Selected consolidated statement of operations data, ending balance sheet data and share data for each of the five years ended December 31, 2012, follows:
(a) During 2009 we experienced $181.8 million in net realized and unrealized investment gains. During 2008 we experienced $244.9 million in net realized and unrealized investment losses. The magnitude of these gains and losses significantly impacted our revenues in those years.
(c) From January 2006 to June 2008, the period prior to Blue Ocean Re Holdings Ltd. (“Blue Ocean”) becoming a wholly-owned subsidiary, we fully consolidated Blue Ocean in our financial statements. Net income attributable to noncontrolling interests represents the portion of Blue Ocean’s net income attributable to shareholders other than the Company.
(e) In October 2012 we issued $300.0 million of senior unsecured debt due in 2022 (the “2022 Senior Notes”) and used the majority of the proceeds to fully redeem $228.0 million of outstanding senior unsecured debt due in 2013 (the “2013 Senior Notes”). During 2010 and 2009 we repurchased and retired $1.0 million and $21.0 million of the 2013 Senior Notes, respectively.
(f) During 2012 we repurchased 5,981,589 Common Shares for $120.9 million. During 2011 we repurchased 4,349,302 Common Shares for $82.7 million. During 2010 we repurchased 16,123,261 Common Shares for $293.8 million. During 2009 we repurchased 6,599,038 Common Shares for $112.6 million. During 2008 we repurchased 7,799,019 Common Shares for $125.7 million.
The following is a discussion and analysis of our results of operations for the years ended December 31, 2012, 2011 and 2010 and our financial condition as of December 31, 2012 and 2011. This discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes thereto included elsewhere in this report.
During 2012 we also incurred a $9.7 million loss on the early extinguishment of our 2013 Senior Notes.
Our underwriting results for 2011 included $409.0 million of net catastrophe losses (not including the benefit of reinstatement premiums), which included, among others, earthquakes in Japan and New Zealand, floods in Thailand, Denmark and Australia, wildfires in Texas and Hurricane Irene. These net losses were partially offset by $89.3 million of prior year favorable loss reserve development. Our investment results for 2011 included $26.2 million of net realized and unrealized investment gains, which were comprised of $34.0 million in net gains from fixed maturities, $1.5 million in net losses from equity securities and $6.3 million in net losses from other investments.
We ended 2010 with a FCBVPCS of $24.61, an increase of 18.2% for the year after taking into account dividends declared on Common Shares during the period. The increase in our FCBVPCS during 2010 resulted from strong underwriting and investment results. Our comprehensive income for 2010 was $208.7 million and our GAAP combined ratio was 82.0%.
Our underwriting results for 2010 included $135.9 million of net catastrophe losses (not including the benefit of reinstatement premiums) from earthquakes in Chile and New Zealand, as well as $20.0 million in net losses from the Deepwater Horizon oil rig explosion and fire. These losses were partially offset by $109.3 million of prior year favorable loss reserve development. Our investment results for 2010 included $50.6 million of net realized and unrealized investment gains, which were comprised of $21.2 million in net gains from fixed maturities, $25.1 million in net gains from equity securities and $4.3 million in net gains from other investments.
The following table presents our computations of book value per Common Share, FCBVPCS and fully converted tangible book value per Common Share as of December 31, 2012, 2011 and 2010:
(2) Computed as the change in FCBVPCS after taking into account dividends declared on Common Shares of $0.43, $0.405 and $0.37 during 2012, 2011 and 2010, respectively.
Our computations of FCBVPCS and the increase or decrease in FCBVPCS are non-GAAP measures that we believe are important to our investors, analysts and other interested parties who benefit from having an objective and consistent basis for comparison with other companies within our industry.
Our results for 2012 benefitted from these improved conditions which, coupled with lower natural catastrophe losses, resulted in our Bermuda and Lloyd’s underwriting platforms delivering strong profitability for the year, as measured by their GAAP combined ratios of 66% and 89%, respectively. Our results for 2012 further benefitted from strong investment performance and active capital management. We also continued to strengthen our competitive position by expanding our marine presence in the Lloyd’s market and by establishing the Blue Capital platform to provide a broader property catastrophe product mix to select clients.
We remain comfortable with our capital position and the level of risk within our portfolio and still retain the flexibility to respond to further market changes. We enter 2013 well-positioned to build on our strengths, and we intend to continue our specialist underwriting approach with a strategic focus on property, marine, and other short-tail lines.
We insure and reinsure exposures throughout the world against various natural catastrophe perils. We manage our exposure to these perils using a combination of methods, including underwriting judgment, CATM (our proprietary risk management system), third-party vendor models and third-party protection such as purchases of outwards reinsurance and derivative instruments.
The following discussion should be read in conjunction with the “Risk Factors” contained in Item 1A herein, in particular the specific risk factor entitled “Our stated catastrophe and enterprise-wide risk management exposures are based on estimates and judgments which are subject to significant uncertainties”.
Our January 1, 2013 net reinsurance treaty limits by zone were as follows:
For certain defined natural catastrophe region and peril combinations, we assess the probability and likely magnitude of losses using a combination of industry third-party vendor models, CATM and underwriting judgment. We attempt to model the projected net impact from a single event, taking into account contributions from property catastrophe reinsurance (including retrocessional business), property pro-rata reinsurance, workers compensation catastrophe reinsurance, event-linked derivative securities and individual risk business, offset by the net benefit of any reinsurance or derivative protections we purchase and the benefit of reinstatement premiums. The projected net impact figures presented also include those single event exposures we have assumed through our investment in the BCGR Listed Fund.
The table below details the projected net impact from single event losses as of January 1, 2013 for selected zones at selected return period levels using AIR Worldwide Corporation’s CLASIC/2 model version 14.0, one of several industry-recognized third-party vendor models. It is important to note that each catastrophe model contains its own assumptions as to the frequency and severity of loss events, and results may vary significantly from model to model.
As we utilize a combination of third-party models, CATM and underwriting judgement to project the net impact from single event losses, our internal projections may be higher or lower than those presented in the table below.
Our single event loss estimates represent snapshots as of January 1, 2013. The composition of our in-force portfolio may change materially at any time due to the acceptance of new policies, the expiration of existing policies, and changes in our outwards reinsurance and derivative protections.
The activities of the Company, certain of its intermediate holding and service companies and eliminations relating to intercompany reinsurance and support services, collectively referred to as “Corporate and Other”, are also presented herein.
Underwriting results for Montpelier Bermuda for the years ended December 31, 2012, 2011 and 2010 were as follows:
The following table summarizes Montpelier Bermuda’s premium writings, by line of business, for the years ended December 31, 2012, 2011 and 2010:
Net premiums written and earned by Montpelier Bermuda in 2012, 2011 and 2010 included reinstatement premiums of $10.5 million, $21.0 million and $10.8 million, respectively. The 2012 reinstatement premiums were mainly attributable to windstorm Sandy, the 2011 reinstatement premiums were mainly attributable to the Japan and New Zealand earthquakes and the 2010 reinstatement premiums were mainly attributable to the Chilean earthquake. The level of reinstatement premiums that we may realize in future periods will be dependent upon the occurrence of future losses.
We estimated Montpelier Bermuda’s gross and net loss and LAE reserves using the methodology outlined in our “Summary of Critical Accounting Estimates” contained in Item 7 herein. We did not make any significant changes in the assumptions or methodology used in Montpelier Bermuda’s reserving process during the year ended December 31, 2012.
· $10.2 million from an earthquake in New Zealand during the second quarter, and
The individually significant loss events contributing to Montpelier Bermuda’s 2010 current year net loss and LAE of $242.3 million included the following:
During 2012 Montpelier Bermuda experienced $45.9 million in net favorable development on prior year loss and LAE reserves, which included loss reserve movements associated with:
During 2010 Montpelier Bermuda experienced $88.9 million in net favorable development on prior year loss and LAE reserves, which included loss reserve movements associated with:
· favorable commutations of reinsurance contracts relating to prior accident years ($4.9 million decrease).
The prior year loss and LAE development recorded by Montpelier Bermuda in each of the periods presented associated with natural catastrophes such as earthquakes, hurricanes, wildfires, floods and windstorms was the result of new information received from multiple cedants and information regarding the impact of such losses on the entire reinsurance market.
All other acquisition costs are generally driven by contract terms and are normally a set percentage of gross premiums written. Such acquisition costs consist of commission expenses incurred on assumed business less commission revenue earned on purchased reinsurance covers. Commission revenue on purchased reinsurance covers is earned over the same period that the corresponding premiums are expensed.
The following table summarizes Montpelier Syndicate 5151’s premium writings, by line of business, for the years ended December 31, 2012, 2011 and 2010:
Gross premiums written by Montpelier Syndicate 5151 during 2012 totaled $246.0 million, an increase of $12.5 million, or 5%, as compared to 2011. This increase was mainly driven by additional marine writings and increased premium on marine renewal business, each within the Property and Specialty Individual Risk line of business. Offsetting this increase was a decrease in gross Property Catastrophe - Treaty premiums written due to: (i) a re-allocation of Property Catastrophe writings from Montpelier Syndicate 5151 to the Montpelier Bermuda segment; and (ii) a reduction in reinstatement premiums written during 2012, versus those written during 2011.
Gross premiums written by Montpelier Syndicate 5151 during 2011 were largely unchanged from 2010. However, there was a sizable business shift that occurred during 2011 among the Property Specialty - Treaty line of business and the Other Specialty - Treaty and Property and Specialty Individual Risk lines of business due primarily to: (i) non-renewals by MUI and transfers of certain lines of MUI business from Montpelier Syndicate 5151 to Montpelier Bermuda (Property Specialty - Treaty); (ii) growth in its financial products writings (Other Specialty - Treaty); and (iii) growth in its marine writings (Property and Specialty Individual Risk).
Gross and net premiums written and reinsurance premiums ceded during the periods presented include amounts assumed and ceded as part of inter-segment excess-of loss reinsurance agreements. See “Corporate and Other” under this Item 7.
Reinsurance premiums ceded by Montpelier Syndicate 5151 in 2012, 2011 and 2010 were $15.9 million, $29.5 million and $21.5 million, respectively. Montpelier Syndicate 5151 purchases reinsurance in the normal course of its business in order to manage its exposures. The amount and type of reinsurance that Montpelier Syndicate 5151 purchases is dependent on a variety of factors, including the cost of a particular reinsurance cover and the nature of its gross exposures assumed during a particular period. Other factors affect Montpelier Syndicate 5151’s appetite and capacity to write and retain risk. These include the impact of changes in frequency and severity assumptions used in our models and the corresponding pricing required to meet our return targets, evolving industry-wide capital requirements, increased competition, market conditions and other considerations.
All of Montpelier Syndicate 5151’s reinsurance purchases to date have represented prospective cover; that is, reinsurance has been purchased to protect Montpelier Syndicate 5151 against the risk of future losses as opposed to covering losses that have already occurred but have not been paid. Montpelier Syndicate 5151 purchases: (i) excess-of-loss reinsurance covering one or more lines of its business; and (ii) quota share reinsurance with respect to specific lines of its business.
The following tables summarize Montpelier Syndicate 5151’s loss and LAE reserve movements for the years ended December 31, 2012, 2011 and 2010, and the composition of its gross loss and LAE reserves at December 31, 2012 and 2011:
(1) Montpelier Syndicate 5151’s gross IBNR at December 31, 2012 and 2011, includes a recoverable from Montpelier Bermuda pursuant to an intercompany reinsurance contract of $8.8 million and $18.9 million, respectively, and its gross case reserves at December 31, 2012 and 2011, includes a recoverable from Montpelier Bermuda pursuant to an intercompany reinsurance contract of $4.5 million and $0.8 million, respectively. The effects of these intercompany reinsurance contracts are eliminated in consolidation.
Our best estimates of Montpelier Syndicate 5151’s ending gross loss and LAE reserves at December 31, 2012 and 2011, were $354.0 million and $341.6 million, respectively. Montpelier Syndicate 5151’s gross IBNR reserves, as a percentage of its total gross reserves, were 53% and 57% as of December 31, 2012 and 2011, respectively. This decrease relates primarily to the cancellation and subsequent run-off of certain casualty insurance contracts previously written at Montpelier Syndicate 5151.
The following table presents Montpelier Syndicate 5151’s net loss and LAE ratios for the years ended December 31, 2012, 2011 and 2010:
During 2010 Montpelier Syndicate 5151 incurred $141.0 million of current year net loss and LAE. The only individually significant loss event contributing to Montpelier Syndicate 5151’s 2010 current year net loss and LAE was the Chilean earthquake, which represented $29.6 million of the current year net loss and LAE. Most of the remaining 2010 current year loss and LAE related to claims and events that had been incurred in that year but had not yet been reported to us.
During 2012 Montpelier Syndicate 5151 experienced $41.0 million in net favorable development on prior year loss and LAE reserves, which included loss reserve movements associated with:
During 2011 Montpelier Syndicate 5151 experienced $38.3 million in net favorable development on prior year loss and LAE reserves, which included loss reserve movements associated with:
During 2010 Montpelier Syndicate 5151 experienced $19.5 million in net favorable development on prior year loss and LAE reserves, which included loss reserve movements associated with:
Montpelier Syndicate 5151 recognized net foreign exchange translation losses (gains) related to its current and prior year loss and LAE of $12.0 million, $(2.0) million and $(2.0) million during the years ended December 31, 2012, 2011 and 2010, respectively. Montpelier Syndicate 5151’s foreign currency translation gains and losses on its loss and LAE reserves (which are recorded as a component of its comprehensive income or loss) do not impact its underwriting results or its underwriting ratios.
Montpelier Syndicate 5151’s operating expenses incurred during 2012 increased versus those incurred during 2011 primarily as result of: (i) an increase in consulting and other professional services associated with Solvency II and other business initiatives; and (ii) the recording of a non-recurring third party management fee. Montpelier Syndicate 5151’s operating expenses incurred during 2011 decreased, versus those incurred during 2010, primarily as result of: (i) a change in the allocation of our centrally managed information technology costs to Montpelier Syndicate 5151; and (ii) decreased salary expenses at MUI due to prior year staff reductions.
The increase in Montpelier Syndicate 5151’s incentive compensation expenses during 2012, versus those of 2011, is the result of significantly improved Company performance during 2012. The decrease in incentive compensation expenses during 2011, versus those of 2010, is the result of significant catastrophe losses incurred during 2011, which adversely impacted Company performance during that year.
Underwriting results for Blue Capital for the year ended December 31, 2012 were as follows:
Since the commencement of its operations in June 2012, Blue Capital has assumed U.S. wind and earthquake exposures on an excess-of-loss basis, all of which was included in our Property Catastrophe - Treaty line of business.
On December 31, 2011, we completed the MUSIC Sale. Since we have either retained, reinsured or otherwise indemnified Selective for all of the business written by MUSIC with an effective date on or prior to December 31, 2011, our former and future operations associated with MUSIC do not constitute a “discontinued operation” in accordance with GAAP. The cash flows that we will retain subsequent to the MUSIC Sale, as well as certain reinsurance balances and other designated assets serving as collateral supporting such cash flows, will continue to be presented within this MUSIC Run-Off segment. See “MUSIC Sale Considerations” contained in Item 1 herein.
Underwriting results for the MUSIC Run-Off segment for the years ended December 31, 2012, 2011 and 2010 were as follows:
During 2012 we assumed $2.5 million of MUSIC’s premium writings, which represented: (i) policies bound by MUSIC in 2012 with an effective date on or prior to December 31, 2011; and (ii) additional audit premiums relating to policies written on or prior to December 31, 2011. We may be required to assume additional MUSIC premium writings in future periods, but we do not expect such additional writings to be significant. During 2011 and 2010, MUSIC wrote $59.7 million and $48.3 million of gross premiums, respectively.
As of December 31, 2012, we had no remaining unearned premiums associated with the MUSIC Sale.
The following tables summarize the loss and LAE reserve movements of the MUSIC Run-Off segment for the years ended December 31, 2012, 2011 and 2010, and the composition of its gross loss and LAE reserves at December 31, 2012 and 2011:
MUSIC experienced $3.0 million of favorable prior year loss reserve development during 2011, which related primarily to MUSIC’s casualty (as opposed to property) classes of business. The MUSIC Run-Off segment did not experience a significant amount of prior year loss reserve development during 2012 or 2010.
The following table summarizes the underwriting expenses of the MUSIC Run-Off segment for the years ended 2012, 2011 and 2010:
Our Corporate and Other results for the years ended December 31, 2012, 2011 and 2010 were as follows:
The gross premiums written and ceded reinsurance premiums presented within Corporate and Other represent the elimination of intercompany excess-of-loss reinsurance arrangements between Montpelier Bermuda and Montpelier Syndicate 5151 and between Montpelier Syndicate 5151 and MUSIC Run-Off while they were in force.
The following table summarizes the general and administrative expenses of Corporate and Other during the years ended December 31, 2012, 2011 and 2010:
Incentive compensation expenses recorded at Corporate and Other consist of two independent components. The first component represents amounts that are not, or are no longer, dependent on Company performance and consist of: (i) Fixed RSUs and Variable RSUs granted in prior years that have been effectively converted to Fixed RSUs because the performance goal has been formally achieved at a level that permits payout; and (ii) the portion of annual employee cash bonuses that is based on individual employee performance goals. The second component represents amounts that are entirely dependent on Company performance and consist of: (i) Variable RSUs in the Initial RSU Period; and (ii) the portion of annual employee cash bonuses that is based on Company performance.
The increase in Corporate and Other’s incentive compensation expenses during 2012, versus those of 2011, is the result of significantly improved Company performance during 2012. The decrease in incentive compensation expenses during 2011, versus those of 2010, is the result of significant catastrophe losses incurred during 2011, which adversely impacted Company performance during that year.
The following table summarizes our consolidated net investment income and total return on cash and investments for the years ended December 31, 2012, 2011 and 2010:
Investment expenses incurred during 2012 were higher than those incurred during 2011 due to: (i) an increase in the weighted average value of the portfolio; and (ii) changes in the allocation of invested balances among investment managers. Investment expenses in 2011 were lower than those incurred during 2010, despite a higher weighted average value, due to changes in the allocation of invested balances among investment managers.
During 2012 we recognized $64.4 million in net realized and unrealized gains from our fixed maturity portfolio, $8.8 million in net realized and unrealized gains from our equity portfolio and $9.2 million in net realized and unrealized gains from our other investments. The fixed maturity net gains we experienced during 2012 were largely the result of declines in U.S. Treasury yields as well as tightening credit spreads between the yield on the fixed maturity investments we held versus that of U.S. Treasuries. The equity portfolio net gains we experienced during 2012 were consistent with trends experienced by the U.S. equity market as a whole, as measured by the S&P 500 Index. The other investment net gains we experienced during 2012 related primarily to the performance of certain private investment funds.
During 2010 we recognized $21.2 million in net realized and unrealized gains from our fixed maturity portfolio, $25.1 million in net realized and unrealized gains from our equity portfolio and $4.3 million in net realized and unrealized gains from our other investments. The fixed maturity and other investment net gains we experienced during 2010 were largely the result of declines in U.S. Treasury yields as well as tightening credit spreads between the yield on the fixed maturity investments we held versus that of U.S. Treasuries. The equity portfolio net gains we experienced during 2010 followed a trend consistent with that of the U.S. equity market, as measured by the S&P 500. The net gains from other investments previously mentioned were partially offset by a $4.3 million realized loss from a limited partnership investment.
Certain of our investment managers have entered into derivative contracts for investment purposes. Our total net losses from investment-related derivative instruments during 2012, 2011 and 2010 were $1.9 million, $8.2 million and $6.2 million, respectively. Each of our derivative instruments, as well as the income and loss derived therefrom during the years presented, are described in Note 7 of the Notes to Consolidated Financial Statements.
As of December 31, 2012, 2011 and 2010, our Level 3 investments measured at fair value, as defined in GAAP, totaled $124.3 million (or 4.5%), $83.7 million (or 3.3%) and $85.2 million (or 3.4%) of our total invested assets measured at fair value, respectively. Our investments classified as Level 3 consist primarily of the following: (i) with respect to our fixed maturity investments, bank loans and certain asset-backed securities, many of which are not actively traded; and (ii) with respect to our other investments, certain limited partnership interests and private investment funds. The increase in our Level 3 investments during 2012, versus that of the prior periods presented, is primarily the result of additional investments in bank loans we made during 2012.
The following table summarizes the components of our consolidated net foreign exchange gains (losses) for the years ended December 31, 2012, 2011 and 2010:
Our other revenue is comprised of: (i) services provided to third parties consisting of third party commissions formerly earned by PUAL, transitional services provided to Selective in connection with the MUSIC Sale and advisory fees and royalties earned from providing catastrophe modeling services and technology to third parties; (ii) recognition of the proceeds from the Loss Development Cover; (iii) interest on funds advanced to ceding companies to cover losses in accordance with contract terms; and (iv) the loss recognized on the sale of PUAL.
We issued the 2022 Senior Notes on October 5, 2012, and the majority of the net proceeds were used to redeem the 2013 Senior Notes on November 5, 2012. We incurred $1.2 million of incremental interest resulting from having both of these debt issuances outstanding during that period (which constituted the redemption notice period we were required to provide to holders of the 2013 Senior Notes).
We are domiciled in Bermuda and have subsidiaries that are domiciled in the U.S., the U.K. and Switzerland. At the present time, no income taxes are levied in Bermuda and the Company and its Bermuda-domiciled subsidiaries have received an assurance from the Bermuda Minister of Finance exempting them from all Bermuda-imposed income, withholding and capital gains taxes until March 31, 2035.
During 2012, 2011 and 2010, our Bermuda operations generated income (loss) before income taxes of $232.2 million, $(105.5) million and $226.6 million, respectively.
During 2012, 2011 and 2010, our U.S. operations generated income (loss) before income taxes of $0.1 million, $7.7 million and $(14.6) million, respectively, and are currently in a cumulative net operating loss position. Due to the uncertainty at this time as to whether such operations will generate sufficient taxable income in future periods to utilize such assets, we have established offsetting valuation allowances against each of our existing U.S. gross deferred tax assets.
During 2012, 2011 and 2010, our income taxes relating to our Switzerland operations totaled less than $0.1 million.
As of December 31, 2012, our sources of immediate and unencumbered liquidity consisted of: (i) $187.6 million of cash and cash equivalents; (ii) $251.4 million of highly liquid fixed maturity investments which currently trade at a very narrow bid-ask spread and whose proceeds are available within two business days; and (iii) $505.5 million of liquid fixed maturity investments which currently trade at a narrow bid-ask spread and whose proceeds are available within four business days. Further, we believe that we have significant sources of additional liquidity within our fixed maturity investment portfolio, although the bid-ask spreads associated with such investment securities would likely be broader, perhaps significantly, than those with respect to the securities referred to above, particularly if a large individual investment were required to be liquidated in an expeditious manner. We also believe that we have additional liquidity within our portfolio of equity securities, whose proceeds are available within four business days.
Our total capital increased by $152.1 million during 2012 as a result of our recording comprehensive income of $228.4 million, recognizing $10.2 million of additional paid-in capital through the amortization and issuances of share-based compensation, declaring $37.6 million in dividends to holders of Common Shares and Preferred Shares, repurchasing $120.9 million of Common Shares, issuing $300.0 million of 2022 Senior Notes and extinguishing $228.0 million of 2013 Senior Notes.
The 2022 Senior Notes, which were issued on October 5, 2012, bear interest at a fixed rate of 4.70% per annum, payable semi-annually in arrears on April 15 and October 15 of each year (beginning April 15, 2013), and were issued at a price of 99.682% of their principal amount, providing an effective yield to investors of 4.74%. We may redeem the 2022 Senior Notes at any time, in whole or in part, at a “make-whole” redemption price, plus accrued and unpaid interest.
The 2013 Senior Notes were fully redeemed on November 5, 2012, at a “make-whole” redemption price of $237.6 million (104.2% of the principal thereof), plus accrued and unpaid interest to the redemption date.
The LIBOR Swap, which we entered into in February 2012, will result in the future net cash flows in connection with the Trust Preferred Securities, for the five-year period beginning March 30, 2012, being the same as if these securities bore interest at a fixed rate of 4.905%, provided we hold the LIBOR Swap to its maturity.
We issued the Preferred Shares in May 2011. The Preferred Shares have no stated maturity, and are not subject to any sinking fund or mandatory redemption and are not convertible into any other securities. Except in certain limited circumstances, the Preferred Shares are not redeemable prior to May 10, 2016. After that date, we may redeem the Preferred Shares at our option, in whole or in part, at a price of $25.00 per share plus any declared and unpaid dividends.
We may need to raise additional capital in the future, through the issuance of debt, equity or hybrid securities, in order to, among other things, write new business, incur and/or pay significant losses, respond to, or comply with, any changes in the capital requirements that rating agencies or various regulatory bodies use to evaluate us, acquire new businesses, invest in existing businesses or refinance our existing obligations.
In the normal course of our business, we maintain letter of credit facilities and trust arrangements as a means of providing collateral and/or statutory credit to certain of our constituents. These letter of credit facilities and trust arrangements are secured by collateral accounts containing cash and investments.
The agreements governing our letter of credit facilities contain covenants that limit our ability, among other things, to grant liens on our assets, sell our assets, merge or consolidate, incur debt and enter into certain agreements. In addition, the syndicated secured facilities require us to maintain a debt to capital ratio of no greater than 30% and for Montpelier Re to maintain an A.M. Best financial strength rating of no less than “B++”. If we were to fail to comply with these covenants or fail to meet these financial ratios, the lenders could revoke these facilities and exercise remedies against our collateral. As of December 31, 2012 and 2011, our debt to capital ratio (which, as defined in such agreements, is the amount of our senior unsecured debt outstanding divided by the sum of: (i) the amount of our senior unsecured debt outstanding; and (ii) the amount of our total shareholders’ equity, expressed as a percentage) was 15.5% and 12.8%, respectively, and Montpelier Re’s A.M. Best financial strength rating was “A” (with a stable outlook) and “A-” (with a positive outlook), respectively.
In 2010 we established the Reinsurance Trust (as a means of providing statutory credit to Montpelier Re’s cedants) and the Lloyd’s Capital Trust (as a means of satisfying Lloyd’s capital requirements). As a result of these, and other, trust arrangements we currently utilize, our ongoing reliance on letter of credit facilities has been significantly reduced. See Note 6 of the Notes to Consolidated Financial Statements.
During 2012, 2011 and 2010 our cash flows used for, or provided from, investing and financing activities widely fluctuated, mainly as a result of: (i) the extent of our repurchases of Common Shares in each of those years; (ii) the issuance of the 2022 Senior Notes and the extinguishment of the 2013 Senior Notes in 2012; (iii) the issuance of the Preferred Shares in 2011; and (iv) purchases and sales of investment securities undertaken in connection with, or as a result of, these financing activities.
Detailed information regarding our cash flows for the years ended December 31, 2012, 2011 and 2010, follows:
Our cash flows used for investing activities totaled $128.9 million, resulting from the following:
· we received $38.4 million from net sales of equity securities and other investments,
Our cash flows used for investing activities totaled $84.2 million, resulting from the following:
We also experienced a $1.3 million decrease in the U.S. dollar value of our cash and cash equivalents due to foreign exchange rate fluctuations.
Our cash flows provided from investing activities totaled $30.3 million, resulting from the following:
Our cash flows used for financing activities totaled $315.8 million, resulting from the following:
We also experienced a $2.0 million decrease in the U.S. dollar value of our cash and cash equivalents due to foreign exchange rate fluctuations.
Of our cash and cash equivalents held in the U.K. at December 31, 2012, $89.1 million represented amounts held in the Lloyd’s Premiums Trust Funds which may be used for the payment of Syndicate 5151’s claims and valid expenses but can only be distributed to its parent annually, subject to meeting Lloyd’s requirements. We do not currently have the intent or ability to repatriate such funds to its parent.
Our case reserve estimates are initially determined on the basis of loss reports received from third parties. Our IBNR reserve estimates are determined using various actuarial methods as well as a combination of our own historical loss experience, historical insurance industry loss experience, estimates of pricing adequacy trends and our professional judgment. The process we use to estimate our IBNR reserves involves projecting our estimated ultimate loss and LAE reserves and then subtracting paid claims and case reserves as notified by the ceding company, to arrive at our IBNR reserve.
To the extent we rely on industry data to aid us in our reserve estimates, there is a risk that the data may not match our risk profile or that the industry’s overall reserving practices differ from our own and those of our cedants. In addition, reserving can prove to be especially difficult should a significant loss take place near the end of a reporting period, particularly if the loss involves a catastrophic event. These factors further contribute to the degree of uncertainty in our reserving process.
Time lags are inherent in loss reporting, especially in the case of excess-of-loss reinsurance contracts. Also, the combined characteristics of low claim frequency and high claim severity make the available data more volatile and less useful for predicting ultimate losses. In the case of proportional contracts, we rely on an analysis of a contract’s historical experience, industry information and the professional judgment of underwriters in estimating reserves for these contracts. In addition, we utilize ultimate loss ratio forecasts when reported by cedants, which are normally subject to a quarterly or six month lag for proportional business. Because of the degree of reliance that we necessarily place on ceding companies for claims reporting, our reserve estimates are highly dependent on ceding companies’ management judgment. Furthermore, during the loss settlement period, which may last several years, additional facts regarding individual claims and trends often will become known, and case law may change, all of which can affect ultimate expected losses.
Since we rely on ceding company estimates of case and IBNR reserves in the process of establishing our own loss and LAE reserves, we maintain certain procedures designed to mitigate the risk that such information is incomplete or inaccurate. These procedures may include: (i) comparisons of expected premiums to reported premiums, which helps us to identify delinquent client periodic reports; (ii) ceding company audits to facilitate loss reporting and identify inaccurate or incomplete claim reporting; and (iii) underwriting reviews to ascertain that the losses ceded are covered as provided under the contract terms. We also use catastrophe model outputs and industry market share information to evaluate the reasonableness of reported losses, which are also compared to loss reports received from other cedants. In addition, each subsequent year of loss experience with a given cedant provides additional insight into the accuracy and timeliness of previously reported information. These procedures are incorporated in our internal controls process on an ongoing basis and are regularly evaluated and amended as market conditions, risk factors, and unanticipated areas of exposure develop. Our claims handling follow-up actions do not permit us to capture data which records the extent to which ceding company claims are subsequently adjusted as a result of these activities, nor do they permit us to determine the extent to which our actions influence the accuracy of subsequent cedant reporting. However, unreliable reporting is a factor which influences our underwriters’ willingness to offer terms to potential cedants. We believe that our diligence in these matters promotes better reporting by brokers and cedants over the long term. In our relatively short history, disputes with ceding companies have been rare and those which have not been resolved in negotiation have been resolved through arbitration in accordance with contractual provisions.
The uncertainties inherent in the reserving process, together with the potential for unforeseen developments, including changes in laws and the prevailing interpretation of policy terms, may result in our loss and LAE reserves being significantly greater or less than the loss and LAE reserves we initially established. Any adjustments to our loss and LAE reserves are reflected in our financial results during the period in which they are determined. Changes to our prior year loss reserves will impact our current underwriting results by improving our results if the prior year reserves prove to be redundant or impairing our results if the prior year reserves prove to be insufficient.
Favorable development of prior period net losses experienced as a percentage of our opening net loss reserves across all underwriting years was 8.7%, 12.4% and 17.9% for the years ended December 31, 2012, 2011 and 2010, respectively. As of December 31, 2012, we estimate that a 15% change in our net unpaid loss and LAE reserves would result in an increase or decrease in our net income or loss and shareholders’ equity of approximately $151.5 million. The net income or loss and shareholders’ equity impact of the change in net reserves might be partially offset by adjustments to items such as reinstatement premiums, profit commission expense, incentive compensation and income taxes.
Excess-of-loss contracts often include contract terms that require an automatic reinstatement of coverage in the event of a loss. The associated reinstatement premium is normally calculated on the basis of: (i) a fixed percentage (normally 100%) of the deposit or minimum premium; and (ii) the proportion of the original limit exhausted. In a year of large loss events, such as 2011, reinstatement premiums will be higher than in a year in which there are no such events. Reinstatement premiums are fully earned or expensed as applicable when a triggering loss event occurs and losses are recorded. We record reinstatement premiums on a basis consistent with our estimates of loss and LAE. During 2012, 2011 and 2010, we recorded written and earned reinstatement premiums totalling $13.1 million, $27.5 million and $17.5 million, respectively.
We are subject to litigation and arbitration proceedings in the normal course of our business. Such proceedings often involve insurance or reinsurance contract disputes, which are typical for the insurance and reinsurance industry. Expected or actual reductions in our reinsurance recoveries due to insurance or reinsurance contract disputes (as opposed to a reinsurer’s inability to pay) are not recorded as an uncollectible reinsurance recoverable. Rather, they are factored into the determination of, and are reflected in, our net loss and LAE reserves.
For 2012, the number of Variable RSUs expected to be formally awarded to employees was based on our 2012 increase in FCBVPCS. FCBVPCS is computed by dividing our common shareholders’ equity by the sum of our outstanding Common Shares and unvested RSUs outstanding. Our calculation of the increase in FCBVPCS represents the increase in our FCBVPCS during the Initial RSU Period, after taking into account dividends on Common Shares declared during such period.
For 2011 and 2010, the actual number of Variable RSUs awarded to employees was based on a targeted return on equity (“ROE”) assuming a standardized investment return. ROE is computed by dividing our adjusted comprehensive income or loss (based on the sum of our actual underwriting result and standard investment result) by our actual average common shareholders’ equity for the Initial RSU Period. Adjusted comprehensive income, for these purposes, is our actual comprehensive income or loss less dividends declared on our Preferred Shares, if any, less the actual investment return on our investments, investment-related derivatives and cash and cash equivalents, plus a standardized investment return on our investments, cash and cash equivalents.
For the 2011-2014 Variable RSU award cycle, the targeted performance metric was based on a 2011 ROE of 9.01%. At an achieved ROE of 9.01% (our target), we would have expected to grant approximately 590,000 Variable RSUs to participants. At an achieved ROE of 3.01% (our threshold) or less, we would not have expected to grant any Variable RSUs to participants. At an achieved ROE of 19.01% (our maximum) or more, we would have expected to grant approximately 1,180,000 Variable RSUs to participants. Throughout the Initial RSU Period for this cycle, our quarterly Variable RSU accrual for this cycle remained at zero. Based on our actual ROE achieved for 2011 of negative 7.4%, the final number of Variable RSUs granted for the 2011-2014 Variable RSU award cycle was determined to be zero by the Compensation Committee in February 2012.
For the periods covered by this report, we assumed an RSU forfeiture rate of between zero and 16%, depending on the nature and term of the individual awards and past and recent experience. Our forfeiture assumptions serve to reduce the unamortized grant date fair value of our outstanding RSUs as well as the associated RSU expense. As RSUs are actually forfeited, the number of RSUs outstanding is reduced and the remaining unamortized grant date fair value is compared to assumed forfeiture levels. True-up adjustments are made as deemed necessary.
During 2012, 2011 and 2010, we recognized $12.1 million, $7.5 million and $13.5 million of RSU expense, respectively.
The financial statements and supplementary data have been filed as a part of this Annual Report on Form 10-K as indicated in the Index to Consolidated Financial Statements and Financial Statement Schedules appearing on page 90 of this report.