The following selected consolidated GAAP financial data of the Company as of and for the years ended December 31, 2007, 2006, 2005, 2004 and 2003 were derived from the consolidated financial statements of the Company, which were audited by PricewaterhouseCoopers LLP. The following financial data should be read in conjunction with the Consolidated Financial Statements and accompanying notes.
Catastrophe losses are presented net of reinsurance and reinstatement premiums. A catastrophe is defined, for purposes of the Selected Consolidated Financial Data, as an event that caused a pre-tax loss on property exposures before reinsurance of at least $5.0 million before corporate level reinsurance and taxes. Catastrophe insurance provides coverage for one event. When limits are exhausted, some contractual arrangements provide for the availability of additional coverage upon the payment of additional premium. This additional premium is referred to as reinstatement premium.
Based on 62.9 million, 65.0 million, 64.6 million, 56.2 million and 55.7 million shares outstanding for December 31, 2007, 2006, 2005, 2004 and 2003, respectively.
Our U.S. and international casualty lines experienced weaker market conditions, led by medical stop loss and D&O reinsurance, as well as the California workers’ compensation insurance line. Increased primary price competition and cedants’ increased appetite for retaining more profitable business net, following several highly profitable years, resulted in modestly softer, but still profitable, reinsurance pricing during the year. Our U.S. insurance operation was also affected by these primary casualty insurance market conditions; however, given the specialty nature of our business, we believe the impact on us to be less severe than on the market generally.
We are unable to predict the impact on future market conditions from increased competition and legislative initiatives. In addition to these market forces, reinsurers continue to reassess their risk appetites and rebalance their property portfolios to obtain a greater spread of risk against the backdrop of: (i) recent revisions to the industry’s catastrophe loss projection models, which are indicating significantly higher loss potentials and consequently higher pricing requirements and (ii) elevated rating agency scrutiny and capital requirements for many catastrophe exposed companies.
Overall, we believe that current marketplace conditions offer solid opportunities for us given our strong ratings, distribution system, reputation and expertise. We continue to employ our strategy of targeting business that offers the greatest profit potential, while maintaining balance and diversification in our overall portfolio.
We monitor and evaluate our overall performance based upon financial results. The following table displays a summary of the consolidated net income (loss), ratios and shareholders’ equity for the periods indicated:
Net investment income increased 20.4% in 2006 compared to 2005, reflecting continued year-over-year growth in invested assets from the $636.3 million cash flow from operations and a $43.2 million increase in income from limited partnership investments. The average investment portfolio yield for 2006 was 4.8% compared to 2005 average investment portfolio yield of 4.4%.
Incurred losses and LAE increased by $113.7 million, or 4.7% in 2007 compared to the same period in 2006, principally as a result of the $280.9 million increase in A&E loss reserve strengthening, which was partially offset by a $127.9 million decrease in catastrophe losses and a $39.3 million decrease in attritional losses. The increase in A&E reserves was due to an extensive in-house study by our actuarial and claim units. The decrease in catastrophe losses reflects the decrease in prior years development.
Our current year attritional loss ratios for 2007, 2006 and 2005 were 54.8%, 59.3% and 60.2%, respectively, reflective of generally favorable market conditions and our business production and risk selection practices.
Commission, Brokerage, Taxes and Fees. Commission, brokerage, and tax expenses increased by $78.5 million, or 8.9% in 2007 compared to 2006. The increase in net earned premiums, an increase in ceding commissions due to market conditions and higher commissions on new insurance programs were the principal drivers of the increase in this directly variable expense.
Other underwriting expenses for 2006 increased by $8.2 million, or 6.3%, compared to 2005, primarily due to higher share-based compensation expense.
Interest Expense. Interest expense was $91.6 million and $69.9 million for 2007 and 2006, respectively. The increase was due to the new long term notes we issued in April, 2007 and the acceleration of the bond amortization costs associated with the November 15, 2007 early retirement of the 7.85% junior subordinated debt securities.
Interest expense was $69.9 million and $74.4 million for 2006 and 2005, respectively. The decrease is primarily due to the retirement on March 15, 2005 of the 8.5% senior notes issued on March 14, 2000.
Income Tax Expense (Benefit). Our income tax expense was $188.7 million, which represented an 18.4% effective tax rate for 2007 compared to $150.9 million, which represented a 15.2% effective tax rate for 2006. The increase in the effective tax rate is principally due to the increase and jurisdictional mix in pre-tax income, including a significant increase in net realized gains and the $12.3 million provision for potential additional tax related to our tax treatment of foreign exchange. Absent this provision, the tax rate would have been 17.2%. The Internal Revenue Service has challenged our foreign exchange treatment, and although we believe we have a strong chance of prevailing on this issue, we have provided for the potential additional tax for all years still open for examination. Aside from such discrete items, our income tax expense is primarily a function of the statutory tax rates and corresponding pre-tax income in the jurisdictions where we operate, coupled with the impact from tax-preferenced investment income. Variations in our effective tax rate generally result from changes in the relative levels of pre-tax income among jurisdictions with different tax rates.
Net income was slightly lower at $839.3 million for 2007 compared to $840.8 million for 2006, as a result of the changes in the various statement lines discussed above.
Our combined ratio decreased by 30.6 points to 89.7% in 2006 compared to 120.3% in 2005, reflective of the lower catastrophe and attritional losses.
Shareholders’ equity increased by $1.0 billion to $5.1 billion in 2006 from $4.1 billion in 2005, principally as a result of the $840.8 million of net income generated for the period and $88.4 million of after-tax appreciation from our investment portfolio, partially offset by the payment of $39.0 million of shareholder dividends.
Net investment income increased 8.4% to $682.4 million in 2007 from $629.4 million in 2006, principally reflecting a growth in invested assets to $14.9 billion at December 31, 2007 from $14.0 billion at December 31, 2006. The asset growth emanated largely from continued positive cash flow from operations.
Imbedded after-tax yield of cash and invested assets at December 31
Because of our historical income orientation, we had generally managed our investments to maximize reportable income. Starting in 2004, we began investing a portion of our assets in equity securities, principally in response to perceived changes in the relative attractiveness of the debt and equity markets. The following table provides a comparison of our total return by asset class relative to broadly accepted industry benchmarks for the periods indicated.
The pre-tax equivalent return for the bond portfolio was approximately 5.7%, 5.3% and 3.7%, respectively, for 2007, 2006 and 2005. The pre-tax equivalent return adjusts the yield on tax-exempt bonds to the fully taxable equivalent.
Premiums.Gross written premiums decreased by 10.7% to $1,193.5 million in 2007 from $1,336.7 million in 2006, primarily due to a $202.6 million (37.9%) decrease in treaty casualty volume and a $70.5 million (32.7%) decrease in facultative volume, partially offset by a $126.8 million (21.6%) increase in treaty property volume. The increase in treaty property writings emanated principally from new quota share treaties. The more competitive environment for the U.S. casualty business resulted in reduced opportunities to write this business profitably. Net written premiums decreased 11.2% to $1,183.1 million in 2007 compared to $1,331.7 million in 2006, primarily due to the decrease in gross written premiums. Net premiums earned increased slightly to $1,282.9 million for 2007 compared to $1,281.1 million for 2006. The change in net premiums earned relative to net written premiums is the result of timing; premiums are earned ratably over the coverage period whereas written premiums are recorded at the initiation of the coverage period.
Gross written premiums decreased 3.6% to $1,336.7 million in 2006 from $1,386.2 million in 2005, primarily due to a $72.7 million (12.0%) decrease in treaty casualty volume, partially offset by a $16.4 million (2.9%) increase in treaty property volume and an $11.6 million (5.7%) increase in facultative volume. Net written premiums decreased 3.8% to $1,331.7 million in 2006 compared to $1,383.7 million in 2005, primarily due to the decrease in gross written premiums.Net premiums earned decreased 8.2% to $1,281.1 million for 2006 compared to $1,396.1 million for 2005. The change in net premiums earned relative to net written premiums is the result of timing; premiums are earned ratably over the coverage period whereas written premiums are recorded at the initiation of the coverage period.
The current year’s attritional loss ratio improved by 7.9 points due to results from increased property quota share business. We experienced $181.7 million of catastrophe loss development in 2006 which did not recur in 2007, which contributed another 14.6 points. In addition, we had a greater amount of favorable reserve development related to prior years, which provided 7.0 points of improvement. These favorable factors were partially mitigated by an 18.6 point increase driven by asbestos reserve strengthening.
Commission and brokerage decreased by 16.8% to $298.1 million in 2006 from $358.1 million in 2005, principally due to decreased earned premium volume and the mix of business. Segment other underwriting expenses for 2006 increased nominally to $24.9 million from $24.0 million for 2005.
Premiums.Gross written premiums increased by 2.2% to $885.6 million for 2007 from $866.3 million for 2006. The increase is primarily the result of a new program we assumed late in 2007 for approximately $76 million of gross written premium. Absent this new program, gross written premiums would have decreased due to the further decline in our workers’ compensation and contractors liability writings in response to increased competition. Net written premiums decreased by 1.2% to $744.3 million for 2007 compared to $753.3 million for 2006 as our retention level fell slightly. Net premiums earned decreased 3.4% to $735.9 million for 2007 from $761.7 million for 2006. The change in net premiums earned relative to net written premiums is the result of timing; premiums are earned ratably over the coverage period whereas written premiums are reflected at the initiation of the coverage period.
The adverse development in 2007 was the result of $60 million of adverse reserve run-off on a canceled auto loan credit insurance program, partially offset by favorable development on the remainder of the reserves. The 2007 accident year loss ratio was 70.5% which was 6.7 points lower than 2006. The 2006 accident year loss ratio was negatively impacted by the auto loan credit insurance program referenced above.
Commission and brokerage decreased 7.2% to $123.1 million for 2006 from $132.6 million in 2005, principally due to a decrease in written and earned premiums. Segment other underwriting expenses for 2006 decreased to $48.9 million as compared to $51.9 million for 2005.
Premiums.Gross written premiums increased by 7.5% to $270.1 million for 2007 from $251.2 million for 2006. This increase was the result of a $36.9 million (58.7%) increase in marine writings and a $12.2 million (14.7%) increase in A&H writings, partially offset by a $24.6 million (34.9%) decrease in surety writings and a $5.7 million (16.5%) decrease in aviation writings. The increased marine premium growth emanated from growth in existing quota share business as well as new quota share contracts. We continued to decrease our aviation and surety writings, in response to more competitive market conditions. Net written premiums increased 8.2% to $263.8 million for 2007 compared to $243.8 million for 2006, as a result of the increase in gross written premiums. Net premiums earned increased 7.2% to $262.0 million for 2007 compared to $244.5 million for 2006, generally in line with the growth in net written premiums. By line of business, we experienced a $31.2 million (51.7%) increase in marine premium and a $14.0 million (18.2%) increase in A&H premium, partially offset by a $21.9 million (30.3%) decrease in surety premium and a $5.2 million (14.9%) decrease in aviation premium, which is in line with the change in gross and net written premiums. The change in net premiums earned relative to net written premiums is the result of timing; premiums are earned ratably over the coverage period whereas written premiums are reflected at the initiation of the coverage period.
Incurred losses and LAE decreased 48.4% to $163.9 million for 2006 compared to $317.9 million for 2005. The segment loss ratio was 38.5 points lower in 2006 than 2005, principally due to decreased catastrophe losses in 2006.
Gross written premiums increased by 3.6% to $731.7 million for 2006 from $706.6 million for 2005. Business written through the Miami and New Jersey offices increased by $47.1 million (12.1%) and business written through the Canadian branch increased by $22.8 million (17.7%). These increases were partially offset by a decrease of $44.1 million (23.5%) in premiums written through the Asian branch. Net written premiums increased by 3.7% to $730.7 million for 2006 compared to $704.9 million for 2005, in line with the increase in gross written premiums. Net premiums earned increased by 5.3% to $719.5 million for 2006 compared to $683.4 million for 2005, consistent with the increase in net written premiums.
Segment Expenses.Commission and brokerage increased 10.5% to $199.5 million for 2007 from $180.5 million in 2006, which was in line with the increase in premiums. Segment other underwriting expenses for 2007 increased to $18.6 million compared to $13.8 million for 2006, primarily due to the allocation of certain corporate charges to segments, which had been previously retained in corporate expenses.
Commission and brokerage increased 8.1% to $180.5 million for 2006 from $167.0 million in 2005. Segment other underwriting expenses increased 9.5% to $13.8 million compared to $12.6 million for 2005.
Incurred losses and LAE decreased 37.1% to $516.6 million for 2006 compared to $821.4 million for 2005. The segment loss ratio for Bermuda decreased 47.2 points, reflecting a 45.9 point decrease for catastrophe losses and a 1.4 point decrease for attritional losses, partially offset by a slight increase for A&E losses. The catastrophe losses for 2005 were primarily driven by Hurricanes Katrina, Rita and Wilma.
Segment Expenses.Commission and brokerage increased 7.8% to $230.4 million for 2007 from $213.7 million for 2006, principally due to increases in premiums earned. Segment other underwriting expenses for 2007 increased to $20.9 million compared to $17.2 million for 2006, primarily due to the allocation of certain corporate charges to segments, which had been previously retained in corporate expenses.
Commission and brokerage increased 20.4% to $213.7 million for 2006 from $177.5 million in 2005, principally due to increases in premiums earned and changes in the mix of business. Segment other underwriting expenses for 2006 increased 6.2% to $17.2 million compared to $16.2 million for 2005, generally in line with the growth in gross written premiums.
Loss and LAE Reserves. Our most critical accounting policy is the determination of our loss and LAE reserves. We maintain reserves equal to our estimated ultimate liability for losses and LAE for reported and unreported claims for our insurance and reinsurance businesses. Because reserves are based on estimates of ultimate losses and LAE by underwriting or accident year, we use a variety of statistical and actuarial techniques to monitor reserve adequacy over time, evaluate new information as it becomes known and adjust reserves whenever an adjustment appears warranted. We consider many factors when setting reserves including: (1) our exposure base and projected ultimate premiums earned; (2) our expected loss ratios by product and class of business, which are developed collaboratively by underwriters and actuaries; (3) actuarial methodologies which analyze our loss reporting and payment experience, reports from ceding companies and historical trends, such as reserving patterns, loss payments and product mix; (4) current legal interpretations of coverage and liability; (5) economic conditions; and (6) uncertainties discussed below regarding our liability for A&E claims. Based on these considerations, management believes that adequate provisions have been made for our insurance and reinsurance loss and LAE reserves. Actual losses and LAE ultimately paid may deviate, perhaps substantially, from such reserves. Our net income will be impacted in a period in which the change in estimated ultimate losses and LAE is recorded. See also Note 1 of Notes to the Consolidated Financial Statements.
property lines. On the other hand, casualty claims tend to take longer to be reported and settled and casualty lines are generally referred to as long tail lines. Our estimates of ultimate losses for shorter tail lines, with the exception of loss estimates for large catastrophic events, generally exhibit less volatility than those for the longer tail lines.
Our carried reserves at each reporting date are our best estimate of ultimate unpaid losses and LAE at that date. We complete detailed reserve studies for each exposure group annually for our reinsurance operations and quarterly for our insurance operations. The completed annual reinsurance reserve studies are “rolled forward” for each accounting period until the subsequent reserve study is completed. The roll-forward process involves comparing actual reported losses to expected losses based on the most recent reserve study. We analyze significant variances between actual and expected losses and post adjustments to our reserves as warranted recorded.
Our reserves include an estimate of our ultimate liability for A&E claims. Our A&E liabilities emanate from Mt. McKinley’s direct insurance business and Everest Re’s assumed reinsurance business. There are significant uncertainties surrounding our estimates of our potential losses from A&E claims. Among the uncertainties are: (a) potentially long waiting periods between exposure and manifestation of any bodily injury or property damage; (b) difficulty in identifying sources of asbestos or environmental contamination; (c) difficulty in properly allocating responsibility and/or liability for asbestos or environmental damage; (d) changes in underlying laws and judicial interpretation of those laws; (e) the potential for an asbestos or environmental claim to involve many insurance providers over many policy periods; (f) questions concerning interpretation and application of insurance and reinsurance coverage; and (g) uncertainty regarding the number and identity of insureds with potential asbestos or environmental exposure.
We have direct relationships with Mt. McKinley policyholders and we attempt to uphold our contractual rights and assert valid defenses to coverage where appropriate. The uncertainties inherent in asbestos coverage and bankruptcy litigations have provided us the opportunity to engage in settlement negotiations with a number of policyholders who have potentially significant asbestos liabilities. Those discussions are aimed at achieving reasonable negotiated settlements that limit Mt. McKinley’s liability to a given policyholder to a sum certain. Because of the risks and uncertainties inherent in litigation, we cannot be certain that this approach will lead to a negotiated settlement in the range expected by us in each or every instance. Between 2004 and 2006, we
As of December 31, 2007 and 2006, we had net unrealized gains, net of tax, of $73.2 million and $302.9 million, respectively. Gains and losses from market fluctuations are reflected as comprehensive income for the fixed income portfolio and also for the equity portfolio prior to January 1, 2007. Subsequent to January 1, 2007, gains and losses from market fluctuations for the equity portfolio are reflected as realized capital gains and losses in accordance with the provisions of FAS 159. Market value declines for the fixed income portfolio, which are considered other than temporary impairments are reflected in the income statement as realized capital losses. We consider many factors when determining whether a market value decline is other than temporary, including: (1) the length of time the market value has been below book value, (2) the credit strength of the issuer, (3) the issuer’s market sector, (4) the length of time to maturity and (5) for asset backed securities, increases in prepayments and underlying default rates. If management assessments change in the future, we may ultimately record a realized loss after management originally concluded that the decline in value was temporary. See also Note 1 of Notes to the Consolidated Financial Statements.
Cash and Invested Assets. Aggregate invested assets, including cash and short-term investments, were $14,936.2 million at December 31, 2007, up by $979.1 million, compared to $13,957.1 million at December 31, 2006. This increase is primarily the result of $854.4 million of cash flows from operations, $395.6 million of net proceeds from the long term debt issuance, $100.6 million of realized capital gains on equity securities, $167.4 million from foreign exchange and $18.2 million from share-based compensation, partially offset by the repurchase in the open market of 2.5 million common shares for $241.6 million, $210.0 million of trust preferred securities redemption, $121.4 million in dividends to shareholders and $21.4 million of unrealized depreciation, primarily on fixed maturities due to rising interest rates.
For outstanding liabilities, we invest in taxable and tax-preferenced fixed income securities with an average credit quality of Aa, as rated by Moody’s, an independent investment rating service. We continually adjust our mix of taxable and tax-preferenced investments in light of our current and projected operating results, market conditions and tax position. This fixed maturity portfolio is externally managed by an independent, professional investment manager using portfolio guidelines developed by us.
The tables below summarize the composition and characteristics of our investment portfolio for the periods indicated:
The classification shift for our equity securities reflects the adoption of FAS 159 effective January 1, 2007.
Reinsurance Receivables. Reinsurance receivables for both paid and unpaid losses totaled $666.2 million at December 21, 2007 and $772.8 million at December 31, 2006. At December 31, 2007, $176.1 million, or 26.4%, was receivable from Transatlantic; $152.1 million, or 22.8%, was receivable from Founders, for which the Company has established a $151.4 million provision for uncollectible reinsurance; $100.0 million, or 15.0%, was receivable from Continental; $54.6 million, or 8.2%, was receivable from Munich Re; $45.4 million, or 6.8%, was receivable from LM; $38.5 million, or 5.8%, was receivable from Ace and $37.7 million, or 5.7%, was receivable from Berkley. The receivable from Continental is collateralized by a funds held arrangements under which we have retained the premium payments due the retrocessionaire, recognized liabilities for such amounts and reduced such liabilities as payments are due from the retrocessionaire. No other retrocessionaire accounted for more than 5% of our receivables.
Changes in earned premiums and business mix, reserve re-estimations, catastrophe losses and changes in catastrophe loss reserves and claim settlement activity all impact loss and LAE reserves by segment and in total. The increase in the December 31, 2007 reserves for A&E reflects the impact of a re-evaluation reserve analysis undertaken in the fourth quarter of 2007 in response to changes we observed in the reported loss trends on these reserves.
There can be no assurance that reserves for, and losses from, claim obligations will not increase in the future, possibly by a material amount. However, we believe that our existing reserves and reserving methodologies
lessen the probability that any such increase would have a material adverse effect on our financial condition, results of operations or cash flows. In this context, we note that over the past 10 years, our past calendar year operations have been affected variably by effects from prior period reserve re-estimates, with such effects ranging from a favorable $26.4 million in 2005, representing 0.5% of the net prior period reserves for the year in which the adjustment was made, to an unfavorable $249.4 million in 2004, representing 3.7% of the net prior period reserves for the year in which the adjustment was made. We have noted that variability had increased for years 2002 to 2004 and we have taken actions to attempt to reduce year to year variability prospectively.
There can be no assurance that reserves will not ultimately exceed the indicated ranges.
Additional losses, including those relating to latent injuries, and other exposures, which are as yet unrecognized, the type or magnitude of which cannot be foreseen by us or the reinsurance and insurance industry generally,
At December 31, 2007, the gross reserves for A&E losses were comprised of $144.5 million representing case reserves reported by ceding companies, $147.1 million representing additional case reserves established by us on assumed reinsurance claims, $148.2 million representing case reserves established by us on direct excess insurance claims, including Mt. McKinley and $483.0 million representing IBNR reserves.
Asbestos reserves represent 92.3% of the outstanding net A&E reserves as of December 31, 2007 and represents a separate exposure group for monitoring and evaluating reserve adequacy.
Industry analysts use the “survival ratio” to compare the A&E reserves among companies with such liabilities. The survival ratio is typically calculated by dividing a company’s current net reserves by the three year average of annual paid losses. Hence, the survival ratio equals the number of years that it would take to exhaust the current reserves if future loss payments were to continue at historical levels. Using this measurement, our net three year asbestos survival ratio was 8.2 years for reinsurance and direct business and 13.6 years for the reinsurance business at December 31, 2007. From a comparison perspective, A.M. Best published survival ratios as of December 31, 2006, the latest available information, of 8.9 years for the overall insurance industry and 9.5 years for the reinsurance sector.
Because the survival ratio was developed as a comparative measure of reserve strength and does not indicate absolute reserve adequacy, we consider, but do not rely on, the survival ratio when evaluating our reserves. In particular, we note that year to year loss payment variability can be material. This is due, in part, to our orientation to negotiated settlements, particularly on our Mt. McKinley exposures, which significantly reduces the credibility and utility of this measure as an analytical tool. During 2007, we made asbestos net claim payments of $57.3 million to Mt McKinley high profile claimants where the claim was either closed or a settlement had been reached. Such payments, which are non-repetitive, distort downward our three year survival ratio for 2007 and will continue to do so for 2008 and 2009. Adjusting for such settlements, recognizing that total settlements are generally considered fully reserved to an agreed settlement, we consider that our adjusted asbestos survival ratio for net unsettled claims is 11.6 years, which is closer to prevailing industry norms.
Shareholders’ Equity. Our shareholders’ equity increased to $5,684.8 million as of December 31, 2007 from $5,107.7 million as of December 31, 2006, principally due to $839.3 million of net income for the twelve months ended December 31, 2007, partially offset by the repurchase of 2.5 million common shares for $241.6 million and $121.4 million of shareholder dividends. The Company’s shareholders’ equity increased to $5,107.7 million as of December 31, 2006 from $4,139.7 million as of December 31, 2005, principally reflecting $840.8 million of net income for 2006, a $54.1 million increase due to net currency translation, a $38.6 million increase in net share-based compensation activity and a $88.3 million increase in net unrealized appreciation on investments, partially offset by $39.0 million of shareholder dividends and an increase of $15.0 million in accumulated other comprehensive income due to FAS 158 for pensions.
Capital. Our business operations are in part dependent on our financial strength, and the market’s perception of our strength, as measured by shareholders’ equity, which was $5,684.8 million and $5,107.7 million at December 31, 2007 and 2006, respectively. We possess significant financial flexibility and access to the debt and equity markets as a result of our perceived financial strength, as evidenced by the financial strength ratings
as assigned by independent rating agencies. We continuously monitor our capital and financial position, as well as investment and security market conditions and respond accordingly.
From time to time, we have used open market share repurchases to effectively adjust our capital position. In September 2004, our authorization to purchase our shares was amended to authorize the repurchase of up to 5 million shares and during 2007, we repurchased 2.5 million shares under this authorization. We made no such purchases in 2006 or in 2005. Outside of our open market repurchase program, we repurchased 20,866 shares in 2007 and 21,384 shares in 2006 from employees in connection with restricted share vestings where individual employees chose to discharge withholding tax liabilities on vesting shares by the surrender of a portion of such shares. At December 31, 2007, there remained 2.5 million shares under the repurchase authorization.
On December 1, 2005, we filed a shelf registration statement on Form S-3 with the SEC, as a Well Known Seasoned Issuer under the new registration and offering revisions to the Securities Act of 1933. Generally, under this shelf registration statement, Group is authorized to issue common shares, preferred shares, debt securities, warrants and hybrid securities, Holdings is authorized to issue debt securities and Everest Re Capital Trust III (“Capital Trust III”) is authorized to issue trust preferred securities.
On April 26, 2007, Holdings completed a public offering of $400.0 million principal amount of 6.6% fixed to floating rate long term subordinated notes with a scheduled maturity date of May 15, 2037 and a final maturity date of May 1, 2067. The net proceeds were used to redeem the 7.85% junior subordinated debt securities of Holdings on November 15, 2007, and for general corporate purposes.
For outstanding liabilities, we invest in taxable and tax-preferenced fixed income securities with an average credit quality of Aa, as rated by the independent investment rating service of Moody’s. Our mix of taxable and tax-preferenced investments is adjusted continuously, consistent with our current and projected operating results, market conditions and our tax position. This fixed maturity portfolio is externally managed by an independent, professional investment manager using portfolio guidelines approved by us.
If disbursements for claims and benefits, policy acquisition costs and other operating expenses exceed premium inflows, cash flow from insurance operations would be negative. The effect on cash flow from operations would be partially offset by cash flow from investment income. Additionally, cash flow from investment maturities and dispositions, both short term investments and longer term maturities, would further mitigate the impact on total cash flow.
As the timing of payments for claims and benefits cannot be predicted with certainty, we maintain portfolios of long term invested assets with varying maturities, along with short-term investments that provide additional liquidity for payment of claims. At December 31, 2007 and December 31, 2006 we held cash and short-term investments of $2,476.3 million and $1,556.4 million, respectively. In addition to these cash and short-term investments at December 31, 2007, we had $585.2 million, at fair value, of available for sale fixed maturity securities maturing within one year or less, $2,588.4 million maturing within one to five years and $6,942.7 million maturing after five years. Our $1,560.0 million of equity securities are comprised primarily of publicly traded securities that can be easily liquidated. We believe that these fixed maturity and equity securities, in conjunction with the short-term investments and positive cash flow from operations, provide adequate sources of liquidity for the expected payment of losses in the near future. We do not anticipate selling securities or using available credit facilities to pay losses and LAE but have the ability to do so. Sales of securities might result in realized capital gains or losses and we note that at December 31, 2007 we had $132.0 million of net pre-tax unrealized appreciation, comprised of $231.4 million of pre-tax unrealized appreciation and $99.4 million of pre-tax unrealized depreciation.
Management expects the trend of positive cash flow from operations, which in general reflects the strength of overall pricing, to persist over the near term. In the intermediate and long term, the trend will be impacted by the extent to which competitive pressures affect overall pricing in our markets and the extent to which we successfully maintain our strategy of emphasizing underwriting profitability.
Effective July 27, 2007, Group, Bermuda Re and Everest International Reinsurance, Ltd. (“Everest International”) entered into a new five year, $850.0 million senior credit facility with a syndicate of lenders, replacing the December 8, 2004, senior credit facilities, which would have expired on December 8, 2007. Both the July 27, 2007 and December 8, 2004 senior credit facilities are referred to as the “Group Credit Facility”. Wachovia Bank is the administrative agent for the Group Credit Facility, which consists of two tranches. Tranche one provides up to $350.0 million of revolving credit for liquidity and general corporate purposes, and for the issuance of unsecured standby letters of credit. The interest on the revolving loans shall, at the Company’s option, be either (1) the Base Rate (as defined below) or (2) an adjusted LIBOR plus a margin. The Base Rate is the higher of (a) the prime commercial lending rate established by Wachovia Bank or (b) the Federal Funds Rate plus 0.5% per annum. The amount of margin and the fees payable for the Group Credit Facility depends on Group’s senior unsecured debt rating. Tranche two exclusively provides up to $500.0 million for the issuance of standby letters of credit on a collateralized basis.
The Group Credit Facility requires Group to maintain a debt to capital ratio of not greater than 0.35 to 1 and to maintain a minimum net worth. Minimum net worth is an amount equal to the sum of $3,575.4 million plus 25% of consolidated net income for each of Group’s fiscal quarters, for which statements are available ending on or after January 1, 2007 and for which consolidated net income is positive, plus 25% of any increase in consolidated net worth during such period attributable to the issuance of ordinary and preferred shares. As of December 31, 2007, we were in compliance with all Group Credit Facility covenants.
The Holdings Credit Facility requires Holdings to maintain a debt to capital ratio of not greater than 0.35 to 1 and Everest Re to maintain its statutory surplus at $1.5 billion plus 25% of future aggregate net income and 25% of future aggregate capital contributions after December 31, 2005. As of December 31, 2007, Holdings was in compliance with all Holdings Credit Facility covenants.
Interest expense and fees incurred in connection with the Group Credit Facility and the Holdings Credit Facility were $0.6 million, $0.4 million and $0.4 million for the years ended December 31, 2007, 2006 and 2005, respectively.
exposure data furnished by ceding companies is not uniformly compatible with the data requirements for our licensed models, which adds to the inherent imprecision in the potential loss projections. Further, the results from multiple models and analytical methods must be combined and interpolated to estimate potential losses by and across business units. The combination of techniques potentially adds to the imprecision of our estimates. Also, while most models have been updated to better incorporate factors that contributed to unprecedented industry storm losses in 2004 and 2005, such as flood, storm surge and demand surge, catastrophe model projections are inherently imprecise. In addition, uncertainties with respect to future climatic patterns and cycles add to the already significant uncertainty of loss projections from models using historic long term frequency and severity data.
From an enterprise risk management perspective, management sets limits on the levels of catastrophe loss exposure the Company may underwrite. The limits are revised periodically based on a variety of factors, including but not limited to the Company’s financial resources and expected earnings and risk/reward analyses of the business being underwritten.
As of January 1, 2008, management estimated that the projected economic loss from its largest 100-year event does not exceed $600 million or about 10% of shareholders’ equity. Economic loss is the gross PML reduced by estimated reinstatement premiums to renew coverage and income taxes. The impact of income taxes on the PML depends on the distribution of the losses by corporate entity, which is also affected by inter-affiliate reinsurance. Management also monitors and controls its largest PMLs at multiple points along the loss distribution curve, such as loss amounts at the 20, 50, 100, 250, 500 and 1,000 year return periods. This process enables management to identify and control exposure accumulations and to integrate such exposures into enterprise risk, underwriting and capital management decisions.
If such a single catastrophe loss were to occur, management estimates that the economic loss to us would be approximately $564 million. The impact represents approximately 10% of our capital as of January 1, 2008. The estimate involves multiple variables, including which Everest entity would experience the loss, and as a result there can be no assurance that this amount would not be exceeded.
For 2005, and through 2007, we have not purchased corporate retrocessional protection and have generally de-emphasized the purchase of specific reinsurance by our underwriters, reflecting our view that our exposures, in the context of our capital, financial position and current market pricing, do not warrant reinsurance purchases at current price levels. See ITEM 1, “Business - Risk Management of Underwriting and Retrocession Arrangements” for further details.
Interest expense on 6.6% long term notes is assumed to be fixed through contractual term.
During 2007, 2006 and 2005, we declared and paid shareholder dividends of $121.4 million, $39.0 million and $25.4 million, respectively. As an insurance holding company, we are partially dependent on dividends and other permitted payments from our subsidiaries to pay cash dividends to our shareholders. The payment of dividends to Group by Holdings and to Holdings by Everest Re is subject to Delaware regulatory restrictions and the payment of dividends to Group by Bermuda Re is subject to Bermuda insurance regulatory restrictions.
In November 2005, the FASB issued FASB Staff Position (“FSP”) FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“FAS 115-1”), which is effective for reporting periods beginning after December 15, 2005. FAS 115-1 addresses the determination as to when an investment is considered impaired, whether the impairment is other than temporary and the measurement of an impairment loss. FAS 115-1 also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses not recognized as other-than-temporary impairments. The Company adopted FAS 115-1 prospectively effective January 1, 2006. The Company believes that all unrealized losses in its investment portfolio are temporary in nature.
In July 2006, FASB released FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” (“FIN 48”), which is effective for fiscal years beginning after December 15, 2006. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes” (“FAS 109”). FIN 48 prescribes the recognition and measurement criteria for the financial statements for tax positions taken or expected to be taken in a tax return. Further, FIN 48 expands the required disclosures associated with uncertain tax positions. As a result of the implementation of FIN 48, the Company recorded no adjustment in the liability for unrecognized income tax benefits and no adjustment to beginning retained earnings.
In September 2006, the FASB issued FAS No. 157 “Fair Value Measurements” (“FAS 157”), which is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years with early application encouraged. FAS 157 defines fair value, establishes a framework for measuring fair value consistently in GAAP and expands disclosures about fair value measurements. The Company adopted FAS 157 as of January 1, 2007.
Our current investment strategy seeks to maximize after-tax income through a high quality, diversified, taxable and tax-preferenced fixed maturity portfolio, while maintaining an adequate level of liquidity. Our mix of taxable and tax-preferenced investments is adjusted continuously, consistent with our current and projected operating results, market conditions and our tax position. The fixed maturities in the investment portfolio are comprised of non-trading available for sale securities. Additionally, we invest in equity securities, which we believe will enhance the risk-adjusted total return of the investment portfolio. We have also written a small number of equity index put options.
Interest Rate Risk. Our $14.9 billion investment portfolio at December 31, 2007 is principally comprised of fixed maturity securities, which are generally subject to interest rate risk and of which 19.6%, are subject to foreign currency rate risk, and equity securities, which are subject to price fluctuations. The impact of the foreign exchange risks on the investment portfolio is partially mitigated by changes in the dollar value of foreign currency denominated liabilities and their associated income statement impact.
The tables below display the potential impact of market value fluctuations and after-tax unrealized appreciation on our fixed maturity portfolio (including $2,225.7 million of short-term investments) for the periods indicated based on upward and downward parallel and immediate 100 and 200 basis point shifts in interest rates. For legal entities with a U.S. dollar functional currency, this modeling was performed on each security individually. To generate appropriate price estimates on mortgage-backed securities, changes in prepayment expectations under different interest rate environments were taken into account. For legal entities with a non-U.S. dollar functional currency, the effective duration of the involved portfolio of securities was used as a proxy for the market value change under the various interest rate change scenarios.
We had $9,040.6 million and $8,840.1 million of reserves for losses and LAE as of December 31, 2007 and December 31, 2006, respectively. These amounts are recorded at their nominal value, as opposed to fair value, which would reflect a discount adjustment to reflect the time value of money. Since losses are paid out over a period of time, the fair value of the reserves is less than the nominal value. As interest rates rise, the fair value of the reserves decreases and, conversely, as interest rates decline, the fair value increases. These movements are the opposite of the interest rate impacts on the fair value of investments. While the difference between fair value and nominal value is not reflected in our financial statements, our financial results will include investment income over time from the investment portfolio until the claims are paid. Our loss and loss reserve obligations have an expected duration of approximately 3.8 years, which is reasonably consistent with our fixed income portfolio. If we were to discount our loss and LAE reserves, net of $666.2 million of reinsurance receivables on unpaid losses, the discount would be approximately $1.6 billion resulting in a discounted reserve balance of approximately $6.7 billion, representing approximately 54% of the market value of the fixed maturity investment portfolio funds.
Equity Risk. Equity risk is the potential change in market value of the common stock and preferred stock portfolios arising from changing equity prices. Our equity investments consist of a diversified portfolio of individual securities and exchange traded and mutual funds, which invest principally in high quality common and preferred stocks that are traded on the major exchanges. The primary objective of the equity portfolio is to obtain greater total return relative to bonds over time through market appreciation and income.
We sold six equity index put options based on the S&P 500 index for total consideration, net of commissions, of $22.5 million. These contracts each have a single exercise date, with maturities ranging from 12 to 30 years and strike prices ranging from $1,141.21 to $1,540.63. No amounts will be payable under these contracts if the S&P 500 index is at or above the strike prices on the exercise dates, which fall between June 2017 and March 2031. If the S&P 500 index is lower than the strike price on the applicable exercise date, the amount due will vary proportionately with the percentage by which the index is below the strike price. Based on historical index volatilities and trends and the December 31, 2007 index value, we estimate the probability for each contract of the S&P 500 index falling below the strike price on the exercise date to be less than 5.4%. The theoretical maximum payouts under the contracts would occur if on each of the exercise dates the S&P 500 index value were zero. The present value of these theoretical maximum payouts using a 6% discount factor is $226.0 million.
maximum payout under the contract would occur if on the exercise date the FTSE 100 index value was zero. The present value of the theoretical maximum payout using a 6.0% discount factor is $31.5 million.
Because the equity index put options meet the definition of a derivative under FAS 133, we report the fair value of these instruments in our balance sheet and record any changes to fair value in our statement of operations. We have recorded fair values for our obligations on these equity put options at December 31, 2007 and 2006 of $39.7 million and $37.5 million, respectively; however, we do not believe that the ultimate settlement of these transactions is likely to require a payment that would exceed the initial consideration received or any payment at all.
This report contains forward-looking statements within the meaning of the U.S. federal securities laws. We intend these forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in the federal securities laws. In some cases, these statements can be identified by the use of forward-looking words such as “may”, “will”, “should”, “could”, “anticipate”, “estimate”, “expect”, “plan”, “believe”, “predict”, “potential” and “intend”. Forward-looking statements contained in this report include information regarding our reserves for losses and LAE, the adequacy of our provision for uncollectible balances, estimates of our catastrophe exposure, the effects of catastrophic events on our financial statements, the ability of Everest Re, Holdings and Bermuda Re to pay dividends and the settlement costs of our specialized equity put options. Forward-looking statements only reflect our expectations and are not guarantees of performance. These statements involve risks, uncertainties and assumptions. Actual events or results may differ materially from our expectations. Important factors that could cause our actual events or results to be materially different from our expectations include those discussed under the caption Item 1A. “Risk Factors”. We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.