We lease approximately 63,100 square feet in our New York City location under a lease and a sub-sublease expiring in 2012 and 2009, respectively. The principal U.S. office of our insurance group is located at One Liberty Plaza, New York, New York. Our insurance group also leases a total of approximately 109,000 square feet for our other offices in Atlanta, Georgia, Chicago, Illinois, Columbus, Ohio, Conshohocken, Pennsylvania, Kansas City, Missouri, Morristown, New Jersey, San Francisco, California, St. Paul, Minnesota and Stamford, Connecticut. We lease approximately 4,500 square feet in Hamilton, Bermuda for our Bermuda insurance operations.
Due to the significant changes in our business during the years 2002, 2001 and 2000, we believe that the comparisons of our results of operations in such periods are not relevant. These changes included (1) the sale of our prior reinsurance operations in May 2000, (2) our change of legal domicile
and reorganization completed in November 2000, (3) our acquisition activity and (4) our new underwriting initiative and the related capital infusions.
(2)On November 30, 2002, we acquired PSIC and recorded an extraordinary gain of $3.9 million for the year ended December 31, 2002. The extraordinary gain represents the excess of the fair value of acquired net assets of $6.4 million over the purchase price of $2.5 million.
(5)Book value per share excludes the effects of stock options and class B warrants. Diluted book value per share as of December 31, 2001 is adjusted on a pro forma basis to reflect the issuance of additional preference shares that were issued by us on June 28, 2002 and December 16, 2002 pursuant to post-closing purchase price adjustment mechanisms under the Subscription Agreement.
This discussion and analysis should be read in conjunction with our audited consolidated financial statements and notes thereto presented under Item 8.
Our costs and expenses primarily consist of losses and loss adjustment expenses, acquisition costs, other operating expenses and non-cash compensation. Losses and loss adjustment expenses include management's best estimate of the ultimate cost of claims incurred during a reporting period. Such costs consist of three components: paid losses, changes in estimated amounts for known losses ("case reserves"), and changes in reserves for incurred but not reported ("IBNR") losses. See "Critical Accounting Policies, Estimates and Recent Accounting Pronouncements-Reserves for Losses and Loss Adjustment Expenses" for further discussion. Acquisition expenses consist primarily of commissions, brokerage and taxes paid to obtain our business. A significant portion of such costs is paid based on a percentage of the premium written and will vary for each class or line of business that we underwrite. Other operating expenses, a significant portion of which are general and administrative expenses, consist primarily of compensation-related expenses. Non-cash compensation relates to certain grants (primarily of restricted common shares) under our stock incentive plans and other arrangements. The issuance of restricted common shares and the related recognition of non-cash compensation expense has no impact on our shareholders' equity.
The insurance and reinsurance industry is influenced by factors such as the frequency and/or severity of claims and losses, including natural disasters or other catastrophic events, variations in interest rates and financial markets, changes in the legal, regulatory and judicial environments, inflationary pressures and general economic conditions. These factors influence the demand for insurance or reinsurance, the supply of which is generally related to the total capital of competitors in the market. During 2001, market conditions had been improving primarily as a result of declining insurance capacity. The events of September 11th and deteriorating underwriting results of the industry accelerated these already improving conditions.
Insurance loss reserves are inherently subject to uncertainty. The period of time from the occurrence of a loss through the settlement of the liability may extend many years into the future. During this period, additional facts and trends will become known and, as these factors become apparent, reserves will be adjusted in the period in which the new information becomes known. While reserves are established based upon available information, certain factors, such as those inherent in the political, judicial and legal system, including judicial and litigation trends and legislation changes, could impact the ultimate liability. Changes to our prior year loss reserves can impact our current underwriting results by (1) reducing our reported results if the prior year reserves prove to be deficient or (2) improving our reported results if the prior year reserves prove to be redundant. The reserves for losses and loss adjustment expenses represent estimates involving actuarial and statistical projections at a given point in time of our expectations of the ultimate settlement and administration costs of losses incurred, and it is likely that the ultimate liability may exceed or be less than such estimates. We utilize actuarial models as well as available historical insurance and reinsurance industry loss ratio experience and loss development patterns to assist in the establishment of appropriate loss reserves. Even actuarially sound methods can lead to subsequent adjustments to loss reserves that are both significant and irregular due to the nature of the risks written, potentially by a material amount.
In establishing the reserves for losses and loss adjustment expenses, we have made various assumptions relating to the pricing of our reinsurance contracts and insurance policies and have also considered available historical industry experience and current industry conditions. Our reserving method for 2002 was primarily the expected loss method, which is commonly applied when limited loss experience exists. We select the initial expected loss and loss adjustment expense ratios based on information derived by our underwriters and actuaries during the initial pricing of the business. These ratios consider, among other things, rate increases and changes in terms and conditions that have been observed in the market. Our reserving process reflects that there is a possibility that the assumptions made could prove to be inaccurate due to several factors, including the fact that very limited historical information has been reported to us through December 31, 2002 due to our start-up nature. As of December 31, 2002, 67% of our total net loss reserves, or $255.5 million, were IBNR reserves. A 5% change in the IBNR reserves would result in an approximately $12.8 million change in our total net loss reserves. Such change would represent approximately 24% of our 2002 net income, or approximately $0.20 per diluted share, and 0.9% of our December 31, 2002 shareholders' equity. As actual loss information is reported to us and we develop our own loss experience, our reserving methods will also include other actuarial techniques. It is possible that claims in respect of events that have occurred could exceed our reserves and have a material adverse effect on our results of operations in a particular period or our financial condition in general.
Under GAAP, we are only permitted to establish loss and loss adjustment expense reserves for losses that have occurred on or before the financial statement date. Case reserves and IBNR reserves contemplate these obligations. No contingency reserve allowances are established to account for future loss occurrences. Losses arising from future events will be estimated and recognized at the time the losses are incurred and could be substantial.
We also write certain business that is intended to provide insurers with risk management solutions that complement traditional reinsurance. Under these contracts, we assume a measured amount of insurance risk in exchange for a specified margin. The terms and conditions of these contracts may include additional or return premiums based on loss experience, loss corridors, sublimits and caps. Examples of such business include aggregate stop-loss coverages and financial quota share coverages.
Certain reinsurance contracts included in our non-traditional business, which pursuant to Statement of Financial Accounting Standards ("SFAS") No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts," issued by the Financial Accounting Standards Board ("FASB"), are deemed, for financial reporting purposes, not to transfer insurance risk, are accounted for using the deposit method of accounting as prescribed in Statement of Position 98-7, "Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk." For those contracts that contain an element of underwriting risk, the estimated profit margin is deferred and amortized over the contract period and such amount is included in our underwriting results. For those contracts that do not transfer an element of underwriting risk, the estimated profit is reflected in earnings over the estimated settlement period using the interest method and such profit is included in investment income.
Acquisition expenses consist principally of commissions and brokerage expenses. Other operating expenses also include expenses that vary with, and are directly related to, the acquisition of business. Acquisition expenses are reflected net of ceding commissions received from unaffiliated reinsurers. Deferred acquisition costs are carried at their estimated realizable value based on the related unearned premiums and take into account anticipated losses and loss adjustment expenses, based on historical and current experience, and anticipated investment income.
We currently classify all of our publicly traded fixed maturity investments, short-term investments and equity securities as "available for sale" and, accordingly, they are carried at estimated fair value. The fair value of publicly traded fixed maturity securities and publicly traded equity securities is estimated using quoted market prices or dealer quotes. Short-term investments comprise securities due to mature within one year of the date of issue. Short-term investments include certain cash equivalents which are part of our investment portfolios under the management of external investment managers. Investments included in our private portfolio include securities issued by privately held companies. Our investments in privately held equity securities, other than those carried under the equity method of accounting, are carried at estimated fair value. Fair value is initially considered to be equal to the cost of such investment until the investment is revalued based on substantive events or other factors which could indicate a diminution or appreciation in value. We apply Accounting Principles Board ("APB") Opinion No. 18, "The Equity Method of Accounting for Investments in Common Stock," for privately held equity investments accounted for under the equity method, and we record our percentage share of the investee company's net income or loss. See note 2, "Significant Accounting Policies-Investments," of the notes accompanying our consolidated financial statements.
The increase in diluted average shares outstanding from 2001 to 2002 was primarily due to: (1) the issuance of 35,687,735 convertible preference shares and 3,776,025 class A warrants in connection with our capital infusion in November 2001; (2) 7,475,000 common shares in connection with an offering completed by us in April 2002; and (3) 875,753 convertible preference shares on June 28, 2002 and 2,831,177 convertible preference shares on December 16, 2002 pursuant to the subscription agreement entered into in connection with the November 2001 capital infusion. See note 11, "Share Capital," of the notes accompanying our consolidated financial statements.
The following table sets forth an analysis of underwriting income or loss, together with a reconciliation of underwriting income or loss to net income or loss for the years ended December 31, 2002, 2001 and 2000:
Net premiums written for 2002 were $1.26 billion, of which our reinsurance and insurance operations contributed net premiums written of $882.7 million, or 70%, and $378.9 million, or 30%, respectively. See "-Segment Information" for additional information on premiums by segment.
(2)The acquisition expense ratio is reflected net of certain policy-related fee income.
For the year ended December 31, 2001, premiums written, losses incurred and acquisition costs resulted primarily from our insurance subsidiaries which were acquired during 2001. The remaining portion of our net income for 2001 was generated through our investment activities, offset by other operating expenses. The corresponding amounts for the year ended December 31, 2000 reflect the results of our prior reinsurance operations, which were sold in May 2000.
In connection with the sale of our prior reinsurance operations in May 2000, we placed $20.0 million of the purchase price in escrow. The agreement required that these funds would be held for a period of five years to reimburse Folksamerica if certain loss reserves transferred to it in the asset sale became deficient as measured at the end for such five-year period or to satisfy certain indemnity claims Folksamerica may have had during such period. In February 2002, we reached a definitive settlement agreement with Folksamerica pursuant to which we satisfied all of our obligations under the escrow agreement for an amount equal to approximately $17.0 million, plus accrued interest income of $1.8 million. In connection with this settlement agreement, for 2001, we recorded a $2.4 million benefit to reflect the net effects of this agreement. During 2000, our net loss included a $15.0 million charge related to the escrowed assets. See note 13, "Acquisition of Subsidiaries and Disposition of Prior Reinsurance Operations," of the notes accompanying our consolidated financial statements.
At December 31, 2002, approximately 98% of our invested assets consisted of fixed maturity and short-term investments, compared to 94% at December 31, 2001, exclusive of securities held in escrow. Net investment income was approximately $51.2 million, $12.1 million and $15.9 million in 2002, 2001 and 2000, respectively. Such amounts are net of investment expenses of $1.3 million, $0.1 million and $0.9 million, respectively. The net investment expenses were offset by advisory fee income that we received from a former investment advisor in the amount of $1.15 million, $1.25 million and $1.25 million in 2002, 2001 and 2000, respectively. The advisory agreement under which we earned such fee income was terminated in 2002.
The substantial increase in net investment income in 2002 was due to the significant increase in our invested assets resulting from (1) the capital raised in November 2001, (2) cash flow from operations and (3) proceeds received from the public offering of our common shares in April 2002 and the exercise of class A warrants in September 2002. The decrease in net investment income in 2001
compared with 2000 primarily reflects the decline in our average invested asset base resulting from the sale of our prior reinsurance operations.
Other expenses primarily represent certain holding company costs necessary to support our growing worldwide insurance and reinsurance operations and costs associated with operating as a publicly-traded company. In addition, other expenses and fee income include the results of Hales & Company Inc.
certain non-cash compensation, net realized investment gains or losses, net foreign exchange gains or losses and other income, was approximately 5.3%. We currently estimate that our comparable income tax provision in 2003 will result in an effective tax rate of approximately 12.5%, although no assurances can be given to that effect. See note 8, "Income Taxes," of the notes accompanying our consolidated financial statements for a reconciliation of the difference between the provision for income taxes and the expected tax provision at the weighted average statutory tax rate for the years ended December 31, 2002, 2001 and 2000.
At December 31, 2002, we have a valuation allowance of $2.1 million against a deferred tax asset in one of our subsidiaries that currently does not have a business plan to produce significant future taxable income. See note 8, "Income Taxes," of the notes accompanying our consolidated financial statements, and "Critical Accounting Policies, Estimates and Recent Accounting Pronouncements-Valuation Allowance."
Following is summary of net realized investment gains (losses) for the years ended December 31, 2002, 2001 and 2000:
Currently, our portfolio is actively managed to maximize total return within certain specific guidelines. The effect of financial market movements on the investment portfolio will directly impact net realized gains and losses as the portfolio is adjusted and rebalanced.
The net realized losses of $6.4 million and $2.1 million for the years ended December 31, 2002 and 2001, respectively, on our fixed income portfolio resulted from the sale of certain securities to reduce credit exposure, and from sales related to rebalancing the portfolio. In 2000, net realized gains included $11.0 million of pre-tax losses, or $8.7 million, after-tax, recorded during the 2000 fourth quarter
We underwrite risks on a worldwide basis. At December 31, 2002, approximately 10% of our aggregate net premiums written are denominated in currencies other than our functional currency, which is the U.S. dollar. Net foreign exchange gains for the year ended December 31, 2002 of $2,449,000 consisted of an unrealized loss of $36,000 and a realized gain of $2,485,000. The net unrealized loss resulted from the translation of foreign denominated monetary assets and liabilities at December 31, 2002, as defined and required under GAAP. Foreign exchange gains and losses vary with fluctuations in currency rates. Accordingly, these gains and losses could add significant volatility to our net income in future periods. We have not attempted, and currently do not expect to attempt, to reduce our exposure to these exchange rate risks by using hedging transactions or by investing in securities denominated in local (foreign) currencies. We may therefore suffer losses solely as a result of exchange rate fluctuations.
The reversal of the deferred tax asset valuation allowance was based on our recently completed restructuring of our U.S.-based insurance underwriting operations and our business plan. The tax valuation allowance for the years ended December 31, 2002, 2001 and 2000 is discussed above under "-Income Taxes," and in note 8, "Income Taxes," of the notes accompanying our consolidated financial statements.
In connection with the sale of our prior reinsurance operations to Folksamerica on May 5, 2000, we recognized an after-tax loss, as described in note 13, "Acquisition of Subsidiaries and Disposition of Prior Reinsurance Operations," of the notes accompanying our consolidated financial statements.
During 2002, our board of directors accelerated the vesting terms of certain restricted common shares granted to Mr. Clements, which had been issued in connection with the November 2001 capital infusion, and Mr. Clements agreed to repay the outstanding $13.5 million loan previously made to him
During the year ended December 31, 2000, due to the sale of our prior reinsurance operations to Folksamerica in May 2000, segment information is not meaningful.
(1)The loss ratios for statutory and GAAP are based on net premiums earned. The statutory expense ratios are based on net premiums written, while the GAAP expense ratios are based on net premiums earned. Underwriting Gain. For the year ended December 31, 2002, the combined ratio on a GAAP basis for the reinsurance segment was 87.8%. The components of the reinsurance segment's underwriting gain are discussed below.
Premiums Written. Net premiums written for the year ended December 31, 2002 were $882.7 million. Of such amount, 59% of net premiums written were generated from pro rata contracts and 41% were derived from excess of loss treaties.
We are currently retaining substantially all of our reinsurance premiums written. We do, however, participate in "common account" retrocessional arrangements for certain treaties. Such arrangements reduce the effect of individual or aggregate losses to all companies participating on such treaties, including the reinsurer, such as us, and the ceding company. We will continue to evaluate our retrocessional requirements.
The reinsurance segment commenced operations with the January 1, 2002 renewal season. As a result, premiums written for the segment reflect only new business. Given this fact and current market conditions, we currently anticipate significant premium growth in 2003, although no assurances can be given to that effect. The amount of premiums written with respect to our various lines of business may fluctuate from year-to-year based on many factors, including changing market conditions.
Net Premiums Earned. For 2002, approximately 56.8% of the reinsurance segment's net premiums written were earned. Due to the significant growth in premiums written during 2002, there is a significant difference between written and earned premiums for such year. Of net premiums earned in 2002, 45.8% were generated from pro rata contracts and 54.2% were derived from excess of loss treaties.
Losses and Loss Adjustment Expenses. Reinsurance segment losses and loss adjustment expenses incurred for the year ended December 31, 2002 were $315.8 million. The 63.0% loss ratio included 6.6 points of paid claims, 16.6 points related to case reserves and 39.8 points related to IBNR reserves. For a discussion of the reserves for losses and loss adjustment expenses, please refer to the section above entitled "Critical Accounting Policies, Estimates and Recent Accounting Pronouncements-Reserves for Losses and Loss Adjustment Expenses."
Net Premiums Earned. For 2002, approximately 40.6% of the insurance segment net premiums written were earned. Due to the significant growth in premiums written during 2002, there is a significant difference between written and earned premiums for such year.
Losses and Loss Adjustment Expenses. Insurance segment losses and loss adjustment expenses incurred for 2002 were $108.8 million. The 70.6% loss ratio included 29.1 points of paid claims (of which 16.5 points were generated from our non-standard automobile business), 3 points related to case reserves and 38.5 points related to IBNR reserves. Our 2002 reported loss ratio reflects a 2.6 point, or $4 million, deficiency in our 2001 reported reserves. Approximately 49% of this deficiency occurred in a small number of program accounts written during 2000 and 2001 and the balance of 51% was in our non-standard automobile business as a result of an actuarial review performed in 2002. For a discussion of the reserves for losses and loss adjustment expenses, please refer to the section above entitled "Critical Accounting Policies, Estimates and Recent Accounting Pronouncements-Reserves for Losses and Loss Adjustment Expenses."
Underwriting Expenses. The acquisition expense ratio for our insurance segment of 2.7% was calculated net of certain policy-related fee income (which reduced the ratio by approximately 6 points), and was influenced by, among other things (1) the amount of business ceded to unaffiliated reinsurers and (2) the amount of business written on a surplus lines (non-admitted) basis. The combination of these two factors resulted in a significant reduction in our acquisition expense ratio for 2002. Other operating expenses for 2002 were 27.8% of net premiums earned, and reflected the start-up nature of the insurance segment. We currently expect that operating expenses will continue to increase as we continue to build our insurance group's infrastructure. However, as a percentage of net premiums earned, operating expenses are currently expected to decline in 2003 since net premiums earned are expected to grow significantly, although no assurances can be given to that effect.
During 2002, ACGL contributed its ownership interest in Arch-U.S. and the U.S. insurance and reinsurance group to Arch Re Bermuda, which increased Arch Re Bermuda's surplus to approximately $1.2 billion as of December 31, 2002. In addition, our U.S. group was restructured in April 2002 such that Arch Re U.S. has become the parent of our principal U.S. insurance subsidiaries, Arch Insurance, Arch Specialty and Arch E&S. At December 31, 2002, Arch Re U.S.'s statutory capital and surplus was approximately $359 million. On a consolidated basis, our aggregate invested assets, including cash and short-term investments, totaled approximately $2.0 billion at December 31, 2002. As of such date, and following such restructurings, ACGL's readily available cash, short-term investments and marketable securities, excluding amounts held by our regulated insurance and reinsurance subsidiaries, totaled $8 million.
such dividends, with the Bermuda Monetary Authority an affidavit stating that it will continue to meet the required margins. In addition, Arch Re Bermuda is prohibited, without prior approval of the Bermuda Monetary Authority, from reducing by 15% or more its total statutory capital, as set out in its previous year's financial statements. At December 31, 2002, Arch Re Bermuda had statutory capital and surplus as determined under Bermuda law of $1.2 billion (including ownership interests in its wholly owned subsidiaries). Accordingly, as of December 31, 2002, 15% of Arch Re Bermuda's capital, or approximately $179 million, is available for dividends without prior approval under Bermuda law, as discussed above. As of December 31, 2002, our U.S. insurance and reinsurance subsidiaries, on a consolidated basis, may not pay any significant dividends or distributions during 2003 without prior regulatory approval. In addition, the ability of our insurance and reinsurance subsidiaries to pay dividends could be constrained by our dependence on financial strength ratings from independent rating agencies. Our ratings from these agencies depend to a large extent on the capitalization levels of our insurance and reinsurance subsidiaries.
ACGL, through its subsidiaries, provides financial support to certain of its insurance subsidiaries and affiliates, through certain reinsurance arrangements essential to the ratings of such subsidiaries. Except as described in the preceding sentence, or where express reinsurance, guarantee or other financial support contractual arrangements are in place, each of ACGL's subsidiaries or affiliates is solely responsible for its own liabilities and commitments (and no other ACGL subsidiary or affiliate is so responsible). Any reinsurance arrangements, guarantees or other financial support contractual arrangements that are in place are solely for the benefit of the ACGL subsidiary or affiliate involved and third parties (creditors or insureds of such entity) are not express beneficiaries of such arrangements.
offering in April 2002 and the exercise of class A warrants in September 2002 and (3) an increase in unrealized appreciation of investments.
For purposes of limiting our risk of loss, we reinsure a portion of our exposures, paying to reinsurers a part of the premiums received on the policies we write, and we may also use retrocessional protection. For the year ended December 31, 2002, ceded premiums written represented approximately 15% of gross premiums written. In our insurance segment, we retained a greater amount of premiums written in our program business in 2002 as compared to 2001 as a result of the new underwriting initiative and our improved financial position. The development of loss reserves, on a gross basis, from 2001 and prior years in our program business in the amount of $58 million substantially increased our amounts recoverable from reinsurers in 2002.
(2)In connection with our acquisition of Arch Specialty in February 2002, the seller, Sentry Insurance a Mutual Company ("Sentry"), agreed to reinsure or otherwise assume all liabilities arising out of Arch Specialty's business prior to the closing of the acquisition. The balance due from Sentry includes all such amounts.
(3)The A.M. Best group rating of "A-" (Excellent) has been applied to all Lloyd's of London syndicates.
(4)Includes amounts recoverable from separate cell accounts in our alternative markets unit. Approximately 85% of such amounts are collateralized with letters of credit or deposit funds.
(5)The following table provides a breakdown of the "All other" category by A.M. Best rating:
We have large aggregate exposures to natural and man-made catastrophic events. Catastrophes can be caused by various events, including, but not limited to, hurricanes, floods, windstorms, earthquakes, hailstorms, explosions, and severe winter weather and fires. Catastrophes can also cause losses in non-property lines of business such as workers' compensation or general liability. In addition to the nature of property business, we believe that economic and geographic trends affecting insured property, including inflation, property value appreciation and geographic concentration tend to generally increase the size of losses from catastrophic events over time.
For our catastrophe exposed business, we seek to limit the amount of exposure we will assume from any one insured or reinsured and the amount of the exposure to catastrophe losses in any geographic zone. We monitor our exposure to catastrophic events, including earthquake, wind and specific terrorism exposures, and periodically reevaluate the estimated probable maximum pre-tax loss for such exposures. Our estimated probable maximum pre-tax loss is determined through the use of modeling techniques, but such estimate does not represent our total potential loss for such exposures. We seek to limit the probable maximum pre-tax loss to a percentage of our total shareholders' equity for severe catastrophic events. Currently, we generally seek to limit the probable maximum pre-tax loss to approximately 25% of total shareholders' equity for severe catastrophic events that could be expected to occur once in every 250 years. There can be no assurances that we will not suffer pre-tax losses greater than 25% of our total shareholders' equity from a catastrophic event due to several factors, including the inherent uncertainties in estimating the frequency and severity of such events and the margin of error in making such determinations resulting from potential inaccuracies in the data provided by clients and brokers, the modeling techniques and the application of such techniques. In addition, depending on business opportunities and the mix of business that may comprise our insurance and reinsurance portfolio, we may seek to limit the probable maximum pre-tax loss to a higher percentage of our total shareholders' equity for our catastrophe exposed business.
We write business on a worldwide basis, and our results of operations may be affected by fluctuations in the value of currencies other than the U.S. dollar. Changes in foreign currency exchange rates can reduce our revenues and increase our liabilities and costs, as measured in the U.S. dollar as our functional currency. We have not attempted and currently do not expect to attempt to reduce our exposure to these exchange rate risks by using hedging transactions or by investing in securities denominated in local (foreign) currencies. We may therefore suffer losses solely as a result of exchange rate fluctuations.
As a relatively new insurance and reinsurance company, our success will depend on our ability to integrate new management and operating personnel and to establish and maintain operating procedures and internal controls (including the timely and successful implementation of our information technology initiatives) to effectively support our business and our regulatory and reporting requirements, and no assurances can be given as to the success of these endeavors.
The Warburg Pincus funds and the Hellman & Friedman funds together control a majority of our voting power on a fully-diluted basis and have the right to nominate a majority of directors to our board under the shareholders agreement entered into in connection with the November 2001 capital infusion. The shareholders agreement also provides that we cannot engage in certain transactions, including mergers and acquisitions and transactions in excess of certain amounts, without the consent of a designee of the Warburg Pincus funds and a designee of the Hellman & Friedman funds. These provisions could have an effect on the operation of our business and, to the extent these provisions discourage takeover attempts, they could deprive our shareholders of opportunities to realize takeover premiums for their shares or could depress the market price of our common shares. By reason of their ownership and the shareholders agreement, the Warburg Pincus funds and the Hellman & Friedman funds are able to strongly influence or effectively control actions to be taken by us. The interests of these shareholders may differ materially from the interests of the holders of our common shares, and these shareholders could take actions that are not in the interests of the holders of our common shares.
See note 13, "Acquisition of Subsidiaries and Disposition of Prior Reinsurance Operations," of the notes accompanying our consolidated financial statements.
Financial strength and claims paying ratings from third party rating agencies are instrumental in establishing the competitive positions of companies in our industry. Periodically, rating agencies evaluate us to confirm that we continue to meet their criteria for the ratings assigned to us by them. Our reinsurance subsidiaries, Arch Re U.S. and Arch Re Bermuda, and our insurance subsidiaries, Arch Insurance, Arch Specialty and Arch E&S, each currently have financial strength ratings of "A-" (Excellent) from A.M. Best. With respect to our non-standard automobile insurers, American Independent has a financial strength rating of "C++" (Marginal) from A.M. Best, and PSIC has a financial strength rating of "A-" (Excellent) from A.M. Best. We do not believe that American Independent or PSIC's non-standard automobile business are particularly ratings sensitive because their insureds purchase insurance primarily to satisfy state and local insurance and financial responsibility requirements.
Recently, rating agencies have been coming under increasing pressure as a result of high-profile corporate bankruptcies and may, as a result, increase their scrutiny of rated companies, revise their rating policies or take other action. We can offer no assurances that our ratings will remain at their current levels. A ratings downgrade, or the potential for such a downgrade, could adversely affect both our relationships with agents, brokers, wholesalers and other distributors of our existing products and services and new sales of our products and services.
At December 31, 2002, the future minimum rental commitments, exclusive of escalation clauses and maintenance costs and net of rental income, for all of our operating leases with remaining non-cancelable terms in excess of one year are as follows:
This bank facility expires April 16, 2003. It is anticipated that the letter of credit facility will be renewed on expiry, but such renewals are subject to the availability of credit from banks which we utilize. In the event such support is insufficient, we could be required to provide alternative security to cedents. This could take the form of additional insurance trusts supported by our investment portfolio
or funds withheld using our cash resources. The amount of letters of credit issued is driven by, among other things, the timing and payment of catastrophe losses, loss development of existing reserves, the payment pattern of such reserves, the further expansion of our business and the loss experience of such business. If we are unable to post security in the form of letters of credit or trust funds when required, our operations could be significantly and negatively affected.
At December 31, 2002, consolidated cash and invested assets totaled approximately $2.0 billion, consisting of $572.2 million of cash and short-term investments, $1.4 billion of publicly traded fixed maturity securities and $31.5 million of privately held securities. At December 31, 2002, our fixed income portfolio, which includes fixed maturity securities and short-term investments, had an average Standard & Poor's quality rating of "AA-" and an average duration of 2.1 years. Our fixed income investment portfolio is currently managed by external investment advisors under our direction in accordance with investment guidelines provided by us. Our current guidelines stress preservation of capital, market liquidity and diversification of risk. At December 31, 2002, there were no securities in our investment portfolio which had market values below their cost basis for a period longer than six months.
Our privately held equity securities consist of securities issued by privately held companies that are generally restricted as to resale or are otherwise illiquid and do not have readily ascertainable market values. The risk of investing in such securities is generally greater than the risk of investing in securities of widely held, publicly traded companies. At December 31, 2002, our private equity portfolio consisted of six investments totaling $31.5 million in fair value, with additional investment portfolio commitments in an aggregate amount of approximately $0.4 million. We do not currently intend to make any significant investments in privately held securities over and above our current commitments. See note 6, "Investment Information," of the notes accompanying our consolidated financial statements.
We have not invested in derivative financial instruments such as futures, forward contracts, swaps or options or other financial instruments with similar characteristics such as interest rate caps or floors and fixed-rate loan commitments. Our portfolio includes mortgage-backed securities which contain embedded options. Our investments in mortgage-backed securities, which amounted to approximately $253.8 million at December 31, 2002, or 12.7% of cash and invested assets, are classified as available for sale and are not held for trading purposes.
(1)Book value per common share at December 31, 2002 and December 31, 2001 was determined by dividing (i) the difference between total shareholders' equity and the aggregate liquidation preference of the Series A convertible preference shares of $815.7 million and $749.4 million, respectively, by (ii) the number of common shares outstanding. Restricted common shares are
(2)Includes 35,687,735 preference shares that were issued on November 20, 2001 in exchange for $763.2 million of cash. The number of preference shares issued was based on the estimated per share price of $21.38. The estimated per share price was based on (i) total shareholders' equity as of June 30, 2001 (adjusted for certain amounts as described in the Subscription Agreement entered in connection with the capital infusion), divided by (ii) the total number of common shares outstanding as of June 30, 2001, which was 12,863,079. In addition, the amount of preference shares at December 31, 2002 includes an additional 3,706,930 preference shares issued pursuant to the Subscription Agreement as follows: (i) 875,753 preference shares were issued on June 28, 2002 pursuant to a post-closing purchase price adjustment mechanism under the Subscription Agreement; and (ii) 2,831,177 preference shares were issued on December 16, 2002 pursuant an agreed upon adjustment under the Subscription Agreement. We had agreed to issue to the new investors additional preference shares such that the per share price would be adjusted downward by $1.50 per preference share when the closing price of our common shares was at least $30 per share for at least 20 out of 30 consecutive trading days on or prior to September 19, 2005, which condition was met on December 16, 2002. Each preference share is convertible at any time and from time to time at the option of the holder thereof into one fully paid and nonassessable common share, subject to possible adjustment. In addition, in December 2002, 550,000 preference shares were converted into an equal number of our common shares.
(4)Represents restricted common shares issued in connection with the November 2001 capital infusion transaction. These restricted common shares are included in common shares at December 31, 2002. Pursuant to the Subscription Agreement, a post-closing purchase price adjustment will be calculated in November 2003 (or such earlier date as agreed upon by us and the investors) based on an adjustment basket. The adjustment basket will be equal to (1) the difference between value realized upon sale and the GAAP book value at the closing of the capital infusion in November 2001 (as adjusted based on a pre-determined growth rate) of agreed upon non-core businesses; plus (2) the difference between GAAP net book value of the insurance balances attributable to our core insurance operations with respect to any policy or contract written or having an effective date prior to November 20, 2001 at the time of the final adjustment and those balances at the closing; minus (3) reductions in book value arising from costs and expenses relating to the transaction provided under the Subscription Agreement, actual losses arising out of breach of representations under the Subscription Agreement and certain other costs and expenses. If the adjustment basket, which will be calculated by our independent auditors, is less than zero, we will issue additional preference shares to the investors based on the decrease in value of the components of the adjustment basket. If the adjustment basket is greater than zero, we are allowed to use cash in an amount based on the increase in value of the components of the adjustment basket to repurchase common shares (other than any common shares issued upon conversion of the preference shares or exercise of the class A warrants). In addition, on the fourth anniversary of the closing, there will be a calculation of a further adjustment basket based on (1) liabilities owed to Folksamerica (if any) under the Asset Purchase Agreement, dated as of January 10, 2000, between us and Folksamerica, and (2) specified tax and ERISA matters
Our ultimate exposure for losses and loss adjustment expenses on claims not yet settled is increased by the effects of inflation, and changes in inflation therefore could be a significant factor in determining the appropriateness of our reserves for losses and loss adjustment expenses and our premium rates. Generally, our methods of calculating the reserves for losses and loss adjustment expenses and determining our premium rates take into account the anticipated effects of inflation. However, until claims are ultimately settled, the full effect of inflation on our results cannot be known.
The aggregate hypothetical loss generated from an immediate parallel, adverse shift in the treasury yield curve of 100 basis points would result in a decrease in market value of approximately $39.1 million on our fixed income portfolio, including short-term investments, as of December 31, 2002, and would decrease diluted book value per share by approximately $0.59 as of such date.
We are exposed to equity price risks on the private equity securities included in our investment portfolio. All of our privately held securities were issued by insurance and reinsurance companies or companies providing services to the insurance industry. We typically do not attempt to reduce or eliminate our market exposure on these securities. Investments included in our private portfolio include
securities issued by privately held companies that are generally restricted as to resale or are otherwise illiquid and do not have readily ascertainable market values. Investments in privately held securities issued by privately held companies may include both equity securities and securities convertible into, or exercisable for, equity securities (some of which may have fixed maturities). Our privately held equity securities, which at December 31, 2002 were carried at a fair value of $31.5 million, have exposure to price risk. The estimated potential losses in fair value for our privately held equity portfolio resulting from a hypothetical 10% decrease in quoted market prices, dealer quotes or fair value is approximately $3.2 million at December 31, 2002.