Selected consolidated income statement data, ending balance sheet data and share data for each of the five years ended December 31, 2007, follows:
(a) On December 31, 2005, we began to consolidate the operations of Blue Ocean in accordance with FIN 46R.
(b) As of January 1, 2007, we adopted FAS 157 and FAS 159. As a result, substantially all of our investments are now carried at fair value with changes in fair value being reported as net realized and unrealized gains (losses) in our statement of operations. Prior to the adoption of FAS 157 and FAS 159, our available for sale investments were carried at fair value with changes in fair value being reported as a separate component of shareholders’ equity, with changes therein reported as a component of other comprehensive income.
The following is a discussion and analysis of our results of operations for the years ended December 31, 2007, 2006 and 2005 and our financial condition as of December 31, 2007 and 2006. This discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes thereto included within this filing.
We ended 2007 with a fully converted tangible book value per share of $17.82, an increase of 17.2% for the year inclusive of dividends. The increase was largely the result of favorable underwriting conditions resulting from satisfactory pricing and a low level of catastrophes experienced throughout the year, as well as solid investment results.
In May 2007, in exchange for a payment of $47.7 million to a former affiliate, we repurchased and retired all remaining warrants to acquire our common shares. This transaction, as of the date effected, reduced our fully converted tangible book value per share by approximately $.50.
We track gross reinsurance treaty contract limits which we deem exposed to a single natural perils occurrence within certain broadly defined major catastrophe zones. The resulting measure represents the sum of all contract limits assumed through property reinsurance treaties, other specialty reinsurance treaties and event-linked insurance derivatives, but excludes limits relating to individual risk insurance business and the benefit of any reinsurance protections we have purchased. As of December 31, 2007, our largest single zonal concentration was Northern European windstorm (the zone consisting of the U.K., Ireland, Germany, France, the Benelux countries, Switzerland, Denmark, Norway and Sweden). For individual risk business, including both direct insurance and facultative reinsurance accounts, we supplement our treaty approach by tracking contract limits to a finer geographic resolution.
In addition to monitoring exposed contract limits and single event accumulation potential, we attempt to measure enterprise-wide risk using a simulated annual aggregate operating result approach. This approach estimates a net operating result over simulated annual return periods, including contributions from certain variables such as aggregate premiums, losses, expenses, and investment results. We view this approach as a supplement to our single event stress test as it allows for multiple losses from natural catastrophe and other sources and attempts to take into account certain risks from non-underwriting sources.
Through our modeling we endeavor to take into account many risks that we face as an enterprise. By the very nature of the insurance and reinsurance business, and the limitations of models generally, our modeling does not cover every potential risk. Examples include emerging risks, changes in liability awards, pandemic illnesses, asteroid strikes, climate change, bioterrorism, scientific accidents, and various imaginable and unimaginable political and financial market catastrophes.
Represents the value of MUSIC’s excess and surplus lines licenses and authorizations acquired in 2007.
Under the terms of the remaining share issuance agreement, 7,920,000 common shares remain issued and outstanding. In view of the contractual undertakings of the forward counterparty in the share issuance agreement, which have the effect of substantially eliminating the economic dilution that would otherwise result from the issuance such shares, we do not consider these shares outstanding for the purposes of this computation.
We believe that fully converted tangible book value per share and the change in fully converted tangible book value per share adjusted for dividends are measurements which are important to investors and other interested parties who benefit from having an objective and consistent basis for comparison with other companies within the industry.
Pricing in most insurance and reinsurance markets is generally cyclical in nature. In 2006 we saw significant price increases in U.S. peak property zones, particularly in the case of business exposed to hurricanes and earthquakes. These increases resulted from the catastrophic hurricanes that occurred in 2004 and 2005. The losses led to an increase in perceived catastrophe risk by market participants, catastrophe modeling firms and rating agencies which directly and indirectly led to increased prices.
During 2007, pricing in virtually all insurance and reinsurance markets declined due to increasing competition from the private sector and, for catastrophe prone business, the impact of the capital markets and certain governmental initiatives that occurred or were anticipated might occur. This trend is expected to continue.
The most significant price decline for us in 2007 was in the case of our writings of collateralized property catastrophe retrocessional business which, from January 1, 2006 to June 30, 2007, was predominantly written by Blue Ocean Re within our Collateralized Property Catastrophe Retrocessional segment. This was the first segment to show significant rate increases following the 2005 catastrophes and likewise, its pricing has deteriorated most rapidly. As a result, in the second half of 2007, Blue Ocean Re wrote no new business and is not expected to write any new business during 2008.
Syndicate 5151 wrote $15.3 million of gross premium during 2007, concentrated in our Property Specialty and Other Specialty lines of business.
I. Results of Operations for the Years Ended December 31, 2007, 2006 and 2005
Our Collateralized Property Catastrophe Retrocessional segment, which began operations January 1, 2006 and consists solely of the operations of Blue Ocean, does not operate with a financial strength rating and, instead, collateralizes its reinsurance obligations to provide assurance to customers that Blue Ocean Re will be able to honor its reinsurance obligations. In the second half of 2007, Blue Ocean Re did not bind any new reinsurance contracts and is not expected to write any new business during 2008. During 2007 Blue Ocean began returning capital to its shareholders and paid a total of $249.0 million in dividends and distributions to its common and preferred shareholders (of which we received $103.9 million) and repurchased a total of $55.0 million of its preferred shares (of which we received $18.5 million).
Earned reinsurance premiums ceded were $128.1 million, a decrease of 32% compared to 2006. This decrease primarily resulted from the purchase of quota share reinsurance during the fourth quarter of 2005 to protect the 2005 underwriting year in-force book of business. This reinsurance transaction had a significant effect on our 2006 earned reinsurance premiums ceded, but had no effect on 2007 premiums ceded.
Acquisition costs incurred during 2007 were $74.5 million, a decrease of 31% compared to 2006. This decrease was primarily due to the rebalancing of our portfolio away from proportional business and towards excess of loss business, which generally carries a lower acquisition cost per dollar of premium earned.
Year Ended December 31, 2006 as compared to Year Ended December 31, 2005
Gross premiums written during 2006 were $632.7 million, a decrease of 35% compared to 2005. Excluding reinstatement premiums, gross premiums written during 2006 were $616.4 million, a decrease of 27% compared to 2005. The significant decrease in gross premiums written from 2005 to 2006 was largely the result of: (i) a $113.0 million decrease in reinstatement premiums recorded in 2006 versus 2005 due to significantly fewer natural catastrophes occurring during 2006; (ii) the formation of Blue Ocean Re on January 1, 2006, which wrote $94.8 million of premium during 2006 within our Collateralized Property Catastrophe Retrocessional segment (excluding reinstatement premiums, we wrote $60.3 million of such premiums within this segment in 2005, versus $3.3 million of premiums written within in this segment during 2006); (iii) the conversion on renewal of certain Florida proportional quota share contracts into lower-premium excess of loss contracts; (iv) a $60.0 million decrease in gross premiums written relating to the December 31, 2005 expiration of reinsurance agreements with Aspen Re; and (v) a decrease in risk excess of loss business due to inadequate pricing and tighter risk-to-capital constraints, resulting in a reduction in our exposures in most U.S. peak zones.
General and administrative expenses incurred during 2006 were $64.8 million, an increase of $38.8 million from 2005. This increase was largely due to a reversal of incentive compensation accruals during 2005 resulting from the severe hurricane losses experienced in that year. Incentive compensation accruals totaled $20.8 million in 2006 versus a negative $14.2 million in 2005.
Underwriting income was $165.2 million during 2006, resulting in a GAAP combined ratio of 67.6%. This compares to an underwriting loss of $854.5 million for 2005, which resulted in a GAAP combined ratio of 200.7%.
During 2007, our mix of premiums written changed significantly, as compared to 2006, mainly as a result of the following:
· A significant increase in excess of loss (Property Catastrophe) business resulting from a repositioning of the portfolio towards a lower concentration of proportional treaty (Property Specialty) business,
· An increase in Property Catastrophe writings within areas of broader geographic diversity than our historical book of business,
· A decline in casualty (Other Specialty) business written as rates have been declining and terms and conditions have weakened. Casualty business includes medical malpractice, public liability and catastrophe and/or clash layers for general liability and retrocessional accounts, predominantly on an excess of loss basis.
· The expiration at December 31, 2005 of our quota share agreements with Aspen Re, representing approximately $60.0 million, which impacted our property specialty and other specialty lines of business.
Looking ahead to future periods, it remains difficult to predict the amount and mix of annual premiums we will write. Various factors will continue to affect our appetite and capacity to write risk. These include the impact of changes in frequency and severity assumptions used in our models and the corresponding pricing required to meet our return targets, evolving industry-wide capital requirements, increased competition, and other considerations. The anticipated level of reinstatement premiums received in future periods will also be dependent upon the volume of catastrophic losses that occur.
The following table summarizes our earned reinsurance premiums ceded within our Rated Reinsurance and Insurance segment for the years ended December 31, 2007, 2006 and 2005:
As previously mentioned, in the fourth quarter of 2005 we purchased a significant amount of quota share protection against catastrophes to protect our 2005 underwriting year in-force book of business. This had a significant effect on our 2006 earned reinsurance premiums ceded.
All of our reinsurance purchases to date have represented prospective cover; meaning that the coverage has been purchased to protect us against the risk of future losses as opposed to covering losses that we have already incurred but have not yet paid. The majority of these contracts are excess of loss contracts covering one or more lines of business. To a lesser extent we have also purchased quota share reinsurance with respect to specific lines of business. We also purchase ILW policies which provide coverage for certain losses, provided they are triggered by events exceeding a specified industry loss size.
The following tables summarize our net loss and LAE and net loss and LAE ratios within our Rated Reinsurance and Insurance segment for the years ended December 31, 2007, 2006 and 2005:
· Net estimated ultimate Property Catastrophe losses for prior years decreased by $4.0 million due to the re-assessment of loss and LAE reserves relating to several small loss events within our Property Catastrophe lines.
· Net estimated ultimate Property Specialty losses for prior years decreased by $26.6 million due primarily to claims emergence on our direct and facultative book of business being lower than expected and lower than expected ultimate losses on proportional business.
· Net estimated ultimate Property Catastrophe losses for prior years increased by $30.2 million due primarily to an increase in expected ultimate losses in our retrocessional book of business relating to the 2005 hurricanes, mainly Hurricane Wilma.
· Net estimated ultimate Other Specialty losses for prior years decreased by $17.7 million due to lower than expected claims frequency within this line of business.
Our best estimate for our ending gross loss and LAE reserves at December 31, 2007, 2006 and 2005 was $860.7 million, $1,089.2 million and $1,781.9 million, respectively. Our best estimate for our ending net loss and LAE reserves at December 31, 2007, 2006 and 2005 was $708.2 million, $891.9 million and $1,476.2 million, respectively.
The following table summarizes our acquisition costs incurred within our Rated Reinsurance and Insurance segment during the years ended December 31, 2007, 2006 and 2005:
Acquisition costs (which include brokerage costs, commissions and excise taxes) are generally driven by contract terms and are normally a set percentage of gross premiums written. Ceding commissions related to our reinsurance premiums ceded are presented as a reduction of the ceding commissions payable by us to brokers and intermediaries and are recognized as earned over the same period the corresponding premiums are expensed.
Profit commissions, which are paid by assuming companies to ceding companies in the event of favorable loss experience, change as our estimates of loss and LAE fluctuate. Profit commissions totaled $6.8 million, $3.8 million and $6.8 million for the years ended December 31, 2007, 2006 and 2005, respectively. Relatively few of our assumed reinsurance contracts contain profit commission clauses. The terms of these commissions are specific to the individual contracts and vary as a percentage of the contract results. Profit commission is expensed based on the estimated results of the subject contract. During 2006, we recorded $2.7 million of profit commission due to us on some of our retrocession agreements which reduced the net amount of profit commission expensed during that period.
We anticipate that our general and administrative expenses will further increase during 2008, as compared to levels incurred in prior years, due to additional costs expected to be incurred associated with upgrading our IT infrastructure and additional costs expected to be incurred in connection with our ongoing process of building an infrastructure to support our new insurance and reinsurance initiatives.
Effective January 1, 2006, Blue Ocean began writing collateralized property catastrophe retrocessional business. Blue Ocean is presently consolidated into our consolidated financial statements and the portion of Blue Ocean’s earnings and shareholders’ equity held by third parties is recorded in our consolidated financial statements as minority interest.
(1) Shown net of intercompany underwriting and performance fees of $12.6 million and $14.9 million for the years ended December 31, 2007 and 2006, respectively.
Blue Ocean was formed in late 2005 in order to capitalize on the attractive market conditions that existed in the property casualty retrocessional market following hurricanes Katrina, Rita and Wilma. While early pricing conditions for this segment were strong, increased competition and weaker demand experienced at the end of 2006 and throughout 2007 adversely impacted pricing. As a result, during 2007, Blue Ocean began returning capital to its shareholders and Blue Ocean Re ceased writing new business. Blue Ocean Re is not expected to write any new business during 2008.
During 2007, Blue Ocean paid $249.0 million in dividends and distributions to its common and preferred shareholders and repurchased $55.0 million of its preferred shares. As a result, Blue Ocean’s total capital (defined as the sum of its debt, preferred shares and common shares) was $220.7 million as of December 31, 2007, as compared to $462.5 million at December 31, 2006.
Investment income increased in 2007 compared to 2006 due primarily to a shift in the portfolio away from U.S. government and U.S. government-sponsored enterprise securities to asset-backed and corporate securities of a longer average duration. This shift, coupled with a significant liquidation of Blue Ocean’s short-duration portfolio, served to modestly increase the average duration of our fixed maturities and cash equivalents to 1.5 years at December 31, 2007, from 1.3 years at December 31, 2006. Investment income increased in 2006 compared to 2005 due primarily to a significant increase in the weighted average size of the investment portfolio, mainly fixed maturity investments, resulting from the formation of Blue Ocean in December 2005. In addition, the weighted average size of the investment portfolio in 2005 had been lowered by the effects of the March 2005 payment of a $387.7 million special dividend to shareholders.
Our investments, premiums receivable and loss reserves denominated in currencies other than the U.S. dollar are exposed to foreign currency risk as fluctuations in exchange rates may affect our financial results in the future. As a result, from time to time, we have entered into foreign currency exchange agreements as described below.
During the years ended December 31, 2007 and 2006, we recorded net expense from derivative instruments of $0.3 million and $9.9 million, respectively. These amounts relate the following instruments: (i) catastrophe bond protection purchased from Champlain (the “CAT Bond Protection”); (ii) an Industry Loss Warranty contract (the “ILW Contract”); (iii) a Catastrophe Bond Total Rate of Return Swap Facility (the “CAT Bond Facility”) and (iv) foreign currency exchange agreements (the “Foreign Exchange Contracts”). Each of these instruments is described in detail below:
Contract payments expensed in connection with the CAT Bond Protection are calculated at 12.83% per annum on the first tranche and 13.58% per annum on the second tranche and totaled $11.9 and $11.8 million for the years ended December 31, 2007 and 2006, respectively. This expense was recognized as a component of net revenue (expense) from derivative instruments in our statement of operations. In addition, during 2006 we incurred $1.9 million in one-time setup costs associated with the CAT Bond Protection.
This transaction had a fair value of zero as of December 31, 2007 and 2006. Since the inception of the CAT Bond Protection, no industry loss event has occurred that would trigger a recovery by us. Should an industry loss event triggering a recovery by us occur during future periods, it would result in our recording the expected ultimate recovery as a component of net revenue (expense) from derivative instruments in our statement of operations.
In June 2006, we entered into the CAT Bond Facility under which we are entitled to receive contract payments from a third party in return for assuming mark-to-market risk on a portfolio of securitized catastrophe risks. The difference between the notional capital amounts of the catastrophe bonds and their market value is marked to market over the terms of the bonds; the difference is settled on a monthly basis. These marked-to-market adjustments, in addition to any interest earned on the bonds, are included as a component of net revenue (expense) from derivative instruments in our statement of operations. The fair value of the CAT Bond Facility as of December 31, 2007 and 2006 of $1.8 million and $0.2 million, respectively, is recorded in other investments and is derived based on inputs that are observable for the asset, either directly or indirectly (Level 2 inputs as defined in FAS 157). The counterparty’s exposure under the CAT Bond Facility is collateralized by a lien over a portfolio of our investment grade securities which equals the amount of the facility utilized, after adjustments for credit quality. As of December 31, 2007 and 2006, we had entered into several CAT Bond Facility transactions having a combined notional capital amount of $70.7 million and $48.7 million, respectively, and recorded net revenues of $5.3 and $1.3 million, respectively, for the years then ended.
MCA began serving as sub-advisor to the Pioneer Fund, a publicly traded closed-end fund offering investors exposure to event-linked bonds known as catastrophe bonds, as well as other fixed income instruments, during the second half of 2007. We are not an investor in the Pioneer Fund.
The following table summarizes our consolidated interest and other financing expenses for the years ended December 31, 2007, 2006 and 2005:
In November 2006, Blue Ocean obtained a secured loan of $75.0 million from a syndicate of lenders (the “Blue Ocean Debt”). The Blue Ocean Debt had an initial maturity date of February 28, 2008. The Blue Ocean Debt bore interest on the outstanding principal amount at a rate equal to a base rate plus a margin of 200 basis points. The Blue Ocean Debt was repaid in full on January 18, 2008.
Our minority interest expense for 2007 and 2006 of $31.9 million and $39.3 million, respectively, represents the portion of Blue Ocean’s net income attributable to its minority shareholders.
Our newly established U.S. domiciled subsidiaries are subject to U.S. income taxes. During the year ended December 31, 2007, these subsidiaries incurred a $5.2 million U.S. net operating loss. Due to the start-up nature of these operations, and the uncertainty at this time of whether such operations will generate sufficient taxable income in future periods, we established a $1.8 million U.S. deferred tax valuation allowance at December 31, 2007. This net operating loss may be carried forward to offset future U.S. income tax liabilities through 2027.
The Company has no operations of its own and relies heavily on dividends and distributions from its subsidiaries to pay its operating expenses, interest on debt and dividends and distributions to shareholders. There are restrictions on the payment of dividends to the Company from its regulated operating companies as described under “Regulation” herein. We currently have in place a regular dividend of $.075 per common share per quarter. Any future determination to pay dividends or distributions to our shareholders will be at the discretion of our Board of Directors and will be dependent upon many factors, including our results of operations, cash flows, financial position, capital requirements, general business opportunities, legal, tax, regulatory and contractual restrictions.
The primary sources of cash for our regulated operating subsidiaries are premium collections, investment income and sales and maturities of investments. The primary uses of cash for our operating subsidiaries are payments of loss and LAE, acquisition costs, operating expenses, investment purchases and dividends and distributions paid to the Company.
The Company and Montpelier Re also maintain a $50.0 million unsecured operational revolving credit facility which, through June 2008, can be used to meet its liquidity needs. As of December 31, 2007, this facility was undrawn.
In the normal course of business, Montpelier Re and MCL Re provide letters of credit for the benefit of their clients. These letter of credit facilities were secured by cash and investments totaling $819.7 million at December 31, 2007. The following table outlines these credit facilities as of December 31, 2007:
In addition, the Company and Montpelier Re also maintained the following unsecured revolving credit facility at December 31, 2007:
In November 2005, Montpelier Re entered into a Standing Agreement for up to $100.0 million in letters of credit with The Bank of New York, known as Bilateral facility A.
In May 2006, Blue Ocean Re amended its Standing Agreement for Letters of Credit with the Bank of New York which served to revise the facility from $75.0 million to $250.0 million. This facility was not in use at December 31, 2007, and was cancelled by Blue Ocean Re in January 2008.
In May 2006, we entered into two equity forward sale agreements (the “Forward Sale Agreements”), one expiring in March 2007 and one expiring in March 2008, under which we agreed to sell (subject to our right to cash settle or net share settle such agreements) an aggregate of between 9,796,388 and 15,694,800 common shares to a third party (the “forward counterparty”) in exchange for proceeds of approximately $180 million (subject to prior prepayment and assuming no subsequent repayment pursuant to the terms of such agreements). The forward counterparty subsequently sold a total of 15,694,800 common shares in order to hedge its position under the Forward Sale Agreements.
In December 2007, the Company and the forward counterparty amended the remaining Forward Sale Agreement, which relates to up to 7,920,000 common shares and proceeds of $89.1 million. The primary results of the amendment were to bifurcate the remaining Forward Sale Agreement into two tranches, extend the term of the remaining Forward Sale Agreement and increase the forward cap price for each tranche.
In connection with the Forward Sale Agreements described above, in May 2006 we entered into a Share Issuance Agreement with the forward counterparty. Under the terms of the Share Issuance Agreement, we issued 15,694,800 common shares during 2006 to the forward counterparty for payment equal to the par value of such common shares. As a result of the settlement of the first Forward Sale Agreement, in May 2007 we repurchased and retired 7,774,800 of these common shares for payment of the par value of such common shares. As a result, we continue to have 7,920,000 common shares issued and outstanding under the Share Issuance Agreement at December 31, 2007.
We may terminate the Share Issuance Agreement at any time. Upon any termination of the Share Issuance Agreement, the common shares issued to the forward counterparty thereunder (or other common shares) must, subject to compliance with Bermuda law, be repurchased for cancellation for nominal consideration by us. The forward counterparty has agreed to post and maintain collateral with a third party as security for certain of its obligations as required under the terms of the Share Issuance Agreement.
Our loss and LAE reserves do not have contractual maturity dates. However, based on historical payment patterns, the preceding table includes an estimate of when we expect our loss reserves will be paid. As a provider of short-tail insurance and reinsurance for losses resulting mainly from natural and man-made catastrophes, we could become liable for significant losses on short notice. As a result, we have structured our fixed maturity investment portfolio with high-quality securities with a short average duration to preserve capital and provide us with adequate liquidity for the settlement of our expected liabilities.
During 2007, our cash flows provided from investing activities totaled $500.6 million resulting primarily from $451.3 million of net sales and maturities of fixed maturities and a $122.3 million net disposition of securities lending collateral.
In December 2007, we paid $3.9 million to the forward counterparty to amend the Forward Share Agreement.
During 2007, Blue Ocean paid a total of $15.0 million in cash dividends to holders of its preferred shares, of which $9.9 million was paid to minority holders.
In June 2007, Blue Ocean repurchased $55.0 million of its preferred shares, of which $36.5 million was repurchased from minority holders.
During 2006, our cash flows used for operating activities totaled $191.3 million (excluding net purchases of trading securities) which resulted primarily from net paid losses of $757.0 million exceeding premiums received, net of acquisition costs.
During 2006, our cash flows used for investing activities totaled $263.1 million (including net purchases of trading securities) resulting primarily from purchases of fixed maturity investments relating to the formation of Blue Ocean.
During 2006, Blue Ocean received $66.5 million in cash proceeds from issuances of preferred and common shares to minority holders.
During 2006, we paid $30.0 million in cash dividends and distributions to common shareholders and warrant holders.
During 2005, our cash flows provided from operating activities totaled $105.1 million which resulted primarily from premiums received, net of acquisition costs, exceeding net paid losses of $489.3 million.
During 2005, we paid $496.8 million in cash dividends and distributions to common shareholders and warrant holders, which included a special dividend paid in March 2005 of $387.7 million.
During 2005, we experienced a $105.3 million net reduction in securities lending payable.
Our loss and LAE reserves include both a component for outstanding case reserves for claims which have been reported and a component for IBNR for claims that have not been reported. Our case reserve estimates are initially set on the basis of loss reports received from third parties. IBNR consists of a provision for additional development in excess of the case reserves reported by ceding companies, as well as a provision for claims which have occurred but which have not yet been reported to us by ceding companies.
The two primary bases for estimating the ultimate loss associated with a particular event and cedant are (a) actual and precautionary claims advices received from the cedant; and (b) the nature and extent of the impact the event is estimated to have on the industry as a whole. This reserving approach is generally applied to all large events. Immediately after the event, the estimated industry market loss, applied against our book of business, is the primary driver of our ultimate loss from such event. In order to estimate the nature and extent of the event, we rely on output provided by commercially available catastrophe models, as well as proprietary models developed in-house. The exposure of each cedant potentially affected by the event is analyzed on the basis of this output. As the amount of information received from cedants increases during the period following an event, so does our reliance on this correspondence. The quality of the cedant’s historical evaluation of losses and loss information received from other cedants in relation to the same event are considered as we shift weight from industry loss-based estimates to specific cedant information.
Since our loss reserve estimate is based principally on assumptions made individually for each loss event and contract, there is significant variability which cannot be quantified at any level of aggregation which is meaningful in the context of our financial reporting. Following a major catastrophic event, the possibility of future litigation or legislative change that may impact interpretation of policy terms further increases the degree of uncertainty in the reserving process.
We have determined that our best estimates for gross loss and LAE reserves at December 31, 2007 and 2006 were $860.7 million and $1,089.2 million, respectively. Of this estimate, at December 31, 2007 and 2006, $66.6 million and $66.7 million related to our insurance business, respectively, and $794.1 and $1,022.5 million related to our reinsurance business, respectively.
Our reserving methodology does not lend itself well to a statistical calculation of a range of estimates surrounding the best point estimate of our loss and LAE reserves. As discussed above, due to the low frequency and high severity nature of our business, our reserving methodology involves arriving at a point estimate for the ultimate expected loss on a contract by contract basis with our aggregate loss reserves being the sum of the individual reserves established per contract. Favorable development of prior period net losses incurred as a percentage of our net loss reserves across all underwriting years were 4.1%, 1.6%, 3.8%, 40.3% and 44.9% for the years ended December 31, 2007, 2006, 2005, 2004 and 2003, respectively. Based on our experience during 2007, 2006 and 2005, and the current makeup of our loss reserves, we believe it is reasonably likely that our net loss and LAE reserves could increase or decrease by up to 10% from current amounts. In view of our small base of our net reserves prior to 2004, arising from both our short period of operations and the low number of catastrophes which occurred during those years, we do not believe that our experience prior to 2005 is a reliable indicator of the potential variability in our current reserves. At that time, a relatively small dollar movement in loss and LAE reserves resulted in a large percentage change. By contrast, at December 31, 2007, we have a larger loss and LAE reserve base and a more mature book of business, which provides us with a higher level of confidence in the level of percentage variability of loss and LAE reserves.
Our assumed reinsurance premium is written on an excess of loss or on a pro-rata basis. Reinsurance contracts are generally written prior to the time the underlying direct policies are written by cedants and accordingly they must estimate such premiums when purchasing reinsurance coverage. For the majority of excess of loss contracts, including insurance contracts, a deposit premium is defined in the contract wording. The deposit premium is based on the ceding companies’ estimated premiums, and this estimate is recorded as written premium in the period the underlying risks incept. In the majority of cases, this premium is adjustable at the end of the contract period to reflect the changes in underlying risks in-force during the contract period. Subsequent adjustments, based on reports by the ceding companies of actual premium, are recorded in the period they are determined, which normally within six months to one year subsequent to the expiration of the policy. To date these adjustments have not been significant.
We regularly evaluate the appropriateness of these premium estimates based on the latest information available, which includes actual reported premium to date, the latest premium estimates as provided by cedants and brokers, historical experience, management’s professional judgment, information obtained during the underwriting renewal process, and a continuing assessment of relevant economic conditions. Any adjustments to premium estimates are recorded in the period in which they become known. Adjustments to original premium estimates could be material and may significantly impact earnings in the period they are determined.
The cost of reinsurance purchased is subject to variability based on a number of factors. Excess of loss reinsurance contracts are generally purchased prior to the time our assumed risks are written and accordingly we must estimate our premiums when purchasing reinsurance coverage. For these contracts, the deposit premium is defined in the contract wording which is based on our estimated assumed premiums and this is the amount we record as ceded premium in the period the coverage incepts. In the majority of cases, the deposit premium paid under these contracts is adjusted at the end of the contract period in order to reflect any change in the premium actually payable in respect of the underlying risks assumed during the contract period. Subsequent adjustments, based on the calculation of our gross premiums written, are recorded in the period they are determined. To date these adjustments have not been significant. In addition, if there is a loss which pierces the reinsurance cover, the cost of excess of loss reinsurance coverage may generate reinstatement premium ceded, depending on the terms of the contract. This reinstatement premium ceded is recognized at the time the reinsurance recovery is estimated and recorded.
Reinsurance recoverable on paid and unpaid loss and LAE includes amounts due to us from reinsurance companies for paid and unpaid loss and LAE based on contracts in force. For excess of loss reinsurance, in some cases the attachment point and exhaustion of these contracts are based on the amount of our actual losses incurred from an event or events. In other cases, our recovery is dependent on an amount of industry loss as well as our own incurred losses.
At target payout, each performance share represents the fair value of a common share. At the end of a performance period, which is generally the three-year period following the date of grant, the value of each performance share is adjusted to represent a harvest of between zero and 200% of target depending on the achievement of specific performance criteria relating to our operating and financial performance over the period. At the discretion of our Compensation and Nominating Committee, any final payment in respect of such performance shares may take the form of cash, common shares or a combination of both.
The primary performance target (that resulting in a 100% harvest) for all participants with respect to performance shares granted for the 2005-2007, 2006-2008 and 2007-2009 performance periods is the achievement of an underwriting return on an internally generated risk-based capital measure of 16% over the period. Additionally, the performance of certain members of senior management is further measured by reference to the ratio of the actual return on equity to the return on risk based capital.
With respect to the 2005-2007 performance period, 400,000 performance shares were granted to employees. Due to the impact of severe hurricane losses on our 2005 results, the estimated harvest ratio for this performance period was reduced to 0% during the 2005 third quarter. This action resulted in an immediate performance share liability reversal of $2.8 during 2005. We also reversed other pre-existing long-term incentive liabilities of $18.8 million at that time.
With respect to the 2006-2008 performance period, 169,000 performance shares have been granted to employees of which 166,000 remained outstanding at December 31, 2007. In accordance with our accounting policy, during 2007 the expected ultimate harvest ratio for this performance share cycle was increased from 100% to 179% and the reference price of our common shares was reduced from $19.23 (the closing price on the date of grant) to $17.01 (the closing price at December 31, 2007). The Company recognized performance share expense for grants made under this performance share cycle of $2.6 million during 2007 and $1.2 million during 2006.
In determining the initial grant date fair value of RSUs, we apply a discount to the price of our common shares as vested RSUs remain outstanding until the completion of the full anniversary period of the RSU award. We apply a 5% discount to RSU grants with a three year term and an 8% discount to RSU grants with a five year term. Since RSU grants were made to a broader group of employees than was the case with performance shares, we also assume a 3% forfeiture rate in the determination of the initial grant date fair value of our RSU grants. Actual forfeitures are periodically compared to assumed forfeitures for reasonableness.
The unamortized grant date fair value of 415,333 RSUs outstanding as of December 31, 2007, which were granted with respect to the 2006-2008 period, was $0.8 million. The fair value of these RSUs was $7.9 million on the date of grant.