Item 1A. Risk Factors.
Risks Related to Our Business
We have a limited operating history.
We were formed in November 2005. In April 2006, CastlePoint Re received from the Bermuda Monetary Authority a registration certificate under the Insurance Act 1978 of Bermuda as a Class 3 Bermuda insurer. In December 2006, we acquired CastlePoint Insurance Company, a New York domestic stock property/casualty insurer that is licensed to transact insurance in the states of New York and New Jersey. As a recently formed company, we have a limited operating history on which you can base an estimate of our future earnings prospects.
Our business relationship with Tower and our management overlap with it may present, and make us vulnerable to, difficult conflicts of interest and business opportunity issues and related challenges.
Michael H. Lee, the Chairman of the Board and Chief Executive Officer of CastlePoint Holdings, Chief Executive Officer of CastlePoint Management and Chief Executive Officer of CastlePoint Insurance Company, who founded Tower in 1990, holds the positions of Chairman of the Board, President and Chief Executive Officer at Tower and, as such, does not serve our company on a full-time basis. Pursuant to his employment agreement, Mr. Lee is obligated to devote a substantial portion of his attention and time during normal working hours to the business and affairs of CastlePoint Holdings and its affiliates, as well as those of Tower and its affiliates. Furthermore, seven other executives of CastlePoint Holdings and/or its subsidiaries are former managers of Tower. Gregory T. Doyle, the President and director of each of CastlePoint Holdings, CastlePoint Management and CastlePoint Insurance Company, and a director of CastlePoint Re, is a former director of Tower.
In addition, we have met our financial objectives during the first two years of our operations primarily through our relationship with Tower, while further developing business opportunities from other sources. In 2008 and subsequent years, we expect that we will continue to be heavily dependent on Tower for a substantial portion of our business.
Because of our close business relationship with Tower, and Mr. Lee’s executive management positions at both companies, conflicts of interest could arise with respect to business opportunities that could be advantageous to Tower or its subsidiaries, on the one hand, and us or any of our subsidiaries, on the other hand. Because of our relationship with Tower and Mr. Lee’s position with both companies, Tower may have the ability to significantly influence us. While we expect that in the near term our interests and Tower’s interests should remain aligned, they may diverge as we develop additional business through other sources and become less dependent on Tower, or as we pursue business opportunities with clients that may be competitors of Tower.
We are dependent on Tower and its subsidiaries for a substantial portion of our business.
For the year ended December 31, 2007, the business we received from Tower represented approximately 75% of our written premium. We expect to derive a substantial portion of our reinsurance business and insurance business from Tower and its subsidiaries during the next several years. Some of the agreements we entered into with Tower had a term of one year. However, we and Tower have agreed to renew these agreements annually through March 31, 2010. The failure to renew, extend or replace these agreements, or the early termination of any of these agreements, would adversely affect us.
Reinsurance of Tower’s insurance companies’ business and Tower’s management of business written on CastlePoint Insurance policies could expose us to substantial risk of loss.
Because we reinsure a substantial amount of Tower’s insurance companies’ business, our results of operations are, and will continue to be, highly dependent on the results of operations of Tower’s insurance company subsidiaries. Tower’s insurance companies write business in New York, New Jersey, Massachusetts, New Hampshire and Maine. Likewise, Tower manages brokerage business written on CastlePoint Insurance polices in New York and New Jersey. As a result, a single catastrophic occurrence, such as a destructive weather pattern or terrorist attack, or other condition, such as an adverse regulatory development or general economic trend
disproportionately affecting the region within which these entities conduct most of their business could adversely affect such subsidiaries, and therefore, adversely affect our financial condition or results of operations. The single most significant catastrophe affecting Tower during its existence was the September 11 terrorist attacks in New York City. According to Tower’s annual report on Form 10-K for the year ended December 31, 2006 as filed with the SEC, Tower’s net losses from that event totaled approximately $400,000. However, there can be no assurance that a future catastrophe will not have a material adverse effect on Tower’s underwriting results or other results of operations, and hence on us.
The reinsurance agreements that we entered into with Tower are expected to continue through March 31, 2010 on their terms or we and Tower have agreed to renew them through that date, and they may be extended beyond that date. To the extent that market conditions change during that period, we will be adversely affected should Tower’s underwriting results deteriorate to the extent we are a reinsurer or a risk sharing participant for that business.
Our agreements with Tower’s insurance companies are subject to regulatory review and may be changed, which would adversely affect us.
We have been deemed an affiliate of Tower by the New York State Insurance Department and the Massachusetts Division of Insurance, and we may be deemed an affiliate of Tower by other regulatory authorities, including other state insurance regulatory authorities. As a result, any transaction or agreement between us and Tower or any of its subsidiaries is subject to regulatory review and modifications may be requested by the applicable regulator.
In addition, the domiciliary states of any other U.S. licensed insurance companies that we may acquire also may require approval of any alternative insurance risk-sharing agreements such companies enter into with Tower’s insurance companies and any of our other insurance subsidiaries. If Tower acquires subsidiaries that desire to participate in our quota share reinsurance agreements or our alternative insurance risk-sharing agreements, the approval of the domiciliary states of those subsidiaries likewise may be required.
Delays in receiving any necessary approvals from, or any further revisions to our agreements with Tower as a result of review by the New York State Insurance Department, the Massachusetts Division of Insurance or any other state insurance department may cause a delay in the implementation of our business strategy or cause us to deviate from our business strategy, which would adversely affect us. The disapproval of any of these agreements in part or in their entirety could adversely affect us.
Our initial arrangements with Tower were negotiated while we were its wholly-owned subsidiary and thus do not necessarily reflect terms that we would agree to in an arms-length negotiations with an independent third party.
In April 2006 we entered into a master agreement, certain reinsurance agreements, a program management agreement and a service and expense sharing agreement with Tower and/or its subsidiaries. We and Tower have subsequently modified certain of these arrangements as described elsewhere in this report. We have also entered into other agreements with Tower
since acquiring CastlePoint Insurance Company. Most of these agreements, as well as the warrants we issued to Tower and the employment agreements and compensation arrangements we entered into with Michael H. Lee, Joel S. Weiner, Joseph P. Beitz and James Dulligan, all current or former managers of Tower, were negotiated while we were a wholly-owned subsidiary of Tower. Because we were a wholly-owned subsidiary of Tower when most of the terms of our initial agreements were negotiated with Tower, such terms do not necessarily reflect terms that we or Tower would have agreed to in arms-length negotiations with an independent third party.
The Chairman of the Board and Chief Executive Officer of CastlePoint Holdings, and the Chief Executive Officer of CastlePoint Management presently holds the positions of Chairman of the Board, President and Chief Executive Officer at Tower, and this dual position may present, and make us vulnerable to, legal challenges under anti-trust laws.
Mr. Lee’s service as Chairman of the Board and Chief Executive Officer of CastlePoint Holdings and as Chairman of the Board, President and Chief Executive Officer of Tower could also raise a potential challenge under anti-trust laws. Section 8 of the Clayton Antitrust Act, or the Clayton Act, prohibits a person from serving as a director or officer in any two competing corporations under certain circumstances. If CastlePoint and Tower are in the future deemed to be competitors within the meaning of the Clayton Act, certain thresholds relating to direct competition between Tower and CastlePoint are met, and the Department of Justice and Federal Trade Commission challenge the arrangement, Mr. Lee may be required to resign his position with one of the companies, and/or fines or other penalties could be assessed against Mr. Lee and CastlePoint.
We plan to make strategic investments in Tower, which would add another dimension to our related party transactions with Tower and which may be influenced by our relationships with Tower or which may lead to perceptions in the marketplace that our operations are too intertwined with Tower; such perceptions may lead customers to pursue business with other reinsurers and insurance companies.
We continue to believe that investing in Tower in the future may be critical to our ongoing success in order to secure a steady source of historically profitable reinsurance business from Tower. Accordingly, we will continue to consider opportunities to invest in Tower if and when prudent. Because of our many relationships with Tower, we might be pressured by Tower, perhaps successfully, to make investments in Tower at times that are not as advantageous to our shareholders as our investments might be absent such pressure. Further, there is a risk that any strategic investments by us in Tower would create a perception in the marketplace that the operations of CastlePoint and Tower are too intertwined, so that potential customers, who otherwise might be willing to transact business with us, might not do so because of our relationships with Tower. For example, a potential customer may not wish to do business with us if it perceives that it is a competitor of Tower and has a concern that trade secrets and/or other material information might be shared with Tower, even though we believe such concerns are unwarranted due to the procedures we have for keeping information regarding our customers confidential. Accordingly, there is a risk that we might not generate as much business as we otherwise might be able to generate from third parties, because of the various dimensions of our relationship with Tower.
Our primary insurance operations may be adversely affected by a failure of Tower to provide services needed for us to conduct our domestic insurance company business.
Our subsidiary, CastlePoint Management, has entered into service and expense sharing agreements with Tower Insurance Company of New York. Under one of these agreements, we have access to various insurance company services, such as claims, policy administration and technology services, necessary to conduct our business, as well as the ability to offer these services to our clients. We rely on such services when conducting our primary insurance operations. That service and expense sharing agreement, however, expires March 31, 2010. Should Tower terminate that agreement before the term expires, fail to renew it, fail to provide such services to us or fulfill any of its other obligations under the agreement, we would need to provide or outsource such services, which, due to market conditions or otherwise, may be on less favorable terms and may adversely affect us. It would take several years and require a significant expenditure in time and expense to hire and train the necessary staff and implement the procedures to provide comparable services internally. Accordingly, we do not anticipate being able to fully provide such services internally in the near term.
If we are unable to implement our business strategy or operate our business as we currently expect, our results may be adversely affected.
We have been in business for approximately two years. As a result, we have limited name recognition and reputation in either the insurance or reinsurance industry. Businesses, such as ours, which do not have long operating histories, may present substantial business and financial risks and may suffer significant losses. In order to fully implement our business strategy, we need to accomplish many tasks, such as:
•
gain greater name recognition and establish a solid reputation in the insurance and reinsurance industry;
•
continue to develop business relationships with clients other than Tower;
•
obtain, as necessary, additional funding to further capitalize CastlePoint Re, CastlePoint Insurance Company and any other U.S. licensed insurance companies that we may acquire or form;
•
successfully capitalize on the industry relationships of our senior management;
•
hire additional key employees and other staff;
•
continue to develop and refine operating procedures;
•
obtain appropriate facilities;
•
implement new technology systems;
•
find and acquire or form an insurer or insurers or further license CastlePoint Insurance Company and receive the necessary regulatory approvals, so that we are able to write
primary insurance policies in the United States in additional states on an admitted or non-admitted basis.
Our failure to successfully complete any of the following tasks above could adversely affect us.
In addition, as a result of industry factors, such as excess industry underwriting capacity, new competition and legislative and/or regulatory developments, or factors specific to us, we may have to alter our anticipated methods of conducting our business, such as the nature, amount and types of risks we assume. For example, if a particular type of risk, such as workers’ compensation, commercial automobile or construction defects, becomes more volatile or less profitable to insure in a particular geographic area, we may cease providing such coverage in such area or provide such coverage to fewer insureds.
We may not be able to manage our growth effectively.
We intend to grow our business in the future, which could require additional capital, systems development and skilled personnel. CastlePoint Management, CastlePoint Insurance Company and CastlePoint Re are actively developing their respective businesses. We plan to develop business relatively rapidly over the next several years, especially since, when we commenced our operations, the amount of business we had from clients other than Tower was small. We cannot assure you that we will be able to meet our capital needs, expand our systems effectively, allocate our human resources optimally, identify and hire qualified employees or incorporate effectively the components of any businesses we may acquire in our effort to achieve growth. The failure to manage our growth effectively could adversely affect us.
If we misevaluate the risks we insure or reinsure, our actual insured losses may be greater than our loss reserves, which would negatively impact our financial condition and results of operations.
Our success depends in part upon our ability to assess accurately the risks associated with the businesses that we reinsure and insure. Significant periods of time often elapse between the occurrence of an insured loss, the reporting of the loss to an insurer and payment by the insurer of that loss. In connection with our writing reinsurance business and recognizing liabilities for unpaid losses, we establish loss reserves (which are liabilities we establish to reflect the estimated cost of claims payments and the related expenses that we will ultimately be required to pay in respect of reinsurance we have written) as balance sheet liabilities, and we also do so for the insurance business we write. These reserves represent estimates of amounts needed to pay reported losses (which are claims or potential claims that have been identified to us as a reinsurer by a ceding company, or will be identified to us as an insurer by an insured) and unreported losses and the related loss adjustment expense. Our loss reserves are only an estimate at a point in time of what we anticipate the ultimate costs of claims to be and therefore cannot and do not represent an exact calculation of actual ultimate liability. Estimating loss reserves is a difficult and complex process involving many variables and subjective judgments, particularly for new companies, such as ours, that have little loss development experience.
As of December 31, 2007, we had approximately $121.4 million of loss reserves. We believe such reserves are adequate. However, actual results may not conform to our estimates.
In our reinsurance business, we, like other reinsurers, do not separately evaluate each of the individual risks assumed under reinsurance treaties. Thus, we are largely dependent on the original underwriting decisions made by ceding companies. We are subject to the risk that our ceding companies may not have adequately evaluated the individual risks to be reinsured and that the premiums ceded to us may not adequately compensate us for the risks we assume. In our insurance business, we underwrite programs in which program underwriting managers are authorized to exercise underwriting authority on our behalf. While we provide underwriting guidelines and review underwriting results, there is no assurance that program underwriting managers will evaluate each of the risks within the program adequately or that the premium charged will be sufficient to compensate us for the underwriting risk insured by us.
To the extent our loss reserves are insufficient to cover actual losses and loss adjustment expenses, we will have to adjust our loss reserves in future years and may incur charges to our earnings in the period in which such adjustment is made, which could adversely affect us.
Even if we accurately assess the risks we insure, the occurrence of severe catastrophic events or unforeseen losses may adversely affect us.
We reinsure or insure on a direct basis property and casualty insurance with large aggregate exposures to the possibility of loss from natural and man-made disasters, such as hurricane, typhoon, windstorm, flood, earthquake, acts of war, acts of terrorism and political instability. We expect that our loss experience generally will include infrequent events of great severity. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. The occurrence of losses from catastrophic events may adversely affect our ability to write new business, results of operations and financial condition. Increases in the values and geographic concentrations of insured property and the effects of inflation have resulted in increased severity of industry losses in recent years and we expect that those factors will increase the severity of catastrophe losses in the future. The occurrence of severe catastrophic events may adversely affect us.
We may require additional capital in the future, which may not be available on favorable terms or at all.
Our future capital requirements will depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover our losses. In addition, we may make strategic investments in some of our clients, including investments in Tower, or acquire or make investments in insurance or reinsurance companies. We anticipate that the funds necessary to make such investments may be raised through equity and/or debt financings. In addition, we may enter into an unsecured revolving credit facility and a term loan facility with one or more syndicates of lenders. We currently have no commitment from any lender with respect to a credit facility or a loan facility. Any equity or debt financing, if available at all, may be on terms that are not favorable to us. If we cannot obtain additional capital, we will not be able to further grow our business and fully implement our business strategy, which would adversely affect us.
Even if we are able to raise capital through equity and/or debt financings, the terms of those financings may adversely affect the holdings or rights of our existing shareholders.
Even if we are able to raise capital through equity and/or debt financings, the interest of existing shareholders in our company may be diluted, and the securities we issue may have rights, preferences and privileges that are senior to those of our common shares or may otherwise materially and adversely affect the holdings or rights of our existing shareholders. In addition, the terms of any debt financings may require guarantees by CastlePoint Holdings or any of our subsidiaries.
Our failure to purchase or form additional U.S. licensed insurance companies or, to obtain and maintain required licenses and regulatory approvals could adversely affect us.
In December 2006 we acquired CastlePoint Insurance Company, our U.S. insurance company that is licensed in the states of New York and New Jersey, and we intend to obtain additional licenses in other states, either by acquiring or forming other U.S. licensed insurance companies, or by having CastlePoint Insurance Company become more broadly licensed. Through these U.S. licensed insurance companies, we intend to write insurance on an admitted basis for risks in those U.S. jurisdictions where such companies are licensed, and may seek to become eligible to write on a non-admitted basis in those U.S. jurisdictions where such companies are not licensed. To acquire or form these U.S. licensed insurance companies or to broaden CastlePoint Insurance Company’s licensing to additional states, we generally will need the approval of insurance regulators in the respective states of domicile of such companies, and we may need the approval of insurance regulators in the states where such companies seek to be admitted or are admitted.
Additionally, CastlePoint Re may seek to become eligible to write insurance on a non-admitted basis, as an eligible excess and surplus lines insurer, in certain states in the United States. A non-admitted insurer that is eligible to act as an excess and surplus lines insurer in a particular state is not licensed as an insurer in such state, but may write insurance business in such state under certain limited circumstances.
Generally, to become eligible to write business on an excess and surplus lines basis in certain states in the United States, our subsidiaries will need the approval of insurance regulators in those states. To obtain such approvals, the subsidiaries generally will be required to file extensive applications, demonstrate financial stability and, in the case of CastlePoint Re, establish and maintain a funded trust account. The application process may take several months to complete in each jurisdiction
We cannot assure you that we will obtain the necessary regulatory approvals to support these operations. Our failure to obtain such regulatory approvals could adversely affect us.
We are dependent on our key executives and may not be able to attract and retain key employees to fully implement our business strategy.
Our success depends largely on the senior management of CastlePoint, which includes, among others, Michael H. Lee, the Chairman of the Board and Chief Executive Officer of
CastlePoint Holdings, Joel S. Weiner, the Chief Financial Officer and Senior Vice President of CastlePoint Holdings, CastlePoint Management and CastlePoint Insurance Company, Gregory T. Doyle, the President and director of each of CastlePoint Holdings, CastlePoint Management and CastlePoint Insurance Company, Richard M. Barrow, the Chief Accounting Officer and Senior Vice President of CastlePoint Holdings, CastlePoint Management and CastlePoint Insurance Company and Joseph P. Beitz, President and director of CastlePoint Re. We do not maintain key man life insurance coverage on the lives of these individuals.
Since our management team and other personnel are now substantially in place, our ability to implement our business strategy will depend on their successful retention. Also, we will need additional personnel as we grow. The number of available, qualified personnel in the insurance and reinsurance industry to fill such additional positions may be limited. Our inability to attract and retain executives or the loss of the services of any of our senior executives or key employees, could delay or prevent us from fully implementing our business strategy and could adversely affect us.
We are currently dependent on our reinsurance business for a substantial portion of our revenues and profits and may not be able to maintain or increase this business.
In 2007, we derived the majority of our income from our reinsurance business. We anticipate that revenues from our reinsurance business will continue to account for a significant portion of our total revenues and total income, particularly if we do not quickly acquire an additional insurance company broadly licensed in the United States or expand CastlePoint Insurance Company’s licensing to additional states, in order to conduct our insurance and insurance risk-sharing businesses. Because our revenue will remain concentrated in this segment, any losses in this segment or any down turn in the reinsurance industry generally would adversely affect us.
A significant amount of our invested assets is subject to changes in interest rates and market volatility, both generally and specifically in the insurance and reinsurance industries.
We invested substantially all of the proceeds we received from our initial public offering and from our trust preferred offerings in fixed income securities in accordance with our investment guidelines. In addition, we invest a portion of the premiums we receive from our reinsurance and insurance underwriting activities in fixed income securities, short-term U.S. Treasury bills, cash and money market equivalents and, to a lesser extent, equity securities. The fair market value of these assets and the investment income from these assets fluctuate depending on general economic and market conditions. Because we classify substantially all of our invested assets as available for sale, we expect changes in the market value of our securities are generally reflected in our shareholders’ equity. We may invest in limited partnerships and, pursuant to the equity method of accounting, record investment income and realized and unrealized gains and losses as a component of net investment income. We expect our investment portfolio will always include a significant amount of interest rate-sensitive instruments, such as bonds. Interest rates are highly sensitive to many factors beyond our control. Increases in interest rates will decrease the value of our investments in fixed-income securities. If increases in interest rates occur during periods when we sell investments to satisfy liquidity needs, we may
experience investment losses. If interest rates decline, reinvested funds will earn less than expected.
Our investment results may also be adversely affected by changes in the business, financial condition or results of operations of the entities in which we invest, as well as changes in government monetary policies, and general economic and overall market conditions. Furthermore, general economic conditions and overall market conditions may be adversely affected by U.S. involvement in hostilities with other countries and large-scale acts of terrorism, or the threat of hostilities or terrorist acts.
Additionally, the insurance and reinsurance industry historically has been cyclical and characterized by periods of intense price competition due to excessive underwriting capacity as well as periods when shortages of capacity permitted favorable premium levels. The supply of insurance and reinsurance may increase, either due to capital provided by new entrants or by the commitment of additional capital by existing insurers or reinsurers, which may cause prices to decrease. Any of these factors could lead to a significant reduction in premium rates and additional competition for business and could significantly affect our profitability.
Our business could be adversely affected by Bermuda employment restrictions.
While CastlePoint Holdings and CastlePoint Re take appropriate measures to attempt to hire qualified Bermudians to work for us, to date all of our key employees have been non-Bermudians. Under Bermuda law, non-Bermudians (other than spouses of Bermudians, holders of Permanent Residents’ Certificates and holders of Working Residents’ Certificates) may not engage in any gainful occupation in Bermuda without an appropriate governmental work permit. Work permits may be granted or extended by the Bermuda government upon showing that, after proper public advertisement in most cases, no Bermudian (or spouse of a Bermudian, holder of Permanent Residents’ Certificates and holder of Working Residents’ Certificates) is available who meets the minimum standard requirements for the advertised position. The Bermuda government’s policy limits the duration of work permits to six years, with certain exemptions for key employees. Permanent work permits typically are issued for a term of three years, and temporary work permits are issued for a term of three months and are renewable for an additional three months. All of our current employees in Bermuda including all of our senior management who are required to obtain a work permit have received permanent work permits. However, the work permit of one employee, not a member of senior management, expires in October 2008 and may not be able to be renewed. If this should occur, we believe we will be able to hire a qualified employee to replace this individual. We may not be able to use the services of one or more of our key employees if we are not able to obtain or renew work permits for them, which could adversely affect us.
Our business is dependent upon reinsurance brokers and program underwriting managers and the failure to develop or maintain these relationships could adversely affect us.
We market our reinsurance products primarily through reinsurance brokers and our insurance products primarily through program underwriting managers. We expect that the number of reinsurance brokers with which we do business will increase over time. Since there
are relatively few reinsurance brokers, however, we expect that we will derive a significant portion of our reinsurance business from up to twelve such firms. While we generally rely on the industry relationships and relationships with a number of brokers and program underwriting managers that our senior management team has developed, our failure to further develop or maintain relationships with brokers and program underwriting managers from whom we expect to receive our business could adversely affect us.
Our reliance on brokers and program underwriting managers subjects us to their credit risk.
In accordance with industry practice, we frequently pay and anticipate that we will continue to frequently pay amounts owed on claims under our insurance or reinsurance contracts to brokers and program underwriting managers, and these brokers and program underwriting managers in turn are required to pay and will pay these amounts over to the clients that have purchased insurance or reinsurance from us. If a broker or a program underwriting managers fails to make such a payment, it is likely that we will be liable to the client for the deficiency under local laws or contractual obligations, notwithstanding the broker or program underwriting manager’s obligation to make such payment. Likewise, when the client pays premiums for these policies to brokers or program underwriting managers for payment over to us, these premiums are considered to have been paid and, in most cases, the client is no longer liable to us for those amounts, whether or not we actually receive the premiums from the brokers or program underwriting managers. Consequently, with respect to most of our insurance and reinsurance business, we assume a degree of credit risk associated with brokers and program underwriting managers with whom we work.
We compete with a large number of companies in the insurance and reinsurance industry for underwriting revenues.
We compete with major U.S. and non-U.S. insurers and reinsurers, including several Bermuda-based insurers, that offer the lines of insurance and reinsurance that we offer, target the same markets as we do and utilize similar business strategies. There are many insurance companies and reinsurance companies throughout the world, and new reinsurance companies, based in Bermuda or elsewhere, may be formed at any time. In addition, we face competition from specialty insurance companies, program underwriting managers and intermediaries, as well as diversified financial services companies. We believe that business conditions became more competitive in 2007 and are likely to remain so in 2008. Since we have a limited operating history, many of our competitors have greater name and brand recognition than we have. Many of them also have substantially more capital and greater marketing and management resources than we have, and may offer a broader range of products and more competitive pricing than we are able to, or will be able to, offer. Since we recently commenced operations, we may not be able to compete successfully on many of these bases. If competition limits our ability to write new business at adequate rates, our return on capital may be adversely affected.
Competition may also prevent us from expanding our reinsurance, programs, or risk-sharing business beyond our agreements with Tower and those clients that we have already attracted. Also, clients other than Tower with whom we are currently conducting business may in
the future reduce the amount of business they conduct with us. Any of these circumstances would increase our dependence on Tower and could adversely affect us.
Additionally, the insurance and reinsurance industry is undergoing a process of consolidation as industry participants seek to enhance their product and geographic reach, client base, operating efficiency and general market power through merger and acquisition activities. We believe that the larger entities resulting from these mergers and acquisition activities may seek to use the benefits of consolidation, including improved efficiencies and economies of scale, to, among other things, implement price reductions for their products and services to increase their market shares. If competitive pressures compel us to reduce our prices, our operating margins will decrease. As the insurance and reinsurance industry consolidates, competition may become more intense and the importance of acquiring and properly servicing each customer will become greater. We could incur greater expenses relating to customer acquisition and retention, which could reduce our operating margins and adversely affect us.
Our competitive position may be adversely affected by new, proposed or potential legislative or industry developments or other developments that affect the markets we serve.
A number of new, proposed or potential legislative developments could further increase competition in our industry. These developments include:
•
Programs in which state-sponsored entities provide property insurance in catastrophe-prone areas or other “alternative markets” types of coverage (for example, the state of Florida has created a state-owned insurer to provide homeowners insurance, which may offer coverage at lower rates than private insurers and may result in lower demand for quota share and property catastrophe reinsurance).
•
The introduction of federal legislation that, if enacted in its current form, would allow insurers to elect federal, as opposed to state, regulation. If enacted, this could increase competition by allowing insurers that are not licensed in particular states to transact insurance in such states if they become federally licensed.
•
The introduction of federal legislation that, if enacted in its current form, would preclude states from prohibiting excess or surplus lines brokers from placing non-admitted insurance with, or procuring non-admitted insurance from, alien insurers that are included on the NAIC list. Such legislation would also impose uniform standards for insurers domiciled in the United States to seek to become excess and surplus lines eligible in each state. If enacted, this could increase competition by allowing certain insurers to act, or to seek to act, as eligible excess and surplus lines insurers in states where they would not otherwise be permitted or qualified to do so.
•
Potential federal legislation that could reduce or eliminate tax advantages in the United States for companies based in and conducting their operations out of Bermuda that reinsure business from the United States.
The insurance industry has attracted increased scrutiny by regulatory and law enforcement authorities, as well as class action attorneys and the general public, relating to allegations of improper special payments, price-fixing, bid-rigging, improper accounting practices and other alleged misconduct, including payments made by insurers to brokers and the practices surrounding the placement of insurance business. Formal and informal inquiries have been made of a large segment of the industry, and a number of companies in the insurance industry have received or may receive subpoenas, requests for information from regulatory agencies or other inquiries relating to these and similar matters. These efforts have resulted in both enforcement actions and proposals for new regulation. It is difficult to predict the outcome of this increased regulatory scrutiny and whether it will expand into other areas not yet contemplated, whether activities and practices currently thought to be lawful will be characterized as unlawful, what form new regulations will have when finally adopted and the impact, if any, of increased regulatory and law enforcement action and litigation on our business and financial condition.
As industry practices and legal, judicial, social and other environmental conditions change, unexpected issues related to claims and coverage may emerge. These issues may adversely affect us by either extending coverage beyond our underwriting intent or by increasing the number or size of claims. In some instances, these changes may not become apparent until some time after we have issued insurance or reinsurance contracts that are affected by the changes. As a result, the full extent of liability under our insurance or reinsurance contracts may not be known for many years after a contract is issued. The effects of this and other unforeseen emerging claim and coverage issues are extremely hard to predict and could adversely affect us.
We may face substantial exposure to losses from terrorism. Our U.S. insurance companies are required by law to offer coverage against such losses and the protection afforded by federal legislation has been reduced.
The location and concentration of business written in New York City and adjacent areas by Tower may expose us to losses from terrorism. U.S. insurers are required by state and Federal law to offer coverage for terrorism in certain commercial lines. The terrorism risk insured by (1) our U.S. licensed insurance companies, and (2) the small insurance companies with whom we share risk, could adversely affect us. Pursuant to the reinsurance agreements that CastlePoint Re entered into with Tower’s insurance companies and others, CastlePoint Re is required to reinsure a portion of each ceding insurer’s losses resulting from terrorism. Although CastlePoint Re may seek to retrocede some or all of this terrorism risk to unaffiliated reinsurers, it may be unable to do so on terms that it considers favorable, or at all.
The reinsurance and retrocessional coverage that we use to limit our exposure to risks may not ultimately provide the protection we sought, and credit and other risks associated with our reinsurance arrangements may result in losses which could adversely affect us.
We provide reinsurance and insurance to our clients and in turn retrocede coverage we assume to other insurers and reinsurers, some of whom may be relatively small agency-owned, association-owned or otherwise privately owned insurers or reinsurers. Some of these insurers or reinsurers to whom we retrocede coverage may be domiciled in Bermuda or other non-U.S.
locations. We are subject to credit and other risks that depend upon the financial strength of these reinsurers because the ceding of risk to reinsurers and retrocessionaires does not relieve us of our liability to the clients or companies we insure or reinsure. Our failure to establish adequate reinsurance or retrocessional arrangements or the failure of our reinsurance or retrocessional arrangements to protect us from overly concentrated risk exposure could adversely affect us.
Our holding company structure and certain regulatory and other constraints affect our ability to pay dividends and make other payments.
CastlePoint Holdings is a holding company. As a result, we do not have, and will not have, any significant operations or assets other than our ownership of the shares of our subsidiaries.
Dividends and other permitted distributions from our operating subsidiaries are our sole source of funds to pay dividends to our shareholders and meet ongoing cash requirements, including debt service payments and other expenses. Bermuda law and regulations, including but not limited to Bermuda insurance regulations, restrict the declaration and payment of dividends and the making of distributions by CastlePoint Re, unless specific regulatory requirements are met. In addition, CastlePoint Insurance Company is, and any other U.S. licensed insurance companies that we may acquire or form will be, subject to significant regulatory restrictions limiting their ability to declare and pay dividends. Furthermore, any dividends paid by CastlePoint Insurance Company or such other U.S. licensed insurance companies is subject to a 30% withholding tax. Therefore, any dividends or other permitted distributions we expect to receive will likely be paid or otherwise made by CastlePoint Re, which is subject to Bermuda regulatory restrictions and any applicable contractual restrictions on any such payments. If we cannot receive dividends or other permitted distributions from CastlePoint Re as a result of such restrictions, we will be unable to pay dividends as currently contemplated by our board of directors. The inability of our operating subsidiaries to pay dividends in an amount sufficient to enable us to meet our cash requirements at the holding company level could adversely affect us.
CastlePoint Holdings is subject to Bermuda regulatory constraints that affect our ability to pay dividends on our shares and make other payments. Under the Companies Act 1981 of Bermuda, as amended (the “Companies Act”), we may declare or pay a dividend out of distributable reserves only if we have reasonable grounds for believing that we are, or would after the payment be, able to pay our liabilities as they become due and if the realizable value of our assets would thereby not be less than the aggregate of our liabilities and issued share capital and share premium accounts. For a discussion of the legal and regulatory limitations on our existing and future subsidiaries’ ability to pay dividends to CastlePoint Holdings and of CastlePoint Holdings to pay dividends to its shareholders, see “Item 7: Management’s Discussion and Analysis of Financial Conditions and Results of Operations-Liquidity -Restrictions on Dividend Payments from our Operating Subsidiaries.”
We have recently become subject to additional financial and other reporting and corporate governance requirements that may be difficult for us to satisfy.
Following our initial public offering in March 2007, we became subject to new financial and other reporting and corporate governance requirements, including the requirements of the
Nasdaq Global Market and certain provisions of the Sarbanes-Oxley Act of 2002 and related regulations, which impose significant compliance obligations upon us. To comply with these additional requirements, we have been required to:
•
supplement our internal accounting function, including hiring staff with expertise in accounting and financial reporting for a public company, as well as implement appropriate and sufficient accounting and reporting systems, and enhance and formalize closing procedures at the end of our accounting periods;
•
prepare and distribute periodic public reports as required by the U.S. federal securities laws;
•
involve and retain to a greater degree outside counsel and accountants in the activities listed above; and
•
enhance our investor relations function.
These obligations require a significant commitment of additional resources. We may not be successful in implementing these requirements, and failure to implement them could adversely affect us. In addition, if we fail to implement the requirements with respect to our internal accounting and audit functions, our ability to report our operating results on a timely and accurate basis would be impaired.
Provisions in our bye-laws may reduce or increase the voting rights of our shares.
Our bye-laws generally provide that shareholders have one vote for each share held by them and are entitled to vote, on a non-cumulative basis, at all meetings of shareholders except that, pursuant to a mechanism specified in our bye-laws, the voting rights exercisable by a shareholder are limited so that certain persons or groups are not deemed to hold more than 9.5% of the total voting power conferred by our shares. Our bye-laws provide generally that any shareholder owning, directly, indirectly or, in the case of any U.S. person, by attribution, more than 9.5% of our common shares will have the voting rights attached to such common shares reduced so that it may not exercise more than 9.5% of the total voting rights. Any reduction in votes will generally be reallocated proportionately among members of the shareholder’s control group or related group, as the case may be. The amount of any reduction of votes that occurs by operation of the above limitations will generally be reallocated proportionately among all other of our shareholders who were not members of these groups so long as such reallocation does not cause any other person to hold more than 9.5% of the total voting power of our shares.
As a result of any reduction in the votes of a shareholder, other shareholders’ voting power might increase above 5% of the aggregate voting power of the outstanding shares, which may result in a shareholder becoming a reporting person subject to Schedule 13D or 13G filing requirements under the Exchange Act.
We also have the authority to request information from any shareholder for the purpose of determining whether a shareholder’s voting rights are to be reallocated pursuant to our bye-
laws. If a shareholder fails to respond to a request for information from us or submits incomplete or inaccurate information (after a reasonable cure period) in response to a request, we, in our reasonable discretion, may reduce or eliminate the shareholder’s voting rights.
Anti-takeover provisions in our bye-laws could impede an attempt to replace or remove our directors or acquire us, which could diminish the value of our common shares.
Pursuant to our bye-laws, election of our directors is staggered, meaning that the members of only one of three classes of our directors are elected each year and the total voting power of any shareholder owning more than 9.5% of our common shares is limited to 9.5% of the total voting power of our common shares. These bye-laws provisions may, or may be seen to, entrench our directors and make it more difficult for shareholders to replace directors even if the shareholders consider it beneficial to do so. In addition, these provisions could delay or prevent a change of control that a shareholder might consider favorable. For example, these provisions may prevent a shareholder from receiving the benefit from any premium over the market price of our common shares offered by a bidder in a potential takeover. Even in the absence of an attempt to effect a change in management or a takeover attempt, these provisions may adversely affect the prevailing market price of our common shares if they are viewed as discouraging changes in management and takeover attempts in the future.
Additionally, provisions of our organizational documents may discourage, delay or prevent a merger, amalgamation, tender offer or other change of control that holders of our shares may consider favorable. These provisions impose various procedural and other requirements that could make it more difficult for shareholders to effect various corporate actions. These provisions could adversely affect the price of, and the voting and other rights of the holders of, our securities.
We are a Bermuda company and it may be more difficult for our shareholders to protect their interests or to enforce judgments against us or our directors and executive officers than if we were a U.S. corporation.
We are incorporated under the laws of Bermuda and our business is based in Bermuda. The Companies Act, which applies to us, differs in certain material respects from laws generally applicable to U.S. corporations and their shareholders. As a result of these differences, U.S. persons who own our shares may have more difficulty protecting their interests than U.S. persons who own shares of a U.S. corporation.
In addition, some of our directors and officers may reside outside the United States, and all or a substantial portion of our assets will be and the assets of these persons are, and will continue to be, located in jurisdictions outside the United States. As such, it may be difficult or impossible to effect service of process within the United States upon us or those persons or to recover against us or them on any judgments of U.S. courts, including any judgments predicated upon civil liability provisions of the U.S. federal securities laws. Further, no claim may be brought in Bermuda against us or our directors and officers in the first instance for violation of U.S. federal securities laws because these laws have no extraterritorial jurisdiction under Bermuda law and do not have the force of law in Bermuda.
We may require our shareholders to sell their shares of CastlePoint Holdings to us.
Our bye-laws provide that we have the option, but not the obligation, to require a shareholder to sell his, her or its shares at a purchase price equal to their fair market value to us, to other shareholders or to third parties if we determine, based on the written advice of legal counsel, that failure to exercise this option would result in adverse tax, regulatory or legal consequences to us or to some U.S. persons as to which the shares held by such shareholder constitute controlled shares. In the latter case, our right to require a shareholder to sell his, her or its shares to us will be limited to the purchase of a number of shares that will permit avoidance of those adverse tax consequences.
Each of CastlePoint Re and CastlePoint Insurance Company has received a rating of “A-” (Excellent) from A.M. Best. Our inability to maintain such ratings or obtain the same rating for any additional primary insurance subsidiaries that we may acquire or a future downgrade in our ratings would adversely affect our competitive position with customers, our standing among brokers, program underwriting managers and insurance company clients and would adversely affect us.
Competition in the types of insurance business that we intend to underwrite and reinsure is based on many factors, including the perceived financial strength of the insurer and ratings assigned by independent rating agencies. Insurance ratings are used by customers, reinsurers and reinsurance intermediaries as an important means of assessing the financial strength and quality of insurers. In addition, the rating of a company seeking reinsurance, also known as a ceding company, may be adversely affected by the lack of a rating of its reinsurer. Therefore, the lack of a satisfactory rating may dissuade a ceding company from reinsuring with us or may influence a ceding company to reinsure with a competitor of ours.
In June 2007, A.M. Best placed the ratings of CastlePoint Re, CastlePoint Insurance Company and CastlePoint Holdings under review with negative implications; however, those existing ratings of “A-” (Excellent) were affirmed by A.M. Best in July 2007. There is no assurance that we will be able to maintain our ratings, or that any additional U.S. licensed insurance companies that we may acquire will receive such rating.
A.M. Best stated that it will closely monitor the flow of business to CastlePoint Re and CastlePoint Insurance Company from Tower, as well as CastlePoint Re’s and CastlePoint Insurance Company’s capital flows to ensure there are no material deviations from projections utilized by A.M. Best to establish the ratings of CastlePoint Re and CastlePoint Insurance Company. A.M. Best also stated that it believes that both CastlePoint Re’s and CastlePoint Insurance Company’s results could be impacted by Tower’s plans for growth and acquisitions, and Tower’s exposure to catastrophes due to its concentration of business in New York City.
The ratings of CastlePoint’s reinsurance and insurance subsidiaries are subject to periodic review by, and may be revised downward or revoked at the sole discretion of, A.M. Best. A.M. Best formally evaluates its Financial Strength ratings at least once every twelve months and monitors the performance of rated companies throughout the year. The maintenance of the assigned ratings depends upon CastlePoint Re and CastlePoint Insurance Company operating in a
manner consistent with the business plan presented to A.M. Best. Even if any additional insurance subsidiaries we may acquire or form receive a desired rating, if A.M. Best subsequently downgrades their ratings, or the current ratings of CastlePoint Re and CastlePoint Insurance Company fall below “A-”, the competitive position of our reinsurance and insurance subsidiaries would suffer, and their ability to market their products, to obtain customers and to compete in the reinsurance and insurance industries would be adversely affected. A subsequent downgrade, therefore, could result in a substantial loss of business as our insurance company and reinsurance company clients and program business managers may move to other insurers with higher claims paying and financial strength ratings. Such a downgrade also would have a negative impact on our ability to obtain or service and manage existing debt.
Our internal audit and reporting systems might not be effective in the future, which could increase the risk that we would become subject to regulatory action or litigation or other developments that could adversely affect us.
Our ability to comply with applicable laws, rules and regulations is largely dependent on our establishment and maintenance of internal audit and reporting systems, as well as on our ability to attract and retain qualified management, and accounting and actuarial personnel to further develop our internal accounting function and control policies. If we fail to effectively establish and maintain such reporting and accounting systems or fail to attract and retain personnel who are capable of designing and operating such systems, these failures will increase the likelihood that we will become subject to legal and regulatory infractions, including civil litigation and investigations by regulatory agencies including the SEC.
Risks Related to Taxation
CastlePoint Holdings or CastlePoint Bermuda Holdings may be deemed to be engaged in a U.S. trade or business, or CastlePoint Re may be considered to be doing business through a permanent establishment in the United States.
We intend that neither CastlePoint Holdings nor CastlePoint Bermuda Holdings “engage in a trade or business” within the United States and that CastlePoint Re does not have a permanent establishment in the United States (as those terms are defined for tax purposes) and, as a result, we expect that none of these companies is subject to U.S. tax (other than U.S. excise tax on premium income for insuring or reinsuring U.S. risks and U.S. withholding tax on certain U.S.-source investment income). Because there is uncertainty as to what activities constitute being engaged in a trade or business within the United States or having a permanent establishment in the United States, and because a significant portion of CastlePoint Re’s business has been, and is expected to continue to be, reinsurance of Tower, whose Chairman of the Board, President and Chief Executive Officer is also the Chairman of the Board and Chief Executive Officer of CastlePoint Holdings, we cannot be certain that the Internal Revenue Service (the “IRS”) will not be able to successfully contend that CastlePoint Holdings or CastlePoint Bermuda Holdings is engaged in a trade or business in the United States or that CastlePoint Re has a permanent establishment in the United States. In the event that CastlePoint Holdings or CastlePoint Bermuda Holdings were engaged in a business within the United States, that company would be subject to U.S. corporate income and branch profits taxes on the portion of its earnings effectively connected to such U.S. business; if CastlePoint Re were to have a permanent
establishment in the United States, CastlePoint Re would be subject to U.S. income and branch profits tax on the portion of its income attributable to that permanent establishment. Any such adverse tax results would adversely affect us.
We may become subject to taxes in Bermuda after March 28, 2016.
The Bermuda Minister of Finance, under the Exempted Undertakings Tax Protection Act 1966, as amended, of Bermuda, has given each of CastlePoint Holdings, CastlePoint Re and CastlePoint Bermuda Holdings an assurance that if any legislation is enacted in Bermuda that would impose tax computed on profits or income, or computed on any capital asset, gain or appreciation, or any tax in the nature of estate duty or inheritance tax, then the imposition of any such tax will not be applicable to CastlePoint Holdings, CastlePoint Re, CastlePoint Bermuda Holdings or any of their respective operations, shares, debentures or other obligations until March 28, 2016. Given the limited duration of the Minister of Finance’s assurance, we cannot be certain that we will not be subject to any Bermuda tax after March 28, 2016. In the event that we become subject to any Bermuda tax after such date, it would have a material adverse effect on our financial condition and results of operations.
U.S. persons who hold shares could be subject to adverse tax consequences if we are considered a “passive foreign investment company,” or PFIC, for U. S. federal income tax purposes.
In general, a foreign corporation will be a PFIC during a given year if (1) 75% or more of its gross income constitutes “passive income” or (2) 50% or more of its assets are held for the production of passive income. For these purposes, passive income generally includes interest, dividends, annuities and other investment income. The PFIC provisions contain an exception for income derived in the active conduct of an insurance business by a corporation that is predominantly engaged in the insurance business. We do not intend to conduct our activities in a manner that would cause us to become a PFIC. However, there are currently no regulations regarding the application of the PFIC provisions to an insurance company and it is possible that we could be held to be a PFIC for 2006, 2007 or any future year. If we were held to be a PFIC, it could have material adverse tax consequences for a shareholder that is subject to U.S. federal income taxation, including subjecting the investor to a greater tax liability than might otherwise apply or subjecting the shareholder to tax on amounts in advance of when tax would otherwise be imposed.
It might be held that transactions between Tower and CastlePoint Re do not constitute insurance, due to the proportion of CastlePoint Re’s premiums provided by Tower.
The IRS, in Revenue Ruling 2005-40, took the position that a transaction between an insurer and an insured did not provide risk distribution, and thus was not insurance for U.S. federal income tax purposes, when the insured provided over 90% of the insurer’s premiums for the year. The IRS has never taken this position with respect to quota share reinsurance transactions in which the ceding company cedes a significant number of unrelated risks to the reinsurer, even if the ceding company provides substantially all of the reinsurer’s business. Nevertheless, if the IRS successfully advocated such a position, and transactions between Tower and CastlePoint Re and/or the other U.S. licensed insurance companies we intend to acquire were
not considered insurance, CastlePoint could be considered a PFIC. As noted above, if CastlePoint were considered a PFIC it could have material adverse tax consequences for an investor that is subject to U.S. tax.
U.S. persons who hold shares may be subject to U.S. income taxation on their pro rata share of our “related person insurance income,” or RPII.
If (1) CastlePoint Re’s gross RPII were to equal or exceed 20% of that company’s gross insurance income in any taxable year, or (2) direct or indirect insureds (and persons related to such insureds) were to own (or be treated as owning, directly or constructively) 20% or more of the voting power or value of our shares, and (3) U.S. persons were to own (directly or constructively) 25% or more of the stock of the voting power or value of our shares, then a U.S. person who owns our shares directly or indirectly through foreign entities on December 31 of a year would be taxable on the shareholder’s pro rata share of CastlePoint Re’s RPII for the U.S. person’s taxable year that includes that date determined as if such RPII were distributed proportionately to shareholders at that date, regardless of whether such income is actually distributed. The amount of RPII earned by CastlePoint Re (generally, premium and related investment income from direct or indirect insurance or reinsurance of any direct or indirect U.S. shareholder of ours or any person related to such shareholder) will depend on a number of factors, including the identity of persons directly or indirectly insured or reinsured by CastlePoint Re. We do not expect that ownership of our shares by direct or indirect insureds and related persons will equal or exceed 20% of the voting power or value of the shares. Because we expect U.S. persons to own in the aggregate 25% or more of the stock of CastlePoint Re by vote and value and our gross RPII to exceed 20% of our gross insurance income, only the exception for less than 20% ownership by direct and indirect insureds and their related persons, described above, is potentially available to CastlePoint Re. We have requested information from insureds to attempt to ensure that the 20% ownership exception is met, and we intend to continue to do so. Tower, which owns approximately 6.7% of our outstanding common shares as a result of its $15.0 million investment in us, will be an insured, and we will not always be able to tell who all of our shareholders or direct or indirect insureds are. Accordingly, it is possible that the IRS will assert that 20% or more of the vote or value of our shares is owned by insureds of CastlePoint Re or their related persons, and that we will be unable to prove otherwise.
The RPII rules provide that if a shareholder that is a U.S. person disposes of shares in a foreign insurance corporation that has RPII (even if the amount of RPII is less than 20% of the corporation’s gross insurance income or the ownership of its shares by direct or indirect insureds and related persons is less than the 20% threshold) and in which U.S. persons own 25% or more of the shares, any gain from the disposition will generally be treated as ordinary income to the extent of the shareholder’s share of the corporation’s undistributed earnings and profits that were accumulated during the period that the shareholder owned the shares (whether or not such earnings and profits are attributable to RPII). In addition, such a shareholder will be required to comply with reporting requirements, regardless of the amount of shares owned by the shareholder. We believe that these rules should not apply to dispositions of our shares because CastlePoint will not itself be directly engaged in the insurance business and because proposed U.S. Treasury regulations appear to apply only in the case of shares of corporations that are directly engaged in the insurance business. However, the IRS might interpret the proposed
regulations in a different manner and the applicable proposed regulations may be promulgated in final form in a manner that would cause these rules to apply to dispositions of our shares.
Changes in U.S. federal income tax law could adversely affect an investment in our shares.
The U.S. federal income tax laws and interpretations, including those regarding whether a company is engaged in a trade or business within the United States or is doing business through a permanent establishment in the United States, or whether a company is a PFIC or whether U.S. persons would be required to include in their gross income the subpart F income or the RPII of a CFC are subject to change, possibly on a retroactive basis. There are currently no regulations regarding the application of the PFIC rules to insurance companies and the regulations regarding RPII are still in proposed form. New regulations or pronouncements interpreting or clarifying these or other U.S. tax rules may be issued in the future.
Changes in U.S. federal income tax rates or Federal Excise Taxes (FET) also could impact the costs and the relative competitiveness for our products and services which could impact our business.
We cannot be certain if, when or in what form such regulations or pronouncements may be provided and whether such regulations or guidance will have a retroactive effect.
Item 1B.
Item 1B. Unresolved Staff Comments.
Not Applicable.
Item 2.
Item 2. Properties.
We lease and/or sublease office space in (i) Hamilton, Bermuda, (ii) New York, New York and (iii) Lisle, Illinois. CastlePoint Re subleases premises in Hamilton, Bermuda, used for the operations of our reinsurance segment. CastlePoint also leased three residential premises (on behalf of certain of its employees located in Bermuda) on varying terms. CastlePoint Management and CastlePoint Insurance Company currently sublease office space in New York, New York from Tower Insurance Company of New York, at its cost, pursuant to an arrangement covered by the service and expense sharing agreement between these parties. This space is used for the operations of our insurance and insurance services segments. CastlePoint Management currently leases office space in Lisle, Illinois which is used for the operations of our insurance services segment.
Item 3.
Item 3. Legal Proceedings.
We are not a party to any pending material litigation and are not currently aware of any pending or threatened material litigation, other than ordinary routine litigation incurred in our business as a reinsurer. We may become involved in various claims and legal proceedings in the normal course of business, as a reinsurer or insurer.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
There were no matters submitted to a vote of security holders during the quarter ended December 31, 2007.
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities.
(a) Market Price of our Common Shares and Related Shareholder Matters
CastlePoint Holding’s common shares started trading on March 23, 2007 on the Nasdaq Global Market under the symbol “CPHL.” On December 31, 2007, the closing price of our common shares on the Nasdaq Global Market was $12.00 per common share. The table below sets forth the reported high and low sales prices for our common shares, as reported on the Nasdaq Global Market for the periods indicated.
Future prices of our common shares will likely vary from the sale price per share set forth above, and such price may not be indicative of the prices at which our common shares will be traded on the Nasdaq Global Market.
For a discussion of our dividend payments to shareholders to date, see “Dividend Policy,” and for a description of the legal and regulatory limitations on our existing and future subsidiaries’ ability to pay dividends to CastlePoint Holdings and of CastlePoint Holdings to pay dividends to its shareholders, see “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity-Restrictions on Dividend Payments from our Operating Subsidiaries.”
Holders of Our Shares
As of March 14, 2008 we had 38,289,430 common shares issued and outstanding, which were held by two holders of record, Cede & Co. and Tower. Cede & Co. holds shares on behalf of The Depository Trust Company, which itself held shares on behalf of in excess of 1,250 beneficial owners of our common shares, as of March 14, 2008.
Dividend Policy
We have historically paid an annual cash dividend of $0.10 per common share to our shareholders of record, payable on a quarterly basis. Any future determination to pay dividends is at the discretion of our board of directors and is dependent upon our results of operations and cash flows, our financial position and capital requirements, general business conditions, legal, tax, regulatory, rating agency and any contractual restrictions on the payment of dividends and any other factors our board of directors deems relevant, including Bermuda and U.S. state legal
and regulatory constraints. We expect that our dividend policy commencing as of the second quarter of 2008 will be $0.20 per common share payable on a quarterly basis.
CastlePoint Holdings is a holding company and has no direct operations. The ability of CastlePoint Holdings to pay dividends or distributions depends almost exclusively on the ability of its subsidiaries to pay dividends to CastlePoint Holdings, which is subject to regulatory, contractual, rating agencies and other constraints. Under Bermuda law, CastlePoint Bermuda Holdings and CastlePoint Re may not declare or pay a dividend if there are reasonable grounds for believing that either company is, or would after the payment be, unable to pay its liabilities as they become due, or the realizable value of either company’s assets would thereby be less than the aggregate of its liabilities and its issued share capital and share premium accounts. Further, CastlePoint Re, as a regulated insurance company in Bermuda, is subject to additional regulatory restrictions on the payment of dividends or other distributions. Under the terms of the reinsurance agreements between CastlePoint Re and Tower’s insurance companies, CastlePoint Re is required to provide security to Tower’s insurance companies to support reinsurance recoverables owed to these reinsureds. We may also be required by other clients to provide similar security as part of our reinsurance business. In addition, CastlePoint Insurance Company is, and any U.S. licensed insurance companies that we may acquire or form will be, subject to significant regulatory restrictions limiting their ability to declare and pay dividends. Furthermore, any dividends paid by CastlePoint Insurance Company and such other U.S. licensed insurance companies we may acquire will be subject to a 30% withholding tax. For a further description of the restrictions on the ability of our subsidiaries to pay dividends, see “Item 1A: Risk Factors-Risks Related to Our Business-Our holding company structure and certain regulatory and other constraints affect our ability to pay dividends and make other payments.”
Equity Compensation Plans
The following table provides information concerning the CastlePoint Holdings’ equity compensation plans as of December 31, 2007:
(1)
The following equity compensation plan was approved by our shareholders: the 2006 Long-Term Equity Compensation Plan, as amended.
(b) See “Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity” for a discussion of the use of proceeds from our initial public offering, which became effective March 22, 2007 (file number 333-139939).
(c) Not applicable.
Item 6.
Item 6. Selected Financial Data
The following table sets forth our selected historical consolidated financial information as of and for the period ended December 31, 2005, and the years ended December 31, 2006 and December 31, 2007. The historical results are not necessarily indicative of results to be expected in any future period. This financial information is derived from our consolidated financial statements included elsewhere in this report. You should read the following selected historical financial information in conjunction with the information contained in this report, including “Item 7:
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview
We provide a broad range of products and services to the insurance industry. See “Item 1: Business.” We offer our products through our operating subsidiaries domiciled in Bermuda and in the United States. We offer our reinsurance products and insurance risk-sharing products to Tower and its subsidiaries as well as to other small insurance companies located in the United States with surplus of less than $100 million. We also conduct business with other insurance companies that are seeking to efficiently manage their capital as well as limit their concentration of risk in certain geographic areas through our insurance risk-sharing and quota share reinsurance solutions. In addition, we offer our insurance and unbundled insurance company services to program underwriting managers located in the United States. In order to form a close and continuing relationship with our clients or to enable clients to expand their business and therefore the amount of business they do with us, we may on occasion, make strategic investments in some of our clients, including Tower. See “Item a: Business-Strategic Investments, Including Investment in Tower.” We do not currently hold such investments.
2007 completes our first full year of operations. We have in place a knowledgeable and experienced senior management team and we continue to build our internal information systems. In 2007, we wrote 1) reinsurance business, both from Tower and third parties, in CastlePoint Re, 2) brokerage business managed by Tower in CastlePoint Insurance and 3) traditional and specialty program business through CastlePoint Management using both Tower and CastlePoint Insurance policies. CastlePoint Management earns fee revenues from Tower on the program business it manages.
The following chart lists key financial highlights for 2007:
Key Operating Highlights: ($ millions, except Operating EPS)
(1)
see Measurement of Results for definition of non-GAAP measures and reconciliation to GAAP
At December 31, 2007 our total investments and cash and cash equivalents are comprised primarily of fixed maturities (70%), equity securities (6%) and cash (22 %) and an $8.5 million investment in a limited partnership investing primarily in AAA rated municipal bonds. The overall rating of our cash and fixed maturity portfolio is AA and the duration is 2.24 years. As of the filing date of this report, we sold an investment in a fund (classified in “Equity securities”) that had subprime exposure and we sold 3 individual asset backed securities that were backed by subprime home equity loans. We currently do not have subprime or alternative A exposure in our portfolio. The average credit rating of all mortgages held is AAA. We have the ability and intent to hold all fixed maturities, including mortgages until maturity, if necessary. Given the current state of the investment marketplace, we have provided substantial information regarding our portfolio in this section of the report.
Tower. In April 2006 we entered into a master agreement, certain reinsurance agreements, a program management agreement and a service and expense sharing agreement with Tower and/or its subsidiaries. We and Tower have subsequently modified certain of these arrangements. Our relationship with Tower and its subsidiaries, including the master agreement and other agreements we entered into with such companies, is described under “Item 1: Business-Description of Our Business Relationships with Tower.”
All of our agreements with Tower, including the alternative insurance risk-sharing agreements, are generally subject to review, approval and requests for modification by the New York State Insurance Department and may be subject to review by the insurance departments of the other domiciliary states of Tower’s domestic insurance companies. All of our agreements with Tower are also subject to the review and approval of the domiciliary states of the U.S. licensed insurance companies we own, to the extent such companies participate in these agreements.
Our revenues and underwriting results are impacted by Tower’s growth and loss ratios. We believe that Tower’s ability to grow its direct premiums written through its existing brokerage distribution network, to expand its brokerage distribution to new territories and to make acquisitions, such as Tower’s acquisition of Preserver in April 2007, will affect the magnitude and profitability of the business that will be subject to the arrangements with CastlePoint Insurance Company and that will be ceded to CastlePoint Re. Although we are a new Company, our relationship with Tower provides us with a steady, predictable flow of profitable and seasoned business.
Other Customers. We also underwrite reinsurance contracts with primary insurance companies other than Tower, insurance policies written under insurance risk-sharing agreements with insurance companies other than Tower, and premiums produced by program underwriting managers. We originated substantial third party business in 2007 (approximating 25% of managed premiums) that will be reflected in revenues in 2008, and expect to maintain or exceed 30% in 2008.
Our Business Segments. We report our business in three segments: insurance, reinsurance and insurance services. The insurance segment includes all of the results of CastlePoint Insurance Company and the results from CastlePoint Re for excess and surplus lines written on a primary basis. The reinsurance segment includes the results from the reinsurance business written through CastlePoint Re. Our insurance services segment includes the results from managing the specialty program business and insurance risk-sharing business through CastlePoint Management, as well as results from providing our unbundled insurance services to program underwriting managers.
Results of Operations
Critical Accounting Estimates
Our consolidated financial statements and the related disclosures included in this report have been prepared in accordance with U.S. GAAP. The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect reported and disclosed amounts of assets and liabilities, as well as disclosure of contingent assets and liabilities at the balance sheet date and the reported amounts of revenues and expenses during the reporting period. Our consolidated financial statements contain certain amounts that are inherently subjective and require management to make assumptions and estimates to determine the reported values. If factors, including those described in “Item 1A: Risk Factors” in this report, cause actual events or results to differ materially from management’s underlying assumptions or estimates, actual results may differ, perhaps substantially, from the estimates.
Estimates are made primarily for unreported written premiums and losses. Differences between estimated and actual unreported written premiums generally do not have a material impact on our financial results, because the unreported written premiums are usually estimated for only the most recent month(s), and the amount of written premiums for the most recent month that is earned as of the end of a given calendar quarter is approximately 1/24 of the written premiums for that month. However, these differences in the estimation of unreported and unpaid losses can have a material impact on our financial results, since the loss reserves accumulate for many years until all losses are paid.
The critical accounting policies and estimates set forth below involve, among others, the reporting of premiums written and earned, reserves for losses and loss adjustment expenses (including reserves for losses that have occurred but had not been reported or paid by the financial statement date), the reporting of deferred acquisition costs and the recording of other-than-temporarily impaired investments.
Premiums. Premiums on insurance and reinsurance policies issued by our operating subsidiaries are usually considered short-duration contracts. Accordingly, premium revenue, including direct writings and reinsurance assumed, net of premiums ceded to reinsurers, is recognized as earned in proportion to the amount of insurance protection provided on a pro-rata basis over the terms of the underlying policies with the unearned portion being reported as unearned premium. Prepaid reinsurance premiums represent the unexpired portion of reinsurance premiums ceded.
Premiums written on assumed reinsurance (generally quota share reinsurance) are expected to be written primarily on a “policies attaching” basis and cover losses which attach to the underlying insurance policies written during the terms of the contracts. Premiums earned on a “policies attaching” basis usually extend beyond the calendar year in which the reinsurance contract is written, typically resulting in recognition of premiums earned over a 24 month period; this is because most policies have a term of 12 months, and policies written with an effective date in December, for instance, are not fully earned until December of the following year. We
may also assume premiums on contracts and policies written on a losses occurring basis, generally on catastrophe treaties, which cover losses that occur during the term of the contract or policy, typically 12 months, and the premium is earned evenly over the term.
Assumed premiums written and ceded may include estimates based on information received from brokers and ceding companies, and any subsequent differences arising on such estimates are recorded in the periods in which they are determined. Our management estimates premiums on our excess of loss reinsurance contracts when the business is underwritten. For such contracts, the deposit premium, as defined in the contract, is generally considered to be the best estimate of the contract’s written premium at inception. This amount is determined by the underwriters based upon analysis of the prior written premium experience of the ceding companies, plans for growth in the current year as stated by the ceding companies, and our proportion of the ceding companies’ written premiums based upon the terms of the reinsurance contracts. Accordingly, we generally record this amount as written premium in the period in which the underlying risks begin. As actual premiums are reported by brokers or ceding companies, management evaluates the appropriateness of the premium estimate and any adjustment to this estimate is recorded in the period in which it becomes known, which, in some cases, involves reducing premiums to the minimum specified in the contract. In addition, if estimates of unreported written premiums are required for a particular ceding company at the end of an accounting period, the monthly trend in written premiums and historical seasonality of written premiums for these ceding companies are analyzed to determine a best estimate of the unreported written premiums. See Note 2 “Summary of Significant Accounting Policies-Premiums Earned” and “Summary of Significant Accounting Policies-Reinsurance Accounting” to the audited financial statements included elsewhere in this report for a discussion of related accounting policies.
While we attempt to obtain current assumed premiums written statements from ceding companies, it is common that the most recent month statements are not received on a timely basis from the ceding company. Therefore, assumed premiums written from these ceding companies are estimated for the most recent month or, in some cases, for several months. With respect to CastlePoint Re’s three quota share reinsurance agreements with Tower’s insurance companies, we obtain current quarterly statements and record assumed premiums written from Tower on an actual, rather than estimated, basis. For ceding companies from which we have not received current, monthly statements and therefore must estimate the most recent period’s assumed premiums written, the difference between the estimated assumed premiums written and actual assumed premiums written is reflected in the subsequent accounting period or as soon as the actual assumed premiums written are obtained. For the year ended December 31, 2007, approximately 3% of the assumed written premiums are based on estimates.
Deposit premiums are generally not changed throughout the term of a reinsurance contract, although this has no impact on final booked net written premiums since the deposit premiums only affect cash receipts.
Reinstatement premiums are written at the time a loss event occurs where coverage limits for the remaining life of the contract are reinstated under pre-defined contract terms. Depending on the terms of the reinstatement premiums, they are earned over the remaining risk period or
immediately. Reinstatement premiums are not expected to be a significant portion of our net written premiums, since we do not write significant amounts of property catastrophe excess of loss treaties where reinstatement premiums are common, and in cases where we write such reinsurance, we do not underwrite it in property catastrophe prone areas where reinstatement premiums are more common.
In addition to the assumptions disclosed under “-Critical Accounting Policies and Estimates” regarding premium and revenue recognition, data received from Tower has a significant impact on our results of operations. As of December 31, 2007, the premiums assumed from Tower’s contracts were updated to reflect the actual written premiums in 2007 and, therefore, no significant estimates were made. If Tower discloses the impact of any changes in its estimates on its direct book of business, this would affect our results of operations. At that time, we would be required to disclose the affect on our results of operations.
Losses and Loss Adjustment Expense Reserves. Our losses and loss adjustment expense reserves, for both reported and unreported claims obligations, are maintained to cover the estimated ultimate liability for all of our insurance and reinsurance obligations. Losses and loss adjustment expense reserves are categorized in one of two ways: (i) case reserves, which represent unpaid losses and loss adjustment expenses as reported by cedents to us or as estimated by our claims adjusters retained by us, and (ii) incurred but not reported reserves, or IBNR reserves, which are reserves for losses and loss adjustment expenses that have been incurred, but have not yet been reported to us, as well as additional amounts relating to losses already reported, that are in excess of case reserves. IBNR reserves are estimates based on all information currently available to us and are reevaluated on a quarterly basis utilizing the most recent information supplied by our cedents and by our own claims adjusters.
We rely on initial and subsequent claims reports received from the program underwriting agencies administering our programs or risk sharing in our insurance segment or from the ceding companies for whom we provide reinsurance in our reinsurance segment to establish our estimate of losses and loss adjustment expenses. For direct policies generated from our insurance programs, we rely on initial and subsequent claims reports as estimated by claims adjusters retained by us or by the program underwriting managers. For insurance risk sharing, we rely on initial and subsequent claims reports received from the insurance companies with which we do business. For reinsurance we rely on initial and subsequent claims reports received from the companies with which we do business.
The types of information that we receive from program underwriting agencies, from companies for whom we are providing risk sharing, or from ceding companies generally vary by the type of contract. Our programs and risk-sharing business is either reported at the detail transaction level when our system is being utilized to administer the business, or reported on a monthly basis if the client is utilizing its own system to administer the business. In reinsurance, proportional, or quota share, contracts are typically reported on a monthly or quarterly basis, providing premium and loss activity as estimated by the ceding company. Reporting for excess of loss contracts includes detailed individual claim information, including a description of the loss, confirmation of liability by the cedent and the cedent’s current estimate of the ultimate liability under the claim. Generally, ceding companies are obligated to notify the reinsurer within
a limited amount of time about any claim that is reported to them, which has characteristics making it probable that the claim will be covered by the excess reinsurance. Upon receipt of claims notices from program underwriting managers, risk-sharing clients, or cedents, we review the nature of the claim against the scope of coverage provided under the contract. Questions arise from time to time regarding the interpretation of the characteristics of a particular claim measured against the scope of contract terms and conditions. Reinsurance contracts under which we assume business generally contain specific dispute resolution provisions in the event that there is a coverage dispute with the ceding company. The resolution of any individual dispute may impact estimates of ultimate claim liabilities.
Reported claims are in various stages of the settlement process. Each claim is settled individually based on its merits, and certain claims may take several years to settle, particularly where legal action is involved. During this period, additional facts may be revealed, and as these factors become apparent, case reserves will be adjusted, sometimes requiring an increase in our overall reserves, including our IBNR reserves.
In our insurance segment, we generally establish reserves separately by line of business. In our reinsurance segment, we generally reserve for each treaty that we reinsure separately, so that we are able to take into consideration the underlying experience reported by each ceding company. While ceding companies may report their own estimate of IBNR, we independently analyze the losses for each treaty, and consequently we may choose to establish IBNR reserves in an amount different from the amount reported by the ceding company.
We may aggregate similar types of treaties and the claim information provided by our ceding companies or insurance companies with which we do business for analysis purposes by the year in which each treaty is written and the type of business included in the treaties. We also supplement this information with claims and underwriting audits of specific contracts, internally developed pricing trends, as well as loss trend data developed from industry sources. We audit both the underwriting and the claims practices of our ceding companies. As part of our underwriting audits, we seek to confirm that the ceding company is insuring the types of risks and achieving the level of pricing that we assumed in our underwriting of the treaty from that ceding company. As part of our claims audits, we seek to confirm the data accuracy of the claim information that we have received from the ceding company, and learn about changes in case reserving approach by the ceding company and any particular information about specific claims that may have a significant impact on the results reinsured in our treaty with the ceding company.
The reserve methodologies employed by us are dependent on the data that we collect from ceding companies and insurance companies with which we do business. This data primarily consists of loss amounts estimated by the claims adjusters handling the claims, loss payments made by the ceding companies or insurance companies with which we do business, and premiums written and earned reported by the ceding companies and insurance companies with which we do business.
Reserves for losses and loss adjustment expenses are also based in part upon the estimation of losses resulting from catastrophic events. Estimation of the losses and loss
adjustment expenses resulting from catastrophic events is inherently difficult because of the possible severity of catastrophe claims, difficulties physically inspecting catastrophe hit areas to estimate claim amounts, and delays in receiving information about claims from program administrators or ceding companies. Therefore, we supplement the methods described above by utilizing commercially available models for purposes of evaluating and providing an estimate of ultimate claims costs.
This information is used to develop point estimates of carried reserves for each business segment and line of business. These individual point estimates, when aggregated, represent the total carried losses and loss adjustment expense reserves reflected in our consolidated financial statements. While we analyze our reserves estimates utilizing different methods, we do not attempt to produce a range around our point estimate of loss. Also, we do not include a specific provision in our loss reserves for adverse deviation. See Note 2 “Summary of Significant Accounting Policies-Liability for Loss and Loss Adjustment Expenses” to our audited financial statements included elsewhere in this report for a discussion of related accounting policies.
Since we are a recently formed company and have a limited operating history, we do not have sufficient historical experience that reflects how our loss reserves estimates will likely develop. Moreover, past experience of how loss reserves estimates develop may not be indicative of future development of loss reserves estimates.
In order to better understand the underlying loss characteristics and further improve our best estimates of loss reserves, our estimate of ultimate loss is determined based on a review of the results of several commonly accepted actuarial projection methodologies. Our estimate of ultimate loss also incorporates qualitative information, such as changes in the claims department, business mix, pricing and knowledge about specific large claims. The specific methodologies we utilize in our loss reserve review process may include, but are not limited to, (i) incurred and paid loss development methods; (ii) incurred and paid Bornhuetter Ferguson, or BF, methods and (iii) loss ratio methods. Due to the nature of our business, any of these methods may not be practical in particular circumstances based upon the information provided by the ceding company for each treaty. Also, various methodologies are actuarially more appropriate given the line of business, the maturity of the treaty, the limits insured or reinsured, the type of treaty, and other considerations. Generally, we rely on BF and loss ratio methods for estimating ultimate loss liabilities for more recent treaty years. These methodologies, at least in part, apply a loss ratio, determined from aggregated analyses of internally developed pricing trends, to premiums earned on that business. Adjustments to premium estimates generate related adjustments to ultimate loss estimates in the quarter in which they occur. To estimate losses for more mature treaty years, we generally rely on the incurred loss development methodology. This methodology relies on loss emergence analyses determined from cedent supplied claim information or industry patterns. For property catastrophe losses, we may utilize vendor catastrophe models to estimate ultimate loss soon after a loss occurs, where loss information is not yet reported to us from cedents. IBNR is determined by subtracting the total of paid loss and reported reserves from the estimated ultimate loss.
The adequacy of our booked loss reserves at CastlePoint Re and CastlePoint Insurance Company are opined upon annually by an independent actuary pursuant to Bermuda and U.S. statutory regulations.
Any future impact to income as a result of changes in losses and loss adjustment expense estimates may vary considerably from historical experience. Our estimates of ultimate loss exposures are based upon the information we have available at any given point in time and our assumptions based upon that information. Changes in estimates of losses and loss adjustment expenses are reflected as adjustments to income in the period in which the estimate is revised. Under U.S. GAAP, we are not permitted to establish loss reserves until the occurrence of an actual loss event, whether reported or unreported. As a result, only loss reserves applicable to losses incurred up to the reporting date may be recorded, with no allowance for the provision of a contingency reserve to account for expected future losses. Losses arising from future events, which could be substantial, are estimated and recognized at the time the loss is incurred.
Estimates of reserves for unpaid losses and loss adjustment expenses also may be impacted by legislative, regulatory, social, economic and legal events and trends that may or may not occur or develop in the future, thereby affecting assumptions in the actuarial projections.
Changes in loss reserves estimates may result from (1) variability in the estimation process itself, and (2) the fact that external factors may cause changes in the future that are not reflected in historical patterns. With respect to the former source of variability, i.e. estimation process variation, we believe that a reasonably likely range for the loss reserves can be represented by a standard utilized by some professional, independent actuaries as part of their certification of an insurer’s reserves. That standard contemplates the number of years of the expected loss payout period (i.e., the longer expected payout period, the more variability inherent in the estimation process and the larger the reasonable range). In considering the business mix between property and casualty lines of business that we write, we believe that a reasonable range surrounding our actuary’s best estimate of loss reserves is from minus 5% to plus 10%. Utilizing this standard as a guide, we believe that most professional actuaries, assuming they are presented with the same information, would determine that the loss reserves can be certified if they fall within a range of minus 5% to plus 10%. Therefore, it is reasonably likely that some professional actuaries, assuming they are presented with the same information relating to our company, would determine a best estimate of our loss reserves to be between $115.4 million and $133.6 million as of December 31, 2007, as compared to our own best estimate of the loss reserves, which is $121.4 million as of that date. If we were to book loss reserves at minus 5% of our actuary’s best estimate, the impact would be an increase of income before income taxes of $6.0 million. Conversely, if we were to book loss reserves at plus 10% of our actuary’s best estimate, the impact would be a reduction of income before taxes of $12.2 million. No assurance can be given that outcomes outside of the above range cannot occur, as outcomes outside of such range are possible. In addition, the above range assumes that future patterns are similar to historical patterns, as to which there can be no assurance. With regard to the potential variability in loss reserves estimates due to the fact that future patterns may differ from historical patterns, we believe there is additional potential variability that cannot be estimated.
Deferred acquisition costs. We defer certain expenses that vary with and are primarily related to the acquisition of new and renewal insurance and reinsurance business, including commission expense on net premiums written, premium taxes, brokerage and certain other costs related to the acquisition of insurance and reinsurance contracts. These costs are capitalized and the resulting asset, deferred acquisition costs, is amortized and charged to expense in future periods as net premiums written are earned. The method followed in computing deferred acquisition costs limits the amount of such deferral to its estimated realizable value. The ultimate recoverability of deferred acquisition costs is dependent on the continued profitability of our insurance and reinsurance underwriting. A probable loss on insurance contracts exists if there is a premium deficiency relating to the policies we write. A premium deficiency is recognized if the sum of expected claim costs and claim adjustment expenses, unamortized acquisition costs and maintenance costs exceeds related unearned premiums. If a premium deficiency exists, it is first recognized by charging any unamortized deferred acquisition costs to expense to the extent required to eliminate the deficiency. If the premium deficiency is greater than unamortized deferred acquisition costs, a liability is accrued for the excess deficiency. In determining whether or not a premium deficiency exists, we group our insurance contracts consistent with the manner of acquiring, servicing and measuring the profitability of our business. See Note 2 “Summary of Significant Accounting Policies-Deferred Acquisition Costs” to our audited financial statements included elsewhere in this report for a discussion of related accounting policies.
The balance in deferred acquisitions cost was $73.1 million as of December 31, 2007. In determining recoverability of deferred acquisition costs, future profitability of our insurance and reinsurance underwriting is considered, including investment income. At each of December 31, 2007, 2006 and 2005, we determined that no premium deficiency existed and that deferred acquisition costs were recoverable.
Investments. In accordance with our investment guidelines, our investments primarily consist of high-grade marketable fixed income securities. We invest a portion of our funds in equity securities (8% at December 31, 2007), including strategic investments that we may make in the insurance companies or program underwriting managers with whom we do business. See Note 4. “Investments” in the notes to our audited financial statements included elsewhere in this report. We do not expect our investment portfolio to include options, warrants, swaps, collars or similar derivative instruments. Also, our portfolio does not contain any direct investments in real estate or mortgage loans.
Impairment of investment securities results in a charge to income when a market decline below cost is deemed to be other-than-temporary. We regularly review our fixed maturity and equity security portfolios to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. In evaluating potential impairment, we consider, among other criteria: the current fair value compared to amortized cost or cost, as appropriate; the length of time the security’s fair value has been below amortized cost or cost; our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in value; specific credit issues related to the issuer; and current economic conditions.
After recording an other-than-temporary impairment charge of $9.0 million at December 31, 2007, the net unrealized loss for the year ended December 31, 2007 was $1.1 million, including gross unrealized gains of $4.8 million and gross unrealized losses of $5.9 million. Securities in an unrealized loss position are reviewed for impairment on a regular and case-by-case basis, during which we look for deterioration of credit quality and other factors that would adversely affect the price of the security. There could be an instance where a security was in an unrealized loss position and not considered impaired by our management; however, due to changes in our liquidity requirements, a future decision may be made to sell the security at a loss. At the time such a decision is made, if the security were still in an unrealized loss position, we would recognize a charge against net income.
Reinsurance accounting. We account for reinsurance in conformity with SFAS 113, “Accounting and Reporting for Reinsurance of Short Duration and Long Duration Contracts.” The requirements of this standard involve significant assumptions relating to the amount and timing of expected cash flows, as well as the interpretation of underlying contract terms. All of our ceded and assumed reinsurance meets the criteria in SFAS 113 for treatment as reinsurance. See Note 2 “Summary of Significant Accounting Policies-Premiums Earned and Reinsurance” to our audited financial statements included elsewhere in this report for a discussion of the related accounting policies.
Although we do not anticipate offering reinsurance contracts that do not meet risk transfer requirements, any reinsurance contracts that do not transfer significant insurance risk will be accounted for as deposits. These deposits are accounted for as financing transactions, with interest expense credited to the contract deposit.
We plan to purchase ceded reinsurance, known as reinsurance on primary business and retrocession reinsurance on reinsurance business, to protect our reinsurance subsidiary, CastlePoint Re, as well as CastlePoint Insurance Company, and plan to purchase reinsurance for any other U.S. licensed insurance companies that we may acquire. The reinsurance and retrocession reinsurance we purchase and plan to purchase is intended to bring our aggregate property excess of loss exposure on all of our business on a net basis to less than 10% of our equity. Also, we monitor and may purchase reinsurance and retrocession reinsurance for our primary or reinsurance companies depending upon their risk profile and level of surplus. We may also purchase reinsurance and retrocession protection in situations where we desire to limit our net loss for any single underlying policy to lower amounts, generally to less than 1% of our equity. The costs to obtain reinsurance and retrocession reinsurance are built into the pricing of our programs and reinsurance treaties and, therefore, we do not expect that such costs will materially affect our future results of operations or cash flow.
Deferred taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the
enactment date. See Note 9 “Taxation” to our audited financial statements included elsewhere in this report for a discussion of the related accounting policies.
The net deferred tax asset at December 31, 2007 was $7.1 million, which was comprised of a deferred tax asset of $16.2 million (primarily consisting of deferred taxes on 20% of the change in the unearned premium reserve and the non-utilization of the net operating loss carryforwards) offset by a deferred tax liability of $9.1 million (primarily consisting of the deferred tax on the deferred acquisition costs). In assessing the valuation of deferred tax assets, we consider whether it is more likely than not that some portion or all the deferred tax will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income to offset previous operating losses during periods in which temporary differences become deductible. Our management currently believes that we will recover all of the deferred tax assets based primarily upon future profitability of our U.S. operations. In the future, if our U.S. subsidiaries do not generate taxable income, we would be required to write off the deferred tax asset by charging income in the year it is deemed that the generation of such income is not likely. If, at December 31, 2007, we deemed that the generation of future profits in our U.S. subsidiaries was not likely, we would have recorded a valuation allowance against the deferred tax asset and net income would have been reduced by $7.1 million.
Unpaid losses and loss adjustment expenses recoverable. Ceded losses recoverable from reinsurers is estimated using techniques and assumptions consistent with those used in estimating the liability for losses and loss adjustment expenses, and represent management’s best estimate of such amounts. However, as changes in the estimated ultimate liability for losses and loss adjustment expenses are determined, the estimated ultimate amount recoverable from reinsurers will also change. Accordingly, the ultimate recoverable could be significantly in excess of or less than the amount indicated in the consolidated financial statements, and adjustments to these estimates are reflected in current operations. See Note 2 “Summary of Significant Accounting Policies-Liability for Loss and Loss Adjustment Expense” to our audited financial statements included elsewhere in this report for a discussion of the related accounting policies.
Measurement of Results
We use various measures to analyze the growth and profitability of business operations. For insurance and reinsurance business, we measure growth in terms of gross and net premiums written and we measure underwriting profitability by examining our loss, expense and combined ratios. A combined ratio is the sum of the loss ratio and the underwriting expense ratio calculated as described below. We also measure our gross and net written premiums to surplus ratios to measure the adequacy of capital in relation to premiums written. For insurance services, we measure growth in terms of fee income produced for insurance company services provided. We analyze profitability by evaluating income before taxes, generally as a percentage of premium and fee income produced. On a consolidated basis, we measure profitability in terms of net income margins and return on average equity.
Premiums written. We use gross premiums written to measure our sales of insurance and reinsurance products. Gross premiums written also correlate to our ability to generate net premiums earned and, for certain products, fee income.
Managed Premiums. We use managed premiums to measure the total amount of business which we produce. Managed premiums include gross written premiums in CastlePoint Insurance and CastlePoint Reinsurance companies plus program and risk sharing gross written premiums generated by CastlePoint Management that is written directly in other companies, e.g. Tower, and excluding all intercompany reinsurance.
Loss ratio. The loss ratio is the ratio of losses and loss adjustment expenses incurred to premiums earned and measures the underwriting profitability of our insurance and reinsurance business after the effect of any ceded reinsurance.
Underwriting expense ratio. The underwriting expense ratio is the ratio of direct and ceding commission expenses and other underwriting expenses less policy billing fees to premiums earned. The underwriting expense ratio measures our operational efficiency in producing, underwriting and administering our insurance and reinsurance business. We calculate our underwriting expense ratios on a gross basis (before the effect of ceded reinsurance) to measure our operational efficiency and on a net basis (after the effect of ceded reinsurance) to measure the effects on our consolidated income before income taxes.
Combined ratio. We use the combined ratio to measure our underwriting performance. The combined ratio is the sum of the loss ratio and the underwriting expense ratio. We analyze the combined ratio on a gross (before the effect of reinsurance) and net basis (after the effect of reinsurance). If the combined ratio is at or above 100%, we are not underwriting profitably and may not be profitable unless investment income is sufficient to offset underwriting losses.
Consolidated combined ratio. One of our key measures of profitability is what we refer to as our consolidated combined ratio, which is calculated by dividing (i) the total expenses (excluding interest expenses) minus commission income by (ii) net premiums earned.
Net income and return on average equity. We use net income to measure our profits and return on average equity to measure our effectiveness in utilizing our shareholders’ equity to generate net income on a consolidated basis. In determining return on average equity for a given year, net income is divided by the average of shareholders’ equity for that year.
Operating net income, operating earnings per share, and operating return on average equity. Each of these terms exclude realized and unrealized gains and losses, and if subject to U.S. taxation, tax at a rate of 35%. This is a common measurement for property and casualty insurance companies. We believe this presentation enhances the understanding of our results of operations by highlighting the underlying profitability of our insurance business. Additionally, these measures are a key internal management performance standard.
The following table provides a reconciliation of operating net income to net income on a GAAP basis. The operating net income is used to calculate operating earnings per share and operating return on average equity.
(1)
Realized and unrealized gains and losses from our investment in a limited partnership were recorded as a component of net investment income
Consolidated Results of Operations
The following table summarizes our results of operations for the years ended December 31, 2007 and 2006. Except for a minimal amount of expenses in 2005, there was no activity reported in 2005.
We also calculate our loss and expense ratios, underwriting expense ratios and combined ratios by segment. See “-Insurance Segment Results of Operations,” “-Reinsurance Segment Results of Operations” and “-Insurance Services Segment Results of Operations” below.
Summary. Despite softening market conditions in the property and casualty industry, we have not experienced significant weakening in pricing or a softening in demand for our products. Management believes that this is in large part due to our emphasis on providing solutions to small insurance companies and program underwriting managers, which results in the transfer by such companies and program underwriting managers to us of large blocks of business composed of small policies. We believe there is a growing industry awareness of our capabilities to provide primary insurance company capacity combined with reinsurance capacity and customized insurance services. We believe this segment of the market is generally underserved by the larger insurers. We target existing profitable, measurable books of business with an actuarial track record. Our senior management is involved in the underwriting assessment of our business.
Net income increased 210.5% to $32.7 million for the year ended December 31, 2007, compared to $10.5 million for the year ended December 31, 2006. Net earned premiums increased 214.5% to $248.4 million, based upon growth from Tower, CastlePoint’s largest client, as well as growth from other clients. CastlePoint Insurance Company implemented its alternative insurance risk-sharing solutions with Tower during 2007, and as a result, wrote $84.2 million in direct premiums from Tower which contributed to $14.4 million of earned premium.
Net income was adversely impacted by an other-than-temporary impairment charge at December 31, 2007 in the amount of $9.0 million included in net realized (loss) gain on investments. See discussion below under “Net investment income and realized gains/(losses).” Operating net income, a non-GAAP measure, increased 296.2% to $41.6 million for the year ended December 31, 2007, compared to $10.5 million for the year ended December 31, 2006.
CastlePoint Re commenced writing business as of April 6, 2006. Therefore, the results for the year ended December 31, 2006 are comprised of operations for the period April 6, 2006 through December 31, 2006. CastlePoint Insurance Company did not conduct any business in 2006.
Total revenues. Total revenues increased by 199.5% to $277.1 million for the year ended December 31, 2007, compared to $92.5 million for the year ended December 31, 2006. The increase is primarily due to the increase in net premiums earned and net investment income.
Revenues for the year ended December 31, 2007 consisted of net premiums earned (89.6% of the total revenues), commission income (2.7% of the total revenues) and net investment income and realized losses (7.7% of the total revenues) compared to net premiums earned (85.4% of the total revenues), commission income (2.5% of the total revenues) and net investment income (12.1% of the total revenues) for the year ended December 31, 2006.
Premiums earned. Net premiums earned increased by 214.5% to $248.4 million for the year ended December 31, 2007 compared to $79.0 million for the year ended December 31, 2006. The increase is due to higher premiums written in 2007 due to our start up in April 2006 and the normal lag between written and earned premiums. The chart shows the percentage of earned premiums related to written premiums.
The business assumed by CastlePoint Re and CastlePoint Insurance Company under our reinsurance agreements with Tower’s insurance companies and the business written directly using CastlePoint Insurance Company’s policies through Tower Risk Management represented 79.3% of net premiums earned for the year ended December 31, 2007 compared to 96.2% of net premiums earned for the year ended December 31, 2006.
Commission income. Commission income increased 219.3% to $7.5 million for the year ended December 31, 2007 compared to $2.3 million for the year ended December 31, 2006. We received this commission income from Tower and to a lesser extent from other companies as a result of CastlePoint Management’s management of the specialty and traditional programs. The higher fees are the result of binding three additional programs in 2007.
Net investment income and realized gains/(losses). Net investment income increased by 163.8% to $29.5 million for the year ended December 31, 2007 compared to $11.2 million for the year ended December 31, 2006. The growth resulted from an increase in cash and invested assets to $693.5 million as of December 31, 2007 compared to $425.0 million as of December 31, 2006. The increase in invested assets primarily resulted from our cash flow from operations, principally from growth in premiums written, which was $140.7 million in 2007 compared with $62.6 million in 2006 and the proceeds of approximately $114.5 million, from our IPO, in March 2007 after the deduction of underwriting discounts and other offering expenses and $30 million of cash received for the issuance of subordinated debentures in connection with the trust
preferred securities issued in September 2007. The book yield on our invested assets was 5.3% for the year ended December 31, 2007 compared to 5.3% for the year ended December 31, 2006. Our book yield in 2007 was negatively impacted by the recording of an unrealized loss of $2.2 million as a component of net investment income on our investment in a limited partnership. Excluding the unrealized loss, the increase in yield during a generally declining interest rate environment in 2007 is primarily due to an extension in the average duration of our fixed maturity portfolio from 1.97 years at December 2006 to 2.24 years at December 2007, to take advantage of a more normalized yield curve compared with a relatively flat yield curve throughout December 2006 and a slight decrease in the average credit quality of our portfolio from AA+ at December 31, 2006 to AA at December 31, 2007.
Net realized investment losses were $8.2 million for the year ended December 31, 2007, compared with a small gain of $35,000 for the year ended December 31, 2006. We recorded an other-than-temporary impairment charge at December 31, 2007 in the amount of $9.0 million recorded in realized losses. This charge primarily relates to an investment in a fund which was subsequently sold in February 2007 and investments in four mortgage real estate investment trust (“REIT”) equity securities.
Loss and loss adjustment expenses. Loss and loss adjustment expenses increased 220.7% to $131.3 million, which produced a 52.9% loss ratio for the year ended December 31, 2007 compared to $41.0 million which produced a 51.9% loss ratio for the year ended December 31, 2006. The 2007 calendar year loss ratio includes an accident year loss ratio of 53.4% and reflects $1.3 million of favorable revised estimates in loss reserves from the prior year. The change in prior year loss reserves resulted mainly from a reduction in the estimated ultimate losses on the Tower brokerage quota share reinsurance agreement and, to a lesser extent, a reduction in the estimated ultimate losses on various excess of loss reinsurance agreements assumed from Tower.
Expenses. Operating expenses increased 163.4% to $109.5 million for the year ended December 31, 2007, from $41.6 million for the year ended December 31, 2006. Operating expenses are comprised of commission expense and other operating expenses, including corporate expenses (primarily, salaries, audit, legal services and insurance expenses). The increase was due primarily to the increase in commission and other acquisition expenses resulting from the growth in premiums earned. In 2006 we recorded an expense of $4.6 million relating to warrants to purchase 1,127,000 of our common shares that we issued to Tower.
Interest Expense. Our interest expense was $9.4 million for the year ended December 31, 2007 compared to $0.6 for the year ended December 31, 2006. Interest expense resulted primarily from the $100 million of subordinated debentures issued by us in December 2006 at an average fixed interest rate of 8.6%, and $30 million of subordinated debentures issued by us in September 2007 at a fixed interest rate of 8.39%.
Income tax benefit. Our income tax benefit was $5.9 million for the year ended December 31, 2007 compared to $1.1 million for the year ended December 31, 2006. The effective income tax rate was negative 21.8% for the year ended December 31, 2007 compared to negative 11.6% for the same period in 2006. The realized loss of $8.2 million (including $9.0 million of impairment losses) and our equity share of the unrealized loss of $2.2 million on the limited
partnership which was included in net investment income, accounted for negative 9.5 percentage points of the negative 21.8% effective tax rate in 2007, compared with the effective rate of negative 11.6% for 2006. The negative effective rates in both years are due to the losses generated in our U.S. operations, which we believe are recoverable from future taxable income.
Net income and return on average equity. Our net income was $32.7 million for the year ended December 31, 2007 compared to $10.5 million for the year ended December 31, 2006. 2007 operating net income, a non-GAAP measure, was $41.6 million. Our return on average equity was 8.6% for the year ended December 31, 2007 compared to 5.1% for the year ended December 31, 2006. The 2007 operating return on average equity was 10.9%. The return for the year ended December 31, 2007 was calculated by dividing net income of $32.7 million by weighted average shareholders’ equity of $382.1 million. The return for the year ended December 31, 2006 was calculated by dividing net income of $10.5 million by weighted average shareholders’ equity of $207.3 million. The increase in the return on average equity resulted primarily from improved underwriting results. Our consolidated combined ratio improved to 93.9% in 2007 from 101.5% on 2006 primarily from an improvement in the underwriting expense ratio component (see below).
Consolidated combined ratio. Our consolidated combined ratio for the year ended December 31, 2007 was 93.9% compared to 101.5% for the same period in 2006. The improved combined ratio in 2007 was primarily the result of a lower underwriting expense ratio of 41.1% in 2007 compared with 49.6% in 2006. The improvement is the result of increased earned premiums in 2007 due to an increased amount of business written in 2007, as well as higher earned premiums from business written in 2006.
Insurance Segment Results of Operations
The following table summarizes the results of operations for our insurance operations for the year ended December 31, 2007. The insurance segment did not conduct any business and did not have any premium income, obligations relating to insurance policies, employees and operations for the year ended December 31, 2006.
Summary. The Insurance segment had an underwriting loss for the year ended December 31, 2007 in large part due to the cost of purchasing property catastrophe reinsurance. The cost of property catastrophe reinsurance is expensed in the year incurred, and in the first year of operations is therefore high relative to the amount of net premiums earned of $19.1 million, which was only 21% of net premiums written in this first year of operations for this segment. On a gross of reinsurance basis, the combined ratio was 94.3% which reflects solid underlying profitability, and when the premiums earned increase relative to premiums written the net combined ratio is expected to decrease and be closer to the gross combined ratio. Premiums written in the year ended December 31, 2007 increased significantly based upon implementation of the alternative insurance risk-sharing solutions with Tower which generated $84.2 million in premiums written during the period, as well as premiums written of $11.1 million on a risk-sharing arrangement with another client.
Gross premiums and net premiums. Gross and net premiums written were $111.0 million and $91.4 million, respectively, for the year ended December 31, 2007. Gross and net premium earned were $25.1 million and $19.1million, respectively, for the year ended December 31, 2007. CastlePoint Insurance Company’s gross premiums written are primarily comprised of $13.6 million through programs managed by CastlePoint Management, approximately $84.2 million of direct business that was produced by Tower Risk Management Corp., a subsidiary of Tower and $12.5 million assumed from Tower under the brokerage quota share agreement. The ceded premium consisted of excess of loss and catastrophe premium of which approximately 37.9% was ceded to third-party reinsurers and 62.1% to CastlePoint Re.
Gross and net loss and loss adjustment expenses and loss ratio. Gross loss and loss adjustment expenses were $15.2 million, which produced a 60.7% gross loss ratio for the year ended December 31, 2007. Net loss and loss adjustment expenses were $11.8 million, which produced a 61.7% net loss ratio for the year ended December 31, 2007. The net loss ratio was negatively impacted by $2.6 million of ceded catastrophe premium written and earned with a zero percent loss ratio. The level of property catastrophe protection that was purchased was determined based upon our risk guidelines although the level of earned premiums currently is small due to the start-up nature of the segment, such that there was a relatively large impact on the net loss ratio due to the ceded property catastrophe premium.
Underwriting expenses and underwriting expense ratio. Underwriting expenses for the year ended December 31, 2007 for the insurance segment were $8.4 million, comprised primarily of commission and other underwriting expenses. Commission expense was $7.8 million and other underwriting expenses included $0.4 million in boards, bureaus and taxes, and a minimal amount for other operating expenses for the year ended December 31, 2007. The gross underwriting expense ratio was 33.6% and the net underwriting expense ratio was 44.1% for the year ended December 31, 2007.
Underwriting loss and net combined ratio. The underwriting loss and net combined ratio from the insurance segment was $1.1 million and 105.8%, respectively, for the year ended December 31, 2007.
Reinsurance Segment Results of Operations
The following table summarizes the results of operations for our reinsurance segment for the years ended December 31, 2007 and 2006.
Summary. The reinsurance segment is comprised of predominantly quota share reinsurance. The segment had excellent results in 2007 driven by a significant increase in premiums written and earned and a net combined ratio of 87.5%. Premiums from Tower represented 74.3%; third parties represented 25.7%. CastlePoint Re assumed 49% of Tower’s brokerage business for the first quarter of 2007 and 40% for the remainder of the year. The net loss ratio of 52.1% benefited by 0.5 points of favorable loss development of $1.3 million on prior accident years. The net expense ratio of 35.4% reflects ceding commissions of 36% to Tower and to clients other than Tower. Ceding commission includes profit-sharing commissions that are based upon loss ratios, and for Tower’s business the ceding commission was comprised of 34% ceding commission plus 2% profit-sharing commission.
Gross premiums and net premiums. Gross and net written premiums increased 72.5% to $284.8 million for the year ended December 31, 2007 from $165.2 million for the year ended December 31, 2006. Business not originated from Tower and CastlePoint Insurance Company represents 26% or $73.2 million of the total written premiums compared to 5% or $7.5 million during the year ended December 31, 2006. Gross and net premiums earned increased by 190.4% to $229.3 million for the year ended December 31, 2007 from $79.0 million for the year ended December 31, 2006. The increase is attributable to the fact we have a full year of written premium included in our earned premium for the year ended December 31, 2007 compared to only three quarters of written premium included for the same period in 2006 and the time lag between writing and earning premiums in a start up company. During the year ended December 31, 2007, CastlePoint Re added 13 new quota share reinsurance agreements (resulting in earned premium of $24.0 million) and 11 new excess of loss reinsurance agreements / property catastrophe treaties (resulting in earned premium of $4.2 million). Of the $24.0 million of earned premium resulting from the 13 new quota share reinsurance agreements, approximately 79% pertains to non-standard auto business and approximately 10% pertains to workers’ compensation business. CastlePoint Re’s new nonstandard auto clients range from mid-size
regional insurance companies to full- service program underwriting managers. The non-standard auto business is comprised of minimum limits business written in the southeast, southwest and western United States. CastlePoint’s 2007 workers compensation clients emanate from two small insurance companies targeting small commercial businesses primarily located in the southeastern and midwestern United States.
Loss and loss adjustment expenses and loss ratio. Loss and loss adjustment expenses increased by 191.9% to $119.6 million, which produced a 52.1% loss ratio for the year ended December 31, 2007 compared to $41.0 million, which produced a 51.9% loss ratio, for the year ended December 31, 2006. Of this $78.6 million increase, $51.6 million was due to new contracts, $31.1 million was due to additional earned premium on contracts written in 2006 and $(4.1) million was due to change in reserve estimates on contracts written in 2006. The 13 new quota share reinsurance agreements written in 2007 had an aggregate loss ratio of 67.1% for the year ended December 31, 2007 and the 11 new excess of loss reinsurance agreements had an aggregate loss ratio of 44.3% for the year ended December 31, 2007. The loss ratios on most of the treaties were approximately equal to our pricing expectations, except for Tower business which had a better than expected loss ratio.
Underwriting expenses and underwriting expense ratio. Underwriting expenses for the reinsurance segment are comprised of ceding commission paid to insurance companies, which cede business to CastlePoint Re, and other underwriting expenses. Ceding commission expense was $77.6 million and other underwriting expenses were $3.5 million for the year ended December 31, 2007 compared to $27.2 million and $1.4 million, respectively, for the year ended December 31, 2006. The gross underwriting expense ratio and the net underwriting expense ratio were 35.3% and 35.4%, respectively, for the year ended December 31, 2007 compared to 36.2% for both for the year ended December 31, 2006. The lower underwriting expense ratio is due to spreading certain fixed costs over a larger earned premium base.
Underwriting profit and combined ratio. The underwriting profit and the net combined ratio from the reinsurance segment was $28.7 million and 87.5% respectively, for the year ended December 31, 2007 compared to $9.4 million and 88.1% for the year ended December 31, 2006.
Insurance Services Segment Results of Operations
The following table summarizes the results of operations for our insurance services segment for the years ended December 31, 2007 and 2006.
Direct commission revenue. Direct commission revenue is dependent upon the premiums written during the year with respect to the program business managed by CastlePoint Management. CastlePoint Management receives a 30% commission from CastlePoint Insurance Company and Tower’s insurance companies for program business placed by CastlePoint Management with these companies, less boards, bureaus and premium taxes (which we refer to as “BB&T”) and less direct commission expenses that are incurred by Tower and CastlePoint Insurance Company. Direct commission revenue increased 219.3% to $7.5 million for the year ended December 31, 2007 compared to $2.3 million for the year ended December 31, 2006. These commission revenues were received for the specialty programs and traditional programs. We also bound three additional programs, which contributed to the increase in revenues in 2007.
Direct commission expense. Direct commission expense increased 269.4% to $6.2 million for the year ended December 31, 2007 from $1.7 million for the year ended December 31, 2006 due to the addition of three new programs. The increase in commission expense was greater than the increase in commission revenue due to the fact that commission expense can and will vary by program, whereas commission revenue is fixed at 30%. Direct commission expense consisted of the commission fees paid by us to producing agents for the placement of program business. Commission expenses can and will vary depending on such factors as loss ratio and underwriting systems used by producing agents.
Other insurance services expenses. Other insurance services expenses were $6.7 million for the year ended December 31, 2007 compared to $3.6 million for the same period in 2006. The increase was due primarily to the increase in expenses resulting from additional staffing, facility expenses and depreciation expense. Included in the amount above were $1.2 million for the year ended December 31, 2007, and $0.8 million for the year ended December 31, 2006, of costs incurred and charged by Tower’s insurance companies for services provided to us.
Insurance services loss. Insurance services loss was $5.5 million for the year ended December 31, 2007 compared to $3.0 million for the year ended December 31, 2006 due to CastlePoint Management’s current incurrence of costs to produce programs that are expected to generate commission revenue in future periods due in part to the lag time associated with launching new programs that require rates and forms to be filed and approved, as well as systems to be implemented.
Liquidity and Capital Resources
CastlePoint Holdings is a holding company, and as such, has no direct operations of its own. We expect substantially all of our operations to be conducted by our insurance, reinsurance, and management company subsidiaries. Accordingly, we expect to have continuing cash needs for administrative expenses, dividends and the payment of principal and interest on any current and future borrowings and any future taxes and to make strategic investments. Funds to meet
these obligations will come primarily from dividend payments from our operating subsidiaries; however, there are restrictions on the payment of dividends by our insurance subsidiaries.
In our operating subsidiaries, we try to maintain sufficient liquidity to pay claims, operating expenses and meet our other obligations. On a consolidated basis, we held $153.6 million and $34.8 million of cash and cash equivalents at December 31, 2007 and 2006, respectively, all of which had maturities of 90 days or less rated A-1/P-1 or above. We monitor our expected claim payment needs and try to maintain a sufficient portion of our invested assets in cash and cash equivalents to enable us to fund our claim payments without having to sell longer-duration investments prior to maturity. As of December 31, 2007, cash and cash equivalents exceeded the booked reserves of $121.4 million, of which $33.6 million is expected to be paid within the next year. The $118.8 million increase in cash and cash equivalents as of December 31, 2007 compared to December 31, 2006 was due to management’s decision to invest funds short term and not take on additional interest rate risk associated with longer-term investments as well as the receipt of $30.0 million of new cash from the trust preferred offering in September 2007 that had not yet been invested. The average weighted yield on cash and cash equivalents at December 31, 2007 was 3.5%. We expect that the majority of these cash funds will be reinvested in longer term investments over the next few months to take advantage of the recent steepening of the yield curve. We expect our portfolio duration to increase from 2.24 years at December 31, 2007 to approximately 3.0 years within the next several months. We believe a target of 3.0 years provides adequate matching of our portfolio assets with expected claim payouts. We also expect our cash flow from operations to continue to be strong throughout 2008 as we expect our premiums written to continue to increase.
Dividends
Dividends and other permitted distributions from our operating subsidiaries are our sole source of funds to pay dividends to shareholders and meet ongoing cash requirements, including debt service payments, if any, and other expenses. Bermuda law and regulations, including, but not limited to, Bermuda insurance regulations, restrict the declaration and payment of dividends and the making of distributions by CastlePoint Re, unless specific regulatory requirements are met. In addition, CastlePoint Insurance Company is, and any other U.S. licensed insurance companies that we may acquire or form and capitalize will be subject to significant regulatory restrictions limiting their ability to declare and pay dividends. Furthermore, any dividends paid by CastlePoint Insurance Company or such other U.S. licensed insurance companies will be subject to a 30% withholding tax. Therefore, we intend that any dividends or other permitted distributions we expect to receive will be paid or otherwise made by CastlePoint Re, which is subject to Bermuda regulatory restrictions and any applicable contractual restrictions on any such payments. If we cannot receive dividends or other permitted distributions from our subsidiaries as a result of such restrictions, we will be unable to pay dividends as currently contemplated by our board of directors. However, cash and invested assets at CastlePoint Bermuda Holdings at December 31, 2007, currently available to pay dividends to CastlePoint Holdings, was $74.4 million.
The inability of our operating subsidiaries to pay dividends in an amount sufficient to enable us to meet our cash requirements at the holding company level could adversely affect us.
We have historically paid an annual cash dividend of $0.10 per common share to our shareholders of record, payable on a quarterly basis. Any future determination to pay dividends is at the discretion of our board of directors and is dependent upon our results of operations and cash flows, our financial position and capital requirements, general business conditions, legal, tax, regulatory, rating agency and any contractual restrictions on the payment of dividends and any other factors our board of directors deems relevant, including Bermuda and U.S. state legal and regulatory constraints.
Bermuda. Bermuda legislation imposes limitations on the dividends that CastlePoint Re may pay. We are subject to Bermuda regulatory constraints that affect our ability to pay dividends on our shares and make other payments. Under the Companies Act 1981 of Bermuda, as amended (the “Companies Act”), we may declare or pay a dividend out of distributable reserves only if we have reasonable grounds for believing that we are, or would after the payment, be able to pay our liabilities as they become due and if the realizable value of our assets would thereby not be less than the aggregate of our liabilities and issued share capital and share premium accounts.
Under the Insurance Act of 1978, as amended (the “Insurance Act”), CastlePoint Re is required to maintain a specified solvency margin and a minimum liquidity ratio and is prohibited from declaring or paying any dividends if doing so would cause CastlePoint Re to fail to meet its solvency margin and its minimum liquidity ratio. Under the Insurance Act, CastlePoint Re is prohibited from declaring or paying dividends without the approval of the Bermuda Monetary Authority, if CastlePoint Re failed to meet its solvency margin and minimum liquidity ratio on the last day of the previous fiscal year. Under the Insurance Act, CastlePoint Re is prohibited, without the approval of the BMA, from reducing by 15% or more its total statutory capital as set forth on its audited statutory financial statements for the previous year.
United States. CastlePoint Insurance Company is subject to regulation by the State of New York, its state of domicile. Under New York State insurance law, CastlePoint Insurance Company may not, during any 12-month period, declare or pay dividends in excess of the lesser of 10% of its policyholders surplus as shown on its last filed financial statement or 100% of CastlePoint Insurance Company’s adjusted net income during such period, without obtaining the New York State Insurance Department’s prior approval. All dividends paid by CastlePoint Insurance Company may only be paid out of earned surplus. CastlePoint Insurance Company did not declare a dividend in 2007.
Additional U.S. licensed insurance companies we may acquire or form and capitalize will be subject to regulation by their respective states of domicile. Under most U.S. state insurance laws, prior regulatory approval is generally required for the payment of dividends or distributions which, together with any other dividends and distributions paid during the immediately preceding twelve month period exceed the greater of 10% of statutory capital and surplus or the prior calendar year’s net income or net investment income. Additionally, dividends generally may only be paid out of an insurer’s earned surplus.
Sources and Uses of Cash and Cash Flows
The primary sources of cash of our operating subsidiaries are net premiums received, investment income and commission income. In addition, we may raise cash from public offerings and from the issuance of debt.
Our principal ongoing consolidated cash requirements are expected to be the capitalization of our existing operating subsidiaries, our operating expenses, our possible acquisition or formation of one or more additional U.S. licensed insurance companies, subject to receipt of regulatory approvals, net cash settlements under insurance risk sharing and reinsurance agreements, payment of losses and loss adjustment expenses, commissions paid to program underwriting managers, ceding commissions to insurance companies including Tower, excise taxes, operating expenses and payments under our service and expense sharing agreements with Tower. In addition, we will need cash to enable us to make strategic investments in some of our clients and potential clients, including Tower, as well as to pay dividends to our shareholders and to service the debt on the subordinated debentures of $103.1 million issued by CastlePoint Management in December 2006, and on the subordinated debentures of $30.9 million issued by CastlePoint Bermuda Holdings in September 2007.
Further, while insurance regulations differ by location, insurers and reinsurers are generally required to maintain certain minimum levels of capital and/or risk-based capital, the calculation of which typically includes numerous factors specified by the respective insurance regulatory authorities and the related insurance regulations. We may acquire or form and capitalize one or more additional U.S. licensed insurance companies in 2008. We anticipate that the purchase price for any additional U.S. licensed insurance companies that we may acquire would consist of the amount to be paid for the value of the target company’s insurance licenses (in our experience, typically no more than $200,000 per state license, depending upon lines of authority) and the amount of its statutory capital and surplus, as well as the value of the business if an ongoing operating insurance company is purchased. See “Item 1: Business-Licensing of U.S. Insurance Companies.”
For the year ended December 31, 2007, net cash provided by operating activities was approximately $140.7 million compared to $62.6 million for the year ended December 31, 2006. The increase in net cash provided by operations resulted primarily from the increase in collected premiums as a result of the growth in premiums written. For the year ended December 31, 2007 net cash flows used in investing activities was approximately $162.8 million compared to $385.8 million for the year ended December 31, 2006, which consisted of purchases and sales of investments.
The net cash flows provided by financing activities for the year ended December 31, 2007 were approximately $140.2 million, which primarily consisted of approximately $114.5 million in net proceeds from the IPO after all offering expenses and net proceeds from the issuance of subordinated debentures of approximately $29.0 million by CastlePoint Bermuda Holdings, less dividends paid to shareholders of $3.6 million, as compared to $357.9 for the year ended December 31, 2006, which primarily consisted of approximately $249.2 million in net proceeds from the private offering, net proceeds from issuance of subordinated debentures of
approximately $96.9 and $15.0 million in net proceeds from Tower Group’s initial investment in the Company, less dividends paid to shareholders of $2.2 million.
On March 28, 2007, the Company completed its initial public offering at an initial offering price per share of $14.50, in which (i) the Company sold 8,697,148 shares it registered on its own behalf, and (ii) selling shareholders sold 119,500 shares the Company registered on their behalf. The net proceeds to the Company, after deducting underwriting discounts of approximately $8.5 million and other offering expenses of approximately $3.6 million, were approximately $114 million. The gross proceeds to the selling shareholders were approximately $1.7 million in the aggregate, and net proceeds to the selling shareholders were approximately $1.6 million in the aggregate. The Company did not receive any of the proceeds of the sale by the selling shareholders. As of December 31, 2007, we have used approximately $70.0 million of these net proceeds to further capitalize CastlePoint Re, and we intend to use the remaining proceeds of the initial public offering to either further capitalize CastlePoint Re or capitalize any U.S. licensed insurance companies we may acquire or form in the future, to make strategic acquisitions or investments, or for general corporate purposes.
In 2007 we received cash, and in 2008 we expect to receive cash, from direct and assumed premiums collected, net cash settlements under our insurance risk sharing and reinsurance agreements, fee income for services provided, investment income and proceeds from sales and redemptions of investments. We also expect that we will raise additional funds in the future through additional equity and/or additional debt financings.
We or one of our subsidiaries may also enter into an unsecured revolving credit facility and a term loan facility with one or more syndicates of lenders, and we expect to use any such facilities for general corporate purposes, working capital requirements and issuances of letters of credit. We believe that any debt financing or credit facility will require compliance with financial covenants, such as a leverage ratio, a consolidated tangible net worth ratio and maintenance of ratings. Any debt financing or credit facility will likely contain additional covenants that restrict the activities of our operating subsidiaries, such as the incurrence of additional indebtedness and liens and the payment of dividends and other payments. In addition, the terms of any debt financings may require guarantees by CastlePoint Holdings or any of our subsidiaries. We currently have no commitment from any lender with respect to a credit facility. We cannot assure you that we will be able to obtain a credit facility on terms acceptable to us.
We constantly monitor and review our internal capital allocation, the performance of our investment portfolio, the need for new debt and or new capital raises and potential acquisitions.
Catastrophes
We estimate that, as of December 31, 2007 and as of December 31, 2006, CastlePoint Re’s probable maximum loss relating to a one in one hundred year property catastrophe event was approximately $28.2 million and $27 million, respectively, based upon computer modeling techniques utilized by us that are commonly used in the insurance industry. The comparable probable maximum loss for CastlePoint Insurance is estimated to be $15 million at December 31, 2007. As we grow our business, we anticipate that our probable maximum loss will increase.
Additionally, although we currently seek to limit our probable maximum loss to 10% of our policyholders’ surplus, in the event of such a property catastrophe event, we cannot predict what our actual losses would be.
Income Taxes
We are subject to U.S. federal, state and local income tax requirements in the states in which we operate. We are not subject to income tax in Bermuda. Actual tax expense is based on taxable earnings reported by our U.S. operations arising from underwriting results, investment income and other income less expense items. Our effective tax rate reflects the proportion of taxable income recognized by our operating subsidiaries, including CastlePoint Management Company and CastlePoint Insurance Company and any U.S. based subsidiaries we expect to acquire or form and capitalize in the future, subject to receipt of regulatory approvals, that generally will be taxed at the U.S. corporate income rate (35%), and CastlePoint Re, which is exempt from corporate tax. CastlePoint Management is taxed by New York State at the rate of 7.5%, net of the federal tax benefit. There is also a 30% withholding tax imposed on dividends, if any, paid to us by our U.S.-based subsidiaries.
Inflation
Property and casualty insurance and reinsurance premiums are established based upon our estimates at the time of the amount of losses and loss adjustment expenses that have been incurred in the past for similar types of business. We attempt to estimate the potential impact of inflation on losses and loss adjustment expenses in establishing our premiums, but we cannot be certain about the extent to which inflation may affect such amounts. Inflation in excess of the levels we have assumed could cause losses and losses adjustment expenses to be higher than we anticipated and therefore insurance and reinsurance premiums to be inadequate.
Substantial future increases in inflation could also result in future increases in interest rates, which in turn are likely to result in a decline in the market value of the investment portfolio and produce unrealized losses.
Investments
The Company has developed specific investment objectives and guidelines for the management of its investment portfolio. These investment guidelines stress capital preservation and maximization of after tax investment income through the maintenance of liquidity, risk diversification and credit quality. Generally, we invest our assets in relatively liquid, high-grade fixed maturity securities of relatively short duration. We seek to manage our credit risk through issuer and industry diversification and interest rate risk by monitoring the duration and structure of the portfolio. Despite the prudent focus of these objectives and guidelines, the Company’s investments are subject to general market risk, as well as to risks inherent to particular securities.
The following table summarizes our investment portfolio at December 31, 2007.
The aggregate fair market value of our available-for-sale investments as of December 31, 2007 was $527.4 million, which excludes our investment in common trust securities of the three statutory business trusts described under “-Off-Balance Sheet Transactions” below and excludes our investment in a limited partnership. Our fixed maturity securities as of this date had a fair market value of $485.0 million and an amortized cost of $484.5 million. Short-term investments were carried at fair value of $0 as of December 31, 2007 compared to $51.6 million as of December 31, 2006.
At December 31, 2007 we held $153.6 million of cash and cash equivalents, which include all securities that, at their purchase date, have a maturity of 90 days or less, of which $30 million was uninvested cash resulting from the proceeds from the offering by CastlePoint Bermuda Holdings of trust preferred securities, which we received at the end of September 2007. The average yield on cash and cash equivalents held at December 31, 2007 was approximately 3.5%. During 2007, our investment manager recommended overweight positions in mortgages, favoring pass-through instruments and high quality collateralized mortgage obligations and
commercial mortgage backed securities. Our investment manager recommended underweight positions in virtually all other sectors. However, since we did not wish to materially increase our exposure to mortgages at this time, we decided to maintain a relatively high amount of cash and cash equivalent balances.
The fair value pricing of our fixed maturity and equity securities at December 31, 2007 is generally based on current marks provided by indices and reputable pricing services and, to a lesser extent, established broker-dealers who routinely make a market in the securities being priced. To the best of our management’s knowledge, substantially all of the prices represent observable prices, including similar securities in active markets, identical or similar securities in an inactive market or market corroborated inputs. Our investment managers and the funds in which we have invested have represented to us that no securities have been priced utilizing unobservable inputs.
The portfolio duration of the fixed maturity securities at December 31, 2007 was approximately 2.24 years (1.97 years at December 31, 2006) and the average credit rating was AA (AA+ at December 31, 2006).
Included in the “Fixed maturity securities” on the balance sheet at December 31, 2007, the Company held $343.9 million ($187.7 million at December 31, 2006), at fair value in residential mortgage-backed, commercial mortgage-backed and asset backed securities (reflecting primarily assets backed by automobile loans and credit card receivables, with approximately $2.5 million of the asset backed securities being backed by home equity loans at December 31, 2007). Of the total residential and commercial mortgage-backed securities of $287.4 million, approximately 77% were residential mortgage-backed securities (“RMBS”) and 23% were commercial mortgage-backed securities (“CMBS”). Approximately $155 million of the RMBS were backed by U.S. government or government charted agencies. The remaining fixed maturity securities at December 31, 2007 and December 31, 2006 consisted primarily of corporate securities in the amount of $132.3 million with an average rating of A+ at December 31, 2007 ($89.2 million at December 31, 2006) and are distributed over the following industries - banks, brokerage, insurance, other finance, media, pipelines and utilities.
Included in “Equity securities” on the balance sheet at December 31, 2007, the Company held an investment in the amount of $13.9 million in a fund that invests in primarily floating rate mortgage and asset backed securities with 40% of the funds assets invested in home equity loans backed by subprime mortgages at December 31,2007. As further described below, we recorded an other-than-temporary impairment charge at December 31, 2007 in the amount of $7.1 million on this investment and then subsequently sold this investment on February 1, 2008 for an additional loss of $0.2 million. Additionally, we have no Alternative A (defined as risks falling between prime and subprime) mortgage exposure in our portfolio or in any of the funds in which we have invested. Also in this category we have an investment of $9.9 million in a fund comprised of primarily investment grade securities with a focus on the financial institutions segment of the credit markets (i.e., primarily trust preferred, subordinated debt and preferred securities). We also hold a $2.3 million investment in a fund investing primarily in securitized bank loans and we hold $2.1 million of publicly traded common stocks whose purpose is to own various mortgage backed securities, including CMBS, non-agency RMBS, and RMBS backed by
U.S. government or government chartered agencies. We recorded an other-than-temporary impairment charge on these common stock securities at December 31, 2007 in the amount of $1.8 million because we do not necessarily have the intent to hold these securities until full recovery. The remaining investments in this category are preferred stocks in the finance and banking industries in the amount of $14.2 million with an average rating of A+.
We constantly monitor our exposure to “real estate” related securities (i.e., commercial and residential mortgage backed securities, asset backed securities backed by home equity loans and mortgage real estate investment trust (“REIT”) securities, whether directly held or held in a fund). Our total exposure to real estate related securities at December 31, 2007 of $306.0 million represented 44.1% of cash and invested assets. At December 31, 2007, of the total $306.0 million exposure to real estate related securities, $284.0 million was rated AAA, of which $154.9 million were U.S. obligations backed by U.S. government or government chartered agencies. Of the remaining $22.0 million, $20.2 million was rated BBB (including the average BBB rating of the underlying securities of an investment in a fund in the amount of $13.9 million) and $1.8 million was rated BB. The $13.9 million represents an investment in a fund (included in equity securities, see above and below) with 40% subprime exposure that was subsequently sold in 2008. We recorded an other-than-temporary impairment charge at December 31, 2007 in the amount of $7.1 million and recorded a loss on the sale in 2008 of $0.2 million. The $2.5 million of assets backed by home equity loans represents subprime exposure and is rated AAA. We recorded an other-than-temporary impairment loss on these securities at December 31, 2007 in the amount of $33,000, since we did not have the intent to hold these securities until a full recovery. We subsequently sold these securities in February 2008 for a loss of $65,000. Therefore, as of the date of this annual report, we have no subprime or Alternative A exposure.
At December 31, 2007, we held an investment of $8.5 million in a limited partnership that invests in municipal bonds. Approximately 82% of the fund securities are rated AAA and 18% are rated AA. Approximately 64% of the bonds are insured.
At December 31, 2007, we had gross unrealized gains of $4.8 million and gross unrealized losses of $5.9 million. Of the $5.9 million of gross unrealized losses, $1.4 million is attributable to corporate fixed maturities, $2.9 million is attributable to mortgage and asset backed securities, and $1.7 million is attributable to equities.
Corporate Fixed Maturities. The unrealized loss position of $1.4 million in corporate fixed maturities relates to 17 securities all rated BBB or above and all of which have been in an unrealized loss position for less than 12 months as of December 31, 2007. The security with the largest unrealized loss in this group of $0.6 million is Lehman Brothers Holdings, Inc., issued May 17, 2007, with a coupon of 5.86% and a book yield of 6.04%, rated A-. The brokerage sector has been negatively impacted by the general market disruptions caused by the significant decline in market liquidity. The remaining corporate securities are distributed over the following industries - banks, brokerage, insurance, other finance, media, pipelines and utilities. The impairment on all fixed corporate maturities is considered temporary at December 31, 2007 and is generally the result of widening spreads during the fourth quarter. The Company has both the ability and intent to hold these securities until a full recovery of fair value, which may not be until maturity.
Mortgage and Asset Backed Securities. The unrealized loss in mortgage and asset backed securities of $2.9 million relates to 23 issues, with 18 issues rated AAA ($0.2 million), 4 issues rated BBB ($2.0 million) and 1 issue rated BB ($0.7 million). All of these securities, except for certain positions with unrealized losses amounting to $11,000, had been in an unrealized loss position for less than 12 months as of December 31, 2007. The five securities rated BBB and BB are CMBS and were purchased after June 30, 2007. Since all five securities are rated less than AA, a cash flow analysis was performed pursuant to Emerging Issues Task Force (“EITF”) 99-20. None of these securities indicated a reduction in cash flow on a present value basis from what was originally expected at the date of purchase. The impairment on all mortgage and asset backed securities, except as discussed below, is considered temporary at December 31, 2007 and is due to the market disruptions caused by the significant decline in market liquidity affecting this sector. The Company has both the ability and intent to hold these securities until a full recovery of fair value, which may not be until maturity.
Equity Securities. The unrealized loss in equity securities of $1.7 million relates to 9 issues. These securities had been in an unrealized loss position for less than 12 months as of December 31, 2007. The largest single equity security in an unrealized loss position at December 31, 2007 was an investment in a fund comprised primarily of collateralized bank loans with an unrealized loss of $0.7 million. The loans have floating rates. The collateralization makes the loans structurally senior in priority to corporate bonds from the same issuers, providing additional credit protection. This security had been in an unrealized loss position for less than 6 months as of December 31, 2007. The unrealized loss is due to market disruptions caused by the significant decline in market liquidity and the general spread widening during the fourth quarter. The remaining unrealized loss of $1.0 million is comprised of 8 preferred stock issues with no individual unrealized loss at December 31, 2007 exceeding $0.2 million. The Company has both the ability and intent to hold all equity securities that were in a loss position at the end of 2007, other than the securities discussed below, until a full recovery of fair value.
At December 31, 2007, we recorded charges for other-than-temporary impairments of $9.0 million primarily relating to an investment in a fund, an investment in three asset backed securities backed by subprime credit and in four equity securities.
•
The unrealized loss on the fund was $7.1 million and was in an unrealized loss position for 7-12 months. The market value at December 31, 2007 was 66% of cost. The fund consists of primarily floating rate mortgage and asset backed securities with 40% of the fund’s assets invested in home equity loans backed by subprime mortgages. The average credit rating of the fund, based on the ratings of the underlying securities, is BBB. We sold our position in the fund on February 1, 2008 and realized a loss of $0.2 million, after recording the other-than-temporary impairment charge at year end.
•
The unrealized loss on the three ABS backed by subprime credit was $33,000 at year end and were in an unrealized loss position for less than 6 months. They are rated AAA. We have subsequently sold these three securities in February 2008 and recorded a $65,000 realized loss, after recording the other-than-temporary impairment charge at year end.
•
The unrealized loss on the four equity securities, all of which are mortgage real estate investment trusts (“REITs”), was $1.8 million and these securities were in an unrealized loss position for less than twelve months. The market values at December 31, 2007 were 54% of cost. These four equity securities are all publicly traded mortgage REITs whose purpose is to own various mortgage backed securities, including CMBS, and agency and non-agency residential MBS. To date, these equity securities continue to generate the earnings necessary to continue the dividend payments. However, the biggest risk of not generating earnings and therefore discontinuing dividend payments is if the funds are forced to unwind holdings due to the inability to borrow against current holdings due to market prices that are based on distressed sale levels vs. actual value. Based on the magnitude of the unrealized loss and the time period it may take for full recovery, we do not necessarily have the intent to hold these securities until full recovery. Therefore, we considered them other-than-temporarily impaired at December 31, 2007.
Subordinated Debt
As further described below, in December 2006 and September 2007, we borrowed $103.1 million and $30.9 million, respectively, the proceeds of which were used for general corporate purposes, including acquisition and capitalization of CastlePoint Insurance Company using the funds generated from the December 2006 borrowing. Also, in December 2006 we made a $40 million investment in Tower’s non-cumulative convertible perpetual preferred stock, all of which was redeemed by Tower in January 2007. We used the proceeds of such redemption to further capitalize CastlePoint Insurance Company. Further, we received approximately $114 million in net proceeds from our initial public offering in March 2007. We utilized $70 million of these proceeds to further capitalize CastlePoint Re, and we are holding the remainder at the holding company level for general corporate purposes.
In November and December 2006, our subsidiary, CastlePoint Management, formed two statutory trusts for the purpose of issuing trust preferred securities to institutional purchasers in transactions not requiring registration under the Securities Act. Additionally, in September 2007, our subsidiary, CastlePoint Bermuda Holdings, formed a statutory trust for the purpose of issuing trust preferred securities to institutional purchasers in transactions not requiring registration under the Securities Act. We own all of the common trust securities of these trusts. On December 1, 2006, the first trust issued $50.0 million of trust preferred securities in a private placement and invested the proceeds thereof and the proceeds from the sale of the common securities of the trust in exchange for approximately $51.5 million of junior subordinated debentures issued by CastlePoint Management. On December 14, 2006, the second trust issued $50.0 million of trust preferred securities in a private placement and invested the proceeds thereof and the proceeds from the sale of the common securities of the trust in exchange for approximately $51.5 million of junior subordinated debentures issued by CastlePoint Management. On September 27, 2007, the third trust issued $30.0 million of trust preferred securities in a private placement and invested the proceeds thereof and the proceeds from the sale of the common securities of the trust in exchange for approximately $30.9 million of junior subordinated debentures issued by CastlePoint Bermuda Holdings.
The subordinated debentures are unsecured obligations of CastlePoint Management and CastlePoint Bermuda Holdings and are subordinated and junior in right of payment to all its present and future senior indebtedness. CastlePoint Management and CastlePoint Bermuda Holdings and CastlePoint Holdings issued guarantees in favor of the holders of the preferred securities of the trusts, all of which provide for full and unconditional guarantee of the guaranteed securities. All of these subordinated debentures have stated maturities of thirty years. CastlePoint Management and CastlePoint Bermuda Holdings have the option to redeem any or all of the subordinated debentures beginning five years from the date of issuance, at the principal amount plus accrued and unpaid interest. The interest rate on the subordinated debentures is a combination fixed and floating rate with a fixed rate equal to 8.66% per annum with respect to the subordinated debentures issued on December 1, 2006, 8.551% per annum with respect to the subordinated debentures issued on December 14, 2006, and equal to 8.39% per annum with respect to the subordinated debentures issued on September 27, 2007, all during the first five years, after which the interest rate will be equal to the three month London Interbank Offered Rate (“LIBOR”) plus 3.5% per annum (calculated quarterly). If CastlePoint Management or CastlePoint Bermuda Holdings chose to redeem the subordinated debentures, the trusts would then redeem the trust preferred securities at the same time.
Posting of Security by Our Non-U.S. Operating Subsidiaries
We anticipate that CastlePoint Re will not be licensed, accredited or otherwise approved as a reinsurer anywhere in the United States. All U.S. jurisdictions prohibit insurance companies from taking credit for reinsurance obtained from unlicensed or non-admitted insurers on their U.S. statutory financial statements without appropriate security. Therefore, insurance companies in these jurisdictions will only receive credit for reinsurance purchased from CastlePoint Re to the extent that CastlePoint Re provides adequate security for the reinsurance obligations. This type of security is typically provided by posting a letter of credit for the benefit of the primary insurer or through the deposit of assets into a trust fund established for the benefit of the primary insurer in accordance with state regulation. The amount of the letter of credit or trust is generally required to be adjusted each calendar quarter. Under the terms of the quota share reinsurance agreements between CastlePoint Re and Tower’s insurance companies, CastlePoint Re is required to provide security to Tower’s insurance companies to support reinsurance recoverables owed to these reinsureds in a form acceptable to the insurance commissioners of the State of New York and Commonwealth of Massachusetts, the domiciliary states of Tower’s insurance companies. CastlePoint Re is also required by its reinsurance agreements with its other cedents to collateralize amounts through a letter of credit, cash advance, funds held or a trust account meeting the requirements of the applicable state insurance regulations. If we are unable to provide the necessary security, insurance companies may be prohibited from purchasing our reinsurance products, which could adversely affect us.
In connection with posting of security as described above, CastlePoint Re will file annual statements in the states of domicile of its reinsureds, to the extent required.
In addition, CastlePoint Re entered into a trust agreement to establish a trust fund in the United States as security for U.S. policyholders and third-party claimants in connection with
seeking to qualify as an eligible or approved excess or surplus lines insurer in certain U.S. jurisdictions.
As of December 31, 2007, CastlePoint Re had trust accounts for the benefit of its reinsureds totaling approximately $216.7 million, an increase of approximately $118.9 million since December 31, 2006. In addition, as of December 31, 2007, CastlePoint Re had letters of credit in the amount of $1.4 million. As of December 31, 2007, CastlePoint Insurance Company also had trust assets in the amount of $8.0 million. CastlePoint Re and CastlePoint Insurance earn and collect the interest on the trust funds. For more information, see Note 11 “Commitments and Contingencies” to our audited financial statements as of and for the year ended December 31, 2007 and the year ended December 31, 2006.
Off-Balance Sheet Arrangements
In 2006, we formed two Delaware statutory business trusts of which CastlePoint Management owns all of the common trust securities, to facilitate the trust preferred financing completed in December 2006.
In 2007 we formed a third Delaware statutory business trust of which CastlePoint Bermuda Holdings owns all of the common trust securities, to facilitate the trust preferred financing completed in September 2007. For additional information, see Note 17 “Debt” to our audited financial statements as of and for the year ended December 31, 2007 included elsewhere in this report.
Contractual Obligations
The following table summarizes our contractual obligations as of December 31, 2007 and the effect those obligations are expected to have on our liquidity in future periods. Changes in our business needs and other factors may cause these estimates to change.
($ in thousands)
(1)
For a description of the terms of the subordinated debentures, see “-Our Liquidity and Capital Resources” above.
(2)
We lease and/or sublease office space in (i) Hamilton, Bermuda, (ii) New York, New York and (iii) Lisle, Illinois. CastlePoint Re executed a sublease agreement for premises in Hamilton, Bermuda, as of September 1, 2006, which is expected to expire on June 30, 2012. In December
2007, CastlePoint Re increased the amount of space at these premises it has been occupying since 2006, with a five-year term of such lease commencing on July 1, 2007. CastlePoint Re’s current sublease arrangement requires monthly payments of $14,599. CastlePoint also leased three residential premises (on behalf of certain of its employees located in Bermuda) on varying terms. CastlePoint Management and CastlePoint Insurance Company currently sublease office space in New York, New York from Tower Insurance Company of New York, at its cost, pursuant to an arrangement covered by the service and expense sharing agreement between these parties. CastlePoint Management currently leases office space in Lisle, Illinois which expires on June 30, 2008.
(3)
The timing and amounts of actual claims payments related to loss reserves vary based on many factors, including large individual losses, changes in the legal environment, as well as general market conditions. The ultimate amount of the claims payments could differ materially from the amounts estimated by us. For more information regarding estimates for unpaid loss and loss adjustment expenses, as well as factors affecting potential payment patterns of reserves for actual and potential claims related to our lines of business, see “Critical Accounting Estimates-Losses and Loss Adjustment Expense Reserves” above. Certain of our lines of business may have loss experience characterized as low frequency and high severity. This may result in significant variability in loss payment patterns and, therefore, may impact the related asset/liability investment management process.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Market risk is the risk that we will incur losses in our investments due to adverse changes in market rates and prices. Market risk is directly influenced by the volatility and liquidity in the market in which the related underlying assets are invested. We believe that we are principally exposed to three types of market risk: changes in interest rates, changes in credit quality of issuers of investment securities and reinsurers, and changes in equity prices. Specifically, rising rates result in a decline in market value of our fixed maturity portfolio and can expose our portfolio, in particular our mortgage-backed securities, to extension risk. Conversely, a decline in interest rates will result in a rise in the market value of our fixed maturity portfolio and can expose our portfolio, in particular our mortgage-backed securities, to prepayment risk. We understand these risks and take certain measures to contain these risks. Because some of our investments will be in small insurance companies and program underwriting managers with which we do business, such investments may have no trading market and may be illiquid.
Credit Risk
Our credit risk is the potential loss in market value resulting from adverse change in the borrower’s ability to repay its obligations. Our investment objectives are to preserve capital, generate investment income and maintain adequate liquidity for the payment of claims and debt service. We seek to achieve these goals by investing in a diversified portfolio of securities. We manage credit risk through regular review and analysis of the credit worthiness of all investments and potential investments.
We also have other receivable amounts subject to credit risk. To mitigate the risk of these counterparties’ nonpayment of amounts due, we establish business and financial standards for reinsurer approval, incorporating ratings and outlook by major rating agencies and considering then-current market information. We continually review our receivables and set up an allowance for doubtful accounts when amounts are past due or when there is a possibility that an account is uncollectible.
Equity Risk
Equity risk is the risk that we may incur economic losses due to adverse changes in equity prices. Our exposure to changes in equity prices will primarily result from our holdings of
common stocks, funds and other equities. Our portfolio of equity securities is carried on the balance sheet at fair value.
Portfolio characteristics are analyzed regularly and market risk will be actively managed through a variety of modeling techniques. If we invest in equity securities, concentrations in any one company or industry will be limited by parameters established by senior management, as well as by statutory requirements. In addition, we may make strategic investments, including potential acquisitions in small insurance companies and program underwriting agents with which we do business, in order to build a distribution system that sources a significant portion of our overall business from these clients. In certain cases, these strategic investments may have no trading market and thus may be illiquid.
Interest Rate Risk
Interest rate risk is the risk that we may incur economic losses due to adverse changes in interest rates. The primary market risk to the investment portfolio is interest rate risk associated with investments in fixed maturity securities. Fluctuations in interest rates have a direct impact on the market valuation of these securities.
For fixed maturity securities, short-term liquidity needs and the potential liquidity needs for our business are key factors in managing our portfolio. We use modified duration analysis to measure the sensitivity of the fixed income portfolio to changes in interest rates. Our portfolio duration is relatively short at 2.24 years at December 31, 2007.
Sensitivity Analysis
Sensitivity analysis is a measurement of potential loss in future earnings, fair values or cash flows of market sensitive instruments resulting from one or more selected hypothetical changes in interest rates and other market rates or prices over a selected time. In our sensitivity analysis model, we select a hypothetical change in interest rates that reflects what we believe are reasonably possible near-term changes in those rates. The term “near-term” means a period of time going forward up to one year from the date of the consolidated financial statements. Actual results may differ from the hypothetical change in market rates assumed in this disclosure, especially since this sensitivity analysis does not reflect the results of any action that we may take to mitigate such hypothetical losses in fair value.
In this sensitivity analysis model, we use fair values to measure our potential loss. The sensitivity analysis model includes investments in fixed maturities.
For invested assets, we use modified duration modeling to calculate changes in fair values. Durations on invested assets are adjusted for call, put and interest rate reset features. Durations on tax-exempt securities are adjusted for the fact that the yield on such securities is less sensitive to changes in interest rates compared to U.S. Treasury securities. Invested asset portfolio durations are calculated on a market value weighted basis, including accrued investment income, using holdings as of December 31, 2007.
The following table summarizes the estimated change in fair value on our fixed maturity portfolio including short-term investments based on specific changes in interest rates as of December 31, 2007:
The sensitivity analysis model used by us produces a predicted pre-tax loss in fair value of market-sensitive instruments of $15.0 million or 3.1% based on a 100 basis point increase in interest rates as of December 31, 2007. This loss amount only reflects the impact of an interest rate increase on the fair value of our fixed maturities, which constituted approximately 89.8% of our total invested assets as of December 31, 2007.
As of December 31, 2007, we had a total of $134.0 million of outstanding debt, all of which is outstanding junior subordinated debentures underlying trust securities issued by our wholly owned statutory business trusts carrying a fixed interest rate during the first five years, after which the interest rate will become floating and equal to the three month LIBOR rate plus 3.5% per annum (calculated quarterly). If LIBOR rates increase, the amount of interest payable by us would also increase. For more information about the junior subordinated debentures, see “-Our Liquidity and Capital Requirements” above.
Item 8.
Item 8. Financial Statements and Supplementary Data
See our consolidated Financial statements and notes thereto and required Financial statement schedules on pages through and S-1 through S-7 below.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Not applicable.
Item 9A.
Item 9A. Controls and Procedures
Our management, with the participation of the Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this annual report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective to provide reasonable assurance that material information relating to us and our consolidated subsidiaries required to be disclosed in our reports filed with or submitted to the SEC under the Securities Exchange Act of 1934, as amended, is made known to
such officers by others within these entities, particularly during the period this quarterly report was prepared, in order to allow timely decisions regarding required disclosure.
In connection with the evaluation process described above, we have not identified any changes in our internal control over financial reporting that occurred during the three months ended December 31, 2007, that materially affected, or are reasonably likely to materially affect our internal control over financial reporting.
This annual report does not include a report of management’s assessment regarding internal control over financial reporting or an attestation report of the Company’s registered public accounting firm due to a transition period established by rules of the Securities and Exchange Commission for newly public companies.
Item 9B.
Item 9B. Other Information
Not applicable
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The information required by this Item is incorporated by reference to, and will be contained in, our definitive proxy statement that will be filed with the SEC not later than 120 days after the close of the fiscal year ended December 31, 2007 pursuant to Regulation 14A.
Item 11.
Item 11. Executive Compensation
The information required by this Item is incorporated by reference to, and will be contained in, our definitive proxy statement that will be filed with the SEC not later than 120 days after the close of the fiscal year ended December 31, 2007 pursuant to Regulation 14A.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management Related Stockholder Matters
The information required by this Item is incorporated by reference to, and will be contained in, our definitive proxy statement that will be filed with the SEC not later than 120 days after the close of the fiscal year ended December 31, 2007 pursuant to Regulation 14A.
Item 13.
Item 13. Certain Relationships and Related Transactions
The information required by this Item is incorporated by reference to, and will be contained in, our definitive proxy statement that will be filed with the SEC not later than 120 days after the close of the fiscal year ended December 31, 2007 pursuant to Regulation 14A.
Item 14.
Item 14. Principal Accounting Fees and Services
The information required by this Item is incorporated by reference to, and will be contained in, our definitive proxy statement that will be filed with the SEC not later than 120 days after the close of the fiscal year ended December 31, 2007 pursuant to Regulation 14A.
Item 15.
Item 15. Exhibits and Financial Statement Schedules
The following documents are included in this report:
(1) Financial Statements beginning on page are filed as part of this report.
(2) The Financial Statement Schedules beginning on page S-1 of this report are filed as a part of this report.
(3) Exhibits
Exhibit No.
Description
*10.8
Master Agreement, dated as of April 4, 2006, among the Company, CastlePoint Management Corp., Tower Group, Inc., Tower Insurance Company of New York and Tower National Insurance Company
10.9
Addendum No. 1 to Master Agreement, dated as of April 4, 2006, between the Company and Tower Group, Inc.
**10.10
Amended and Restated Brokerage Business Quota Share Reinsurance Agreement, effective as of April 1, 2006, among CastlePoint Reinsurance Company, Ltd., Tower Insurance Company of New York and Tower National Insurance Company
**10.11
Amended and Restated Traditional Program Business Quota Share Reinsurance Agreement, effective as of April 1, 2006, among CastlePoint Reinsurance Company, Ltd., Tower Insurance Company of New York and Tower National Insurance Company
**10.12
Amended and Restated Specialty Program Business and Insurance Risk Sharing Business Quota Share Reinsurance Agreement, effective as of April 1, 2006, among CastlePoint Reinsurance Company, Ltd., Tower Insurance Company of New York and Tower National Insurance Company
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant and in the capacities indicated below on March 31, 2008.
Signature
Capacity
/s/ Michael H. Lee
Chief Executive Officer and Director
Michael H. Lee
(principal executive officer)
/s/ Joel S. Weiner
Chief Financial Officer
Joel S. Weiner
(principal financial officer)
/s/ Richard M. Barrow
Chief Accounting Officer
Richard M. Barrow
(principal accounting officer)
/s/ Gregory T. Doyle
Director
Gregory T. Doyle
/s/ William A. Robbie
Director
William A. Robbie
/s/ Robert S. Smith
Director
Robert S. Smith
/s/ Jan Van Gorder
Director
Jan Van Gorder
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Index to Consolidated Financial Statements
PricewaterhouseCoopers
Chartered Accountants
Dorchester House
7 Church Street
Hamilton HM11
Bermuda
Telephone +1 (441) 295 2000
Facsimile +1 (441) 295 1242
www.pwc.com/bermuda
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders
of CastlePoint Holdings, Ltd:
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of CastlePoint Holdings, Ltd. and its subsidiaries at December 31, 2007 and December 31, 2006, and the results of their operations and their cash flows for each of the years ended December 31, 2007 and 2006 and the period from November 16, 2005 to December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedules listed in the accompanying index present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
PricewaterhouseCoopers
Hamilton, Bermuda
March 31, 2008
A list of partners can be obtained from the above address
PricewaterhouseCoopers refers to the members of the worldwide PricewaterhouseCoopers organization
CastlePoint Holdings, Ltd.
Consolidated Balance Sheets
($ in thousands)
See accompanying notes to the consolidated financial statements.
CastlePoint Holdings, Ltd.
Consolidated Statement of Income and Comprehensive Income
($ in thousands except per share amounts)
Note: “NM” denotes not meaningful.
See accompanying notes to the consolidated financial statements.
CastlePoint Holdings, Ltd.
Consolidated Statements of Cash Flows
($ in thousands)
See accompanying notes to the consolidated financial statements.
CastlePoint Holdings, Ltd.
Consolidated Statement of Changes in Shareholders’ Equity
($ in thousands)
See accompanying notes to the consolidated financial statements.
CASTLEPOINT HOLDINGS, LTD.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
for the years, ended December 31, 2007, 2006 and the period ended 2005
Note 1-General
CastlePoint Holdings, Ltd. (the “Company”), a Bermuda holding company incorporated on November 16, 2005, was organized to provide, through its subsidiaries, property and casualty insurance and reinsurance business solutions, products and services primarily to small insurance companies and program underwriting managers in the United States. The Company’s subsidiaries are CastlePoint Bermuda Holdings, Ltd. (“CastlePoint Bermuda Holdings”), another holding company, CastlePoint Reinsurance Company, Ltd. (“CastlePoint Re”) an operating reinsurance subsidiary, CastlePoint Management Corp. (“CastlePoint Management”) an insurance management company and CastlePoint Insurance Company (“CastlePoint Insurance Company”) an operating insurance company licensed in New York and New Jersey.
On February 6, 2006, Tower Group, Inc. (“Tower”), a Delaware corporation that is publicly traded in the U.S. and the Company’s sponsor, invested $15.0 million in the Company in consideration of receiving 2,555,000 shares of the Company’s common shares. At that time, the Company and Tower entered into a master agreement (“Master Agreement”) that set forth the terms and conditions under which the companies would do business with each other over the subsequent three years. References herein to “Tower” refer to Tower Group, Inc. and its subsidiaries, which include Tower Insurance Company of New York (“TICNY”), Tower National Insurance Company (“TNIC”) and its managing general agency, Tower Risk Management (“TRM”).
On April 4 and 5, 2006, the Company issued a total of 27,025,000 common shares in a private offering for net proceeds of $249.2 million. The Company used these proceeds and the $15.0 million Tower invested in the Company prior to the private offering as follows: (1) approximately $250.0 million to capitalize the Company’s reinsurance subsidiary, CastlePoint Re; and (2) approximately $14.0 million to capitalize the Company’s intermediate Bermuda holding company, CastlePoint Bermuda Holdings, which owns CastlePoint Re.
On March 28, 2007, the Company completed its initial public offering at an initial offering price per share of $14.50, in which (i) the Company sold 8,697,148 shares it registered on its own behalf, and (ii) certain selling shareholders sold 119,500 shares the Company registered on their behalf. The managing underwriters for the initial public offering were Friedman, Billings, Ramsey & Co., Inc., Keefe, Bruyette & Woods, Inc., Cochran Caronia Waller Securities LLC and Piper Jaffray & Co. The aggregate proceeds of the offering were approximately $127.8 million, of which the gross proceeds to the Company were approximately $126.1 million. Net proceeds to the Company, after deducting underwriting discounts of approximately $8.5 million and other offering expenses of approximately $3.6 million, were approximately $114 million. The gross proceeds to the selling shareholders were approximately $1.7 million in the aggregate, and net proceeds to the selling shareholders were approximately $1.6 million in the aggregate. The Company did not receive any of the proceeds of the sale by the selling shareholders. Following the initial public offering, the Company filed a second Registration Statement on Form S-1, as amended (Registration No. 333-1346628) covering the resale by selling shareholders named therein of 26,646,589 common shares originally issued by the Company in the private offering completed April 2006. The Company will not receive any proceeds from the sales of selling shareholders pursuant to this registration statement. On March 7th 2008, the Company terminated its shelf registration statement that was filed in August 2007 for the shares purchased in the private offering in April 2006. As a result of modifications to the SEC rules that became effective February 15, 2008, non affiliated shareholders who still own the private offering shares may sell their shares in an open market without the shelf registration.
In November and December 2006, CastlePoint Management formed two statutory business trusts, CastlePoint Management Statutory Trust I and CastlePoint Management Statutory Trust II (“Trust I” and “Trust II”, or collectively, the “Trusts”), of which the Company owns all of the common trust securities. In September 2007, CastlePoint Bermuda Holdings formed a statutory business trust, CastlePoint Bermuda Holdings Statutory Trust I (the “CPBH
Trust”), of which the Company owns all of the common trust securities. For additional information see Note 17-“Debt”.
On December 4, 2006, CastlePoint Management purchased 40,000 shares of Tower’s Series A non-cumulative convertible redeemable perpetual preferred stock (“the Tower Preferred Stock”) with a $0.01 par value per share and a $1,000 liquidation preference per share for an aggregate amount of $40 million. As part of this agreement, the Company also obtained an extension of the Master Agreement for one year and the right of first refusal on any loss portfolio transfers that Tower might cede during the life of the Master Agreement. The dividends on Tower Preferred Stock were non-cumulative and payable quarterly at a rate of 8.66% per annum. Tower redeemed all of its perpetual preferred stock held by CastlePoint Management on January 26, 2007, at the redemption price of $40 million in the aggregate plus approximately $0.3 million in interest that was paid in January 2007. The proceeds of such redemption were used to further capitalize CastlePoint Insurance. Although Tower effected such redemption, CastlePoint retained the right of first refusal from Tower, with respect to any insurance companies Tower may acquire during the term of the Master Agreement, subject to the receipt of any necessary regulatory approvals, to assume such companies’ historical losses pursuant to a loss portfolio transfer agreement (which must be on mutually acceptable market competitive terms) if Tower desires to cause these insurance companies to effect loss portfolio transfers.
On December 4, 2006, CastlePoint Management purchased from Tower all of the issued and outstanding capital stock of a company known at that time as Tower Indemnity Company of America, subsequently renamed to CastlePoint Insurance in early 2007. As of December 31, 2007, CastlePoint Insurance Company is a licensed insurer in New York and New Jersey. As of July 1, 2007 CastlePoint Insurance Company writes direct and assumed insurance business, on an admitted basis, in New York and will write in New Jersey once it completes further necessary regulatory filings and receives necessary regulatory approvals in New Jersey, as well as in those states in which it subsequently applies to become, and is approved as, a licensed insurer.
Note 2-Summary of Significant Accounting Policies
Basis of Presentation
The consolidated financial statements include the financial statements of CastlePoint Holdings, Ltd. and its wholly-owned subsidiaries, CastlePoint Bermuda Holdings, CastlePoint Re, CastlePoint Management and CastlePoint Insurance Company and their respective finance subsidiaries. These accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). All significant inter-company balances have been eliminated in consolidation. Business segments results are presented gross of all material inter-segment transactions. The accompanying financial statements present the financial position of CastlePoint Holdings, Ltd. and its subsidiaries at December 31, 2007 and 2006 and its operations for the years, ended December 31, 2007, 2006 and the period ended 2005.
Use of Estimates
The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Premiums Earned
Premiums on insurance and reinsurance policies issued by the Company’s operating subsidiaries are considered short-duration contracts. Accordingly, premium revenue, including direct writings and reinsurance assumed, net of premiums ceded to reinsurers, is recognized as earned in proportion to the amount of insurance protection provided on a pro-rata basis over the terms of the underlying policies with the unearned portion being reported as unearned premium. Prepaid reinsurance premiums represent the unexpired portion of reinsurance premiums ceded.
Reinsurance Accounting
Reinsurance arrangements are those that qualify for reinsurance accounting in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts.” Management believes the Company’s reinsurance arrangements qualify for reinsurance accounting in accordance with SFAS 113. Management has evaluated its reinsurance arrangements and determined that insurance risk is transferred to the reinsurers. Reinsurance agreements have been determined to be short-duration prospective contracts and are earned in proportion to the amount of reinsurance protection provided on a pro-rata basis over the terms of the underlying policies with the unearned portion being reported as unearned premium. These premiums can be subject to estimates based upon information received from ceding companies and any subsequent differences arising on such estimates are recorded in the period in which they are determined.
Liability for Loss and Loss Adjustment Expenses
The liability for loss and loss adjustment expenses represents management’s best estimate of the ultimate cost of all reported and incurred but not reported losses that are unpaid as of the balance sheet date. The liability for loss and loss adjustment expenses is estimated on an undiscounted basis, using individual case-basis valuation, statistical analyses, and various actuarial procedures. Management believes that the reserves for loss and loss adjustment expenses are adequate to cover the ultimate cost of losses and claims to date; however, because of the uncertainty from various sources, including changes in reporting patterns, claims settlement patterns, judicial decisions, legislation, and economic conditions, actual loss experience may not conform to the assumptions used in determining the estimated amounts for such liability at the balance sheet date. As adjustments to these estimates become necessary, such adjustments are reflected in current operations.
The Company’s losses and loss adjustment expense reserves, for both reported and unreported claims obligations, are maintained to cover the estimated ultimate liability for all of the Company’s insurance and reinsurance obligations. Losses and loss adjustment expense reserves are categorized in one of two ways: (i) case reserves, which represent unpaid losses and loss adjustment expenses as reported by cedents to the Company or as estimated by the Company’s claims adjusters retained by the Company, and (ii) incurred but not reported reserves, or IBNR reserves, which are reserves for losses and loss adjustment expenses that have been incurred, but have not yet been reported to the Company, as well as additional amounts relating to losses already reported, that are in excess of case reserves. IBNR reserves are estimates based on all information currently available to the Company and are reevaluated on a quarterly basis utilizing the most recent information supplied by the Company’s cedents and by the Company’s own claims adjusters.
For insurance business the Company generally reserves separately by line of business. The Company generally reserves for each reinsurance treaty that the Company reinsures separately, so that the Company is able to take into consideration the underlying loss development patterns of each ceding company to the extent supported in the data reported by each ceding company. While ceding companies may report their own estimates of IBNR, the Company independently analyzes the losses for each treaty, and consequently the Company may choose to establish IBNR reserves in an amount different from the amount reported by the ceding company.
Cash and Cash Equivalents
Cash and cash equivalents are carried at cost, which approximates fair value, and include all securities that, at their purchase date, have a maturity of 90 days or less.
Investments
The Company accounts for its investments generally in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS No. 115”), which requires that fixed-maturity and equity securities that have readily determinable fair values be segregated into categories based upon the Company’s intention for those securities. In accordance with SFAS No. 115, the Company has classified its fixed maturity securities and equity securities as available-for-sale. The Company may sell its available-for-sale securities in response to changes in interest rates, risk/reward characteristics, liquidity needs or other factors. Investments in limited partnerships are accounted for under the equity method, at cost or at fair value, depending upon the nature of the partnership and the Company’s ownership interest. See “-Investments in partnerships and other funds” below. Short term investments are securities with a remaining maturity of less than one year at the date of purchase and are classified as available for sale.
Fixed maturity and equity securities: Marketable fixed-maturity securities and equity securities are reported at their estimated fair values based primarily on quoted market prices from a recognized pricing service or a broker- dealer, with unrealized gains and losses, net of tax effects, excluded from net income and reported as a separate component of accumulated other comprehensive income in shareholders’ equity. Premiums and discounts on fixed maturity investments are charged or accreted to income over the anticipated life of the investment. Net investment income, consisting of interest and dividends, net of investment expenses, is recognized when earned and included in “Net investment income” in the accompanying statement of income. Realized investment gains and losses on the sale of investments are determined based on the specific identification method and are included in the accompanying statement of income.
Investments in partnerships and other funds: Investments in limited partnerships where the Company has more than a minor interest are accounted for under the equity method of accounting pursuant to Statement of Position (“SOP”) 78-9, “Accounting for Investments in Real Estate Ventures,” and classified on the balance sheet as “Investments in partnerships, equity method.” The Company’s share of net income is reported in the Company’s net investment income. The Company calculates its share of net income on the basis of the Company’s ownership percentage. Investments in limited partnerships where the Company’s interest is considered to be minor and all other fund investments are accounted for at either cost or fair value and classified on the balance sheet as “Equity securities.” For these investments, net investment income and realized gains and losses are recognized as related distributions are received. Unrealized gains (losses), net of tax effects, are excluded from net income and reported as a separate component of accumulated other comprehensive income in shareholders’ equity. The Company calculates its fair value on the basis of the Company’s ownership percentage generally using the net asset value.
Common trust securities-statutory business trusts: The Company’s investment in the common trust securities of the trusts are reported as investments in separately in the balance sheet. The securities are recorded using the equity basis of accounting, which currently approximates original cost.
Impairment of investment securities and limited partnerships results in a charge to net realized gains or losses on investments when market value decline below cost is deemed to be other-than-temporary. The Company regularly reviews all investments to evaluate the necessity of recording impairment losses for other-than-temporary declines in the fair value of investments. In general, attention is focused on those securities where fair value has been less than 80% of the amortized cost or cost, as appropriate, for six or more consecutive months. In evaluating potential impairment, management considers, among other criteria: the current fair value compared to amortized cost or cost, as appropriate; the length of time the security’s fair value has been below amortized cost or cost; management’s intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in value; specific credit issues related to the issuer; and current economic conditions. Other-than-temporary impairment losses result in a charge to income and a permanent reduction of the cost basis of the underlying investment.
Premiums Receivable/Payable-Programs
For all policies written, CastlePoint Management has the authority and responsibility to collect, account, provide receipt for and remit premiums; and to hold all monies, including premiums, return premiums and monies received in a fiduciary capacity. Program business is currently produced by an agent appointed by CastlePoint Management; therefore premiums are agency billed and are due to CastlePoint Management net of commission. Net premiums due from agents are recorded as premiums receivable on the balance sheet. Premiums payable to insurance companies, after deducting any management fee due to CastlePoint Management, are recorded as premiums payable-programs.
Commission Income/Expenses-Programs
Direct commission revenue from the Company’s insurance services segment is earned as the related insurance policies are placed in relation to the services discussed below, which are provided in performing the Company’s program business. Agency commission expenses are commissions paid to agents, which are calculated as a percentage of premiums placed and recorded as commission expenses. The services provided by the Company include marketing and oversight of the programs. Fees for services such as policy and claims administration and insurance technology are negotiated at market terms. When such services are rendered, the fees for such services are charged either as an amount per policy or per claim or as a percentage of premium. The Company recognizes such
fees as income over the period in which such services are rendered. In addition, the Company may source these services from Tower pursuant to the service and expense sharing agreement described in Note 3-“Related Party Transactions.”
Assumed Commission Expense
Assumed commission expense on reinsurance premiums assumed is expensed in a manner consistent with the recognition of reinsurance premiums assumed, generally on a pro-rata basis over the terms of the policies reinsured. Certain reinsurance agreements contain provisions where the ceding commission rates vary based on the loss experience under the agreements. The Company records adjustments to the assumed commission expense in the period in which changes in the estimated loss ratio are determined. The Company records such assumed commission expense based on its current estimate of subject losses.
Deferred Acquisition Costs
Acquisition costs represent the costs of writing business that vary with, and are primarily related to, the production of insurance and reinsurance business. Policy and contract acquisition costs, including assumed commissions and other direct operating expenses are deferred and recognized as expense as related premiums are earned. The Company considers anticipated investment income in determining the recoverability of these costs and believes they are fully recoverable.
Debt Issuance Cost
The issuance costs related to the issuance of the junior subordinated debentures by CastlePoint Management and CastlePoint Bermuda Holdings have been recorded as deferred financing fees and are being amortized over the term of the debentures using the effective interest method.
Income Taxes
The Company records taxes on its U.S. subsidiaries in accordance with SFAS No. 109, “Accounting for Income Taxes.” Under SFAS No. 109, income taxes are recognized for tax payable or refundable for the current year and deferred tax assets and liabilities are recognized for the future tax consequences attributable to the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. In accordance with SFAS No. 109, deferred tax assets and liabilities are determined using enacted tax rates applicable to the period in which the temporary differences are expected to be recovered or settled. Accordingly, the current period income tax provision can be affected by the enactment of new tax rates. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
SFAS No. 109 requires that all deferred income tax assets be given full recognition, subject to the possible provision of an allowance when it is determined that this asset is unlikely to be realized. The Financial Accounting Standards Board (“FASB”) developed a threshold by which the valuation is to be measured, the “more-likely-than-not” criterion. The process of evaluating whether a valuation allowance is needed involves the weighing of both positive and negative factors to determine whether, based on the available evidence, it is more likely than not that the deferred tax assets will be realized. Positive factors (those suggesting that an allowance is not necessary) that the Company considers include: evidence of sufficient future taxable income and evidence of the existence of prudent tax planning strategies that would permit realization of the deferred tax asset.
In June 2006, the FASB issued FIN No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”) , an interpretation of FASB Statement No. 109. FIN 48 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement for uncertain tax positions taken or expected to be taken in income tax returns. The relevant company has to determine whether it is more likely than not that the position would be sustained upon examination by tax authorities. Tax positions that meet the more likely than not threshold are then measured using a probability weighted approach recognizing the largest amount of tax benefit that has greater than a 50% likelihood of being realized upon ultimate settlement. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company reviewed whether it is more likely than not that its tax positions will be
sustained upon examination and concluded that it had no uncertain tax positions as of December 31, 2007 that meet the FIN 48 criteria for measurement and disclosure.
Equity Compensation Plans
The Company accounts for its share compensation plans in accordance with SFAS No. 123-R, “Share-Based Payment.” Accordingly, the Company recognizes the compensation expense for awards of stock options and restricted stock, based on the fair value of the award on the date of grant, over the vesting period, which is the requisite service period. The fair value of the awards will amortize ratably over the vesting period as a charge to compensation expense and an increase to additional paid in capital in Shareholders’ Equity.
Earnings Per Share
In accordance with SFAS No. 128, “Earnings Per Share”, the Company measures earnings per share at two levels: basic earnings per share and diluted earnings per share. Basic earnings per share is calculated by dividing income allocable to common shareholders by the weighted average number of shares outstanding during the period, excluding any issued but unvested restricted shares. Diluted earnings per share is calculated by dividing income allocable to common shareholders by the weighted average number of shares outstanding during the period, as adjusted for the potentially dilutive effects of stock options, warrants, unvested restricted shares and/or convertible preferred stock, unless such common equivalent shares are anti-dilutive.
Offerings and Incorporation Expense
Offering expenses incurred in connection with the Company’s initial public offering in March 2007 and the common share offering in April 2006, were recorded as a reduction in paid in capital. Offering expenses incurred in connection with the Company’s registration statement for an offering by selling shareholders in August 2007, were recorded as expense.
Incorporation expenses not related to the raising of capital are expensed as incurred and included in other operating expense.
Intangible Assets
The Company has recorded, as an identifiable intangible asset, state insurance licenses acquired through the purchase of CastlePoint Insurance Company. The Company believes that these licenses have an indefinite useful life. In accounting for such assets, the Company follows SFAS No. 142, “Goodwill and Other Intangible Assets.” In accordance with SFAS No. 142, the Company does not amortize the licenses but evaluates the recoverability of the assets on an annual basis. An impairment loss is recognized if the carrying value of an intangible asset is not recoverable and its carrying value exceeds its fair value. No impairment losses were recognized in 2007.
Fixed Assets
Furniture, computer equipment, leasehold improvements and software are reported at cost less accumulated depreciation and amortization. Depreciation and amortization is provided using the straight line method over the estimated useful lives of the assets. The Company estimates the useful life for computer equipment and software is for three years, servers for five years, furniture for seven years and leasehold improvements for the term of the lease.
Variable Interest Entities
In December 2003, the FASB issued FASB Interpretation No. 46(R), “Consolidation of Variable Interest Entities” (“FIN46 (R)”), which establishes accounting guidance for the identification of a variable interest entity (“VIE”) and the consolidation of a VIE by the party deemed to be the primary beneficiary. The primary beneficiary of a VIE is the party that absorbs a majority of the VIE’s expected losses, receives a majority of the VIE’s expected residual returns, or both, as a result of ownership, controlling interest, contractual relationship or other business relationship
with a VIE. The Company has applied the guidance in FIN 46(R) in determining that the Trusts meet the definition of a VIE and that the Company is not the primary beneficiary. See Note 17-“Debt.”
Segment Reporting
The Company manages its operations through three reportable segments: insurance, reinsurance and insurance services. See Note 15-“Segment Information.”
Recent Accounting Developments
In February 2006, the FASB issued SFAS No.155, “Accounting for Certain Hybrid Financial Instruments,” an amendment of SFAS No.133 and SFAS No.140. This standard permits fair value re-measurement of an entire hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; narrows the scope exemption applicable to interest-only strips and principal-only strips from SFAS 133 and clarifies that only the simplest separations of interest payments and principal payments qualify as not being subject to the requirements of SFAS 133; establishes a requirement to evaluate interests in securitized financial assets to identify interests that are free standing derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and amends SFAS 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. This statement is intended to require more consistent accounting that eliminates exemption and provides a means to simplify the accounting for hybrid financial instruments. This statement is effective for all financial instruments acquired or issued after January 1, 2007. The implementation of SFAS No. 155 has not had a material impact on the Company’s financial position or operating results.
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” This new standard provides guidance for using fair value to measure assets and liabilities. Under SFAS 157, fair value refers to the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity operates. In this standard, the FASB clarifies the principle that fair value should be based on the assumptions market participants would use when pricing the asset or liability. In support of this principle, SFAS 157 establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. The fair value hierarchy gives the highest priority to quoted prices in active markets and the lowest priority to unobservable data such as the reporting entity’s own data. Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy. The provisions of SFAS 157 are effective for financial statements issued for years beginning after November 15, 2007. The Company has determined the implementation of SFAS 157 will not have a material impact on its consolidated results of operations and financial position.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” This statement permits entities to choose to measure many financial instruments and certain other items at fair value at specified election dates. The objective is to improve financial reporting by providing the entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This standard also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. This statement is expected to expand the use of fair value measurement. The standard is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. The Company is currently reviewing the impact SFAS 159 will have on its consolidated results of operations and financial position. The Company did not elect to implement the fair value option for eligible financial assets and liabilities as of January 1, 2008.
In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” (“SFAS No. 141(R)”). This standard establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. SFAS No. 141(R) also provides guidance for recognizing and measuring the goodwill acquired in the
business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. The guidance will become effective for fiscal years beginning after December 15, 2008. The Company is currently evaluating the impact that the adoption of SFAS No. 141(R) will have on its consolidated financial position or results of operations.
In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements-an amendment of ARB No. 51” (“SFAS No. 160”). This standard establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. The guidance will become effective for fiscal years beginning after December 15, 2008. The Company is currently evaluating the impact that the adoption of SFAS No. 160 will have on its consolidated financial position or results of operations.
Note 3-Related Party Transactions
The Company and/or its subsidiaries are parties to a Master Agreement, certain reinsurance agreements, management agreements and service and expense sharing agreements with Tower and/or its subsidiaries. In addition, CastlePoint Re participates as a reinsurer on certain of Tower’s excess of loss reinsurance agreements. The transactions listed below are classified as related party transactions, as each counterparty may be deemed to be an affiliate of the Company.
The Company sub-leases the space in New York, New York for the headquarters of its subsidiaries, CastlePoint Management and CastlePoint Insurance Company, from Tower Insurance Company of New York, a subsidiary of Tower, at its cost.
Reinsurance Agreements: In April 2006, CastlePoint Re entered into three multi-year quota share reinsurance agreements with Tower’s insurance subsidiaries which will expire in April 2010: the brokerage business quota share reinsurance agreement, the traditional program business quota share reinsurance agreement, and the specialty program business and insurance risk-sharing business quota share reinsurance agreement. In 2007, under the brokerage business quota share agreement 49% was ceded to CastlePoint Reinsurance Company in the first quarter; 40% to CastlePoint Reinsurance Company and 9% to CastlePoint Insurance Company in the second quarter; and 40% was ceded to CastlePoint Reinsurance Company in the third and fourth quarter. There were no changes during the year ended December 31, 2007 to the arrangements with Tower pursuant to the traditional program business quota share reinsurance agreement and the specialty program business and insurance risk-sharing business quota share reinsurance agreement which ceded 50% and 85% respectively.
The Company and Tower jointly submitted two aggregate excess of loss reinsurance agreements for the brokerage business for review by the New York State Insurance Department. These agreements remain subject to regulatory review and are deemed approved and in effect. The purpose of the two aggregate excess of loss reinsurance agreements is to cause the loss ratios for the brokerage business of CastlePoint Insurance Company and Tower to be approximately equal. Under the first agreement, Tower will reinsure 85% (the percentage will be adjusted to equal Tower’s actual percentage of the total brokerage business written by Tower and CastlePoint Insurance Company) of CastlePoint Insurance Company’s brokerage business losses that are in excess of a specified loss ratio for brokerage business written through Tower Risk Management Corp., and under the second agreement CastlePoint Insurance Company will reinsure 15% (the percentage will be adjusted to equal CastlePoint’s actual percentage of the total brokerage business written by Tower and CastlePoint) of Tower’ brokerage business losses that are in excess of a specified loss ratio for brokerage business. Under both agreements, the loss ratio is calculated net of premiums paid for and losses recovered from specific excess reinsurance, property catastrophe reinsurance and facultative reinsurance, if any, which inure to the benefit of the agreement, and before any cessions to quota share reinsurance. For the three months ended December 31, 2007 premiums ceded to Tower for the aggregate excess of loss treaty were $0.8 million and premiums assumed from Tower for the same corresponding aggregate excess of loss treaty were $0.8 million. Also CastlePoint Insurance Company ceded net $0.3 million incurred losses for the same period.
Premiums receivable from and losses payable to Tower as of December 31, 2007 were $105.4 million and $1.7 million, respectively, compared to $42.4 million and $3.5 million as of December 31, 2006. The unearned premium reserves and loss reserves with Tower as of December 31, 2007 were $175.2 million and $108.8 million, respectively, compared to $80.7 million and $33.2 million as of December 31, 2006. Deferred acquisition costs were
$61.7 million and $28.0 million as of December 31, 2007 and December 31, 2006, respectively. The total underwriting impact related to the agreements with Tower discussed above is as follows:
The following summarizes the consolidated related party transactions as of December 31, 2007 and 2006:
Management Agreements: In June 2007 the Company and Tower filed alternative insurance risk-sharing agreements and related business management agreements for brokerage business so that Tower’s brokerage business would be written directly in CastlePoint Insurance Company with Tower Risk Management as the program manager of the business for fees which are explained below. The New York State Insurance Department has approved the business management agreement regarding the brokerage business and the aggregate excess of loss agreements in connection with the insurance risk sharing are considered to be deemed approved.
The business management agreement for brokerage business dated July 1, 2007 with Tower Risk Management Corp. has been approved by the New York State Insurance Department and provides that Tower Risk Management Corp., a subsidiary of Tower, is authorized to write brokerage business using CastlePoint Insurance Company ‘s policies and manage such business for CastlePoint Insurance Company. For managing such business, Tower Risk Management Corp. is paid a management fee calculated using the sliding scale formula that was originally intended by the Master Agreement to be paid to Tower Insurance Company of New York for managing the brokerage business, net of specific aggregate and property catastrophe excess of loss reinsurance costs. The sliding scale commission provides that Tower Risk Management’s commission for the brokerage business is 31% of net premiums written which can increase to 33% or decline to 28% depending on the loss ratio.
CastlePoint Management is a party to program management agreements with Tower and certain of its subsidiaries, whereby CastlePoint Management performs certain underwriting and claims services with respect to the traditional program business and specialty program business. Premiums collected and due to Tower for program business at December 31, 2007 and 2006 were $8.6 million and $1.1 million respectively. For years ended December 31, 2007 and 2006, CastlePoint Management recorded commission revenue of $6.3 million and $2.3 million, respectively, from Tower.
Service and Expense Sharing Agreements: CastlePoint Management is a party to service and expense sharing agreements with Tower and certain of its subsidiaries. Tower charged CastlePoint Management $0.7 million and $0.5 million for the years ended December 31, 2007 and 2006 respectively, for services rendered in support of CastlePoint Management’s infrastructure as contemplated by the service and expense sharing agreements.
In addition to the services rendered in support of CastlePoint Management’s infrastructure, Tower rendered services for CastlePoint Management’s program business contemplated by the service and expense sharing agreements. For these services, Tower charged CastlePoint Management $0.5 million and $0.2 million for the years ended December 31, 2007 and 2006 respectively.
Note 4-Investments
The amortized cost and fair value of the total available-for-sale investments as of December 31, 2007 and 2006 were as follows (in 000’s):
A summary of the amortized cost and fair value of the Company’s investment in fixed-maturity securities as of December 31, 2007, and 2006 by contractual maturity is shown below. Actual maturity may differ from contractual maturity because certain borrowers may have the right to call or prepay certain obligations with or without call or prepayment penalties.
Amortized cost and fair value of the Company’s investment in fixed-maturity securities as of December 31, 2007 and 2006 is shown below:
Major categories of the Company’s net investment income are as follows:
Pursuant to the equity method of accounting, the results of the Company’s investment in a limited partnership (loss of $1.5 million) for the year ended December 31, 2007 was included in net investment income. This loss is comprised of the Company’s equity share of net investment income of $0.5 million, realized gains of $0.2 million and an unrealized loss of $2.2 million. There were no investments in limited partnerships in 2006.
Proceeds from the sale of fixed maturity securities were $302.6 million and $127.3 million as of December 31, 2007 and December 31, 2006, respectively. The Company’s net realized gains/(losses) and the change in net unrealized appreciation/(depreciation) on investments, net of deferred taxes, are as follows:
Substantially all of the Company’s invested assets that were in an unrealized loss position at December 31, 2007 and 2006 had all been held for less than 12 months and are as follows:
At December 31, 2007, the Company had 49 securities in a gross unrealized loss position amounting to $5.9 million of which $4.3 million (40 securities) was attributable to fixed maturities and $1.6 million (9 securities) was attributable to equity securities. Of the $4.3 million attributable to fixed maturities, $3.6 million was rated investment grade. The remaining $0.7 million unrealized loss was attributed to one security rated BB. This is a commercial mortgage backed security (CMBS) that represents the Company’s single largest unrealized loss in a fixed maturity security. This security has been in an unrealized loss position for less than 6 months. The market value at December 31, 2007 of the security is 66% of amortized cost. The largest single unrealized loss in an equity security was $0.7 million, representing an investment in a fund primarily comprised of collateralized bank loans.
Corporate Fixed Maturities - The unrealized loss position of $1.4 million in corporate fixed maturities relates to 17 securities all rated BBB or above and all in an unrealized loss position for less than 12 months as of December 31, 2007. The security with the largest unrealized loss in this group of $0.6 million is Lehman Brothers Holdings, Inc, issued May 17, 2007, with a coupon of 5.86% and a book yield of 6.04%, rated A-. The brokerage sector has been negatively impacted by the general market disruptions caused by the significant decline in market liquidity. The remaining corporate securities are distributed over the following industries - banks, brokerage, insurance, other finance, media, pipelines and utilities. The impairment on all fixed corporate maturities is considered temporary at December 31, 2007 and is generally the result of widening spreads during the fourth quarter. The Company has both the ability and intent to hold these securities until a full recovery of fair value, which may be maturity.
Mortgage and Asset Backed Securities - The unrealized loss in mortgage and asset backed securities of $2.9 million relates to 23 issues, with 18 issues rated AAA ($0.2 million), 4 issues rated BBB ($2.0 million) and 1 issue rated BB ($0.7 million). All of these securities, except for certain positions with unrealized losses amounting to $11,000, had been in an unrealized loss position for less than 12 months as of December 31, 2007.. The five securities rated BBB and BB are CMBS and were purchased after June 30, 2007. Since all five securities are rated less than AA, a cash flow analysis was performed pursuant to Emerging Issues Task Force (“EITF”) 99-20. None of these securities indicated a reduction in cash flow on a present value basis from what was originally expected at the date of purchase. The impairment on all mortgage and asset backed securities, except as discussed below, is considered temporary at December 31, 2007 and is due to the market disruptions caused by the significant decline in market liquidity affecting this sector. The Company has both the ability and intent to hold these securities until a full recovery of fair value, which may be maturity.
Equity Securities - The unrealized loss in equity securities of $1.7 million relates to 9 issues. These securities are in an unrealized loss position for less than 12 months as of December 31, 2007. The largest single equity security in an unrealized loss position at December 31, 2007 was an investment in a fund comprised primarily of collateralized bank loans with an unrealized loss of $0.7 million. The loans have floating rates. The collateralization makes the loans structurally senior in priority to corporate bonds from the same issuers, providing additional credit protection. This security has been in an unrealized loss position for less than 6 months. The unrealized loss is due to market disruptions caused by the significant decline in market liquidity and the general spread widening during the fourth quarter. The remaining unrealized loss of $1.0 million is comprised of eight preferred stock issues with no one unrealized loss at December 31, 2007 exceeding $0.2 million. Other than the securities discussed below, the Company has both the ability and intent to hold all equity securities in a loss position at year end, until a full recovery of fair value.
At December 31, 2007, the company recorded charges for other-than-temporary impairments of $9.0 million primarily relating to an investment in a fund, an investment in three Asset Backed Securities backed by subprime credit and four equity securities.
•
The unrealized loss on the fund was $7.1 million and was in an unrealized loss position for 7 -12 months. The market value at December 31, 2007 was 34% of cost. The fund consists of primarily floating rate mortgage and asset backed securities with 40% of the fund’s assets invested in home equity loans backed by subprime mortgages. The average credit rating of the fund, based on the ratings of the underlying securities, is BBB. We sold our position in the fund on February 1, 2008 and realized a loss of $0.2 million, after recording the other-than-temporary charge at year end.
•
The unrealized loss on the three ABS backed by subprime credit was $33,000 at year end and were in an unrealized loss position for less than 6 months. They are rated AAA. We have subsequently sold these 3 securities in February 2008 and recorded a $0.1 million realized loss, after recording the other-than-temporary charge at year end.
•
The unrealized loss on the four equity securities, all of which are mortgage real estate investment trusts (“REITs”), was $1.8 million and these securities were in an unrealized loss position for less than 12 months. The market values at December 31, 2007 were 54% of cost. These 4 equity securities are all publicly traded mortgage REITs whose purpose is to own various mortgage backed securities, including CMBS and agency and non-agency residential MBS. To date, these equity securities continue to generate the earnings necessary to continue the dividend payments. However, the biggest risk of not generating earnings and therefore discontinuing dividend payments is if the funds are forced to unwind holdings due to the inability to borrow against current holdings due to market prices that are based on distressed sale levels vs. expected longer term value. Based on the magnitude of the unrealized loss and the time period it may take for full recovery, the Company does not necessarily have the intent to hold these securities until full recovery. Therefore the Company considered them other-than-temporarily impaired at December 31, 2007.
Management believes the securities that are other-than-temporarily impaired at December 31, 2007 have been identified and are properly reflected in the financial statements.
Note 5-Property-Casualty Insurance Activity
(a) Premiums written, ceded and earned are as follows:
(b) The components of the liability for loss and loss adjustment expenses as of December 31, 2007 and 2006 are as follows:
Activity in the liability for loss and loss adjustment expenses for 2007 and 2006 is summarized as follows:
During calendar year 2007, the Company experienced favorable development due to the Company’s brokerage business quota share reinsurance agreement with Tower and, to a lesser extent, to Tower’s property and casualty excess of loss reinsurance agreements, in which CastlePoint Re participates. The favorable development in both treaties was due to lower than expected loss emergence.
The Company’s reserves represent management’s best estimate of the ultimate unpaid cost of all losses and loss adjustment expenses incurred. Actuarial methodologies used to estimate reserves include, but are not limited to, the paid and incurred loss development methods, the loss ratio method, and the paid and incurred Bornhuetter-Ferguson methods. Due to the uncertainty associated with the reserving process, the ultimate liability may differ, perhaps significantly, from the amounts currently reserved by the Company.
The Company does not have exposure to asbestos and environmental claims.
The Company does not discount reserves and books all reserves on an undiscounted basis.
Note 6-Deferred Acquisition Costs
Acquisition costs incurred that have been deferred and amortized to income in 2007 and 2006 are as follows:
Note 7-Capital Stock
(a) Authorized and issued
The Company’s authorized share capital is 100,000,000 common shares with a par value of $0.01 each, of which there were 38,289,430 and 29,580,000 common shares issued and outstanding as of December 31, 2007 and 2006 respectively.
Tower currently holds 6.7% of the Company’s outstanding common shares. The Company also issued ten-year warrants to Tower to purchase an additional 1,127,000 of the Company’s common shares at an exercise price of $10.00 per share, which shares currently represent 2.7% of the common shares outstanding on a fully-diluted basis. The shares held by Tower, together with the shares issuable upon exercise of the Tower warrants, currently represent 9.3% of the Company’s outstanding common shares on a fully-diluted basis.
The holders of the Company’s common shares are entitled to receive dividends and are allocated one vote per share, provided that, if the controlled shares of any shareholder or group of related shareholders constitute more than 9.5% percent of the outstanding common shares of the Company, their voting power will be reduced to 9.5% percent. There are various restrictions on the ability of certain shareholders to dispose of their shares.
(b) Warrants
The warrants were issued to Tower in recognition of the full value received from Tower as the Company’s sponsor, which included the development of the Company’s business strategy, the development of the private offering to raise initial funds for the Company’s operations, and the transfer of certain executives to the Company. In consideration of Tower’s contribution, the Company issued warrants to Tower to purchase up to 1,127,000 common shares of the Company. The 1,127,000 common shares issuable upon exercise of the warrants represent what the company believed would be an acceptable number of common shares to grant to Tower to compensate Tower for its contributions to the Company. The warrants became effective as of April 6, 2006 and will expire on April 6, 2016. The warrants are exercisable at a price per share of $10.00, equal to the price per share paid by investors in the private offering.
The warrants may be settled using either the physical settlement or net-share settlement methods. The warrants have been classified as equity instruments, in accordance with EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.” The warrants were initially measured at an aggregate fair value of $4.6 million and recorded as additional paid-in capital with an offsetting charge to other operating expenses in the Statement of Income.
The fair value of the warrants issued was estimated on the date of grant using the Black-Scholes option-pricing model. The volatility assumption used, of 25%, was derived from the historical volatility of the share price of a range of publicly-traded Bermuda reinsurance companies with similar types of business to that of the Company. No allowance was made for any potential illiquidity associated with the absence of public trading of the Company’s shares at that time. The other assumptions in the option pricing model were as follows: risk free interest rate of 5%, expected life of ten years and a dividend yield of 1%.
Note 8-Equity Compensation Plans
2006 Long-Term Equity Compensation Plan
The Company adopted the provision of SFAS No. 123-R effective January 1, 2006 and granted all of its stock compensation after that date. The compensation cost of awards is based on the grant-date value of those awards as calculated under SFAS No. 123-R and amortized over the vesting period. The Company’s 2006 Long-Term Equity Compensation Plan (the “Plan”) provides for grants of any option, stock appreciation right (“SAR”), restricted share, restricted share unit, performance share, performance unit, dividend equivalent or other share-based award. The total number of shares initially reserved for issuance under the Plan was 1,735,021 common shares, of which 1,126,166 options were issued to senior management and non-employee directors of the Company and its subsidiaries in 2006, and 556,254 options were issued to certain officers and employees and non-employee directors of the Company and its subsidiaries in 2007. In 2007, the number of shares authorized under the Plan was increased by 1 million shares,
to a total of 2,735,021. This increase was approved on February 27, 2007 by the Company’s Board of Directors, and by the shareholders at the Company’s Annual General Meeting of Members on July 30, 2007.
The Plan is administered by the Compensation Committee of the Board of Directors of the Company. The stock options granted to employees vest in three equal installments (14 months) over 42 months of service. For non-employee directors, the cost is expected to be recognized over the vesting period of 12 months for grants dated April 4, 2006 and over the vesting period of 36 months for grants dated March 22, 2007. Each of the Company’s three current non-employee directors received 4,094 restricted common shares during the year ended December 31, 2007, which vest after 12 months of service. No SARs have been granted to date.
The fair value of the options granted in 2006 was estimated using the Black-Scholes pricing model as of April 4, 2006, the date of the initial grant, with the following weighted average assumptions: risk free interest rate of 5.0%, dividend yield of 1.0%, volatility factors of the expected market price of the Company’s common shares of 25.0% and a weighted-average expected life of the options of 10 years. The fair value measurement objective of SFAS No. 123-R is achieved using the Black-Scholes model as the model (a) is applied in a manner consistent with the fair value measurement objective and other requirements of SFAS No.123-R, (b) is based on established principles of financial economic theory and generally applied in that field and (c) reflects all substantive characteristics of the instrument.
The fair value of the options granted in 2007 was estimated using the Black-Scholes pricing model as of March 21, 2007 and April 30, 2007 the date of the grants, respectively with the following weighted average assumptions: risk free interest rate of 5.0%, dividend yield of 1.0%, volatility factors of the expected market price of the Company’s common shares of 25.0% and a weighted-average expected life of the options of 6.2 years. The fair value measurement objective of SFAS No. 123-R is achieved using the Black-Scholes model consistent with the paragraph above.
Stock Options
The following table provides an analysis of stock option activity for the year ended December 31, 2007 and 2006:
Options outstanding as of December 31, 2007 and 2006 are shown on the following schedules:
As of December 31, 2007, and 2006 there was $4.0 million and $3.4 million of unrecognized compensation costs related to 1,242,650 and 1,082,666 non-vested stock options, respectively. For employees, the cost is expected to be recognized over the vesting periods of the individual options which extend up to 42 months. For non-employee directors, the cost is expected to be recognized over the vesting period of 12 months for grants dated April 4, 2006 and over the vesting period of 36 months for grants dated March 22, 2007. For the years ended December 31, 2007 and 2006, the Company recognized $2.0 million and $1.0 million of compensation expense related to share-based compensation, respectively.
As of December 31, 2007 there were $0.1 million of unrecognized compensation costs related to 12,282 non-vested restricted stock grants for non-employee directors. These will vest over 12 months.
Note 9 -Taxation
Bermuda
Under current Bermuda law, the Company has received an undertaking from the Bermuda government exempting it from all local income, withholding and capital gains taxes until March 28, 2016. At the present time, no such taxes are levied in Bermuda.
United States
The Company and its non-U.S. subsidiaries believe that they do not “engage in a trade or business” in the United States. Accordingly, the Company and its non-U.S. subsidiaries have not recorded any provision for U.S. taxation.
The Company’s U.S. subsidiaries, CastlePoint Management and CastlePoint Insurance Company, are subject to income taxes and have recorded the appropriate balances for current and deferred income taxes under SFAS No. 109 as follows:
Deferred tax assets and liabilities are determined using enacted tax rates applicable to the period the temporary differences are expected to be recovered or net operating losses utilized. Accordingly, the current period income tax provision can be affected by the enactment of new tax rates. The net deferred income taxes on the balance sheet reflect temporary differences between the carrying amounts of the assets and liabilities for financial reporting purposes and income tax purposes, tax affected at a 35% rate for the period.
The component of deferred taxes is as follows:
Based upon projections of future taxable income over the periods in which the deferred tax assets are deductible, the Company believes it is more likely than not that it will realize the benefits of these deductible differences and therefore did not establish a valuation allowance for the years ended December 31, 2007 and 2006. In accordance with SFAS No. 109, the Company anticipates that the related deferred tax assets will be realized based on the generation of net commission income by CastlePoint Management and the profitable premium volume written in CastlePoint Insurance Company.
The provision for federal income tax incurred is different from that which would be obtained by applying the federal income tax rate to net income before income taxes. The items causing these differences are as follows:
The Company adopted the provisions of Fin 48 on January 1, 2007. The Company reviewed whether it is more likely than not that its tax positions will be sustained upon examination and concluded that it had no uncertain tax positions as of December 31, 2007 that meet the FIN 48 criteria for measurement and disclosure.
Note 10-Employee Benefit Plans
United States
The Company maintains a defined contribution Employee Pre-tax Savings Plan (the “401(k) Plan”) for its employees. The Company contributes 50% of each participant’s contribution up to 8% of the participant’s compensation.
Bermuda
The Company maintains three separate defined contribution plans for its employees, all of which are managed externally. One plan is for Bermudian employees (the “Bermuda Plan”), one is for non-U.S. and non-Bermudian employees (the “Non-Resident Plan”) and one is for U.S. citizens based in Bermuda (the 401(k) Plan). Employees are only eligible to join these plans on reaching the age of 23. For both the Bermuda and Non-Resident Plans, the Company matches the employees’ contribution at 5% of the participant’s compensation. The Company’s contribution vests over 2 years. For U.S. citizens based in Bermuda, a defined contribution Employee Pre-tax Savings Plan (401(k) Plan) is available. The Company contributes 50% of each participant’s contribution up to 8% of the participant’s compensation.
In 2007 and 2006, the Company expensed $99,395 and $31,042 for its defined contribution retirement plans, respectively. The Company does not provide defined benefit pension plans for its employees.
Note 11-Commitments and Contingencies
(a) Concentrations of credit risk
As of December 31, 2007, the Company’s assets primarily consisted of investments, cash and assumed premium receivable. The Company believes it bears minimal credit risk in its cash on deposit. Although there may be credit risk with respect to its assumed premium receivable from Tower Insurance Company of New York, an insurance company subsidiary of Tower, the Company believes these premiums will be fully collectible.
At December 31, 2007, the Company does not have aggregate investments in a single entity that are in excess of 10% of shareholders equity.
At December 31, 2007, the Company had exposure to real estate related securities in the form of mortgage backed securities (CMBS, RMBS and ABS backed by home equity loans), investment in a fund and investment in common stocks in the amount of $306.0 million or 44% of cash and invested assets. On February 1, 2008, the Company sold its investment in the fund, with an average credit rating, based on the underlying securities in the fund, of BBB, which accounted for $13.9 million of the $306.0 million of exposure at year end. The Company realized a loss of $0.2 million on this sale, after recording an impairment charge of $7.1 million at December 31, 2007. In addition, the Company sold 3 ABS securities backed by home equity loans in February 2008, all rated AAA, which accounted for $2.5 million of the $306.0 million at year end. Of the total year end mortgage related exposure of $306.0 million, $284.0 million is rated AAA, of which $154.9 million is backed by government agencies.
Subsequent to the sale of the securities post year end noted above, the Company had no exposure to subprime securities.
(b) Employment agreements
The Company has entered into various employment agreements, effective April 4, 2006 and thereafter with certain individuals. The employment agreements provide for option awards, executive benefits and severance payments under certain circumstances.
During the year ended December 31, 2007 the company did not have any accrued severance expense. During the year ended December 31 2006, the Company recorded accrued severance expense in the amount of $0.3 million for one employee.
(c) Operating leases
The Company leases and/or subleases space in Hamilton, Bermuda, Warwick, Bermuda, New York, New York and Lisle, Illinois. CastlePoint Re executed a sublease agreement for premises in Hamilton, Bermuda, as of September 1, 2006, which is expected to expire on June 30, 2012. CastlePoint Holdings, Ltd. entered into two-year sublease agreements (on behalf of two of its employees) for two residential premises in Warwick, Bermuda as of December 22, 2006 and January 1, 2007, respectively. The terms of these sublease agreements will expire December 21, 2008 and December 31, 2008, respectively. Additionally, CastlePoint Holdings, Ltd. entered in a one-year sublease agreement (on behalf of one employee) for one residential premise in Hamilton, Bermuda as of June 1, 2007. The term of this sublease will expire May 30, 2009. CastlePoint Management currently subleases office space in New York, New York from Tower Insurance Company of New York, at its cost, pursuant to an arrangement covered by the service and expense sharing agreement between these parties. CastlePoint Management entered into an agreement to lease office space in Lisle, Illinois, as of October 1, 2006, which has been extended to expire on June 30, 2008. Future minimum lease commitments for 2008 and 2009 are $1.9 million and $0.5 million, respectively and $0.8 million thereafter.
(d) Security Requirements
As required by the Company’s reinsurance agreements with its cedents , CastlePoint Re is required to collateralize amounts through a letter of credit, cash advance, funds held or a trust account. The amount of the letter of credit or trust is to be adjusted each calendar quarter, and the required amount is to be at least equal to the sum of the following contract amounts: (i) unearned premium reserve, (ii) paid loss and loss adjustment expense payable, (iii) loss and loss adjustment expenses reserves, (iv) loss incurred but not reported, (v) return and refund premiums, and (vi) less premium receivable. As of December 31, 2007 and 2006, CastlePoint Re maintained trusts and a letter of credit in the amount of $218.1 million and $97.8 million, respectively, at State Street Bank and Trust Company, a Massachusetts trust company. As of December 31, 2007 CastlePoint Insurance Company maintained a trust at the same trust company in the amount of $8.0 million. Both CastlePoint Re and CastlePoint Insurance Company earn and collect the interest on the trust funds.
Regulatory trusts
At December 31, 2007 and 2006, U.S. Treasury Notes with fair values of approximately $2.6 million and $2.5 million, respectively were on deposit with New York state to comply with the insurance laws of the state of New York, in which CastlePoint Insurance Company is licensed.
Alien Excess or Surplus Lines Insurers
Effective July 31, 2006, CastlePoint Re entered into an “Alien Excess or Surplus Lines” Trust Agreement with State Street Bank and Trust Company, a Massachusetts trust company, to establish a trust fund in the United States as security for U.S. policyholders and third party claimants in connection with seeking to qualify as an eligible or approved excess or surplus lines insurer in certain U.S. jurisdictions. As of December 31, 2007 and 2006, CastlePoint Re maintained an alien excess or surplus lines trust in the amount of $5.8 million and $6.0 million, respectively, at State Street Bank and Trust Company. CastlePoint Re earns and collects the interest on the trust funds. At this time we do not have any policyholders which would benefit from this trust.
(e) Deposit Insurance
The Company maintains its cash balances at financial institutions in both United States and Bermuda. In the United States, the Federal Deposit Insurance Corporation secures accounts up to $100,000 at these institutions. Bermuda laws do not give similar protection to Bermuda depositors or checking account users or savers. Management monitors balances in excess of insured limits and believes they do not represent a significant credit risk to the Company.
(f) Commitments through guarantees
In December 2006, the Company formed two Trusts, of which the Company owns all of the common trust securities, through CastlePoint Management. CastlePoint Holdings, Ltd. has guaranteed, on a subordinated basis, CastlePoint Management’s obligations under its junior subordinated debentures and distributions and other payments due on the Trusts’ preferred securities. These guarantees, relating to $104 million of outstanding debt, provide a full and unconditional guarantee of amounts due on the Trusts’ preferred securities. See Note 17-“Debt” for additional details.
In September 2007, the Company formed a third Trust, of which the Company owns all of the common trust securities, through CastlePoint Bermuda Holdings. CastlePoint Holdings, Ltd. has guaranteed, on a subordinated basis, CastlePoint Bermuda Holdings’s obligations under its junior subordinated debentures and distributions and other payments due on the Trust’s preferred securities. This guarantee, relating to $31 million of outstanding debt, provides a full and unconditional guarantee of amounts due on the Trust’s preferred securities. See Note 17-“Debt” for additional details.
Note 12-Statutory Financial Information and Accounting Policies
Bermuda
CastlePoint Re is registered as a Class 3 reinsurer under The Insurance Act 1978 (Bermuda), amendments thereto and related regulations (the “Insurance Act”). Under the Insurance Act, CastlePoint Re is required to prepare Statutory Financial Statements and to file a Statutory Financial Return. The Insurance Act also requires CastlePoint Re to maintain a minimum share capital and surplus of $1,000,000 and to meet a minimum solvency margin. To satisfy these requirements, CastlePoint Re was required to maintain a minimum level of statutory capital and surplus of $43.0 and $25.1 million at December 31, 2007 and 2006. CastlePoint Re was also required to maintain a minimum liquidity ratio. All requirements were met by CastlePoint Re throughout the year ended December 31, 2007 and 2006.
The statutory assets were approximately $592.5 million and $367.8 million and statutory capital and surplus was approximately $331.0 million and $243.1 million, as of December 31, 2007 and 2006, respectively.
For Bermuda registered companies, there are some differences between financial statements prepared in accordance with GAAP and those prepared on a statutory basis. Certain assets are non-admitted under Bermuda regulations and deferred policy acquisition costs have been fully expensed to income under Bermuda regulations and prepaid expenses and fixed assets have been removed from the statutory balance sheet under Bermuda regulations.
United States
For regulatory purposes, CastlePoint Insurance Company, domiciled in the state of New York, prepares its statutory basis financial statements in accordance with practices prescribed or permitted by the statutory accounting practices of CastlePoint Insurance Company’s state of domicile, New York, which differ in certain significant respects from GAAP. Prescribed statutory accounting practices (SAP) include state laws, regulations, and general administrative rules, as well as a variety of publications of the National Association of Insurance Commissioners (NAIC). Permitted statutory accounting practices encompass all accounting practices that are not prescribed; such practices differ from state to state, may differ from company to company within a state, and may change in the future.
For the years ended December 31, 2007 and 2006, CastlePoint Insurance Company reported statutory basis surplus with respect to policyholders of $59.6 million and $8.4 million, respectively, and was required to maintain
minimum capital and surplus of $4.0 million and $4.0 million, respectively, in accordance with New York Insurance Law.
Note 13-Fair Value of Financial Instruments
SFAS No. 107, “Disclosure about Fair Value of Financial Instruments,” requires all entities to disclose the fair value of financial instruments, both assets and liabilities recognized and not recognized in the balance sheet, for which it is practicable to estimate fair value. The Company’s assets and liabilities in the balance sheet approximate fair value, except for balances relating to reinsurance contracts which are not in the scope of SFAS No. 107. The Company uses the following methods and assumptions in estimating the fair value of the financial instruments presented:
Cash and cash equivalents and short term investments: The carrying amounts approximate fair values.
Investments: Fair value disclosures for investments are included in Note 4-“Investments.”
Subordinated debentures: The carrying values reported in the accompanying balance sheets for these instruments approximate fair value due to the stability in our credit quality and a reduction since issuance in the risk free rate offset by overall credit spread widening due to tighter liquidity in the market place.
Note 14-Earnings Per Share
The following table shows the computation of the Company’s basic and diluted earnings per share:
Basic earnings per common share is net income divided by the weighted average number of common shares outstanding during the period. Diluted earnings per common share includes the dilutive effect of additional potential common shares issuable under agreements relating to grants or issuances thereof.
For the year ended December 31, 2007 and 2006, weighted outstanding stock options of 420,497 and 802,977 and weighted restricted stock of 6,986 and zero, respectively, were not considered in computing diluted earnings per share because they were antidilutive. For the year ended December 31, 2007 and 2006, weighted average warrants
outstanding of zero and 829,597 respectively, were not considered in computing diluted earnings per share because they were antidilutive.
Note 15-Segment Information
The Company reports its business in three segments: insurance, reinsurance and insurance services. The insurance segment includes the results of CastlePoint Insurance Company and CastlePoint Re for excess and surplus lines written on a primary basis. CastlePoint Insurance Company did not conduct any business and did not have any premium income, obligations relating to insurance policies, employees and operations in the year ended December 31, 2006. The reinsurance segment includes the results from the reinsurance business written through CastlePoint Re. The insurance services segment includes the results from managing the specialty and traditional program business and insurance risk-sharing business through CastlePoint Management, as well as results from providing unbundled insurance services to program underwriting managers. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates segment performance based on segment profit, which excludes investment income, realized gains and losses, general corporate expenses, interest expenses, income taxes and any other non-core business income or expenses.
The following table reconciles revenues by segment to consolidated revenues:
The following table reconciles the results of the Company’s individual segments to consolidated income before taxes:
Note 16-Dividends Declared
The aggregate amount of dividends declared and paid for the years ended December 31, 2007 and 2006 were $3.6 million and $2.2 million respectively.
Note 17-Debt
Subordinated Debentures
In November and December 2006, CastlePoint Management formed two Trusts, of which CastlePoint Management owns all of the common trust securities. On December 1, 2006 and December 14, 2006, respectively, the Trusts each issued $50.0 million of trust preferred securities for cash at a fixed rate during the first five years (equal to 8.66% and 8.551% per annum, respectively), after which the interest rate will become floating and equal to the three month London Interbank Offered Rate (LIBOR) plus 3.5% per annum (calculated quarterly). The Trusts invested the proceeds thereof and the proceeds received from the issuance of the common trust securities in exchange for approximately $103.1 million of junior subordinated debentures (the “CPM Debentures”) issued by CastlePoint Management, with terms which mirror those of the trust preferred securities. On September 2007, CastlePoint Bermuda Holdings formed a third Trust, of which CastlePoint Bermuda Holdings owns all of the common trust securities. On September 27, 2007, this Trust issued $30.0 million of trust preferred securities for cash at a fixed rate during the first five years (equal to 8.39 % per annum), after which the interest rate will become floating and equal to the three month London Interbank Offered Rate (LIBOR) plus 3.5 % per annum (calculated quarterly). The Trust
invested the proceeds thereof and the proceeds received from the issuance of the common trust securities in exchange for approximately $30.9 million of junior subordinated debentures (the “CPBH Debentures”) issued by CastlePoint Bermuda Holdings, with terms which mirror those of the trust preferred securities.
The CPM Debentures and the CPBH Debentures are unsecured obligations of CastlePoint Management and CastlePoint Bermuda Holdings, respectively, and are subordinated and junior in right of payment to all present and future senior indebtedness of CastlePoint Management and CastlePoint Bermuda Holdings. The CPM Debentures issued to Trust I for CastlePoint Management bear interest that is fixed at 8.66% until December 1, 2011, and the coupon will float quarterly thereafter at the three months LIBOR rate plus 3.5% per annum calculated quarterly. The CPM Debentures issued to Trust II for CastlePoint Management bear interest that is fixed at 8.551% until December 14, 2011, and the coupon will float quarterly thereafter at the three months LIBOR rate plus 3.5% per annum calculated quarterly. The CPBH Debentures issued to Trust I for CastlePoint Bermuda Holdings bear interest that is fixed at 8.39% until September , 27 2012, and the coupon will float quarterly thereafter at the three months LIBOR rate plus 3.5% per annum calculated quarterly. All of these subordinated debentures have stated maturities of thirty years. CastlePoint Management and CastlePoint Bermuda Holdings have the option to redeem any or all of the debentures beginning five years from the date of issuance, at the principal amount plus accrued and unpaid interest. If CastlePoint Management or CastlePoint Bermuda Holdings choose to redeem their debentures, the Trusts would then redeem the trust preferred securities at the same time. The issuer of the debentures has the right under the indenture to defer payments of interest on the debentures, so long as no event of default has occurred and is continuing, by deferring the payment of interest on the debentures for up to 20 consecutive quarterly periods (“Extension Period”) at any time and from time to time. During any Extension Period, interest will continue to accrue on the debentures.
The Company has guaranteed, on a subordinated basis, CastlePoint Management’s obligations and CastlePoint Bermuda Holdings’s obligations under the debentures and distributions and other payments due on the Trusts’ preferred securities. These guarantees provided a full and unconditional guarantee of amounts due on the Trusts’ preferred securities. Issuance costs of $1.5 million each for Trust I and Trust II for CastlePoint Management respectively were deferred and are being amortized over the term of the subordinated debentures using the effective interest method. Issuance costs of $0.9 million for Trust I for CastlePoint Bermuda Holdings were deferred and are being amortized over the term of the subordinated debentures using the effective interest method . The proceeds of these issuances of subordinated debentures were used for general corporate purposes, including acquisition and capitalization of CastlePoint Insurance Company.
The Trusts are unconsolidated variable interest entities pursuant to FIN 46(R) because the holders of the equity investment at risk do not have adequate decision making ability over the Trusts’ activities.
Note 18-Business Combination
On December 4, 2006, CastlePoint Management closed on its purchase of the outstanding common stock of a shell property casualty insurance company, Tower Indemnity Company of America (“TICA”) from Tower. TICA was renamed to “CastlePoint Insurance Company” in early 2007. The purchase price was $8.8 million and included $8.5 million of invested assets and two state licenses, from New York and New Jersey. Of the $8.5 million in invested assets, $6.1 million was cash and cash equivalents and $2.4 million was fixed maturity securities deposited with the state of New York to comply with the insurance laws of the state in which the Company is licensed. The Company capitalized $350,000 of the $8.8 million as intangible assets related to state licenses with indefinite useful lives subject to annual impairment test. The primary purpose of this purchase was the acquisition of two state licenses.
Note 19-Subsequent Events
On February 29, 2008, the Board of Directors of CastlePoint Holdings approved a quarterly dividend of $0.025 per share payable March 31, 2007 to the Company’s shareholders of record as of March 17, 2007.
Note 20-Unaudited Quarterly Financial Information
NM-not meaningful
Index to Financial Statement Schedules
Page
Schedule I - Summary of Investments Other than Investments in Related Parties
S-1
Schedule II - Condensed Financial Information of Registrant
S-2
Schedule III - Supplementary Insurance Information
S-5
Schedule IV - Reinsurance
S-6
Schedule VI - Supplemental Information Concerning Property and Casualty Operations
S-7
Other Schedules not listed above have been omitted as they are not applicable to the Company
CASTLEPOINT HOLDINGS, LTD.
SCHEDULE I - SUMMARY OF INVESTMENTS
OTHER THAN INVESTMENTS IN RELATED PARTIES
($ in thousands)
S-1
CASTLEPOINT HOLDINGS, LTD.
SCHEDULE II-CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT
CONDENSED BALANCE SHEETS
($ in thousands)
S-2
CASTLEPOINT HOLDINGS, LTD.
SCHEDULE II-CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT
CONDENSED STATEMENTS OF CASH FLOWS
($ in thousands)
S-3
CASTLEPOINT HOLDINGS, LTD.
SCHEDULE II-CONDENSED FINANCIAL INFORMATION OF THE REGISTRANT
CONDENSED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
($ in thousands)
S-4
CASTLEPOINT HOLDINGS, LTD.
SCHEDULE III - SUPPLEMENTARY INSURANCE INFORMATION
($ in thousands)
S-5
CASTLEPOINT HOLDINGS, LTD.
SCHEDULE IV - REINSURANCE
($ in thousands)
S-6
CASTLEPOINT HOLDINGS, LTD.
SCHEDULE VI - SUPPLEMENTAL INFORMATION CONCERNING PROPERTY AND CASUALTY OPERATIONS
($ in thousands)
S-7