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ESGR > SEC Filings for ESGR > Form 10-K on 3-Mar-2014All Recent SEC Filings

Show all filings for ENSTAR GROUP LTD

Form 10-K for ENSTAR GROUP LTD


3-Mar-2014

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this annual report. Some of the information contained in this discussion and analysis or included elsewhere in this annual report, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks, uncertainties and assumptions. Our actual results and the timing of events could differ materially from those anticipated by these forward-looking statements as a result of many factors, including those discussed under "Cautionary Statement Regarding Forward-Looking Statements," "Risk Factors" and elsewhere in this annual report.

Management's Discussion and Analysis of Financial Condition and Results of Operations

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Section Page Business Overview 55 Key Performance Indicators 56 Drivers of Book Value Growth 57 Critical Accounting Policies 58 Accounting for Acquisitions - Fair Value Measurement - Non-life Run-off Losses and Loss Adjustment Expenses - Non-life Run-off 60 Losses and Loss Adjustment Expenses - Active Underwriting 73 Net Reduction in Ultimate Losses and Loss Adjustment Expense Liabilities 74 Policy Benefits for Life and Annuity Contracts 74 Reinsurance Balances Recoverable 75 Premium Revenue Recognition 75 Investments 76 Goodwill 79 Intangible Assets 79 Redeemable Noncontrolling Interest 79 Consolidated Results of Operations - for the Years Ended December 31, 2013, 2012, and 2011 80 Segment Reporting 83 Results of Operations by Segment - for the Years Ended December 31, 2013, 2012, and 2011 84 Non-life Run-off Segment 84 Life and Annuities Segment 94 Active Underwriting Segment 97 Liquidity and Capital Resources 98 Reinsurance Balances Recoverable 99 Cash Flows 100 Investments 102 Loans Payable 111 Aggregate Contractual Obligations 114 Commitments and Contingencies 114 Off-Balance Sheet Arrangements 115

Business Overview

We are a Bermuda-based holding company with a core focus of acquiring and managing insurance and reinsurance companies in run-off and portfolios of insurance and reinsurance business in run-off, and providing management, consulting and other services to the insurance and reinsurance industry.

Until 2013, all but one of our acquisitions had been in the non-life run-off business, which for us generally includes property and casualty, workers' compensation, asbestos and environmental, construction defect, marine, aviation and transit, and other closed business.


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While our core focus remains the same, we have recently diversified our business profile in two distinct ways: first, by significantly increasing our closed life and annuities business through our acquisition of Pavonia, and second, by entering into the active underwriting business through our acquisitions of Atrium and Arden. Our active underwriting business will expand in 2014 following the closing of our acquisition of Torus, a transaction that we agreed to in July 2013 and that we expect to close in the first quarter of 2014. We are partnering with the Trident V funds in each of these active underwriting acquisitions, with Enstar taking 60% equity interests and Trident taking 40% equity interests.

Our strategies with respect to these new lines of business and our core non-life run-off business are discussed in "Item 1. Business - Company Overview" and "-Strategy," beginning on page 5.

We operate our business internationally through our insurance and reinsurance subsidiaries and our consulting subsidiaries in Bermuda, the United Kingdom, the United States, Europe and Australia.

The table below summarizes the total number of employees we had as at December 31, 2013 by operating segment:

                                              2013      2012
                        Non-life run-off        529       379
                        Life and annuities       49         4
                        Active underwriting     161         -

                        Total                   739       383

Upon completion of the Torus acquisition, we expect our total number of employees to increase by approximately 600 to 1,339. All of these new employees will be included as part of our active underwriting segment.

Key Performance Indicators

Our primary corporate objective is growing our net book value per share. We believe this is driven primarily by growth in our net earnings, which is in turn driven in large part by successfully completing new acquisitions, effectively managing companies and portfolios of business that we have acquired, and executing on our active underwriting strategies. Our growth in book value per share on a fully diluted basis since becoming a public company on January 31, 2007 is set forth in the table below. We have achieved a compounded annual growth rate on our fully diluted book value per share of approximately 18.6% during this time.

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Drivers of Book Value Growth

During the year ended December 31, 2013, we increased our book value per share on a fully diluted basis by 12.8% to $105.20 per share. We grow our book value primarily in the following ways:

settling our non-life run-off net loss reserves from acquired businesses below their acquired fair value (net reduction in ultimate losses and loss adjustment expense liabilities);

earning premiums in excess of related losses for our life and annuities and active underwriting segments (although during 2013 we also earned premiums in our non-life run-off segment as we implemented the run-off process at SeaBright) (net premiums earned);

generating investment income on our cash and investment portfolios (net investment income and net realized and unrealized gains);

earning fees and commission income by providing expert run-off management services for a fixed and/or incentive based fee in our non-life run-off segment, and by providing managing general agency services through Atrium in our active underwriting segment (fees and commission income); and

managing our expenses as we continue to grow our operations (expenses).

The following description summarizes these and other financial statement measures that largely drive the amount of book value per share that we attain.

Net Reduction in Ultimate Losses and Loss Adjustment Expense Liabilities

Our non-life run-off segment earnings comprise primarily reductions, or potential increases, of net ultimate losses and loss adjustment expense liabilities. These liabilities are comprised of outstanding loss or case reserves (or OLR), losses incurred but not reported (or IBNR) and unallocated loss adjustment expenses (or ULAE) reserves.

Net ultimate losses and loss adjustment expense liabilities established by management utilizing analysis performed by independent actuaries prepared on an annual basis are reviewed by our management each quarter. Reserves reflect management's best estimate of the remaining unpaid portion of these liabilities. Prior period estimates of net ultimate losses and loss adjustment expense liabilities may change as our management considers the combined impact of commutations, policy buy-backs, settlement of losses on carried reserves and the trend of incurred loss development compared to prior forecasts. Net reductions in ultimate losses and loss adjustment expense liabilities are reported as negative expenses by us. For more information on how the reserves are calculated, see "- Critical Accounting Policies - Losses and Loss Adjustment Expenses" on page 60.

Net Premiums Earned

We derive income from premiums from our insurance and reinsurance businesses. Insurance and reinsurance premiums are a function of the amount and type of contracts written as well as prevailing market prices and conditions. Property and casualty premiums are earned over the terms of the underlying coverage. Life and annuity premiums are generally earned when the premium is due from policyholders. Each of our insurance and reinsurance contracts contain different pricing, terms and conditions and expected profit margins. Therefore, the amount of premiums is not necessarily an accurate indicator of our anticipated profitability. Premium estimates are based upon information in underlying contracts and data received from clients, cedants and brokers. Changes in premium estimates are expected and may result in significant adjustments in any period. These estimates change over time as additional information regarding the underlying business volume or insured values of our clients is obtained. There is often a delay in the receipt of updated premium information from clients due to the time lag in preparing and reporting the data to us. After review by our underwriters and finance staff, we increase or decrease premium estimates as updated information from our clients is received.


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Net Investment Income and Net Realized and Unrealized Gains

Our net investment income is a function of the average invested assets and the average yield that we earn on those invested assets. The investment yield on our fixed maturities investments is a function of market interest rates as well as the credit quality and duration of our fixed maturities portfolio. Our net realized and unrealized gains or losses on investments includes realized gains and losses on our fixed maturity securities and changes in fair value of our trading and available-for-sale securities and other investments. We recognize realized gains and losses at the time of sale, and they, along with the changes in fair value of our trading and available-for-sale securities reflect the results of changing market conditions, including changes in market interest rates and changes in the market's perception of the credit quality of our fixed maturities holdings. The change in fair value of other investments is principally a function of the success of the funds in which we are invested, which depends on, among other things, the underlying strategies of the funds, the ability of the fund managers to execute the fund strategies and general economic and investment market conditions.

Fees and Commission Income

Our non-life run-off segment generates fee income for run-off and claims services based on a combination of fixed and success-based fee arrangements. Fee income will vary from period to period depending on the timing of completion of success-based fee arrangements. Success-based fees are recorded when targets related to overall project completion or profitability goals are achieved. Our active underwriting segment earns profit commission income related to the provision of managing general agency services to the syndicate 609 and its third-party members.

Expenses

Salaries and Benefits

We are a service-based company and, as such, employee salaries and benefits are our largest expense. We have experienced significant increases in our salaries and benefits expenses as we have grown our operations, and we expect that trend to continue if we are able to expand our operations successfully.

We provide for the annual grant of bonus compensation to our officers and employees, including our senior executive officers. Bonus awards are based on a percentage of our consolidated net after-tax profits. The percentage is 15% unless our Compensation Committee exercises its discretion to change the percentage no later than 30 days after our year end. Bonus awards are payable in cash, ordinary shares or a combination of both.

General and Administrative Expenses

General and administrative expenses include rent and rent-related costs, professional fees (legal, investment, audit and actuarial) and travel expenses. We have operations in multiple jurisdictions and our employees travel frequently in connection with the search for acquisition opportunities and in the general management of the business.

Net Earnings Attributable to Noncontrolling Interest

Net earnings attributable to noncontrolling interest relates to the share of earnings of our subsidiaries in which there is either a noncontrolling interest or a redeemable noncontrolling interest.

Critical Accounting Policies

We believe the following accounting policies affect the more significant judgment and estimates used in the preparation of our financial statements.


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Accounting for Acquisitions - Fair Value Measurement

Non-Life Run-off

The most significant liability and asset of an acquired company are typically the liability for losses and loss adjustment expenses and the asset related to any reinsurance balances recoverable on these liabilities that may be contractually due to the acquired entity. The market for acquisition of run-off companies is not sufficiently active and transparent to enable us to identify reliable, market exit values for acquired assets and liabilities. Accordingly, consistent with provisions of U.S. GAAP, we have developed internal models that we believe allow us to determine fair values that are reasonable proxies for market exit values. We are familiar with the major participants in the acquisition run-off market and believe that the key assumptions we make in valuing acquired assets and liabilities are consistent with the kinds of assumptions made by such market participants. Furthermore, in our negotiation of purchase prices with sellers, it is frequently clear to us that other bidders in the market are using models and assumptions similar in nature to ours during the competitive bid process. The majority of acquisitions are completed following a public tender process whereby the seller invites market participants to provide bids for the target acquisition.

We account for acquisitions using the purchase method of accounting, which requires that the acquirer record the assets and liabilities acquired at their estimated fair value. The fair values of each of the insurance and reinsurance assets and liabilities acquired are derived from probability-weighted ranges of the associated projected cash flows, based on actuarially prepared information and management's run-off strategy. Our run-off strategy, as well as that of other run-off market participants, is expected to be different from the seller's as generally sellers are not specialized in running off insurance and reinsurance liabilities whereas we and other market participants do specialize in such run-offs.

The key assumptions used by us and, we believe, by other run-off market participants in the fair valuation of acquired companies are (i) the projected payout, timing and amounts of claims liabilities; (ii) the related projected timing and amount of reinsurance collections; (iii) a risk-free discount rate, which is applied to determine the present value of the future cash flows;
(iv) the estimated unallocated loss adjustment expenses to be incurred over the life of the run-off; (v) the impact that any accelerated run-off strategy may have on the adequacy of acquired bad debt provisions; and (vi) an appropriate risk margin.

The probability-weighted projected cash flows of the acquired company are based on projected claims payouts provided by the seller predominantly in the form of the seller's most recent independent actuarial reserve report. In the absence of the seller's actuarial reserve report, our independent actuaries will determine the estimated claims payout.

With respect to our U.K., Bermudian and Australian insurance and reinsurance subsidiaries, we are able to pursue strategies to achieve complete finality and conclude the run-off of a company by promoting solvent schemes of arrangement. Solvent schemes of arrangement are a popular means of achieving financial certainty and finality for insurance and reinsurance companies incorporated or managed in the U.K., Bermuda and Australia by making a one-time full and final settlement of an insurance and reinsurance company's liabilities to policyholders. On acquisition of a U.K., Bermudian or Australian company, the claims payout projection is weighted according to management's estimated probability of being able to complete a solvent scheme of arrangement. To the extent that solvent schemes of arrangement are not available to an acquired company, no weighting is applied to the projected claims payout.

On acquisition, we make a provision for unallocated loss adjustment expense liabilities. This provision considers the adequacy of the provision maintained and recorded by the seller in light of our run-off strategy and estimated unallocated loss adjustment expenses to be incurred over the life of the acquired run-off as projected by the seller's actuaries or, in their absence, our actuaries. To the extent that our estimate of the total unallocated loss adjustment expense provision is different from the seller's, an adjustment will be made. While our objective is to accelerate the run-off by completing commutations of assumed and ceded business (which would have the


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effect of shortening the life, and therefore the cost, of the run-off), the success of this strategy is far from certain. Therefore, the estimates of unallocated loss adjustment expenses are based on running off the liabilities and assets over the actuarially projected life of the run-off. In those domiciles where solvent schemes of arrangement are available, management's estimates of the total unallocated loss adjustment expenses are probability-weighted in accordance with the estimated time that a solvent scheme of arrangement could be completed, which has the effect of reducing the period of the run-off and the related unallocated loss adjustment expenses. For those acquisitions in domiciles where solvent schemes of arrangement are not available, the unallocated loss adjustment expenses are estimated over the projected life of the run-off.

We believe that providing for unallocated loss adjustment expenses based on our run-off strategy is appropriate in determining the fair value of the assets and liabilities acquired in an acquisition of a run-off company. We believe that other participants in the run-off acquisition marketplace factor into the price to pay for an acquisition the estimated cost of running off the acquired company based on how that participant expects to manage the assets and liabilities.

The difference between the carrying value of reserves acquired at the date of acquisition and the fair value is the Fair Value Adjustment, or FVA. The FVA is amortized over the estimated payout period and adjusted for accelerations on commutation settlements or any other new information or subsequent change in circumstances after the date of acquisition. To the extent the actual payout experience after the acquisition is materially faster or slower than anticipated at the time of the acquisition, there is an adjustment to the estimated ultimate loss reserves, or there are changes in bad debt provisions or in estimates of future run-off costs following accelerated payouts, then the amortization of the FVA is accelerated or decelerated, as the case may be, to reflect such changes.

Losses and Loss Adjustment Expenses

Non-life Run-off

The following table provides a breakdown of gross losses and loss adjustment
expense reserves by type of exposure as of December 31, 2013 and 2012.



                                                      2013                                            2012
                                       OLR            IBNR            Total            OLR            IBNR            Total
                                                                 (in thousands of U.S. dollars)
Asbestos                           $   152,478     $   298,612     $   451,090     $   179,917     $   355,006     $   534,923
Environmental                           47,518          40,886          88,404          51,632          42,088          93,720
General casualty                       383,609         261,911         645,520         565,250         384,640         949,890
Workers compensation/personal
accident                               944,077         383,287       1,327,364         652,034         135,966         788,000
Marine, aviation and transit           137,054          45,597         182,651         163,367          26,898         190,265
Construction defect                     74,275          89,365         163,640          92,279         150,520         242,799
Other                                  664,419         233,784         898,203         489,445         127,896         617,341

Total                              $ 2,403,430     $ 1,353,442     $ 3,756,872     $ 2,193,924     $ 1,223,014     $ 3,416,938

Unallocated loss adjustment
expenses                                                               247,641                                         233,189

Total                                                              $ 4,004,513                                     $ 3,650,127

Our primary objective in running off the operations of acquired companies and portfolios of insurance and reinsurance business in run-off is to increase book value by settling loss reserves below their acquired fair value. The earnings created in each acquired company or portfolio of insurance and reinsurance business, together with the related decrease in loss reserves, lead to a reduction in the capital required for each company, thereby providing the ability to distribute both earnings and excess capital to the parent company.


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To the extent that the nature of the acquired loss reserves are conducive to commutation, our aim is to settle the majority of the acquired loss reserves within a timeframe of approximately five to seven years from the date of acquisition. To the extent that acquired reserves are not conducive to commutation, we will instead adopt a disciplined claims management approach to pay only valid claims on a timely basis and endeavor to reduce the level of acquired loss adjustment expense provisions by withdrawing, where appropriate, from existing litigation and otherwise streamlining claims handling procedures.

By adopting either of the above run-off strategies, we would expect that over the targeted life of the run-off, acquired ultimate loss reserves would settle below their recorded fair value, resulting in reductions in ultimate losses and loss adjustment expense liabilities. There can be no assurance, however, that we will successfully implement our strategy.

Commutations of blocks of policies, along with disciplined claims management, have the potential to produce favorable claims development compared to established reserves. For each newly-acquired company, we determine a commutation strategy that broadly identifies commutation targets using the following criteria:

Previous commutations completed by existing portfolio companies with policyholders of the newly-acquired company;

Nature of liabilities;

Size of incurred loss reserves;

Recent loss development history; and

Targets for claims audits.

Once commutation targets are identified, they are prioritized into target years of completion. At the beginning of each year, the approach to commutation negotiations is determined by the commutation team, including claims and exposure analysis and broker account reconciliations. On completion of this analysis, settlement parameters are set around incurred liabilities. Commutation discussions can take many months or even years to come to fruition. Commutation targets not completed in a particular year are re-prioritized for the following year.

Every commutation, irrespective of value, requires the approval of our Chief Financial Officer or one of our two Joint Chief Operating Officers. The impact of the commutation activity on the IBNR reserve is reflected as part of our annual actuarial reviews of reserves. However, if a significant commutation is completed during the year, loss reserves will be adjusted in the corresponding quarter to reflect management's then best estimate of the impact on remaining IBNR reserves.

The following table provides a breakdown of losses and loss adjustment expense reserves (net of reinsurance balances recoverable) by type of exposure as of December 31, 2013 and 2012:

                                                        2013                           2012
                                                                % of                           % of
                                                 Total          Total           Total          Total
                                                          (in thousands of U.S. dollars)
Asbestos                                      $   405,323         14.1 %     $   478,154         17.2 %
Environmental                                      75,542          2.6 %          79,397          2.9 %
General casualty                                  431,362         15.0 %         728,976         26.3 %
Workers compensation/personal accident            903,756         31.3 %         451,980         16.3 %
Marine, aviation and transit                      101,547          3.5 %         140,412          5.1 %
Construction defect                               100,576          3.5 %         145,700          5.3 %
Other                                             617,233         21.4 %         516,100         18.5 %
Unallocated loss adjustment expenses              247,641          8.6 %         233,189          8.4 %

Total                                         $ 2,882,980        100.0 %     $ 2,773,908        100.0 %


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