Montpelier RE Holdings 10-K 2009
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2008
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
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 x
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, 2008, was $910,734,163.
As of February 25, 2009, 92,175,879 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 20, 2009, is incorporated by reference in Part III of this Form 10-K to the extent described therein.
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 our actual results, future dividends 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, in particular catastrophes that are weather-related; the effectiveness of our loss limitation methods; our dependence on principal employees; our ability to execute the business plans of Syndicate 5151 and MUSIC effectively; 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 and our ability to capitalize on those opportunities; the sensitivity of our business to financial strength ratings established by independent rating agencies; the inherent uncertainty of our risk management process, which is subject to, among other things, industry loss estimates and estimates generated by modeling techniques; the accuracy of estimates reported by cedants and brokers on pro-rata contracts and certain excess-of-loss contracts where a deposit or minimum 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; unanticipated adjustments to premium estimates; changes in the availability, cost or quality of reinsurance or retrocessional coverage; changes in general economic and financial market conditions; changes in and impact of governmental legislation or regulation, including changes in 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; rating agency policies and practices; unexpected developments concerning the small number of insurance and reinsurance brokers upon whom we rely for a large portion of revenues; our dependence as a holding company upon dividends or distributions from our reinsurance and insurance operating subsidiaries; and the impact of foreign currency fluctuation.
We undertake no obligation to publicly update 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 in Bermuda, the U.S., the United Kingdom (the U.K.) and Switzerland (collectively Montpelier), provides customized and innovative reinsurance and insurance solutions to the global market.
At December 31, 2008 and 2007, the Company had $2,797.6 million and $3,525.2 million of consolidated total assets, respectively, and shareholders equity of $1,357.6 million and $1,653.1 million, respectively. The Companys headquarters and principal executive offices are located at Montpelier House, 94 Pitts Bay Road, Pembroke, Bermuda HM 08.
Our Operating Segments
We currently operate through four operating segments consisting of Montpelier Bermuda, Montpelier Syndicate 5151, MUSIC and Blue Ocean. Each of our operating segments is a separate underwriting platform through which we write reinsurance and insurance business. In addition to our operating segments, the activities of the Company, certain of its intermediate holding and service companies and intercompany eliminations relating to inter-segment reinsurance and service charges are collectively referred to as Corporate and Other.
Detailed financial information about each of our operating segments for the three years ended December 31, 2008 is presented in Note 13 of the Notes to Consolidated Financial Statements included in this Form 10-K. During 2008, we changed the composition of our operating segments. All prior periods presented have been re-segmented to conform with the current presentation.
The nature and composition of each of our operating segments and our Corporate and Other activities are as follows:
Our Montpelier Bermuda segment consists of the collective operations of Montpelier Reinsurance Ltd. (Montpelier Re) and Montpelier Marketing Services Limited (MMSL).
Montpelier Re, our principal wholly-owned operating subsidiary based in Pembroke, Bermuda, is registered as a Bermuda Class 4 insurer. Montpelier Re seeks to identify and underwrite attractive reinsurance and insurance opportunities by utilizing proprietary risk pricing and capital allocation models and catastrophe modeling tools.
MMSL, our wholly-owned U.K. company based in London, provides marketing services to Montpelier Re.
At December 31, 2008 and 2007, our Montpelier Bermuda segment had $2,584.7 million and $3,168.9 million of total assets, respectively, and shareholders equity of $1,620.3 million and $1,895.1 million, respectively.
Montpelier Syndicate 5151
Our Montpelier Syndicate 5151 segment consists of the collective operations of Montpelier Syndicate 5151 (Syndicate 5151), Montpelier Capital Limited (MCL), Montpelier Underwriting Agencies Limited (MUA), Montpelier Underwriting Services Limited (MUSL), Montpelier Underwriting Inc. (MUI) and Montpelier Europa AG (MEAG).
Syndicate 5151, our wholly-owned Lloyds of London (Lloyds) syndicate based in London, was established on July 1, 2007. Syndicate 5151 underwrites primarily short-tail lines, mainly property insurance and reinsurance, engineering and a limited amount of specialty casualty classes sourced from the London, U.S. and European markets.
MCL, our wholly-owned U.K. company based in London, serves as Syndicate 5151s sole corporate member.
MUA, our recently established, wholly-owned Lloyds Managing Agent based in London, currently manages Syndicate 5151. Through December 31, 2008, Syndicate 5151 was managed by Spectrum Syndicate Management Limited (Spectrum), a third-party Lloyds Managing Agent, also based in London.
MUSL, our wholly-owned U.K. company based in London, provides support services to Syndicate 5151 and MUA.
MUI and MEAG serve as our wholly-owned Lloyds Coverholders, meaning that they are each authorized to enter into contracts of reinsurance and insurance and/or issue documentation on behalf of Syndicate 5151. MUI, our wholly-owned U.S. company based in Hartford, Connecticut, underwrites reinsurance and insurance business through managing general agents and intermediaries with a focus on program business. MEAG, our wholly-owned Swiss company based in Zug, focuses on reinsurance and insurance markets in Continental Europe and the Middle East. MEAG also provides marketing services to Syndicate 5151 and, to a lesser extent, Montpelier Re.
At December 31, 2008 and 2007, our Montpelier Syndicate 5151 segment had $96.3 million and $21.4 million of total assets, respectively, and a shareholders deficit of $9.1 million and $10.0 million, respectively.
Our MUSIC segment consists solely of the operations of Montpelier U.S. Insurance Company (MUSIC), our wholly-owned U.S. company based in Scottsdale, Arizona.
MUSIC, formerly known as General Agents Insurance Company of America, Inc., is an Oklahoma domiciled stock property and casualty insurance corporation that we acquired from GAINSCO, Inc. (GAINSCO) on November 1, 2007. MUSIC is an admitted insurer in Oklahoma and is authorized as an excess and surplus lines insurer in 43 additional states and the District of Columbia. At the time of acquisition, MUSIC had no employees or in force premium. MUSIC underwrites smaller commercial property and casualty risks that do not conform to standard insurance lines.
At December 31, 2008 and 2007, our MUSIC segment had $68.8 million and $72.9 million of total assets, respectively, and shareholders equity of $49.1 million and $53.9 million, respectively.
Our Blue Ocean segment consists of the collective operations of Blue Ocean Re Holdings Ltd. (Blue Ocean) and Blue Ocean Reinsurance Ltd. (Blue Ocean Re).
Blue Ocean, our wholly-owned Bermuda company based in Pembroke, Bermuda, is a holding company that owns Blue Ocean Re which is also based in Pembroke, Bermuda. Blue Ocean Re had, in the past, provided property catastrophe retrocessional reinsurance and was formerly registered as a Bermuda Class 3 insurer. Blue Ocean Re was deregistered as a Bermuda insurer in 2008.
We acquired all the outstanding share capital of Blue Ocean in June 2008 (the Blue Ocean Transaction). Prior to the Blue Ocean Transaction, we owned 42.2% of Blue Oceans outstanding common shares. Prior to Blue Oceans repurchase of all its outstanding preferred shares on January 11, 2008, we owned 33.6% of such preferred shares.
Prior to Blue Ocean becoming a wholly-owned subsidiary, it was 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 and was consolidated into our financial statements.
At December 31, 2008 and 2007, our Blue Ocean segment had $1.2 million and $240.4 million of total assets, respectively, and shareholders equity of $1.1 million and $135.2 million, respectively.
Corporate and Other
Our Corporate and Other activities consist of the operations of the Company and certain of our intermediate holding and service companies including Montpelier Technical Resources Ltd. (MTR) and Montpelier Agency Ltd. (MAL).
MTR, our wholly-owned U.S. company based in Woburn, Massachusetts, provides accounting, finance, risk management, advisory and information technology services to many of our subsidiaries.
MAL, our wholly-owned Bermuda company based in Pembroke, Bermuda, provided Blue Ocean with underwriting, risk management, claims management, ceded retrocession management, actuarial and accounting services. MAL has conducted no significant operations subsequent to the Blue Ocean Transaction.
Our Strategy and Operating Principles
We manage our business by the following tenets:
Maintaining a Strong Balance Sheet. We focus on maintaining a strong balance sheet in support of our underwriting activities and actively manage our capital with a view towards maximizing our fully-converted book value per share based on prudent risk tolerances. Our capital currently consists of our shareholders equity, debt and contingent capital (our forward sale and share issuance agreements). Also, as part of our capital management strategy, we may choose to reduce debt or return some capital to shareholders through dividends, distributions or share repurchases.
Enhancing Our Lead Position With Brokers and Cedants. We often take a lead position in underwriting treaties. 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 seek to 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.
Developing and Maintaining a Balanced Portfolio of Reinsurance and Insurance Risks. We aim to maintain a balanced portfolio of risks, diversified by product, geography and marketing source within each chosen class of business. 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, however we may be overweight in certain classes, products and geographies from time to time based on market opportunities.
Delivering Customized, Innovative and Timely Reinsurance and Insurance 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 in General
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 can benefit a ceding company in a number of ways, including reducing exposure on individual risks, and providing catastrophe protections from larger or multiple losses. 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, 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 assumed reinsurance 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 acquisition costs, such as commissions paid to agents and brokers and premium and excise taxes.
A widely-used measure of relative underwriting performance for insurance and reinsurance companies is the combined ratio. Our combined ratio is calculated by adding: (i) the ratio of net incurred losses and LAE to net earned premiums (known as the loss ratio); and (ii) the ratio of acquisition costs and other underwriting expenses to net earned premiums (known as the expense ratio), each computed based on our net losses and LAE, underwriting expenses and net earned premiums, determined in accordance with generally accepted accounting principles in the U.S. (GAAP). 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 companies operating at a GAAP combined ratio of greater than 100% can be profitable when investment income and investment gains or losses are taken into account. The length of time between receiving premiums and paying out claims, commonly referred to as the tail, can significantly affect 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 float. Short tail losses, such as fire or physical damage, pay out over shorter periods of time providing the insurance or reinsurance company with a reduced opportunity to generate significant investment earnings from float.
Underwriting and Risk Strategy
Our reinsurance contracts can be written on either a quota share basis (also known as proportional or pro-rata basis), or on an excess-of-loss basis. In the case of reinsurance written on an excess-of-loss basis, we receive a 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.
Our primary business 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 operation in Bermuda. During 2007 we expanded our underwriting platform to include operations located in the U.S., the U.K. and Switzerland.
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 reinsurance and insurance 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) 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 available 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; (iv) the historical loss data 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 (v) 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 key policy terms and pricing of reinsurance contracts with a broker. In the current environment, brokers generally obtain prices and terms submitted by select reinsurers, all of which are taken into account during the binding process. 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-wide risk model which we use as a guide in managing our exposure to liability, asset and business risk.
Our Treaty Reinsurance Book of Business
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. The majority of our current treaty reinsurance book of business represents short-tail property reinsurance including retrocessional business. Our gross short-tail treaty reinsurance writings totaled $496.8 million, $530.1 million and $576.8 million during the years ended December 31, 2008, 2007 and 2006, respectively. We also write a modest amount of long-tail treaty reinsurance business, mainly casualty risks, which totaled $41.0 million, $50.8 million and $56.3 million during the years ended December 31, 2008, 2007 and 2006, respectively.
Most of our treaty 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.
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 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.
Treaty reinsurance premiums, which are generally due in installments, are a function of the number and type of contracts we write, as well as prevailing market prices. 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. In the case of pro-rata contracts and excess-of-loss contracts where no deposit or minimum premium is specified in the contract, written premium is recognized evenly through the year based on estimates of ultimate premiums provided by the ceding companies. Subsequent adjustments, based on reports of actual premium or revisions in estimates by ceding companies, are recorded in the period in which they are determined.
Excess-of-loss contracts are generally written on a losses occurring basis, which means that they cover losses that occur during the contract term, regardless of when the underlying policies incept. Premiums from excess-of-loss contracts are earned ratably over the contract term, which is ordinarily twelve months. In contrast, most pro-rata contracts are written on a risks attaching basis, which means that we assume a stated percent share of each original policy that the ceding company writes during the contract term. As a result, the risk period for pro rata contracts, which extends from the inception date of the first policy bound during the contract term to the termination date of the last policy bound, tends to exceed the contract term. Premiums from pro rata contracts are earned over the associated risk periods.
Our Direct Insurance and Facultative Reinsurance Book of Business
We write a limited amount of direct insurance and facultative reinsurance contracts where we insure and reinsure individual risks on a case-by-case basis. Our direct insurance business consists of a modest book of short-tail property business written by Montpelier Bermuda and Montpelier Syndicate 5151.
Direct property facultative reinsurance involves the selection of individual risks and is characterized by large excess-of-loss limits and low frequency of losses. Brokered property facultative reinsurance involves proportional, primary or excess-of-loss positions.
Through the formation of Syndicate 5151 and the acquisition of MUSIC, we have expanded our ability to write property facultative reinsurance, whether produced by brokers or entered into directly with the ceding companies, as well as excess and surplus lines risks. Although these risks only represent a small portion of our current book of business, we expect that these new lines will gradually become a greater portion of our future business.
Excess and surplus lines insurance arises from a segment of the 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) elected 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.
Our gross short-tail direct insurance and facultative reinsurance writings totaled $54.5 million, $65.4 million and $94.4 million during the years ended December 31, 2008, 2007 and 2006, respectively. We also write a small amount of long-tail direct insurance and facultative reinsurance business, mainly casualty risks, which totaled $27.7 million and $7.5 million during the years ended December 31, 2008 and 2007, respectively. We did not write any long tail direct insurance and facultative reinsurance during 2006.
Our Operating Platforms
Montpelier Re focuses on writing large, short tail U.S. and international catastrophe treaty reinsurance on both an excess-of-loss and proportional basis. Prior to 2006, Montpelier Re was our only operating platform and today it continues to be our primary operating platform.
Syndicate 5151 underwrites a book of non-marine property and engineering classes and a limited amount of specialty casualty business with a view to capturing business that would not normally find its way to our Bermuda underwriters. Syndicate 5151 focuses primarily on non-catastrophe exposures while remaining within our core competency of underwriting short-tailed accounts. Syndicate 5151s focus may change from time to time based on market opportunities.
MUI, our Lloyds Coverholder in the U.S., underwrites both treaty and facultative reinsurance and insurance business on behalf of Syndicate 5151. Currently, MUIs reinsurance business is produced through three underwriting divisions as follows:
(i) the Property Treaty division of MUI underwrites proportional and low layer excess-of-loss treaty business, mostly short-tail. MUIs target market is excess & surplus lines companies and regional and specialty insurance companies. This division looks for clients who have demonstrated ability to profitably underwrite their chosen classes and manage the catastrophe exposure associated with their risks. The Property Treaty division seeks meaningful participations and strives to create and maintain longstanding relationships.
(ii) the Brokered Property Facultative division of MUI underwrites a portfolio of North American property exposures attaching in a proportional, primary or excess-of-loss position. A large majority of this business is catastrophe driven, and we heavily rely on our proprietary models to price and aggregate this business.
(iii) the Direct Property Facultative division of MUI writes reinsurance business that is produced without broker involvement. The policies generally incorporate low-frequency, high severity risks written on an excess-of-loss basis. Only a small portion of this business is catastrophe driven. This division relies on strong customer relationships developed through prompt and consistent client response. The Direct Property Facultative division targets large, national carriers writing large property exposures as well as regional and specialty carriers.
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 retained by MUI.
MEAG, our Lloyds Coverholder in Switzerland, seeks to produce catastrophe, risk excess-of-loss and pro rata business from within Continental Europe and Middle Eastern markets on behalf of Syndicate 5151 and, to a lesser extent, Montpelier Re.
Since its inception, MCL, Syndicate 5151s sole corporate member, has ceded 70% of its business to Montpelier Re.
MUSIC, our 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.
Since its inception, MUSIC has ceded 75% of its business to Montpelier Re.
Blue Ocean was formed in the fourth quarter of 2005 in order to capitalize on the attractive market conditions that existed in the property casualty retrocessional market following hurricanes Katrina, Rita and Wilma. While early pricing conditions for Blue Ocean were strong, increased competition and weaker demand experienced at the end of 2006 and throughout 2007 adversely impacted pricing. As a result, during 2007, Blue Ocean began returning capital to its shareholders and Blue Ocean Re ceased writing new business.
Blue Ocean Re did not write any new business in 2008 and has been deregistered. As of the date of the Blue Ocean Transaction, Blue Oceans assets consisted primarily of cash and investments and it had no in force reinsurance contracts.
Outwards Reinsurance Protection
In the normal course of business, we purchase reinsurance from third-parties in order to manage our exposures. The amount of outwards reinsurance that we buy varies from year-to-year depending on our risk appetite, availability and cost. 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 have already occurred but have not yet been 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 is unable or unwilling to make timely payments to us under our reinsurance agreements.
Under our reinsurance security policy, reinsurers are generally required to be rated A- (Excellent) or better by A.M. Best at the time the policy is written. We also consider reinsurers that are not rated or do not fall within the above threshold on a case-by-case basis when collateralized up to policy limits, net of any premiums owed. We monitor the financial condition and ratings of our reinsurers on an ongoing basis.
Our personnel administer claims arising from our reinsurance and insurance contracts, including validating and monitoring claims, posting case reserves and approving payments. Authority for establishing reserves and paying claims is based upon the level and experience of our 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 and claimants. IBNR consists of a provision for additional development in excess of the case reserves reported by ceding companies and insureds, as well as a provision for claims which have occurred but which have not yet been reported to us.
The process of establishing our loss reserves can be complex and is subject to considerable variability as it requires the use of informed estimates and judgments based on circumstances known at the date of accrual. 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 foreign exchange fluctuations, demand surge and inflation.
We believe that our loss and LAE reserves fairly estimate the 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.
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 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 for 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 an automatic reinstatement of coverage for which we receive 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 natural perils, which is the most expansive form, to more limited types 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 detailed than the information received directly from the original insurance 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.
We write Property Specialty reinsurance and insurance contracts that include 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 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 write property pro-rata reinsurance contracts which reinsures 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 ceased renewing our catastrophe-exposed offshore marine 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 such 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 being 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 also write a limited amount of auto liability coverage and errors and omissions business on an excess-of-loss basis, and quota share treaties covering auto liability and commercial general liability for municipalities in the U.S. Our current portfolio contains only a modest amount of casualty clash business. Clash is a form of reinsurance that covers the ceding companys exposure to multiple retentions that may occur when two or more of its insureds suffer a loss from the same occurrence.
We have written a number of reinsurance and insurance 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 TRIAs 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 and high severity profiles, similar to catastrophe business. We also seek to manage the correlation of this business with our property catastrophe exposures through the use of CATM.
Excess and Surplus Lines
We write certain insurance risks, referred to as excess and surplus lines, that do not conform to normal underwriting patterns for standard lines. These risks, primarily smaller commercial property and casualty risks, are written through select general agents and brokers enabling us to capitalize on the underwriting expertise, and the territorial and product knowledge of the producer. These risks involve specialized treatment with respect to coverage, forms, price and other policy terms.
By Line of Business and Segment
The following tables present our gross premiums written, by line of business, within each of our operating segments during the years ended December 31, 2008, 2007 and 2006:
(1) Represents an inter-segment reinsurance cover among Montpelier Bermuda and Montpelier Syndicate 5151 which is eliminated in consolidation.
The majority of our reinsurance and insurance business is originated through large 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 reinsurance and insurance solutions to our clients; and (iii) timely payment of claims. We target brokers who 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.
We monitor our broker concentrations on a Company-wide basis rather than by individual operating segment.
The following table sets forth a breakdown of our gross premiums written by broker:
(1) Aon Corporation acquired Benfield Group Limited in November 2008. The historic gross premiums shown as sourced by Aon Corporation also include those historically sourced by Benfield.
As illustrated above, the majority of our gross premiums written are sourced through a limited number of brokers with Aon Corporation, Marsh & McLennan Companies, Inc. and Willis Group Holdings Limited providing a total of 74% of our gross premiums written for the year ended December 31, 2008. 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.
By Geographic Area of Risks Insured
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.
We monitor our geographic exposures on a Company-wide basis rather than by individual operating segment.
The following table sets forth a breakdown of our gross premiums written by geographic area of risks insured:
(1) Worldwide comprises reinsurance and insurance 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.
Loss and LAE reserves 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 for time value.
The following information presents (i) our loss and LAE reserve development over the preceding eight 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 GAAP, each as prescribed by Securities Act Industry Guide No. 6.
The Loss Table represents the development of our loss and LAE reserves for 2001 (the year of our inception) through December 31, 2008. 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, both case and IBNR, arising in the current year and all prior years that are unpaid at the balance sheet date. 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, which had 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 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.
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 November 1, 2007, 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 in connection 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, 2008, MUSIC had remaining gross loss and LAE reserves relating to business underwritten prior to the MUSIC Acquisition of $8.8 million (the Acquired Reserves). In support of the Acquired Reserves, at December 31, 2008, MUSIC held a trust deposit maintained by GAINSCO and reinsurance recoverable from third-party reinsurers rated A- (Excellent) or better by A.M. Best in a combined amount exceeding $8.8 million. The market value of the trust deposit was $11.6 million as of December 31, 2008. In addition, we have received a full indemnification from GAINSCO covering any adverse development from its past business. If the Acquired Reserves were to develop unfavorably during future periods and the various protective arrangements, including GAINSCOs indemnification, ultimately proved to be insufficient, these liabilities would become our responsibility.
Our investment portfolio is managed by a small number of professional 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 Committee (the Finance Committee) establishes our 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 their individual objectives and guidelines. The Finance Committee regularly monitors our overall investment results, reviews compliance with our investment objectives and guidelines and ultimately reports the overall investment results to the Board of Directors. Our investment 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.
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.
The current components of our investment portfolio follows:
Fixed Maturity Investments. As a provider of reinsurance and insurance for 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 with a short average duration in order to reduce our sensitivity to interest rate fluctuations and to provide adequate liquidity for the settlement of our expected liabilities. As of December 31, 2008, our fixed maturities had an average credit quality of AA+ (Very Strong) by Standard & Poors and an average duration of 2.3 years. As of December 31, 2008, our fixed maturities comprised 81% of our total investment portfolio.
In August 2008, we terminated our securities lending program. Prior to the termination, we lent certain of our fixed maturity investments to other institutions for short periods of time through a lending agent. We received a fee from the borrower for the temporary use of our securities.
Equity Securities. Over longer time horizons, we believe that modest investments in equity securities will enhance our investment returns. 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. As of December 31, 2008, equity securities comprised 12% of our total investment portfolio.
Other Investments. Our other investments consist of investments in limited partnership interests and private investment funds, event-linked securities (CAT Bonds), private placements and certain derivative instruments. As of December 31, 2008, other investments comprised 7% of our total investment portfolio. As of December 31, 2008, we had unfunded commitments to limited partnerships and private investment funds totaling $30.0 million.
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, 2008, we held $219.6 million in cash (including our restricted cash) and held $48.4 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.
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 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 stable 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 A.M. Best or Standard & Poors, 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 amount of business it writes in order to maintain its claims paying and financial strength ratings.
A downgrade of Montpelier Res A.M. Best financial strength rating below B++ would constitute an event of default under our secured operational letter of credit facilities. A downgrade of Montpelier Res A.M. Best or Standard & Poors rating could also trigger provisions allowing some ceding companies to opt to cancel their reinsurance contracts with us. For the majority of contracts that incorporate ratings provision, a downgrade of below A- by A.M. Best, or A- by Standard and Poors constitutes grounds for cancellation. 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, equally. 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.
In June 2008, Standard & Poors assigned Syndicate 5151 an interactive Lloyds Syndicate Assessment (LSA) of 3- (Average Dependency, with a stable outlook). A rating of 3 is the third highest of five Standard & Poors LSA ratings. A syndicate assigned an LSA of 5 is considered to have a very low dependency on Lloyds single market rating and is viewed as possessing strong business continuity characteristics. A syndicate assigned an LSA of 1 indicates a very high dependency on Lloyds single market rating and is viewed as possessing weak business continuity characteristics.
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. As a result, 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.
Blue Ocean Re
Blue Ocean Re did not operate with a financial strength rating. Historically, it collateralized its reinsurance obligations to provide assurance to customers that it would be able to honor its reinsurance obligations. Blue Ocean Re did not write any new business in 2008 and has been deregistered as a Bermuda Class 3 insurer.
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 Holdings Ltd., Flagstone Reinsurance Holdings Limited, IPC Holdings, Ltd., Lancashire Holdings Limited, various Lloyds 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) quality of 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 traditional reinsurance products. We are unable to predict the extent to which these factors may affect the future demand for our reinsurance and insurance products.
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 regulation than primary insurers. Montpelier Re is regulated by the Bermuda Monetary Authority (the BMA), Syndicate 5151, MUA and MMSL are regulated by the U.K. Financial Services Authority (the FSA) and, in regard to Syndicate 5151, the Council of Lloyds, MUI and MEAG are supervised by Lloyds as Coverholders for Syndicate 5151, MUSIC is regulated by individual U.S. state insurance commissioners and MEAG is regulated by the Swiss Financial Market Supervisory Authority (FINMA). Prior to being deregistered as a Class 3 insurer in 2008, Blue Ocean Re was regulated by the BMA.
The Insurance Act 1978 of Bermuda and related regulations, as amended (the Insurance Act), regulates the insurance business of Montpelier Re, and prior to its deregistration as a Class 3 insurer, Blue Ocean Re, and provides that no person may carry on any insurance business in or from within Bermuda unless registered as an insurer by the BMA. Montpelier Re is registered as a Class 4 insurer by the BMA, which is responsible for the day-to-day supervision of insurers; however, as a holding company, the Company is not subject to Bermuda insurance regulations. Insurance, as well as reinsurance, is regulated under the Insurance Act.
The Insurance Act imposes on Bermuda insurance companies solvency and liquidity standards and auditing and reporting requirements and grants the BMA powers to supervise, investigate, require information and the production of documents and to intervene in the affairs of insurance companies.
In July 2008 the Insurance Amendment Act 2008 was promulgated (the Amendment Act). The Amendment Act created a new supervisory framework for Bermuda insurers by establishing new risk-based regulatory capital adequacy and solvency margin requirements, including the calculation of a Class 4 insurers Enhanced Capital Requirement (ECR) as further detailed below.
In December 2008 the Bermuda House of Assembly approved amendments to Bermudas existing insurance regulations (the Regulations) which compliment, and in certain respects are consequential to, the changes instituted under the Amendment Act.
Certain significant aspects of Bermudas insurance regulatory framework are set forth below.
The BMA utilizes a risk-based approach when it comes to licensing and supervising insurance companies. As part of the BMAs risk-based system, an assessment of the inherent risks within each particular class of insurer is utilized in the first instance to determine the limitations and specific requirements which may be imposed. Thereafter the BMA keeps its analysis of relative risk within individual institutions under review on an ongoing basis, including through the scrutiny of regular audited statutory financial statements, and, as appropriate, meeting with senior management during onsite visits.
Classification of Insurers
The Insurance Act distinguishes between insurers carrying on long-term business and insurers carrying on general business. There are six classifications of insurers carrying on general business, with Class 4 insurers subject to the strictest regulation. Montpelier Re, which is incorporated to carry on general insurance and reinsurance business, is registered as a Class 4 insurer in Bermuda and is regulated as such under the Insurance Act.
Cancellation of Insurers Registration
An insurers registration may be cancelled by the Supervisor of Insurance of 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.
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, Montpelier Res principal office is located at Montpelier House, 94 Pitts Bay Road, Pembroke, HM 08, Bermuda. Christopher L. Harris, Montpelier Res President and Chief Executive Officer, has been appointed by the Board of Directors as Montpelier Res principal representative and has been approved by the BMA.
Independent Approved Auditor
Every registered insurer must appoint an independent auditor who will audit and report annually on the statutory financial statements and the statutory financial return of the insurer, both of which, in the case of Montpelier Re, are required to be filed annually with the BMA. Montpelier Res independent auditor must be approved by the BMA.
Loss Reserve Specialist
As a registered Class 4 insurer, Montpelier Re is required to submit an opinion of its approved loss reserve specialist with its statutory financial return in respect of its losses and loss expenses provisions. The loss reserve specialist, who will normally be a qualified property and casualty actuary, must be approved by the BMA.
An insurer must prepare annual statutory financial statements. The Insurance Act prescribes rules for the preparation and substance of such statements (which include, in statutory form, a balance sheet, an income statement, a statement of capital and surplus and notes thereto). The insurer is required to give detailed information and analyses regarding premiums, claims, reinsurance and investments. The Amendment Act and amended Regulations have introduced a new accounts regime applicable to Class 4 insurers, the most significant aspect of which involves the obligation to detail, on a line-by-line basis, specific asset and liability classes in the insurers statutory balance sheet as well as the requirement to identify and distinguish between what is or is not attributable to affiliates of the insurer. With effect from December 31, 2008, Class 4 insurers are also required to prepare and file with the BMA audited annual financial statements prepared in accordance with GAAP or International Financial Reporting Standards.
Annual Statutory Financial Return
Montpelier Re is required to file with the BMA a statutory financial return no later than four months after its financial year end (unless specifically extended by the BMA). The statutory financial return for a Class 4 insurer includes, among other matters, a report of the approved independent auditor on the insurers statutory financial statements, solvency certificates, the statutory financial statements themselves, the opinion of the loss reserve specialist in respect of the loss and loss expense provisions and a schedule of reinsurance ceded. The solvency certificates must be signed by the principal representative and at least two directors of the insurer certifying that the minimum solvency margin and, in the case of the solvency certificate, the minimum liquidity ratio, have been met and whether the insurer complied with the conditions attached to its certificate of registration. The independent auditor is required to state whether, in its opinion, it was reasonable for the directors to make these certifications and whether the declaration of the statutory ratios complies with the requirements of the Insurance Act. If 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.
Enhanced Capital Requirement (ECR), Minimum Solvency Margin and Restrictions on Dividends and Distributions
The new risk-based regulatory capital adequacy and solvency margin regime introduced under the Amendment Act (termed the Bermuda Solvency Capital Requirement (BSCR) provides a risk-based capital model as a tool to assist the BMA both in measuring risk and in determining appropriate levels of capitalization. BSCR employs a standard mathematical model that correlates the risk underwritten by Bermuda insurers to the capital that is dedicated to their business. The framework that has been developed applies a standard measurement format to the risk associated with an insurers assets, liabilities and premiums, including a formula to take account of the catastrophe risk exposure.
Where an insurer believes that its own internal model for measuring risk and determining appropriate levels of capital better reflects the inherent risk of its business, it may apply to the BMA for approval to use its internal capital model in substitution for the BSCR model. The BMA may approve an insurers internal model, provided certain conditions have been established, and may revoke approval of an internal model in the event that the conditions are no longer met or where it feels that the revocation is appropriate. The BMA will review the internal model regularly to confirm that the model continues to meet the conditions.
In order to minimize the risk of a shortfall in capital arising from an unexpected adverse deviation, the BMA seeks that insurers operate at or above a threshold capital level (termed the Target Capital Level (TCL)), which exceeds the BSCR or approved internal model minimum amounts. The Amendment Act also introduced prudential standards in relation to the ECR and Capital and Solvency Return (CSR). The ECR is determined using the BSCR or an approved internal model, provided that at all times the ECR must be an amount equal to, or exceeding the minimum margin of solvency. The CSR is the return setting out the insurers risk management practices and other information used by the insurer to calculate its approved internal model ECR. The new capital requirements require Class 4 insurers to hold available statutory capital and surplus equal to, or exceeding ECR and set TCL at 120% of ECR. In circumstances where an insurer has failed to comply with an ECR given by the BMA, such insurer is prohibited from declaring or paying any dividends until the failure is rectified.
The new risk-based solvency capital framework described above represents a modification of the minimum solvency margin test set out in the Insurance Returns and Solvency Amendment Regulations 1980 (as amended). While it must calculate its ECR annually by reference to either the BSCR or an approved internal model, a Class 4 insurer such as Montpelier Re must also ensure at all times that its ECR is at least equal to the minimum solvency margin for a Class 4 insurer in respect of its general business, which is the greater of: (i) $100.0 million; (ii) 50% of net premiums written; and (iii) 15% of net loss and loss expense provisions and other general business insurance reserves.
In addition, under the Insurance Act, a Class 4 insurer is prohibited from declaring or paying any dividends of more than 25% of its total statutory capital and surplus, as shown on its previous financial year statutory balance sheet. Montpelier Re, as a Class 4 insurer, must obtain the BMAs prior approval before reducing its total statutory capital, as shown on its previous financial year statutory balance sheet, by 15% or more.
Furthermore, under the Companies Act, the Company and Montpelier Re may only declare or pay a dividend if the Company or Montpelier Re, as the case may be, has no reasonable grounds for believing that it is, or would after the payment be, unable to pay its liabilities as they become due, or if the realizable value of its assets would not be less than the aggregate of its liabilities and its issued share capital and share premium accounts.
Minimum Liquidity Ratio
The Insurance Act provides a minimum liquidity ratio for general business insurers. An insurer engaged in general business is required to maintain the value of its relevant assets at not less than 75% of the amount of its relevant liabilities. Relevant assets include, but are not limited to, cash and time deposits, quoted investments, unquoted bonds and debentures, first liens on real estate, investment income due and accrued, accounts and premiums receivable, reinsurance balances receivable and funds held by ceding reinsurers. There are certain categories of assets which, unless specifically permitted by the BMA, do not automatically 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), letters of credit and guarantees.
Supervision, Investigation and Intervention
The BMA may appoint an inspector with extensive powers to investigate the affairs of Montpelier Re if it believes that such an investigation is in the best interests of Montpelier Res policyholders or persons who may become policyholders. In order to verify or supplement information otherwise provided to the BMA, the BMA may direct Montpelier Re to produce documents or information relating to matters connected with its business. Further, the BMA has the power to appoint a professional person to prepare a report on any aspect of any matter about which the BMA has required or could require information. If it appears to the BMA that there is a risk of Montpelier Re becoming insolvent, or that Montpelier Re is in breach of the Insurance Act or any conditions imposed upon its registration, the BMA may, among other things, direct Montpelier Re 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.
Certain Other Bermuda Law Considerations
Although Montpelier Re is incorporated in Bermuda, it is classified as a non-resident of Bermuda for exchange control purposes by the BMA. Pursuant to its non-resident status, Montpelier Re may engage in transactions in currencies other than Bermuda dollars and there are no restrictions on its ability to transfer funds (other than funds denominated in Bermuda dollars) in and out of Bermuda or to pay dividends to U.S. residents who are holders of its ordinary shares.
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, the Syndicates sole corporate member of Lloyds, provides 100% of the stamp capacity of Syndicate 5151. Stamp capacity for 2007 and 2008 was £47 million and £143 million, respectively, and is expected to remain at £143 million for 2009, 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 currently managed by MUA but, through December 31, 2008, Syndicate 5151 was managed by Spectrum. 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.
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. Local regulators may require Lloyds to demonstrate that it has control over, and responsibility for, the business carried out by Coverholders 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 currently MUA or, through December 31, 2008, was Spectrum.
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 a members Funds at Lloyds. 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 (historically 35% on average) to the capital requirement figure produced by the ICA across the Lloyds market. This uplifted figure is known as a syndicates Economic Capital Assessment (ECA). Lloyds uses the ECA to calculate each syndicates 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 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 underwriting year of account 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 syndicates 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 Lloyds Central Fund levy, which is funded annually by members, was determined by Lloyds as being 2% of Syndicate 5151s underwriting capacity with respect to 2007 and 2% of Syndicate 5151s written premiums 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 to 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.
MUSIC is domiciled in Oklahoma and is eligible to write surplus lines primary insurance in 38 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.
Non-Admitted Reinsurers. Ceding insurers generally receive full credit for outwards reinsurance protections in their U.S. statutory financial statements with respect to liabilities ceded to admitted U.S. domestic reinsurers. However, most states in the U.S. do not confer full credit for outwards reinsurance protections for liabilities ceded to non-admitted or unlicensed reinsurers, such as Montpelier Re, unless such reinsurers collateralize all ceded liabilities. Under applicable statutory provisions, permissible security arrangements include letters of credit, reinsurance trusts maintained by third-party trustees and funds withheld arrangements.
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 also 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.
MEAG is also subject to registration and supervision by FINMA as an insurance intermediary. Unlike supervision of insurance undertakings, Swiss intermediary supervision does not involve a solvency review. There is, however, ongoing supervision aimed at protecting insurance customers and ensuring compliance with Swiss obligations.
As of December 31, 2008, we had 169 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 has no employees.
Many of our employees, including some of our executive officers, are employed in Bermuda 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 currently 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 at the same time 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 (the CN Committee) charters, 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). Requests should be directed to Investor Relations, Montpelier Re Holdings Ltd., PO Box HM 2079, Hamilton, Bermuda HM HX, telephone number (441) 297-9570 or firstname.lastname@example.org. 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. Many of our reinsurance and insurance 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 the frequency of loss events, the total amount of insured exposure in the area affected by each event and the severity of the events. 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 reinsurance and insurance 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 reinsurance and insurance 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.
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 Aon Corporation (which includes Benfield Group Limited), Marsh & McLennan Companies, Inc. and Willis Group Holdings Limited providing a total of 74% of our gross premiums written for the year ended December 31, 2008. 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 significant weakening in its financial condition. A number of reinsurers in the industry were significantly weakened in the aftermath of the active 2005 hurricane season and the deterioration of world-wide credit and financial markets experienced during 2008.
It is possible that one or more of our reinsurers will be significantly weakened by future significant events, causing them to be unable to honor 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.
Our ability to provide reinsurance to many ceding companies is dependant upon the availability and cost of permissible security arrangements.
Ceding insurers generally receive full credit for outwards reinsurance protections in their U.S. statutory financial statements with respect to liabilities ceded to admitted U.S. domestic reinsurers. However, most states in the U.S. do not confer full credit for outwards reinsurance protections for liabilities ceded to non-admitted or unlicensed reinsurers, such as Montpelier Re, unless such reinsurers collateralize all ceded liabilities. Under applicable statutory provisions, permissible security arrangements include letters of credit, reinsurance trusts maintained by third-party trustees and funds withheld arrangements.
The cost and availability of these security arrangements vary, and adverse changes in cost or availability could negatively impact Montpelier Res ability to provide reinsurance to U.S. ceding insurers.
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 coverages may emerge. These issues may adversely affect our business by either extending coverages 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 determination and 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 loss and LAE reserves to cover our estimated ultimate liabilities. Loss and LAE reserves are typically comprised of case reserves for losses reported and 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 that we are developing through MUI 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 being pursued by 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 its cyclical nature can be more pronounced than 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. In softer market conditions (i.e. those less favorable to insurers), 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.
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 the value of our investment portfolio.
Our investment portfolio consists of fixed maturity investments, equity securities and other investments including private placements, limited partnerships and derivative contracts. Our primary investment focus 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 year-to-year.
The value of our investment portfolio can be significantly affected by fluctuations in interest rates, issuer credit concerns and volatility in financial markets. Our investments are sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions, the financial position of issuers and financial guarantors of investment securities and other factors beyond our control.
Throughout 2008, the fair value and overall liquidity of our investment portfolio was adversely affected by unfavorable and uncertain economic and market conditions experienced worldwide. These unfavorable and uncertain conditions originated, in large part, from difficulties encountered in the mortgage and broader credit markets in the U.S. and elsewhere and resulted in a sudden decrease in the availability of credit, a corresponding increase in borrowing 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. These factors resulted in broad and significant declines in the fair value of fixed income and equity securities worldwide, including the investment securities held within our investment portfolio. We cannot predict how long these conditions will exist and how we might be further 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, 2008, we had 169 full-time employees worldwide upon which we depend for the generation and servicing of our business. Our future success depends on our ability to hire and retain personnel. Difficulty in hiring or retaining personnel could adversely affect our results of operations and financial condition.
In addition, many of our employees, including some of our executive officers, are employed in Bermuda. 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. Many of our Bermuda employees are required to have 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 currently has a policy that limits the duration of work permits to six years, subject to certain exemptions for key employees.
Operational risks, including potential human and system failures, are inherent in our business.
Operational risks that are inherent to our business can result in losses, including those resulting from fraud or errors by our employees or a failure of our information technology systems.
In particular, we believe that the performance of our information technology systems is critical to our business and our ability to properly service our business. Such systems are, and will continue to be, a crucial part of our underwriting process. Any defect or error in our information technology systems could result in, among other things, a loss or delay of revenues, higher than expected losses or harm to our reputation.
We believe we have established appropriate controls and mitigation procedures to prevent significant errors or irregularities, but such procedures provide only reasonable, not absolute, assurance as to the absence of errors or irregularities.
As a holding company, we are dependent upon dividends or distributions from our reinsurance and insurance 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 reinsurance and insurance subsidiaries and affiliates to pay our operating expenses, interest on our debt and dividends or distributions to our shareholders. Our reinsurance and insurance operations are highly regulated by various authoritative bodies in Bermuda, the U.K., the U.S. and Switzerland. The various laws and regulations that we are subject to within these jurisdictions limit the declaration and payment of dividends or distributions from our reinsurance and insurance 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 its respective liabilities as they become due and the realizable value of its assets would be more than the aggregate of their liabilities, its issued share capital and its additional paid-in capital.
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 reinsurance and insurance 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.
We may require additional capital in the future, which may not be available or may be available only on unfavorable terms.
We may need to raise additional capital in the future, through the issuance of debt, equity or hybrid securities, in order to, among other things, write new business, pay significant losses, respond to, or comply with, any changes in the capital requirements that rating agencies use to evaluate us, acquire new businesses, invest in existing businesses or to refinance our existing obligations.
The issuance of any new debt, equity or hybrid financial instruments might contain terms and conditions that are unfavorable to us and our shareholders. More specifically, any new issuances of equity or hybrid securities could result in the issuance of securities with rights, preferences and privileges that are senior or otherwise superior to those of our common shares and could prove to be dilutive to our existing common shares. Further, if we cannot obtain adequate capital on favorable terms or otherwise, our business, operating results and financial condition could be adversely affected.
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, MUA, 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 may 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. 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. 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. 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.
Our reinsurance and insurance operations are subject to extensive regulation under Bermuda, U.S., U.K. and Swiss laws. Governmental agencies have broad administrative power to regulate many aspects of our business, which may 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, since 2007 there have been 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 any 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. 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.
We may also be subject to political, regulatory and industry initiatives in other jurisdictions in which we do business.
Risks Related to Our Common Shares
The market price and trading volume of our common shares may be subject to significant volatility.
The market price and trading volume of our common shares, as well as the market prices of securities of our peers, may be subject to significant volatility in response to a variety of events and factors, including:
· catastrophes that may specifically impact us or are perceived by investors as impacting the insurance and reinsurance industries in general;
· exposure to capital market risks related to changes in interest rates, realized investment losses, credit spreads, equity prices and foreign exchange rates;
Five-Year Cumulative Total Return
(value of $100 invested January 1, 2004)