The following financial information for the five years ended December 31, 2008, has been derived from RAM’s Financial Statements. This information should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” located in Part II, Item 7, and the Financial Statements and related notes located in Part II, Item 8. In particular, see Note 19 to the Financial Statements for a discussion of certain risks and uncertainties.
Financial statement information included is on a consolidated basis for December 31, 2008, 2007 and 2006. Prior to that financial information is presented on a combined basis. See Note 1 in the audited financial statements.
Certain reclassifications have been made to the prior year’s amounts to conform to the current year’s presentation. See Note 2 to the audited financial statements.
Calculated by dividing loss and loss adjustment expenses by net earned premiums
We are a Bermuda-based provider of financial guaranty reinsurance, conducting substantially all of our operations through our wholly owned subsidiary, RAM Re. Our financial strength ratings from the rating agencies affect our ability to compete in the market of providing reinsurance to the primary financial guaranty insurers.
We are rated A+ (with a negative outlook) by Standard &Poor’s and Baa3 (outlook developing) by Moody’s. We requested withdrawal of our Moody’s rating on March 17, 2009. On September 24, 2008, S&P lowered its financial strength rating of RAM Re to “A+”, with negative outlook. S&P stated that the “A+” rating, issued on September 24, 2008, reflects its view that the diversity and scope of RAM Re’s reinsurance relationships have suffered as more of the primary insurers’ new business production has declined in the current environment. These changes raise the likelihood in S&P’s view that RAM Re’s new business generation will be limited until the primary insurers can stabilize their franchises. The rating changes also reflect the difficulty S&P believes RAM Re may face, in light of the current environment, toward improving its historically below-average return on equity (ROE). Finally, S&P stated that the rating changes reflect S&P’s view of RAM Re’s weakened capital adequacy position, which is the result of a significant amount of projected losses relating primarily to reinsured subprime and second-lien RMBS and secondarily CDOs of ABS. Although the Company’s capital adequacy margin of safety in S&P’s analysis was at the low end of the range of 1.0x -1.1x, which exceeds S&P ‘A’ criteria of 0.8x, it has declined from prior years when the margin of safety was in excess of 1.25x. On December 4, 2008 Moody’s downgraded RAM to “Baa3”, with developing outlook. Moody’s stated that its rating action on December 4, 2008, reflected Moody’s views on RAM Re’s overall credit profile in the current environment, including the potential for increased losses among its mortgage-related exposures and significantly constrained new business prospects. Moody’s stated that the downgrade resulted from three primary factors, the first being Moody’s expectations of greater losses on mortgage-related exposures, reflecting continued adverse delinquency trends. Moody’s stated that although RAM Re has reduced the size of its RMBS and ABS CDO portfolios through recent commutation transactions with MBIA Insurance Corporation (“MBIA”) and Syncora Guaranty Re (formerly XL Financial Assurance Ltd.) (“XLFA”), loss expectations relating to RAM Re’s direct RMBS portfolio were material relative to capital. The second factor was Moody’s view of diminished business prospects as reflected by low underwriting volume. The third factor according to Moody’s was the Company’s impaired financial flexibility.
The downgrades of our ratings by S&P and Moody’s have had a material adverse affect on our ability to compete, on the terms of our reinsurance and on our financial results. Due to adverse developments in the financial markets and the financial guaranty industry generally beginning in the latter half of 2007, as well as the downgrades of our ratings, we wrote only a modest amount of business in 2008 and have written no new business in 2009. In addition, due to the above mentioned downgrades, certain of the primary financial guarantors that have previously ceded business to RAM, which we refer to as “ceding companies,” have the right, after a cure period, to increase the ceding commission, as stipulated in the treaties, or terminate the treaties and recapture the business previously ceded to RAM Re whether written in financial guaranty or credit derivative form. To the extent policies are recaptured, RAM must forfeit to the ceding company an amount determined by formula under each treaty which generally consists of RAM’s allocated share of the U.S. statutory unearned premium, net of the ceding commission paid by RAM to the ceding company (subject to a penalty amount in some cases), and loss reserves established with respect to the policies ceded, as applicable.
Reducing our insured risk exposure: We commuted our entire insured portfolio assumed from Syncora Guaranty Re Ltd. and MBIA, effective July 25, 2008 and November 30, 2008, respectively. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations, “Results of operations: Net income - Commutations”. As a result of these commutations, we reduced our exposure to the troubled sectors as follows:
Total 2005-2007 vintage US RMBS was reduced by $733.4 million par outstanding consisting of $609.2 million of second-lien RMBS (HELOCs and Closed-End Seconds) and $124.2 million of first-lien RMBS. As a percent of outstanding par at December 31, 2007, the commuted amounts represent 35.4% of total 2005-2007 vintage US RMBS, 50.7% of second-lien RMBS, and 14.3% of first-lien RMBS, respectively.
Total ABS CDO par outstanding, predominantly 2005-2007 vintages, was reduced by $1,149.9 million. As a percent of outstanding par at December 31, 2007, the commuted amount represents 81.6% of total ABS CDOs.
We commuted our entire insured portfolio assumed from Ambac Assurance Corporation effective April 8, 2009. See Note 27, “Subsequent Events,” in the notes to our consolidated financial statements. We are pursuing further commutations in cases where they can be negotiated at acceptable prices. In addition, we are pursuing legal actions against our ceding companies in cases where we dispute the validity of cessions made under our treaties or ceded losses.
We are not seeking to write any new business in the near term, although we believe that if we are successful in the strategic measures set forth above, it will improve our position to potentially write new business in the future. We continue to evaluate our business model and may pursue a different set of strategies in the future. There can be no assurance that the strategies that have been implemented or that will be pursued in the future in connection with this evaluation will improve our business, financial condition, liquidity or results of operations or will not have a material adverse effect on the Company. Because we are not writing any new business, our Board may consider strategic options or determine to wind down the Company. See Item IA. Risk Factors - “We are not seeking to write any new business in the near term, and the lack of new premiums written could have a material adverse effect on our business, financial condition, liquidity and results of operations;” “We may not be able to execute our business strategy or any other strategic alternatives the Board may determine to pursue;” and “If RAM is unable to execute its business strategy or other strategic alternatives, the Board of Directors of RAM may determine that the best course of action is to commence an orderly winding up and liquidation of RAM Re’s operations over some period of time that is not currently determinable.”
Treaty reinsurance requires primary insurers to cede to us, and requires us to reinsure, financial guarantees for specific types of obligations as determined by the treaty terms. We have not renewed any of our reinsurance treaties in 2009. This means that we do not expect to write any financial guaranty reinsurance in the current year but this does not reduce our in-force business, unless the business is commuted or recaptured by the primaries. Facultative reinsurance, the reinsurance of individual policies, is subject to separate negotiation for each reinsurance cession. We continue to have facultative reinsurance agreements in place with the primaries under which we could reinsure business on a case by case basis. The initial underwriting of insured risks and the reporting of underwriting results to us are the responsibility of the primary insurers. As a result, we are highly dependent on the underwriting, operating and reporting standards of our primary insurers. The monitoring and oversight of primary insurers by RAM are integral parts of our business. These activities include reviews of the underwriting, risk management, surveillance and reporting practices of primaries both before entering into a reinsurance treaty and on an ongoing basis.
During 2008 RAM Re renewed two treaties that were effective in the first quarter with AAA-rated ceding companies both of which were subsequently downgraded by Moody’s (but not S&P) to the Aa-level. The remaining treaties that were in effect in 2007 were either cancelled or expired in 2008. New business written in 2008 was minimal as a result of a number of factors arising out of the effect of the subprime and credit crisis on the financial guaranty industry, including the following:
We believe that financial guaranty business is significantly affected by economic cycles. For example, a robust economy featuring a good or improving credit environment is beneficial to the in-force insured portfolios of financial guaranty insurers and reinsurers. If such conditions persist for an extended period, however, credit spreads tend to narrow and pricing and/or demand for financial guaranty insurance
In addition to broad economic cycles, the financial guaranty industry, along with other financial institutions, continue to be affected by specific credit events relating to insured obligations that expose guarantors to claims or potential claims. As can be seen in the current economic environment, the continued increase in mortgage delinquencies since late 2007 has resulted in the establishment of a significant amount of case-basis loss reserves being recorded on policies that have defaulted or have a high probability of defaulting and the widening of credit spreads has resulted in large unrealized losses being recorded on policies written on credit derivatives. The financial guaranty industry, including RAM, continues to be exposed to uncertainties around these events, including interest rates and housing prices, which may compromise an obligor’s ability to meet guaranteed obligations and result in claims. The Company continues to monitor these exposures and updates loss estimates as new information is obtained.
Losses and Loss Expense Reserves. The estimated liability for losses and loss adjustment expenses consists of case reserves and unallocated reserves. Case reserves are established by the primary insurer and our proportionate share of these reserves is reported to us at least quarterly. Case reserves are established in an amount that is estimated to be sufficient to cover the present value of the anticipated defaulted debt service payments over the expected period of default and estimated expenses associated with settling the claims, less estimated recoveries under collateral and subrogation rights offset by the present value of installment premiums expected to be received. Case reserves are discounted by the ceding companies in accordance with discount rates prescribed or permitted by state regulatory authorities. We review and assess the ceded case reserves and our evaluation may result in the case reserve recorded by RAM Re differing from the amount reported to us by the primary insurer.
For RMBS, the Company’s loss reserving methodology assumes that all 90+ day delinquent loans are liquidated, and the loss severity for these loans is equal to 100% for second liens, 55% for subprime and 45% for Alt-A and Prime loans, while the remainder of the collateral pool experiences losses based on loss assumptions determined by the vintage year in the case of Home Equity Lines of Credit (HELOCs), Subprime, Alt-A and prime mortgages. Borrower credit quality is also considered in the case of Closed End Seconds (CES). Correlation is not one of the inputs in our loss reserving methodology for RMBS.
Our risk management staff reviews each transaction and may make adjustments to the above assumptions depending on the information provided by the primaries and the historical performance of each transaction. Other key assumptions include the spread between the prime rate and 1-month LIBOR for HELOC transactions, which is assumed to be fixed at 240 basis points, and the remaining average life of the collateral pool, which is generally assumed to be four years.
We also establish an unallocated reserve because we believe that additional losses are inherent in our portfolio of reinsured risks although we cannot currently specify which risks or where we have specified the risks but the losses are not sufficiently probable or estimable to establish case reserves.
At December 31, 2008, and December 31, 2007, our balance sheet included reserves as follows:
Our unallocated reserve estimate is primarily based on the composition of our outstanding par exposure and reserve factors that we apply to this exposure. As a result, in the absence of other offsetting developments, increases in outstanding par will result in increases in unallocated reserves. Our reserve factors, in turn, are the product of the ratios of (i) the unallocated reserves of our primary insurer customers relative to their outstanding exposures weighted by (ii) the credit risk of our outstanding exposure relative to the credit risk of the portfolios of our primary insurer customers, where the ratio in (i) is calculated by dividing unallocated reserves carried by our primary insurers by their net par outstanding and the ratio in (ii) is calculated by dividing the weighted average capital charge for our outstanding par by the weighted average capital charge for the primary insured portfolio. RAM Re’s insured portfolio is segregated by primary insurer, and the ratios in (i) and (ii) are calculated individually by primary insurer. Our credit risk is determined by the ratio of our weighted average capital charges (a commonly recognized measure of credit risk promulgated by S&P) to the weighted average capital charges of our primary insurer customers. The following provides a numerical example of the mechanics of calculating the reserve factors.
extension of our reserving methodology and is based generally on increases in unallocated reserves for RMBS by our primary insurers. Additionally, the Company monitors credit impairments relating to CDOs (see “non GAAP measures).
Estimates of our reserves for losses and loss adjustment expenses are substantially dependent on the surveillance activities and reserving policies of our primary insurer customers and such estimates are subjective and are based on the judgment of our senior risk and finance personnel and, therefore, the final liability may materially differ from amounts estimated and reserved.
Valuation of Derivative Financial Instruments. Certain transactions reinsured by the Company meet the definition of a derivative under FAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”), and FAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“FAS 149”), and require that an entity recognize all derivatives as either assets or liabilities in the consolidated balance sheets and measure those instruments at fair value. RAM’s exposure to credit derivative instruments is through reinsurance of credit default swap (“CDS”) contracts issued by ceding companies. These contracts are held to maturity by the ceding companies and were generally considered risk remote at underwriting because at origination they insured highly rated tranches of structured CDS obligations with significant first loss protection. Management considers these agreements to be a normal extension of its financial guaranty reinsurance business and reinsurance in substance but they do not meet the scope exception that excludes most financial guaranty policies from the fair value provisions of FAS 149. Therefore, we are required to account for these assumed credit default swaps on the balance sheet at fair value and changes in fair value due to market conditions are reported in our Consolidated Statement of Operations. Changes in fair value are recorded in “Net change in fair value of credit derivatives” on the Consolidated Statement of Operations. The “Realized gains and losses and other settlements” component of this change in fair value includes, net premiums earned on credit derivative policies, including current premiums receivable on assumed credit derivative polices, net of ceding commissions, and loss payments to the reinsured including losses payable upon the occurrence of a credit event. The “Unrealized gains and losses” component of the “Net change in fair value of credit derivatives” includes all other changes in fair value, including changes in instrument specific credit spreads.
As a result of these differences, we believe there have been few, if any, relevant third-party exit transactions for CDS contracts written by financial guarantors. In the absence of a principal exit market, a financial guarantor determines the fair value of a CDS contract it writes by using an internally developed model, as more fully discussed below.
Each ceding company uses its own internal valuation models where market prices are not available. Given the contractual terms of RAM’s reinsurance that limit its access to the terms of the underlying credit derivatives, which are highly individualized, and the underlying loan level data, RAM believes that an exit market participant would look to the information that is available from the ceding companies to determine the exit value of RAM’s reinsurance contract, as discussed above. Therefore, the Company, in determining the fair value of derivative instruments, uses credit derivative contract valuations from its ceding companies as a key input. Management then assesses the reasonableness of the ceding companies’ valuations on a quarterly basis by i) discussing with primary insurers their mark-to-market valuation methodology including the nature of changes in key assumptions, ii) reviewing the primaries’ publicly available information regarding their mark-to-market process, including methodology and key assumptions, and iii) analyzing the movement of each individual derivative policy compared to observable market data, including credit spread movements and collateral delinquency information. Spreads and the related movements quarter to quarter are identified from observable market information such as indices, including the CDX, ABX, CMBX and LCDX indices, as related to specific types of derivative contracts. Overall, the relationship between the widening of credit spreads and fair value is not a linear one due to the mix of policy types (duration, rating, and maturities) within the portfolio. Therefore it is difficult to calculate the actual magnitude of any increase/decrease in the unrealized gain/(loss) with the movement of spreads alone. Additionally, there are many other assumptions that drive the ceding companies’ ultimate fair value assessment namely, asset recovery assumptions, correlation across asset assumptions, discount rate used, time to maturity, timing of default assumptions and collateral posting requirements, where applicable. So while spreads are a significant driving factor in models of fair value they are not the only ones. Changes in correlation and recovery assumptions can result in valuations moving more or less than the absolute movement of spreads. RAM’s reinsurance contracts do not provide rights to the detailed underlying data for each policy, or the inputs and assumptions used to obtain the fair valuations as calculated by the ceding companies, and therefore RAM can only generally analyze the fair valuations for consistency with market movements, in conformity with the manner in which RAM believes an exit market participant would analyze the fair valuations given the contractual terms of RAM’s reinsurance.
Premium method; A model that calculates the difference between the present value of remaining expected premiums a primary receives for the credit protection on a CDS contract and the estimated present value of premiums that a comparable financial guarantor would hypothetically charge for the same protection at the balance sheet date. The fair value of the primary’s credit derivatives depends on a number of factors including notional amount of the contract, expected term, credit spreads, changes in interest rates, the credit ratings of referenced entities, the primary’s own credit risk and the remaining contractual cash flows.
Expected loss method; A model of the CDS contract that derives a probabilistic measure of expected loss for the primary’s exposure using market pricing on the underlying referenced collateral within the transaction. The model calculates expected losses on a collateral pool within an insured credit derivative transaction by reference to the following: credit spreads of the underlying collateral, based on actual spreads or spreads on similar collateral with similar ratings, diversity score of the collateral pool as an indication of correlation of collateral defaults, and recovery rate for all defaulted collateral. The model then allocates the expected losses for each tranche of the transaction according to its subordination level within the transaction structure.
The model is a well-documented, consistent approach to valuing positions that minimizes subjectivity according to its users. Each company has developed a hierarchy for market-based spread inputs that helps mitigate the degree of subjectivity during periods of high illiquidity.
The model takes account of transaction structure and the key drivers of market value. The transaction structure includes par insured, weighted average life, level of deductible or subordination and composition of collateral.
There is no market in which to verify the fair values developed by the model, and at December 31, 2008, the markets for the inputs to the model were highly illiquid, which impacts their reliability.
Fair values from the ceding companies’ models may differ from values calculated by companies outside of the financial guaranty industry because, according to the ceding companies, the terms of the CDS contracts insured generally differ from other non-insured CDS contracts. Because of these terms and conditions, the fair value of the ceding companies’ credit derivatives may not reflect the same prices observed in an actively traded market of credit default swaps that do not contain terms and conditions similar to those observed in the financial guaranty market. These models and the related assumptions are continuously reevaluated by the ceding companies and enhanced, as appropriate, based upon improvements in modeling techniques and availability of market information.
On January 1, 2008, the Company adopted FAS 157. Under FAS 157, the use of valuation information provided to us by our ceding companies as a key input remains appropriate for the reasons described above, Under FAS 157, the fair value of RAM’s contract represents the exit price that would be paid to a market participant to assume the reinsurance contract as written; that is, the amount the market participant would require to assume RAM’s potential obligations under the contract with the same contractual rights and obligations, including those which limit the information about the ceding companies’ underlying contracts that are being reinsured. Given the contractual terms that exist, RAM believes that an exit market participant would look to the information that is available from the ceding companies to determine the exit value of RAM’s reinsurance contract, as discussed above. In compliance with the requirements of FAS 157, the Company adjusts the fair value of its credit derivatives liabilities to account for RAM’s own non performance risk.
Valuation of Other Financial Instruments. The put option relating to the Company’s preference share soft capital facility of $50.0 million, which is described in more detail under “Liquidity and Capital Resources - Capital Resources”, is a financial instrument and is fair valued with the fair value measurement representing the value to the Company in the current market environment. The gain or loss on the put option is recorded on the consolidated balance sheet and changes in fair value are reported through the statement of operations in “Unrealized Gain/(Loss) on Other Financial Instruments”. Unobservable inputs are used to value the put option and include assumptions regarding the creditworthiness of the Company and the structure of the facility as well as other similar instruments in the market. Subsequent to year end, on February 17, 2009, the put option was exercised. Preferred shares were issued with a fair value of $8.1 million and $41.9 million was recorded as a realized gain in the fair value in the statement of operations.
Valuation of Investment Portfolio. Our investment securities are designated as available for sale in accordance with Statement of Financial Accounting Standards No. 115 (“FAS 115”), “Accounting for Certain Investments in Debt and Equity Securities”. Available for sale investments are carried at fair value, with unrealized appreciation or depreciation reported as a separate component of accumulated other comprehensive income in shareholders’ equity. The Company’s fair values of fixed maturity and short-term investments are based on prices obtained from nationally recognized independent pricing services. All investment transactions are recorded on a trade date basis. Realized gains and losses on sales of fixed maturity investments are determined on the basis of amortized cost. Gains and losses on sale of investments are included in investment income when realized. The cost of securities sold is determined using the specific identification method. Short-term investments are carried at amortized cost, which approximates fair value, and include all securities with maturities greater than 90 days but less than one year at time of purchase. We have a formal review process for all securities in our investment portfolio, including a review for other than temporary impairment losses. All declines in fair value below cost that are considered other than temporary are recognized in income. Factors management considered when assessing other than temporary impairment include, but are not limited to: (i) securities with market values having declined by 20% or more below amortized cost for a continuous period of at least six months; (ii) recent credit downgrades by rating agencies; (iii) the financial condition of the issuer; (iv) whether scheduled interest payments are past due; and (v) whether we have the ability and intent to hold the security for a sufficient period of time to allow for anticipated recoveries in fair value. If we believe a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss in “Accumulated other comprehensive income” on our balance sheet. If we believe the decline is “other than temporary,” we write-down the carrying value of the investment and record a loss on our income statement. Our assessment of a decline in value includes our current judgment of the factors noted above. If that judgment changes in the future, we may ultimately record a loss after having originally concluded that the decline in value was temporary. The Company’s investment guidelines require the orderly sale of securities that do not meet investment guidelines due to a downgrade by rating agencies or other circumstances, unless otherwise authorized by management to hold.
When assessing the recoverability of deferred policy acquisition costs, the Company considers the future earnings of premiums paid upfront, the estimated present value of net installment premiums to be received and anticipated investment income and compares this to the sum of unamortized policy acquisition costs and expected loss and loss adjustment expenses. This comparison is completed by underwriting year and risk type. If a premium deficiency were calculated the unamortized acquisition costs would be reduced by a charge to expense.
Upfront premiums are recorded as written at policy inception and earned over the life of the policy in relation to the amount of insurance protection provided. Unearned premium reserves represent that portion of written premiums applicable to the outstanding amount at risk with respect to the obligations reinsured. Public finance premiums are customarily paid upfront and earned over the life of an issue which may extend to 30 years or more. Upfront premiums have relatively little effect on earnings in the year written, but cumulatively affect future years’ earned premiums. When an issue reinsured by us is retired early, has been called by the issuer, or is paid in advance through refunding, any remaining unearned premium is earned at that time, since there is no longer any risk outstanding in connection with the issue. Refunding levels
vary depending upon a number of conditions, primarily the relationship between current interest rates and interest rates on outstanding debt. Installment premiums are received in accordance with contractual terms over the life of an issue, recorded as written at each installment due date and earned over the installment period which corresponds to the expiration of risk. Structured finance premiums are customarily paid in installments and earned over installment periods that generally range from three months to one year in duration. We do not record a provision for doubtful accounts because historically we have not experienced any material issues related to the collectability of assumed premiums.
For fiscal years beginning after December 15, 2008, and all interim periods within those fiscal years, FASB statement No.163 “Accounting for Financial Guarantee Insurance Contracts” (“FAS 163”) is effective. FAS 163 clarifies how FASB Statement No.60 “Accounting and reporting by Insurance Enterprises” applies to financial guaranty insurance contracts. FAS 163 is focused on the recognition and measurement of premium revenue and claims liabilities, along with additional disclosure requirements for financial guaranty contracts. Premium revenue will be recognized as a function of the amount of insurance protection provided over the contract term and the adjustment from the current measurement of premium revenue will be recognized as an adjustment to opening retained earnings for the fiscal year beginning January 1, 2009
Net Income. Net (loss) income was $(159.5) million in 2008, $(144.1) million in 2007, and $41.1 million in 2006. The increase in net (loss) for the year ended December 31, 2008, compared to 2007, of $15.4 million or 10.7% is due primarily to the following factors:
Unrealized gains on credit derivatives of $94.3 million for the year ended December 31, 2008, an increase of $272.1 million over the losses of $(177.8) million in 2007. The increase is a result of (i) a decrease in net unrealized losses of $203.3 million due to the adjustment for RAM’s own non-performance risk under FAS 157, (ii) a reduction in unrealized losses in 2008 of $232.0 million due to the commutations with XLFA and MBIA, offset by (iii) an increase in unrealized losses due to the continuing deterioration in subprime mortgage assets and the corresponding widening credit spreads in the market. The unrealized gains on credit derivatives in 2008 are reduced by the realized losses of $86.3 million primarily relating to the payments made to XLFA and MBIA on commutations (see “Commutations” below).
The decrease in net income of $185.2 million in 2007 relative to 2006 is primarily the result of (i) a year-over-year increase of $50.8 million in losses and loss adjustment expenses, (ii) $177.8 million in losses on credit derivatives in 2007 due to widening credit spreads and the deterioration of underlying collateral, compared to immaterial unrealized losses during 2006, offset by (iii) a $35.3 million unrealized gain in 2007 on the fair value of the put option on the Company’s preference share soft capital facility in 2007 compared to $Nil in 2006, and (iv) an $8.9 million increase in investment income in 2007 compared to 2006.
Effective November 30, 2008, RAM Re entered into a Commutation Agreement with MBIA Insurance Corporation and its affiliates (“MBIA”) to commute its entire portfolio of business previously assumed from MBIA back to MBIA. As consideration for the commutation RAM Re paid MBIA $156.5 million. The commutation reduced the outstanding par amount of RAM’s insured portfolio by $10.6 billion, including $439.3 million of collateralized debt obligations of asset-backed securities (ABS CDOs) (all structured as credit derivatives), $2.4 billion of collateralized debt obligations of commercial mortgage-backed securities (CMBS CDOs) and $453.0 million of 2005 - 2008 vintage U.S. RMBS.
The effect of the MBIA commutation on the Company’s results of operations was to (i) reduce gross written premiums and unearned premiums by $36.4 million, resulting in no impact on earned premiums (ii) increase realized losses on credit derivatives by $25.5 million and decrease unrealized losses on credit derivatives by $136.1 million, and (iii) increase loss and loss adjustment expenses by a loss of $61.4 million, resulting in an overall gain to net income at the time of commutation of $49.3 million.
During the second quarter of 2008, the Company commuted $1 billion in par outstanding on policies with two primary insurers. All the Company’s obligations with respect to the commuted policies were terminated on commutation. The effect of these commutations on the Company’s income statement was to reduce (i) net earned premiums by $1.8 million and (ii) acquisition expenses by $0.6 million, giving an overall reduction to net income of $1.2 million. The net income effect was the result of paying back the primary insurers statutory unearned premiums, net of ceding commissions, which earn on a slower basis than GAAP premium earnings
As at January 1, 2008, RAM implemented a change in the presentation of revenues, expenses and balance sheet items relating to financial guaranty contracts that the Company reinsures in the form of credit default swap (“CDS”) contracts. This reclassification did not change the Company’s net income/(loss), comprehensive income/(loss), earnings per share or shareholders’ equity. This reclassification was adopted after agreement between members of the Association of Financial Guaranty insurers (“AFGI”) and discussions with the Securities and Exchange Commission, to increase comparability of the Company’s financial statements with other financial guaranty companies that have credit derivative contracts.
CDS contract revenue has been reclassified in the consolidated statement of operations (see above derivative instruments accounting policy note for further details). Amounts relating to CDS contracts within “net earned premiums”, “acquisition expenses” (or ceding commissions) and “loss and loss adjustment expenses” have been reclassified to “realized (losses) gains and other settlements on credit derivatives”. The Company has reclassified all CDS-related balances in the consolidated balance sheet included in “unearned premiums” to “derivatives liabilities”. The balances on the Company’s balance sheet as of December 31, 2007, and related statements of operations and comprehensive income and cash flows for the years ended December 31, 2007 and 2006, affected by the reclassifications are as follows:
Gross Written Premiums. Gross written premiums were $(11.2) million in 2008, compared to $98.5 million for 2007. Excluding the effect of the commutations during the year, gross premiums written for 2008 were $46.8 million, a decrease of $51.7 million or 52.5% in comparison to the 2007 period. Gross written premiums were $98.5 million in 2007, an increase of 34.6% from $73.2 million of gross written premiums in 2006. The decrease in gross written premiums in 2008 relative to 2007 was a result of a number of factors arising out of the effect of the subprime and credit crisis on the financial guaranty industry as discussed in the “Overview” above, along with the reduction in treaties the Company had in place during 2008 as compared to 2007. The increase in gross written premiums in 2007 relative to 2006 is the combined result of two new treaties with two of our primaries, which contributed $26.1 million for the year ended December 31, 2007, along with an overall increase in market volume in 2007 over prior year.
Gross written premiums are highly dependent upon the amount of business ceded by the primary insurers which, in turn, is related to the overall volume of business they underwrite, and the size and type of obligations they insure. In general, a growing volume of insured business, a stable or growing usage of reinsurance and higher premium rates will benefit our gross written premiums. During 2008, RAM Re renewed two treaties that were effective in the first quarter with AAA-rated ceding companies, which were subsequently downgraded by Moody’s (but
Net Written Premiums. Net premiums written were $(11.7) million in 2008, compared to $97.7 million in 2007. Net written premiums in 2008 reflect ceded premiums of $0.5 million compared to $0.8 million in 2007. Excluding the effect of the commutations during the year, net premiums written for 2008 were $46.3 million, a decrease of $51.4 million or 52.6% in comparison to the 2007 period. Net premiums written were $97.7 million in 2007, a 37.4% increase over the 2006 level of $71.1 million. Net written premiums in 2006 reflected ceded premiums of $2.1 million, the first such activity for RAM Re. During 2008, we ceded premiums of $1.0 million pursuant to an agreement under which RAM retrocedes a portion of business in excess of specified levels of par exposure that we have assumed from a single issuer, additionally $(0.5) million of premiums previously retroceded were returned to RAM relating to underlying policies which were commuted by RAM during the year. Our purchase of reinsurance protection does not relieve us of the full liability that we assumed from our ceding companies. In the event that a reinsurer of RAM is unable to meet its obligation under a retrocession agreement, we would continue to be liable to ceding companies in the full amount of their cession to RAM. RAM currently has one retrocession agreement in place with a company rated Ba1 by Moody’s and BBB- by S&P (a “AA” rated financial guaranty company at the time of writing the agreement). This agreement has been terminated on a “run-off” basis effective December 31, 2008. As a result of the downgrade of the retrocessionaire, the Company has the right to terminate the agreement on a “cutoff” basis and recapture all the policies previously ceded. The Company has not exercised this right as of April 13, 2009.
Net Change in Fair Value of Credit Derivatives: The net change in fair value of credit derivatives consists of the following related to our credit derivative policies:
Net change in fair value of credit derivatives was $8.0 million in 2008 compared to $(171.8) million in 2007 and $3.2 million in 2006. The movement in the net change in fair value of credit derivatives is driven by the following factors:
Net unrealized losses on credit derivative contracts were $177.8 million in 2007, compared to immaterial unrealized losses in 2006. The significant increase in net unrealized losses on derivative financial instruments reported during 2007 was primarily due to the deterioration in subprime mortgage assets and the corresponding widening credit spreads in the market. The Company also monitors credit impairments (see “non GAAP measures” below).
In compliance with the requirements of FAS 157, the Company considered its own non-performance risk when measuring the fair value of its derivative liability. The effect of applying this requirement in 2008 was a reduction in the Company’s derivative liability of approximately $203.3 million at December 31, 2008 (see “FAS 157 disclosures” below for further information on this adjustment).
Net Investment Income. Net investment income of $29.3 million in 2008 was 11.5% below the $33.1 million recorded in 2007, while the 2007 level represented a 36.8% increase from the $24.2 million recorded in 2006. During 2008, net investment income decreased relative to 2007 primarily as a result of the reduction in the investment portfolio due to payments on commutations with XLFA and MBIA totaling $250.9 million, along with a decrease in the book yield on invested assets. During 2007, net investment income increased relative to 2006 primarily as a result of growth in the portfolio due to our issuance of $75 million of preference shares on December 14, 2006 and net cash flows from operations. A secondary element of investment income growth in 2007 was our ability to invest at higher yields than were available in 2006. The investment portfolio is comprised predominantly of taxable securities, and had an average yield of 4.5% at December 31, 2008, compared with 5.0% and 4.9% at December 31, 2007 and 2006, respectively.
Net Unrealized Gains(Losses) on Other Financial Instruments. Net unrealized gains on other financial instruments were $7.8 million in 2008 compared to $35.3 million in 2007 and $Nil in 2006. The unrealized gain on other financial instruments relates to a $50.0 million put option the Company has in place with respect to its preference share soft capital facility. The put option allows the Company to issues preference shares to a trust that held the $50.0 million in investments in exchange for the proceeds from the liquidation of the investments held in the trust. The unrealized gains of $7.8 million and $35.3 million in 2008 and 2007, respectively, relates to the increased value of the soft capital facility to the Company compared to the estimated current cost of similar capital that could be obtained in the current market. Subsequent to year end, on February 17, 2009, the put option was exercised.
Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses in 2008 were $214.8 million compared to $48.0 million in 2007. The increase in loss and loss adjustment expense for 2008 is mainly driven by:
Net loss on commutations with XLFA and MBIA in 2008 of $45.9 million, including $121.8 million paid on commutations (see “Commutations” above).
The above increases are offset by a decrease in unallocated loss reserve of $19.3 million. During 2008 and 2007, an additional $10.9 million and $15.6 million, respectively, of unallocated loss reserves were established relating to RMBS losses. During 2008, this was reduced by transfers to case reserves of $17.6 million relating to the RMBS losses along with a reduction due to the decline in our outstanding par exposure primarily as a result of the commutations during the year. Additionally, we gave credit of $28.8 million in our case reserves for the benefit of expected recoveries in 18 RMBS transactions resulting from required repurchases by the originators due to contractual breaches of representations and warranties in the RMBS securitization agreements. The $28.8 million of credit given matches the credit reported to us by the primaries. The primaries performed detailed examinations of
At December 31, 2008, we carried total reserves for losses and loss adjustment expenses of $95.8 million, of which $81.8 million were case reserves and the remaining $14.0 million related to unallocated loss reserves.
Losses and loss adjustment expenses in 2007 were $48.0 million compared to $(2.8) million in 2006. The increase in loss and loss adjustment expense for 2007 as compared to 2006 is mainly driven by the establishment of reserves relating to the RMBS deals, primarily those underwritten with vintages between 2005-2007. Case-basis loss reserves directly relating to subprime mortgages, Alt-A, Closed-End Seconds and HELOCs account for $26.4 million of the increase in loss and loss adjustment expenses. Additionally, the unallocated loss reserve increased by $21.9 million, of which $15.6 million relates to future RMBS losses that are probable to default but cannot be allocated directly to a specific policy. The remaining increase in unallocated loss reserves was directly related to the increase in business written in the 2007 year. Loss activity that results in net negative incurred losses during a full year period, as occurred during 2006, is atypical although recoveries on previously paid losses are a normal part of our business. Loss and loss adjustment expenses are generally affected by changes in the mix, size, and credit quality of our portfolio, as well as specific credit events within reinsured obligations and trends in the reserving practices of our ceding insurers.
Since the latter half of 2007, there has been considerable stress in the US residential mortgage market, particularly related to mortgage loans originated during 2005, 2006 and 2007. RAM Re is exposed to US residential mortgages through our RMBS, and indirectly through our guarantees of CDOs backed by RMBS. CDOs are securities backed by portfolios of assets that may include a combination of corporate bonds, loans, RMBS, asset-backed securities, tranches of other collateralized debt obligations or credit derivatives representing any of the former. CDOs backed by significant amounts of RMBS are known as “ABS CDOs”. As of December 31, 2008, we have established $48.2 million of case reserves relating to specific 2005-2007 RMBS exposures and an additional $26.5 million of unallocated loss reserves relating to RMBS losses that are probable but can not be specifically identified, less $17.6 million of unallocated reserves relating to RMBS transferred to case reserves. Additionally, the Company monitors credit impairments relating to ABS CDOs (see “non GAAP measures” below).
To determine the adequacy of its aggregate reserves, the Company considers the case reserves established by its ceding companies for the exposures it has reinsured as well as the methodologies used by the ceding companies to calculate such ceded case reserves. When the ceding companies provide additional non-case-basis reserves associated with ceded exposures, the Company also takes these reserves into consideration and is generally included in our unallocated loss reserves if not already included in our case reserves. To further evaluate the ceded reserve amounts established by the ceding companies, the Company uses its own loss forecasting methodology. For RMBS, the Company takes into account the first loss protective features inherent in the structure of the insured exposure, collateral losses to date, current delinquency rates and loan product characteristics such as loan-to-value ratio and credit score. The first loss protection in most of the Company’s RMBS transactions is provided by excess spread, overcollateralization, subordination, and in some cases mortgage pool insurance.
For RMBS, the Company’s loss reserving methodology assumes that all 90+ day delinquent loans are liquidated, and the loss severity for these loans is equal to 100% for second liens, 55% for subprime and 45% for Alt-A and prime loans, while the remainder of the collateral pool experiences losses based on loss assumptions determined by the vintage year in the case of Home Equity Lines of Credit (HELOCs), subprime, Alt-A and prime mortgages. Borrower credit quality is also considered in the case of Closed End Seconds (CES). Correlation is not one of the inputs in our loss reserving methodology for RMBS.
If the Company’s remaining loss assumption is increased by 25% over our current assumptions (which approximates the effect of estimated peak monthly default rates continuing for an additional six months beyond the Company’s current nine-month assumption for second liens and 24-month assumption for first liens), we estimate the addition to our total loss and LAE reserve for 2005-2007 vintage US RMBS would be approximately $31.9 million. Management believes extending the peak default rate by 6 months is representative of a typical stress scenario and a prolonged recession period. Such estimated increase assumes our current remediation recovery estimates remain constant; however, our actual remediation recoveries could be lower than our current estimates if the sponsors of these transactions either: i) fail to honor their obligations to repurchase the mortgage loans; ii) successfully dispute the primaries’ breach findings; or iii) no longer have the financial means to fully satisfy their obligations under the transaction documents. In addition, such estimated increase does not include the effect of the stress scenario on approximately $89.1 million par outstanding of 2005-2007 vintage RMBS for which the Company has insufficient data to perform this analysis.
The following summarizes RAM Re’s exposure to residential mortgage-backed securities, or RMBS, and CDOs, as of December 31, 20082. RAM Re generally follows the classifications for mortgage and CDO securities used by the ceding companies and reported to RAM Re.
The following table summarizes RAM Re’s RMBS outstanding par exposure as of December 31, 2008 by loan type and vintage.
Closed-End Seconds (CES) - Second-lien loans similar to HELOCs except that they have a fixed amount disbursed at closing and no additional borrowing allowed over the life of the loan and are typically fixed rate.
Manufactured Housing - Loans on single family homes constructed in a factory, including chattel paper only secured by the factory-built home and mortgage loans secured by both the land and the home.
The following table lists the top five largest issuers of US mortgage securities in RAM Re’s portfolio by RAM Re par outstanding and provides the outstanding par amount of HELOC, Closed-End Seconds (CES), Subprime and Alt-A issued by each:
The following table segregates RAM Re’s MS CDOs into four classifications:
As shown in the following table, RAM Re’s total CDO par exposure was $4.3 billion as of December 31, 2008. The following table breaks down RAM Re’s total CDO exposure by type of CDO:
DBL - “Double-Wrap” or “second-to-default” CDOs that are backed by collateral, but are wrapped by a financial guaranty company.
RAM primarily identifies problem credits through information provided by the primary insurers at least on a quarterly basis. Such information generally consists of surveillance and underwriting reports and quarterly conference calls with the primary ceding companies’ analysts. The Risk Management staff supplements this input with their own research to identify and assess the status of individual credits. Research performed includes reviews of rating agency and fixed income research publications and analysis of historical performance data. Each of the ceding companies maintains a “watch list” for credits that have been identified as requiring greater than the usual level of ongoing scrutiny and/or intervention. The ceding companies notify us when any transaction they have reinsured has been placed on such a watch list.
The Management Committee is comprised of RAM’s senior officers and meets quarterly to formally review the Company’s Watch List and approve case and unallocated reserves.
The above table includes all financial guarantee contracts on the Company’s Watch List at December 31, 2008. Policies written in credit derivative form are not included in the above table.
Acquisition Expenses. Acquisition expenses were $30.6 million in 2008, $18.4 million in 2007, and $16.3 million in 2006. The increase in acquisition costs in 2008 over 2007 is due to additional ceding commission costs relating to the Company’s downgrade and the write-off of unrecoverable deferred acquisition costs. Excluding such unusual items, the changes in acquisition costs period over period are directly related to the changes in earned premiums. The ratio of acquisition costs to earned premiums was 44.6% in 2008, up from 36.1% in 2007, which had decreased relative to the 2006 ratio of 36.8%. The increase in the ratio of acquisition costs to earned premiums in 2008 as compared to 2007 is primarily due to (i) expensing of the additional ceding commissions incurred on the Company’s downgrade of $1.4 million and (ii) the write-off of deferred acquisition costs of $2.0 million considered unrecoverable. The decline in the ratio of acquisition costs to earned premiums in 2007 as compared to 2006 reflected the combination of improvements (decreases) in ceding commissions paid to primary insurers and a lesser share of direct expenses allocated to the acquisition of business as a general result of the company maturation as supported by our analysis of expenses that qualify for deferral.
On January 1, 2008, the Company adopted FAS 157. This Statement provides guidance for fair value measurement of assets and liabilities and associated disclosures about fair value measurement. Under this standard, the definition of fair value focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price). FAS 157 clarifies that fair value is a market-based measurement, not an entity-specific measurement. FAS 157 establishes a fair value hierarchy of inputs in measuring fair value, with the highest level being observable inputs and the lowest being unobservable data as follows:
valuations based on quoted prices in active markets for identical assets or liabilities. Valuations in this level do not entail a significant degree of judgment.
valuations based on quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active and model derived valuations where all significant inputs are observable in active markets.
The following table presents the fair value measurement levels for assets and liabilities, which the Company has recorded at fair value as of December 31, 2008. As required by FAS 157, items are classified in their entirety based on the lowest level of input that is significant to the fair value measurement:
The Company’s fair values of fixed maturity and short-term investments are based on prices obtained from nationally recognized independent pricing services. Where available, the prices are obtained from market quotations in active markets. Where there is no quoted price for an identical security, then the pricing service may use matrix pricing or model processes, such as the option adjusted spread model, to estimate the fair value of a security. The matrix pricing or model processes consist primarily of observable inputs, which may include; benchmark yields, reported trades, broker/dealer quotes, issuer spreads, two-sided markets, benchmark securities, bids, offers and reference data. The Company receives at least one fair value price for each of its investment securities and has not adjusted any of the prices received from the pricing services.
At January 1, 2008, two securities within the Company’s fixed maturity portfolio were valued using unobservable inputs, therefore the valuations were assessed as Level 3. During the year ended December 31, 2008, one of these securities fully paid down and therefore only one security is included in the level 3 classification at December 31, 2008. The following table presents the fixed maturity investments for which fair value was measured under Level 3 for the year to December 31, 2008:
The Company’s insured credit default swap policies are not readily tradable as there is no active market for them. Therefore, the Company views its principal market as the financial guaranty insurance and reinsurance market, whose participants would hypothetically be able to assume this business if the Company were to hypothetically transfer a policy.
Our credit derivative policies are classified as Level 3 in the above fair value hierarchy since the valuations provided to us by our ceding companies are from valuation models which place reliance on at least one significant unobservable input. Consistent with the requirements of FAS 157, we believe these models use observable market data when available.
As of December 31, 2008, there is no active market for the put option and due to the significant number of the unobservable inputs used in the valuation, the put option valuation was classified as a Level 3 fair value measurement.
Cash Flows. During 2008, net operating cash flows were ($269.5) million compared to $84.5million and $57.1 million for 2007 and 2006, respectively. Our operating cash flows are primarily the result of the net premiums received and investment income less operating expenses, claims payments and interest expenses. The decrease in operating cash flows in 2008 is primarily the result of commutation payments to XLFA and MBIA totaling $250.9 million and loss payments of $61.0 million largely relating to RMBS exposure. Net cash flows from financing activities were $Nil in both 2008 and 2007 and $90.0 million in 2006. In 2006, net financing cash flows related primarily to the issuance of preference shares amounting to $75.0 million, net of preference share issuance costs of $1.1 million and an additional common share issuance. Net cash provided by (used for) investment activities amounted to $265.9 million, $(107.9) million, and $(114.0) million for the periods ending December 31, 2008, 2007 and 2006, respectively, and related to the proceeds on sales and maturities of investments offset by the purchase of investments.
Capital Resources. RAM Re maintains a $90.0 million contingent capital facility with a group of highly rated commercial banks as lenders. The facility is specifically designed to provide rating-agency qualified capital to support RAM Re’s claims paying resources and may not be drawn upon except for the payment of catastrophic losses where losses exceed minimum thresholds in respect of cumulative losses on public finance bonds and, in a limited capacity, asset-backed securities reinsured by RAM Re. Loan obligations under this facility have limited recourse and are repayable from, and collateralized by, a pledge of recoveries realized on defaulted reinsured obligations covered by the facility, including certain installment premiums and other collateral. The facility has a term ending on May 11, 2015. As of December 31, 2008, no amounts were outstanding nor have there been any borrowings under this facility.
On February 3, 2006, RAM Re closed a $40.0 million contingent capital facility with two highly rated commercial banks. This facility is essentially the same as the $90.0 million contingent capital facility described above although it may be drawn upon only to cover catastrophic losses, exceeding the minimum threshold, from municipal obligations reinsured by RAM Re. Loan obligations under this facility also have limited recourse and are repayable from, and collateralized by, a pledge of recoveries realized on defaulted reinsured obligations covered by this facility, including certain installment premiums and other collateral, on a subordinate basis to the pledge made to secure the $90.0 million facility described above. The facility has a term ending on February 3, 2014. As of December 31, 2008, no amounts were outstanding nor have there been any borrowings under this facility.
On March 26, 2004, we issued $40.0 million aggregate principal amount of senior unsecured debt. The net proceeds of this issuance were contributed to RAM Re to be used for general corporate purposes. The senior notes bear interest at a rate of 6.875%, payable semi-annually in arrears on April 1 and October 1 of each year, beginning on October 1, 2004. Unless previously redeemed, the senior notes will mature on April 1, 2024. We may redeem the senior notes at any time and from time to time, in whole or in part, at a “make-whole” redemption price. The senior notes contain certain covenants regarding limitations on liens and delivery of financial information, but do not contain any covenants regarding financial ratios or specified levels of net worth or liquidity to which RAM must adhere. We were in compliance with all covenants at December 31, 2008. During the years ended December 31, 2008 and 2007, RAM Re paid dividends to Holdings in the amount of $2.8 million, which was used to pay interest on the senior debt.
On December 23, 2003, RAM Re entered into a $50.0 million soft capital facility whereby it was granted the right to exercise perpetual put options in respect of its Class B preference shares against the counterparty to the option agreement, in return for which it paid the counterparty a floating put option fee through February 17, 2009. The counterparty was a trust established by an investment bank. The trust was created as a vehicle for providing capital support to RAM Re by allowing it to obtain, at its discretion and subject to the terms of the option agreement, access to new capital through the exercise of a put option and the subsequent purchase by the trust of RAM Re preference shares. In the years ended December 31, 2008, 2007 and 2006, $1.6 million, $0.8 million and $0.5 million, respectively, of expenses relating to the operation of this facility were paid. As of December 31, 2008, the put option had not been exercised. Subsequent to December 31, 2008, on February 17, 2009, RAM Re exercised the put option in the soft capital facility and issued $500.01 Class B preference shares to the trust in exchange for $50,001,000 of proceeds. On March 16, 2009, RAM Re elected to pay a fixed rate dividend on the Class B preference shares, as a result of which the Class B preference shares were distributed to the holders of the trust’s securities and the trust is now in the process of dissolution. As a result of the fixed rate election, dividends are payable on the Class B preference shares every 90 days at a rate of 6.276%. The Class B preference shares give investors the rights of an equity investor in RAM Re. Such rights are subordinate to insurance claims, as well as the general unsecured creditors of RAM Re. Dividends on the Class B preference shares are cumulative, only if RAM Re pays dividends on its common shares without paying accrued and unpaid dividends on the Class B preference shares. The Class B preference shares are rated ‘BBB’ by S&P. As of the date of filing of this Form 10-K, Moody’s has not assigned a rating to the Class B preference shares. RAM Re has the option to redeem the Class B preference shares, subject to certain specified terms and conditions. The fair value of the put option at the exercise date was $41.9 million and therefore the value of the preference shares will be $8.1 million, being the difference between the proceeds received and the fair value of the put option on the date of exercise.
As noted above, we believe our ability to access additional capital in the debt and equity markets on acceptable terms, if at all, is unlikely in the near term given current market conditions and the Company’s current share valuation.
Investment Portfolio. At December 31, 2008, our investment portfolio consisted of $421.9 million of fixed income securities and $16.2 million of cash and cash equivalents. At December 31, 2007, our investment portfolio consisted of $696.5 million of fixed income securities, $19.9 million of cash and cash equivalents. Our fixed income securities are designated as available for sale in accordance with FAS 115 “Accounting for Certain Investments in Debt and Equity Securities.” Short-term investments consist primarily of money market funds, domestic time deposits and discount notes. There were no short-term investments in our portfolio at December 31, 2008 and 2007. We report changes in fair value as part of “Accumulated other comprehensive income” in shareholders’ equity. Our portfolio is managed by an outside professional asset management firm, in accordance with specific investment policies approved by our Board of Directors. These policies establish liquidity requirements, portfolio duration, single-risk concentration limits and minimum credit quality and investment eligibilities. Fair values of fixed income securities are based on quoted market prices from nationally recognized pricing services, dealer quotes, or matrix pricing, all of which are based on observable market inputs where available. Our investment objectives include preservation of principal, maintaining a high credit quality, liquid investment portfolio within a prescribed duration range and achieving stable net investment income. The effective duration of our portfolio at December 31, 2008, is 4.80 years and our investment policy and guidelines require the minimum portfolio weighted credit quality to be at least “Aa2” rating by Moody’s. The yield to maturity of the portfolio was 5.16% and the book yield of the portfolio was 4.45% at December 31, 2008. The effective duration of our portfolio at December 31, 2007 was 4.83 years. The yield to maturity of the portfolio was 4.92% and the book yield of the portfolio was 5.04% at December 31, 2007. At December 31, 2008, RAM Re had $378.9 million of our invested assets in trust accounts for the benefit of primary insurers (out of $438.9 million of total cash and investments). At year-end 2007, RAM Re had $414.9 million of our invested assets in trust accounts for the benefit of primary insurers (out of $716.4 million of total cash and investments). Under our reinsurance agreements with primary insurers, RAM Re is required to secure its obligations and may not withdraw funds from the trust accounts without their express permission. The increase in the unrealized losses as at December 31, 2008 is primarily attributable to the market reaction to corporate bonds and the current economic climate, and therefore management does not believe these investments to be other than temporarily impaired and intends to hold these investments until recovery. The investments held by the Company are considered to be available-for-sale but the Company has the ability and the intent to hold these investments until the security recovers its value, or to their contractual maturity. The unrealized gains and losses are expected to decrease as the investment approaches maturity and the Company expects to realize a value substantially equal to amortized cost. At December 31, 2008, unrealized losses and gains were $14.6 million and $20.9 million, respectively, of the $421.9 million of the invested assets.
The amortized cost and estimated fair value of fixed income securities available for sale as of December 31, 2008 and December 31, 2007 by contractual maturity are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations.
The following table provides the ratings distribution of our investment portfolio at each of December 31, 2008 and December 31, 2007:
Includes U.S. Treasury and agency obligations, which comprised approximately 33.5% and 35.7% of the investment portfolio as of December 31, 2008 and December 31, 2007, respectively.
The Company has no material investments in securities guaranteed by third parties and has no direct investments in financial guarantors as at December 31, 2008 and 2007.
We have various contractual obligations as of December 31, 2008 that are summarized in the following table:
As of December 31, 2008, we did not have off-balance sheet arrangements that were not accounted for or disclosed in the consolidated financial statements.
We also conduct on-site due diligence reviews of the companies with whom we have treaty arrangements, which include:
Financial instruments that may be adversely affected by changes in credit spreads include our outstanding exposure to credit derivative transactions. The Company’s credit derivative exposures are substantially similar to its financial guaranty insurance contracts and provide for
FAS 163 is effective for fiscal years beginning after December 15, 2008, and all interim periods within those fiscal years, with the exception of certain risk management disclosures which are effective for the interim financial statements prepared as of September 30, 2008, and are presented and disclosed for the current period in “Note 11 - Loss and Loss Adjustment Expense Reserve” in the Notes to the Consolidated Financial Statements. Early application is not permitted. The standard does not apply to credit derivatives. The effect of fully adopting FAS 163 will be recognized as an adjustment to opening retained earnings for the fiscal year beginning January 1, 2009. The Company is currently assessing the potential impact, which is likely to be material, of applying FAS 163 and at this time is unable to quantify the effect of the adoption of this standard.
In September 2008, the FASB issued FSP No. FAS 133-1 and FIN 45-4 “Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 145; and Clarification of the Effective Date of FASB Statement No. 161”. FSP No. FAS 133-1 requires enhanced disclosures about credit derivatives and guarantees and amends FIN 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” to exclude derivative instruments accounted for at fair value under SFAS No. 133. The FSP is effective for financial statements issued for reporting periods ending after November 15, 2008. The Company has adopted FSP FAS No. 133-1 and FIN 45-4 for the reporting period ending December 31, 2008. Since FSP FAS No. 133-1 and FIN 45-4 only requires additional disclosures concerning credit derivatives and guarantees, adoption of FSP FAS No. 133-1 and FIN 45-4 has not affected the Company’s financial position or results of operations.
In March 2008 the FASB issued FAS No. 161 “Disclosures About Derivative Instruments and Hedging Activities - An Amendment of FASB Statement No. 133” (“FAS 161”). FAS 161 establishes the disclosure requirements for derivative instruments and for hedging activities. FAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. Early adoption is encouraged. FAS 161 was adopted for the reporting period ending December 31, 2008. Since FAS 161 only requires additional disclosures concerning credit derivatives, FAS 161 did not impact the Company’s results of operations or financial position.
In September 2006, the FASB issued FAS No. 157 (“FAS 157”), “Fair Value Measurements”. This Statement provides guidance for using fair value to measure assets and liabilities and associated disclosures about fair value measurement. Under this standard, the definition of fair value focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price). FAS 157 clarifies that fair value is a market-based measurement, not an entity-specific measurement, and establishes a fair value hierarchy with the highest priority being quoted prices in active markets and the lowest priority to unobservable data. Further, FAS 157 requires expanded disclosures of the fair value measurements by level within the fair value hierarchy that distinguishes market data between observable independent market inputs and unobservable market assumptions by the reporting entity. The Company adopted FAS 157 effective January 1, 2008. See Note 4, Derivative Instruments and Note 10, Fair value of Financial Instruments for further information.
In October 2008, the FASB issued FASB Staff Position No. 157-3 “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“FSP 157-3”). FSP 157-3 clarifies the application of FAS 157 in an inactive market and the provisions of the FSP were effective upon issuance. FSP 157-3 did not have an effect on the Company’s results of operations or financial position. The Company had minimal assets in its investment portfolio which were not active at December 31, 2008. The provisions were applied to its soft capital facility put option (see Item 8 - Financial Statement Footnote 9).
We do not believe that inflation has had a material impact on our business or operating results during the periods presented in this annual report.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of operations, comprehensive (loss) income, shareholders’ equity and retained (deficit) earnings and of cash flows present fairly, in all material respects, the financial position of RAM Holdings Ltd. and its subsidiary (the “Company”) at December 31, 2008 and December 31, 2007, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2008 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a)(2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 4 to the consolidated financial statements, the Company has adopted SFAS No. 157, “Fair Value Measurements” in 2008. As discussed in Note 1 to the consolidated financial statements, the Company has not renewed its reinsurance treaties with any of the primary financial guaranty insurers in 2009 or written any new business to date in 2009.
Capital preservation and evaluation: We reduced our new business growth in 2008 and have not written any business to date in 2009. We are evaluating our capital position in light of ongoing deterioration in the credit markets to determine whether we have sufficient capital in excess of that required to pay claims and other obligations under various stress scenarios to pursue opportunities to deleverage our capital structure by repurchasing our outstanding securities and, in the longer term, new business opportunities.
Reducing expenses: In order to reduce our expenses, we are actively considering whether to de-list our common shares from trading on NASDAQ and de-register our securities under the Securities Exchange Act of 1934 as promptly as possible after the filing of this annual report on Form 10-K. If we de-list and de-register, we would no longer file annual, quarterly and current reports or proxy statements with the U.S. Securities and Exchange Commission. We estimate that these actions will reduce our expenses by at least $2 million per year, although the full effect of this cost savings is not expected until 2010. We also requested on March 17, 2009 that Moody’s withdraw our financial strength rating, which will result in us no longer paying an annual fee to Moody’s. We are also evaluating other measures to reduce expenses.
We are not seeking to write any new business in the near term, although we believe that if we are successful in the strategic measures set forth above, it will improve our position to potentially write new business in the future. We continue to evaluate our business model and may pursue a different set of strategies in the future. There can be no assurance that the strategies that have been implemented or that will be pursued in the future in connection with this evaluation will improve our business, financial condition, liquidity or results of operations or will not have a material adverse effect on the Company.
On September 24, 2008 RAM Re was downgraded by S&P to A+ from AA and on December 4, 2008 RAM Re was downgraded by Moody’s to Baa3 from A3. On March 17, 2009, RAM Re requested that Moody’s withdraw its rating. The downgrade of RAM Re’s ratings has had an adverse effect on RAM Re’s ability to compete in the financial guaranty reinsurance industry and significantly decreased the value of the reinsurance provided. Due to the above mentioned downgrades, certain ceding companies have the right, after a cure period, to increase the ceding commission, as stipulated in the treaties, or terminate the treaties and recapture the business previously ceded to RAM Re whether written in financial guaranty or credit derivative form. To the extent policies are recaptured, RAM must forfeit to the ceding company an amount determined by formula under each treaty which generally consists of RAM’s allocated share of the U.S. statutory unearned premium, net of the ceding commission paid by RAM to the ceding company (subject to a penalty amount in some cases), and loss reserves established with respect to the policies ceded, as applicable. U.S statutory premiums usually earn at a slower rate than GAAP premiums and therefore any forfeiture of U.S. statutory unearned premiums would result in a loss on a GAAP basis. In some cases, the ceding companies have the right to select specific years of business written to recapture, and a decision by a ceding company to recapture, for example, all business written prior to
2006, could have a material adverse effect on RAM Re because of the projected losses associated with the business written in the last three years. As of April 13, 2009, none of the primaries have recaptured any business. The commutations negotiated during the year were not a result of these treaty terms. As at December 31, 2008, we have accrued or paid additional ceding commissions related to the S&P downgrade totaling $20.3 million which is being expensed as the related premiums are earned. We are unable to estimate any further ceding commission increase resulting from the Moody’s downgrade because Moody’s has not yet established the amount of further reinsurance credit we provide to each of the primaries at the Baa3 level.
At December 31, 2008, the Company has $438.9 million of cash and investments of which $378.9 million is held in trust for the benefit of our ceding companies, leaving $60.0 million cash and investments available for the cost of ongoing business. The trust accounts are required to hold cash and investments equivalent to unearned premiums, case-basis loss reserves and credit impairments, and a contingency reserve calculated by the ceding companies, and the balances are adjusted at least annually. Currently, losses are paid out of our unrestricted cash rather than our trust accounts which reduces available cash until the trust accounts are adjusted. Subsequent to December 31, 2008, approximately $32.9 million was released from the trust accounts to the Company’s operating account.
RAM Re’s unallocated reserve is reviewed periodically by the Management Committee and the estimate may be modified if industry experience or company specific-developments are judged to warrant such an adjustment. For example, as at December 31, 2008, some of the primaries increased the unallocated reserves for residential mortgage-backed securities, which has been reflected in our unallocated loss reserve calculation.
The Company reviews the portfolio on a continuous basis to identify problem credits. Quarterly, the Management Committee formally reviews case and the unallocated reserves. Management establishes reserves that it believes are adequate to cover the present value of the ultimate liability for claims. The reserves are based on estimates and are substantially dependent on the surveillance activities and reserving policies of our ceding companies and may vary materially from actual results. Adjustments based on actual loss experience will be recorded in the periods in which they become known.
In the ordinary course of business, the Company cedes business to other insurance and reinsurance companies. These agreements enable the Company to manage its risk concentration limits thereby providing greater risk diversification and may minimize the net potential loss from large risks. Retrocessional contracts do not relieve the Company of its obligation to the reinsured. Prepaid reinsurance premiums represent the portion of premiums ceded to reinsurers relating to the unexpired terms of the reinsurance contracts in force. During 2008, the Company had one retrocessional agreement in place. This agreement has been terminated on a “run-off” basis effective December 31, 2008.
The Company has entered into agreements to reinsure derivative instruments, consisting primarily of credit default swaps that it intends to reinsure for the full term of the contract. While management considers these agreements to be a normal
Level 1 inputs - valuations based on quoted prices in active markets for identical assets or liabilities. Valuations in this level do not entail a significant degree of judgment.
Level 2 inputs - valuations based on quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets that are not active and model derived valuations where all significant inputs are observable in active markets.
4. Additional disclosures will be required on financial guaranty contracts, the accounting and risk management activities used to evaluate credit deterioration in the Company’s insured obligations and surveillance lists.
FAS 163 is effective for fiscal years beginning after December 15, 2008, and all interim periods within those fiscal years, with the exception of certain risk management disclosures which are effective for the interim financial statements prepared as of September 30, 2008, and are presented and disclosed for the current period in “Note 11 - Loss and Loss Adjustment Expense Reserve” in the Notes to the Consolidated Financial Statements. Early application is not permitted. The standard does not apply to credit derivatives. The effect of fully adopting FAS 163 will be recognized as an adjustment to opening retained earnings for the fiscal year beginning January 1, 2009. The Company is currently assessing the potential impact, which is likely to be material, of applying FAS 163 and at this time is unable to quantify
In September 2008, the FASB issued FSP No. FAS 133-1 and FIN 45-4 “Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 145; and Clarification of the Effective Date of FASB Statement No. 161”. FSP No. FAS 133-1 requires enhanced disclosures about credit derivatives and guarantees and amends FIN 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” to exclude derivative instruments accounted for at fair value under SFAS No. 133. The FSP is effective for financial statements issued for reporting periods ending after November 15, 2008. The Company has adopted FSP FAS No. 133-1 and FIN 45-4 for the reporting period ending December 31, 2008 (see Note 4, Derivative instruments for disclosures on our credit derivatives). Since FSP FAS No. 133-1 and FIN 45-4 only requires additional disclosures concerning credit derivatives and guarantees, adoption of FSP FAS No. 133-1 and FIN 45-4 has not affected the Company’s financial position or results of operations.
In March 2008 the FASB issued FAS No. 161 “Disclosures About Derivative Instruments and Hedging Activities - An Amendment of FASB Statement No. 133” (“FAS 161”). FAS 161 establishes the disclosure requirements for derivative instruments and for hedging activities. FAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. Early adoption is encouraged. FAS 161 was adopted for the reporting period ending December 31, 2008. See Note 4, Derivative instruments for disclosures on our credit derivatives. Since FAS 161 only requires additional disclosures concerning credit derivatives, FAS 161 has not affected the Company’s results of operations or financial position.
As at January 1, 2008, RAM implemented a change in the presentation of revenues, expenses and balance sheet items relating to financial guaranty contracts that the Company reinsures in the form of credit default swap (“CDS”) contracts. This reclassification did not change the Company’s (loss)/net income, comprehensive (loss)/ income, (loss)/earnings per share or shareholders’ equity. This reclassification was adopted after agreement between members of the Association of Financial Guaranty insurers (“AFGI”) and discussions with the Securities and Exchange Commission, to increase comparability of the Company’s financial statements with other financial guaranty companies that have credit derivative
The statement of cash flows for the period ended December 31, 2008 appropriately segregates the effect of changes in restricted cash into a separate line item within investing activities. Restricted cash and the effect of changes in restricted cash balances have historically been included in the balance of cash and cash equivalents and the net increase/(decrease) in cash and cash equivalents, respectively. The statement of cash flows for the years ended December 31, 2007 and 2006 have been revised to conform to the current period presentation. The effect of the prior-period revised presentation has an immaterial effect on the statement of cash flows.
The Company has entered into agreements to reinsure derivative instruments, consisting primarily of Credit default swaps (“CDS”) that it intends to reinsure for the full term of the contract. While management considers these agreements to be a normal extension of its financial guaranty reinsurance business and reinsurance in substance, these transactions reinsured by the Company meet the definition of a derivative under FAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”), and FAS No. 149,”Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“FAS 149”), and the Company is required to recognize all derivatives as either assets or liabilities in the consolidated balance sheets and measure those instruments at fair value. The gain or loss on credit derivatives will change at each measurement date based on the underlying assumptions and information used in the estimate of fair value. Such fair value changes may not be indicative of ultimate claims. The credit derivative contracts the Company reinsures require us to make payments upon the occurrence of certain defined credit events relating to an underlying obligation. Credit derivative exposures are substantially similar to financial guaranty insurance contracts and provide for credit protection against payment default, are generally held to maturity, and the unrealized gains and losses on derivative financial instruments will approach zero as the exposure approaches its maturity date, unless there is a credit impairment.
In accordance with FAS 157, Fair Value Measurements, fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is determined based on quoted market prices, if available. Financial guarantors sell credit protection in CDS form to financial institutions in a principal-to-principal market in which transactions are highly customized and negotiated independently. Based on disclosures by the primaries, a CDS contract written by a financial guarantor differs from typical CDS contracts entered into by parties that are not financial guarantors because:
Financial guarantors are not entitled to terminate a CDS contract they write that is “in-the-money” and realize a profit on such a position. A counterparty to a CDS contract written by a financial guarantor generally is not able to force the financial guarantor to terminate a CDS contract that is “out-of-the-money.”
As a result of these differences, we believe there have been few, if any, relevant third-party exit transactions for CDS contracts written by financial guarantors. In the absence of a principal exit market, a financial guarantor determines the fair value of a CDS contract it writes by using internally developed models, as more fully discussed below.
1. Premium method; A model that calculates the difference between the present value of remaining expected premiums a primary receives for the credit protection on a CDS contract and the estimated present value of premiums that a comparable financial guarantor would hypothetically charge for the same protection at the balance sheet date. The fair value of the primary’s credit derivatives depends on a number of factors including notional amount of the contract, expected term, credit spreads, changes in interest rates, the credit ratings of referenced entities, the primary’s own credit risk and the remaining contractual cash flows.
2. Expected loss method; A model of the CDS contract that derives a probabilistic measure of expected loss for the primary’s exposure using market pricing on the underlying referenced collateral within the transaction. The model calculates expected losses on a collateral pool within an insured credit derivative transaction by reference to the following: credit spreads of the underlying collateral, based on actual spreads or spreads on similar collateral with similar ratings, diversity score of the collateral pool as an indication of correlation of collateral defaults, and recovery rate for all defaulted collateral. The model then allocates the expected losses for each tranche of the transaction according to its subordination level within the transaction structure.
The model is a well-documented, consistent approach to valuing positions that minimizes subjectivity, according to its users. Each company has developed a hierarchy for market-based spread inputs that helps mitigate the degree of subjectivity during periods of high illiquidity.
There is diversity of approach to estimating the fair value of these transactions among the financial guarantee insurance companies.
RAM measures the value of its derivative assets and liabilities based on an assumption that a market participant would consider the fair value information provided by the ceding companies. The assumption that a market participant would consider the fair value information provided by the ceding companies when determining the fair value of RAM’s reinsurance contract makes intuitive sense given the lack of contractual rights to more detailed information about individual ceding company contracts. The primary insurers underwrite each of the transactions underlying the reinsurance contract and they have access to all the underlying data related to the transactions. In addition, they have sophisticated modeling capabilities and services (i.e. Loan Performance and Intex) that allow them to evaluate the performance of all of the underlying credits in a transaction. RAM also employs procedures to test the reasonableness of the mark both in process and absolute terms because we believe that an exit market participant would perform similar procedures when determining an exit price for our reinsurance contract. If it appears that the marks are consistent with macro spread movements, and general market trends and RAM believes that the modeling and assumptions that drive the modeling are reasonable (based on RAM’s ceding company audits and review of publicly available information), RAM will use the mark provided by the ceding company as a key input in the determination of the fair value of reinsurance contract.
As of December 31, 2008, 2007 and 2006, included in the Company’s outstanding par exposure was $5.0 billion, $11.9 billion and $5.5 billion, respectively, of credit default swaps that have been fair valued under FAS 133. These derivative instruments had an average legal term to maturity of 18.1 years, 25.1 years and 12.5 years as of December 31, 2008, 2007 and 2006, respectively. The increase in average legal term to maturity of derivative instruments as at December 31, 2007 as compared to December 31, 2006, primarily resulted from an increase of $6.4 billion in the outstanding par amount of credit default swaps, of which approximately 33% related to Commercial Mortgage-Backed Securities with an average legal term of 43.5 years. During the year ended December 31, 2008, the Company commuted substantially all of its CMBS derivative instruments which led to the decline in the average legal term to maturity as at December 31, 2008. The average legal term to maturity as at December 31, 2008 remains higher than 2006 due to the change in mix of the Company’s CDS portfolio including increased RMBS and Trust Preferred CDOs assumed by the Company in 2007. Actual maturity of credit default swaps is generally expected to be significantly less than the legal term. The Company’s determination of derivative liabilities is not affected by the one-quarter lag in reporting of exposure data included in Note 12.
The following table sets forth the Company’s exposure to credit derivative by major asset type as at December 31, 2008:
The Company’s credit default swap policies are not readily tradable as there is no active market for them. Therefore, the Company views its principal market as the financial guaranty insurance and reinsurance market, whose participants would hypothetically be able to assume this business if the Company were to hypothetically transfer a policy.
The following table sets forth the Company’s derivative liabilities that were accounted for at fair value as of December 31, 2008 by level within the fair value hierarchy. As required by FAS 157, items are classified in their entirety based on the lowest level of input that is significant to the fair value measurement:
Our credit derivative policies are classified as Level 3 in the above fair value hierarchy since the inputs provided to us by our ceding companies and our own non-performance risk adjustments are from valuation models which place reliance on at least one significant unobservable input. Consistent with the requirements of FAS 157, we believe these models use observable market data when available.
Our customers through December 31, 2007 were the primary monoline financial guaranty insurers and in some cases, reinsurers, namely Ambac Assurance Corporation, or Ambac, Assured Guaranty Corp., or Assured Guaranty, CIFG IXIS Financial Guaranty North America, Inc., or CIFG, Financial Guaranty Insurance Company, or FGIC, Financial Security Assurance Inc., or FSA, MBIA Insurance Corporation, or MBIA, and Syncora Guaranty Re Ltd. (formerly XL Financial Assurance Ltd.) and Syncora Guaranty Inc. (formerly XL Capital Assurance Inc.).
We commuted our entire insured portfolio assumed from Syncora Guaranty Re Ltd. and MBIA effective July 25, 2008 and November 30, 2008, respectively (see Note 16 Commutations). As a result, substantially our entire insured portfolio outstanding as of December 31, 2008 consists of business assumed from Ambac, Assured Guaranty, FGIC, and FSA. Subsequent to year end, effective April 8, 2009, we commuted our entire insured portfolio assumed from Ambac. See Note 27, “Subsequent Events.”
The Company did not have an aggregate investment in a single entity, other than the U.S. Treasury securities, in excess of 10% of total investments at December 31, 2008 and 2007.
During the year ended December 31, 2008, the Company recognized other than temporary impairments of $10.5 million. The Company recognized an additional $2.2 million ($3.6 million during 2007) relating to an investment with subprime exposure, and the fair value of this investment was $0.2 million at December 31, 2008. The Company had a second investment with subprime exposure on which it realized a $0.1 million loss in 2008 and the fair value of this investment at December 31, 2008 was $0.2 million. Two other securities have been other than temporarily impaired during the year. These were corporate bonds that realized a total of $8.2 million of losses and the combined fair value of these investments at December 31, 2008 was $0.9 million. The company has no material investments in securities guaranteed by third parties and has no direct investments in financial guarantors as at December 31, 2008 and 2007.
On July 1, 2005, the Company entered into a retrocession agreement with a “AA” rated financial guaranty company, which has subsequently been downgraded to Ba1 by Moody’s and BBB- by S&P, to retrocede certain business that exceeds its single-risk limits on a facultative basis, thereby limiting its exposure to loss from large individual risks. This retrocessional agreement does not relieve RAM Re from its obligation to the reinsured. The retrocessional agreement requires an annual minimum of $1.0 million written premiums or $750,000 in premiums written and $1.5 million of adjusted gross premiums (a non GAAP measure of business assumed during a period) on installment transactions. As at December 31, 2008, the Company has complied with these requirements for 2008. This agreement has been terminated on a “run-off” basis effective December 31, 2008. As a result of the downgrade of the retrocessionaire, the Company has the right to terminate the agreement on a “cutoff” basis and recapture all the policies previously ceded. The Company has not exercised this right as of April 13, 2009. As at December 31, 2008, there were no established losses recoverable on the retroceded business.
As of December 31, 2008 and 2007, the Company maintained a $90.0 million credit facility with major commercial banks. The facility may be drawn upon by the Company if cumulative losses exceed certain minimum thresholds in respect of cumulative losses on public finance bonds and, in a limited capacity, asset-backed securities reinsured by the Company. Loan obligations under this facility have limited recourse and would be repayable from, and collateralized by, a pledge of recoveries realized on defaulted reinsured obligations covered by the facility, including certain installment premiums and other collateral. The facility, which contains an annual extension provision subject to approval by the banks, was not extended for an additional year on May 11, 2008. The facility has a term ending on May 11, 2015. As of December 31, 2008 and 2007, no amounts were outstanding nor have there been any borrowings under this facility.
On December 23, 2003, RAM Re entered into a $50.0 million soft capital facility whereby it was granted the right to exercise perpetual put options in respect of its Class B preference shares against the counterparty to the option agreement, in return for which it paid the counterparty a floating put option fee through February 17, 2009. The counterparty was a trust established by an investment bank. The trust was created as a vehicle for providing capital support to RAM Re by allowing it to obtain, at its discretion and subject to the terms of the option agreement, access to new capital through the exercise of a put option and the subsequent purchase by the trust of RAM Re preference shares. In the years
The Company’s fair value on Other Financial Instruments relates to the put option on the Company’s preference share soft capital facility, which represents the value to the Company in the current market environment. The put option is a financial instrument and is required to be fair valued. As at December 31, 2008, the unrealized gain on this put option was $43.1 million and is included in other financial instruments on the consolidated balance sheet. The unrealized gain on this financial instrument was $35.3 million at December 31, 2007. The movement in fair value of $7.8 million for the year ended December 31, 2008 is included as an unrealized gain on other financial instruments in the statement of operations. Valuations are based on unobservable inputs including assumptions over the Company’s performance and future outlook, the facility, the current market conditions, and other similar instruments in the market. Assumptions include the current rate paid for the facility (LIBOR plus 300 bps at December 31, 2008), the term of the facility and the Company’s rating, along with judgmental factors such as the market perception of the facility and the Company.
Since, as of December 31, 2008, there is no active market for the put option and due to the significant number of the unobservable inputs used in the valuation, the put option valuation was classified as a Level 3 fair value measurement.
Management has estimated the fair value of certain financial instruments based upon market information using appropriate valuation methodologies.
As of December 31, 2008, the fair value of the Company’s $75.0 million redeemable preference shares was approximately $10.4 million. The fair values of the Company’s long-term debt is estimated to be approximately $12.0 million. Accrued interest payable is assumed to approximate carrying value..
The carrying amount of unearned premiums represents the Company’s future earned premium revenue on policies where the premium was received at the inception of the policy and the risk is not yet expired. The fair value of the unearned premiums is the value the Company would receive as the Company’s market would be the ceding company from which we originally assumed the business; we perceive the market value
The Company’s liability for losses and loss adjustment expenses consists of case-basis loss reserves and an unallocated reserve. Movement in the provision for losses and loss adjustment expenses is summarized as follows:
The deterioration in the US residential mortgage markets has resulted in the establishment of a significant amount of case-basis loss reserves being recorded on the policies that have defaulted or have a high probability of defaulting. Additions to case-basis reserves of $234.2 million in 2008, $26.2 million in 2007, and ($3.9) million in 2006 represent the Company’s proportionate share of loss reserves established by ceding companies and are based on notification by ceding companies and the judgment of management. The net unallocated reserve increase of $4.2 million in 2008 includes (i) additional calculated amounts of $26.5 million relating to US residential mortgage-backed securities (“RMBS”) exposure where the development of a default is probable and $7.1 million on other structured finance products, offset by (ii) a decrease in par of the inforce insured portfolio primarily as a result of the commutations during the year (see Note 16). During the year ended December 31, 2008, $23.5 million was transferred from unallocated to case reserves. The company has insured par relating to US RMBS exposure of $1.3 billion, of which $445.3 million has case reserves amounting to $48.7 million at December 31, 2008. RMBS exposure includes obligations backed by Alt-A, subprime, closed-end second mortgage loans and home equity lines of credit. The Company’s estimate of loss reserves related to RMBS exposure represent management’s best estimate of total losses for these exposures but actual losses may differ materially from these estimates. The Company continues to monitor the performance of these exposures and will update estimates of loss as new information reflecting future performance is available. The increase of the unallocated reserve of $21.9 million in 2007 is partially due to the increase in exposure reinsured by the Company as well as an additional calculated amount of $15.6 million relating to residential mortgage-backed securities (“RMBS”) exposure where the development of a default is probable but the actual loss has not been specifically identified. The
As of December 31, 2008 the Company gave credit of $28.8 million in its case reserves for the benefit of expected recoveries in 18 RMBS transactions resulting from required repurchases by the originators due to contractual breaches of representations and warranties in the RMBS securitization agreements. The $28.8 million of credit given matches the credit reported to the Company by the primaries. The primaries performed detailed examinations of sampled RMBS loan files to determine whether the loans conformed to the representation and warranties made by the originators. The sampled loans were either in later stages of delinquency or had been charged off. Those loans that showed a material breach of representations and warranties are in the process of being put-back to the originators for repurchase. All of the primaries have stated that they intend to vigorously pursue enforcement of the contractual repurchase obligations of the originators. The Company views the obligation to repurchase as a standard provision of RMBS securitizations that has been enforced for many years. Thus the Company views the inclusion of remediation credit taken by the primaries in its case reserves to be probable and estimable and has assumed its proportionate share of the credit given by the primaries when establishing its case reserves.
To determine the adequacy of its aggregate reserves, the Company considers the case reserves established by its ceding companies for the exposures it has reinsured as well as the methodologies used by the ceding companies to calculate such ceded case reserves. When the ceding companies provide additional non-case-basis reserves associated with ceded exposures, the Company also takes these reserves into consideration and is generally included in our unallocated loss reserves if not already included in our case reserves. To further evaluate the ceded reserve amounts established by the ceding companies, the Company uses its own loss forecasting methodology. For RMBS, the Company takes into account the first loss protective features inherent in the structure of the insured exposure, collateral losses to date, current delinquency rates and loan product characteristics such as loan-to-value ratio and credit score. The first-loss protection in most of the Company’s RMBS transactions is provided by excess spread, overcollateralization, subordination, and in some cases mortgage pool insurance.
RAM maintains its own Watch List to identify those transactions requiring increased monitoring. The Company typically places transactions on the Watch List if the ceding company places a transaction on its watch list, and RAM generally employs a mapping of each watch list category of each primary insurer to the Company’s own Watch List categories. Risk Management surveys market segments on an as-needed basis based on market trends, and may add transactions to the Watch List as a result of such survey even if the ceding company has not added the transaction to its watch list.
The following table provides information about the financial guaranty policies and related loss reserves in each of RAM’s Watch List categories as of December 31, 2008:
Financial guarantees are unconditional commitments that guaranty the performance of obligations under a debt service schedule. The Company’s potential liability in the event of non-performance by the issuer of the reinsured obligation is represented by its proportionate share of the aggregate outstanding principal and interest payable on such insured obligations.
Based on the public reports of our ceding companies, the payment terms of their CDS contracts are generally “pay as you go”, meaning they insure payment of timely interest and ultimate principal or ultimate principal only at final maturity. However, based on these reports, in some cases payment terms are other than “pay as you go.” For example, in some cases payments are required upon settlement of individual referenced collateral losses in excess of policy-specific deductibles and subordination. The deductible or loss threshold is the amount of losses experienced with respect to the underlying or referenced collateral that would be required to occur before a claim against the ceding company’s insurance policy can be made.
In determining the timing and terms of potential payments under our insured credit derivatives, all of our insured credit derivatives are “pay as you go,” unless the transaction is on our Watch List and the ceding company states that the insured credit derivatives have different payment terms. We believe that defaults are probable only with respect to policies in category 4 of our Watch List, and because we know the payment
The following table sets forth our in-force portfolio net exposure outstanding as of each of the years indicated, by product line and bond type for transactions issued both in the U.S. and internationally.
All exposure outstanding in this table is reported with a one-quarter lag. 2008 data excludes amounts commuted back to MBIA per the Commutation Agreement dated November 30, 2008. Due to rounding, the numbers may not add up to the totals.
(1)As a reinsurer we report outstanding exposure on a one-quarter lag, which is consistent with the reinsurance industry practice, data excludes amounts commuted back to MBIA per the Commutation Agreement dated November 30, 2008. However, we closely monitor any credit changes on an ongoing basis through discussions with the ceding companies and rating agencies and our loss and loss expense reserves are current as of the end of the applicable quarter reported.
On November 11, 2008, the Company approved certain technical amendments to the deferred compensation plan for highly compensated U.S. citizen executives (the “Affected Executives”) in order to comply with Section 409A of the U.S. Internal Revenue Code. Under recently enacted Section 457A of the U.S. internal Revenue Code, unless further regulations are promulgated that would exempt the Company from its application, the Affected Executives would be unable to defer income tax on contributions to the deferred compensation plan in respect of services rendered after December 31, 2008. Consequently, the deferred compensation plan was also amended to provide that no further contributions to the deferred compensation plan would be made by the Company after December 31, 2008. Further, the Company approved permitting the Affected Executives to make a change in their payment elections under the 409A transition rules on or before December 31, 2008. As a consequence of elections made by the Affected Executives, subsequent to December 31, 2008, all of the funds held in the rabbi trust established under the deferred compensation plan were paid out to the Affected Executives. It is not expected that additional funds will be deposited in the rabbi trust because the Company has ceased contributing to the deferred compensation plan, but the Affected Executives are permitted to continue to make contributions to the deferred compensation plan at their election.
On June 4, 2008, S&P lowered its financial strength rating of RAM Re from AAA on credit watch with negative implications to AA with a negative outlook. On September 24, 2008, S&P further lowered RAM Re’s financial strength rating to A+ (with negative outlook). As a result of these downgrades certain of the ceding companies have a right under some of our treaty agreements to increase the ceding commission charged to RAM Re on the U.S. statutory unearned premium balance, as well as premiums payable after the downgrade. This increase applies to all financial guaranty and derivative policies covered by the relevant treaties. As at December 31, 2008, RAM Re estimates the increase in ceding commission on U.S. statutory unearned premiums to be $20.3 million and has recorded this in deferred acquisition costs on the balance sheet. These additional ceding commissions are being expensed in proportion to the earning of the remaining unearned premium. As of December 31, 2008, $20.0 million of this balance has been accrued to reinsurance balances payable, and the remainder has been paid to one of RAM Re’s ceding companies under the terms of the agreements.
As at December 31, 2008 and 2007, $4.7 million and $Nil, respectively, was due to primary insurers in the ordinary course of business, representing RAM Re’s proportionate share of paid losses net of premiums receivable and ceding commission on the periodic cessions received from the primary insurers.
Effective November 30, 2008, RAM Re entered into a commutation agreement with MBIA Insurance Corporation and its affiliates (“MBIA”), to commute its entire portfolio of business previously assumed from MBIA back to MBIA. As consideration for the commutation RAM Re paid MBIA $156.5 million. The commutation reduced the outstanding par amount of RAM’s insured portfolio by $10.6 billion, including $439.3 million of collateralized debt obligations of asset-backed securities (ABS CDOs) (all structured as credit derivatives), $2.4 billion of collateralized debt obligations of commercial mortgage-backed securities (CMBS CDOs) and $453.0 million of 2005 - 2008 vintage U.S. RMBS.
On July 25, 2008, RAM Re entered into a Commutation Agreement with Syncora Guaranty Re (formerly XL Financial Assurance Ltd.) (“XLFA”), whereby RAM Re transferred all business previously ceded to RAM Re by XLFA back to XLFA and each of RAM Re and XLFA released each other from claims under the reinsurance agreements. As consideration for the Commutation Agreement, RAM Re paid $94.4 million which comprised the repayment of $8.6 million of unearned premiums, net of ceding commission, $16.1 million towards estimated loss reserves on RMBS and $69.7 million towards unrealized losses on ABS CDOs. The transaction reduced the par amount of RAM’s insured
During the second quarter of 2008, the Company entered into partial commutation agreements with two of the Company’s primary insurers. Under these agreements $1.0 billion in par outstanding of insurance policies previously reinsured by the Company was commuted back to the primary insurers. All the Company’s obligations with respect to these policies were terminated on commutation. The Company paid $7.1 million in consideration of these commutations, calculated as U.S statutory unearned premiums net of ceding commissions at the effective date of the commutations. The effect of these commutations on the Company’s income statement was to reduce (i) gross written premiums by $10.2 million, (ii) net earned premiums by $1.8 million and (iii) acquisition expenses by $0.6 million, giving an overall reduction to net income of $1.2 million.
Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised), “Share-Based Payment” (“FAS 123R”), utilizing the prospective transition method. Under the prospective transition method, compensation costs recognized relate to the estimated fair value at the grant date of share options granted subsequent to January 1, 2006 in accordance with FAS 123R. The Company continues to account for share options issued under APB 25, where no compensation expense is recognized in net income for share options granted under the plan as the exercise price is equal to the fair value of the underlying common shares at the date of grant. In accordance with the provisions of FAS 123R, options granted prior to January 1, 2006 using APB 25, have not been restated to reflect the adoption of FAS 123R. For the periods ended December 31, 2008, 2007, and 2006, the Company recognized $0.1 million, $0.1 million and $0.1 million, respectively, of compensation expense in the period for share options with an exercise price less than the market value of the underlying common shares on the date of the grant.
As at December 31, 2008, there was $1.6 million of unrecognized compensation expense related to the share options granted under FAS 123R which is expected to be recognized over the remaining service period of 2.61 years.
(1) The aggregate intrinsic value was calculated based on the market value of $0.37 as at December 31, 2008, and is calculated as the difference between the market value and the exercise price of the underlying options.
(2) During the year ended December 31, 2006, the Company purchased from employees 31,200 options that were fully vested at an expense of $0.1 million.
The following table summarizes the restricted share unit activity for the years ended December 31, 2008, 2007, and 2006:
The Company expensed $0.2 million and $0.2 million in compensation expense related to the restricted share units for 2008 and 2007 respectively (2006 - immaterial). The compensation expense for restricted share units is expensed on a prorated basis over the vesting period. At December 31, 2008, there is unrecognized compensation expense related to the non-vested restricted share units of $0.5 million, which will be recognized over the weighted average remaining service period of 2.90 years.
The downgrade of RAM Re’s ratings has had a material adverse affect on RAM Re’s ability to compete in the financial guaranty reinsurance industry and significantly decreased the value of the reinsurance provided. Due to the above mentioned downgrades, certain ceding companies have the right to increase the ceding commission, as stipulated in the treaties, or terminate the treaties and recapture the business previously ceded to RAM Re whether written in financial guaranty or credit derivative form. To the extent policies are recaptured, RAM must forfeit to the ceding company an amount determined by formula under each treaty which generally consists of RAM’s allocated share of the U.S. statutory unearned premium, net of the ceding commission paid by RAM to the ceding company (subject to a penalty amount in some cases), and loss reserves established with respect to the policies ceded, as applicable. U.S statutory premiums usually earn at a slower rate than GAAP premiums and therefore any forfeiture of U.S. statutory unearned premiums would result in a loss on a GAAP basis. The difference between U.S. statutory unearned premiums and GAAP unearned premiums was $31.0 million at December 31, 2008. In some cases, the ceding companies have the right to select specific years of business written to recapture, and a decision by a ceding company to recapture, for example, all business written prior to 2006, could have a material adverse effect on RAM Re because of the projected losses associated with the business written in the last three years. As of April 13, 2009, none of the primaries have recaptured any business. The commutations negotiated during the year were not a result of these treaty terms. As at December 31, 2008, we have accrued or paid additional ceding commissions related to the S&P downgrade totaling $20.3 million which is being expensed as the related premiums are earned. See Note 15, Reinsurance balances payable, for disclosure on the financial statement effect of increased ceding commission relating to these downgrades.
RAM Re has been downgraded and was in a rating agency capital constrained position
RAM Re discontinued treaties with four ceding companies that were downgraded below AAA
The Company has not renewed its reinsurance treaties with any of the primaries or otherwise written any new business in 2009. This means that we do not expect to write any financial guaranty reinsurance in the current year but this does not reduce our in-force business, unless the business is commuted or recaptured by the primaries.
RAM Holdings is a holding company and therefore our liquidity, both on a short-term basis (for the next 12 months) and a long-term basis (beyond the next year), is largely dependent upon (1) the ability of RAM Re to pay dividends or make other payments to the Company and (2) its ability to access debt and equity markets, which is unlikely in the near term given current market conditions and the Company’s current share valuation. RAM Re’s ability to declare and pay dividends to us may be influenced by a variety of factors such as additional losses, amount and timing of claims payments, the amounts required to be held in trust for the benefit of U.S. regulated customers, adverse market changes, insurance regulatory changes, changes in general economic conditions beyond the next twelve months and Bermuda law. Further
increases in loss reserves and credit impairments would require RAM Re to deposit additional collateral in the applicable trust account(s); and resulting claims payments in respect of those losses and impairments would increase cash outflows and could decrease the size of RAM Re’s investment portfolio, in turn decreasing income from investments. RAM Holdings principal uses of liquidity are for payment of interest on its senior notes, payment of dividends on preference shares if declared by the Board of Directors of RAM Holdings and capital investments in RAM Re.
The applicable interest rate is 6.875% and is payable semi-annually. The Notes are subject to redemption at the option of RAM Holdings Ltd., in whole or in part at any time upon 30 days advance notice by paying principal, accrued interest and the Make Whole Amount, amounting to a portion of the future scheduled payments over the principal amount. There are no financial covenants in place. Interest expense amounting to $2.8 million for each of the years ended December 31, 2008, 2007 and 2006 has been recorded.
As at December 31, 2005, MBIA, one of the four major primary insurers, owned 11.4% of our aggregate issued and outstanding common shares. MBIA sold all of its RAM Holdings shares in our initial public offering, which closed on May 2, 2006, and is no longer a “related party.” During the year ended December 31, 2008, the Company commuted all business previously assumed from MBIA, back to MBIA, see Note 16 Commutations, for further details of this transaction. Prior to the initial public offering, MBIA Capital, a wholly-owned subsidiary of the parent company to MBIA, had been engaged to provide the Company with investment advisory and management services. The Company had agreed to pay an annual investment management fee payable quarterly in arrears based on the average market value of the assets under management for each quarter. In addition, the Company had agreed to reimburse custodian fees, transfer agent fees and brokerage costs, fees and commissions and certain other out-of -pocket expenses. During the year ended December 31, 2008, the Company ceased to use MBIA Capital for its investment advisory and management services.
The Act limits the maximum amount of the annual distributions paid by RAM Reinsurance without notifying the Bermuda Monetary Authority of such payment. The maximum amount of dividends that could be paid by RAM Reinsurance as a reduction of statutory capital, without such notification, was $39.6 million and $51.5 million as at December 31, 2008 and 2007, respectively without consideration of GAAP retained earnings.
RAM Re must also comply with the provisions of the Bermuda Companies Act regulating the payment of dividends and making of distributions from contributed surplus. A company is prohibited from declaring or paying a dividend, or making a distribution out of contributed surplus, if there are reasonable grounds for believing that: (a) the company is, or would after the payment, be unable to pay its liabilities as they become due; or (b) the realizable value of the company’s assets would thereby be less than the aggregate of its liabilities and its issued share capital and share premium accounts.