payment by RAM Re is approximately $39.6 million, which amounts may be further restricted by Enhanced Credit Requirements expected to be applied by the BMA to Class 3B insurers in the future. See Item 1 - “Business - Regulation in Bermuda”.
On September 24, 2008 RAM Re was downgraded by S&P to A+ from AA and on December 4, 2008 RAM Re was downgraded by Moody’s to Baa3 from A3. On March 17, 2009, RAM Re requested that Moody’s withdraw its rating. The downgrade of RAM Re’s ratings has had an adverse effect on RAM Re’s ability to compete in the financial guaranty reinsurance industry and significantly decreased the value of the reinsurance provided. Due to the above mentioned downgrades, certain ceding companies have the right, after a cure period, to increase the ceding commission, as stipulated in the treaties, or terminate the treaties and recapture the business previously ceded to RAM Re whether written in financial guaranty or credit derivative form. To the extent policies are recaptured, RAM must forfeit to the ceding company an amount determined by formula under each treaty which generally consists of RAM’s allocated share of the U.S. statutory unearned premium, net of the ceding commission paid by RAM to the ceding company (subject to a penalty amount in some cases), and loss reserves established with respect to the policies ceded, as applicable. U.S statutory premiums usually earn at a slower rate than GAAP premiums and therefore any forfeiture of U.S. statutory unearned premiums would result in a loss on a GAAP basis. In some cases, the ceding companies have the right to select specific years of business written to recapture, and a decision by a ceding company to recapture, for example, all business written prior to 2006, could have a material adverse effect on RAM Re because of the projected losses associated with the business written in the last three years. As of April 13, 2009, none of the primaries have recaptured any business. The commutations negotiated during the year were not a result of these treaty terms. As at December 31, 2008, we have accrued or paid additional ceding commissions related to the S&P downgrade totaling $20.3 million which is being expensed as the related premiums are earned. We are unable to estimate any further ceding commission increase resulting from the Moody’s downgrade because Moody’s has not yet established the amount of further reinsurance credit we provide to each of the primaries at the Baa3 level.
At December 31, 2008, the Company has $438.9 million of cash and investments of which $378.9 million is held in trust for the benefit of our ceding companies, leaving $60.0 million cash and investments available for the cost of ongoing business. The trust accounts are required to hold cash and investments equivalent to unearned premiums, case-basis loss reserves and credit impairments, and a contingency reserve calculated by the ceding companies, and the balances are adjusted at least annually. Currently, losses are paid out of unrestricted cash rather than our trust accounts which reduces available cash until the trust accounts are adjusted. Subsequent to December 31, 2008, approximately $32.9 million was released from the trust accounts to the Company’s operating account.
On December 14, 2006, the Company issued 75,000 preference shares at $1,000 per share for total consideration of $75.0 million. Underwriting expenses were $0.75 million and other issuance costs were approximately $0.3 million resulting in estimated net proceeds of approximately $73.9 million all of which was contributed to RAM Re to support new writings in its reinsurance business. The preference shares bear a dividend rate of 7.50% which is payable semi-annually on June 15 and December 15 each year upon approval by the Board of Directors. Unless previously redeemed, the preference shares have a mandatory redemption date of December 15, 2066. We can redeem the preference shares at any time from December 15, 2016 with no penalty to the Company but redemptions prior to that would require a redemption price equal to par value plus a “make-whole” amount reflecting the value of dividends for the remainder of the period to December 15, 2016. During the years ended December 31, 2008 and 2007, dividends amounting to $5.6 million have been declared and paid. There were no dividends declared or paid in 2006.
Our finance personnel monitor the portfolio for performance and adherence to policies, including market valuation, credit quality, portfolio duration and liquidity. We have a formal review process for all securities in our investment portfolio, including a review for impairment losses based on the factors described above under “Critical Accounting Policies - Valuation of Investment Portfolio.” We have recognized other than temporary impairments totaling $10.5 million relating to two investments with subprime exposure and two investments in corporate bonds at December 31, 2008. We had recognized an other than temporary impairment of $3.6 million relating to a single investment with subprime exposure at year-end 2007. The following table summarizes our investment portfolio by bond type, fair value and amortized cost thereof at December 31, 2008 and December 31, 2007:
In the ordinary course of business, we manage a variety of risks, primarily credit, market, liquidity and legal. These risks are identified, measured and monitored through a variety of control mechanisms, which are in place at different levels throughout the organization.
Like other reinsurers, we rely for both our facultative and treaty-based business on the surveillance and remediation activities of the primary insurers that provide us with updated information on the performance of the transactions in our reinsured portfolio. The surveillance information provided to us by the primary insurers is supplemented by our own independent evaluations of the analysis and underlying performance data provided by the ceding primary with regard to watch list transactions and verification (where possible) of ratings information provided by the primary insurers on large exposures and on transactions where significant discrepancies are evident between a ceding primary insurer’s internal rating and the reported ratings of S&P or Moody’s. These results are reviewed periodically by senior finance and risk management personnel. Our management committee determines the adequacy of our loss reserves and makes any necessary adjustments following such assessment.
Our investment portfolio is managed by a professional asset management firm, New England Asset Management. Our investment policies are designed to require the portfolio to be managed in a manner that preserves principal, provides long term predictable growth while maximizing income, meets statutory requirements, provides adequate liquidity to meet claims and other cash needs and maintains high credit quality. Our investment policy and guidelines as adopted by our board specify eligible investments and establish a portfolio duration target, high liquidity, minimum credit ratings, single-risk limits, diversification and asset allocation standards. Our finance personnel review our portfolio for compliance with investment policies and procedures; and the Risk Management Committee of our Board of Directors reviews investments and performance reports and discusses those reports with our portfolio managers at least quarterly.
Changes in interest rates may adversely affect the value of fixed income investment securities. The following table summarizes the estimated change in fair value on the net balance of investment securities and cash in the investment portfolio, assuming immediate changes in interest rates at specified levels at December 31, 2008:
credit protection against payment default. The primary insurer enters into these types of contracts, which require the insurer to make payments upon the occurrence of certain defined credit events relating to underlying obligations. If credit spreads relating to the underlying obligations change, the market value of the related credit derivative changes accordingly. Market liquidity can also impact valuations of the underlying obligations, resulting in gains or losses. Changes in credit spreads are generally caused by changes in the market’s perception or market liquidity of the credit quality of the underlying obligations. As credit spreads change, we experience unrealized fair value gains or losses on credit derivative transactions reinsured by us. We generally hold these derivative contracts to maturity. The unrealized gains and losses on derivative financial instruments will amortize to zero as the exposure approaches its maturity date, unless there is a payment default on the exposure. Changes in credit spreads can result in large variations in the credit derivative liability quarter on quarter, resulting in further losses if credit spreads widen and gains if the spreads tighten. See “FAS 157 disclosures” for the effect of changes in the Company’s estimated non-performance credit risk on our derivative balances.
Legal Risk. Legal risks include uncertainty with respect to the enforceability of rights under our contractual agreements and with respect to the enforceability of rights under the financial guaranty policies which we reinsure. We seek to remove or minimize such uncertainties through consultation with internal and external legal advisers to analyze and understand the nature of legal risk, to improve documentation and to understand transaction structure.
1. Premium revenue will be recognized as a function of the amount of insurance protection provided over the contract term.
In February 2007, the FASB issued FAS No. 159 (“FAS 159”), Fair Value Option for Financial Assets and Financial Liabilities. This statement provides companies with an option to report selected financial assets and liabilities at fair value. The statement requires the fair value of the assets and liabilities that the company has chosen to fair value be shown on the face of the balance sheet. The standard also requires companies to provide additional information to enable users of the financial statements to understand the company’s reasons for electing the fair value option and how changes in the fair values affect earnings for the period. FAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. This statement is effective for fiscal years beginning on or after November 15, 2007. The Company adopted FAS 159 effective January 1, 2008. The fair value option was not applied to any eligible items on the adoption date.
As of December 31, 2008, management has evaluated the effectiveness of the Company’s internal control over financial reporting based on the criteria established in “Internal Control-Integrated Framework,” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, we have concluded that RAM Holdings Ltd.’s internal control over financial reporting was effective as of December 31, 2008.
To the Board of Directors and Shareholders of RAM Holdings Ltd.
RAM Re is a Bermuda-based company whose principal activity is the reinsurance of financial guarantees of public finance and structured finance debt obligations insured by monoline financial guaranty companies (the “primary insurers” or the “primaries”). We refer to the primaries that reinsure with RAM Re as “ceding companies”. RAM Re provides reinsurance through treaty and facultative agreements that it maintains with each of its customers. Financial guaranty reinsurance written by RAM Re generally provides for guarantees of scheduled principal and interest payments on an issuer’s obligation in accordance with the obligation’s original payment schedule and, in rare circumstances, such amounts are payable on an accelerated basis.
The principal sources of RAM Re’s liquidity are gross written premiums, scheduled investment maturities, existing soft capital facilities and net investment income. The principal uses of RAM Re’s liquidity are for the payment of operating expenses, claims, ceding commissions, reinsurance premiums, dividends on RAM Re preference shares, dividends to RAM Holdings and for purchases of new investments and more recently funding commutation agreements. We believe that RAM Re’s expected operating liquidity needs can be funded from its operating and investing cash flows for the next twelve months. Further increases in loss reserves and credit impairments would require RAM Re to deposit additional collateral in the applicable trust account(s); and resulting claims payments in respect of those losses and impairments would increase cash outflows and could decrease the size of RAM Re’s investment portfolio, in turn decreasing income from investments.
RAM Re may declare dividends, provided that, after giving effect to the distribution, it would not violate certain statutory equity, solvency and asset tests. The Bermuda Insurance Act requires RAM Re to meet a minimum solvency margin equal to the greater of (i) $1.0 million, (ii) 20% of net premiums written up to $6.0 million plus 15% of net premiums written over $6.0 million, and (iii) 15% of loss and other insurance reserves. To satisfy these requirements, RAM Re was required to maintain a minimum level of statutory capital and surplus of $15.3 million at December 31, 2008. RAM Re’s statutory capital and surplus was $158.4 million at December 31, 2008. In addition to the solvency margin, the Bermuda Insurance Act requires RAM Re to comply with a liquidity ratio whereby the value of its relevant assets must be not less than 75% of the amount of its relevant liabilities. In the event RAM Re fails to meet its Relevant Margins on the last day of any financial year, it shall not without the approval of the Bermuda Monetary Authority (the “BMA”), declare or pay any dividend during the next financial year. In addition, under the Bermuda Insurance Act, Class 3B insurers are prohibited from declaring or paying any dividends of more than 25% of its total statutory capital and surplus, as shown on its previous financial year statutory balance sheet, unless at least seven days before payment of the dividends it files with the BMA an affidavit that it will continue to meet its required solvency margins. Based upon these tests, without filing an affidavit with the BMA, the maximum amount that will be available during 2009 for payment by RAM Re is approximately $39.6 million, which amounts may be further restricted by Enhanced Credit Requirements expected to be applied by the BMA to Class 3B insurers in the future.
Management believes that the Company has sufficient capital resources and liquidity to meet its obligations for at least the twelve months subsequent to the balance sheet date and therefore that the Company remains a “going concern”, even if the Company does not write any new business during that time period.
As discussed in Note 1, RAM Holdings Ltd and RAM Holdings II Ltd were amalgamated on May 1, 2006 and these consolidated financial statements reflect the amalgamation. There was no effect to shareholders’ equity or results of operations on amalgamation. The consolidated accounts of Holdings include those of its subsidiary, RAM Re. All significant intercompany balances have been eliminated on consolidation.
The Company considers all highly liquid investments, including fixed-interest and money market fund deposits, with a maturity of 90 days or less when purchased as cash equivalents.
The Company has classified its fixed-maturity investments as available for sale as defined by Statement of Financial Accounting Standards No. 115 (“SFAS 115”). Available for sale investments are carried at fair value, with unrealized appreciation or depreciation reported as a separate component of accumulated other comprehensive income. The Company’s fair values of fixed maturity and short-term investments are based on prices obtained from nationally recognized independent pricing services. All investment transactions are recorded on a trade date basis. Realized gains and losses on sales of fixed maturity investments are determined on the basis of amortized cost. Gains and losses on sale of investments are included in investment income when realized. The cost of securities sold is determined using the specific identification method. Short-term investments are carried at amortized cost, which approximates fair value, and include all securities with maturities greater than 90 days but less than one year at time of purchase. All declines in fair value below cost that are considered other than temporary are recognized in income. Factors considered when assessing impairment include: (i) securities whose market values have declined by 20% or more below amortized cost for a continuous period of at least six months; (ii)
credit downgrades by rating agencies; (iii) the financial condition of the issuer; (iv) whether scheduled interest payments are past due; and (v) whether the Company has the ability and intent to hold the security for a sufficient period of time to allow for anticipated recoveries in fair value. The Company’s investment guidelines require the orderly sale of securities that do not meet investment guidelines due to a downgrade by rating agencies or other circumstances, unless otherwise authorized by management to hold.
Deferred policy acquisition costs comprise those expenses that vary with and are primarily related to the production of business, including ceding commissions paid on reinsurance assumed, a portion of salaries and related costs of underwriting personnel, rating agency fees, and certain other underwriting expenses. Policy acquisition costs are deferred and amortized over the period in which the related premiums are earned. Policy acquisition costs related to insured derivative transactions are expensed as incurred. When assessing the recoverability of deferred policy acquisition costs, the Company considers the future earnings of premiums paid upfront, the estimated present value of net installment premiums to be received and anticipated investment income and compares this to the sum of unamortized policy acquisition costs and expected loss and loss adjustment expenses. This comparison is completed by underwriting year and risk type. If a premium deficiency were calculated the unamortized acquisition costs would be reduced by a charge to expense.
The Company’s liability for losses and loss adjustment expenses consists of case-basis reserves and an unallocated reserve.
Case-basis reserves are established based on ceding company reports and internal review and evaluation of exposures related to guaranteed obligations that either have already defaulted or have a high and estimable probability of default. Management’s review and analysis of case-basis reserves includes an analysis of the present value of the expected ultimate losses and loss adjustment expense that the Company expects to pay less estimated recoveries. The amount of the expected loss, net of expected recoveries, is discounted based on a discount rate of approximately 5% for all periods presented. Changes to the ceding company’s reserves are reported at regular intervals and are reviewed for reasonableness by the Chief Risk Manager and the Company’s Management Committee.
Case-basis reserves for policies with installment premiums are established net of expected future installments premiums, as such premiums are considered a form of recovery when installment premiums are considered collectible. Case-basis reserves established for policies with upfront premiums do not reflect the benefit of deferred premium revenue, which the Company continues to earn over the remaining life of the policy.
The Company maintains an unallocated reserve as established by the Management Committee and estimated based on the composition of our outstanding par exposure and reserve factors applied to this exposure so that, all else being equal, increases in outstanding par will result in increases in unallocated reserves. Our reserve factors are the product of i) the ratios of the unallocated reserves of our ceding companies relative to their outstanding exposures and ii) the credit risk of our outstanding exposure relative to the credit risk of the portfolios of our ceding companies, where credit risk is assessed by weighted average capital charges (a commonly recognized measure of credit risk promulgated by S&P). RAM Re’s insured portfolio is segregated by primary insurer, and the above ratios are calculated individually by primary insurer. Therefore, changes in the following factors would result in changes in our unallocated reserves under our current practices:
Additionally, management considers internal guidelines in place which address the procedures followed to determine that the total best estimate continues to be based upon expected loss experience over the long term and is not overly influenced by one short term development on one loss. Specifically, the Management Committee has two guidelines with respect to the interaction of unallocated (excluding any calculated by management on specific policies) and case reserves. No more than 20% of the unallocated reserve balance at quarter end can be reduced to offset a case reserve associated with a single default. No more than 50% of the unallocated reserve balance at year end can be reduced to offset aggregate case reserve activity during the following year. These internal guidelines are not mandatory as they are subject to management judgment based on specific facts and circumstances.
The Company recognizes that there is diversity in practice among financial guaranty insurers and reinsurers with respect to their accounting policies for unallocated loss reserves. Current accounting literature, specifically FASB Statement of Financial Accounting Standards No. 60 “Accounting and Reporting by Insurance Enterprises” (FAS 60) and FASB Statement of Financial Accounting Standards No. 97 “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments” (“FAS 97”), do not specifically address the unique characteristics of financial guarantee insurance contracts. Consequently, the accounting principles applied by the industry, as well as the Company, have evolved over time and incorporate the concepts of both short-duration contracts, accounted for under the provisions of FAS 60 and long duration accounting under FAS 97, as well as other accounting literature, such as FASB No. 5 “Accounting for Contingencies” and Emerging Issues Task Force (“EITF”) Issue No. 85-20 “Recognition of Fees for Guaranteeing a Loan”. The Company will continue its loss reserving methodology as noted above until the adoption of FAS 163. See recent accounting pronouncements (part 2(k) of this note) for further discussion of this issue.
Level 3 inputs - valuations based on significant inputs that are unobservable.
Under FAS 157, the use of valuation information provided to us by our ceding companies remains appropriate for the reasons described above, as well as the fact that the credit default swaps we reinsure are the same as that valued by our primaries, and the Company views its hypothetical principal market to be the same as our primaries, being the financial guaranty insurance and reinsurance market. The Company’s fair value on credit derivatives is adjusted for the Company’s own non-performance risk in accordance with FAS 157 (see Note 4, Derivative instruments).
The put option relating to the Company’s preference share soft capital facility is a financial instrument and is fair valued with the fair value measurement representing the value to the Company in the current market environment. The gain or loss on the put option is recorded on the consolidated balance sheet and changes in fair value are reported through the statement of operations in “Unrealized Gain/(Loss) on Other Financial Instruments”. Valuations are based on unobservable inputs including assumptions over the Company’s performance and future outlook, the facility, the current market conditions, and other similar instruments in the market. Subsequent to year end on February 17, 2009, the put option was exercised.
On May 23, 2008, the Financial Accounting Standards Board (“FASB”) issued FASB statement No.163 “Accounting for Financial Guarantee Insurance Contracts” (“FAS 163”). FAS 163 clarifies how FASB Statement No.60 “Accounting and reporting by Insurance Enterprises” applies to financial guaranty insurance contracts. FAS 163 is focused on the recognition and measurement of premium revenue and claims liabilities, along with additional disclosure requirements for financial guaranty contracts. The standard requires the following:
2. Present value of installment premiums due pursuant to the terms of a financial guaranty insurance contract will be recognized at inception of the contract as unearned premiums and premiums receivable, which is inconsistent with current industry accounting practice.
3. A claim liability will be established on a financial guaranty contract when the probability weighted net present value of an expected claim loss is estimated to exceed the related unearned premium revenue. Provision of unallocated reserves is not permitted under the standard.
In October 2008, the FASB issued FASB Staff Position No. 157-3 “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“FSP 157-3”). FSP 157-3 clarifies the application of FAS 157 in an inactive market and the provisions of the FSP were effective upon issuance. FSP 157-3 did not have an effect on the Company’s results of operations or financial position. The Company had minimal assets in its investment portfolio which were not active at December 31, 2008. The provisions were applied to its financial instrument asset (see Note 10).
The following table provides the components of “net change in fair value of credit derivatives” included in the Company’s consolidated statement of operations related to our credit derivative policies:
CDS contracts written by financial guarantors are neither held for trading purposes (i.e., a short-term duration contract written for the purpose of generating trading gains) nor used as hedging instruments. Instead they are written with the intent to provide protection for the stated duration of the contract, similar to the financial guarantor’s intent with regard to a financial guaranty contract.
There is a very limited market in which to verify the fair values developed by the model.
The primary believes its model is a well-documented, consistent approach to marking positions that minimizes the level of subjectivity. The primary has also developed a hierarchy for market-based spread inputs that helps reduce the level of subjectivity, especially during periods of high illiquidity.
The primary weaknesses of the Expected Loss Method of valuing CDS are:
Fair values from the ceding companies’ models may differ from values calculated by companies outside of the financial guaranty industry because, according to the ceding companies, the terms of the CDS contracts insured generally differ from other non-insured credit default swap contracts. Because of these terms and conditions, the fair value of the ceding companies’ credit derivatives may not reflect the same prices observed in an actively traded market of CDS that do not contain terms and conditions similar to those observed in the financial guaranty market. These models and the related assumptions are continuously reevaluated by the ceding companies and enhanced, as appropriate, based upon improvements in modeling techniques and availability of market information.
The definitions of the collateralized debt obligation (“CDO”) types in the above table are as follows:
IG - Investment grade corporate (predominantly corporate, may include limited ABS)
HY - Non-investment grade corporates, predominantly CLOs backed by corporate loans
MS - Multi-sector collateral, which may include MBS (including subprime), ABS, CDOs, CMBS and other asset-backed securities
RAM Re ratings are current as of February 27, 2009. These ratings are assigned by RAM Re based on management’s judgment and take into consideration the ratings assigned by the ceding companies and the rating agencies. RAM Re undertakes no obligation to update its ratings, and such ratings do not constitute investment advice.
In compliance with the requirements of FAS 157, the Company considered its own non-performance risk when measuring the fair value of a liability.. An adjustment to these valuations is needed to reflect RAM’s own non performance risk in the measurement of the fair value of these liabilities.
There is no observable credit spread for RAM Re or RAM Holdings, and as such there is inherently a significant amount of judgment, subjectivity and uncertainty involved in the estimation of the adjustment for RAM’s non performance risk. Management has used inputs that reflect assumptions market participants may use in pricing RAM’s creditworthiness. In determining the Company’s own non-performance risk when measuring the fair value of a liability, the Company uses an implied market price for buying credit protection on RAM and a cash flow model, which models a CDS contract, to calculate a value price based on those spreads and cash flows. The Company identifies comparable entities with active CDS markets to estimate credit spreads for RAM. Such identification focuses on the nature of risk positions (primarily public finance and structured products) and of approximate capital adequacy as depicted by publicly available credit ratings agencies reports. Based on this information, as at December 31, 2008, the Company estimated its credit spread to be approximately 2254 basis points. An approximation of a CDS contract is made based on a 5-year insured CDS contract, an assumption of a 10 year weighted average life, and an assumption for par, coupon, duration and the appropriate discount rate based on a 5-year swap rate. The Company believes that these data points may be considered by hypothetical market participants in determining RAM’s creditworthiness. The effect of applying this requirement of FAS 157 was a reduction in the Company’s derivative liability at December 31, 2008 of approximately $203.3 million.
In 2008, we renewed our treaty reinsurance agreements with Assured Guaranty and FSA but either cancelled or did not renew our treaty reinsurance agreements with our other customers, due to the downgrades of our customers. During 2008, Assured Guaranty and FSA accounted for substantially all of the new business assumed by us under our treaties. We have not renewed our reinsurance treaties with any of the primaries in 2009 and we do not expect to write any new financial guaranty business in the near term. This means that we do not expect to write any financial guaranty reinsurance in the current year but this does not reduce our in-force business, unless the business is commuted or recaptured by the primaries.
Our business consists of a single operating segment, financial guaranty reinsurance, the purpose of which is to indemnify a primary financial guarantor, referred to as the primary insurer or “ceding company”, against the portion of any loss it may sustain under financial guaranty policies it has ceded to us. We reinsure policies covering both U.S. and international exposures. Through 2008, we marketed our reinsurance directly through the execution of treaty and facultative contracts with primary insurers.
Primary financial guaranty companies choose reinsurance providers based upon several factors, including overall financial strength, financial strength ratings by the major rating agencies, single-risk capacity, and, to a lesser extent, level of service quality and whether or not the reinsurer competes with the primary company. There has been limited demand for reinsurance on new business since late 2007, and reinsurance activity in 2008 consisted primarily of transactions in which the primaries reinsured substantial portions of their existing insured portfolio of public finance transactions for regulatory capital purposes. Primaries with excess capital for their current ratings were the only reinsurers of these portfolio transactions. We did not compete for these transactions because we did not have sufficient capacity for these large transactions. We are not currently competing in the financial guaranty reinsurance market and we believe that Assured Guaranty Re is our only historical competitor that continues to compete in this market.
Basic earnings per share is computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share shows the dilutive effect of all stock options and restricted stock units outstanding during the period that could potentially result in the issuance of common shares. The calculation of diluted loss per share excludes the dilutive effect of stock options and restricted stock awards outstanding because it would otherwise have an anti-dilutive effect on net loss per share. As of December 31, 2008, 2007 and 2006, there were 2,116,497, 1,252,197 and Nil, respectively, of stock options excluded from the diluted earnings per share calculation because they were anti-dilutive. At December 31, 2008, 2007 and 2006, all restricted stock units outstanding were anti-dilutive and therefore excluded from the diluted earnings per share calculations.
The investments that have unrealized loss positions as of December 31, 2008 and 2007, aggregated by investment category and the length of time they have been in a continued unrealized loss position, are as follows:
As of December 31, 2008, 48 out of 151 securities were in unrealized loss positions compared to 71 out of 168 securities as of December 31, 2007. As at December 31, 2008 the Company’s gross unrealized loss position was $14.6 million compared to $4.1 million at December 31, 2007. The increase is primarily related to increases of $2.3 million and $8.0 million in corporate securities and mortgage and asset-backed securities, respectively. The increase in the unrealized losses as at December 31, 2008 is primarily attributable to the market reaction to corporate bonds and the current economic climate, and therefore management does not believe these investments to be other than temporarily impaired and intends to hold these investments until recovery. The investments held by the Company are considered to be available-for-sale but the Company has the ability and the intent to hold these investments until the security recovers its value, or to their contractual maturity. Unrealized gains and losses relating to investments are currently recorded in accumulated other comprehensive (loss)/income in shareholders’ equity as the Company generally holds these investments to maturity. The unrealized gains and losses are expected to decrease as the investment approaches maturity and the Company expects to realize a value substantially equal to amortized cost.
The amortized cost and estimated fair value of fixed interest securities classified as available for sale as of December 31, 2008, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or repay obligations with or without call or prepayment penalties.
As of December 31, 2008 and 2007, RAM Re has contingent capital and credit facilities totaling $180 million, the details of which are discussed in the following:
As of December 31, 2008 and 2007, the Company also maintained a second $40.0 million contingent capital facility with two highly rated commercial banks. This facility is essentially the same as the $90.0 million contingent capital facility described above although it may be drawn upon only to cover catastrophic losses, exceeding the minimum threshold, from public finance obligations reinsured by RAM Re. Loan obligations under this facility also have limited recourse and are repayable from, and collateralized by, a pledge of recoveries realized on defaulted reinsured obligations covered by this facility, including certain installment premiums and other collateral, on a subordinate basis to the pledge made to secure the $90.0 million facility described above. The $40.0 million facility has an annual extension feature, subject to approval of the lenders, and was not extended for an additional year on February 3, 2008. The facility has a term ending on February 3, 2014. As of December 31, 2008 and 2007, no amounts were outstanding nor have there been any borrowings under this facility.
Effective January 1, 2008, the Company adopted FAS 157. FAS 157 establishes a hierarchy of inputs in measuring fair value, with the highest level being observable inputs and the lowest being unobservable data, with the standard requiring that the use of observable inputs is maximized (see Note 4 Derivative Instruments for a description of each of the three levels). The following table presents the fair value measurement levels for assets and liabilities, which the Company has recorded at fair value as of December 31, 2008. As required by FAS 157, items are classified in their entirety based on the lowest level of input that is significant to the fair value measurement:
See Note 4 Derivative Instruments for further disclosures on the application of FAS 157 to the Company’s derivative liabilities.
As management is ultimately responsible for determining the fair value measurements for all securities, the Company assesses the reasonableness of the fair values received by comparing them to other pricing information readily available and management’s knowledge of the current markets. The Company also assesses the pricing methodologies and related inputs used by the pricing services to estimate fair value. Any prices that, in managements’ opinion, may not be representative of fair value are challenged with the pricing service. Based on the information obtained from the above reviews, the Company evaluated the fixed income securities in the investment portfolio to determine the appropriate FAS 157 fair value hierarchy level based on trading activity and observability of inputs. Based on the Company’s evaluation, each security was classified as Level 1, 2, or 3. Prices on money market funds and US treasuries were classified as Level 1, prices with observable
market inputs were classified as Level 2, and valuations with no significant observable inputs were classified as Level 3 as of December 31, 2008.
The carrying amounts of cash and cash equivalents, interest and premiums receivable, other assets, accounts payable and accrued liabilities and other liabilities are considered reasonable estimates of their fair values.
to approximate the carrying value. For installment premiums, consistent with industry practice, there is no carrying amount since the Company will receive premiums on an installment basis over the term of the reinsurance contract. Similar to the treatment of unearned premiums, the fair value of installment premiums is estimated as the present value of the future contractual premiums that are expected to be received under a reinsurance agreement. The present value of future installment premiums, discounted at a rate of 3.00% and 4.26%, was $120.2 million and $234.2 million at December 31, 2008 and 2007, respectively.
increase of the unallocated reserve of $1.2 million in 2006 are due primarily to the combination of increased exposures reinsured by the Company in the ordinary course of business and changes in unallocated reserve factors applied in estimating the unallocated loss reserve.
Individual primaries began recording these remediation benefits in their case reserves in mid-2008, with all of our ceding companies recording remediation benefits at year end. Prior to the fourth quarter we did not have access to sufficient information to assess the reliability of the remediation benefits ceded by the primaries. In the fourth quarter, we began to record our pro rata share of the remediation benefits in the ceded case reserves as a result of additional supporting information received from the primaries,
For RMBS, the Company’s loss reserving methodology assumes that all 90+ day delinquent loans are liquidated, and the loss severity for these loans is equal to 100% for second liens, 55% for subprime and 45% for Alt-A and prime loans, while the remainder of the collateral pool experiences losses based on loss assumptions determined by the vintage year in the case of Home Equity Lines of Credit (HELOCs), Subprime, Alt-A and Prime mortgages. Borrower credit quality is also considered in the case of Closed-End Seconds (CES). Correlation is not one of the inputs in our loss reserving methodology for RMBS.
The following table summarizes the subordination and overcollateralization (“OC”) in the Company’s 2005-2007 US RMBS exposures by product type and vintage. The severity of loss (or loss given default) is the Company’s lifetime severity assumption. The table also sets forth the mortgage collateral lifetime default and cumulative lifetime loss rates that result from our modeling methodology, our assumptions and the performance to date of our exposures.
The Company believes that it is appropriate to determine its total loss and LAE reserves using the loss and LAE reserves ceded by the ceding companies as a key input and the analysis performed by the Company, which validates or results in adjustments to the ceding company reserves. Although the Company believes its methodology for determining loss reserves is appropriate, there can be no assurance that actual, ultimate losses will not be higher or lower than the Company’s reserves. The ultimate performance of the Company’s RMBS transactions remains highly uncertain and may be subject to considerable volatility due to the influence of many factors, including the level and timing of loan defaults, changes in housing prices and other variables.
RAM primarily identifies problem credits through information provided by the primary insurers at least on a quarterly basis. Such information generally consists of surveillance and underwriting reports and quarterly conference calls with the primary ceding companies’ analysts. The Risk Management staff supplements this input with their own research to identify and assess the status of individual credits. Research performed includes reviews of rating agency and fixed income research publications and analysis of historical performance data. Each of the ceding companies maintains a “watch list” for credits that have been identified as requiring greater than the usual level of ongoing scrutiny and/or intervention. The ceding companies notify us when any transaction they have reinsured has been placed on such a watch list. The Management Committee is comprised of RAM’s senior officers and meets quarterly to formally review the Company’s Watch List and approve case and unallocated reserves.
RAM does not perform loss mitigation activities and instead relies on the loss mitigation efforts of the ceding companies, who report RAM’s proportionate share of the expenses incurred and liability for such activities. RAM pays the ceding companies a ceding commission for all policies reinsured. The ceding commission represents RAM’s portion of the cost to the ceding companies to write the transaction, perform ongoing surveillance and engage in loss mitigation activities. Ceding commissions are deferred and expensed as each policy’s exposure matures and is included as an asset in deferred policy acquisition costs and as acquisition expenses in the statement of operations. RAM reports loss expenses associated with claims as a liability in loss reserves on the balance sheet and in loss and loss adjustment expenses of the statement of operations.
We have not written any credit default swap (“CDS”) contracts on a direct basis, meaning that we have not written any individual International Swaps and Derivatives Association, Inc. (“ISDA”) contracts. However, we have reinsured quota share portions of CDS insured by our ceding companies. Our ceding companies generally do not provide us with payment terms of their insured credit derivatives unless the transaction is on their Watch List. We may also request the payment information on policies but the primaries are not contractually obligated to provide this to us and we have not received complete information from all of the primaries.
Further, based on the public reports of our ceding companies, their credit derivative transactions are governed by ISDA documentation and operate differently from financial guaranty insurance policies. For example, unlike financial guaranty insurance policies, a credit derivative may be terminated for a breach of the ISDA documentation or other specific early termination event, such as insolvency of or failure to pay by the ceding company. If a credit derivative is terminated early, a ceding company could be required to make a mark-to-market payment as determined under the ISDA documentation. We believe our contractual obligation to indemnify the ceding companies for losses under our reinsurance contracts only extends to defaults in the underlying transaction covered by the ISDA documentation and not defaults by the primary company or its affiliates under the ISDA documentation.
terms of these transactions, our liquidity risk is mitigated. However, we are at risk of unanticipated loss payments under insured credit derivative policies that are not on our Watch List. Such an unanticipated payment could have an adverse effect on our liquidity. If an unexpected loss were to arise, we have a highly liquid and short duration investment portfolio in place to handle any unanticipated losses.
Outstanding principal reinsured as of December 31, 2008 and 2007 by credit sector was (in millions) (1):
Outstanding principal reinsured at December 31, 2008 and 2007 by geographic location was (in millions) (1) :
The Company maintains qualified and non-qualified, non-contributory, defined contribution pension plans for the benefit of eligible employees. These plans are administered by a third party. The Company’s contributions are based upon a fixed percentage of employee compensation. Pension expense, which is funded as accrued, for the years ended December 31, 2008, 2007, and 2006 was $0.4 million, $0.4 million, and $0.5 million, respectively.
The Company maintains a rabbi trust for deferred compensation plans for executives. The rabbi trust holds assets such as cash, fixed income and equity securities in the form of mutual funds. These assets of the rabbi trust are consolidated with those of the Company and are reflected in other assets. These assets are classified as trading securities and reported at fair value with changes in fair value reflected in net investment income. The related deferred compensation obligation is carried at fair value and reflected in other liabilities with changes reflected as a corresponding increase or decrease to administrative expenses.
portfolio by $3.5 billion of which $711 million related to 2005 - 2007 vintage ABS CDOs (all structured as credit derivatives) and $280 million of 2005 - 2007 vintage RMBS.
Prior to January 1, 2006, share options were issued to senior management and directors on an ad hoc basis and accounted for under Accounting Principles Board Opinion (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), and related Interpretations as permitted by Statement of Financial Accounting Standards No. 123, Accounting for Stock Based Compensation (“FAS 123”). Under APB 25 the fair value per share at the grant date was estimated as book value at the most recent quarterly reporting period and the strike price of the options granted was the book value at the date of grant. Therefore, the intrinsic value is zero for all options granted under APB 25 that have the same fair value and strike price and no compensation expense is recognized for the cost of the share options.
As of April 26, 2006, the Company adopted the RAM Holdings Ltd. 2006 Equity Plan (the “Plan”). The number of common shares that may be delivered under the Plan may not exceed 2,470,000. In the event of certain transactions affecting the common shares of RAM Holdings Ltd., the number or type of shares subject to the Plan, the number and type of shares subject to outstanding awards under the Plan, and the exercise price of awards under the Plan, may be adjusted. The Plan authorizes the grant of share options, share appreciation rights, share awards, restricted share units, performance units, or other awards that are based on the Company’s common shares. The awards granted are contingent on the achievement of service conditions during a specified period, and may be subject to a risk of forfeiture or other restrictions that will lapse upon the achievement of one or more goals relating to completion of service by the participant. Awards under the Plan may accelerate and become vested upon a change in control of the Company. The Plan is administered by the compensation committee of the Board of Directors. The plan is subject to amendment or termination by the board.
The Company has used the Black-Scholes option pricing model to estimate the fair value of share options using the following weighted average assumptions as at December 31, 2008, 2007 and 2006:
These assumptions are based on a number of factors as follows: (i) dividend yield was determined based on the Company’s historical dividend payments which have been nil and expected dividend payments in the future which are also expected to be nil, (ii) expected volatility was determined using the historical volatility of the share price of the Company and similar companies within the financial guaranty industry, (iii) the expected term of the options is based on the period of time that the options granted are expected to be outstanding and (iv) the risk-free rate is the U.S. Treasury rate effective at the time of grant for the duration of the options granted. Compensation cost is recognized on a straight-line basis over the vesting period and is net of estimated prevesting forfeitures. The estimated forfeiture rate is based on actual forfeitures adjusted for future forfeiture expectations due to limited historical forfeiture data. At December 31, 2008, the weighted average grant date fair value, using FAS 123 for disclosure purposes was $1.96.
The following tables summarize the share option activity for the years ended December 31, 2008, 2007, and 2006:
(3) FAS 123R was adopted on January 1, 2006, prior to that share options were accounted for under APB 25.
As of June 30, 2005, the Company entered into Payment Agreements that terminated both the Contingent Share Agreements and 472,420 vested Stock Options of three management employees. On June 30, 2006, the Company paid $1.6 million to the employees and subsequently paid an additional $0.7 million in the third quarter of 2006 which represented the remaining value of the ultimate liability.
In December 2008, RAM Re commuted a further $158.3 million in par outstanding on two policies with another primary insurer. One policy was a partial commutation of $41.8 million par outstanding on a 2007 subprime RMBS whereas RAM Re’s total obligations on the second policy were terminated fully. The Commutation payment of $3.1 million reduced the total loss reserve accordingly.
As at December 31, 2008, RAM Re had been assigned an “A+” rating with negative outlook from S&P and a “Baa3”, with developing outlook rating from Moody’s. S&P stated that the “A+” rating, issued on September 24, 2008, reflects its view that the diversity and scope of RAM Re’s reinsurance relationships have suffered as more of the primary insurers’ new business production has declined in the current environment. These changes raise the likelihood in S&P’s view that RAM Re’s new business generation will be limited until the primary insurers can stabilize their franchises. The rating changes also reflect the difficulty S&P believes RAM Re may face, in light of the current environment, toward improving its historically below-average return on equity (ROE). Finally, S&P stated that the rating changes reflect S&P’s view of RAM Re’s weakened capital adequacy position, which is the result of a significant amount of projected losses relating primarily to reinsured subprime and second-lien RMBS and, secondarily, CDOs of ABS. Although the company’s capital adequacy margin of safety in S&P’s analysis was at the low end of the range of 1.0x -1.1x, which exceeds S&P’s ‘A’ criteria of 0.8x, it has declined from prior years when the margin of safety was in excess of 1.25x. Moody’s stated that its rating action on December 4, 2008, reflected Moody’s views on RAM Re’s overall credit profile in the current environment, including the potential for increased losses among its mortgage-related exposures and significantly constrained new business prospects. Moody’s stated that the downgrade resulted from three primary factors, the first being Moody’s expectations of greater losses on mortgage-related exposures, reflecting continued adverse delinquency trends. Moody’s stated that although RAM Re has reduced the size of its RMBS and ABS CDO portfolios through recent commutation transactions with MBIA and Syncora, loss expectations relating to RAM Re’s direct RMBS portfolio were material relative to capital. The second factor was Moody’s view of diminished business prospects as reflected by low underwriting volume. The third factor according to Moody’s was the Company’s impaired financial flexibility.
There were only two AAA-rated ceding companies with which RAM Re had treaties in 2008.
On December 14, 2006, the Company issued 75,000 preference shares at $1,000 per share for total consideration of $75.0 million. The preference shares bear a non-cumulative, non mandatory dividend rate of 7.50% which is payable semi-annually on June 15 and December 15 each year upon declaration by the Board of Directors. Unless previously redeemed, the preference shares have a mandatory redemption date of December 15, 2066. The Company can redeem the preference shares at any time from December 15, 2016 with no penalty to the Company. Prior to December 15, 2016, the Company can redeem the preference shares at the redemption price and a “make-whole” amount, amounting to dividends for the remainder of the period to December 15, 2016. During the years ended December 31, 2008 and 2007 dividends amounting to $5.6 million have been declared and paid. There were no dividends declared or paid in 2006. The payment of preference share dividends is classified as interest expense.
The Company does not consider itself to be engaged in trade or business in the U.S. and, accordingly, does not expect to be subject to U.S. taxation.
RAM Re is registered under the Bermuda Insurance Act 1978, amendments thereto and related Regulations (the “Act”), which require that they maintain minimum levels of solvency and liquidity. For the years ended December 31, 2008 and 2007 these requirements have been met. The minimum required statutory capital and surplus was $15.3 million and $16.7 million and actual statutory capital and surplus was $158.4 million and $369.7 million as of December 31, 2008 and 2007, respectively. The minimum required level of liquid assets was $217.6 million and $268.1 million and actual liquid assets were $444.5 million and $727.1 million as of December 31, 2008 and 2007, respectively.
Investments are discussed in note 7, Derivatives in note 4 and Losses and loss expense reserves in note 11 to these financial statements.
See Note 9 Contingent Capital and Credit Facilities regarding the exercise of the Company’s soft capital facility put option subsequent to year end.
On April 7, 2009, RAM Re entered into a commutation agreement (the “Ambac Commutation Agreement”) with Ambac Assurance Corporation and its affiliate (“Ambac”). The Ambac Commutation Agreement provided, among other things, for RAM Re to pay a $97 million settlement payment and $1.3 million of claims payments, by means of a release to Ambac of securities in Ambac’s trust account valued at $97.8 million and a cash payment of $0.5 million, to commute the entire $7.4 billion insured portfolio assumed from Ambac, and for each party thereto to release the other party from all liabilities and obligations under all reinsurance agreements between the parties. The securities in the trust account and cash payment were received by Ambac, and the releases set forth in the Commutation Agreement became effective, on April 8, 2009. If the Ambac commutation had been effective at December 31, 2008, it would have resulted in a reduction of RAM Re’s statutory capital and surplus under Bermuda law from $158.4 million to approximately $148.4 million.