We currently lease office space in Grand Cayman, Cayman Islands under an operating lease that expires on August 31, 2010. We believe that for the foreseeable future this office space will be sufficient for us to conduct our operations.
We are a Cayman Islands-based specialty property and casualty reinsurer with a reinsurance and investment strategy that we believe differentiates us from our competitors. Our goal is to build long-term shareholder value by selectively offering customized reinsurance solutions, in markets where capacity and alternatives are limited, that we believe will provide favorable long-term returns on equity.
We aim to complement our underwriting results with a non-traditional investment approach in order to achieve higher rates of return over the long term than reinsurance companies that employ more traditional, fixed-income investment strategies. We manage our investment portfolio according to a value-oriented philosophy, in which we take long positions in perceived undervalued securities and short positions in perceived overvalued securities.
Because we have a limited operating history, period-to-period comparisons of our underwriting results are not yet possible and may not be meaningful in the near future. In addition, our historical investment results may not necessarily be indicative of future performance. In addition, due to the nature of our reinsurance and investment strategies, our operating results will likely fluctuate from period to period.
We manage our business on the basis of one operating segment; property and casualty reinsurance, in accordance with the qualitative and quantitative criteria established by SFAS No. 131, ‘‘Disclosure about Segments of an Enterprise and Related Information.’’ Within the property and casualty reinsurance segment, we analyze our underwriting operations using two categories:
Frequency business is characterized by contracts containing a potentially large number of smaller losses emanating from multiple events. Clients generally buy this protection to increase their own underwriting capacity and typically select a reinsurer based upon the reinsurer’s financial strength and expertise. We expect the results of frequency business to be less volatile than those of severity business from period to period due to its greater predictability. We also expect that over time the profit margins and return on equity for our frequency business will be lower than those of our severity business.
General and administrative expenses consist primarily of salaries and benefits and related costs, including costs associated with our incentive compensation plan, stock compensation expenses, professional fees, travel and entertainment, letter of credit facility, information technology, rent and other general operating expenses.
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. 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 the client’s initial estimates and then adjust the estimates as advised by our client. We believe that the client’s estimate of the volume of business it expects to cede to us represents the best estimate of gross premiums written at the beginning of the contract. 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. Premiums are earned on a pro rata basis over the coverage period. Unearned premiums consist of the unexpired portion of reinsurance provided.
We account for reinsurance contracts in accordance with SFAS No. 60, ‘‘Accounting and Reporting by Insurance Enterprises,’’ and SFAS No. 113, ‘‘Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts.’’ Assessing whether or not a reinsurance contract meets the conditions for risk transfer requires judgment. The determination of risk transfer is critical to reporting premiums written and is based, in part, on the use of actuarial and pricing models and assumptions. If we determine that a reinsurance contract does not transfer sufficient risk, we account for the contract as a deposit liability.
Loss and Loss Adjustment Expense Reserves. We establish reserves for contracts based on estimates of the ultimate cost of all losses including losses incurred but not reported, or IBNR. These estimated ultimate reserves are based on reports received from ceding companies, historical experience and actuarial estimates. These estimates are periodically reviewed and adjusted when necessary. Since reserves are estimates, the setting of appropriate reserves is an inherently uncertain process. Our estimates are based upon actuarial and statistical projections and on our assessment of currently available data, predictions of future developments and estimates of future trends and other factors. The final settlement of losses may vary, perhaps materially, from the reserves initially established and any adjustments to the estimates are recorded in the period in which they are determined. 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.
• 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.
• Expected Loss Ratio Method. We estimate ultimate losses under the expected loss ratio method, by multiplying earned premiums by an expected loss ratio. We select the expected loss ratio using industry data, historical company data and our professional judgment. We use this method for lines of business and contracts where there are no historical losses or where past loss experience is not credible.
• Bornheutter-Ferguson Reported Loss Method. We estimate ultimate losses by modifying expected loss ratios to the extent reported losses experienced to date differ from what would have been expected to have been reported based upon the selected reported 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 reported losses to calculate ultimate losses. We use this method for lines of business and contracts where there are limited historical reported losses.
Share-Based Payments. We have established a Stock Incentive Plan for directors, employees and consultants which we account under SFAS 123R, ‘‘Share-Based Payments.’’ SFAS 123R 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. Due to our limited operating history, we use the ‘‘calculated value method,’’ which relies on historical
We believe that the increase of $255.7 million to our capital base from the net proceeds of our May 2007 initial public offering and private placement will allow us to access greater and more attractive reinsurance opportunities. We expect that the increase in capital and the access to opportunities will enable us to write a number of new contracts as well as successfully renew our most attractive contracts. We expect to see an increase in business written in 2008 compared to 2007 and a continued diversification of business by client, line of business, broker and geography.
At the same time, we believe there is an excess of capacity in the reinsurance business as a whole, mainly due to two consecutive years of low natural catastrophe losses. In the absence of a market changing event in 2008, we believe that this excess capacity will exert downward pricing pressure on a number of the products we sell or wish to sell in the near term. We intend to maintain our underwriting standards and discipline in the face of such potential market conditions.
• a limited number of reinsurers underwrite certain types of casualty reinsurance;
• there have been a number of companies that have suffered a financial ratings downgrade due to the current credit crisis and other issues that operate in business segments we find attractive and, therefore, competition may decrease;
• there are companies that, due to management turnover or other changes, have left or curtailed writings in certain lines of business creating potential opportunities;
We intend to continue to monitor market conditions so as to be positioned to participate in future underserved or capacity-constrained markets as they arise and offer products that we believe will generate favorable returns on equity over the long term. Accordingly, our underwriting results and product line concentrations in any given period may not be indicative of our future results of operations.
Our investment portfolio has investments, both long and short, in financial services and other sectors which may be affected directly and indirectly by the current credit crisis. The current volatility and uncertainty in the broader equity markets may have a negative impact on our short-term investment results.
For the year ended December 31, 2007, our net income decreased by $21.7 million as compared to the same period in 2006 due to a decrease of $30.9 million in net investment income which was partially offset by income generated from expanded underwriting operations. Our investment portfolio reported a return of 5.9% for the year ended December 31, 2007 as compared to a return of 24.4% for the year ended December 31, 2006.
One of our primary financial goals is to increase the long-term value in fully diluted book value per share. During the year ended December 31, 2007, fully diluted book value increased by $2.30 per share or 16.1% to $16.57. This increase includes the increase associated with our initial public offering in May 2007.
For the year ended December 31, 2006, fully diluted book value increased by $2.64 per share or 22.7% to $14.27 per share.
We entered into certain retrocessional contracts with gross ceded premiums of $26.2 million for the year ended December 31, 2007 relating to the risks assumed from certain frequency reinsurance contracts. We did not purchase any retrocessional coverage in 2006.
As the underwriting portfolio grows and develops, net premiums earned are likewise expected to increase. The significant increases in net premiums earned are attributable principally to increased premiums written during 2007 as well as further earning of premiums for those contracts written during 2006 whose coverage continued into 2007.
The loss ratios for our frequency business were 47.9% and 55.9% for the years ended December 31, 2007 and 2006, respectively.
Losses incurred can be further broken down into losses paid and changes in loss reserves. Losses incurred for the years ended December 31, 2007 and 2006 were comprised as follows:
Increased acquisition costs for the year ended December 31, 2007 compared to the same period for 2006 are a direct result of the increases in premiums written. For the years ended December 31, 2007 and 2006 the acquisition cost ratios for frequency business were 46.3% and 40.8%, respectively. We expect that acquisition costs will be higher for frequency business than for severity business. The acquisition cost ratios for severity business were 21.8% and 36.8% for the years ended December 31, 2007 and 2006, respectively.
A summary of net investment income for the years ended December 31, is as follows:
Investment income, net of all fees and expenses, resulted in a 5.9% gain on our investment portfolio for the year ended December 31, 2007. This compares to 24.4% and 14.2% investment returns reported for the years ended December 31, 2006 and 2005, respectively. Investment returns are calculated monthly and compounded to calculate the annual returns. The resulting actual investment income may vary depending on cash flows into or out of the investment account.
Our investment advisor, DME Advisors, and its affiliates manage and expect to manage other client accounts besides ours, some of which have investment objectives similar to ours. To comply with regulation FD, our investment returns are posted on our website on a monthly basis. Additionally, on our website we provide the names of the largest disclosed long positions in our investment portfolio as of the last date of the month of the relevant posting.
We are not obligated to pay any taxes in the Cayman Islands on either income or capital gains. We have been granted an exemption by the Governor-in-Cabinet from any taxes that may be imposed in the Cayman Islands for a period of 20 years, expiring on February 1, 2025.
Due to the opportunistic and customized nature of our underwriting operations, we expect to report different loss and expense ratios in both our frequency and severity businesses from period to period. For the years ended December 31, 2007 and 2006, the following ratios are reported:
Given that we opportunistically underwrite a concentrated portfolio across several lines of business which have varying expected loss ratios, we can expect there to be significant annual variations in the loss ratios reported from our frequency business. The loss ratio for frequency business has decreased from 55.9% for the year ended December 31, 2006 to 47.9% for 2007. This reduction is primarily the result of better than expected losses being reported on certain personal property coverage as well as writing a mix of business during 2007 with an overall lower expected loss ratio.
The loss ratio for severity business has increased from 8.5% reported for the year ended December 31, 2006 to 19.9% for the year ended December 31, 2007. While both years experienced benign natural peril losses, the increased loss ratio is primarily due to a different mix of business during 2007 which included casualty and liability coverages. Unlike natural peril coverages in which zero losses are booked until a covered natural catastrophe event occurs, casualty and liability severity coverages typically have the potential for unreported event to occur during the term of the coverage and thus IBNR reserves are booked based on an expected loss ratio for the business underwritten, resulting in a higher initial loss ratio being reported.
The acquisition cost ratio is calculated by dividing acquisition costs by net premiums earned. This ratio demonstrates the higher acquisition costs incurred for our frequency business than for our severity business. The acquisition cost ratio for our severity business decreased to 21.8% for the year ended December 31, 2007 from 36.8% for the year ended December 31, 2006. This decrease is primarily due to certain professional liability coverages written during 2007 which did not have any associated acquisition costs, as well as a severity contract written in 2006, that was not renewed in 2007, which had a profit commission element to the contract.
Restricted cash totaled $371.6 million as of December 31, 2007 compared to $154.7 million as of December 31, 2006, an increase of 140.2%. The increase in restricted cash was principally due to increased investment in securities sold, not yet purchased.
We are organized as a holding company with no operations of our own. All of our operations are conducted through our reinsurance subsidiary, Greenlight Re, which underwrites risks associated with our property and casualty reinsurance programs. We have minimal continuing cash needs which are principally related to the payment of administrative expenses. There are restrictions on Greenlight Re’s ability to pay dividends which are described in more detail below. It is our initial policy to retain earnings to support the growth of our business. We currently do not expect to pay dividends on our ordinary shares.
Our sources of funds primarily consist of premium receipts (net of brokerage and ceding commissions) and investment income, including realized gains. We use cash to pay losses and loss adjustment expenses, profit commissions and general and administrative expenses. Substantially all of our surplus funds, net of funds required for cash liquidity purposes, are invested with our investment advisor to invest in accordance with our investment guidelines. Our investment portfolio is primarily comprised of publicly-traded securities, which we classify as trading securities and can be liquidated to meet current liabilities. We believe that we have sufficient flexibility to liquidate the long securities that we own in a rising market to generate liquidity. Similarly, we can generate liquidity in a declining market from our short portfolio by covering securities and by freeing up restricted cash no longer required for collateral.
As of December 31, 2007, 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.
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. Accordingly, we have established letter of credit facilities in the aggregate amount of $425.0 million, which we believe is sufficient to support expected collateral needs during 2008. We intend to increase these facilities or obtain additional letter of credit facilities in 2008. As of December 31, 2007, $76.5 million in letters of credit were issued. Under the letter of credit facilities, we provide collateral that may consist of equity securities. The letter of credit facilities agreements contain various covenants that, in part, restrict Greenlight Re’s ability to place a lien or charge on the pledged assets and further restricts Greenlight Re’s ability to issue any debt without the consent of the letter of credit provider. Additionally, if an event of default exists, as defined in the letter of credit agreements, Greenlight Re will be prohibited from paying dividends to us.
(1) We have made total commitments of $10.5 million to two separate private equity investments. As of December 31, 2007, we have invested $8.5 million of this amount, and our remaining commitments to these investments total $2.0 million. Given the nature of the private equity investments, we are unable to determine with any degree of accuracy on when the commitments will be called. As such, for the purposes of the above table, we have assumed that all commitments will be made within one year. Under our investment guidelines, in effect as of the date hereof, no more than 10% of the assets in the investment portfolio may be held in private equity securities without specific approval from the Board of Directors.
As of September 1, 2005, we entered into a five-year lease agreement for office premises in the Cayman Islands. The lease repayment schedule is provided in the accompanying consolidated financial statements.
Effective January 15, 2008, we entered into a subscription agreement as a limited partner with a commitment to invest $12.7 million in a partnership as part of our investment strategy.