Montpelier RE Holdings 10-K 2008
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
x ANNUAL REPORT
PURSUANT TO SECTION 13 OR 15(d) OF
For the fiscal year ended December 31, 2007
o TRANSITION REPORT
PURSUANT TO SECTION 13 OR 15(d) OF
For the transition period from to
Commission file number 1-8993
MONTPELIER RE HOLDINGS LTD.
(Exact name of Registrant as specified in its charter)
Montpelier House, 94 Pitts Bay Road
Pembroke, Bermuda HM 08
(Address of principal executive offices)
Registrants telephone number, including area code: (441) 296-5550
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No o
Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes o No x
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
The aggregate market value of voting shares (based on the closing price of those shares listed on the New York Stock Exchange and the consideration received for those shares not listed on a national or regional exchange) held by non-affiliates of the Registrant as of June 30, 2007, was $1,449,441,033.
As of February 27, 2008, 97,143,517 common shares were outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
The definitive proxy statement relating to Montpelier Re Holdings Ltd.s Annual Meeting of Shareholders, to be held May 21, 2008, is incorporated by reference in Part III of this Form 10-K to the extent described therein.
TABLE OF CONTENTS
This Form 10-K contains forward-looking statements within the meaning of the United States (the U.S.) federal securities laws, pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, that are not historical facts, including statements about our beliefs and expectations. These statements are based upon current plans, estimates and projections. Forward-looking statements rely on a number of assumptions concerning future events and are subject to a number of uncertainties and various risk factors, many of which are outside our control. See Risk Factors contained in Item 1A herein for specific important factors that could cause actual results to differ materially from those contained in forward-looking statements. In particular, statements using words such as may, should, estimate, expect, anticipate, intend, believe, predict, potential, or words of similar import generally involve forward-looking statements.
Important events and uncertainties that could cause the actual results, future dividends, distributions or future common share repurchases to differ include, but are not necessarily limited to: market conditions affecting our common share price; the possibility of severe or unanticipated losses from natural or man-made catastrophes; the effectiveness of our loss limitation methods; our dependence on principal employees; our ability to execute the business plan of our new insurance and reinsurance initiatives effectively, including the integration of those operations into our existing operations; increases in our general and administrative expenses due to new business ventures, which expenses may not be recoverable through additional profits; the cyclical nature of the reinsurance business; the levels of new and renewal business achieved; opportunities to increase writings in our core property and specialty reinsurance and insurance lines of business and in specific areas of the casualty reinsurance market; the sensitivity of our business to financial strength ratings established by independent rating agencies; the estimates reported by cedants and brokers on pro-rata contracts and certain excess of loss contracts where the deposit premium is not specified in the contract; the inherent uncertainties of establishing reserves for loss and loss adjustment expenses, particularly on longer-tail classes of business such as casualty; our reliance on industry loss estimates and those generated by modeling techniques; unanticipated adjustments to premium estimates; changes in the availability, cost or quality of reinsurance or retrocessional coverage; changes in general economic conditions; changes in governmental regulation or tax laws in the jurisdictions where we conduct business; our ability to assimilate effectively the additional regulatory issues created by our entry into new markets; the amount and timing of reinsurance recoverables and reimbursements we actually receive from our reinsurers; the overall level of competition, and the related demand and supply dynamics in our markets relating to growing capital levels in the reinsurance industry; declining demand due to increased retentions by cedants and other factors; the impact of terrorist activities on the economy; and rating agency policies and practices.
We undertake no obligation to update publicly or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the dates on which they are made.
Montpelier Re Holdings Ltd. (the Company or the Registrant) was incorporated as an exempted Bermuda limited liability company under the laws of Bermuda on November 14, 2001. The Company, through its subsidiaries and affiliates in Bermuda, the U.S. and Europe (collectively Montpelier), provides customized, innovative, and timely reinsurance and insurance solutions to the global market.
Our principal wholly-owned operating subsidiary, Montpelier Reinsurance Ltd. (Montpelier Re), is a Bermuda Class 4 insurer. Montpelier Re seeks to identify and underwrite attractive insurance and reinsurance opportunities by utilizing catastrophe modeling software and proprietary risk pricing and capital allocation models. We provide marketing services to Montpelier Re through our wholly-owned subsidiary, Montpelier Marketing Services Limited (MMSL), a United Kingdom (U.K.) company based in London.
On July 1, 2007, we commenced the operations of our newly-formed Lloyds of London (Lloyds) syndicate known as Montpelier Syndicate 5151 (Syndicate 5151). Syndicate 5151 underwrites primarily short-tail lines, mainly property insurance and reinsurance, engineering and specialty casualty classes sourced from the London, U.S. and European markets. Montpelier Capital Limited (MCL), a wholly-owned subsidiary of the Company, serves as Syndicate 5151s sole corporate member. Syndicate 5151 is managed by Spectrum Syndicate Management Limited (Spectrum), a third party Lloyds Managing Agent based in London. Syndicate 5151 also accepts business from our wholly-owned U.S. managing general agent, Montpelier Underwriting Inc. (MUI) and from our wholly-owned Swiss subsidiary, Montpelier Europa AG (MEAG). MUI and MEAG each received Lloyds Coverholder approval during 2007. A Coverholder is a firm that is authorised by a Lloyds managing agent to enter into contracts of insurance and/or issue insurance documentation on behalf of a syndicate it manages. MEAG, whose focus is on markets in Continental Europe and Middle East, also provides marketing services to Syndicate 5151 and supports Montpelier Res existing regional marketing effort with respect to certain established lines of business.
On November 1, 2007, we acquired General Agents Insurance Company of America, Inc. (General Agents), an Oklahoma domiciled stock property and casualty insurance corporation, from GAINSCO, Inc. (GAINSCO). General Agents is an admitted insurer in Oklahoma and is authorized as an excess and surplus lines insurer in 37 additional states. At the time the acquisition was completed, General Agents had no employees or in force premium. General Agents was renamed Montpelier U.S. Insurance Company (MUSIC) shortly after the acquisition.
We provide insurance, accounting, finance, advisory and information technology services to our affiliates and to third parties through our wholly-owned Bermuda subsidiaries, Montpelier Agency Ltd. (MAL) and Montpelier Capital Advisors Ltd. (MCA), and our wholly-owned U.S. subsidiary, Montpelier Technical Resources Ltd. (MTR). We provide underwriting support services to our affiliates and to third parties in the U.K. and Switzerland through our U.K. wholly-owned subsidiary, Montpelier Underwriting Services Limited (MUSL).
We have a significant investment in Blue Ocean Re Holdings Ltd. (Blue Ocean), a holding company that owns 100% of Blue Ocean Reinsurance Ltd. (Blue Ocean Re). Blue Ocean Re is a Bermuda Class 3 insurer which provides property catastrophe retrocessional protection. Blue Ocean Re began its operations in January 2006. During the second half of 2007, Blue Ocean Re ceased writing new business and is not currently expected to write any new business during 2008. As of December 31, 2007 and 2006, we owned 42.2% of Blue Oceans outstanding common shares and 33.6% of Blue Oceans outstanding preferred shares. Blue Ocean is considered a variable interest entity as defined under Financial Accounting Standards Board (FASB) Interpretation (FIN) No. 46R, entitled Consolidation of Variable Interest Entities - an interpretation of Accounting Research Bulletin No. 51 as amended. In accordance with FIN 46R, Blue Ocean is currently consolidated into our financial statements. MAL provides Blue Ocean Re with underwriting, risk management, claims management, ceded retrocession agreement management, actuarial and accounting services and receives fees for such services.
Our Strategy and Operating Principles
We aim to maximize long-term growth in our fully-converted tangible book value per share by pursuing the following strategies:
Maintaining a Strong Balance Sheet. We focus on generating underwriting profits while maintaining a strong balance sheet. We aim to manage our capital relative to our risk exposure in an effort to maximize long-term growth in fully-converted tangible book value per share and to support our underwriting activities. Our capital currently consists of our shareholders equity, debt, contingent capital (our forward sale and share issuance agreement) and third party capital (Blue Ocean minority interest). Also, as part of our capital management strategy, if we have idle or excess capital, we may reduce debt and/or consider dividends, distributions and common share repurchases to return capital to our stakeholders.
Enhancing Our Lead Position With Brokers and Cedants. We often take a lead position in underwriting treaties. Doing so may increase our access to business. Through the use of underwriting tools, our underwriters seek to identify those exposures which meet our objectives in terms of return on capital and underwriting criteria. By leading reinsurance programs, we believe our underwriters attract, and can selectively write, exposures from a broad range of business in the marketplace.
Combining Subjective Underwriting Methods With Objective Modeling Tools. We exploit pricing inefficiencies that may exist in the market from time to time. To achieve this, we disseminate market information to our underwriting teams and facilitate personal contact among our underwriters. Generally, our underwriters use risk modeling tools, both proprietary and third party, together with their market knowledge and judgment, and seek to achieve the highest available price per unit of risk assumed by our portfolio.
Developing and Maintaining a Balanced Portfolio of Insurance and Reinsurance Risks. We aim to maintain a balanced portfolio of risks, diversified by class, product, geography and marketing source. We employ risk management techniques to monitor correlation risk and seek to enhance underwriting returns through careful risk selection using advanced capital allocation methodologies. We also actively seek to write more business in classes experiencing attractive conditions and avoid those classes suffering from intense price competition or poor fundamentals. We believe a balanced portfolio of risks reduces the volatility of returns and optimizes the growth of shareholder value, but we may be overweight in certain classes, products and geographies from time-to-time based on market opportunities.
Delivering Customized, Innovative and Timely Insurance and Reinsurance Solutions for Our Clients. We aim to be a premier provider of global property and casualty reinsurance and insurance products and aim to provide superior customer service. Our objective is to solidify long-term relationships with brokers and clients while developing an industry reputation for innovative and timely quotes for difficult technical risks.
Property and Casualty Insurance and Reinsurance
Property and casualty insurers write insurance policies in exchange for premiums paid by the policyholder. An insurance policy is a contract between the insurance company and the policyholder whereby the insurance company agrees to pay for losses suffered by the policyholder that are covered under the contract. Property insurance typically covers the financial consequences of accidental losses to the policyholders property. Casualty insurance typically covers the financial consequences of losses to a third party that are the direct result of unforeseen accidents.
Property and casualty reinsurers assume, from insurance and reinsurance companies (referred to as ceding companies), all or a portion of the insurance risks that the ceding company has underwritten under one or more insurance policies. In return, the reinsurer receives a premium for the risks that it assumes from the ceding company. Reinsurance, however, does not discharge the ceding company from its liabilities to policyholders. Reinsurance can benefit a ceding company in a number of ways, including reducing exposure on individual risks, providing catastrophe protections from larger or multiple losses and assisting in maintaining acceptable capital levels as well as financial and operating ratios. Reinsurance can also provide a ceding company with additional underwriting capacity permitting it to accept larger risks and or write more business than would be possible without an accompanying increase in its capital or surplus. Reinsurers may also purchase reinsurance, known as retrocessional reinsurance, to cover their own risks assumed from ceding companies. Reinsurance companies often enter into retrocessional agreements for many of the same reasons that ceding companies enter into reinsurance agreements.
Insurance and reinsurance companies derive substantially all of their revenues from earned premiums, net investment income and net gains and losses from investment securities. Earned premiums represent premiums received from policyholders and ceding companies, which are recognized as revenue over the period of time that coverage is provided (i.e., ratably over the life of the policy). In insurance and reinsurance operations, float arises when premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money and earns investment income and may generate investment gains and losses.
Insurance and reinsurance companies incur a significant amount of their total expenses from policyholder and reinsured losses, commonly referred to as claims. In settling claims, various loss adjustment expenses (LAE) are incurred, such as claim adjusters fees and litigation expenses. In addition, insurance and reinsurance companies incur policy acquisition expenses, such as commissions paid to agents and brokers and premium and excise taxes.
A widely-used measure of relative underwriting performance for an insurance or reinsurance company is the combined ratio. Our combined ratio is calculated by adding the ratio of incurred losses and LAE to earned premiums (known as the loss ratio) and the ratio of policy acquisition and other underwriting expenses to earned premiums (known as the expense ratio), each computed based on our losses and LAE, underwriting expenses and earned premiums, determined in accordance with generally accepted accounting principles in the U.S. (GAAP combined ratio). A GAAP combined ratio under 100% indicates that an insurance or reinsurance company is generating an underwriting profit. A GAAP combined ratio over 100% indicates that an insurance or reinsurance company is generating an underwriting loss.
Insurance and reinsurance operations generate float which, in turn, generates investment income and investment gains and losses. As such, insurance and reinsurance companies operating at a GAAP combined ratio of greater than 100% can be profitable when considering investment income and investment gains or losses. The length of time between receiving premiums and paying out claims, commonly referred to as the tail, affects how profitable float can be. Long-tail losses, such as product liability, pay out over longer periods of time providing the insurance or reinsurance company the opportunity to generate significant investment earnings from its float. Short-tail losses, such as fire or physical damage, pay out over shorter periods of time providing the insurance or reinsurance company with little opportunity to generate significant investment earnings from its float.
Our Business Focus
Underwriting and Risk Strategy
Our primary focus is on short-tail property treaty reinsurance, written on both an excess of loss and proportional basis. We also underwrite certain direct insurance and casualty specialty risks.
Prior to 2007, we operated from a single seat of operations in Bermuda. During 2007 we expanded our underwriting platform to include the U.S., the U.K. and Europe.
Across all our locations and classes of business our operating strategy is to write only those risks which we expect will generate an acceptable return on allocated capital while seeking to limit our exposure to the potential loss that may arise from a single or a series of catastrophic events to within acceptable levels.
Coverage, Risk Selection and Exposure
Our insurance and reinsurance underwriting teams work with proprietary risk analytic and exposure databases which have been designed to provide consistent pricing, prudent risk selection and real-time portfolio management. Our underwriters adhere to guidelines established by senior management, as approved by the Underwriting Committee of our Board of Directors, and seek to: (i) limit the scope of coverage on regular property classes to traditional perils and generally exclude perils or causes of loss that are difficult to measure such as cyber risks, pollution and nuclear, biological and chemical acts of terrorism; (ii) entertain difficult risks such as terrorism but only on a specific basis when the risk is adequately priced and exposures are controlled through limits, terms and conditions; (iii) generally exclude single risk exposures from catastrophe and retrocessional business; and (iv) use risk assessment models to assist in the underwriting process and to quantify our catastrophe aggregate exposures.
Reinsurance Modeling and Pricing
In the case of our reinsurance pricing and underwriting process, we also assess a variety of other factors, including, but not limited to: (i) the reputation of the ceding company and the likelihood of establishing a long-term relationship with them; (ii) the geographical location of the ceding companys original risks; (iii) the historical loss data of the ceding company and, where available, of the industry as a whole in the relevant regions, in order to compare the ceding companys historical catastrophe loss experience to industry averages; and (iv) the perceived financial strength of the ceding company.
Historically in the reinsurance market, one lead reinsurer would act as the principal underwriter in terms of negotiating principal policy terms and pricing of reinsurance contracts with a broker. In the current environment, a consensus of price and terms is produced from a select group of reinsurers which collectively act as the lead underwriter. Our financial strength and the experience and reputation of our underwriters permits us to play an active role in this process. We believe this provides us with greater access to preferred risks and greater influence in negotiation of policy terms, attachment points and premium rates than many other reinsurers.
We have developed a sophisticated proprietary modeling tool to analyze and manage the reinsurance exposures we assume from cedants, called CATM. This computer-based underwriting system, the technical components of which incorporate the fundamentals of modern portfolio theory, is designed to measure the amount of capital required to support individual contracts based on the degree of correlation between contracts that we underwrite as well as other factors. CATM consists of a set of risk assessment tools which estimate the amount of loss and volatility associated with the contracts we assume. CATM is designed to use output from models developed by our actuarial team as well as from those of commercial vendors. In addition, CATM serves as an important component of our corporate enterprise risk model which we use as a guide in managing our exposure to liability, asset and business risk.
Whereas a principal focus of our Bermuda underwriters is to underwrite large U.S. and international catastrophe risks, the goal of our newly established U.K. syndicate underwriting team is to focus primarily on non-catastrophe exposures, remaining within Montpelier Res core competency of underwriting short-tailed accounts, but tapping directly into the London and regional European markets through the establishment of a local presence.
Syndicate 5151 aims to underwrite a book of non-marine property and engineering classes, and a limited amount of specialty casualty business, with a view to capturing new business that would not normally find its way to our Bermuda underwriters. Syndicate 5151s focus may change from-time-to-time based on market opportunities.
MEAG, our Swiss approved Lloyds Coverholder for Syndicate 5151, seeks to produce to the Syndicate and to Montpelier Re catastrophe, risk excess of loss and pro rata business from within Continental Europe and Middle Eastern markets that would not otherwise find its way into either Lloyds or Bermuda.
MUI, our U.S. approved Lloyds Coverholder for Syndicate 5151, underwrites both reinsurance and insurance business. Currently MUIs reinsurance business is produced through three underwriting divisions as follows:
MUIs insurance business targets managing general agents and program business. MUIs approach is to identify, develop and manage underwriters who have demonstrated expertise in their specific segments. Despite the fact that the underwriting of these programs is outsourced, the management and administration of this business is fully retained by MUI.
MUSIC, our newly acquired U.S. excess and surplus lines insurer, writes insurance risks that do not conform to normal underwriting patterns for standard lines. These risks are written through select general agents and brokers enabling MUSIC to capitalize on the underwriting expertise, and the territorial and product knowledge of the producer. These risks require specialized treatment with respect to coverage, forms, price and other policy terms. Generally, MUSIC targets smaller commercial property and casualty risks that are not subject to extreme competitive pressures. Limited binding authority is granted to general agents for low to medium hazard risks with low severity exposure. Business with medium to high hazard risks and with low frequency and high severity exposure to loss is written through MUSICs underwriters.
The majority of our insurance and reinsurance business is originated through third party brokers. Brokers are intermediaries that assist the ceding company in structuring a program to meet their specific reinsurance needs. Once the ceding company has approved the terms of a certain reinsurance program, as quoted by the lead underwriter or a group of reinsurers acting as such, the broker will offer participation to qualified reinsurers until the program is fully subscribed. We seek to build long-term relationships with our brokers by providing: (i) prompt and responsive service on underwriting submissions; (ii) innovative and customized insurance and reinsurance solutions to our clients; and (iii) timely payment of claims. We target brokers that are capable of supplying detailed and accurate underwriting data and can offer us a diverse book of business. Brokers receive compensation in the form of commissions based on negotiated percentages of the premium they produce and performing other necessary services. Broker commissions constitute a significant portion of our total acquisition costs.
The following table sets forth a breakdown of our gross premiums written by broker:
As illustrated above, the majority of our gross premiums written are sourced through a limited number of brokers with Marsh & McLennan Companies, Inc., Benfield Group Limited, Willis Group Holdings Limited and Aon Corporation providing a total of 76.5% of our gross premiums written for the year ended December 31, 2007. As such, we are highly dependent on these brokers and a loss of all or a substantial portion of the business provided by one or more of these brokers could have a material adverse effect on our business.
Reinsurance. The majority of our current book of business is short-tail property reinsurance. We also write a small amount of long-tail reinsurance, mainly casualty risks. The majority of the reinsurance products we currently write are in the form of treaty reinsurance contracts, which are contractual arrangements that provide for the automatic reinsurance of a type or category of risk underwritten by our clients. When we write treaty reinsurance contracts, we do not evaluate separately each of the individual risks assumed under the contracts and are largely dependent on the individual underwriting decisions made by the cedant. Accordingly, we consider the cedants risk management and underwriting practices in deciding whether to provide treaty reinsurance and in appropriately pricing the treaty. We also write a small amount of direct insurance and facultative reinsurance contracts where we reinsure individual risks on a case-by-case basis.
Our reinsurance contracts can be written on either an excess of loss or on a quota share basis, also known as proportional or pro-rata basis. In the case of reinsurance written on an excess of loss basis, we generally receive the premium for the risk assumed and indemnify the cedant against all or a specified portion of losses and expenses in excess of a specified dollar or percentage amount. With quota share reinsurance, we share the premiums as well as the losses and expenses in an agreed proportion with the cedant. In both types of contracts, we may provide a ceding commission to the cedant.
Most of our reinsurance contracts provide protection against sudden catastrophic losses, typically related to natural or man-made catastrophes. The terms of our reinsurance contracts vary by contract and by type, whether they are excess of loss or proportional. Some of our contracts exclude coverage for terrorism, nuclear events and natural perils. Generally, we provide coverage under excess of loss contracts on an occurrence basis or on an aggregate basis. Some contracts also provide coverage on a per risk basis as opposed to a per event basis. Most of our excess of loss contracts provide for a reinstatement of coverage following a covered loss event in return for an additional premium. Many contracts contain cancellation provisions which enable the cedant to cancel the contract in certain circumstances. The most common provisions relate to rating agency downgrades of the Company or certain of its subsidiaries.
We manage certain key risks using a combination of CATM, various third party vendor models and underwriting judgment. Our three-tiered approach focuses on tracking exposed contract limits, estimating the potential impact of a single natural catastrophe event, and simulating our yearly net operating result to reflect aggregate underwriting and investment risk. We seek to refine and improve each of these approaches over time based on operational feedback. Underwriting judgment involves important assumptions about matters that are inherently unpredictable and beyond our control, and for which historical experience and probability analysis may not provide sufficient guidance.
Reinsurance premiums are a function of the number and type of contracts we write, as well as prevailing market prices. Renewal dates for reinsurance business tend to be concentrated at the beginning of quarters, and the timing of premiums written varies by line of business. Most property catastrophe business is written in the January 1, April 1, June 1 and July 1 renewal periods, while the property specialty and other specialty lines are written throughout the year. Written premiums are generally lowest during the fourth quarter of the year. For pro-rata contracts and excess of loss contracts where no deposit premium is specified in the contract, written premium is recognized based on estimates of ultimate premiums provided by the ceding companies. Subsequent adjustments, based on reports of actual premium by the ceding companies, or revisions in estimates, are recorded in the period in which they are determined. Earned premiums do not necessarily follow the written premium pattern as certain premiums written are earned ratably over the contract term, which is ordinarily twelve months, although many pro-rata contracts are written on a risks attaching basis and are generally earned over a 24-month period which is the risk period of the underlying (12 month) policies. Premiums are generally due in installments on an excess of loss basis.
Direct Insurance and Reinsurance. Historically, our direct insurance business consisted solely of a small book of short-tail property insurance business written from Bermuda. Beginning in 2007, through the formation of MUI, Syndicate 5151 and the acquisition of MUSIC, we have expanded our ability to write direct property facultative reinsurance and excess and surplus lines risks. Although our direct insurance represents only a small portion of our current book of business, we expect that these new books of business will gradually become a greater portion of our future business.
Direct property facultative reinsurance involves the selection of individual risks and is characterized by large excess of loss limits and low frequency of losses. We expect to largely underwrite non-catastrophe property business in this manner. Brokered property facultative reinsurance involves proportional, primary or low excess of loss positions. We expect to largely underwrite property catastrophe business in this manner.
Excess and surplus lines insurance arises from a segment of the insurance market that allows customers to buy property and casualty insurance through the non-admitted market. It grew out of the need for insurance coverage which standard carriers (or admitted carriers) elect not to cover for a variety of reasons. The excess and surplus lines market is not subject to the strict pricing and form regulations applicable to the admitted insurance market, allowing us to tailor insurance contracts for our customers.
In the normal course of our business, we purchase reinsurance from third parties in order to manage our exposures. All of our reinsurance purchases to date have represented prospective cover; meaning that the coverage has been purchased to protect us against the risk of future losses as opposed to covering losses that we have already incurred but have not yet paid. The majority of our reinsurance contracts are excess of loss contracts covering one or more lines of business. To a lesser extent, we have also purchased quota share reinsurance with respect to specific lines of our business. We also purchase industry loss warranty policies which provide us with coverage for certain losses we incur provided they are triggered by events exceeding a specified industry loss size. In addition, for certain pro-rata contracts that we enter into, the associated direct insurance contracts carry underlying reinsurance protection from third party reinsurers, known as inuring reinsurance, which we net against our gross premiums written.
We remain liable for losses we incur to the extent that any third-party reinsurer or other obligor fails to meet our obligations and, with respect to certain contracts that carry underlying reinsurance protection, we remain liable in the event that the ceding companies are unable to collect amounts due from underlying third party reinsurers.
We generally require our reinsurers to be rated A- (Excellent) or better by A.M. Best at the time the policy is written. We consider reinsurers that are not rated A- or better by A.M. Best on a case-by-case basis, often requiring collateral up to policy limits, net of any premiums owed. We monitor the financial condition and ratings of our reinsurers on an ongoing basis.
Our claims personnel administer claims arising from our insurance and reinsurance contracts, including validating and monitoring claims, posting case reserves and approving payment of claims. Authority for establishing reserves and payment of claims is based upon the level and experience of claims personnel.
Our reinsurance claim specialists work closely with our brokers to obtain specific claims information from ceding companies. In addition, when necessary, we perform on-site claims reviews of the claims handling abilities and reserving techniques of ceding companies. The results of such claims reviews are shared with our underwriters and actuaries to assist them in pricing products and establishing loss reserves.
As a reinsurer, we recognize that fair interpretation of our reinsurance agreements and timely payment of covered claims is a valuable service to our clients and enhances our reputation.
Loss and LAE Reserves
Our loss and LAE reserves are estimates of the future amounts needed to pay claims and related expenses for insured events that have occurred. We utilize a reserving methodology that calculates a point estimate for our ultimate losses. Our internal actuaries review our reserving assumptions and our methodologies on a quarterly basis. Our third quarter and year-end loss estimates are subject to a corroborative review by independent actuaries using generally accepted actuarial principles. The Audit Committee of our Board of Directors also reviews our quarterly and annual reserve analyses.
Our loss and LAE reserves include both a component for outstanding case reserves for claims which have been reported and a component for incurred but not reported losses (IBNR). Our case reserve estimates are initially set on the basis of loss reports received from third parties. IBNR consists of a provision for additional development in excess of the case reserves reported by ceding companies, as well as a provision for claims which have occurred but which have not yet been reported to us by ceding companies.
Loss reserve calculations for insurance and reinsurance companies are not precise in that they must deal with the inherent uncertainty of future contingent events. Estimating loss reserves requires us to make assumptions regarding future reporting and development patterns, frequency and severity trends, claims settlement practices, potential changes in the legal environment and other factors such as demand surge and inflation.
We believe that our loss and LAE reserves are sufficient to cover losses that fall within our assumed coverages. However, there can be no assurance that actual losses will not exceed our total established reserves. Our loss and LAE reserve estimates and our methodology of estimating such reserves are regularly reviewed and updated as new information becomes known. Any resulting adjustments are reflected in income in the period in which they become known.
We currently operate through two operating segments, our Rated Reinsurance and Insurance Business and our Collateralized Property Catastrophe Retrocessional Business.
Our Rated Reinsurance and Insurance Business segment, which consists of the operations of the Company and its wholly-owned subsidiaries (including our insurance and reinsurance operating subsidiaries Montpelier Re, Syndicate 5151 and MUSIC), relies on its financial strength ratings to provide assurance to customers that we will be able to honor our insurance and reinsurance obligations. During the years ended December 31, 2007, 2006 and 2005, our Rated Reinsurance and Insurance Business wrote 93.5%, 87.0% and 100.0% of our total gross premiums, respectively, and earned 88.9%, 87.5% and 100.0% of our total net premiums, respectively.
Within our Rated Reinsurance and Insurance Business reporting segment we write the following three lines of business:
· Our Property Catastrophe lines principally include all risk protections against losses from earthquakes and hurricanes, as well as other natural or man-made catastrophes such as floods, tornados, fires and storms. Our Property Catastrophe lines also include Property Catastrophe retrocessional contracts, which are catastrophe reinsurance protections of other reinsurers, also called retrocedants. However, from January 2006 through June 2007, a substantial amount of our Property Catastrophe retrocessional business was written within our Collateralized Property Catastrophe Retrocessional Business segment.
· Our Property Specialty lines include risk excess of loss, property pro-rata and direct insurance and facultative reinsurance.
· Other Specialty lines include aviation, marine, personal accident catastrophe, workers compensation catastrophe, terrorism, other casualty and other reinsurance business.
Previously, we provided whole account quota share reinsurance, or Qualifying Quota Share reinsurance, to three Lloyds syndicates for the 2002 and 2003 underwriting years. All of these agreements were commuted in 2005 and 2006.
Our Collateralized Property Catastrophe Retrocessional Business, which consists solely of the operations of Blue Ocean, does not operate with a financial strength rating and, instead, collateralizes its reinsurance obligations to provide assurance to customers that Blue Ocean Re will be able to honor its reinsurance obligations. Blue Ocean was formed in the fourth quarter of 2005 and began writing Property Catastrophe retrocessional business effective January 1, 2006. During the years ended December 31, 2007 and 2006, our Collateralized Property Catastrophe Retrocessional Business wrote 6.5% and 13.0% of our total gross premiums, respectively, and earned 11.1% and 12.5% of our total net premiums, respectively.
During 2007, Blue Ocean began returning capital to its shareholders. Blue Ocean Re did not bind any new reinsurance contracts during the second half of 2007 and is not currently expected to write any new business during 2008. As of December 31, 2007, Blue Ocean Re had a remaining unearned premium reserve of $3.0 million.
During 2008, we expect to revise our reportable operating segments as the insurance and reinsurance initiatives we have undertaken in 2007 gain significance.
Rated Reinsurance and Insurance Business
Lines of Business
We write the following lines of business within our Rated Reinsurance and Insurance segment:
Our Property Catastrophe reinsurance contracts are typically all risk in nature, providing protection to the ceding company against losses from earthquakes and hurricanes, as well as other natural and man-made catastrophes such as floods, tornados, fires and storms. The predominant exposures covered by these contracts are losses stemming from property damage and business interruption coverage resulting from a covered peril.
Our Property Catastrophe reinsurance contracts are generally written on an excess of loss basis, which provides coverage to the ceding company when aggregate claims and claim expenses from a single occurrence from a covered peril exceed a certain amount specified in a particular contract. Under these contracts, we provide protection to an insurer for a portion of the total losses in excess of a specified loss amount, up to a maximum amount per loss specified in the contract. In the event of a loss, most of our Property Catastrophe contracts provide the ceding company with the opportunity for reinstatement of coverage upon the receipt of a reinstatement premium. The coverage provided under excess of loss reinsurance contracts may be on a worldwide basis or limited in scope to specific regions or geographical areas. Coverage can also vary from all property perils, which is the most expansive form of coverage, to more limited coverage of specified perils such as windstorm only coverage.
We write retrocessional coverage contracts, which provide reinsurance protection to retrocedants. Retrocessional coverage generally provides catastrophe protection for the property portfolios of other reinsurers. Retrocessional contracts protect against concentrations of exposures written by retrocedants, which in turn may experience an aggregation of losses from a single catastrophic
event. In addition, the information available to retrocessional underwriters concerning the original primary risk is typically less precise than the information received directly from primary companies. Exposures from retrocessional business can also change within a contract term as the underwriters of a retrocedant may alter their book of business after retrocessional coverage has been bound. From January 1, 2006 through June 30, 2007, a significant portion our Property Catastrophe retrocessional business was written within our Collateralized Property Catastrophe Retrocessional Business segment.
We write Property Specialty insurance and reinsurance contracts that cover risk excess of loss, property pro-rata and direct insurance and facultative reinsurance. Risk excess of loss reinsurance protects the ceding company on its primary insurance risks and facultative reinsurance transactions on a single risk basis. A risk in this context might mean the insurance coverage on one building or a group of buildings or the insurance coverage under a single policy which the reinsured treats as a single risk. Such property risk coverages are written on an excess of loss basis, which provide the reinsured protection beyond a specified amount up to the limit set within the reinsurance contract. Coverage is usually triggered by a large loss sustained by an individual risk rather than by smaller losses which fall below the specified retention of the reinsurance contract.
We also write direct insurance and facultative reinsurance coverage on commercial property risks where we assume all or part of a risk under a single insurance contract. We generally write such coverage on an excess of loss basis. Facultative reinsurance is normally purchased by clients where individual risks are not covered by their reinsurance treaties, for amounts in excess of the dollar limits of their reinsurance treaties, or for unusual risks.
We also write property pro-rata reinsurance contracts which are reinsurances of individual property risks written on a proportional basis rather than on an excess of loss basis.
We write Other Specialty risks such as aviation liability, aviation war, marine, personal accident catastrophe, workers compensation, terrorism, casualty and specialty reinsurance business. Aviation contracts are primarily written on a retrocessional excess of loss basis. We write stand-alone terrorism coverage on a direct basis and through reinsurance treaties. Beginning in 2006, we significantly reduced our catastrophe-exposed offshore marine class of business.
Coverage for workers compensation and personal accident catastrophe contracts are generally written to respond to losses in which a minimum of two insured persons are involved in the same event. However, we tend to attach at the upper layers of reinsurance programs where significantly more insured persons would need to be involved in the same event. We therefore regard our workers compensation and personal accident classes as catastrophe exposed and relatively short-tail in nature.
Our casualty portfolio of risks focuses on selected classes, with an emphasis on medical malpractice and casualty clash excess of loss reinsurance business. Although we do write excess hospital treaty reinsurance, our medical malpractice book is biased towards excess physicians treaty reinsurance, generally single state insurers. In addition, we write a limited amount of auto liability coverage and errors and omissions business, on an excess of loss basis, and two quota share treaties covering auto liability and commercial general liability for municipalities in the U.S. Although we do write casualty clash excess of loss business when conditions are favorable, we do not have any casualty clash business within our current in-force book.
We have written a number of insurance and reinsurance contracts providing coverage for losses arising from acts of terrorism. Most of these contracts exclude coverage protecting against nuclear, biological or chemical attacks. Losses arising from acts of terrorism are typically covered on a limited basis, for example, where the covered risks fall below a stated insured value or into classes or categories we deem less likely to be targets of terrorism than others or where an act of terrorism does not meet the definition of act of terrorism set forth in the Terrorism Risk Insurance Act of 2002 (TRIA). TRIA was enacted to ensure the availability of insurance coverage for certain types of terrorist acts in the U.S. TRIA established a federal assistance program to help insurers and reinsurers in the property and casualty insurance industry cover claims related to future terrorism losses and regulates the terms of insurance relating to terrorism coverage. In December 2007, the Terrorism Risk Insurance Program Reauthorization Act of 2007 (TRIPRA) was enacted which extended the programs expiration from December 31, 2007 to December 31, 2014. In addition, TRIPRA eliminated the distinction between domestic and foreign acts of terrorism and retained the insurer deductible level of 20% of direct earned premium for insured losses.
We write specialty reinsurance on an opportunistic basis. We target short-tail lines of business, often with low frequency, high severity profiles similar to catastrophe business. We also seek to manage the correlations of this business with property catastrophe through the use of CATM.
The following table sets forth a breakdown of our gross premiums written by line of business within our Rated Reinsurance and Insurance segment:
Gross Premiums Written by Geographic Area of Risks Insured
The following table sets forth a breakdown of our gross premiums written by geographic area of risks insured within our Rated Reinsurance and Insurance segment:
(1) Worldwide comprises insurance and reinsurance contracts that insure or reinsure risks in more than one geographic area and do not specifically exclude the U.S. and Canada.
(2) Worldwide, excluding U.S. and Canada comprises insurance and reinsurance contracts that insure or reinsure risks in more than one geographic area but specifically exclude the U.S. and Canada.
We seek to diversify our exposure across geographic zones around the world in order to obtain a prudent spread of risk. The spread of these exposures is also a function of market conditions and opportunities.
Reinsurance contracts do not discharge ceding companies from obligations to their policyholders. Therefore, ceding companies often require their reinsurers to have, and to maintain, strong financial strength ratings as assurance that their claims will be paid. Montpelier Re, Syndicate 5151 and MUSIC each maintain financial strength ratings, as discussed below, from one or more rating agencies, including A.M. Best, Standard & Poors, Moodys Investor Services and Fitch Ratings Ltd.
The financial strength ratings of our rated insurance and reinsurance businesses stated below are not evaluations directed to the investment community with regard to our common shares or debt securities or a recommendation to buy, sell or hold such securities. Our financial strength ratings may be revised or revoked at the sole discretion of the independent rating agencies.
Montpelier Re is currently rated A- by A.M. Best (Excellent, with a stable outlook), A- by Standard & Poors (Strong, with a negative outlook), Baa1 by Moodys Investors Services (Adequate, with a stable outlook) and A- by Fitch Ratings Ltd. (Strong, with a stable outlook). A- is the fourth highest of fifteen A.M. Best financial strength ratings, A- is the seventh highest of twenty-one Standard & Poors financial strength ratings, Baa1 is the eighth highest of twenty-one Moodys Investors Services financial strength ratings and A- is the seventh highest of twenty-four Fitch Ratings Ltd. financial strength ratings.
Montpelier Res ability to underwrite business is dependent upon the quality of its claims paying and financial strength ratings as evaluated by these independent rating agencies. In the event that Montpelier Re is downgraded below A- by Standard & Poors or A.M. Best, we believe our ability to write business through Montpelier Re would be adversely affected. In the normal course of business, we evaluate Montpelier Res capital needs to support the volume of business it writes in order to maintain its claims paying and financial strength ratings. We regularly provide financial information to rating agencies to both maintain and enhance Montpelier Res existing ratings.
A downgrade of Montpelier Res A.M. Best financial strength rating below B++ would constitute an event of default under our letter of credit and revolving credit facility with Bank of America, N.A. and our Lloyds standby letter of credit facility with The Royal Bank of Scotland and a downgrade by A.M. Best or Standard & Poors could trigger provisions allowing some ceding companies to opt to cancel their reinsurance contracts with us. Either of these events could reduce our financial flexibility.
Syndicate 5151, as is the case with all Lloyds syndicates, benefits from Lloyds central resources, including the Lloyds brand, its network of global licences and the Lloyds Central Fund. The Lloyds Central Fund is available at the discretion of the Council of Lloyds to meet any valid claim that cannot be met by the resources of any member. As all Lloyds policies are ultimately backed by this common security, the Lloyds single market rating can be applied to all syndicates, including Syndicate 5151. Lloyds is currently rated A by A.M. Best (Excellent, with a stable outlook), A+ by Standard & Poors (Strong, with a stable outlook) and A+ by Fitch Ratings Ltd. (Strong, with a stable outlook). A is the third highest of fifteen A.M. Best financial strength ratings, A+ is the fifth highest of twenty-one Standard & Poors financial strength ratings and A+ is the fifth highest of twenty-four Fitch Ratings Ltd. financial strength ratings.
Since its inception, Syndicate 5151 has ceded 70% of its business to Montpelier Re.
MUSIC is currently rated A- by A.M. Best (Excellent, with a stable outlook). Since its inception, MUSIC has ceded 75% of its business to Montpelier Re. In the event that Montpelier Re is downgraded below A- by A.M. Best, our ability to write business through MUSIC could be adversely affected.
Loss and LAE Reserve Development
We establish loss and LAE reserves which consist of estimates of future amounts needed to pay claims and related expenses for insured events that have occurred. The process of estimating reserves involves a considerable degree of judgment and, as of any given date, is inherently uncertain. See Summary of Critical Accounting Estimates contained in Item 7 herein for a full discussion regarding our loss and LAE reserving process. We do not discount any of our loss and LAE reserves.
The following information presents (i) the loss and LAE reserve development of our Rated Reinsurance and Insurance segment over the preceding seven years (the Loss Table) and (ii) a reconciliation of reserves in accordance with accounting principles and practices prescribed or permitted by insurance authorities (Statutory basis) to such reserves determined in accordance with generally accepted accounting principles in the U.S. (GAAP), each as prescribed by Securities Act Industry Guide No. 6.
As previously mentioned, the Loss Table represents the development of our loss and LAE reserves for 2001 (the date of our inception) through December 31, 2007. This table does not present accident or policy year development data. The top line of the table shows the gross loss and LAE reserves at the balance sheet date for each of the indicated years. This represents the estimated amounts of loss and LAE reserves arising in the current year and all prior years that are unpaid at the balance sheet date, including additional case reserves and IBNR reserves. The table also shows the re-estimated amount of the previously recorded reserves based on experience as of the end of each succeeding year.
The estimate changes as more information becomes known about the frequency and severity of claims for individual years. The cumulative redundancy (deficiency) on net reserves represents the aggregate change to date from the indicated estimate of the gross reserve for claims and claim expenses, net of losses recoverable on the third line of the table. The table also shows the cumulative net paid amounts as of successive years with respect to the net reserve liability.
The Loss Table does not reflect any loss development relating to MUSIC for periods prior to the date we acquired the company. We acquired MUSIC, a shell company with no employees or in force premium, on November 1, 2007 (the MUSIC Acquisition) solely for the purpose of obtaining its multi-state insurance licenses and its excess and surplus lines authorizations. See Acquired Loss Reserves - MUSIC contained in Item 1 herein.
See Managements Discussion and Analysis of Financial Condition and Results of Operations and Summary of Critical Accounting Estimates, each contained herein in Item 7 herein, for an analysis of our aggregate loss and LAE reserves for each of the latest three years, including a discussion of our loss reserve development experienced during those periods.
The following table reconciles our loss and LAE reserves determined on a statutory basis to our loss and LAE reserves determined in accordance with GAAP at December 31, as follows:
(1) Represents adjustments made to add-back reinsurance recoverables included with the presentation of reserves under Statutory accounting.
Acquired Loss Reserves - MUSIC
Prior to the MUSIC Acquisition, MUSIC wrote general liability, commercial auto liability, specialty and umbrella lines of business. From 2003 to 2007 MUSIC did not write any new business and entered into run-off. As of the date of the MUSIC Acquisition, MUSIC had gross loss and LAE reserves of $20.2 million and had both third party and GAINSCO reinsurance recoverables totaling $20.2 million. The gross loss and LAE reserves we acquired are subject to various protective arrangements that we entered into with the MUSIC Acquisition. These protective arrangements were established specifically for the purpose of minimizing our exposure to the past business underwritten by MUSIC and any adverse developments to MUSICs loss reserves as they existed at the time of the acquisition.
As of December 31, 2007, MUSIC had remaining gross loss and LAE reserves relating to business underwritten prior to the MUSIC Acquisition of $16.7 million (the Acquired Reserves). In support of the Acquired Reserves, at December 31, 2007, MUSIC held a trust deposit maintained by GAINSCO (which totaled $11.6 million) and reinsurance recoverable from third party reinsurers rated A- or better in a combined amount exceeding $16.7 million. In addition, MUSIC has received a full indemnification from GAINSCO covering any adverse development from its past business. To the extent that future adverse developments to MUSICs loss reserves relating to business underwritten prior to the MUSIC Acquisition were to exceed the various protective arrangements described above and GAINSCO were unable to honor its Buyers Indemnification, these liabilities would become our responsibility.
Collateralized Property Catastrophe Retrocessional Business
Blue Ocean Re began writing business as of January 1, 2006 and was formed specifically to capitalize on the significant rate increases experienced for property retrocessional coverages following the severe 2005 catastrophe season in a capital efficient manner.
Retrocessional coverage generally provides catastrophe protection for the property portfolios of other reinsurers. Retrocessional contracts typically carry a higher degree of volatility than reinsurance contracts as they protect against concentrations of exposures written by retrocedants, which in turn may experience an aggregation of losses from a single catastrophic event. In addition, the information available to retrocessional underwriters concerning the original primary risk is typically less precise than the information received directly from primary companies. Exposures from retrocessional business can also change within a contract term as the underwriters of a retrocedant may alter their book of business after retrocessional coverage has been bound.
From January 1, 2006 to June 30, 2007, a significant proportion of our property retrocessional business was written through Blue Ocean Re. During the years ended December 31, 2007 and 2006, Blue Ocean Re wrote $42.8 million and $94.8 million of premiums. Blue Ocean Re did not bind any new reinsurance contracts during the second half of 2007and is not currently expected to write any new business during 2008. During 2007, Blue Ocean began returning capital to its shareholders.
As of December 31, 2007 and 2006, we owned 42.2% of Blue Oceans outstanding common shares and 33.6% of Blue Oceans outstanding preferred shares. Blue Ocean is considered a variable interest entity as defined under FIN 46R and is currently consolidated into our financial statements.
Gross Premiums Written by Geographic Area of Risks Insured
The following table sets forth a breakdown of our gross premiums written by geographic area of risks insured within our Collateralized Property Catastrophe Retrocessional segment:
Collateralized Trust Agreements
Blue Ocean Re does not operate with a financial strength rating and, instead, collateralizes its reinsurance obligations through trust funds established for the benefit of ceding companies. As of December 31, 2007 and 2006, Blue Ocean Re held restricted assets in trust consisting of cash and cash equivalents of $35.5 million and $35.5 million, respectively, and fixed maturity investments of $153.7 million and $335.6 million, respectively.
Loss and LAE Reserve Development
During the years ended December 31, 2007 and 2006, Blue Ocean Re did not incur any losses and has not established any loss and LAE reserves.
See Managements Discussion and Analysis of Financial Condition and Results of Operations contained in Item 7 herein for further information concerning our operating segments.
Our investment portfolio is managed by a handful of investment advisors and is structured to support our need for: (i) maximizing our risk-adjusted total return; (ii) adequate liquidity, (iii) financial strength and stability and (iv) regulatory and legal compliance. Our Finance and Risk Committee (the Finance Committee) establishes investment guidelines and monitors our investment activities. These objectives and guidelines stress diversification of risk, capital preservation, market liquidity, and stability of portfolio income. Our investment advisors have the flexibility to invest our assets as they see fit provided that they comply with such objectives and guidelines. The Finance Committee regularly monitors the overall investment results, reviews compliance with our investment objectives and guidelines, and ultimately reports the overall investment results to the Board of Directors. These guidelines specify minimum criteria on the overall credit quality and liquidity characteristics of the portfolio. They also include limitations on the size of certain holdings as well as restrictions on purchasing certain types of securities or investing in certain industries.
The current components of our investment portfolio are as follows:
Fixed Maturities. As a provider of short-tail insurance and reinsurance for losses resulting mainly from natural and man-made catastrophes, we could become liable for significant losses on short notice. As a result, we have structured our fixed maturity investment portfolio with high-quality securities of a short average duration to preserve capital and provide us with adequate liquidity for the settlement of our expected liabilities. As of December 31, 2007, our cash equivalents and fixed maturities had an average credit quality of AA+ and an average duration of 1.5 years. As of December 31, 2007, our fixed maturities comprised 87.4% of our total investment portfolio.
Equity Securities. Over longer time horizons, we believe that modest investments in equity securities will enhance our investment returns without significantly raising the risk profile of the investment portfolio. Our equity investment strategy is to maximize our risk-adjusted total return through investments in a variety of equity and equity-related instruments with a focus on value investing and the preservation of capital. As of December 31, 2007, equity securities comprised 9.3% of our total investment portfolio.
Other Investments. Our other investments currently consist of investments in private placements, limited partnership interests and derivative contracts. As of December 31, 2007, other investments comprised 3.3% of our total investment portfolio and, at December 31, 2007, we had unfunded commitments to invest $39.0 million into three separate private investment funds.
During 2007, we began to modestly increase our exposure to equity securities and other investments in order to increase expected returns. We expect to continue this trend in future periods.
As of January 1, 2007, we adopted Statement of Financial Accounting Standard (FAS) 157 entitled Fair Value Measurements and FAS 159 entitled The Fair Value Option for Financial Assets and Financial Liabilities. As a result, substantially all of our investments are now carried at fair value with changes in fair value being reported as net realized and unrealized gains (losses) in our statement of operations. Prior to the adoption of FAS 157 and FAS 159, our available for sale investments were carried at fair value with changes in fair value being reported as a separate component of shareholders equity, with changes therein reported as a component of other comprehensive income.
Cash and Cash Equivalents
Our cash and cash equivalents consist of cash and fixed income securities with maturities of less than three months from the date of purchase. We maintain a modest amount of cash and cash equivalents at all times in order to be in a position to pay losses that arise on short notice, pay our operating expenses and unfunded obligations and meet other commitments and contingencies. As of December 31, 2007, we held $279.3 million in cash and restricted cash and had $209.4 million of cash equivalents.
See Managements Discussion and Analysis of Financial Condition and Results of Operations contained in Item 7 herein for further information concerning our investment portfolio, our investment results and our liquidity and capital resources.
We compete with major U.S., Bermuda and other international insurers and reinsurers and certain underwriting syndicates and insurers, many of which have greater financial, marketing and management resources than we do. We consider our primary competitors to include: Ariel Reinsurance Ltd., Flagstone Reinsurance Holdings Ltd., IPC Holdings, Ltd., Lancashire Insurance Group, various Lloyds of London syndicates, RenaissanceRe Holdings Ltd. and Validus Holdings, Ltd. Competition varies depending on the type of business being insured or reinsured and whether we are in a leading position or acting on a following basis. We also compete with various capital market participants who offer or access insurance and reinsurance business in securitized form or through special purpose entities or derivative transactions. We also compete with government-sponsored insurers and reinsurers.
Competition in the types of business that we underwrite is based on many factors, including: (i) premiums charged and other terms and conditions offered; (ii) services provided; (iii) financial ratings assigned by independent rating agencies; (iv) speed of claims payment; (v) reputation; (vi) perceived financial strength; and (vii) the experience of the underwriter in the line of insurance or reinsurance to be written.
Increased competition could result in fewer submissions, lower premium rates, and less favorable policy terms, which could adversely impact our growth and profitability. In addition, capital market participants have created alternative products such as catastrophe bonds that are intended to compete with reinsurance products. We are unable to predict the extent to which these new, proposed or potential initiatives may affect the demand for our products or the risks that may be available for us to consider underwriting.
Insurance and reinsurance entities are highly regulated in most countries, although the degree and type of regulation varies significantly from one jurisdiction to another; with reinsurers generally subject to less direct regulation than primary insurers. Montpelier Re and Blue Ocean Re are regulated by the Bermuda Monetary Authority (the BMA), MEAG is regulated by the Swiss Federal Office of Private Insurance, Syndicate 5151, MEAG, MUI and MMSL are regulated by the U.K. Financial Services Authority (the FSA) and the Council of Lloyds and MUSIC is regulated by individual U.S. state insurance commissioners.
Registration. The Insurance Act 1978, as amended, and related regulations (the Insurance Act) regulates the business of Montpelier Re and Blue Ocean Re and provides that no person may carry on an insurance or reinsurance business in or from within Bermuda unless registered as an insurer under the Insurance Act by the BMA. As holding companies, the Company and Blue Ocean are not subject to Bermuda insurance law and regulations. Montpelier Re is registered as a Class 4 insurer and Blue Ocean Re is registered as a Class 3 insurer under the Insurance Act. The BMA, in deciding whether to grant registration, has broad discretion to act as it thinks fit in the public interest. The BMA is required by the Insurance Act to determine whether the applicant is a fit and proper body to be engaged in the insurance business and, in particular, whether it has, or has available to it, adequate knowledge and expertise. In connection with the applicants registration, the BMA may impose conditions relating to the writing of certain types of insurance. Further, the Insurance Act stipulates that no person shall, in or from within Bermuda, act as an insurance manager, broker, agent or salesman unless registered for the purpose by the BMA.
The Insurance Act imposes on Bermuda insurance companies certain solvency and liquidity standards and auditing and reporting requirements. The Insurance Act also grants the BMA powers to supervise, investigate and intervene in the affairs of insurance companies. Certain significant aspects of the Bermuda insurance regulatory framework are set forth below.
Cancellation of Insurers Registration. An insurers registration may be canceled by the BMA on certain grounds specified in the Insurance Act, including failure of the insurer to comply with its obligations under the Insurance Act or if, in the opinion of the BMA, after consultation with the Insurance Advisory Committee, the insurer has not been carrying on business in accordance with sound insurance principles.
Independent Approved Auditor. Every registered insurer must appoint an independent auditor who will annually audit and report on the Statutory Financial Statements and the Statutory Financial Return of the insurer, which in the case of a Class 3 or Class 4 insurer, are required to be filed annually with the BMA. The auditor must be approved by the BMA as the independent auditor of the insurer. If the insurer fails to appoint an approved auditor or at any time fails to fill a vacancy for such auditor, the BMA may appoint an approved auditor for the insurer and shall fix the remuneration to be paid to the approved auditor within fourteen days, if not agreed sooner by the insurer and the auditor. The approved auditor may be the same person or firm which audits the insurers financial statements and reports for presentation to its shareholders.
Loss Reserve Specialist. Each Class 3 and Class 4 insurer is required to submit an annual loss reserve opinion on the adequacy of the loss and loss expense provisions reflected in its Statutory Financial Statements and Statutory Financial Return and other matters required by the BMA when filing the Annual Statutory Financial Return. This opinion must be issued by the insurers approved Loss Reserve Specialist. The Loss Reserve Specialist, who will normally be a qualified casualty actuary, must be approved by the BMA.
Statutory Financial Statements. An insurer must prepare Annual Statutory Financial Statements. The Insurance Act prescribes rules for the preparation and substance of such Statutory Financial Statements (which include, in statutory form, a balance sheet, income statement, and a statement of capital and surplus, and detailed notes thereto). The insurer is required to give detailed information and analyses regarding premiums, claims, reinsurance and investments. The Statutory Financial Statements are not prepared in accordance with GAAP and are distinct from the financial statements prepared for presentation to the insurers shareholders under the Companies Act 1981 of Bermuda, as amended (the Companies Act), which financial statements may be prepared in accordance with GAAP. The insurer is required to submit the Annual Statutory Financial Statements as part of the Annual Statutory Financial Return. The Statutory Financial Statements and the Statutory Financial Return do not form part of the public records maintained by the BMA.
Minimum Solvency Margin. The Insurance Act provides that the statutory assets of an insurer must exceed its statutory liabilities by an amount greater than the prescribed minimum solvency margin which varies with the type of registration of the insurer under the Insurance Act and the insurers net premiums written and loss reserve level. The minimum solvency margin for a Class 4 insurer with respect to its general business is the greatest of $100.0 million, 50% of net premiums written (with a credit for reinsurance ceded not exceeding 25% of gross premiums) and 15% of loss and loss expense provisions and other insurance reserves. The minimum solvency margin for a Class 3 insurer with respect to its general business is the greater of $1.0 million or 20% of the first $6.0 million of net premiums written; if in excess of $6.0 million, the figure is $1.2 million plus 15% of net premiums written in excess of $6.0 million.
Minimum Liquidity Ratio. The Insurance Act provides a minimum liquidity ratio for general business. An insurer engaged in general business is required to maintain the value of its relevant assets as not less than 75% of the amount of its relevant liabilities. Relevant assets include cash and time deposits, quoted investments, unquoted bonds and debentures, first liens on real estate, investment income due and accrued, accounts and premiums receivable, and reinsurance balances receivable.
There are certain categories of assets, which, unless specifically permitted by the BMA, do not qualify as relevant assets, such as unquoted equity securities, investments in and advances to affiliates, and real estate and collateral loans. The relevant liabilities are total general business insurance reserves and total other liabilities less deferred income tax and sundry liabilities (by interpretation, those not specifically defined).
Restrictions on Dividends and Distributions. The Insurance Act mandates certain actions and filings with the BMA if a Class 3 insurer or a Class 4 insurer fails to meet and/or maintain the required minimum solvency margin or minimum liquidity ratio (the Relevant Margins). Both Class 3 insurers and Class 4 insurers are prohibited from declaring or paying any dividends or distributions in breach of the Relevant Margins or if the declaration or payment of such dividend or distribution would cause the insurer to fail to meet the Relevant Margins. If an insurer fails to meet its Relevant Margins on the last day of any financial year, it is prohibited from declaring or paying any dividends or distributions during the next financial year without the approval of the BMA. Further, a Class 4 insurer is prohibited from declaring or paying in any financial year dividends or distributions of more than 25% of its total statutory capital and surplus (as shown on its previous financial years statutory balance sheet) unless it files (at least seven days before payment of such dividends or distributions) with the BMA an affidavit stating that it will continue to meet its Relevant Margins. Class 3 insurers and Class 4 insurers must obtain the BMAs prior approval for a reduction by 15% or more of their total statutory capital as set forth in their previous years financial statements. These restrictions on declaring or paying dividends and distributions under the Insurance Act are in addition to those under the Companies Act which apply to all Bermuda companies.
Annual Statutory Financial Return. Class 3 and Class 4 insurers are required to file with the BMA a Statutory Financial Return no later than four months after the insurers financial year end (unless specifically extended). The Statutory Financial Return includes, among other Items, a report of the approved independent auditor on the Statutory Financial Statements of the insurer; a declaration of the statutory ratios; a solvency certificate; the Statutory Financial Statements themselves; the opinion of the approved Loss Reserve Specialist in respect of the loss and loss expense provisions and, only in the case of Class 4 insurers, certain details concerning ceded reinsurance. The solvency certificate and the declaration of the statutory ratios must be signed by the principal representative and at least two directors of the insurer, who are required to state whether the minimum solvency margin and, in the case of the solvency certificate, the minimum liquidity ratio, have been met, and the independent approved auditor is required to state whether in its opinion it was reasonable for them to so state and whether the declaration of the statutory ratios complies with the requirements of the Insurance Act. Where an insurers accounts have been audited for any purpose other than compliance with the Insurance Act, a statement to that effect must be filed with the Statutory Financial Return.
Supervision, Investigation and Intervention. The BMA may appoint an inspector with extensive powers to investigate the affairs of an insurer if the BMA believes that an investigation is required in the interest of the insurers policyholders or persons who may become policyholders. In order to verify or supplement information otherwise provided to it, the BMA may direct an insurer to produce documents or information relating to matters connected with the insurers business. Moreover, the BMA has the power to appoint professional persons to prepare reports about registered insurers, such as Montpelier Re and Blue Ocean Re. If it appears to the BMA to be desirable in the interests of policyholders, the BMA may also exercise these powers in relation to subsidiaries, parents and other affiliates of registered insurers.
An inspector may examine under oath any past or present officer, employee or insurance manager of the insurer under investigation in relation to its business and apply to the court in Bermuda for an order that other persons may also be examined on any matter relevant to the investigation. It will be the duty of any insurer in relation to whose affairs an inspector has been appointed and of any past or present officer, employee or insurance manager of such insurer, to produce to the inspector on request all books, records and documents relating to the insurer under investigation which are in its or his custody or control and otherwise to give to the inspector all assistance in connection with the investigation which it or he is reasonably able to give.
If it appears to the BMA that there is a risk of the insurer becoming insolvent, or that the insurer is in breach of the Insurance Act or any conditions of its registration under the Insurance Act, the BMA may direct the insurer not to take on any new insurance business; not to vary any insurance contract if the effect would be to increase the insurers liabilities; not to make certain investments; to realize or not to realize certain investments; to maintain in, or transfer to the custody of, a specified bank, certain assets; not to declare or pay any dividends or other distributions or to restrict the making of such payments and/or to limit its premium income and to remove a controller or officer.
In addition to powers under the Insurance Act to investigate the affairs of an insurer, the BMA has also been granted powers, under both the Companies Act and the Insurance Act, to assist other regulatory authorities, including foreign regulatory authorities which have requested assistance in connection with inquiries being carried out by it in the performance of its regulatory functions. The BMAs powers include requiring an insurer (or certain other persons) to furnish information, to produce documents, to attend and answer questions and to give assistance in connection with inquiries. The BMA must be satisfied that the assistance requested by the foreign regulatory authority is for the purpose of its regulatory functions and that the request is in relation to information in Bermuda which a person has in his possession or under his control. The BMA must consider, among other things, whether it is in the public interest to give the information sought. The grounds for disclosure by the BMA to a foreign regulatory authority without consent of the insurer are limited and the Insurance Act provides for sanctions for breach of the statutory duty of confidentiality.
An insurer is required to maintain a principal office in Bermuda and to appoint and maintain a principal representative in Bermuda. For the purpose of the Insurance Act, the principal office of Montpelier Re is at the Companys principal executive offices in Bermuda and its principal representative is Anthony Taylor, its Chief Executive Officer. For purposes of the Insurance Act, the principal office of Blue Ocean Re is at Clarendon House 2 Church Street, Hamilton HM 12, Bermuda and its principal representative is Lal Gunawardene, a director of Blue Ocean Re. Without a reason acceptable to the BMA, an insurer may not terminate the appointment of its principal representative, and the principal representative may not cease to act as such, unless fourteen days notice in writing to the BMA is given of the intention to do so. It is the duty of the principal representative, having formed the view that there is a likelihood of the insurer for which he acts becoming insolvent or its coming to his knowledge, or his having reason to believe that a reportable event has occurred, to orally notify the BMA immediately and, within fourteen days of the relevant view having been formed, to make a report in writing to the BMA setting out all the particulars of the case that are available to him. Examples of such an event include failure by the insurer to comply substantially with a condition imposed upon the insurer by the BMA relating to a solvency margin, a liquidity ratio or other ratio.
Certain Other Bermuda Law Considerations. As exempted companies, the Company, Blue Ocean and their Bermuda subsidiaries are exempt from certain Bermuda laws restricting the percentage of share capital that may be held by non-Bermudians. However, as exempted companies, the Company, Blue Ocean and their Bermuda subsidiaries may not participate in certain business transactions, including (1) the acquisition or holding of land in Bermuda (except that required for their business and held by way of lease or tenancy for terms of not more than 50 years) without required authorization, (2) the taking of mortgages on land in Bermuda to secure an amount in excess of $50,000 without the consent of the Insurance Supervisor, (3) the acquisition of any bonds or debentures secured by any land in Bermuda, other than certain types of Bermuda government securities or securities issued by Bermuda public authorities or, (4) the carrying on of business of any kind in Bermuda, except in furtherance of their business carried on outside Bermuda or under license granted by the Insurance Supervisor. Generally it is not permitted without a special license granted by the Insurance Supervisor to insure Bermuda domestic risks or risks of persons of, in or based in Bermuda.
The Company, Blue Ocean and their Bermuda subsidiaries must comply with the provisions of the Companies Act regulating the payment of dividends or distributions and making distributions from contributed surplus. A company may not declare or pay a dividend, or make a distribution out of contributed surplus, if there are reasonable grounds for believing that: (a) the company is, or would after the payment be, unable to pay its liabilities as they become due; or (b) the realizable value of the companys assets would thereby be less than the aggregate of its liabilities and its issued share capital and share premium accounts.
We participate in the Lloyds market through Syndicate 5151. Syndicate 5151s operations are subject to regulation by the U.K. Financial Services Authority (the FSA) and the Council of Lloyds. The FSA is responsible under the Financial Services and Markets Act 2000 for regulating U.K. insurers. It regulates the Society of Lloyds as well as individual Lloyds managing agents. The Council of Lloyds regulates Lloyds members and Lloyds managing agents.
MCL is the sole corporate member of Lloyds and as such, it provides 100% of the stamp capacity of Syndicate 5151. Stamp capacity for 2007 was £47 million, but is planned to increase to £143 million in 2008, subject to market conditions. Stamp capacity is a measure of the amount of premium a syndicate is authorized to write by Lloyds.
As a corporate member of Lloyds, MCL is bound by the rules of the Society of Lloyds, which are prescribed by Byelaws and requirements made by the Council of Lloyds under powers conferred by the Lloyds Act 1982. These govern MCLs participation in Syndicate 5151 and (among other matters) prescribe its membership subscription, the level of its contribution to the Lloyds Central Fund and the assets it provides to Lloyds in support of its underwriting.
The Council of Lloyds has broad powers to sanction breaches of its rules, including the power to restrict or prohibit a members participation on Lloyds syndicates. In addition, the FSA monitors Lloyds rules to ensure these are adequate to allow the Society of Lloyds to meet its own regulatory obligations to the FSA.
Syndicate 5151 is managed by Spectrum Syndicate Management Limited, a third party Lloyds managing agent based in London. Under the FSAs regulatory regime, managing agents are required, among other matters, to adopt internal systems and controls appropriate to the risks of their business, obtain regulatory approval for those members of staff responsible for performing certain controlled functions and calculate the level of capital required to support the underwriting of the syndicates that they manage. They are also required to conduct their business according to eleven core regulatory principles, to which all firms regulated by the FSA are subject. The FSA and the Council of Lloyds have entered into an agreement by which the Council of Lloyds undertakes primary supervision of managing agents in relation to certain aspects of the FSAs regulatory regime. This arrangement is intended to minimize duplication of supervision.
Each member of Lloyds is required to deposit cash, securities or letters of credit (or a combination of these assets) with Lloyds to support its participation on Lloyds syndicates. These assets are known as members Funds at Lloyds. Members Funds at Lloyds requirements are calculated according to a minimum capital resources requirement, which is assessed at the syndicate level by Lloyds and at the level of the Lloyds market as a whole by the FSA. This requirement is similar in effect to a required solvency margin.
At the syndicate level, managing agents are required to calculate the capital resource requirements of the members of each syndicate they manage. They do this by carrying out a syndicate Individual Capital Assessment (ICA) according to detailed rules prescribed by the FSA. The ICA process evaluates the risks faced by the syndicate, including insurance risk, operational risk, market risk, credit risk, liquidity risk and group risk, and assesses the amount of capital that syndicate members should hold against those risks. Lloyds reviews each syndicates ICA annually and may challenge it. In order to ensure that Lloyds aggregate capital is maintained at a high enough level to support its overall security rating, Lloyds adds an uplift to the capital requirement figure produced by the ICA, the uplift is expected to be 35% on average across the Lloyds market. This uplifted figure is known as a syndicates Economic Capital Assessment (ECA). Lloyds uses the ECA to calculate each syndicate members Funds at Lloyds requirement.
At a Lloyds market level, Lloyds is required to demonstrate to the FSA that each members capital resources requirement is met by that members available capital resources, which for this purpose comprises its Funds at Lloyds, its share of member capital held at syndicate level and the funds held within the Lloyds Central Fund. In this way the FSA monitors the solvency of the Lloyds market as a whole. The Council of Lloyds has wide discretionary powers to regulate members underwriting at Lloyds. It may, for instance, vary the amount of a members Funds at Lloyds requirement (or alter the ways in which those funds may be invested). The exercise of any of these powers may reduce the amount of premium which a member is allowed to accept for its account in an underwriting year and/or increase a members costs of doing business at Lloyds. As a consequence, the members ability to achieve an anticipated return on capital during that year may be compromised.
Each syndicate is required to submit a business plan to Lloyds on an annual basis, which is subject to the review and approval of the Lloyds Franchise Board. The Lloyds Franchise Board is the managing agents principal interface with the Council of Lloyds. The main goal of the Franchise Board is to seek to create and maintain a commercial environment at Lloyds in which underwriting risk is prudently managed while providing maximum long term returns to capital providers.
Lloyds syndicates are treated as annual ventures and members participation on syndicates may change from underwriting year to underwriting year. Ordinarily, a syndicate will accept business over the course of one calendar year (an underwriting year of account), which will remain open for a further two calendar years before being closed by means of reinsurance to close. An underwriting year may be reinsured to close by the next underwriting year of the same syndicate or by an underwriting year of a different syndicate. Lloyds moved to annual accounting on January 1, 2005. Previously, the market operated according to a three-year accounting cycle, so that members were not able to take profits made in an underwriting year until it had been reinsured to close, usually at the end of three years. Now, provided that certain solvency requirements are met, underwriting profits may effectively be taken in part before the year has been reinsured to close. Once an underwriting year has been reinsured to close, Lloyds will release the members Funds at Lloyds provided that these are not required to support the members other underwriting years or to meet a loss made on the closed underwriting year. If reinsurance to close cannot be obtained at the end of an underwriting years third open year (either at all, or on terms that the managing agent considers to be acceptable on behalf of the members participating on that underwriting year), then the managing agent of the syndicate must determine that the underwriting year will remain open. If the managing agent determines to keep the underwriting year open, then the syndicate will be considered to be in run-off, and the Funds at Lloyds of the participating members will continue to be held by Lloyds to support their continuing liabilities unless the members can show that their Funds at Lloyds are in excess of the amount required to be held in respect of their liabilities in relation to that year.
The reinsurance to close of an underwriting year does not discharge participating members from the insurance liabilities they incurred during that year. Rather, it provides them with a full indemnity from the members participating in the reinsuring underwriting year in respect of those liabilities. Therefore, even after all the underwriting years in which a member has participated have been reinsured to close, the member is required to stay in existence and to remain a non-underwriting member of Lloyds. Accordingly, although Lloyds will release members Funds at Lloyds, there nevertheless continues to be an administrative and financial burden for corporate members between the time of the reinsurance to close of the underwriting years on which they participated and the time that their insurance obligations are entirely extinguished. This includes the completion of financial accounts in accordance with the Companies Act 1985 and the submission of an annual compliance declaration to Lloyds.
Underwriting losses incurred by a syndicate during an underwriting year must be paid according to the links in the Lloyds chain of security. Claims must be funded first from the members premiums trust fund (which is held under the control of the syndicate managing agent), second from a cash call made to the corporate name and third from members Funds at Lloyds. In the event that any member is unable to pay its debts owed to policyholders from these assets, such debts may, at the discretion of the Council of Lloyds, be paid by the Lloyds Central Fund.
The Central Fund is funded by an annual levy imposed on members which is determined annually by Lloyds as a percentage of each members underwriting capacity (1% with respect to 2007, 2% with respect to 2008). In addition, the Council of Lloyds has power to call on members to make an additional contribution to the Central Fund of up to 3% of their underwriting capacity each year should it decide that such additional contributions are necessary.
Lloyds also makes other charges on its members and the syndicates on which they participate, including an annual subscription charge (0.5% of underwriting capacity with respect to 2007, 0.5% of written premiums with respect to 2008) and an overseas business charge, levied as a percentage of gross international premiums (that is premiums on business outside the U.K. and the Channel Islands), with the percentage depending on the type of business written. Lloyds also has power to impose additional charges under Lloyds Powers of Charging Byelaw.
Lloyds supervises Coverholders such as MEAG and MUI as part of its statutory role in managing and supervising the Lloyds market. This supervision is carried out through the approval process and then through Lloyds ongoing supervision of all approved Coverholders.
Lloyds also supervises Coverholders since, in many jurisdictions, Lloyds is authorized to operate as a single entity, with a single collective license. Local regulators may require Lloyds to demonstrate that it has control over, and responsibility for, the business carried out under the terms of Lloyds authorization in that jurisdiction.
Nonetheless, the primary responsibility to supervise Coverholders and binding authorities on a day-to-day basis rests with Lloyds managing agents, which in our case is Spectrum.
MUSIC is domiciled in Oklahoma and is eligible to write surplus lines primary insurance in 37 additional jurisdictions of the U.S. MUSIC is subject to the laws of Oklahoma and the surplus lines regulation and reporting requirements of the jurisdictions in which it is eligible to write surplus lines insurance. In accordance with certain provisions of the National Association of Insurance Commissioners (NAIC) Non-Admitted Insurance Model Act, which provisions have been adopted by a number of states, MUSIC has established, and is required to maintain, specified amounts on deposit as a condition of its status as an eligible, non-admitted insurer in the U.S.
The regulation of surplus lines insurance differs significantly from the licensed or admitted market. The regulations governing the surplus lines market have been designed to facilitate the procurement of coverage, through specially licensed surplus lines brokers, for hard-to-place risks that do not fit standard underwriting criteria and are otherwise eligible to be written on a surplus lines basis. Particularly, surplus lines regulation generally provides for more flexible rules relating to insurance rates and forms. However, strict regulations apply to surplus lines placements under the laws of every state, and certain state insurance regulations require that a risk must be declined by up to three admitted carriers before it may be placed in the surplus lines market. Initial eligibility requirements and annual requalification standards apply to insurance carriers writing on a surplus basis and filing obligations must also be met. In most states, surplus lines brokers are responsible for collecting and remitting the surplus lines tax payable to the state where the risk is located. Companies such as MUSIC, which conducts business on a surplus lines basis in a particular state, are generally exempt from that states guaranty fund laws.
Holding Company Regulation. We and MUSIC are subject to regulation under the insurance holding company laws of various jurisdictions. The insurance holding company laws and regulations vary from jurisdiction to jurisdiction, but generally require an insurance holding company, and insurers that are subsidiaries of insurance holding companies, to register with state regulatory authorities and to file with those authorities certain reports, including information concerning their capital structure, ownership, financial condition, certain intercompany transactions and general business operations.
Further, in order to protect insurance company solvency, state insurance statutes typically place limitations on the amount of dividends or other distributions payable by insurance companies. Oklahoma, MUSICs state of domicile, currently requires that dividends be paid only out of earned statutory surplus and limits the annual amount of dividends payable without the prior approval of the Oklahoma Insurance Department to the greater of 10% of statutory capital and surplus at the end of the previous calendar year or 100% of statutory net income from operations for the previous calendar year. These insurance holding company laws also impose prior approval requirements for certain transactions with affiliates. In addition, as a result of our ownership of MUSIC under the terms of applicable state statutes, any person or entity desiring to purchase more than 10% of our outstanding voting securities is required to obtain prior regulatory approval for the purchase.
NAIC Ratios. The NAIC has established 13 financial ratios to assist state insurance departments in their oversight of the financial condition of licensed U.S. insurance companies operating in their respective states. The NAICs Insurance Regulatory Information System (IRIS) calculates these ratios based on information submitted by insurers on an annual basis and shares the information with the applicable state insurance departments. Each ratio has an established usual range of results and assists state insurance departments in executing their statutory mandate to oversee the financial condition of insurance companies. A ratio result falling outside the usual range of IRIS ratios is not considered a failing result; rather unusual values are viewed as part of the regulatory early monitoring system. Furthermore, in some years, it may not be unusual for financially sound companies to have several ratios with results outside the usual ranges. An insurance company may fall out of the usual range for one or more ratios because of specific transactions that are in themselves immaterial. Generally, an insurance company will be subject to regulatory scrutiny if it falls outside the usual ranges with respect to four or more of the ratios.
Risk-Based Capital. The NAIC has implemented a risk-based capital (RBC) formula and model law applicable to all licensed U.S. property/casualty insurance companies. The RBC formula is designed to measure the adequacy of an insurers statutory surplus in relation to the risks inherent in its business. Such analysis permits regulators to identify inadequately capitalized insurers. The RBC formula develops a risk-adjusted target level of statutory capital by applying certain factors to insurers business risks such as asset risk, underwriting risk, credit risk and off-balance sheet risk. The target level of statutory surplus varies not only as a result of the insurers size, but also on the risk profile of the insurers operations. Insurers that have less statutory capital than the RBC calculation requires are considered to have inadequate capital and are subject to varying degrees of regulatory action depending upon the level of capital inadequacy. The RBC formulas have not been designed to differentiate among adequately capitalized companies that operate with higher levels of capital. Therefore, it is inappropriate and ineffective to use the formulas to rate or to rank such companies. MUSIC currently satisfies the RBC formula and exceeds all recognized industry solvency standards.
Legislative and Regulatory Proposals. Government intervention in the insurance and reinsurance markets, both in the U.S. and worldwide, continues to evolve. For example, Florida has enacted recent insurance reforms that have caused a decline in our property catastrophe gross premiums written in recent years. See Risk Factors contained in Item 1A herein. Federal and state legislators have also considered numerous government initiatives. While we cannot predict the exact nature, timing, or scope of other such proposals, if adopted they could adversely affect our business by: (i) providing government supported insurance and reinsurance capacity in markets and to consumers that we target, such as the legislation enacted in Florida in early 2007; (ii) regulating the terms of insurance and reinsurance policies; (iii) impacting producer compensation; or (iv) disproportionately benefitting the companies of one country over those of another.
For example, new federal legislation, the Non-Admitted and Reinsurance Reform Act of 2007 (the NRRA), was passed by the U.S. House of Representatives in June 2007 and has been introduced in the U.S. Senate. If enacted in its current form, the NRRA would, among other things, (i) grant sole regulatory authority with respect to the placement of non-admitted insurance to the policyholders home state, (ii) limit states to uniform standards for surplus lines eligibility in conformity with the NAIC Non-Admitted Insurance Model Act, (iii) establish a streamlined insurance procurement process for exempt commercial purchasers by eliminating the requirement that brokers conduct a due diligence search to determine whether the insurance is available from admitted insurers, (iv) establish the domicile state of the ceding insurer as the sole regulatory authority with respect to credit for reinsurance and solvency determinations if such state is an NAIC-accredited state or has financial solvency requirements substantially similar to those required for such accreditation and (v) require that premium taxes related to non-admitted insurance only be paid to the policyholders home state, although the states may enter into a compact or establish procedures to allocate such premium taxes among the states.
In addition, the Insurance Industry Competition Act of 2007 (the IICA) has been introduced in the U.S. Senate and the U.S. House of Representatives. The IICA, if enacted in its current form, would remove the insurance industrys antitrust exemption created by the McCarran-Ferguson Act, which provides that insurance companies are exempted from federal antitrust law so long as they are regulated by state law, absent boycott, coercion or intimidation. If enacted in its current form, the IICA would, among other things, (i) effect a different judicial standard providing that joint conduct by insurance companies, such as price sharing, would be subject to scrutiny by the U.S. Department of Justice unless the conduct was undertaken pursuant to a clearly articulated state policy that is actively supervised by the state and (ii) delegate authority to the Federal Trade Commission to identify insurance industry practices that are not anti-competitive.
We are unable to predict whether any of the foregoing proposed legislation, or any other proposed laws and regulations will be adopted, the form in which any such laws and regulations would be adopted, or the effect, if any, these developments would have on our operations and financial condition.
As of December 31, 2007, we had 109 full-time employees worldwide. None of our employees are subject to collective bargaining agreements, and we know of no current efforts to implement such agreements. Blue Ocean and Blue Ocean Re have no employees.
Many of Montpelier Res employees, including some of our executive officers, are employed pursuant to work permits granted by Bermuda authorities. These permits expire at various times over the next several years. We have no assurance that these permits would be extended at expiration upon request. The Bermuda government has a policy that limits the duration of work permits to six years, subject to certain exemptions for key employees.
We are subject to the informational reporting requirements of the Securities Exchange Act of 1934 (the Exchange Act). In accordance therewith, we file reports, proxy statements and other information with Securities and Exchange Commission (the SEC). These documents are electronically available at www.montpelierre.bm and www.sec.gov shortly after they are filed with or furnished to the SEC. They are also available to copy or view at the SECs Public Reference Room at 100 F Street NE, Washington, DC 20549. For further information call 1-800-SEC-0330. In addition, our Code of Conduct and Ethics as well as the various charters governing the actions of certain of our Committees of the Board of Directors, including our Audit Committee and our Compensation and Nominating Committee, are available at www.montpelierre.bm. Our website is not part of this report and nothing from our website shall be deemed to be incorporated into this report.
We will provide to any shareholder, upon request and without charge, copies of these documents (excluding any applicable exhibits unless specifically requested). Written or telephone requests should be directed to Investor Relations, Montpelier Re Holdings Ltd., PO Box HM 2079, Hamilton, Bermuda, HM HX, telephone number (441) 297-9570. Additionally, all such documents are physically available at our principal office at 94 Pitts Bay Road, Pembroke, Bermuda, HM 08.
Factors that could cause our actual results to differ materially from those in the forward looking statements contained in this Form 10-K and other documents we file with the SEC are outlined below. Additional risks not presently known to us or that we currently deem immaterial may also impair our business or results of operations. Any of the risks described below could result in a significant or material adverse effect on our results of operations or financial condition.
Risks Related to Our Company
Unpredictable disasters and other catastrophic events could adversely affect our financial condition or results of operations.
We have substantial exposure to losses resulting from natural and man-made disasters and other catastrophic events. Our policies cover unpredictable natural and other disasters, such as hurricanes, windstorms, earthquakes, floods, fires, explosions and terrorism. In recent years, the frequency of major weather-related catastrophes is largely believed to have increased.
The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Increases in the value of insured property, the effects of inflation and changes in cyclical weather patterns may increase the severity of claims from catastrophic events in the future. Claims from catastrophic events could reduce our earnings and cause substantial volatility in our results of operations for any fiscal period and adversely affect our financial condition. Our ability to write new insurance and reinsurance policies could also be impacted as a result of corresponding reductions in our capital.
We manage certain key quantifiable risks using a combination of CATM, various third party vendor models and underwriting judgment. We focus on tracking exposed contract limits, estimating the potential impact of a single natural catastrophe event, and simulating our yearly net operating result to reflect aggregate underwriting and investment risk. Accordingly, if our assumptions are materially incorrect, the losses we might incur from an actual catastrophe could be significantly higher than our expectation of losses generated from modeled catastrophe scenarios and our financial condition and results of operations could be materially and adversely affected.
We may not maintain favorable financial strength ratings which could adversely affect our ability to conduct business.
Third party rating agencies assess and rate the financial strength, including claims-paying ability, of insurers and reinsurers. These ratings are based upon criteria established by the rating agencies and are subject to revision at any time at the sole discretion of the agencies. Some of the criteria relate to general economic conditions and other circumstances outside the rated companys control. Financial strength ratings are used by policyholders, agents and brokers as an important means of assessing the suitability of insurers as business counterparties and have become an increasingly important factor in establishing the competitive position of insurance and reinsurance companies. These financial strength ratings do not refer to our ability to meet non-insurance obligations and are not a recommendation to purchase or discontinue any policy or contract issued by us or to buy, hold or sell our securities.
Rating agencies periodically evaluate us to determine whether we continue to meet the criteria of the ratings previously assigned to us. A downgrade or withdrawal of our financial strength ratings could severely limit or prevent us from writing new insurance or reinsurance contracts or renewing existing contracts, which could have a material adverse effect on our financial condition and results of operations.
In addition, a ratings downgrade by A.M. Best or Standard & Poors could trigger provisions allowing some cedants to opt to cancel their reinsurance contracts with us and a downgrade of Montpelier Res A.M. Best financial strength rating to below B++ would constitute an event of default under certain of our letter of credit and revolving credit facilities. Either of these events could reduce our financial flexibility.
Our current Standard & Poors rating is A- with a negative outlook. The negative outlook qualifier assesses the potential direction of the rating over the intermediate term (typically six months to two years) and indicates that the rating may be lowered, although the outlook is not necessarily a precursor of a rating change or future creditwatch action by Standard & Poors.
We are highly dependent on a small number of insurance and reinsurance brokers for a large portion of our revenues. Additionally, we are subject to credit risk with respect to brokers.
We market our reinsurance worldwide primarily through insurance and reinsurance brokers. The majority of our gross premiums written are sourced through a limited number of brokers with Marsh & McLennan Companies, Inc., Benfield Group Limited, Willis Group Holdings Limited and Aon Corporation providing a total of 76.5% of our gross premiums written for the year ended December 31, 2007. Affiliates of some of these brokers have also co-sponsored the formation of reinsurance companies that directly compete with us, and these brokers may favor those reinsurers over us. A loss of all or a substantial portion of the business provided by one or more of these brokers could have a material adverse effect on our financial condition and results of operations.
We are frequently required to pay amounts owed on claims under our policies to brokers, and these brokers, in turn, pay these amounts to the ceding companies that have reinsured a portion of their liabilities with us. In some jurisdictions, if a broker fails to make such a payment, we might remain liable to the ceding company for the deficiency. In addition, in certain jurisdictions, when the ceding company pays premiums for these policies to brokers, these premiums are considered to have been paid and the ceding insurer is no longer liable to us for those amounts, whether or not we have actually received the premiums.
We may be unable to purchase reinsurance protection to the extent we desire on acceptable terms. Additionally, we may be unable to collect all amounts due from our reinsurers under our existing reinsurance arrangements.
In the normal course of business, we purchase reinsurance from third parties in order to manage our exposures. The availability and cost of reinsurance protection is subject to market conditions, which are outside of our control. As a result, we may not be able to successfully alleviate risk through these arrangements, which could have a material adverse effect on our financial condition and results of operations.
We are not relieved of our obligation to our policyholders or ceding companies by purchasing reinsurance. Accordingly, we are subject to credit risk with respect to our reinsurance protections in the event that a reinsurer is unable to pay amounts owed to us as a result of a deterioration in its financial condition. A number of reinsurers in the industry experienced such a deterioration in the aftermath of the 2001 terrorist attacks and the active 2005 hurricane season.
It is possible that one or more of our reinsurers will be significantly adversely affected by future significant loss events, causing them to be unable to pay amounts owed to us. We also may be unable to recover amounts due under our reinsurance arrangements if our reinsurers choose to withhold payment due to a dispute or other factors beyond our control. Our inability to collect amounts due from our reinsurers could have a material adverse effect on our financial condition and results of operations.
Emerging claims and coverage issues could adversely affect our business.
As industry practices and legal, judicial, social and other environmental conditions change, unexpected and unintended issues related to claims and coverage may emerge. These issues may adversely affect our business by either extending coverage beyond our underwriting intent or by increasing the number or size of claims. In some instances, these changes may not become apparent until some time after we have issued reinsurance contracts that are affected by the changes. In addition, we are unable to predict the extent to which the courts may expand the theory of liability under a casualty insurance contract, such as the range of occupational hazards causing losses under employers liability insurance, thereby increasing our reinsurance exposure.
In addition, coverage disputes are also common within the insurance and reinsurance industries. For example, a reinsurance contract might limit the amount that can be recovered as a result of flooding. However, if the flood damage was caused by an event that also caused extensive wind damage, the quantification of the two types of damage is often a matter of judgment. Similarly, one geographic zone could be affected by more than one catastrophic event. In this case, the amount recoverable from a reinsurer may in part be determined by the judgmental allocation of damage between the storms. Given the magnitude of the amounts at stake involved with a catastrophic event, these types of judgment occasionally necessitate third-party resolution. As a result, the full extent of liability under our reinsurance contracts may not be known for many years after a contract is issued.
Our loss reserves may be inadequate to cover our ultimate liability for losses and LAE and as a result our financial results could be adversely affected.
We maintain reserves to cover our estimated ultimate liabilities for loss and LAE. Loss and LAE reserves are typically comprised of (1) case reserves for losses reported and (2) IBNR reserves for losses that have occurred but for which claims have not yet been reported which include a provision for expected future development on case reserves. These reserves are estimates based on actuarial and statistical projections of what we believe the settlement and administration of claims will cost based on facts and circumstances then known to us. Because of the uncertainties that surround estimating loss and LAE reserves, we cannot be certain that our reserves are adequate and actual claims and claim expenses paid might exceed our reserves due to the uncertainties that surround estimating loss and LAE reserves.
If we determine in the future that our reserves are insufficient to cover our actual loss and LAE, we would have to strengthen our reserves, which could have a material adverse effect on our financial condition and results of operations.
New lines of business we develop through Syndicate 5151 and MUSIC will change the composition of our overall book of business in ways which could adversely impact our financial results.
One of the lines of business that will be pursued by Syndicate 5151 (through MUI) and MUSIC is excess and surplus lines insurance. Excess and surplus lines insurance covers risks that are typically more complex and unusual than standard risks and requires a high degree of specialized underwriting. As such, excess and surplus lines risks do not often fit the underwriting criteria of standard insurance carriers. The business that we intend to underwrite in this market fills the insurance needs of businesses with unique characteristics and is generally considered higher risk than that in the standard market. If our underwriting staff inadequately judges and prices the risks associated with the business underwritten in the excess and surplus lines market, our financial results could be adversely impacted.
Further, the excess and surplus lines market is significantly affected by the conditions of the property and casualty insurance market in general and the cyclical nature can be more pronounced in the excess and surplus market than in the standard insurance market. During times of hard market conditions (i.e., those favorable to insurers), as rates increase and coverage terms become more restrictive, business tends to move from the admitted market back to the excess and surplus lines market and growth in the excess and surplus market can be significantly more rapid than growth in the standard insurance market. When soft market conditions are prevalent, standard insurance carriers tend to loosen underwriting standards and seek to expand market share by moving into business lines traditionally characterized as excess and surplus lines, exacerbating the effect of rates decreases. If we fail to manage the cyclical nature and volatility of the revenues and profit we generate in the excess and surplus lines market, our financial condition and results of operations could be adversely impacted.
The integration of our new insurance and reinsurance initiatives into our existing operations presents significant challenges.
We face significant challenges in integrating our new insurance and reinsurance initiatives into our existing operations in a timely, efficient and effective manner. Successful integration will depend on, among other things, the effective execution of our business plan for the new insurance and reinsurance initiatives, our ability to effectively integrate the operations of our new insurance and reinsurance initiatives into our existing risk management techniques, our ability to effectively manage regulatory issues created by our entry into new markets and geographic locations, our ability to retain key personnel and other operational and economic factors. There can be no assurance that the integration of our new insurance and reinsurance initiatives will be successful or that the business derived therefrom will be profitable. The failure to integrate our new insurance and reinsurance initiatives successfully or to manage the challenges presented by the integration process may adversely impact our financial condition and results of operations.
Our stated catastrophe and enterprise-wide risk management exposures are based on estimates and judgments which are subject to significant uncertainties.
Our approach to risk management relies on subjective variables which entail significant uncertainties. For example, in our treaty reinsurance business, the effectiveness of gross reinsurance contract zonal limits in managing risk depends largely on the degree to which an actual event is confined to the zone in question and our ability to determine the actual location of the risks insured. Moreover, in the treaties we write, the definition of a single occurrence may differ from policy to policy and the legal interpretation of a policys various terms and conditions following a catastrophic event may be different than we envisioned at its inception. For these and other reasons, there can be no assurance that our aggregate gross reinsurance treaty exposure in a single zone, from a single event, will not exceed our reported measure of that zones stated maximum gross treaty contract limit.
Our Natural Catastrophe Risk Management disclosure provided in Item 7 herein involves a substantial number of subjective variables, factors and uncertainties. Small changes in assumptions, which are heavily reliant upon our judgment, can have a significant impact on the modeled output resulting from our internal simulations. Further, these disclosures do not take into account numerous real but non-quantifiable inputs and risks such as the implications of a loss of our financial strength ratings on our business. Although we believe that these probabilistic measures provide a meaningful indicator of the relative riskiness of certain events and changes to our business over time, these measures do not predict our actual exposure to, nor guarantee our successful management of, future losses that could have a material adverse effect on our financial condition and results of operations.
Global financial markets and economic conditions, which may change suddenly and dramatically, could adversely affect our investment income and the value of our investment portfolio.
Our investment portfolio consists of fixed maturity securities, equity securities, other investments including private placements, limited partnerships and derivative contracts. Our primary investment objective is to maximize risk-adjusted total returns while maintaining adequate liquidity. Since investing entails substantial risks, we cannot assure you that we will achieve our investment objectives, and our investment performance may vary substantially over time.
Our investment income and the fair market value of our investment portfolio are affected by fluctuations in interest rates and volatility in the stock market. Interest rates and stock market volatility are sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions and other factors beyond our control. For example, a significant increase in interest rates could result in significant losses in the fair value of our investment portfolio and, consequently, could have an adverse affect on our financial condition and results of operations. In addition, stock market volatility could also have an adverse affect on our financial condition and results of operations.
The fair value and the overall liquidity of our investment portfolio can also be adversely affected by other unfavorable or uncertain economic and market conditions. For example, beginning in the second half of 2007, difficulties in the mortgage and broader credit markets in the U.S. and elsewhere resulted in a sudden decrease in the availability of credit, a corresponding increase in funding costs and an increase in residential mortgage delinquencies and foreclosures. As a result many issuers of such securities, as well as the financial guarantors of such securities, experienced a sudden deterioration in credit quality which caused both a decline in liquidity and prices for these types of securities. We cannot predict how long these conditions will exist and how we might be affected.
We could be adversely affected by the loss of one or more principal employees or by an inability to attract and retain staff.
Our success will depend in substantial part upon our ability to attract and retain our principal employees. As of December 31, 2007, we had 109 full-time employees worldwide upon which we depend for the generation and servicing of our business. Although to date we have generally been successful in recruiting employees in Bermuda, its location may be an impediment to attracting and retaining experienced personnel, particularly if we are unable to secure work permits. In addition, Bermuda is currently a highly-competitive location for qualified staff making it harder to retain employees.
Our future success depends on our ability to hire and retain additional personnel. Difficulty in hiring or retaining personnel could adversely affect our results of operations and financial condition.
As a holding company, we are dependent upon dividends or distributions from our insurance and reinsurance operating subsidiaries.
We are a holding company and, as such, we have no substantial operations of our own. We rely primarily on cash dividends or distributions from our insurance and reinsurance subsidiaries and affiliates to pay our operating expenses, interest on our debt and dividends or distributions to our shareholders. Our insurance and reinsurance operations are highly regulated by various authoritative bodies in Bermuda, the U.K. and the U.S. The various laws and regulations that we are subject to within these jurisdictions limit the declaration and payment of dividends or distributions from our insurance and reinsurance operating subsidiaries and affiliates. In addition, under the Companies Act, the Company and Montpelier Re may only declare or pay a dividend or distribution if, among other matters, there are reasonable grounds for believing that each of them is, or would after the payment be, able to pay their respective liabilities as they become due.
Accordingly, we cannot assure you that we will declare or pay dividends or distributions in the future. Any determination to pay future dividends or distributions will be at the discretion of our Board of Directors and will be dependent upon our results of operations and cash flows, our financial position and capital requirements, general business conditions, legal, tax, regulatory and any contractual restrictions on the payment of dividends or distributions, and any other factors our Board of Directors deems relevant. The inability of our insurance and reinsurance operating subsidiaries and affiliates to pay dividends or distributions in an amount sufficient to enable us to meet our cash requirements at the holding company level could have a material adverse effect on the Company.
Our operating results may be adversely affected by foreign currency fluctuations.
Our functional currency is the U.S. dollar. The British pound is the functional currency for the operations of Syndicate 5151, MCL, MUSL and MMSL and the Swiss franc is the functional currency for the operations of MEAG. In addition, we write a portion of our business, receive premiums and pay losses in foreign currencies and may maintain a portion of our investment portfolio in investments denominated in currencies other than U.S. dollars. We may experience foreign exchange losses to the extent our foreign currency exposure is not successfully managed or otherwise hedged, which in turn could adversely affect our results of operations and financial condition.
Competition could reduce our operating margins.
Competition in the insurance and reinsurance industry has increased as industry participants seek to enhance their product and geographic reach, client base, operating efficiency and general market share through organic growth, mergers and acquisitions, and reorganization activities. As the industry evolves, competition for customers may become more intense and the importance of acquiring and properly servicing each customer will grow. We could incur greater expenses relating to customer acquisition and retention, which could reduce our operating margins.
We currently compete, and will continue to compete, with major U.S. and non-U.S. insurers and reinsurers, many of which have greater financial, marketing and management resources than we have. We also compete with several other Bermuda-based reinsurers that write reinsurance and that target the same market as we do and utilize similar business strategies, and some of these companies currently have more capital than we have. We also compete with capital markets participants such as investment banks and investment funds that access business in securitized form or through special purpose vehicles or derivative transactions, the usage of which continues to grow in volume. As new insurance and reinsurance companies are formed and established competitors raise additional capital, any resulting increase in competition could affect our ability to attract or retain business or to write business at premium rates sufficient to cover losses. If competition limits our ability to write new business and renew existing business at adequate rates, our return on capital may be adversely affected.
Regulation may restrict our ability to operate.
The insurance and reinsurance industry is subject to extensive regulation under Bermuda, U.S., U.K., Swiss and foreign laws. Governmental agencies have broad administrative power to regulate many aspects of the insurance business, which include premium rates, marketing practices, advertising, policy forms and capital adequacy. These governmental agencies are concerned primarily with the protection of policyholders rather than shareholders. Insurance laws and regulations impose restrictions on the amount and type of investments, prescribe solvency standards that must be met and maintained and require the maintenance of reserves.
Changes in laws and regulations may restrict our ability to operate and/or have an adverse effect upon the profitability of our business within a given jurisdiction. For example, in 2007 there were a number of government initiatives in Florida designed to decrease insurance rates in the state. Of most significance to reinsurers was the large increase in the capacity of the Florida Hurricane Catastrophe Fund (FHCF), a state-run reinsurer. We believe the increase in capacity of private reinsurers and the FHCF will cause downward pressure on windstorm catastrophe rates for the foreseeable future, particularly for Florida residential exposures. In addition, state and Federal legislation has been proposed to establish catastrophe funds and underwriting in coastal areas which could adversely impact our business.
Political, regulatory and industry initiatives could adversely affect our business.
The supply of property catastrophe reinsurance coverage decreased due to the withdrawal of capacity and substantial reductions in capital resulting from, among other things, the September 11th terrorist attacks. This tightening of supply resulted in government intervention significantly increasing the governments role in insurance and reinsurance markets at the expense of private markets. TRIA was enacted to ensure the availability of insurance coverage for certain types of terrorist acts in the U.S. This law establishes a federal assistance program to help commercial insurers and reinsurers in the property and casualty insurance industry cover claims related to future terrorism related losses and regulates the terms of insurance relating to terrorism coverage. The enactment of the TRIPRA in December 2007 extended the programs expiration from December 31, 2007 to December 31, 2014.
Similarly, following the 2005 storm season, rates significantly increased which prompted legislative and administrative regulatory actions by the State of Florida in 2006 and 2007. This government intervention and the possibility of future interventions have created uncertainty in the insurance and reinsurance markets. Government regulators are generally concerned with the protection of policyholders to the exclusion of other constituencies, including shareholders of insurers and reinsurers. While we cannot predict the exact nature, timing or scope of possible governmental initiatives, such proposals could adversely affect our business by:
· Providing insurance and reinsurance capacity, in some cases at government-subsidized rates, in markets and to consumers that we target;
· Requiring our participation in industry pools and guaranty associations;
· Expanding the scope of coverage under existing policies;
· Regulating the terms of insurance and reinsurance policies; or
· Disproportionately benefitting the companies of one country over those of another.
The insurance industry is also affected by political, judicial and legal developments that may create new and expanded theories of liability. Such changes may result in delays or cancellations of products and services by insurers and reinsurers, which could adversely affect our business.
Some direct writers are currently facing lawsuits and other actions designed to expand coverage related to hurricane Katrina losses beyond that which those insurers believed they would be held liable for prior to that event. It is impossible to predict what impact similar actions may have on us in the future.
Risks Related to Our Common Shares
Provisions in our charter documents restrict the voting rights of our common shares.
Our bye-laws generally provide that, if any person owns, directly or by attribution, more than 9.5% of our common shares, the voting rights attached to such common shares will be reduced so that such person may not exercise and is not attributed more than 9.5% of the total voting rights.
Bermuda law differs from the laws in effect in the U.S. and may afford less protection to our shareholders.
We are organized under the laws of Bermuda. As a result, it may not be possible for our shareholders to enforce court judgments obtained in the U.S. against us based on the civil liability provisions of the Federal or state securities laws of the U.S., either in Bermuda or in countries other than the U.S. where we have assets. In addition, there is some doubt as to whether the courts of Bermuda and other countries would recognize or enforce judgments of U.S. courts obtained against us or our directors or officers based on the civil liabilities provisions of the Federal or state securities laws of the U.S. or would hear actions against us or those persons based on those laws.
Our corporate affairs are governed by the Companies Act which differs in some material respects from laws generally applicable to U.S. corporations and shareholders, including the provisions relating to interested directors, amalgamations, mergers and acquisitions, takeovers, shareholder lawsuits and indemnification of directors. Generally, the duties of directors and officers of a Bermuda company are owed to the company only. Shareholders of Bermuda companies generally do not have rights to take action against directors or officers of the company and may only do so in limited circumstances. Class actions and derivative actions are generally not available to shareholders under Bermuda law. The Bermuda courts, however, would ordinarily be expected to permit a shareholder to commence an action in the name of a company to remedy a wrong to the company where the act complained of is alleged to be beyond the corporate power of the company or illegal, or would result in the violation of the companys memorandum of association or bye-laws. Furthermore, consideration would be given by a Bermuda court to acts that are alleged to constitute a fraud against the minority shareholders or, for instance, where an act requires the approval of a greater percentage of the companys shareholders than that which actually approved it.
When the affairs of a company are being conducted in a manner that is oppressive or prejudicial to the interests of some shareholders, one or more shareholders may apply to the Supreme Court of Bermuda, which may make such order as it sees fit, including an order regulating the conduct of the companys affairs in the future or ordering the purchase of the shares of any shareholders by other shareholders or by the company. Additionally, under our bye-laws and as permitted by Bermuda law, each shareholder has waived any claim or right of action against our directors or officers for any action taken by directors or officers in the performance of their duties, except for actions involving fraud or dishonesty. In addition, the rights of our shareholders and the fiduciary responsibilities of our directors under Bermuda law are not as clearly established as under statutes or judicial precedent in existence in jurisdictions in the U.S., particularly the State of Delaware. Therefore, our shareholders may have more difficulty protecting their interests than would shareholders of a corporation incorporated in a jurisdiction within the U.S.
Holders of common shares may have difficulty effecting service of process on us or enforcing judgments against us in the U.S.
We are incorporated pursuant to the laws of Bermuda and are based in Bermuda. In addition, certain of our directors and officers reside outside the U.S. and a substantial portion of our assets, and the assets of such persons, are located in jurisdictions outside the U.S. As such, we have been advised that there is doubt as to whether:
· a holder of our common shares would be able to enforce, in the courts of Bermuda, judgments of U.S. courts based upon the civil liability provisions of the U.S. federal securities laws;
· a holder of our common shares would be able to bring an original action in the Bermuda courts to enforce liabilities against us or our directors and officers, as well as the experts named in this Form 10-K, who reside outside the U.S. based solely upon U.S. federal securities laws.
Further, we have been advised that there is no treaty in effect between the U.S. and Bermuda providing for the enforcement of judgments of U.S. courts, and there are grounds upon which Bermuda courts may not enforce judgments of U.S. courts. Because judgments of U.S. courts are not automatically enforceable in Bermuda, it may be difficult for a holder of common shares to recover against us based upon such judgments.
We may require our shareholders to sell us their common shares.
Under our bye-laws and subject to Bermuda law, we have the option, but not the obligation, to require a shareholder to sell some or all of their common shares to us at fair market value (which would be based upon the average closing price of the common shares as defined under our bye-laws) if the Board of Directors reasonably determines, in good faith based on an opinion of counsel, that share ownership, directly, indirectly or constructively by any shareholder is likely to result in adverse tax, regulatory or legal consequences to us, certain of our other shareholders or our subsidiaries.
Risks Related to Taxation
Our Bermuda companies may be subject to U.S. tax.
The Company, Montpelier Re and Blue Ocean Re currently intend to conduct substantially all of their operations in Bermuda in a manner such that they will not be engaged in a trade or business in the U.S. However, because there is no definitive authority regarding activities that constitute being engaged in a trade or business in the U.S. for U.S. federal income tax purposes, there can be no assurance that the Internal Revenue Service will not contend, perhaps successfully, that the Company, Montpelier Re or Blue Ocean Re is engaged in a trade or business in the U.S. A foreign corporation deemed to be so engaged would be subject to U.S. income tax, as well as the branch profits tax, on its income that is treated as effectively connected with the conduct of that trade or business unless the corporation is entitled to relief under a tax treaty.
In addition, Congress has discussed from time-to-time legislation intended to eliminate certain perceived tax advantages of Bermuda insurance companies and U.S. companies having Bermuda affiliates. While currently there is no specific legislative proposal which, if enacted, would adversely affect us or our shareholders, legislative proposals could emerge that could conceivably have an adverse impact on us or our shareholders.
Proposed U.S. tax legislation could adversely affect U.S. shareholders.
Under current U.S. law, non-corporate U.S. holders of our common shares generally are taxed on dividends at a capital gains tax rate rather than ordinary income tax rates. Currently, there is proposed legislation before both Houses of Congress that would exclude shareholders of foreign corporations from this advantageous income tax treatment unless either (i) the corporation is organized or created under the laws of a country that has entered into a comprehensive income tax treaty with the U.S. or (ii) the stock of such corporation is readily tradable on an established securities market in the U.S. and the corporation is organized or created under the laws of a country that has a comprehensive income tax system that the U.S. Secretary of the Treasury determines is satisfactory for this purpose. We would likely not satisfy either of these tests and, accordingly, if this legislation became law, individual U.S. shareholders would no longer qualify for the capital gains tax rate on dividends paid by us.
We may become subject to taxes in Bermuda after 2016, which may have a material adverse effect on our financial condition.
The Bermuda Minister of Finance, under the Exempted Undertaking Tax Protection Act 1966, as amended, of Bermuda, has given us an assurance that if any legislation is enacted in Bermuda that would impose tax on profits or income, or computed on any capital asset, gain or appreciation, or any tax in the nature of estate duty or inheritance tax, then the imposition of any such tax will not be applicable to us or any of our operations or our shares, debentures or other obligations until March 28, 2016. We cannot assure you that we will not be subject to any Bermuda tax after that date.
Item 1B. Unresolved Staff Comments
As of the date of this report, we had no unresolved comments from the Commission staff regarding our periodic or current reports under the Exchange Act.
Item 2. Properties
We lease office space in Hamilton, Bermuda, where our principal executive offices are located. We also lease office space in London, U.K., where MCL, MMSL and MUSL are located; in Zug, Switzerland, where MEAG is located; in Hartford, CT, Overland Park, KS, Stamford, CT and Shelton, CT where MUI is located; in Scottsdale, AZ where MUSIC is located; in Hanover, NH where MTR is located; and Toronto, Canada, where our disaster recovery center is located.
We believe our facilities are adequate for our current needs.
Item 3. Legal Proceedings
We are subject to litigation and arbitration proceedings in the normal course of our business. Such proceedings generally involve reinsurance contract disputes which are typical for the property and casualty insurance and reinsurance industry in general and are considered in connection with our net loss and loss expense reserves.
On October 17, 2007, following the failure of contractually-mandated mediation, we received a notice of arbitration from Manufacturers Property and Casualty Limited (MPCL), a subsidiary of Manulife Financial Corporation of Toronto, Canada (Manulife). The notice involves two contracts pursuant to which we purchased reinsurance protection from MPCL (the Disputed Contracts). Although the grounds for relief are not stated in the notice, MPCL seeks thereby to rescind, in whole or in part, the Disputed Contracts, and seeks further relief, including but not limited to attorneys fees, interest, costs and bad faith damages.
Subject to purported reservation of rights, MPCL has to-date paid to us $25.0 million in respect of ceded claims under the Disputed Contracts, which is net of deposit, reinstatement and additional premiums.
In the event that MPCL is awarded rescission of the Disputed Contracts, the reduction in our total losses expected to be ceded under the Disputed Contracts, net of reinsurance premiums earned and accrued, would total $73.0 million.
We believe that MPCLs case is without merit and that the Disputed Contracts are fully enforceable. In the circumstances, we believe that the results of the arbitration will not have a materially adverse effect on our financial condition, results of operations or cash flows.
The arbitration is expected to commence during the first half of 2008.
Other than the contract dispute with MPCL described above, we had no other potentially material litigation or arbitration proceedings at December 31, 2007.
There were no matters submitted to a vote of our shareholders during the fourth quarter of 2007.
Market Information, Registered Holders and Dividends and Distributions on Common Shares and Warrants
Our common shares are listed on the New York Stock Exchange (symbol MRH). The quarterly range of the high and low sales price for our common shares during 2007 and 2006 is presented below:
As of February 27, 2008, we had 49 registered holders of our common shares, par value 1/6 cent per share.
During 2007 and 2006 we declared and paid regular cash dividends and distributions on our common shares and warrants to acquire common shares (during periods in which the warrants were outstanding) of $.075 per quarter.
Issuer Purchases of Common Shares
The following table provides information with respect to purchases of our common shares during the three months ended December 31, 2007:
(a) On July 26, 2007, the Board of Directors authorized the purchase up to $100.0 million of our common shares from time-to-time. Shares may be purchased in the open market or through privately negotiated transactions. As of December 31, 2007, we had remaining authority to purchase up to $36.3 million of our common shares.
Securities Authorized for Issuance Under Equity Compensation Plans
The following table provides information as of December 31, 2007 with respect to our equity compensation plans.
(1) The Montpelier Long Term Incentive Plan (the LTIP) is the Companys primary long-term incentive plan and was approved by shareholders in May 2007. Incentive awards that may be granted under the LTIP consist of share appreciation rights, RSUs and performance shares. LTIP awards outstanding at December 31, 2007, consisted of 335,000 performance shares at target and 1,109,083 restricted share units (RSUs).
At target payout, each performance share represents the fair value of a common share. At the end of a performance period, which is generally the three-year period following the date of grant, participants may receive a harvest of between zero and 200% of the performance shares granted depending on the achievement of specific performance criteria relating to our operating and financial performance over the period. At the discretion of our Compensation and Nominating Committee, any final payment in respect of such performance shares may take the form of cash, common shares or a combination of both. The number of common shares subject to the performance share awards shown in the table above represents the maximum number of common shares that may be issued if the performance targets applicable to such units are achieved at the maximum level.
Each RSU represents a phantom restricted share which vests ratably in equal tranches, typically over three-to-five year periods, subject to the employee remaining employed at the applicable vesting date. RSUs are payable only in common shares, or in common shares net of applicable tax withholdings, at the end of the RSU term.
Neither performance shares nor RSUs require the payment of an exercise price. Accordingly, there is no weighted average exercise price for either of these awards.
(2) All non-management directors are eligible to participate voluntarily in the Directors Share Plan. Participants receive, in lieu of a portion of their annual cash retainer, a number of Director Share Units (DSUs) of the same dollar value based on the value of common shares at that date. DSUs comprise a contractual right to receive common shares, or an equivalent amount of cash, upon termination of service as a director. While the DSUs are outstanding, they are credited with common share dividend equivalents.
The following graph shows the five-year cumulative total return for a shareholder who invested $100 in our common shares as of January 1, 2003, assuming re-investment of dividends and distributions. Cumulative returns for the five-year period ended December 31, 2007 are also shown for the Standard & Poors 500 Index (S&P 500) and the Standard & Poors 500 Property & Casualty Insurance Index (S&P P&C) for comparison.
Five-Year Cumulative Total Return
(value of $100 invested January 1, 2003)
Selected consolidated income statement data, ending balance sheet data and share data for each of the five years ended December 31, 2007, follows:
(a) On December 31, 2005, we began to consolidate the operations of Blue Ocean in accordance with FIN 46R.
(b) As of January 1, 2007, we adopted FAS 157 and FAS 159. As a result, substantially all of our investments are now carried at fair value with changes in fair value being reported as net realized and unrealized gains (losses) in our statement of operations. Prior to the adoption of FAS 157 and FAS 159, our available for sale investments were carried at fair value with changes in fair value being reported as a separate component of shareholders equity, with changes therein reported as a component of other comprehensive income.
(c) During 2005, we incurred substantial losses associated with hurricanes Katrina, Wilma and Rita which resulted in a net loss for the year.
(d) During 2007, Blue Ocean paid a total of $249.0 million in dividends and distributions to its common and preferred shareholders (of which we received $103.9 million) and repurchased a total of $55.0 million of its preferred shares (of which we received $18.5 million).
(e) During 2007, we publicly repurchased 3,776,989 common shares for $63.7 million. In addition, we privately repurchased 939,039 common shares and 7,172,375.5 warrants from White Mountains Insurance Group, Ltd. (White Mountains), a former affiliate, for $65.0 million.
(f) During 2006, we privately sold 6,896,552 common shares for $100.0 million.
(g) During 2005, we publicly sold 25,850,926 common shares for $600.0 million.
(h) During 2004, we publicly repurchased 1,888,865 common shares for $65.5 million.
(i) See Managements Discussion and Analysis contained in Item 7 herein for a description and computation of our fully converted book value per share and fully converted tangible book value per share.
(j) During 2007, we modified our method of calculating basic and diluted earnings per share. In determining the basic earnings per share numerator, when applicable, dividends and distributions declared on outstanding warrants are deducted from net income. In the diluted earnings per share calculation, this same adjustment is made provided that the result is more dilutive than if we were simply to include the average number of warrants outstanding during the period in the diluted earnings per share denominator (as computed using the treasury stock method). Prior periods have been revised to reflect this approach resulting in a reduction to basic earnings per share of $.02, $.67, $.16 and $.04 for the years ended December 31, 2006, 2005, 2004 and 2003, respectively, and a reduction in diluted earnings per share of $.01 and $.67 for the years ended December 31, 2006 and 2005, respectively.
(k) During 2005, we declared and paid a one-time special dividend of $5.50 per common share and warrant, in addition to regular quarterly dividends.
The following is a discussion and analysis of our results of operations for the years ended December 31, 2007, 2006 and 2005 and our financial condition as of December 31, 2007 and 2006. This discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes thereto included within this filing.
This discussion contains forward-looking statements that are not historical facts, including statements about our beliefs and expectations. These statements are based upon current plans, estimates and projections. Our actual results may differ materially from those projected in these forward-looking statements as a result of various factors. See Forward Looking Statements appearing at the beginning of this report and Risk Factors contained in Item 1A herein.
Summary Financial Results
We ended 2007 with a fully converted tangible book value per share of $17.82, an increase of 17.2% for the year inclusive of dividends. The increase was largely the result of favorable underwriting conditions resulting from satisfactory pricing and a low level of catastrophes experienced throughout the year, as well as solid investment results.
In May 2007, in exchange for a payment of $47.7 million to a former affiliate, we repurchased and retired all remaining warrants to acquire our common shares. This transaction, as of the date effected, reduced our fully converted tangible book value per share by approximately $.50.
As of the date of the warrant repurchase, our fully converted book value per share was less than the $16.67 strike price of the warrants, meaning that the warrants were not dilutive to our book value at that time. As of December 31, 2007, our fully converted tangible book value per share of $17.82 exceeded the strike price of the warrants meaning that the warrants, had they continued to be outstanding, would have been dilutive to our book value at the end of 2007. We have determined that we have recouped approximately 20% of the cost of the warrants in the form of reduced dilution to shareholders in the eight month period since the date of the transaction.
We ended 2006 with a fully converted tangible book value per share of $15.46, an increase of 33.2% for the year inclusive of dividends. The increase was largely the result of favorable underwriting conditions resulting from attractive pricing and a low level of catastrophes experienced throughout the year, as well as strong investment results.
Our comprehensive income for 2007 was $314.0 million and our GAAP combined ratio was 61.3%, compared to $361.5 million and a GAAP combined ratio of 60.3% for 2006. The favorable results we achieved in 2007 and 2006 were largely a function of the low level of catastrophic losses that we experienced during those periods. In 2005, we had a comprehensive loss of $752.9 million with a GAAP combined ratio of 200.7%. The unfavorable results we achieved in 2005 were largely the result of substantial catastrophic losses we experienced during that year from hurricanes Katrina, Rita and Wilma.
Natural Catastrophe Risk Management
As a predominantly short-tail property reinsurer, we have exposure to various natural catastrophes around the world. We manage our exposure to catastrophes using a combination of CATM, third party vendor models, underwriting judgment, and our own reinsurance purchases.
Our three-tiered risk management approach focuses on tracking exposed contract limits, estimating the potential impact of a single natural catastrophe event, and simulating our yearly net operating result to reflect certain modellable underwriting and investment risks we face on an aggregate basis. We seek to refine and improve our risk management process over time.
We track gross reinsurance treaty contract limits which we deem exposed to a single natural perils occurrence within certain broadly defined major catastrophe zones. The resulting measure represents the sum of all contract limits assumed through property reinsurance treaties, other specialty reinsurance treaties and event-linked insurance derivatives, but excludes limits relating to individual risk insurance business and the benefit of any reinsurance protections we have purchased. As of December 31, 2007, our largest single zonal concentration was Northern European windstorm (the zone consisting of the U.K., Ireland, Germany, France, the Benelux countries, Switzerland, Denmark, Norway and Sweden). For individual risk business, including both direct insurance and facultative reinsurance accounts, we supplement our treaty approach by tracking contract limits to a finer geographic resolution.
Single Event Losses
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 our inward portfolio of property, aviation, workers compensation, casualty, and personal accident insurance policies, reinsurance policies, and event-linked derivative securities offset by the net benefit of any reinsurance or derivative protections we purchase and the net benefit of reinstatement premiums. The table below details our estimated average net impact market share for selected natural catastrophe events of various industry loss magnitudes:
The market share estimates above represent an estimate of our average market share across our largest possible event scenarios corresponding to industry losses of a given size. However, it is important to note that our average market share may vary considerably within a particular territory depending on the specific characteristics of the event. This is particularly true for the direct insurance and facultative reinsurance portfolio we underwrite. Other factors contributing to such variation may include our decision to be overweight or underweight in certain regions within a territory. For example, our market share for a large European wind event may differ depending on whether the majority of loss comes from the U.K. or from Continental Europe. Additionally, our net market share may be impacted by the number and order of occurrence of catastrophic events during a year which could exhaust individual policy limits or trigger additional losses from certain policies offering second-event or aggregate protection. Further, certain reinsurance we purchase may have geographic restrictions or provide coverage for only a single occurrence within the policy period. Lastly, these estimates represent snapshots at a point in time. The composition of our in-force portfolio will fluctuate due to the acceptance of new policies, the expiration of existing policies, and changes in our reinsurance program.
Each industry-recognized catastrophe model contains its own assumptions as to the frequency and severity of large events, and results may vary significantly from model to model. Given the relatively limited historical record, there is a great deal of uncertainty with regard to the accuracy of any catastrophe model, especially at relatively remote return periods.
There is no single standard methodology or set of assumptions utilized industry-wide in estimating property catastrophe losses. As a consequence, it may be difficult to compare estimates of risk exposure among different insurance and reinsurance companies, due to differences in modeling, portfolio composition and concentrations, modeling assumptions, and selected event scenarios.
Annual Operating Result
In addition to monitoring exposed contract limits and single event accumulation potential, we attempt to measure enterprise-wide risk using a simulated annual aggregate operating result approach. This approach estimates a net operating result over simulated annual return periods, including contributions from certain variables such as aggregate premiums, losses, expenses, and investment results. We view this approach as a supplement to our single event stress test as it allows for multiple losses from natural catastrophe and other sources and attempts to take into account certain risks from non-underwriting sources.
Through our modeling we endeavor to take into account many risks that we face as an enterprise. By the very nature of the insurance and reinsurance business, and the limitations of models generally, our modeling does not cover every potential risk. Examples include emerging risks, changes in liability awards, pandemic illnesses, asteroid strikes, climate change, bioterrorism, scientific accidents, and various imaginable and unimaginable political and financial market catastrophes.
Our catastrophe and enterprise-wide risk management metrics entail significant estimates, judgments and uncertainties. See Risk Factors contained in Item 1A herein.
Book Value Per Share
The following table presents our computation of book value per share, fully converted book value per share and fully converted tangible book value per share: