The following table sets forth our selected financial data and other financial information as at December 31, 2006, 2005, 2004, 2003 and 2002 and for the years ended December 31, 2006, 2005, 2004, 2003 and 2002. The historical financial information was prepared in accordance with U.S. GAAP. The statement of income data for the periods ended December 31, 2006, 2005, 2004, 2003 and 2002, and the balance sheet data at December 31, 2006, 2005, 2004, 2003 and 2002 were derived from our audited consolidated financial statements, which have been audited by PricewaterhouseCoopers, our independent registered public accounting firm. You should read the selected financial data in conjunction with our consolidated financial statements and related notes thereto contained in Item 8 - “Financial Statements and Supplementary Data” and
Our principal operating subsidiary, Montpelier Re, operates as a Bermuda-based provider of global property and casualty reinsurance and insurance products. We operate in markets where we believe our underwriting expertise and financial strength represent a relative advantage. Our profitability in any given period is based upon our premium and investment revenues less net loss and loss adjustment expenses and operating expenses.
Premiums are a function of the number and type of reinsurance and insurance contracts we write, as well as prevailing market prices. Renewal dates for reinsurance business tends to be concentrated at the beginning of quarters, and the timing of premium written varies by line of business. Most property catastrophe business is written in the January 1, April 1, June 1 and July 1 renewal periods, while the property specialty and other specialty lines are written throughout the year. Written premiums are generally lower during the fourth quarter of the year as compared to prior quarters.
We also write direct insurance and facultative reinsurance coverage on commercial property risks where we assume all or part of a risk under a single insurance contract. We generally write such coverage on an excess of loss basis.
Other Specialty - Reinsurance contracts of aviation liability, aviation war, marine, personal accident catastrophe, workers’ compensation, terrorism, other casualty and other reinsurance business are included in this category. Marine and aviation contracts are primarily written on a retrocessional excess of loss basis. We aim to control our risk by writing predominantly short-tail lines of business. Aviation contracts are primarily written on a retrocessional excess of loss basis. As for terrorism, a limited number of direct risks, reinsurance treaties and national pools are written as well. In 2006 we significantly reduced our catastrophe-exposed offshore marine class of business.
Qualifying Quota Share (“QQS”) - This category represented whole account quota share reinsurance to three Lloyd’s syndicates for the 2002 and 2003 underwriting years, which we have now commuted. We do not anticipate writing any additional QQS contracts at this time.
Loss and loss adjustment expenses are a function of the amount and type of reinsurance and insurance contracts we write and of the loss experience of the underlying risks. Loss and loss adjustment expense reserves include a component for outstanding case reserves for claims which have been reported and a component for losses
General and administrative expenses are comprised of fixed expenses which include salaries and benefits, professional fees, office and risk management expenses, and variable expenses which include costs related to our performance unit plan, bonuses and stock option plan. Other than bonuses and expenses related to the Long-Term Incentive Plan, expenses are primarily fixed in nature and do not vary with the amount of premiums written or losses incurred.
We utilize a reserving methodology that calculates a point estimate for our ultimate losses. The point estimate represents management’s best estimate of ultimate loss and loss adjustment expenses. Our internal actuaries review our reserving assumptions and our methodologies on a quarterly basis. Our third quarter and year-end loss estimates
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 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.
While the approach we use in reserving for large events is generally consistent for large events, at any point in time the particular reserving assumptions applied to an individual contract may vary. The assumptions for a specific contract may depend upon the class of business, historical reporting patterns of the cedant, whether or not the cedant provides an IBNR estimate, how much of the loss has been paid, the number of underlying claims still open, and other factors. For example, the expected loss development for a contract with 1% of claims still outstanding would likely be less than for a contract with 50% of claims still open.
As predominantly a broker market reinsurer for both excess of loss and proportional contracts, we must rely on loss information reported to brokers by primary insurers who, in turn, must estimate their own losses at the policy level, often based on incomplete and changing information. The information we receive varies by cedant and may include paid losses, estimated case reserves, and, infrequently, an estimated provision for IBNR reserves. Reserving practices and the quality of data reporting varies among ceding companies, which adds further uncertainty to the estimation of our ultimate losses. The nature and extent of information received from ceding companies also varies widely depending on the type of coverage, the contractual reporting terms (which are affected by market conditions and practices) and other factors. Due to the lack of standardization of the terms and conditions of reinsurance contracts, the wide variability of coverage provided to individual clients and the tendency of those coverages to change rapidly in response to market conditions, the ongoing economic impact of such uncertainties and inconsistencies cannot be reliably measured. Additional risks to us involved in the reporting of retrocessional contracts include varying reserving methodologies used by the original cedants and an additional reporting lag due to the time required for the retrocedant to aggregate its assumed losses before reporting them to us. Furthermore, the number of contractual intermediaries is generally greater for retrocessional business than for direct business, thereby increasing the time lag and imprecision associated with loss reporting.
Time lags are inherent in reporting to the primary insurer then to the broker and then to the reinsurer, especially in the case of excess of loss reinsurance contracts. Also, the combined characteristics of low claim frequency and high claim severity make the available data more volatile and less useful for predicting ultimate losses. In the case of proportional contracts, we rely on an analysis of a contract’s historical experience, industry information, and the professional judgment of underwriters in estimating reserves for these contracts. In addition, if available, we utilize ultimate loss ratio forecasts when reported by cedants, which are normally subject to a quarterly or six month lag for proportional business. Because of the degree of reliance that we necessarily place on ceding companies for claims reporting, our reserve estimates are highly dependent on management judgment. Furthermore, during the loss settlement period, which may be several years in duration, additional facts regarding individual claims and trends often will become known, and current laws and case law may change, all of which can affect ultimate expected losses.
The nature and extent of loss information provided under many facultative and per occurrence excess contracts, where company personnel work closely with the ceding company in settling individual claims, may not differ significantly from the information received under a primary insurance contract. Loss information from aggregate excess of loss contracts, including catastrophe losses and proportional share treaties, will often be less detailed. Occasionally, such information is reported in summary format rather than on an individual claim basis.
Estimating loss reserves for our small book of longer-tail casualty reinsurance business, which can be either on an excess of loss or proportional basis, involves further uncertainties. In addition to the uncertainties inherent in the reserving process described above, casualty business can be subject to longer reporting lags than property business, and claims often take many years to settle. During this period, additional factors and trends will be revealed and as these factors become apparent we will adjust our reserves. There is also the potential for the emergence of new types of losses within the casualty book. Any factors that extend the time until claims are settled add uncertainty to the reserving process. At December 31, 2006, management has estimated gross loss and loss adjustment expense reserves related to our casualty business of $156.6 million.
We do not expect to experience significant claims processing backlogs. Following a major catastrophic event, claims processing backlogs may occur. At December 31, 2006, we did not have a significant backlog in either our insurance or reinsurance claims processing.
The uncertainties inherent in the reserving process, together with the potential for unforeseen developments, including changes in laws and the prevailing interpretation of policy terms, may result in loss and loss adjustment expenses significantly greater or less than the reserves initially established. Changes to our prior year loss reserves will impact our current underwriting results by improving our results if the prior year reserves prove to be redundant or reducing our results if the prior year reserves prove to be insufficient. For additional discussion on development of loss and loss adjustment expense reserves related to prior years see “- Results of Operations - Loss and Loss Adjustment Expenses” below. We expect volatility in our results in periods that significant loss events occur because U.S. GAAP does not permit insurers or reinsurers to reserve for loss events until they have occurred and are expected to give rise to a claim. As a result, we are not allowed to record contingency reserves to account for expected future losses. We anticipate that claims arising from future events will require the establishment of substantial reserves from time to time.
Management believes that the reserves for loss and loss adjustment expenses are sufficient to cover losses that fall within the terms of our policies and agreements with our insured and reinsured customers on the basis of the methodologies used to estimate those reserves. However, there can be no assurance that actual losses will not exceed our total reserves. Any adjustments for reserves are reflected in income in the period in which they become known.
Management has determined that the best estimate for gross loss and loss adjustment expense reserves at December 31, 2006 and 2005 was $1,089.2 million and $1,781.9 million, respectively. Of this estimate $66.7 million relates to our insurance business and $1,022.5 million relates to our reinsurance business.
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 loss adjustment expense reserves. As discussed above, due to the
Premiums. Though we are principally a provider of reinsurance, we write both insurance and reinsurance contracts. Our insurance premium is all written on an excess of loss basis. 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 all insurance business, the deposit premium is defined in the contract wording. The deposit premium is based on the ceding companies’ estimated premiums, and this estimate is the amount we record as written premium in the period the underlying risks incept. In the majority of cases, these contracts are adjustable at the end of the contract period to reflect the changes in underlying risks 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 are normally reported within six months to one year subsequent to the expiration of the policy. To date these adjustments have not been significant.
Generally, on pro-rata contracts and certain excess of loss contracts where the deposit premium is not specified in the contract, an estimate of written premium is recorded in the period in which the underlying risks incept. The premium estimate is based on information provided by ceding companies. At the inception of the contract the ceding company estimates how much premium they expect to write during the year. Our gross written premium related to pro-rata contracts is a function of the amount of premium they estimate they will write. When the actual premium is reported by the ceding company, which may be on a quarterly or six month lag, it may be significantly higher or lower than the estimate.
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, as well as a continuing assessment of relevant economic conditions. Any adjustments to
Excess of loss contracts can include contract terms that require the mandatory reinstatement of coverage. Generally, reinstatement premiums assumed and ceded are a fixed percentage (normally 100%) of the original premium amount assumed or ceded by us and are triggered by our losses exceeding the aggregate loss limit provided in the contract. In a year of large individual losses, reinstatement premiums will be higher than in a year in which there are no such large loss events. Reinstatement premiums are fully earned or expensed as applicable when a triggering loss event occurs and losses are recorded. We accrue reinstatement premiums based on case reserves reported by ceding companies and on management’s best estimate of IBNR reserves as described above under “Loss and Loss Adjustment Expense Reserves” when the IBNR reserves can be identified on an individual contract basis. Generally pro-rata contracts do not contain provisions for the reinstatement of coverage.
Management includes an assessment of the creditworthiness of cedants in the review process above, primarily based on market knowledge, the timeliness of cedants’ past payments and the status of current balances owing. In addition, management may also review the financial statements of ceding companies. Based on this assessment, management believes that as at December 31, 2006 no provision for doubtful accounts is necessary.
For pro-rata contracts where the expected risk period is 12 months and for excess of loss contracts, other than risk attaching contracts or contracts where the deposit premium is not defined, premium income is generally earned ratably over the term of the reinsurance contract, usually 12 months. For all other contracts, comprising contracts written on a pro-rata or risks attaching basis, premiums are generally earned over a 24 month period which is the risk period of the underlying (12 month) policies. The portion of the premium related to the unexpired portion of the policy at the end of any reporting period is reflected on the balance sheet in unearned premium.
Reinsurance Ceded. All of our reinsurance purchases to date have represented prospective cover; that is, our ceded reinsurance has been purchased to protect us against the risk of future losses as opposed to covering losses that have already occurred but have not been 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.
The cost of quota share reinsurance is initially based on our estimated gross premium written related to the specific lines of business covered by the reinsurance. As we write gross premiums during the period of coverage, reinsurance premiums ceded are adjusted similarly according to the terms of the quota share agreement.
In addition, we have entered into a derivative transaction which provides reinsurance-like protection. As the coverage responds to parametric triggers, whereby payment amounts are determined on the basis of modeled losses incurred by a notional portfolio rather than by actual losses we incur, this transaction is accounted for as a weather derivative in accordance with the guidance in EITF 99-2 and not as a reinsurance transaction.
Montpelier Long-Term Incentive Plan (“LTIP”). The LTIP was approved at the Company’s 2004 Annual General Meeting of Shareholders and became effective as of January 1, 2005. At the discretion of the Compensation and Nominating Committee of Board of Directors (the “Committee”). incentive awards, the value of which is based on the Company’s Common Shares, may be made to all eligible plan participants. The Compensation and Nominating Committee has sole discretion regarding the payout level of the incentive awards.
Incentive awards that may be granted under the LTIP consist of share appreciation rights (“SARs”), restricted share units (“RSUs”) and performance shares (“Performance Shares”). Each type of award gives a plan participant the right to receive a payment in cash, common shares or a combination thereof, including in the case of RSUs dividend equivalents at the discretion of the Committee.
For the 2005-2007 and 2006-2008 performance periods, the primary performance target for all participants for a 100% harvest ratio of Performance Shares 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.
Under the LTIP for the 2005-2007 performance period, the Committee granted Performance Share awards only to plan participants and no awards of SARs or RSUs were made. The total number of Performance Share awards outstanding under the LTIP related to this performance period at December 31, 2006 was 400,000 (or up to 800,000 common shares should the maximum harvest of 200% of awards for the 2005-2007 performance period apply). Due to the impact of the natural catastrophes which occurred during the third quarter of 2005 on our results, the estimated harvest ratio for this performance period is 0% and, therefore, it is expected that there will be no payout related to this performance period.
In 2006 we generally saw significant price increases in U.S. peak property zones, particularly on business exposed to hurricanes and earthquakes. These increases were a result of the catastrophic hurricanes that occurred in 2004 and 2005. The attendant large industry losses led to an increase in the perception of catastrophe risk by market participants creating a supply/demand imbalance.
Outside of property business in U.S. peak zones, including both casualty lines and non-peak property business, we observed less favorable pricing trends during 2006. There was a mix of upward price movement as well as price decreases. In 2007, we expect to see adverse pricing trends in virtually all reinsurance and insurance markets. We expect this will be driven by a surplus of reinsurance capacity available which will likely put downward pressure on rates. We expect this to occur not only in property lines, but also casualty lines as competitors look to achieve diversification.
In addition, we also expect a decrease in demand and more competitive rates specific to property exposed lines in Florida as a result of recent legislation in that state. This may also have an adverse impact on pricing outside of Florida.
The low level of catastrophes that occurred during 2006 which resulted in a $1,338.1 million decrease in loss and loss adjustment expenses in 2006 as compared to 2005; and
A significant increase in net investment income of $38.7 million over 2005.
A decrease in net premiums earned mainly as a result of the reduction in gross premiums written and an increase in reinsurance premiums ceded earned;
An increase in incentive compensation over 2005 as a result of the increase in our net income during 2006; and
An increase in financing and other operating expenses due interest paid on the junior subordinated debt securities and contract payments related to the catastrophe bond.
The decrease in net income of $993.2 million for the year ended December 31, 2005 year compared to 2004 was principally driven by net losses incurred related to the 2005 U.S. hurricanes, the effects of which far exceeded the 2004 hurricanes. The overall net loss for the year ended December 31, 2005 was $752.9 million. The main factors driving this decrease were:
Hurricanes Katrina, Rita and Wilma, which resulted in $1,202.8 million of net losses incurred at December 31, 2005 compared to net losses incurred related to the 2004 hurricanes for the year ended December 31, 2004 of $261.6 million;
An increase in reinstatement premium written as a result of the 2005 hurricanes;
Based on total shareholders’ equity divided by basic shares outstanding, excluding the common shares issued and outstanding under the share issuance agreement discussed in the Capital Resources section below.
Fully converted book value per share at December 31, 2006 is based on total shareholders’ equity divided by common shares outstanding of 111,775,682 less 15,694,800 common shares subject to the share issuance agreement entered into in connection with, and contemporaneously with, the forward sale agreements discussed in the Capital Resources section below, plus common shares issuable upon conversion of outstanding share equivalents of 473,771 at December 31, 2006. At December 31, 2005, fully converted book value per share is based on total shareholders’ equity divided by common shares outstanding of 89,178,490 plus common shares issuable upon conversion of outstanding share equivalents of 9,170. At December 31, 2004 fully converted book value per share is based on total shareholders’ equity plus the assumed proceeds from the exercise of outstanding options and warrants of $157.5 million divided by the sum of shares, options and outstanding warrants (assuming their exercise) of 71,372,892. Warrants outstanding at December 31, 2006 and 2005 are not included as the exercise price of $16.67 per common share is greater than book value per share.
We ended 2006 with a fully converted book value per share (as defined above) of $15.46, an increase of $3.60 from December 31, 2005. The internal rate of return of the change in fully converted book value per share from December 31, 2005 to December 31, 2006 after giving effect to the dividends of $0.30 per common share and warrant, was 33.2%. This calculation excludes 15,694,800 common shares subject to the share issuance agreement entered into in connection with, and contemporaneously with, the forward sale agreements discussed in the Capital Resources section below. For these purposes, fully converted book value per share assumes that the warrants are not exercised if the book value per share is less than the strike price. We believe that this measure most accurately reflects the return made by our shareholders as it takes into account the effect of dilutive securities and dividends.
A summary of the significant components of our revenues and expenses by segment is as follows for the years ended December 31, ($ in millions):
Relates to the Rated Reinsurance and Insurance Business reporting segment only.
Gross premiums written during the year ended December 31, 2006 decreased by 25.7% as compared to 2005, mainly as a result of the following factors:
A substantially lower amount of reinstatement premium recorded during the year ended December 31, 2006 as compared to 2005 due to the lack of natural catastrophes which occurred during 2006 compared to 2005;
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; and
the non-renewal of certain large excess of loss and proportional contracts.
For the years ended December 31, 2006 and 2005, casualty business represented approximately 7.8% and 9.0% of our gross premiums written. Casualty business written decreased for the year ended December 31, 2006 as compared to 2005 mainly due to the cancellation of the U.K. employers’ liability business contract with Aspen affiliates noted above. Casualty business includes medical malpractice, specialized errors and omissions business, U.K. employer’s liability and public liability and catastrophe and/or clash layers for general liability and retrocessional accounts, predominantly on an excess of loss basis. We have not written any U.K. employers’ liability business in 2006.
In 2006, reinstatement premium assumed represented 8.0% of gross losses incurred, compared with 7.1% and 4.9% in 2005 and 2004, respectively.
During 2005 and 2006 we commuted all of the 2002 and 2003 underwriting year QQS contracts.
Looking ahead to future periods, it still remains difficult to predict the amount of premiums we will write. Various factors will continue to affect our appetite and capacity to write risk. These include the impact of increasing 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. In addition, the mix of business will significantly affect our ultimate premium volume. For example, as noted above, we have replaced some proportional business and used that capacity to write excess of loss protections, which generate less premium per dollar of risk but add a higher expected profit margin. We do, however, expect a decrease in demand and more competitive pricing due to recent legislation in Florida, which is expected to negatively impact a portion of our business. The level of reinstatement premiums written in future periods will also be dependant upon the volume of catastrophes that occur.
In 2006, reinstatement premium ceded represented 17.0% of loss recoveries, compared with 17.1% and 21.9% in 2005 and 2004, respectively.
As a result of the impact of catastrophes in 2005, traditional reinsurance markets provided a decreased level of catastrophe retrocessional capacity in 2006, particularly in peak exposure zones. As supply contracted and prices increased, the remaining traditional markets and certain non-traditional markets, such as hedge funds and investment banks, increasingly endeavored to provide protection through ILWs, under which the cedant’s prospect of recovery is based on the size of the market loss, as opposed to being solely tied to a cedant’s own ultimate net loss (“UNL”) in the case of a traditional reinsurance contract. Therefore, ILWs require less underwriting due diligence and also leave the risk of incurring a disproportionately large share of an industry loss with the buyer of protection. For these reasons, ILWs are often more attractively priced from the ceding company’s perspective than UNL covers. The availability of traditional reinsurance and ILW reinsurance is a function of market capacity, which is in turn a function of the perceived returns that retrocessional providers expect to earn, and their appetite and capacity for assuming risk. The catastrophe losses in 2005 caused a degree of retrenchment by traditional markets and the advent of new capital and risk-bearing financial structures.
We did not cede any reinsurance premiums related to the Collateralized Property Catastrophe Retrocession reporting segment for the year ended December 31, 2006.
Excluding reinstatement premium ceded related to catastrophes which may occur during 2007, we anticipate that reinsurance premiums ceded written for 2007 will be lower than in 2006.
For the years ended December 31, 2005 and 2004, we purchased reinsurance protecting our direct and assumed reinsurance portfolio against large risk losses on our direct and facultative book and certain catastrophes on our overall property writings. In addition, in 2005 we also purchased additional catastrophe and sabotage and terrorism retrocessional protection and specific retrocessional coverage on certain contracts during 2005. We also ceded property catastrophe reinsurance to Rockridge as discussed above in the amount of approximately $6.6 million during the year ended December 31, 2005 with no comparable amount in 2004. During 2005 we purchased Industry Loss Warranty (“ILWs”) reinsurance protection and quota share protection on our property catastrophe excess of loss book. In 2005 reinsurance premiums ceded increased by approximately $98.5 million due to additional reinstatement premium related to Hurricane Wilma and the purchase of additional ILWs and quota share reinsurance to protect the fourth quarter of 2005 and for the 2006 year. The impact on net earned premium of these purchases was approximately $17.6 million, with the remaining $80.9 million relating to pre-purchases for the 2006 year. These reinsurance purchases were principally designed to reduce our net exposure to large catastrophes.
The decrease in gross premiums earned was largely due to the lack of natural catastrophes during 2006. This resulted in a lower level of loss activity and a lower level of reinstatement premium written and earned in 2006 as compared to 2005. In addition, the expiration of our agreements with Aspen affiliates also contributed to the decrease in gross premiums earned. Reinsurance premiums ceded earned increased mainly as a result of the earning effect of quota share reinsurance purchased during the fourth quarter of 2005 to protect the 2005 underwriting year in-force book of business.
For comparative purposes, our combined ratio and components thereof are set out below for the years indicated:
Net loss and loss adjustment expenses were $172.6 million, $1,510.7 million and $404.8 million for the years ended December 31, 2006, 2005 and 2004, respectively. Reinsurance recoveries of $31.3 million, $318.6 million and $88.5 million were netted against loss and loss adjustment expenses for the years ended December 31, 2006,
2005 and 2004, respectively. The majority of the reinsurance recoveries for all three years related to the U.S. hurricanes which occurred during 2004 and 2005. We paid net losses of $756.9 million, $489.3 million and $192.0 million for the years ended December 31, 2006, 2005 and 2004, respectively. The majority of the paid losses in 2006 and 2005 related to claims from the hurricane losses as discussed above. In addition, excluding the catastrophes, net paid losses have increased each year as our book of business has matured and we make claim payments related to multiple underwriting years. We expect that our paid losses from the 2005 and 2004 catastrophes will begin to decrease in next 12 months as the majority of claims will have been paid. At December 31, 2006, approximately 57.1% of our gross reserves related to the five 2005 catastrophes mentioned above.
Because we stopped writing QQS business in 2004 earned premium for these periods is minimal and as a consequence, the net loss ratio is no longer a meaningful measurement for this category.
We did not record any loss and loss adjustment expenses related to the Collateralized Property Catastrophe Retrocessional Business for the year ended December 31, 2006.
The following tables set forth a reconciliation of our gross and net loss and loss adjustment expense reserves by line of business for the year ended December 31, 2006 ($ in millions):
The 2006, 2005 and 2004 years include approximately $23.8 million, $17.1 million and $97.6 million, respectively, of favorable development of net losses from prior years. Favorable prior year development benefited the net loss ratio for the years ended December 31, 2006, 2005 and 2004 by approximately 4.1%, 2.0% and 12.4%, respectively.
In the Property Specialty category, our gross estimated ultimate losses for prior years decreased by $9.6 million while our net estimated ultimate losses decreased by $30.6 million during the year ended December 31, 2006. Gross loss estimates for the 2005 hurricanes increased by $15.8 million during the year for Property Specialty. However estimated ceded losses for the hurricanes increased by $22.5 million, so on a net basis there was favorable development of $6.7 million from the hurricanes. Most of the improvement on the remainder of the Property Specialty prior year losses was on our proportional book of business. The losses for this business developed less than we had projected at the end of 2005.
Property Catastrophe gross ultimate losses as at December 31, 2005 increased by $37.8 million during the year ended December 31, 2006 and net ultimate losses increased by $30.2 million during that period. The increase in ultimate losses for the year was principally driven by changes in our estimated ultimate loss for Wilma. In particular, the projected gross losses on our assumed retrocessional business for Hurricane Wilma increased by $37.8 million as the estimated total industry losses increased during the year. For Hurricanes Katrina and Rita, we experienced some smaller increases in our retrocessional business losses partially offset by decreases in our Property Catastrophe losses.
Other Specialty gross ultimate losses decreased by $24.5 million during the year ended December 31, 2006 while net losses decreased by $19.9 million during the year. A significant portion of this improvement was related to commutations of a related group of contracts. Approximately $6.1 million of the realized benefit was due to the fact that the loss reserves were held on an undiscounted basis and on commutation a discount was applied. As this business has matured, we have given more weight to the actual loss experience compared to the initial expected loss ratios in our reserving process. The low level of loss development experienced during the year resulted in reduced projections for prior accident years and lower selected net loss ratios.
Favorable development during the year ended December 31, 2005 of losses incurred during prior accident years amounted to $17.1 million. This favorable development resulted primarily from an increase in ceded losses attributable to the 2004 hurricanes in the Property Specialty category and lower than expected claim frequency in the Other Specialty category. These reductions were partially offset by increases in estimated ultimate losses in the Property Catastrophe category associated with the 2004 hurricanes and Typhoon Songda.
We did not make any significant changes in the assumptions or methodology used in our reserving process during the year ended December 31, 2006.
At December 31, 2006, we estimated our gross and net reserves for loss and loss adjustment expenses using the methodology as outlined in our Summary of Critical Accounting Estimates earlier in this section.
Management has determined that the best estimate for gross loss and loss adjustment expense reserves at December 31, 2006, 2005 and 2004 was $1,089.2 million, $1,781.9 million and $549.5 million, respectively.
The Collateralized Property Catastrophe Retrocessional segment incurred $5.4 million in acquisition costs and $16.1 million in general and administrative expenses for the year ended December 31, 2006 which are included above.
Total general and administrative expenses have increased for 2006 as compared to 2005, principally due to the reversal of current and deferred incentive compensation accruals during 2005 as a result of the 2005 hurricanes. This reversal is also the reason for the decline in general and administrative expenses in 2005 as compared to 2004.
Current and deferred incentive compensation also includes the expense of Performance Shares issued under the LTIP. For 2006, the LTIP Performance Shares expense relates to the 2006-2008 period only because during the
During the first quarter of 2005, all outstanding share options were converted into restricted and unrestricted common voting shares. There have been no share options outstanding during 2006.
A portion of investment management fees incurred related to White Mountains Advisors LLC, a wholly-owned indirect subsidiary of White Mountains Insurance Group, one of our founding members and formerly a major shareholder. These fees were $2.1 million, $2.9 million and $2.4 million for the years ended December 31, 2006, 2005 and 2004, respectively. The fees for White Mountains Advisors LLC have declined for the 2006 period as compared to 2005 as we have engaged other investment managers to manage certain aspects of our investment portfolio. Overall, investment management fees are higher for 2006 as compared to 2005 and also to 2004 due to the greater average size of the portfolio under management and the mix of investments during the period. The fees will vary as our mix of investments changes. Management believes that the fees charged were consistent with those that would have been charged by an unrelated party.
Based on the weighted average monthly investments held, and including net unrealized gains (losses), and foreign exchange gains (losses) on investments, the total investment returns were as follows:
In 2005, our investment return decreased compared with the same period in 2004. This was principally a result of the overall market movement in bond prices during each respective period. In addition, the level of the investment portfolio and related investment income was affected by the special dividend we declared on February 25, 2005 of $387.7 million.
Because we provide short-tail reinsurance and insurance coverage for losses resulting mainly from natural and man-made catastrophes, we could become liable to pay substantial claims on short notice. Accordingly, we have structured our investment portfolio to preserve capital and provide us with a high level of liquidity, which means that the large majority of our investment portfolio contains shorter term fixed maturity investments, such as U.S. government and agency bonds, U.S. government-sponsored enterprises, corporate debt securities and mortgage-backed and asset-backed securities. However, we do invest in equities to a degree as we believe the returns will be higher over time.
We paid interest expense related to the Senior Notes during each of the years ended December 31, 2006, 2005 and 2004 of $15.4 million. This amount is the same for all periods as the Senior Notes bear a fixed interest rate of 6.125%.
In June 2006, the Company entered into a $100.0 million Catastrophe Bond Total Rate of Return Swap Facility (the “Facility”) with Bank of America. Under FAS 133 “Accounting for Derivative Instruments and Hedging Activities”, Facility transactions are accounted for as derivative transactions. Under the Facility, the Company receives contract payments in return for assuming mark-to-market risk on a portfolio of securitized catastrophe risks. The quarterly net contract payments are included in other income. The difference between the notional capital amounts of the cat bonds and their market values will be marked to market as realized investment gains/losses over the terms of the swap agreements. The Company’s exposure under the Facility is collateralized by a lien over a portfolio of the Company’s investment grade securities which equals the amount of the facility utilized, after adjustments for credit quality. As at December 31, 2006, the Company had entered into seven cat bond total rate of return swap transactions with a combined notional capital amount of $48.7 million.
Contract payments expensed in relation to the fully-collateralized counterparty agreement with Champlain Limited are calculated at 12.75% plus 8 basis points per annum on the first tranche and 13.5% plus 8 basis points on the second tranche and are payable quarterly. The set-up fees above are non-recurring.
During the year ended December 31, 2005 net realized gains from the sale of available-for sale fixed maturities and equity investments included $44.5 million in realized gains from the sales of Aspen shares.
$75.0 million of debt in November 2006. Our contractual obligations and commitments are set out below as at December 31, 2006.
On January 6, 2006, we participated in a private placement of $100.0 million of floating rate capital securities (the “Trust Preferred Securities”) issued by Montpelier Capital Trust III. The Trust Preferred Securities mature on March 30, 2036, are redeemable at our option at par beginning March 30, 2011, and require quarterly distributions of interest by Montpelier Capital Trust III to the holders of the Trust Preferred Securities. Distributions of interest will be payable at 8.55% per annum through March 30, 2011, and thereafter at a floating rate of 3-month LIBOR plus 380 basis points, reset quarterly. Montpelier Capital Trust III simultaneously issued 3,093 of its common securities to us for a purchase price of $3.1 million, which constitutes all of the issued and outstanding common securities of Montpelier Capital Trust III. Our investment of $3.1 million in the common shares of Montpelier Capital Trust III is recorded in other investments in the consolidated balance sheet.
On November 29, 2006, Blue Ocean obtained a secured long-term loan from a syndicate of lenders. The loan has an initial maturity date of February 28, 2008, however, Blue Ocean may extend the maturity date up to August 29, 2008. The loan bears interest on the outstanding principal amount at a rate equal to a base rate plus a margin of 200 basis points, which may be increased to 400 basis points, depending on certain conditions.
Effective December 30, 2005, we purchased fully-collateralized coverage for losses sustained from qualifying hurricane and earthquake loss events. We acquired this protection from Champlain Limited, a Cayman Islands special purpose vehicle, which financed this coverage through the issuance of $90 million in catastrophe bonds to investors under two separate bond tranches, each of which matures on January 7, 2009. The first $75 million tranche covers large earthquakes affecting Japan and/or the U.S. The remaining $15 million coverage provides second event coverage for a U.S. hurricane or earthquake. Both tranches respond to parametric triggers, whereby payment amounts are determined on the basis of modeled losses incurred by a notional portfolio rather than by actual losses incurred by us. For this reason, this cover is accounted for as a weather derivative, rather than a reinsurance transaction. Paragraph 10 (e) of FAS 133 exempts weather derivatives from the fair value requirements of that Statement. For accounting guidance, we followed the provisions of EITF Abstract 99-2, “Accounting for Weather Derivatives,” which addresses non- exchange traded contracts indexed to climatic or geological variables. This abstract specifies that weather derivatives should be accounted for at fair value if these contracts are “entered into under trading or speculative activities.” As we entered into the transactions to mitigate our exposure to assumed reinsurance losses rather than for trading activity, the weather derivatives have been measured by applying the “intrinsic value method” as required by the Abstract. Our application of this method results in a $nil value adjustment in the absence of an industry loss event triggering recovery. Should an industry loss event triggering a recovery occur, our application of the intrinsic value method results in the present value of the expected ultimate recovery being recorded. Contract payments in relation to the catastrophe bond are calculated at 12.75% plus 8 basis points per annum on the coverage provided by the first tranche and 13.5% plus 8 basis points on the coverage provided by the second tranche. These costs are expensed as they are incurred and are included in other operating expenses.
On May 25, 2006 we entered into a Purchase Agreement with WLR Recovery Fund, II, L.P. and WLR Recovery Fund III, L.P. for a private sale of 6,896,552 common shares at a price of $14.50 per common share. The first $50.0 million purchase of 3,448,276 common shares closed on June 1, 2006 and the second purchase of 3,448,276 common shares closed on June 28, 2006. The net proceeds after deducting estimated offering expenses of $0.8 million was approximately $99.2 million, which was used for general corporate purposes.
On May 31, 2006, we entered into two equity forward sale agreements under which we will sell (subject to the Company’s right to cash settle or net share settle such agreements) an aggregate of between 9,796,388 and 15,694,800 common shares to an affiliate of Credit Suisse Securities (USA) LLC (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).
On May 31, 2006, the forward counterparty sold 6,800,000 common shares in a public offering at $15.05 per share in order to hedge its position under the forward sale agreements. Subsequent to such initial sale, in connection with the forward sale agreements, the forward counterparty has sold a total of 8,894,800 additional common shares.
Each forward sale agreement is composed of twenty equal components. Subject to our right (a) in the case of the first forward sale agreement, to elect physical, cash, modified physical or net share settlement with respect to all of or a portion of all of the components of such forward sale agreement or (b) in the case of the second forward sale agreement, to elect cash or net share settlement with respect to all of or a portion of all of the components of either forward sale agreement, or in the case of either forward sale agreement, to terminate early, or accelerate settlement of any component of such forward sale agreement, (x) the first forward sale agreement will be subject to physical settlement and (y) the second forward sale agreement will be subject to physical settlement (if the closing price of our common shares on the valuation date for the relevant component is less than or equal to $19.465 per share), modified physical settlement (if the closing price of our common shares on the valuation date for the relevant component is less than or equal to $23.465 per share) or a combination thereof in the proportions set forth in such forward sale agreement (if the closing price of our common shares on the valuation date for the relevant component is greater than $19.465 per share and less than $23.465 per share), by issuance of the requisite number of our common shares,over a twenty business day period beginning March 8, 2007 (in the case of the first forward sale agreement) and March 6, 2008 (in the case of the second forward sale agreement), with each day in each such period relating to a single component.
Upon full physical settlement of any component of a forward sale agreement, we will issue to the forward counterparty a number of common shares equal to:
and, assuming we have not previously elected prepayment with respect to such component (or have subsequently repaid such prepayment), the forward counterparty will pay us an amount of cash equal to the forward floor price, multiplied by the number of common shares underlying such component.
Upon modified physical settlement of any component of the second forward sale agreement, we will issue to the forward counterparty 388,740 common shares (the maximum number of shares underlying such component) and the forward counterparty will pay us an amount of cash equal to:
if such volume-weighted average price is greater than the forward floor price but less than the forward cap price, such volume-weighted average price multiplied by the maximum number of shares underlying such component; and
In connection with, and at the same time as, entering into the forward sale agreement described above, we also entered into a share issuance agreement, dated May 31, 2006, with the forward counterparty under which we may issue, for payment of the par value thereof, to the forward counterparty up to 15,694,800 common shares, subject to our right to repurchase for cancellation an equal number of common shares for nominal consideration.
share as the proceeds received per share would exceed the book value per share, the transactions have been excluded from this calculation.
As neither Montpelier Re nor Blue Ocean Re is an admitted insurer or reinsurer in the U.S., the terms of certain U.S. insurance and reinsurance contracts require Montpelier Re and Blue Ocean Re to provide letters of credit to clients.
The following table details the Company’s, Montpelier Re’s and Blue Ocean Re’s letter of credit facilities as at December 31, 2006 (in thousands):
Effective November 15, 2005, Montpelier Re entered into a Standing Agreement for Letters of Credit with The Bank of New York for the provision of a letter of credit facility in favor of U.S. ceding companies (“Bilateral Facility A”). The agreement allows Montpelier Re to request the issuance of up to $100.0 million in letters of credit.
Effective January 10, 2006, Blue Ocean Re entered into a Standing Agreement for Letters of Credit with the Bank of New York for the provision of a letter of credit facility for the account of Blue Ocean Re in an amount up to $75.0 million. The facility was revised on May 15, 2006 to $250.0 million. Letters of credit issued under this facility are secured by cash and investments pledged to The Bank of New York. If Blue Ocean Re fails to maintain sufficient collateral, and in certain other circumstances, the lenders could declare a default and begin exercising remedies against the collateral and Blue Ocean Re would not be able to request the issuance of additional letters of credit under this facility.
We expect these letter of credit facilities to be sufficient to support Montpelier Re’s and Blue Ocean Re’s estimated obligations for the next 12 months in the absence of another very major catastrophe.
The following are Montpelier Re’s current financial strength ratings from internationally recognized rating agencies:
Our ability to underwrite business is dependent upon the quality of our claims paying and financial strength ratings as evaluated by independent rating agencies. On December 15, 2006, A.M. Best changed our outlook from negative to stable. In the event that we are downgraded below A- by Standard & Poor’s or A.M. Best, we believe our ability to write business would be adversely affected. In the normal course of business, we evaluate our capital needs to support the volume of business written in order to maintain our claims paying and financial strength ratings. We regularly provide financial information to rating agencies to both maintain and enhance existing ratings.
A downgrade of our A.M. Best financial strength rating below B++ would constitute an event of default under our letter of credit and revolving credit facility with Bank of America, N.A. and a downgrade by A.M. Best or Standard & Poor’s could trigger provisions allowing some cedants to opt to cancel their reinsurance contracts with us. Either of these events could reduce our financial flexibility.
described above, we are not party to any other off-balance sheet transaction, agreement or other contractual arrangement to which an entity unconsolidated with us is a party that management believes is reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that we believe is material to investors.
The table below shows the aggregate amounts of investments comprising our portfolio of invested assets:
Substantially all of the fixed maturity investments we currently hold were publicly traded at December 31, 2006. Based on the weighted average monthly investments held, and including net unrealized gains (losses), foreign exchange gains (losses) on investments and the foreign exchange effect of insurance balances, our total return for the year ended December 31, 2006 was 6.7%. The average duration of our fixed maturity portfolio was 1.4 years and the average rating of the portfolio was AA+ at December 31, 2006. If the right conditions arise in 2006, we may deploy further capital in strategic investments or investment classes other than existing classes. We are currently considering the early adoption of certain accounting pronouncements that would result in the reclassification of our fixed maturity and equity investments from available for sale to trading.
On August 2, 2004, we invested an aggregate of $20.0 million as part of an investor group, which included one of our major shareholders, acquiring the life and investments business of Safeco Corporation (since renamed Symetra Financial Corporation), pursuant to a Stock Purchase Agreement. Symetra is an unquoted investment and is carried at estimated fair value at December 31, 2006 of $23.9 million based on reported net asset values and other information available to management, with the unrealized gain included in accumulated other comprehensive income.
Cash is used primarily to pay loss and loss adjustment expenses, brokerage commissions, excise taxes, general and administrative expenses, to purchase new investments, to pay dividends, to pay for any premiums retroceded and to pay for future authorized share repurchases.
In addition to relying on premiums received and investment income from our investment portfolio, we intend to meet these cash flow demands by carrying a substantial amount of short and medium term investments that would mature, or possibly be sold, prior to the settlement of our expected liabilities. We cannot assure you, however, that we will successfully match the structure of our investments with our liabilities. If our calculations with respect to liabilities are incorrect, or if we improperly structure our investments, we could be forced to liquidate investments prior to maturity, potentially at a significant loss. At this point we do not anticipate liquidating any investments prior to maturity.
The estimated fair value of fixed maturity, equity, other investments and cash and cash equivalents balance was $3,086.3 million as of December 31, 2006, compared to $2,902.3 million at December 31, 2005. The primary cause of this increase was as a result of the receipt of $602.9 million in premiums net of acquisition costs, the net proceeds of $99.5 million from the issuance of junior subordinated debt securities related to our trust preferred securities, the net proceeds of $99.1 million from the issuance of 6,896,552 common shares and net investment income of $125.8 million, offset by the payment of dividends of $30.0 million, the payment of net claims of $756.9 million and the increase in net unrealized gains on investments of $58.5 million. Included in cash and cash equivalents and fixed maturities is $159.9 million and $340.4 million, respectively, related to Blue Ocean.
For the period from inception until December 31, 2006, we have had sufficient resources to meet our liquidity requirements. To the extent that capital is not utilized in our reinsurance or insurance operations we have used such capital to invest in new opportunities and returned capital to shareholders in the form of dividends or share repurchases under certain circumstances. We may take additional capital management measures in the future.