The following table sets forth our selected historical statement of income data for the fiscal years ended December 31, 2008, 2007, 2006 and 2005 and the period from inception on July 13, 2004 to December 31, 2004, as well as our selected balance sheet data as of December 31, 2008, 2007, 2006, 2005 and 2004, which are derived from our audited consolidated financial statements. The audited consolidated financial statements are prepared in accordance with U.S. GAAP and have been audited by BDO Seidman, LLP, an independent registered public accounting firm. Since we commenced underwriting business in April 2006 and did not write any reinsurance contracts in 2005 and 2004, comparisons to periods prior to April 2006 may not be meaningful.
In September 2008, the Cayman Islands Monetary Authority granted approval for the Company's request to amend its business plan enabling us to engage in long-term business (e.g., life insurance, long-term disability, long-term care, etc.) in addition to our current property and casualty reinsurance program. As of the date of this filing, we had not written any long-term business. However, as part of our opportunistic strategy, we now have the license to selectively evaluate opportunities relating to long-term business.
We manage our business on the basis of one operating segment: property and casualty reinsurance, in accordance with the qualitative and quantitative criteria established by SFAS No. 131, ‘‘Disclosure about Segments of an Enterprise and Related Information.’’ Within the property and casualty reinsurance segment, we analyze our underwriting operations using two categories:
Investment-related expenses primarily consist of management and performance fees we pay to our investment advisor. We net these expenses against investment income in our financial statements.
Our consolidated financial statements contain certain amounts that are inherently subjective in nature and have required management to make assumptions and best estimates to determine reported values. If certain factors, including those described in ‘‘Risk Factors,’’ cause actual events or results to differ materially from our underlying assumptions or estimates, there could be a material adverse effect on our results of operations, financial condition or liquidity. We believe that the following accounting policies affect the more significant estimates used in the preparation of our consolidated financial statements. The descriptions below are summarized and have been simplified for clarity. A more detailed description of our significant accounting policies as well as recently issued accounting standards is included in Note 2 to the consolidated financial statements.
For each quota-share or proportional property and casualty reinsurance contract we underwrite, our client estimates gross premiums written at inception of the contract. We generally account for such premiums using the client’s initial estimates and then adjust the estimates as advised by our client. We believe that the client's estimate of the volume of business it expects to cede to us represents the best estimate of gross premiums written at the beginning of the contract. As the contract progresses, we monitor actual premiums received in conjunction with correspondence from the client in order to refine our estimate. Variances from initial gross premiums written estimates can be greater for quota-share contracts than for excess of loss contracts. All premiums are earned on a pro rata basis over the coverage period. Unearned premiums consist of the unexpired portion of reinsurance provided.
For all non-natural peril business, we initially reserve every individual contract to the expected loss and loss expense ratio in the pricing analysis. In our pricing analyses, we typically utilize a significant amount of information both from the individual client and from industry data. Where practical, we compare reserving data that we receive from our client, if any, to publicly-available financial statements of the client in an effort to identify, confirm and monitor the accuracy and completeness of the received data. If we do not receive reserving data from a client, we rely on industry data, as well as the judgment and experience of our underwriters and actuaries. We complete our analyses for all contracts for all lines of business. The information may include many years of history. Depending on the type of business underwritten, we are entitled to receive client and industry information on historical paid losses, incurred losses, number of open claims, number of closed claims, number of total claims, listings of individual large losses, earned premiums, policy count, policy limits underwritten, exposure information and rate change information. We also may receive information by class or subclass of business. As we are a new company, we currently rely more on client and industry data than our own data to identify unusual trends requiring changes in reserve estimates. Where available, we receive relevant actuarial reports from the client. We supplement this information with subjective information on each client, which may include management biographies, competitor information, meetings with the client, and supplementary industry research and data. Generally, we obtain regular updates of premium and loss related information for the current period and historical periods, which we utilize to update our initial expected loss and loss expense ratio. There may be a time lag from when claims are reported to our client and when our client reports the claims to us. This time lag may impact our loss reserve estimates from period to period. Once we receive this updated information we use a variety of standard actuarial methods in our analysis each quarter. Such methods may include:
Our aggregate reserves are the sum of the point estimate of all contracts. Because our reserves are the sum of our point estimates, we do not adjust our reserves from the amounts our actuaries determine. We perform a quarterly loss reserve analysis on each contract. This analysis may incorporate some or all of the information described above, using some or all of the methodologies described above. Each contract is analyzed every quarter regardless of the line of business. We generally calculate IBNR reserves for each contract by estimating the ultimate incurred losses at any point in time and subtracting cumulative paid claims and case reserves, which incorporate specific exposures, loss payment and reporting patterns and other relevant factors. We also have our loss reserves reviewed, at least on an annual basis, by an independent outside actuary who tests and reviews the work done by our actuaries to corroborate that reserves we report are being established consistently and appropriately.
at the grant date and recognize the expense over the vesting period. Determining the fair value of share option awards at the grant date requires significant estimation and judgment. We use an option-pricing model (Black-Scholes pricing model) to assist in the calculation of fair value. Our shares have not been publicly traded for a sufficient length of time to reasonably estimate the expected volatility. Therefore we have based our expected volatility on the historical volatility of similar entities. We considered factors such as an entity's industry, stage of life cycle, size and financial leverage when selecting similar entities. Additionally, we used the full life of the option, ten years, as the estimated term of the option, and we have assumed that dividends will not be paid. If actual results differ significantly from these estimates and assumptions, particularly in relation to our estimation of volatility which requires the most judgment due to our limited operating history, share-based compensation expense, primarily with respect to future share-based awards, could be materially impacted.
Our investment strategy has been affected by the difficulties faced by the overall financial markets. We believe that over the past few months, the marketplace has increased the risk premium on most asset classes as a result of headline news events, including corporate failures, recent government interventions, current economic slowdown and the ever-widening credit crisis. We believe that when the macro economic and political uncertainties eventually subside, security selection will again be the primary driver of performance. This is a basic premise of our value oriented investment strategy. While this has created disappointing investment results for our strategy over the last 12 months, we believe that this also creates long-term opportunities for us due to a significant number of mispriced securities.
The significant economic slowdown has resulted in an increased number of corporate failures. We believe that corporate default rates will continue to increase through 2009. As opportunistic investors, we have started to purchase distressed debt of corporate issuers in the last quarter of 2008, and expect to continue doing so in 2009.
We intend to continue monitoring market conditions to be positioned to participate in future underserved or capacity-constrained markets as they arise and intend to offer products that we believe will generate favorable returns on equity over the long term. Accordingly, our underlying results and product line concentrations in any given period may not be indicative of our future results of operations.
For the year ended December 31, 2007, our net income decreased by $21.7 million as compared to the same period in 2006 due to a decrease of $30.9 million in net investment income which was partially offset by income generated from expanded underwriting operations. Our investment portfolio reported a return of 5.9% for the year ended December 31, 2007 compared to a return of 24.4% for the year ended December 31, 2006.
Details of gross premiums written for the years ended December 31, are provided in the following table:
year ended December 31, 2008, frequency business generated 74.3% higher premiums written than for the year ended December 31, 2007. The increase reflects the continuing development of our underwriting activities which resulted in a number of new frequency contracts written during the year ended December 31, 2008. Approximately 84.2% of the frequency premiums written during the year ended December 31, 2008 related to motor liability and health lines of business. By comparison, 53.7% of the frequency premiums written during the year ended December 31, 2007 related to personal property line of business. The shift in premiums written relating to our lines of business is consistent with our opportunistic underwriting strategy.
For the year ended December 31, 2008, the premiums written relating to severity contracts decreased by 43.5% compared to the year ended December 31, 2007. The decrease is mainly attributed to a multi-year professional liability contract written during the year ended December 31, 2007, for which all premiums were recognized as written premiums at inception in accordance with our accounting policy for premium recognition. The premiums on this contract continue to be earned over the multi-year term of the contract as discussed below under “Net Premiums Earned.”
Premiums relating to quota share contracts are earned over the contract period in proportion to the period of protection. The increase in frequency earned premiums of 13.3% reflects the additional quota share contracts written throughout the 2008 year. For the year ended December 31, 2008, 73.6% of the earned premiums on frequency contracts related to motor liability and health lines of business. For the year ended December 31, 2008, severity earned premiums increased 27.8% compared to the 2007 year. As mentioned above under the section “Premiums Written,” the earned premiums on severity contracts increased while the written premiums on severity contracts decreased during the year ended December 31, 2008. This was due to a multi-year professional liability contract written during the year ended December 31, 2007, which continues to earn premiums over the multi-year term of the contract. In addition, the severity earned premiums increased due to reinstatement premiums on severity contracts which were earned in full for the year ended December 31, 2008. There were no reinstatement premiums on severity contracts during the year ended December 31, 2007.
The loss ratio on our frequency business was 44.4%, 47.9% and 55.9% for the years ended December 31, 2008, 2007 and 2006, respectively. The decrease in loss ratio is mainly due to the favorable loss development on a personal lines contract written in 2006.
Losses incurred can be further broken down into losses paid and changes in loss reserves. Losses incurred for the years ended December 31, 2008, 2007 and 2006 were comprised as follows:
For the year ended December 31, 2008, the increase in losses incurred of $55.5 million included an increase of $67.5 million related to current year incurred losses on 2008 contracts, offset by a decrease of $12.0 million related to net favorable loss development on prior year incurred losses. The loss development on prior year losses primarily related to the following:
Favorable loss development of $12.4 million on a personal lines contract entered into during the year ended December 31, 2006. The favorable loss development was a result of reserves being released based on updated information received from the client indicating lower than expected claims development;
For the year ended December 31, 2007, the decrease in severity acquisition cost ratio was due to the change in composition of the severity portfolio from being composed entirely of natural peril business, to a portfolio that included casualty and professional liability exposures as well as natural peril business.
Our general and administrative expenses for the years ended December 31, 2008, 2007 and 2006 were $13.8 million, $11.9 million and $9.1 million, respectively. For the year ended December 31, 2008, the increase in general and administrative expenses of $1.9 million primarily relates to higher personnel costs including employee bonus accruals relating to the 2007 year.
Investment loss, net of all fees and expenses, resulted in a loss of 17.6% on our investment portfolio for the year ended December 31, 2008. This compares to returns of 5.9% and 24.4% reported for the years ended December 31, 2007 and 2006, respectively. Investment returns are calculated monthly and compounded to calculate the annual returns. The resulting actual investment income may vary depending on cash flows into or out of the investment account. Given the net investment loss for the year ended December 31, 2008, no performance fee was paid to DME Advisors in 2008. In addition, based on the advisory agreement, the performance compensation for the subsequent years will be reduced to 10% until all the investment losses have been recouped and an additional amount equal to 150% of the investment loss is earned.
Due to the opportunistic and customized nature of our underwriting operations, we expect to report different loss and expense ratios in both our frequency and severity businesses from period to period. For the years ended December 31, 2008, 2007 and 2006, we reported the following ratios:
The internal expense ratio is the ratio of all general and administrative expenses to net premiums earned. The internal expense ratio for year ended December 31, 2008 decreased to 12.0% from 12.2% for the year ended December 31, 2007. We expect our internal expense ratio to decrease as we continue to expand our underwriting operations. The high internal expense ratio of 34.1% reported for the year ended December 31, 2006 reflected that underwriting operations only commenced in April 2006 and as such start up costs were high relative to the initial premiums earned.
The combined ratio is the sum of the composite ratio and the internal expense ratio. The combined ratio measures the total profitability of our underwriting operations and does not take net investment income or loss into account. Given the nature of our opportunistic underwriting strategy, we expect that our combined ratio may also be volatile from period to period.
Effective January 1, 2008, we adopted SFAS No. 157. Consistent with SFAS No. 157, our entire investment portfolio, including any derivatives, is valued at fair value and any unrealized gains or losses are reflected in net investment income in the consolidated statements of income. As of December 31, 2008, 84.3% of our investment portfolio (excluding restricted and unrestricted cash and cash equivalents) was comprised of securities valued based on quoted prices in actively traded markets (Level 1), 13.7% comprised of securities valued based on observable inputs other than quoted prices (Level 2) and 2.0% was comprised of securities valued based on non-observable inputs (Level 3).
In determining whether a market for a financial instrument is active or inactive, we obtain information from our investment advisor who makes the determination based on feedback from executing brokers, market makers, and in-house traders to assess the level of market activity and available liquidity for any given financial instrument. Where a financial instrument is valued based on broker quotes, our investment advisor generally requests multiple quotes. The ultimate value is based on an average of the quotes obtained. Broker quoted prices are generally not adjusted in determining the ultimate values and are obtained with the expectation of the quotes being binding. As of December 31, 2008, $82.2 million of our investments in securities were valued based on broker quotes, of which $80.5 million were based on observable market information and classified as level 2, and $1.7 million were based on non-observable inputs and classified as level 3.
Non-observable inputs used by our investment advisor include discounted cash flow models for valuing certain corporate debt securities. In addition, other non-observable inputs include the use of investment manager statements and management estimates based on third party appraisals of underlying assets for valuing private equity investments.
Restricted cash totaled $248.3 million as of December 31, 2008 compared to $371.6 million as of December 31, 2007, a decrease of 33.2%. The decrease in restricted cash was principally due to a decrease in securities sold, not yet purchased since restricted cash balances are used to support the liability created from securities sold, not yet purchased.
Our shareholders’ equity decreased to $485.4 million as of December 31, 2008 from $605.6 million as of December 31, 2007, a decrease of 19.8%. The decrease is principally attributable to the net loss of $120.9 million for the year ended December 31, 2008.
We are organized as a holding company with no operations of our own. As a holding company, we have minimal continuing cash needs, and most of such needs are principally related to the payment of administrative expenses. All of our operations are conducted through our sole reinsurance subsidiary, Greenlight Reinsurance, Ltd., which underwrites risks associated with our property and casualty reinsurance programs. There are restrictions on Greenlight Reinsurance, Ltd.’s ability to pay dividends which are described in more detail below. It is our current policy to retain earnings to support the growth of our business. We currently do not expect to pay dividends on our ordinary shares.
Our sources of funds primarily consist of premium receipts (net of brokerage and ceding commissions) and investment income, including realized gains. We use cash from our operations to pay losses and loss adjustment expenses, profit commissions and general and administrative expenses. Substantially all of our surplus funds, net of funds required for cash liquidity purposes, are invested with our investment advisor to invest in accordance with our investment guidelines. Our investment portfolio is primarily comprised of publicly-traded securities, which we classify as trading securities and can be liquidated to meet current liabilities. We believe that we have sufficient flexibility to liquidate the long securities that we own in a rising market to generate liquidity. Similarly, we can generate liquidity in a declining market from our short portfolio by covering securities and by freeing up restricted cash no longer required for collateral.
As of December 31, 2008, we believe we have sufficient cash flow from operations to meet our foreseeable liquidity requirements. We expect that our operational needs for liquidity will be met by cash, funds generated from underwriting activities and investment income, including realized gains. We have no current plans to issue debt and expect to fund our operations for the next 12 months from operating cash flow. However, we cannot provide assurances that in the future we will not incur indebtedness to implement our business strategy, pay claims or make acquisitions.
Although Greenlight Capital Re is not subject to any significant legal prohibitions on the payment of dividends, Greenlight Re is subject to Cayman Islands regulatory constraints that affect its ability to pay dividends to us and include a minimum net worth requirement. Currently the minimum net worth
requirement for Greenlight Re is $120,000. As of December 31, 2008 Greenlight Re exceeded the minimum required by $488.1 million. By law, Greenlight Re is restricted from paying a dividend if such a dividend would cause its net worth to drop to less than the required minimum.
Greenlight Re is not licensed or admitted as a reinsurer in any jurisdiction other than the Cayman Islands. Because many jurisdictions do not permit domestic insurance companies to take credit on their statutory financial statements unless appropriate measures are in place from reinsurance obtained from unlicensed or non-admitted insurers we anticipate that all of our U.S. clients and some of our non-U.S. clients will require us to provide collateral through funds withheld, trust arrangements, letters of credit or a combination thereof.
In addition, at December 31, 2008, the Company had a $25.0 million letter of credit facility with Butterfield Bank (Cayman) Limited (“Butterfield Bank”). This facility is the result of a novation to Butterfield Bank of a letter of credit facility previously issued by UniCredit Bank Cayman Islands Ltd (formerly Bank Austria Cayman Islands Ltd).
On August 5, 2008, the Board adopted a share repurchase plan authorizing management to repurchase up to two million Class A ordinary shares. Management may from time to time repurchase these shares to optimize our capital structure. Shares may be purchased in the open market or through privately negotiated transactions. The timing of such repurchases and actual number of shares repurchased will depend on a
variety of factors including price, market conditions and applicable regulatory and corporate requirements. The plan, which expires on June 30, 2011, does not require management to repurchase any specific number of shares and may be modified, suspended or terminated at any time without prior notice. As of December 31, 2008, we had repurchased 228,900 shares under the share repurchase plan.
We have been assigned a financial strength rating of ‘‘A− (Excellent)’’ by A.M. Best. This rating reflects the rating agency’s opinion of our financial strength, operating performance and ability to meet obligations. If an independent rating agency downgrades or withdraws our rating, we could be severely limited or prevented from writing any new reinsurance contracts, which would significantly and negatively affect our business. Insurer financial strength ratings are based upon factors relevant to policyholders and are not directed toward the protection of investors. Our rating may be revised or revoked at the sole discretion of the rating agency.
Effective September 1, 2007, we entered into a service agreement with a specialist service provider whereby the specialist service provider provides administration and support in developing and maintaining relationships, reviewing and recommending programs and managing risks on certain specialty lines of business. The specialist service provider does not have any authority to bind the Company to any reinsurance contracts. Under the terms of the agreement, the Company has committed to quarterly payments to the specialist service provider. If the agreement is terminated after two years, the Company is obligated to make minimum payments for another two years to ensure any bound contracts are adequately run-off by the specialist service provider.