On July 9, 2008, we entered into an operating lease agreement for new office space in Grand Cayman, Cayman Islands which expires on June 30, 2018. We occupied the new office space in August 2009. Previously, we leased and occupied office space in Grand Cayman under an operating lease that was terminated effective March 23, 2010. We believe that for the foreseeable future the new office space will be sufficient for conducting our operations in the Cayman Islands. GRIL is currently in the process of leasing office space in Dublin which we believe will be sufficient for conducting its operations in Ireland for the foreseeable future.
The following table sets forth our selected historical consolidated statement of income data for the fiscal years ended December 31, 2010, 2009, 2008, 2007 and 2006, as well as our selected consolidated balance sheet data as of December 31, 2010, 2009, 2008, 2007, and 2006, which are derived from our audited consolidated financial statements. The audited consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (‘‘U.S. GAAP”) and have been audited by BDO USA, LLP, an independent registered public accounting firm.
We manage our business on the basis of one operating segment: property and casualty reinsurance, in accordance with the qualitative and quantitative criteria established by United States generally accepted accounting principles (“U.S. GAAP”). Within the property and casualty reinsurance segment, we analyze our underwriting operations using two categories:
In addition, we may from time to time derive other income from gains on deposit accounted contracts, fees generated from advisory services provided by Verdant and penalty fees relating to early terminations of contracts.
For securities classified as “trading securities” and “other investments”, any realized and unrealized gains or losses are determined on the basis of specific identification method (by reference to cost and amortized cost, as appropriate) and included in net investment income in the consolidated statements of income.
Financial contracts which include total return swaps, credit default swaps and other derivative instruments are recorded at their fair value with any unrealized gains and losses included in net investment income in the consolidated statements of income. Fair values on total return swaps are based on the underlying security’s fair value which are obtained from closing prices on a recognized exchange (for equity or commodity swaps), or from market makers or broker quotes. Fair values for credit default swaps trading in an active market are based on market maker or broker quotes taking into account credit spreads on identical contracts. Fair values for other derivative instruments are determined based on multiple broker or market maker quotes taking into account the liquidity and the availability of an active market for the derivative.
For natural peril exposed business we generally establish loss reserves based on loss payments and case reserves reported by our clients, when and if received. We then add to these case reserves our estimates for IBNR. To establish our IBNR loss estimates, in addition to the loss information and estimates communicated by ceding companies, we use industry information, knowledge of the business written and management’s judgment.
Acquisition Costs. We capitalize brokerage fees, ceding commissions, premium taxes and other direct expenses that relate directly to and vary with the writing of reinsurance contracts. Acquisition costs are deferred subject to ultimate recoverability and amortized over the related period of risk covered. Acquisition costs also include profit commissions. Certain contracts include provisions for profit commissions to be paid to the ceding insurer based upon the ultimate experience of the contracts. The methodology for calculating profit commissions are specific to the individual contracts and vary from contract to contract. Typically profit commissions are calculated and accrued based on the expected loss experience for such contracts and recorded when the expected loss experience indicates that a profit commission is probable under the contract terms. Profit commission reserves, if any, are included in reinsurance balances payable on the consolidated balance sheets.
We believe that the rebound in the financial markets during 2009 and 2010 resulted in restored financial positions in the property and casualty insurance and reinsurance industry. As a result, we believe that underwriting capacity has become more available in the property and casualty market, which in turn has resulted in a delay in significant price increases for our specialty products. In addition, the lack of large catastrophes in 2009 and 2010 has increased industry capital. Further, we believe the slowdown in worldwide economic activity has decreased the overall demand for insurance. Notwithstanding, price reductions from prior years appear to have slowed and in some areas reversed. We believe that pricing of the property and casualty industry will be relatively flat for the near term until insurers and reinsurers begin to realize that the current price levels are not economically rational. Given that prior years' reserve redundancies have been reduced substantially and current interest rates are low, which limits opportunities for traditional reinsurers that principally invest in fixed maturity investments, we believe the industry will eventually need to increase pricing. However, we do not expect to see the effects of this until 2012 or beyond. Price increases could occur earlier if financial and credit markets experience additional adverse shocks and loss of capital of insurers and reinsurers, or if there is one or more major catastrophic events. One exception to this general trend of flat to downward pricing is the Florida homeowners’ insurance market which has been experiencing significant rate increases and, in accordance with our strategy, we have increased our portfolio in this market.
Property catastrophe retrocession pricing started to decline in January 2011. At the same time, property catastrophe reinsurance pricing softened by an estimated 5% to 10% versus January 2010. We believe this soft pricing is due to the increased underwriting capacity of the industry, and in accordance with our strategy, we have begun to reduce our property catastrophe retrocession portfolio. While it is unclear what other businesses could be significantly affected by the current economic downturn, we believe that opportunities are likely to arise in a number of areas, including the following:
We intend to continue monitoring market conditions to position ourselves to participate in future underserved or capacity-constrained markets as they arise and intend to offer products that we believe will generate favorable returns on equity over the long term. Accordingly, our underlying results and product line concentrations in any given period may not be indicative of our future results of operations.
For the year ended December 31, 2010, we reported a net income of $90.6 million as compared to net income of $209.5 million for the year ended December 31, 2009. The net income reported in 2010 principally related to a net investment income of $104.0 million. Our investment portfolio reported a gain of 11.0% for the year ended December 31, 2010 compared to a gain of 32.1% for the year ended December 31, 2009. The underwriting income before general and administrative expenses for the year ended December 31, 2010 decreased by 69.7% to $8.0 million compared to $26.4 million for the year ended December 31, 2009.
Our primary financial goal is to increase the long-term value in fully diluted adjusted book value per share. During the year ended December 31, 2010, the fully diluted adjusted book value per share increased by $2.44 per share, or 12.9%, to $21.39 per share from $18.95 per share at December 31, 2009. For the year ended December 31, 2009, the fully diluted adjusted book value per share increased by $5.56 per share, or 41.5%, to $18.95 per share from $13.39 per share at December 31, 2008.
Basic adjusted book value per share is a non-GAAP measure as it excludes the non-controlling interest in joint venture from total shareholders' equity. In addition, fully diluted adjusted book value per share is also a non-GAAP measure and represents basic adjusted book value per share combined with the impact from dilution of all in-the-money stock options issued and outstanding as of any period end. We believe that long-term growth in fully diluted adjusted book value per share is the most relevant measure of our financial performance. In addition, fully diluted adjusted book value per share may be of benefit to our investors, shareholders, and other interested parties to form a basis of comparison with other companies within the property and casualty reinsurance industry.
We expect our annual reporting of premiums written to be volatile as our underwriting portfolio continues to develop. Additionally, the composition of premiums written between frequency and severity business will vary from year to year depending on the specific market opportunities that we pursue. For the year ended December 31, 2010, the premiums written relating to frequency business increased by $165.0 million, or 72.7%, from the year ended December 31, 2009. The increase reflects the continuing development of our underwriting activities which resulted in a number of new and renewing frequency contracts written during the year ended December 31, 2010. The largest increase in frequency premiums written related to several new multi-year homeowners’ personal lines contracts entered into during 2010 which accounted for 87.7% of the increase. The Florida homeowners’ insurance market was a key area of our underwriting focus during 2010. We continued to generate growth in most of our other lines of business, such as health, general liability, and professional liability which contributed 10.7%, 8.8%, and 4.7%, respectively, to the increase in frequency premiums written for the year ended December 31, 2010. The growth in health, general liability, and professional liability lines was achieved through a combination of renewals and new relationships created during 2010. In addition, during 2010, we entered into financial line (surety and trade credit) which contributed 9.3% to the increase in premiums. These increases were partially offset by a decrease in our motor liability premiums of $40.1 million, as some of our commercial motor contracts were placed into run-off during 2010.
For the year ended December 31, 2009, the premiums written relating to frequency business increased by $92.9 million, or 69.3%, from the year ended December 31, 2008. The increase reflects the continuing development of our underwriting activities which resulted in a number of new and renewing frequency contracts written during the year ended December 31, 2009. The largest increase in premiums written for the year ended December 31, 2009 was a result of a new multi-year homeowners’ personal lines contract entered into during 2009 which accounted for 41.4% of the increase. General liability, workers’ compensation, health, motor liability and medical malpractice lines also contributed 28.9%, 10.8%, 8.1%, 6.0% and 4.8% respectively, to the increase in frequency premiums written for the year ended December 31, 2009.
Net premiums earned reflect the pro rata inclusion into income of net premiums written over the life of the reinsurance contracts. Details of net premiums earned for the years ended December 31, are provided in the following table:
Premiums relating to quota share contracts are earned over the contract period in proportion to the period of protection. Similarly, incoming unearned premiums are earned in proportion to the remaining period of protection. For the year ended December 31, 2010, the increase in frequency earned premiums of $89.3 million, or 52.7%, reflects the additional quota share contracts written throughout the 2010 year. The increase primarily related to the new Florida homeowners’ property insurance contracts written during 2010 which accounted for $65.2 million of the increase. The remaining increase in earned premiums related to growth in existing general liability and health contracts, which together accounting for $40.0 million of the increase, and to a lesser extent from new relationships formed during 2010 in other lines such as financial (surety and trade credit), and professional indemnity which together accounted for $9.8 million of the increase. The increase in frequency earned premiums was partially offset by a $25.7 million decrease relating to motor liability contracts that were placed into run-off during 2010. For the year ended December 31, 2010, severity earned premiums decreased $16.3 million or 36.2% compared to the 2009 year. The decrease was principally due to our decision to significantly reduce our participation in a property catastrophe contract during 2010. In addition, to lesser extent the decrease was a result of a multi-year professional liability contract written in 2007 that expired in 2010 without being renewed; and a result of commuting two contracts, one relating to medical malpractice and another relating to professional liability aggregate stop-loss. These decreases were offset by the premiums earned from our recently added financial line.
For the year ended December 31, 2009 total losses incurred on frequency contracts increased as a result of increases in premiums earned. For the year ended December 31, 2009 the increase in frequency loss ratio was principally due to the increase in earned premiums on certain lines of business that typically have higher loss ratios. Specifically, the increase in premiums earned on our motor liability and health lines contributed to the majority of the increase in the frequency loss ratio.
Losses incurred can be further broken down into losses paid and changes in loss reserves. Losses incurred for the years ended December 31, 2010, 2009 and 2008 were comprised as follows:
For the year ended December 31, 2010, the losses incurred included $8.7 million related to net adverse loss development on reserves relating to prior years.
During the year ended December 31, 2010, the loss development on prior year contracts primarily related to the following:
Adverse loss development of $3.4 million based on data received from the client and our quarterly reserve analysis, relating to California wildfires on a 2007 casualty clash contract, resulting in losses being reserved at the full contract limit;
Adverse loss development of $0.7 million on a 2008 professional liability excess of loss contract, based on data received from the client and our quarterly reserve analysis;
Adverse loss development of $0.6 million on a 2007 quota share motor contract, based on data received from the client and our quarterly reserve analysis;
Favorable loss development of $1.3 million in aggregate, on specialty health contracts relating to 2007 and 2008 years, based on data received from the client and our quarterly reserve analysis;
· Favorable loss development of $8.0 million on a 2006 Florida personal lines contract. We review loss reserves based upon the most recent available information. In general, initially on a contract, loss reserves are estimated based on historic or modeled information. These reserve estimates are adjusted, up or down, as the actual loss experience is realized. Our loss reserves on this contract were adjusted quarterly as new information was presented by our client and we reported these adjustments quarterly. The client reports incurred losses on this contract to us on a quarterly basis. The reserves we book are based on a combination of data received from the client as well as historic and industry data. During each quarter of 2009, the client reported favorable development of claims data resulting from lower than expected paid and incurred losses which impacted our own reserve analysis and correspondingly caused us to reduce our reserves by approximately $8.0 million during the year ended December 31, 2009;
· Eliminating $1.0 million of reserves, held on two casualty clash contracts which were commuted during the year ended December 31, 2009, without any reported losses;
· Adverse loss development of $3.4 million on a 2007 casualty clash contract resulting from claims relating to California wildfires; and
For the year ended December 31, 2010, the decrease in the frequency acquisition cost ratio was principally due to no further profit commissions expensed on a Florida homeowners' personal lines contract which commuted during 2010. This decrease was partially offset by the ceding commissions on the new Florida homeowners’ personal lines contracts which are generally higher than the commissions on our other lines of business.
Our general and administrative expenses for the years ended December 31, 2010, 2009 and 2008 were $16.2 million, $19.0 million and $13.8 million, respectively. For the year ended December 31, 2010, the decrease in general and administrative expenses primarily related to a reduction in employee bonus accruals which resulted from adverse loss development negatively impacting the underwriting income, as well as due to a decrease in investment income accrued on the deferred bonus compensation relating to the 2008 and 2009 underwriting years, which is payable to the employees during 2011 and 2012, respectively. The decrease was partially offset by an increase in salaries and benefits expenses resulting from the addition of new staff during 2010.
For the year ended December 31, 2009, approximately 84.6% of the increase in general and administrative expenses related to higher personnel costs including employee bonuses, stock compensation, salaries and benefits. While we added three new employees during the year ended December 31, 2009, the increase in personnel costs primarily related to higher accrued employee bonuses, which resulted from net favorable loss development and investment income accrued on the deferred bonus compensation relating to the 2007 and 2008 underwriting years, payable to the employees during 2010 and 2011, respectively. Higher rent and office expenses relating to new office space (including expensing the remaining lease payments relating to the original office space) accounted for approximately 13.5% of the increase in general and administrative expenses.
Verdant is incorporated in Delaware, and therefore is subject to taxes in accordance with the U.S. federal rates and regulations prescribed by the Internal Revenue Service. Verdant’s taxable income is expected to be taxed at a rate of 35%.
Due to the opportunistic and customized nature of our underwriting operations, we expect to report different loss and expense ratios in both our frequency and severity businesses from period to period. For the years ended December 31, 2010, 2009 and 2008, we reported the following ratios:
For the year ended December 31, 2010, the increase in our invested assets, on a net basis, was the result of net contributions of $69.5 million from our underwriting activities and a net investment gain of $104.0 million.
In determining whether a market for a financial instrument is active or inactive, we obtain information from our investment advisor who makes the determination based on feedback from executing brokers, market makers, and in-house traders to assess the level of market activity and available liquidity for any given financial instrument. Where a financial instrument is valued based on broker quotes, our investment advisor generally requests multiple quotes. The ultimate value is based on an average of the quotes obtained. Broker quoted prices are generally not adjusted in determining the ultimate values and are obtained with the expectation of the quotes being binding. As of December 31, 2010, $98.6 million of our investments were valued based on broker quotes, of which $72.1 million were based on observable market information and classified as Level 2, and $26.5 million were based on non-observable inputs and classified as Level 3.
For the year ended December 31, 2010, we transferred, from Level 1 to Level 2, an equity security for which a quoted price on an active market was not available and as a result we relied on broker quotes to determine the fair value. There were no other transfers between Level 1, Level 2 or Level 3 fair value measurements during the year ended December 31, 2010. The increase in our Level 3 investments was primarily due to private equity investments purchased during the year.
Restricted cash totaled $977.3 million as of December 31, 2010 compared to $590.9 million as of December 31, 2009, an increase of 65.4%. The increase in restricted cash was principally attributed to providing collateral against the letters of credit outstanding. Under a term margin agreement and an amended letter of credit facility agreement, which became effective during the fourth quarter of 2010, we pledge certain investment securities to borrow cash from the prime broker and place the cash in a custodial account in our name. The cash in the custodial account is used to provide collateral for letters of credit issued under this agreement. As a result, restricted cash at December 31, 2010, included $218.7 million (2009: nil) of cash collateral relating to letters of credit issued. In addition, the increase in restricted cash as of December 31, 2010, was also due to the increase in our short securities of $155.8 million for which additional cash and cash equivalents were pledged as collateral.
At December 31, 2010, deferred acquisition costs and unearned premium reserves increased by 154.0% and 97.6%, respectively, compared to December 31, 2009. These increases were primarily driven by the increase in premiums written including unearned premiums assumed at inception of several quota share homeowners' insurance contracts written during 2010 on which we generally pay higher ceding commissions than our other frequency contracts. We evaluate the recoverability of deferred acquisition costs by determining if the sum of future earned premiums and anticipated investment income is greater than the expected future claims and expenses. If a loss is probable on the unexpired portion of policies in force, a premium deficiency loss is recognized. As of December 31, 2010, we believe the deferred acquisition costs were fully recoverable and no premium deficiency loss was recorded.
Reserves for loss and loss adjustment expenses as of December 31, 2010 and 2009 were comprised of the following:
Although Greenlight Capital Re is not subject to any significant legal prohibitions on the payment of dividends, Greenlight Re and GRIL are both subject to regulatory minimum capital requirements and regulatory constraints that affect their ability to pay dividends to us. In addition, any dividend payment would have to be approved by the relevant regulatory authorities prior to payment. As of December 31, 2010, Greenlight Re and GRIL both exceeded the regulatory minimum capital requirements.
Both our reinsurance subsidiaries, Greenlight Re and GRIL, have been assigned a financial strength rating of ‘‘A− (Excellent)’’ by A.M. Best. This rating reflects the rating agency’s opinion of our reinsurance subsidiaries’ financial strength, operating performance and ability to meet obligations. If an independent rating agency downgrades or withdraws our rating, we could be severely limited or prevented from writing any new reinsurance contracts, which would significantly and negatively affect our business. Insurer financial strength ratings are based upon factors relevant to policyholders and are not directed toward the protection of investors. Our rating may be revised or revoked at the sole discretion of the rating agency.
The following table shows our aggregate contractual obligations by time period remaining to due date as of December 31, 2010:
Reflects our contractual obligations pursuant to the July 9, 2008 lease agreement as described below.
On July 9, 2008, we signed a ten year lease agreement for office space in the Cayman Islands with the option to renew for an additional five year term. The lease term was effective from July 1, 2008 and ends on June 30, 2018. Under the terms of the lease agreement, our minimum annual rent payments are $253,539 for the first three years, increasing by 3% thereafter each year to reach $311,821 by the tenth year. The minimum lease payments are included in the above table under operating lease obligations and in Note 15 to the accompanying consolidated financial statements.
We have entered into a service agreement with a specialist service provider for the provision of administration and support in developing and maintaining business relationships, reviewing and recommending programs and managing risks relating to certain specialty lines of business. The specialist service provider does not have any authority to bind the Company to any reinsurance contracts. Under the terms of the agreement, the Company has committed to quarterly payments to the specialist service provider. If the agreement is terminated, the Company is obligated to make minimum payments for another two years to ensure any contracts to which the Company is bound are adequately administered by the specialist service provider. The minimum payments are included in the above table under specialist service agreement and in Note 15 to the accompanying consolidated financial statements.
On January 1, 2008, we entered into an agreement wherein the Company and DME Advisors agreed to create a joint venture for the purposes of managing certain jointly held assets. This agreement was amended effective August 31, 2010 to include GRIL as a participant to the agreement. The term of the amended agreement is August 31, 2010 through December 31, 2013 with automatic three-year renewals unless 90 days prior to the end of the then current term, either DME Advisors terminates the agreement or any of the participants notifies DME Advisors of its desire to withdraw from the agreement. Pursuant to this agreement, we pay a monthly management fee of 0.125% on our share of the assets managed by DME Advisors and a performance allocation of 20% on the net investment income of the Company’s share of assets managed by DME Advisors subject to a loss carry forward provision. The loss carry forward provision allows DME Advisors to earn reduced incentive compensation of 10% on net investment income in any year subsequent to the year in which the investment account incurs a loss, until all the losses are recouped and an additional amount equal to 150% of the aggregate loss is earned. DME Advisors is not entitled to earn performance compensation in a year in which the investment portfolio incurs a loss. As of December 31, 2010, the loss carry forward balance was reduced to nil and the performance allocation rate returned to 20%. For the year ended December 31, 2010, $9.4 million of the performance compensation was calculated using the reduced rate of 10% and $3.5 million was calculated using the full rate of 20%.
In February 2007, we entered into a service agreement with DME Advisors pursuant to which DME Advisors will provide investor relations services to us for compensation of $5,000 per month plus expenses. The agreement had an initial term of one year, and continues for sequential one year periods until terminated by us or DME Advisors. Either party may terminate the agreement for any reason with 30 days prior written notice to the other party.
We have no obligations, assets or liabilities, other than those derivatives in our investment portfolio and those disclosed in the 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.