The Company and Validus Re currently occupy office space in Hamilton, Bermuda under a lease expiring on August 31, 2011. Validus Research Inc. currently occupies office space in Waterloo, Canada under a lease expiring on February 28, 2018. Validus Reaseguros, Inc. currently occupies office space in Miami, United States under a
You should read the following summary consolidated financial information together with the other information contained in this annual report on form 10K, including “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes included elsewhere in this annual report on form 10K.
The following table is derived from audited results for the years ended December 31, 2007 and December 31, 2006 and the period from October 19, 2005, the date of our incorporation, to December 31, 2005:
The Company has early adopted FAS 157 and FAS 159 as of January 1, 2007 and elected the fair value option on all securities previously accounted for as available-for-sale. Unrealized gains and losses on available-for-sale investments at December 31, 2006 of $875,000, previously included in accumulated other comprehensive income, were treated as a cumulative-effect adjustment as of January 1, 2007. The cumulative-effect adjustment transferred the balance of unrealized gains and losses from accumulated other comprehensive income to retained earnings and has no impact on the results of operations for the annual or interim periods beginning January 1, 2007. The Company’s investments were accounted for as trading for the annual or interim periods beginning January 1, 2007 and as such all unrealized gains and losses are included in net income.
FAS 123R require that any unrecognized stock-based compensation expense that will be recorded in future periods be included as proceeds for purposes of treasury stock repurchases, which is applied against the unvested restricted shares balance. On March 1, 2007 we effected a 1.75 for one reverse stock split of our outstanding common shares. The stock split does not affect our financial statements other than to the extent it decreases the number of outstanding shares and correspondingly increases per share information for all periods presented. The share consolidation has been reflected retroactively in these financial statements.
The following is a discussion and analysis of the Company’s consolidated results of operations for the three months and year ended December 31, 2007 and 2006 and the Company’s consolidated financial condition and liquidity and capital resources at December 31, 2007 and December 31, 2006. The Company completed the acquisition of Talbot Holdings Ltd. (“Talbot”) on July 2, 2007. As a result, Talbot is only included in the Company’s consolidated results from July 2, 2007 through December 31, 2007. Talbot is not included in consolidated results for the year ended December 31, 2006 and the first six months of 2007. This discussion and analysis pertains to the results of the Company inclusive of Talbot from the date of acquisition. Talbot 2006 results are included in discussion of segment results for comparison purposes only and are not consolidated in the Company results for 2006 periods. This discussion and analysis should be read in conjunction with the Company’s audited consolidated financial statements and related notes for the fiscal years ended December 31, 2007 and 2006.
The Company underwrites from two distinct global operating subsidiaries, Validus Re and Talbot. Validus Re, the Company’s principal reinsurance operating subsidiary, operates as a Bermuda-based provider of short-tail reinsurance products on a global basis. Talbot, the Company’s principal insurance operating subsidiary, operates through its two underwriting platforms: Talbot Underwriting Ltd, which manages syndicate 1183 at Lloyd’s, and
Written premiums are a function of the number and type of contracts written, as well as prevailing market prices. 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 inception and renewal periods, while most insurance and specialty lines are written throughout the year. Written premiums are generally highest in the first quarter and lowest during the fourth quarter of the year. Gross premiums written for pro rata programs are initially recorded as estimates and are adjusted as actual results are reported by the cedant during the period. Pro rata reinsurance is a type of reinsurance whereby the reinsurer indemnifies the policyholder against a predetermined portion of losses. Earned premiums do not necessarily follow the written premium pattern as premiums written are primarily earned ratably over the contract term, which is ordinarily twelve months, although many pro rata contracts are written on a risks attaching basis, which means that the contracts cover claims that arise on underlying insurance policies that incept during the term of the reinsurance contract, and are generally earned over a 24 month period, which is the risk period of the underlying (twelve month) policies. Premiums are generally due in monthly or quarterly installments.
Acquisition costs consist principally of brokerage expenses and commissions which are driven by contract terms on reinsurance contracts written, and are normally a specific percentage of premiums. Under certain contracts, cedants may also receive profit commissions which will vary depending on the loss experience on the contract. Acquisition costs are presented net of commissions or fees received on any ceded premium, including premium ceded to Petrel Re.
General and administrative expenses are generally comprised of fixed expenses which do not vary with the amount of premiums written or losses incurred. Applicable expenses include salaries and benefits, professional fees, office, risk management, and stock compensation expenses. Stock compensation expenses include costs related to the Company’s long-term incentive plan, under which restricted stock and stock options are granted to certain employees.
Property and other reinsurance premiums have historically risen in the aftermath of significant catastrophic losses. As loss reserves are established, industry surplus is depleted and the industry’s capacity to write new business diminishes. At the same time, management believes that there is a heightened awareness of exposure to natural catastrophes on the part of cedants, rating agencies and catastrophe modeling firms, resulting in an increase in the demand for reinsurance protection. The large industry losses in 2004 and 2005 led to an increase in the perception of catastrophe risk by market participants creating a supply/demand imbalance for reinsurance capacity. The Company was formed in October 2005 to take advantage of these opportunities; we have also built our operations so that we may effectively take advantage of future market conditions as they develop. Talbot, which the Company acquired on July 2, 2007, has also seen an increase in insurance and reinsurance rates in the aftermath of 2005.
Following significant losses from Hurricane Ivan in 2004 and Hurricanes Katrina and Rita in 2005, the marine and offshore energy insurance and reinsurance accounts experienced material price increases and more restrictive conditions. Losses resulting from Katrina affected nearly all lines of business written within the marine class and reinsurance and retrocessional capacity has been reduced sharply. Management believes that many reinsurers withdrew from marine and energy business and remaining reinsurers increased pricing and tightened conditions across all sectors. In addition to rate increases, coverage terms have become more restrictive including increased use of mutually exclusive pillars and other parametric devices.
We underwrite global specialty property insurance and reinsurance and have large aggregate exposures to natural and man-made disasters. The relatively low claim experience for Validus Re has been the result of few events of high magnitude. The occurrence of claims from catastrophic events is likely to result in substantial volatility in, and could have a material adverse effect on, the Company’s financial condition and results and ability to write new business. This volatility will affect results for the period in which the loss occurs because U.S. accounting principles do not permit reinsurers to reserve for such catastrophic events until they occur. Catastrophic events of significant magnitude historically have been relatively infrequent, although management believes the property catastrophe reinsurance market has experienced a higher level of worldwide catastrophic losses in terms of both frequency and severity in the period from 1992 to the present. We also expect that increases in the values and concentrations of insured property will increase the severity of such occurrences in the future. The Company seeks to reflect these trends when pricing contracts.
Reserve for Losses and Loss Expenses. For insurance and reinsurance companies, a significant judgment made by management is the estimation of the reserve for losses and loss expenses. The Company establishes its reserve for losses and loss expenses to cover the estimated remaining liability incurred for both reported claims (“case reserves”) and unreported amounts (“incurred but not reported” or “IBNR reserves”). For insurance and reinsurance business, the IBNR reserves include provision for circumstances that have occurred but not yet been reported to the Company as well as for future variation in case reserves (where the claim has been reported but the ultimate value is not yet known). Within the reinsurance business, the portion of total IBNR related to future variation on known claims is calculated at the individual claim level in some instances (an additional case reserve or individual claim IBNR). Within the insurance business, the provision for future variation in current case reserves is generally calculated on an implicit basis via the direct projection of total IBNR, and ACRs are not used.
For insurance business, for risks that the Company leads, the Company receives from brokers details of potential claims, on the basis of which the Company’s loss adjusters make estimates of the likely ultimate outcome of the claims. For insurance business where another company is the lead, the Company additionally receives and reviews case estimates from the lead insurer. In determining these reserves, the Company takes into account a number of factors including the facts and circumstances of the individual claim, the nature of the coverage, and historical information about its experience on similar types of claims. The sum of the individual claim estimates for lead and follow business constitutes the case reserves.
The Company additionally writes a relatively small amount of longer tail insurance business, predominantly financial institutions and marine and energy liabilities. For such business, the time from the occurrence of a claim to its being reported, and in particular, the subsequent time before settlement of the claim, can be years, in which time additional facts regarding individual claims and trends often will become known and current laws and case law may change.
As a result of the uncertainties described above, the Company must estimate IBNR reserves, which consist of a provision for future development on known loss events, as well as a provision for claims which have occurred but which have not yet been reported to us by clients. Because of the degree of reliance that is necessarily placed on brokers and (re)insured companies for claims reporting, the associated time lag, the low frequency/high severity nature of much of the business underwritten, and, for reinsurance business, the varying reserving practices among ceding companies as described above, reserve estimates are highly dependent on management’s judgment and are subject to uncertainty.
estimate of future payments that should be reflected in reserves. Expected loss ratios are a primary component in the Company’s calculation of estimated ultimate losses for business at an early stage in its development.
Loss emergence patterns for the business written by Talbot are generally derived from the Company’s own historic loss development triangulations, supplemented in some instances by Lloyd’s market data. For the business written by Validus Re, where the Company’s own historic loss development triangulations are currently more limited, greater use is made of market data including reinsurance industry data available from organizations such as statistical bureaus and consulting firms, where appropriate. Expected loss ratios are estimated in a variety of ways, largely dependent upon the data available. Wherever it deems appropriate, management incorporates the Company’s own loss experience in establishing initial expected loss ratios and reserves. This is particularly true for the business written by Talbot where a longer reserving history exists and expected losses and loss ratios consider, among other things, rate increases and changes in terms and conditions that have been observed in the market. For reinsurance business, expected losses and loss ratios are typically developed using vendor and proprietary computer models. The information used in these models is collected by underwriters and actuaries during the initial pricing of the business.
Other methodologies are also used by the Company in the reserving process for specific types of claims or events, such as catastrophic or other specific major events. These include estimation based on vendor catastrophe models and analyses of specific industry events, such as large claims or lawsuits.
1. Case reserves - Case reserves generally are analyzed and established by the Company’s claims department on all lines, making use of third party input where appropriate (including, for the reinsurance business, reports of losses from the ceding companies). For insurance business where Talbot is not the Lead underwriter on the business, the case reserves are established by the lead underwriter and validated by central Lloyd’s market claims bureau, with a sample reviewed by Talbot.
2. ACR reserves - ACRs are established for Validus Re business by our claims department in cases where we believe the case reserves reported by the cedant require adjustment. ACRs supplement case reserves based on information obtained through ceding company audits or other sources. ACRs are not used at Talbot as claim volumes are generally greater and thus the potential for future variation in case reserve estimates on known claims often can be analyzed at an aggregate level using historical data.
a. Large or catastrophe events - IBNR reserves are established for all lines based on the Company’s estimates for known loss events for which not all claims have been reported to the Company. In establishing such IBNR, the Company accumulates loss information from modeling agencies, where possible, and publicly available sources. The loss information is applied to the Company’s book of in-force contracts using internal and third party vendor models to establish an estimate of the Company’s
ultimate exposure to the loss event. Paid losses, case reserves and additional case reserves are deducted from the ultimate to ascertain the IBNR estimate for individual large claims or catastrophe events.
For all sources of IBNR, net reserves are estimated by first estimating gross IBNR reserves, then estimating reinsurance recoverables on IBNR. To date, reinsurance recoverables are most material for the business written by Talbot.
The Company’s reserving methodology was not changed in the quarter ended December 31, 2007 from the methodology used in the year ended December 31, 2006 for either Validus Re or Talbot. Management’s best estimate of the gross reserve for losses and loss expenses and loss reserves recoverable at December 31, 2007 were $926.1 million and $134.4 million, respectively. The following table sets forth a breakdown between gross case reserves and gross IBNR by business segment at December 31, 2007.
Management’s best estimate of the gross reserve for losses and loss expenses at December 31, 2006 was $77.4 million. The following table sets forth a breakdown between gross case reserves and gross IBNR by segment at December 31, 2006.
Given the risks and uncertainties associated with the process for estimating reserves for losses and loss expenses, management has performed an evaluation of the potential variability in loss reserves and the impact this variability may have on reported results, financial condition and liquidity. Management’s best estimate of the net reserve for losses and loss expenses at December 31, 2007 is $791.7 million. The following tables show the effect on net reserves for losses and loss expenses as of December 31, 2007 of a change in two of the most critical assumptions in establishing reserves: (1) loss emergence patterns, accelerated or decelerated by three and six months; and (2) expected loss ratios varied by plus or minus five and ten percent. Management believes that a reasonably likely scenario is represented by such a standard, as used by some professional actuaries as part of their review of an insurer’s or reinsurer’s reserves. Utilizing this standard as a guide, management has selected these variances to determine reasonably likely scenarios of variability in the loss emergence and loss ratio assumptions. These scenarios consider normal levels of catastrophe events. Loss reserves may vary beyond these scenarios in periods of heightened claim activity. The reserves resulting from the changes in the assumptions are not additive and should be considered separately. The following tables vary the assumptions employed therein independently.
accordance with the type of contract written. The majority of our insurance premium is accepted on a direct open market or facultative basis. We receive a premium which is identified in the policy and recorded as unearned premium on the inception date of the contract. This premium will adjust only if the underlying insured values adjust. We actively monitor underlying insured values and record adjustment premiums in the period in which amounts are reasonably determinable.
For business written on a facility basis, although a premium estimate is not contractually stated for the amount of business to be written under any particular facility, an initial estimate of the expected premium written is received from the coverholder via the broker. Our estimate of premium is derived by reference to one or more of the following: the historical premium volume experienced by the facility; historical premium volume of similar facilities; the estimates provided by the broker; and industry information on the underlying business. We actively monitor the development of actual reported premium against the estimates made; where actual reported premiums deviate from the estimate, we carry out an analysis to determine the cause and may, if necessary, adjust the estimated premiums. In the year ended December 31, 2007, premiums written on a facility basis accounted for $169.8 million or 24.7% of total gross premiums written at Talbot.
Talbot results for the year ended December 31, 2006 are presented for comparative purposes. The results of operations for Talbot are consolidated only from the July 2007 date of acquisition.
Very little proportional reinsurance is purchased. This is recorded and earned in line with the underlying inwards premium.
At December 31, 2007, the use of different assumptions within the model could have a material effect on the provision for uncollectible reinsurance reflected in the Company’s consolidated financial statements. To the extent the creditworthiness of the Company’s reinsurers was to deteriorate due to an adverse event affecting the reinsurance industry, such as a large number of major catastrophes, actual uncollectible amounts could be significantly greater than the Company’s provision.
Validus Holdings, Ltd. and Validus Re were formed on October 19, 2005, and Validus Re commenced operations on December 16, 2005. Neither company had any prior operating history. The Company began writing reinsurance contracts on January 1, 2006. As there were no premiums written during period ended December 31, 2005, this period has been excluded from the following discussions. On July 2, 2007 the Company acquired Talbot Holdings Ltd. (“Talbot”) and is consolidating Talbot as of that date. The Company’s fiscal year ends on December 31. Financial statements are prepared in accordance with U.S. GAAP.
The following table presents results of operations for the three months and the year ended December 31, 2007 and 2006:
Talbot 2006 results are included in discussion of segment results for comparison purposes only and are not consolidated in the Company’s results for 2006 periods.
Non-GAAP Financial Measures. In presenting the Company’s results, management has included and discussed certain schedules containing underwriting income (loss) that is not calculated under standards or rules that comprise U.S. GAAP. Such measures are referred to as non-GAAP. Non-GAAP measures may be defined or calculated differently by other companies. These measures should not be viewed as a substitute for those determined in accordance with U.S. GAAP. A reconciliation of this measure to net income, the most comparable U.S. GAAP financial measure, is presented in the section below entitled “Underwriting Income.”
Three months ended December 31, 2007 compared to three months ended December 31, 2006
The consolidation of Talbot for the first time in 2007 increased underwriting income in the quarter by $40.4 million;
An increase in net investment income of $19.9 million or 112.6% as a result of growth in the Validus Re investment portfolio and the addition of the Talbot portfolio; and
Gross premiums written for the three months ended December 31, 2007 were $191.0 million compared to $65.5 million for the three months ended December 31, 2006, an increase of $125.5 million or 191.6%. The increase in gross premiums written was primarily driven by the addition of Talbot which added $143.5 million of gross premiums written. The increase from Talbot was partially offset by a $25.6 million decrease in the Validus Re property lines, discussed further below.
Validus Re. Validus Re reinsurance premiums ceded for the three months ended December 31, 2007 were $3.8 million compared to $(0.4) million for the three months ended December 31, 2006, an increase of $4.2 million. Validus Re reinsurance premiums ceded increased primarily as a result of premiums ceded of $3.8 million related to a quota share property contract. During the three month periods ended December 31, 2007 and 2006, no premiums were ceded to Petrel Re.
Validus Re. Validus Re net premiums written for the three months ended December 31, 2007 were $43.7 million compared to $65.9 million for the three months ended December 31, 2006, a decrease of $22.2 million or 33.7%. Details of net premiums written by line of business are provided below:
The decrease in Validus Re net premiums written was primarily driven by the property line which accounted for $29.2 million of the decrease. The decrease in property lines reflects the decrease in gross premiums written discussed above.
Validus Re. Validus Re’s change in unearned premiums for the three months ended December 31, 2007 was $118.8 million compared to $39.3 million for the three months ended December 31, 2006, an increase of $79.5 million or 202.4%. This reflects the higher level of premiums written in 2007 compared to 2006 and the earning of premiums on business written in 2006, as mentioned above. There was a lower balance of unearned premium at the outset of the three month period ended December 31, 2006 compared to the corresponding period in 2007 due to 2006 being Validus Re’s first year of operations.
Talbot. The Talbot change in unearned premiums for the three months ended December 31, 2007 was $12.8 million compared to $(23.4) million for the three months ended December 31, 2006, an increase of $36.2 million.
The change in gross unearned premiums reflects the higher gross written premium in 2007 relative to 2006 while the change in prepaid reinsurance premiums reflects lower reinsurance ceded in 2007 compared to 2006.
Losses and loss expenses for the three months ended December 31, 2007 were $107.6 million compared to $24.3 million for the three months ended December 31, 2006, an increase of $83.3 million or 343.3%. $59.3 million of the increase is attributable to the consolidation of Talbot. The loss ratio, which is defined as losses and loss expenses divided by net premiums earned, was 33.8% and 23.1% for the three months ended December 31, 2007 and 2006, respectively. Details of loss ratios by line of business are provided below.
The following table sets forth a reconciliation of gross and net reserves for losses and loss expenses by segment for the three months ended December 31, 2007:
Validus Re paid losses of $14.8 million for the three months ended December 31, 2007. The loss ratios in the specialty line increased by 36.4 percentage points primarily as a result of a loss of $6.1 million related to a satellite
launch. Losses in the property line included $10.0 million for the California wildland fires partially offset by the low level of catastrophic events in the three months ended December 31, 2007.
The amount recorded represents management’s estimate of expected losses and loss expenses on premiums earned. Favorable loss development was experienced mainly on the financial institutions, marine liabilities and war accounts which totaled $29.7 million. Favorable loss development primarily resulted from better than expected loss experience on the 2005 and earlier underwriting years and accounted for 19.1 percentage points of benefit to the Talbot’s loss ratio.
Talbot. Talbot policy acquisition costs for the three months ended December 31, 2007 were $31.2 million compared to $32.8 million for the three months ended December 31, 2006, a decrease of $1.6 million or 4.9%. Policy acquisition costs were lower as a result of lower acquisition ratios on the premium earned in the three months to December 31, 2007 compared to the same period in 2006. Policy acquisition costs as a percent of net premiums earned were 20.0% and 22.6%, respectively, for the three month periods ended December 31, 2007 and 2006.
General and administrative expenses of $33.7 million in the three months ended December 31, 2007 represents 10.6 percentage points of the expense ratio. Share compensation expense is discussed in the following section.
Talbot. Talbot general and administrative expenses for the three months ended December 31, 2007 were $23.6 million. General and administrative expenses are generally comprised of salaries and benefits, professional fees and rent and office expenses. Expenses in dollar terms have increased as a result of planned increases to personnel and other expenses of $1.8 million and intangible asset amortization of $1.0 million. General and administrative expenses as a percent of net premiums earned for the three month period ended December 31, 2007 was 15.2%.
Share compensation expense of $6.1 million in the three months ended December 31, 2007 represents 1.9 percentage points of the general and administrative expense ratio.
Corporate. Corporate share compensation expense for the three months ended December 31, 2007 was $4.0 million compared to $0.7 million for the three months ended December 31, 2006, an increase of $3.3 million or 484.4%. The increase is primarily a result of $2.6 million in respect of the Employee Seller shares issued to Talbot employees as part of the purchase of the group by the Company.
The underwriting results of an insurance or reinsurance company are also often measured by reference to its underwriting income, which is a non-GAAP measure as previously defined. Underwriting income, as set out in the table below, is reconciled to net income (the most directly comparable GAAP financial measure) by the addition or subtraction of net investment income (loss), other income, finance expenses, net realized and unrealized gains (losses) on investments, foreign exchange gains (losses), fair value of warrants issued and the Aquiline termination fee.
Underwriting income indicates the performance of the Company’s core underwriting function, excluding revenues and expenses such as the reconciling items in the table above. The Company believes the reporting of underwriting income enhances the understanding of our results by highlighting the underlying profitability of the Company’s core reinsurance business. Underwriting profitability is influenced significantly by earned premium growth and the adequacy of the Company’s pricing. Underwriting profitability over time is also influenced by the Company’s underwriting discipline, which seeks to manage exposure to loss through favorable risk selection and diversification, its management of claims, its use of reinsurance and its ability to manage its expense ratio, which it accomplishes through its management of acquisition costs and other underwriting expenses. The Company believes that underwriting income provides investors with a valuable measure of profitability derived from underwriting activities.
The Company excludes the U.S. GAAP measures noted above, in particular net realized and unrealized gains and losses on investments, from its calculation of underwriting income because the amount of these gains and losses is heavily influenced by, and fluctuates in part, according to availability of investment market opportunities. The Company believes these amounts are largely independent of its underwriting business and including them distorts the analysis of trends in its operations. In addition to presenting net income determined in accordance with U.S. GAAP, the Company believes that showing underwriting income enables investors, analysts, rating agencies and other users of its financial information to more easily analyze the Company’s results of operations in a manner similar to how management analyzes the Company’s underlying business performance. The Company uses underwriting income as a primary measure of underwriting results in its analysis of historical financial information and when performing its budgeting and forecasting processes. Analysts, investors and rating agencies who follow the Company request this non-GAAP financial information on a regular basis. In addition, the bonus component of the total annual incentive compensation for the 2006 and 2007 performance years as approved by the compensation committee of our Board of Directors was established using underwriting income as one of the factors used. The bonus component of the total annual incentive compensation for the Company’s named executives is 150% of base salary.
Finance expenses for the three months ended December 31, 2007 were $25.4 million compared to $3.7 million for the three months ended December 31, 2006, an increase of $21.8 million or 595.9%. The higher finance expenses in 2007 were primarily attributable to of the following:
Capital in Lloyd’s entities, whether personal or corporate, is required to be set annually for the prospective year and held by Lloyd’s in trust (“Funds at Lloyd’s” or “FAL”). In underwriting years up to and including 2007, Talbot’s FAL has been provided both by Talbot and by third parties. Because the third party FAL providers remain “on risk” until each year of account that they support closes normally after three years, Talbot must manage third party FAL even if a third party FAL provider has ceased to support the active underwriting year. This is achieved by placing such FAL in escrow outside Lloyd’s. Thus the total FAL facility available to the company is the total FAL for active and prior underwriting years, although the company can only apply specific FAL against losses incurred by an underwriting year that such FAL is contracted to support.
Between 30% and 40% of an amount equivalent to each underwriting years’ profit is payable to Talbot third party FAL providers. However some of these costs are fixed. Further, the 2005 underwriting year only became profitable on a cumulative basis in September 2007, thus triggering profit-related payments for that underwriting year.
The FAL finance charges are analyzed by underwriting year as follows.
The FAL finance charges respond to the total syndicate profit which was analyzed by underwriting year as follows.
Net realized gains on investments for the three months ended December 31, 2007 were $0.7 million compared to losses of $0.2 million for the three months ended December 31, 2006. Net realized gains resulted from the sale of fixed maturity investments.
Foreign exchange losses for the three month period ended December 31, 2007 were $2.5 million compared to gains of $1.1 for the three months ended December 31, 2006, a decrease of $3.6 million. Foreign exchange losses resulted from the effect of the fluctuation in foreign currency exchange rates on liabilities denominated in foreign currencies, primarily at Talbot. The foreign exchange losses during the three months ended December 31, 2007 were partially offset by the weakening of the U.S. dollar resulting in gains on translation arising out of receipts of non-U.S. dollar premium installments. Certain premiums receivable and liabilities for losses incurred in currencies other than the U.S. dollar are exposed to the risk of changes in value resulting from fluctuations in foreign exchange rates and may affect financial results in the future. The consolidation of Talbot increased foreign exchanges losses by $2.2 million. At December 31, 2007, 8.7% of our investments and 30.9% of our reserves for losses and loss expenses were in foreign currencies.
The Company has early adopted FAS 157 and FAS 159 as of January 1, 2007 and elected the fair value option on all securities previously accounted for as available-for-sale. Validus Re’s unrealized gains on available-for-sale investments at December 31, 2006 of $875,000 previously included in accumulated other comprehensive income, were treated as a cumulative-effect adjustment as of January 1, 2007. The cumulative-effect adjustment transferred the balance of unrealized gains from accumulated other comprehensive income to retained earnings and had no impact on the results of operations for the annual or interim periods beginning January 1, 2007. The Company’s investments are accounted for as trading for the annual or interim periods beginning January 1, 2007 and as such, all unrealized gains and losses are included in net income. Upon acquisition by the Company, Talbot adopted FAS 157 and FAS 159. On January 1, 2007 Talbot had unrealized losses (net on gains) on available-for-sale investments of $769,000.
The consolidation of Talbot effective in the third quarter of 2007 increased annual underwriting income by $76.0 million;
An increase in Validus Re underwriting income of $126.3 million or 83.4% as a result of an increase of $252.5 million in net premiums earned, offset by losses including those related to windstorm Kyrill, the Australian windstorms, flooding in parts of England and the California wildland fires;
An increase in foreign exchange gains of $4.5 million due primarily to the weakening U.S. dollar.
Increased finance expenses of $43.0 million, primarily resulting from $6.6 million on the 9.069% Junior Subordinated Deferrable Debentures, $8.9 million finance expense on the 8.480% Junior Subordinated Deferrable Debentures, $26.1 million of Talbot FAL finance expense and $1.0 million finance expense on unsecured credit facility borrowings of $188.0 million; and
Fair value of warrants issued expense of $2.9 million due to an anti-dilution provision of the warrants arising from the issuance of restricted common shares in to the Talbot acquisition.
On July 2, 2007 the Company acquired Talbot and is only consolidating Talbot effective as of that date. As a result, Talbot is only included in the Company’s consolidated results for July 2, 2007 through December 31, 2007. Talbot is not included in the consolidated results for the year ended December 31, 2006 and the first six months of 2007. In the section that follows, all separate analysis of the Talbot segment includes both the consolidated results prior to acquisition (i.e. for the year ended December 31, 2006 and the first six months of 2007) as well as the results of operations from July 2, 2007 through December 31, 2007.
Gross premiums written for the year ended December 31, 2007, were $988.6 million compared to $540.8 million for the year ended December 31, 2006, an increase of $447.8 million or 82.8%. Gross premiums written were primarily driven by the property line which accounted for $547.6 million of gross premium written. Details of gross premiums written by line of business are provided below.
Talbot. In the year ended December 31, 2007, Talbot gross premiums written were $687.7 million compared to $648.7 million for the year ended December 31, 2006, an increase of $39.1 million or 6.0%. Gross premiums written were primarily driven by the specialty and marine lines which contributed $536.5 million. Details of gross premiums written by line of business are provided below.
The addition of two new classes in 2007, accident & health and bloodstock & livestock, which collectively added $29.8 million of gross premiums written.
Validus Re. Validus Re net premiums written for the year ended December 31, 2007 were $633.3 million compared to $477.1 million for the year ended December 31, 2006, an increase of $156.2 million or 32.7%. Details of net premiums written by line of business are provided below:
The increase in net premiums written was primarily driven by the property and marine lines which accounted for $125.6 million and $30.6 million of the increase, respectively. The increase in property and marine lines reflects the increase in gross premiums written.
Validus Re. Validus Re change in unearned premiums for the year ended December 31, 2007 was $74.2 million compared to $170.6 million for the year ended December 31, 2006, a decrease of $96.4 million or 56.5%. This reflects the higher level of premiums written in 2007 compared to 2006 and the earning of premiums on business written in 2006, as mentioned above.
earned was driven by $299.1 million resulting from the consolidation of Talbot effective and an increase in premiums earned at Validus Re which accounted for $252.5 million of the increase.
The results of operations for Talbot are consolidated only from the July 2, 2007 date of acquisition. Consequently, 2006 (1) data does not include Talbot financial results.
Validus Re. Validus Re net premiums earned for the year ended December 31, 2007 were $559.0 million compared to $306.5 million for the year ended December 31, 2006, an increase of $252.5 million or 82.4%. The increase in net premiums earned reflects the increased premiums written in 2007 and the earning of premiums on business written in 2006. Contracts written on a risks-attaching basis are generally earned over 24 months and therefore have less immediate effect on premiums earned than contracts written on a losses-occurring basis which are generally earned on a 12 month basis.
The amount recorded represents management’s best estimate of expected losses and loss expenses on premiums earned. The increase in loss and loss expenses reflects the consolidation of Talbot effective in the third quarter of 2007. The relative absence of major catastrophes in 2006 and 2007 has contributed to the overall low level of losses experienced. Favorable loss development on prior years totaled $67.9 million and was experienced in all lines of business. Favorable loss development primarily resulted from better than expected loss experience on the 2006 underwriting year at Validus Re and 2005 and prior underwriting years at Talbot and accounted for a reduction of 7.9 percentage points on the Company’s loss ratio.
Validus Re. Validus Re losses and loss expenses for the year ended December 31, 2007 were $175.5 million compared to $91.3 million for the year ended December 31, 2006, an increase of $84.2 million or 92.2%. The loss ratio, which is defined as losses and loss expenses divided by net premiums earned, was 31.4% and 29.8% for the year ended December 31, 2007 and 2006, respectively. Details of loss ratios by line of business are provided below.
Talbot. Talbot policy acquisition costs for the year ended December 31, 2007 were $125.4 million compared to $115.5 million for the year ended December 31, 2006, an increase of $9.9 million or 8.6%. Policy acquisition costs were higher as a result of the higher level of premiums written and earned in the year ended December 31 2007 compared to the same period in 2006. Policy acquisition costs as a percent of net premiums earned were 21.5% and 23.5%, respectively, for the year ended December 31, 2007 and 2006. Policy acquisition costs as a percent of gross premiums earned were 18.6% and 18.9% respectively for the year ended December 31, 2007 and 2006.
General and administrative expenses for the year ended December 31, 2007 were $97.8 million compared to $38.4 million for the year ended December 31, 2006, an increase of $59.4 million or 154.9%. The increase is primarily a result of $48.9 million resulting from the consolidation of Talbot.
Corporate. Corporate general and administrative expenses for the year ended December 31, 2007 were $17.5 million compared to $13.8 million for the year ended December 31, 2006. Corporate general and administrative expenses are comprised of executive and board expenses, internal and external audit expenses and other cost relating to the Company as a whole.
Talbot results for the year ended December 31, 2006 are presented for comparative purposes. The results of operations for Talbot are consolidated only from the July 2, 2007 date of acquisition.
The underwriting results of an insurance or reinsurance company are also often measured by reference to its underwriting income, which is a non-GAAP measure as previously defined. Underwriting income, as set out in the table below, is reconciled to net income by the addition or subtraction of net investment income (loss), other income, finance expenses, net realized and unrealized gains (losses) on investments, fair value of warrants issued, foreign exchange gains (losses) and the Aquiline termination fee.
Net investment income for the year ended December 31, 2007 was $112.3 million compared to $58.0 million for the year ended December 31, 2006, an increase of $54.3 million or 93.6%. Net investment income increased as a result of growth in the Validus Re investment portfolio and the addition of the Talbot investment portfolio. Net investment income is comprised of accretion of premium or discount on fixed maturities, interest on coupon-paying bonds, short-term investments and cash and cash equivalents, partially offset by investment management fees. The components of net investment income for the year ended December 31, 2007 and 2006 are presented below.
Because the Company provides short-tail reinsurance coverage for losses resulting mainly from natural and man-made catastrophes, the Company could become liable to pay substantial claims on short notice. Accordingly, the investment portfolio has been structured to preserve capital and provide a high level of liquidity, which means that the large majority of the investment portfolio contains short-term fixed maturity investments, such as U.S. government and agency bonds, U.S. government-sponsored enterprises’ securities, corporate debt securities and mortgage-backed and asset-backed securities.
$1.0 million on unsecured credit facility borrowings of $188.0 million; and
Historical FAL finance charges which include both fixed and variable elements are analyzed by underwriting year as follows.
In July 2007 additional warrants were issued to the founding shareholder and sponsoring investors to maintain the allocation at 12.0% of the fully diluted shares of the Company pursuant to a particular anti-dilution provision of the warrants. Such provision is no longer applicable effective with the completion of the IPO, although the warrants continue to have certain anti-dilution protections in respect of asset distributions, share dividends and common stock dividends, among other events. 256,409 warrants were issued in July 2007 resulting in an expense of $2.9 million.
Net realized gains on investments for the year ended December 31, 2007 were $1.6 million compared to losses of $1.1 million for the year ended December 31, 2006. Net realized gains (losses) resulted from the sale of fixed maturity investments.
On June 21, 2007, the Company completed a private placement of $200.0 million of junior subordinated deferrable interest debentures due 2037 (the “8.480% Junior Subordinated Deferrable Debentures”). The 8.480% Junior Subordinated Deferrable Debentures mature on June 15, 2037, are redeemable at the Company’s option at par beginning June 15, 2012, and require quarterly interest payments by the Company to the holders of the 8.480% Junior Subordinated Deferrable Debentures. Interest will be payable at 8.480% per annum through June 15, 2012, and thereafter at a floating rate of three-month LIBOR plus 295 basis points, reset quarterly. On May 15, 2007, we entered into a Share Sale Agreement to acquire all of the outstanding shares of Talbot Holdings Ltd. The proceeds of $200.0 million from the sale of the 8.480% Junior Subordinated Deferrable Debentures, after the deduction of commissions paid to the placement agents in the transaction and other expenses, were used by the Company to fund a portion of the purchase of Talbot Holdings Ltd. Debt issuance costs of $2.0 million were deferred as an asset and are amortized to income over the five year optional redemption period.
In September 2006, the FASB issued FAS No. 157, Fair Value Measurements (“FAS 157”) which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. FAS 157 is applicable in conjunction with other accounting pronouncements that require or permit fair value measurements, where the FASB previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, FAS 157 does not require any new fair value measurements. FAS No. 157 is effective for interim and annual financial statements issued after January 1, 2008 and was early adopted.
The Company has early adopted FAS 157 and FAS 159 as of January 1, 2007 and elected the fair value option on all securities previously accounted for as available-for-sale. The Company believes that accounting for its investment portfolio as trading more closely reflects its investment guidelines. Unrealized gains on available-for-sale investments at December 31, 2006 of $875, previously included in the accumulated other comprehensive income, were treated as a cumulative-effect adjustment as of January 1, 2007. The cumulative-effect adjustment has resulted in the transfer of the balance of unrealized gains and losses from accumulated other comprehensive income to retained earnings and had no impact on the results of operations for the period beginning January 1, 2007. The Company’s investments are accounted for as trading for period beginning January 1, 2007 and as such, all unrealized gains and losses are now included in Net Income on the Statement of Operations.
In December 2007, the FASB issued Statement No. 141(R), Business Combinations (“FAS 141(R)”) and Statement No. 160, Accounting and Reporting of Noncontrolling Interest in Consolidated Financial Statements, an amendment of ARB No. 51 (“FAS 160”). These new standards will significantly change the accounting for and reporting of business combination transactions and noncontrolling (minority) interests in consolidated financial statements. FAS 141(R) expands the scope of acquisition accounting to all transactions and circumstances under which control of a business is obtained. Under FAS 160, noncontrolling interests are classified as a component of consolidated shareholders’ equity and ’minority interest’ accounting is eliminated such that earnings attributable to noncontrolling interests are reported as part of consolidated earnings and not as a separate component of income or expense. FAS 141(R) and FAS 160 are required to be adopted simultaneously and are effective for the first annual reporting period beginning on or after December 15, 2008. Earlier adoption is prohibited. The Company is currently evaluating the impact of the adoption of FAS 141(R) and FAS 160 on the Company’s statements of operations and financial condition when adopted.
The following table details the Company’s and Validus Re’s borrowings and credit facilities as at December 31, 2007:
On March 10, 2006, Talbot entered into $25,000,000 revolving loan facility, as subsequently amended (the “Talbot Revolving Loan Facility”), which provided for dollar or sterling-based revolving credit availability for Talbot. The facility limit for the Talbot Revolving Loan Facility automatically reduced to $7,500,000 at July 1, 2007. The Talbot Revolving Loan Facility was provided by Lloyds TSB Bank plc. The Talbot Revolving Loan Facility contains affirmative covenants that include, among other things the requirement that Talbot maintain a minimum level of consolidated tangible net worth and also contains restrictions on Talbot’s ability to incur debt, incur liens and sell or transfer assets on non-arms length terms. As of December 31, 2006 and throughout the reporting periods presented, where appropriate, the Company was in compliance with all covenants and restrictions. This facility was cancelled in November 2007 and Lloyds TSB Bank plc entered into the $200,000,000 three-year unsecured facility by assuming $7,500,000 from the existing syndicate of commercial banks.
facilities were provided by a syndicate of commercial banks arranged by J.P. Morgan Securities Inc. and Deutsche Bank Securities Inc. The new credit facilities replaced our existing 364-day $100,000,000 senior unsecured revolving credit facility and our existing three-year $200,000,000 senior secured letter of credit facility, which have each been terminated.
On October 25, 2007, the Company entered into the First Amendment to each of its Three-Year Unsecured Letter of Credit Facility Agreement, dated as of March 12, 2007 and its Five-Year Secured Letter of Credit Facility Agreement, dated as of March 12, 2007 (together, the “Credit Facilities”), among the Company, Validus Reinsurance, Ltd., the Lenders party thereto, and JPMorgan Chase Bank, National Association, as administrative agent, to provide for, among other things, additional capacity to incur up to $100,000,000 under a new Funds at Lloyd’s Letter of Credit Facility (“FAL LoC Facility”) to support underwriting capacity provided to Talbot 2002 Underwriting Ltd through Syndicate 1183 at Lloyd’s of London for the 2008 and 2009 underwriting years of account. The amendment also modifies certain provisions in the Credit Facilities in order to permit dividend payments on existing and future preferred and hybrid securities notwithstanding certain events of default.
among other things, (i) the requirement that we initially maintain a minimum level of consolidated net worth of at least $1,164,265,000, and commencing with the end of the fiscal quarter ending December 31, 2007 to be increased quarterly by an amount equal to 50% of our consolidated net income (if positive) for such quarter plus 50% of any net proceeds received from any issuance of common shares during such quarter, and (ii) the requirement that we maintain at all times a consolidated total debt to consolidated total capitalization ratio not greater than 0.35:1.00. This Talbot FAL Facility replaced the Talbot FAL Facility issued in 2003.
The Talbot FAL Facility also contains restrictions on our ability to make investments, incur debt at our subsidiaries, incur liens, sell assets and merge or consolidate with others. Other than in respect of existing and future preferred and hybrid securities, the payment of dividends and other payments in respect of equity interests are not permitted at any time that we are in default with respect to certain provisions under the credit facilities. As of December 31, 2007 the Company was in compliance with all covenants and restrictions.
Talbot’s underwriting at Lloyd’s is supported by Funds at Lloyd’s (“FAL”) comprising: cash, investments and undrawn letters of credit provided by various banks on behalf of various companies and persons under reinsurance and other agreements. The FAL are provided in exchange for payment calculated principally by reference to the syndicate’s results, as appropriate, when they are declared. The amounts of cash, investments and letters of credit at December 31, 2007 supporting the 2008 underwriting year amount to $316,483,000, all of which is provided by the Company. A third party FAL facility comprising $174,365,000 which supports the 2007 and prior underwriting years has now been withdrawn from Lloyd’s and placed in escrow, however, the funds remain available to pay losses on those years for which that FAL has been contracted to support.
Bermuda law limits the maximum amount of annual dividends or distributions payable by Bermuda registered companies to the Company and in certain cases requires the prior notification to, or the approval of, the Bermuda Monetary Authority. Subject to such laws, the directors of the Bermuda registered companies have the unilateral authority to declare or not declare dividends to the Company. There is no assurance that dividends will be declared or paid in the future.
Talbot’s underwriting activities are regulated by the U.K. Financial Services Authority (“FSA”). The FSA has substantial powers of intervention in relation to the Lloyd’s managing agents which it regulates including the power to remove their authorization to manage Lloyd’s syndicates. In addition, Talbot’s managing agent operates under the Lloyd’s “franchise”. Lloyd’s approves annually Syndicate 1183’s business plan and any subsequent material changes, and the amount of capital required to support that plan. Lloyd’s may require changes to any business plan presented to it or additional capital to be provided to support the underwriting (known as Funds at Lloyd’s).
The Company’s ability to underwrite business is dependent upon the quality of claims paying and financial strength ratings as evaluated by independent rating agencies. Validus Re was assigned a rating of “A−” (Excellent) by A.M. Best Company in December 2005 (which was affirmed by A.M. Best on August 29, 2007). Lloyd’s is rated “A” (Excellent) by A.M. Best and “A+”’ (Strong) by Standard & Poor’s (“S&P”). Ratings are not an evaluation directed to investors in the Company’s securities or a recommendation to buy, sell or hold the Company’s securities. Ratings may be revised or revoked at the sole discretion of A.M. Best and S & P. In the normal course of business, the Company evaluates its capital needs to support the volume of business written in order to maintain claims paying and financial strength ratings. Financial information is regularly provided to rating agencies to both maintain and enhance existing ratings. In the event of a downgrade below “A−” (Excellent), the Company believes its ability to write business would be materially adversely affected.
A significant portion of contracts written provide short-tail reinsurance coverage for losses resulting mainly from natural and man-made catastrophes, which could result in a significant amount of losses on short notice. Accordingly, the Company’s investment portfolio is structured to preserve capital and provide significant liquidity, which means the investment portfolio contains a significant amount of relatively short-term fixed maturity investments, such as U.S. government securities, U.S. government-sponsored enterprises securities, corporate debt securities and mortgage-backed and asset-backed securities.
Substantially all of the fixed maturity investments held at December 31, 2007 were publicly traded. The average duration of the Company’s fixed maturity portfolio was 2.0 years (December 31, 2006 and 2005: 0.9 and 0.56 years) and the average rating of the portfolio was AAA (December 31, 2006 and 2005: AA+ and AAA), of which $2,029.6 million or 84.2% (December 31, 2006 and 2005: $644.1 million and $192.6 million) were rated AAA, at December 31, 2007.
The Company has written certain business that has loss experience generally characterized as having low frequency and high severity. This results in volatility in both results and operational cash flows. The potential for large claims or a series of claims under one or more reinsurance contracts means that substantial and unpredictable payments may be required within relatively short periods of time. As a result, cash flows from operating activities may fluctuate, perhaps significantly, between individual quarters and years.
All forward-looking statements address matters that involve risks and uncertainties. Accordingly, there are or will be important factors that could cause actual results to differ materially from those indicated in such statements. This report may include forward-looking statements, both with respect to us and our industry, that reflect our current views with respect to future events and financial performance. Statements that include the words “expect,” “intend,” “plan,” “believe,” “project,” “anticipate,” “will,” “may” and similar statements of a future or forward-looking nature identify forward-looking statements.
our ability to obtain and maintain ratings, which may be affected by our ability to raise additional equity or debt financings, as well as other factors described herein;
acceptance of our business strategy, security and financial condition by rating agencies and regulators, as well as by brokers and reinsureds;
competition, including increased competition, on the basis of pricing, capacity, coverage terms or other factors;
our ability to implement, successfully and on a timely basis, complex infrastructure, distribution capabilities, systems, procedures and internal controls, and to develop accurate actuarial data to support the business and regulatory and reporting requirements;
the integration of Talbot Holdings, Ltd., or other businesses we may acquire or new business ventures we may start;
accuracy of those estimates and judgments used in the preparation of our financial statements, including those related to revenue recognition, insurance and other reserves, reinsurance recoverables, investment valuations, intangible assets, bad debts, income taxes, contingencies, litigation and any determination to use the deposit method of accounting, which, for a relatively new insurance and reinsurance company like our
acts of terrorism, political unrest and other hostilities or other non-forecasted and unpredictable events;
availability of reinsurance and retrocession coverage to manage our gross and net exposures and the cost of such reinsurance and retrocession;
changes in accounting principles or the application of such principles by regulators;
statutory or regulatory or rating agency developments, including as to tax policy and matters and reinsurance and other regulatory matters such as the adoption of proposed legislation that would affect Bermuda-headquartered companies and/or Bermuda-based insurers or reinsurers, and
In addition, other general factors could affect our results, including: (a) developments in the world’s financial and capital markets and our access to such markets; (b) changes in regulations or tax laws applicable to us, including, without limitation, any such changes resulting from the recent investigations relating to the insurance industry and any attendant litigation; and (c) the effects of business disruption or economic contraction due to terrorism or other hostilities.