Montpelier Re Holdings Ltd. and Montpelier Re were formed on November 14, 2001, and Montpelier Re commenced operations on December 16, 2001. Neither company had any prior operating history. Accordingly, there are no material comparable results from the prior period. The following is a discussion and analysis of our results of operations for the year ended December 31, 2002 and, if relevant, for the period from November 14, 2001, the date of incorporation, to December 31, 2001. The following also includes a discussion of our financial condition at December 31, 2002. This discussion and analysis should be read in conjunction with the audited combined financial statements and related notes thereto included in this filing. This filing contains forward-looking statements that are not historical facts, including statements about the Company’s beliefs and expectations. These statements are based upon current plans, estimates and projections. Our actual results may differ materially from those projected in these forward-looking statements as a result of various factors. See “Note on Forward Looking Statements” and "Risk Factors” contained in Item 1 “Business” of this filing.
Coverage is usually triggered by a large loss sustained by an individual risk rather than by smaller losses which fall below the specified retention of the reinsurance contract.
We also write property pro-rata reinsurance contracts which are comprised of property risk programs written on a proportional basis rather than on an excess of loss basis.
Qualifying Quota Share (“QQS”) - This category represents whole account quota share reinsurance to select Lloyd’s syndicates. Under QQS contracts, we assume a specified portion of the risk on a specified coverage in exchange for an equal proportion of the premiums. Gross premiums written related to QQS arrangements have been recorded gross of original commissions to the syndicates. This accounting treatment, when compared to recording such premiums net of original commissions, has the effect of increasing gross premiums written and increasing acquisition costs by an equal amount.
In October 2002, we completed an initial public offering of 10,952,600 common shares. Our common shares began trading on the New York Stock Exchange on October 10, 2002. The offering raised approximately $201.2 million in net proceeds, substantially all of which was contributed to our principal operating subsidiary, Montpelier Re for use in its underwriting operations.
Income from our investment portfolio is primarily comprised of interest on fixed maturity investments net of investment expenses, and to a lesser extent from realized gains and losses on the sale of investments.
Acquisition costs consist principally of brokerage expenses and commissions that represent a percentage of the premiums on reinsurance contracts written, and vary depending upon the amount and types of contracts written, and to a lesser extent ceding commissions paid to ceding insurers and excise taxes. Under certain contracts we may also pay profit commission to cedents. This will vary depending on the loss experience on the contract.
At the discretion of the Compensation and Nominating Committee of the Board of Directors, the Company has awarded, and will in the future award, performance units to executive officers and certain other key employees. The ultimate value of these performance units, which vest at the end of three-year performance periods, is dependent upon the Company’s achievement of specified performance targets over the course of the overlapping three-year periods and the market value of the Company’s shares at the date of redemption. Performance units are payable in cash, common stock or a combination of both. The liability is expensed over the vesting period of the performance units granted. The liability is recalculated as the relevant financial results and share price of the Company evolve. Any adjustments are reflected in the income statement in the period in which they are determined.
Our fixed maturity investments are classified as available for sale under U.S. GAAP and are carried at fair value based on quoted market prices. Unrealized gains and losses on these investments are included in accumulated other comprehensive income as a separate component of shareholders’ equity. If management has determined that an investment has sustained an impairment in value that is determined to be other than temporary, the unrealized loss will be charged to income in the period it is determined
Our only equity investment is in Aspen Insurance Holdings Limited (“Aspen”) (formerly Exali Reinsurance Holdings Limited), the unquoted Bermuda-based holding company of Aspen Insurance UK Limited (“Aspen Re”) (formerly Wellington Reinsurance Limited). Under U.S. GAAP, such unquoted investments are carried at estimated fair value. Unrealized gains and losses on these investments are also included in accumulated other comprehensive income as a separate component of shareholders’ equity.
Loss and Loss Adjustment Expense Reserves. For most insurance and reinsurance companies, the most significant judgment made by management is the estimation of the loss and loss adjustment expense reserve. Due to the short-tail nature of our business, generally, we expect that the majority of our losses will be paid relatively quickly; however, this can be affected by such factors as the event causing the loss, the location of the loss, and whether our losses are from policies with insurers or reinsurers. Accordingly, it is necessary to estimate, as part of the loss and loss adjustment expense reserve, an amount for losses incurred but not reported (“IBNR”).
A significant portion of our business is property catastrophe and other classes with high attachment points of coverage. Reserving for losses in such programs is inherently complicated in that losses in excess of the attachment level of the Company’s policies are characterized by high severity and low frequency. This limits the volume of industry claims experience available from which to reliably predict ultimate loss levels following a loss event. In addition, there always exists a reporting lag between a loss event taking place and the reporting of the loss to the Company, which can sometimes be several years. During this period, additional facts and trends will be revealed and as these factors become apparent, reserves will be adjusted. These incurred but not reported losses are inherently difficult to predict. Changes to our prior year loss reserves can impact our current underwriting results by improving our results if the prior year reserves prove to be redundant or reducing our results if the prior year reserves prove to be insufficient. Because of the variability and uncertainty associated with loss estimation, it is possible that our individual case reserves for each catastrophic event and other case reserves are incorrect, possibly materially. This volatility will affect our results in the period that the loss occurs because GAAP does not permit reinsurers to reserve for such catastrophic events until they occur and may give rise to a claim. As a result, no allowance for the provision of a contingency reserve to account for expected future losses can be recorded. Claims arising from future catastrophic events can be expected to require the establishment of substantial reserves from time to time. We expect that increases in the values and concentrations of insured property will increase the severity of worldwide catastrophic losses in the future.
We estimate IBNR using actuarial methods. We also utilize historical insurance industry loss development patterns, as well as estimates of future trends in claims severity, frequency and other factors, to aid us in establishing IBNR.
projections supplied by the underlying cedents and actuarial support of the underwriting year forecasts. The resulting changes in incurred losses are recorded in the period in which they are determined.
Loss and loss adjustment reserve estimates are regularly reviewed and updated, as new information becomes known to us. Any resulting adjustments are included in income in the period in which they become known.
Unrealized depreciation in the value of individual investments, considered by management to be other than temporary, is charged to income in the period it is determined.
Our results for the 2002 year were primarily driven by the following factors:
The extensive and diverse experience of our team of underwriters, who have particular expertise in the property and specialty areas;
Our superior service capabilities driven by our investment in operational and modeling technologies;
Our A.M. Best financial strength rating of “A-”(Excellent), which is the fourth highest of fifteen rating levels.
The following table summarizes the Company’s combined financial results for the periods indicated:
“Worldwide” comprises insurance and reinsurance contracts that insure or reinsure risks on a worldwide basis.
The Qualifying Quota Share contracts and substantial amounts of other lines of business are worldwide in nature, with the majority of business related to North America and Europe.
The QQS business incepting in the year ended December 31, 2002 are estimated on the basis of projections for the twelve months of 2002 supplied by the underlying syndicates, adjusted for actual reported results from the underlying syndicates for the nine months ended September 30, 2002. Estimated annual premiums can change, based on revised projections supplied by the underlying syndicates. The resulting changes in accrued premium are recorded in the period in which they are determined.
Reinsurance premiums ceded were $2.0 million for the fourth quarter and $41.8 million for the year ended December 31, 2002. Reinsurance premiums ceded are attributable to the reinsurance purchased by the QQS syndicates with respect to the contracts in which we participate. Reinsurance premiums ceded represented approximately 24% of gross premiums written from the syndicates for the year ended December 31, 2002. This reinsurance inures to the benefit of the Company and will potentially result in lower loss ratio volatility in the QQS book of business than in the remainder of the book of business over which reinsurance protection was not purchased in 2002. We would remain liable to the extent that any of the underlying reinsurers fails to pay our claims; however, we have reviewed the financial condition of the reinsurers on the QQS syndicates and do not consider it necessary to write off any reinsurance recoveries. In 2003 we have purchased specific retrocessional protection for our direct insurance and facultative reinsurance programs on an “any one risk” basis to limit our exposure from losses at one location. We may purchase additional retrocessional protection for our own account in 2003.
For comparative purposes, our combined ratio and components thereof are set out below for the nine months ended September 30, 2002 and for the year ended December 31, 2002.
A portion of our business is property catastrophe reinsurance, which has loss experience that is generally categorized as low frequency but high severity in nature. This may result in volatility in our financial results for any fiscal year or quarter. Property catastrophe losses are generally notified and paid within a short period of time from the covered event. The majority of the other classes of business that the Company writes are also short-tail in nature and claims are generally notified and paid within reasonably short periods of time following the loss event.
The release of reserves benefited our fourth quarter loss ratio by approximately 24 points, which reduced the loss ratio to 40.4% for the year ended December 31, 2002 from 54.5% for the nine months ended September 30, 2002. Overall, for the year ended December 31, 2002, we have benefited from the relatively low level of catastrophes.
Pro-rata contracts, including QQS business incepting in the year ended December 31, 2002 are estimated on the basis of projections supplied by the underlying cedents, together with actual reported results for portions of 2002. Estimated losses can change, based on revised projections supplied by the underlying cedents. The resulting changes in incurred losses are recorded in the period in which they are determined. Reported loss ratios for the 2002 underwriting year were generally lower than anticipated and our fourth quarter loss ratio selections reflect this improvement. We have estimated the QQS loss ratios based on figures provided by the syndicates. We will monitor changes in these estimates closely to determine any deviation from previously published forecasts and any required adjustments will be
Management has determined that the best estimate for net loss and loss adjustment expense reserves at December 31, 2002 was $129.5 million. Management’s best estimate of a range of likely outcomes around this estimate is between $114.4 million and $140.5 million. The reserve range for net loss and loss adjustment expense reserves was calculated in a manner consistent with the range for gross reserves as discussed above.
Our net loss and loss adjustment expense reserves at December 31, 2002 and our net loss ratios by line of business for the year ended December 31, 2002 are set out below:
Gross loss and loss adjustment expense reserves per the balance sheet are $146.1 million which has been reduced by $16.6 million in reinsurance recoverable related to the Qualifying Quota Share programs to derive the net loss and loss adjustment expense reserves of $129.5 million noted above.
The gross loss and loss adjustment expense ratio for the year ended December 31, 2002 was 41.0%.
General and administrative expenses for the fourth quarter and for the year ended December 31, 2002 consisted of the following:
Because we provide short-tail insurance and reinsurance coverage for losses resulting mainly from natural and man-made catastrophes, it is possible that we could become liable to pay substantial claims on short notice. Accordingly, we have structured our investment portfolio to preserve capital and provide us with a high level of liquidity, which means that the large majority of our investment portfolio contains shorter
term fixed maturity investments, such as U.S. government bonds, corporate bonds and mortgage-backed and asset-backed securities.
Based on the weighted average monthly investments held, and including net unrealized gains of $8.3 million for the fourth quarter and $33.6 million for the year ended December 31, 2002, the total investment return was 1.4% and 7.0%, respectively. Interest rates declined in 2002, which resulted in decreasing reinvestment yields on our portfolio. In 2003 we expect that our investment income will increase as a result of our larger capital base but that percentage returns will fall as a result of lower interest rates.
We did not experience any other-than-temporary impairment charges relating to our portfolio of investments for the year ended December 31, 2002.
Interest expensed relating to the $150.0 million outstanding balance on our long-term credit facility for the periods ended December 31, 2002 and 2001 was $4.5 million and $0.2 million, which represents an average rate of 2.80% and 2.99%, respectively. The interest rate on the loan was variable from the inception of the loan on December 12, 2001 until April 20, 2002. Thereafter, the interest rate was fixed at 2.96% from April 21, 2002 until October 21, 2002 and has been fixed at 2.59% for the period from October 21, 2002 until April 21, 2003. After April 21, 2003, the rate will revert back to a floating rate, unless another fixed rate is agreed upon. At December 31, 2002 and 2001, the Company accrued interest expense of $800,000 and $236,000 and paid interest of $3.5 million and $Nil, respectively.
Net realized investment gains for the year ended December 31, 2002 were $7.7 million, which were due to gains realized from the sale of fixed maturity investments.
Comprehensive income for the year ended December 31, 2002 was $185.7 million, which includes net income of $152.0 million and $33.7 million of net unrealized gains on investments and changes in currency translation adjustments.
The cost or amortized cost, gross unrealized gains and losses, and carrying values of our investments as of December 31, 2002 were as follows (in thousands):
A significant portion of our business is property catastrophe and other classes with high attachment points of coverage. Reserving for losses in such programs is inherently complicated in that losses in excess of the attachment level of the Company’s policies are characterized by high severity and low frequency. This limits the volume of industry claims experience available from which to reliably predict ultimate loss levels following a loss event. In addition, there always exists a reporting lag between a loss event taking place and the reporting of the loss to the Company, which can sometimes be several years, particularly on longer-tail classes of business such as casualty. During this period, additional facts and trends will be revealed and as these factors become apparent, reserves will be adjusted. These incurred but not reported losses are inherently difficult to predict. Changes to our prior year loss reserves can impact our current underwriting results by improving our results if the prior year reserves prove to be redundant or reducing our results if the prior year reserves prove to be insufficient. Because of the
variability and uncertainty associated with loss estimation, it is possible that our individual case reserves for each catastrophic event and other case reserves are incorrect, possibly materially. This volatility will affect our results in the period that the loss occurs because GAAP does not permit reinsurers to reserve for such catastrophic events until they occur which may give rise to a claim. As a result, no allowance for the provision of a contingency reserve to account for expected future losses can be recorded. Claims arising from future catastrophic events can be expected to require the establishment of substantial reserves from time to time. We expect that increases in the values and concentrations of insured property will increase the severity of the level of worldwide catastrophic losses in the future.
On pro-rata contracts, including QQS arrangements, we estimate ultimate losses based on loss ratio forecasts as reported quarterly by cedents, which is normally on a quarterly lag. We also review historical loss ratios from prior years as provided by each cedent, as well as public reports. We base our estimate of the ultimate losses on both of these factors. Estimated losses can change, based on revised projections supplied by the underlying cedents and actuarial support of the underwriting year forecasts. The resulting changes in incurred losses are recorded in the period in which they are determined.
Because a significant portion of our contracts provide short-tail reinsurance coverage for damages resulting mainly from natural and man-made catastrophes, it is possible that we could become liable for a significant amount of losses on short-term notice. Accordingly, we have structured our investment portfolio to preserve capital and provide us with a high level of liquidity, which means that the large majority of our investment portfolio contains shorter term fixed maturity investments, such as U.S. government bonds, corporate bonds and mortgage backed and asset backed securities.
The Company has invested a total of £40.0 million (or $60.8 million) in the common shares of Aspen Insurance Holdings Limited (“Aspen”) (formerly Exali Reinsurance Holdings Limited), the Bermuda-based holding company of Aspen Insurance UK Limited (“Aspen Re”) (formerly Wellington Reinsurance Limited). At December 31, 2002, Montpelier Re held approximately 7% of Aspen on an undiluted basis and approximately 6% on a fully diluted basis. Under U.S. GAAP, such unquoted investments are carried at estimated fair value. At December 31, 2002, the investment is carried at estimated fair value which is based on Aspen’s reported net asset value, with the difference being recorded as an unrealized gain included within accumulated other comprehensive income.
The successful completion of our IPO during October 2002, together with the results of a successful underwriting year, resulted in a significant growth in assets. In 2003, we expect that our investment income will increase as a result of our larger capital base.
Cash flows for the year ended December 31, 2002. In the year ended December 31, 2002, we generated an operating net cash inflow of $295.2 million, primarily relating to premiums received by Montpelier Re. We paid losses of $4.2 million during the year ended December 31, 2002. We invested a net amount of $706.3 million during the year ended December 31, 2002, and had a cash balance of $162.9 million at December 31, 2002. The increase in liquidity has resulted from premiums received and the addition of approximately $201.2 million in net proceeds as a result of the successful completion of our initial public offering (“IPO”) of 10,952,600 common shares (including the exercise of the over-allotment provision of 1,428,600 common shares) in October, 2002, which was offset by equity raising costs of $18.3 million. We also received approximately $26.0 million in cash from the completion of our private placement of our common shares which occurred in December, 2001. The Company’s common shares began trading on the New York Stock Exchange on October 10, 2002. The net proceeds of the offering were contributed to our principal operating subsidiary, Montpelier Re to provide additional capital for use in its underwriting operations. In addition, this has been a year with a relatively low level of catastrophes, resulting in a low level of claims payments.
covenants which include maintaining: (i) a ratio of debt to total capital no greater than 30%; (ii) a tangible net worth equal to at least the sum of: (x) $525.0 million; (y) 50% of positive quarterly net income (with no deduction for net losses); and (z) 50% of any net equity proceeds, minus certain dividends; and (iii) the ratio of the aggregate statutory net written premiums to the net worth of all our insurance subsidiaries at a level no greater than 1.5 to 1 at the end of any fiscal quarter. Also, these covenants restrict our other borrowings, the ability of our subsidiaries to merge, consolidate, make acquisitions, sell any assets or assign any receivables, and our ability to create liens on any assets, make certain capital expenditures and to hold margin stock. In addition, a change in control of our Company or unpaid final judgments against us which exceed an aggregate of $5.0 million (excluding any portion thereof which will likely be recovered through insurance) each constitute an event of default under our credit facilities.
The Company’s liquidity depends on operating, investing and financing cash flows as described below.
Our cash flows from operations represent the difference between premiums collected and investment earnings realized, and the loss and loss adjustment expenses paid, underwriting and other expenses paid and investment losses realized. Cash flows from operations may differ substantially, however, from net income. To date, we have invested substantially all cash flows not required for operating purposes.
The market value of fixed maturity investments, our unquoted equity investment and our cash and cash equivalents balance was $1,581.5 million as of December 31, 2002, compared to $991.0 million at December 31, 2001. The primary cause of this increase was the receipt of $286.0 million in premiums net of acquisition costs, net IPO proceeds of approximately $201.2 million, net investment income of $39.7 million, the change in net unrealized gains on investments of $33.6 million during the year and the receipt of $26.0 million in subscriptions for common shares on January 3, 2002, which related to the second and final closing of our initial capitalization in December, 2001.
In the third quarter of 2002, we moved to larger office premises in Bermuda. Approximately $1.1 million in related costs were incurred for the year ended December 31, 2002, the majority of which were capitalized. We anticipate leasing additional office space in Bermuda later in 2003, and may incur additional related costs which we would expect to be less than those incurred in 2002.
For the period from inception until December 31, 2002, we have had sufficient cash flow from operations to meet our liquidity requirements. The cash generated from the private placement and the successful completion of our IPO in October 2002, together with our credit facilities, and our positive operating results for 2002 have provided us with sufficient liquidity to enable Montpelier Re to meet its Bermuda statutory requirements under The Insurance Act 1978, related regulations and amendments thereto (the “Insurance Act”), as described below.
Bermuda law limits the maximum amount of annual dividends or distributions payable by Montpelier Re to us and in certain cases requires the prior notification to, or the approval of, the Bermuda Monetary Authority. Subject to such laws, the directors of Montpelier Re have the unilateral authority to declare or not to declare dividends to us. The maximum amount of dividends that could have been paid by Montpelier Re to us at December 31, 2002, without such notification, was $151.4 million. There is no assurance that dividends will be declared or paid in the future.
Montpelier Re is not licensed or admitted as an insurer or reinsurer in any jurisdiction other than Bermuda. Because many jurisdictions do not permit insurance companies to take credit for reinsurance obtained from unlicensed or non-admitted insurers on their statutory financial statements unless appropriate security mechanisms are in place, we anticipate that our reinsurance clients will typically require Montpelier Re to post a letter of credit or other collateral. In order for Montpelier Re to write Lloyd’s Qualifying Quota Share business, it must provide an evergreen letter of credit in favor of The Society and Council of Lloyd’s (“Lloyd’s”) in accordance with Lloyd’s rules. We have made arrangements with Fleet National Bank for the provision of a standby letter of credit in a form acceptable to Lloyd’s in an amount of up to $200.0 million, which we consider sufficient to support Montpelier Re’s estimated qualifying quota share obligations for the next 12 months. Depending on the level of business written by the QQS syndicates over the next 12 months, the standby letter of credit may need to be extended. Letters of credit outstanding at December 31, 2002 under this facility were approximately $99.9 million, which were secured by investments of approximately $107.5 million.
An increase in penetration of existing accounts as we replace capacity of exiting reinsurers;
An increase in written lines on current business, and less sign-downs on many classes;
A continued strong premium rate environment, with premium rate increases in some lines; and
An increase in general new business and unit growth as a result of the decrease in the supply of market capacity caused by the decline in the U.S. equity markets and the significant reserve strengthening which has taken place in the insurance and reinsurance industries.
As our gross premiums written increase, we anticipate that our mix of business will shift over the next few years with a decrease in the percentage of QQS business and an increase in the percentage of direct insurance and facultative and specialty reinsurance business, as a result of expected improved market conditions. Our current estimated gross premiums written for QQS business in 2003 are broadly consistent with gross premiums written for 2002, although ultimate premiums written will depend on the volume of premium actually written by the syndicates.
As part of a subscription and shareholders agreement with Aspen Re, Montpelier Re has agreed to provide quota share reinsurance to Aspen Re comprising annual assumed premiums by Montpelier Re of approximately $60.0 million per year for the underwriting years 2003, 2004 and 2005. These arrangements cover mainly property and casualty risks. Our President and Chief Executive Officer, Anthony Taylor, has joined the Board of Directors of Aspen Insurance Holdings Limited and Aspen Insurance Limited, a wholly-owned subsidiary of Aspen Re, and will remain on the board of Aspen Insurance Holdings Limited for so long as we retain a specified level of shareholdings and maintain the quota share business. On an ongoing basis, we expect our internally generated funds, together with the revolving credit agreement and the capital base provided by the IPO and the private placement, to be sufficient to operate our business and implement our business strategy.
Our financial results in 2002 were affected positively by the unusually relatively low frequency of large natural catastrophic events impacting our business during the year. We would anticipate that we may be impacted in future periods on average by a higher frequency of large natural catastrophic events than those experienced in 2002. Such events could have a material adverse impact on our financial position and results of operations.
The Financial Accounting Standards Board issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”) an interpretation of ARB No. 51 “Consolidated Financial Statements”, in January 2003. FIN 46 clarifies the accounting and reporting for certain entities in which equity investors do not have the characteristics of a controlling financial interest. As disclosed in Notes 1 and 2 of the combined financial statements contained in Item 8 of this filing, the financial statements at December 31, 2002 are prepared on a combined basis as a result of the fact that Montpelier Re’s and the Company’s bye-laws include certain restrictions relating to the election of directors of Montpelier Re. FIN 46 becomes effective in the first quarter of 2003. The impact of adoption of FIN 46 will be that the Company’s financial statements for the quarter ending March 31, 2003 and for future periods will be presented on a consolidated basis instead of on a combined basis. There is no impact on the Company’s net income or shareholders’ equity as presented in the combined financial statements as a result of the adoption of FIN 46.