The Company leases office space in Pembroke, Bermuda where the Company’s principal executive office is located. Additionally, the Company leases office space in Summit, New Jersey for Third Point Re USA’s operations. We renew and enter into new leases in the ordinary course of business. For further discussion of our leasing commitments at December 31, 2016, refer to Note 21 - “Commitments and Contingencies” to the accompanying consolidated financial statements.
We manage our business on the basis of one operating segment, Property and Casualty Reinsurance. We also have a corporate function that includes our investment income on capital, certain general and administrative expenses related to corporate activities, interest expense, foreign exchange gains (losses) and income tax expense. As of December 31, 2015, all investments in the Catastrophe Fund had been redeemed. In February 2016, the Company completed the dissolution of the Catastrophe Fund and Catastrophe Reinsurer. As a result, there is no further activity in the Catastrophe Risk Management segment.
We provide reinsurance products to insurance and reinsurance companies, government entities, and other risk bearing vehicles. Contracts can be written on an excess of loss basis or quota share basis, although the majority of contracts written to date have been on a quota share basis. In addition, we write contracts on both a prospective basis and a retroactive basis. Prospective reinsurance contracts cover losses incurred as a result of future insurable events. Retroactive reinsurance contracts cover the potential for changes in estimates of loss and loss adjustment expense reserves related to loss events that have occurred in the past. Retroactive reinsurance contracts can be an attractive type of contract for us as the premiums received at the inception of the contract generate insurance float. The product lines that we currently underwrite for this operating segment are: property, casualty and specialty. We assume a minimal amount of property catastrophe risk and we anticipate that our property catastrophe exposures will consistently remain low when compared to many other reinsurers with whom we compete.
We believe that by combining a disciplined and opportunistic approach to reinsurance underwriting with investment results from the active management of our investment portfolio, we will be able to generate attractive returns for our shareholders. The key financial measures that we believe are most meaningful in analyzing our performance are: net underwriting income (loss) for our property and casualty reinsurance segment, combined ratio for our property and casualty reinsurance segment, net investment income (loss), net investment return on investments managed by Third Point LLC, book value per share, diluted book value per share, growth in diluted book value per share and return on beginning shareholders’ equity.
The table below shows the key performance indicators for our consolidated business for the years ended December 31, 2016, 2015 and 2014:
Book value per share, diluted book value per share, change in diluted book value per share and return on beginning shareholders’ equity are non-GAAP financial measures. See reconciliations below.
One way that we evaluate the performance of our property and casualty reinsurance results is by measuring net underwriting income (loss). We do not measure performance based on the amount of gross premiums written. Net underwriting income or loss is calculated from net premiums earned, less net loss and loss adjustment expenses, acquisition costs and general and administrative expenses related to underwriting activities. See additional information in Note 22 to our consolidated financial statements.
Combined ratio is calculated by dividing the sum of loss and loss adjustment expenses incurred, net, acquisition costs, net and general and administrative expenses related to underwriting activities by net premiums earned. This ratio is a key indicator of a reinsurance company’s profitability. A combined ratio of greater than 100% means that loss and loss adjustment expenses, acquisition costs and general and administrative expenses related to underwriting activities exceeded net premiums earned. See additional information in Note 22 to our consolidated financial statements.
Net investment income (loss) for the years ended December 31, 2016, 2015 and 2014 was comprised of the following:
Book value per share and diluted book value per share are non-GAAP financial measures. Book value per share is calculated by dividing shareholders’ equity attributable to shareholders by the number of issued and outstanding shares at period end, net of treasury shares. Diluted book value per share represents book value per share combined with the impact from dilution of all in-the-money share options issued, warrants and unvested restricted shares outstanding as of any period end. For unvested restricted shares with a performance condition, we include the unvested restricted shares for which we consider vesting to be probable.
Change in book value per share is calculated by taking the change in book value per share divided by the beginning of period book value per share. Change in diluted book value per share is calculated by taking the change in diluted book value per share divided by the beginning of period diluted book value per share.
The changes in book value per share and diluted book value per share for the year ended December 31, 2016 compared to the year ended December 31, 2015 was primarily due to net income during the year. The decrease in book value per share and diluted book value per share for the year ended December 31, 2015 compared to the year ended December 31, 2014 was primarily due to a net loss during the year as a result of our negative investment return and, to a lesser extent, our underwriting loss in the year.
Return on beginning shareholders’ equity as presented is a non-GAAP financial measure. Return on beginning shareholders’ equity is calculated by dividing net income (loss) by the beginning shareholders’ equity attributable to shareholders. We believe that return on beginning shareholders’ equity is an important measure because it assists our management and investors in evaluating the Company’s profitability. For the year ended December 31, 2016, we have also adjusted the beginning shareholders’ equity for the impact of the shares repurchased on a weighted average basis. This adjustment increased the stated return on beginning shareholders’ equity
Investment-related expenses primarily consist of management fees we pay to our investment manager, Third Point LLC, and certain of our Founders and performance fees we pay to TP GP. A 2% management fee calculated on assets under management was paid monthly to Third Point LLC and certain of our Founders, up to December 22, 2016 and 1.5% to Third Point LLC thereafter. In addition, a performance fee equal to 20% of the net investment income is paid annually to TP GP. See Note 9 to our consolidated financial statements for additional information on our Founders and management, performance and founders fees. We include these expenses in net investment income (loss) in our consolidated statements of income (loss). The performance fee is subject to a loss carryforward provision pursuant to which TP GP is required to maintain a Loss Recovery Account, which represents the sum of all prior period net loss
Interest expense consists of interest expense incurred on TPRUSA’s $115.0 million senior unsecured notes (the “Notes”) issued in February 2015. The Notes bear interest at 7.0% and interest is payable semi-annually on February 13 and August 13 of each year. Also included in interest expense is the amortization of certain costs incurred in issuing the Notes. These costs are amortized over the term of the debt and are included in interest expense.
While management believes pricing remains adequate for certain types of business on which we focus, there is significant underwriting capacity currently available. Market conditions remain challenging and have continued to deteriorate during the year, and we believe they could deteriorate further in the near term. We believe excess capacity is due to strong retained earnings in the reinsurance industry primarily as a result of historically low catastrophe losses in recent years, an influx of capacity from collateralized reinsurance and other insurance-linked securities vehicles and increased competition from new entrants with similar total return business models to ours. While we do not participate in the property catastrophe excess of loss reinsurance segment, we believe that traditional reinsurers facing extreme price pressure in this segment are more aggressively pursuing our targeted lines of business.
We focus on segments and clients where we believe we benefit from relatively more attractive pricing opportunities due to the strength of our relationships, the tailored nature of our reinsurance solutions, an acute need for reinsurance capital as a result of market dislocation, a client’s growth or historically poor performance. An example of a dislocated market where there is significant demand for reinsurance is the U.S. mortgage market. After suffering severe losses during the financial crisis of 2008, private mortgage insurers and the government sponsored mortgage lenders have been recapitalized and we believe the insurers and lenders have been increasingly using reinsurance as a component of their capital structure.
The following table sets forth the key items discussed in the consolidated results of operations section, and the period over period changes, for the years ended December 31, 2016, 2015 and 2014:
A key driver of our results of operations is the performance of our investments managed by Third Point LLC. Given the nature of the underlying investment strategies, we expect volatility in our investment returns and therefore in our consolidated net income (loss). See additional information regarding investment performance in “Investment Results” section below.
The other key changes in net income (loss) for the year ended December 31, 2016 compared to the year ended December 31, 2015 were primarily due to the following:
The increase in net underwriting loss and related combined ratio primarily reflects adverse development for the year ended December 31, 2016 on certain contracts and continued deterioration in market conditions. See “Segment Results” below for additional details.
The change in net income for the year ended December 31, 2015 compared to the year ended December 31, 2014 was primarily due to the following:
The increase in net underwriting loss and related combined ratio primarily reflects adverse development for the year ended December 31, 2015 on certain contracts and deterioration in market conditions. See “Segment Results” below for additional details.
We may extend and/or amend contracts resulting in premium that will not necessarily renew in a comparable period;
Changes in renewal premiums for the year ended December 31, 2016 resulted in a net increase in premiums of $27.1 million primarily due to increases in participations and underlying premium volume on contracts that renewed in the period. Premiums can change on renewals of contracts due to a number of factors, including: changes in our line size or participation, changes in the underlying premium volume and pricing trends of the client’s program as well as other contractual terms and conditions.
The increase in gross premiums written of $101.2 million, or 16.8%, for the year ended December 31, 2015 compared to the year ended December 31, 2014 was driven by:
Contracts that were canceled and re-written in 2015 resulted in $34.6 million of additional premiums compared to $79.2 million in 2014.
Additionally, two contracts were commuted in the year ended December 31, 2015, which resulted in return premium of $48.9 million, compared to none in the year ended December 31, 2014.
The reinsurance contracts we write have a wide range of initial loss ratio estimates. As a result, our net loss and loss expense ratio can vary significantly from period to period depending on the mix of business. The changes in our net loss and loss adjustment expenses and related ratio was impacted by changes in mix of business, deterioration in market conditions and prior years’ reserve development.
For the year ended December 31, 2016, we incurred $10.5 million, or 1.8 percentage points, of net adverse prior years’ reserve development. The $10.5 million of net adverse prior years’ reserve development for the year ended December 31, 2016 was accompanied by net increases of $2.0 million in acquisition costs, resulting in a net increase of $12.5 million in net underwriting loss, or 2.1 percentage points. The net underwriting loss impact of the adverse loss development was due to:
$3.7 million of net adverse underwriting loss development relating to our Florida homeowners’ contracts primarily as a result of higher than anticipated water damage claims and an increase in the practice of assignment of benefits whereby homeowners assign their rights for filing and settling claims to attorneys and public adjusters, which we believe has led to an increase in the frequency of claims reported as well as the severity of losses and loss adjustment expenses;
Acquisition costs include commissions, brokerage and excise taxes. Acquisition costs are presented net of commissions on reinsurance ceded. The reinsurance contracts we write have a wide range of acquisition cost ratios. As a result, our acquisition cost ratio can vary significantly from period to period depending on the mix of business. Furthermore, a number of our contracts have a sliding scale commission or profit commission feature that will vary depending on the expected loss expense for the contract. As a result, changes in estimates of loss and loss adjustment expenses on a contract can result in changes in the sliding scale commissions or profit commissions and a contract’s overall acquisition cost ratio.
Net investment income (loss) allocated to the Property and Casualty Reinsurance segment consists of net investment income (loss) on float. The change in net investment income (loss) on float for the year ended December 31, 2016 compared to the year ended December 31, 2015 and for the year ended December 31, 2015 compared the year ended December 31, 2014 was primarily due to change in investment returns compared to the prior year. See the discussion of net investment income (loss) under “Corporate Function” below for explanations of the investment returns on investments managed by Third Point LLC and total net investment income (loss) for the years presented.
The increase in general and administrative expenses allocated to underwriting activities for the year ended December 31, 2015 compared to the year ended December 31, 2014 was primarily due to increased headcount and related employee costs, increased share compensation expense and increased credit facility fees due to higher usage of our letter of credit facilities. Although general and administrative expenses increased compared to the prior year, the general and administrative expense ratio decreased due to proportionately higher net premiums earned during the current year.
For the year ended December 31, 2016, the net investment results were primarily driven by positive returns in our Credit strategy. Within Credit, profits in corporate and sovereign credit were partially offset by modest losses in structured credit. Corporate credit was the main driver in the Credit strategy and resulted from positive returns on investments in the energy sector. Within equities, negative performance from two large healthcare positions were partially offset by positive performance from investments in the financial and industrials sectors. During the year, Third Point LLC increased exposure to risk arbitrage transactions, which generated positive performance from several merger-related investments and partially offset losses in the currency and macroeconomic portions of the other portfolio.
For the year ended December 31, 2014, the net investment results were largely attributable to Third Point LLC’s equity and structured credit strategies. Within equities, healthcare and industrials and commodities were the strongest performing sectors, accounting for nearly half of total returns for the year. In credit, strong performance in structured credit was partially offset by the performing credit portfolio.
General and administrative expenses allocated to corporate activities include allocations of payroll and related costs for certain executives and non-underwriting staff. We also allocate a portion of overhead and other related costs based on a related headcount analysis. The decrease in general and administrative expenses related to corporate activities for the year ended December 31, 2016 compared to the year ended December 31, 2015 was primarily due to a decrease in our annual incentive plan compensation expense where we did not achieve the threshold performance target, lower share compensation expense in the current year due to forfeitures and fewer restricted shares with performance and service conditions considered probable of vesting.
The increase in foreign exchange gains for the year ended December 31, 2016 compared to the year ended December 31, 2015 was primarily due to the revaluation of foreign currency loss and loss adjustment expense reserves denominated in British pounds into the United States dollar, which had strengthened during the current year. Loss and loss adjustment expense reserves denominated in British pounds increased in the year ended December 31, 2016, which also contributed to the variance. For these contracts, non-U.S. dollar reinsurance assets, or balances held in trust accounts securing reinsurance liabilities, generally offset reinsurance liabilities in the same non-U.S. dollar currencies resulting in minimal net exposure. Refer to “ITEM 3. Quantitative and Qualitative Disclosures about Market Risks” for further discussion on foreign currency risk related to our reinsurance contracts.
Our investment portfolio is concentrated in tradeable securities and is marked to market each day. Pursuant to our investment guidelines as specified in our two investment management agreements with Third Point LLC, at least 60% of our portfolio must be invested in securities of publicly traded companies and governments of OECD high income countries, asset-backed securities, cash, cash equivalents and gold and other precious metals. We can liquidate all or a portion of our investment portfolio at any time with not less than three days’ notice to pay claims on our reinsurance contracts, and with not less than five days’ notice to pay for expenses, and on not less than 3 days’ notice in order to satisfy a requirement of A.M. Best. Since we do not write excess of loss property catastrophe contracts or other types of reinsurance contracts that are typically subject to sudden, acute, liquidity demands, we believe the liquidity provided by our investment portfolio will be sufficient to satisfy our liquidity requirements to manage our operations.
As of December 31, 2016, Third Point Re could pay dividends to Third Point Reinsurance Ltd. of approximately $315.0 million (December 31, 2015 - $261.1 million). Third Point Re USA has also entered into a Net Worth Maintenance Agreement that further restricts the amount of capital and surplus it has available for the payment of dividends. In order to remain in compliance with the Net Worth Maintenance Agreement we have entered into with Third Point Re USA (the “Net Worth Maintenance Agreement”), we have committed to ensuring that Third Point Re USA will maintain a minimum level of capital of $250.0 million. Failure of Third Point re USA to maintain the minimum level of capital required by the Net Worth Maintenance Agreement could limit or prevent Third Point Re USA from paying dividends to us. As a result, Third Point Re USA could pay dividends ultimately to Third Point Reinsurance Ltd. of approximately $19.6 million as of December 31, 2016 (December 31, 2015 - $11.1 million).
our expense base and appropriately utilize our capital. Given the continued deterioration in market conditions and our focus on improving our underwriting results, we plan to remain selective in our underwriting which may slow the growth rate of our gross written premium.
Historically, our sources of funds have primarily consisted of premiums written, reinsurance recoveries, investment income and proceeds from sales and redemptions of investments. Cash is used primarily to pay loss and loss adjustment expenses, reinsurance premiums, acquisition costs, interest expense, taxes, general and administrative expenses and to purchase investments.
Our cash flows from operations generally represent the difference between: (l) premiums collected and investment earnings realized and (2) loss and loss expenses paid, reinsurance purchased and underwriting and other expenses paid. Cash flows from operations may differ substantially from net income (loss) and may be volatile from period to period depending on the underwriting opportunities available to us and other factors. Due to the nature of our underwriting portfolio, claim payments can be unpredictable and may need to be made within relatively short periods of time. Claim payments can also be required several months or years after premiums are collected.
Operating, investing and financing cash flows for the years ended December 31, 2016, 2015 and 2014 were as follows:
Cash flows provided by operating activities generally represent net premiums collected less loss and loss adjustment expenses, acquisition costs and general and administrative expenses paid. The decrease in cash flows from operating activities in the year ended December 31, 2016 compared to the year ended December 31, 2015 is primarily due to lower float generated from our reinsurance operations in the year ended December 31, 2016 compared to the year ended December 31, 2015. This decrease was primarily due to not having written any retroactive reinsurance contracts during 2016, which typically result in up-front premiums paid, compared to $108.1 million for the year ended December 31, 2015.
Cash flows provided by financing activities for the year ended December 31, 2016 consisted of contributions received on deposit liability contracts and proceeds from the exercise of stock options, partially offset by $7.4 million of shares repurchased. Cash flows used in financing activities for the year ended December 31, 2015 consisted primarily of the proceeds from issuance of Notes, partially offset by distributions of non-controlling interests from the investment affiliate and Catastrophe Fund and payments to settle two deposit liability contracts. The cash flows used in financing activities for the year ended December 31, 2014 consisted primarily of distributions of non-controlling interests from the investment affiliate.
In addition, we expect that our existing cash and cash flow from operations will provide us with the financial flexibility to execute our strategic objectives. Our ability to generate cash, however, is subject to our performance, general economic conditions, industry trends and other factors. To the extent existing cash and cash equivalents, investment returns and operating cash flow are insufficient to fund our future activities and requirements, we may need to raise additional funds through public or private equity or debt financing. If we issue equity securities in order to raise additional funds, substantial dilution to existing shareholders may occur. If we raise cash through the issuance of additional indebtedness, we may be subject to additional contractual restrictions on our business. There is no assurance that we would be able to raise the additional funds on favorable terms or at all. There are regulatory and contractual restrictions and rating agency considerations that might impact the ability of our reinsurance subsidiaries to pay dividends to their respective parent companies, including for purposes of servicing TPRUSA’s debt obligations.
See Note 3 to our consolidated financial statements for additional information on restricted cash, cash equivalents and investments.
As of December 31, 2016, $231.8 million (December 31, 2015 - $270.4 million) of letters of credit, representing 44.2% of the total available facilities, had been issued (December 31, 2015 - 49.2% (based on total available facilities of $550.0 million)).
On February 13, 2015, TPRUSA issued Notes in the aggregate principal amount of $115.0 million. The Notes bear interest at 7.0% and interest is payable semi-annually on February 13 and August 13 of each year. The Notes are fully and unconditionally guaranteed by Third Point Reinsurance Ltd., and, in certain circumstances specified in the indenture governing the Notes, certain existing or future subsidiaries of the Company may be required to guarantee the Notes, as described in the indenture governing the Notes.
The indenture governing the Notes contains customary events of default, and limits our ability to merge or consolidate or to transfer or sell all or substantially all of our assets and TPRUSA’s ability to create liens on the voting securities or profit participating equity interests of Third Point Re USA, its wholly-owned insurance subsidiary. In certain circumstances specified in the indenture governing the Notes, certain of our existing or future subsidiaries may be required to guarantee the Notes. Interest on the Notes is subject to adjustment from time to time in the event of a downgrade or subsequent upgrade of the rating assigned to the Notes or in connection with certain changes in the ratio of consolidated total long-term indebtedness to capitalization (each as defined in the indenture governing the Notes). As of December 31, 2016, we were in compliance with all of the covenants under the indenture governing the Notes, and during the twelve months then ended, no event requiring an increase in the interest rate applicable to the Notes occurred.
In September 2016, the Company acquired from NetJets Sales Inc. (“NetJets”) an undivided 31.25% interest in an aircraft for a five year period. The agreement with NetJets provides for monthly management fees, occupied hourly fees and other fees.
We lease office space at Point House in Pembroke, Bermuda. This five year lease expires on November 30, 2020. We also lease office space in Summit, New Jersey, U.S.A. This five year lease expires on February 28, 2021.
See Note 10 to our consolidated financial statements for detailed information on deposit liability contracts. For purposes of this contractual obligations table, we have included estimates of future interest accruals and the amount we expect the deposit liability contracts would settle for at their probable settlement dates.
We have no obligations, assets or liabilities, other than those derivatives in our investment portfolio and disclosed in the notes to our consolidated financial statements, which would be considered off-balance sheet arrangements. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements.
See Note 4 to our consolidated financial statements for additional information on the framework for measuring fair value established by U.S. GAAP disclosure requirements. In addition to the framework discussed in Note 4, we perform several processes to ascertain the reasonableness of the valuation of all of its investments comprising its investment portfolio. These processes include (i) obtaining and reviewing weekly and monthly investment portfolio reports from Third Point LLC, (ii) obtaining and reviewing monthly NAV and investment return reports received directly from the Company’s third-party fund administrator, which are compared to the reports noted in (i), and (iii) monthly update discussions with Third Point LLC regarding the investment portfolio, including, their process for reviewing and validating pricing obtained from third party service providers.