Statement of operations data for the years ended December 31, 2010, 2009 and 2008 and balance sheet data as of December 31, 2010 and 2009 are derived from our audited consolidated financial statements included in Item 8, “Financial Statements and Supplementary Data” in this Annual Report, which have been prepared in accordance with U.S. GAAP.
As of January 1, 2007, we adopted the Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”) Topic on Fair Value Measurements and Disclosures and the FASB ASC Topic on Financial Instruments. As a result, substantially all of our investments are now carried at fair value with changes in fair value being reported as net realized and unrealized gains (losses) in our statement of operations and comprehensive income (loss). Prior to the adoption of these Topics, our available for sale investments were carried at fair value with changes in fair value with changes therein reported as a component of other comprehensive income.
We commenced operations in December 2005. On March 30, 2007, our common shares began trading on the New York Stock Exchange (“NYSE”). On May 14, 2010, the Company’s shareholders approved a redomestication to change Flagstone’s jurisdiction of incorporation from Bermuda to Luxembourg and thereby discontinued its existence as a Bermuda company as provided in Section 132G of The Companies Act 1981 of Bermuda and continued its existence as a société anonyme under the laws of Luxembourg effective May 17, 2010 (the “Redomestication”). The Redomestication has not had, and we do not expect the Redomestication to have, a material impact on the way we operate or on our financial condition or results of operations.
We believe we remained disciplined throughout 2010, which resulted in benefits to our North American portfolio. At January 1, 2011, North American catastrophe pricing in the market was generally down 7 to 10 percent on a risk adjusted basis, and as such we were content to reduce risk by not renewing underpriced business. The Northeast was among the more disappointing regions and we believe that at current market price levels increasing our number of programs is no longer supportable on a marginal pricing basis. The only region that saw some price increases was the Midwest, driven by programs directly affected by the high tornado and hail loss activity of the past three years. Overall, we expect cycle management to play a key role as the year progresses. The recent catastrophe model changes may partially offset this softening trend and increase demand; however, we expect the large industry loss activity to be the major catalyst for change.
For a breakdown of reserves for losses and loss adjustment expenses refer to Note 8 “Loss and Loss Adjustment Expense Reserves” and Note 9 “Reinsurance” in Item 8, “Financial Statements and Supplementary Data” of this Annual Report.
For reinsurance written on an excess of loss basis, which represents approximately 66.2%, 72.0% and 65.0% of the premiums we wrote for the years ended December 31, 2010, 2009 and 2008, respectively, our exposure is limited by the fact that most treaties have a defined limit of liability arising from a single loss event. Once the limit has been reached, we have no further exposure to additional losses from that relevant treaty for the same loss event. For reinsurance on a pro rata basis, we typically have event caps so these liabilities are contained.
Our actuarial group performs a quarterly loss reserve analysis. This analysis incorporates specific exposures, loss payment and reporting patterns and other relevant factors. This process involves the segregation of risks between catastrophic and non-catastrophic risks to ensure appropriate treatment.
All of our critical assumptions can be thought of as key assumptions in the sense that they can have a material impact on the adequacy of our reserves. In general, the various actuarial techniques we use assume that loss reporting and payment patterns in the future can be estimated from past experience. Future payment and reporting patterns could differ from historical experience. In practice it is difficult to be precise on the effect of each assumption. However, due to a greater potential for estimation error, and thus greater volatility, our reserves may be more sensitive to the effects of deviations from assumptions (iv), (v) and (vi) above than the other assumptions.
During the year ended December 31, 2010, the losses on our catastrophe business were primarily from the Chile earthquake ($62.2 million), the Deepwater Horizon oil rig explosion ($41.3 million), the New Zealand earthquake ($75.5 million) and the Australian floods ($10.0 million). During the year ended December 31, 2009, the significant losses on our catastrophe business were primarily from a series of small catastrophe events and one significant event, floods in Ireland ($13.6 million). During the year ended December 31, 2008, the significant losses on our catastrophe business were as follows: Hurricane Ike ($158.4 million), Hurricane Gustav ($14.5 million), Chinese winter storms ($18.2 million) and the U.S. Memorial Day Weekend storms ($11.1 million). Because we expect a small volume of large claims, we believe the variability in our catastrophe related loss ratio could be relatively large. Claims from catastrophic events could reduce our earnings and cause substantial volatility in our results of operations for any fiscal quarter or year which could adversely affect our financial condition and liquidity position.
A significant component of our loss ratio relates to non-catastrophe business for the years ended December 31, 2010, 2009 and 2008. As we commonly write net lines of non-catastrophe business exceeding $10.0 million, we expect that the ultimate loss ratio for non-catastrophe business could vary significantly from our initial loss ratios. Thus, a 10% increase or decrease in loss ratios for non-catastrophe business is reasonably likely to occur and, for the years ended December 31, 2010, 2009 and 2008, this would have resulted in an approximate increase or decrease in our net income or shareholders’ equity of approximately $29.1 million, $27.7 million and $21.4 million, respectively.
For pro rata contracts, gross premiums written and related acquisition costs are normally estimated on a quarterly basis based on discussions with ceding companies, together with historical experience and management’s judgment. Premiums written on pro rata contracts are earned over the risk periods of the underlying policies issued and renewed. As a result, the earning pattern of pro rata contracts may extend up to 24 months. This is generally twice the contract period due to the fact that some of the underlying exposures may attach towards the end of our contracts (i.e., risks attaching basis), and such underlying exposures generally have a one year coverage period. Total premiums written and earned on our pro rata business for the year ended December 31, 2010 were $288.5 million (26.3%), and $222.1 million (26.1%), respectively, for the year ended December 31, 2009 were $220.6 million (22.3%), and $213.0 million (28.1%), respectively and were $195.0 million (24.9%), and $159.7 million (24.4%), respectively, for the year ended December 31, 2008. Total earned acquisition costs estimated on pro rata contracts for the year ended December 31, 2010, 2009 and 2008 were $61.8 million (37.5%), $64.2 million (47.0%) and $41.9 million (39.6%), respectively. On a quarterly basis, we track the actual premium received and acquisition costs incurred and compare this to the estimates previously booked. Such estimates are subject to adjustment in subsequent periods when actual figures are recorded.
Acquisition costs, which are primarily comprised of ceding commissions, brokerage, premium taxes, profit commissions, sliding scale commissions and other expenses that relate directly to the writing of reinsurance contracts are expensed over the underlying risk period of the related contracts. Acquisition costs relating to the unearned portion of premiums written are deferred and carried on the balance sheet as deferred acquisition costs. Deferred acquisition costs are amortized over the period of the related contract and are limited to their estimated realizable value based on the related unearned premiums, anticipated claims expenses and investment income.
Investments are recorded on a trade date basis and realized gains and losses on sales of investments are determined on a first-in, first-out basis. Net investment income includes interest income on fixed maturity investments, recorded when earned, dividend income on equity investments, recorded when declared, and the amortization of premiums and discounts on investments net of investment management and custody expenses.
In accordance with the Fair Value Measurements and Disclosures Topic of the FASB ASC, we determined that investments in U.S. government treasury securities and listed equity securities are classified as Level 1 fair value as determined by the quoted market price of these securities, as provided either by independent pricing services or exchange market prices. The U.S. government treasury securities represented 12.1% of our total fixed maturities portfolio.
Investments in U.S. government agency securities, corporate bonds, mortgage-backed securities, foreign government bonds and asset-backed securities are classified as Level 2 fair value. The fair value of these securities is derived from broker quotes based on inputs that are observable for the asset, either directly or indirectly, such as yield curves and transactional history. Catastrophe bonds are classified as Level 2 fair value as determined by reference to broker indications. Those indications are based on current market conditions, including liquidity and transactional history, recent issue price of similar catastrophe bonds and seasonality of the underlying risks.
At December 31, 2010, the fair value of the securities classified as Level 3 under the Fair Value Measurements and Disclosures Topic of the FASB ASC was $40.0 million, or approximately 2.5% of total investment assets measured at fair value. We do not carry investments accounted for under the equity method at fair value. Refer to Note 7 “Investments” in Item 8, “Financial Statements and Supplementary Data” of this Annual Report for a breakdown of the fair value measurements.
At December 31, 2010, pricing for all of our fixed maturities, excluding U.S. government securities, was based on prices provided by nationally recognized independent pricing services. Generally, pricing services provide pricing for less-complex, liquid securities based on market quotations in active markets. For fixed maturities that do not trade on a listed exchange, these pricing services may use matrix pricing consisting of observable market inputs to estimate the fair value of a security. These observable market inputs include: reported trades, benchmark yields, broker/dealer quotes, issuer spreads, two-side markets, benchmark securities, bids, offers, reference data, and industry and economic factors. Additionally, pricing services may use a valuation model such as an option adjusted spread model commonly used for estimating fair values of mortgage-backed and asset-backed securities. At December 31, 2010, we have not adjusted any pricing provided by independent pricing services.
Derivative instruments are stated at fair value as determined by the quoted market price for futures contracts within Level 1 and by observable market inputs for foreign currency forwards, total return swaps, currency swaps, interest rates swaps and “to be announced” mortgage-backed securities (“TBAs”) within Level 2. We estimate the fair value of reinsurance derivative contracts by utilizing the unearned premium as the carrying value as an approximation of the present value of cash flows as these contracts are under one year in duration.
Upon vesting, the PSU holder shall be entitled to receive a number of our common shares (or the cash equivalent, at the election of the Company) equal to the product of the number of PSUs granted multiplied by a factor. The factor will range between 50% and 150%, depending on the DROE achieved during the vesting period.
We estimate the fair value of PSUs granted under the PSU Plan on the date of grant using the closing price of our common shares on the grant date and the most probable DROE outcome and record the compensation expense in our consolidated statement of operations over the course of each two-year or three-year performance period. At the end of each quarter, we reassess the projected results for each two-year or three-year performance period as our financial results evolve. If we determine that a change in estimate is required, we recalculate the compensation expense under the PSU Plan and reflect any adjustments in the consolidated statements of operations in the period in which they are determined.
The total number of PSUs outstanding under the PSU Plan at December 31, 2010, 2009 and 2008 were 3,998,558, 3,305,713 and 2,189,982, respectively (or up to 5,751,765 common shares at December 31, 2010, should the maximum factor for each of the performance periods apply). Taking into account the results to date and the expected results for the remainder of the performance periods, we have established the most probable factor at 100%, with the exception of one series which has been established to have the most probable factor of 150%. As such, the expected number of common shares to be issued under the plan is 3,998,558 at December 31, 2010. As at December 31, 2010, 2009 and 2008, there was a total of $12.2 million, $19.4 million and $21.0 million, respectively, of unrecognized compensation cost related to non-vested PSUs, the cost of which is expected to be recognized over a period of approximately 1.5 years, 1.6 years and 2.5 years, respectively.
We generated $97.1 million of net income in 2010, compared to a net income of $242.2 million and net loss of $187.3 million in 2009 and 2008, respectively. As highlighted in the tables below, the two most significant items impacting our 2010 financial performance compared to 2009 and 2009 compared to 2008 include: (1) A decrease in underwriting income due to significant catastrophe losses (net of reinsurance and reinstatements) in the year 2010 compared to 2009. The main loss events in the year ended December 31, 2010 which caused the decrease are the Chile earthquake ($62.2 million; Reinsurance segment - $57.3 million, Lloyd’s segment $4.9 million), which occurred in the first quarter; the Deepwater Horizon oil rig explosion ($41.5 million; Reinsurance segment - $27.5 million, Lloyd’s segment $14.0 million), which occurred in the second quarter; the New Zealand earthquake ($75.5 million; Reinsurance segment - $74.2 million, Lloyd’s segment $1.3 million), which occurred during the third quarter; a number of losses in Australia during 2010 covered under an aggregate excess cover (Reinsurance segment - $25.0 million) and the Queensland floods (Reinsurance segment - $10.0 million), the first of which occurred in the fourth quarter. As described in the year to date reinsurance segment discussion below, $22.9 million of loss expenses related to the Deepwater Horizon oil rig during the second quarter relate to losses incurred by Mont Fort. Although such loss expenses are consolidated within our results, they do not impact Flagstone’s net income as they are attributable to the noncontrolling interest; and (2) a significant increase in 2009 in net realized and unrealized gains (losses) - investments primarily due to recoveries from the significant declines in the global equity, bond and commodities markets in 2008, attributable to the broader deterioration and volatility in the credit markets and financial markets and the lingering impact of the sub-prime crisis, partially offset by a decrease in net investment income in 2009 resulting from lower interest rates.
The net underwriting income for the Reinsurance segment for the year ended December 31, 2010 amounted to $24.7 million as compared to $210.4 million for the year ended December 31, 2009. The decrease in net underwriting income for the Reinsurance segment is primarily related to incurred losses on more significant catastrophic events in 2010, such as the Queensland floods and aggregate cover losses in Australia which occurred in the fourth quarter, the New Zealand earthquake, which occurred in the third quarter, Deepwater Horizon loss, which occurred in the second quarter and the net losses on the first quarter Chile earthquake, as compared to 2009.
The net underwriting income for the Reinsurance segment for the year ended December 31, 2009 amounted to $210.4 million ($217.2 excluding the impact of acquisitions during 2008) as compared to $73.0 million ($74.3 excluding the impact of acquisitions during 2008) for the year ended December 31, 2008. The increase in net underwriting income for the Reinsurance segment is primarily related to higher levels of premiums earned in 2009 and net losses incurred in 2008 due to Hurricanes Ike and Gustav of $158.4 million and $14.5 million, respectively, which struck the Caribbean region and the U.S. Gulf coast.
Short-tail specialty and casualty reinsurance is comprised of reinsurance programs such as aviation, energy, personal accident and health, workers compensation, catastrophe, satellite and marine. Most short-tail specialty and casualty reinsurance is written with loss limitation provisions.
Because of our relatively short operating history, our loss experience is limited and reliable evidence of changes in trends of numbers of claims incurred, average settlement amounts, numbers of claims outstanding and average losses per claim could take years to develop. A significant portion of our business is property catastrophe reinsurance and other classes of reinsurance with high attachment points of coverage. Attachment points refer to the dollar amount of loss above which excess of loss reinsurance coverage is triggered. Reserving for losses in such programs is inherently complicated in that losses in excess of the attachment level of our policies are characterized by high severity and low frequency. In addition, as a broker market reinsurer, we must rely on loss information reported to such brokers by primary insurers who must estimate their own losses at the policy level, often based on incomplete and changing information. See “Critical Accounting Estimates-Loss and Loss Adjustment Expense Reserves” and Item 1A, “Risk Factors-Risks Related to the Company.” If we underestimate our loss reserves, so that they are inadequate to cover our ultimate liability for losses, the underestimation could materially adversely affect our financial condition and results of operations.
The increase in the loss ratio was primarily due to more significant losses from catastrophic events in the current year compared to last year, including net incurred losses related to the Queensland floods ($10.0 million), the New Zealand earthquake ($74.2 million), the Chile earthquake ($64.0 million), Deepwater Horizon oil rig ($27.5 million) and a number of events impacting an Australia aggregate cover ($25.0 million), The Deepwater Horizon loss is driven by an ILW loss of $25.0 million, approximately 91.0% of which is attributable to Mont Fort. While such loss expenses are consolidated within our results, they do not impact Flagstone’s net income as they are attributable to the noncontrolling interest. The loss (net of recoveries and reinstatement premiums) to Flagstone’s reinsurance segment from the Deepwater Horizon rig was $4.4 million.
Each quarter we revisit our loss estimates for previous loss events. During the year ended December 31, 2010, based on updated estimates provided by clients and brokers, we recorded net favorable developments for prior accident years of $11.1 million. During the year ended December 31, 2009, the net favorable developments for prior catastrophe events were $6.6 million.
The increase in property catastrophe premiums written of $10.3 million, excluding the impact of acquisitions, or 2.1%, is primarily due to hardening of prices in the property catastrophe market partially offset by our non-renewal of certain treaties that no longer met our profitability objectives.
During the year ended December 31, 2009, we recorded $11.4 million of gross reinstatement premiums on property catastrophe reinsurance compared to $28.2 million recorded for the year ended December 31, 2008, which was primarily related to Hurricanes Gustav and Ike.
As the levels of net premiums written increase, the levels of net premiums earned also increase. The increase in reinsurance net premiums earned is primarily due to ongoing growth in premium writings, partially offset by the increase in premiums ceded.
Loss and loss adjustment expenses for the year ended December 31, 2009 were $241.4 million, or 35.0% of net premiums earned ($230.4 million, or 34.0% of net premiums earned, excluding the impact of acquisitions made in 2008), compared to $377.2 million, or 58.8% of net premiums earned ($370.7 million, or 58.8% of net premiums earned, excluding the impact of acquisitions made in 2008), for the year ended December 31, 2008. The decrease in the loss ratio was primarily due to more severe catastrophic events during 2008 than during 2009. Significant loss events for 2008 included Hurricane Ike ($158.4 million), Hurricane Gustav ($14.5 million), Chinese winter storms ($18.2 million) and the U.S. Memorial Day weekend storms ($11.1 million). During the year ended December 31, 2009, based on updated estimates provided by clients and brokers, we recorded net favorable developments for prior period loss events of $6.6 million, related to small releases on several catastrophe events. During the year ended December 31, 2008, the net favorable developments for prior catastrophe events were $15.7 million.
Syndicate 1861 began writing business for the benefit of Flagstone effective January 1, 2009. As a result, there are no comparative numbers for 2008. Due to the start-up nature of the 2009 year of account for Syndicate 1861, the level of earned premium income has gradually ramped up with new business writings, placing strain on the underwriting results as we have incurred expenses for the full periods.
Below is a summary of the underwriting results and ratios for our Lloyd’s segment for the years ended December 31, 2010 and 2009:
The increase in the gross property premiums written is primarily due to the growth in direct and facultative and binder business.
Premiums ceded were 13.0% of gross premiums written compared to 12.7% of gross premiums written for the same period in 2009.
Second quarter 2010 - loss of $17.3 million related to the Deepwater Horizon oil rig ($14.0 million net of reinstatement premiums), and
The slight increase in gross premiums written is primarily related to continued growth in the Bahamas, offset by softening of rates in the U.S. Virgin Islands and the Cayman Islands. Contracts are written on a per risk basis and consist primarily of property lines.
Other related income consists primarily of quota share reinsurance ceding commissions. The other related income includes $15.5 million related to the quota share arrangement between Island Heritage and Flagstone Suisse compared to $14.3 million for the same period in 2009. This amount is eliminated upon consolidation.
Premiums ceded were 89.4% of gross premiums written compared to 98.5% of gross premiums written for the same period in 2008. Island Heritage’s reinsurance program, which is an April 1 renewal, comprising excess of loss and quota share programs, was significantly changed on April 1, 2008, compared to prior years, resulting in the addition of increased net quota share reinsurance as at April 1, 2008 resulted in the addition of increased net quota share reinsurance as at April 1, 2008 and subsequent to April 1, 2009 program renewal. The change in the reinsurance program enabled Island Heritage to enter into new markets as well as increase penetration in existing markets whilst reducing its net loss exposure and results volatility due to the impact of catastrophic losses.
Premiums ceded to Flagstone Suisse under our intercompany reinsurance programs were $34.8 million and $35.2 million for the years ended December 31, 2009 and 2008, respectively.
Net premiums earned for 2009 were lower compared to the same period in 2008, primarily due to the difference in the reinsurance program in place for both years.
The decrease in loss and loss adjustment expenses in the year ended December 31, 2009 is primarily related to the favorable settlement of claims incurred during 2008 in respect of Hurricanes Gustav, Hanna, Ike, Omar and Paloma.
General and administrative expenses increased as Island Heritage continues to grow its operations including its Puerto Rico office and to enhance its underwriting and claims operating platform.
The change in the return on invested assets of during the year ended December 31, 2009, compared to the same period in 2008 is primarily due to the 2008 return being negatively impacted by the global financial crisis.
The following table sets forth net investment income for the years ended December 31, 2009 and 2008:
The decrease is principally due to a significant decrease in interest rates and lower amortization on the Treasury Inflation Protected Securities (“TIPS”) caused by the impact of the negative inflation index. On the TIPS, the negative amortization is offset by gains reported in net realized and unrealized gains (losses) - investments.
The following table is the breakdown of net realized and unrealized gains (losses) - investments for the years ended December 31, 2010 and 2009:
The change in net realized and unrealized losses on foreign currency forward contracts are related to currency hedges on non-U.S. dollar bonds and are offset by net realized and unrealized gains on the fixed maturities.
The change in net realized and unrealized gains on fixed maturities were due to the tightening of the credit spreads during 2009 and also to the realized and unrealized gains on the foreign currency portfolios caused by the weakening of the U.S. dollar. Foreign exchange gains were largely offset by losses on derivatives used for foreign exchange hedging.
The change in net realized and unrealized gains on equities were primarily due to the positive performance of the emerging equity markets during the year.
The change in net realized and unrealized losses on other investments were due to gains on the Catastrophe Bond portfolio and losses on the investment funds held.
Net change in realized and unrealized gains on futures contracts were primarily due to the positive performance of equity and commodities markets offset by losses on global bond futures.
The decrease in net realized and unrealized gains on reinsurance derivatives was due to the decreased number of ILWs classified as derivatives written during 2010.
The decrease in net realized and unrealized gains on reinsurance derivatives was due to the decreased number of ILWs determined to be derivatives written during 2009.
Interest expense was $12.1 million for the year ended December 31, 2009, compared to $18.3 million for the year ended December 31, 2008. For the year ended December 31, 2009, compared to the same period in 2008, the decrease of $6.2 million in interest expense is primarily related to the decrease in short term interest rates and the repurchase of $11.25 million of principal amount of our outstanding $100.0 million Notes during the second quarter of 2008.
For the year ended December 31, 2010, we experienced net foreign exchange losses of $4.7 million compared to net foreign exchange losses of $3.2 million for the year ended December 31, 2009. For the year ended December 31, 2010, the net foreign exchange losses were principally experienced on the net monetary asset and liability balances denominated in foreign currencies which generally strengthened against the U.S. dollar, during the year. Our policy is to hedge the majority of our foreign currency exposures with derivative instruments such as foreign currency swaps and foreign currency forward contracts. Net realized and unrealized gains and losses on derivatives used to hedge those balances are included in “Net realized and unrealized gains - other” in the consolidated statements of operations and comprehensive income.
For the year ended December 31, 2009, we experienced net foreign exchange losses of $3.2 million compared to net foreign exchange losses of $21.5 million for the year ended December 31, 2008. For the year ended December 31, 2009, the net foreign exchange losses were principally experienced on the net monetary asset and liability balances denominated in foreign currencies which generally weakened against the U.S. dollar, especially during the third and fourth quarters of 2009. Our policy is to hedge the majority of our foreign currency exposures with derivative instruments such as foreign currency swaps and forward contracts. Net realized and unrealized gains and losses on derivatives used to hedge those balances are included in “Net realized and unrealized gains - other” in the consolidated statements of operations and comprehensive income.
During the year ended December 31, 2009, income tax expense was $5.4 million compared to $1.2 million for the year ended December 31, 2008. The increase for the year ended December 31, 2009, compared to the same period in 2008, is primarily attributable to higher taxable income in jurisdictions around the world that are subject to tax as well as the acquisition of Flagstone Africa in June 2008, which resulted in taxable income being earned in South Africa.
The results of Mont Fort have been included in our audited consolidated financial statements, with the portions of Mont Fort’s net income and shareholders’ equity attributable to the preferred shareholders recorded as noncontrolling interest since January 12, 2007 in accordance with the FASB ASC Topic on Consolidation. In relation to Mont Fort, we recorded losses attributable to noncontrolling interest of $10.5 million for the year ended December 31, 2010, compared to income of $26.3 million for the year ended December 31, 2009, an increase of $36.8 million primarily due to the losses recorded in the second quarter of 2010 of $22.9 million related to the Deepwater Horizon oil rig.
The results of Mont Fort have been included in our audited consolidated financial statements, with the portions of Mont Fort’s net income and shareholders’ equity attributable to the preferred shareholders recorded as noncontrolling interest since January 12, 2007 in accordance with the FASB ASC Topic on Consolidation. In relation to Mont Fort, we recorded income attributable to noncontrolling interest of $26.3 million for the year ended December 31, 2009, compared to $14.2 million for the year ended December 31, 2008, an increase of $12.1 million due to the positive underwriting results of Mont Fort in 2009 as the 2008 results were impacted by negative investment returns and Hurricane Ike losses.
No long term debt repayment as in 2009 of $15.0 million.
Our investment management guidelines are set by the Finance Committee of our Board. The Finance Committee establishes investment policies and guidelines for both internal and external investment managers. Our investment philosophy is to maintain a high-quality, well-balanced and liquid portfolio having the dual objectives of optimizing current investment income and achieving capital appreciation.
We have a bias against active management in favor of indexing and passive securities that are generally the most liquid. When they are part of the asset allocation, a number of our equity and other exposure implementations use futures contracts and swaps, whereas the short term investments, support the futures contracts as if those assets were pledged and not available for liquidity purposes. The portfolio managers are required to adhere to investment guidelines as to minimum ratings and issuer and sector concentration limitations. This implementation strategy gives us a low cost and efficient way, using a mixture of passive assets and outside managers, to complement our in-house capability for overall portfolio management, liquidity management and hedging.
Our investment portfolio on a risk basis, at December 31, 2010, comprised 87.1% fixed maturities, short-term investments and cash and cash equivalents, 6.0% equities and the balance in other investments. We believe our investments can be liquidated and converted into cash within a very short period of time. However, our investment funds, which represent 2.0% of our total investments and cash and cash equivalents at December 31, 2010, do not trade in active markets and are subject to redemption provisions that prevent us from converting them into cash immediately.
At December 31, 2010, all of the fixed maturity securities in our investment portfolio were rated investment-grade (BBB- or higher) by Standard & Poor’s (or an equivalent rating by another rating agency) with an average rating of AA+. At December 31, 2009, all of the fixed maturity securities in our investment portfolio, with the exception of $0.5 million were rated investment-grade (BBB- or higher) by Standard & Poor’s (or estimated equivalent by another rating agency) with an average rating of AA+.
At December 31, 2010 and 2009, the average duration of our investment portfolio was 2.0 years and 2.3 years, respectively. The decrease is mostly due to the interest rate futures contracts used to manage duration.
As noted above, our investment strategy allows the use of derivative instruments such as futures contracts, total return swaps, foreign exchange forward contracts, interest rate swaps, and TBAs, subject to strict limitations. Derivative instruments may be used to replicate investment positions or to manage currency and market exposures and duration risk that would be allowed under our investment policy if implemented in other ways. These derivatives seek investment results that generally correspond to the price and yield performance of the underlying markets. The fair value of our derivatives at December 31, 2010 was $(5.1) million, compared to $9.7 million at December 31, 2009.
Other investments do not include an investment accounted for under the equity method in which the Company is deemed to have a significant influence and accordingly is not accounted for at fair value under the FASB ASC guidance for financial instruments.
At December 31, 2010, other investments amounted to $119.8 million compared to $45.9 million at December 31, 2009. At December 31, 2010, the other investments comprised of $76.7 million in catastrophe bonds and $40.0 million in investment funds, which are recorded at fair value and our equity method investment of $3.1 million. The increase in other investments during the year ended December 31, 2010 is principally related to net purchases of catastrophe bonds and investment funds.
We establish loss reserves to estimate the liability for the payment of all loss and loss adjustment expenses incurred with respect to premiums earned on our contracts. Loss reserves do not represent an exact calculation of the liability.
The prior year reduction in the net incurred losses arose from the revision of our loss estimates upon receipt of updated information from our clients and brokers. During the year ended December 31, 2010, we had total net positive development of $11.1 million; $(18.3) million relating to the 2009 year and $29.4 million relating to the 2008 year and prior. The net favorable development in 2010 was primarily due to actual loss emergence in the property catastrophe, property, and the short-tail specialty and casualty lines of business being lower than the initial expected loss emergence.
The significant increase in the reserves in 2010 is primarily attributable to more severe catastrophe losses in 2010 than in 2009 resulting from the Chile earthquake, the New Zealand earthquake and the Queensland floods and the Australia aggregate cover.
As at December 31, 2010, Flagstone’s shareholders’ equity was $1.1 billion, a 6.3% decrease compared to $1.2 billion at December 31, 2009. The decrease in shareholders’ equity is principally due to net income attributable to Flagstone for the year ended December 31, 2010 of $97.1 million, offset by share repurchases of $164.3 million, distributions declared of $17.5 million and repurchase of Mont Fort ILW 2 preferred shares of $79.5 million.
Management uses growth in diluted book value per share as a prime measure of value generated for our common shareholders. Diluted book value per share is defined as total Flagstone shareholders’ equity divided by the number of common shares and common share equivalents outstanding at the end of the period including all potentially dilutive securities such as the warrant, PSU and RSU. In 2010, our diluted book value per share increased from $13.97 at December 31, 2009 to $15.51 at December 31, 2010, an increase of 12.1% inclusive of distributions paid during 2010 of $0.16 per share.
On August 23, 2006, we raised gross and net proceeds of $136.7 million and $132.8 million, respectively, of Deferrable Interest Debentures. The Deferrable Interest Debentures have a floating rate of interest equal to (i) LIBOR plus 354 basis points per annum, reset quarterly for the dollar-denominated principal amount and (ii) Euro Interbank Offered Rated (“Euribor”) plus 354 basis points per annum, reset quarterly for the Euro-denominated principal amount. The Deferrable Interest Debentures mature on September 15, 2036, and may be called at par by us at any time after September 15, 2011. We may defer payment of the interest for up to 20 consecutive quarterly periods, but no later than September 15, 2011. Any deferred interest payments would accrue interest quarterly on a compounded basis.
Cash flows from operations for the year ended December 31, 2010 decreased to $292.5 million from $338.4 million as compared to the same period in 2009. This decrease in cash flows from operations was primarily related to a lower net income and increased reinsurance premium receivables, offset by increased loss and loss adjustment expense reserves. Because a large portion of the coverages we provide typically can produce losses of high severity and low frequency, it is not possible to accurately predict our future cash flows from operating activities. As a consequence, cash flows from operating activities may fluctuate, perhaps significantly, between individual quarters and years.
Cash used in investing activities was $25.6 million for 2010, compared with $660.0 million for 2009. The decrease for 2010 was due primarily to less net purchases and sales of fixed income securities, increased purchases of fixed assets and decreased restricted cash.
Cash flows relating to financing activities include the payment of distributions to shareholders, share related transactions and the issuance or repayment of debt. During the year ended December 31, 2010, net cash of $269.8 million was used in financing activities, compared to $110.8 million provided by financing activities for the year ended December 31, 2009. In 2010, the net cash used in financing activities related principally to the redemption of preferred shares in Mont Fort ILW 2, the repurchase of common shares held in treasury, and the repurchase of a warrant. In 2009, the net cash used in financing activities related principally to the payment of distributions, the redemption of preferred shares in Mont Fort ILW 1, the repurchase of common shares and the repayment of debt.
These facilities are used to provide security to reinsureds and for Funds at Lloyd’s, and they are fully collateralized by the Company, to the extent of the letters of credit outstanding at any given time.
The Bermuda Insurance Act requires Flagstone Suisse to maintain a minimum solvency margin (being the minimum amount that the statutory assets must exceed the statutory liabilities as required by the Bermuda Insurance Act) equal to the greatest of (i) $100 million, (ii) 50% of net premiums written or (iii) 15% of the reserve for losses and loss adjustment expenses. To satisfy these requirements, Flagstone Suisse was required to maintain a minimum level of statutory capital and surplus of $316.6 million as at December 31, 2009. In addition, Flagstone Suisse is required to maintain a minimum liquidity ratio. As at December 31, 2010, 2009, and 2008, Flagstone Suisse was in compliance with all of the requirements of the Bermuda Insurance Act.
In 2009, the BMA launched its Bermuda Insurance Solvency Framework, which is designed to enable Bermuda to achieve "equivalence" with Solvency II. The impact of this initiative is currently being monitored by the Company.
A Class “A” Insurer’s license permits an insurer to carry on insurance business generally in or from within the islands. The Insurance Law mandates that changes to the information provided upon application for a license be approved or notified to CIMA, including director and ownership changes and the nature of the business. A relatively low capital requirement is currently prescribed in the Insurance Law, in order to accommodate the large captive insurance market in the Cayman Islands, but CIMA is able to attach conditions to licenses and thereby prescribe an appropriate capital and solvency requirement. A new law was passed in 2010 and is due to come into effect in 2011 pending the finalization of subsidiary legislation. It is expected that the 2010 Law will prescribe a risk based capital requirement comprising a minimum and a prescribed amount, which failure to meet will lead to enforcement and remedial action respectively.
FSML’s underwriting activities are therefore regulated by the FSA as well as being subject to the Lloyd’s “franchise”. Both FSA and Lloyd’s have powers to remove their respective authorization to manage Lloyd’s syndicates. Lloyd’s approves annually Syndicate 1861’s business plan and any subsequent material changes, and the amount of capital required to support that plan. Lloyd’s may require changes to any business plan presented to it or additional capital to be provided to support the underwriting (known as Funds at Lloyd’s).
The European Parliament passed the Solvency II directive in April 2009, to establish a revised set of European Union (EU) wide capital requirements and risk management standards. All (re)insurers, including Lloyd’s and its managing agents, within the EU need to be compliant with Solvency II by January 1, 2013.
Flagstone’s existing risk management framework and mechanisms closely mirror the requirements for Solvency II. Since its inception, Flagstone has invested in its internal model that generates the Group’s risk profile and is currently also used to calculate the internal capital requirements for Lloyd’s. Flagstone is working closely with Lloyd’s to ensure full compliance with the regulations. Flagstone believes that Solvency II will have a positive impact on its operations and risk management framework.
Valais Re is a special purpose Cayman Islands exempted company licensed as a restricted Class B reinsurer in the Cayman Islands and formed solely for the purpose of entering into certain reinsurance agreements and other risk transfer agreements with subsidiaries of Flagstone Suisse.
During 2008, we entered into a reinsurance agreement with Valais Re that provides us with $104.0 million of aggregate indemnity protection for certain losses from global catastrophe events.
The Company has determined that Valais Re has the characteristics of a variable interest entity that are addressed by the Consolidation Topic of the FASB ASC. In accordance with the Consolidation Topic, Valais Re is not consolidated because the Company is not the primary beneficiary.
Montana Re is a special purpose reinsurer established in the Cayman Islands and was formed as a program structure enabling further issuance of additional series of notes in the future. During 2009, we entered into a reinsurance agreement with Montana Re that provides us with $175.0 million of protection for certain losses from global catastrophe events. During 2010, we entered into an additional reinsurance agreement with Montana Re, incepting on January 1, 2011, that provides us with $210.0 million of protection for certain losses from global catastrophe events.
(4) We have made certain commitments with respect to investment funds and may receive capital call requests in 2011.
We designated $43.2 million of foreign currency forwards contractual value as hedge instruments, which had a fair value of $(0.5) million at December 31, 2010. During the year ended December 31, 2010, we recorded $0.2 million of realized and unrealized losses directly into comprehensive income as part of the cumulative translation adjustment for the effective portion of the hedge. The losses on forward contracts resulted from the continued weakening of the U.S. dollar against the Swiss franc.
At December 31, 2010, the value of the U.S. dollar strengthened approximately 3.5% against the British pound sterling, 6.9% against the Euro and weakened approximately 10.6% against the Swiss franc, compared to December 31, 2009. Since a large proportion of our assets and liabilities are expressed in these currencies, there was a net decrease in the U.S. dollar value of the assets and liabilities denominated in these currencies in 2010.
Consolidated Statements of Operations and Comprehensive Income (Loss) for the Years Ended December 31, 2010, 2009 and 2008
Consolidated Statements of Changes in Shareholders’ Equity for the Years Ended December 31, 2010, 2009 and 2008
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of December 31, 2010, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 2, 2011 expressed an unqualified opinion on the Company's internal control over financial reporting.
Flagstone Reinsurance Holdings, S.A (“Flagstone” or the “Company”) is a holding company incorporated as a société anonyme under the laws of Luxembourg. On May 14, 2010, the Company’s shareholders approved the redomestication to change the Company’s jurisdiction of incorporation from Bermuda to Luxembourg and the Company thereby discontinued its existence as a Bermuda company as provided in Section 132G of The Companies Act 1981 of Bermuda and continued its existence as a société anonyme under the laws of Luxembourg effective May 17, 2010 (the “Redomestication”). As a result of the Redomestication, the Company changed its name from Flagstone Reinsurance Holdings Limited to Flagstone Reinsurance Holdings, S.A. The Company was originally incorporated on October 4, 2005 under the laws of Bermuda.
These financial statements contain certain reclassifications of prior period amounts to be consistent with the current period presentation with no effect on net income or loss.
The Company has entered into industry loss warranty (“ILW”) transactions that are structured as reinsurance or derivatives. The Company evaluates each contract in accordance with Derivatives Implementation Group B26, “Dual Trigger Property and Casualty Contracts” to determine if the amounts received from these contracts should be recorded as reinsurance transactions or as derivatives. When the transactions are determined to be reinsurance, the consideration received is recorded as premiums written and earned over the contract period.
Acquisition costs are comprised of ceding commissions, brokerage, premium taxes, profit commissions and other expenses that relate directly to the writing of reinsurance contracts. Deferred acquisition costs are amortized over the underlying term of the related contracts and are limited to their estimated realizable value based on the related unearned premiums, anticipated loss and loss adjustment expenses and investment income.
Investments in U.S. government agency securities, corporate bonds, mortgage-backed securities, other foreign government bonds and asset-backed securities are classified as Level 2 fair value. The fair value of these securities is derived from broker quotes based on inputs that are observable for the asset, either directly or indirectly, such as yield curves and transactional history. Catastrophe bonds are classified as Level 2 fair value as determined by reference to broker indications. Those indications are based on current market conditions, including liquidity and transactional history, recent issue price of similar catastrophe bonds and seasonality of the underlying risks.
The Company’s share based compensation plans consists of Performance Share Units (“PSUs”) and Restricted Share Units (“RSUs”). The PSUs are designed to maximize shareholder value over long periods of time by aligning the financial interests of the Company’s management with those of its shareholders. The Company estimates the fair value of PSUs granted under the PSU Plan on the date of grant using the grant date fair value and the most probable performance factor for the two-year and three-year performance period and records the compensation expense in its consolidated statements of operations and comprehensive income (loss) over the course of such period. At the end of each quarter, the Company reassesses the projected results for each two-year and three-year performance period as its financial results evolve. The Company recalculates the compensation expense under the PSU Plan and reflects any adjustments in the consolidated statements of operations and comprehensive income (loss) in the period in which they are determined.
The Company accounts for its derivative instruments using the Derivatives and Hedging Topic of the FASB ASC which requires an entity to recognize all derivative instruments as either assets or liabilities in the balance sheet and measure those instruments at fair value, with the fair value recorded in other assets or liabilities.
The Company utilizes foreign currency forward contracts to manage its foreign currency exposure. On the date the Company enters into a forward contract, it designates whether the derivative is to be used as a hedge of an identified foreign currency exposure (a designated hedge). As part of the overall currency risk management strategy, the Company uses forward contracts to hedge the currency exposure of their investments and loans to subsidiaries (hedged items).
The Company has entered into ILW transactions that are structured as reinsurance or derivatives. When ILW transactions are determined to be derivatives, they are recorded at fair value in other assets or liabilities with the changes in fair value reported in realized gains and losses in the consolidated statements of operations and comprehensive income (loss).
The issuance of shares with respect to the PSUs is contingent upon the attainment of certain levels of diluted return-on-equity (“DROE”). Because the number of common shares contingently issuable under the Performance Share Unit Plan (“PSU Plan”) depends on the geometric average DROE over a two-year or three year period, the PSUs are excluded from the calculation of diluted earnings per share until the end of the performance period, when the number of shares issuable under the PSU Plan will be known.
Certain subsidiaries of the Company operate in jurisdictions where they are subject to taxation. Current and deferred income taxes are charged or credited to net income based upon enacted tax laws and rates applicable in the relevant jurisdiction in the period in which the tax becomes realizable. Deferred income taxes are provided for all temporary differences between the bases of assets and liabilities used in the consolidated balance sheets and those used in the various jurisdictional tax returns.
When management’s assessment indicates that it is more likely than not that deferred income tax assets will not be realized, a valuation allowance is recorded against the deferred tax assets. In accordance with the FASB ASC Topic on Income Taxes, the tax benefits of uncertain tax positions may only be recognized when the position is more-likely-than-not to be sustained upon audit by the relevant taxing authorities.
Flagstone Africa is domiciled in South Africa and writes multiple lines of reinsurance in sub-Saharan Africa.
On June 30, 2009, Flagstone Alliance Insurance & Reinsurance PLC (“Flagstone Alliance”) disposed of 100% of the share capital in Uni-Alliance Holdings Limited, a subsidiary of Flagstone Alliance since January 1, 2007. The transaction was completed with Mr. Khader Hemsi, Chief Executive Officer of Flagstone Alliance, who retired from Flagstone Alliance during the third quarter of 2009. The sale was completed to eliminate conflict with existing broker relationships and resulted in a net loss of $1.2 million, which has been recorded in other income.
The following tables detail goodwill and intangible assets at December 31, 2010 and 2009:
Mont Fort Re Limited (“Mont Fort”) is a Bermuda insurer registered under the Segregated Accounts Companies Act 2000, which gives Mont Fort the power to allocate assets and liabilities to segregated accounts. Assets allocated to a segregated account may only be used to meet the liabilities of that segregated account. Mont Fort enables third party investors to participate in insurance risk. To date Mont Fort has formed three segregated accounts, which have been capitalized by third party investors. The Company cedes industry loss warranty policies risks to the cells and charges a ceding commission on those ceded premiums. The Company also charges the cells investment management fees and a performance fee of 15% of the increase, if any, in the net asset value of each cell during the year.
Mont Fort has repurchased 55.0 million (2010 - 50.0 million, 2008 - 5.0 million) preferred shares relating to its second cell, Mont Fort ILW 2 for $86.1 million (2010 - $79.5 million, 2008 - $6.6 million).
The cost or amortized cost, gross unrealized gains and losses, and carrying values as at December 31, 2010 and 2009 are as follows:
Other investments do not include an investment accounted for under the equity method in which the Company is deemed to have a significant influence and accordingly is not accounted for at fair value under the FASB ASC guidance for financial instruments. This investment is recorded at $3.1 million and $4.3 million at December 31, 2010 and 2009, respectively.
Investments in U.S. government agency securities, corporate bonds, mortgage-backed securities, foreign government bonds and asset-backed securities are classified as Level 2 in the fair value hierarchy. The fair value of these securities is derived from broker quotes based on inputs that are observable for the asset, either directly or indirectly, such as yield curves and transactional history. Catastrophe bonds are classified as Level 2 fair value as determined by reference to broker indications. Those indications are based on current market conditions, including liquidity and transactional history, recent issue price of similar catastrophe bonds and seasonality of the underlying risks.
The Catastrophe bonds held pay a variable and fixed interest coupon and generate investment return, and their performance is contingent upon climatological and geological events.
The Company’s investment funds consist of investments in private equity and mortgage-backed investment funds. As at December 31, 2010 and 2009, the Company had total outstanding investment commitments of $13.7 million and $3.4 million, respectively. Redemptions from these investments occur at the discretion of the general partner, board of directors or, in other cases, subject to a majority vote by the investors. The Company is not able to redeem a significant portion of these investments prior to 2017.
Realized investment gains (losses) on the sale of fixed maturity, short term and equity investments for the years ended December 31, 2010, 2009 and 2008 are as follows:
The Company holds cash and cash equivalents and fixed maturity securities that were deposited or pledged in favor of ceding companies and other counterparties or government authorities to comply with reinsurance contract provisions, Lloyd’s of London requirements and insurance laws.
The total amount of such cash and cash equivalents and fixed maturity securities as at December 31, 2010 and 2009 are as follows:
The following table represents an analysis of paid and incurred losses and a reconciliation of the beginning and ending loss and loss adjustment expense reserves for the years ended December 31, 2010 and 2009:
For the year ended December 31, 2009, the Company had total net positive development of $6.6 million; $(7.6) million relating to the 2008 loss year and $14.2 million relating to the 2007 and prior loss years. The favorable development was primarily due to actual loss emergence in the property catastrophe, property, and the short-tail specialty and casualty lines of business being lower than the initial expected loss emergence.
Assumed and ceded net premiums written and earned and loss and loss adjustment expenses for the years ended December 31, 2010, 2009 and 2008 are as follows:
As at December 31, 2010, 2009 and 2008, the provision for doubtful accounts was $1.9 million, $2.0 million, and $2.1 million, respectively, which has been recorded in premiums receivable on the balance sheet.
The Company accounts for its derivative instruments using the Derivatives and Hedging Topic of the FASB ASC, which requires an entity to recognize all derivative instruments as either assets or liabilities on the balance sheet and measure those instruments at fair value, with the fair value recorded in other assets or liabilities. The accounting for realized and unrealized gains and losses associated with changes in the fair value of derivatives depends on the hedge designation and, if designated as a hedging instrument, whether the hedge is effective in achieving offsetting changes in the fair value of the asset or liability being hedged. The realized and unrealized gains and losses on derivatives not designated as hedging instruments are included in net realized and unrealized gains and losses in the consolidated financial statements. Gains and losses associated with changes in fair value of the designated hedge instruments are recorded with the gains and losses on the hedged items, to the extent that the hedge is effective.
The Company enters into foreign currency forward contracts for the purpose of hedging its net investment in foreign subsidiaries which are recorded as designated hedges. All other foreign currency forward contracts are not designated as hedges and are entered into for the purpose of hedging our foreign currency fixed maturities investments and our net foreign currency operational assets and liabilities.
On May 17, 2010, the Company became a Luxembourg tax resident and therefore became subject to corporate income tax and municipal business tax on its worldwide income at the Luxembourg statutory tax rate, currently of 28.6% (for companies registered in Luxembourg City). Qualifying dividend income and net capital gains on the sale of qualifying investments in subsidiaries generally are exempt from corporate income tax and municipal business tax under Luxembourg's "participation exemption". Consequently, qualifying dividends received by the Company from subsidiaries and capital gains from the sale by the Company of investments in subsidiaries should be exempt from corporate income tax and municipal business tax.
The Company does not expect any material unrecognized tax benefits within 12 months of December 31, 2010.
Realization of deferred tax assets is dependent on generating sufficient taxable income in the future periods. Although realization is not assured, management believes it is more likely than not that the tax benefit of the deferred tax assets net of valuation allowance will be realized.
The following table is a reconciliation of the difference between the actual tax rate and the Luxembourg statutory rate of 28.59%. For the years ended December 31, 2009 and 2008, the Company was a Bermuda domiciled company subject to a 0% statutory rate under Bermuda law. As a result, the reconciliation has been presented starting with a 0% rate for these periods.
The Company incurred expenses for these defined contribution arrangements of $3.5 million, $2.0 million, and $0.9 million for the years ended December 31, 2010, 2009, and 2008, respectively.
Interest expense includes interest payable and amortization of debt offering expenses. The debt offering expenses are amortized over the period from the issuance of the Deferrable Interest Debentures to the earliest date that they may be called by the Company. For the years ended December 31, 2010, 2009 and 2008, the Company incurred interest expense of $10.4 million, $11.1 million and $18.3 million, respectively, on the Deferrable Interest Debentures. Also, at December 31, 2010 and 2009, the Company had $0.8 million and $0.8 million, respectively, of interest payable included in other liabilities.
On April 28, 2010, Flagstone Suisse and Flagstone Capital Management Luxembourg SICAF - FIS entered into a secured $450.0 million standby letter of credit facility with Citibank Europe Plc (the “Citi Facility”). The Citi Facility comprised a $225.0 million facility for letters of credit with a maximum tenor of 15 months, to be used to support reinsurance obligations of the Company and its subsidiaries, and a $225.0 million facility for letters of credit drawn in respect of Funds at Lloyd’s with a maximum tenor of 60 months. On December 21, 2010, the Citi Facility was amended to increase the amount available under the facility by $100.0 million to $550.0 million, with all the terms and conditions remaining unchanged. The Citi Facility now comprises a $275.0 million facility for letters of credit with a maximum tenor of 15 months, to be used to support reinsurance obligations of the Company and its subsidiaries, and a $275.0 million facility for letters of credit drawn in respect of Funds at Lloyds’s with a maximum tenor of 60 months. As at December 31, 2010, $435.6 million had been drawn under the Citi Facility, and the drawn amount of the facility was secured by $502.6 million of fixed maturity securities from the Company’s investment portfolio. This facility replaced a $450.0 million credit facility with Citibank Europe Plc which commenced on January 22, 2009.
The holders of common voting shares are entitled to receive distributions (previously in the form of dividends prior to the Redomestication) as declared from time to time and are entitled to one vote per common share, subject to certain restrictions.
On May 21, 2010, in connection with the resignation of Mr. Byrne as Executive Chairman of the Company’s Board, the Company entered into a General Release and Settlement Agreement for the repurchase of 2,000,000 common shares from Limestone Business Limited, a company controlled and capitalized by Mr. Byrne. These shares were repurchased pursuant to the Company’s buyback program on May 25, 2010, at a total cost of $24.0 million.
During the third quarter of 2010, the Company repurchased 1,420,960 common shares pursuant to its buyback program at a total cost of $14.8 million. Of the common shares repurchased, 900,000 common shares were purchased on August 20, 2010, under a private purchase agreement for the employee share compensation plans (PSU Plan and Restricted Share Unit Plan (“RSU Plan”)), while the remaining 520,960 common shares were purchased on the open market. As of December 31, 2010, authority to repurchase up to $11.2 million of common shares remained available under the buyback program.
On December 14, 2010, pursuant to the Purchase Agreement between Bermuda Holdings, Mr. Byrne, and certain companies associated with Mr. Byrne, Bermuda Holdings purchased 8,005,024 shares of Flagstone from such companies in connection with the retirement of Mr. Byrne as a member of the Board at a total cost of $91.9 million.
As at December 31, 2010, 2009 and 2008, there was a total of $0.9 million, $0.9 million and $1.0 million, respectively, of unrecognized compensation cost related to non-vested RSUs; that cost is expected to be recognized over a period of approximately 1.0 year, 1.0 year, and 1.0 year, respectively. A compensation expense of $2.4 million, $2.7 million and $3.0 million has been recorded in general and administrative expenses for the years ended December 31, 2010, 2009 and 2008, respectively, in relation to the RSU Plan.
Since the inception of the RSU Plan in July 2006, 400,842 RSUs granted to employees have vested and no RSUs granted to employees have been cancelled. During the years ended December 31, 2010, 2009 and 2008, 64,896, 72,666, and 55,715 RSUs, respectively, were granted to the directors. During the years ended December 31, 2010, 2009 and 2008, 8,040, 2,985, and 25,299 RSUs, respectively, granted to directors were converted into common shares of the Company as elected by the directors.
The Company uses a nil forfeiture assumption for its PSUs and RSUs. The intrinsic value of the PSUs and RSUs outstanding as of December 31, 2010 was $50.4 million and $7.3 million, respectively.
The computation of basic and diluted earnings (loss) per common share for the years ended December 31, 2010, 2009, and 2008 is as follows:
Dilutive share equivalents have been excluded in the weighted average common shares used for the calculation of earnings per share in periods of net loss because the effect of such securities would be anti-dilutive. The number of anti-dilutive share equivalents that were excluded in the computation of diluted earnings per share for the year ended December 31, 2008, was 243,124. Also at December 31, 2010, 2009, and 2008, there was a warrant outstanding which would result in the issuance of 630,194, 8,585,747 and 8,585,747 common shares, respectively, that were excluded from the computation of diluted earnings per common share because the effect would be anti-dilutive. Because the number of shares contingently issuable under the PSU Plan depends on the average DROE over a two or three year period, the PSUs are excluded from the calculation of diluted earnings per common share until the end of the performance period, at which time the number of shares issuable under the PSU Plan will be known. As at December 31, 2010, 2009, and 2008, there were 3,998,558, 3,305,713, and 2,189,982 PSUs, respectively, which were expected to vest. The maximum number of common shares that could be issued under the PSU Plan at December 31, 2010, 2009, and 2008, was 5,751,765, 4,712,498, and 3,284,973 respectively.
The Company’s consolidated results include the results of Flagstone Africa from June 30, 2008 onwards. On November 10, 2009, Flagstone Suisse became the sole shareholder of Flagstone Africa by acquiring the remaining 35% of shares owned by Imperial Holdings Limited for a purchase price of $11.4 million (see Note 3). In accordance with the Consolidation Topic of the FASB ASC, Flagstone Africa has been fully consolidated in the Company’s financial statements for the years ending December 31, 2010 and 2009. The portions of Flagstone Africa’s net income and shareholders’ equity attributable to minority shareholders for the year ended December 31, 2008 was recorded in the consolidated financial statements of the Company as noncontrolling interest. In relation to Flagstone Africa, the Company recorded income attributable to noncontrolling interest of $0.5 million for the year ended December 31, 2009, and $nil was included in noncontrolling interest on the consolidated balance sheets as at December 31, 2010 and 2009.
On November 24, 2009, Flagstone Suisse entered into a senior unsecured loan agreement with Star and Shield Holdings LLC (“Star and Shield”), a member owned insurance company in which the Company holds a 43.3% equity investment interest. Under the terms of the agreement, the Company agreed to a revolving basis commitment of $2.5 million with an interest rate of LIBOR plus 8.5% per annum, adjusted and compounded quarterly on any unpaid balance of principal and interest until the maturity of the loan which is no later than November 24, 2012. On December 21, 2010, the agreement was amended to increase the commitment to $3.5 million. As at December 31, 2010 and December 31, 2009, the Company had advanced $2.5 million and $0.4 million, respectively, as a loan receivable from Star and Shield on its consolidated balance sheet.
On December 8, 2010 Bermuda Holdings entered into a Share Purchase and Warrant Agreement (the “Purchase Agreement”) with Mr. Byrne, Limestone, and Haverford pursuant to which Bermuda Holdings (i) purchased from Limestone 5,155,156 shares of the Company at a price of $11.4823 per share, (ii) purchased from Haverford 2,849,868 shares of Flagstone at a price of $11.4823 per share, and (iii) purchased from Haverford, at a price of $13,500,000, the Haverford Warrant. The transactions contemplated by the Purchase Agreement were completed on December 14, 2010. For further information on these purchases, refer to Note 14 “Shareholders’ Equity”.
On December 14, 2010, Mr. Byrne retired as a member of the Board. In connection with his retirement, the Company, Mr. Byrne, Limestone and Haverford entered into a letter agreement dated December 8, 2010 (the “Letter Agreement”), pursuant to which the Company agreed to continue to indemnify Mr. Byrne for actions taken by him while an employee or a director of the Company to the same extent as other former employees and directors of the Company.
On May 17, 2010, the Company entered into a commitment agreement to purchase $25.0 million of Marathon Legacy Securities Public-Private Investment Funds, Ltd. On September 30, 2010, the Company entered into a further commitment agreement to purchase $9.0 million of the fund. A member of the Company’s Board is also a managing director of Marathon Asset Management, L.P., the investment manager of the fund. As of December 31, 2010, the market value of the Company’s investment in this fund was $31.9 million and the remaining capital commitment was $6.8 million.
Flagstone Suisse has cash and cash equivalent investments in money market funds that are managed by the BlackRock group, which owns shares in the Company. As of December 31, 2010, the Company held $4.3 million in these investments.
The Company and its subsidiaries lease office space and guest accommodations in the countries in which they operate under operating leases which expire at various dates. The Company renews and enters into new leases in the ordinary course of business as required. Total rent expense with respect to these operating leases for the years ended December 31, 2010 and 2009 and 2008 was approximately $3.8 million, $4.2 million, and $2.6 million.
As at December 31, 2010 and 2009, the Company was not a party to any material litigation or arbitration proceedings.
Dividends may be paid in (1) cash in the form a check, or by warrant, or (2) wholly or partly in kind by the distribution of assets (in particular, paid up shares, debentures or debenture stock) to shareholders.
Since the Redomestication of the Company from Bermuda to Luxembourg in May 2010, the Company has, on September 15 and December 15, 2010, paid two distributions to shareholders in the amount of $0.04 per share, which are subject to the provisions of article 72-2 of the Law of 10 August 1915 on commercial companies, as amended.
Swiss law permits dividends to be declared only after profits have been allocated to the reserves required by law and to any reserves required by the articles of incorporation. The articles of incorporation of Flagstone Suisse do not require any specific reserves. Therefore, Flagstone Suisse must allocate any profits first to the reserve required by Swiss law generally, and may pay as dividends only the balance of the profits remaining after that allocation. In the case of Flagstone Suisse, Swiss law requires that 20% of the company’s profits be allocated to a “general reserve” until the reserve reaches 50% of its paid-in share capital. In addition, a Swiss reinsurance company may pay a dividend only if, after payment of the dividend, it will continue to comply with regulatory requirements regarding minimum capital, special reserves and solvency requirements.
Island Heritage is domiciled in the Cayman Islands and is required to maintain a Class A Domestic Insurance License issued under the Insurance Law (as revised) of the Cayman Islands. It is thereby subject to regulation by the Cayman Islands Monetary Authority (“CIMA”) which enforces the applicable provisions of the Insurance Law and also the Monetary Authority Law. Whilst there is no general requirement to prohibit dividend payments in the law, if a dividend policy has been previously agreed and filed with the regulator then any change must be approved. Furthermore, once the 2010 capital requirements are applied, assuming subsidiary legislation as drafted on February 7, 2011 is implemented, insurers must notify the regulator where its capital falls below the prescribed amount and will then be subject to remedial action and thus proposed dividend payments could be restricted.
U.K. company law prohibits Flagstone Syndicate Management Limited (“FSML”) and Flagstone Corporate Name Limited from declaring a dividend to its shareholders unless it has “profits available for distribution”. The determination of whether a company has profits available for distribution is based on its accumulated realized profits less its accumulated realized losses. While the U.K. insurance regulatory laws impose no statutory restrictions on a Lloyd’s managing agent’s ability to declare a dividend, the Financial Services Authority’s (“FSA”) rules require maintenance of adequate resources, including each company’s solvency margin within its jurisdiction. In addition, under Lloyd’s rules, a managing agent must maintain a minimum level of capital based, among other things, on the amount of capacity it manages subject to a minimum of £400,000.
The financial services industry in the U.K. is regulated by the FSA. The FSA is an independent non-governmental body, given statutory powers by the Financial Services and Markets Act 2000. Although accountable to treasury ministers and through them to Parliament, it is funded entirely by the firms it regulates. The FSA has wide ranging powers in relation to rule-making, investigation and enforcement to enable it to meet its four statutory objectives, which are summarized as one overall aim: “to promote efficient, orderly and fair markets and to help retail consumers achieve a fair deal”.
Accordingly, as a Lloyd’s managing agent, FSML is not only regulated by the FSA but is also bound by the rules of the Society of Lloyd’s, which are prescribed by Byelaws and requirements made by the Council of Lloyd’s under powers conferred by the Lloyd’s Act 1982. Both FSA and Lloyd’s have powers to withdraw their respective authorization of any person to manage Lloyd’s syndicates. Lloyd’s approves annually Syndicate 1861’s business plan and any subsequent material changes, and the amount of capital required to support that plan. Lloyd’s may require changes to any business plan presented to it or additional capital to be provided to support the underwriting (known as Funds at Lloyd’s).
In accordance with the Private Placement Memorandum of FCML, the general meeting of FCML shall determine how the profits (including net realized capital gains) of FCML shall be disposed of and may from time to time declare, or authorize the board of directors of FCML to declare dividends, provided however that the capital of FCML including issue premiums does not fall below €1,250,000 or the equivalent thereof in any currency in which shares in FCML are issued. Dividends may also be paid out of net unrealized capital gains after deduction of realized losses. Dividends declared will be paid in the applicable sub-funds base currency and may be paid at such places and times as may be determined by the board of directors of FCML.
Short-tail Specialty and Casualty Reinsurance. The Company also provides short-tail specialty and casualty reinsurance for risks such as aviation, energy, personal accident and health, satellite, marine and workers’ compensation catastrophe. Most short-tail specialty and casualty reinsurance is written with loss limitation provisions.
The Company’s Lloyd’s segment includes the business generated through the Lloyd’s Syndicate 1861 and FSML. Syndicate 1861, based in London, primarily provides property and short-tail specialty and casualty insurance and reinsurance for risks such as energy, hull and cargo, marine liability, engineering and aviation. Syndicate 1861 began writing business for the benefit of Flagstone effective January 1, 2009. As such, there are no comparative numbers for the Lloyd’s segment for the prior year. FSML generates fee income for the provision of services to syndicates and third parties.
(Amounts in tables expressed in thousands of U.S. dollars, except for share amounts, per share amounts and percentages)
The Company has evaluated subsequent events through to the date the financial statements were available to be issued.
In January 2011, following the December 2010 Queensland floods subsequent flooding occurred in large areas of Australia; and on February 3, 2011, Cyclone Yasi hit Northern Queensland, Australia. These 2011 events are expected to have a net impact the Company’s first quarter 2011 financial results of between $60 million to $80 million.
On February 22, 2011, a powerful 6.3 magnitude earthquake struck Christchurch, New Zealand, causing widespread damage and business interruption. This event is expected to cause sizeable losses to the insurance industry. The Company has commenced the estimation process for expected claims relating to its exposures from these events but believes it is too early to issue an estimate of claims given the significant unknowns and early stages of the claims reporting process.
Interest expense includes interest payable and amortization of debt offering expenses. The debt offering expenses are amortized over the period from the issuance of the Notes to the earliest they may be called by the Company. For the years ended December 31, 2010, 2009, and 2008, the Company incurred interest expense and amortization of debt offering expenses of $7.2 million, $8.3 million, and $11.5 million on the Notes. Also, at December 31, 2010 and 2009, the Company had $0.3 million and $0.3 million, respectively, of interest payable included in other liabilities in the consolidated balance sheets.