We currently occupy office space in Hamilton, Bermuda. In addition, we lease office space in Halifax, Canada; Hyderabad, India; London, England; Martigny, Switzerland; Zurich, Switzerland; San Juan, Puerto Rico; Dubai, UAE; and the Isle of Man. We are in the construction phase of building a more suitable office building in India, and have paid for and been allotted a one-acre lot for this purpose in a new government-promoted office park development. While we believe that for the foreseeable future our current office spaces combined with the project in India will be sufficient for us to conduct our operations, we anticipate future growth and we will likely need to expand into additional facilities to accommodate this growth. To date, the cost of acquiring and maintaining our office space has not been material.
You should read the following selected financial data in conjunction with the information included under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, and the consolidated financial statements and related notes included elsewhere in this Form 10-K.
(3) The acquisition cost ratio is calculated by dividing acquisition costs by net premiums earned.
(6) Book value per common share is defined as total shareholders’ equity divided by the number of common shares outstanding and vested RSUs at the end of the period, giving no effect to dilutive securities.
The following is a discussion and analysis of our financial condition as at December 31, 2007 and 2006 and our results of operations for the years ended December 31, 2007 and 2006 and the period from October 4, 2005 through December 31, 2005. This discussion should be read in conjunction with our audited consolidated financial statements and related notes included in Item 8 of this Form 10-K. Some of the information contained in this discussion and analysis is included elsewhere in this document, including information with respect to our plans and strategy for our business, and includes forward-looking statements that involve risks and uncertainties. Please see the “Cautionary Statement Regarding Forward-Looking Statements” for more information. You should review Item 1A, “Risk Factors” for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements.
We are a global reinsurance company and through our subsidiaries, we write primarily property, property catastrophe and short-tail specialty and casualty reinsurance.
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 initial public offering (“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).
Other income includes earned revenue relating to upfront commitment fees on reinsurance contracts and ceding commissions earned by Island Heritage.
Our expenses consist primarily of the following types: loss and loss adjustment expenses, acquisition costs, general and administrative expenses, interest expense and minority interest.
Loss and loss adjustment expenses are a function of the amount and type of reinsurance contracts we write and of the loss experience of the underlying risks. We estimate loss and loss adjustment expenses based on an actuarial analysis of the estimated losses we expect to be reported on contracts written. As described below, we will reserve for catastrophic losses that we anticipate will accrue to us as soon as a loss event is known to have occurred. The ultimate loss and loss adjustment expenses will depend on our actual costs to settle claims. We will increase or decrease our initial loss and loss adjustment estimates as actual claims are reported and settled.
Acquisition costs are primarily comprised of ceding commissions, brokerage, premium taxes, profit commissions and other expenses that relate directly to the writing of reinsurance contracts. Deferred acquisition costs are amortized over the related contract term, which is ordinarily twelve months.
General and administrative expenses consist primarily of salaries, benefits and related costs, including costs associated with awards under our PSU and RSU Plans, compensation expense based on the fair value of the Warrant and other general operating expenses.
The following are the accounting policies 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 reserves and IBNR, 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.
Reserves for losses and loss adjustment expenses as at December 31, 2007 and 2006 were comprised of the following:
As we are a broker market reinsurer, reserving for our business can involve added uncertainty because we depend on information from ceding companies. There is a time lag inherent in reporting information from the primary insurer to us and ceding companies have differing reserving practices. The information we receive varies by cedent and broker and may include paid losses and estimated case reserves. We may also receive an estimated provision for IBNR reserves, especially when the cedent is providing data in support of a request for collateral for loss reserves ceded. The information received from ceding companies is typically in the form of bordereaux, which are reports providing premium or loss data with respect to identified risks, broker notifications of loss and/or discussions with ceding companies or their brokers. This information can be received on a monthly, quarterly or transactional basis. As we are a reinsurer, our reserve estimates may be inherently less reliable than the reserve estimates of our primary insurer cedents.
The Company’s actuarial group performs a quarterly loss reserve analysis on a contract by contract basis. This analysis incorporates specific exposures, loss payment and reporting patterns and other relevant factors. This process involves the segregation of risks between catastrophic and non-catastrophic risks to ensure appropriate treatment.
Bornheutter-Ferguson Paid Loss Method. The Bornheutter-Ferguson paid loss method is a combination of the paid loss development method and the expected loss ratio method. The amount of losses yet to be paid is based upon the expected loss ratios. These expected loss ratios are modified to the extent paid losses to date differ from what would have been expected to have been paid based upon the selected paid loss development pattern. This method avoids some of the distortions that could result from a large development factor being applied to a small base of paid losses to calculate ultimate losses. This method will react slowly if actual loss ratios develop differently because of major changes in rate levels, retentions or deductibles, the forms and conditions of reinsurance coverage, the types of risks covered or a variety of other changes. The Company uses this method for lines of business and contracts where there are limited historical paid losses.
We reaffirm the validity of the assumptions we use in the reserving process on a quarterly basis during our internal review process. During this process, the Company’s actuaries verify that the assumptions continue to form a sound basis for projection of future liabilities.
in cases where benchmarks are used, they are derived from the experience of similar business; and
Although we believe that we are prudent in our assumptions and methodologies, we cannot be certain that our ultimate payments will not vary, perhaps materially, from the estimates we have made. If we determine that adjustments to an earlier estimate are appropriate, such adjustments are recorded in the quarter in which they are identified. The establishment of new reserves, or the adjustment of reserves for reported claims, could result in significant upward or downward changes to our financial condition or results of operations in any particular period. We regularly review and update these estimates using the most current information available to us.
A significant component of our loss ratio relates to non-catastrophe business for the years ended December 31, 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, 2007 and 2006, this would have resulted in an approximate increase or decrease in our net income or shareholders’ equity of approximately $6.3 million and $1.4 million, respectively.
Our estimates are reviewed annually by an independent actuary in order to provide additional insight into the reasonableness of our loss reserves.
We write treaty and facultative reinsurance on either a non-proportional (also referred to as excess of loss) basis or a proportional (also referred to as pro rata) basis.
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, 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, 2007 and 2006 were $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.
Acquisition costs, which are primarily comprised of ceding commissions, brokerage, premium taxes, profit commissions and other expenses that relate directly to the writing of reinsurance contracts are expensed over the underlying risk period of the related contracts. Acquisition costs relating to the unearned portion of premiums written are deferred and carried on the balance sheet as deferred acquisition costs. Deferred acquisition costs are amortized over the period of the related contract and are limited to their estimated realizable value based on the related unearned premiums, anticipated claims expenses and investment income.
The election of SFAS 159 will 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 Company’s U.S. government securities, equity securities and fixed income fund 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 or, when such prices are not available, by reference to broker or underwriter quotes. For securities priced using broker or underwriter quotes, we have determined that these quotes are the best estimates of the fair value of these securities when the market for the securities is considered active and multiple quotes with identical prices can be obtained. The fair value of the corporate bonds, mortgage-backed securities, asset-backed securities and REITs are derived from broker quotes based on inputs that are observable for the asset, either directly or indirectly, such as yield curves and transactional history. Investment funds and other investments are stated at fair value as determined by either the most recently published net asset value -- being the fund’s holdings in quoted securities adjusted for administration expenses -- or the most recently advised net asset value as advised by the fund adjusted for cash flows -- where the fund’s holdings are in private equity investments. 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 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. Derivative instruments are stated at fair value and are determined by the quoted market price for futures contracts and by observable market inputs for foreign currency forwards, total return swaps, currency swaps, interest rates swaps, and to-be-announced securities (“TBAs”). The Company fair values reinsurance derivative contracts using internal valuation models, with the significant inputs to the valuation models being the underlying risk exposure and the time left to the end of the contract.
The Company accounts for share based compensation in accordance with SFAS No. 123(R), “Share-Based Payment” (“SFAS 123(R)”). SFAS 123(R) requires entities to measure the cost of services received from employees and directors in exchange for an award of equity instruments based on the grant date fair value of the award. The cost of such services will be recognized as compensation expense over the period during which an employee or director is required to provide service in exchange for the award.
369,000 PSUs granted between December 20, 2005 and February 20, 2006 valued at $10.00 on the grant date. The $10.00 valuation was based on the subscription price paid by investors in the private placement on December 20, 2005 and additional closings on February 1, 2006 and February 23, 2006. The valuation was selected as the equity securities in the private placement are the same securities as those for which the fair value determination is being made and the transaction is a current transaction between willing parties.
We estimate the fair value of PSUs granted under the PSU Plan on the date of grant using the grant date fair value and the most probable diluted return-on-equity outcome and record the compensation expense in our consolidated statement of operations over the course of each three-year performance period. At the end of each quarter, we reassess the projected results for each three-year performance period as our financial results evolve. If we determine that a change in estimate is required, we recalculate the compensation expense under the PSU Plan and reflect any adjustments in the consolidated statements of operations in the period in which they are determined.
The total number of PSUs outstanding under the PSU Plan at December 31, 2007 and 2006 were 1,658,700 and 713,000, respectively (or up to 3,317,400 common shares at December 31, 2007, 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 1,658,700 at December 31, 2007. As at December 31, 2007 and 2006, there was a total of $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 2.1 years and 2.0 years, respectively.
The RSU Plan is the Company’s incentive scheme for officers, employees and non-management directors. The Compensation Committee has the authority to grant RSUs. Upon vesting, the value of an RSU grant may be paid in common shares, in cash, or partly in cash and partly in common shares at the discretion of the Compensation Committee. RSUs granted to employees generally vest two years after the date of grant and RSUs granted to directors vest on the date of grant. The Company estimates the fair value of RSUs on the date of grant and records the compensation expense in its consolidated statements of operations over the vesting period.
The grant date fair value of the common shares underlying the RSUs granted during 2007 was determined by reference to the closing share price effective at the date of grant. The grant date fair value of the common shares underlying the RSUs granted during 2006 was determined by reference to the price to book value multiple of a group of comparable publicly traded reinsurers with a longer track record, more mature infrastructure and a more established franchise.
The total number of RSUs outstanding under the RSU Plan as at December 31, 2007 and 2006 were 326,610 and 117,727, respectively. As at December 31, 2007 and 2006, there was a total of $1.3 million and $0.5 million, respectively, of unrecognized compensation cost related to non-vested RSUs, the cost of which is expected to be recognized over a period of approximately 0.9 years and 1.5 years, respectively.
In December 2007, the FASB issued SFAS No. 141 (revised 2007) “Business Combinations” (“SFAS 141(R)”). SFAS 141(R) improves reporting by creating greater consistency in the accounting and financial reporting of business combinations, resulting in more complete, comparable, and relevant information for investors and other users of financial statements. To achieve this goal, the new standard requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction; establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; and requires the acquirer to disclose to investors and other users all of the information needed to evaluate and understand the nature and financial effect of the business combination. SFAS 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. An entity may not apply it before that date. The effective date of this Statement is the same as that of the related FASB SFAS No. 160 “Non-controlling Interests in Consolidated Financial Statements - an amendment of ARB No. 51” (“SFAS 160”). We are currently assessing the impact of the adoption of this Statement on our results and financial position.
In December 2007, the FASB issued SFAS 160 which improves the relevance, comparability, and transparency of financial information provided to investors by requiring all entities to report non-controlling (minority) interests in subsidiaries as equity in the consolidated financial statements. Moreover, SFAS 160 eliminates the diversity that currently exists in accounting for transactions between an entity and non-controlling interests by requiring they all be treated as equity transactions. SFAS 160 is effective for financial statements issued for fiscal years beginning after December 15, 2008 and interim periods within those fiscal years, and early adoption is prohibited. If SFAS 160 was adopted as of December 31, 2007, the $184.8 million of minority interest would be reclassified as a separate component of shareholders’ equity.
On March 6, 2008, the Company signed an agreement to subscribe to a majority stake (65%) in Imperial Reinsurance Company Limited (“Imperial Re”). The transaction is subject to regulatory approvals and closing conditions and is expected to close in the second quarter of 2008. The subscription amount, to be determined upon completion of Imperial Re’s audited financial statements, will be approximately $20.8 million.
The following is a discussion and analysis of our financial condition as at December 31, 2007 and 2006 and our results of operations for the years ended December 31, 2007 and 2006 and the period October 4, 2005 through December 31, 2005. All amounts in the following tables are expressed in thousands of U.S. dollars.
The Company’s reporting currency is the U.S. dollar. The Company’s subsidiaries have one of the following functional currencies: U.S. dollar, Euro, Swiss franc, Indian rupee, British pound or Canadian dollar. As a significant portion of the Company’s operations is transacted in foreign currencies, fluctuations in foreign exchange rates may affect period-to-period comparisons. To the extent that fluctuations in foreign exchange rates affect comparisons, their impact has been quantified, when possible, and discussed in each of the relevant sections. See Item 8, Note 2 to the consolidated financial statements in the Company’s financial statements for a discussion on translation of foreign currencies.
This geographic area includes contracts that cover risks primarily in two or more geographic zones.
Gross premiums written were primarily driven by excess of loss reinsurance contracts, generally with a twelve-month term, which for the years ended December 31, 2007 and 2006 accounted for $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 Island Heritage primarily relate to a select property insurance portfolio in the Caribbean region. For the year ended December 31, 2007, gross premiums written from Island Heritage were $32.9 million and were classified as property catastrophe premiums in the line of business table 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.
During the years ended December 31, 2007 and 2006, the Company recorded $10.4 million and $0.7 million of gross reinstatement premiums. In 2007, the reinstatement premiums were primarily attributable to European Windstorm Kyrill and the U.K. floods. In 2006, the lack of gross reinstatement premiums was due to low catastrophe activity during the period.
Due to the potential volatility of our reinsurance contracts, especially our property catastrophe reinsurance contracts which we sell, we purchase reinsurance to reduce our exposure to large losses and as part of our overall risk management process. To the extent that appropriately priced coverage is available, we anticipate use of reinsurance to reduce the financial impact of large losses on our results and to optimize our overall risk profile. We segment our reinsurance purchases into the following areas - common account reinsurance purchased mutually on behalf of our needs and the client’s needs on specific treaties, business written with the intent to cede directly to our sidecar facility, and opportunistic and core purchases.
In 2006, the primary component was attributable to premiums ceded to our sidecar facility, Mont Fort, of $15.1 million. Through Mont Fort, we participated in reinsurance opportunities that otherwise would be outside or in excess of our own exposure limits, which provides additional capacity typically in times of market dislocations where capacity for a given risk is in short supply. With effect from January 12, 2007, the results of Mont Fort are consolidated in the Company’s consolidated financial statements, and therefore, premiums ceded to Mont Fort during the year ended December 31, 2007 have been eliminated with the consolidation of Mont Fort’s results into the Company’s consolidated financial statements.
The underwriting results of a reinsurance company are often measured by reference to its loss ratio and expense ratios. The loss ratio is calculated by dividing loss and loss adjustment expenses (including estimates for IBNR losses) by net premiums earned. The two components of the expense ratio may be expressed as separate ratios, the acquisition cost ratio and the general and administrative expense ratio. The acquisition cost ratio is calculated by dividing acquisition costs by net premiums earned. The general and administrative expense ratio is calculated by dividing general and administrative expenses by net premiums earned. The combined ratio is the sum of these three ratios.
Our combined ratio and components thereof are set out below for the years ended December 31, 2007 and 2006:
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 on premiums earned to date of $22.5 million reflecting the low insured catastrophe activity for the period.
The acquisition of the controlling interest in Island Heritage in July 2007 resulted in the inclusion of $6.4 million in acquisition costs for the year ended December 31, 2007.
General and administrative expenses consist primarily of salaries, benefits, and related costs, including costs associated with our PSU and RSU Plans and other general operating expenses. General and administrative expenses for the years ended December 31, 2007 and 2006 were $72.5 million (15.2% general and administrative expense ratio) and $34.7 million (18.1% general and administrative expense ratio), respectively. The increase of $37.8 million during 2007, or 108.6%, is principally due to expenses related to the increase in staffing levels as we continue to build our global platform and associated general operating expenses. In addition, $3.5 million of expenses for 2007 resulted from the inclusion of Island Heritage from July 1, 2007 onwards. Because the growth in our net premiums earned has outpaced the growth in our general and administrative expenses, the general and administrative expense ratio has decreased 2.9% from 2006.
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 $264.4 million of foreign currency forwards contractual value as hedges, which had a fair value of $(3.4) million as of December 31, 2007. All other derivatives are not designated as hedges, and accordingly, the realized and unrealized gains and losses are included in “Net realized gains and losses -investments” and “-other” in the consolidated financial statements. There were no derivatives designated as hedges as of December 31, 2006.
The total return on our investment portfolio comprises investment income and realized and unrealized gains and losses on investments. 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 equitites) 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 LIBOR. We continue to refine and develop our investment strategy. 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.
Net realized and unrealized gains on fixed maturities of $7.8 million for the year ended December 31, 2007 were primarily due to the positive impact of declining interest rates over the year on our portfolio offset by realized losses on disposals of fixed maturities.
The Company enters into investment portfolio derivatives including global equity, global bond, commodity and real estate futures, TBAs, total return swaps and interest rate swaps. The Company enters into index futures contracts and total return swaps to gain or reduce its exposure to an underlying asset or index. The Company also purchases TBAs as part of its investing activities. The Company enters into interest rate swaps in order to manage portfolio duration and interest rate risk. The Company manages the exposure to these instruments based on guidelines established by management and approved by the Board of Directors. The decrease in net realized and unrealized losses and gains on derivatives in 2007 was due to the poor performance of our swap contracts which had exposure to the real estate market and to the lower performance in 2007 of equity markets compared to 2006 which affected our net gains on futures contracts.
The following table is the breakdown of net realized and unrealized gains and losses-other in the consolidated statements of operations into its various components:
We use currency swaps and foreign currency forwards to economically hedge the 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. The losses on foreign currency forwards were due to the continued weakening of the U.S. dollar against other major currencies.
On July 3, 2007, the Company purchased 73,110 shares (representing a 21.4% interest) in Island Heritage for a purchase price of $12.6 million. Island Heritage is a property insurer based in the Cayman Islands which primarily is in the business of insuring homes, condominiums and office buildings in the Caribbean region. With this acquisition, the Company took a controlling interest in Island Heritage by increasing its interest to 54.6% of the voting shares. The Company’s share of Island Heritage’s results from operations was recorded in the Company’s consolidated financial statements under the equity method of accounting through June 30, 2007. As a result of the acquisition of this controlling interest, the results of operations of Island Heritage have been included in the Company’s consolidated financial statements from July 1, 2007, with the portions of Island Heritage’s net income and shareholders’ equity attributable to minority shareholders recorded as minority interest in the Company’s consolidated financial statements. In relation to Island Heritage, the Company recorded a minority interest expense of $2.2 million for the year ended December 31, 2007.
The total of investments and cash and cash equivalents was $1.9 billion at December 31, 2007, compared to $1.0 billion at December 31, 2006.
net proceeds of $168.7 million from the issuance of our common shares through our IPO in April 2007;
net proceeds of $98.9 million, through a private placement of Junior Subordinated Deferrable Interest Notes in June 2007;
net proceeds through a private sale of subordinated debt of $24.7 million in September 2007;
net realized and unrealized gains on invested assets during the year of $17.2 million; and
At December 31, 2007, the average duration of the Company’s investment portfolio was 3.2 years, compared to 2.5 years at December 31, 2006. The duration increased due to the higher weighting of TIPs in our December 31, 2007 portfolio compared to December 31, 2006.
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, 2007 and 2006, were as follows:
The difference as a result of the election of the fair value option is in respect to 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 these investments at December 31, 2006. Subsequent to January 1, 2007, any movement in unrealized gains and losses has been recorded within net realized and unrealized gains and losses on investments within the consolidated statements of operations. 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.
The following table provides a breakdown of the credit quality of the Company’s fixed maturity investments at December 31, 2007 and 2006:
The contractual maturity dates of fixed maturity and short term investments as at December 31, 2007 and 2006 is shown below. Actual maturities may differ from contractual maturities because certain borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.
The investment funds consist of investments in a hedge fund and private equity funds. The catastrophe bonds held pay a variable interest coupon and their return, from interest and return of principal, is contingent upon climatological and geological events. REITs are an investment in a corporation investing in real estate. The fixed income fund is a Swiss franc money market fund.
Global financial markets experienced significant stress during the third and fourth quarters of 2007 and early 2008, primarily driven by challenging conditions in the markets related to U.S. sub-prime mortgages (including collateralized debt obligations (“CDOs”) based on sub-prime collateral), and in the markets for loans and bonds related to leveraged finance transactions (collectively referred to as “sub-prime”). This adverse market environment began to intensify toward the end of July 2007 and was characterized by significant credit spread widening, prolonged illiquidity, reduced price transparency and increased volatility. As conditions in these markets deteriorated, other areas such as the asset-backed commercial paper market also experienced decreased liquidity and the equity markets experienced short-term weakness and increased volatility. In addition, a number of participants in the financial guaranty market, have reported significant mark-to-market losses on their portfolio of financial guaranty contracts accounted for as derivatives under GAAP. Certain of these market participants have had their financial strength ratings put on review for possible downgrade by various rating agencies, or such ratings were downgraded and the market capitalization of such participants decreased significantly. In response and in an effort to stabilize market conditions generally, the Federal Reserve and other central banks injected significant liquidity into the markets and lowered benchmark interest rates.
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, 2007. See “-Critical Accounting Policies-Loss and Loss Adjustment Expense Reserves” for additional information concerning loss and loss adjustment expenses.
The $3.9 million prior year reduction in the net incurred losses arose from the revision of our loss estimates upon receipt of updated information from our clients and brokers.
The Company actively manages its capital to support its underwriting operations and for the benefit of its shareholders, subject to the ability to maintain strong ratings from the agencies and maintain its ability to pay claims as they arise. Generally, the Company will seek to raise additional capital when its current capital position is not sufficient to support attractive business opportunities available. Conversely, the Company will seek to reduce its capital, through dividends or stock repurchases when the opportunity set is insufficient to utilize our capital to earn our long term return targets.
On August 23, 2006, the Company raised gross and net proceeds of $136.7 million and $132.8 million through a private placement of Deferrable Interest Debentures. The Deferrable Interest Debentures have a floating rate of interest equal to (i) London Interbank Offering Rate (“LIBOR”) plus 354 basis points per annum, reset quarterly for the dollar-denominated principal amount and (ii) Euro Interbank Offered Rated (“Euribor”) plus 354 basis points per annum, reset quarterly for the Euro-denominated principal amount. The Deferrable Interest Debentures mature on September 15, 2036, and may be called at par by the Company at any time after September 15, 2011. The Company may defer payment of the interest for up to 20 consecutive quarterly periods, but no later than September 15, 2011. Any deferred interest payments would accrue interest quarterly on a compounded basis.
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 September 2007, the Company raised gross and net proceeds of $25.0 million and $24.7 million, respectively, through a private placement of Junior Subordinated Deferrable Interest Notes. These Notes have a floating rate of interest equal to LIBOR plus 310 basis points per annum, reset quarterly. These Notes mature on September 15, 2037, and may be called at par by the Company at any time after September 15, 2012. The Company may defer interest payment for up to 20 consecutive quarterly periods, but no later than September 15, 2012. Any deferred interest payments would accrue interest quarterly on a compounded basis.
At December 31, 2007 and 2006, the Company was in compliance with all required covenants, and no conditions of default existed related to the Company’s long term debt. We may incur additional indebtedness in the future if we determine that it would be an efficient part of our capital structure.
Our capital management strategy is to preserve sufficient capital to support the Company’s financial strength ratings and our future growth while maintaining conservative financial leverage and earnings coverage ratios.
Cash flows from operations in 2007 increased to $326.9 million, from $172.4 million in 2006. This increase in cash flows from operations was primarily attributable to higher underwriting cash flows due to higher premium writings in 2007 compared to 2006. Because a large portion of the coverages we provide typically can produce losses of high severity and low frequency, it is not possible to accurately predict our future cash flows from operating activities. As a consequence, cash flows from operating activities may fluctuate, perhaps significantly, between individual quarters and years.
Generally, positive cash flows from our operating and financing activities are invested in the Company’s investment portfolio. For further discussion of our investment activities, including our strategy and current durations, refer to “Business” and also Note 5 to our Consolidated Financial Statements included in Item 8 of this report.
Financial strength ratings and senior unsecured debt ratings represent the opinions of rating agencies on the Company’s capacity to meet its obligations. In the event of a significant downgrade in ratings, the Company’s ability to write business and to access the capital markets could be impacted. Some of the Company’s reinsurance treaties contain special funding and termination clauses that are triggered in the event the Company or one of its subsidiaries is downgraded by one of the major rating agencies to levels specified in the treaties, or the Company’s capital is significantly reduced. If such an event were to occur, the Company would be required, in certain instances, to post collateral in the form of letters of credit and/or trust accounts against existing outstanding losses, if any, related to the treaty.
In 2008, we anticipate expenditures of approximately $5.0 million for our information technology infrastructure and systems enhancements, including proprietary software expenditures and $6.0 million primarily for the building costs associated with the completion of our office building in Hyderabad. We expect our operating cash flows, together with our existing capital base, to be sufficient to meet these requirements and to operate our business.
In the normal course of its operations, the Company enters into agreements with financial institutions to obtain secured credit facilities. Under the terms of certain reinsurance agreements, irrevocable letters of credit are issued on a secured basis in respect of cedents’ reported loss and unearned premium reserves.
In September 2007, the Company entered into a $200.0 million uncommitted letter of credit facility agreement with Wachovia Bank, N.A. While the Company has not drawn upon this facility as at December 31, 2007, if drawn upon, the utilized portion of the facility will be secured by an appropriate portion of securities from the Company’s investment portfolio.
The Insurance Act requires Flagstone to maintain a minimum solvency margin (being the minimum amount that the statutory assets must exceed the statutory liabilities as required by the 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 was required to maintain a minimum level of statutory capital and surplus of $228.0 million as at December 31, 2007. In addition, Flagstone is required to maintain a minimum liquidity ratio. As at December 31, 2007, 2006 and 2005, Flagstone was in compliance with all of the requirements of the Insurance Act.
Flagstone is not licensed or admitted as an insurer or reinsurer in any jurisdiction other than Bermuda. Because many jurisdictions do not permit insurance companies to take credit for reinsurance obtained from unlicensed or non-admitted insurers on their statutory financial statements unless appropriate security mechanisms are in place, we anticipate that our reinsurance clients will typically require Flagstone to post a letter of credit or other collateral.
Island Heritage is currently licensed to transact domestic insurance business in sixteen Caribbean countries.
The following table shows our aggregate contractual obligations by time period remaining to due date as at December 31, 2007:
(4) The Company has made certain commitments with respect to an investment in a private equity fund and may receive capital call requests in 2008.
The Company’s reporting currency is the U.S. dollar. The Company has exposure to foreign currency risk due to the following: its investments in foreign subsidiaries whose functional currencies are typically their national currencies; Flagstone Suisse’s underwriting reinsurance exposures; the collection of premiums and payment of claims and other general operating expenses denominated in currencies other than the U.S. dollar; and, holding certain net assets in foreign currencies. The Company’s most significant foreign currency exposure is to the Swiss franc.
Net foreign exchange gains amounted to a gain of $5.3 million, a gain of $2.1 million and a gain of $nil for the years ended December 31, 2007 and 2006 and the period from October 4, 2005 through December 31, 2005, respectively (See “-Results of Operations” above).
Flagstone Reinsurance Holdings Limited (“the Company”) is a holding company incorporated on October 4, 2005 under the laws of Bermuda. The Company, through its principal operating, wholly owned subsidiaries, Flagstone Reinsurance Limited (“Flagstone”) and Flagstone Réassurance Suisse SA (“Flagstone Suisse”), is a provider of global property, property catastrophe, and short-tail specialty and casualty reinsurance. Flagstone was incorporated in Bermuda on November 10, 2005 and licensed as a Class 4 insurer under The Insurance Act 1978, as amended and related Regulations (the “Insurance Act”). Flagstone Suisse was formed in Switzerland on September 7, 2006 and is an indirect wholly owned subsidiary of Flagstone. Flagstone Suisse was formed to serve as the Company’s European underwriting platform and was licensed by the Federal Office of Private Insurance in Switzerland on December 20, 2006.
On March 6, 2006, the Company entered into a share purchase agreement to purchase 370,000 common shares, representing 100% of the outstanding common shares of Mont Fort Re Limited (“Mont Fort”), a segregated accounts or “cell” company registered under the Bermuda Segregated Accounts Companies Act 2000 (as amended). In May 2006, the Company invested an additional $1.3 million in Mont Fort. Mont Fort raises capital from investors through offerings of its preferred shares, and uses the proceeds of those offerings to underwrite reinsurance, which will be ceded to Mont Fort solely by Flagstone pursuant to a reinsurance agreement. On June 6, 2006, Mont Fort closed an offering of preferred shares relating to its first cell, Mont Fort ILW, which yielded gross proceeds of $60.0 million including investments by Flagstone of $5.0 million (8.3%) and LB I Group Inc. (“LB I”) of $50.0 million (83.3%). LB I is a related party due to its investment in common shares of the Company. On August 28, 2006, Mont Fort repurchased the preferred shares held by Flagstone for $5.1 million. As at December 31, 2006, and for the year ended December 31, 2006, 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)”) the Company had determined that Mont Fort was a Variable Interest Entity (“VIE”). The Company was not considered to be the primary beneficiary and, therefore, was not required to consolidate Mont Fort into its financial statements. On January 2, 2007, Mont Fort closed an offering of preferred shares relating to its second cell, Mont Fort ILW 2 Cell (“Mont Fort ILW 2”) which yielded gross proceeds of $55.0 million from LB I. On January 12, 2007, Mont Fort closed an offering of preferred shares, with an unrelated party, relating to a third cell, Mont Fort High Layer (“Mont Fort HL”), which yielded gross proceeds of $28.1 million. The Company determined that the establishment of these cells was a reconsideration event under the provisions of paragraph 7 and paragraph 15 of FIN 46(R). The Company assessed the impact of these reconsideration events on its results and financial position, and concluded that the establishment of the Mont Fort HL cell on January 12, 2007 was the reconsideration event that resulted in the Company being the primary beneficiary of Mont Fort. As such, the results of Mont Fort are included in the Company’s consolidated financial statements with effect from January 12, 2007.
The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”). All inter-company accounts and transactions have been eliminated on consolidation.
The accompanying financial statements as at December 31, 2007 include all adjustments (consisting of normal recurring accruals) considered necessary to present fairly the financial position as at December 31, 2007 and 2006 and the results of operations and cash flows for the years ended December 31, 2007 and 2006 and the period October 4, 2005 through December 31, 2005.
The preparation of these consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported disclosed amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The Company’s principal estimates are for loss and loss adjustment expenses and estimates of premiums written, premiums earned, acquisition costs and share based compensation. The Company reviews and revises these estimates as appropriate. Any adjustments made to these estimates are reflected in the period the estimates are revised.
A significant portion of the Company’s business is property catastrophe and programs with high attachment points of coverage. Reserving for losses in such programs is inherently judgmental in that losses in excess of the attachment level on those programs are characterized as high severity and low frequency and other factors which could vary significantly as claims are settled. This limits the volume of relevant industry claims experience available from which to reliably predict ultimate losses following a loss event. In addition, the Company has limited past loss experience due to its relatively short operating history, which increases the inherent uncertainty in estimating ultimate loss levels.
The uncertainties inherent in the reserving process, delays in ceding companies reporting losses to the Company together with the potential for unforeseen adverse developments, may result in loss and loss adjustment expense reserves significantly greater or less than the reserve provided at the time of the loss event. Loss and loss adjustment expense reserve estimates are regularly reviewed and updated as new information becomes known. Any resulting adjustments are reflected in the period in which they become known.
Reinsurance premiums ceded are expensed over the period the reinsurance coverage is provided. Unearned ceded premiums represent the portion of premiums ceded related to the unexpired portion of the risk period.
Prior to January 1, 2007, investments were considered available-for-sale in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS 115”), and were carried at fair value with unrealized gains and losses recorded in accumulated other comprehensive income (loss). Following the issuance by the FASB of SFAS 159, “The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115” (“SFAS 159”), the Company elected to early adopt the fair value option for all fixed maturity investments, equity investments (excluding investments accounted for under the equity method of accounting), real estate investment trusts (“REITs”), investment funds, catastrophe bonds, and fixed income funds commencing January 1, 2007. This election requires the Company to adopt SFAS No. 157, "Fair Value Measurements ("SFAS 157") regarding fair value measurements. 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.
The Company has elected the fair value option to simplify the accounting, as this election will reduce 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 difference as a result of the election of the fair value option is in respect to 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 (loss) as a separate component of shareholders’ equity. On January 1, 2007, a cumulative-effect adjustment was made to reclassify the net unrealized losses, which represented the difference between the cost or amortized cost of investments and the fair value of those investments at December 31, 2006, from accumulated other comprehensive loss as at December 31, 2006 into retained earnings in the amount of $4.0 million. Subsequent to January 1, 2007, any movement in unrealized gains and losses has been recorded within net realized and unrealized gains (losses) on investments within the audited 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 are 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.
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.
Short term investments, if any, comprise fixed maturity investments with a maturity greater than three months but less than one year from the date of purchase. Cash and cash equivalents include amounts held in banks, money market funds and time deposits with maturities of less than three months at the date of purchase.
The RSUs are granted to employees and directors of the Company. RSUs granted to employees generally vest two years after the date of grant and RSUs granted to directors vest on the date of grant. The company estimates the fair value of RSUs on the date of grant and records the compensation expense in its consolidated statements of operations over the vesting period.
The Company accounts for the warrant granted to Haverford (Bermuda) Ltd. (“Haverford”), a related party due to common ownership, as stock compensation in accordance with SFAS No. 123(R). Compensation expense for the warrant was measured at fair value at the date of issuance of the warrant and recorded as compensation expense in the issuance period as there was no required service period. (See Note 11 for additional details)
The Company accounts for its derivative instruments using SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). SFAS 133 requires an entity to recognize all derivative instruments as either assets or liabilities in the balance sheet and measure those instruments at fair value, with the fair value recorded in other assets or liabilities. The accounting for realized and unrealized gains and losses associated with changes in the fair value of derivatives depends on its hedge designation and whether the hedge is highly effective in achieving offsetting changes in the fair value of the asset or liability being hedged. The realized and unrealized gains and losses on derivatives not designated as hedging instruments are included in net realized and unrealized gains and losses in the consolidated financial statements. Gains and losses associated with changes in fair value of the designated hedge instruments are recorded with the gains and losses on the hedged items, to the extent that the hedge is effective. Derivative instruments are stated at fair value in accordance with SFAS 157 based on quoted market price for futures contracts and based on observable market inputs (such as currency spot and forward rates, underlying exchange traded securities yield curves and transactional history) for foreign currency forwards, total return swaps, currency swaps, interest rates swaps and “to be announced” mortgage-backed securities (“TBAs”). The Company fair values reinsurance derivative contracts using internal valuation models, with the significant inputs to the valuation models being the underlying risk exposure and the time left to the end of the contract.
The Company formally documents all relationships between designated hedging instruments and hedged items, as well as its risk management objective and strategy for undertaking various hedge transactions. In this documentation, the Company specifically identifies the investments in or loans to subsidiaries that have been designated as a hedged item and states how the hedging instrument is expected to hedge the risks related to the hedged item. The Company formally measures effectiveness of its designated hedging relationships, both at the hedge inception and on an ongoing basis. The Company assesses the effectiveness of its designated foreign currency hedges based on the value of the investment in and loans to subsidiaries and the currency translation adjustment recorded upon consolidation. The time value component of the designated fair value hedges is excluded from the assessment of hedge effectiveness.
In connection with its purchase of West End, the Company recorded goodwill in the amount of $2.0 million. In connection with its interest in Island Heritage, the Company recorded goodwill in the amount of $3.6 million at December 31, 2006 and an additional $5.2 million in 2007 for a total of $8.8 million at December 31, 2007.
For acquisitions under the purchase method, 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 asset to test it for impairment. If, as a result of the assessment, the Company determines that the value of its goodwill asset is 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 subsidiaries are generally their national currencies, except for the Bermuda subsidiaries, whose functional currency is the U.S. dollar. 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 income (loss).
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 gains.
In December 2007, the FASB issued SFAS 141 (revised 2007) “Business Combinations” (“SFAS 141(R)”). SFAS 141(R) improves reporting by creating greater consistency in the accounting and financial reporting of business combinations, resulting in more complete, comparable, and relevant information for investors and other users of financial statements. To achieve this goal, the new standard requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction; establishes the acquisition date fair value as the measurement objective for all assets acquired and liabilities assumed; and requires the acquirer to disclose to investors and other users all of the information needed to evaluate and understand the nature and financial effect of the business combination. SFAS 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. An entity may not apply it before that date. The effective date of this Statement is the same as that of the related FASB Statement No. 160 “Noncontrolling Interests in Consolidated Financial Statements- an amendment of ARB No. 51” (“SFAS 160”). The Company is currently assessing the impact of the adoption of this Statement on its results and financial position.
In December 2007, the FASB issued SFAS 160 which improves the relevance, comparability, and transparency of financial information provided to investors by requiring all entities to report non-controlling (minority) interests in subsidiaries as equity in the consolidated financial statements. Moreover, SFAS 160 eliminates the diversity that currently exists in accounting for transactions between an entity and non-controlling interests by requiring they all be treated as equity transactions. SFAS 160 is effective for financial statements issued for fiscal years beginning on or after December 15, 2008 and interim periods within those fiscal years, and early adoption is prohibited. If SFAS 160 was adopted as of December 31, 2007, the $184.8 million of minority interest would be reclassified as a separate component of shareholders’ equity.
Included in the pro-forma revenue and net income (loss) amounts above for the year ended December 31, 2006 and the period from October 4, 2005 through December 31, 2005 is revenue of $4.0 million and $3.4 million and net (loss) income of $(1.7) million and $0.6 million, respectively, primarily relating to an investment management agreement that was terminated by West End effective June 30, 2006.
The fair value of the net assets acquired is summarized as follows:
As at December 31, 2006, and for the year ended December 31, 2006, in accordance with FIN 46(R) the Company had determined that Mont Fort was a VIE. The Company was not considered to be the primary beneficiary and, therefore, was not required to consolidate Mont Fort into its financial statements. The Company was deemed to have significant influence over the operating and financial policies of Mont Fort due to its board representation and 100% voting interests and Mont Fort was accounted for under the equity method of accounting. Under this method, the Company recorded all of the income or loss from the general account of Mont Fort but no income or losses arising from the activities of the segregated account of Mont Fort.
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 Flagstone under which Flagstone assumes 8.3% of the business written by Mont Fort ILW 2.
Further, with the addition of any new contracts that the Company enters into with each of the new cells, the Company will evaluate whether the contracts with Mont Fort continue to meet the risk transfer parameters of SFAS No. 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts” ("SFAS 113") considered individually and, where appropriate, in the aggregate. In the event that these cells caused any contract or group of contracts to fail to meet the risk transfer parameters, the Company’s future financial statements would account for these reinsurance transactions in accordance with the provisions of Statement of Position 98-7 “Deposit Accounting: Accounting for Insurance and Reinsurance Contracts that do not Transfer Insurance Risk.”
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, 2007 and 2006 are as follows:
Proceeds from the sale of fixed maturity, short term and equity investments during the year ended December 31, 2007 and 2006 amounted to $1.4 billion and $1.1 billion, respectively.
The contractual maturity dates of fixed maturity and short term investments as at December 31, 2007 and 2006 are as follows:
As at December 31, 2007 and 2006, 100% of the Company’s fixed maturity investment portfolio was invested in securities which were investment grade. As at December 31, 2007, the Company did not hold any security with direct exposure to the sub-prime markets.
The investment funds consist of investments in a hedge fund and private equity funds. The Company accounts for its other investments at fair value based on the most recent financial information available from fund managers and third party administrators.
The election of SFAS 159 will 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. In accordance with SFAS 157, the Company determined that its investments in U.S. government securities, equity securities and fixed income fund are stated at Level 1 fair value. Investments in corporate bonds, mortgage-backed securities, hedge fund, asset backed securities and REITs are stated at Level 2 whereas investment funds that are private placement investments and catastrophe bonds are stated at Level 3 fair value.
As at December 31, 2007, the Company’s investments are allocated between levels as follows:
The table above does not include an equity investment of $112,000 in which the Company is deemed to have a significant influence and as such, is not accounted for at fair value under SFAS 159.
The reconciliation of the fair value for the Level 3 investments, including net purchases and sales, realized gains and change in unrealized gains, is set out below:
Net investment income for the years ended December 31, 2007 and 2006, and the period from October 4, 2005 through December 31, 2005 was $73.8 million, $34.2 million, and $0.6 million, respectively. The components are set out below:
The analysis of the change in net unrealized gains (losses) on investments reflected in accumulated other comprehensive income (loss) for the years ended December 31, 2007 and 2006 and the period from October 4, 2005 through December 31, 2005 is as follows:
The following table presents an analysis of the available for sale fixed maturity investment positions which were carried at an unrealized loss as at December 31, 2006:
For the year ended December 31, 2006 (prior to the adoption of SFAS 159), the Company considered several factors and circumstances in the determination of other-than-temporary impairment, including the issuer’s overall financial condition, the issuer’s credit and financial strength ratings, the general market conditions in the industry or geographic region in which the issuer operates, the length of time the fair value of an issuer’s securities remains below cost, ability and intent to hold the security and any other factors that may raise doubt about the issuer’s ability to continue as a going concern. Other-than-temporary impairment were recorded as a realized loss which reduced net income and earnings per share. Temporary losses were recorded as unrealized losses which did not impact net income and earnings per share but reduced other comprehensive income. The Company recorded other-than-temporary impairment charges of $1.2 million relating to its portfolio of investment securities during the year ended December 31, 2006 as the Company did not have the ability nor intent to hold these securities to recovery.
In accordance with the terms of the letter of credit facility, the Company is required to maintain assets on deposit to secure the drawn portion of the facility. As at December 31, 2007 and 2006, approximately $82.0 million and $75.4 million, respectively, of fixed maturity securities were pledged in favor of ceding companies and other counterparties to comply with reinsurance contract provisions and insurance laws.
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, 2007, we had net positive development relating to the 2006 year of $3.9 million primarily related to the property catastrophe line of business.
For the period ended December 31, 2005, the Company recorded no premiums written or premiums earned.
As at December 31, 2007 and 2006, the provision for doubtful accounts was $1.0 million and $0.1 million, respectively.
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 TBAs as part of its investing activities. The Company manages the exposure to these instruments based on guidelines established by management and approved by the Board of Directors.
The Company uses 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 also uses interest rate swaps to manage its borrowing costs on long term debt. 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, 2007, the Company recorded $0.5 million of realized and unrealized gains on interest rate swaps. As at December 31, 2006, there were no interest rate swaps in the portfolio.
To convert the interest on long term debt from floating to fixed, the Company entered into interest rate swaps. On December 7, 2007, the Company entered into interest rate swap agreements with Lehman Brothers Special Financing Inc. Under the terms of these agreements, the Company exchanged interest on notional amounts of $120.0 million and $25.0 million, respectively, will receive interest at three month London Interbank Offered Rate (“LIBOR”) and pay 3.962% and 4.096% interest, respectively. The agreements will terminate on September 15, 2011 and September 15, 2012, respectively. On December 7, 2007, the Company entered into an interest rate swap agreement with Citibank N.A. Under the terms of the agreement, the Company exchanged interest on the notional amount of $100.0 million, and will receive three month LIBOR and pay 4.095% interest. The agreement will terminate on July 30, 2012. As of December 31, 2007, the fair value of these swaps was $0.4 million and the Company recorded $0.4 million of unrealized gains on these swaps.
The Company periodically uses foreign currency swaps to minimize the effect of fluctuating foreign currencies or to gain exposure to interest rate differentials between differing market rates. In September 2006, the Company entered into a foreign currency swap in relation to the euro-denominated Deferrable Interest Debentures. Under the terms of the foreign currency swap, the Company exchanged €13.0 million for $16.7 million, will receive Euro Interbank Offered Rate (“Euribor”) plus 354 basis points and pay LIBOR plus 371 basis points. The swap expires on September 15, 2011 and had a fair value of $2.5 million and $0.4 million as at December 31, 2007 and 2006, respectively. During the years ended December 31, 2007 and 2006, the Company recorded $2.0 million and $0.4 million, respectively, of realized and unrealized gains on foreign currency swaps.
The Company and its subsidiaries use foreign currency forward contracts to manage currency exposure. The contractual amount of these contracts as at December 31, 2007 and 2006 was $311.1 million and $84.9 million, and had a fair value of $(7.1) million and $0.5 million, respectively. The Company designated $264.4 million of foreign currency forwards contractual value as hedges, which had a fair value of $(3.4) million as of December 31, 2007. During the years ended December 31, 2007 and 2006, the Company recorded $14.0 million and $1.0 million respectively of realized and unrealized losses on foreign currency forward contracts. The Company recorded $3.5 million of unrealized losses directly into comprehensive income as part of the cumulative translation adjustment for the effective portion of the hedge. There were no foreign currency forwards designated as hedges as of December 31, 2006.
By acquiring a TBA, the Company makes a commitment to purchase a future issuance of mortgage-backed securities. For the period between purchase of the TBA and issuance of the underlying security, the Company’s position is accounted for as a derivative in the consolidated financial statements. At December 31, 2007 and 2006, the notional principal amount of TBAs was $18.2 million and $35.9 million and the fair value was $0.2 million and $(0.1) million, respectively. During the years ended December 31, 2007 and 2006, the Company recorded $(0.8) million and $1.6 million respectively of realized and unrealized gains (losses) on TBAs.
The Company has entered into industry loss warranty (“ILW”) transactions that are structured as reinsurance or derivatives. For those transactions determined to be derivatives, the fair value was $(1.3) million and $(0.2) million at December 31, 2007 and 2006, respectively. During the years ended December 31, 2007 and 2006, the Company recorded $1.7 million and $0.4 million respectively of realized gains on ILWs determined to be derivatives.
In accordance with SFAS 157, the fair value of derivative instruments held as of December 31, 2007 is allocated between levels as follows:
As a global organization, the Company may be subject to a variety of transfer pricing or permanent establishment challenges by taxing authorities in various jurisdictions. Management believes that adequate provision has been made in the consolidated financial statements for any potential assessments that may result from tax examinations for all open tax years.
On January 1, 2007, the Company adopted the provisions of FIN 48. The adoption of FIN 48 did not result in any unrecognized tax benefits or expenses for the year ended December 31, 2007. Management has deemed all material tax positions to have a greater than 50% likelihood of being sustained on technical merits if challenged. The Company does not expect any material unrecognized tax benefits within 12 months of December 31, 2007.
Deferred tax assets reflect the tax impact of temporary differences between the carrying amounts of assets and liabilities for financial reporting and income tax purposes. Significant components of the net deferred tax assets as of December 31, 2007 and 2006 were as follows:
The Note indentures contain various covenants, including limitations on liens on the stock restricted subsidiaries, restrictions as to the disposition of the stock of restricted subsidiaries and limitations on mergers and consolidations. The Company was in compliance with all the covenants contained in the Note indentures at December 31, 2007.
Interest expense includes interest payable and amortization of debt offering expenses. The debt offering expenses are amortized over the period from the issuance of the Notes to the earliest they may be called by the Company. For the years ended December 31, 2007 and 2006, the Company incurred interest expense and amortization of debt offering expenses of $18.7 million, and $4.6 million on the Notes. For the period October 4, 2005 through December 31, 2005, the Company did not incur any interest expense. Also, at December 31, 2007 and 2006, the Company had $1.9 million and $0.5 million, respectively, of interest payable included in other liabilities in the consolidated balance sheets.
In August 2006, the Company entered into a $200.0 million uncommitted letter of credit facility agreement with Citibank N.A. In April 2007, the Company increased its uncommitted letter of credit facility agreement with Citibank N.A. from $200.0 million to $400.0 million. As at December 31, 2007 and 2006, $73.8 million and $67.8 million, respectively, had been drawn under this facility, and the drawn amount of the facility was secured by respectively $82.0 million and $75.4 million of fixed maturity securities from the Company’s investment portfolio.
On December 20, 2005, the Company issued 55,239,491 common shares for gross proceeds of $552.4 million and incurred issuance costs of $4.6 million.
The Warrant has been classified as an equity instrument, in accordance with Emerging Issues Task Force Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock”. The compensation expense based on the fair value at the date of grant was $12.2 million for the initial closing of the private placement, and is included in general and administrative expenses and in additional paid-in capital in the consolidated financial statements for the period ended December 31, 2005. This value has been calculated using the Black-Scholes option pricing model. The assumptions used were: risk-free interest rate 4.4%; expected life 4.95 years; volatility 26.0%; dividend yield nil. 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. As at December 31, 2005, 6,628,739 common shares would be issuable pursuant to the Warrant.
The Company accounts for share based compensation in accordance with SFAS No. 123(R) which requires entities to measure the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award. The cost of such services will be recognized over the period during which an employee is required to provide service in exchange for the award.
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 (the “Committee”), 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 zero and two, depending on the DROE achieved during the vesting period. PSUs vest over a period of approximately three years. At the Company’s board meeting and the special general meeting of shareholders held on November 16, 2006, the PSU Plan was amended to increase the maximum number of PSUs that can be issued under the PSU Plan from 1.5 million to 2.8 million and to increase the maximum number of common shares that can be issued under the PSU Plan from 3.0 million to 5.6 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. If certain DROE goals are not met, no compensation cost is recognized. A summary of the activity under the PSU Plan as at December 31, 2007, 2006 and 2005 and changes during the year ended December 31, 2007 and 2006 and the period from October 4, 2005 through December 31, 2005, are as follows:
As at December 31, 2007 and 2006, there was a total of $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 2.1 and 2.0 years, respectively. A compensation expense of $6.0 million, $2.1 million and $34,000 has been recorded in general and administrative expenses for the years ended December 31, 2007 and 2006 and for the period from October 4, 2005 through December 31, 2005, respectively, in relation to the PSU Plan.
A summary of the activity under the RSU Plan as at December 31, 2007 and 2006 and changes during the years ended December 31, 2007 and 2006 are as follows:
As at December 31, 2007 and 2006, there was a total of $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 0.9 and 1.5 years, respectively. A compensation expense of $2.2 million and $0.7 million has been recorded in general and administrative expenses for the years ended December 31, 2007 and 2006, respectively, in relation to the RSU Plan.
No RSUs granted to employees have vested or been cancelled since the inception of the Plan. During the years ended December 31, 2007 and 2006, 62,449 and 53,827 RSU’s, respectively, were granted to the directors. During the year ended 2007, upon termination of service of a director, 11,216 RSUs were converted into common shares of the Company.
As at December 31, 2007 and 2006, Haverford directly owns 10.0 million common shares, or 11.7% and 13.9% respectively, of the Company’s outstanding common shares and is the holder of the Warrant which will entitle it to purchase up to an additional 8,585,747 common shares of the Company in December 2010. The impact of the conversion of the Warrant would increase Haverford’s ownership interest to 19.8% and 23.2% of the outstanding voting common shares at December 31, 2007 and 2006, respectively. The Company paid $1.0 million to Haverford in relation to services performed in respect of the initial private placement.
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% and 3.5% of the outstanding common shares of the Company at December 31, 2007 and 2006, respectively.
On December 20, 2005 Flagstone entered into a 24-month Operational Support Agreement (“OSA”) with West End. Mr. Byrne and Mr. Brown had ownership interests in West End, of 70.6% and 16.6%, respectively. West End provided Flagstone with certain insurance management and related support services for a fee pursuant to an OSA. Flagstone incurred $nil, $1.0 million and $25,000 in expenses under the OSA for the years ended December 31, 2007 and 2006 and the period from October 4, 2005 through December 31, 2005, respectively. Fees charged under the OSA were based on an hourly fee rate for certain individuals.
The Company has 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. The Company’s Code of Ethics adopted in June of 2006 and the Audit Committees Charter require the Audit Committee to review any situation in which a private interest of an employee or Director has a potential conflict of interest or is a related party transaction. The above transactions were reviewed directly with the Chairman of the Audit Committee in accordance with its Charter.
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, $1.9 million and $20,000 in relation to this agreement during the years ended December 31, 2007 and 2006 and the period October 4, 2005 through December 31, 2005, 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.
In July 2006, the Company entered into a sale agreement with IAL for the purchase of a Westwind 1124A aircraft. The Company paid IAL $1.8 million for the private aircraft. The value for the transaction was determined by the average of two independent appraisals from qualified aircraft valuation experts. The transaction closed on July 31, 2006. Prior to the acquisition of Longtail in August 2007, Flagstone Westwind Holdings Limited (“Flagstone Westwind”), a wholly owned subsidiary of the Company, had entered into a 24-month management and joint use agreement on August 1, 2006 with Longtail for the management and charter of its Westwind 1124A aircraft. Pursuant to the agreement, Flagstone Westwind paid Longtail a management fee of $6,000 per month and received a fee from Longtail of $2,000 per charter hour flown. Flagstone Westwind bears the costs of maintaining the aircraft. As at December 31, 2006, Flagstone Westwind had an amount of $0.1 million due to Longtail which was included in amounts due to related parties.
During the year ended December 31, 2006, West End earned advisory and performance fees from Rockridge, Mont Fort and Island Heritage of $1.8 million, $1.3 million, and $39,044. As a result of the acquisition of the controlling interest in Island Heritage by Flagstone, the results of operations of Island Heritage have been included in the Company’s consolidated financial statements from July 1, 2007, and therefore, the investment advisory fees from July 1, 2007 onwards have been eliminated with the consolidation of Island Heritage’s results into the Company’s consolidated financial statements. Investment advisory fees earned from Island Heritage from January 1, 2007 through June 30, 2007 were $nil. With effect from January 12, 2007, the results of Mont Fort are consolidated in the Company’s consolidated financial statements, and therefore, Mont Fort’s investment advisory fees during year ended December 31, 2007 have been eliminated. During the year ended December 31, 2006, the Company earned investment advisory fees of $1.4 million from Value Capital L.P. A subsidiary of the Company was the General Partner of Value Capital L.P. On June 30, 2006, the Company terminated its investment advisory agreement with Value Capital L.P.
As at December 31, 2007 and 2006, substantially all of the Company’s cash and investments were held with two custodians.
For the years ended December 31, 2007 and 2006, four brokers respectively accounted for approximately 83% and 87% of gross premiums written respectively, each of which individually accounted for 10% or more of the total gross premiums written.
On September 25, 2007, IAL Leasing entered into an operating lease with BoA to lease a Dassault Falcon 900B aircraft which an original cost of $18.5 million for a term of 10 years. The monthly rent commenced in November 2007 in the amount of $0.1 million per month. During the term of the lease, the Company has the option to exercise an early buyout option at month 60 of the lease term for 83.90% of the lessor’s cost, at month 96 for 69.79% of the lessor’s cost, purchase the aircraft at fair value at the end of the lease term, or return the aircraft to the lessor. The Company and Flagstone are acting as guarantors under the lease agreement.
On April 15, 2007, Flagstone King Air Holdings entered into an operating lease with BoA to lease a King Air 350 aircraft which an original cost of $2.9 million for a term of 10 years. The monthly rent commenced in May 2007 in the amount of $27,388 per month. During the term of the lease, the Company has the option to exercise an early buyout option at month 60 of the lease term for 75.986% of the lessor’s cost, at month 102 for 51.465% of the lessor’s cost, purchase the aircraft at fair value at the end of the lease term, or return the aircraft to the lessor. Flagstone is acting as guarantor under the lease agreement.
Effective November 20, 2007, Island Heritage entered into a share re-purchase agreement with one of its minority shareholders. Under this agreement, Island Heritage will buy back 16,919 shares (representing 5% of its common shares) on June 30, 2008 at a price of 1.78 times the fully diluted book value as at December 31, 2007, amounting to $3.5 million. The amount will be settled with fifty percent cash on or before June 30, 2008 and fifty percent cash on or before December 31, 2008.
The Company’s management views the operations and management of the Company as one operating segment. The Company is primarily focused on writing global property, property catastrophe and short tail specialty and casualty reinsurance. The Company regularly reviews the financial results and assesses its performance on a single segment basis. As the Company commenced operations on December 20, 2005, the Company did not underwrite any risks for the period ended December 31, 2005.
Except as otherwise noted, each of these categories includes contracts that cover risks located primarily in the designated geographic area.
Certain prior year balances were reclassified to conform with the current year classifications.
For the years December 31, 2007 and 2006 and the Period from October 4, 2005 through December 31, 2005
The Company’s debt outstanding as at December 31, 2007 and 2006 is as follows: