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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ending December 31, 2020 Commission file number: 001-38788
https://cdn.kscope.io/9d06e9a2c651f8dff6dd36162f066a29-wtre-20201231_g1.jpg
Watford Holdings Ltd.
(Exact Name of Registrant as Specified in its Charter)
Bermuda
98-1155442
(State or other jurisdiction
of incorporation or organization)
(I.R.S. Employer Identification Number)
Waterloo House, 1st Floor
(441)
278-3455
100 Pitts Bay Road,PembrokeHM 08,Bermuda
(Registrant’s telephone number, including area code)
(Address of principal executive offices)
Securities registered pursuant to Section 12(b) of the Act:
Title of each classTrading Symbol(s)Name of each exchange on which registered
Common SharesWTRENasdaq Global Select Market
8½% Cumulative Redeemable Preference SharesWTREPNasdaq Global Select Market
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☐ No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer ☐
Accelerated filer
Non-accelerated filerSmaller reporting company
Emerging growth company
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.
Indicate by check mark whether the registrant has filed a report on and attestation to its management's assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No ☒
The aggregate market value of the voting and non-voting equity held by non-affiliates, computed by reference to the closing price as reported by the Nasdaq Global Select Market as of the last business day of the registrant’s most recently completed second fiscal quarter, was approximately $282.9 million.

As of February 26, 2021, there were 19,886,979 of the registrant’s common shares outstanding.




DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant’s definitive proxy statement for its 2021 annual meeting of shareholders are incorporated by reference into Part III of this Annual Report on Form 10-K, provided that if such proxy statement is not filed with the U.S. Securities and Exchange Commission within 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K, an amendment to this Annual Report on Form 10-K will be filed no later than the end of such 120-day period.



Watford Holdings Ltd.
Index to Form 10-K
Page
Item 1.
Item 1A.
Item 1B.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.
Item 7.
Management’s discussion and analysis of financial condition and results of operations
Item 7A.
Item 8.
Item 9.
Item 9A.
Item 9B.
Item 10.
Item 11.
Item 12.
Item 13.
Item 14.
Item 15.
Item 16.
1


Explanatory note - Certain defined terms
Unless the context suggests otherwise, any reference in this report to:
“ACGL” refers to Arch Capital Group Ltd. and its controlled subsidiaries;
“Arch” refers to any one or more of the following direct or indirect subsidiaries of ACGL, as applicable in the context in which such term appears:
Arch Investment Management Ltd., or AIM, which manages the majority of our investment grade portfolio;
Arch Reinsurance Company, or ARC, which is a party to certain quota share agreements with one or more of our operating subsidiaries and a services agreement with Watford Holdings (U.S.) Inc.;
Arch Reinsurance Ltd., or ARL, which is a party to certain quota share agreements with one or more of our operating subsidiaries and owned approximately 12.6% of our outstanding common shares as of December 31, 2020;
Arch Underwriters Inc., or AUI, which manages the underwriting business of our U.S. operating subsidiaries;
Arch Underwriters Ltd., or AUL, which manages the underwriting business of our non-U.S. operating subsidiaries, including Watford Re;
“HPS” refers to HPS Investment Partners, LLC (formerly known as Highbridge Principal Strategies, LLC), which manages our non-investment grade portfolio, as well as accounts in our investment grade portfolio;
our “Investment Managers” refers to AIM, HPS or any other investment managers that manage our investment grade portfolio or our non-investment grade portfolio from time to time;
“Watford,” “we,” “us” and “our” refers to Watford Holdings Ltd. and its subsidiaries;
“Watford Holdings” refers to our company, Watford Holdings Ltd., a Bermuda exempted company;
“Watford Re” refers to Watford Re Ltd., a Bermuda domiciled insurance company and a wholly-owned subsidiary of our company;
“Watford Trust” refers to Watford Asset Trust I, a statutory trust organized under the laws of the State of Delaware;
“WIC” refers to Watford Insurance Company, a New Jersey domiciled insurance company and a wholly-owned subsidiary of our company;
“WICE” refers to Watford Insurance Company Europe Limited, a Gibraltar domiciled insurance company and a wholly-owned subsidiary of our company; and
“WSIC” refers to Watford Specialty Insurance Company, a New Jersey domiciled insurance company and a wholly-owned subsidiary of our company.
In addition, unless the context suggests otherwise, any reference in this report to:
“HoldCo” refers to Greysbridge Holdings Ltd., a newly formed entity of which ACGL will own approximately 40%, and funds managed by Warburg Pincus LLC and Kelso & Company will each own approximately 30%;

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“Merger” refers to the merger of Merger Sub with and into Watford Holdings pursuant to the Merger Agreement, with Watford Holdings surviving as a wholly-owned subsidiary of HoldCo;
“Merger Agreement” refers to the Agreement and Plan of Merger, dated as of October 9, 2020, among Watford Holdings, ACGL and Merger Sub, as amended by Amendment No. 1 to Agreement and Plan of Merger, dated as of November 2, 2020, among Watford Holdings, ACGL and Merger Sub; and
“Merger Sub” refers to Greysbridge Ltd., a newly formed entity that is a wholly-owned subsidiary of HoldCo.
Explanatory note - Proposed merger
On October 9, 2020, we announced that we had entered into an Agreement and Plan of Merger with ACGL and Merger Sub pursuant to which, among other things, Merger Sub will merge with and into Watford Holdings, with Watford Holdings surviving as a wholly-owned subsidiary of ACGL. On November 2, 2020, we announced that we had entered into an amendment to the merger agreement with ACGL and Merger Sub to amend certain terms of the agreement. Further, on November 2, 2020, ACGL assigned its interests and obligations in connection with this acquisition to HoldCo, a newly formed entity of which ACGL will own approximately 40%, and funds managed by Warburg Pincus LLC and Kelso & Company will each own approximately 30%. Unless stated otherwise, all forward-looking information contained in this Annual Report on Form 10-K does not take into account or give any effect to the impact of the Merger (as defined herein). For additional details regarding the Merger, see Part I Item 1 “Business”, Part I Item 1A “Risk factors”, Part I Item 3 “Legal proceedings” and Part II Item 7 “Management’s discussion and analysis of financial condition and results of operations” of this Annual Report on Form 10-K.

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Cautionary note regarding forward-looking statements
The Private Securities Litigation Reform Act of 1995 (or the PSLRA) provides a “safe harbor” for forward-looking statements. This report contains forward-looking statements that are intended to enhance the reader’s ability to assess our future financial and business performance. These statements are based on the beliefs and assumptions of our management, and are subject to risks and uncertainties. Generally, statements that are not about historical facts, including statements concerning our possible or assumed future actions or results of operations are forward-looking statements. Forward-looking statements include, but are not limited to, statements that represent our beliefs, expectations or estimates concerning future operations, strategies, financial results or performance, financings, investments, acquisitions, expenditures or other developments and anticipated trends and competition in the markets in which we operate. Forward-looking statements, for purposes of the PSLRA or otherwise, can also be identified by the use of forward-looking terminology such as “may,” “believes,” “intends,” “anticipates,” “plans,” “estimates,” “expects,” “should” or similar expressions.
Forward-looking statements involve our current assessment of risks and uncertainties. Actual events and results may differ materially from those expressed or implied in these statements. Important factors that could cause actual events or results to differ materially from those indicated in such statements are discussed below and elsewhere in this report and in our other reports and other documents filed with the Securities and Exchange Commission, or the SEC, and include:
adverse general, societal, economic and market conditions, including those caused by pandemics, including the current global pandemic related to the novel coronavirus, or COVID-19, and government actions in response thereto;
our limited operating history;
fluctuations in the results of our operations;
our ability to compete successfully with more established competitors;
our losses exceeding our reserves;
downgrades, potential downgrades or other negative actions by rating agencies, including the announcements by A.M. Best Company, or A.M. Best, that it has placed under review with negative implications status for our financial strength and credit ratings and Kroll Bond Rating Agency, or KBRA, that it has revised the outlook of our financial strength and credit ratings to negative;
our dependence on key executives and inability to attract qualified personnel, or the potential loss of suitably qualified personnel as a result of Bermuda employment and immigration restrictions;
our dependence on letter of credit facilities and borrowing facilities that may not be available on commercially acceptable terms;
our potential inability to pay dividends or distributions;
our potential need for additional capital in the future and the potential unavailability of such capital to us on favorable terms or at all;
our dependence on clients’ evaluations of risks associated with such clients’ insurance underwriting;
the suspension or revocation of our subsidiaries’ insurance licenses;
Watford Holdings potentially being deemed an investment company under U.S. federal securities law;
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the potential characterization of us and/or any of our subsidiaries as a passive foreign investment company, or PFIC;
our dependence on Arch for services critical to our underwriting operations;
changes to our strategic relationship with Arch or the termination by Arch of any of our services agreements or quota share agreements;
our dependence on HPS and AIM to implement our investment strategy;
the termination by HPS or AIM of any of our investment management agreements;
risks associated with our investment strategy being greater than those faced by competitors;
changes in the regulatory environment;
our potentially becoming subject to U.S. federal income taxation;
our potentially becoming subject to U.S. withholding and information reporting requirements under the U.S. Foreign Account Tax Compliance Act, or FATCA, provisions;
our ability to complete acquisitions and integrate businesses successfully;
one or more closing conditions to the Merger, including certain regulatory approvals, may not be satisfied or waived, on a timely basis or otherwise, including that a governmental entity may prohibit, delay or refuse to grant approval for the consummation of the Merger, or that the required approval of the Merger Agreement by our shareholders may not be obtained;
uncertainties regarding the proposed acquisition of Watford Holdings by HoldCo;
our business may suffer as a result of uncertainty surrounding the proposed transaction with HoldCo, and there may be challenges with employee retention as a result of the proposed transaction with HoldCo;
the proposed transaction with HoldCo may involve unexpected costs, liabilities or delays;
legal proceedings that have been, and additional proceedings that may be initiated against us or our directors related to the proposed transactions with HoldCo;
an event, change or other circumstance may occur that could give rise to the termination of the Merger Agreement (including circumstances requiring us to pay HoldCo a termination fee pursuant to the Merger Agreement); and
the other matters set forth under Item 1A “Risk factors” and Item 7 “Management’s discussion and analysis of financial condition and results of operations” as well as the other factors set forth in the Company’s other documents on file with the SEC and management’s response to any of the aforementioned factors.
Consequently, such forward-looking statements should be regarded solely as our current plans, estimates or belief as of the date of this report. All subsequent forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with other cautionary statements that are included herein or elsewhere. We do not intend, and do not undertake, any obligation to update any forward-looking statements to reflect future events or circumstances after the date of this report.


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Risk factors summary
The following is a summary of the principal risks that could adversely affect our business, operations and financial results. This summary does not address all of the risks and uncertainties that we face. Additional discussion of the risks and uncertainties summarized below, as well as other risks and uncertainties that we face, can be found under “Risk Factors” in Part I, Item 1A of this Annual Report on Form 10-K. The summary below is qualified in its entirety by that more complete discussion of such risks and uncertainties. You should carefully consider the risks and uncertainties described under “Risk Factors” in Part I, Item 1A of this Annual Report on Form 10-K as part of your evaluation of an investment in our securities.
Risks related to the COVID-19 global pandemic
The impact of the COVID-19 global pandemic and related risks could materially affect our results of operations, financial position and/or liquidity.
Risks related to our insurance and reinsurance business
We operate in a highly competitive environment and we may not be able to compete successfully in our industry.
The insurance and reinsurance industry is from time to time subject to regulatory, legislative, judicial or other unforeseen developments, which could adversely affect our business.
Risks related to our company
We began operations in March 2014 and, therefore, limited historical information is available for investors to evaluate our performance or a potential investment in our shares.
The failure of any of the loss limitation methods we employ could have a material adverse effect on our financial condition or results of operations.
We depend heavily on the performance of Arch, HPS and other third-party service providers under their respective agreements. In particular, we rely on Arch for services critical to our underwriting operations and we depend upon HPS to manage the investments of the funds in our non-investment grade portfolio.
Our business is dependent upon insurance and reinsurance brokers, intermediaries and program administrators and the loss of these important relationships could materially adversely affect our ability to market our products and services.
We may not be able to write as much premium as expected on business with the desired level of targeted profitability.
A downgrade or withdrawal of our financial strength ratings by insurance rating agencies could adversely affect the volume and quality of business presented to us and could negatively impact our relationships with clients and the sales of our products.
If we are unsuccessful in managing our underwriting operations and investments in relation to each other, our ability to conduct our business could be significantly and negatively affected.
A single or series of insurable events could result in simultaneous, correlated and substantial losses from underwriting operations and investment losses, which would adversely affect our financial condition and results of operations.
The failure to maintain our credit facilities and letter of credit facilities or to have adequate available collateral in connection with reinsurance contracts may negatively affect our ability to successfully implement our business strategy.
Our liquidity position is affected by our underwriting, investment and internal operations, and adverse developments in any of these inputs could have a significantly negative impact on our business and liquidity.
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Risks related to Arch
Arch may take actions in the future that cause its and our interests to be less aligned.
Risks related to our investments
The performance of our investments is highly dependent upon conditions in the global economy or financial markets that are outside of our Investment Managers’ control and can be difficult to predict.
Risks related to HPS and the HPS-managed non-investment grade portfolio
HPS utilizes investment strategies and employs trading techniques that involve inherent exposures, which could result in substantial losses to our non-investment grade portfolio and, as a result, to us.
Our investments differ from those of many insurers and reinsurers because our non-investment grade portfolio is predominantly invested in corporate credit investments, which can be speculative and volatile and which could increase the riskiness and volatility of our results. In addition, the use of financial leverage could increase the riskiness of our non-investment grade portfolio’s investment strategy and volatility of our net income.
We do not control the decisions of HPS, and HPS may invest the assets in our non-investment grade portfolio in its discretion within the framework of the applicable non-investment grade investment guidelines. The performance of our non-investment grade portfolio depends on the ability of HPS to select and manage appropriate investments.
Risks related to regulation of us and our operating subsidiaries
Any suspension or revocation of Watford Re’s license as a Bermuda Class 4 insurer would materially impact our ability to do business and implement our business strategy.
Our non-Bermuda operating insurance subsidiaries are subject to regulation in various jurisdictions, and violations of existing regulations or material changes in the regulation of their operations could adversely affect us.
Risks related to taxation
U.S. Holders may be subject to certain adverse tax consequences based on the application of rules regarding passive foreign investment companies, or PFICs.
Changes in U.S. federal tax laws, which may be retroactive, including the finalization of proposed Treasury Regulations, could subject Watford Holdings, Watford Re or U.S. Holders to U.S. federal income taxation on the earnings of Watford Holdings, Watford Re or our subsidiaries or could otherwise adversely impact Watford Holdings and its subsidiaries or shareholders.
Risks related to our common shares
The share voting limitations that are contained in our bye-laws may result in our shareholders having fewer voting rights than a shareholder would otherwise have been entitled to based upon such shareholder’s economic interest in our company.
Risks related to the proposed Merger
The Merger is subject to closing conditions, including governmental, regulatory and shareholder approvals, as well as other uncertainties and there can be no assurances as to whether and when it may be completed. Failure to complete the Merger could negatively impact our share price, future business and financial results.
The pendency of the Merger may cause disruptions in our business, which could have an adverse effect on our business, financial condition or results of operations.
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Part I.
Item 1. Business
Our company
We are a global property and casualty, or P&C, insurance and reinsurance company with approximately $1.2 billion in capital as of December 31, 2020 and with operations in Bermuda, the United States and Europe. Our strategy combines a diversified, casualty-focused underwriting portfolio, accessed through our multi-year, renewable strategic underwriting management relationship with Arch, with a disciplined investment strategy comprising primarily non-investment grade corporate credit assets, managed by HPS Investment Partners, LLC, or HPS. We have designed our investment strategy to complement the characteristics of our target underwriting portfolio in order to generate attractive risk-adjusted returns for our shareholders. Our strategy involves a greater degree of investment risk balanced with a less volatile underwriting portfolio, especially in relation to the amount of catastrophe exposure we assume, as compared with traditional insurers and reinsurers.
We were formed in Bermuda in the second quarter of 2013. In March 2014, we raised $1.1 billion in our initial funding and began underwriting reinsurance in the first half of 2014. Our operating subsidiaries all carry a financial strength rating of “A-” (Excellent) from A.M. Best Company, or A.M. Best, which is the fourth highest of 16 ratings that A.M. Best confers. As of December 31, 2020, A.M. Best has maintained its “under review with negative implications” status for the “A-” financial strength rating of our operating subsidiaries. Each of our operating subsidiaries also carries a financial strength rating of “A” from Kroll Bond Rating Agency, or KBRA, which is the sixth highest of 22 ratings that KBRA confers. On June 17, 2020, KBRA revised the outlook for all of our ratings to negative. These ratings are each intended to provide an independent opinion of an insurer’s ability to meet its obligations to policyholders and are not ratings of our common shares.
We manage our insurance and reinsurance underwriting through our relationship with Arch, which, through Arch Reinsurance Ltd., or ARL, is one of our founding equity investors. ARL, which is a subsidiary of Arch Capital Group Ltd., or ACGL, a leading global insurance and reinsurance company whose shares are listed on the Nasdaq Global Select Market under the symbol “ACGL,” invested $100 million in our common shares. ACGL had approximately $15.8 billion in capital and a market capitalization of approximately $14.7 billion as of December 31, 2020 and provides a full range of property, casualty and mortgage insurance and reinsurance lines, with a particular focus on writing specialty lines on a worldwide basis through operations in Bermuda, the United States, Canada, Europe and Australia.
Our strategic relationship with Arch provides us with unique underwriting expertise and market access based upon our ability to leverage Arch’s global underwriting infrastructure and distribution platform and has enabled us to build a diversified global portfolio of insurance and reinsurance risks. Our operating subsidiaries have written an aggregate of approximately $4.1 billion in gross premiums written from inception to December 31, 2020.
Our main operating subsidiary is Watford Re Ltd., or Watford Re, a Bermuda-based company that began writing business in early 2014 and is registered as a Class 4 insurer with the Bermuda Monetary Authority, or the BMA. Bermuda is one of the largest insurance and reinsurance centers in the world, particularly for P&C markets, providing insurance and reinsurance capacity for risks on a global basis. In addition to traditional P&C lines, Watford Re also writes mortgage insurance and reinsurance on a worldwide basis. Our Bermuda presence gives us direct and efficient access to reinsure these risks. In mid-2015, we formed and capitalized Watford Insurance Company Europe Limited, or WICE, in Gibraltar to conduct business in Europe. In December 2015, WICE began writing business with access to markets across the European Union, targeting both personal lines and commercial lines of P&C insurance, which it distributes through coinsurance relationships and
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specialized insurance agents (also known as program managers). Following the United Kingdom and Gibraltar’s exit from the European Union, WICE now focuses solely on United Kingdom business with all relevant regulatory approvals obtained to run off its remaining European Union exposures. In December 2019, we entered into an agreement to acquire Axeria IARD, a P&C insurance company based in France. The completion of this acquisition is subject to regulatory approval and other customary closing conditions, and is expected to close in the first quarter of 2021.
In late 2015, we formed and capitalized Watford Specialty Insurance Company, or WSIC, a U.S.-based excess & surplus, or E&S, lines insurer. In April 2016, WSIC began writing insurance business in the U.S. E&S market, concentrating its efforts on commercial lines of property and casualty coverage, which it distributes through program managers. We further expanded our U.S. capabilities in August 2016 through the acquisition and capitalization of Watford Insurance Company, or WIC, which has enabled us to access the larger admitted (or licensed) U.S. insurance market, also through program managers. Between WSIC and WIC, we are able to access the entire U.S. P&C insurance market, offering either admitted insurance products or E&S insurance products to service market demand.
The majority of our investments are allocated to non-investment grade corporate credit assets managed by HPS, which we refer to as our non-investment grade portfolio.
HPS is a global investment platform with a focus on non-investment grade credit. HPS had approximately $68 billion of assets under management as of December 31, 2020. HPS manages our non-investment grade portfolio pursuant to investment guidelines formulated to complement our underwriting portfolio. The primary objective of our non-investment grade investment strategy is to generate attractive risk-adjusted returns comprising current interest income, trading gains and capital appreciation, with an emphasis on capital preservation. As of December 31, 2020, non-investment grade corporate credit assets comprised approximately 69% of our overall investment portfolio.
We refer to the remainder of our invested assets as our investment grade portfolio, which is primarily managed by Arch Investment Management Ltd., or AIM, a subsidiary of Arch that manages the investments of Arch’s own funds. We also have several investment grade accounts managed by other Investment Managers, including HPS.
Since formation, we have meaningfully grown our business, generating sizable underwriting revenue and significant interest income. We believe that we are well-positioned to continue delivering prudent growth by balancing our complementary underwriting and investment strategies. From inception through December 31, 2020, our net premiums written and net interest income were as follows:
Year Ended December 31,ITD
202020192018
($ in thousands)
Net premiums written$537,589 $532,862 $604,175 $3,481,946 
Net interest income106,390 116,211 107,533 597,582 
On March 28, 2019, we completed a direct listing of our common shares on the Nasdaq Global Select Market. On June 28, 2019, we also completed a direct listing of our 8½% Cumulative Redeemable Preference Shares, or our preference shares, on the Nasdaq Global Select Market.
In the first quarter of 2020, our board of directors authorized a share repurchase program, which allowed us to make repurchases of up to $50 million of our common shares from time to time in open market or privately negotiated transactions. From the inception of the share repurchase program in September 2019 through December 31, 2020, we repurchased 2.9 million common shares for a purchase price of $77.9 million, excluding transaction costs.
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In the third quarter of 2020, we entered into the Merger Agreement, pursuant to which, among other things, Merger Sub will merge with and into Watford Holdings, which we refer to as the Merger, with Watford Holdings surviving as a wholly owned subsidiary of HoldCo.
We do not anticipate making any further repurchases under the current share repurchase program as a result of our entry into the Merger Agreement, which generally prohibits us from repurchasing our shares as well as certain other securities prior to the consummation of the Merger or the earlier termination of the Merger Agreement. Accordingly, at the present time, we do not expect to repurchase common shares, declare or pay dividends on our common shares or otherwise return capital to our common shareholders for the foreseeable future.
Pursuant to the Merger Agreement, subject to certain conditions set forth therein, at the effective time of the Merger, (a) each issued and outstanding common share of Watford Holdings (other than (i) shares to be canceled pursuant to the Merger Agreement and (ii) restricted share units to be canceled and exchanged pursuant to the Merger Agreement (as described below)), will be converted into the right to receive $35.00 in cash, without interest, and (b) each issued and outstanding preference share will remain outstanding as a preference share of the surviving company and will be entitled to the same dividend and other relative rights, preferences, limitations and restrictions as are now provided to the preference shares.
Consummation of the Merger is subject to customary conditions, including without limitation, (i) approval of the Merger Agreement and the transactions contemplated thereby by the affirmative votes of not less than 50% of the holders of the outstanding common shares and the preference shares, voting as a single class, at a meeting of our shareholders, (ii) the receipt of certain remaining regulatory approvals without the imposition of a Burdensome Condition (as defined in the Merger Agreement), (iii) the absence of any law, judgment or other legal restraint that prevents, makes illegal or prohibits the consummation of the Merger and the other transactions contemplated by the Merger Agreement, (iv) the accuracy of each party’s representations and warranties (subject to certain qualifications), (v) each party’s performance in all material respects of its obligations contained in the Merger Agreement and (vi) the absence of a Company Material Adverse Effect (as defined in the Merger Agreement). In addition, HoldCo’s obligation to consummate the Merger is conditioned on our non-investment grade portfolio not suffering a loss of more than $208 million from September 30, 2020, through the date that is two business days prior to the closing of the Merger.
The Merger Agreement includes customary representations, warranties and covenants of Watford Holdings, HoldCo, and Merger Sub. Among other things, Watford Holdings has agreed to customary covenants regarding the operation of the business of Watford prior to the closing.
The Merger Agreement contains specified termination rights for each of the parties. Upon termination of the Merger Agreement under specified circumstances, including with respect to our entry into an agreement with respect to a qualifying Superior Proposal (as defined in the Merger Agreement), we will be required to pay HoldCo a termination fee of $28.1 million.
The Merger is expected to close in the first half of 2021, subject to the closing conditions described above and contained in the Merger Agreement.
Strategy
Execute a dynamic business model focused on total returns
We are a total return-driven insurance and reinsurance company. We strive to deliver attractive long-term returns to our shareholders by writing a diversified underwriting portfolio through a proven, disciplined approach, augmented by an investment strategy comprising primarily non-investment grade fixed income corporate credit assets and designed to complement our target underwriting business mix. We feel that this combination enhances our opportunity to thoughtfully
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deploy our capital in the most effective manner and to produce attractive risk-adjusted returns across both sides of the balance sheet, thereby maximizing the total return for our shareholders.
Build an insurance platform that supplements our reinsurance business
In 2015, we expanded our platform to include P&C insurance business in the United States and European markets. The business we access at the insurance level generally has lower acquisition costs than similar business accessed at the reinsurance level, and provides other operating efficiencies. In addition, we expect that our insurance business will produce further diversification benefits resulting in lower volatility of our underwriting results.
The table below shows the net insurance premiums written generated by our insurance business for the years ended December 31, 2020, 2019 and 2018. We intend to continue to grow our insurance business opportunistically by leveraging our strategic relationship with Arch.
Year Ended December 31,
202020192018
($ in thousands)
Insurance programs and coinsurance - net premiums written
$213,459 $176,711 $139,838 
Capitalize on the expertise and infrastructure of Arch, our exclusive underwriting manager
We have partnered with Arch to source and manage our underwriting portfolio in accordance with our underwriting guidelines. We believe this relationship will enable us to execute our chosen, casualty-focused underwriting strategy based on Arch’s expertise in our target lines of business. This arrangement provides us with access to Arch’s global underwriting infrastructure and distribution platform, and has allowed us to quickly build a global portfolio of diversified insurance and reinsurance risks.
Pursue an investment approach that complements our underwriting strategy
Our investment strategy seeks to generate attractive risk-adjusted returns comprising interest income, trading gains and capital appreciation with an emphasis on capital preservation. This investment strategy complements our underwriting portfolio, which predominantly targets medium- to long-tail casualty business. Our non-investment grade portfolio, which is managed by HPS, consists of high yielding corporate credit assets. Our goal in pursuing this strategy is to generate superior investment returns, as compared with investment returns achieved by our peers, through disciplined and prudent credit risk analysis and proper pricing for the risk assumed. We seek to achieve risk-adjusted returns that exceed those of typical reinsurer investment portfolios while also producing stable cash flows from scheduled interest payments. Our lower volatility, casualty-focused underwriting portfolio should have predictability in terms of the timing of payments to insurance claimants, thereby mitigating the risk of having to sell assets during times of temporary investment market stresses.
Maintain a robust risk management program
We have a strong risk management function, overseen by our Chief Risk Officer. We benefit from our ability to leverage the risk management infrastructures in place within each of Arch and HPS. We regularly receive relevant exposure and modeling information from Arch and HPS. On that data we overlay our proprietary analytics, tailored risk appetites and controls for an integrated approach to monitoring and reviewing our exposures. We maintain active oversight of our underwriting and investment management service providers at both the management and board level.
Conservative approach to underwriting risk
We have designed our underwriting and investment strategies toward the goal of maintaining our balance sheet strength on a long-term basis through varying phases of market cycles. We target a
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medium-to long-term, lower volatility underwriting portfolio with tightly managed natural catastrophe exposure. We seek to limit our modeled net probable maximum loss, or PML, for property catastrophe exposures for each peak peril and peak zone from a 1-in-250 year occurrence to no more than 10% of the value of our total shareholders’ equity plus our senior notes and our preference shares, or our total capital, which is less than most of our principal reinsurance competitors. As of January 1, 2021, this modeled net PML was 4.4% of our total capital. Our conscious effort to limit our catastrophe exposure lowers the volatility of our overall underwriting portfolio and provides greater certainty as to future claims-related payout patterns and timing. Our casualty-focused underwriting portfolio’s payout pattern is slower than that of most of our competitors due to the longer tail lines of business we write, and that slower payout pattern provides us with the potential for greater investment income on those premiums, thereby providing us an underwriting modeling advantage when competing for those target lines of business.
We have a robust process for setting loss reserves, leveraging the established processes and procedures employed by Arch, making our own analyses and judgments, and through periodic reviews by external actuarial firms. We also regularly monitor our investment portfolios, including performance of the underlying credits, overall liquidity and how well that liquidity matches with the projected claims payments related to our underwriting portfolio. Being prudent stewards of our balance sheet allows us to maintain the confidence of all of our constituents and thereby to position ourselves to better achieve our goals.
Our operations
Underwriting operations: insurance and reinsurance
Through our underwriting operations we are able to offer a variety of P&C insurance and reinsurance products on a global basis. We target an underwriting portfolio that is diversified by line of business and geography, with a focus on medium- to long-tail casualty business. Given the inception of our insurance operations, our underwriting portfolio to-date has been predominantly reinsurance, although we expect our insurance writings to continue to increase going forward. We have built a diversified, low volatility portfolio by purposely limiting our modeled natural catastrophe exposure to a level lower than many other insurers and reinsurers. Our strategy is to operate in lines of business in which underwriting skill and specialized knowledge can make a meaningful difference in operating results.
We have been well-received in the market and successful in writing what we believe to be attractive underwriting opportunities. We benefit from Arch’s broad underwriting expertise and worldwide distribution network. Arch’s global, multi-line market presence facilitates the ability for Arch to strategically adapt our mix of business by geography, product line or type, as we or Arch perceive potential opportunities. In addition, as a result of our operating subsidiaries’ “A-” (Excellent) rating from A.M. Best and “A” rating from KBRA, as well as our strong balance sheet, we are well-positioned to increase our premium volume in favorable market cycles, creating additional attractive underwriting opportunities.
Similar to other reinsurers and to other insurers writing business through program managers, we do not separately evaluate each individual risk assumed and are, therefore, largely dependent upon the original underwriting decisions made by the ceding companies and program managers in accordance with agreed underwriting guidelines. However, we believe Arch’s experience in portfolio risk selection and detailed monitoring of cedants and program managers provides us with a competitive advantage.
Our Bermuda-based operating subsidiary, Watford Re, writes a broad range of P&C coverages. In addition to traditional P&C lines, Watford Re also writes mortgage insurance and reinsurance on a worldwide basis. Our reinsurance business leverages Arch’s global underwriting platform to distribute a wide variety of products covering lines of business around the world. We write business for third-party cedants and also assume a meaningful portion of our business as a reinsurance or
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retrocession of business that Arch has underwritten for its own portfolio and that also meets our underwriting guidelines and return metrics. The table below provides the percentage of our total gross premiums written assumed from Arch for years ended December 31, 2020, 2019 and 2018.
Year Ended December 31,
202020192018
Gross premiums written - assumed from Arch
27.7 %26.6 %34.4 %
Arch competes with us and will continue to underwrite business for its own distinct portfolios in accordance with its own policies, strategies and business plans. In sourcing insurance and reinsurance opportunities through its worldwide platform, Arch evaluates the perceived risk exposure pursuant to its proprietary underwriting methodology, and then models the required pricing based on both its and our underwriting criteria. In furtherance of our underwriting philosophy to pursue lines of business in which underwriting knowledge and expertise can drive attractive returns, our underwriting guidelines are based largely on Arch’s own, leveraging the experience of Arch’s underwriting professionals. Our underwriting guidelines differ from Arch’s in several aspects, most notably in that our guidelines purposely limit catastrophe risk and our portfolio focus is on mid- to long-tail casualty and other lines of business with similar tenor, whereas Arch’s target business mix includes more catastrophe exposure and a higher percentage of shorter-tail lines.
In underwriting business on our behalf, Arch fundamentally employs the same qualitative and quantitative evaluation and selection criteria for our underwriting portfolio as it does for its own account and each potential contract is evaluated qualitatively and quantitatively for both Arch’s portfolio and ours. For each opportunity that passes Arch’s qualitative and quantitative screening, when performing the pricing evaluation of a contract on our behalf, Arch applies our investment return assumptions to determine our expected return on the allocated capital for each such business opportunity. The determination by Arch as to whether to offer only Arch capacity, only our capacity, or both as side-by-side capacity, depends on the result of the pricing analysis using differing investment assumptions for us and Arch, reflecting our differentiated investment strategies. The mid- to long-tail business on which we focus can benefit from a higher return on the premium float and thus, certain opportunities that meet our metrics may not meet those of insurers and reinsurers like Arch with a more traditional investment strategy. In underwriting operations, “float” arises when premiums are received before losses and other expenses are paid and is an interval that sometimes extends over many years. During that time, the insurer invests the premiums, earns interest income and may generate capital gains and losses. In order to provide solutions to its reinsurance brokers and potential insurance clients, Arch has a strategic incentive to place that business with us rather than simply declining to provide capacity to the broker or potential client in such circumstances.
Other than renewals of business previously written by our underwriting subsidiaries, Arch is not required to allocate any particular business opportunities to us. However, we believe that Arch has strong incentives to allocate attractive business to us, based on Arch’s investments in us, our contractual arrangements through which Arch earns premium-based fees and a profit commission for business written on our behalf, and Arch’s ability to offer potential clients additional solutions, thus gaining a strategic benefit in the competitive, syndicated reinsurance market in which it is often necessary to be on an expiring contract to have the opportunity to bid to provide capacity at the next annual renewal.
Through our relationship with Arch, we have built a diversified portfolio of medium- to long-tail commercial lines casualty, other specialty and property risks. Our underwriting segment captures
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the results of our underwriting lines of business, which are comprised of specialty products on a worldwide basis. Our four major lines of business are described as follows:
Casualty reinsurance: coverage provided to ceding company clients on third-party liability and workers’ compensation exposures, primarily on a treaty basis. Business written includes coverages such as: executive assurance, medical malpractice liability, other professional liability, workers’ compensation, excess and umbrella liability and excess auto liability.
Other specialty reinsurance: coverage provided to ceding company clients for personal and commercial auto (other than excess auto liability), mortgage, surety, accident and health, workers’ compensation catastrophe, agriculture and marine and aviation.
Property catastrophe reinsurance: protects ceding company clients for most catastrophic losses that are covered in the underlying policies. Perils covered may include hurricane, earthquake, flood, tornado, hail and fire, and coverage for other perils on a case-by-case basis. Property catastrophe reinsurance provides coverage on an excess of loss basis when aggregate losses and loss adjustment expense from a single occurrence of a covered peril exceed the retention specified in the contract.
Insurance programs and coinsurance: targeting program managers and/or coinsurers with unique expertise and niche products offering primary and excess general liability, umbrella liability, professional liability, workers’ compensation, personal and commercial automobile, inland marine and property business with minimal catastrophe exposure.
Our insurance operations are conducted in the United States and Europe. We established our insurance platform as a complement to our reinsurance strategy to expand our distribution channels. Our insurance strategy is focused on pursuing attractive underwriting opportunities in the U.S. and European insurance markets and we view our insurance platform as having the potential to provide meaningful premium growth.
In the United States, we are authorized to write commercial P&C lines of business in both the admitted market and the E&S market through our WIC and WSIC subsidiaries, respectively, with distribution through coinsurance relationships or through select program managers that develop and distribute specialized insurance products for these subsidiaries. In the U.K., we write direct insurance and coinsurance business, primarily in personal P&C lines, through lead insurers and program managers that develop and distribute specialized insurance products for our WICE subsidiary. The acquisition of Axeria will extend our insurance platform across the European Union.
We operate and monitor our lines of business through our underwriting operations. The table below provides a breakdown of our gross premiums written for the years ended December 31, 2020, 2019 and 2018:
Year Ended December 31,
202020192018
Amount%Amount%Amount%
($ in thousands)
Casualty reinsurance$188,042 25.8 %$279,967 37.1 %$274,661 37.4 %
Other specialty reinsurance117,177 16.1 %119,518 15.8 %196,170 26.7 %
Property catastrophe reinsurance
27,334 3.8 %16,226 2.1 %10,424 1.4 %
Insurance programs and coinsurance
395,993 54.3 %339,170 45.0 %253,760 34.5 %
Total$728,546 100.0 %$754,881 100.0 %$735,015 100.0 %
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Reinsurance operations
Watford Re is a licensed, Class 4 Bermuda-based reinsurer operating under the supervision of the BMA. Arch serves as our exclusive reinsurance portfolio manager and provides reinsurance-related services including exposure modeling, loss reserve recommendations, claims handling and other related services as part of our long-term services agreements with them. All reinsurance contracts are bound on our behalf by designated employees made available to us by Arch, or, in certain circumstances, by Watford Re management.
We assume reinsurance from third-party cedants or from Arch entities on a reinsurance or retrocessional basis. The retrocessions from Arch are from its reinsurance operations in the United States, Bermuda, Europe, and Australia, levering Arch’s distribution and local expertise in its markets. We also have provided, and may continue to provide, reinsurance to Arch’s insurance operations in the United States, the United Kingdom and elsewhere.
Insurance operations
In 2015 and 2016, we established insurance operations in Europe and the United States. These insurance operations provide additional points of access to our target lines of business, with the potential added benefit for lower acquisition costs and other distribution efficiencies. All of our insurance subsidiaries carry an A.M. Best “A-” (Excellent) rating and a KBRA “A” rating and through them we pursue insurance product lines similar to those we target through our reinsurance operations.
In the United States, our principal insurance subsidiaries are WSIC and its wholly-owned subsidiary, WIC, both of which are domiciled in New Jersey. WSIC is an eligible E&S lines insurer in all 50 states and the District of Columbia. WIC is an admitted insurer in all 50 states and the District of Columbia. Following our acquisition of WIC in 2016, we have expanded our certificates of authority to cover a broad range of lines of business in 49 states and the District of Columbia, and we are in the process of similarly expanding our authority in one remaining state. Both WSIC and WIC are located in New Jersey. Through WSIC and WIC we have the flexibility to access both the E&S and admitted sectors of the U.S. P&C market. Our U.S. insurance subsidiaries concentrate primarily on commercial casualty lines of insurance and have initiated writing business through select program managers.
Our insurance operations in Europe are conducted through WICE, which has its principal office in the British Overseas Territory of Gibraltar. WICE was initially formed to provide access to insurance risks across the European Union. Following Brexit, WICE concentrates on U.K. risks, predominantly in personal lines of insurance but will also entertain commercial casualty lines. The acquisition of Axeria will provide access to insurance risks across the European Union.
Our goal within our insurance operations is to be a valued, long-term capacity partner with a select group of well-established, proven program managers, with our integrated total return strategy providing them with competitive solutions for their clients. We have a strong market position with approximately $1.2 billion in capital and an “A-” rating from A.M. Best for each of our operating subsidiaries. Many of the insurers providing capacity to program managers are neither as substantially capitalized nor as highly rated as we are; having a strong insurance partner gives program managers an edge when promoting products to clients.
We believe that our ability to enter insurance markets on a largely variable cost basis, unburdened by the fixed costs that would otherwise be required to create a standalone insurance operation, provides us with another significant and fundamental advantage. We benefit from AUI’s and AUL’s industry contacts and market acumen to identify, attract and retain those program managers that satisfy our guidelines in terms of reputation, technical track record and quality of administration. While we benefit from AUI’s and AUL’s infrastructure, our acquisition and administrative costs are largely based on premiums actually produced.
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Subject to our overall underwriting guidelines, on our behalf, AUL, for WICE, or AUI, for WSIC and WIC, thoroughly conducts due diligence on each prospective program manager and approves underwriting guidelines for each specific line and class of business before delegation of the underwriting and/or claims-handling authority to any such program manager. We believe that by stringently vetting potential program managers we can advantageously and efficiently access a broad customer base while maintaining underwriting control and discipline. Fundamentally, AUL and AUI employ the same evaluation and selection criteria in scrutinizing our prospective program managers as they do for Arch’s own account. The determination by AUL and AUI as to whether to offer our policies, Arch’s policies, or both, depends on the result of the pricing analysis using the differing return assumptions of each company. On an ongoing basis, we and AUL or AUI, as applicable, monitor the business produced and financial condition of each program manager through periodic audits of underwriting, claims and operations.
Sourcing and underwriting
We have a strategic relationship pursuant to which Arch assists us in our pursuit of a highly disciplined underwriting approach, targeting lines of business that we believe will allow us to generate attractive risk-adjusted returns throughout industry market cycles. On our behalf, Arch continuously monitors the broad insurance and reinsurance market for opportunities. Specifically, Arch monitors opportunities that are anticipated to provide attractive risk-adjusted returns with a particular focus on product lines, which may have previously experienced adverse results and are therefore beginning to benefit from an increase in premium rates, and thus provide a potentially beneficial time to enter, or increase activity in, those markets. Similarly, on our behalf, Arch analyzes the market for softening product lines for which the applicable rates may provide less attractive risk-adjusted returns and potentially reduces our exposure to such lines accordingly at renewal.
Our strategy is to operate in lines of business in which underwriting expertise can make a meaningful difference in operating results. We are opportunistic in our pursuit of underwriting risks and binding business where we believe we have a competitive advantage in risk evaluation, distribution, investment strategy, or a combination of these factors. The establishment of our U.S. and European insurance operations enables us to directly access similar types of underlying risk premium as we underwrite as reinsurance, with what we believe to be better risk-adjusted pricing. Accessing premium through our insurance operations should also provide the benefit of lower acquisitions costs.
Our underwriting philosophy is based on prudent risk selection, risk diversification and comprehensive pricing analysis. We believe that the key to our approach is adherence to underwriting rigor across all types of business we underwrite. We employ a disciplined, analytical approach to underwriting. As part of the underwriting process, a variety of factors are typically assessed, including: (i) adequacy of underlying rates combined with the expected return on equity for a given insurance or reinsurance program; (ii) the industry reputation, track record, perceived financial strength and stability of the proposed client, or program manager in the case of our insurance business; (iii) the likelihood of establishing a long-term relationship with the client or program manager; (iv) the specialized knowledge and access to business that they possess; (v) the geographic area in which the client or program manager does business, together with our aggregate exposures in that area; (vi) historical loss data for the client or program manager; and (vii) projections of future loss frequency and severity.
Pursuant to our underwriting guidelines, we target an underwriting portfolio with tightly managed natural catastrophe exposure. We currently seek to limit our modeled PML for property catastrophe exposures for each peak peril and peak zone from a 1-in-250 year occurrence to no more than 10% of our total capital, which is less than most of our principal reinsurance competitors. Our conscious effort to limit our catastrophe exposure lowers the volatility of our overall underwriting portfolio and provides greater certainty as to future claims-related payout patterns and timing, dovetailing
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well with our non-investment grade investment strategy by minimizing the possibility of needing to sell investments at inopportune times in the investment market cycles.
We believe that our experienced senior management, combined with Arch’s underwriting expertise and broad market access, allows us to identify business with attractive risk-reward characteristics. As new underwriting opportunities are identified, we explore the suitability of underwriting the new business in order to take advantage of perceived market trends, particularly in lines of business for which Arch already possesses deep underwriting expertise.
Policy service and claims management
Arch provides underwriting services, portfolio management, exposure modeling, loss reserve recommendations, claims-handling, legal oversight, regulatory compliance, policy issuance and development, underwriting systems review, program manager audits, accounting support and administrative support, in each case, subject to the terms and conditions of our services agreements with Arch, including our underwriting and operational guidelines, as well as the oversight of our management and board of directors.
We believe that handling claims is an important component of customer service through which we can differentiate ourselves from our competitors. The ability to handle claims in accordance with industry best practices and standards fosters credibility in the market both with customers and with program managers. Through this arrangement with Arch, we gain access on a very cost-effective basis to highly experienced underwriting, claims and support function professionals and benefit from the exemplary customer service reputation Arch has earned over its 19-year history.
In administering claims on our behalf, Arch may engage third-party claims-handling firms to monitor, adjust and pay claims up to designated approval levels. Arch provides close supervision over any such third-party managers. Claims-handling firms are monitored and audited on an ongoing basis by Arch. When considering any proposed claims-handling delegation, Arch evaluates the candidate’s expertise, track record, staffing adequacy, reputation and licensing as required.
Reinsurance relationships
We have entered into outward quota share reinsurance agreements with Arch for each of our operating subsidiaries, which we believe provides a strong alignment of interest through Arch’s assuming a direct and meaningful sharing of the risk it underwrites for us. Subject to limited exceptions, Arch participates in a minimum 15% interest in all risks written by us, either by its own original participation, writing a companion line with us, or by accepting a minimum 15% quota share participation on all other contracts.
From time to time, we purchase third-party reinsurance when deemed advantageous from a portfolio management standpoint. We only use reinsurers carrying an “A-” or higher rating from A.M. Best or Standard & Poor’s or, alternatively, reinsurers that provide sufficient collateral to mitigate credit risk exposure.
Investment operations
Overview
Our invested assets are funded with our capital, accumulated net underwriting float, reinvested net interest income, net capital gains and borrowings to purchase investments. These invested assets are allocated between our non-investment grade portfolio and our investment grade portfolio. As of December 31, 2020, our non-investment grade portfolio represented approximately 69% of our invested assets and our investment grade portfolio represented approximately 31% of our invested assets. Our investment operations are monitored by our Chief Executive Officer, and our Chief Risk Officer and the investment committee of our board of directors.
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Our non-investment grade portfolio is comprised principally of corporate credit assets managed by HPS pursuant to separate investment management agreements with Watford Re, Watford Asset Trust I, or Watford Trust, and each of our insurance subsidiaries. Each such investment management agreement with HPS includes investment guidelines. Subject to these guidelines, HPS makes all investment decisions with respect to our non-investment grade portfolio on our behalf. Our non-investment grade investment strategy and guidelines are formulated to complement our target underwriting portfolio, and are designed to meet the projected payout characteristics of the medium- to long-tail, lower-volatility underwriting portfolio we underwrite.
The remainder of our investment portfolio is invested in investment grade assets, the largest portion of which is managed by AIM. We also have several investment grade accounts managed by other Investment Managers, including HPS.
The following chart shows the breakdown of our total investments among our non-investment grade portfolio and our investment grade portfolio as of December 31, 2020:
https://cdn.kscope.io/9d06e9a2c651f8dff6dd36162f066a29-wtre-20201231_g2.jpg
Total: $2.5 billion
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The following chart shows the breakdown of our investments by rating within our total investment portfolio as of December 31, 2020:
https://cdn.kscope.io/9d06e9a2c651f8dff6dd36162f066a29-wtre-20201231_g3.jpg
Total: $2.5 billion
Investment grade ratings, such as “BBB” and above, indicate the applicable rating agency’s view that the investment has a low risk of credit default and that the obligor has at least adequate capacity to meet its financial commitments on the obligation.
Ratings below investment grade, such as “BB”, “B” and “CCC,” indicate the applicable rating agency’s view that the investment is speculative, that the obligor is more vulnerable than investment grade-rated obligors, and that, in the event of adverse business, financial, or economic conditions, the obligor is less likely to have the capacity to meet its financial commitments on the obligation. Based on published criteria, a “BB” rating reflects the applicable rating agency’s view that, while the obligation is less vulnerable to non-payment than other speculative issues, it faces major ongoing uncertainties or exposure to adverse business, financial, or economic conditions, which could lead to the obligor’s inadequate capacity to meet its financial commitment on the obligation. A rating of “B” reflects the applicable rating agency’s view that the obligor currently has the capacity to meet its financial commitment on the obligation, but adverse business, financial, or economic conditions will likely impair the obligor’s capacity or willingness to meet its financial commitment on the obligation. A rating of “CCC” indicates the applicable rating agency’s view that the obligation is currently vulnerable to non-payment and is dependent upon favorable business, financial, and economic conditions for the obligor to meet its financial commitment on the obligation. A rating below “CCC” indicates the applicable rating agency’s view that the obligation is currently highly vulnerable to non-payment.
The following is a representative list of the industries in which we may invest: Consumer Products, Food and Beverage, Health Care, Pharmaceuticals, Tobacco, Technology, Automotive, Consumer Cyclical Services, Home Construction, Restaurants, Retailers, Insurance (Health, Life and Property and Casualty), Communications (Cable and Satellite, Media and Entertainment, Wireless and Wirelines), Banking and Other Financial Services, Capital Goods (Aerospace and Defense, Building Materials, Construction Machinery, Diversified Manufacturing), Energy, Other Industrial, and Transportation. However, we may invest in other industries if presented with attractive opportunities.
As of December 31, 2020, the composition of our portfolio by industry, excluding asset-backed securities and mortgage-backed securities, was as follows: 15.3% of our portfolio was invested in Financial Services, 10.3% in Technology, 9.7% in Health Care, 8.4% in Consumer Services and 7.5%
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in Industrials with the remainder invested in other industries (with no other industry comprising greater than 5%). As of December 31, 2020, the geographic composition of our portfolio, excluding asset-backed securities and mortgage-backed securities, was as follows: 81.6% in the United States, 10.3% in the United Kingdom, 3.6% in the Cayman Islands, and the remainder in other regions (with no other geographic region comprising greater than 2%).
A portion of our investment portfolio consists of assets that do not have a rating from one of the major rating agencies. Just as is done in connection with a potential investment in a rated debt obligation, when offered the opportunity to invest our assets into an unrated obligation, HPS thoroughly evaluates the obligor and the potential investment and makes a determination as to the inherent risks and whether the terms provide an attractive risk-adjusted return. A debt issuer may choose to forgo obtaining a rating for a number of reasons, particularly if the debt issuer is conducting a small privately placed transaction for which the ratings fees would be a burdensome expense or if the desired transaction date does not allow sufficient time for the completion of the rating process. It is also possible that a prospective issuer or the terms of the proposed obligation would not meet the rating agency requirements for the level of rating desired by the obligor company.
The following table shows the components of our net investment income (loss) on investments for the periods indicated:
Year Ended December 31,
202020192018
($ in thousands)
Interest income$140,390 $163,888 $152,916 
Investment management fees - related parties(17,193)(18,392)(17,006)
Borrowing and miscellaneous other investment expenses
(16,807)(29,285)(28,377)
Net interest income106,390 116,211 107,533 
Realized and unrealized gain (loss) on investments
19,629 24,243 (113,834)
Investment performance fees - related parties(12,037)(12,191)(48)
Net investment income (loss)$113,982 $128,263 $(6,349)
Non-investment grade portfolio
Background on HPS. HPS is a global investment firm with a focus on non-investment grade credit. Established in 2007, HPS has over 150 investment professionals and over 380 total employees. HPS manages capital for sophisticated investors, including financial institutions, public and corporate pension funds, sovereign wealth funds, funds of funds, endowments, foundations and family offices, as well as individuals. HPS is headquartered in New York with eleven additional offices globally. HPS has approximately $68 billion of assets under management as of December 31, 2020.
Investment strategy.
Our non-investment grade portfolio seeks to generate attractive risk-adjusted returns comprising current interest income, trading gains and capital appreciation, with an emphasis on capital preservation. To execute the non-investment grade component of our investment strategy, we mandated HPS with a strategy that (i) is designed to meet the projected payout characteristics of the medium- to long-term, lower-volatility underwriting portfolio we underwrite and (ii) seeks to achieve risk-adjusted returns that exceed those of typical reinsurer investment portfolios by focusing on non-investment grade assets, with the flexibility to invest a limited portion of this portfolio in less liquid assets. Specifically, we seek to achieve investment returns that exceed those returns achieved by our competitors from their fixed-income portfolios. We believe this strategy provides us with risk-adjusted returns that are both attractive and appropriate given our underwriting portfolio.
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HPS manages our non-investment grade corporate credit assets, including bank loans and high yield bonds, and may also invest in other instruments such as mezzanine debt, equities, credit default swaps, structured credit instruments and other derivative products. Our non-investment grade portfolio seeks to generate attractive risk-adjusted returns comprising current interest income, trading gains and capital appreciation, with an emphasis on capital preservation. Pursuant to these investment guidelines, HPS is permitted to hedge the assets in our non-investment grade portfolio to reduce volatility and protect against systemic risks, as well as to enter into opportunistic short positions. Other than cash and cash equivalents, investment positions with a single issuer will comprise no more than 7.5% of the aggregate Long Market Value (defined as the value of the long investments of the portfolio of Watford Re or Watford Trust, valued using the methodologies set forth in Watford Re’s or Watford Trust’s investment management agreement with HPS, as applicable) of our non-investment grade portfolio. Positions established primarily for hedging purposes (including, without limitation, index positions) are not subject to this limit, and capital structure arbitrage positions in an issuer are deemed separate investments for the purposes of these limitations.
Through this strategy, we seek to achieve risk-adjusted returns that exceed those of typical reinsurer investment portfolios by focusing on non-investment grade assets, with the flexibility to invest a limited portion of this portfolio in less liquid assets. Limited positions in equity securities are also permitted, subject to our non-investment grade investment guidelines, which are an integral component of each applicable investment management agreement. Generally, any equity investments are not expected, in the aggregate, to represent more than 10% of the Long Market Value of our non-investment grade portfolio, and are expected to be focused on either a value-oriented approach or a catalyst to a realization event, which include restructurings, lawsuits and regulatory changes, among other examples. Equity investments resulting in ownership exceeding 18.5% of the outstanding equity securities of an issuer, measured at the time of investment, will require our prior approval. HPS may also utilize other investment instruments for our non-investment grade portfolio, subject to our non-investment grade investment guidelines.
The non-investment grade investment guidelines under Watford Trust’s and our insurance subsidiaries’ respective investment management agreements with HPS also contain certain limitations relating to, among other things, the concentration of investments and utilization of leverage. As of December 31, 2020, HPS was in compliance with all non-investment grade investment guidelines.
In order to implement our non-investment grade investment strategy, HPS may also, from time to time and upon consultation with us, invest a portion of our non-investment grade portfolio in investment funds managed by HPS. While there is no codified limit on the portion of our non-investment grade portfolio that may be invested in funds managed by HPS, we only expect to invest additional assets from our non-investment grade portfolio in funds managed by HPS to the extent that HPS, in consultation with us, determines that such investment would provide economic, tax, regulatory or other benefits to us (for instance, such as allowing us to access a strategy that we would not have been able to efficiently access other than through investment in such a fund). To the extent that any such assets are invested directly or indirectly in funds managed by HPS, such assets invested in funds managed by HPS are part of our non-investment grade portfolio. We pay HPS performance and management fees on the assets in our non-investment grade portfolio. Such fees are calculated on the non-investment grade portfolio as a whole such that the assets, if any, invested in HPS-managed funds were to increase in value in a given period but the non-investment grade portfolio as a whole were to decrease during such period, we would not owe HPS a performance fee for such period. Similarly, if the assets, if any, invested in HPS-managed funds were to decrease in value in a given period but the non-investment grade portfolio as a whole were to increase during such period, we would owe HPS a performance fee for such period. We do not pay HPS any separate or additional fees with respect to any such assets invested in HPS-managed funds. As of December 31, 2020 and 2019, the balance of such assets were $Nil and $30.5 million, respectively.
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When evaluating an insurer’s financial strength and determining minimum capital requirements, rating agencies and applicable regulators typically assign capital charges to not only the underwriting portfolio but also to the different classes of investment assets held by that insurer, based on the perceived level of risk and volatility. Our non-investment grade assets are viewed as riskier than investment grade assets and thereby carry higher capital charges than those assigned to investment grade assets, and therefore we may be required to hold more capital than similarly-sized traditional insurers and reinsurers, and it is possible that, for certain atypical, non-investment grade assets, we might receive minimal or no regulatory capital credit. While our strategy involves a greater degree of investment risk than is typical for traditional insurers and reinsurers, in our overall enterprise risk management framework, such increased investment risk is balanced with the more predictable timing of claims payments inherent in our underwriting portfolio, especially in relation to the lesser amount of catastrophe exposure we assume, as compared with the amount of such catastrophe risk assumed by many of our insurance and reinsurance peers. Our having a mid- to long-tail underwriting portfolio reduces, but does not entirely eliminate, the risk of needing to sell investment assets into an inopportune market cycle in order to generate cash for claims payments.
In undertaking this strategy, based on the interest rate and/or credit spread environment as of any given quarter-end, we may periodically be required to absorb mark-to-market movements in our asset valuation on our financial statements. Our model is designed to create relatively stable and predictable cash flows from both underwriting and interest income to meet insurance liabilities, which should allow us to avoid being forced to sell assets at inopportune times.
The following chart shows the composition of our non-investment grade portfolio as of December 31, 2020:
https://cdn.kscope.io/9d06e9a2c651f8dff6dd36162f066a29-wtre-20201231_g4.jpg
Total: $1.7 billion
Our investment guidelines permit HPS to utilize leverage in managing assets of Watford Re and Watford Trust (but not WICE, WSIC or WIC). Any such leverage, expressed as the excess of the value of the long investments of the portfolio of Watford Re or Watford Trust (valued using the methodologies set forth in Watford Re’s or Watford Trust’s investment management agreement with HPS, as applicable, and referred to as the Long Market Value), as applicable, over the net asset value of the portfolio as a percentage of the net asset value of the portfolio, is generally not to exceed 80%. Leverage may take a variety of forms, including borrowings to purchase additional assets, trading on margin total return swaps and other derivatives, and the use of inherently leveraged instruments. Depending upon the extent of the leverage utilized for our non-investment
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grade portfolio, the net value of our investment assets will increase or decrease at a greater rate than if leverage were not utilized.
The following chart shows the use of borrowings in our non-investment grade portfolio since 2014 and the Credit Suisse High Yield Index’s Spread-to-Worst since 2014. The spread-to-worst of the index is defined as the weighted average spread-to-worst of the bonds included in the index, where the spread-to-worst for each bond is the difference between the yield-to-worst for that bond and the yield of a U.S. Treasury security with a comparable maturity. The yield-to-worst for each bond is determined by computing the yield for that bond at all possible principal repayment dates, including the maturity date and each redemption date. The minimum of these calculated yields is the yield-to-worst, provided that, by definition, the yield must be above the yield of a U.S. Treasury security with a maturity date comparable to the bond’s yield-to-worst principal repayment date.
In the period since our inception, the credit-focused investment market experienced both a widening and then a tightening of credit spreads. As shown on the chart below, HPS, on our behalf, increased the deployment of assets into our credit-focused strategy through borrowings from our credit facility during the period in which credit spreads widened and then contracted the deployment of assets accordingly when credit spreads tightened. As demonstrated by the “Non-Investment Grade Portfolio Borrowing Ratio” chart below, our usage of borrowings to purchase additional assets in the non-investment grade portfolio increased as the Credit Suisse High Yield Index’s Spread-to-Worst widened, reflecting HPS’s view that these periods presented more attractive investment opportunities. When credit spreads later tightened, HPS, on our behalf, sold assets and we used the proceeds to repay borrowings from the credit facility.
https://cdn.kscope.io/9d06e9a2c651f8dff6dd36162f066a29-wtre-20201231_g5.jpg
(1) The non-investment grade borrowing ratio is calculated as revolving credit agreement borrowings divided by net assets.
In the chart above, the term “Borrowing Ratio” represents borrowings to purchase investments, divided by the market value of the non-investment grade portfolio net of these borrowings. From time to time, HPS takes short positions, and hedges or leverages the portfolio exposure through derivative instruments or otherwise. The chart above does not reflect the value of short positions or
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leverage inherent in derivative positions, and thus may not be fully reflective of the market exposure of the portfolio at any given time.
Our non-investment grade portfolio may purchase or short-sell securities without an offsetting position in a related security based on HPS’s determination that a particular security is undervalued or overvalued. Our non-investment grade portfolio may engage in interest rate hedging using swaps, treasuries, interest rate futures or other derivative instruments. Additionally, our non-investment grade portfolio may employ single name and index credit derivatives in an attempt to hedge credit exposure.
HPS combines a disciplined investment approach with a substantial platform for transaction sourcing. Through this platform, HPS’s investment professionals seek to identify and invest in a select number of investment opportunities. HPS is required to adhere to our non-investment grade portfolio’s investment guidelines and provides us with regular non-investment grade portfolio risk and performance updates, and provides a risk and performance review to our board of directors on a quarterly basis.
HPS’s investment process is driven by a rigorous investment screening and selection process, with the stated objective of generating attractive risk-adjusted returns comprising current interest income, trading gains and capital appreciation, with an emphasis on capital preservation. As part of HPS’s investment process, HPS manages our non-investment grade portfolio in accordance with the non-investment grade investment guidelines. HPS’s investment process emphasizes fundamental analysis and due diligence by seeking to evaluate potential investments based upon review and analysis of available public and private information including: (i) historical financial information; (ii) financial projections; (iii) business, sector and industry diligence; and (iv) legal analysis of the company and investment documentation. When possible, HPS seeks to achieve robust asset coverage in its investments.
Since our inception in 2014, starting with our initial $1.1 billion capital raise, HPS has methodically deployed the assets that we have allocated to our non-investment grade portfolio as market opportunities arose. As a result, until our non-investment grade allocation of our initial capital and underwriting float was fully deployed by HPS, our historical investment income was not reflective of a fully invested non-investment grade portfolio. The following chart depicts the deployment of the portion of our assets allocated to this non-investment grade investment strategy, including a breakout of the amount of borrowings related to purchases of non-investment grade investments in this portfolio and the commensurate increase in net interest income during the period of higher asset deployment into our credit-focused strategy. In the chart below and throughout this report, in connection with our non-investment grade portfolio, the term “net non-investment grade assets” are our total invested assets allocated to our non-investment grade investment strategy less borrowings to purchase such investments, and “net interest income” is interest income net of management fees paid to HPS and borrowing costs.
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https://cdn.kscope.io/9d06e9a2c651f8dff6dd36162f066a29-wtre-20201231_g6.jpg
The following chart shows the size and composition of our non-investment grade portfolio.https://cdn.kscope.io/9d06e9a2c651f8dff6dd36162f066a29-wtre-20201231_g7.jpg
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The table below provides the compensation to HPS, in relation to our non-investment grade portfolio, incurred for the years ended December 31, 2020, 2019 and 2018.
Year Ended December 31,
202020192018
($ in thousands)
Investment management fees and performance fees to HPS
$27,854 $29,068 $15,865 
Investment grade portfolio
In conducting our underwriting business, we maintain a portion of our assets in investment grade securities and cash. The size of our investment grade portfolio and the amount we hold in cash will vary over time based on the business we write. We hold a certain amount of investment grade securities and short-term investments, largely to satisfy regulatory requirements for our U.S. insurance subsidiaries or to post as collateral for certain of Watford Re’s clients for commercial reasons or to obtain regulatory credit for the reinsurance they purchase. As of December 31, 2020, approximately 6.2% of our investment grade portfolio was held in our U.S. subsidiaries, 89.7% was posted as collateral and the remaining 4.1% were discretionary investments.
Our investment grade portfolio is primarily managed by AIM, with certain accounts managed by other Investment Managers, including HPS, and generally holds corporate credits assets, government bonds, and asset and mortgage-backed securities. Each of AIM, HPS and our other Investment Managers manage its respective allocation of our investment grade portfolio pursuant to investment management agreements that it has entered into with Watford Re and each of our operating subsidiaries. Subject to our investment guidelines for this portfolio, AIM, HPS and our other Investment Managers make all applicable investment decisions on our behalf.
As of December 31, 2020, we had $2,498.8 million of invested assets, with $774.6 million in our investment grade portfolio, of which $589.6 million were investment grade assets managed by AIM. The following chart describes the composition of our investment grade portfolio as of December 31, 2020:
https://cdn.kscope.io/9d06e9a2c651f8dff6dd36162f066a29-wtre-20201231_g8.jpg
Total: $774.6 million
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The table below provides the compensation to AIM and HPS in relation to our investment grade portfolio for the years ended December 31, 2020, 2019 and 2018.
Year Ended December 31,
202020192018
($ in thousands)
Investment management fees to AIM
$937 $1,062 $1,176 
Investment management fees to HPS439 453 13 
Competition
The worldwide insurance and reinsurance industry is highly competitive. We compete, and will continue to compete, with major U.S. and non-U.S. insurers and reinsurers, many of which have greater financial, marketing and management resources than we do, as well as other potential providers of capital willing to assume insurance or reinsurance risk. We compete with other insurers and reinsurers primarily on the basis of overall financial strength, ratings assigned by independent rating agencies, geographic scope of business, premiums charged, contract terms and conditions, products and services offered, speed of claims payment, general reputation and experience in the particular line of insurance to be written.
We also compete with new companies that continue to be formed to enter the insurance and reinsurance markets. In addition, continued consolidation within the industry will further enhance the already competitive underwriting environment. These consolidated entities may use their enhanced market power and broader capital base to negotiate price reductions for products and services that compete with ours and we may experience rate declines and possibly write less business.
In our underwriting business, we compete with insurers that provide specialty P&C lines of insurance and reinsurance, including, among others: Aspen Insurance Holdings Limited, AXIS Capital Holdings Limited, Berkshire Hathaway, Inc., Chubb Limited, Everest Re Group Ltd., Fairfax Financial Holdings Limited, Greenlight Capital Re, Ltd., Hannover Rückversicherung AG, Lloyd’s, Markel Corporation, Munich Re Group, PartnerRe Ltd., RenaissanceRe Holdings Ltd., Third Point Reinsurance Ltd., Transatlantic Reinsurance Company and AXA XL Ltd.
See Part I, Item 1A, “Risk factors-Risks related to our insurance and reinsurance business-We operate in a highly competitive environment and we may not be able to compete successfully in our industry.”
Human Resources
Our Culture and Human Resources
Collaboration is at the heart of our culture, fostered by our management team and fundamental to our strategic alliances with Arch and HPS. Our culture relies on our talented, driven and dedicated employees, consultants and business partners and our values embrace teamwork, honesty and inclusiveness. The dedication of our team was reflected in how quickly and successfully we transitioned to working remotely as a result of navigating through the COVID-19 global pandemic. This was also demonstrated through our team’s commitment to the Company’s transition from a private company to a public company in 2019.
In order to support our values of honesty and integrity our employees annually certify that they have reviewed, understand and agree to comply with the Company’s Code of Business Conduct and Employee Handbook.
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Employees
In accordance with our strategy to maintain an efficient operational structure with minimal fixed expenses, we have chosen to operate largely through experienced service partners, each of which is paid on a variable cost basis and which is monitored by our senior management team.
As of December 31, 2020, we had eleven full-time employees, nine of whom were based in Bermuda, one of whom was based in the United States and one of whom was based in Europe. In addition, pursuant to our services agreements with Arch, as of December 31, 2020, there were sixty-three designated employees of Arch, who were provided to us on a non-exclusive basis to perform various services in connection with our insurance and reinsurance operations.
We invest in our employees by offering competitive salaries and benefits, including share based compensation for eligible employees under our stock incentive plan. Employees are encouraged to continue their education and professional development, which are supported by Watford.
Information technology
Pursuant to our services agreements with Arch, Arch is responsible for the connectivity and maintenance of our information technology systems in Bermuda, the United States and Europe. These are the same systems that Arch utilizes for its own operations, accounting and to service its underwriting portfolios. Arch maintains the secure information technology environment, including secure Internet connections and electronic data transmission.
Such information technology and application systems are an important part of our underwriting process and our ability to compete successfully. We license the majority of our systems and data from third parties. Arch’s information technology team constantly monitors the system for breaches or failures, including those resulting from a cyberattack on us or our business partners and service providers.
We use our information technology systems to process, transmit, store and protect our electronic information, financial data and proprietary models that we utilize in our business and for the communications between our employees and our business, banking and investment partners.
Arch has established and implemented security measures, controls and procedures that it believes are appropriate to safeguard its and our information technology systems and to prevent unauthorized access to such systems and any data processed or stored in such systems, and our system is periodically evaluated and tested by expert third parties for the adequacy of such systems, controls and procedures. In addition, we have established, and continue to augment, a business continuity plan, which is designed to ensure that we are able to maintain all aspects of our key business processes functioning in the midst of certain disruptive events, including any disruptions to or breaches of our information technology systems. Our business continuity plan has been tested and evaluated for adequacy.
Regulation
General
Our insurance and reinsurance subsidiaries are subject to varying degrees of regulation and supervision in the various jurisdictions in which they operate. We are subject to extensive regulation under applicable statutes in these countries and any other jurisdictions in which we operate. The current material regulations under which we operate are described below. We may become subject in the future to regulation in new jurisdictions or to additional regulations in existing jurisdictions.
Bermuda insurance regulation
The Insurance Act, pursuant to which the BMA regulates Watford Re, provides that no person shall carry on insurance or reinsurance business in or from within Bermuda, unless registered under the
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Insurance Act by the BMA. The Insurance Act does not distinguish between insurers and reinsurers: companies are registered under the Insurance Act as “insurers.” The Insurance Act uses the defined term “insurance business” to include reinsurance.
The BMA is required by the Insurance Act to determine whether the applicant is a fit and proper body to be engaged in the insurance or reinsurance business and, in particular, whether it has, or has available to it, adequate knowledge and expertise. The registration of an applicant as an insurer is subject to its complying with the terms of its registration and such other conditions as the BMA may impose at any time.
The Insurance Act imposes solvency and liquidity standards on Bermuda insurance and reinsurance companies, as well as auditing and reporting requirements. The Insurance Act also grants to the BMA powers to supervise, investigate and intervene in the affairs of insurance and reinsurance companies.
Certain significant aspects of the Bermuda insurance and reinsurance regulatory framework are set forth below.
Classification of insurers
The Insurance Act distinguishes between insurers and reinsurers carrying on long-term business, insurers and reinsurers carrying on general business and insurers and reinsurers carrying on special purpose business. There are six classifications of insurers and reinsurers carrying on general business, ranging from Class 1 insurers (pure captives subject to the lightest regulation) to Class 4 insurers (large commercial carriers subject to the most stringent regulation). Watford Re is licensed as a Class 4 insurer in Bermuda and is regulated as such under the Insurance Act.
Classification as a Class 4 insurer
A body corporate is registrable as a Class 4 insurer where (i) it has at the time of its application for registration, or will have before it carries on insurance or reinsurance business, a total statutory capital and surplus of not less than U.S. $100 million; and (ii) it intends to carry on general insurance and/or reinsurance business, including excess liability business or property catastrophe reinsurance business.
Minimum paid up share capital
Class 4 insurers are required to maintain fully paid-up share capital of at least U.S. $1 million.
Principal office and principal representative
As a Class 4 insurer, Watford Re is required to maintain a head and a principal office in Bermuda and to appoint and maintain a principal representative in Bermuda. For the purposes of the Insurance Act, the principal office of Watford Re is located at Waterloo House, 1st Floor, 100 Pitts Bay Road, Pembroke HM 08, Bermuda. Watford Re’s principal representative is Robert Hawley, the Chief Financial Officer of Watford Re.
Without a reason acceptable to the BMA, a Class 4 insurer may not terminate the appointment of its principal representative, and the principal representative may not cease to act as such, unless 30 days’ notice in writing to the BMA is given of the intention to do so.
It is the duty of the principal representative to forthwith notify the BMA where the principal representative reaches the view that there is a likelihood of the Class 4 insurer becoming insolvent, or on it coming to the knowledge of the principal representative, or the principal representative has reasonable grounds for believing that a reportable “event” has occurred. Examples of a reportable “event” include a failure by the Class 4 insurer to comply substantially with a condition imposed upon it by the BMA relating to a solvency margin or a liquidity or other ratio, a significant loss reasonably likely to cause the Class 4 insurer to fail to comply with its enhanced capital requirement
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(discussed below) and the occurrence of a “material change” (as such term is defined under the Insurance Act) in its business operations.
Within 14 days of such notification to the BMA, the principal representative must furnish the BMA with a written report setting out all the particulars of the case that are available to the principal representative.
Where there has been a significant loss which is reasonably likely to cause the Class 4 insurer to fail to comply with its enhanced capital requirement, the principal representative must also furnish the BMA with a capital and solvency return reflecting an enhanced capital requirement prepared using post-loss data. The principal representative must provide this within 45 days of notifying the BMA regarding the loss.
Furthermore, where a notification has been made to the BMA regarding a material change, the principal representative has 30 days from the date of such notification to furnish the BMA with unaudited interim statutory financial statements in relation to such period as the BMA may require, together with a general business solvency certificate in respect of those statements.
Head office
As a Class 4 insurer, Watford Re is required to maintain its head office in Bermuda and its insurance business must be directed and managed from Bermuda. In determining whether Watford Re satisfies this requirement, the BMA shall consider, among other things, the following factors: (i) where the underwriting, risk management and operational decision making of Watford Re occurs; (ii) whether the presence of senior executives who are responsible for, and involved in, the decision making related to the insurance business of Watford Re are located in Bermuda; and (iii) where meetings of the board of directors of Watford Re occur. In making its determination, the BMA may also have regard to: (i) the location where management of Watford Re meets to effect policy decisions of Watford Re; (ii) the residence of the officers, insurance managers or employees of Watford Re; and (iii) the residence of one or more directors of Watford Re in Bermuda. This provision does not apply to an insurer that has a permit to conduct business in Bermuda under the Companies Act or the Non-Resident Insurance Undertakings Act 1967.
Loss reserve specialist
As a Class 4 insurer, Watford Re is required to appoint an individual approved by the BMA to be its loss reserve specialist. In order to qualify as an approved loss reserve specialist, the applicant must be an individual qualified to provide an opinion in accordance with the requirements of the Insurance Act and the BMA must be satisfied that the individual is fit and proper to hold such an appointment.
A Class 4 insurer is required to submit annually an opinion of its approved loss reserve specialist with its capital and solvency return. The loss reserve specialist’s opinion must state, among other things, whether or not the aggregate amount of technical provisions shown in the statutory economic balance sheet as at the end of the relevant financial year: (i) meets the requirements of the Insurance Act and (ii) makes reasonable provision for the total technical provisions of the insurer or reinsurer under the terms of its insurance or reinsurance contracts and agreements.
Annual financial statements
Watford Re is required to prepare and submit, on an annual basis, audited GAAP and statutory financial statements, as defined below.
The Insurance Act prescribes rules for the preparation and substance of statutory financial statements (which include, in statutory form, a balance sheet, an income statement, a statement of capital and surplus and notes thereto). The statutory financial statements include detailed
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information and analysis regarding premiums, claims, reinsurance and investments of the insurer or reinsurer.
In addition, Watford Re is also required to prepare and submit to the BMA financial statements which have been prepared under generally accepted accounting principles or international financial reporting standards, or GAAP financial statements. Watford Re’s annual GAAP financial statements and the auditor’s report thereon, and the statutory financial statements are required to be filed with the BMA within four months from the end of the relevant financial year (unless specifically extended with the approval of the BMA). The statutory financial statements do not form a part of the public records maintained by the BMA, but the GAAP financial statements are available for public inspection.
Declaration of compliance
At the time of filing its statutory financial statements, a Class 4 insurer is also required to deliver to the BMA a declaration of compliance, in such form and with such content as may be prescribed by the BMA, declaring whether or not the Class 4 insurer has, with respect to the preceding financial year: (i) complied with all requirements of the minimum criteria applicable to it; (ii) complied with the minimum margin of solvency as at its financial year end; (iii) complied with the applicable enhanced capital requirements as at its financial year end; (iv) complied with applicable conditions, directions and restrictions on, or approvals granted to, the Class 4 insurer; and (v) complied with the minimum liquidity ratio as at its financial year end. The declaration of compliance is required to be signed by two directors of the Class 4 insurer and if the Class 4 insurer has failed to comply with any of the requirements referenced in (i) through (v) above, the Class 4 insurer will be required to provide the BMA with particulars of such failure in writing. A Class 4 insurer shall be liable to a civil penalty by way of a fine for failure to comply with a duty imposed on it in connection with the delivery of the declaration of compliance.
Annual statutory financial return and annual capital and solvency return
As a Class 4 insurer, Watford Re is required to file with the BMA a statutory financial return no later than four months after its financial year end (unless specifically extended with the approval of the BMA). The statutory financial return of a Class 4 insurer shall consist of: (i) an insurer information sheet; (ii) an auditor’s report; (iii) the statutory financial statements; and (iv) notes to the statutory financial statements.
The insurer information sheet shall state, among other matters: (i) whether the general purpose financial statements of Watford Re for the relevant year have been audited and an unqualified opinion issued; (ii) the minimum margin of solvency applying to Watford Re and whether such margin was met; (iii) whether or not the minimum liquidity ratio applying to Watford Re for the relevant year was met; and (iv) whether or not Watford Re has complied with every condition attached to its certificate of registration. The insurer information sheet shall state if any of the questions identified in items (ii), (iii) or (iv) above is answered in the negative, whether or not Watford Re has taken corrective action in any case and, where Watford Re has taken such action, describe the action in an attached statement. The directors are required to certify whether the minimum solvency margin has been met.
Where an insurer’s accounts have been audited for any purpose other than compliance with the Insurance Act, a statement to that effect must be filed with the statutory financial return.
In addition, each year Watford Re is required to file with the BMA a capital and solvency return along with its annual statutory financial return. The prescribed form of capital and solvency return comprises Watford Re’s Bermuda Solvency Capital Requirement, or BSCR, model or an approved internal capital model in lieu thereof (more fully described below), a schedule of fixed income and equity investments by BSCR rating, a schedule of funds held by ceding reinsurers in segregated accounts/trusts by BSCR rating, a schedule of net loss and loss expense provisions by line of business,
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a schedule of geographic diversification of net loss and loss expense provisions, a schedule of premiums written by line of business, a schedule of geographic diversification of net premiums written by line of business, a schedule of risk management, a schedule of fixed income securities, a schedule of commercial insurer’s solvency self-assessment, a schedule of catastrophe risk return, a schedule of loss triangles or reconciliation of net loss reserves, a schedule of eligible capital, a statutory economic balance sheet, the loss reserve specialist’s opinion, a schedule of regulated non-insurance financial operating entities, a schedule of solvency, a schedule of particulars of ceded reinsurance, a schedule of cash and cash equivalent counterparty analysis, a schedule of currency risk and a schedule of concentration risk.
Neither the statutory financial return nor the capital and solvency return is available for public inspection.
Quarterly financial return
As a Class 4 insurer, Watford Re is required to prepare and file quarterly financial returns with the BMA on or before the last day of the months of May, August and November of each year. The quarterly financial returns consist of: (i) quarterly unaudited financial statements for each financial quarter (which must minimally include a balance sheet and income statement and must also be recent and not reflect a financial position that exceeds two months); (ii) a list and details of material intra-group transactions that Watford Re is a party to and Watford Re’s risk concentrations that have materialized since the most recent quarterly or annual financial returns, details surrounding all intra-group reinsurance and retrocession arrangements and other intra-group risk transfer insurance business arrangements that have materialized since the most recent quarterly or annual financial returns; and (iii) details of the ten largest exposures to unaffiliated counterparties and any other unaffiliated counterparty exposures exceeding 10% of Watford Re’s statutory capital and surplus.
Public disclosures
Pursuant to recent amendments to the Insurance Act all commercial insurers, reinsurers, insurance groups and reinsurance groups are required to prepare and file with the BMA, and also publish on their website, a financial condition report. The BMA has discretion to approve modifications and exemptions to the public disclosure rules, on application by the insurer or reinsurer if, among other things, the BMA is satisfied that the disclosure of certain information will result in a competitive disadvantage or compromise confidentiality obligations of the insurer or reinsurer.
Independent approved auditor
A Class 4 insurer must appoint an independent auditor who will audit and report on the Class 4 insurer’s GAAP financial statements and provide audit assurance that its statutory financial statements were derived from its GAAP financial statements, each of which are required to be filed annually with the BMA.
Non-insurance business
No Class 4 insurer may engage in non-insurance business, unless that non-insurance business is ancillary to its core business. Non-insurance business means any business other than insurance or reinsurance business and includes carrying on investment business, managing an investment fund as operator, carrying on business as a fund administrator, carrying on banking business, underwriting debt or securities or otherwise engaging in investment banking, engaging in commercial or industrial activities and carrying on the business of management, sales or leasing of real property.
Minimum solvency margin and enhanced capital requirements
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The Insurance Act provides that the value of the statutory assets of an insurer must exceed the value of its statutory liabilities by an amount greater than its prescribed minimum solvency margin, or MSM.
The MSM that must be maintained by a Class 4 insurer with respect to its general business is the greater of (i) $100 million or (ii) 50% of net premiums written (with a credit for reinsurance ceded not exceeding 25% of gross premiums) or (iii) 15% of net loss and loss expense provisions and other insurance reserves or (iv) 25% of the ECR as reported at the end of the relevant year.
Class 4 insurers are also required to maintain available statutory economic capital and surplus at a level equal to or in excess of its ECR which is established by reference to either the BSCR model or an approved internal capital model.
The BSCR model is a risk-based capital model which provides a method for determining an insurer’s capital requirements (statutory economic capital and surplus) by taking into account the risk characteristics of different aspects of Watford Re’s business. The BSCR formula establishes capital requirements for ten categories of risk: fixed income investment risk, equity investment risk, interest rate/liquidity risk, currency risk, concentration risk, premium risk, reserve risk, credit risk, catastrophe risk and operational risk. For each category, the capital requirement is determined by applying factors to asset, premium, reserve, creditor, probable maximum loss and operation items, with higher factors applied to items with greater underlying risk and lower factors for less risky items.
While not specifically referred to in the Insurance Act (or required thereunder), the BMA has also established a target capital level, or TCL, for each Class 4 insurer equal to 120% of its ECR. The TCL serves as an early warning tool for the BMA and failure to maintain statutory capital at least equal to the TCL will likely result in increased regulatory oversight.
Any Class 4 insurer which at any time fails to meet its MSM requirements must, upon becoming aware of such failure, immediately notify the BMA and, within 14 days thereafter, file a written report with the BMA containing particulars of the circumstances that gave rise to the failure and setting out its plan detailing specific actions to be taken and the expected timeframe in which Watford Re intends to rectify the failure.
Any Class 4 insurer which at any time fails to meet its applicable enhanced capital requirement shall upon becoming aware of that failure, or of having reason to believe that such a failure has occurred, immediately notify the BMA in writing and within 14 days of such notification file with the BMA a written report containing particulars of the circumstances leading to the failure; and a plan detailing the manner, specific actions to be taken and time within which Watford Re intends to rectify the failure and within 45 days of becoming aware of that failure, or of having reason to believe that such a failure has occurred, furnish the BMA with: (i) unaudited statutory economic balance sheets and unaudited interim statutory financial statements prepared in accordance with GAAP covering such period as the BMA may require; (ii) the opinion of a loss reserve specialist in relation to the total general business insurance technical provisions as set out in the economic balance sheet, where applicable; (iii) a general business solvency certificate in respect of the financial statements; and (iv) a capital and solvency return reflecting an enhanced capital requirement prepared using post-failure data where applicable.
Eligible capital
To enable the BMA to better assess the quality of the Class 4 insurer’s capital resources, a Class 4 insurer is required to disclose the makeup of its capital in accordance with the “3-tiered eligible capital system.” Under this system, all of the Class 4 insurer’s capital instruments will be classified as either basic or ancillary capital which in turn will be classified into one of three tiers based on their “loss absorbency” characteristics. Highest quality capital will be classified Tier 1 Capital and lesser quality capital will be classified as either Tier 2 Capital or Tier 3 Capital. Under this regime, up to
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certain specified percentages of Tier 1, Tier 2 and Tier 3 Capital may be used to support the Class 4 insurer’s MSM, ECR and TCL.
The characteristics of the capital instruments that must be satisfied to qualify as Tier 1, Tier 2 and Tier 3 Capital are set out in the Insurance (Eligible Capital) Rules 2012, and amendments thereto. Under these rules, Tier 1, Tier 2 and Tier 3 Capital may, until January 1, 2026, include capital instruments that do not satisfy the requirement that the instrument be non-redeemable or settled only with the issuance of an instrument of equal or higher quality upon a breach, or if it would cause a breach, of the ECR.
Minimum liquidity ratio
The Insurance Act provides a minimum liquidity ratio for general business insurers and reinsurers. A Class 4 insurer engaged in general business is required to maintain the value of its relevant assets at not less than 75% of the amount of its relevant liabilities. Relevant assets include cash and time deposits, quoted investments, unquoted bonds and debentures, first liens on real estate, investment income due and accrued, accounts and premiums receivable, reinsurance balances receivable, funds held by ceding reinsurers and any other assets which the BMA, on application in any particular case made to it with reasons, accepts in that case.
Certain categories of assets which, unless specifically permitted by the BMA, do not automatically qualify as relevant assets, such as unquoted equity securities, investments in and advances to affiliates and real estate and collateral loans.
The relevant liabilities include total general business insurance and reinsurance reserves and total other liabilities less deferred income tax and letters of credit and guarantees.
Code of conduct
The Insurance Code of Conduct, or the Insurance Code prescribes the duties, standards, procedures and sound business principles which must be complied with by all insurers and reinsurers registered under the Insurance Act. Failure to comply with the requirements of the Insurance Code will be taken into account by the BMA in determining whether an insurer or reinsurer is conducting its business in a sound and prudent manner as prescribed by the Insurance Act, may result in the BMA exercising its powers of intervention and investigation (see below) and will be a factor in calculating the operational risk charge under the insurer or reinsurer’s BSCR or approved internal model.
Restrictions on dividends and distributions
A Class 4 insurer is prohibited from declaring or paying a dividend if it is in breach of its MSM, ECR or minimum liquidity ratio or if the declaration or payment of such dividend would cause such a breach. Where a Class 4 insurer fails to meet its MSM or minimum liquidity ratio on the last day of any financial year, it will be prohibited from declaring or paying any dividends during the next financial year without the approval of the BMA.
In addition, a Class 4 insurer is prohibited from declaring or paying in any financial year dividends of more than 25% of its total statutory capital and surplus (as shown on its previous financial year’s statutory balance sheet), unless it files (at least seven days before payment of such dividends) with the BMA an affidavit signed by at least two directors (one of whom must be a Bermuda-resident director if any of the Class 4 insurer’s directors are resident in Bermuda) and the principal representative stating that it will continue to meet its solvency margin and minimum liquidity ratio. Where such an affidavit is filed, it shall be available for public inspection at the offices of the BMA.
Reduction of capital
A Class 4 insurer may not reduce its total statutory capital by 15% or more, as set out in its previous year’s financial statements, unless it has received the prior approval of the BMA. Total statutory capital consists of the insurer’s paid in share capital and its contributed surplus (sometimes called
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additional paid in capital) and any other fixed capital designated by the BMA as statutory capital (such as letters of credit).
A Class 4 insurer seeking to reduce its statutory capital by 15% or more, as set out in its previous year’s financial statements, is also required to submit an affidavit signed by at least two directors (one of whom must be a Bermuda-resident director if any of the Class 4 insurer’s directors are resident in Bermuda) and the principal representative stating that the proposed reduction will not cause it to fail its relevant margins and such other information as the BMA may require. Where such an affidavit is filed, it shall be available for public inspection at the offices of the BMA.
Supervision, investigation and intervention
The BMA may, by notice in writing served on a registered person or a designated insurer or reinsurer, require the registered person or designated insurer or reinsurer to provide such information and/or documentation as the BMA may reasonably require with respect to matters that are likely to be material to the performance of its supervisory functions under the Insurance Act. In addition, it may require the auditor, underwriter, accountant or any other person with relevant professional skill of such registered person or a designated insurer or reinsurer to prepare a report on any aspect pertaining thereto. In the case of a report, the person so appointed shall immediately give the BMA written notice of any fact or matter of which he becomes aware or which indicates to him that any condition attaching to his registration under the Insurance Act is not or has not, or may not be or may not have been fulfilled and that such matters are likely to be material to the performance of its functions under the Insurance Act. If it appears to the BMA to be desirable in the interests of the clients of a registered person or relevant insurance or reinsurance group, the BMA may also exercise these powers in relation to subsidiaries, parent companies and other affiliates of the registered person or designated insurer or reinsurer.
If the BMA deems it necessary to protect the interests of the policyholders or potential policyholders of an insurer, reinsurer, insurance group or reinsurance group, it may appoint one or more competent persons to investigate and report on the nature, conduct or state of the insurer, reinsurer, insurance group or reinsurance group’s business, or any aspect thereof, or the ownership or control of the insurer, reinsurer, insurance group or reinsurance group. If the person so appointed thinks it necessary for the purposes of his investigation, he may also investigate the business of any person who is or has been, at any relevant time, a member of the insurance group or reinsurance group or of a partnership of which the person being investigated is a member. In this regard, it shall be the duty of every person who is or was a controller, officer, employee, agent, banker, auditor, accountant, barrister, attorney or insurance manager to produce to the person appointed such documentation as he may reasonably require for the purpose of the investigation, and to attend and answer questions relevant to the investigation and to otherwise provide such assistance as may be necessary in connection therewith.
Where the BMA suspects that a person has failed to properly register under the Insurance Act or that a registered person or designated insurer or reinsurer has failed to comply with a requirement of the Insurance Act or that a person is not, or is no longer, a fit and proper person to perform functions in relation to a regulated activity, it may, by notice in writing, carry out an investigation into such person (or any other person connected thereto). In connection therewith, the BMA may require every person who is or was a controller, officer, employee, agent, banker, auditor, accountant, barrister, attorney or insurance manager to make a report and produce such documents in his care, custody and control and to attend before the BMA to answer questions relevant to the BMA’s investigation and to take such actions as the BMA may direct. The BMA may also enter any premises for the purposes of carrying out its investigation and may petition the court for a warrant if: (i) it believes a person has failed to comply with a notice served on him; (ii) there are reasonable grounds for suspecting the incompleteness of any information or documentation produced in response to such notice; or (iii) that its directions will not be complied with or that any relevant documents would be removed, tampered with or destroyed.
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If it appears to the BMA that the business of the registered insurer or reinsurer is being conducted in a way that there is a significant risk of the insurer or reinsurer becoming insolvent or unable to meet its obligations to its policyholders, or that the insurer or reinsurer is in breach of the Insurance Act or any conditions imposed upon its registration, or the minimum criteria stipulated in the Insurance Act is not or has not been fulfilled in respect of a registered insurer or reinsurer, or that a person has become a controller without providing the BMA with the appropriate notice or in contravention of a notice of objection, or the registered insurer or reinsurer is in breach of its ECR, the BMA may issue such directions as it deems desirable for safeguarding the interests of the policyholders or potential policyholders of the insurer, reinsurer, insurance group or reinsurance group. The BMA may, among other things, direct an insurer or reinsurer: (i) not to take on any new insurance or reinsurance business; (ii) not to vary any insurance or reinsurance contract if the effect would be to increase its liabilities; (iii) not to make certain investments; (iv) to realize certain investments; (v) to maintain or transfer to the custody of a specified bank, certain assets; (vi) not to declare or pay any dividends or other distributions or to restrict the making of such payments; (vii) to limit its premium income; (viii) not to enter into any specified transaction with any specified persons or persons of a specified class; (ix) to provide such written particulars relating to the financial circumstances of the insurer or reinsurer as the BMA thinks fit; (x) to obtain the opinion of a loss reserve specialist and to submit it to the BMA; and (xi) to remove a controller or officer.
Fit and proper controller
The BMA maintains supervision over the controllers of all registered insurers and reinsurers in Bermuda.
A controller includes: (i) the managing director of the registered insurer, reinsurer or its parent company; (ii) the chief executive of the registered insurer, reinsurer, or of its parent company; (iii) a 10%, 20%, 33% or 50% shareholder controller; and (iv) any person in accordance with whose directions or instructions the directors of the registered insurer, reinsurer, or of its parent company are accustomed to act.
The definition of shareholder controller is set out in the Insurance Act, but generally refers to: (i) a person who holds 10% or more of the shares carrying rights to vote at a shareholders’ meeting of the registered insurer, reinsurer, or its parent company; (ii) a person who is entitled to exercise 10% or more of the voting power at any shareholders’ meeting of such registered insurer, reinsurer, or its parent company; or (iii) a person who is able to exercise significant influence over the management of the registered insurer, reinsurer, or its parent company by virtue of its shareholding or its entitlement to exercise, or control the exercise of, the voting power at any shareholders’ meeting.
A shareholder controller that owns 10% or more, but less than 20% of the shares as described above is defined as a 10% shareholder controller. A shareholder controller that owns 20% or more, but less than 33% of the shares as described above is defined as a 20% shareholder controller. A shareholder controller that owns 33% or more but less than 50% of the shares as described above is defined as a 33% shareholder controller. A shareholder controller that owns 50% or more of the shares as described above is defined as a 50% shareholder controller.
Any person who becomes a 10%, 20%, 33% or 50% shareholder controller of us shall be required, within 45 days, to notify the BMA in writing that he or she has become such a controller. A shareholder controller is also required to serve notice in writing on the BMA within 45 days of reducing or disposing of shares such that it ceases to be a 50%, 33%, 20% or 10% shareholder controller. Any person who fails to give any such notice is guilty of an offense and shall be liable on summary conviction to a fine of U.S. $25,000.
The BMA may file a notice of objection to any person who has become a controller of any description where it appears that such person is not or is no longer, a fit and proper person to be a controller of the registered insurer or reinsurer. Before issuing a notice of objection, the BMA is
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required to serve upon the person concerned a preliminary written notice stating the BMA’s intention to issue formal notice of objection and the reasons for which it appears that the person is not or no longer considered a fit and proper person. Upon receipt of the preliminary written notice, the person served may, within 28 days, file written representations with the BMA, which shall be taken into account by the BMA in making their final determination. Any person who continues to be a controller of any description after having received a notice of objection shall be guilty of an offense and shall be liable on summary conviction to a fine of U.S. $25,000 (and a continuing fine of U.S. $500 per day for each day that the offense is continuing) or, if convicted on indictment, to a fine of U.S. $100,000 or two years in prison or both.
Notification of material changes
All registered insurers and reinsurers are required to give notice to the BMA of their intention to effect a material change within the meaning of the Insurance Act. For the purposes of the Insurance Act, the following changes are material: (i) the transfer or acquisition of insurance or reinsurance business being part of a scheme falling within, or any transaction relating to a scheme of arrangement under, Section 25 of the Insurance Act or Section 99 of the Companies Act; (ii) the amalgamation with or acquisition of another firm; (iii) engaging in unrelated business that is retail business; (iv) the acquisition of a controlling interest in an undertaking that is engaged in non-insurance or non-reinsurance business which offers services and products to persons who are not affiliates of the insurer or reinsurer; (v) outsourcing all or substantially all of the company’s actuarial, risk management compliance and internal audit functions; (vi) outsourcing all or a material part of an insurer or reinsurer’s underwriting activity; (vii) the transfer other than by way of reinsurance of all or substantially all of a line of business; (viii) the expansion into a material new line of business; (ix) the sale of an insurer or reinsurer; and (x) outsourcing the role of the chief executive or senior executive performing the duties of underwriting, actuarial, risk management, compliance, internal audit, finance or investment matters.
No registered insurer or reinsurer shall take any steps to give effect to a material change, unless it has first served notice on the BMA that it intends to effect such material change and before the end of 30 days, either the BMA has notified such company in writing that it has no objection to such change or that period has lapsed without the BMA having issued a notice of objection.
Before issuing a notice of objection, the BMA is required to serve upon the person concerned a preliminary written notice stating the BMA’s intention to issue a formal notice of objection. Upon receipt of the preliminary written notice, the person served may, within 28 days, file written representations with the BMA which shall be taken into account by the BMA in making their final determination.
Notification by registered person of change of controllers and officers
Watford Re, as a Class 4 insurer, is required to give written notice to the BMA of the fact that a person has become, or ceased to be, a controller or officer of the Class 4 insurer within 45 days of becoming aware of such fact. An officer in relation to a registered insurer or reinsurer means a director, chief executive or senior executive performing duties of underwriting, actuarial, risk management, compliance, internal audit, finance or investment matters.
Group supervision
The BMA may, in respect of an insurance group, determine whether it is appropriate for it to act as its group supervisor. An insurance group is defined as a group of companies that conducts insurance business. The Authority may make such determination where it ascertains that: (i) the group is headed by a “specified insurer” (that is to say, it is headed by either a Class 3A, Class 3B or Class 4 general business insurer or a Class C, Class D or Class E long-term insurer or another class of insurer designated by order of the BMA); (ii) where the insurance group is not headed by a “specified insurer,” where it is headed by a parent company which is incorporated in Bermuda; or (iii) where
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the parent company of the group is not a Bermuda company, in circumstances where the BMA is satisfied that the insurance group is directed and managed from Bermuda or the insurer with the largest balance sheet total is a specified insurer.
Where the BMA determines that it should act as the group supervisor, it shall designate a specified insurer that is a member of the insurance group to be the designated insurer, or the Designated Insurer, and it shall give to the Designated Insurer and other applicable insurance regulatory authority written notice of its intention to act as group supervisor. Before the BMA makes a final determination whether or not to act as group supervisor, it shall take into account any written representations made by the Designated Insurer submitted within such period as is specified in the notice.
The BMA may exclude any company that is a member of an insurance group from group supervision on the application of the Designated Insurer, or on its own initiative, provided the BMA is satisfied that: (i) the company is situated in a country or territory where there are legal impediments to cooperation and exchange of information; (ii) the financial operations of the company have a negligible impact on insurance group operations; or (iii) the inclusion of the company would be inappropriate with respect to the objectives of group supervision.
The BMA may, on its own initiative or on the application of the relevant Designated Insurer, include within group supervision a company that is a member of the group that is not on the Register of Group Particulars (described below) if it is satisfied the financial operations of the company in question may have a material impact on the insurance group’s operations and its inclusion would be appropriate having regard to the objectives of group supervision.
Once the BMA has been designated as group supervisor, the Designated Insurer must ensure that the insurance group of which it is a member appoints: (i) an individual approved by the BMA who is qualified as a group actuary to provide an opinion on the insurance group’s insurance technical provisions in accordance with the requirements of Schedule XIV “Group Statutory Economic Balance Sheet” of the Insurance (Prudential Standards) (Insurance Group Solvency Requirement) Rules 2011; and (ii) an auditor approved by the BMA to audit the financial statements of the group.
Pursuant to its powers under the Insurance Act, the BMA will maintain a register of particulars for every insurance group, or the Register of Group Particulars, for which it acts as the group supervisor, detailing the names and addresses of: (i) the Designated Insurer; (ii) each member company of the insurance group falling within the scope of group supervision; (iii) the principal representative of the insurance group in Bermuda; (iv) other competent authorities supervising other member companies of the insurance group; and (v) the insurance group auditors. The Designated Insurer must immediately notify the BMA of any changes to the above details entered on the Register of Group Particulars.
As group supervisor, the BMA will perform a number of supervisory functions including: (i) coordinating the gathering and dissemination of relevant or essential information for going concerns and emergency situations, including the dissemination of information which is of importance for the supervisory task of other competent authorities; (ii) carrying out supervisory reviews and assessments of the insurance group; (iii) carrying out assessments of the insurance group’s compliance with the rules on solvency, risk concentration, intra-group transactions and good governance procedures; (iv) planning and coordinating through regular meetings held at least annually (or by other appropriate means) with other competent authorities, supervisory activities in respect of the insurance group, both as a going concern and in emergency situations; (v) coordinating enforcement actions that may need to be taken against the insurance group or any of its members; and (vi) planning and coordinating meetings of colleges of supervisors in order to facilitate the carrying out of the functions described above.
The BMA may, for the purposes of group supervision, make rules applying to Designated Insurers which take into account any activities of the insurance group of which they are members or of
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other members of the insurance group. Such rules may make provision for the assessment of the financial situation of the insurance group; the solvency position of the insurance group (including the imposition of prudential standards in relation to enhanced capital requirements, capital and solvency returns, insurance reserves and eligible capital that must be complied with by the Designated Insurers); the system of governance and risk management of the insurance group; intra-group transactions and risk concentrations; and supervisory reporting and disclosure in respect of the insurance group.
Watford Re was designated by the BMA as a Designated Insurer on May 5, 2017 and as such we are currently subject to group supervision.
Disclosure of information
In addition to powers under the Insurance Act to investigate the affairs of an insurer or reinsurer, the BMA may require certain information from an insurer or reinsurer (or certain other persons) to be produced to the BMA. Further, the BMA has been given powers to assist other regulatory authorities, including foreign insurance regulatory authorities, with their investigations involving insurance and reinsurance companies in Bermuda if it is satisfied that the assistance being requested is in connection with the discharge of regulatory responsibilities and that such cooperation is in the public interest. The grounds for disclosure are limited and the Insurance Act provides for sanctions for breach of the statutory duty of confidentiality.
Cancellation of insurer or reinsurer’s registration
An insurer or reinsurer’s registration may be canceled by the BMA on certain grounds specified in the Insurance Act. Failure by the insurer or reinsurer to comply with its obligations under the Insurance Act, or if the BMA believes that the insurer or reinsurer has not been carrying on business in accordance with sound insurance or reinsurance principles, would be such grounds.
Certain other Bermuda law considerations
All Bermuda exempted companies are exempt from certain Bermuda laws restricting the percentage of share capital that may be held by non-Bermudians. However, exempted companies may not participate in certain business transactions, including: (i) the acquisition or holding of land in Bermuda except that required for their business held by way of lease or tenancy for a term not exceeding 50 years or, with the consent of the Minister of Economic Development granted in his discretion, land by way of lease or tenancy for a term not exceeding 21 years in order to provide accommodation or recreational facilities for its officers and employees; (ii) the taking of mortgages on land in Bermuda to secure an amount in excess of B.D.$50,000 without the consent of the relevant Ministers; (iii) the acquisition of any bonds or debentures secured by any land in Bermuda, other bonds or debentures issued by the Bermuda Government or a public authority; or (iv) the carrying on of business of any kind in Bermuda, except in furtherance of their business carried on outside Bermuda or under license granted by the Minister of Economic Development. Generally, it is not permitted without a special license granted by the Minister to insure or reinsure Bermuda domestic risks or risks of persons of, in or based in Bermuda.
All Bermuda companies must comply with the provisions of the Companies Act regulating the payment of dividends and making distributions from contributed surplus. A company may not declare or pay a dividend, or make a distribution out of contributed surplus, if there are reasonable grounds for believing that (i) it is, or would after the payment be, unable to pay its liabilities as they become due; or (ii) the realizable value of its assets would thereby be less than its liabilities.
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United States insurance regulation
General
In common with other insurers, our U.S.-based subsidiaries are subject to extensive governmental regulation and supervision in the various states and jurisdictions in which they are domiciled and licensed and/or approved to conduct business. The laws and regulations of the state of domicile have the most significant impact on operations. This regulation and supervision is designed to protect policyholders rather than investors. Generally, regulatory authorities have broad regulatory powers over such matters as licenses, standards of solvency, premium rates, policy forms, marketing practices, claims practices, investments, security deposits, methods of accounting, form and content of financial statements, reserves and provisions for unearned premiums, unpaid losses and loss adjustment expenses, reinsurance, minimum capital and surplus requirements, dividends and other distributions to shareholders, periodic examinations and annual and other report filings.
In addition, transactions among affiliates, including reinsurance agreements or arrangements, as well as certain third-party transactions, require prior regulatory approval from, or prior notice to and no disapproval by, the applicable regulator under certain circumstances. Certain insurance regulatory requirements are highlighted below. In addition, regulatory authorities conduct periodic financial, claims and market conduct examinations.
Increased federal or state regulatory scrutiny could lead to new legal precedents, new regulations, new practices, or regulatory actions or investigations, which could adversely affect our financial condition and operating results.
Credit for reinsurance
Except for certain mandated provisions that must be included in order for a ceding company to obtain credit for reinsurance ceded, the terms and conditions of reinsurance agreements generally are not subject to regulation by any governmental authority. This contrasts with admitted primary insurance policies and agreements, the rates and terms of which generally are regulated by state insurance regulators.
Certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, or the Dodd-Frank Act, provide that only the state in which a primary insurer is domiciled may regulate the financial statement credit for reinsurance taken by that primary insurer.
A primary insurer ordinarily will enter into a reinsurance agreement only if it can obtain credit for the reinsurance ceded on its U.S. statutory-basis financial statements. In general, credit for reinsurance is allowed in the following circumstances: if the reinsurer is licensed in the state in which the primary insurer is domiciled; if the reinsurer is an “accredited” or otherwise approved reinsurer in the state in which the primary insurer is domiciled; in some instances, if the reinsurer (i) is domiciled in a state that is deemed to have substantially similar credit for reinsurance standards as the state in which the primary insurer is domiciled and (ii) meets certain financial requirements; or if none of the above applies, to the extent that the reinsurance obligations of the reinsurer are collateralized appropriately, typically through the posting of a letter of credit for the benefit of the primary insurer or the deposit of assets into a trust fund established for the benefit of the primary insurer.
WIC is an admitted insurer in 50 states and the District of Columbia. WSIC is eligible to issue insurance on an excess and surplus lines basis in 50 states and the District of Columbia. Watford Re does not expect to become licensed, accredited or so approved in any U.S. jurisdiction.
On April 4, 2018, the United States and the European Union entered into the Bilateral Agreement between the United States and the European Union on Prudential Matters Regarding Insurance and Reinsurance, or the EU-US Covered Agreement, that, among other things, would eliminate reinsurance collateral requirements for qualified U.S. reinsurers operating in the EU insurance
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market, and eliminate reinsurance collateral requirements for qualified E.U. reinsurers operating in the U.S. insurance market. In December 2018, the U.S. Secretary of the Treasury and the U.S. Trade Representative announced that they had reached agreement with the United Kingdom on a covered agreement, or the UK-US Covered Agreement, that would extend terms nearly identical to the EU-US Covered Agreement to insurers and reinsurers operating in the United Kingdom in connection with the United Kingdom’s withdrawal from the European Union. In June 2019, the National Association of Insurance Commissioners, or the NAIC, adopted revisions to the Credit for Reinsurance Model Law and Regulation to address the reinsurance collateral provisions of the EU-US Covered Agreement and the UK-US Covered Agreement and that eliminate reinsurance collateral requirements for qualified reinsurers domiciled in other jurisdictions deemed “Reciprocal Jurisdictions”. The revisions also provide “Reciprocal Jurisdiction” status for accredited U.S. jurisdictions and jurisdictions deemed Qualified Jurisdictions if they meet certain requirements in the credit for reinsurance models. U.S. states must adopt these revisions prior to September 1, 2022 or face potential federal preemption by the Federal Insurance Office.
Holding company regulation
All states have enacted legislation that regulates insurance holding company systems. These regulations generally provide that each insurance company in the system is required to register with the insurance department of its state of domicile and furnish information concerning the operations of companies within the holding company system which may materially affect the operations, management or financial condition of the insurers within the system. All transactions within a holding company system affecting insurers must be fair and reasonable. Notice to the state insurance departments is required prior to the consummation of certain material transactions between an insurer and any entity in its holding company system. In addition, certain of such transactions cannot be consummated without the applicable insurance department’s prior approval, or its failure to disapprove after receiving notice. The holding company acts also prohibit any person from directly or indirectly acquiring control of a U.S. insurance company unless that person has filed an application with specified information with the insurance company’s domiciliary commissioner and has obtained the commissioner’s prior approval. Under most states’ statutes, including New Jersey (the state of domicile of our U.S. insurance subsidiaries), acquiring 10% or more of the voting securities of an insurance company or its parent company is presumptively considered an acquisition of control of the insurance company, although such presumption may be rebutted, as was the case for us, with Arch filing a disclaimer of control in connection with WSIC and WIC.