We do not own any facilities or real estate. We lease office space at Chesney House in Pembroke, Bermuda, pursuant to a two-year lease agreement. This two-year lease is scheduled to expire on November 30, 2015. We believe for the foreseeable future this office space will be sufficient for us to conduct our operations.
The selected consolidated statements of operations data for fiscal 2013, fiscal 2012 and the period from October 6, 2011 (date of incorporation) to December 31, 2011, and the selected consolidated balance sheet data as of December 31, 2013, 2012 and 2011 have been derived from our audited consolidated financial statements. Our historical results are not necessarily indicative of the results that may be expected for any future period. The selected financial data should be read in conjunction with Part II,
The following discussion and analysis is intended to help the reader understand our business, financial condition, results of operations, liquidity and capital resources. You should read this discussion in conjunction with
We manage our business on the basis of two operating segments: Property and Casualty Reinsurance and Catastrophe Risk Management. We also have a corporate function that includes our investment results and certain general and administrative expenses related to corporate activities.
We provide reinsurance products to insurance and reinsurance companies, government entities, and other risk bearing vehicles. Contracts can be written on an excess of loss basis or quota share basis, although the majority of contracts written to date have been on a quota share basis. In addition, we write contracts on both a prospective basis and a retroactive basis. Prospective reinsurance contracts cover losses incurred as a result of future insurable events. Retroactive reinsurance contracts cover the potential for changes in estimates of loss and loss adjustment expense reserves related to loss events that have occurred in the past. Retroactive reinsurance contracts can be an attractive type of contract for us as they can generate an underwriting profit should the ultimate loss and loss adjustment expenses settle for less than the initial estimate of reserves and the premiums received at the inception of the contract generate insurance float. The product lines that we currently underwrite for this operating segment are: property, casualty and specialty.
We believe that our property and casualty reinsurance segment will contribute to our results by both generating underwriting income as well as generating float. In addition, we expect that float will grow over time as our reinsurance operations expand.
As of December 31, 2013, the Catastrophe Fund had a net asset value of $104.0 million, of which our share was $54.8 million. As a result of our controlling interest in the Catastrophe Fund, we are required to consolidate the results of the Catastrophe Fund and the Catastrophe Reinsurer. The Catastrophe Fund is actively seeking new third party investments and we expect our interest to drop in the future which would potentially allow us to deconsolidate the Catastrophe Fund. However, market conditions have been challenging due to the recent launch of several similar funds and a drop in catastrophe reinsurance pricing. Given current market conditions, we expect to limit the size of the Catastrophe Fund to ensure we can continue to profitably deploy the funds under management until market conditions improve.
We believe that by combining a disciplined and opportunistic approach to reinsurance underwriting with investment results from the active management of our investment portfolio, we will be able to generate attractive returns for our shareholders. The key financial measures that we believe are most meaningful in analyzing our performance are: net underwriting income (loss) for our property and casualty reinsurance segment, combined ratio for our property and casualty reinsurance segment, net investment income, net investment return on investments managed by Third Point LLC, book value per share, diluted book value per share, growth in diluted book value per share and return on beginning shareholders’ equity.
The combined ratio compares the amount of net premiums earned to the amount incurred in claims and underwriting related expenses. This ratio is a key indicator of a reinsurance company’s profitability. It is calculated by dividing net premiums earned by the sum of loss and loss adjustment expenses, acquisition costs and general and administrative expenses related to underwriting activities. A combined ratio greater than 100% means that loss and loss adjustment expenses, acquisition costs and general and administrative expenses related to underwriting activities exceeded net premiums earned.
Net investment income for the years ended December 31, 2013 and 2012 was comprised of the following:
The net investment return on investments managed by Third Point LLC is the percentage change in value of a dollar invested over the reporting period on our investment assets managed by Third Point LLC, net of non-controlling interest. Net investment return is the key indicator by which we measure the performance of Third Point LLC, our investment manager.
Return on beginning shareholders’ equity as presented is a non-GAAP financial measure. Return on beginning shareholders’ equity is calculated by dividing net income by the beginning shareholders’ equity attributable to shareholders and is a commonly used calculation to measure profitability. For purposes of this calculation, we add back the impact of subscriptions receivable to shareholders’ equity attributable to shareholders as of December 31, 2011. For the year ended December 31, 2013, we have also adjusted the beginning shareholders' equity for the impact of the issuance of shares in our IPO on a weighted average basis. These adjustments lower the stated returns on beginning shareholders' equity.
Return on beginning shareholders' equity for the years ended December 31, 2013 and 2012 was calculated as follows:
Income from our investments is primarily comprised of interest income, dividends, and net realized and unrealized gains on investment securities included in our investment portfolio.
Loss and loss adjustment expenses are a function of the amount and type of reinsurance contracts we write and loss experience of the underlying coverage. Loss and loss adjustment expenses are based on an actuarial analysis of the estimated losses, including losses incurred during the period and changes in estimates from prior periods. Depending on the nature of the contract, loss and loss adjustment expenses may be paid over a number of years.
Acquisition costs consist primarily of brokerage fees, ceding commissions, premium taxes and other direct expenses that relate to our writing reinsurance contracts and are presented net of commissions ceded under reinsurance contracts. We amortize deferred acquisition costs over the related contract term in the same proportion that the premiums are earned.
Investment-related expenses primarily consist of management fees we pay to our investment manager, Third Point LLC, and certain of our Founders, pursuant to the investment management agreement and performance fees we pay to Third Point Advisors LLC. A 2% management fee calculated on assets under management is paid monthly to Third Point LLC and certain of our Founders, and a performance fee equal to 20% of the net investment income is paid annually to Third Point Advisors LLC. We include these expenses in net investment income in our consolidated statement of income.
Changes in premium estimates are expected and may result in adjustments in any reporting period. These estimates change over time as additional information regarding the underlying business volume is obtained. Along with uncertainty regarding the underlying business volume, our contracts also contain a number of contractual features that can significantly impact the amount of premium that we ultimately recognize. These include commutation provisions, multi-year contracts with cancellation provisions, provisions to return premium at the expiration of the contract in certain circumstances. In certain contracts, these provisions can be exercised by the client, in some cases provisions can be exercised by us and in other cases by mutual consent. In addition, we write a small number of large contracts and the majority of our property and casualty reinsurance segment premiums written to date has been quota share business. As a result, we may be subject to greater volatility around our premium estimates compared to other property and casualty companies. We continuously monitor the premium estimate of each of our contracts considering the cash premiums received, reported premiums, discussions with our clients regarding their premium projections as well as evaluating the potential impact of contractual features. Any subsequent adjustments arising on such estimates are recorded in the period in which they are determined.
Changes in premium estimates do not necessarily result in a direct impact to net income or shareholders’ equity since changes in premium estimates do not necessarily impact the amount of net premiums earned at the time of the premium estimate change and would generally be offset by pro rata changes in acquisition costs and net loss and loss adjustment expenses.
We perform an actuarial projection of our reserves quarterly and have a third-party actuarial review performed annually. All reserves are estimated on an individual contract basis; there is no aggregation of contracts for projection of ultimate loss or reserves.
Incurred Loss Development Method. This method estimates ultimate losses by using past incurred loss development factors and applying them to exposure periods with further expected incurred loss development. Since incurred losses include payments and case reserves, changes in both of these amounts are incorporated in this method. This approach provides a larger volume of data to estimate ultimate losses than paid loss methods. Thus, incurred loss patterns may be less varied than paid loss patterns, especially for coverages that have historically been paid out over a long period of time but for which claims are incurred relatively early and case loss reserve estimates established.
Key to the projection of ultimate loss is the amount of credibility or weight assigned to each actuarial method. Each method has advantages and disadvantages, and those can change depending on numerous factors including the reliability of the underlying data. For most actuaries, the selection and weighting of the projection methods is a highly subjective process. In order to achieve a desirable amount of consistency from study to study and between contracts, we have implemented a weighting scheme that incorporates numerous “rules” for the weighting of actuarial methods. These rules attempt to effectively codify the judgmental process used for selecting weights for the various methods. There can be extenuating circumstances where the rules would be modified for a specific reinsurance contract; examples would include a large market event or new information on historical years that may cause us to increase our a priori loss ratio.
We do not produce a range of IBNR reserves. However, a 10% increase in IBNR reserves would translate into a 0.7% decrease in total shareholders’ equity as of December 31, 2013 and a 0.7% decrease in total shareholders’ equity as of December 31, 2012.
As an extension of our underwriting activities, the Catastrophe Reinsurer has sold derivative instruments that provide reinsurance-like protection to third parties for specific loss events associated with certain lines of business. These derivatives are recorded in the consolidated balance sheets at fair value, with the offset recorded in net investment income in the consolidated statements of income (loss). These contracts are valued on the basis of models developed by us, which approximates fair value.
We perform several processes to ascertain the reasonableness of the valuation of all of our investments comprising our investment portfolio, including securities that are categorized as Level 2 and Level 3 within the fair value hierarchy. These processes include (i) obtaining and reviewing weekly and monthly investment portfolio reports from Third Point LLC, (ii) obtaining and reviewing monthly NAV and investment return reports received directly from our third-party fund administrator which are compared to the reports noted in (i), and (iii) monthly update discussions with Third Point LLC regarding the investment portfolio, including, their process for reviewing and validating pricing obtained from outside service providers.
Monetary assets and liabilities denominated in foreign currencies are translated at the closing rates of exchange as of December 31, 2013. Transactions during the period are translated at the rate of exchange prevailing on the date of the transaction. We do not isolate that portion of the results of operations resulting from changes in foreign exchange rates on investments, dividends and interest from the fluctuations arising from changes in fair values of securities and
Level 2 - Observable inputs to the valuation methodology other than unadjusted quoted market prices for identical assets or liabilities in active markets. Level 2 inputs include, but are not limited to, prices quoted for similar assets or liabilities in active markets/exchanges, prices quoted for identical or similar assets or liabilities in markets that are not active and fair values determined through the use of models or other valuation methodologies.
Level 3 - Pricing inputs unobservable for the investment and include activities where there is little, if any, market activity for the investment. The inputs applied in the determination of fair value require significant management judgment and estimation.
Inputs refer broadly to the assumptions that market participants would use in pricing the asset or liability including assumptions about risk; for example, the risk inherent in a particular valuation technique used to measure fair value including such a pricing model and/or the risk inherent in the inputs to the valuation technique. Inputs may be observable or unobservable.
Observable inputs are inputs that reflect the assumptions market participants would use in pricing the asset or liability based on market data obtained from sources other than those of the reporting entity. Unobservable inputs are inputs that reflect the reporting entity’s own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances.
The key inputs for corporate, government and sovereign bond valuation are coupon frequency, coupon rate and underlying bond spread. The key inputs for asset-backed securities are yield, probability of default, loss severity and prepayment.
Key inputs for OTC valuations vary based on the type of underlying security on which the contract was written:
The key inputs for most forward contracts include notional, maturity, forward rate, spot rate, various interest rate curves and discount factor.
In non-catastrophe lines of business, we focus on segments and clients where there is relatively more attractive pricing opportunities due to the strength of our relationships, uniqueness of our reinsurance solutions or an acute need for reinsurance capital as result of a client’s rapid growth or historical poor performance. Most of our senior management team have spent decades within the reinsurance market and as they cultivate their relationships with intermediaries and reinsurance buyers, we are seeing an increased flow of submissions in the lines and types of reinsurance that we target. Although we are typically presented by brokers with proposed structures on syndicated deals, we work to improve and enhance the proposed solution for the client while improving our economics and establishing our position as the lead reinsurer in the transaction. We also look for non-syndicated opportunities where a highly customized solution is needed. These often take the form of loss portfolio transfers or adverse development reserve covers where clients want capital relief and enhanced investment returns on the reserves. Many of our primary insurance company clients are growing gross premium primarily through realizing rate increases and, to a lesser extent, expansion of the number of policies they write. As a consequence, their need for quota share reinsurance has increased. Finally, the number of distressed insurance company situations, for which our customized solutions may be helpful, appears to be increasing.
For the year ended December 31, 2013, our net income increased by $127.9 million, or 128.7%, to $227.3 million, compared to net income of $99.4 million for the year ended December 31, 2012 and a net loss of $1.1 million for the period from October 6, 2011 (date of incorporation) to December 31, 2011.
We began underwriting on January 1, 2012 and continue to cultivate our underwriting relationships with intermediaries and reinsurance buyers and as a result submission flow continues to increase. We write a small number of large contracts so individual renewals or new business can have a significant impact on premiums recognised in a period. In addition, our quota share contracts are subject to significant judgment in the amount of premiums that we ultimately recognize. Changes in premium estimates are recorded in the period they are determined and can be significant. We also offer customized solutions to our clients, including adverse development covers, on which we will not have a regular renewal opportunity. Furthermore, we record gross premiums written and earned for adverse development covers, which are considered retroactive reinsurance contracts, at the inception of the contract. This premium recognition policy can further distort the comparability of premiums earned in a period and trends.
Reductions in premium estimates relating to prior years' contracts were $35.7 million for the year ended December 31, 2013 primarily due to return premiums on contracts that expired during the period that included provisions within the contract to return the unearned premiums at expiration. For contracts that renewed or were written in 2013 with these provisions, we considered the expected return premium in determining our initial premium estimates.
Premiums ceded. The $10.0 million of premiums ceded for the year ended December 31, 2013 related to the purchase of retrocessional protection related to our one assumed crop contract. There was no premiums ceded for the year ended December 31, 2012.
Net premiums earned. Net premiums earned for the year ended December 31, 2013 increased $116.1 million, or 120.3%, to $212.6 million. Third Point Reinsurance Company Ltd. ("Third Point Re") began underwriting on January 1, 2012. The year ended December 31, 2013 reflects net premiums earned on a larger in-force underwriting portfolio, including new business written and increased premiums from renewals, compared to the year ended December 31, 2012. In addition, the year ended December 31, 2013, includes net premiums earned of $39.8 million related to retroactive reinsurance contracts where we recorded the gross premiums written and earned at the inception of the contract. We did not write any retroactive reinsurance contracts for the year ended December 31, 2012.
Acquisition costs. Acquisition costs include commissions, brokerage and excise taxes. Acquisition costs are presented net of commissions ceded under reinsurance contracts. Acquisition costs for the year ended December 31, 2013 were $67.0 million, or 31.5% of net premiums earned, compared to $24.6 million, or 25.5% of net premiums earned, for the year ended December 31, 2012. The acquisition cost ratio for the year ended December 31, 2013 was higher due to a change in business mix. The acquisition cost ratio for the year ended December 31, 2012 included a higher proportion of net premiums earned related to one crop contract which had a lower acquisition cost ratio.
General and administrative expenses. General and administrative expenses for the year ended December 31, 2013 were $21.8 million, or 10.3% of net premiums earned, compared to $20.3 million, or 21.0% of net premiums earned, for the year ended December 31, 2012.
The Catastrophe Reinsurer wrote no business before January 1, 2013. From January 1, 2013, the underwriting results of the Catastrophe Reinsurer as well as results of the Catastrophe Fund, the entities for which the Catastrophe Fund Manager underwrites and manages catastrophe risk, are captured with the Catastrophe Fund Manager in this segment. We are currently required to consolidate the results of the Catastrophe Fund and the Catastrophe Reinsurer with our other operations because we control a majority of the outstanding interests in these entities. However, as an open-ended investment fund, the Catastrophe Fund is continuing to market its interests to third-party investors. We expect that the Catastrophe Fund may achieve levels of third-party investment to potentially allow us to deconsolidate its results in the future.
Net premiums earned. Net premiums earned was $8.1 million for the year ended December 31, 2013.
Net investment income. Net investment income of $4.4 million for the year ended December 31, 2013 consisting of $4.3 million related to net gain on derivative reinsurance contracts written by the Catastrophe Reinsurer.
Acquisition costs. Acquisition costs include commissions, brokerage and excise taxes. Acquisition costs for the year ended December 31, 2013 were $1.0 million, or 11.9% of net premiums earned.
General and administrative expenses. General and administrative expenses for the year ended December 31, 2013 were $3.9 million compared to $1.5 million for the year ended December 31, 2012. The Catastrophe Reinsurer and Catastrophe Fund were incorporated in June 2012 and the Catastrophe Reinsurer did not begin underwriting until January 1, 2013. The 2012 period reflects certain start-up related expenses compared to a full period of operations for 2013. General and administrative expenses consist of costs associated with the employee leasing agreement, cat modeling and legal and accounting expenses.
All of our assets managed by Third Point LLC are held in a separate account and managed under an investment management agreement whereby Third Point Advisors LLC, an affiliate of Third Point LLC, has a non-controlling interest in the assets held in the separate account. The value of the non-controlling interest is equal to the amounts invested by Third Point Advisors LLC, plus performance fees paid by us to Third Point Advisors LLC and investment gains and losses thereon.
Also impacting net investment income for the year ended December 31, 2013 was the allocation of $4.9 million of net investment expense related to deposit and reinsurance contracts compared to $0.4 million for the year ended December 31, 2012.
General and administrative expenses for the period from October 6, 2011 (date of incorporation) to December 31, 2011 included $1.1 million related to start-up expenses.
Our investment portfolio is concentrated in tradeable securities and is valued to market each day. Pursuant to our investment guidelines as specified in our Investment Management Agreement with Third Point LLC, at least 60% of our portfolio must be invested in securities of publicly traded companies and governments of OECD high income countries, asset-backed securities, cash, cash equivalents and gold and other precious metals. We can liquidate all or a portion of our investment portfolio at any time with not less than three days’ notice to pay claims on our reinsurance contracts, and with not less than five days’ notice to pay for expenses or on not less than 30 days’ notice in order to satisfy a requirement of A.M. Best. Since we do not write excess of loss property catastrophe contracts or other types of reinsurance contracts that are typically subject to sudden, acute, liquidity demands, we believe the liquidity provided by our investment portfolio will be sufficient to satisfy all liquidity requirements.
We and our Bermuda subsidiaries are subject to Bermuda regulatory constraints that affect our ability to pay dividends. Under the Companies Act, as amended, a Bermuda company may declare or pay a dividend out of distributable reserves only if it has reasonable grounds for believing that it is, or would after the payment, be able to pay its liabilities as they become due and if the realizable value of its assets would thereby not be less than its liabilities. Under the Insurance Act, Third Point Re, as a Class 4 insurer, is prohibited from declaring or paying a dividend if it is in breach of its minimum solvency margin (“MSM”), enhanced capital ratio (“ECR”) or minimum liquidity ratio or if the declaration or payment of such dividend would cause such a breach. Where Third Point Re, as a Class 4 insurer, fails to meet its MSM or minimum liquidity ratio on the last day of any financial year, it is prohibited from declaring or paying any dividends during the next financial year without the approval of the BMA.
Cash flows used in investing activities for the year ended December 31, 2013 were $397.6 million compared to cash flows used in investment activities of $766.0 million for the year ended December 31, 2012. The cash flows used in investing activities for the year ended December 31, 2013 reflects the investment of the net proceeds from our IPO and the investment of float generated by our reinsurance operations. The cash flows used in investing activities for the year ended December 31, 2012, reflected the initial investment of our portfolio. There were no cash flows used for investing activities for the period from October 6, 2011 (date of incorporation) to December 31, 2011.
In addition, we expect that the net proceeds from our IPO and cash flow from operations will provide us with the financial flexibility to execute our strategic objectives. Our ability to generate cash, however, is subject to our performance, general economic conditions, industry trends and other factors. To the extent that the net proceeds from our IPO, combined with existing cash and cash equivalents, investment returns and operating cash flow are insufficient to fund our future activities and requirements, we may need to raise additional funds through public or private equity or debt financing. If we issue equity securities in order to raise additional funds, substantial dilution to existing shareholders may occur. If we raise cash through the issuance of additional indebtedness, we may be subject to additional contractual restrictions on our business. There is no assurance that we would be able to raise the additional funds on favorable terms or at all.
As of December 31, 2013, we had entered into the following letter of credit facilities, which automatically renew annually unless terminated by either party in accordance with the required notice period:
As of December 31, 2013, $127.3 million (December 31, 2012 - $60.9 million) of letters of credit, representing 42.4% of the total available facilities, had been drawn upon (December 31, 2012 - 15.3% (based on total available facilities of $400 million)).
Under the facilities, we provide collateral that may consist of equity securities, repurchase agreements, restricted cash, and cash and cash equivalents. As of December 31, 2013, total cash and cash equivalents with a fair value of $100.6 million (December 31, 2012 - $64.8 million) were pledged as security against the letters of credit issued. These amounts are included in restricted cash and cash equivalents in the consolidated balance sheets. Each of the facilities contain customary events of default and restrictive covenants, including but not limited to, limitations on liens on collateral, transactions with affiliates, mergers and sales of assets, as well as solvency and maintenance of certain minimum pledged equity requirements, A.M. Best Company rating of “A-” or higher, and restricts issuance of any debt without the consent of the letter of credit provider. Additionally, if an event of default exists, as defined in the letter of credit facilities, we will be prohibited from paying dividends. We were in compliance with all of the covenants as of December 31, 2013.
As of December 31, 2013, total cash and net investments managed by Third Point LLC at fair value was $1,581.0 million compared to $972.3 million as of December 31, 2012. The increase was primarily due to the net proceeds of $286.0 million generated in our IPO, float generated by our reinsurance operations and net investment income for the year ended December 31, 2013.
We have estimated the expected payout pattern of the loss and loss adjustment expense reserves by applying estimated payout patterns by contract. The amount and timing of actual loss payments could differ materially from the estimated payouts in the table above. Please refer to Critical Accounting Estimates-Reserve for losses and loss expenses for additional information.
On December 20, 2011, Third Point Reinsurance Company Ltd. acquired from Netjets Sales Inc., two 12.5%, five year, undivided interests in two aircraft. The agreement with Netjets provides for monthly management fees, occupied hourly fees and other fees.