Financial statement information included is on a consolidated basis for December 31, 2007 and 2006. Prior to that financial information is presented on a combined basis. See Note 1 in the audited financial statements.
Our business consists of a single operating segment, financial guaranty reinsurance, the purpose of which is to indemnify a primary financial guarantor, referred to as the primary insurer, against the portion of any loss it may sustain under financial guaranty policies it has ceded to us. We reinsure policies covering both U.S. and international exposures. We market our reinsurance directly through the execution of treaty and facultative contracts with seven primary insurers, with approximately 85% of our 2007 gross written premiums ceded from four companies.
The written premiums we receive are directly related to the amount and type of business assumed from primary insurers under treaty and facultative reinsurance contracts as well as to prevailing premium rates at the time of reinsurance cessions. Written premiums are usually received on an upfront basis for public finance transactions and earned over the life of a policy, while premiums for structured finance transactions are typically written on an installment basis and earned ratably over the installment period. Investment income is primarily a function of invested assets and the market interest rates prevailing at the time of investing money, as well as the type, credit quality and maturity of the securities purchased. Unrealized gains (losses) on credit derivatives are a function of changes in estimated fair value of our assumed credit derivative transactions (primarily credit default swaps). U.S. GAAP requires us to recognize unrealized gains and losses on credit derivative contracts to the extent that the estimated fair value of these contracts change from the beginning to the end of each reporting period, which is referred to as “mark-to-market” accounting. We expect these unrealized gains or losses to fluctuate primarily based on changes in credit spreads and underlying collateral performance of the contracts reinsured by us except for unrealized losses associated with credit impairments. Because such contracts are held to maturity, unless actual losses are incurred due to defaults, the cumulative unrealized gains and losses will net to zero at the end of the contract. Unrealized gains (losses) on other financial instruments reflect estimated fair values of instruments required to be measured at fair
value on the balance sheet. These gains or losses are expected to fluctuate based on current market trends and the financial strength of the Company, among other factors.
In addition to broad economic cycles, the financial guaranty industry, along with other financial institutions, continue to be affected by specific credit events relating to insured obligations that expose guarantors to claims or potential claims. As can be seen in the current economic environment, the effect of the credit and mortgage markets as a consequence of the subprime crisis has resulted in the establishment of a significant amount of case basis loss reserves being recorded on policies that have defaulted or have a high probability of defaulting. The financial guaranty industry, including RAM, continues to be exposed to uncertainties around these events, including interest rates and housing prices, which may compromise an obligor’s ability to meet guaranteed obligations and result in claims. The Company continues to monitor these exposures and updates loss estimates as new information is obtained.
Our consolidated financial statements include amounts that, either by their nature or due to requirements of U.S. GAAP, are determined using estimates and assumptions. The actual amounts realized could ultimately be materially different from the amounts currently provided for in our consolidated financial statements. Critical accounting policies are those that management believes to be inherently complex and subjective. There were no changes to our accounting policies compared to those in our December 31, 2006 audited financial statements, with the exception of the reclassification of expenses on our preferred share soft capital facility. We believe loss and loss adjustment expense reserves, valuation of derivative financial instruments, valuation of the investment portfolio including other than temporary impairments of investments, determination of deferred acquisition costs and premium revenue recognition to be inherently complex and subjective, and therefore an understanding of the accounting policies pertaining to these items is critically important. These policies are summarized below, and described in further detail in the notes to our consolidated financial statements contained elsewhere in this Form 10-K filing, and the discussion that follows should be read in conjunction with our consolidated financial statements and the related notes.
Our unallocated reserve estimate is primarily based on the composition of our outstanding par exposure and reserve factors that we apply to this exposure. As a result, in the absence of other offsetting developments, increases in outstanding par will result in increases in unallocated reserves. Our reserve factors, in turn, are the product of the ratios of (i) the unallocated reserves of our primary insurer customers relative to their outstanding exposures weighted by (ii) the credit risk of our outstanding exposure relative to the credit risk of the portfolios of our primary insurer customers, where the ratio in (i) is calculated by dividing unallocated reserves carried by our primary insurers by their net par outstanding and the ratio in (ii) is calculated by dividing the weighted average capital charge for our outstanding par by the weighted average capital charge for the primary insured portfolio. RAM Re’s insured portfolio is segregated by primary insurer, and the ratios in (i) and (ii) are calculated individually by primary insurer. Our credit risk is determined by the ratio of our weighted average capital charges (a commonly recognized measure of credit risk promulgated by Standard & Poor’s) to the weighted average capital charges of our primary insurer customers. The following provides a numerical example of the mechanics of calculating the reserve factors.
If we assume (i) the ratio of a ceding company’s unallocated reserves to their outstanding par was .05% (or .0005) and (ii) the ratio of our weighted average capital charge to that of the ceding company was 125% (or 1.25), then our unallocated reserve factor would be .000625, calculated as the product of the two ratios, (i) .0005 multiplied by (ii) 1.25, and the resultant factor of .000625 would be applied to the outstanding par ceded to us by that particular primary insurer, such that for each $1 billion of outstanding par ceded to RAM Re we would have an unallocated reserve of $625,000. The calculation described is performed individually for each of RAM Re’s major ceding companies and the resulting reserve factor is applied to our outstanding par ceded by that ceding company. Therefore, under our reserving practices, our unallocated reserves would be affected by occurrences such as changes in the reserving practices of the primary insurers (which could occur if estimates of default frequency or severities of loss were to change), changes in the weighted average capital charge for our portfolio exposures versus those of ceding companies (which could occur if modifications of capital charges by Standard & Poor’s were to impact RAM Re and the primary insurers differently) or developments in the credit quality of our portfolio relative to primary insurers. For example, if the reserve factors applied at December 31, 2007 were calculated as the product of (1) the highest ratio of unallocated reserves to outstanding par that we have calculated for each ceding company during the years 2005, 2006 or 2007 and (2) the highest ratio of our weighted average capital charge to the weighted average capital charge of each ceding company that we have calculated during the years 2005, 2006 and 2007, the calculation of unallocated reserves would have resulted in a value that was $8.4 million, or 20%, greater than that recorded at December 31, 2007. We
believe that developments resulting in a change in unallocated reserve of this magnitude are reasonably possible in that the values employed in the above calculation, although they did not occur simultaneously, are based on actual past experience. We can provide no assurance that conditions resulting in a material increase in reserves of that amount or greater amounts will not develop or that final claim liabilities will not materially differ from amounts estimated and reserved. An increase in unallocated reserves, in the absence of any offsetting claims related activity, would directly impact reported financial results by increasing incurred losses and would also affect financial position by increasing the unallocated reserve balance, although an increase would not by itself impact liquidity in that the unallocated reserve does not affect cash flows.
FAS 133 requires us to mark-to-market gains or losses on those credit derivative transactions we reinsure. Changes in fair value due to market conditions are reported as unrealized gains and losses on derivative financial instruments in our income statement. These unrealized gains and losses cumulatively will net to zero if no credit defaults occur on these contracts. Should actual claim losses be incurred as a result of credit defaults, the primary insurer may be required to either purchase the security in default at par, or pay to the counterparty to a credit derivative transaction the difference between par and market value and as a reinsurer we would be obligated to reimburse the primary insurer for our proportional share of the loss. In this respect, credit derivative transactions may differ from traditional financial guarantee contracts since financial guarantee contracts require the insurer to make payments of principal and interest only on scheduled debt service dates, whereas defaults in our credit derivatives portfolio may cause immediate payments of outstanding par, net of market value.
The ceding companies use their own internal valuation models where market prices are not available. There is no single accepted model for fair valuing credit default swaps and there is generally not an active market for the type of credit default swaps insured by ceding companies and reinsured by us. Therefore, due to the limited availability of quoted market prices for these derivative contracts and the inherent uncertainties in the assumptions used in models, different valuation models may produce materially different results and be materially different from actual experience.
The models used to fair value these instruments include a number of factors, where available, including credit spreads, changes in interest rates, changes in correlation assumptions, current delinquencies, recovery rates and the credit ratings of referenced entities. Some of the primaries use market prices when available to determine the fair value of credit derivatives. If the market prices are not available, the fair value is estimated using a combination of observable market data and valuation models incorporating the above factors. Fair values from the primaries’ models may differ from values calculated by companies outside of the financial guaranty industry because terms of the credit default swap contract generally differ. Financial guaranty credit derivative terms generally include the absence of collateral support agreements or immediate settlement provisions, and are generally structured as “pay as you go” obligations requiring payment only as losses come due. Most importantly the primaries have the intent and the ability to hold the contracts to maturity. Because of these terms and conditions, the fair value of the primaries’ credit derivatives may not reflect the same prices observed in an actively traded market of credit default swaps that do not contain terms and conditions similar to those observed in the financial guaranty market. These models and the related assumptions are continuously reevaluated by the primaries and enhanced, as appropriate, based upon improvements in modeling techniques and availability of more timely market information.
In September 2006, the FASB issued FAS No. 157 (“FAS 157”), Fair Value Measurement. This Statement provides guidance for using fair value to measure assets and liabilities and associated disclosures about fair value measurement. Under this standard, the definition of fair value focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price). FAS 157 clarifies that fair value is a market-based measurement, not an entity-specific measurement, and establishes a fair value hierarchy with the highest priority being quoted prices in active markets and the lowest priority to unobservable data. Further, FAS 157 requires expanded disclosures of the fair value measurements by level within the fair value hierarchy. FAS 157 is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company adopted FAS 157 effective January 1, 2008. FAS 157 is not expected to have a material impact on our results of operations or financial position.
Valuation of Other Financial Instruments. The put option relating to the Company’s preferred share soft capital facility of $50.0 million, which is described in more detail under “Liquidity and Capital Resources - Capital Resources”, is fair valued with the fair value measurement representing the value to the Company in the current market environment. The gain or loss on the put option is recorded on the consolidated balance sheet and changes in fair value are reported through the statement of operations in “Unrealized Gain/(Loss) on Other Financial Instruments”. Valuations are obtained from banks that value the put option using assumptions over the Company and the facility as well as other similar instruments in the market. While the gain reported is a measurement against similar instruments in the market, the Company would most likely not have the ability to realize the gain as it would be subject to negotiation.
Valuation of Investment Portfolio. Our investment securities are designated as available for sale in accordance with FAS 115, “Accounting for Certain Investments in Debt and Equity Securities.” Changes in the fair value of our securities are reported in “Accumulated other comprehensive income” in shareholders’ equity. Fair values of all our investments are calculated from independent valuations. We have a formal review process for all securities in our investment portfolio, including a review for other than temporary impairment losses. Factors considered when assessing other than temporary impairment include: (i) securities with market values having declined by 20% or more below amortized cost for a continuous period of at least six months; (ii) recent credit downgrades by rating agencies; (iii) the financial condition of the
issuer; (iv) whether scheduled interest payments are past due; and (v) whether we have the ability and intent to hold the security for a sufficient period of time to allow for anticipated recoveries in fair value. If we believe a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss in “Accumulated other comprehensive income” on our balance sheet. If we believe the decline is “other than temporary,” we write-down the carrying value of the investment and record a loss on our income statement. Our assessment of a decline in value includes our current judgment of the factors noted above. If that judgment changes in the future, we may ultimately record a loss after having originally concluded that the decline in value was temporary.
Determination of Deferred Acquisition Costs. We defer certain costs that vary with and are directly related to the production of new business, including direct expenses such as ceding commissions and underwriting salaries, as well as allocated costs attributable to the production of new business. Deferred costs are amortized over the period in which the related premiums are earned. Acquisition costs in the income statement represent gross policy acquisition costs, less the deferral of expenses to future periods, plus the amortization of previously deferred expenses. The amount of expenses that qualify for deferral is determined on the basis of periodic analysis, and is dependent on new business production, ceding commissions negotiated with primary insurers, management’s judgment as to what costs and percentage thereof are deferrable, and the level of normal and refunded earned premiums. We periodically conduct a study to determine the deferability of expenses and in recent years a lesser percentage of our expenses have been deferred than was the case in our initial years of operation.
The Company will recognize a premium deficiency if the sum of expected losses and loss adjustment expenses, maintenance costs and unamortized policy acquisition costs exceed the related unearned premiums, the anticipated present value of future premiums for installment contracts written, and anticipated investment income. If a premium deficiency is calculated that is greater than unamortized acquisition costs, the unamortized acquisition costs would be reduced by a charge to expense, and a liability would be established for any remaining deficiency. There have been no premium deficiencies recorded by the Company since its inception. For policies retroceded, the Company receives ceding commissions to compensate for acquisition costs incurred. The Company nets ceding commissions received against deferred acquisition costs and earns these ceding commissions over the period in which the related premiums are earned.
Upfront premiums are recorded as written at policy inception and earned over the life of the policy in relation to the amount of insurance protection provided. Unearned premium reserves represent that portion of written premiums applicable to the outstanding amount at risk with respect to the obligations reinsured. Public finance premiums are customarily paid upfront and earned over the life of an issue which may extend to 30 years or more. Upfront premiums have relatively little effect on earnings in the year written, but cumulatively affect future years’ earned premiums. When an issue reinsured by us is retired early, has been called by the issuer, or is paid in advance through refunding, any remaining unearned premium is earned at that time, since there is no longer any risk outstanding in connection with the issue. Refunding levels vary depending upon a number of conditions, primarily the relationship between current interest rates and interest rates on outstanding debt. Installment premiums are received in accordance with contractual terms over the life of an issue, recorded as written at each installment due date and earned over the installment period which corresponds to the expiration of risk. Structured finance premiums are customarily paid in installments and earned over installment periods that generally range from three months to one year in duration. We do not record a provision for doubtful accounts because historically we have not experienced any material issues related to the collectability of assumed premiums.
Net Income. Net (loss) income was $(144.1) million in 2007, $41.1 million in 2006, and $19.6 million in 2005. The decrease in net income of $185.2 million, in 2007 relative to 2006 is primarily the result of a year-over-year increase of $50.8 million in losses and loss adjustment expenses, $177.8 million in losses on credit derivatives in 2007 due to widening credit spreads and the deterioration of underlying collateral, including $44.4 million of credit impairments, compared to immaterial unrealized losses during 2006, offset by a $35.3 million unrealized gain in 2007 on the fair value of the put option on the Company’s preferred share soft capital facility in 2007 compared to $Nil in 2006, and an $8.9 million increase in investment income. Net income of $41.1 million in 2006, an increase of $21.5 million, or 109.7%, in 2006 relative to 2005 is primarily the result of a year over year decrease of $10.0 million in losses and loss adjustment expenses, realized investment losses of $1.0 million in 2006 compared to realized investment losses of $1.6 million in 2005, and immaterial unrealized losses on credit derivatives in 2006 versus unrealized losses of $2.5 million during 2005, along with an increase in net earned premium of $6.2 million and in investment income of $6.0 million.
Public finance gross written premiums were $74.0 million in 2007, 52.3% more than in 2006 when public finance written premiums were $48.6 million. Public finance gross written premiums increased by 10.7% in 2006, from $43.9 million in 2005. The increase in public finance gross premiums written in 2007 is largely due to the one new treaty in 2007, along with increases within our existing treaties. The increase in public finance gross premiums written in 2006 is due to a large amount of facultative business written during the year as well as an increase in the portion of upfront premiums relative to installment premiums written. Installment premiums are written and earned over the various installment periods and generally a higher portion of business assumed having installment premiums results in less written premiums in the period in which the business is assumed compared to business having upfront premiums.
Gross written premiums are highly dependent upon the amount of business ceded by the primary insurers which, in turn, is related to the overall volume of business they underwrite, and the size and type of obligations they insure. In general, a growing volume of insured business, a stable or growing usage of reinsurance and higher premium rates will benefit our gross written premiums. During 2007, the aggregate gross premiums written by our three largest customers was slightly below the level of premiums written in 2006, and this same result occurred in 2006 as compared to 2005. While these customers ceded premiums written slightly below prior years, our other primaries with new treaties ceded the remaining increase in premiums written in 2007 over 2006. Overall, the three largest insurers ceded a lesser overall portion of the gross written premiums but the overall amount ceded to reinsurers increased during 2007 compared to 2006 and 2005. The average premium rates for public finance business assumed by RAM Re in 2007 were comparable to those of 2006, and the 2006 public finance average premium rates were lower than those of 2005. Structured finance business assumed by RAM Re in 2007 had average premium rates that were lower than those of 2006, while 2006 average premium rates for structured finance business assumed by RAM Re were above the 2005 level. Premium rates reflect market conditions, the type and mix of business ceded by RAM Re’s customers and the credit quality of such business so that an increase or decrease in average premium rates is the result of a several factors.
Net Written Premiums. Net premiums written were $108.0 million in 2007, a 43.0% increase over the 2006 level. Net written premiums in 2007 reflect ceded premiums of $0.8 million. Net premiums written were $75.5 million in 2006, an 10.9% increase over the 2005 level of $68.1 million. Net written premiums in 2006 reflect ceded premiums of $2.1 million, the first such activity for RAM Re and, thus, net and gross written premiums are identical for 2005. During 2007 we ceded premiums of $0.8 million pursuant to an agreement under which RAM retrocedes a portion of business in excess of specified levels of par exposure that we have assumed from a single issuer. Our purchase of reinsurance protection does not relieve us of the full liability that we assumed from our ceding companies. In the event that a reinsurer of RAM is unable to meet its obligation under a retrocession agreement, we would continue to be liable to ceding companies in the full amount of their cession to RAM. We retrocede only to highly rated companies and we monitor the financial condition of our reinsurer. Under our retrocession agreement, we also have cancellation rights that can be exercised in the event of a rating downgrade of a reinsurer.
31, 2007, we carried total reserves for losses and loss adjustment expenses of $63.8 million, of which $30.4 million were case reserves and the remaining $33.4 million related to unallocated loss reserves.
In addition, the market experienced significant price declines across all mortgage-related products in 2007. These price declines were further driven by forced sales of assets in order to meet demands by investors for the return of their investments and collateral calls by lenders. During the second half of 2007, the economic impact of these problems spread on a global basis and disrupted the broader financial markets. The combination of these events caused a large number of major financial institutions and investors, including RAM Re, to recognize substantial losses as they revalued their mortgage-related exposure downward.
Over the past several months, there has been considerable stress in the U.S. residential mortgage market, particularly related to mortgage loans originated during 2005, 2006 and 2007. RAM Re is exposed to U.S. residential mortgages through our reinsurance of residential mortgage-backed securities, or “RMBS”, and indirectly through our guarantees of collateralized debt obligations or “CDOs” backed by RMBS. CDOs are securities backed by portfolios of assets that may include a combination of corporate bonds, loans, RMBS, asset-backed securities, tranches of other collateralized debt obligations or credit derivatives representing any of the former. As of December 31, 2007, we have established $26.4 million of case reserves relating to specific 2005-2007 RMBS exposures and an additional increase of $15.6 million to our unallocated loss reserve relating to RMBS losses that are probable but can not be specifically identified. Additionally, the Company has been ceded credit impairments relating to CDOs amounting to $44.4 million that is reported separately in the valuation of credit derivatives.
The risk of loss inherent in the 2005, 2006 and 2007 vintage subprime and second lien mortgage loans has been elevated due to a number of factors. These factors increase current and potential future losses and include but are not limited to the following:
The very unfavorable residential mortgage market in the United States has been marked by nationally declining home prices. As home prices fall, the value of collateral available to pay loan balances is diminished, which will cause significantly higher loss severities in the event a borrower defaults.
Prime 1sts - First lien, predominantly single family residential mortgage loans to prime borrowers. Prime borrowers typically have credit scores above 660, on average better than 680.
HELOCs - Revolving home equity lines of credit, typically second lien and floating rate. These loans are typically made to prime quality borrowers, but may include loans to subprime borrowers. A second lien mortgage loan is a type of loan in which the borrower uses the equity in their home as collateral and the second lien loan is subordinate to the first lien on the home. The borrower is obligated to make monthly payments on both their first and second lien loans. If the borrower defaults on their payments due on these loans and the property is subsequently liquidated, the liquidation proceeds are first allocated to pay off the first lien loan and any remaining funds are applied to pay off the second lien. As a result of this subordinate position to the first lien, second lien loans carry a significantly higher risk of loss.
Subprime - A first- or second-lien residential mortgage loans made to a borrower who has a history of delinquency or other credit problems.
International - Mortgage loans on properties outside of the United States.
Recent credit downgrades of the RMBS by the major independent rating agencies have been concentrated in transactions which are comprised principally of first and second lien mortgage loans originated during the 2005 through 2007 period. The primary factors driving these rating downgrades are increasing foreclosure and delinquency rates for loans originated during this time period. Market participants believe a primary factor contributing to this poor credit performance was a pronounced deterioration in credit underwriting standards by mortgage originators.
portion of our HELOC exposure and a portion of our CES to below investment grade. Our ratings reflect our own judgement regarding the credit quality of our exposures and are believed to represent more timely ratings than provided by the rating agencies.
The following table lists the top five largest issuers of U.S. mortgage securities in RAM Re’s portfolio by RAM Re par outstanding and provides the outstanding par amount of HELOC, closed-end seconds (CES), subprime and Alt-A issued by each.
CMBS MS CDOs include Structured CMBS Pools and Commercial Real Estate CDOs. The CMBS CDOs we reinsured in 2007 are all rated AAA and have super-senior attachment points.
The multi-sector CDOs shown in the table above include reinsured exposures representing both the most senior tranches of the CDO capital structure and other, less than “senior-most,” tranches. In instances where our exposure is to a non-senior-most tranche, our exposure is to the next most-senior tranche in the capital structure below the senior-most tranche. The total outstanding par amount of CDOs in the table above representing non-senior-most tranches is $178 million. The subordination percentage (shown in the table above) is sometimes referred to as our “attachment point” and represents the percent of the total CDO collateral available to absorb losses prior to our exposure. When our exposure is senior-most, the “detachment point” for our exposure is 100% of the total CDO collateral. The difference between the detachment point and attachment point represents the total principal balance of our exposure. In instances where our exposure is non-senior-most, our detachment points are in the range of 40% to 90%. All of the CDOs shown in the table above were “super-senior” tranches at the time of underwriting, which means that, whether or not they were senior-most tranches, they had subordination in excess of the subordination required by the rating agencies for triple-A ratings. On average, the initial subordination was approximately 2.5 times of the rating agency triple-A requirement.
The definitions of the CDO types in the above table are as follows:
MS - Multi-sector collateral, which may include RMBS (including subprime), ABS, CDOs, CMBS and other asset-backed securities
Acquisition Expenses. Acquisition expenses were $21.5 million in 2007, $17.7 million in 2006, and $15.6 million in 2005. The changes in acquisition costs over the periods are directly related to the changes in earned premiums. The ratio of acquisition costs to earned premiums was 35.8% in 2007, down from 36.2% in 2006, which was also a decrease relative to the 2005 ratio of 36.6%. The decline in the ratio of acquisition costs to earned premiums reflects the combination of improvements (decreases) in ceding commissions paid to primary insurers and a lesser share of direct expenses allocated to the acquisition of business as a general result of the company maturation as supported by our analysis of expenses that qualify for deferral.
Interest Expense. Interest expense was $8.4 million in 2007 and $2.8 million in both 2006 and 2005. Preferred share dividends, classified as interest expense, of $5.6 million were paid during 2007. The preferred shares were issued on December 14, 2006 and therefore no dividends were paid in the prior years. Dividends on the preferred shares are payable semi-annually on June 15 and December 15 each year if declared by the board of directors. Interest expense on long term debt was $2.8 million in 2007, 2006 and 2005.
Liquidity. RAM Holdings is a holding company and therefore our liquidity, both on a short-term basis (for the next twelve months) and a long-term basis (beyond the next twelve months), is largely dependent upon (1) the ability of RAM Re to pay dividends or make other payments to us and (2) our ability to access the capital markets, which may be unlikely in the near term given current market conditions and RAM’s current stock valuation. Our principal uses of liquidity are for payment of interest on our senior notes, dividends on our preference shares and capital investments in RAM Re. Based on the amount of dividends that we expect to receive from RAM Re in 2008, we believe that we will have sufficient liquidity to satisfy our needs over the next twelve months. RAM Re’s ability to declare and pay dividends to us may be influenced by a variety of factors such as adverse market changes, insurance regulatory changes and changes in general economic conditions, beyond the next twelve months, the amounts required to be held by us in trust for the benefit of our U.S. regulated customers and Bermuda law as described below. Consequently, although we believe that we will continue to have sufficient liquidity to meet our obligations over the long term, we cannot guarantee that RAM Re will be able to dividend amounts sufficient to satisfy all our obligations, and there can be no assurance that dividends will be declared or paid in the future.
RAM Re may declare dividends, provided that, after giving effect to the distribution, it would not violate certain statutory equity, solvency and asset tests. The Bermuda Insurance Act requires RAM Re to meet a minimum solvency margin equal to the greater of (i) $1.0 million, (ii) 20% of net premiums written up to $6.0 million plus 15% of net premiums written over $6.0 million, and (iii) 15% of loss and other insurance reserves. To satisfy these requirements, RAM Re was required to maintain a minimum level of statutory capital and surplus of $16.7 million at December 31, 2007. RAM Re’s statutory capital and surplus was $369.7 million at December 31, 2007. In addition to the foregoing solvency criteria, Bermuda law limits the maximum amount of annual dividends or distributions payable and in certain instances
requires the prior notification to, or approval of, the BMA. Based upon these tests, without regulatory approval, the maximum amount that will be available during 2008 for payment by RAM Re is approximately $51.3 million.
Capital Resources. RAM Re maintains a $90.0 million contingent capital facility with a group of highly rated commercial banks as lenders. The facility is specifically designed to provide rating-agency qualified capital to support RAM Re’s claims paying resources and may not be drawn upon except for the payment of catastrophic losses where losses exceed minimum thresholds in respect of cumulative losses on public finance bonds and, in a limited capacity, asset-backed securities reinsured by RAM Re. Loan obligations under this facility have limited recourse and are repayable from, and collateralized by, a pledge of recoveries realized on defaulted reinsured obligations covered by the facility, including certain installment premiums and other collateral. The facility, which contains an annual extension provision subject to bank approval, has a term ending on May 11, 2015. As of December 31, 2007, no amounts were outstanding under this facility.
On February 3, 2006, RAM Re closed a $40.0 million contingent capital facility with two highly rated commercial banks. This facility is essentially the same as the $90.0 million contingent capital facility described above although it may be drawn upon only to cover catastrophic losses, exceeding the minimum threshold, from municipal obligations reinsured by RAM Re. Loan obligations under this facility also have limited recourse and are repayable from, and collateralized by, a pledge of recoveries realized on defaulted reinsured obligations covered by this facility, including certain installment premiums and other collateral, on a subordinate basis to the pledge made to secure the $90.0 million facility described above. The $40.0 million facility has a term ending on February 3, 2014, and had an annual extension feature, subject to approval of the lenders. This facility was not extended for an additional year on February 3, 2008. As of December 31, 2007, no amounts are outstanding under this facility.
On December 23, 2003, RAM Re entered into a $50.0 million soft capital facility whereby it was granted the right to exercise perpetual put options in respect of its Class B preference shares against the counterparty to the option agreement, in return for which it pays the counterparty a floating put option fee. The counterparty is a trust established by Lehman Brothers Inc. The trust was created as a vehicle for providing capital support to RAM Re by allowing it to obtain, at its discretion and following the procedures of the option agreement, access to new capital through the exercise of a put option and the subsequent purchase by the trust of RAM Re preference shares. The option agreement has no scheduled termination date or maturity, but will be terminated if RAM Re takes certain actions as specified in the operative facility
documents. RAM Re has the option to redeem the Class B preference shares issued upon exercise of its put option, subject to certain specified terms and conditions. If the put option is exercised in full, RAM Re would receive up to $50.0 million in connection with the issuance of the preference shares, the proceeds of which may be used for any purpose including the payment of claims. To fund the purchase of preference shares upon exercise of the put option by RAM Re, the trust issued $50.0 million of its own auction market perpetual preferred securities which are rated “A+” by Standard & Poor’s, on CreditWatch with negative implications, and “A2” with a negative outlook by Moody’s. The rate paid by the trust on these securities is currently at its maximum rate for our current rating of LIBOR plus 200. A downgrade of the trust’s auction market perpetual preferred securities would increase the maximum rate paid by the trust on these securities from LIBOR plus 200 to LIBOR plus 300, and RAM Re’s put option fee (calculated as the rate paid on the auction market perpetual preferred securities less the stated yield on the commercial paper held by the trust during the relevant period after deducting certain expenses of the trust) would be increased correspondingly. The proceeds of this issuance are held by the trust in certain high-quality, short-term commercial paper investments. In the years ended December 31, 2007 and 2006 $0.8 million and $0.5 million, respectively, of expenses relating to the operation of this facility have been paid. As of December 31, 2007 the put option has not been exercised.
The following table summarizes our investment portfolio by bond type, fair value and amortized cost thereof at December 31, 2007 and December 31, 2006:
Ratings represent Standard & Poor’s classifications. If unavailable, Moody’s ratings are used.
In addition, we also review rating agency releases and other publicly available information on the credits reinsured by us to further refine our loss estimation and reserving process.
Our investment portfolio is managed by two professional asset management firms, New England Asset Management and MBIA Capital. Our investment policies are designed to require the portfolio to be managed in a manner that preserves principal, provides long term predictable growth while maximizing income, meets statutory requirements, provides adequate liquidity to meet claims and other cash needs and maintains high credit quality. Our investment policy and guidelines as adopted by our board specify eligible investments and establish a portfolio duration target, high liquidity, minimum credit ratings, single risk limits, diversification and asset allocation standards. Our finance personnel reviews our portfolio for compliance with investment policies and procedures; and the Risk Management Committee of our board of directors reviews investments and performance reports and discusses those reports with our portfolio managers at least quarterly.
Changes in interest rates may adversely affect the value of fixed income investment securities. The following table summarizes the estimated change in fair value on the net balance of our investment securities, assuming immediate changes in interest rates at specified levels at December 31, 2007:
Financial instruments that may be adversely affected by changes in credit spreads include our outstanding exposure to credit derivative transactions. The Company’s credit derivative exposures are substantially similar to its financial guaranty insurance contracts and provide for credit protection against payment default. The primary insurer enters into these types of contracts, which require the insurer to make payments upon the occurrence of certain defined credit events relating to underlying obligations. If credit spreads relating to the underlying obligations change, the market value of the related credit derivative changes accordingly. Market liquidity can also impact valuations of the underlying obligations, resulting in gains or losses. Changes in credit spreads are generally caused by changes in the market’s perception or market liquidity of the credit quality of the underlying obligations. As credit spreads change, we experience unrealized fair value gains or losses on credit derivative transactions reinsured by us. We generally hold these derivative contracts to maturity. The unrealized gains and losses on derivative financial instruments will amortize to zero as the exposure approaches its maturity date, unless there is a payment default on the exposure. We estimate the potential impact of credit spread changes on the value of our contracts
The consolidated financial statements of RAM Holdings Ltd. were prepared by management, who are responsible for their reliability and objectivity. The statements have been prepared in conformity with accounting principles generally accepted in the United States of America and, as such, include amounts based on informed estimates and judgments of management. Financial information elsewhere in this annual report is consistent with that in the consolidated financial statements.
As of December 31, 2007, management has evaluated the effectiveness of the Company’s internal control over financial reporting based on the criteria established in “Internal Control-Integrated Framework,” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, we have concluded that RAM Holdings Ltd.’s internal control over financial reporting was effective as of December 31, 2007.
The effectiveness of the Company’s internal controls over financial reporting as of December 31, 2007 has been audited by PricewaterhouseCoopers, an independent registered public accounting firm, as stated in their report included in this Item under the heading “Report of Independent Registered Public Accounting Firm.”
In our opinion, the accompanying consolidated balance sheets as of December 31, 2007 and 2006 and the related consolidated statements of operations, of comprehensive income, of shareholders’ equity and retained earnings, and of cash flows for the years then ended, and the combined statements of operations, of comprehensive income, of shareholders’ equity and retained earnings, and of cash flows for the year ended December 31, 2005, present fairly, in all material respects, the financial position of RAM Holdings Ltd. and its subsidiary at December 31, 2007 and 2006, and the results of their operations and their cash flows for the years then ended, and the combined results of RAM Holdings Ltd. and its subsidiary’s operations and cash flows for the year ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 15(a)(2) present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated and combined financial statements. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements, on the financial statement schedules, and on the Company’s internal control over financial reporting based on our audits (which was an integrated audit in 2007). We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
On May 2, 2006, the Company completed an initial public offering (“IPO”). The Company’s common shares are traded on the NASDAQ Global Market under the symbol of “RAMR”.
RAM Re is a Bermuda-based company whose principal activity is the reinsurance of financial guarantees of public finance and structured finance debt obligations insured by monoline financial guaranty companies. RAM Re provides reinsurance through treaty and facultative agreements that it maintains with each of its customers. Financial guaranty reinsurance written by RAM Re generally provides for guarantees of scheduled principal and interest payments on an issuer’s obligation in accordance with the obligation’s original payment schedule and, in rare circumstances, such amounts are payable on an accelerated basis.
The following is a summary of the significant accounting policies adopted by the Company:
The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“US GAAP”). The preparation of financial statements in accordance with generally accepted accounting principles requires management to make estimates and assumptions that affect reported amounts of assets and liabilities, as well as disclosure of contingent assets and liabilities as of the balance sheet date. Estimates also affect the reported amounts of income and expenses for the reporting period. Actual results could differ materially from those estimates.
As discussed in Note 1, RAM Holdings Ltd and RAM Holdings II Ltd were amalgamated on May 1, 2006 and the December 31, 2007 and 2006 consolidated financial statements reflect the amalgamation. There was no effect to shareholders’ equity or results of operations on amalgamation. The consolidated accounts of Holdings include those of its subsidiary, RAM Re. All significant intercompany balances have been eliminated on consolidation. Comparative financial information for the year ended December 31, 2005 is presented on a combined basis as the amalgamation was not yet effective. Holdings and Holdings II had common shareholders and were under common management. Intercompany balances and transactions were eliminated on consolidation and/or combination. There are no significant differences between financial statements prepared on a combined basis and those prepared on a consolidated basis.
credit downgrades by rating agencies; (iii) the financial condition of the issuer; (iv) whether scheduled interest payments are past due; and (v) whether the Company has the ability and intent to hold the security for a sufficient period of time to allow for anticipated recoveries in fair value. The Company’s investment guidelines require the orderly sale of securities that do not meet investment guidelines due to a downgrade by rating agencies or other circumstances.
Installment premiums are recorded as written at each installment due date and are earned over the respective installment period, which equates to the period of risk. All other premiums written are recorded as written at the inception of the policy and are earned ratably over the period of risk. When insured issues are refunded or called, the remaining unearned premiums are earned at that time, since there is no longer risk to the Company. Premiums are recorded on a one month lag due to the timing of receipt of the information from the ceding companies. Premiums earned for 2007, 2006, and 2005, respectively, includes $5.7 million, $6.3 million, and $3.3 million related to refundings.
Case basis reserves are established based on ceding company reports and internal review and evaluation of exposures related to guaranteed obligations that either have already defaulted or have a high and estimable probability of default. Management’s review and analysis of case basis reserves includes an analysis of the present value of the expected ultimate losses and loss adjustment expense that the Company expects to pay less estimated recoveries. The amount of the expected loss, net of expected recoveries, is discounted based on a discount rate of approximately 5% for all periods presented. Changes to the ceding company’s reserves are reported at regular intervals and are reviewed for reasonableness by the Chief Risk Manager and the Company’s Management Committee.
The reserving practices of the primaries (such as could occur if estimates of default frequency or severities of loss given default were to change);
RAM Re’s unallocated reserve is reviewed periodically by the Management Committee and the estimate may be modified if industry experience or company specific-developments are judged to warrant such an adjustment.
The unallocated reserve is established to cover estimated losses on par exposures based on historical industry experiences of losses and defaults. As case reserves are established, the par related to that particular credit is removed from the total par used to calculate the unallocated reserve as described above.
Through June 30, 2007, RAM had valued its credit default swap portfolio using an internally developed model. While the model estimated an appropriate fair value during normal market conditions, the internal model output would not fully reflect the effect of the present market conditions and the large changes in credit spreads currently being experienced. Management therefore determined that a more appropriate basis for our estimate of fair value was to use, from September 30, 2007 onward, the valuation information provided to us by our ceding companies as they have access to each underlying risk and their internal models are able to reflect more detailed market data for each of those underlying risks. The ceding companies use their own internal valuation models where market prices are not available. Due to the limited availability of quoted market prices for these derivative contracts and the inherent uncertainties in the assumptions used in models, different valuation models may produce materially different results and be materially different from actual experience. There is no single accepted model for fair valuing credit default swaps and there is generally not an active market for the type of credit default swaps insured by ceding companies and reinsured by us. In addition, due to the complexity of fair value accounting and the application of FAS 133, future amendments or interpretations of FAS 133 may cause us to modify our accounting methodology in a manner which may have an adverse impact on our financial results. Management assess the reasonableness of the ceding companies’ valuations by i) discussions with primary insurers on their mark-to-market valuation methodology including the nature of changes in key assumptions, ii) reviewing the primaries’ publicly available information regarding their mark-to-market process, including methodology and key assumptions, and iii) assessing the reasonableness of the valuations, including changes in the reported valuations against current observable market data including credit spread movements and collateral delinquency information. Upon occurrence of specific credit events such as a default, an appropriate reserve is established in the derivative liability line item on the balance sheet to reflect the market value. See further information on derivative instruments in Note 4 to these consolidated financial statements
The put option relating to the Company’s preferred share soft capital facility, is fair valued with the fair value measurement representing the value to the Company in the current market environment. The gain or loss on the put option is recorded on the consolidated balance sheet and changes in fair value are reported through the statement of operations in “Unrealized Gain/(Loss) on Other Financial Instruments”. Valuations are obtained from banks that value the put option using assumptions over the Company and the facility as well as other similar instruments in the market. While the gain reported is a measurement against similar instruments in the market, the Company would most likely not have the ability to realize the gain as it would be subject to negotiation.
On April 18, 2007, the Financial Accounting Standards Board (“FASB”) issued the Exposure Draft “Accounting for Financial Guarantee Insurance Contracts - an interpretation of FASB Statement No. 60” (“Exposure Draft”). The Exposure Draft among other things, would change current industry practices with respect to the recognition of premium revenue and claim liabilities. In addition, the Exposure Draft would require that the measurement of the initial deferred premium revenue (liability) be the present value of the contractual premium due pursuant to the terms of the financial guarantee insurance contract, thereby changing current industry accounting practice with respect to insurance policies with installments by requiring that the present value of contractual premiums due under such contracts, currently or in the future, be recorded on the Company’s balance sheet as premiums receivable and unearned premiums. Under current industry practice such premiums are not reflected on the balance sheet. When the FASB issues authoritative guidance the Company and the rest of the financial guaranty industry may be required to change some aspects of their accounting for loss reserves, premium recognition and acquisition cost recognition, and these changes could have a material effect on our financial statements. The comment period for the Exposure Draft closed on June 15, 2007. A FASB Round Table discussion was held in early September 2007 with another FASB meeting held in January 2008. The FASB has indicated that the final FASB Statement is expected to be issued in the first or second quarter of 2008. The Company is assessing the potential impact and at this time is unable to quantify the effect of the adoption of the proposed interpretation. Until the authoritative guidance is issued, the Company intends to continue to apply its existing policies with respect to its accounting for the establishment of both case and unallocated reserves as well as for premium recognition and deferred acquisition costs.
Certain reclassifications have been made to the prior year’s amounts to conform to the current year’s presentation. In the current year we have reclassified committed preferred expenses amounting to $1.2 million to retained earnings, as this presentation reflects a more appropriate recording of these costs.
Certain transactions reinsured by the Company have been deemed to meet the definition of a derivative under FAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”), and FAS No. 149,”Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (“FAS 149”), and require that an entity recognize all derivatives as either assets or liabilities in the consolidated balance sheets and measure those instruments at fair value. The gain or loss on credit derivatives will change at each measurement date based on the underlying assumptions and information used in the estimate of fair value. Such fair value changes may not be indicative of ultimate claims. Fair value is defined as the amount at which an asset or liability could be bought or sold in a current transaction between willing parties. The credit derivative contracts the Company reinsure require us to make payments upon the occurrence of certain defined credit events relating to an underlying obligation. Credit derivative exposures are substantially similar to financial guaranty insurance contracts and provide for credit protection against payment default, are generally held to maturity, and the unrealized gains and losses on derivative financial instruments will amortize to zero as the exposure approaches its maturity date, unless there is a credit impairment.
As of December 31, 2007, 2006, and 2005, included in the Company’s outstanding par exposure were $11.9 billion, $5.5 billion, and $3.3 billion, respectively, credit default swaps that have been fair valued under Statement of Financial Accounting Standards No. 133. These derivative instruments had an average legal term to maturity of 25.2 years, 12.5 years, and 11.8 years as of December 31, 2007, 2006, and 2005, respectively, although actual maturity of credit default swaps is generally expected to be less than the legal term. In accordance with predominant industry practice, the Company believes that the most meaningful presentation of the financial statement impact of these derivative instruments is to record premiums as installments are received and changes in fair value as incurred. Changes in fair value are recorded in net losses on credit derivatives and in derivative assets/liabilities. The estimated income statement impact of derivative activity, by category, is as follows:
In determining the fair value of derivative instruments, management relies on an evaluation of ceding company reports of credit derivative contract valuations. The ceding companies use their own internal valuation models where market prices are not available. The models used to fair value these instruments include a number of factors, including credit spreads, changes in interest rates, changes in correlation assumptions, current delinquencies, recovery rates and the credit ratings of referenced entities. Some of the primaries use market prices when available to determine the fair value of credit derivatives. If the market prices are not available, the fair value is estimated using a combination of observable market data and valuation models incorporating the above factors. Fair values from the primaries’ models may differ from values calculated by companies outside of the financial guaranty industry because terms of the credit default swap contracts insured generally differ from other non insured CDS contracts. Financial guaranty credit derivative terms generally include the absence of collateral support agreements or immediate settlement provisions, and are generally structured as “pay as you go” obligations requiring payment only as losses come due. Most importantly the primaries have the intent and the ability to hold the contracts to maturity. Because of these terms and conditions, the fair value of the primaries’ credit derivatives may not reflect the same prices observed in an actively traded market of credit default swaps that do not contain terms and conditions similar to those observed in the financial guaranty market. These models and the related assumptions are continuously revaluated by the primaries and enhanced, as appropriate, based upon improvements in modeling techniques and availability of more timely market information.
Our major competitors include Assured Guaranty Re, XL Financial Assurance Ltd., Channel Reinsurance Ltd., BluePoint Re Limited, and Radian Asset Assurance Inc., while several multiline insurance companies continue to offer financial guaranty reinsurance capacity as well. The capital adequacy of the financial guaranty reinsurers that we compete with has been reviewed by or is under review by the applicable rating agencies, and our competitive position will be determined in part by the ultimate outcome of the rating agencies’ reviews of RAM Re and its competitors. At least one new Bermuda-based financial guaranty reinsurance company has been formed recently, and it is possible that more will be formed in the near term, although we believe the barriers to entry, particularly rating agency requirements, remain significant. It is also possible that one or more of the primaries that has been downgraded will choose to become a reinsurer on a temporary or permanent basis. In this changing environment, it is not possible to predict with accuracy our competitors or competitive position in 2008. We also compete directly and indirectly with certain credit derivative transactions and other alternative transaction structures that may be a more attractive alternative to traditional financial guaranty reinsurance. In addition, issuers may choose to divide large transactions among several primary insurers reducing or eliminating the need for reinsurance. Primary insurers may also choose to reinsure transactions with other primary insurers directly also reducing or eliminating the need for reinsurance.
Basic earnings per share is computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share shows the dilutive effect of all stock options and restricted stock units outstanding during the period that could potentially result in the issuance of common stock. The calculation of diluted loss per share excludes the dilutive effect of stock options and restricted stock awards outstanding because it would otherwise have an antidilutive effect on net loss per share. As of December 31, 2007, there were 1,302,612 stock options and restricted stock units excluded from the diluted earnings per share calculation because they were antidilutive. As of December 31, 2006 and 2005, there were no stock options that were not included in the diluted earnings per share calculation because they were antidilutive.
The following table sets forth the computation of basic and diluted earnings per share for the years ended December 31, 2007, 2006 and 2005:
The amortized cost and estimated fair value of fixed interest securities classified as available for sale as of December 31, 2007, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or repay obligations with or without call or prepayment penalties.
On July 1, 2005, RAM Re entered into a retrocession agreement with a “AA” rated financial guaranty company to retrocede business that exceeds its single risk limits on a facultative basis, thereby limiting its exposure to loss from large individual risks. This retrocessional agreement does not relieve RAM Re from its obligation to the reinsured. As at December 31, 2007 and 2006, premiums of $0.8 million and $2.1 million respectively, had been retroceded as part of the treaty. There are currently no loss recoveries recorded under this agreement.
As of December 31, 2007 the fair value of the Company’s $75.0 million redeemable preferred shares was $22.0 million. The fair values of the Company’s long term debt and accrued interest payable are assumed to approximate carrying value. The put option on the Company’s contingent capital facility is a financial instrument and is required to be fair valued. As at December 31, 2007, the unrealized gain on this financial instrument was $35.3 million and is included in other financial instruments on the
As of December 31, 2007 and included within net losses on credit derivatives was $44.4 million related to credit impairments which are expected to be paid out over the term of the contracts, see Note 4 Derivative instruments.
Financial guarantees are unconditional commitments that guaranty the performance of obligations under a debt service schedule. The Company’s potential liability in the event of non-performance by the issuer of the reinsured obligation is represented by its proportionate share of the aggregate outstanding principal and interest payable on such insured obligations. As of December 31, 2007 and 2006, the Company’s outstanding principal reinsured was $45.4 billion and $31.1 billion, respectively. If a primary financial guaranty insurance company pays a claim and has recourse through subrogation rights, the Company would benefit based on its proportionate share of risk.
Outstanding principal reinsured as of December 31, 2007 and 2006 by credit sector was (in millions) (1):
The Company attempts to limit its exposure to credit risk through risk management guidelines, the objectives of which are to ensure that the Company maintains a reinsured portfolio that is of high quality and is sufficiently diversified to protect the Company from unexpected severe deterioration in any particular credit sector or geographic location.
The Company maintains qualified and non-qualified, non-contributory, defined contribution pension plans for the benefit of eligible employees. These plans are administered by a third party. The Company’s contributions are based upon a fixed percentage of employee compensation. Pension expense, which is funded as accrued, for the years ended December 31, 2007, 2006, and 2005 was $0.4 million, $0.5 million, and $0.4 million, respectively.
As at December 31, 2007, outstanding awards of 1,252,197 share options and 50,415 restricted share units had been granted to the Company’s officers and employees. Each of the options will vest in equal annual installments over a four-year period and will expire on the seventh anniversary of the date of grant. The grant price is the average of the highest and lowest quoted selling price on the grant date. The exercise price of the options at December 31, 2007 ranges from $5.46 to $16.20. Restricted share units will vest in equal annual installments over a four-year period.
These assumptions are based on a number of factors as follows: (i) dividend yield was determined based on the Company’s historical dividend payments which have been nil and expected dividend payments in the future which are also expected to be nil, (ii) expected volatility was determined using the historical volatility of the stock price, of the Company and similar companies within the financial guaranty industry, (iii) the expected term of the options is based on the period of time that the options granted are expected to be outstanding, (iv) the risk free rate is the U.S. Treasury rate effective at the time of grant for the duration of the options granted, and (v) the forfeiture rate is based on actual forfeitures adjusted for future forfeiture expectations due to limited historical forfeiture data. Compensation cost is recognized on a straight-line basis over the vesting period and is net of estimated forfeitures. At December 31, 2007, the weighted average grant date fair value, using FAS 123 for disclosure purposes, was $3.95.
(1) The aggregate intrinsic value was calculated based on the market value of $14.29 as at December 31, 2006, and is calculated as the difference between the market value and the exercise price of the underlying options.
During the year ended December 31, 2006, the Company purchased from employees 31,200 options that were fully vested at an expense of $0.1 million.
(2) FAS 123R was adopted on January 1, 2006, prior to that stock options were accounted for under APB 25.
The Company expensed $0.2 million in compensation expense related to the restricted share units for 2007 (2006 - immaterial). The compensation expense for restricted share units is expensed on a prorated basis over the vesting period. At December 31, 2007, there is unrecognized compensation expense related to the nonvested restricted share units of $0.6 million, which will be recognized over the weighted average remaining service period of 2.96 years.
As of June 30, 2005, the Company entered into Payment Agreements that terminated both the Contingent Share Agreements and 472,420 vested Stock Options of three management employees. On June 30, 2006 the Company paid $1.6 million to the employees and subsequently paid an additional $0.7 million in the third quarter of 2006 which represented the remaining value of the ultimate liability.
During 2007, the Company renewed its agreement to lease office space for the two years ending December 31, 2009. As of December 31, 2007, the future minimum commitment under the lease, for the years remaining, is $0.7 million. Rental expense for the aforementioned lease amounted to $0.3 million in all years presented.
Through December 31, 2007, RAM Re had been assigned a “AAA” (Extremely Strong) rating with negative outlook from Standard & Poor’s and a “Aa3” (Excellent) rating from Moody’s. Moody’s rating outlook was “stable” while in July of 2006 S&P revised its outlook for the rating from “stable” to “negative”, commenting that the revision “reflects the below-average earnings and ROE earned by the company over the past several years, coupled with concern regarding the level and pace of improvement in the near to intermediate future.” On February 1, 2008, Moody’s announced that it had placed the Aa3 rating of RAM Re on review for possible downgrade, reflecting Moody’s revised expected loss projections for residential mortgage backed securities and related collateralized debt obligations risk, and the corresponding implications for RAM Re’s capital adequacy. On February 14, 2008, Standard & Poor’s placed the AAA rating on RAM Re on CreditWatch with negative implications. Standard & Poor’s stated that under its guidelines, CreditWatch with negative implications means that there is a one-in-two chance of a ratings change within the short term, typically within 90 days. Standard & Poor’s stated that the ratings action reflects Standard & Poor’s view of the shortfall of approximately $82 - $132 million in RAM Re’s capital cushion at December 31, 2007, relative to projected subprime losses. Standard & Poor’s also stated that the action incorporates and elevates the importance of RAM Re demonstrating improved financial metrics, as first cited in July 2006 when Standard & Poor’s assigned a negative outlook to RAM Re and RAM Holdings. On March 7, 2008, Moody’s confirmed the Aa3 insurance financial strength rating of RAM Re and changed the outlook to negative. Moody’s stated that RAM Re remains adequately capitalized for its Aa3 rating. Moody’s stated that the negative outlook assigned reflects continued uncertainty regarding both the ultimate performance of mortgage and mortgage-related collateralized debt obligation exposures, as well as RAM Re’s future underwriting prospects given its reliance on the primaries for business.
On March 26, 2004 RAM Holdings Ltd. issued $40.0 million of unsecured senior notes (the “Notes”) to a qualified institutional buyer as defined in Rule 144A of the Securities Act. The term of the Notes is 20 years with the full principal amount due at maturity. The Notes rank pari passu in right of repayment with RAM Holding Ltd.’s other unsecured senior debt, of which there is currently none. The net proceeds from the Notes have been used to provide capital for RAM Reinsurance Company Ltd.
The applicable interest rate is 6.875% and is payable semi-annually. The Notes are subject to redemption at the option of RAM Holdings Ltd., in whole or in part at any time upon 30 days advance notice by paying principal, accrued interest and the Make Whole Amount, a portion of the future scheduled payments over the principal amount. There are no financial covenants in place. Interest expense amounting to $2.8 million for each of the years ended December 31, 2007, 2006 and 2005 has been recorded.
On December 14, 2006, the Company issued 75,000 preferred shares at $1,000 per share for total consideration of $75.0 million. The preferred shares bear a non-cumulative, non mandatory dividend rate of 7.50% which is payable semi-annually on June 15 and December 15 each year upon declaration by the board of directors. Unless previously redeemed, the preferred shares have a mandatory redemption date of December 15, 2066. The Company can redeem the preferred shares at any time from December 15, 2016 with no penalty to the Company but redemptions prior to that can be redeemed at the redemption price and a “make-whole” amount, amounting to dividends for the remainder of the period to December 15, 2016. As of December 31, 2007 there have been dividends amounting to $5.6 million declared and paid. There were no dividends declared or paid in 2006
In December 2003, two of our shareholders became investors in FGIC Corporation, an insurance holding company whose subsidiary FGIC is one of the four largest United States based primary financial guaranty insurance companies. In the ordinary course of business, we have entered into facultative reinsurance agreements with FGIC. In 2007 and 2006, gross written premiums ceded from FGIC accounted for 26% and 12% of total gross premiums written by us, respectively. Amounts due from FGIC as of December 31, 2007 and 2006 were $Nil and $1.1 million respectively and have been included in premiums receivable.
The Company has received an undertaking from the Bermuda government exempting it from all local income, withholding and capital gains taxes until March 28, 2016. At the present time no such taxes are levied in Bermuda.
RAM Re is registered under the Bermuda Insurance Act 1978, amendments thereto and related Regulations (the “Act”), which require that they maintain minimum levels of solvency and liquidity. For the years ended December 31, 2007 and 2006 these requirements have been met. The minimum required statutory capital and surplus was $16.7 million and $11.6 million and actual statutory capital and surplus was $369.7 million and $413.5 million as of December 31, 2007 and 2006, respectively. The minimum required level of liquid assets was $268.1 million and $221.4 million and actual liquid assets were $727.1 million and $629.2 million as of December 31, 2007 and 2006, respectively.
Basic and diluted EPS prior to the second quarter 2006 are based on shares outstanding prior to the IPO.
The Company holds three investments with exposure to the subprime sector. Subsequent to December 31, 2007, one of these subprime investments, which was other than temporarily impaired at December 31, 2007, decreased in fair value to $1.5 million at February 29, 2008 from $2.4 million at December 31, 2007, an unrealized losses of $0.9 million. This investment was also downgraded from AAA at December 31, 2007 to BBB+ at February 29, 2008. There was no significant change in the unrealized loss position or rating of the other two subprime investments and Management continues to have the intent and ability to hold these investments to recovery, and therefore, no loss has been realized on these two investments at December 31, 2007 or subsequent thereto.
The primaries have reported that insured volume as a percentage of total volume in the public finance market has reduced significantly since December 2007 as a result of uncertainty regarding the financial stability and ratings of the primaries. This uncertainty has also reportedly caused a reduction in new issuance as certain municipalities either (i) delayed issuance or (ii) were unable to find purchasers for their uninsured obligations at acceptable prices. The primaries have also reported that structured finance volume has decreased since the fourth quarter of 2007 as a result of the credit crisis and that such volume is uncertain for the future. Ambac and MBIA have announced not to underwrite structured finance transactions for six months. In addition, Ambac and MBIA have reported that they have determined not to insure credit derivatives transactions in the future. Furthermore, we believe FGIC and SCA have essentially ceased to write new business, at least temporarily. Finally there is currently uncertainty regarding future actions regulators may take regarding participants within the financial guaranty industry. Reinsurance ceded by the aforementioned primaries have been a significant part of RAM’s business volume in recent years. The reduction in business origination by these primaries is therefore anticipated to result in a lower volume of reinsurance business ceded.