The statements in this discussion regarding business outlook, our expectations regarding our future performance, liquidity and capital resources and other non-historical statements in this discussion are forward-looking statements. These forward-looking statements are subject to numerous risks and uncertainties, including, but not limited to our Introductory Note to this Annual Report and the risks and uncertainties described in Part I, Item 1A “Risk Factors.” Our actual results may differ materially from those contained in or implied by any forward-looking statements.
Insurance float is an important aspect of our property and casualty reinsurance operation. In an insurance or reinsurance operation, float arises because premiums from reinsurance contracts and consideration received for deposit accounted contracts are collected before losses are paid on reinsurance contracts and payments are made on deposit accounted contracts. In some instances, the interval between cash receipts and payments can extend over many years. During this time interval, we invest the cash received and seek to generate investment returns. Float is not a concept defined by U.S. GAAP and therefore, there are no comparable U.S. GAAP measures. As a result, net investment income on float is considered to be a non-GAAP measure.
Our investment strategy is implemented by our investment manager, Third Point LLC, under two long-term investment management contracts. We directly own the investments that are held in two separate accounts and managed by Third Point LLC on substantially the same basis as Third Point LLC’s main hedge funds. In June 2016, Third Point Reinsurance Ltd., Third Point Re, TPRUSA and Third Point Re USA entered into amended and restated Joint Venture and Investment Management Agreements with Third Point LLC and TP GP for an additional five year term, effective on December 22, 2016. These agreements have similar terms to the expired agreements, however, the management fee was reduced from 2% to 1.5%. See Note 9 to our consolidated financial statements for additional information.
We track cash flows generated by our property and casualty reinsurance operations, or float, in separate accounts that allow us to also track the net investment income (loss) generated on the float. We believe that net investment income (loss) on float is an important consideration because it assists our management and investors in evaluating the overall contribution of our property and casualty reinsurance operations to our consolidated results. It is also explicitly considered as part of the evaluation of management’s performance for purposes of long-term incentive compensation. Net investment income (loss) on float as presented is a non-GAAP financial measure. See the table below for a reconciliation of net investment income (loss) on float to net investment income (loss).
We believe that long-term growth in diluted book value per share is the most important measure of our financial performance because it allows our management and investors to track over time the value created by the retention of earnings. In addition, we believe this metric is used by investors because it provides a basis for comparison with other companies in our industry that also report a similar measure.
As of December 31, 2016, book value per share of $13.57 increased by $0.34 per share, or 2.6%, from $13.23 per share as of December 31, 2015. As of December 31, 2015, book value per share of $13.23 decreased by $0.81 per share, or 5.8%, from $14.04 per share as of December 31, 2014.
As December 31, 2016, diluted book value per share of $13.16 increased by $0.31 per share, or 2.4%, from $12.85 per share as of December 31, 2015. As of December 31, 2015, diluted book value per share of $12.85 decreased by $0.70 per share, or 5.2%, from $13.55 per share as of December 31, 2014.
The changes in book value per share and diluted book value per share were also impacted by share activity including share repurchases and the issuance of performance restricted shares.
The following table sets forth the computation of basic and diluted book value per share as of December 31, 2016, 2015 and 2014 :
As of December 31, 2016, the effect of dilutive restricted shares issued to directors and employees was comprised of 301,043 restricted shares with a service condition only and 577,486 restricted shares with a service and performance condition that were considered probable of vesting.
Return on beginning shareholders’ equity for the years ended December 31, 2016, 2015 and 2014 was calculated as follows:
amounts, not offset by prior year net profit amounts, and which is allocated to future profit amounts until the Loss Recovery Account has returned to a positive balance. Until such time, no performance fees are payable under the Investment Agreements.
Other expenses consist of investment credit expenses on deposit and reinsurance contracts and changes in the fair value of embedded derivatives in our deposit and reinsurance contracts.
Foreign exchange gains (losses) consist of the revaluation of monetary assets and liabilities denominated in foreign currencies to U.S. dollar, our functional currency.
Income taxes consist primarily of taxes incurred in the U.S. as a result of our U.S. operations and withholding taxes and uncertain tax positions on certain investment transactions in the U.S. and in certain foreign jurisdictions.
Most of our senior management team have spent decades within the reinsurance market and have strong relationships with intermediaries and reinsurance buyers from which we are receiving a strong flow of submissions in the lines and types of reinsurance we target. Although we are typically presented by brokers with proposed structures on syndicated deals, we often seek to customize the proposed solution for the client while improving our risk and return profile and establishing our position as the lead reinsurer in the transaction. We also look for non-syndicated opportunities where a highly customized solution is needed. These solutions may take the form of aggregate stop loss covers, loss portfolio transfers or other forms of reserve covers where clients seek capital relief and enhanced investment returns on the assets that back their loss and unearned premium reserves.
During our first four years of operation through 2015, we had significant premium growth and float generation and reached a premium level that supports our fixed expense base and an invested assets to equity ratio that appropriately utilizes our capital. As market conditions have continued to deteriorate, it has been more difficult to originate reinsurance opportunities that meet our underwriting standards and therefore gross written premium in 2016 was slightly lower than 2015. Given current market conditions and our focus on improving underwriting results, it is possible that our premiums written for 2017 may decline further.
In February 2015, we began reinsurance operations in the United States through Third Point Re USA, a Bermuda company licensed as a Class 4 insurer and a wholly owned operating subsidiary of TPRUSA. Third Point Re USA’s U.S. presence is a strategic component of our overall growth strategy. As a result of Third Point Re USA’s U.S. presence, we have expanded our marketing activities and have broadened our profile in the U.S. marketplace. In addition to developing new opportunities, we are strengthening our relationships with existing cedents and brokers. We also intend to continue developing a firsthand understanding of cedent underwriting and claims capabilities that will benefit our underwriting decisions.
Consolidated Results of Operations-Years ended December 31, 2016, 2015 and 2014
The decrease in general and administrative expenses related to corporate activities for the year ended December 31, 2016 compared to 2015 was primarily due to a decrease in our annual incentive plan compensation expense where we did not achieve the threshold performance target, lower share compensation expense in the current year due to forfeitures and fewer restricted shares with performance and service conditions considered probable of vesting.
In February 2015, TPRUSA issued $115.0 million of senior notes bearing 7.0% interest. As a result, our consolidated results of operations for the current year include a full year of interest expense.
The foreign exchange gains were primarily due to the revaluation of foreign currency loss and loss adjustment expense reserves denominated in British pounds to the United States dollar, which had strengthened during the year.
Income tax expense for the year ended December 31, 2016 is primarily due to withholding taxes on our investment portfolio, partially offset by tax benefit as a result of a pre-tax loss generated by our U.S. subsidiaries.
As a result of the net loss generated by our U.S. subsidiaries, we recorded an income tax benefit in the year ended December 31, 2015.
The following table sets forth net underwriting results and ratios, and the year over year changes for the Property and Casualty Reinsurance segment for the years ended December 31, 2016, 2015 and 2014:
We write a small number of large contracts; therefore individual renewals or new business can have a significant impact on premiums recognized in a period;
Our reinsurance contracts often contain commutation provisions or can be canceled or terminated upon agreement from both parties; and
Our quota share reinsurance contracts are subject to significant judgment in the amount of premiums that we expect to recognize and changes in premium estimates are recorded in the period they are determined.
As a result of these factors, we may experience volatility in the amount of gross premiums written and net premiums earned and year to year comparisons may not be meaningful.
The following table provides a breakdown of our Property and Casualty Reinsurance segment’s gross premiums written by line of business for the years ended December 31, 2016, 2015 and 2014:
We recognized $193.1 million of premium in the year ended December 31, 2015 that did not renew in the year ended December 31, 2016, consisting of $107.5 million for contracts that were not subject to renewal in 2016 and $85.6 million for contracts that we made a decision not to renew in 2016 due to changes in pricing and/or terms and conditions.
We recorded increases in premium estimates relating to prior periods of $106.6 million and $39.3 million for the years ended December 31, 2016 and 2015, respectively. The 2016 increases in premium estimates were primarily due to the following factors:
We wrote a multi-line contract for several underwriting years covering commercial auto physical damage and auto extended warranty. As this was a new and growing program, we initially recorded the cedent’s estimate of expected written premium at a lower amount than their initial estimate. The ceding company exceeded their premium projections resulting in an increase of $23.6 million related to that contract;
We wrote a general liability quota share whereby the ceding company increased their writings, which resulted in a $20.8 million premium estimate increase during the year on this contract; and
The decrease in net premiums earned for the year ended December 31, 2016 compared to the year ended December 31, 2015 was primarily due to retroactive reinsurance contracts of $108.1 million that were written and earned in the year ended December 31, 2015 whereas we did not write any retroactive reinsurance contract in the year ended December 31, 2016. This decrease was partially offset by an increase in net premiums earned as a result of a larger in-force underwriting portfolio.
The increase in net premiums earned for the year ended December 31, 2015 compared to the year ended December 31, 2014, was a result of a larger number of retroactive reinsurance contracts written in 2015 and net premiums earned on a larger in-force underwriting portfolio.
The following is a summary of reserve development for the years ended December 31, 2016, 2015 and 2014:
For the year ended December 31, 2015, we incurred $5.4 million, or 0.9 percentage points, of net favorable prior years’ reserve development. The $5.4 million of net favorable prior years’ reserve development for the year ended December 31, 2015 was accompanied by net increases of $13.2 million in acquisition costs, resulting in a net increase of $7.8 million in net underwriting loss, or 1.3 percentage points. The $7.8 million net increase in net underwriting loss was a result of having favorable loss reserve development on certain contracts that were either fully or partially offset by increases in sliding scale or profit commissions whereas certain workers’ compensation, auto and property contracts with adverse loss development did not have offsetting decreases in acquisition costs to the same degree, resulting in the net favorable development being more than offset by acquisition costs in the period.
For the year ended December 31, 2014, we incurred $0.7 million, or 0.2 percentage points, of net favorable prior years’ reserve development. The $0.7 million of net favorable prior years’ reserve development for the year ended December 31, 2015 was accompanied by net increases of $0.3 million in acquisition costs, resulting in a net decrease of $0.4 million in net underwriting loss.
Many of our contracts have similar expected composite ratios (combined ratio before general and administrative expenses); therefore, contracts with higher initial loss ratio estimates have lower acquisition cost ratios and contracts with lower initial loss ratios have higher acquisition cost ratios.
The decrease in general and administrative expenses allocated to underwriting activities for the year ended December 31, 2016 compared to the year ended December 31, 2015 was primarily due to a decrease in our annual incentive plan compensation expense where we did not achieve the threshold performance target, lower share compensation expense in the current year due to forfeitures and fewer restricted shares with performance and service conditions considered probable of vesting.
The primary driver of our net investment income (loss) is the returns generated by our investment portfolio managed by our investment manager, Third Point LLC. The following is a summary of the net investment return on investments managed by Third Point LLC by investment strategy for the years ended December 31, 2016, 2015 and 2014:
For the year ended December 31, 2015, the net investment results were primarily attributable to losses in our long equity and performing credit portfolios. Within credit, gains from one large sovereign debt investment and strong performance from the structured credit portfolio outweighed modest losses in performing credit positions in the energy sector. In equities, negative performance was partially offset by gains from short equity investments. During the year, Third Point LLC reduced net exposure by both exiting long positions and adding to the short portfolio.
Refer to “ITEM 3. Quantitative and Qualitative Disclosures about Market Risks” for a list of risks and factors that could adversely impact our investments results.
The increase for the year ended December 31, 2015 compared to the year ended December 31, 2014 was primarily due to separation costs, increased share compensation expense and increased legal and other professional advisor expenses.
See Note 14 to our consolidated financial statements for additional information regarding income taxes. The increase in income tax expense for the year ended December 31, 2016 compared to the year ended December 31, 2015 was primarily due to greater withholding taxes on our investment portfolio and a smaller income tax benefit generated by our U.S. subsidiaries.
As of December 31, 2016, $1,452.3 million, or 54.9% (December 31, 2015 - $1,182.3 million, or 51.0%) of our total investments in securities were classified as Level 1 assets, which are defined as securities valued using quoted prices available in active markets. See Note 4 to our consolidated financial statements for additional information on the framework for measuring fair value established by U.S. GAAP disclosure requirements.
Third Point Reinsurance Ltd. is a holding company and has no substantial operations of its own and has moderate cash needs, most of which are related to the payment of corporate expenses. Its assets consist primarily of its investments in subsidiaries. Third Point Reinsurance Ltd.’s ability to pay dividends or return capital to shareholders will depend upon the availability of dividends or other statutorily permissible distributions from those subsidiaries.
We and our Bermuda subsidiaries are subject to Bermuda regulatory constraints that affect our ability to pay dividends. Under the Companies Act, as amended, a Bermuda company may declare or pay a dividend out of distributable reserves only if it has reasonable grounds for believing that it is, or would after the payment, be able to pay its liabilities as they become due and if the realizable value of its assets would thereby not be less than its liabilities. Under the Insurance Act, Third Point Re and Third Point Re USA, as Class 4 insurers, are prohibited from declaring or paying a dividend if they are in breach of their respective minimum solvency margin (“MSM”), enhanced capital requirement (“ECR”) or minimum liquidity ratio or if the declaration or payment of such dividend would cause such a breach. Where either Third Point Re or Third Point Re USA, as Class 4 insurers, fails to meet its MSM or minimum liquidity ratio on the last day of any financial year, it is prohibited from declaring or paying any dividends during the next financial year without the approval of the BMA.
In addition to the regulatory and other contractual constraints to paying dividends, we manage the capital of the group and each of our operating subsidiaries to support our current ratings from A.M. Best. This could further reduce the ability and amount of dividends that could be paid from Third Point Re to Third Point Reinsurance Ltd. After several years of premium growth and float generation from our inception, we have reached a level that allows us to rationalize
For the years ended December 31, 2016, 2015 and 2014, we contributed $53.3 million, $147.1 million and $163.0 million, respectively, to our separate accounts managed by Third Point LLC from float generated from our reinsurance operations. These amounts do not correspond to the net cash provided by operating activities as presented in the consolidated statements of cash flows prepared in accordance with U.S. GAAP. The amount of float can vary significantly from period to period depending on the timing, type and size of reinsurance contracts we bind. Refer to “ITEM 2. Management’s Discussion and Analysis - Property and Casualty Reinsurance” for a definition of insurance float.
Cash flows used in investing activities primarily reflects investment activities related to our separate accounts managed by Third Point LLC. Cash flows used in investing activities for the years ended December 31, 2016, 2015 and 2014 primarily reflects the investment of float generated from our reinsurance operations, including the net proceeds from deposit liability contracts. Cash flows used in investing activities for the year ended December 31, 2015 also includes the investment of the net proceeds from our issuance of Notes as part of the initial capitalization of Third Point Re USA.
We do not believe that inflation has had a material effect on our consolidated results of operations to date. The effects of inflation are considered implicitly in pricing our reinsurance contracts. Loss reserves are established to recognize likely loss settlements at the date payment is made. Those reserves inherently recognize the effects of inflation. However, the actual effects of inflation on our results cannot be accurately known until claims are ultimately resolved.
Restricted cash and cash equivalents and restricted investments increased by $103.2 million, or 16.6%, to $726.2 million as of December 31, 2016 from $623.0 million as of December 31, 2015. The increase was primarily due to an increase in the number of reinsurance contracts that required collateral partially offset by lower letter of credit usage. In addition, we are now investing a portion of the collateral securing certain reinsurance contracts in U.S. treasury securities and sovereign debt. This portion of the collateral is included in debt securities in the consolidated balance sheets and is disclosed as part of restricted investments.
See Note 11 to our consolidated financial statements for additional information regarding our letter of credit facilities.
Under the letter of credit facilities, we provide collateral that may consist of cash and cash equivalents, U.S. treasuries or sovereign debt. As of December 31, 2016, total cash and cash equivalents with a fair value of $231.8 million (December 31, 2015 - $270.8 million) was pledged as collateral against the letters of credit issued. Our ability to post collateral securing letters of credit and certain reinsurance contracts depends in part on our ability to borrow against certain assets in our Investment Accounts through prime brokerage arrangements. See Note 6 to our consolidated financial statements for additional information regarding our prime brokerage arrangements. The loss or reduction in
this borrowing capacity could reduce the amount of reinsurance we write or reduce the amount of float that we contribute to our Investment Accounts. The collateral amounts securing letters of credit are included in restricted cash and cash equivalents in the consolidated balance sheets. Each of the facilities contain customary events of default and restrictive covenants, including but not limited to, limitations on liens on collateral, transactions with affiliates, mergers and sales of assets, as well as solvency and maintenance of certain minimum pledged equity requirements, and an A.M. Best Company rating of “A-“ or higher. Each restricts issuance of any debt without the consent of the letter of credit provider. Additionally, if an event of default exists, as defined in the letter of credit facilities, we will be prohibited from paying dividends. We were in compliance with all of the covenants under the aforementioned facilities as of December 31, 2016.
As of December 31, 2016, total shareholders’ equity was $1,449.7 million compared to $1,395.9 million as of December 31, 2015. The increase was primarily due to net income of $27.6 million and share compensation expense and issuance of common shares totaling $14.1 million, partially offset by share repurchases of $7.4 million in the current year period.
As of December 31, 2016, total cash and net investments managed by Third Point LLC was $2,191.6 million, compared to $2,062.8 million as of December 31, 2015. The increase was primarily due to float of $53.3 million generated by our reinsurance operations and net investment income on investments managed by Third Point LLC of $97.3 million.
Our contractual obligations as of December 31, 2016 by estimated maturity are presented below:
The contractual obligations table above does not include an estimate of the time period of cash settlement of our $1.6 million of uncertain tax positions with the respective tax authorities given that we cannot reasonably estimate the timing of potential settlement.
As of December 31, 2016, we had an unfunded capital commitment of $3.2 million related to our investment in the Hellenic Fund (see Note 17 to our consolidated financial statements for additional information).
Determining whether or not a reinsurance contract meets the condition for risk transfer requires judgment. The determination of risk transfer is critical to recognizing premiums written and is based, in part, on the use of actuarial pricing models and assumptions and evaluating contractual features that could impact the determination of whether a contract meets risk transfer. If we determine that a reinsurance contract does not transfer sufficient risk, we use deposit accounting. See Note 10 to our consolidated financial statements for additional information on deposit contracts entered into to date.
See Note 8 to our notes to consolidated financial statements included elsewhere in this Annual Report on Form 10-K for additional information regarding loss and loss adjustment expense reserves including reserving methodologies and additional information on loss development.
The table below shows the impact of reasonably likely changes to our actuarial estimates of our client’s ceded loss on the following: loss and loss adjustment expense reserves, net; acquisition costs, net; net underwriting loss and shareholders’ equity as of and for the year ended December 31, 2016. Since many contracts that we write have sliding scale commissions, profit commissions, loss corridors or other loss mitigating features that adjust with or offset the loss and loss adjustment expenses incurred, we consider these contractual features to be important in understanding the sensitivity of our results to changes in loss ratio assumptions.
As a result of the contractual features mentioned above, many of our reinsurance contracts provide for a maximum margin. Consequently, our upside potential on these contracts is limited. In these cases, the relative impact of the adverse development scenario is greater than the impact of the favorable development scenario.