As filed with the Securities and Exchange Commission on January 16, 2007

Registration No. 333-      

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

 

Validus Holdings, Ltd.

19 Par-La-Ville Road

Hamilton HM11 Bermuda

(441) 278-9000

(Address, including zip code, and telephone number, including area code, of

registrant’s principal executive offices)

CT Corporation System

111 Eighth Avenue

New York, New York 10011

(212) 590-9200

(Name, address, including zip code, and telephone number,

including area code, of agent for service)

 

 

 

 

 

Approximate date of commencement of proposed sale to the public:   As soon as practicable after the effective date of this registration statement.

 

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.   o

 

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.   o

 

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.   o

 

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.   o

 

 

Table of Contents

 

 

You should rely only on the information contained in this prospectus. Neither we nor the underwriters have authorized any other person to provide you with different information. This prospectus is an offer to sell only the shares offered hereby, but only under circumstances and in jurisdictions where it is lawful to do so. The information contained in this prospectus is current only as of its date, regardless of the time of delivery of this prospectus or any sale of our common shares.

 

The selling shareholders are offering to sell, and seeking offers to buy, our common shares only in jurisdictions where offers and sales are permitted. The distribution of this prospectus and the public offering of our common shares in certain jurisdictions may be restricted by law. Persons outside the United States who come into possession of this prospectus must inform themselves about and observe any restrictions relating to the offering of our common shares and the distribution of this prospectus outside the United States. This prospectus does not constitute, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy, any securities offered by this prospectus by any person in any jurisdiction in which it is unlawful for such person to make such an offer or solicitation.

 

Common shares may be offered or sold in Bermuda only in compliance with the provisions of the Investment Business Act of 2003 and the Exchange Control Act of 1972, and related regulations of Bermuda which regulate the sale of securities in Bermuda. In addition, the Bermuda Monetary Authority, which we refer to herein as the “BMA,” must approve all issuances and transfers of securities of a Bermuda exempted company. We have received from the BMA permission for the issue of our common shares and for the free transferability of our common shares as long as the common shares are listed on the New York Stock Exchange or other appointed stock exchange. Any other transfers remain subject to approval by the BMA. The BMA accepts no responsibility for the financial soundness of any proposal or for the correctness of any of the statements made or opinions expressed in this prospectus.

 

PROSPECTUS SUMMARY

	•	Focus on Short-Tail Lines of Reinsurance.   Substantially all of our $475.3 million in gross premiums written for the nine months ended September 30, 2006 are in short-tail lines. Since inception we have focused on writing short-tail reinsurance risks, which is an area where we believe prices and terms provide an attractive risk adjusted return and our management team has proven expertise. We believe based on industry data that rates for U.S.  property catastrophe insurance are at the highest levels recorded, as measured by rate on line. Conversely, we believe that rates for most casualty or long-tail lines of business are declining and do not afford equivalent attractive risk adjusted returns at this point in the underwriting cycle .
	•	Management with Proven Industry Leadership Experience.   Our executive management team has an average of 21 years of industry experience and senior expertise spanning multiple aspects of the global reinsurance business. Edward J. Noonan, our chairman and chief executive officer, has 27 years of industry experience and was previously president and chief executive officer of American Re-Insurance Company. George P. Reeth, our deputy chairman and president, has 30 years of industry experience and previously served as chairman and chief executive officer of Willis Re Inc., a division of Willis Group Holdings Limited. Conan M. Ward, our chief underwriting officer, has 15 years of insurance industry experience and was previously executive vice president of the Global Reinsurance division of Axis Capital Holdings, Limited.
	•	Highly Skilled Underwriters and Analytical Staff.   Since the Company’s inception, management’s objective has been to target underwriting and technical staff who can differentiate our company through expertise and experience and who can apply analytical rigor to our goal of building a diversified portfolio of reinsurance risks. We currently employ eight underwriters in the property catastrophe, international property, marine and other specialty lines areas. These underwriters have an average of 16 years of industry experience and have produced $475.3 million in gross premiums written for the nine months ended September 30, 2006 while evaluating over 3,000 submissions and declining approximately 60% of the risks presented to them. Our risk analytics staff is comprised of 14 individuals, many of whom have advanced technical degrees, including four PhDs and three Masters degrees in related fields.
	•	Concentrated Investor Group with Strong Industry Insight. Aquiline Capital Partners and our five largest shareholders have an equity ownership interest in our company of approximately 80.0%. Members of our investor group have been sponsoring investors in previous Bermuda insurance and reinsurance companies (including GCR Holdings Limited; AXIS Capital Holdings Limited; Allied World Assurance Company Holdings, Limited; and Montpelier Re Holdings Limited) and have participated in the formation, governance, initial public offering and, in some cases, sale processes for these entities. In addition, management holds an approximate 5.5% ownership interest in the company and has similar experience in the full range of such activities at American Re-Insurance Company, Willis Group Holdings Limited and AXIS Capital Holdings Limited, among other companies.
	•	Substantial Capital with No Prior Liabilities or Contingencies.   We commenced operations with approximately $1.0 billion of equity capital and augmented our equity through the placement of $150.0 million of Junior Subordinated Deferrable Debentures in June 2006. As we are a newly formed company, our balance sheet is unencumbered by any historical losses relating to the 2005 hurricane season, the events of September 11, 2001, asbestos or other legacy exposures affecting our industry. As a result, we have no risk that deteriorating loss reserves related to legacy exposures prior to our formation will impact our future financial results.
	•	Timely Response to Market Dislocation and Capacity Shortage.   We entered the global reinsurance market during a period of imbalance between the supply of underwriting capacity

		available for reinsurance on catastrophe-exposed property, marine and energy risks and demand for such reinsurance coverage. Our business strategy was responsive to these capacity needs and as of January 1, 2006 a significant portion of our current underwriting and analytical staff was in place, including six underwriters and four catastrophe modellers and risk analytic experts. As a consequence, we believe we developed an industry reputation for thorough and timely quotes for difficult technical risks. A significant volume of property catastrophe business is written in the January 1 renewal period and we believe the combination of our available capacity, staffing levels and management leadership permitted us to underwrite an attractive portfolio of catastrophe-exposed risks at January 1, 2006. Our gross premiums written for the three months ended March 31, 2006 were $248.2 million, of which $217.4 million was underwritten at January 1. We believe based on publicly-available information that our premium volume at the January 1, 2006 renewal date exceeded that of many of our competitors, many of whom we believe were either capacity constrained based on their 2005 losses and reduced risk appetites or not yet adequately organized to respond to submissions.

	•	Balanced, Diverse Book of Short-Tail Reinsurance.   We seek to balance and diversify our portfolio both by line of business and by geography. Of our $475.3 million in gross premiums written for the nine months ended September 30, 2006, $230.2 million (48.4%) is property catastrophe reinsurance. Among other property coverages, we wrote $57.7 million (12.1%) of property pro rata and $41.2 million (8.7%) of property per risk. We also underwrote $98.0 million (20.6%) of marine reinsurance and $48.2 million (10.2%) of other specialty lines. The other specialty lines of reinsurance we underwrite — such as aerospace, life and accident & health, terrorism and workers’ compensation catastrophe coverages — are short-tail and provide us with risk diversification as they are generally non- accumulating with our property risks. We actively manage our exposures by geographic zone to maintain a diverse portfolio of underlying risks. For the nine months ended September 30, 2006, we wrote $214.2 million of gross premiums written in the United States (45.1% of total gross premiums written), $92.4 million in territories outside the United States (19.4%) and $42.4 million on a worldwide basis including the United States (8.9%). The remaining $126.3 million of our gross premiums written (26.6%) related to our marine and aerospace lines of business, which we do not classify by geographic area as risks may span multiple zones and risk exposures may not reside at fixed locations in some cases.
	•	Effective Use of Third-party Capital.   In May 2006, Validus entered into a collateralized quota share retrocession treaty with Petrel Re Limited (“Petrel Re”), a newly-formed Bermuda reinsurance company, pursuant to which Petrel Re assumes a quota share of certain lines of marine and energy and other lines of business underwritten by the Company for the 2006 and 2007 underwriting years. Petrel Re is a separate legal entity of which Validus has no equity investment, management or board interests, or “related party” relationships. This “ sidecar ” relationship provides the Company with the capacity to increase premiums written in specific programs where favorable underwriting opportunities are seen. A specified portion of this incremental business is then ceded to Petrel Re and fees are earned for the services provided in underwriting the original business. The equity investor in Petrel Re is First Reserve Corporation, a leading private equity firm with a 25-year history of investing exclusively in the energy industry. We believe that the quality of our underwriting and analytical staff, as well as our management, was one of the primary reasons that First Reserve Corporation selected us as the cedant to Petrel Re when it organized and funded the vehicle.

	•	Build on Our Already Established Market Position.   We believe that our company is widely accepted by intermediaries and ceding clients as an important provider of targeted short-tail reinsurance lines. We base this belief on subjective feedback we receive from intermediaries and ceding clients as well as objective data such as our $475.3 million in gross premiums written for the nine months ended September 30, 2006 or over 3,000 submissions received from inception to date. We approach the January 1 renewal season as the incumbent on contracts which represented $217.4 million of gross premiums written to us in 2006. Our intention is to build on our already established market position to further establish ourselves as a premier provider of global specialized short-tail reinsurance.
	•	Assess Underwriting Decisions Based on Incremental Return on Equity.   Our principal operating objective is to utilize our capital efficiently by underwriting short-tail reinsurance contracts with superior risk and return characteristics. We have developed Validus Capital Allocation and Pricing System (“VCAPS”), a proprietary computer-based system for modeling, pricing, allocating capital and analyzing catastrophe-exposed risks, and that also enables us to model various contract features, all on an expedited basis. VCAPS permits us to make underwriting decisions based on incremental return on capital.
	•	Prudently Manage Risk Accumulations.   We believe expertise in risk management is intrinsic to building a successful reinsurance organization. We have employed a chief risk officer — Stuart W. Mercer — since the formation of the company. Mr. Mercer manages a staff of 13, including four PhDs. Our primary risk measure is the aggregate amount of contractual limits to which we expose our capital. While we believe this is a more conservative risk tolerance than many of our competitors and while it may serve to diminish our profit potential in low loss years, we believe in higher loss years we will lose a smaller proportion of our capital.
	•	Employ All Forms of Capital Efficiently.   We aim to underwrite as much attractively priced business as is available and manage all forms of capital accordingly. In the current hard market for catastrophe-exposed lines of reinsurance, we have raised in excess of $1.0 billion in common equity in our initial capitalization and then augmented this capital with the creation of a $200.0 million collateralized quota share sidecar facility, Petrel Re in May 2006 and the placement of $150.0 million of Junior Subordinated Deferrable Debentures in June 2006. In addition to the prudent use of financial leverage, we intend to actively manage our capital by evaluating the returns available in the short-tail reinsurance lines, assessing returns in complementary lines of business and, where appropriate and subject to applicable law and rating agency and other considerations, returning excess capital to shareholders.

	•	We have a limited operating history and our historical financial results do not accurately indicate our future performance.   We were formed in October 2005 and were fully operational by December 2005. We, therefore, have a limited operating and financial history. We then began underwriting with risks attaching no earlier than January 1, 2006. It has been reported that among the last 20 years, 2006 has produced the third-lowest level of insured losses, after 1997 and 1988. As of December 31, 2006, we have not experienced any catastrophe events such as those experienced by the industry in 2004 and 2005 and the events of September 11, 2001, and as a result we cannot provide assurances as to how our business model or risk controls would respond to such events. There is limited historical financial and operating information available to help you evaluate our past performance or make a decision about an investment in our common shares. As a recently formed company, we face substantial business and financial risks and may suffer significant losses. As a result of these risks, it is possible that we may not be successful in the continued implementation of our business strategy or completing the development of the infrastructure necessary to run our business. In addition, particularly as a recently-formed company, our business strategy may change and may be affected by acquisition, joint venture or other business, investment and/or growth opportunities that may, in the future, become available to us or that we may pursue.
	•	Claims arising from unpredictable and severe catastrophic events could adversely affect our financial condition or results of operations.   Our reinsurance operations expose us to claims arising out of unpredictable natural and other catastrophic events, such as hurricanes, windstorms, tsunamis, severe winter weather, earthquakes, floods, fires, explosions, acts of terrorism and other natural and man-made disasters. One or more catastrophic or other events could result in claims that substantially exceed our expectations.
	•	We depend on ratings by A.M. Best Company.   Our financial strength rating could be revised downward, which could affect our standing among brokers and customers and cause our premiums and earnings to decrease. Third-party rating agencies, such as A.M. Best Company, assess and rate the financial strength of insurers and reinsurers based upon criteria established by the rating agencies, which criteria are subject to change. Our financial strength rating is subject to periodic review, and may be revised downward or revoked at the sole discretion of A.M. Best in response to a variety of factors, including a minimum capital adequacy ratio, management, earnings, capitalization and risk profile.
	•	The reinsurance business is historically cyclical, and we expect to experience periods with excess underwriting capacity and unfavorable premium rates and policy terms and conditions.   The reinsurance business historically has been characterized by periods of intense competition on price and policy terms due to excessive underwriting capacity as well as periods when shortages of capacity permit favorable premium rates and policy terms and conditions, and as a result we may experience significant fluctuations in operating results.

The Offering

 

Issuer		Validus Holdings, Ltd.
Common shares offered by us		common shares.
Common shares offered by the selling shareholders		common shares(1).
Common shares to be outstanding immediately after this offering		common shares(2).
Use of proceeds		We estimate that the net proceeds to us from this offering will be approximately $      million, based upon an assumed initial public offering price of $      per common share, representing the midpoint of the offering range set forth on the cover of this prospectus, and after deducting the underwriters’ discount and fees and expenses of the offering. We intend to use such net proceeds for general corporate purposes and to support future growth of our reinsurance operations.
		We will not receive any proceeds from the sale of common shares by the selling shareholders.
Dividend policy		We intend to pay quarterly cash dividends on our common shares at an initial rate of $      per common share payable in the first full fiscal quarter end after the date hereof. The timing and amount of any cash dividends, however, will be at the discretion of our Board of Directors and will depend upon our results of operations and cash flows, our financial position and capital requirements, general business conditions, legal, tax, regulatory, rating agency and contractual constraints or restrictions and any other factors that our Board of Directors deems relevant. See “Dividend Policy,” “Business — Regulation” and “Description of Share Capital — Dividends.”
Voting rights		Shareholders have one vote for each voting common share held by them and are entitled to vote at all meetings of shareholders. However, there are provisions in our Bye-laws that reduce the voting rights of common shares that are owned, directly, indirectly or by attribution, by a person or group to the extent that such person or group holds more than 9.09% of the aggregate voting power of all common shares entitled to vote on a matter.
NYSE symbol		Our common shares have been approved for listing on the New York Stock Exchange under the symbol “VR,” subject to official notice of issuance.

	•	assumes no exercise of the underwriters’ over-allotment option; and
	•	assumes an initial public offering price of $      per share, the midpoint of the range set forth on the cover page of this prospectus.

(1)		Does not include           common shares that the underwriters may purchase from the selling shareholders upon the exercise by the underwriters of their option to purchase additional common shares from the selling shareholders.

(2)		Of these shares,          will be voting common shares and          will be non-voting common shares. In addition, certain of our shareholders have warrants to purchase in the aggregate 14,796,810 common shares, which may be voting or non-voting, and certain of our employees have restricted shares and stock options to acquire an aggregate of 6,165,337 voting common shares as of September 30, 2006. Unvested restricted shares are not considered to be outstanding in the above table but do accumulate dividends and may be voted. See “Capitalization.”

		Three months ended				Nine months ended
		September 30, 2006				September 30, 2006
		(unaudited)				(unaudited)
		(Dollars in thousands, except share and per share amounts)
Revenues
Gross premiums written		$	116,505			$	475,284
Reinsurance premiums ceded			(38,892	)			(64,051	)
Net premiums written			77,613				411,233
Change in unearned premiums			14,885				(209,872	)
Net premiums earned			92,498				201,361
Net investment income			16,272				40,369
Net realized losses on investments			(154	)			(894	)
Foreign exchange gains			369				1,061
Total revenues			108,985				241,897
Expenses
Losses and loss expenses			11,577				67,058
Policy acquisition costs			10,638				24,574
General and administrative expenses(1)			13,641				31,007
Finance fees			3,453				5,136
Fair value of warrants issued			—				77
Total expenses			39,309				127,852
Net income			69,676				114,045
Comprehensive income
Unrealized gains arising during the period			7,353				190
Adjustment for reclassification of losses realized in income			154				894
Comprehensive income		$	77,183			$	115,129
Earnings per share (2)
Weighted average number of common shares and common share equivalents outstanding
Basic			102,344,600				102,331,833
Diluted			102,623,533				102,511,504
Basic earnings per share		$	0.68			$	1.11
Diluted earnings per share		$	0.68			$	1.11
Selected financial ratios
Losses and loss expenses ratio (3)			12.5%				33.3%
Policy acquisition cost ratio(4)			11.5%				12.2%
General and administrative expense ratio(5)			14.8%				15.4%
Expense ratio(6)			26.3%				27.6%
Combined ratio(7)			38.8%				60.9%
Annualized return on average equity(8)			25.8%				14.6%

										As of December
		As of September 30, 2006								31, 2005
		Actual				As adjusted(9)				Actual
		(Dollars in thousands, except per share amounts)
Summary Balance Sheet Data:
Investments at fair value		$	1,279,614			$				$	610,800
Cash and cash equivalents			87,457								398,488
Total assets			1,624,890								1,014,453
Unearned premiums			244,172				244,172				—
Reserve for losses and loss expenses			63,211				63,211				—
Junior Subordinated Deferrable Debentures			150,000				150,000				—
Total shareholders’ equity			1,121,707								999,806
Book value per common share(10)		$	10.96			$				$	9.78
Diluted book value per common share(11)			10.70								9.67

		Notes
(1)		General and administrative expenses for the three and nine months ended September 30, 2006 include $250,000 and $750,000, respectively, related to our Advisory Agreement with Aquiline.
(2)		Stock options which carry an average exercise price of $10.00 per option are anti-dilutive and consequently are not included in weighted average diluted shares outstanding. SFAS No. 123R requires that any unrecognized stock-based compensation expense that will be recorded in future periods be included as proceeds for purposes of treasury stock repurchases, which is applied against the unvested restricted shares balance.
(3)		Calculated by dividing losses and loss expenses by net premiums earned .
(4)		Calculated by dividing policy acquisition costs by net premiums earned.
(5)		Calculated by dividing general and administrative expenses by net premiums earned.
(6)		Calculated by combining the policy acquisition cost ratio and the general and administrative expense ratio .
(7)		Calculated by combining the loss ratio , the policy acquisition cost ratio and the general and administrative expense ratio.
(8)		Annualized return on average equity is calculated by dividing the net income for the period by the average shareholders’ equity during the period. Quarterly average shareholders’ equity is the average of the beginning and ending shareholders’ equity balances. Nine month average shareholders’ equity is the average of the beginning, ending and intervening quarter end shareholders’ equity balances.
(9)		In the “As Adjusted” column, the calculation of basic and diluted book value per share reflects payment of total fees and expenses, including underwriting discounts and commissions of $      million. The “As Adjusted” column also gives effect to this offering of our common shares at an assumed public offering price of $      per share (the midpoint of the price range set forth on the cover page of this prospectus) and the application of the net proceeds thereof, as described under “Use of Proceeds.”
(10)		Book value per common share is defined as total shareholders’ equity divided by the number of common shares outstanding as at the end of the period, giving no effect to dilutive securities.
(11)		Diluted book value per common share is calculated based on total shareholders’ equity plus the assumed proceeds from the exercise of outstanding options and warrants, divided by the sum of common shares, unvested restricted shares, options and warrants outstanding (assuming their exercise).

 

An investment in our common shares involves a number of risks. You should carefully consider the following information about these risks, together with the other information contained in this prospectus, before investing in our common shares. Additional risks not presently known to us or which we currently deem immaterial may also adversely affect our business or results of operations and/or the value of our common shares. Any of the risks described below could have a significant or material adverse effect on our results of operations or financial condition and result in a corresponding decline in the market price of our common shares. You could lose all or part of your investment.

 

This prospectus also contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements as a result of certain factors, including the risks described below and elsewhere in this prospectus. See “Cautionary Note Regarding Forward-Looking Statements.”

 

Risks Related to Our Company

 

We have a limited operating history and our historical financial results do not accurately indicate our future performance.

 

We were formed in October 2005 and were fully operational by December 2005. We, therefore, have a limited operating and financial history. We then began underwriting with risks attaching no earlier than January 1, 2006. It has been reported that among the last 20 years, 2006 has produced the third-lowest level of insured losses, after 1997 and 1988. As of December 31, 2006, we have not experienced any catastrophe events such as those experienced by the industry in 2004 and 2005 and the events of September 11, 2001, and as a result we cannot provide assurances as to how our business model or risk controls would respond to such events. There is limited historical financial and operating information available to help you evaluate our past performance or make a decision about an investment in our common shares. As a recently-formed company, we face substantial business and financial risks and may suffer significant losses. As a result of these risks, it is possible that we may not be successful in the continued implementation of our business strategy or completing the development of the infrastructure necessary to run our business. In addition, particularly as a recently-formed company, our business strategy may change and may be affected by acquisition, joint venture or other business, investment and/or growth opportunities that may, in the future, become available to us or that we may pursue.

 

Claims arising from unpredictable and severe catastrophic events could adversely affect our financial condition or results of operations.

 

Our reinsurance operations expose us to claims arising out of unpredictable natural and other catastrophic events, such as hurricanes, windstorms, tsunamis, severe winter weather, earthquakes, floods, fires, explosions, acts of terrorism and other natural and man-made disasters. Many observers believe that the Atlantic basin is in the active phase of a multi-decade cycle in which conditions in the ocean and atmosphere, including warmer-than-average sea-surface temperatures and low wind shear, enhance hurricane activity. This increase in the number and intensity of tropical storms and hurricanes can span multiple decades (approximately 20 to 30 years). These conditions may translate to a greater potential for hurricanes to make landfall in the U.S. at higher intensities over the next five years. The frequency and severity of catastrophes are inherently unpredictable.

 

The extent of losses from catastrophes is a function of both the number and severity of the insured events and the total amount of insured exposure in the areas affected. Increases in the value and concentrations of insured property, the effects of inflation and changes in cyclical weather patterns may increase the severity of claims from catastrophic events in the future. Claims from catastrophic events could reduce our earnings and cause substantial volatility in our results of operations for any fiscal quarter or year, which could adversely affect our financial condition, possibly to the extent of eliminating our shareholders’ equity. Our ability to write new reinsurance policies could also be affected as a result of corresponding reductions in our capital.

Underwriting is inherently a matter of judgment, involving important assumptions about matters that are unpredictable and beyond our control, and for which historical experience and probability analysis may not provide sufficient guidance. One or more catastrophic or other events could result in claims that substantially exceed our expectations and materially adversely effect our financial condition or results of operations.

 

We depend on ratings by A.M. Best Company. Our financial strength rating could be revised downward, which could affect our standing among brokers and customers, cause our premiums and earnings to decrease and limit our ability to pay dividends on the common shares.

 

Third-party rating agencies, such as A.M. Best Company, assess and rate the financial strength of reinsurers based upon criteria established by the rating agencies, which criteria are subject to change. The financial strength ratings assigned by rating agencies to insurance and reinsurance companies represent independent opinions of financial strength and ability to meet policyholder obligations and are not directed toward the protection of investors. Ratings have become an increasingly important factor in establishing the competitive position of insurance and reinsurance companies. Insurers and intermediaries use these ratings as one measure by which to assess the financial strength and quality of insurers and reinsurers. These ratings are often a key factor in the decision by an insured or intermediary of whether to place business with a particular insurance or reinsurance provider. These ratings are not an evaluation directed toward the protection of investors or a recommendation to buy, sell or hold our common shares.

 

In December 2005, A.M. Best assigned a financial strength rating of “A−” (Excellent) to us. A.M. Best financial strength ratings currently range from “A++” (Superior) to “F” (In Liquidation) and include 15 separate ratings categories, of which “A−” (Excellent) is the fourth highest ratings category. A.M. Best publications indicate that an “A−” (Excellent) financial strength rating is assigned to companies that, in A.M. Best’s opinion, have demonstrated excellent overall performance when compared to the standards established by A.M. Best and have demonstrated a strong ability to meet their obligations to policyholders. Our financial strength rating is subject to periodic review by, and may be revised downward or revoked at the sole discretion of, A.M. Best in response to a variety of factors. Such factors include, but are not limited to, a minimum capital adequacy ratio, management, earnings, capitalization and risk profile. Although we may seek additional financial strength ratings from other nationally recognized statistical ratings organizations, there can be no assurance that we will be able to obtain or maintain any particular insurance rating.

 

If our financial strength rating is reduced from its current level by A.M. Best, our competitive position in the reinsurance industry would suffer, and it would be more difficult for us to market our products. A downgrade could result in a significant reduction in the number of reinsurance contracts we write and in a substantial loss of business as our customers, and brokers that place such business, move to other competitors with higher financial strength ratings.

 

It is increasingly common for our reinsurance contracts to contain terms that would allow the ceding companies to cancel the contract for the remaining portion of our period of obligation if our financial strength rating is downgraded below “A−” (Excellent) by A.M. Best. We cannot predict in advance the extent to which this cancellation right would be exercised, if at all, or what effect any such cancellations would have on our financial condition or future operations, but such effect could be material.

 

The indenture governing our Junior Subordinated Deferrable Debentures would restrict us from declaring or paying dividends on our common shares if we are downgraded by A.M. Best to a financial strength rating of “B” (Fair) or below or if A.M. Best withdraws its financial strength rating on any of our material insurance subsidiaries.

 

A downgrade of the Company’s A.M. Best financial strength rating below “B++” (Fair) would also constitute an event of default under our credit facilities. Either of these events could, among other things, reduce the Company’s financial flexibility.

If our risk management and loss limitation methods fail to adequately manage our exposure to losses from catastrophic events, our financial condition and results of operations could be adversely affected.

 

We manage our exposure to catastrophic losses by analyzing the probability and severity of the occurrence of catastrophic events and the impact of such events on our overall reinsurance and investment portfolio. We use various tools to analyze and manage the reinsurance exposures we assume from ceding companies and risks from a catastrophic event that could have an adverse effect on our investment portfolio. VCAPS, our proprietary risk modeling software, enables us to assess the adequacy of risk pricing and to monitor our overall exposure to risk in correlated geographic zones. VCAPS is new and relatively untested and we cannot assure you the models and assumptions used by the software will accurately predict losses. Further, we cannot assure you that it is free of defects in the modeling logic or in the software code. In addition, we have not sought copyright or other legal protection for VCAPS.

 

In addition, much of the information that we enter into our risk modeling software is based on third-party data that we cannot assure to be reliable, as well as estimates and assumptions that are dependent on many variables, such as assumptions about demand surge and storm surge, loss adjustment expenses , insurance-to-value and storm intensity. Accordingly, if the estimates and assumptions that we enter into our proprietary risk model are incorrect, or if our proprietary risk model proves to be an inaccurate forecasting tool, the losses we might incur from an actual catastrophe could be materially higher than our expectation of losses generated from modeled catastrophe scenarios, and our financial condition and results of operations could be adversely affected.

 

We also seek to limit our loss exposure through loss limitation provisions in our policies, such as limitations on the amount of losses that can be claimed under a policy, limitations or exclusions from coverage and provisions relating to choice of forum, which are intended to assure that our policies are legally interpreted as we intend. We cannot assure you that these contractual provisions will be enforceable in the manner we expect or that disputes relating to coverage will be resolved in our favor. If the loss limitation provisions in our policies are not enforceable or disputes arise concerning the application of such provisions, the losses we might incur from a catastrophic event could be materially higher than our expectations, and our financial condition and results of operations could be adversely affected.

 

The reinsurance business is historically cyclical, and we expect to experience periods with excess underwriting capacity and unfavorable premium rates and policy terms and conditions.

 

The reinsurance industry has historically been cyclical. Reinsurers have experienced significant fluctuations in operating results due to competition, frequency of occurrence or severity of catastrophic events, levels of underwriting capacity, underwriting results of primary insurers, general economic conditions and other factors. The supply of reinsurance is related to prevailing prices, the level of insured losses and the level of industry surplus which, in turn, may fluctuate, including in response to changes in rates of return on investments being earned in the reinsurance industry.

 

As a result, the reinsurance business historically has been characterized by periods of intense competition on price and policy terms due to excessive underwriting capacity as well as periods when shortages of capacity permit favorable premium rates and policy terms and conditions. Premium levels may be adversely affected by a number of factors which fluctuate and may contribute to price declines generally in the reinsurance industry. Because premium levels for many products have increased over the past several years, the supply of reinsurance has increased and is likely to increase further, either as a result of capital provided by new entrants or by the commitment of additional capital by existing reinsurers. Continued increases in the supply of reinsurance may have consequences for the reinsurance industry generally and for us, including fewer contracts written, lower premium rates, increased expenses for customer acquisition and retention , and less favorable policy terms and conditions.

 

The cyclical trends in the industry and the industry’s profitability can also be affected significantly by volatile and unpredictable developments, such as natural disasters (such as catastrophic hurricanes, windstorms, tornados, earthquakes and floods), courts granting large awards for certain damages, fluctuations in interest rates, changes in the investment environment that affect market prices of investments and inflationary pressures

that may tend to affect the size of losses experienced by insureds and primary insurance companies. We expect to experience the effects of cyclicality, which could materially adversely affect our financial condition and results of operations.

 

If we underestimate our reserve for losses and loss expenses, our financial condition and results of operations could be adversely affected.

 

Our success depends on our ability to accurately assess the risks associated with the businesses and properties that we reinsure. If unpredictable catastrophic events occur, or if we fail to adequately manage our exposure to losses or fail to adequately estimate our reserve requirements, our actual losses and loss expenses may deviate, perhaps substantially, from our reserve estimates.

 

We estimate the risks associated with our outstanding obligations, including the risk embedded within our unearned premiums. However, under U.S. GAAP, we are not permitted to establish reserves for losses and loss expenses (or loss reserves ), which include case reserves and incurred but not reported (“IBNR”) reserves, with respect to our property catastrophe reinsurance until an event which gives rise to a claim occurs. As a result, only reserves applicable to losses incurred up to the reporting date may be set aside on our financial statements, with no allowance for the provision of loss reserves to account for possible other future losses with respect to our catastrophe-exposed reinsurance.

 

Our reserve estimates do not represent an exact calculation of liability. Rather, they are estimates of what we expect the ultimate settlement and administration of claims will cost. These estimates are based upon actuarial and statistical projections and on our assessment of currently available data, predictions of future developments and estimates of future trends and other variable factors such as inflation. Establishing an appropriate level of our loss reserve estimates is an inherently uncertain process. It is likely that the ultimate liability will be greater or less than these estimates and that, at times, this variance will be material. Our reserve estimates are refined continually as experience develops and claims are reported and settled. Establishing an appropriate level for our reserve estimates is an inherently uncertain process. In addition, as we operate solely through intermediaries, reserving for our business can involve added uncertainty arising from our dependence on information from ceding companies which, in addition to the risk of receiving inaccurate information involves an inherent time lag between reporting information from the primary insurer to us. Additionally, ceding companies employ differing reserving practices which adds further uncertainty to the establishment of our reserves. Moreover, these uncertainties are greater for reinsurers like us than for reinsurers with a longer operating history, because we do not yet have an established loss history. The lack of historical information for the Company has necessitated the use of industry loss emergence patterns in deriving IBNR. Further, expected losses and loss ratios are typically developed using vendor and proprietary computer models and these expected loss ratios are a material component in the calculation deriving IBNR. Actual loss ratios will deviate from expected loss ratios and ultimate loss ratios will be greater or less than expected loss ratios. Because of these uncertainties, it is possible that our estimates for reserves at any given time could prove inadequate.

 

To the extent we determine that actual losses and loss adjustment expenses from events which have occurred exceed our expectations and the loss reserves reflected in our financial statements, we will be required to reflect these changes in the current period. This could cause a sudden and material increase in our liabilities and a reduction in our profitability, including operating losses and reduction of capital, which could materially restrict our ability to write new business and adversely affect our financial condition and results of operations and potentially our A.M. Best rating.

 

We rely on key personnel and the loss of their services may adversely affect us. Our operating location may be an impediment to attracting and retaining experienced personnel.

 

Various aspects of our business depend on the services and skills of key personnel of the Company. We enter into employment contracts and take other steps to encourage the retention of these individuals, and to identify and retain additional personnel, but there can be no assurance that we will be able to retain our key personnel and other employees.

Our operating location may be an impediment to attracting and retaining experienced personnel. Under Bermuda law, non-Bermudians (other than spouses of Bermudians) may not engage in any gainful occupation in Bermuda without an appropriate governmental work permit. Our success may depend in part on the continued services of key employees in Bermuda. A work permit may be granted or renewed upon demonstrating that, after proper public advertisement, no Bermudian (or spouse of a Bermudian or a holder of a permanent resident’s certificate or holder of a working resident’s certificate) is available who meets the minimum standards reasonably required by the employer. The Bermuda government’s policy places a six-year term limit on individuals with work permits, subject to certain exemptions for key employees. A work permit is issued with an expiry date (up to five years) and no assurances can be given that any work permit will be issued or, if issued, renewed upon the expiration of the relevant term. If work permits are not obtained, or are not renewed, for our principal employees, we would lose their services, which could materially affect our business.

 

We may require additional capital or credit in the future, which may not be available or only available on unfavorable terms.

 

We monitor our capital adequacy on a regular basis. The capital requirements of our business depend on many factors, including our premiums written, loss reserves, investment portfolio composition and risk exposures, as well as satisfying regulatory and rating agency capital requirements. Our ability to underwrite is largely dependent upon the quality of our claims paying and financial strength ratings as evaluated by independent rating agencies. To the extent that our existing capital is insufficient to fund our future operating requirements and/or cover claim losses, we may need to raise additional funds through financings or limit our growth. Any equity or debt financing, if available at all, may be on terms that are unfavorable to us. In the case of equity financings, dilution to our shareholders could result, and, in any case, such securities may have rights, preferences and privileges that are senior to those of our outstanding securities. If we are not able to obtain adequate capital, our business, results of operations and financial condition could be adversely affected.

 

In addition, as an alien reinsurer (not licensed in the United States), we are required to post collateral security with respect to any reinsurance liabilities that we assume from ceding insurers domiciled in the United States in order for U.S. ceding companies to obtain full statutory and regulatory credit for our reinsurance. Other jurisdictions and non-U.S. ceding insurers may have similar collateral requirements. Under applicable statutory provisions, these security arrangements may be in the form of letters of credit, reinsurance trusts maintained by trustees or funds-withheld arrangements where assets are held by the ceding company . We intend to satisfy such statutory requirements by providing to primary insurers letters of credit issued under our credit facilities. To the extent that we are required to post additional security in the future, we may require additional letter of credit capacity and we cannot assure you that we will be able to obtain such additional capacity or arrange for other types of security on commercially acceptable terms or on terms as favorable as under our current letter of credit facility. See “Description of Certain Indebtedness — Credit Facilities.” Our inability to provide collateral satisfying the statutory and regulatory guidelines applicable to primary insurers would have a material effect on our ability to provide reinsurance to third parties and negatively affect our financial position and results of operations.

 

Security arrangements may subject our assets to security interests and/or require that a portion of our assets be pledged to, or otherwise held by, third parties. Although the investment income derived from our assets while held in trust typically accrues to our benefit, the investment of these assets is governed by the investment regulations of the state of domicile of the ceding insurer.

 

Competition for business in our industry is intense, and if we are unable to compete effectively, we may not be able to gain market share and our business may be materially adversely affected.

 

The reinsurance industry is highly competitive. We face intense competition, based upon (among other things) global capacity, product breadth, reputation and experience with respect to particular lines of business, relationships with reinsurance intermediaries, capital and perceived financial strength (including independent rating agencies’ ratings), innovation, quality of service and price. We compete with major global insurance and reinsurance companies and underwriting syndicates, many of which have extensive experience

in reinsurance and may have greater financial, marketing and employee resources available to them than us. Other financial institutions, such as banks and hedge funds, now offer products and services similar to our products and services through alternative capital markets products that are structured to provide protections similar to those provided by reinsurers. These products, such as catastrophe-linked bonds, compete with our products. In the future, underwriting capacity will continue to enter the market from these identified competitors and perhaps other sources. After the events of September 11, 2001, and then again following the three major hurricanes of 2005 (Katrina, Rita and Wilma), new capital flowed into Bermuda, and much of these new proceeds went to a variety of Bermuda-based start-up companies. The full extent and effect of this additional capital on the reinsurance market will not be known for some time and market conditions could become less favorable. Increased competition could result in fewer submissions and lower rates, which could have an adverse effect on our growth and profitability. If we are unable to compete effectively against these competitors, we may not be able to gain market share.

 

In addition, insureds have been retaining a greater proportion of their risk portfolios than previously, and industrial and commercial companies have been increasingly relying upon their own subsidiary insurance companies, known as captive insurance companies, self-insurance pools, risk retention groups, mutual insurance companies and other mechanisms for funding their risks, rather than risk transferring insurance. This has put downward pressure on insurance premiums.

 

Loss of business from one or more major reinsurance brokers could adversely affect us.

 

We market our reinsurance on a worldwide basis primarily through reinsurance brokers, and we depend on a small number of reinsurance brokers for a large portion of our revenues. For the nine months ended September 30, 2006, our business was primarily sourced from the following brokers: Guy Carpenter & Co. (35.8%), Willis Re Inc. (21.1%), Aon Re Inc. (17.1%), and Benfield Group Ltd. (14.0%). These four brokers provided a total of 88.0% of our gross premiums written for the nine months ended September 30, 2006. Loss of all or a substantial portion of the business provided by one or more of these brokers could adversely affect our business.

 

We assume a degree of credit risk associated with certain of our reinsurance brokers.

 

In accordance with industry practice, we frequently pay amounts owed on claims under our policies to reinsurance brokers and the brokers, in turn, pay these amounts over to the ceding insurers and reinsurers that have reinsured a portion of their liabilities with us. In some jurisdictions, if a broker fails to make such a payment, we might remain liable to the ceding insurer or reinsurer for the deficiency notwithstanding the broker’s obligation to make such payment. Conversely, in certain jurisdictions, when the ceding insurer or reinsurer pays premiums for these policies to reinsurance brokers for payment to us, these premiums are considered to have been paid and the ceding insurer or reinsurer will no longer be liable to us for these premiums, whether or not we have actually received them. Consequently, we assume a degree of credit risk associated with certain brokers.

 

Our success depends on our ability to establish and maintain effective operating procedures and internal controls.

 

Our success is dependent upon our ability to establish and maintain operating procedures and internal controls (including the timely and successful implementation of information technology systems and programs) to effectively support our business and our regulatory and reporting requirements. We may not be successful in such efforts. Even if and when implemented, as a result of the inherent limitations in all control systems, no evaluation of controls can provide full assurance that all control issues and instances of fraud, if any, within the Company will be detected.

We may be unable to purchase retrocessional reinsurance in the future, and if we successfully purchase retrocessional reinsurance, we may be unable to collect, which could adversely affect our business, financial condition and results of operations.

 

We purchase retrocessional reinsurance , including that provided by Petrel Re, in order that we may offer cedants greater capacity, and to mitigate the effect of large and multiple losses upon our financial condition. A reinsurer’s insolvency or inability or refusal to make timely payments under the terms of its reinsurance agreement with us could have an adverse effect on us because we remain liable to our client. From time to time, market conditions have limited, and in some cases have prevented, reinsurers from obtaining the types and amounts of retrocessional reinsurance that they consider adequate for their business needs. Accordingly, we may not be able to obtain our desired amounts of retrocessional reinsurance or negotiate terms that we deem appropriate or acceptable or obtain retrocessional reinsurance from entities with satisfactory creditworthiness.

 

We are a new company and the information technology systems necessary to run our business have not been fully tested. In addition, VCAPS, our proprietary modeling in software, is new and is relatively untested.

 

The performance of our information technology systems is critical to our business and reputation and our ability to process transactions and provide high quality customer service. Such systems are and will continue to be a very important part of our underwriting process. We make use of commercially available catastrophe models, licensing the models of all three major vendors, and we enhance the output from these models with our proprietary software, VCAPS. We cannot be certain that we will be able to replace these service providers or consultants, if necessary, without slowing our underwriting response time, or that our proprietary technology, once established, will operate as intended. A defect or error in our information technology systems could result in a loss or delay of revenues, higher than expected loss levels, diversion of management resources, harm to our reputation or an increase in costs. VCAPS is new and we cannot assure you the models and assumptions used by the software will accurately predict losses. Further, we cannot assure you that it is free of defects in the modeling logic or in the software code. In addition, we have not sought copyright or other legal protection for VCAPS. Further, to date, we have limited back-up and disaster recovery for our information technology systems.

 

The preparation of our financial statements will require us to make many estimates and judgments, which are even more difficult than those made in a mature company.

 

The Company’s consolidated financial statements have been prepared in accordance with U.S. GAAP. Management believes the items that require the most subjective and complex estimates are (1) reserve for losses and loss expenses and (2) premiums. Due to the Company’s short operating history, loss experience is limited and reliable evidence of changes in trends of numbers of claims incurred, average settlement amounts, numbers of claims outstanding and average losses per claim will necessarily take many years to develop. Following a major catastrophic event, the possibility of future litigation or legislative change that may affect interpretation of policy terms further increases the degree of uncertainty in the reserving process. The uncertainties inherent in the reserving process, together with the potential for unforeseen developments, including changes in laws and the prevailing interpretation of policy terms, may result in losses and loss expenses materially different than the reserves initially established. Changes to prior year reserves will affect current underwriting results by increasing net income if the prior year reserves prove to be redundant or decreasing net income if the prior year reserves prove to be insufficient. The Company expects volatility in results in periods in which significant loss events occur because U.S. GAAP does not permit insurers or reinsurers to reserve for loss events until they have occurred and are expected to give rise to a claim. As a result, the Company is not allowed to record contingency reserves to account for expected future losses. The Company anticipates that claims arising from future events will require the establishment of substantial reserves from time to time.

An inability to implement, for the fiscal year ended December 31, 2008, the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 in a timely and satisfactory manner could cause the price of our common shares to fall.

 

We are presently evaluating our existing internal controls with respect to the standards adopted by the Public Company Accounting Oversight Board. We cannot be certain at this time that we will be able to successfully and satisfactorily complete the procedures, certification and attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002 by the time that we are required to file our Annual Report on Form 10-K for the year ended December 31, 2008, which is the first time that our management and our outside auditors will be required to deliver reports on our internal controls and procedures in accordance with the Sarbanes-Oxley Act of 2002. Uncertainty as to our ability to comply with such requirements or any material weaknesses uncovered as a result of such procedures could have a material adverse effect on the trading price of our common shares. In addition, we may incur increased costs associated with such procedures or a diversion of internal resources necessary to prepare for or comply with such requirements.

 

Risks Related to Taxation

 

We may be subject to U.S. tax.

 

We are organized under the laws of Bermuda and presently intend to structure our activities to minimize the risk that we would be considered engaged in a U.S. trade or business. No definitive standards, however, are provided by the Internal Revenue Code of 1986, as amended (the “Code”), U.S. Treasury regulations or court decisions regarding activities that constitute the conduct of a U.S. trade or business. Because that determination is essentially factual, we cannot assure you that the Internal Revenue Service (the “IRS”) will not contend that we are engaged in a U.S. trade or business. If we were found to be so engaged, we would be subject to U.S. corporate income and branch profits tax on our earnings that are effectively connected to such U.S. trade or business.

 

If Validus Re is entitled to the benefits of the income tax treaty between the U.S. and Bermuda (the “Bermuda Treaty”), it would not be subject to U.S. income tax on any income protected by the Bermuda Treaty unless that income is attributable to a permanent establishment in the U.S. The treaty clearly applies to premium income, but may be construed as not protecting other income such as investment income. If Validus Re were found to be engaged in a trade or business in the U.S. and were entitled to the benefits of the treaty in general, but the treaty were found not to protect investment income, a portion of Validus Re’s investment income could be subject to U.S. tax. See “Certain Tax Considerations — U.S. Taxation — Taxation of Validus and its Subsidiaries.”

 

U.S. persons who hold common shares may be subject to U.S. income taxation at ordinary income rates on our undistributed earnings and profits.

 

Controlled Foreign Corporation Status.   Validus should not be a controlled foreign corporation (“CFC”) immediately following the offering because its organizational documents provide that if the common shares owned, directly, indirectly or by attribution, by any person would otherwise represent more than 9.09% of the aggregate voting power of all Validus’s common shares, the voting rights attached to those common shares will be reduced so that such person may not exercise and is not attributed more than 9.09% of the total voting power of the common shares. We cannot assure you, however, that the provisions of the Organizational Documents will operate as intended and that Validus will not be considered a CFC. If Validus were considered a CFC, any shareholder that is a U.S. person that owns directly, indirectly or by attribution, 10% or more of the voting power of Validus may be subject to current U.S. income taxation at ordinary income tax rates on all or a portion of Validus’s undistributed earnings and profits attributable to “subpart F income.” Any gain realized on sale of common shares by such 10% shareholder may also be taxed as a dividend to the extent of Validus’s earnings and profits attributed to such shares during the period that the shareholder held the shares and while Validus was a CFC (with certain adjustments). See “Certain Tax Considerations — U.S. Taxation — Taxation of Shareholders — CFC Provisions.”

Related Person Insurance Income.   If the related person insurance income (“RPII”) of any of Validus’s non-U.S. insurance subsidiaries were to equal or exceed 20% of that subsidiary’s gross insurance income in any taxable year, and U.S. persons were treated as owning 25% or more of the subsidiary’s stock, by vote or value, a U.S. person who directly or indirectly owns any common shares on the last day of such taxable year on which the 25% threshold is met would be required to include in income for U.S. federal income tax purposes that person’s ratable share of that subsidiary’s RPII for the taxable year. The amount includible in income is determined as if the RPII were distributed proportionately to U.S. holders on that date, regardless of whether that income is distributed. The amount of RPII includible in income is limited by such shareholder’s share of the subsidiary’s current-year earnings and profits, and possibly reduced by the shareholder’s share of prior year deficits in earnings and profits. The amount of RPII earned by a subsidiary will depend on several factors, including the identity of persons directly or indirectly insured or reinsured by that subsidiary. Although we do not believe that the 20% threshold will be met for our non-U.S. insurance subsidiaries, some of the factors that might affect that determination in any period may be beyond our control. Consequently, we cannot assure you that we will not exceed the RPII threshold in any taxable year.

 

If a U.S. person disposes of shares in a non-U.S. insurance corporation that had RPII (even if the 20% threshold was not met) and the 25% threshold is met at any time during the five-year period ending on the date of disposition, and the U.S. person owned any shares at such time, any gain from the disposition will generally be treated as a dividend to the extent of the holder’s share of the corporation’s undistributed earnings and profits that were accumulated during the period that the holder owned the shares (possibly whether or not those earnings and profits are attributable to RPII). In addition, the shareholder will be required to comply with specified reporting requirements, regardless of the amount of shares owned. We believe that those rules should not apply to a disposition of common shares because Validus is not itself directly engaged in the insurance business. We cannot assure you, however, that the IRS will not successfully assert that those rules apply to a disposition of common shares. See “Certain Tax Considerations — U.S. Taxation — Taxation of Shareholders — RPII Provisions.”

 

U.S. persons who hold common shares will be subject to adverse tax consequences if Validus is considered a passive foreign investment company for U.S. federal income tax purposes.

 

If Validus is considered a passive foreign investment company (“PFIC”) for U.S. federal income tax purposes, a U.S. holder who owns common shares will be subject to adverse tax consequences, including a greater tax liability than might otherwise apply and an interest charge on certain taxes that are deferred as a result of Validus’s non-U.S. status. We currently do not expect that Validus will be a PFIC for U.S. federal income tax purposes in the current taxable year or the foreseeable future because, through Validus Re, it intends to be predominantly engaged in the active conduct of a global reinsurance business. We cannot assure you, however, that Validus will not be deemed to be a PFIC by the IRS. No regulations currently exist regarding the application of the PFIC provisions to an insurance company. New regulations or pronouncements interpreting or clarifying such provisions may be forthcoming. We cannot predict what effect, if any, such guidance would have on an investor that is subject to U.S. federal income taxation. See “Certain Tax Considerations — U.S. Taxation — Taxation of Shareholders — PFIC Provisions.”

 

Changes in U.S. tax laws may be retroactive and could subject a U.S. holder of common shares to other adverse tax consequences.

 

The tax treatment of non-U.S. companies and their U.S. and non-U.S. insurance and reinsurance subsidiaries has been the subject of Congressional discussion and legislative proposals in the U.S. We cannot assure you that future legislative action will not increase the amount of U.S. tax payable by us. If that happens, our financial condition and results of operations could be materially adversely affected.

 

In addition, the U.S. federal income tax laws and interpretations, including those regarding whether a company is engaged in a U.S. trade or business or is a PFIC, or whether U.S. holders would be required to include “subpart F income” or RPII in their gross income, are subject to change, possibly on a retroactive basis. No regulations regarding the application of the PFIC rules to insurance companies are currently in effect, and the regulations regarding RPII are still in proposed form. New regulations or pronouncements

interpreting or clarifying such rules may be forthcoming. We cannot be certain if, when, or in what form, such regulations or pronouncements may be provided, and whether such guidance will have a retroactive effect.

 

We may become subject to taxes in Bermuda after March 28, 2016, which may have a material adverse effect on our results of operations.

 

Under current Bermuda law, we are not subject to tax on income or capital gains. We have received from the Minister of Finance under The Exempted Undertaking Tax Protection Act 1966, as amended, an assurance that, in the event that Bermuda enacts legislation imposing tax computed on profits, income, any capital asset, gain or appreciation, or any tax in the nature of estate duty or inheritance, then the imposition of any such tax shall not be applicable to us or to any of our operations or shares, debentures or other obligations, until March 28, 2016. We could be subject to taxes in Bermuda after that date. This assurance is subject to the proviso that it is not to be construed to prevent the application of any tax or duty to such persons as are ordinarily resident in Bermuda or to prevent the application of any tax payable in accordance with the provisions of the Land Tax Act 1967 or otherwise payable in relation to any property leased to us. We and Validus Re each pay annual Bermuda government fees; Validus Re pays annual insurance license fees. In addition, all entities employing individuals in Bermuda are required to pay a payroll tax and there are other sundry taxes payable, directly or indirectly, to the Bermuda government.

 

The Organisation for Economic Cooperation and Development and other multinational organisations are considering measures that might increase our taxes and reduce our net income.

 

The Organisation for Economic Cooperation and Development, which is commonly referred to as the OECD, has published reports and launched a global dialogue among member and non-member countries on measures to limit harmful tax competition. These measures are largely directed at counteracting the effects of tax havens and preferential tax regimes in countries around the world. In the OECD’s report dated 18 April 2002 and updated as of June 2004, Bermuda was not listed as an uncooperative tax haven jurisdiction because it had previously committed to eliminate harmful tax practices and to embrace international tax standards for transparency, exchange of information and the elimination of any aspects of the regimes for financial and other services that attract business with no substantial domestic activity. We are not able to predict what changes will arise from the commitment or whether such changes will subject us to additional taxes.

 

Risks Related to Laws and Regulations Applicable to Us

 

If we become subject to insurance statutes and regulations in addition to the statutes and regulations that currently apply to us, there could be a significant and negative impact on our business.

 

We currently conduct our business in a manner such that we expect Validus will not be subject to insurance and/or reinsurance licensing requirements or regulations in any jurisdiction other than Bermuda. Although we do not currently intend for Validus Re to engage in activities which would require it to comply with insurance and reinsurance licensing requirements outside of Bermuda, should we choose to engage in activities that would require us to become licensed in such jurisdictions, we cannot assure you that we will be able to do so or to do so in a timely manner. Furthermore, the laws and regulations applicable to direct insurers could indirectly affect us, such as collateral requirements in various U.S. states to enable such insurers to receive credit for reinsurance ceded to us.

 

The insurance and reinsurance regulatory framework of Bermuda recently has become subject to increased scrutiny in many jurisdictions, including the United States. We are not able to predict the future impact on our operations of changes in the laws and regulations to which we are or may become subject.

 

We will incur increased costs as a result of being a public company.

 

As a public company, we will incur significant levels of legal, accounting and other expenses that we did not incur as a privately-owned company. The U.S. Sarbanes-Oxley Act of 2002, particularly Section 404, and related rules and regulations of the U.S. Securities and Exchange Commission and the New York Stock

Exchange regulate corporate governance practices of public companies. We expect compliance with these public company requirements will increase our costs and make some activities more time-consuming than they have been in the past when we were a privately-owned company. Furthermore, the cost of compliance could be material to us because of our size and scale of operations.

 

Risks Related to This Offering and Ownership of Our Common Shares

 

Because we are a holding company and substantially all of our operations are conducted by our main operating subsidiary, Validus Re, our ability to meet any ongoing cash requirements and to pay dividends will depend on our ability to obtain cash dividends or other cash payments or obtain loans from Validus Re.

 

We conduct substantially all of our operations through Validus Re. Our ability to meet our ongoing cash requirements, including any debt service payments or other expenses, and pay dividends on our common shares in the future, will depend on our ability to obtain cash dividends or other cash payments or obtain loans from Validus Re and will also depend on the financial condition of Validus Re. The inability of Validus Re to pay dividends in an amount sufficient to enable us to meet our cash requirements could have a material adverse effect on us and the value of our common shares. Validus Re is a separate and distinct legal entity that has no obligation to pay any dividends or to lend or advance us funds and may be restricted from doing so by contract, including other financing arrangements, charter provisions or applicable legal and regulatory requirements or rating agency constraints. The payment of dividends by Validus Re to us is limited under Bermuda law and regulations.

 

Although we may declare dividends to our shareholders, it is uncertain when, if ever, such dividends will be declared. Future dividend declarations and payments and stock repurchases will be made at the discretion of our Board of Directors and will depend on, among other things, the capital needed to satisfy current and projected business opportunities. In addition, the indenture governing our Junior Subordinated Deferrable Debentures would restrict us from declaring or paying dividends on our common shares if we are downgraded by A.M. Best to a financial strength rating of “B” (Fair) or below or if A.M. Best withdraws its financial strength rating on any of our material insurance subsidiaries. See “Description of Share Capital — Dividends.”

 

There has been no public market for our common shares and we cannot assure you that an active trading market will develop.

 

Prior to the closing of this offering, there has been no public trading market of our common shares. Our common shares have been approved for listing on the NYSE under the symbol “VR”, subject to official notice of issuance. If an active trading market does not develop and continue after the closing of this offering, your investment may become less liquid and the market price of the common shares may decline below the initial public offering price. The initial public offering price per common share was determined by negotiation among us and the underwriters and may not be indicative of the market price of our common stock after completion of this offering. The price of our common shares after the closing of this offering may fluctuate widely, depending upon many factors, including:

 

 

Our common shares may trade at prices significantly below the initial public offering price and holders of the common shares may experience difficulty in reselling, or an inability to sell, the common shares.

 

Future sales of our common shares may affect their market price and the future exercise of options and warrants may result in immediate and substantial dilution of the common shares.

 

Our Bye-laws authorize our Board of Directors to issue one or more series of common shares and preferred shares without stockholder approval. Specifically, we have an authorized share capital of 1,000,000,000 shares ($0.10 par value per share), which can consist of common shares and/or preference shares, as determined by our Board of Directors. The Board of Directors has the right to issue the remaining shares without obtaining any approval from our stockholders and to fix the rights, preferences, privileges and restrictions thereof, including dividend rights, conversion rights, voting rights, terms of redemption, liquidation preferences and the number of shares constituting any series or designation of such series. Any issuance of our preferred stock could adversely affect the voting power of the holders of our common shares and could have the effect of delaying, deferring, or preventing the payment of any dividends (including any liquidating dividends) and any change in control of us. If a significant number of either common or preferred shares are issued, it may cause the market price of our common shares to decline.

 

We, certain of our officers and directors and the selling shareholders have agreed with the underwriters not to dispose of or hedge any of our or their common shares or securities convertible into or exchangeable for common shares during the period from the date of this prospectus continuing through the date that is           days after the date of the prospectus, except with the prior written consent of          . We cannot predict what effect, if any, future sales of our common shares, or the availability of common shares for future sale, will have on the market price of our common shares, including after the expiration of the          -day lock-up period. Sales of substantial amounts of our common shares in the public market following our initial public offering, or the perception that such sales could occur, may adversely affect the market price of our common shares and may make it more difficult for you to sell your common shares at a time and price which you deem appropriate. See “Shares Eligible for Future Sale — Lock-up Agreements.”

 

Our classified board structure may prevent a change in our control.

 

Our board of directors is divided into three classes of directors. The current terms of the directors expire in 2008, 2009 and 2010. Until three years following this offering, each year one class of directors is elected by the shareholders. Until that three year period has elapsed, the staggered terms of our directors may reduce the possibility of a tender offer or an attempt at a change in control, even though a tender offer or change in control might be in the best interest of our shareholders.

 

Future sales of our common shares may adversely affect the market price of our common shares.

 

After this offering, we will have           common shares outstanding, of which approximately           shares will be “restricted securities” subject to the volume limitations and other conditions of Rule 144 under the Securities Act of 1933, as amended, which we refer to as the “Securities Act.” Furthermore, after this offering certain of our sponsoring shareholders and their transferees will have the right to require us to register these common shares under the Securities Act for sale to the public, either in an independent offering pursuant to a demand registration or in conjunction with a public offering, subject to a “lock-up” agreement of no more than 180 days. Following any registration of this type, the common shares to which the registration relates will be freely transferable. In addition, after this offering, we intend to file one or more registration statements on Form S-8 under the Securities Act to register common shares issued or reserved for issuance under the Long Term Incentive Plan. We cannot predict what effect, if any, future sales of our common shares, or the availability of common shares for future sale, will have on the market price of our common shares. Sales of substantial amounts of our common shares in the public market following this offering, or the perception that sales of this type could occur, could depress the market price of our common shares and may make it more difficult for you to sell your common shares at a time and price that you deem appropriate.

There are provisions in our Bye-laws that reduce the voting rights of voting common shares that are held by a person or group to the extent that such person or group holds more than 9.09% of the aggregate voting power of all common shares entitled to vote on a matter.

 

In general, and except as provided below, shareholders have one vote for each voting common share held by them and are entitled to vote at all meetings of shareholders. However, if, and for so long as, the common shares of a shareholder, including any votes conferred by “controlled shares” (as defined below), would otherwise represent more than 9.09% of the aggregate voting power of all common shares entitled to vote on a matter, including an election of directors, the votes conferred by such shares will be reduced by whatever amount is necessary such that, after giving effect to any such reduction (and any other reductions in voting power required by our Bye-laws), the votes conferred by such shares represent 9.09% of the aggregate voting power of all common shares entitled to vote on such matter. “Controlled shares” include, among other things, all shares that a person is deemed to own directly, indirectly or constructively (within the meaning of Section 958 of the Code, or Section 13(d)(3) of the Securities and Exchange Act of 1934, as amended (the “Exchange Act”)). Upon completion of our initial public offering, there will be           common shares outstanding, of which           common shares would confer votes that represent 9.09% of the aggregate voting power of all common shares entitled to vote generally at an election of directors. An investor who does not hold, and is not deemed under the provisions of our Bye-laws to own, any of our common shares may therefore purchase up to           common shares without being subject to voting cutback provisions in our Bye-laws.

 

In addition, we have the authority under our Bye-laws to request information from any shareholder for the purpose of determining ownership of controlled shares by such shareholder.

 

There are regulatory limitations on the ownership and transfer of our common shares.

 

The BMA must approve all issuances and transfers of securities of a Bermuda exempted company like us. We have received permission from the BMA to issue our common shares, and for the free transferability of our common shares as long as the common shares are listed on the New York Stock Exchange or other appointed exchange, to and among persons who are residents and non-residents of Bermuda for exchange control purposes. Any other transfers remain subject to approval by the BMA and such approval may be denied or delayed.

 

As a shareholder of our company, you may have greater difficulties in protecting your interests than as a shareholder of a U.S. corporation.

 

The Companies Act 1981 (the “Companies Act”), which applies to our company, differs in material respects from laws generally applicable to U.S. corporations and their shareholders. Taken together with the provisions of our Bye-laws, some of these differences may result in your having greater difficulties in protecting your interests as a shareholder of our company than you would have as a shareholder of a U.S. corporation. This affects, among other things, the circumstances under which transactions involving an interested director are voidable, whether an interested director can be held accountable for any benefit realized in a transaction with our company, what approvals are required for business combinations by our company with a large shareholder or a wholly-owned subsidiary, what rights you may have as a shareholder to enforce specified provisions of the Companies Act or our Bye-laws, and the circumstances under which we may indemnify our directors and officers.

 

We are a Bermuda company and it may be difficult for you to enforce judgments against us or against our directors and executive officers.

 

We were incorporated under the laws of Bermuda and our business is based in Bermuda. In addition, certain of our directors and officers reside outside the United States, and a portion of our assets and the assets of such persons may be located in jurisdictions outside the United States. As such, it may be difficult or impossible to effect service of process within the United States upon us or those persons, or to recover against us or them on judgments of U.S. courts, including judgments predicated upon the civil liability provisions of the U.S. federal securities laws. Further, no claim may be brought in Bermuda against us or our directors and

officers in the first instance for violation of U.S. federal securities laws because these laws have no extraterritorial application under Bermuda law and do not have force of law in Bermuda; however, a Bermuda court may impose civil liability, including the possibility of monetary damages, on us or our directors and officers if the facts alleged in a complaint constitute or give rise to a cause of action under Bermuda law.

 

We have been advised by Conyers Dill & Pearman, our special Bermuda counsel, that there is doubt as to whether the courts of Bermuda would enforce judgments of U.S. courts obtained in actions against us or our directors and officers, as well as the experts named herein, predicated upon the civil liability provisions of the U.S. federal securities laws, or original actions brought in Bermuda against us or such persons predicated solely upon U.S. federal securities laws. Further, we have been advised by Conyers Dill & Pearman that there is no treaty in effect between the United States and Bermuda providing for the enforcement of judgments of U.S. courts in civil and commercial matters, and there are grounds upon which Bermuda courts may decline to enforce the judgments of U.S. courts. Some remedies available under the laws of U.S. jurisdictions, including some remedies available under the U.S. federal securities laws, may not be allowed in Bermuda courts as contrary to public policy in Bermuda. Because judgments of U.S. courts are not automatically enforceable in Bermuda, it may be difficult for you to recover against us based upon such judgments.

 

All forward-looking statements address matters that involve risks and uncertainties. Accordingly, there are or will be important factors that could cause actual results to differ materially from those indicated in such statements. This prospectus includes forward-looking statements, both with respect to us and our industry, that reflect our current views with respect to future events and financial performance. Statements that include the words “expect,” “intend,” “plan,” “believe,” “project,” “anticipate,” “will,” “may” and similar statements of a future or forward-looking nature identify forward-looking statements.

 

We believe that these factors include, but are not limited to, the following:

 

 

 

In addition, other general factors could affect our results, including: (a) developments in the world’s financial and capital markets and our access to such markets; (b) changes in regulations or tax laws applicable to us, including, without limitation, any such changes resulting from the recent investigations relating to the insurance industry and any attendant litigation; and (c) the effects of business disruption or economic contraction due to terrorism or other hostilities.

 

The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with the other cautionary statements that are included herein or elsewhere including the Risk Factors beginning on page 10. All of the forward-looking statements made in this prospectus are qualified by these cautionary statements, and there can be no assurance that the actual results or developments anticipated by us will be realized or, even if substantially realized, that they will have the expected consequences to, or effects on, us or our business or operations. We undertake no obligation to update publicly or revise any forward-looking statement, whether as a result of new information, future developments or otherwise.

 

We estimate that the net proceeds to us from this offering will be approximately $      million, based upon an assumed initial public offering price of $      per common share, representing the midpoint of the offering range set forth on the cover of this prospectus, and after deducting the underwriters’ discount and fees and expenses of the offering. We intend to use such net proceeds for general corporate purposes, including a $3.0 million payment to Aquiline in connection with the termination of our Advisory Agreement with them, and to support future growth of our reinsurance operations.

 

We will not receive any of the net proceeds from the sale of common shares by the selling shareholders, including any proceeds received by them in connection with any exercise of the underwriters’ option to purchase additional common shares.

 

We intend to pay quarterly cash dividends on our common shares at an initial rate of $      per common share payable in the first full fiscal quarter end after the date hereof. The timing and amount of any cash dividends, however, will be at the discretion of our Board of Directors and will depend upon our results of operations and cash flows, our financial position and capital requirements, general business conditions, legal, tax, regulatory, rating agency and contractual constraints or restrictions and any other factors that our Board of Directors deems relevant.

 

We are a holding company and have no direct operations. Our ability to pay dividends depends, in part, on the ability of Validus Re to pay dividends to us. Validus Re is subject to significant regulatory restrictions limiting its ability to declare and pay dividends, as well as rating agency and other considerations. See “Business — Regulation — Bermuda” and “Risk Factors — Risks Related to This Offering and Ownership of Our Common Shares — Because we are a holding company and substantially all of our operations are conducted by our main operating subsidiary, Validus Re, our ability to meet any ongoing cash requirements and to pay dividends will depend on our ability to obtain cash dividends or other cash payments or obtain loans from Validus Re.”

 

The following table sets forth our consolidated capitalization as of September 30, 2006 and as adjusted as of that date to give effect to the issuance by us of common shares in this offering. This table should be read in conjunction with “Selected Consolidated Financial Information,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes included elsewhere in this prospectus.

 

 

 

 

The initial public offering price per common share is higher than our net tangible book value per common share. Net tangible book value per common share represents the amount of tangible assets less total liabilities, divided by the number of common shares outstanding. Dilution in net tangible book value per common share represents the difference between (1) the amount per common share paid by purchasers of our common shares in this offering and (2) the net tangible book value per common share immediately after this offering. As of September 30, 2006, our net tangible book value was approximately $1,121.7 million or $10.96 per common share. The following table illustrates this per share dilution:

 

 

The following table sets forth the number of our common shares issued, the total consideration paid and the average price per common share paid by our existing shareholder and new investors, after giving effect to the issuance of           common shares in this offering at an assumed initial offering price of $      per share (before deducting the estimated underwriting discounts and commissions and our estimated offering expenses payable by us).

 

 

The foregoing tables do not give effect to:

 

(a) common shares that may be issued pursuant to outstanding warrants;

 

(b) common shares that may be issued pursuant to options that have been granted to our employees;

 

(c) unvested restricted shares that have been granted to our employees; and

 

(d) additional common shares available for future issuance under our stock option and incentive plans.

 

The summary consolidated statement of operations data for the period ended and the summary consolidated balance sheet data as of December 31, 2005 are derived from our audited consolidated financial statements. The summary consolidated statement of operations data for the three and nine months ended September 30, 2006 and the summary consolidated balance sheet data as of September 30, 2006 are derived from our unaudited interim condensed consolidated financial statements.

 

You should read the following summary consolidated financial information together with the other information contained in this prospectus, including “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes included elsewhere in this prospectus.

 

The following table presents results of operations for the three and nine months ended September 30, 2006:

 

The following table sets forth summarized balance sheet data as of December 31, 2005 and September 30, 2006:

 

 

 Notes

 

 

The following is a discussion and analysis of the Company’s consolidated results of operations for the three and nine months ended September 30, 2006 and the Company’s consolidated financial condition and liquidity and capital resources at September 30, 2006. This discussion and analysis should be read in conjunction with the Company’s unaudited consolidated financial statements and related notes thereto.

 

The Company was recently formed and has limited historical financial and operating information. Insurance and reinsurance companies face substantial risk in their initial stages of development. See “Cautionary Note Regarding Forward-Looking Statements” and “Risk Factors.” In addition, for a variety of reasons, including the Company’s recent formation and relatively few significant catastrophe events in the first nine months of 2006, the Company’s historical financial results may not accurately indicate future performance.

 

Executive Overview

 

The Company’s principal operating subsidiary, Validus Re, operates as a Bermuda-based provider of short-tail reinsurance products on a global basis. The Company’s strategy is to concentrate on short-tail reinsurance risks, which is an area where management believes current prices and terms provide an attractive risk adjusted return and the management team has proven expertise. The Company’s profitability in any given period is based upon premium and investment revenues less net losses and loss expenses, acquisition expenses and operating expenses. Financial results in the insurance and reinsurance industry are influenced by the frequency and/or severity of claims and losses, including as a result of catastrophic events, changes in interest rates, financial markets and general economic conditions, the supply of insurance and reinsurance capacity and changes in legal, regulatory and judicial environments.

 

Premiums are a function of the number and type of contracts written, as well as prevailing market prices. Renewal dates for reinsurance business tend to be concentrated at the beginning of quarters, and the timing of premiums written varies by line of business. Most property catastrophe business is written in the January 1, April 1, June 1 and July 1 inception and renewal periods, while other lines are written throughout the year. Written premiums are generally highest in the first quarter and lowest during the fourth quarter of the year. Gross premiums written for pro rata programs are initially recorded as estimates and are adjusted as actual results are reported by the cedant during the period. Earned premiums do not necessarily follow the written premium pattern as certain premiums written are earned ratably over the contract term, which is ordinarily twelve months, although many pro rata contracts are written on a risks attaching basis and are generally earned over a 24 month period, which is the risk period of the underlying (twelve month) policies. Premiums are generally due in monthly or quarterly installments.

 

The following are the primary lines in which the Company conducts business:

 

Property:   Validus underwrites property catastrophe reinsurance, property per risk reinsurance and property pro rata reinsurance.

 

Property Catastrophe :   Property catastrophe includes reinsurance for insurance companies’ exposures to an accumulation of property and related losses from separate policies, typically relating to natural disasters or other catastrophic events. Property catastrophe reinsurance is generally written on an excess of loss basis, which provides coverage to primary insurance companies when aggregate claims and claim expenses from a single occurrence from a covered peril exceed a certain amount specified in a particular contract. Under these contracts, the Company provides protection to an insurer for a portion of the total losses in excess of a specified loss amount, up to a maximum amount per loss specified in the contract. In the event of a loss, most contracts provide for coverage of a second occurrence following the payment of a premium to reinstate the coverage under the contract, which is referred to as a reinstatement premium . The coverage provided under excess of loss reinsurance contracts may be on a worldwide basis or limited in scope to specific regions or geographical areas. Coverage can also vary from “all property” perils , which is the most expansive form of coverage, to more limited coverage of specified perils such as windstorm-only coverage. Property catastrophe reinsurance contracts are typically “all risk” in nature, providing protection against losses from earthquakes and hurricanes, as well as other natural and man-made catastrophes such as floods, tornadoes, fires and storms. The predominant exposures

covered are losses stemming from property damage and business interruption coverage resulting from a covered peril. Certain risks, such as war or nuclear contamination may be excluded, partially or wholly, from certain contracts.

 

Property Per Risk :   Property per risk provides reinsurance for insurance companies’ excess retention on individual property and related risks, such as highly-valued buildings. Risk excess of loss reinsurance protects insurance companies on their primary insurance risks on a “single risk” basis. A “risk” in this context might mean the insurance coverage on one building or a group of buildings or the insurance coverage under a single policy which the reinsured treats as a single risk. Coverage is usually triggered by a large loss sustained by an individual risk rather than by smaller losses which fall below the specified retention of the reinsurance contract. Such property risk coverages are generally written on an excess of loss basis, which provides the reinsured protection beyond a specified amount up to the limit set within the reinsurance contract.

 

Property Pro Rata :   In property pro rata contracts the reinsurer shares the premiums as well as the losses and expenses in an agreed proportion with the cedant.

 

Marine:   We underwrite reinsurance on marine risks covering damage to or losses of marine vessels or cargo, third-party liability for marine accidents and physical loss and liability from principally offshore energy properties. Validus underwrites marine reinsurance on an excess of loss basis, and to a lesser extent, on a pro rata basis.

 

In May 2006, Validus entered into a collateralized quota share retrocession treaty with Petrel Re, a newly-formed Bermuda reinsurance company, pursuant to which Petrel Re assumes a quota share of certain lines of marine and energy and other lines of business underwritten by the Company. Petrel Re is a separate legal entity of which Validus has no equity investment, management or board interests, or related party relationships.

 

Other Specialty Lines:   Validus underwrites other lines of business depending on an evaluation of pricing and market conditions, which include aerospace, terrorism, life and accident & health and workers’ compensation catastrophe. The Company seeks to underwrite other specialty lines with very limited exposure correlation with its property, marine and energy portfolios. With the exception of the aerospace line of business, which has a meaningful portion of its gross premiums written volume on a proportional basis, the Company’s other specialty lines are currently written on an excess of loss basis.

 

Income from the Company’s investment portfolio is primarily comprised of interest on fixed maturity investments net of investment expenses and net realized gains/losses on the sale of investments. A significant portion of the Company’s contracts provide short-tail reinsurance coverage for damages resulting mainly from natural and man-made catastrophes, which means that the Company could become liable for a significant amount of losses on short notice. Accordingly, the Company has structured its investment portfolio to preserve capital and maintain a high level of liquidity, which means that the large majority of the Company’s investment portfolio consists of shorter term fixed maturity investments. The Company’s fixed income investments are held as available for sale. Under U.S. GAAP, these securities are carried at fair value, and unrealized gains and losses on these securities are not included in investment income in the Company’s consolidated statements of income, but are included in other comprehensive income as a separate component of shareholders’ equity.

 

The Company’s expenses consist primarily of losses and loss expenses, acquisition costs, general and administrative expenses, and finance fees related to debentures and our credit facility. Organizational expenses and expenses associated with the issuance of warrants were also incurred in the first quarter of 2006 as well as in the period ended December 31, 2005.

 

Losses and loss expenses are a function of the amount and type of reinsurance contracts written and of the loss experience of the underlying risks. Reserves for losses and loss expense include a component for outstanding case reserves for claims which have been reported and a component for losses incurred but not reported. The uncertainties inherent in the reserving process, together with the potential for unforeseen developments, may result in losses and loss expenses materially different than the reserve initially established. Changes to prior year loss reserves will affect current underwriting results by increasing net income if the prior year reserves prove to be redundant or decreasing net income if the prior year reserves prove to be

insufficient. Adjustments resulting from new information will be reflected in income in the period in which they become known. The Company’s ability to estimate losses and loss expenses accurately, and the resulting impact on contract pricing, is a critical factor in determining profitability.

 

Since the lines of business underwritten have large aggregate exposures to natural and man-made catastrophes, Validus expects that claims experience will predominantly be the result of relatively few events of significant severity. The occurrence of claims from catastrophic events is likely to result in substantial volatility in, and could have a material adverse effect on, the Company’s financial condition, results of operations, and ability to write new business.

 

Acquisition costs consist principally of brokerage expenses and commissions which are driven by contract terms on reinsurance contracts written, and are normally a specific percentage of premiums. Under certain contracts, cedants may also receive profit commissions which will vary depending on the loss experience on the contract. Acquisition costs are presented net of commissions or fees received on any ceded premium, including premium ceded to Petrel Re.

 

General and administrative expenses are generally comprised of fixed expenses which do not vary with the amount of premiums written or losses incurred. Applicable expenses include salaries and benefits, professional fees, office, risk management, and stock compensation expenses. Stock compensation expenses include costs related to the Company’s long-term incentive plan, under which restricted stock and stock options are granted to certain employees.

 

U.S. in 2004 and 2005. Management believes these supply and demand pressures which have exerted upward pressure on prices in peak U.S. property zones will remain in the near term.

 

Following significant losses from Hurricane Ivan in 2004 and Hurricanes Katrina and Rita in 2005, the marine and energy reinsurance accounts have experienced material price increases and more restrictive conditions. Losses resulting from Katrina affected nearly all lines of business written within the marine class and retrocessional capacity has been reduced sharply. Management believes that many reinsurers withdrew from marine and energy business and remaining reinsurers increased pricing and tightened conditions across all sectors. In addition to rate increases, coverage terms have become more restrictive including increased use of mutually exclusive pillars and other parametric devices.

 

Outside of property business in U.S. peak zones, there has been less upward movement in reinsurance prices in the nine months ended September 30, 2006. The pricing of worldwide property catastrophe business may increase as updated catastrophe vendor models are released and adapted outside of the U.S. However, to the extent risks are not correlated with peak zone modeled catastrophe losses, there may not be a shortfall of capacity available which may diminish or preclude rate increases.

 

Since we underwrite global specialty property reinsurance and have large aggregate exposures to natural and man-made disasters, claim experience has been the result of relatively few events of high magnitude. The occurrence of claims from catastrophic events is likely to result in substantial volatility in, and could have a material adverse effect on, the Company’s financial condition and results and ability to write new business. This volatility will affect results for the period in which the loss occurs because U.S. accounting principles do not permit reinsurers to reserve for such catastrophic events until they occur. Catastrophic events of significant magnitude historically have been relatively infrequent, although management believes the property catastrophe reinsurance market has experienced a higher level of worldwide catastrophic losses in terms of both frequency and severity in the period from 1992 to the present. We also expect that increases in the values and concentrations of insured property will increase the severity of such occurrences in the future. The Company seeks to reflect these trends when pricing contracts.

 

Critical Accounting Policies and Estimates

 

The Company’s consolidated financial statements have been prepared in accordance with U.S. GAAP. The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect reported and disclosed amounts of assets and liabilities, as well as disclosure of contingent assets and liabilities as at the balance sheet date and the reported amounts of revenues and expenses during the reporting period. Management believes the following accounting policies are critical to the Company’s operations as the application of these policies requires management to make significant judgments. Management believes the items that require the most subjective and complex estimates are (1) reserve for losses and loss expenses and (2) premiums.

 

Reserve for Losses and Loss Expenses.   For most insurance and reinsurance companies, the most significant judgment made by management is the estimation of the reserve for losses and loss expenses. The Company establishes its reserve for losses and loss expenses to cover the estimated liability for both reported and unreported claims.

 

Loss reserve estimations for insurance business are not precise in that they deal with the inherent uncertainty of future events. Estimating loss reserves requires management to make assumptions regarding future reporting and development patterns, frequency and severity trends, claims settlement practices, potential changes in the legal environment and other factors such as inflation. These estimates and judgments are based on numerous factors, and may be revised as additional experience or other data becomes available, as new or improved methodologies are developed or as current laws change.

 

Reserving for reinsurance business introduces further uncertainties. As predominantly a broker market reinsurer for both excess of loss and proportional contracts, the Company must rely on loss information reported to brokers by primary insurers who must estimate their own losses at the policy level, often based on incomplete and changing information. The information received varies by cedant and may include paid losses, estimated case reserves, and an estimated provision for incurred but not reported losses (“IBNR reserves”).

Additionally, reserving practices and the quality of data reporting may vary among ceding companies which adds further uncertainty to the estimation of ultimate losses.

 

A time lag is inherent in reporting from the original claimant to the primary insurer to the broker and then to the reinsurer, especially in the case of excess of loss reinsurance contracts due to the accumulation of losses required prior to reaching the Company’s attachment point . Also, the combination of low claim frequency and high severity make the available data more volatile and less useful for predicting ultimate losses. In the case of proportional contracts, the Company relies on an analysis of a contract’s historical experience, industry information, and the professional judgment of underwriters in estimating reserves for these contracts. In addition, if available, ultimate loss ratio forecasts as reported by cedants are incorporated, normally on a three or six month lag.

 

As a result of the time lag described above, the Company must estimate IBNR reserves, which consist of a provision for additional development in excess of the case reserves reported by ceding companies, as well as a provision for claims which have occurred but which have not yet been reported to us by ceding companies. Because of the degree of reliance that is necessarily placed on ceding companies for claims reporting, the associated time lag, the low frequency/high severity nature of much of the business underwritten, and the varying reserving practices among ceding companies, reserve estimates are highly dependent on management judgment and therefore uncertain. During the loss settlement period, which may be several years in duration, additional facts regarding individual claims and trends often will become known, and current laws and case law may change.

 

The reserve for losses and loss expenses includes both a component for outstanding case reserves for claims which have been reported and a component for IBNR reserves. IBNR reserves are estimated by management using various actuarial methods. These methods are based on the assumption that ultimate losses vary proportionately with premiums. Expected losses and loss ratios are typically developed using vendor and proprietary computer models. The information used in the models is derived by underwriters and actuaries during the initial pricing of the business, supplemented by industry data available from organizations, such as statistical bureaus and consulting firms, where appropriate. Management expects to incorporate over time the Company’s own loss experience in establishing reserves. Expected losses and loss ratios consider, among other things, rate increases and changes in terms and conditions that have been observed in the market. Other methodologies are also used by the Company in the reserving process for specific types of claims or events, such as catastrophic or other specific major events. These include vendor catastrophe models, and analyses of specific industry events, such as large claims or lawsuits. Ceding company reports on IBNR reserves are also taken into account in making the Company’s estimates. The Company utilizes a reserving methodology that calculates a point estimate for ultimate losses. The point estimate represents management’s best estimate of ultimate losses and loss expenses. The Company does not utilize range estimation in the loss reserving process. The extent of reliance on management judgment in the reserving process differs as to whether the business is insurance or reinsurance and as to whether the business is written on an excess of loss or on a pro rata basis. The Company reviews its reserving assumptions and methodologies on a quarterly basis. The two most critical assumptions in establishing reserves are loss emergence patterns and expected loss ratios. Management anticipates that the loss estimates will be subject to an annual corroborative review by independent actuaries using generally accepted actuarial principles.

 

Due to the Company’s short operating history, loss experience is limited and reliable evidence of changes in trends of numbers of claims incurred, average settlement amounts, numbers of claims outstanding and average losses per claim will necessarily take many years to develop. The lack of historical information for the Company has necessitated the use of industry loss emergence patterns in deriving IBNR. Further, expected losses and loss ratios are typically developed using vendor and proprietary computer models and these expected loss ratios are a material component in the calculation deriving IBNR. Actual loss ratios may deviate from expected loss ratios and ultimate loss ratios will be greater or less than expected loss ratios. In addition, due to the nature of the business, this information is not routinely provided by the cedants for every contract. For catastrophic events, the Company considers aggregate industry loss reports and catastrophe model projections in addition to ceding company estimates and other factors as described above. For other lines, industry loss ratio and development pattern information is utilized in conjunction with the Company’s own experience.

To the extent industry data is relied upon to aid in establishing reserve estimates, there is a risk that the data may not match the Company’s risk profile or that the industry’s reserving practices overall differ from that of the Company and its cedants. In addition, reserving can prove especially difficult should a significant loss event take place near the end of an accounting period, particularly if it involves a catastrophic event. These factors further contribute to the degree of uncertainty in the reserving process.

 

Management’s best estimate of the gross reserve for losses and loss expenses at September 30, 2006 was $63.2 million. The following tables show the effect on gross reserves for losses and loss expenses as of September 30, 2006 of a five and ten percent change in the two most critical assumptions in establishing reserves: (1) loss emergence patterns and (2) expected loss ratios. The reserves resulting from the changes in the assumptions are not additive and should be considered separately. The following tables vary the assumptions employed therein independently.

 

Gross reserve for losses and loss expenses at September 30, 2006 — Sensitivity to
loss emergence patterns

 

 

Gross reserves for loss and loss expenses at September 30, 2006 — Sensitivity to
expected loss ratios

 

 

Following a major catastrophic event, the possibility of future litigation or legislative change that may affect interpretation of policy terms further increases the degree of uncertainty in the reserving process.

 

The uncertainties inherent in the reserving process, together with the potential for unforeseen developments, including changes in laws and the prevailing interpretation of policy terms, may result in losses and loss expenses materially different than the reserves initially established. Changes to prior year reserves will affect current underwriting results by increasing net income if the prior year reserves prove to be redundant or decreasing net income if the prior year reserves prove to be insufficient. The Company expects volatility in results in periods that significant loss events occur because U.S. GAAP does not permit insurers or reinsurers to reserve for loss events until they have occurred and are expected to give rise to a claim. As a result, the Company is not allowed to record contingency reserves to account for expected future losses. The Company anticipates that claims arising from future events will require the establishment of substantial reserves from time to time.

 

Management believes that the reserve for losses and loss expenses is sufficient to cover expected claims within the terms of the policies and agreements with insured and reinsured customers on the basis of the methodologies used to estimate those reserves. However, there can be no assurance that actual losses will not exceed total reserves. The reserve for losses and loss expenses and the methodology of estimating such reserve are regularly reviewed and updated as new information becomes known. Any resulting adjustments are reflected in income in the period in which they become known.

Management’s best estimate of the gross reserve for losses and loss expenses at September 30, 2006 was $63.2 million. The following table sets forth a breakdown between gross case reserves and gross IBNR by line of business at September 30, 2006.

 

 

Premiums.   Assumed reinsurance premium is written on an excess of loss or on a pro rata basis. Reinsurance contracts are generally written prior to the time the underlying direct policies are written by cedants and accordingly cedants must estimate such premiums when purchasing reinsurance coverage. For excess of loss contracts, the deposit premium is defined in the contract. The deposit premium is based on the ceding companies’ estimated premiums, and this estimate is the amount recorded as written premium in the period the risk incepts. In the majority of cases, these contracts are adjustable at the end of the contract period to reflect the changes in underlying risks during the contract period. Subsequent adjustments, based on reports by the ceding companies of actual premium, are recorded in the period they are determined, which would normally be reported within six months to one year subsequent to the expiration of the contract.

 

For pro rata contracts, an estimate of written premium is recorded in the period in which the risk incepts. The premium estimate is based on information provided by ceding companies and management’s judgment. At the inception of the contract the ceding company estimates how much premium they expect to write during the year. As these are pro rata contracts, gross premiums written related to these contracts is a function of the amount of premium the ceding company estimates they will write. Subsequent adjustments will be recorded when the actual premium is reported by the ceding company. Reporting by the ceding company may be on a three or six month lag and it may be significantly different than the estimate.

 

The Company evaluates the appropriateness of these premium estimates based on the latest information available, which includes actual reported premium to date, the latest premium estimates as provided by cedants and brokers, historical experience, management’s professional judgment, information obtained during the underwriting renewal process, as well as a continuing assessment of relevant economic conditions. Adjustments to premium estimates will be recorded in the period in which they become known. Adjustments to original premium estimates could be material and may significantly affect earnings in the period they are determined.

 

Where contract terms on excess of loss contracts require the reinstatement of coverage after a ceding company’s loss, the mandatory reinstatement premiums are recorded as written and earned premiums when the loss event occurs. Pro rata contracts generally do not contain provisions for the reinstatement of coverage.

 

Management includes an assessment of the creditworthiness of cedants in the review process above, primarily based on market knowledge, reports from rating agencies, the timeliness of cedants’ payments and the status of current balances owing. Based on this assessment, management believes that as at September 30, 2006 no provision for doubtful accounts is necessary.

 

For pro rata contracts and excess of loss contracts written on a losses occurring basis premium income is generally earned ratably over the expected risk period, usually 12 months. For all other contracts,

comprising contracts written on a risks attaching basis, premiums are generally earned over a 24 month period due to the fact that some of the underlying exposures may attach towards the end of the contract, and such underlying exposures generally have a 12 month coverage period. The portion of the premium related to the unexpired portion of the policy at the end of any reporting period is reflected on the balance sheet in unearned premiums .

 

Segment Reporting

 

Management has determined that the Company operates in a single business segment.

 

Results of Operations

 

Validus Holdings, Ltd. and Validus Re were formed on October 19, 2005, and Validus Re commenced operations on December 16, 2005. Neither company had any prior operating history. Accordingly, no comparable results from prior periods exist. The Company’s fiscal year ends on December 31. Financial statements are prepared in accordance with U.S. GAAP.

 

Underwriting income is a non-GAAP measure that is reconciled to net income in the table above by the addition of net investment income and foreign exchange gains and the subtraction of finance fees, fair value of warrants issued and net realized losses on investments. Annual incentive compensation for the 2006 performance year as approved by the compensation committee of our Board of Directors is set in reference to underwriting income.

 

 

 

 

Looking ahead to subsequent quarters, the amount of premiums the Company will write is difficult to predict. Various factors will continue to affect the Company’s appetite and capacity to write risk. These include the pricing required to meet return targets, evolving industry-wide capital requirements and other considerations. In addition, the mix of business will significantly affect ultimate premium volume.

 

Reinsurance Premiums Ceded

 

Reinsurance premiums ceded for the three and nine month periods ended September 30, 2006 were $38.9 million and $64.1 million, respectively. On May 8, 2006, Validus Re entered into a collateralized quota share retrocession treaty with Petrel Re, a newly-formed Bermuda reinsurance company, pursuant to which Petrel Re assumes a quota share of certain lines of marine and energy business and other lines of business underwritten by Validus Re for unaffiliated third parties for the 2006 and 2007 underwriting years. This relationship provides the Company with the capacity to increase premiums written in specific programs where favorable underwriting opportunities are seen. A specified portion of this incremental business is then ceded to Petrel Re and fees are earned for the services provided in underwriting the original business. During the three and nine months ended September 30, 2006, premium of $35.4 million and $44.5 million, respectively, was ceded to Petrel Re.

 

 

 

The ratio of net premiums written to gross premiums written was 66.6% for the three months ended September 30, 2006 and 86.5% for the nine months ended September 30, 2006. Reinsurance premiums ceded to Petrel Re in the third quarter is the principal reason for the decrease in this ratio as Petrel Re was not formed until May 15, 2006.

 

Change in Unearned Premiums

 

Change in unearned premiums for the three and nine months ended September 30, 2006 were $14.9 million and $(209.9 million), respectively. This reflects the fact that most contracts are written on a one year basis, with the premiums earned over twelve months.

 

Net Premiums Earned

 

Net premiums earned for the three and nine months ended September 30, 2006 were $92.5 million and $201.4 million, respectively. The large difference between net premiums written and net premiums earned during the nine months ended September 30, 2006 reflects that most contracts are written on a one year basis, with the premiums earned over twelve months, except contracts written on a risks-attaching basis are generally earned over 24 months.

 

Losses and Loss Expenses

 

Losses and loss expenses for the three and nine months ended September 30, 2006 were $11.6 million and $67.1 million, respectively. The loss ratio, which is defined as losses and loss expenses divided by net premiums earned, was 12.5% for the three months ended September 30, 2006 and 33.3% for the nine months ended September 30, 2006. The amount recorded represents management’s estimate of expected losses and loss expenses on premiums earned. For the nine months ended September 30, 2006 this was due to incurred-but-not-reported reserves of $47.6 million and case reserves of $15.6 million. The Company paid losses of $5.8 million in the nine months ended September 30, 2006. Details of loss ratios by line of business are provided below.

 

 

 

 

The following tables set forth a reconciliation of gross and net reserves for losses and loss expenses by line of business for the nine months ended September 30, 2006:

 

 

 

 

 

 

The Company did not make any significant changes in the assumptions or methodology used in its reserving process during the three and nine months ended September 30, 2006.

 

At September 30, 2006, gross and net reserves for losses and loss expenses were estimated using the methodology as outlined in the Summary of Critical Accounting Policies and Estimates above.

 

Management has determined that the gross reserve for losses and loss expenses at September 30, 2006 was $63.2 million.

 

The following table sets forth a breakdown between case reserves and IBNR by line of business at September 30, 2006: