On July 9, 2008, we entered into an operating lease agreement for new office space in Grand Cayman, Cayman Islands which expires on June 30, 2018. We occupied the new office space in August 2009. Previously, we leased and occupied office space in Grand Cayman under an operating lease that expires on August 31, 2010. We do not expect to renew this lease upon it’s expiration in August 2010. We believe that for the foreseeable future the new office space will be sufficient for conducting our operations.
These historic results are not necessarily indicative of results for any future period. You should read the following selected financial data in conjunction with our consolidated financial statements and related notes thereto contained in Item 8 ‘‘Financial Statements and Supplementary Data’’ and
Premiums from reinsurance on property and casualty business assumed are directly related to the number, type and pricing of contracts we write. For financial reporting purposes, we earn premiums over the contract term, which is typically twelve months.
Premium Revenues and Risk Transfer. Our property and casualty reinsurance premiums are recorded as premiums written at the inception of each contract, based upon contract terms and information received from ceding companies and their brokers. For excess of loss reinsurance contracts, premiums are typically stated as a percentage of the subject premiums written by the client, subject to a minimum and deposit premium. The minimum and deposit premium is typically based on an estimate of subject premiums expected to be written by the client during the contract term. Generally, the minimum and deposit premium is reported initially as premiums written and adjusted, if necessary, in subsequent periods once the actual subject premium is known.
For each quota-share or proportional property and casualty reinsurance contract we underwrite, our client estimates gross premiums written at inception of the contract. We generally account for such premiums using our best estimates and then adjust our estimates based on actual reports provided by our client and based on our expectations of the industry developments. As the contract progresses, we monitor actual premiums received in conjunction with correspondence from the client in order to refine our estimate. Variances from initial gross premiums written estimates can be greater for quota-share contracts than for excess of loss contracts. All premiums are earned on a pro rata basis over the coverage period. Unearned premiums consist of the unexpired portion of reinsurance provided.
Case reserves and IBNR are estimated each reporting period based on a contract by contract review of all data available to us for each individual contract. Each of our reinsurance contracts is unique and the methods and estimates we use vary depending on the facts and circumstances of each contract. The resulting total loss reserves, including IBNR, are the sum of each loss reserve estimated on a contract by contract basis.
We rely more on client and industry data than our own data to identify unusual trends requiring changes in reserve estimates. Each reinsurance contract is different and the degree to which we rely on client data versus our own data varies greatly from contract to contract. The extent to which we rely on client data for reserve setting purposes depends upon the availability of historical loss data from the client and our judgment as to how reliable we believe the client’s historic loss performance is compared to its current book of business. We may from time to time supplement client data with industry and competitor information where we deem appropriate. Where available, we also receive relevant actuarial reports from the client. We supplement this information with subjective information on each client, which may include management biographies, competitor information, meetings with the client, and supplementary industry research and data.
Paid Loss Development Method. We estimate ultimate losses by calculating past paid loss development factors and applying them to exposure periods with further expected paid loss development. The paid loss development method assumes that losses are paid in a consistent pattern. It provides an objective test of reported loss projections because paid losses contain no reserve estimates. For many coverages, claim payments are made very slowly and it may take years for claims to be fully reported and settled.
Because of the uncertainties that surround our estimates of loss and loss adjustment expense reserves, we cannot be certain that ultimate loss and loss adjustment expense payments will not exceed our estimates, or be less than our estimates. If our estimated reserves are deficient, we would be required to increase loss reserves in the period in which such deficiencies are identified which would cause a charge to our earnings and a reduction of our capital. Similarly, if our estimated reserves are excessive, we would decrease loss reserves in such period in which the excesses are identified. By way of illustration, since we started underwriting operations in 2006, the reserve re-estimation process has resulted in a decrease to prior year reserves and an increase in net income during each of the three years ended December 31, as follows:
Acquisition Costs. We capitalize brokerage fees, ceding commissions, premium taxes and other direct expenses that relate directly to and vary with the writing of reinsurance contracts. Acquisition costs are deferred subject to ultimate recoverability and amortized over the related contract term. Acquisition costs also include profit commissions. Certain contracts include provisions for profit commissions to be paid to the ceding insurer based upon the ultimate experience of the contracts. The methodology for calculating profit commissions are specific to the individual contracts and vary from contract to contract. Typically profit commissions are calculated and accrued based on the expected loss experience for such contracts and recorded when the expected loss experience indicates that a profit commission is probable under the contract terms. Profit commission reserves, if any, are included in reinsurance balances payable on the consolidated balance sheets.
Bonus accruals. Under the Company's bonus program, each employee’s target bonus consists of two components: a discretionary component based on a qualitative assessment of each employee’s performance and a quantitative component based on the return on deployed equity ("RODE") for each underwriting year relating to reinsurance operations. The qualitative portion of an employee’s annual bonus is accrued at each employee's target amount, which may differ significantly from the actual amount approved and awarded annually by the Compensation Committee. The quantitative portion of each employee’s annual bonus is accrued based on the expected RODE for each underwriting year and adjusted for changes in the expected RODE each quarter until the final quantitative bonus is calculated and paid two years from the end of the fiscal year in which the business was underwritten. The expected RODE calculation utilizes proprietary models which requires significant estimation and judgment. Actual RODE may vary significantly from the expected RODE and any adjustments to the quantitative bonus estimates, which may be material, are recorded in the period in which they are determined.
Share-Based Payments. We have established a Stock Incentive Plan for directors, employees and consultants. U.S. GAAP requires us to recognize share-based compensation transactions using the fair value at the grant date of the award. We calculate the compensation for restricted stock awards based on the price of the Company’s common shares at the grant date and recognize the expense over the vesting period. Determining the fair value of share option awards at the grant date requires significant estimation and judgment. We use an option-pricing model (Black-Scholes pricing model) to assist in the calculation of fair value. Our shares have not been publicly traded for a sufficient length of time to reasonably estimate the expected volatility. Therefore we have based our expected volatility on the historical volatility of similar entities. We typically considered factors such as an entity's industry, stage of life cycle, size and financial leverage when selecting similar entities. Additionally, we used the full life of the option, ten years, as the estimated term of the option, and we have assumed that dividends will not be paid. If actual results differ significantly from these estimates and assumptions, particularly in relation to our estimation of volatility which requires significant judgment due to our limited operating history, share-based compensation expense, primarily with respect to future share-based awards, could be materially impacted.
For the year ended December 31, 2008, we reported a net loss of $120.9 million compared to net income of $35.3 million for the year ended December 31, 2007. For the year ended December 31, 2008, we reported underwriting income of $17.8 million compared to underwriting income of $19.6 million for the year ended December 31, 2007. Our investment portfolio reported a loss of $126.1 million, or 17.6%, for the year ended December 31, 2008 compared to a gain of $27.6 million, or 5.9%, for the year ended December 31, 2007.
For the year ended December 31, 2009, the adjusted book value per share increased by $5.77 per share, or 42.8%, to $19.24 per share from $13.47 per share at December 31, 2008. For the year ended December 31, 2008, the adjusted book value decreased by $3.30 per share, or 19.7%, to $13.47 per share.
Adjusted book value per share is a non-GAAP measure as it excludes the non-controlling interest in joint venture from total shareholders' equity. In addition, fully diluted adjusted book value per share is also a non-GAAP measure and represents basic adjusted book value per share combined with the impact from dilution of all in-the-money stock options issued and outstanding as of any period end. We believe that long-term growth in fully diluted adjusted book value per share is the most relevant measure of our financial performance. In addition, fully diluted adjusted book value per share may be of benefit to our investors, shareholders, and other interested parties to form a basis of comparison with other companies within the property and casualty reinsurance industry.
We expect our annual reporting of premiums written to be volatile as our underwriting portfolio continues to develop. Additionally, the composition of premiums written between frequency and severity business will vary from year to year depending on the specific market opportunities that we pursue. For the year ended December 31, 2009, the premiums written relating to frequency business increased by $92.9 million, or 69.3%, from the year ended December 31, 2008. The increase reflects the continuing development of our underwriting activities which resulted in a number of new and renewing frequency contracts written during the year ended December 31, 2009. The largest increase in premiums written for the year ended December 31, 2009 was a result of a new multi-year homeowners’ personal lines contract entered into during 2009 which accounted for 41.4% of the increase. General liability, workers’ compensation, health, motor liability and medical malpractice lines also contributed 28.9%, 10.8%, 8.1%, 6.0% and 4.8% respectively, to the increase in frequency premiums written for the year ended December 31, 2009.
For the year ended December 31, 2009, the premiums written relating to severity contracts increased by $3.5 million, or 12.3%, from the year ended December 31, 2008. The increase was the net effect of an increase in commercial property lines ($12.5 million) offset by decreases in medical malpractice ($3.4 million), general liability ($3.5 million), and professional liability ($2.1 million) lines of business.
Total losses incurred on frequency contracts continued to increase as a result of increases in premiums earned. Losses incurred as a percentage of premiums earned (i.e. loss ratio) fluctuate based on the mix of business, and the favorable or adverse development of our larger contracts. The loss ratio of our frequency business was 56.6%, 44.4% and 47.9% for the years ended December 31, 2009, 2008 and 2007, respectively. For the year ended December 31, 2009 the increase in frequency loss ratio was principally due to the increase in earned premiums on certain lines of business that typically have higher loss ratios. Specifically, the increase in premiums earned on our motor liability and health lines contributed to the majority of the increase in the frequency loss ratio.
For the year ended December 31, 2008, the decrease in frequency loss ratio was mainly due to the favorable loss development on a prior year personal lines contract written.
The increase in our severity loss ratio during the year ended December 31, 2008 was a result of losses primarily related to sub-prime related claims on casualty clash contracts.
Losses incurred can be further broken down into losses paid and changes in loss reserves. Losses incurred for the years ended December 31, 2009, 2008 and 2007 were comprised as follows:
For the year ended December 31, 2009, the losses incurred included an increase of $126.6 million related to current year contracts offset by $7.6 million related to net favorable loss development on prior year contracts. For the year ended December 31, 2009, the decrease in ceded reserves of $4.4 million were primarily due to favorable loss development on an inward contract and the reduction in reserves recoverable on the corresponding retroceded contract.
During the year ended December 31, 2009, the loss development on prior year contracts primarily related to the following:
Favorable loss development of $8.0 million on a 2006 Florida personal lines contract. We review loss reserves based upon the most recent available information. In general, initially on a contract, loss reserves are estimated based on historic or modeled information. These reserve estimates are adjusted, up or down, as the actual loss experience is realized. Our loss reserves on this contract were adjusted quarterly as new information was presented by our client and we reported these adjustments quarterly. The client reports incurred losses on this contract to us on a quarterly basis. The reserves we book are based on a combination of data received from the client as well as historic and industry data. During each quarter of 2009, the client reported favorable development of claims data resulting from lower than expected paid and incurred losses which impacted our own reserve analysis and correspondingly caused us to reduce our reserves by approximately $8.0 million during the year ended December 31, 2009.
Adverse loss development of $3.4 million on a 2007 casualty clash contract resulting from claims relating to California wildfires.
Adverse loss development of $1.1 million on a 2007 health contract based on our quarterly reserve analysis.
Favorable loss development of $12.4 million on a 2006 Florida personal lines contract. During 2008, each quarter the client reported improved (i.e. lower) loss ratio estimates. This decrease, supported by the favorable development of claims data, impacted our own reserve analysis and correspondingly caused us to reduce our reserves by approximately $12.4 million.
Eliminating $1.2 million of reserves, held on two frequency contracts covering excess of loss medical malpractice, due to commutation without any reported losses.
Adverse loss development of $1.4 million on a casualty clash severity contract due to notification of claims relating to sub-prime related events. This resulted in reserving for a full limit loss.
Increased acquisition costs for the year ended December 31, 2009 compared to the same period for 2008 are a direct result of the increases in premiums written and earned. For the years ended December 31, 2009, 2008 and 2007 the acquisition cost ratios for frequency business were 38.6%, 46.8% and 46.3%, respectively. We expect that acquisition costs will be higher for frequency business than for severity business. The acquisition cost ratios for severity business were 8.3%, 10.8% and 21.8% for the years ended December 31, 2009, 2008 and 2007, respectively.
For the year ended December 31, 2009, the decrease in severity acquisition cost ratio was primarily due to a reversal of profit commissions on a 2008 catastrophe excess of loss contract upon notification of losses from the insured during 2009.
Our general and administrative expenses for the years ended December 31, 2009, 2008 and 2007 were $19.0 million, $13.8 million and $11.9 million, respectively. For the year ended December 31, 2009, approximately 84.6% of the increase in general and administrative expenses related to higher personnel costs including employee bonuses, stock compensation, salaries and benefits. While we added three new employees during the year ended December 31, 2009, the increase in personnel costs primarily related to higher accrued employee bonuses, which resulted from net favorable loss development and investment income accrued on the deferred bonus compensation relating to the 2007 and 2008 underwriting years, payable to the employees during 2010 and 2011, respectively. Higher rent and office expenses relating to new office space (including expensing the remaining lease payments relating to the original office space) accounted for approximately 13.5% of the increase in general and administrative expenses.
A summary of net investment income (loss) for the years ended December 31, is as follows:
Our wholly owned subsidiary, Verdant, is incorporated in Delaware, and therefore is subject to taxes in accordance with the U.S. federal rates and regulations prescribed by the Internal Revenue Service. Verdant’s taxable income is expected to be taxed at a rate of 35%. For the year ended December 31, 2009, we recorded a deferred tax asset of $68,719 resulting solely from the temporary differences in recognition of expenses for tax purposes. An accrual of $19,529 has been recorded for current taxes payable as of December 31, 2009. Based on the timing of the reversal of the temporary differences and likelihood of generating sufficient taxable income to realize the future tax benefit, management believes it is more likely than not that the deferred tax asset will be fully realized in the future and therefore no valuation allowance has been recorded. Verdant has not taken any tax positions that are subject to uncertainty or that are reasonably likely to have a material impact to Verdant or the Company.
The following table sets forth our current and deferred income tax expense for the years ended December 31, 2009, 2008 and 2007.
Investments reported on our consolidated balance sheet as of December 31, 2009 were $830.6 million compared to $494.0 million as of December 31, 2008, an increase of 68.1%. The increase in investments was due to an investment gain of 32.1% for the year ended December 31, 2009, and cash flows from our underwriting operations used to purchase investments.
Our investment portfolio, including any derivatives, is valued at fair value and any unrealized gains or losses are reflected in net investment income in the consolidated statements of income. As of December 31, 2009, 87.6% of our investment portfolio (excluding restricted and unrestricted cash and cash equivalents) was comprised of investments valued based on quoted prices in actively traded markets (Level 1), 10.5% comprised of securities valued based on observable inputs other than quoted prices (Level 2) and 1.9% was comprised of securities valued based on non-observable inputs (Level 3).
During the year ended December 31, 2009, debt instruments with a fair value of $5.0 million were transferred from Level 2 to Level 3, as there was no longer an active market for these instruments and we were unable to obtain multiple quotes for these instruments. The fair values of these securities were estimated using the last available transaction price, adjusted for credit risk, expectation of future cash flows, and other non-observable inputs. In addition, during the year ended December 31, 2009, debt instruments with a fair value of $3.2 million were transferred out of Level 3, as multiple broker quotes were obtained for determining fair values. In addition, during the year ended December 31, 2009, unlisted equity securities with a fair value of $1.6 million were transferred from Level 2 to Level 3 as there was no longer an active market for these securities. The fair value of these securities was estimated based on a single quote from a market maker.
Loss reserves totaled $137.4 million as of December 31, 2009 compared to $81.4 million as of December 31, 2008. The increases are principally attributable to estimated losses incurred associated with the increase in premiums earned during the year ended December 31, 2009 resulting from our increased underwriting activities. Case reserves increased $33.5 million accounting for 59.9% of the increase, while reserves for losses incurred but not reported increased by approximately $22.4 million accounting for 40.1% of the increase as of December 31, 2009. The increase in frequency case reserves related primarily to motor liability contracts ($8.9 million) along with small increases in workers' compensation ($1.4 million), general liability ($1.1 million), and personal lines ($1.1 million). The increase in severity case reserves as of December 31, 2009 related primarily to general liability casualty clash contracts ($9.2 million), commercial lines ($9.0 million) and professional liability lines ($2.2 million).
Our severity business includes contracts that contain or may contain natural peril loss exposure. As of February 1, 2010, our maximum aggregate loss exposure to any series of natural peril events was $97.5 million. For purposes of the preceding sentence, aggregate loss exposure is equal to the difference between the aggregate limits available in the contracts that contain natural peril exposure minus reinstatement premiums for the same contracts. We categorize peak zones as: United States, Europe, Japan and the rest of the world. The following table provides single event loss exposure and aggregate loss exposure information for the peak zones of our natural peril coverage as of February 1, 2010:
Our shareholders’ equity increased to $729.2 million as of December 31, 2009 from $491.4 million as of December 31, 2008, an increase of 48.4%. The increase is principally attributable to the increase in retained earnings from net income of $209.5 million for the year ended December 31, 2009. In addition, the non-controlling interest in joint venture increased by $24.5 million primarily as a result of DME Advisors retaining its performance compensation of $21.9 million for the year ended December 31, 2009, in the joint venture account.
As of December 31, 2009, we believe we have sufficient cash flow from operations to meet our foreseeable liquidity requirements. We expect that our operational needs for liquidity will be met by cash, funds generated from underwriting activities and investment income, including realized gains. We have no current plans to issue debt and expect to fund our operations for the next 12 months from operating cash flow. However, we cannot provide assurances that in the future we will not incur indebtedness to implement our business strategy, pay claims or make acquisitions.
Greenlight Re is currently not licensed or admitted as a reinsurer in any jurisdiction other than the Cayman Islands. Because certain jurisdictions do not permit domestic insurance companies to take credit on their statutory financial statements unless appropriate measures are in place for reinsurance obtained from unlicensed or non-admitted insurers we anticipate that all of our U.S. clients and some of our non-U.S. clients will require us to provide collateral through funds withheld, trust arrangements, letters of credit or a combination thereof.
As of December 31, 2009, Greenlight Re had a $25.0 million letter of credit facility with Butterfield Bank (Cayman) Limited ("Butterfield Bank") with a termination date of June 6, 2010. The termination date is automatically extended for an additional year unless written notice of cancellation is delivered to the other party at least 30 days prior to the termination date.
Once letters of credit are issued to our clients, the minimum amount of assets that we pledge to our letter of credit providers depends upon the requirements stated in the specific letter of credit facility agreement. The amount of pledged assets required depends on the specific investment instrument that we transfer to the pledge account. The amount of credit that is given on the pledged assets depends on the type of instrument and the exchange on which that instrument is traded. For example, under the terms of the letter of credit facility with Citibank, N.A., if we pledge an equity security that is traded on the New York Stock Exchange, we receive a fixed percentage credit for the market value of such a security. If the market value of these securities were to decline, we would be obligated to pledge additional assets. Conversely if the market value of these securities increased we would be entitled to withdraw any excess pledged assets from the account if we so choose. The ultimate amount of pledged assets posted is simply the value of securities held in a designated pledge account, which may be greater than the minimum required.
Our capital structure currently consists entirely of equity issued in two separate classes of ordinary shares. We expect that existing capital base and internally generated funds will be sufficient to implement our business strategy. Consequently, we do not presently anticipate that we will incur any material indebtedness in the ordinary course of our business. We filed a Form S-3 registration statement for an aggregate principal amount of $200.0 million in securities, which was declared effective by the SEC on July 10, 2009, in order to provide us with additional flexibility and timely access to public capital markets should we require additional capital for working capital, capital expenditures, acquisitions, and for other general corporate purposes. We have not made any significant commitments for capital expenditures during the period as of December 31, 2009.
The following table shows our aggregate contractual obligations by time period remaining to due date as of December 31, 2009:
On July 9, 2008, we signed a ten year lease agreement for new office space in the Cayman Islands with the option to renew for an additional five year term. The lease term is effective from July 1, 2008, and the rental payments commenced on December 1, 2008. We occupied the premises in August 2009. Under the terms of the lease agreement, our minimum annual rent payments will be $253,539 for the first three years, increasing by 3% thereafter each year to reach $311,821 by the tenth year. The minimum lease payments are included in the above table under operating lease obligations and in Note 14 to the accompanying consolidated financial statements.
We have entered into a service agreement with a specialist service provider for the provision of administration and support in developing and maintaining business relationships, reviewing and recommending programs and managing risks relating to certain specialty lines of business. The specialist service provider does not have any authority to bind the Company to any reinsurance contracts. Under the terms of the agreement, the Company has committed to quarterly payments to the specialist service provider. If the agreement is terminated, the Company is obligated to make minimum payments for another two years to ensure any contracts to which the Company is bound are adequately administered by the specialist service provider. The minimum payments are included in the above table under specialist service agreement and in Note 14 to the accompanying consolidated financial statements.