GREENLIGHT CAPITAL RE, LTD. – 10-Q – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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References to "we," "us," "our," "our company," "Greenlight Re," or "the Company" refer toGreenlight Capital Re, Ltd. ("GLRE") and its wholly-owned subsidiaries,Greenlight Reinsurance, Ltd , ("Greenlight Reinsurance"),Greenlight Reinsurance Ireland, Ltd. ("GRIL") andVerdant Holding Company, Ltd. ("Verdant"), unless the context dictates otherwise. References to our "Ordinary Shares" refers collectively to our Class A Ordinary Shares and ClassB Ordinary Shares. The following is a discussion and analysis of our results of operations for the three months endedMarch 31, 2012 and 2011 and financial condition as ofMarch 31, 2012 andDecember 31, 2011 . The following discussion should be read in conjunction with the audited consolidated financial statements and accompanying notes, which appear in our annual report on Form 10-K for the fiscal year endedDecember 31, 2011 .
Special Note About Forward-Looking Statements
Certain statements in Management's Discussion and Analysis ("MD&A"), other than purely historical information, including estimates, projections, statements relating to our business plans, objectives and expected operating results, and the assumptions upon which those statements are based, are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). These forward-looking statements generally are identified by the words "believe," "project," "predict," "expect," "anticipate," "estimate," "intend," "plan," "may," "should," "will," "would," "will be," "will continue," "will likely result," and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially from the forward-looking statements. A detailed discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section entitled "Risk Factors" (refer to Part I, Item 1A) contained in our annual report on Form 10-K for the fiscal year endedDecember 31, 2011 . 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 the forward looking statements which speak only to the dates on which they were made. We intend to communicate certain events that we believe may have a material adverse impact on our operations or financial position, including property and casualty catastrophic events and material losses in our investment portfolio, in a timely manner through a public announcement. Other than as required by the Exchange Act, we do not intend to make public announcements regarding reinsurance or investments events that we do not believe, based on management's estimates and current information, will have a material adverse impact on our operations or financial position.
General
We are aCayman Islands headquartered global specialty property and casualty reinsurer with a reinsurance and investment strategy that we believe differentiates us from our competitors. Our goal is to build long-term shareholder value by selectively offering customized reinsurance solutions, in markets where capacity and alternatives are limited, which we believe will yield favorable long-term returns on equity. We aim to complement our underwriting results with a non-traditional investment approach in order to achieve higher rates of return over the long term than reinsurance companies that employ more traditional, fixed-income investment strategies. We manage our investment portfolio according to a value-oriented philosophy, in which we take long positions in perceived undervalued securities and short positions in perceived overvalued securities. Because we employ an opportunistic underwriting philosophy, period-to-period comparisons of our underwriting results may not be meaningful. In addition, our historical investment results may not necessarily be indicative of future performance. Due to the nature of our reinsurance and investment strategies, our operating results will likely fluctuate from period to period.
Segments
We manage our business on the basis of one operating segment, property and casualty reinsurance, in accordance with the qualitative and quantitative criteria established byUnited States generally accepted accounting principles ("U.S. GAAP"). Within the property and casualty reinsurance segment, we analyze our underwriting operations using two categories: • frequency business; and 25
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Return to table of contents • severity business. Frequency business is characterized by contracts containing a potentially large number of small losses emanating from multiple events. Clients generally buy this protection to increase their own underwriting capacity and typically select a reinsurer based upon the reinsurer's financial strength, service and expertise. We expect the results of frequency business to be less volatile than those of severity business from period to period due to greater predictability. We also expect that over time the profit margins and return on equity of our frequency business will be lower than those of our severity business. Severity business is typically characterized by contracts with the potential for significant losses emanating from one event or multiple events. Clients generally buy this protection to remove volatility from their balance sheets, and accordingly, we expect the results of severity business to be volatile from period to period. However, over the long term, we also expect that our severity business will generate higher profit margins and return on equity than those of our frequency business. Outlook and Trends We believe the 2011 catastrophes, specifically theNew Zealand earthquakes and theJapan earthquake and tsunami, have eroded industry capital. However, we believe the reinsurance industry, in general, remains over capitalized and there is an influx of new capital for peak zone catastrophe risk from alternative capital market participants such as hedge funds, pension funds and other fixed income bond managers. Further, we believe that the slowdown in worldwide economic activity continues to weaken the overall demand for property and casualty insurance and, accordingly, reinsurance. Countering the over-capitalization of the reinsurance industry, and the slowdown in economic activity, is the introduction of more stringent capital requirements in the industry, particularly inEurope , the recalibration of catastrophe risk models to reflect recent catastrophic activity, and the sustained low interest rate environment. We believe the introduction of Solvency II for European insurers and reinsurers will create a demand for capital and/or reinsurance solutions for some smaller and less well diversified companies. Risk Management Solutions ("RMS") released a new version of the widely used catastrophe model ("RMS 11.0") which has had the impact of increasing the modeled expected losses for many catastrophe programs inthe United States . If the new model version is adopted by the reinsurance market, property catastrophe pricing could increase. The persistent low interest rate environment has reduced the earnings of many insurance and reinsurance companies. We believe the continuation of the low interest rates, coupled with the reduction of prior years' reserve redundancies could lead to overall higher pricing. Overall, we believe we are in a hardening market, but that over-capitalization will temper the increases and that overall increases will not significantly exceed loss trends. The result is a slightly improving market, but with many areas of the market continuing to operate at levels which we believe are economically irrational. Price increases could occur earlier if financial and credit markets experience adverse shocks that result in the loss of capital of insurers and reinsurers, or if there are more major catastrophic events, especially inNorth America . It is unclear what lines of business could be significantly affected by current economic conditions. However, we believe that opportunities are likely to arise in a number of areas, including the lines of business: • that experience significant losses;
• where current market participants are experiencing financial distress
or uncertainty; and • that are premium and capital intensive due to regulatory and other requirements. Our reinsurance portfolio is currently concentrated in five areas -Florida homeowners, small account workers' compensation and general liability for contractors, U.S. employer health stop loss, catastrophe retrocession and private passenger automobile. While each of these areas is competitive, we believe we are experiencing rate increases that are in excess of loss trends. In particular, theFlorida homeowners' insurance market continues to experience rate increases, although the rate of increase has slowed relative to the prior period. Additionally, property catastrophe retrocession pricing increased moderately during 2011 and increased again during the first quarter of 2012. We continue to look for attractive opportunities in this area of the market; however, as mentioned earlier, the influx of new capacity is increasing competition. We believe that we are well positioned to compete for frequency business due to our increasing market recognition, the development of strategic relationships and our "A (Excellent)" rating byA.M. Best . Meanwhile, there are a number of insurers and reinsurers that have suffered and continue to suffer from capacity issues. So far in 2012, we have seen a number of large, frequency-oriented opportunities that we believe fit well within our business strategy. We converted some of these opportunities into bound contracts, and are currently working on underwriting others. Further, there has been additional 26
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consolidation activity in the industry and we believe if such activity continues and the number of industry participants decreases, we could benefit from increased opportunities since insurers may prefer to diversify their reinsurance placements. We believe our investment portfolio continues to be conservatively postured in 2012, with a net long position of 33% as ofMarch 31, 2012 . The challenging investment environment has continued throughout the year, with significant uncertainty and global geopolitical and economic headwinds. Equity markets in the U.S. andEurope are volatile, due to slowing economic growth and concerns about the sustainability of monetary and fiscal policies. Rising concern about sovereign debt appears likely to limit further fiscal stimulus. Given the challenging macroeconomic environment, we intend, for the foreseeable future, to continue holding a significant position in gold and other macro hedges in the form of options on higher interest rates and foreign exchange rates, short positions in sovereign debt and sovereign credit default swaps. We intend to continue to monitor market conditions to position ourselves to participate in future underserved or capacity-constrained markets as they arise and intend to offer products that we believe will generate favorable returns on equity over the long term. Accordingly, our underlying results and product line concentrations in any given period may not be indicative of our future results of operations. Critical Accounting Policies Our condensed consolidated financial statements are prepared in accordance with U.S. GAAP, which requires management to make estimates and assumptions that affect reported and disclosed amounts of assets and liabilities and the reported amounts of revenues and expenses during the reporting period. We believe that the critical accounting policies set forth in our annual report on Form 10-K for the fiscal year endedDecember 31, 2011 continue to describe the more significant judgments and estimates used in the preparation of our condensed consolidated financial statements. These accounting policies pertain to premium revenues and risk transfer, valuation of investments, loss and loss adjustment expense reserves, acquisition costs, bonus accruals and share-based payments. If actual events differ significantly from the underlying judgments or estimates used by management in the application of these accounting policies, there could be a material effect on our results of operations and financial condition.
Recently issued accounting standards and their impact to the Company have been presented under "Recently Issued Accounting Standards" in Note 2 of the accompanying condensed consolidated financial statements.
Results of Operations
Three months ended
For the three months endedMarch 31, 2012 , we reported a net income of$65.1 million , as compared to a net loss of$43.0 million reported for the same period in 2011. The underwriting income before general and administrative expenses for the three months endedMarch 31, 2012 was$2.3 million , compared to an underwriting loss of$2.7 million for the same period in 2011. The increase in underwriting income for the three months endedMarch 31, 2012 was primarily due to no catastrophe losses on our severity contracts for the three months endedMarch 31, 2012 , whereas for the same period in 2011, the underwriting loss included$8.8 million of estimated losses relating to the 2011 New Zealand earthquake and 2011 Japan earthquake and tsunami. For the three months endedMarch 31, 2012 , our overall composite ratio decreased to 97.8%, from 102.6% for the same period in 2011, driven mainly by the absence of catastrophe losses. For the three months endedMarch 31, 2012 , our investment portfolio reported a net income of$71.6 million , or a return of 6.5% on our investment account, as compared to a net investment loss of$36.2 million , or a loss of 3.4%, for the same period in 2011. For the three months endedMarch 31, 2012 , the basic adjusted book value per share increased by$1.74 per share, or 7.9%, to$23.72 per share from$21.98 per share atDecember 31, 2011 . During the three months endedMarch 31, 2012 , fully diluted adjusted book value increased by$1.68 per share, or 7.8%, to$23.29 per share from$21.61 per share atDecember 31, 2011 .Basic adjusted book value per share is a non-GAAP measure as it excludes the non-controlling interest in a joint venture from total equity. In addition, fully diluted adjusted book value per share is also a non-GAAP measure and represents basic adjusted book value per share combined with the impact from dilution of all in-the-money stock options issued and outstanding as of any period end. We believe that long-term growth in fully diluted adjusted book value per share is the most relevant measure of our financial performance. In addition, fully diluted adjusted book value per share may be of benefit to our 27
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investors, shareholders and other interested parties to form a basis of comparison with other companies within the property and casualty reinsurance industry.
The following table presents a reconciliation of the non-GAAP basic adjusted and fully diluted adjusted book value per share to the most comparable GAAP measure. March 31, December 31, September 30, June 30, March 31, 2012 2011 2011 2011 2011 ($ in thousands, except per share and share amounts)Basic adjusted and fully diluted adjusted book value per share numerator: Total equity (GAAP) $ 881,304 $ 845,698 $ 765,958 $ 770,185 $ 785,654 Less: Non-controlling interest in joint venture (12,227 ) (42,595 ) (33,866 ) (33,709 ) (34,222 )Basic adjusted book value per share numerator 869,077 803,103 732,092 736,476 751,432 Add: Proceeds from in-the-money stock options issued and outstanding 18,215 18,215 16,590 16,590 16,590 Fully diluted adjusted book value per share numerator $ 887,292 $ 821,318 $ 748,682 $ 753,066 $ 768,022 Basic adjusted and fully diluted adjusted book value per share denominator: Ordinary shares issued and outstanding for basic adjusted book value per share denominator 36,633,638 36,538,149 36,509,036 36,575,816 36,540,521 Add: In-the-money stock options issued and outstanding 1,469,000 1,469,000 1,419,000 1,419,000 1,419,000 Fully diluted adjusted book value per share denominator 38,102,638 38,007,149 37,928,036 37,994,816 37,959,521Basic adjusted book value per share $ 23.72 $ 21.98 $ 20.05 $ 20.14 $ 20.56 Fully diluted adjusted book value per share $ 23.29 $ 21.61 $ 19.74 $ 19.82 $ 20.23 Premiums Written
Details of gross premiums written are provided in the following table:
Three months endedMarch 31, 2012 2011 ($ in thousands)
Frequency
We expect quarterly reporting of premiums written to be volatile as our underwriting portfolio continues to develop. Additionally, the composition of premiums written between frequency and severity business may vary from quarter to quarter depending on the specific market opportunities that we pursue. For the three months endedMarch 31, 2012 , the premiums written relating to frequency contracts increased by$44.3 million , or 47.9% compared to the same period in 2011, primarily due to new private passenger motor contracts written during 2011 and 2012 which increased the motor liability and motor physical damage premiums by$58.7 million compared to same period in 2011. This increase was partially offset by decreases in workers' compensation ($8.0 million ), health ($2.8 million ) and financial lines of business ($2.9 million ). The decrease in our workers' compensation premiums was due to the downward 28
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revision to premium estimates on a 2011 contract as well as lower premiums estimated for a 2012 contract due to weaker than expected market conditions for the underlying workers' compensation policies. During the three months endedMarch 31, 2012 , we decided not to renew a health contract and a surety and trade credit contract which contributed to the decreases in premiums written for health and financial lines respectively. For the three months endedMarch 31, 2012 , the premiums written relating to severity contracts increased by$7.2 million , or 86.2%, compared to the same period in 2011. The increase was primarily due to the renewal of our existing multi-line property catastrophe contracts with higher aggregate limits as well as due to higher pricing. During theJanuary 1, 2012 catastrophe contracts renewal period, we restructured some of our property catastrophe contracts and increased our limits of coverage while also increasing the thresholds for losses entering our layer of coverage. As a result, while direct comparison of pricing is not possible, overall we obtained slightly higher prices on renewing contracts that had no claims reported during the prior year; and significantly higher prices on catastrophe contracts that had experienced losses during 2011. For the three months endedMarch 31, 2012 , our ceded premiums were$11.0 million compared to$3.5 million for the same period in 2011. The increase in ceded premiums for the three months endedMarch 31, 2012 was principally due to aFlorida homeowners' contract retroceded on a quota share basis to the ceding insurer's affiliated reinsurer. Additionally, during 2012, we entered into a retroceded stop loss severity contract relating to private passenger motor coverage which contributed$0.8 million to the increase in ceded premiums.
Details of net premiums written are provided in the following table:
Three months ended March 31, 2012 2011 ($ in thousands) Frequency $ 126,406 89.5 % $ 88,877 91.4 % Severity 14,820 10.5 8,386 8.6 Total $ 141,226 100.0 % $ 97,263 100.0 % Net Premiums Earned
Net premiums earned reflect the pro-rata inclusion into income of net premiums written over the life of the reinsurance contracts. Details of net premiums earned are provided in the following table:
Three months ended March 31, 2012 2011 ($ in thousands) Frequency $ 96,950 95.4 % $ 98,283 93.5 % Severity 4,639 4.6 6,874 6.5 Total $ 101,589 100.0 % $ 105,157 100.0 % Premiums relating to quota share contracts are earned over the contract period in proportion to the period of protection. Similarly, incoming unearned premiums are earned in proportion to the remaining period of protection. For the three months endedMarch 31, 2012 , the frequency earned premiums decreased by$1.3 million , or 1.4%, which was a result of decreases primarily in personal lines due to aFlorida homeowners' contract commuted during the fourth quarter of 2011, and to a lesser extent, by decreases in workers' compensation and general liability lines as a result of decreases in the volume of underlying premiums written by the ceding insurers. The decreases were partially offset by increases in premiums earned primarily from several new private passenger motor contracts and to a lesser extent, a new professional indemnity contract written during 2011. Premiums relating to severity contracts are earned over the contract period in proportion to the period of protection. For the three months endedMarch 31, 2012 , severity net earned premiums decreased$2.2 million , or 32.5%, compared to the same period in 2011. The decrease in earned premiums is principally a result of$2.6 million of additional premiums that were included in the comparative figure for 2011, as well as due to accelerated earning of premiums, during the comparative 2011 period, on catastrophe contracts which had reported losses during the three months endedMarch 31, 2011 . 29
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Losses Incurred
Losses incurred include losses paid and changes in loss reserves, including reserves for IBNR, net of actual and estimated loss recoverables. Details of net losses incurred for the three months endedMarch 31, 2012 and 2011, are provided in the following table: Three months endedMarch 31, 2012 2011 ($ in thousands)
Frequency
We establish reserves for each contract based on estimates of the ultimate cost of all losses including losses incurred but not reported. These estimated ultimate reserves are based on reports received from ceding companies, industry data and historical experience as well as our own actuarial estimates. Quarterly, we review these estimates on a contract by contract basis and adjust as we deem necessary based on updated information and our internal actuarial estimates. We expect losses incurred on our severity business to be volatile from period to period. For the three months endedMarch 31, 2012 and 2011, the loss ratios for our frequency business were 65.2% and 57.1%, respectively. For the three months endedMarch 31, 2012 , our multi-line commercial motor and general liability contracts reported higher loss ratios, compared to the same period in 2011, due to adverse loss development and an increase in large loss activity. To a lesser extent, the loss ratios for our health and professional liability lines also increased compared to the same period in 2011. While the increase in the loss ratio for the health line was primarily attributable to adverse loss development, the higher loss ratio for the professional liability line related to new and renewed contracts which are expected to have higher loss ratios. Partially offsetting these increases, were decreases in loss ratios reported for workers' compensation and personal lines. For the three months endedMarch 31, 2012 and 2011, the loss ratios for our severity business were 2.1% and 139.8%, respectively. There were no losses incurred on any natural peril severity contracts during the three months endedMarch 31, 2012 . The loss ratio for 2011 primarily related to the estimated loss reserves booked in the first quarter of 2011 relating to theNew Zealand earthquakes and the Japanese earthquake and tsunami. Losses incurred for the three months endedMarch 31, 2012 can be further broken down into losses paid and changes in loss and loss adjustment expense reserves as follows: Three months ended Three months ended March 31, 2012 March 31, 2011 Gross Ceded Net Gross Ceded Net ($ in thousands) Losses paid (recovered) $ 35,979 $ (2,388 ) $ 33,591 $ 36,459 $ (1,251 ) $ 35,208 Change in reserves 36,634 (6,918 ) 29,716 33,122 (2,605 ) 30,517 Total $ 72,613 $ (9,306 ) $ 63,307 $ 69,581 $ (3,856 ) $ 65,725 For the three months endedMarch 31, 2012 , our loss reserves on prior period contracts increased by$5.7 million which primarily related to$5.3 million of adverse loss development, net of retrocesssion recoveries, on multi-line commercial motor and general liability quota share contracts based on data received from the clients and a reassessment in connection with our quarterly reserve analysis which indicated higher large loss activity on the accounts than originally expected. There were no other significant developments of prior period reserves during the three months endedMarch 31, 2012 .
For the three months ended
•
relating to the earthquake and tsunami in 30
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•
contract currently in run off; and
•
loss contract which expired with no reported claims.
There were no other significant developments of prior period reserves during the three months ended
Acquisition Costs, Net
Acquisition costs represent the amortization of commission and brokerage expenses incurred on contracts written as well as profit commissions and other underwriting expenses which are expensed when incurred. Deferred acquisition costs are limited to the amount of commission and brokerage expenses that are expected to be recovered from future earned premiums and anticipated investment income. Details of acquisition costs are provided in the following table: Three months ended March 31, 2012 2011 ($ in thousands) Frequency $ 35,235 97.8 % $ 41,320 98.1 % Severity 790 2.2 801 1.9 Total $ 36,025 100.0 % $ 42,121 100.0 % We expect that acquisition costs will be higher for frequency business than for severity business. For the three months endedMarch 31, 2012 and 2011, the acquisition cost ratios for frequency business were 36.3% and 42.0%, respectively. The acquisition cost ratios for severity business were 17.0% and 11.7% for the three months endedMarch 31, 2012 and 2011, respectively. Overall, our total acquisition cost ratio decreased to 35.5% for the three months endedMarch 31, 2012 from 40.1% for the corresponding 2011 period. For the three months endedMarch 31, 2012 , the decrease in the frequency acquisition cost ratio primarily related to the motor liability line. Our private passenger motor contracts carry a lower ceding commissions than our commercial motor contracts. For the three months endedMarch 31, 2012 , the increase in volume of private passenger motor business resulted in a decrease in the average acquisition cost ratio for the motor liability line. Additionally, due to the adverse loss development on the multi-line contracts during the three months endedMarch 31, 2012 , the sliding scale ceding commissions on these contracts were adjusted downward which also contributed to the decrease in the overall acquisition cost ratio for the three months endedMarch 31, 2012 compared to the same period in 2011. For the three months endedMarch 31, 2012 , the increase in the severity acquisition cost ratio from 11.7% to 17.0% was principally related to a multi-year professional liability excess of loss contract where we are holding a profit commission payable to the client and accrue interest on the amount payable. We record this interest expense as an acquisition cost included in underwriting expense since it is directly related to the profit commission payable on this contract. Given that all the premiums on this contract were earned in prior periods, the interest expense is expected to continue accruing until the profit commission is paid. Since the amount of severity earned premiums were lower during first quarter of 2012 compared to the same period in 2011, the interest expense caused the acquisition cost ratio for the three months endedMarch 31, 2012 to increase compared to the same period in 2011.
General and Administrative Expenses
For the three months endedMarch 31, 2012 and 2011, our general and administrative expenses were$4.6 million and$5.0 million , respectively. The decrease in general and administrative expenses was partially due to lower share based compensation expenses and lower bonus expense for the three months endedMarch 31, 2012 . General and administrative expenses for the three months endedMarch 31, 2012 and 2011 included$0.8 million and$1.0 million , respectively, for the expensing of the fair value of stock options and restricted stock granted to employees and directors. 31
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Return to table of contents Net Investment Income (Loss)
A summary of our net investment income (loss) for the three months ended
Three months endedMarch 31, 2012 2011 ($ in thousands)
Realized gains (losses) and change in unrealized gains and losses, net
$ 97,332 $ (28,293 ) Interest, dividend and other income 1,327
2,492
Interest, dividend and other expenses (5,986 ) (6,523 ) Investment advisor compensation (21,067 ) (3,852 ) Net investment income (loss) $ 71,606 $ (36,176 ) For the three months endedMarch 31, 2012 , investment income, net of all fees and expenses, resulted in a gain of 6.5% on our investment portfolio. This compares to a loss of 3.4% for the same period in 2011. For the three months endedMarch 31, 2012 , our long portfolio reported a gross gain of 15.6% which was partially offset by gross losses of 7.2% on our short portfolio.
For the three months ended
Pursuant to the Advisory Agreement, performance compensation equal to 20% of the net income of the Company's share of the account managed byDME Advisors is payable toDME Advisors , subject to a loss carry forward provision. The loss carry forward provision allowsDME Advisors to earn reduced incentive compensation of 10% on net investment income in any year subsequent to the year in which the investment account incurs a loss, until all the losses are recouped and an additional amount equal to 150% of the aggregate investment loss is earned. Included in investment advisor compensation for the three months endedMarch 31, 2012 and 2011 was performance compensation of$17.0 million and$0 , respectively. No performance compensation was recorded for the three months endedMarch 31, 2011 due to a net loss being reported during the three months endedMarch 31, 2011 . Our investment advisor,DME Advisors , and its affiliates manage and expect to manage other client accounts besides ours, some of which have investment objectives similar to ours. To comply with Regulation FD, our investment returns are posted on our website on a monthly basis. Additionally, our website (www.greenlightre.ky) provides the names of the largest disclosed long positions in our investment portfolio as of the last business day of the month of the relevant posting.DME Advisors may choose not to disclose certain positions to its clients in order to protect its investment strategy. Therefore, we present on our website the largest long positions held by us that are disclosed byDME Advisors or its affiliates to their other clients.
Income Taxes
We are not obligated to pay any taxes in theCayman Islands on either income or capital gains. We have been granted an exemption by the Governor-In-Cabinet from any taxes that may be imposed in theCayman Islands for a period of 20 years, expiring onFebruary 1, 2025 .
GRIL is incorporated in
Verdant is incorporated in
For the three months endedMarch 31, 2012 , a deferred tax asset of$0.1 million (December 31, 2011 :$0.1 million ) resulting solely from the temporary differences in recognition of expenses for tax purposes was included in other assets on the condensed consolidated balance sheets. As ofMarch 31, 2012 , an accrual for current taxes payable of$0.5 million (December 31, 2011 :$0.2 million ) was recorded in other liabilities on the condensed consolidated balance sheets. Based on the timing of the reversal of the temporary differences and likelihood of generating sufficient taxable income to realize the future tax benefit, management believes it is more likely than not that the deferred tax asset will be fully realized in the future and 32
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therefore no valuation allowance has been recorded. The Company has not taken any tax positions that are subject to uncertainty or that are reasonably likely to have a material impact to the Company, GRIL or Verdant.
Ratio Analysis
Due to the opportunistic and customized nature of our underwriting operations, we expect to report different loss and expense ratios in both our frequency and severity businesses from period to period. The following table provides the ratios for the three months endedMarch 31, 2012 and 2011: Three months ended Three months ended March 31, 2012 March 31, 2011 Frequency Severity Total Frequency Severity Total Loss ratio 65.2 % 2.1 % 62.3 % 57.1 % 139.8 % 62.5 % Acquisition cost ratio 36.3 % 17.0 % 35.5 % 42.0 % 11.7 % 40.1 % Composite ratio 101.5 % 19.1 % 97.8 % 99.1 % 151.5 % 102.6 % Internal expense ratio 4.6 % 4.8 % Combined ratio 102.4 % 107.4 % The loss ratio is calculated by dividing loss and loss adjustment expenses incurred by net premiums earned. We expect that the loss ratio will be volatile for our severity business and may exceed that of our frequency business in certain periods. Given that we opportunistically underwrite a concentrated portfolio across several lines of business that have varying expected loss ratios, we can expect there to be significant annual variations in the loss ratios reported from our frequency business. In addition, the loss ratios for both frequency and severity business can vary depending on the lines of business written. The acquisition cost ratio is calculated by dividing acquisition costs by net premiums earned. This ratio demonstrates the higher acquisition costs incurred for our frequency business than for our severity business. The composite ratio is the ratio of underwriting losses incurred, loss adjustment expenses and acquisition costs, excluding general and administrative expenses, to net premiums earned. Similar to the loss ratio, we expect that this ratio will be more volatile for our severity business depending on loss activity in any particular period.
The internal expense ratio is the ratio of all general and administrative expenses to net premiums earned.
The combined ratio is the sum of the composite ratio and the internal expense ratio. The combined ratio measures the total profitability of our underwriting operations and does not take net investment income or loss into account. Given the nature of our opportunistic underwriting strategy, we expect that our combined ratio may also be volatile from period to period.
Financial Condition
Investments and Due to Prime Brokers
Our long investments (including financial contracts receivable) reported in the condensed consolidated balance sheets as ofMarch 31, 2012 were$1,212.4 million compared to$1,053.8 million as ofDecember 31, 2011 , an increase of$158.6 million , or 15.1%, due to increase in unrealized gains on our long investments as well as additional purchases of long investments during the quarter. As ofMarch 31, 2012 , our exposure to long investments increased to 96%, compared to 89% as ofDecember 31, 2011 , while our exposure to short investments increased to 63%, compared to 52% as ofDecember 31, 2011 , as we increased the number and size of long and short positions in our portfolio. This exposure analysis is conducted on a notional basis and does not include gold, CDS, sovereign debt, cash, foreign currency positions, interest rate options and other macro positions. From time to time, we incur indebtedness to our prime brokers to implement our investment strategy in accordance with our investment guidelines. As ofMarch 31, 2012 , we had borrowed$72.2 million (December 31, 2011 :$4.3 million ) from our prime brokers in order to purchase investment securities and$243.1 million (December 31, 2011 :$256.1 million ) under term margin agreements from prime brokers to provide collateral for our letters of credit outstanding. The increase in amounts 33
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borrowed from prime brokers for investing was due to the increase in our exposure to long and short investments during the three months endedMarch 31, 2012 . The decrease in the collateral for letters of credit was a result of a decrease in letters of credit outstanding under those term margin agreements and letter of credit facility agreements whereby we pledge certain investment securities to borrow cash from the prime brokers. Our investment portfolio, including any derivatives, is valued at fair value and any unrealized gains or losses are reflected in net investment income (loss) in the condensed consolidated statements of income. As ofMarch 31, 2012 , 86.2% (December 31, 2011 : 86.3%) of our investment portfolio (excluding restricted and unrestricted cash and cash equivalents) was comprised of investments valued based on quoted prices in actively traded markets (Level 1), 12.0% (December 31, 2011 : 11.9%) was comprised of securities valued based on observable inputs other than quoted prices (Level 2) and 1.8% (December 31, 2011 : 1.8%) was comprised of securities valued based on non-observable inputs (Level 3). In determining whether a market for a financial instrument is active or inactive, we obtain information fromDME Advisors , our investment advisor, which makes the determination based on feedback from executing brokers, market makers and in-house traders to assess the level of market activity and available liquidity for any given financial instrument. Where a financial instrument is valued based on broker quotes,DME Advisors requests multiple quotes. The ultimate value is based on an average of the quotes obtained. Broker quoted prices are generally not adjusted in determining the ultimate values and are obtained with the expectation of the quotes being binding. As ofMarch 31, 2012 ,$199.0 million (December 31, 2011 :$182.8 million ) of our investments (longs, shorts and derivatives) were valued based on broker quotes, of which$190.6 million (December 31, 2011 :$174.9 million ) were based on broker quotes that utilized observable market information and classified as Level 2 fair value measurements, and$8.4 million (December 31, 2011 :$7.9 million ) were based on broker quotes that utilized non-observable inputs and classified as Level 3 fair value measurements.
There were no transfers between Level 1, Level 2 and Level 3 fair value measurements during the three months ended
Non-observable inputs used by our investment advisor include discounted cash flow models for valuing certain corporate debt instruments. In addition, other non-observable inputs include the use of investment manager statements and management estimates based on third party appraisals of underlying assets for valuing private equity investments.
Restricted Cash and Cash Equivalents; Securities Sold, Not Yet Purchased
As ofMarch 31, 2012 , our securities sold, not yet purchased increased by$61.7 million , or 9.0%, to$745.5 million from$683.8 million atDecember 31, 2011 . For the same period, our restricted cash increased from$957.5 million to$1,021.0 million , an increase of$63.5 million , or 6.6%. The increase in restricted cash resulted from increases in securities sold, not yet purchased as we increased our short exposure from 52% to 63% as ofMarch 31, 2012 .
Loss and Loss Adjustment Expense Reserves; Loss and Loss Expenses Recoverable
Reserves for loss and loss adjustment expenses as of
March 31, 2012 December 31, 2011 Case Case Reserves IBNR Total Reserves IBNR Total ($ in thousands) Frequency $ 99,544 $ 145,572 $ 245,116 $ 85,186 $ 117,850 $ 203,036 Severity 12,776 20,021 32,797 18,136 20,107 38,243 Total $ 112,320 $ 165,593 $ 277,913 $ 103,322 $ 137,957 $ 241,279 The increase in frequency loss reserves is principally a result of estimated losses incurred associated with the additional premiums earned during the three months endedMarch 31, 2012 . The decrease in severity case reserves is due to loss payments being made on older severity contracts. For most of our contracts written as ofMarch 31, 2012 , our risk exposure is limited by the fact that the contracts have defined limits of liability. Once the loss limit for a contract has been reached, we have no further exposure to additional losses from that contract. However, certain contracts, particularly quota share contracts that relate to first dollar exposure, may not contain aggregate limits. 34
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Our severity business includes contracts that contain or may contain natural peril loss exposure. As ofApril 27, 2012 , our maximum aggregate loss exposure to any series of natural peril events was$102.7 million . For purposes of the preceding sentence, aggregate loss exposure is net of any retrocession and is equal to the difference between the aggregate limits available in the contracts that contain natural peril exposure minus reinstatement premiums, if any, for the same contracts. We categorize peak zones as:United States ,Europe ,Japan and the rest of the world. The following table provides single event loss exposure and aggregate loss exposure information for the peak zones of our natural peril coverage as of the date of this filing: Single Event Aggregate Zone Loss Loss ($ in thousands) United States (1) $ 69,750 $ 102,700 Europe 44,500 49,500 Japan 44,500 49,500 Rest of the world 44,500 49,500 Maximum Aggregate 69,750 102,700
(1) Includes the
For the three months endedMarch 31, 2011 , loss and loss expenses recoverable increased by$6.9 million , or 23.2%, to$36.7 million principally due to the increase in ceded premiums relating to aFlorida homeowners' contract, and to a lesser extent, due to our prior year multi-line retroceded contracts which experienced adverse loss development as a result of an increase in large losses on the corresponding assumed quota share contracts.
Shareholders' Equity
Total equity reported on the balance sheet, which includes non-controlling interest, increased to$881.3 million as ofMarch 31, 2012 from$845.7 million as ofDecember 31, 2011 , an increase of$35.6 million , or 4.2%. The increase was principally due to net income of$65.1 million reported for the three months endedMarch 31, 2012 , offset by a withdrawal of$34.0 million byDME Advisors from the non-controlling interest in the joint venture during the period.
Liquidity and Capital Resources
General
We are organized as a holding company with no operations of our own. As a holding company, we have minimal continuing cash needs, most of which are related to the payment of administrative expenses. All of our underwriting operations are conducted through our wholly-owned reinsurance subsidiaries, Greenlight Re and GRIL, which underwrite risks associated with our property and casualty reinsurance programs. There are restrictions on each of Greenlight Re's and GRIL's ability to pay dividends which are described in more detail below. It is our current policy to retain earnings to support the growth of our business. We currently do not expect to pay dividends on our ordinary shares.
As of
Sources and Uses of Funds
Our sources of funds primarily consist of premium receipts (net of brokerage and ceding commissions), investment income (net of advisory compensation and investment expenses), including realized gains, and other income. We use cash from our operations to pay losses and loss adjustment expenses, profit commissions and general and administrative expenses. Substantially all of our funds, including shareholders' capital, net of funds required for cash liquidity purposes, are invested byDME Advisors in accordance with our investment guidelines. As ofMarch 31, 2012 , approximately 86% of our investments were comprised of publicly-traded equity securities and gold bullion which can be readily liquidated to meet current and future liabilities. As ofMarch 31, 2012 , the majority of our investments were valued based on quoted prices in active markets for identical assets (Level 1). Given our value-oriented long and short investment strategy, if markets are distressed we would expect the liability of the short portfolio to decline. Any reduction in the liability would cause our need for restricted cash to 35
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decrease and thereby freeing up cash to be used for any purpose. Additionally, since the majority of our invested assets are liquid, even in distressed markets, we believe securities can be sold or covered to generate cash to pay claims. Since we classify our investments as "trading," we book all gains and losses (including unrealized gains and losses) on all our investments (including derivatives) as net investment income in our condensed consolidated statements of income for each reporting period. For the three months endedMarch 31, 2012 , we generated$2.7 million in cash from operations principally from underwriting activities. We used$39.7 million in net investing activities which included$34.0 million withdrawn by our investment advisor to reduce its non-controlling interest in the joint venture. Our short-term borrowings from prime brokers also increased by$67.9 million as a result of increases in the long and short exposures of our investment portfolio. There were no notable cash flows related to financing activities during the three months endedMarch 31, 2012 . As ofMarch 31, 2012 , we believe we have sufficient cash flow from operations to meet our foreseeable liquidity requirements. We expect that our operational needs for liquidity will be met by cash, funds generated from underwriting activities and investment income, including realized gains. As ofMarch 31, 2012 , we had no plans to issue debt and expect to fund our operations for the next 12 months from operating cash flow. However, we cannot provide assurances that in the future we will not incur indebtedness to implement our business strategy, pay claims or make acquisitions. Although we are not subject to any significant legal prohibitions on the payment of dividends, Greenlight Re and GRIL are each subject to regulatory minimum capital requirements and regulatory constraints that affect its ability to pay dividends to us. In addition, any dividend payment would have to be approved by the relevant regulatory authorities prior to payment. As ofMarch 31, 2012 , Greenlight Re and GRIL both exceeded the regulatory minimum capital requirements.
Letters of Credit
As ofMarch 31, 2012 , neither Greenlight Re nor GRIL was licensed or admitted as a reinsurer in any jurisdiction other than theCayman Islands and the European Economic Area, respectively. Because many jurisdictions do not permit domestic insurance companies to take credit on their statutory financial statements, unless appropriate measures are in place from reinsurance obtained from unlicensed or non-admitted insurers, we anticipate that all of our U.S. clients and some of our non-U.S. clients will require us to provide collateral through funds withheld, trust arrangements, letters of credit or a combination thereof. As ofMarch 31, 2012 , we had four letter of credit facilities totaling$760.0 million (December 31, 2011 :$760.0 million ) with various financial institutions. See Note 8 of the accompanying condensed consolidated financial statements for details on each of these facilities. As ofMarch 31, 2012 , an aggregate amount of$390.1 million (December 31, 2011 :$382.8 million ) in letters of credit was issued under these facilities. Under the facilities, we provide collateral that may consist of equity securities, restricted cash, and cash equivalents. AtMarch 31, 2012 , total equity securities, restricted cash, and cash and cash equivalents with a fair value in the aggregate of$413.5 million (December 31, 2011 :$410.5 million ) were pledged as security against the letters of credit issued. Each of the facilities contain customary events of default and restrictive covenants, including but not limited to, limitations on liens on collateral, transactions with affiliates, mergers and sales of assets, as well as solvency and maintenance of certain minimum pledged equity requirements, and restricts issuance of any debt without the consent of the letter of credit provider. Additionally, if an event of default exists, as defined in the letter of credit facilities, Greenlight Re would be prohibited from paying dividends to its parent company. The Company was in compliance with all the covenants of each of these facilities for the three months endedMarch 31, 2012 .
Capital
Our capital structure currently consists entirely of equity issued in two separate classes of ordinary shares. We expect that the existing capital base and internally generated funds will be sufficient to implement our business strategy. Consequently, we do not presently anticipate that we will incur any material indebtedness in the ordinary course of our business. In order to provide us with additional flexibility and timely access to public capital markets should we require additional capital for working capital, capital expenditures, acquisitions and other general corporate purposes, we have filed a Form S-3 registration statement for an aggregate principal amount of$200.0 million in securities, which was declared effective by theSEC onJuly 10, 2009 and expires inJuly 2012 unless renewed. We intend to renew the Form S-3 prior to it expiring inJuly 2012 . We did not make any significant commitments for capital expenditures during the three months endedMarch 31, 2012 .
On
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Directors. As ofMarch 31, 2012 , the Company was authorized to purchase up to 1,771,100 Class A ordinary shares or securities convertible into Class A ordinary shares in the open market or through privately negotiated transactions. OnApril 26, 2012 , our Board of Directors extended the duration of the repurchase plan fromJune 30, 2012 toJune 30, 2013 . The Company is not required to make any repurchase of Class A ordinary shares and the repurchase plan may be modified, suspended or terminated at any time without prior notice. No Class A ordinary shares were repurchased by the Company in January, February orMarch 2012 . OnApril 28, 2010 , our shareholders approved an amendment to our stock incentive plan to increase the number of Class A ordinary shares available for issuance from 2.0 million to 3.5 million. As ofMarch 31, 2012 , there were 1,227,284 Class A ordinary shares available for future issuance. OnSeptember 26, 2011 ,A.M. Best upgraded the rating for our reinsurance subsidiary, Greenlight Re from "A- (Excellent)" to "A (Excellent)" and reaffirmed the "A- (Excellent)" rating for GRIL. These ratings reflect the rating agency's opinion of our reinsurance subsidiaries' financial strength, operating performance and ability to meet obligations. If an independent rating agency downgrades our ratings below "A- (Excellent)" or withdraws our rating, we could be severely limited or prevented from writing any new reinsurance contracts, which would significantly and negatively affect our business. Insurer financial strength ratings are based upon factors relevant to policyholders and are not directed toward the protection of investors. OurA.M. Best ratings may be revised or revoked at the sole discretion of the rating agency.
Contractual Obligations and Commitments
The following table shows our aggregate contractual obligations as of
Less than More than 1 year 1-3 years 3-5 years 5 years Total ($ in thousands)
Operating lease obligations (1) $ 372 $ 744 $ 660 $ 345
617 425 - - 1,042 Private equity and limited partnerships (2) 15,836 - - - 15,836 Loss and loss adjustment expense reserves (3) 127,057 109,028 31,721 10,107 277,913 $ 143,882 $ 110,197 $ 32,381 $ 10,452 $ 296,912
(1) Reflects our contractual obligations pursuant to the lease agreements as described below.
(2) As ofMarch 31, 2012 , we had made total commitments of$41.2 million in private investments of which we have invested$25.4 million , and our remaining commitments to these investments total$15.8 million . Given the nature of the private equity investments, we are unable to determine with any degree of accuracy as to when the commitments will be called. As such, for the purposes of the above table, we have assumed that all commitments with no fixed payment schedule will be made within one year. Under our investment guidelines, in effect as of the date hereof, no more than 10% of the assets in the investment portfolio may be held in private equity securities without specific approval from the Board of Directors.
(3) Due to the nature of our reinsurance operations the amount and timing of the cash flows associated with our reinsurance contractual liabilities will fluctuate, perhaps materially, and, therefore, are highly uncertain.
GLRE has entered into a ten year lease agreement for office space in theCayman Islands with the option to renew for an additional five year term. The lease term is effective fromJuly 1, 2008 and ends onJune 30, 2018 . Under the terms of the lease agreement, our minimum annual rent payments are$253,539 for the first three years, increasing by 3% thereafter each year to reach$311,821 by the tenth year. The minimum lease payment obligations are included in the above table under operating lease obligations and in Note 8 to the accompanying condensed consolidated financial statements. GRIL has entered into a lease agreement for office space inDublin, Ireland . Under the terms of this lease agreement, GRIL is committed to average annual rent payments denominated in Euros approximating €67,528 per annum untilMay 2016 (net of rent inducements), and adjusted to the prevailing market rates for each of the three subsequent five-year terms. GRIL has the option to terminate the lease agreement in 2016 and 2021. The minimum lease payment obligations are included in the above table under operating lease obligations and in Note 8 to the accompanying condensed consolidated financial statements.
We have entered into a service agreement with a specialist service provider for the provision of administration and
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support in developing and maintaining business relationships, reviewing and recommending programs and managing risks relating to certain specialty lines of business. The specialist service provider does not have any authority to bind the Company to any reinsurance contracts. Under the terms of the agreement, the Company has committed to quarterly payments to the specialist service provider. If the agreement is terminated, the Company is obligated to make minimum payments for another two years to ensure any contracts to which the Company is bound are adequately administered by the specialist service provider. The minimum payments are included in the above table under specialist service agreement and in Note 8 to the accompanying condensed consolidated financial statements. OnJanuary 1, 2008 , we entered into an Advisory Agreement wherein the Company andDME Advisors agreed to create a joint venture for the purposes of managing certain jointly-held assets. The Advisory Agreement was amended effectiveAugust 31, 2010 to include GRIL as a participant to the agreement. The term of the amended agreement isAugust 31, 2010 throughDecember 31, 2013 , with automatic three-year renewals unless 90 days prior to the end of the then current term, eitherDME Advisors terminates the agreement or any of the participants notifiesDME Advisors of its desire to withdraw from the agreement. Pursuant to the Advisory Agreement, we pay a monthly management fee of 0.125% on our share of the assets managed byDME Advisors and performance allocation of 20% on the net investment income of the Company's share of assets managed byDME Advisors subject to a loss carry forward provision. The loss carry forward provision allowsDME Advisors to earn reduced incentive compensation of 10% on net investment income in any year subsequent to the year in which the investment account incurs a loss, until all the losses are recouped and an additional amount equal to 150% of the aggregate loss is earned.DME Advisors is not entitled to earn performance compensation in a year in which the investment portfolio incurs a loss. For the three months endedMarch 31, 2012 , performance allocation of$17.0 million was included in net investment income for the period and was accrued and included in the condensed consolidated balance sheets atMarch 31, 2012 , as performance compensation payable to related party. InFebruary 2007 , we entered into a service agreement withDME Advisors pursuant to whichDME Advisors will provide investor relations services to us for compensation of$5,000 per month plus expenses. The agreement had an initial term of one year, and continues for sequential one-year periods until terminated by us orDME Advisors . Either party may terminate the agreement for any reason with 30 days prior written notice to the other party.
Off-Balance Sheet Financing Arrangements
We have no obligations, assets or liabilities, other than those derivatives in our investment portfolio that are disclosed in the condensed consolidated financial statements, which would be considered off-balance sheet arrangements. We do not participate in transactions that create relationships with unconsolidated entities or financial partnerships, often referred to as variable interest entities, which would have been established for the purpose of facilitating off-balance sheet arrangements.
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