The Company leases office space in Hamilton, Bermuda, where the Company’s principal executive offices are located. The Company also leases office space in London, United Kingdom, where the Company’s subsidiary, Montpelier Marketing Services (UK) Limited is located. We believe our facilities are adequate for our current needs, although we anticipate leasing additional office space in Hamilton, Bermuda, later in 2003.
The following table sets forth our selected financial data and other financial information at December 31, 2002 and 2001 and for the period from November 14, 2001 to December 31, 2001 and the year ended December 31, 2002. The historical financial information was prepared in accordance with U.S. generally accepted accounting principles. The statement of income data for the periods ended December 31, 2002 and 2001 and the balance sheet data at December 31, 2002 and 2001 were derived from our audited combined financial statements, which have been audited by PricewaterhouseCoopers, our independent auditors. You should read the selected financial data in conjunction with our combined financial statements and related notes thereto contained in Item 8 - “Financial Statements and Supplementary Data” and
We derive our revenues primarily from premiums from our insurance and reinsurance contracts and, to a lesser extent, income from our investment portfolio. Premiums are a function of the number and type of contracts we write, as well as prevailing market prices. Renewal dates for reinsurance business tends to be concentrated at the beginning of quarters, and the timing of premium written varies by line of business. Most property catastrophe business is written in the January 1, April 1 and July 1 renewal periods, whilst the property specialty and other specialty lines are written throughout the year. Written premiums are generally lower during the fourth quarter of the year as compared to prior quarters. Gross premiums written for pro-rata contracts, including QQS programs, are initially booked as estimated and are adjusted as actual results are reported by the cedents during the period. Earned premiums do not necessarily follow the written premium pattern as certain written premiums are earned ratably over the contract term, which ordinarily is twelve months, although many pro-rata contracts are written on a risks attaching basis and are generally earned over a 24 month period, consistent with industry practice. Earned premiums are affected by our growing book of business; as written premium levels increase, earned premium levels will correspondingly increase over the earning period. Premiums are generally due in installments.
Property Specialty - Contracts in this category include risk excess of loss, property pro-rata and direct insurance and facultative reinsurance business. Risk excess of loss reinsurance protects insurance companies on their primary insurance risks and facultative reinsurance transactions on a “single risk” basis.
Property Catastrophe - These contracts are typically “all risk” in nature, providing protection against losses from earthquakes and hurricanes, as well as other natural and man-made catastrophes such as floods, tornadoes, fires and storms. The predominant exposures covered are losses stemming from property damage and business interruption coverage resulting from a covered peril. Certain risks, such as war, nuclear contamination and terrorism, are generally excluded from these contracts. Property catastrophe reinsurance is written on an excess of loss basis, which provides coverage to primary insurance companies when aggregate claims and claims expenses from a single occurrence from a covered peril exceed a certain amount specified in a particular contract.
Other Specialty - Reinsurance contracts of aviation liability, aviation war, marine, personal accident catastrophe, workers’ compensation, terrorism, casualty and other reinsurance business are included in this category. Marine and aviation contracts are primarily written on a retrocessional excess of loss basis.
Since the classes of business we underwrite have large aggregate exposures to natural and man-made disasters, we expect that our claims experience will predominantly be the result of relatively few events of significant severity. The occurrence of claims from catastrophic events is likely to result in substantial volatility in, and could have a material adverse effect on, our financial condition and results of operations and our ability to write new business. This volatility will affect our results in the period that the loss occurs because accounting principles do not permit reinsurers to reserve for such catastrophic events until they occur. Catastrophic events of significant magnitude have historically been relatively infrequent, although we believe the property catastrophe reinsurance market has experienced a high level of worldwide catastrophic losses in terms of both frequency and severity from 1987 to the present as compared to prior years. We also expect that increases in the values and concentrations of insured property will increase the severity of such occurrences in the future. We seek to reflect these trends as we price our reinsurance.
As part of our formation, we granted 2,040,000 share options to our President and Chief Executive Officer, Anthony Taylor. In September 2002, 510,000 additional options for common shares were granted to other senior executives. From inception, we have adopted FAS 123 “Accounting for Stock-Based Compensation,’’ which recommends the recognition of compensation expense for the fair value of stock compensation awards on the date of grant. The compensation expense is recognized over the vesting period of each grant, with a corresponding recognition of the equity expected to be issued in Additional paid-in capital.
The Company’s combined financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect reported and disclosed amounts of assets and liabilities, as well as disclosure of contingent assets and liabilities as at the balance sheet date and the reported amounts of revenues and expenses during the reporting period. We believe the following accounting policies are critical to our operations as their application requires management to make the most significant judgments.
We write both excess of loss and pro-rata contracts. On excess of loss contracts, the minimum and deposit premium is defined in the contract wording and this is the amount we record as written premium in the period the underlying risks incept, therefore no management judgment is necessary. Subsequent adjustments to the minimum and deposit premium are recorded in the period in which they are determined.
Where contract terms require the reinstatement of coverage after a ceding company’s loss, the mandatory reinstatement premiums are recorded as written premiums when the loss event occurs, and are recognized as earned premium ratably over the remaining contract period.
Accrual of reinstatement premiums is based on our estimate of loss and loss adjustment expense reserves, which involves management judgment as described below. Reinstatement premiums are not accrued on reserves for losses incurred but not reported.
These factors require us to make significant assumptions when establishing loss reserves. For losses which have been reported to the Company, we estimate our ultimate loss using the following: (1) claims reports from insureds; (2) our underwriters and management experience in setting claims reserves; and (3) the use of computer models where applicable. Since the Company has insufficient past loss experience, management supplements this information with industry data. This industry data may not match the risk profile of the Company, which introduces a further degree of uncertainty into the process. For losses which have been incurred but not reported, the reserving process is further complicated.
On pro-rata contracts, including QQS arrangements, we estimate ultimate losses based on loss ratio forecasts as reported quarterly by cedents, which is normally on a quarterly or six month lag. We also review historical loss ratios from prior years as provided by each cedent, as well as public reports. We base our estimate of the ultimate losses on both of these factors. Estimated losses can change, based on revised
These complications, together with the potential for unforeseen adverse developments, may result in loss and loss adjustment expenses significantly greater or less than the reserve provided. Reserving can prove especially difficult should a significant loss event take place near the end of an accounting period, particularly if it involves a catastrophic event.
Management has determined that the best estimate for gross loss and loss adjustment expense reserves at December 31, 2002 was $146.1 million. Management’s best estimate of a range of likely outcomes around this estimate is between $131.0 million and $157.1 million.
The Company ended the 2002 year with a fully converted book value per share (as defined below) of $19.39, an increase of $2.98 from December 31, 2001. This increase of 18.2% resulted from premium rate levels being relatively high across the major classes that the Company specializes in, together with a relatively low level of catastrophes during the year. The Company also benefited from a positive total return of approximately 7.0% on its investment portfolio for the year ended December 31, 2002.
As the Company commenced writing business on December 16, 2001, it is not meaningful to compare 2002 results with 2001 results. We only wrote one reinsurance policy during this period and did not incur any related losses. In addition, we incurred significant start-up expenses which included the results of expensing the fair value of warrants issued to the founding shareholders. Therefore, both the loss ratio and the expense ratio for the period ended December 31, 2001 are not useful for comparative purposes and are not indicative of future results.
High premium rate levels coupled with the relatively low levels of catastrophe/large loss frequency;
The existence of a substantial capital base, with approximately $1 billion raised from our initial capitalization in 2001, combined with an additional $201.2 million from the successful completion of our Initial Public Offering in October, 2002; and
The following table summarizes our book values per common share as of the periods indicated:
Based on total shareholders’ equity plus the assumed proceeds from the exercise of dilutive options and warrants, divided by fully converted shares outstanding. The Company believes this to be the best single meaningful measure of the return made by our shareholders as it takes into account the effect of all dilutive securities.
The Company commenced operations on December 16, 2001; therefore there are no meaningful comparative prior period results.
Net underwriting income consists of net premiums earned less net loss and loss adjustment expenses incurred and acquisition costs.
The Company focuses on writing global specialty property and other specialty classes of insurance and reinsurance business. During the period ended December 31, 2001, the Company wrote one specialty reinsurance policy with a premium of $150,000, which was for worldwide risks.
“Worldwide, excluding USA and Canada” comprises insurance and reinsurance contracts that insure or reinsure risks on a worldwide basis but specifically exclude the USA and Canada.
Net premiums earned for the fourth quarter and for the year ended December 31, 2002 were $105.4 million and $329.9 million, respectively. In the fourth quarter we experienced an acceleration of premiums earned as the majority of our business is written during the January 1, April 1, and July 1 renewal periods and, therefore, it is reasonable to anticipate that the earned premium would generally increase over the course of our first full fiscal year as premiums written in earlier months are increasingly earned. We also did not have our full complement of underwriters until the end of the second quarter of 2002 and, therefore, we were not able to fully participate in the 2002 renewal season, resulting in a higher level of unearned premium at December 31, 2002.
The underwriting results of an insurance or reinsurance company are often measured by reference to its loss ratio and expense ratio. The loss ratio is calculated by dividing loss and loss adjustment expenses incurred (including estimates for incurred but not reported losses) by net premiums earned. The expense ratio is calculated by dividing acquisition costs combined with general and administrative expenses by net premiums earned. The combined ratio is the sum of the loss ratio and the expense ratio.
Loss and loss adjustment expenses were $10.9 million for the fourth quarter and $133.3 million for the year ended December 31, 2002, representing loss ratios of 10.4% and 40.4%, respectively. At September 30, 2002 and December 31, 2002, net loss reserves were $121.9 million and $129.5 million, respectively, of which $100.6 million and $91.7 million, respectively, related to an estimate of losses incurred but not yet reported. Reinsurance recoveries of $10.6 million and $16.7 million related to the QQS business written were netted against loss and loss adjustment expenses for the nine months ended September 30, 2002, and for the year ended December 31, 2002, respectively. We paid losses of $0.5 million and $4.2 million, respectively, for the nine months ended September 30, 2002 and for the year ended December 31, 2002.
recorded in income in the period in which they are determined. We have experienced a year with a relatively low level of claims activity. This may not be indicative of future results.
At December 31, 2002, we estimated our gross reserve for loss and loss adjustment expenses using the methodology as outlined in our Critical Accounting Policy earlier in this section. Management has determined that the best estimate for gross loss and loss adjustment expense reserves at December 31, 2002 was $146.1 million. Management’s best estimate of a range of likely outcomes around this estimate is between $131.0 million and $157.1 million. Having regard to the limited number of paid losses arising during the Company’s short operating history, management used the following methodology in determining this range: (1) a combination of actuarial methods; (2) industry loss information to estimate loss ratios and expected reporting patterns for companies that write similar lines of business; and (3) professional judgment. Management calculated a range around our best estimate for each class of business which reflects the potential variability in our loss ratio and the reporting pattern assumptions.
Underwriting expenses consist of acquisition costs and general and administrative expenses. Acquisition costs and general and administrative expenses were $31.6 million for the fourth quarter and $89.2 million for the year ended December 31, 2002, representing expense ratios of 30% and 27%, respectively. General and administrative expenses are comprised of fixed expenses which include costs for salaries and benefits, stock options and office and risk management expenses. Variable general and administrative expenses include expenses related to our performance unit plan and bonuses. Acquisition costs are generally driven by contract terms and are normally a set percentage of premiums. Therefore, as our premiums increase in 2003 as anticipated, acquisition costs will also increase as these costs vary directly with the level of premiums written.
However, for 2003 we expect premiums earned will increase at a more rapid pace than general and administrative expenses. We therefore expect that we will have a lower expense ratio in 2003 than we had in 2002. Other factors could also affect the expense ratio, including the mix of business written, and the amount of acquisition costs incurred. The expense ratio has increased during the fourth quarter as a result of the accrual of approximately $1.5 million in profit commission and the accrual of additional variable compensation expense, driven by the lower combined ratio than in prior quarters.
For the year ended December 31, 2002, acquisition costs incurred were $62.9 million, which were principally due to brokerage commissions for our insurance and reinsurance contracts of $29.6 million, commissions paid to ceding insurers and other costs of $31.8 million and an accrual for profit commission of $1.5 million.
Net investment income for the fourth quarter and for the year ended December 31, 2002 was $10.7 million and $39.7 million, respectively. Net investment income for the period ended December 31, 2001 was $1.1 million which reflects the receipt of the private placement proceeds in mid-December 2001. Net investment income is primarily composed of interest on coupon-paying bonds and bank interest, partially offset by accretion of premium on bonds of $1.7 million and $3.8 million, respectively, and investment management and custodian fees of $0.7 million and $2.3 million, respectively, for the periods ended December 31, 2002 and 2001. The investment management fees were paid to White Mountains Advisors LLC, a wholly-owned indirect subsidiary of White Mountains Insurance Group, one of our major shareholders. The fees charged are consistent with those that would be charged by a non-related party.
The performance results of our fixed maturity portfolio, with a comparison to the Lehman Brothers Government/Corporate 1-3 Year Index, for the year ended December 31, 2002 was as follows:
Total return is calculated by dividing total net investment income on fixed maturity investments by the average of the sum of such investments at amortized cost at the end of each month in 2002.
The Lehman Brothers Government/Corporate 1-3 Year Index is used for comparative purposes as it lines up with our assets and the nature of our business.
We are a holding company that conducts no operations of its own. We rely primarily on cash dividends and management fees from Montpelier Re to pay our operating expenses, interest on debt facilities and dividends, if any. There are restrictions on the payment of dividends from Montpelier Re to the Company, which are described in more detail below. It is our continuing policy to retain earnings to support the growth of our business. We do not currently intend to pay dividends.
The Company’s shareholders’ equity at December 31, 2002 was $1,252.5 million, of which $90.4 million was retained earnings. As expected, the Company’s balance sheet changed significantly from December 31, 2001 to December 31, 2002 as 2002 was the first full year of operations. The positive operating results for 2002, combined with the successful completion of our IPO resulting in net proceeds of approximately $201.2 million, increased shareholders’ equity by approximately $391.9 million. Our capital resources also include our loan agreement with Bank of America, N.A. and a syndicate of commercial banks with an aggregate borrowing limit of $150.0 million under the term loan facility and a further $50.0 million under a revolving credit facility. See the liquidity section below for additional detail regarding this facility.
For most insurance and reinsurance companies, the most significant judgment made by management is the estimation of the loss and loss adjustment expense reserves. Due to the short-tail nature of our business, generally we expect that the majority of our losses will be paid relatively quickly. However, this can be affected by such factors as the event causing the loss, the location of the loss, and whether our losses are from policies with insurers or reinsurers. Accordingly, it is necessary to estimate, as part of the loss and loss adjustment expense reserve, an amount for losses incurred but not reported (“IBNR”).
These factors require us to make significant assumptions when establishing loss reserves. For losses which have been reported to the Company, we estimate our ultimate loss using the following: (1) claims reports from insureds; (2) our underwriters and management experience in setting claims reserves; and (3) the use of computer models, where applicable. Since the Company has insufficient past loss experience, management supplements this information with industry data. This industry data may not match the risk profile of the Company, which introduces a further degree of uncertainty into the process. For losses which have been incurred but not reported, the reserving process is further complicated.
The market value of our portfolio of fixed maturity investments comprises investment grade corporate debt securities (24%), U.S. government and agency bonds (59%) and mortgage-backed and asset-backed securities (17%). All of the fixed maturity investments currently held by us were publicly traded at December 31, 2002. Based on the weighted average monthly investments held, and including unrealized gains, our total return for the year ended December 31, 2002 was 7.1%. The average duration of the portfolio was 1.9 years and the average rating of the portfolio was AA+ at December 31, 2002.
Cash flows for the Period from Inception to December 31, 2001. In the period from November 14, 2001, our date of incorporation, to December 31, 2001, we received $848.2 million in cash from a private placement of our common shares, which was partially offset by equity raising costs of $5.2 million. Substantially all of these funds were contributed to Montpelier Re to provide capital for use in its underwriting operations. During the period ended December 31, 2001, we used $3.9 million of cash in operating activities, largely because Montpelier Re did not commence operations until mid December 2001. Montpelier Re invested $638.5 million in investments in the period, and had a cash balance of $350.6 million at December 31, 2001.
On December 12, 2001, we entered into two senior credit facilities with Bank of America, N.A. and a syndicate of commercial banks, consisting of the Bank of N.T. Butterfield & Son Limited, Credit Suisse First Boston, The Bank of Bermuda Ltd., Fleet National Bank, The Bank of New York and Barclays Bank PLC. In 2002, Comerica Bank also became a party to this agreement. The credit facilities consist of a 364-day revolving credit facility with a $50.0 million borrowing limit and a three-year term loan facility with a $150.0 million aggregate borrowing limit. The $50.0 million revolving credit facility was renewed in December, 2002. In connection with this renewal, the Company paid approximately $62,500 in fees. As of December 31, 2002, we had borrowed $150.0 million under the term loan facility and had not accessed the revolving credit facility. Substantially all of the $150.0 million was contributed to Montpelier Re to provide capital for use in its underwriting operations. These credit facilities contain
Furthermore, our ability to pay dividends is limited under these credit facilities. Under these facilities, we cannot pay dividends to our shareholders until April 1, 2003. After this date, we can only pay dividends in an amount equal to 50% of our net income at the end of any quarter, excluding all extraordinary gains and losses. If we pay dividends in excess of this amount, we are required to simultaneously refund our debt in an amount equal to at least 43% of the excess dividend payment. This debt repayment would be used to pay any amounts owing under our term loan facility and then amounts outstanding under the revolving loan facility. We do not currently intend to pay dividends in the foreseeable future.
Cash is used primarily to pay loss and loss adjustment expenses, brokerage commissions, excise taxes, general and administrative expenses and to purchase new investments. In the future, we will use cash to pay for any premiums retroceded and any authorized share repurchases. In 2003 we have purchased specific retrocessional protection for our direct insurance and facultative reinsurance programs on an “any one risk” basis to limit our exposure from losses at one location. We may purchase additional retrocessional protection for our own account in 2003.
Certain business written by the Company has loss experience generally characterized as having low frequency and high severity. This may result in volatility in both the Company’s results and operational cash flows. The potential for a large claim under one of our insurance or reinsurance contracts means that substantial and unpredictable payments may need to be made within relatively short periods of time.
We intend to manage these risks by structuring our investments in an effort to anticipate the payout patterns of our liabilities under insurance or reinsurance policies. No assurance can be given, however, that we will successfully match the structure of Montpelier Re’s investments with its liabilities under insurance or reinsurance contracts. If our calculations with respect to these reinsurance liabilities
are incorrect, or if we improperly structure our investments to match such liabilities, we could be forced to liquidate investments prior to maturity, potentially at a significant loss.
Montpelier Re is registered under the Insurance Act. Under the Insurance Act, Montpelier Re is required to file on an annual basis, Statutory Financial Statements and a Statutory Financial Return. The Insurance Act also requires Montpelier Re to meet a minimum solvency margin equal to the greatest of (i) $100.0 million, (ii) 50% of net premiums written or (iii) 15% of the reserve for loss and loss adjustment expenses. To satisfy these requirements, Montpelier Re was required to maintain a minimum level of statutory capital and surplus of $282.9 million and $100.0 million at December 31, 2002 and 2001, respectively, and a minimum share capital of $1.0 million for both years. In the periods ended December 31, 2002 and 2001, Montpelier Re satisfied these requirements.
Montpelier Re has the ability to provide sufficient unencumbered assets to support the standby letter of credit.
There is substantial evidence that insurance and reinsurance prices rise in the short term for property and other classes of reinsurance in the aftermath of significant catastrophic events. Other factors may impact reinsurance prices as well. We believe that the relatively high current price levels for property and certain other “short-tail” reinsurance products we write are principally due to a supply/demand imbalance in capacity caused by losses sustained by the global insurance and reinsurance industry resulting from the September 11th terrorist attacks, a general decline of global equity markets thereafter, and the more recent significant loss reserve strengthening of major insurance and reinsurance companies. Through Montpelier Re, we seek to help fulfill the need for additional underwriting capacity in the global property and casualty insurance and reinsurance market. We intend to take advantage of current conditions in that market by opportunistically providing capacity to ceding companies at prices commensurate with the risk we assume.
We believe that prices in general for the “short-tail” insurance and reinsurance products we write will be more stable in 2003 than they were in 2002. We believe that prices for the specific reinsurance contracts we write in 2003 will be affected primarily by: (1) the supply of, and demand for, capacity in the global reinsurance market; (2) the historical loss experience of the contracts under consideration; (3) the loss exposure of the contracts under consideration; and (4) the financial strength of the ceding companies purchasing the contracts. While we believe that overall price levels are currently favorable for reinsurers and better than they have been in many years, capital provided by newly-formed reinsurers or additional capital raised by existing reinsurers may increase the supply of reinsurance which could impact negatively the prices that we receive for the products we write. Also, successful initiatives by capital market participants to produce alternative products that may compete with the products that we write could significantly affect supply, pricing and competition in our industry.
An increase in premiums written as a result of our quota share arrangements with Aspen Re;
Reference is made to Item 15 (a) of this Report for the Combined Financial Statements of Montpelier Re Holdings Ltd. and the Notes thereto, as well as the Schedules to the Combined Financial Statements.