As of January 1, 2007, we adopted SFAS 157 and SFAS 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 SFAS 157 and SFAS 159, our available for sale investments were carried at fair value with changes in fair value with changes therein reported as a component of other comprehensive income.
On January 12, 2007 we began to consolidate the operations of Mont Fort in accordance with FIN 46(R).
On July 1, 2008 we began to consolidate the operations of Flagstone Africa, on October 1, 2008 we began to consolidate the operations of Flagstone Alliance and on November 18, 2008 we began to consolidate the operations of Marlborough in accordance with Accounting Research Bulletin No. 51 - Consolidated Financial Statements.
We were formed by Haverford, a company controlled and capitalized by Mark Byrne, the Executive Chairman of our Board of Directors, and David Brown, our Chief Executive Officer, and we commenced operations in December 2005. On March 30, 2007, the Company’s common shares began trading on the New York Stock Exchange. The Company completed the IPO of 13.0 million of its common shares on April 4, 2007 resulting in gross proceeds to the Company of $175.5 million ($159.3 million net of expenses). In connection with this IPO, the Company filed a Registration Statement on Form S-1 (Registration No. 333-138182) with the Securities and Exchange Commission (the “SEC”) on March 30, 2007. On April 30, 2007, the underwriters of the IPO exercised their option to purchase an additional 750,000 common shares of the Company at the public offering price less underwriting discounts and commissions resulting in gross proceeds of $10.1 million ($9.4 million net of expenses).
The various components of our operating model are unified through our centralized management in Hamilton, Bermuda and Martigny, Switzerland and integrated through our use of advanced technology. Flagstone Suisse is based in Martigny in the canton of Valais, Switzerland. We believe that for many lines of business we can be more effective in marketing and attracting continental European business in Switzerland than in Bermuda, and that for many clients, a Swiss counterparty would be preferred. Through this local presence, we are in a position to closely follow and respond effectively to the changing needs of the various European insurance markets. Flagstone Suisse is licensed by the FINMA, in Switzerland. Flagstone Suisse is also licensed as a permit company registered in Bermuda and is registered as a Class 4 insurer under the Bermuda Insurance Act and complements our Swiss based underwriters with a separately staffed Bermuda underwriting platform. During 2008, we continued to expand our global operating platform through the acquisition of 65% of the outstanding common shares of Flagstone Africa, formerly known as Imperial Re, a South African reinsurer who primarily writes multiple lines of reinsurance in sub-Saharan Africa. Also during 2008, the Company acquired 100% of the outstanding common shares of Flagstone Alliance, formerly known as Alliance Re, a Cypriot reinsurer writing multiple lines of business in Europe, Asia, and the Middle East & North Africa region. On November 18, 2008, the Company acquired 100% of the common shares of Marlborough the managing agency for Lloyd’s Syndicate 1861 - a Lloyd’s syndicate underwriting a specialist portfolio of short-tail insurance and reinsurance. The Marlborough acquisition provides the Company with a Lloyd’s platform with access to both London business and that sourced globally from our network of offices. For further information on these acquisitions refer to Note 3 “Acquisitions” in Item 8 - Financial Statements and Supplementary Data of this Form 10-K. Our research and development efforts and part of our catastrophe modeling and risk analysis team, and part of finance and accounting are based in Hyderabad, India, and our international reinsurance marketing operations are conducted from London, England. Our computer data center is in our Halifax, Canada office, where we also run support services such as accounting, claims, application support, administration, risk modeling, proprietary systems development and high performance computing. The result is an operating platform which provides significant efficiencies in our operations and access to a large and highly qualified staff at a relatively low cost.
Because we have a limited operating history, period to period comparisons of our results of operations are limited and may not be meaningful in the near future. Our financial statements are prepared in accordance with U.S. GAAP and our fiscal year ends on December 31. Since a substantial portion of the reinsurance we write provides protection from damages relating to natural and man-made catastrophes, our results depend to a large extent on the frequency and severity of such catastrophic events, and the specific insurance coverages we offer to clients affected by these events. This may result in volatility in our results of operations and financial condition. In addition, the amount of premiums written with respect to any particular line of business may vary from quarter to quarter and year to year as a result of changes in market conditions.
We measure our financial success through long term growth in diluted book value per share plus accumulated dividends measured over intervals of three years, which we believe is the most appropriate measure of the performance of the Company, a measure that focuses on the return provided to the Company’s common shareholders. Diluted book value per share is obtained by dividing shareholders’ equity by the number of common shares and common share equivalents outstanding.
We derive our revenues primarily from net premiums earned from the reinsurance and insurance policies we write, net of any retrocessional or reinsurance coverage purchased, net investment income from our investment portfolio, and fees for services provided. Premiums are generally a function of the number and type of contracts we write, as well as prevailing market prices. Premiums are normally due in installments and earned over the contract term, which ordinarily is twelve months.
Income from our investment portfolio is primarily comprised of interest on fixed maturity, short term investments and cash and cash equivalents, dividends and proportionate share of net income for those investments accounted for on an equity basis, net realized and unrealized gains (losses) on our investment portfolio including our derivative positions, net of investment expenses.
Our expenses consist primarily of the following types: loss and loss adjustment expenses incurred on the policies of reinsurance and insurance that we sell; acquisition costs which typically represent a percentage of the premiums that we write; general and administrative expenses which primarily consist of salaries, benefits and related costs, including costs associated with awards under our PSU and RSU Plans, and other general operating expenses; interest expenses related to our debt obligations; and minority interest, which represents the interest of external parties with respect to the net income of Mont Fort, Island Heritage, and Flagstone Africa. We are also subject to taxes in certain jurisdictions in which we operate; however, since the majority of our income to date has been earned in Bermuda, a non-taxable jurisdiction, the tax impact on our operations has historically been minimal. As a result of the merger between Flagstone Reinsurance Limited and Flagstone Suisse, we expect our tax expense to increase to approximate our effective Swiss Federal tax rate of approximately 8% on the portion of underwriting profits, if any, generated by Flagstone Suisse, excluding the underwriting profits generated in Bermuda through the Flagstone Suisse branch office.
The following are the accounting estimates that, in management’s judgment, are critical due to the judgments, assumptions and uncertainties underlying the application of those policies and the potential for results to differ from management’s assumptions.
Under U.S. GAAP, we are not permitted to establish loss reserves, which include case and IBNR reserves, until the occurrence of an event which may give rise to a claim. As a result, only loss reserves applicable to losses incurred up to the reporting date are established, with no allowance for the establishment of loss reserves to account for expected future losses. Claims arising from future catastrophic events can be expected to require the establishment of substantial loss reserves from time to time.
For a breakdown of reserves for losses and loss adjustment expenses refer to Note 7 “Loss and Loss Adjustment Expense Reserves” and Note 8 “Reinsurance” in Item 8, “Financial Statements and Supplementary Data” of this Annual Report on Form 10-K.
Because a significant component of our business is generally characterized by loss events of low frequency and high severity, reporting of claims in general tends to be prompt (as compared to reporting of claims for casualty or other “long-tail” lines of business). However, the timing of claims reporting can vary depending on various factors, including: the nature of the event (e.g., hurricane, earthquake and hail); the quality of the cedent’s claims management and reserving practices; the geographic area involved; and whether the claims arise under reinsurance or insurance contracts for primary companies, or reinsurance of other reinsurance companies. Because the events from which catastrophe claims arise are typically prominent, public occurrences, we are often able to use independent reports of such events to augment our loss reserve estimation process. Because of the degree of reliance that we place on ceding companies for claims reporting, the associated time lag, the low frequency and high severity nature of the business we underwrite and the varying reserving practices among ceding companies, our reserve estimates are highly dependent on management’s judgment and are therefore subject to significant variability from one quarter to another. During the loss settlement period, additional facts regarding individual claims and trends may become known, and current laws and case law may change.
For reinsurance written on an excess of loss basis, which represents approximately 65.0%, 68.0% and 80.1% of the premiums we wrote for the years ended December 31, 2008, 2007 and 2006, respectively, our exposure is limited by the fact that most treaties have a defined limit of liability arising from a single loss event. Once the limit has been reached, we have no further exposure to additional losses from that treaty for the same loss event. For reinsurance on a pro rata basis, we typically have event caps so these liabilities are contained.
For our property catastrophe policies which comprise 58.5%, 65.6% and 72.4% of our total gross premiums written for the years ended December 31, 2008, 2007 and 2006, respectively, and other catastrophe policies, we initially establish our loss reserves based on loss payments and case reserves reported by ceding companies. We then add to these case reserves our estimates for IBNR. To establish our IBNR estimates, in addition to the loss information and estimates communicated by cedents, we use industry information, knowledge of the business written by us, management’s judgment and general market trends observed from our underwriting activities.
Reported Loss Development Method. We estimate ultimate losses by calculating past reported loss development factors and applying them to exposure periods with further expected reported loss development. Since reported losses include payments and case reserves, changes in both of these amounts are incorporated in this method. This approach provides a larger volume of data to estimate ultimate losses than paid loss methods. Thus, reported loss patterns may be less varied than paid loss patterns, especially for coverages that have historically been paid out over a long period of time but for which claims are reported relatively early and case loss reserve estimates established. This method is a key input into the Bornheutter-Ferguson reported loss method discussed below.
A significant component of our loss ratio relates to non-catastrophe business for the years ended December 31, 2008, 2007 and 2006. As we commonly write net lines of non-catastrophe business exceeding $10.0 million, we expect that the ultimate loss ratio for non-catastrophe business can vary significantly from our initial loss ratios. Thus, a 10% increase or decrease in loss ratios for non-catastrophe business is likely to occur and, for the years ended December 31, 2008, 2007 and 2006, this would have resulted in an approximate increase or decrease in our net income or shareholders’ equity of approximately $21.4 million, $6.3 million and $1.4 million, respectively.
For pro rata contracts, gross premiums written and related acquisition costs are normally estimated on a quarterly basis based on discussions with ceding companies, together with historical experience and management’s judgment. Premiums written on pro rata contracts are earned over the risk periods of the underlying policies issued and renewed. As a result, the earning pattern of pro rata contracts may extend up to 24 months. This is generally twice the contract period due to the fact that some of the underlying exposures may attach towards the end of our contracts (i.e., risks attaching basis), and such underlying exposures generally have a one year coverage period. Total premiums written and earned on our pro rata business for the year ended December 31, 2008 were $195.0 million (24.9%), and $159.7 million (24.4%), respectively, for the year ended December 31, 2007 were $152.0 million (26.3%), and $101.5 million (21.3%), respectively and were $60.3 million (19.9%), and $36.9 million (19.2%), respectively, for the year ended December 31, 2006. Total earned acquisition costs estimated on pro rata contracts for the year ended December 31, 2008, 2007 and 2006 were $41.9 million (39.6%), $35.1 million (42.6%) and $11.2 million (37.4%), respectively. On a quarterly basis, we track the actual premium received and acquisition costs incurred and compare this to the estimates previously booked. Such estimates are subject to adjustment in subsequent periods when actual figures are recorded.
Reinstatement premiums are estimated after the occurrence of a significant loss and are recorded in accordance with the contract terms based upon the amount of loss reserves expected to be paid, including IBNR. Reinstatement premiums are earned when written.
The Company elected the fair value option to simplify the accounting, as this election reduces the burden of monitoring differences between the cost and fair value of our investments, including the assessment as to whether declines in value are temporary in nature and, therefore, further removes an element of management judgment. The election of SFAS 159 did not change the carrying value of our fixed maturity investments, equity investments, REITs, investment funds, catastrophe bonds, fixed income funds and derivative instruments as they were previously carried at fair value. The difference as a result of the election of the fair value option is in respect of the treatment of unrealized gains and losses. Prior to January 1, 2007, unrealized gains and losses on fixed maturity investments and equities were included within accumulated other comprehensive income as a separate component of shareholders’ equity. On January 1, 2007, a cumulative-effect adjustment was made to reclassify the net unrealized losses from accumulated other comprehensive loss as at December 31, 2006 into retained earnings in the amount of $4.0 million. This adjustment represented the difference between the cost or amortized cost of our investments and the fair value of those investments at December 31, 2006. Subsequent to January 1, 2007, any movement in unrealized gains and losses is now recorded within net realized and unrealized gains (losses) on investments within the consolidated statements of operations and comprehensive income (loss).
Investments are recorded on a trade date basis and realized gains and losses on sales of investments continue to be determined on a first-in, first-out basis. Net investment income includes interest income on fixed maturity investments, recorded when earned, dividend income on equity investments, recorded when declared, and the amortization of premiums and discounts on investments net of investment management and custody expenses.
The fair value of the corporate bonds, mortgage-backed securities, and asset-backed securities are provided by independent pricing services or by broker quotes based on inputs that are observable for the asset, either directly or indirectly. These securities are classified within Level 2 and Level 3, and the specific details of the sources are described below.
In some cases, we obtain a minimum of two quotes directly from broker-dealers who are active in the corresponding markets when prices are unavailable from independent pricing services. This may also be the case if the pricing from these pricing services is not reflective of current market levels. At December 31, 2008, approximately 2.0% of our fixed maturities were priced using non-binding broker quotes, for which the lowest broker quotes were used for the valuation. Generally, broker-dealers value securities through their trading desks based on observable market inputs. Their pricing methodologies include mapping securities based on trade data, bids or offers, observed spreads and performance on newly issued securities. They may also establish pricing through observing secondary trading of similar securities. Given the severe credit market dislocation experienced during the later part of 2008, it has been more challenging for broker-dealers to observe actual trades due to the lack of liquid and active secondary markets. The market illiquidity has been evidenced by a significant decrease in the volume of trades relative to historical levels and the significant widening of the bid-ask spread in the brokered markets, in particular for our Alt-A securities, which represents less than 0.4% of our total fixed maturity portfolio. To price these securities, although thinly traded, the broker-dealers may consider both pricing from recent limited trades (market approach) and discounted cash flows (income approach) using significant observable market inputs. All broker quotes are reviewed by the investment managers to determine if they reflect the fair value of the securities by comparing them to both internal models and the valuation of comparable securities. The evaluation of whether or not actual transactions in the current financial markets represent distressed sales requires significant management judgment. We do not believe quotes received from broker-dealers reflect distressed transactions that would warrant an adjustment to fair value. At December 31, 2008, we have not adjusted any pricing provided by broker-dealers based on the review performed by our investment managers.
The Company’s equity exchange traded funds are stated at fair value as determined by the quoted market price of these securities as provided either by independent pricing services or exchange market prices. The Company held no equity exchange traded funds as at December 31, 2008.
Investment funds and REIT funds are stated at fair value as determined by the most recently published net asset value, being the fund’s holdings in quoted securities adjusted for administration expenses. These investments are classified within Level 2.
Catastrophe bonds are stated at fair value as determined by reference to broker indications. Those indications are based on current market conditions, including liquidity and transactional history, recent issue price of similar catastrophe bonds and seasonality of the underlying risks and accordingly we have classified within Level 3.
The private equity investments are valued by the investment fund managers using the valuations and financial statements provided by the general partners on a quarterly basis. These valuations are then adjusted by the investment fund managers for the cash flows since the most recent valuation. The valuation methodology used for the investment funds are consistent with the investment industry and we have classified the hedge funds within Level 2 and the private equity funds within Level 3.
Derivative instruments are stated at fair value and are determined by the quoted market price for futures contracts within Level 1 and by observable market inputs for foreign currency forwards, total return swaps, currency swaps, interest rates swaps and TBAs within Level 2. The Company fair values reinsurance derivative contracts by approximating the present value of cash flows as the carrying value equal to the unearned premium as these contracts are under one year in duration within Level 3.
At December 31, 2008, the fair value of the derivative instruments classified as Level 3 under SFAS 157 was $(0.5) million. Refer to Note 9 “Derivatives” in Item 8, “Financial Statements and Supplementary Data” of this Form 10-K for a breakdown of the fair value measurements.
The total number of PSUs outstanding under the PSU Plan at December 31, 2008, 2007 and 2006 were 2,189,982, 1,658,700 and 713,000, respectively (or up to 3,284,973 common shares at December 31, 2008, should the maximum factor for each of the performance periods apply). Taking into account the results to date and the expected results for the remainder of the performance periods, we have established the most probable factor at 100% and as such the expected number of common shares to be issued under the plan is 2,189,982 at December 31, 2008. As at December 31, 2008, 2007 and 2006, there was a total of $21.0 million, $11.9 million and $5.0 million, respectively, of unrecognized compensation cost related to non-vested PSUs, the cost of which is expected to be recognized over a period of approximately 2.5 years, 2.1 years and 2.0 years, respectively.
On October 10, 2008, the FASB issued a FASB staff position No. 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active” (“SFAS 157-3”) to clarify the application of SFAS 157 in a market that is not active. SFAS 157-3 provides that determination of fair value in a dislocated market depends on facts and circumstances and may require the use of significant judgment about whether individual transactions are forced liquidations or distressed sales. The use of a reporting entity’s own assumptions about future cash flows and appropriately risk-adjusted discount rates is acceptable when relevant observable inputs are not available. Regardless of the valuation technique used, an entity must include appropriate risk adjustments that market participants would make for nonperformance and liquidity risks. SFAS 157-3 is effective immediately, including prior periods for which financial statements have not been issued. The Company has considered the provisions of SFAS 157-3 on the current period and determined that the application of SFAS 157-3 is not anticipated to have an effect on the Company’s current financial position.
On November 13, 2008, the FASB issued EITF No. 08-6, “Equity Method Investment Accounting Considerations,” (“EITF 08-6”). EITF 08-6 clarifies that the initial carrying value of an equity method investment should be determined in accordance with SFAS No. 141(revised 2007), “Business Combinations”. Other-than-temporary impairment of an equity method investment should be recognized in accordance with FSP No. APB 18-1, “Accounting by an Investor for Its Proportionate Share of Accumulated Other Comprehensive Income of an Investee Accounted for under the Equity Method in Accordance with APB Opinion No. 18 upon a Loss of Significant Influence.” EITF 08-6 is effective on a prospective basis in fiscal years beginning on or after December 15, 2008 and interim periods within those fiscal years, and will be adopted by the Company in the first quarter of fiscal year 2010. The Company is assessing the potential impact, if any, of the adoption of EITF 08-6 on its consolidated results of operations and financial condition.
The following is a discussion and analysis of our financial condition as at December 31, 2008 and 2007 and our results of operations for the years ended December 31, 2008, 2007 and 2006. All amounts in the following tables are expressed in thousands of U.S. dollars.
We generated $187.3 million of net loss in 2008, compared to net income of $167.9 million and $152.3 million in 2007 and 2006, respectively. As highlighted in the table below, the three most significant items impacting our 2008 financial performance compared to 2007 and 2006 include: (1) A decrease in underwriting income due to an increase in loss and loss adjustment expenses in 2008 impacted by Hurricanes Ike and Gustav, Chinese winter storms and the U.S. Memorial Day weekend storms versus 2007 which was impacted by Windstorm Kyrill, U.K. floods and New South Wales storms partially offset by an increase in our net premiums earned, principally resulting from the growth in business by increased participation in programs from our existing clients and the addition of new clients due to our increased capital base and growth in our franchise; (2) A significant decrease in investment income, net realized and unrealized gains (losses) - investments and net realized and unrealized gains (losses) - other primarily due to the significant declines in the global equity, bond and commodities markets in 2008. Such declines in the equity, bond and commodities markets are attributable to the broader deterioration and volatility in the credit markets, the widening of credit spreads in fixed income sectors, significant failures of large financial institutions, uncertainty regarding the effectiveness of governmental solutions and the lingering impact of the sub-prime residential mortgage crisis; and (3) As a significant portion of the Company’s operations are transacted in foreign currencies and fluctuations in foreign exchange rates against the U.S. dollar have resulted in substantial foreign exchange losses in 2008.
The following tables provide a summary of gross and net written and earned premiums, underwriting results, total assets, and ratios for each of our business segments for the years ended December 31, 2008, 2007 and 2006:
Gross reinsurance premiums written of $740.2 million ($705.0 million net of quota share with Island Heritage), $544.3 million and $302.5 million for the years ended December 31, 2008, 2007, and 2006, respectively, were primarily driven by excess of loss reinsurance contracts, generally with a twelve-month term, which for the years ended December 31, 2008, 2007, and 2006 accounted for $509.9 million (65.2% of gross premiums written), $392.3 million (68.0% of gross premiums written) and $242.2 million (80.1% of gross premiums written), respectively. Gross premiums written relating to the Insurance segment primarily relate to a select property insurance portfolio in the Caribbean region and for the year ended December 31, 2008, amounted to $76.9 million compared to $33.0 million for the year ended December 31, 2007. For the year ended December 31, 2008, Flagstone Suisse and Island Heritage entered into a quota share arrangement. Total gross written premiums related to this arrangement were $35.2 million and were included in the gross reinsurance premiums written of $740.2 million above. Renewal dates for reinsurance business tend to be concentrated at the beginning of quarters, and the timing of premiums 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 lines and the short-tail specialty and casualty lines are written throughout the year. Seasonality is inherent for most Caribbean insurers given that the storm season begins June 1 and concludes November 30. Therefore, proportionally higher volumes of insurance property business are traditionally written in the first two quarters of the year.
The net underwriting income for the Reinsurance segment for the year ended December 31, 2008 amounted to $73.0 million ($74.3 million excluding the impact of acquisitions during 2008) as compared to $129.3 million for the year ended December 31, 2007. The decrease in net underwriting income is primarily related to losses incurred in 2008 exceeding those in 2007 due to Hurricanes Ike and Gustav, which struck the Caribbean and US Gulf coast during the fall of 2008, losses on Chinese winter storms which occurred during late January and early February 2008, and losses from the U.S. Memorial Day Weekend storms, partially offset by higher levels of premiums earned.
Gross property catastrophe premiums written for the year ended December 31, 2008 were $492.7 million ($492.6 excluding acquisitions during 2008), compared to $378.7 million for the year ended December 31, 2007. The increase in property catastrophe premiums written of $113.9 million, excluding the impact of acquisitions, or 30.1%, results from a $74.2 million increase in non-proportional premiums, a $4.5 million increase in proportional premiums and $35.2 million related to the quota share arrangement with Island Heritage. Our property catastrophe book of business has grown due to the addition of new clients through our new offices in Dubai and Puerto Rico, and the addition of new clients and increased business through participation in new programs and increased signed shares on existing programs by our Switzerland and Bermuda operations due to our growth in capital and franchise value, offset by the Company’s non-renewal of certain treaties that no longer met the Company’s profitability objectives. The proportional premium revenue increase in 2008 was due to a new contract written in the period, partially offset by revenue declines from certain contracts.
During the year ended December 31, 2008, we recorded $28.2 million of gross reinstatement premiums primarily related to Hurricanes Ike and Gustav as well as the Chinese winter storms and the Memorial Day Weekend Storm in the United States, compared to $10.4 million recorded for the year ended December 31, 2007, which was primarily related to European Windstorm Kyrill and the United Kingdom floods.
Short-tail specialty and casualty reinsurance is comprised of reinsurance programs such as aviation, energy, accident and health, workers compensation catastrophe, satellite and marine. Most short-tail specialty and casualty reinsurance is written with loss limitation provisions.
During the year ended December 31, 2007, we recorded $2.6 million of gross reinstatement premiums compared to $nil recorded for the year ended December 31, 2006. The reinstatement premiums in the year ended December 31, 2007 were primarily attributable to aviation and marine contracts.
For the year ended December 31, 2008, the Company purchased common account reinsurance of $15.6 million and $31.0 million of opportunistic and core reinsurance protection to optimize our overall risk profile.
As the levels of net premiums written increase, the levels of net premiums earned also increase. Reinsurance net premiums earned were $641.5 million ($630.5 million excluding the impact of acquisitions) for the year ended December 31, 2008, compared to $464.2 million for the year ended December 31, 2007, representing an increase of $166.3 million, or 35.8%, excluding the impact of acquisitions in 2008. The increases are primarily due to higher levels of premium writings and the impact of reinstatements earned in 2008 on Hurricanes Ike and Gustav. The majority of our business is written at the January 1, April 1, June 1 and July 1 renewal periods and therefore it is reasonable to anticipate that the earned premiums would generally increase over the course of the fiscal year as premiums written in earlier months are increasingly earned.
Net premiums earned for the years ended December 31, 2007 and 2006 were $464.2 million and $192.1 million, respectively. The increase of $272.1 million, during 2007, or 141.6%, is primarily due to the increased levels of net premiums written over the last twelve months. The large difference between net premiums written and net premiums earned during the years ended December 31, 2007 and 2006 reflects the fact that most of our contracts are written on an annual basis, with the premiums earned over the course of the contract period. The majority of our business is written at the January 1, April 1, June 1 and July 1 renewal periods and therefore it is reasonable to anticipate that the earned premiums would generally increase over the course of the fiscal year as premiums written in earlier months are increasingly earned.
Our combined ratio and components thereof related to the Reinsurance segment are set out below for the years ended December 31, 2008, 2007 and 2006:
Because of our short operating history, our loss experience is limited and reliable evidence of changes in trends of numbers of claims incurred, average settlement amounts, numbers of claims outstanding and average losses per claim will necessarily take years to develop. A significant portion of our business is property catastrophe reinsurance and other classes of reinsurance with high attachment points of coverage. Attachment points refer to the dollar amount of loss above which excess of loss reinsurance becomes operative. Reserving for losses in such programs is inherently complicated in that losses in excess of the attachment level of our policies are characterized by high severity and low frequency. In addition, as a broker market reinsurer, we must rely on loss information reported to such brokers by primary insurers who must estimate their own losses at the policy level, often based on incomplete and changing information. See “- Critical Accounting Estimates-Loss and Loss Adjustment Expense Reserves” and Item 1A, “Risk Factors-Risks Related to the Company.” If we underestimate our loss reserves, so that they are inadequate to cover our ultimate liability for losses, the underestimation could materially adversely affect our financial condition and results of operations.
The increase in the loss ratio of 17.6% in 2008 is as a result of the more severe catastrophe events that occurred in 2008 (described below) compared to the catastrophe activity experienced in 2007.
Loss and loss adjustment expenses for the years ended December 31, 2007 and 2006 were $191.3 million and $26.7 million, respectively. The components of loss and loss adjustment expenses of $191.3 million for the year ended December 31, 2007 include $39.6 million paid losses and our actuaries’ estimate of case reserves and IBNR of $151.7 million on premiums earned to date. The change in the case reserves and IBNR of $151.7 million includes the following key loss events: Windstorm Kyrill in January 2007 ($32.4 million); United Kingdom flood losses in June and July 2007 ($38.0 million); New South Wales (Australia) flood losses in June 2007 ($18.5 million); three satellite losses during 2007 ($13.8 million); and the Sydney (Australia) hailstorm in December 2007 ($11.4 million).
The components of loss and loss adjustment expenses of $26.7 million for the year ended December 31, 2006 include $4.2 million paid losses and our actuaries’ estimate of case reserves and IBNR of $22.5 million on premiums earned to date reflecting the low insured catastrophe activity for the period.
Acquisition costs consist principally of ceding commissions, brokerage, premium taxes, sliding scale profit commissions and other expenses that relate directly to the writing of reinsurance contracts. Acquisition costs are driven by contract terms and are generally determined based upon a set percentage of premiums. Acquisition costs are expensed over the period of their related contracts.
For the years ended December 31, 2007 and 2006, acquisition costs were $75.9 million and $29.9 million, respectively, representing an increase of 153.8%. The acquisition cost ratio has increased 0.7% from 2006 due to increased levels of proportional contracts written in 2007 which typically have higher levels of acquisition costs.
General and administrative expenses for the year ended December 31, 2008, were $90.0 million ($86.8 million excluding acquisitions) compared to $68.9 million in the year ended December 31, 2007. The increase of $17.9 million, excluding the impact of acquisitions, in 2008 as compared to 2007 was primarily due to the cost of additional staff and infrastructure as we continue to build our global operations and enhance our technology platform, partially offset by a decrease in stock compensation expenses. Considering the net loss incurred in the year ended December 31, 2008, the Company reviewed its DROE estimates for the performance periods and revised accordingly the number of PSUs expected to vest. As a result of the revised DROE estimates, the Company reversed previously expensed stock compensation related to the PSU Plan of $8.1 million. At the Company’s board meeting held on November 14, 2008, the Warrant was amended. As a result of the amendments, additional compensation expense of $3.6 million has been recognized in the year ended December 31, 2008.
For Flagstone Suisse and its Bermuda branch, we expect to see moderate price increases in 2009. However due to capital constraints, primarily as a result of negative investment returns in 2008, we expect to see limited ability to grow premiums in 2009.
The net underwriting income for the year ended December 31, 2008 amounted to $0.4 million compared to $4.6 million for the six months ended December 31, 2007. The decrease in net underwriting income for 2008 was primarily related to a change in the reinsurance program as well as an increase in general and administrative expenses related to expansion into Latin America markets.
Gross premiums written were $76.9 million for the year ended December 31, 2008, compared to $33.0 million for the six months ended December 31, 2007. Contracts are written on a per risk basis and consist primarily of property lines. Seasonality is inherent for most Caribbean insurers given that the storm season begins June 1 and concludes November 30. Therefore, proportionally higher volumes of property business are traditionally written in the first two quarters in the fiscal year.
Insurance premiums ceded for the year ended December 31, 2008 were $75.8 million (98.5% of gross insurance premiums written) which amounts to $40.6 million net of premiums ceded to Flagstone Suisse through the quota share arrangement, compared to $20.4 million (61.7% of gross insurance premiums written) for the six months ended December 31, 2007. Island Heritage’s reinsurance program, comprising excess of loss and quota share programs, was significantly changed on April 1, 2008 compared to prior years, resulting in a significant net quota share reinsurance portfolio transfer. The change in the reinsurance program enables Island Heritage to enter into new markets as well as increase penetration in existing markets.
Loss and loss adjustment expenses amounted to $2.7 million, for the year ended December 31, 2008, compared to $1.6 million for the six months ended December 31, 2007. The increase in loss and loss adjustment expense in the year ended December 31, 2008 is primarily related to the claims incurred in respect of Hurricanes Gustav, Hanna, Ike, Omar and Paloma. The components of loss and loss adjustment expenses of $2.7 million for the year ended December 31, 2008 include $14.5 million paid losses, $(17.9) million of losses recovered and our actuaries’ estimate of case reserves and IBNR of $6.1 million on premiums earned to date.
For the year ended December 31, 2007, the total return was $91.0 million, compared to $44.5 million for the year ended December 31, 2006. The increase of 104.4% during 2007 is primarily due to increased investment income resulting from our higher average invested assets in our portfolio, net positive performance of the relevant markets (such as fixed income and equities) during 2007, offset by our net realized and unrealized losses on our foreign currency forward positions.
The Company’s overall fixed maturities strategy, established by the Finance Committee of the Board of Directors and executed by a combination of internal investment professionals and external investment managers, is to match appropriate indices after fees and trading costs, including taxes. Our investment managers generally manage the interest rate risk associated with holding fixed maturity investments by actively managing the average duration of the portfolio to achieve an adequate total return without subjecting the portfolio to an unreasonable level of interest rate risk. Our principal fixed maturity measurement index is the Lehman Aggregate Index. Our principal index for inflation-protected securities is the Treasury Inflation-Protected Securities (“TIPS”) Index and our principal short-term portfolio index is 3-month London Interbank Offering Rate (“LIBOR”). Substantially all of our fixed maturity securities consisted of investment grade securities. As at December 31, 2007, the average credit rating, provided by a recognized national rating agency, of our fixed maturity portfolio is AA+ with an average duration of 3.2 years.
Substantially all of our fixed maturity investments consisted of investment grade securities. As at December 31, 2008, the average credit rating provided by a recognized national rating agency of our fixed maturity portfolio was AA+ with an average duration of 2.9 years.
Net investment income for the year ended December 31, 2007 was $73.8 million, compared to $34.2 million for the year ended December 31, 2006, an increase of 115.7% from the prior year.
Our investment portfolio is structured to preserve capital and provide us with a high level of liquidity and is managed to produce a total return. In assessing returns under this approach, we include investment income and realized and unrealized gains and losses generated by the investment portfolio. The following table is the breakdown of net realized and unrealized (losses) gains - investments in the audited consolidated statements of operations into its various components:
Net realized and unrealized losses and gains on our investment portfolio amounted to a $272.2 million loss for the year ended December 31, 2008, compared to a $17.2 million gain for the year ended December 31, 2007. These amounts comprise net realized and unrealized gains and losses on our fixed maturities, equities, and other investments and on our investment portfolio of derivatives which includes global equity, global bond, commodity and real estate futures, TBA securities, interest rate swaps and total return swaps. The decrease during the year ended December 31, 2008 compared to the same period in 2007, was primarily due to the significant declines in the global equity, bond and commodities markets in 2008. Such declines in the equity, bond and commodities markets are attributable to the broader deterioration and volatility in the credit markets, the widening of credit spreads in fixed income sectors, significant failures of large financial institutions, uncertainty regarding the effectiveness of governmental solutions and the lingering impact of the sub-prime residential mortgage crisis.
Net realized and unrealized losses on equities of $54.8 million for the year ended December 31, 2008 were primarily due to the negative performance of the emerging equity markets during the year ended December 31, 2008.
We use currency swaps and foreign currency forwards to hedge the economic currency exposure of the Company’s investment in foreign subsidiaries, primarily our Swiss subsidiary, and to hedge operational balances such as premiums receivable, loss reserves and the portion of our long term debt issued in Euros.
Net realized and unrealized gains and losses-other amounted to a $9.8 million loss for the year ended December 31, 2007 compared to a $1.9 million gain for the year ended December 31, 2006. These amounts comprise net gains and losses on foreign currency forward contracts, interest rate and currency swaps on our subordinated debt and on reinsurance derivatives.
The losses on foreign currency forwards were due to the continued weakening of the U.S. dollar against other major currencies.
Interest expense was $18.7 million for the year ended December 31, 2007 compared to $4.6 million for the year ended December 31, 2006. The primary reason for the increase is that the first debt issuances of $120.0 million and $16.7 million occurred in August 2006, resulting in only five months of interest expense in 2006. During 2007, the Company incurred twelve months of interest expense on the debt contracted in 2006 and interest expense on the additional debt offerings of $100.0 million and $25.0 million which occurred in June and September 2007, respectively.
For the year ended December 31, 2008, we experienced net foreign exchange losses of $21.5 million compared to net foreign exchange gains of $5.3 million for the year ended December 31, 2007. For the year ended December 31, 2008, the net foreign exchange losses were principally experienced on the net monetary asset and liability balances denominated in foreign currencies which generally weakened against the U.S. dollar, especially during the third and fourth quarters of 2008. The Company’s policy is to hedge the majority of its foreign currency exposures with derivative instruments such as foreign currency swaps and forward contracts. Net realized and unrealized gains and losses on derivatives used to hedge those balances are included in “Net realized and unrealized gains and losses - other” in the consolidated financial statements.
The Company has entered into certain foreign currency forward contracts that are designated as hedges in order to hedge its net investments in foreign subsidiaries. The accounting for the gains and losses associated with changes in fair value of the designated hedge instruments were recorded in other comprehensive income as part of the cumulative translation adjustment, to the extent that it is effective as a hedge. The Company designated foreign currency forwards with notional contractual value of $337.7 million as hedging instruments, which had a fair value of $(5.7) million as of December 31, 2008. During the year ended December 31, 2008, the Company recorded $17.0 million of realized and unrealized losses directly into comprehensive income as part of the cumulative translation adjustment for the effective portion of the hedge. All other derivatives are not designated as hedges, and accordingly, the realized and unrealized gains and losses arising during the year are included in income in “Net realized gains and losses -investments” and “Net realized gains and losses -other” in the consolidated financial statements.
During the year ended December 31, 2008, income tax expense was $1.2 million compared to $0.8 million for the year ended December 31, 2007. The increase for the year ended December 31, 2008, compared to the same period in 2007, is primarily attributable to higher taxable income in jurisdictions around the world that are subject to tax as well as the acquisition of Island Heritage in July 2007, which resulted in taxable income being earned in the USVI. As a result of the merger between Flagstone Reinsurance Limited and Flagstone Suisse, we expect our tax expense to increase to approximate our effective Swiss Federal tax rate of approximately 8% on the portion of underwriting profits, if any, generated by Flagstone Suisse, excluding the underwriting profits generated in Bermuda through the Flagstone Suisse branch office.
On July 1, 2008, Island Heritage, in which the Company holds a controlling interest, issued 1,789 shares to certain of its employees under a performance share unit plan. Prior to this transaction, the Company held an ownership interest in Island Heritage of 59.6% and now holds an interest of 59.2%. The Company has elected to record gains and losses resulting from the issuance of subsidiary’s stock as an equity transaction. Accordingly, the Company recorded a loss of $0.1 million as a decrease to additional paid-in capital.
On June 26, 2008, Flagstone Suisse purchased 3,714,286 shares (representing a 65% interest) in Flagstone Africa (previously known as Imperial Reinsurance Company Limited) for a purchase price of $18.6 million. The results of operations of Flagstone Africa have been included in the Company’s consolidated financial statements from June 26, 2008 onwards, with the portions of Flagstone Africa’s net income and shareholders’ equity attributable to minority shareholders recorded as minority interest. The Company recorded a minority interest charge of $0.1 million for the year ended December 31, 2008.
Comprehensive (loss) income for the year ended December 31, 2008 was $(203.0) million compared to $175.9 million for the same period in 2007. For the year ended December 31, 2008, comprehensive (loss) income included $(187.3) million of net loss, $(14.8) million for the change in the currency translation adjustment, and $(0.9) million for the change in the defined benefit pension plan transitional obligation compared to $167.9 million of net income and $7.9 million for the change in the currency translation adjustment for the year ended December 31, 2007.
When the Company was formed, the Finance Committee decided to invest initially in a conventional portfolio consisting of mainly high grade bonds and a 10% component of passive U.S. equities. Subsequently, the Finance Committee conducted a comprehensive asset allocation study, consistent with modern practice in portfolio optimization, and developed a sophisticated optimization model using asset classes the Company is allowed to invest in from fiscal, regulatory, and liquidity aspects. The model aimed at achieving higher expected total returns while maintaining adequate liquidity to pay potential claims and preserving our financial strength rating. The asset class composition of the model output included a significant allocation to high grade fixed maturity securities, with the balance invested between other asset classes, such as U.S. equities, developed and emerging market equities, commodities, and cash equivalents. A smaller portion of our investments were allocated to private equity, real estate and hedge funds. In October 2008, given the turbulent worldwide financial markets, the Finance Committee of the Board decided to revise the Company’s asset allocation and accordingly, significantly reduce the risk of the Company’s portfolio by eliminating our direct exposure to equities and to non-U.S. real estate and by lowering our exposure to commodities.
Our investment portfolio on a risk basis, at December 31, 2008, comprised 91.7% fixed maturities, short-term investments and cash and cash equivalents, 3.1% equities and the balance in other investments. We believe our investments can be liquidated and converted into cash within a very short period of time. However, our investments in investment funds and catastrophe bonds, which represent 3.0% of our total investments and cash and cash equivalents at December 31, 2008, do not trade on liquid markets or are subject to redemption provisions that prevent us from converting them into cash immediately.
At December 31, 2008, all of our fixed maturity securities, with the exception of $0.3 million, were rated investment-grade (BBB- or higher) by Standard & Poor’s (or estimated equivalent) with an average rating of AA+. At December 31, 2007, 100.0% of our fixed maturity securities were rated investment-grade (BBB- or higher) by Standard & Poor’s (or estimated equivalent).
At December 31, 2008 and 2007, the average duration of the Company’s investment portfolio was 2.9 years and 3.2 years, respectively. The duration decreased due to the lower weighting of TIPs and the change in external managers for our bond portfolios during the year.
The cost or amortized cost, gross unrealized gains and losses and carrying values of the Company’s fixed maturity, short term and equity investments as at December 31, 2008 and 2007, were as follows:
Other investments as at December 31, 2008 amounted to $54.7 million compared to $293.2 million at December 31, 2007. The December 31, 2008 investments are comprised mainly of our investment in catastrophe bonds of $39.2 million, in private equity and hedge funds of $9.8 million and the Company’s $5.7 million equity investment. The Company’s other investments as of December 31, 2008 and 2007 are as follows:
The investment in the fixed income fund and real estate investment funds were liquidated during 2008 and at December 31, 2008 the proceeds were held in cash and cash equivalents.
The Company establishes loss reserves to estimate the liability for the payment of all loss and loss adjustment expenses incurred with respect to premiums earned on the contracts that the Company writes. Loss reserves do not represent an exact calculation of the liability. Loss reserves represent estimates, including actuarial and statistical projections at a given point in time to reflect the Company’s expectations of the ultimate settlement and administration costs of claims incurred. Estimates of ultimate liabilities are contingent on many future events and the eventual outcome of these events may be different from the assumptions underlying the reserve estimates. The Company believes that the recorded unpaid loss and loss adjustment expenses represent management’s best estimate of the cost to settle the ultimate liabilities based on information available at December 31, 2008. See “- Critical Accounting Estimates -Loss and Loss Adjustment Expense Reserves” for additional information concerning loss and loss adjustment expenses.
As at December 31, 2008, total shareholders’ equity was $986.0 million, an 18.5% decrease compared to $1.21 billion at December 31, 2007. The decrease in shareholders’ equity is principally due to net losses for the year ended December 31, 2008 of $187.3 million, accumulated other comprehensive loss of $15.7 million, dividends declared of $13.5 million and share repurchases of $6.6 million. Other comprehensive income consists of the change in currency translation adjustment arising from the translation of the Company’s foreign subsidiaries into U.S. dollars and the change in the defined benefit pension plan obligation.
In June 2007, the Company, through its wholly-owned subsidiary Flagstone Finance SA, raised gross and net proceeds of $100.0 million and $98.9 million, respectively, through a private placement of Junior Subordinated Deferrable Interest Notes. These notes have a floating rate of interest equal to LIBOR plus 300 basis points per annum, reset quarterly. These notes mature on July 30, 2037, and may be called at par by the Company at any time after July 30, 2012. The Company may defer interest payment for up to 20 consecutive quarterly periods, but no later than July 30, 2012. Any deferred interest payments would accrue interest quarterly on a compounded basis.
In May 2008, the Company repurchased, in a privately negotiated transaction, $11.25 million of principal amount of its outstanding $100.0 million Notes. The purchase price paid for the notes was 81% of face value, representing a discount of 19%. The repurchase resulted in a gain of $1.8 million, net of unamortized debt issuance costs of $0.1 million that were written off. As a result, the gain has been included as a gain on early extinguishment of debt under other income.
Through the acquisition of IAL King Air on July 22, 2007, the company acquired debt of $0.9 million. At December 31, 2008 there was $0.8 million outstanding. The loan has a floating rate of interest equal to 30-day LIBOR plus 195 basis points per annum, reset monthly. The debt matures March 15, 2009 and is not expected to be refinanced.
The table below sets forth the capital structure of the Company at December 31, 2008 and 2007:
Liquidity is a measure of the Company’s ability to access sufficient cash flows to meet the short-term and long-term cash requirements of its business operations. Management believes that its significant cash flows from operations and high quality liquid investment portfolio will provide sufficient liquidity for the foreseeable future. For the period from October 2005 until December 31, 2008, we have had sufficient cash flows from operations to meet our liquidity requirements. We expect that our operational needs for liquidity for at least the next twelve months will be met by our balance of cash, funds generated from underwriting activities, investment income and the proceeds from sales and maturities of our investment portfolio. The Company may require additional capital in the near term, whether through letters of credit or otherwise. Due to the current financial market crisis, it may be difficult for the insurance industry generally, and the Company in particular, to raise additional capital when required, on acceptable terms or at all. Cash and cash equivalents were $783.7 million at December 31, 2008.
Cash provided by (used in) investing activities was $233.4 million for 2008, compared with $(575.2) million for 2007. The change for 2008 was due primarily to increased net sales and maturities of fixed income securities and other investments.
Cash flows relating to financing activities include the payment of dividends, share related transactions and the issuance or repayment of debt. During the year ended December 31, 2008, net cash of $40.6 million was used in financing activities, compared to $336.2 million provided by financing activities for the year ended December 31, 2007. In 2008, the net cash used in financing activities related principally to the payment of dividends, the redemption of preferred shares in Mont Fort ILW 2, the repurchase of common shares and the repayment of principal on long term debt. In 2007, the net cash provided by financing activities related to proceeds of the capital provided by the preferred investors in Mont Fort ILW 2 and Mont Fort HL, the net proceeds from the closing of our initial public offering and the net proceeds from the issuance of the Notes.
On January 22, 2009, Flagstone Suisse entered into a secured $450.0 million standby letter of credit facility with Citibank Europe Plc (the “Facility”). The Facility comprises a $300.0 million facility for letters of credit with a maximum tenor of 15 months and a $150.0 million facility for letters of credit issued in respect of Funds at Lloyds with a maximum tenor of 60 months, in each case subject to automatic extension for successive periods, but in no event longer than one year. The Facility will be used to support the reinsurance obligations of the Company and its subsidiaries. This Facility replaces the existing $400.0 million uncommitted letter of credit facility agreement with Citibank N.A. mentioned above.
In September 2007, Flagstone Reinsurance Limited entered into a $200.0 million uncommitted letter of credit facility agreement with Wachovia Bank, N.A. (“Wachovia”). Flagstone Reinsurance Limited had not drawn upon this facility as at December 31, 2008. Wachovia and the Company are currently engaged in negotiations to potentially amend or revise the facility to accommodate the restructuring of the Company’s global reinsurance operations which occurred on September 30, 2008, as discussed more fully above in Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Executive Overwiew”.
On March 5, 2009, Flagstone Suisse entered into a secured $200.0 million secured committed letter of credit facility with Barclays Bank Plc (the “Facility”). The Facility comprises a $200.0 million facility for letters of credit with a maximum tenor of 15 months, subject to automatic extension for successive periods, but in no event longer than one year. The Facility will be used to support the reinsurance obligations of the Company and its subsidiaries.
The Bermuda Insurance Act requires Flagstone Suisse to maintain a minimum solvency margin (being the minimum amount that the statutory assets must exceed the statutory liabilities as required by the Bermuda Insurance Act) equal to the greatest of (i) $100 million, (ii) 50% of net premiums written or (iii) 15% of the reserve for losses and loss adjustment expenses. To satisfy these requirements, Flagstone Suisse was required to maintain a minimum level of statutory capital and surplus of $326.8 million as at December 31, 2008. In addition, Flagstone Suisse is required to maintain a minimum liquidity ratio. As at December 31, 2008, 2007, and 2006, Flagstone Suisse was in compliance with all of the requirements of the Bermuda Insurance Act.
The Company has determined that Mont Gele has the characteristics of a variable interest entity that are addressed by FASB Interpretation No. 46R ‘‘Consolidation of Variable Interest Entities’’ (‘‘FIN 46R’’). In accordance with FIN 46R, Mont Gele is not consolidated because the Company is not the primary beneficiary.
The Company has determined that Valais Re has the characteristics of a variable interest entity that are addressed by FASB Interpretation No. 46R ‘‘Consolidation of Variable Interest Entities’’ (‘‘FIN 46R’’). In accordance with FIN 46R, Valais Re is not consolidated because the Company is not the primary beneficiary.
For details relating to our letter of credit facilities see “Financial Condition, Liquidity and Capital Resources - Financial Condition - Letter of Credit Facilities”.
(2) The Company has based its estimate of future claim payments upon benchmark payment patterns constructed internally, drawing upon available relevant industry sources of loss and allocated loss adjustment expense development data which may include both internal and external data sources. We also supplement these benchmark payment patterns with information received from treaty submissions and periodically update them. We believe that it is likely that this benchmark data will not be predictive of our future claim payments and that material fluctuations can occur due to the nature of the losses which we insure and the coverages which we provide. Because of the nature of the coverages that we provide, the amount and timing of the cash flows associated with our policy liabilities will fluctuate, perhaps significantly, and therefore are highly uncertain. See “- Critical Accounting Estimates-Loss and Loss Adjustment Expense Reserves.”
Prior to December 2007, gains and losses on foreign currency forward contracts and on foreign currency swaps used to hedge the foreign currency exposure of the Company’s debt, investments in and loan to various subsidiaries, and operational balances (premiums and reserves) of our investments in foreign subsidiaries were recorded with realized gains and losses - other on the income statement, while gains and losses on the translation of foreign subsidiaries’ assets and liabilities were recorded in accordance with SFAS No. 52 “Foreign Currency Translation” (“SFAS 52”) as a change in currency translation adjustment, a component of comprehensive income. Since the change in currency translation adjustment is not a component of net income, there was volatility created in our reported earnings from the translation of our foreign subsidiaries. Prior to renewing our forward contracts in December 2007, we considered the guidance under SFAS No. 133 “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”) which outlines the designated hedge accounting method, which permits the offset of gains and losses on the hedged instruments (i.e. the forward contracts) against the gains and losses recorded for the hedged items (i.e. net investment in foreign subsidiaries). The Company designated $337.7 million of foreign currency forwards contractual value as hedge instruments, which had a fair value of $(5.7) million at December 31, 2008. During the year ended December 31, 2008, the Company recorded $17.0 million of realized and unrealized losses directly into comprehensive income as part of the cumulative translation adjustment for the effective portion of the hedge. The losses on forward contracts resulted from the continued weakening of the U.S. dollar against the Swiss franc.
At December 31, 2008, the value of the U.S. dollar strengthened approximately 27.8% against the British pound, 4.9% against the Euro, 20.1% against the Canadian dollar, and weakened 6.4% against the Swiss franc, compared to December 31, 2007. Since a large proportion of the Company’s assets and liabilities are expressed in these currencies, there was a net decrease in the U.S. dollar value of the assets and liabilities denominated in these currencies in 2008.
Consolidated Statements of Cash Flows for the Years Ended December 31, 2008, 2007 and 2006
On March 31, 2006, the Company acquired an equity interest in Island Heritage Holdings Limited (“Island Heritage”), a Caribbean property insurer based in the Cayman Islands. With subsequent purchases in October 2006 and May 2007, the Company increased its equity interest in Island Heritage to 33.2%. On July 3, 2007, the Company took a controlling interest in Island Heritage by increasing its ownership to 54.6% of Island Heritage’s voting shares. On June 30, 2008, the Company acquired an additional 16,919 shares in Island Heritage (representing 5% of its common shares) for total consideration of $3.3 million, taking its total shareholding in Island Heritage to 203,129 shares (representing a 59.6% interest). In July 2008, Island Heritage issued common shares to certain employees under a stock based compensation plan which resulted in a small dilution of the Company’s ownership to 59.2%. Through Island Heritage, the Company primarily writes property insurance.
These consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). These consolidated financial statements include the accounts of the Company and its subsidiaries, including those that meet the consolidation requirements of variable interest entities (“VIEs”). The Company assesses the consolidation of VIEs based on whether the Company is the primary beneficiary of the entity in accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. 46, as revised, “Consolidation of Variable Interest Entities - an interpretation of ARB No. 51” (“FIN 46(R)”). Entities in which the Company has an ownership of more than 20% and less than 50% of the voting shares are accounted for using the equity method. All inter-company accounts and transactions have been eliminated on consolidation.
Prior to 2008, the Company operated through one reportable segment, consisting of Reinsurance. Following a review of its operating segments in 2008, the Company revised its reportable business segments and is currently organized into two reportable business segments: Reinsurance and Insurance. Prior periods have been re-segmented to conform to the current presentation.
Premiums are first recognized as written as at the date that the contract is bound. The Company writes both excess of loss and pro rata reinsurance contracts, and also writes a select property insurance portfolio.
The election of SFAS 159 did not change the carrying value of our fixed maturity investments, equity investments, REITs, investment funds, catastrophe bonds, fixed income fund and derivative instruments as they were previously carried at fair value.
Investments in preferred or voting common shares in which the Company has significant influence over the operating and financial policies of the investee are classified as other investments and are accounted for under the equity method of accounting. Under this method, the Company records its proportionate share of income or loss from such investments in interest in earnings of equity investments for the period. Any decline in value of the equity method investments considered by management to be other-than-temporary is charged to income in the period in which it is determined.
The Company’s share based compensation plans consists of performance share units (“PSUs”) and restricted share units (“RSUs”). The PSUs are designed to maximize shareholder value over long periods of time by aligning the financial interests of the Company’s management with those of its shareholders. The Company estimates the fair value of PSUs granted under the Performance Share Unit Plan (“PSU Plan”) on the date of grant using the grant date fair value and the most probable performance factor for the two-year and three-year performance period and records the compensation expense in its consolidated statements of operations over the course of such period. At the end of each quarter, the Company reassesses the projected results for each two-year and three-year performance period as its financial results evolve. The Company recalculates the compensation expense under the PSU Plan and reflects any adjustments in the consolidated statements of operations in the period in which they are determined.
Effective January 1, 2008, the Company adopted SFAS 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans-an amendment of FASB Statements No. 87, 88, 106 and 132(R)” (“SFAS 158”). This statement requires an entity to, among other things: (a) recognize an asset or a liability in the Consolidated Balance Sheets for the funded status of defined benefit plans that are overfunded or underfunded, respectively, measured as the difference between the fair value of plan assets and the pension obligation; (b) recognize changes in the funded status of defined benefit plans in the year in which the changes occur as a component of other comprehensive income, net of tax; and (c) measure defined benefit plan assets and obligations as of the date of the employer’s balance sheet (see Note 11 “Retirement Benefit Arrangements”).
The Company will discontinue hedge accounting prospectively if it is determined that the derivative is no longer effective in offsetting changes in the foreign currency exposure of a hedged item. To the extent that the Company in the future chooses to discontinue hedge accounting related to its foreign currency hedging of its investment in and loans to subsidiaries because, based on Management’s assessment, the derivative no longer qualifies as an effective hedge, the derivative will continue to be carried in the consolidated balance sheets at its fair value, with changes in its fair value recognized in current period net income.
Business combinations are accounted for under the purchase method in accordance with SFAS No. 141, “Business Combinations” (“SFAS 141”). See Note 3 “Acquisitions” for further details.
Goodwill represents the excess of the purchase price over the fair value of the net assets acquired by the Company. Goodwill is recorded as an asset and is not amortized.
In accordance with SFAS No. 142 “Goodwill and Other Intangible Assets”, (“SFAS 142”), the Company will perform, at a minimum, an annual valuation of its goodwill and intangible assets to test for impairment or more frequently if events or changes in circumstances indicate that the carrying amount may not be recoverable. If, as a result of the assessment, the Company determines that the value of its goodwill and intangible assets are impaired, the Company will record an impairment charge in the period in which the determination is made.
The reporting currency of the Company is the U.S. dollar. The functional currencies of the Company’s operating subsidiaries are generally their national currencies. In translating the financial statements of those subsidiaries whose functional currency is other than the U.S. dollar, assets and liabilities are converted into U.S. dollars using the rates of exchange in effect at the balance sheet dates, and revenues and expenses are converted using the weighted average foreign exchange rates for the period. The cumulative translation adjustment is reported in the consolidated balance sheets as a separate component of accumulated other comprehensive (loss) income.
In recording foreign currency transactions, revenues and expense items are converted at the prevailing exchange rate at the transaction date. Monetary assets and liabilities denominated in foreign currencies are translated at exchange rates in effect at the balance sheet date, which may result in the recognition of exchange gains or losses. The exchange gains and losses are reported in the consolidated statements of operations as net foreign exchange (losses) gains.
Certain subsidiaries of the Company operate in jurisdictions where they are subject to taxation. Current and deferred income taxes are charged or credited to net income based upon enacted tax laws and rates applicable in the relevant jurisdiction in the period in which the tax becomes realizable. Deferred income taxes are provided for all temporary differences between the bases of assets and liabilities used in the consolidated balance sheets and those used in the various jurisdictional tax returns. When management’s assessment indicates that it is more likely than not that deferred income tax assets will not be realized, a valuation allowance is recorded against the deferred tax assets. We adopted the provisions of FASB Interpretation No. 48, “According for Uncertainty in Income Taxes - An Interpretation of FASB Statement No. 109” (“FIN 48”) on January 1, 2007. Under FIN 48, the tax benefits of uncertain tax positions may only be recognized when the position is more-likely-than-not to be sustained upon audit by the relevant taxing authorities.
On June 26, 2008, Flagstone Suisse purchased 3,714,286 shares (representing a 65% interest) in Flagstone Africa for a purchase price of $18.6 million. The Company recorded $1.1 million of goodwill on the date of acquisition. In July, 2008, the South Africa Registrar of Companies recorded a change of name from Imperial Re to Flagstone Africa. Flagstone Africa is domiciled in South Africa and writes multiple lines of reinsurance in sub-Saharan Africa.
The Company recorded $1.1 million of goodwill on the acquisition and recorded intangible assets of $1.1 million related to the value of licenses which are estimated to have an indefinite useful life. The Company is in the process of determining the value of certain net assets acquired, therefore the allocation of the purchase price is subject to change to account for the outcome of the valuation.
On October 17, 2008, the Company announced that it had entered into an agreement to acquire 100% of the common shares of Marlborough Underwriting Agency Limited, the managing agency for Lloyd’s Syndicate 1861 - a Lloyd’s syndicate underwriting a specialist portfolio of short-tail insurance and reinsurance, from the Berkshire Hathaway Group. The acquisition does not include the existing corporate Lloyd’s member or any liability for business written during or prior to 2008. The acquisition closed on November 18, 2008, following receipt of approval from Lloyd’s and UK Financial Services Authority. Total consideration for the acquisition of the shares of Marlborough was $48.4 million, including $1.0 million of acquisition costs paid to external parties. The Company licensed its own corporate capital vehicle, Flagstone Corporate Name Limited, to be the capital provider for Lloyd’s Syndicate 1861 for fiscal year 2009 onwards. The acquisition provides the Company with a Lloyd’s platform with access to both London business and that sourced globally from our network of offices.
The fair value of the net assets acquired and allocation of purchase price is summarized as follows:
Prior to the acquisition, the purpose of Mont Fort was to facilitate third-party transactions in credit insurance and reinsurance through its segregated accounts on a 100% matched, fully offset basis so that it would bear no net retained insurance risk. Each policy written by a segregated account would be entirely reinsured at the closing of the transaction with high-credit quality counterparties.
On January 2, 2007, Mont Fort closed an offering of preferred shares relating to its second cell, Mont Fort ILW 2 which yielded gross proceeds of $55.0 million from LB I. Mont Fort, in respect of Mont Fort ILW 2, entered into a quota share reinsurance contract with the Company under which the Company assumes 8.3% of the business written by Mont Fort ILW 2.
The cost or amortized cost, gross unrealized gains and losses, and carrying values of the Company’s fixed maturity, short term and equity investments as at December 31, 2008 and 2007 are as follows:
The contractual maturity dates of fixed maturity and short term investments as at December 31, 2008 and 2007 are as follows:
At December 31, 2008, the Company’s entire fixed maturity investment portfolio, with the exception of $0.3 million, was invested in securities which were investment grade. At December 31, 2007, 100% of the Company’s fixed maturity investment portfolio was invested in securities which were investment grade. As at December 31, 2008 and 2007, the Company did not hold any security with direct exposure to the sub-prime markets.
The valuation technique used to fair value the financial instruments is the market approach which uses prices and other relevant information generated by market transactions involving identical or comparable assets. In accordance with SFAS No. 157, the Company determined that its investments in U.S. government securities, listed equity securities and fixed income fund are stated at Level 1 fair value. Investments in corporate bonds, mortgage-backed securities, equity exchange traded funds, investment funds that are hedge funds, asset backed securities, real estate investment trust (“REITs”) and REIT funds are stated at Level 2, whereas the investment funds that are private placement investments, catastrophe bonds and two corporate bond securities are stated at Level 3 fair value.
The Company has reviewed its Level 3 investments and the valuation methods. Catastrophe bonds are stated at fair value as determined by reference to broker indications. Those indications are based on current market conditions, including liquidity and transactional history, recent issue price of similar catastrophe bonds and seasonality of the underlying risks. The private equity investments are valued based on valuations received from the investment fund managers using the valuations and financial statements provided by the underlying general partners of the funds on a quarterly basis. These valuations are then adjusted by the investment fund managers for cash flows since the most recent valuation. The valuation methodology used for investment funds is consistent with the methodology that is generally employed in the investment industry. The Company also transferred two corporate bonds at fair value from Level 2 into Level 3 as of December 31, 2008 due to limited availability of market data and significant reliance on model valuation by the pricing sources.
As at December 31, 2008 and 2007, the Company’s investments are allocated between levels as follows:
For reconciliation purposes, the table above does not include an equity investment of $5.7 million in which the Company is deemed to have a significant influence and is accounted for under the equity method and as such, is not accounted for at fair value under SFAS 159.
For reconciliation purposes, the table above does not include an equity investment of $112,000 in which the Company is deemed to have a significant influence and is accounted for under the equity method and as such, is not accounted for at fair value under SFAS 159.
The reconciliation of the fair value for the Level 3 investments for the years ended December 31, 2008 and 2007, including net purchases and sales, realized gains and change in unrealized gains (losses), is set out below:
The total change in fair value of the Level 3 items still held as of December 31, 2008 is $(6.2) million.
Net investment income for the years ended December 31, 2008, 2007 and 2006 was $51.4 million, $73.8 million and $34.2 million, respectively. The components are set out below:
Certain business written by the Company has loss experience generally characterized as low frequency and high severity in nature. This may result in volatility in the Company’s financial results. Actuarial assumptions used to establish the liability for losses and loss adjustment expenses are periodically adjusted to reflect comparisons to actual losses and loss adjustment expenses development, inflation and other considerations. Prior period development arises from changes to loss estimates recognized in the current year that relate to loss reserves first reported in the previous calendar year. These reserve changes were made as part of our regular quarterly reserving process and primarily arose from better than expected emergence of actual claims relative to our prior year estimates.
During the year ended December 31, 2008, we had total net positive development of $15.7 million; $10.5 million relating to the 2007 loss year and $5.2 million relating to the 2006 loss year. The favorable development was primarily due to actual loss emergence in the property catastrophe, property, and the short-tail specialty and casualty lines of business being lower than the initial expected loss emergence.
The Company purchases reinsurance to reduce its net exposure to losses. Reinsurance provides for recovery by the Company of a portion of gross losses and loss adjustment expenses from its reinsurers. The Company remains liable to the extent that its reinsurers do not meet their obligations under these agreements and the Company therefore regularly evaluates the financial condition of its reinsurers and monitors concentration of credit risk. The reinsurance claims recoverable as at December 31, 2008 and 2007 was $16.4 million and $1.4 million, respectively, against which the Company has determined that no provision for doubtful debt is required.
Assumed and ceded net premiums written and earned and loss and loss adjustment expenses for the years ended December 31, 2008, 2007 and 2006 are as follows:
The Company writes certain reinsurance contracts that are classified as derivatives under SFAS 133. In addition, the Company enters into derivative instruments such as interest rate futures contracts, interest rate swaps, foreign currency forward contracts and foreign currency swaps in order to manage portfolio duration and interest rate risk, borrowing costs and foreign currency exposure. The Company enters into index futures contracts and total return swaps to gain or reduce its exposure to the underlying asset or index. The Company also purchases “to be announced” mortgage-backed securities (“TBAs”) as part of its investing activities and futures options on weather indexes as part of its reinsurance activities. The Company manages the exposure to these instruments based on guidelines established by management and approved by the Board of Directors.
The Company has used interest rate swap contracts in the portfolio as protection against unexpected shifts in interest rates, which would affect the fair value of the fixed maturity portfolio. By using interest rate swaps, the overall duration or interest rate sensitivity of the portfolio can be altered. The Company has also used interest rate swaps to manage its borrowing costs on its long term debt. As of December 31, 2008, the Company did not have any interest rate swaps and as of December 31, 2007, there were a total of $389.9 million of interest rate swaps in the portfolio with a total fair value of $2.3 million. During the year ended December 31, 2008, the Company recorded realized and unrealized losses on interest rate swaps of $0.2 million, and for the year ended December 31 2007, the Company recorded realized and unrealized gains of $0.5 million.
The Company and its subsidiaries use foreign currency forward contracts to manage currency exposure. The net contractual amount of these contracts as at December 31, 2008 and 2007 was $432.4 million and $311.1 million, respectively, and these contracts had a fair value of $(9.5) million and $(7.1) million, respectively. The Company has designated $337.7 million and $264.4 million of foreign currency forwards contractual value as hedging instruments, which had a fair value of $(5.7) million and $(3.4) million as at December 31, 2008 and December 31, 2007, respectively. During the years ended December 31, 2008 and 2007, the Company recorded $7.1 million of realized and unrealized gains and $14.0 million of realized and unrealized losses, respectively, on foreign currency forward contracts. During the years ended December 31, 2008 and 2007, the Company recorded $17.0 million and $3.5 million of realized and unrealized losses, respectively, directly into comprehensive income as part of the cumulative translation adjustment for the effective portion of the hedge.
The Company has subsidiaries that operate in various other jurisdictions around the world that are subject to tax and examination by taxing authorities in the jurisdictions in which they operate. The significant jurisdictions in which the Company’s subsidiaries are subject to tax are South Africa, Canada, Cyprus, India, Mauritius, Switzerland, U.S. Virgin Islands and the United Kingdom. Income tax returns are open for examination for the tax years 2005-2007 in Canada, 2005-2007 in the U.S. Virgin Islands, 2007 in the UK, 2003-2007 in Cyprus and 2006-2007 in India. Due to its limited history, the Company’s subsidiary in Switzerland has not yet filed income tax returns and therefore does not yet have any tax years open for examination.
The valuation allowance relates to an operating loss in one of the Company’s foreign subsidiaries. Although local tax laws allow tax losses to be carried forward for a period of seven years, the Company believes it is necessary to establish a valuation allowance against this deferred tax asset due to its short operating history and uncertainty regarding the Company’s ability to generate sufficient future income to utilize the loss carried forward and realize the asset.
The Company incurred expenses for these defined contribution arrangements of $0.9 million, $0.7 million and $0.1 million for the years ended December 31, 2008, 2007 and 2006, respectively.
Since 2007, the Company has maintained a pension plan for its employees in Switzerland (the “Swiss Plan”), which was classified and accounted for as a defined contribution plan. Recent changes to the Swiss Plan, have led the Company to conclude that the current features of the plan now indicate that under the Swiss pension law (“BVG”) it should be accounted for as a defined benefit pension plan for the year ended December 31, 2008.
At December 31, 2008 the funded status of the Swiss Plan was as follows:
At December 31, 2008 the funded status at the end of the year was included in other liabilities in the Consolidated Balance Sheet. Employer contributions for the year ended December 31, 2008 were $0.8 million.
The assumptions used to determine the pension obligation and net periodic benefit cost for the year ended December 31, 2008 were as follows:
At December 31, 2008, estimated employer contributions to be paid in 2009 were $0.9 million and future benefit payments were estimated to be paid as follows:
The Company repurchased, in a privately negotiated transaction, $11.25 million of principal amount of its outstanding $100.0 million Floating Rate Deferrable Interest Junior Subordinated Notes during the quarter ended June 30, 2008. The purchase price paid for the Notes was 81% of face value, representing a discount of 19%. The repurchase resulted in a gain of $1.8 million, net of unamortized debt issuance costs of $0.1 million that were written off. As a result, the gain has been included as a gain on early extinguishment of debt under other income.
At December 31, 2008 and 2007, the total authorized common voting shares of the Company were 150,000,000, with a par value of $0.01 per common share.
The holders of common voting shares are entitled to receive dividends as declared from time to time and are entitled to one vote per common share, subject to certain restrictions. Voting rights of all shares may be amended under the voting adjustment provisions in the Company’s bye-laws designed to preserve certain U.S. shareholders’ tax positions with respect to their shares to ensure their voting interest is less than 9.9% to comply with certain provisions of the Internal Revenue Code and the rules and regulations promulgated there under.
On February 1 and February 23, 2006, the Company had two additional share subscriptions from which it raised $148.0 million and $15.1 million, respectively, raising the total number of issued common shares to 71,547,891. Issuance costs related to February 2006 subscriptions were $0.3 million.
At the Company’s board meeting held on November 14, 2008, the Warrant was amended to change the exercise date from December 1, 2010 to December 31, 2010, to December 1, 2013 to December 31, 2013, change the strike price to $14.80 from $14.00 and include a provision that amends the strike price for all dividends paid by the company from the issuance of the Warrant to its exercise date. As a result of the amendments additional compensation expense of $3.6 million has been recognized in general and administrative expenses and in additional paid-in capital in the consolidated financial statements for the year ended December 31, 2008. This value has been calculated using the Black-Scholes option pricing model. The assumptions used were: risk-free interest rate 2.8%; expected life 5.05 years; volatility 38.6%; dividend yield 1.59%. The volatility assumption was based on the average historical volatility of a group of comparable companies over a period equal to the expected life of the Warrant.
The Company accounts for the issuance of a subsidiary’s stock in accordance with SEC Staff Accounting Bulletin Topic 5H “Accounting for sales of stock by a subsidiary”, which requires that the difference between the carrying amount of the parent’s investment in a subsidiary and the underlying net book value of the subsidiary after the issuance of stock by the subsidiary be reflected as either a gain or loss in the statement of operations or reflected as an equity transaction. The Company has elected to record gains and losses resulting from the issuance of subsidiary’s stock as an equity transaction. Accordingly, the Company recorded a loss of $0.1 million as a decrease to additional paid-in capital.
The PSU Plan is the Company’s shareholder approved primary executive long-term incentive scheme. Pursuant to the terms of the PSU Plan, at the discretion of the Compensation Committee of the Board of Directors, PSUs may be granted to executive officers and certain other key employees and vesting is contingent upon the Company meeting certain DROE goals.
Upon vesting, the PSU holder shall be entitled to receive a number of common shares of the Company (or the cash equivalent, at the election of the Company) equal to the product of the number of PSUs granted multiplied by a factor based on the Company’s DROE during the vesting period. The factor will range between 0.5 and 1.5, depending on the DROE achieved during the vesting period. This factor was amended on November 13, 2008, from the previous factor which ranged between 0.0 and 2.0. PSUs vest over a period of two or three years. At the Company’s Annual General Meeting of shareholders held on May 16, 2008, the PSU Plan was amended to increase the maximum number of PSUs that can be issued under the PSU Plan from 2.8 million to 5.6 million and to increase the maximum number of common shares that can be issued under the PSU Plan from 5.6 million to 11.2 million. The fair value of PSUs granted under the PSU Plan is estimated on the date of grant using the fair value on the grant date and the most probable DROE outcome.
A summary of the activity under the PSU Plan as at December 31, 2008, 2007 and 2006 and changes during the years ended December 31, 2008, 2007 and 2006, is as follows:
The Company reviews its assumptions in relation to the PSUs on a quarterly basis. For the years ended December 31, 2008, 2007 and 2006, respectively, $(6.9) million, $6.0 million and $2.1 million has been recorded in general and administrative expenses in relation to the PSU Plan. As at December 31, 2008, 2007 and 2006, there was a total of $21.0 million, $11.9 million and $5.0 million, respectively, of unrecognized compensation cost related to non-vested PSUs; that cost is expected to be recognized over a period of approximately 2.5 years, 2.1 years and 2.0 years, respectively.
Beginning July 1, 2006, the Company granted RSUs to certain employees and directors of the Company. The purpose of the Restricted Share Unit Plan (“RSU Plan”) is to encourage employees and directors of the Company to further the development of the Company and to attract and retain key employees for the Company’s long-term success. The RSUs granted to employees vest over a period of approximately two years while RSUs granted to directors vest on the grant date.
As at December 31, 2008 and 2007, there was a total of $1.0 million, $1.3 million and $0.5 million, respectively, of unrecognized compensation cost related to non-vested RSUs; that cost is expected to be recognized over a period of approximately 1.0 years, 0.9 years and 1.5 years, respectively. A compensation expense of $3.0 million, $2.2 million and $0.7 million has been recorded in general and administrative expenses for the years ended December 31, 2008, 2007 and 2006, respectively, in relation to the RSU Plan.
Dilutive share equivalents have been excluded in the weighted average common shares used for the calculation of earnings per share in periods of net loss because the effect of such securities would be anti-dilutive. The number of anti-dilutive share equivalents that have been excluded in the computation of diluted earnings per share for the year ended December 31, 2008, were 243,124. Also at December 31, 2008, 2007, and 2006, there was a warrant outstanding which would result in the issuance of 8,585,747 common shares that were excluded from the computation of diluted earnings per common share because the effect would be anti-dilutive. Because the number of shares contingently issuable under the PSU Plan depends on the average DROE over a two or three year period, the PSUs are excluded from the calculation of diluted earnings per common share until the end of the performance period, at which time the number of shares issuable under the PSU Plan will be known. As at December 31, 2008, 2007 and 2006, there were 2,189,982, 1,658,700 and 713,000 PSUs outstanding, respectively. The maximum number of common shares that could be issued under the PSU Plan at December 31, 2008, 2007 and 2006 was 3,284,973, 3,317,400 and 1,426,000 respectively.
Haverford also owns all of the share capital of Haverford Investment Holdings Ltd., which owns 6.0% of the voting common shares of Haverford Capital Partners (Cayman) Limited (“HCP”). The Chief Executive Officer of HCP is also a director of the Company. HCP directly owns 2.5 million common shares, or 2.9% of the outstanding common shares of the Company at both December 31, 2008 and 2007.
On March 31, 2006, Flagstone acquired 63,783 common shares of Island Heritage from Haverford, representing at the time 18.7% of the common shares and 22.5% of the votes for a purchase price of $7.3 million.
The Company had extensively used two aircraft owned and operated by entities controlled by Mr. Byrne. Given the Company’s worldwide operations, in July 2007 the Company’s Board voted unanimously that it was in the Company’s best interest to acquire from Mr. Byrne the aircraft and the operating company that supported the aircraft.
On August 23, 2007, Flagstone Leasing entered into a Share Purchase Agreement (“IAL Agreement”) with Mr. Byrne, Haverford and West End to acquire 100% of the issued and outstanding common voting shares of IAL Leasing Limited (“IAL”). Mr. Byrne, Haverford and West End owned 90%, 5% and 5%, respectively, of the issued and outstanding common voting shares of IAL. Pursuant to the terms of the IAL Agreement, Flagstone Leasing, on August 28, 2007, acquired all of the issued and outstanding common voting shares of IAL for a cash purchase price of $1.4 million. The purchase price equaled the value of the net assets acquired, inclusive of debt of $17.1 million due to Banc of America Leasing and Capital LLC (“BoA”). IAL owned, as its principal asset, a Dassault Falcon 900B aircraft (“the Falcon”). In consideration of Mr. Byrne forgiving debt due to him from IAL, and his undertaking with respect to the indemnities contained in the IAL Agreement, he received 100% of the purchase price. The value attributed to the aircraft for the purpose of this transaction was determined by the average of two independent appraisals. On September 25, 2007, IAL concluded a sale lease-back transaction with BoA in relation to the Falcon. With this transaction, IAL sold the Falcon and the related debt financing to BoA for a cash consideration of $1.4 million and entered into an operating lease with BoA to lease the Falcon for a term of 10 years.
Prior to the acquisition of Longtail in August 2007, the Company participated in a charter agreement with Longtail which permitted the Company to charter private aircraft. The Company incurred an expense of $1.1 million and $1.9 million in relation to this agreement during the years ended December 31, 2007 and 2006, respectively, which was included within general and administrative expenses, and $0.2 million was included in due to related parties as at December 31, 2006.
During the eight months ended August 31, 2008 and the years ended December 31, 2007 and 2006, the Company made lease payments of $0.3 million, $0.3 million and $0.4 million, respectively, to Eye Patch Holdings Limited (“Eye Patch”), a company in which Haverford has a 40.0% stake and from which the Company leases office space. Haverford sold its 40.0% interest in Eye Patch on August 28, 2008, therefore the expense for 2008 is for the period from January 1, 2008 to August 28, 2008.
On September 5, 2006, the Company entered into a foreign currency swap agreement with Lehman Brothers Inc. in relation to the issuance of the Deferrable Interest Debentures. Under the terms of the agreement, the Company exchanged €13.0 million for $16.7 million, received Euribor plus 354 basis points and paid LIBOR plus 371 basis points. The agreement was terminated, as per the term of the swap agreement, on September 15, 2008 due to the bankruptcy of Lehman Brothers Inc. At the termination date, the Company has a recoverable balance of $0.1 million, however, due to the uncertainty of the recovery the full amount was written off as of December 31, 2008.
Credit risk arises out of the failure of a counter-party to perform according to the terms of the contract. The Company is exposed to credit risk in the event of non-performance by the counterparties to the Company’s foreign exchange forward contracts, currency swaps and interest rate swaps. However, because the counterparties to these agreements are high credit quality international banks, the Company does not anticipate any non-performance. The Company also holds counterparty collateral or posts collateral with the derivative counterparties, as allowed for in the ISDA agreements, in order to mitigate the counterparty exposure risk related to the fair value of the derivatives. The difference between the contract amounts and collateral held or posted is the Company’s credit exposure with these counterparties.
During 2006, the Company made certain commitments with respect to an investment in a private equity fund. As at December 31, 2008 and 2007, the total outstanding investment commitment was $4.2 million and $6.4 million, respectively.
As at December 31, 2008 and 2007, the Company was not a party to any material litigation or arbitration proceedings.
Bermuda law limits the maximum amount of annual dividends or distributions that can be paid by Flagstone Suisse to the Company and in certain cases requires the prior notification to, or the approval of, the Bermuda Monetary Authority (the “BMA”). As a Bermuda Class 4 reinsurer, Flagstone Suisse may not pay dividends in any financial year which would exceed 25% of its total statutory capital and surplus, as shown on its statutory balance sheet in relation to the previous financial year, unless at least seven days before payment of those dividends, it files an affidavit with the BMA signed by at least two directors and Flagstone Suisse’s principal representative, which states that in their opinion, declaration of those dividends will not cause Flagstone Suisse to fail to meet its prescribed solvency margin and liquidity ratio. Further, Flagstone Suisse may not reduce by 15% or more its total statutory capital as set out in its previous year’s financial statements, without the prior approval of the BMA. This may limit the amount of funds available for distribution to the Company, restricting the Company’s ability to pay dividends, make distributions and repurchase any of its common shares. Flagstone Suisse was required to maintain a minimum level of statutory capital and surplus of $326.8 million and $228.0 million, as at December 31, 2008 and 2007, respectively. Actual statutory capital and surplus as at December 31, 2008 and 2007 was $1.3 billion and $1.4 billion, respectively. Actual statutory net (loss) income for the years ended December 31, 2008, 2007 and 2006 were $(121.5) million, $190.8 million and $155.3 million respectively.
Flagstone Africa is licensed to operate as a reinsurer in South Africa and is subject to statutory minimum capital requirements under applicable legislation. In addition, a South African reinsurance company may pay a dividend only if, after payment of the dividend, it will continue to comply with regulatory requirements regarding minimum capital, special reserves and solvency requirements.
The Company holds a controlling interest in Island Heritage, whose primary business is insurance. As a result of the strategic significance of the insurance business to the Company, and given the relative size of revenues generated by the insurance business, the Company modified its internal reporting process and the manner in which the business is managed and as a result the Company revised its segment structure, effective January 1, 2008, to include a new Insurance segment. As a result of this process the company is now reporting its results to the chief operating decision maker based on two reporting segments: Reinsurance and Insurance. The 2007 comparative information below reflects our current segment structure. As the Company did not undertake any insurance business prior to its acquisition of Island Heritage in the third quarter of 2007, there is no 2006 comparative information. The Company regularly reviews its financial results and assesses performance on the basis of these two reporting segments.
Property Reinsurance. We also provide reinsurance on a pro rata share basis and per risk excess of loss basis. Per risk reinsurance protects insurance companies on their primary insurance risks on a single risk basis, for example, covering a single large building. All property per risk and pro rata business is written with loss limitation provisions, such as per occurrence or per event caps, which serve to limit exposure to catastrophic events.
The Company has established an Insurance segment as a result of the insurance business operated through Island Heritage, a property insurer based in the Cayman Islands which is primarily in the business of insuring homes, condominiums and office buildings in the Caribbean region. The Company gained a controlling interest in Island Heritage in the third quarter of 2007, and as a result, the comparatives for the year December 31, 2007 include the results of Island Heritage for six months only.
The following tables provide a summary of gross and net written and earned premiums, underwriting results, a reconciliation of underwriting income to income before income taxes, minority interest and interest in earnings of equity investments, total assets, reserves and ratios for each of our business segments for the years ended December 31, 2008, 2007 and 2006. There was only one segment for the year ended December 31, 2006:
Gross written premiums related to the Insurance segment are included in the Caribbean geographic area.
For the years ended December 31, 2008, 2007 and 2006, premiums produced by brokers were as follows:
Sale of an Aircraft Delivery Slot by Mr. Byrne to the Company
On March 6, 2009, Flagstone Leasing entered into a Share Purchase Agreement with Mr. Byrne to acquire 100% of the issued and outstanding common voting shares of IAL 7X. Mr. Byrne owned 100% of the issued and outstanding common voting shares of IAL 7X. Pursuant to the terms of the IAL 7X Agreement, Flagstone Leasing, on March 6 2009, acquired all of the issued and outstanding common voting shares of IAL 7X for a cash purchase price of $10,000. The purchase price equaled the value of the net assets acquired, inclusive of debt of $14.3 million due to Banc of America Leasing and Capital LLC (“BoA”). IAL 7X owned, as its principal asset, a delivery slot for a Dassault Falcon 7X aircraft (“the 7X”). IAL 7X had made progress payments of $14.0 million as of March 6, 2009 and had recorded such payments as purchase deposits on its balance sheet. IAL 7X has entered into an agreement with BoA for the financing of 100% of the purchase cost of the 7X up to an amount of $45.2 million. Mr. Byrne served as guarantor of the financing with BoA and this guarantee was replaced with one from the Company. The 7X is expected to be delivered at the end of 2009 for an estimated cost of $44.0 million (the “contract price”).
Mr. Byrne and the Company have agreed that upon delivery of the aircraft, the Company will either sell the aircraft or retain it as determined by the Board according to the Company’s needs at that time, and if not sold will have it appraised by two independent appraisers. If the sale price, or appraisal value, is greater than the contract price, the Company will pay Mr. Byrne 85% of the excess in cash. If the sale price, or appraisal value, is less than the contract price, Mr. Byrne will reimburse the Company 100% of the shortfall in cash.