We currently occupy our office space in Grand Cayman, Cayman Islands under operating lease agreements which expired on June 30, 2018. We are in negotiations with the lessor for renewal of the lease and meanwhile both parties have agreed to extend the lease until December 31, 2020. Additionally, we have an operating lease agreement for office space in Dublin, Ireland which expires in 2031, but provides us an option to terminate the lease in 2021 without any penalty. We believe that for the foreseeable future the office spaces in the Cayman Islands and Ireland will be sufficient for conducting our operations.
The following discussion should be read in conjunction with the audited consolidated financial statements and accompanying notes, which appear elsewhere in this filing.
Historically, we have aimed to complement our underwriting results with a non-traditional investment approach in order to achieve higher rates of return over the long term than reinsurance companies that employ more traditional investment strategies. Our investment portfolio is managed according to a value-oriented philosophy, in which our investment advisor takes long positions in perceived undervalued securities and short positions in perceived overvalued securities. During the second quarter of 2019, A.M. Best revised its rating outlook of the Company’s subsidiaries’ Financial Strength Rating of A- (Excellent) from “stable” to “negative.” The Company’s Board of Directors has initiated a strategic review to address the risk of a downgrade. Additionally, to reduce volatility near-term, the Company has de-risked its investment portfolio. As of the date of this Annual Report, the majority of our investable assets are held in cash and short-term treasuries which we expect to maintain until the strategic review is complete.
Because our portfolio will evolve in response to market conditions and underwriting opportunities, period-to-period comparisons of our underwriting results may not be meaningful. In addition, our historical investment results may not necessarily be indicative of future performance. Due to the nature of our reinsurance and investment strategies, our operating results will likely fluctuate from period to period.
The size of our capital base, combined with A.M Best’s revised outlook on our subsidiaries’ A- (Excellent) rating from “stable” to “negative,” may constrain our capacity and our ability to access underwriting business in the short term. To date these have had minimal impact on our ability to execute our 2019 business plan and the January 1, 2020 renewals. However, our ability to execute our remaining 2020 business plan may be adversely impacted by a prolonged negative outlook from A.M. Best.
We manage our business on the basis of one operating segment, Property & Casualty reinsurance, and we analyze our business based on the following categories:
Casualty business covers general liability, motor liability, professional liability and workers’ compensation exposures. The Company’s multi-line business predominantly relates to casualty reinsurance and as such all multi-line business is included within the casualty category. Casualty business generally has losses reported and paid over a longer period of time than property business.
Premiums written are recognized as revenues, net of of any applicable underlying reinsurance coverage, and are earned over the term of the related policy or contract. Depending on the contract structure, the earnings period could be the same as the reinsurance contract, or based on the terms of the underlying insurance policies.
General and administrative expenses consist primarily of salaries and benefits and related costs, including costs associated with our incentive compensation plan, bonuses and stock compensation expenses. General and administrative expenses also include professional fees, travel and entertainment, information technology, rent and other general operating expenses. General and administrative expenses reported on our consolidated statements of operations include both underwriting expenses as well as corporate expenses.
For stock option expenses, we calculate compensation cost using the Black-Scholes option pricing model and expense stock options over their vesting period, which varies and has historically ranged from zero to six years. For restricted stock awards and restricted stock units with only service conditions, we calculate compensation cost using the grant date fair value of each award and recognize the associated expense of the stock awards over their vesting periods, which typically range from one to five years. For restricted stock awards that include both service and performance conditions, the associated expense is recognized when the Company determines that it is probable that the performance conditions will be achieved.
For each quota share or proportional property and casualty reinsurance contract we underwrite, our client estimates gross premiums written at inception of the contract. We generally account for such premiums using our best estimates and then adjust our estimates based on actual reports provided by our client and based on our expectations of industry developments. As the contract progresses, we monitor actual premiums received in conjunction with correspondence from the client in order to refine our estimate. Variances from initial gross premiums written estimates are generally greater for quota share contracts than for excess of loss contracts. All premiums on quota share contracts are earned over the risk coverage period. Unearned premiums represent the unexpired portion of reinsurance provided.
We are able to confirm the accuracy and completeness of premiums reported by our clients by either reviewing the client’s statutory filings and/or performing an audit of the client, in accordance with the terms of the contract. Discrepancies between premiums ceded and reported under a contract are, in our experience, rare. To date, we have not had any material discrepancy in premiums reported by a client that required a formal dispute resolution process.
Loss and Loss Adjustment Expense Reserves.The process of estimating our loss and LAE reserves involves a considerable degree of judgment and our estimates as of any given date are inherently uncertain. Estimating loss and LAE reserves requires us to make assumptions regarding reporting and development patterns, frequency and severity trends, claims settlement practices, potential changes in legal environments, inflation, loss amplification, foreign exchange movements and other factors. These estimates and judgments are based on numerous considerations and are often revised as: (i) we receive changes in loss amounts reported by ceding companies and brokers; (ii) we obtain additional information, experience or other data; (iii) new or improved methodologies are developed; or (iv) changes in the legal environment occur.
Our loss and LAE reserves are composed of case reserves (which are based on claims that have been reported to us) and IBNR reserves.
Our case reserve estimates are initially determined on the basis of loss reports received. Our IBNR reserve estimates are determined using various actuarial methods as well as a combination of our own historical and current loss experience,
insurance industry loss experience, estimates of pricing adequacy trends and our professional judgment. The process we use to estimate our IBNR reserves involves projecting our estimated ultimate loss and LAE reserves and then subtracting paid claims and case reserves as notified by the ceding company, to arrive at our IBNR reserve.
Reserving can prove especially difficult should a significant loss take place near the end of a financial reporting period, particularly if the loss involves a catastrophic event. These factors further contribute to the degree of uncertainty in our reserving process.
As a predominantly broker-market reinsurer for both excess-of-loss and proportional contracts, we must rely on loss information reported to brokers by primary insurers who, in turn, must estimate their own losses at the policy level, often based on incomplete and changing information. The information we receive varies by cedent and may include paid losses, estimated case reserves and an estimated provision for IBNR reserves. Reserving practices and the quality of data reporting vary among ceding companies, which adds further uncertainty to the estimation of our ultimate losses. The nature and extent of information received from ceding companies and brokers also vary widely depending on the type of coverage, the contractual reporting terms (which are affected by market conditions and practices) and other factors. Due to the lack of standardization of the terms and conditions of reinsurance contracts, the wide variability of coverage provided to individual clients and the tendency of those coverages to change rapidly in response to market conditions, the ongoing economic impact of such uncertainties and inconsistencies cannot always be reliably measured.
Time lags are inherent in loss reporting, especially in the case of excess-of-loss reinsurance contracts. The combined characteristics of low claim frequency and high claim severity make the available data less useful for predicting ultimate losses. In the case of proportional contracts, we rely on an analysis of a cedent’s historical experience, industry information and the professional judgment of underwriters in estimating reserves for these contracts. In addition, we utilize ultimate loss ratio forecasts when reported by cedents and brokers, which are normally subject to three to six month lags for proportional business. Due to the degree of reliance we place on ceding companies for claims reporting, our reserve estimates are highly dependent on ceding companies’ judgment. Furthermore, during the loss settlement period, which may last several years, additional facts regarding individual claims and trends often will become known and case law may change, which can affect ultimate expected losses.
We believe that our reserves for loss and LAE are sufficient to cover losses that fall within the terms of our policies and agreements with our insured and reinsured customers on the basis of the methodologies used to estimate those reserves. We can provide no assurance, however, that actual losses will not (i) be less than or (ii) exceed our total established reserves.
Please refer to Notes 2 and 7 of our consolidated financial statements for a more detailed explanation of our loss reserving methodology and the loss development tables by accident year, respectively, as required under U.S. GAAP.
Bonus Accruals. Under the Company’s bonus program, most employees’ target bonuses consist of two components: a discretionary component based on a qualitative assessment of each employee’s performance and a quantitative component based on the return on deployed equity (“RODE”) for each underwriting year relating to reinsurance operations. The qualitative portion of an employee’s annual bonus is accrued quarterly at each employee’s prorata target amount and updated to actual at year end . The quantitative portion of each employee’s annual bonus is accrued based on the expected RODE for each underwriting year and adjusted for changes in the expected RODE and actual investment return each quarter until all losses are settled and the underwriting year is declared closed. The quantitative bonus is calculated and paid in annual installments between three to five years from the end of the fiscal year in which the business was underwritten. Any subsequent changes to the quantitative bonus are incorporated into the following open underwriting year. The Compensation Committee of our Board of Directors approves all quantitative bonuses prior to being paid. The initial RODE calculation utilizes proprietary models which require significant estimation and judgment. Actual RODE may vary significantly from the expected RODE and any adjustments to the quantitative bonus estimates, which may be material, are recorded in the period in which they are determined.
Share purchase options are expensed over the vesting period on a graded vesting basis. Determining the fair value of share option awards at the grant date requires significant estimation and judgment. We use an option-pricing model (Black-Scholes pricing model) to assist in the calculation of fair value. The estimate of expected volatility is based on the daily historical trading data of our Class A ordinary shares from the date that these shares commenced trading (May 24, 2007) to the grant date.
Basic Adjusted Book Value Per Share and Fully Diluted Adjusted Book Value Per Share
Our primary financial goal is to increase fully diluted adjusted book value per share over the long term.
Net underwriting income (loss) is considered a non-GAAP financial measure because it excludes items used in the calculation of net income before taxes under U.S. GAAP. Net underwriting income (loss) is calculated as net premiums earned, plus other income (expense) relating to deposit-accounted contracts, less net loss and loss adjustment expenses, less acquisition costs, and less underwriting expenses. The measure excludes, on a recurring basis: (1) investment income (loss); (2) other income (expense) not related to underwriting, including foreign exchange gains or losses; (3) corporate general and administrative expenses; (4) interest expense and (5) income taxes. We exclude total investment related income or loss and foreign exchange gains or losses as we believe these items are influenced by market conditions and other factors not related to underwriting decisions. We exclude corporate expenses because these expenses are generally fixed and not incremental to or directly related to our underwriting operations. We believe all of these amounts are largely independent of our underwriting process and including them could hinder the analysis of trends in our underwriting operations. Net underwriting income (loss) should not be viewed as a substitute for U.S. GAAP net income.
For the year ended December 31, 2019, fully diluted adjusted book value per share decreased by $0.22 per share, or 1.7%, to $12.88 per share from $13.10 per share at December 31, 2018. For the year ended December 31, 2019, the basic adjusted book value per share decreased by $0.22 per share, or 1.7%, to $12.90 per share at December 31, 2019.
The developments that most significantly affected our financial performance during the year ended December 31, 2019, on a comparative basis to 2018, are provided below:
•Investment income and losses - Our net investment related income for the year ended December 31, 2019 was $52.3 million, including a return of 9.3% on our Investment Portfolio, compared to an investment loss of $323.1 million, or a return of (30.3)% on our investments managed by DME Advisors, during the year ended December 31, 2018.
For the year ended December 31, 2019, retrocessional premiums ceded decreased by $54.1 million, or 52.7%, to $48.7 million compared to $102.8 million for the year ended December 31, 2018. This decrease in ceded premiums was primarily related to our non-renewal of inward motor contracts in 2019, which resulted in us not renewing the outward retrocession contracts in 2019. We expect the remaining impact of the non-renewed retrocession contracts to flow through during 2020. Additionally, during 2019 we reduced the amount of retrocessional coverage that we purchased relating to catastrophe exposure compared to the same period in 2018. In general, we use retrocessional coverage to manage our net portfolio exposure, to leverage areas of expertise and to improve our strategic position in meeting the needs of clients and brokers.
For the year ended December 31, 2019, the general and administrative expenses increased by $4.6 million, or 18.5%, compared to the same period in 2018. The increase was primarily due to higher legal and other professional fees, personnel costs and information technology expenses. For the years ended December 31, 2019 and 2018, the general and administrative expenses included $3.9 million and $4.6 million, respectively, of expenses related to stock compensation granted to employees and directors.
For the year ended December 31, 2019, the investment income, net of fees and expenses, represented a gain of 9.3% on the Investment Portfolio managed by DME Advisors, compared to a loss of 30.3% for the year ended December 31, 2018. The investment gain for the year ended December 31, 2019 was driven by SILP’s long portfolio, which reported an investment gain of 16.2%, while the short portfolio reported a loss of 5.3% for the year ended December 31, 2019. Additionally, macro positions reported a gain of 0.8%. The noteworthy contributors to the investment gains for the year ended December 31, 2019 were Brighthouse Financial (BHF), General Motors (GM) and Green Brick Partners (GRBK). The noteworthy detractors for the year ended December 31, 2019 were short positions in Amazon (AMZN), Netflix (NFLX) and a group of perceived overpriced momentum driven short equity positions (the “Bubble Basket”).
The caption “Income (loss) from investments in related party investment fund” also includes performance compensation allocated from the Company’s investment in SILP to DME II. For the year ended December 31, 2019, the performance allocation of $5.0 million was deducted from the Company’s investment in SILP and allocated to DME II. No performance compensation was allocated during the year ended December 31, 2018 due to investment losses.
For the year ended December 31, 2019 net realized losses of $14.2 million were offset by a corresponding change in unrealized gains and losses. This reclassification resulted from the transfer of assets from the Joint Venture to SILP in January 2019. We expect our investment income (loss), including any change in the net asset value of the investment in SILP and any realized and unrealized gains (or losses), to fluctuate from period to period. The change in unrealized gains and losses for year ended December 31, 2019, also included a net increase in the valuation allowance provision of $6.0 million relating to notes receivable.
Verdant is incorporated in Delaware and, therefore, is subject to taxes in accordance with the U.S. federal rates and regulations prescribed by the Internal Revenue Service. Verdant’s future taxable income is expected to be taxed at a rate of 21% (2018: 21%).
The total investments reported in the consolidated balance sheets as of December 31, 2019, was $256.4 million, compared to $283.9 million as of December 31, 2018, a decrease of $27.5 million, or 9.7%. The decrease was primarily related to withdrawals from SILP for claim payments and to provide collateral to our ceding insurers. The decrease was partially offset by net investment income from our investment in SILP, transfer of equity securities from the Joint Venture to SILP and additional investments in insurtech companies as part of our innovations initiative during the year ended December 31, 2019.
As of December 31, 2019, the restricted cash and cash equivalents are used for funding trusts and letters of credits issued to our ceding insurers. Our restricted cash increased by $57.1 million, or 8.3%, from $685.0 million at December 31, 2018 to $742.1 million, as of December 31, 2019, primarily due to increased collateral provided to our ceding insurers. The increase was partially funded by withdrawals from SILP.
During the year ended December 31, 2019, reinsurance balances receivable decreased by $69.9 million, or 23.3%, to $230.4 million from $300.3 million, as of December 31, 2018. The decrease was primarily related to premiums receivable on a large motor contract that we did not renew during 2019 and as a result the premiums receivable decreased as premiums on the expiring contract were collected.
During the year ended December 31, 2019, the total loss and loss adjustment expenses recoverable decreased by $16.2 million, or 37.0%, to $27.5 million from $43.7 million as of December 31, 2018. The decrease primarily related to losses recovered relating to retroceded private passenger automobile contracts that were not renewed during 2019. See Note 8 of the accompanying consolidated financial statements for a description of the credit risk associated with our retrocessionaires.
For most of the contracts we write, our risk exposure is limited by defined limits of liability. Once the loss limit has been reached, we have no further exposure to additional losses from that contract outside of contract failure. However, certain contracts, particularly quota share contracts that relate to first-dollar exposure, may not contain aggregate limits.
Our property business, and to a lesser extent our casualty and other business, include certain contracts that contain or may contain natural peril loss exposure. We estimate catastrophe loss exposure in terms of the probable maximum loss (“PML”). We define PML as the anticipated loss, taking into account contract terms and limits, caused by a catastrophe affecting a broad geographic area, such as that caused by an earthquake or hurricane. We anticipate that the PML will vary from period to period depending upon the modeled simulated losses and the composition of the in-force book of business. The projected severity levels are described in terms of a 1-in-250 year return period. The 1-in-250 year return period PML means that we believe there is a 0.4% chance in any given year that an occurrence of a natural catastrophe will lead to losses exceeding the stated estimate. In other words, it corresponds to a 99.6% probability that the loss from an event will fall below the indicated PML.
Total equity reported on the consolidated balance sheet decreased by $0.6 million to $477.2 million as of December 31, 2019, compared to $477.8 million as of December 31, 2018. Retained earnings decreased primarily due to a net loss of $4.0 million reported for the year ended December 31, 2019. The non-controlling interest was eliminated as a result of the termination of the Joint Venture.
As of December 31, 2019, Greenlight Re and GRIL were each rated “A- (Excellent)” with a negative outlook, by A.M. Best. The ratings reflect A.M. Best’s opinion of our reinsurance subsidiaries’ financial strength, operating performance and ability to meet obligations and it is not an evaluation directed toward the protection of investors or a recommendation to buy, sell or hold our Class A ordinary shares. If A.M. Best downgrades our ratings below “A- (Excellent)” or withdraws our rating, we could be severely limited or prevented from writing any new reinsurance contracts, which would significantly and negatively affect our business. Our A.M. Best ratings may be revised or revoked at the sole discretion of the rating agency.
Our sources of funds consist primarily of premium receipts (net of brokerage and ceding commissions), investment income and other income. We use cash from our operations to pay losses and loss adjustment expenses, profit commissions, interest and general and administrative expenses. As of December 31, 2019, all of our investable assets, excluding strategic investments and funds required for business operations and for capital risk management, are invested by DME Advisors in SILP, subject to our investment guidelines. We have the ability to redeem funds from SILP at any time for operational purposes by providing three days’ notice to the general partner. As of December 31, 2019, the majority of SILP’s long investments were composed of cash and cash equivalents, and publicly-traded equity securities, which can be readily liquidated to meet our redemption requests. We record all investment income (loss), including any changes in the net asset value of SILP, and any unrealized gains and losses, in our consolidated statements of operations for each reporting period.
For the years ended December 31, 2019 and 2018, the net cash provided by (used in) operating activities was $1.6 million and $(59.3) million, respectively. The net cash primarily provided by (used for) our underwriting activities (which excludes investment related expenses) was $(9.6) million and $(65.6) million for the years ended December 31, 2019 and 2018, respectively. Generally, if the premiums collected exceed claim payments within a given period, we would generate cash from our underwriting activities. Our underwriting activities represented a net use of cash for the year ended December 31, 2019, as the losses we paid exceeded the premiums we collected. The cash used in, and generated from underwriting activities may vary significantly from period to period depending on the underwriting opportunities available and claims submitted to us by our cedents.
The letter of credit facility contains customary events of default and restrictive covenants, including but not limited to, limitations on liens on collateral, transactions with affiliates, mergers and sales of assets, as well as solvency and maintenance of certain minimum pledged equity requirements, and restricts issuance of any debt without the consent of the letter of credit provider. Additionally, if an event of default exists, as defined in the letter of credit facility, Greenlight Re would be prohibited
from paying dividends to its parent company. The Company was in compliance with all the covenants of this facility as of December 31, 2019.
(2) Includes interest payments due on $100.0 million of senior convertible note payable at 4.0% per annum, as well as the payment of principal upon maturity on August 1, 2023.
(5) Due to the nature of our reinsurance operations, the amount and timing of the cash flows associated with our reinsurance contractual liabilities will fluctuate, perhaps materially, and, therefore, are highly uncertain.
We have no obligations, assets or liabilities which would be considered off-balance sheet arrangements. Other than our investments in SILP and AccuRisk Holdings LLC (see Notes 3 and 4 of the accompanying consolidated financial statements), we have not participated in transactions that created relationships with unconsolidated entities or financial partnerships, including VIEs, established for the purpose of facilitating off-balance sheet arrangements.