• for insolvent insurers, management develops default factors based on an evaluation of each of the insolvent entities.
We provide for income taxes in accordance with the provisions of FAS No. 109, “Accounting for Income Taxes” (FAS 109). Deferred tax assets and liabilities are recognized consistent with the asset and liability method required by FAS 109. Our deferred tax assets and liabilities primarily result from temporary differences between the amounts recorded in our Consolidated Financial Statements and the tax basis of our assets and liabilities. We determine deferred tax assets and liabilities separately for each tax-paying component (an individual entity or group of entities that is consolidated for tax purposes) in each tax jurisdiction.
Goodwill, which represents the excess of the cost of our acquisitions over the tangible net assets we acquired, was $2.7 billion at December 31, 2003. The ACE INA acquisition comprises approximately 79 percent of this balance. In June 2001, the Financial Accounting Standards Board (FASB) issued FAS 142, “Goodwill and Other Intangible Assets”, which primarily addresses accounting for goodwill and intangible assets subsequent to their acquisition. Under FAS 142, goodwill is no longer amortized to income but instead, is subject to annual impairment tests. At January 1, 2002, the initial adoption date of FAS 142, and January 1, 2003, goodwill was assigned to the applicable reporting units of the acquired entities giving rise to goodwill. Our reporting units for purposes of impairment testing are primarily based on legal entities within our operating segments. The allocation of goodwill to these reporting units is consistent with goodwill recognized at acquisition. In effect, impairment tests are performed for each acquired entity giving rise to goodwill. The most significant reporting units are the domestic and international divisions of ACE INA which were acquired in 1999, ACE Tempest Re acquired in 1996, Tarquin Limited acquired in 1998 and Capital Re Corporation acquired in 1999. There are other reporting units that resulted from smaller acquisitions that are also assessed annually. The transitional impairment test of goodwill determined that there was no impairment in goodwill in 2002. In our impairment tests, we principally use both an earnings model, that includes relevant financial data of comparable companies to the reporting unit being tested, such as the relationship of price to book value for recent transactions and market valuations of publicly traded companies, and an estimation of fair value based on present value of estimated net cash flows. We must assess whether the current fair value of our operating units is at least equal to the fair value used in the determination of goodwill. In doing this, we make assumptions and estimates about the profitability attributable to our operating segments, as this is important in assessing whether an impairment has occurred. As part of our ongoing management assessments, we regularly analyze our operating companies in an effort to maximize future cash flows and profitability. As a result of that review, updated forecasts supported indications that two relatively small majority-owned companies would not, under current market conditions, achieve sufficient contract sales volumes to generate and sustain future profitable results. As a consequence of these revised expectations, we recognized a goodwill impairment loss of $6 million during the first quarter of 2003. If, in the future, our assumptions and estimates made in assessing the fair value of acquired entities prove to be incorrect, goodwill carried on our balance sheet could be materially overstated. This would cause us to write-down the carrying value of goodwill, resulting in a charge to earnings in the period recorded. Accordingly, this could have a material adverse effect on our results of operations.
The following table provides a consolidated breakdown of net premiums earned by line of business for the years ended December 31, 2003 and 2002.
The loss and loss expense ratio declined in 2003, as the 2002 year was impacted by the increase to our A&E reserve. This reserve strengthening resulted in a net increase in our losses and loss expenses of $516 million ($354 million after tax) and added 7.7 percentage points to our loss and loss expense ratio. In 2003, our losses and loss expenses were higher by $164 million due to the depreciation of the U.S. dollar. Our loss and loss expense ratio is impacted by changes in the mix of business written and the level of catastrophe losses in a period. In 2003, we incurred $112 million of catastrophe losses, compared with $156 million in 2002. We have taken advantage of increasing rates and market opportunities, and most of these opportunities are in the casualty insurance and reinsurance areas, where rate increases are accelerating. Casualty business is typically written at higher loss ratios than property business because in some cases, the losses for casualty business can emerge long after the coverage period has expired, and claim settlement can be more complex than for property claims, which tends to lengthen the settlement period. However, because of the longer claim-payout duration, we benefit from investing the premiums for a longer period of time, therefore potentially increasing our net investment income. We have also increased our loss ratio assumptions over the past year in some of our casualty lines in connection with increases we have made in our retained risk levels. Our loss and loss expense ratio is also influenced by the size of LPTs written in a particular quarter. LPTs are typically recorded at higher loss ratios than our other lines of business. In 2002, we recorded gross premiums written attributed to LPT business of $311 million compared with $274 million in 2003. Also impacting our loss and loss expense ratio is adverse prior period development. We incurred $164 million of adverse prior period development in 2003, compared with $709 million ($193 million excluding A&E) in 2002. Our segment discussions below contain more information about prior period development. The 2001 loss and loss expense ratio was impacted by the September 11 tragedy and reserve strengthening for casualty lines, which added $650 million and $170 million, respectively to losses and loss expenses. Together, these two events added 14.7 percentage points to our 2001 loss and loss expense ratio.
ACE Westchester Specialty specializes in the wholesale distribution of excess and surplus lines property, inland marine and casualty coverages and products. ACE Westchester Specialty also provides coverage for agriculture business and specialty programs through its Program division. ACE Westchester Specialty’s net premiums earned for 2003 increased 26 percent, compared with 2002. This increase primarily reflects higher casualty writings due to the robust casualty market and growth in agriculture business.
ARM, which offers custom coverage solutions for large companies and national accounts, reported an increase of 68 percent in net premiums earned for 2003, compared with 2002. ARM’s increase in net premiums earned is being driven by growth in excess workers’ compensation (primarily high deductible policies in national accounts business) and, to a lesser extent custom casualty due to new business and increased retention ratios.
Gross premiums written for the Insurance - Overseas General segment increased 26 percent in 2003 compared with 2002. The depreciation of the U.S. dollar against the major currencies accounted for approximately ten percent of the increase in gross premiums written in 2003. ACE International experienced growth across most of its regions, and ACE Global Markets experienced improved market conditions across most of its lines of business. This segment’s gross premiums written increased in 2002 compared with 2001, due to rate increases, new business writings and the weakening of the U.S. dollar.
The Global Reinsurance segment comprises ACE Tempest Re Bermuda, ACE Tempest Re USA, ACE Tempest Re Europe, and ACE Tempest Life Re (ACE Life Re). ACE Life Re is our Bermuda-based life reinsurance operation and is addressed separately.
The table below shows net premiums earned by each of the Global Reinsurance segment’s key components for the years ended December 31, 2003, 2002 and 2001.
FAS 133 requires us to recognize all derivatives as either assets or liabilities on our consolidated balance sheet, and measure them at fair value. We record the gains and losses resulting from the fair value measurement of derivatives in net realized gains (losses). We participate in derivative instruments in two principal ways as follows: i) to offer protection to others as the seller or writer of the derivative, such as our credit derivatives business; or ii) to mitigate our own risk, principally arising from our investment holdings. We do not consider either type of transaction to be speculative. For the year ended December 31, 2003, we recorded net realized gains of $197 million on derivative transactions, compared with net realized losses of $265 million and $28 million for the years ended December 31, 2002 and 2001, respectively.
A security that meets any of the following criteria is to be evaluated for a potential impairment:
We evaluate all other fixed maturity and equity securities for a potential impairment when the unrealized loss at the balance sheet date exceeds a certain scope, based on both a percentage (i.e., market value is less than 80 percent of amortized cost, or cost for equity securities) and aggregate dollar decline, and certain indicators of an “other than temporary” impairment are present including:
• the degree to which any appearance of impairment is attributable to an overall change in market conditions such as interest rates rather than changes in the individual factual circumstances and risk profile of the issuer;
Securities will be assessed to have an “other than temporary” impairment if cost is not expected to be recovered or we do not have the ability and specific intent to hold the security until its expected recovery. We typically make this latter assessment when such intent is considered inconsistent with our investment objectives, such as maximizing total return.
We are required to maintain assets on deposit with various regulatory authorities to support our insurance and reinsurance operations. These requirements are generally promulgated in the statutory regulations of the individual jurisdictions. The assets on deposit are available to settle insurance and reinsurance liabilities. We also utilize trust funds in certain large transactions where the trust funds are set up for the benefit of the ceding companies and generally take the place of Letter of Credit (LOC) requirements. We also have investments in segregated portfolios primarily to provide collateral or guarantees for LOCs and debt instruments. (See Notes 7 and 8 of the Consolidated Financial Statements)
The following table identifies the value of restricted assets at December 31, 2003 and 2002.
We establish reserves for the estimated unpaid ultimate liability for losses and loss expenses under the terms of our policies and agreements. These reserves take into account estimates both for claims that have been reported and for IBNR, and include estimates of expenses associated with processing and settling claims. The table below presents a rollforward of our unpaid losses and loss expenses for the year ended December 31, 2003.
In 2001, we incurred net losses of $650 million relating to the September 11 tragedy. At December 31, 2003, we had paid $1 billion of losses related to the September 11 tragedy and collected $684 million or 96 percent of the $708 million billed to reinsurers. Our net unpaid loss in connection with the September 11 tragedy was $323 million at December 31, 2003. We continue to evaluate our total potential liability based upon individual insurance and reinsurance policy language, legal and factual developments in underlying matters involving our insureds, relevant court decisions and legislative developments in the U.S. involving the terrorist attack. If our current assessments of future developments are proven wrong, the financial impact of any of them, singularly or in the aggregate, could be material.
We believe our financial strength provides us with the flexibility and capacity to obtain funds externally through debt or equity financing on both a short-term and long-term basis. Our ability to access the capital markets is dependent on, among other things, market conditions and our perceived financial strength. We have accessed both the debt and equity markets from time to time.
As part of our capital management program, in November 2001, our Board of Directors authorized the repurchase of any ACE issued debt or capital securities including ordinary shares, up to $250 million. At December 31, 2003, this authorization had not been utilized.