The following is a discussion of the results of operations of the Company. This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and the notes thereto presented under ITEM 8.
On September 19, 2000, the Company completed the acquisition of all of the issued and outstanding capital stock of Gibraltar from The Prudential for $51.8 million, which approximated book value. As a result of the acquisition, Gibraltar became a wholly-owned subsidiary of the Company and, immediately following the acquisition, its name was changed to Mt. McKinley. In connection with the acquisition of Mt. McKinley, which has significant exposure to asbestos and environmental (“A&E”) claims, Prudential Property and Casualty Insurance Company of Indiana (“Prupac”), a subsidiary of The Prudential, provided reinsurance to Mt. McKinley covering 80% ($160.0 million) of the first $200.0 million of any adverse development of Mt. McKinley’s reserves as of September 19, 2000. In addition, The Prudential guaranteed Prupac’s obligation to Mt. McKinley. There were $81.1 million, $56.7 million and $22.2 million of cessions under this reinsurance for years ended December 31, 2003, 2002 and 2001, respectively, exhausting the limit available under this contract.
The worldwide reinsurance and insurance businesses are highly competitive yet cyclical by product and market. Competition with respect to the types of reinsurance and insurance business in which the Company is engaged is based on many factors, including the perceived overall financial strength of the reinsurer or insurer, A.M. Best’s and/or Standard & Poor’s rating of the reinsurer or insurer, underwriting expertise, the jurisdictions where the reinsurer or insurer is licensed or otherwise authorized, capacity and coverages offered, premiums charged, other terms and conditions of the reinsurance and insurance business offered, services offered, speed of claims payment and reputation and experience in lines written. The Company competes in the U.S. and international reinsurance and insurance markets with numerous international and domestic reinsurance and insurance companies. The Company’s competitors include independent reinsurance and insurance companies, subsidiaries or affiliates of established worldwide insurance companies, reinsurance departments of certain insurance companies and domestic and international underwriting operations, including underwriting syndicates at Lloyd’s. Some of these competitors have greater financial resources than the Company and have established long-term and continuing business relationships throughout the industry, which can be a significant competitive advantage. In addition, the potential for securitization of reinsurance and insurance risks through capital markets provides an additional source of potential reinsurance and insurance capacity and competition.
As indicated in the preceding Industry Conditions section, the reinsurance and insurance industry has experienced very favorable market conditions over the past three years. The favorable market conditions coupled with the Company’s financial strength, strategic positioning and market and underwriting expertise enabled it to significantly increase its volume of business. As a result, gross written premiums for the year ended December 31, 2003 increased by 55.8% compared with the year ended December 31, 2002, which had increased 49.0% compared with the year ended December 31, 2001. Gross written premiums for the year ended December 31, 2001 had increased by 34.6% compared with the year ended December 31, 2000. Due to the nature of its businesses, the Company is unable to precisely differentiate the effects of price changes as compared to changes in exposure. Similarly, because individual reinsurance arrangements often reflect revised coverages, structuring, pricing, terms and/or conditions from period to period, the Company is unable to differentiate between the premium volumes attributable to new business as compared to renewal business. Management believes however, that on balance, during the past three years, the more significant component of growth related to growth in exposures underwritten with a lesser but still significant component relating to increased pricing and/or improved terms and conditions. Management believes further that market conditions are generally more favorable for casualty business classes than for property business classes; however, management notes that it continues to see business opportunities in virtually all operating classes and markets. Although premium volumes have increased significantly, the Company continues to decline business that does not meet its objectives regarding underwriting profitability.
The other components of underwriting gain (loss) are highly correlated to the level of premium volume. The amount of net written premiums reflects gross written premiums less ceded premiums. Premiums ceded were $1,206.0 million (28.1% of gross written premiums), $565.9 million (20.5% of gross written premiums) and $432.9 million (23.4% of gross written premiums) for the years ended December 31, 2003, 2002 and 2001, respectively. The increase in ceded premiums was principally attributable to a quota share agreement between Everest Re and Bermuda Re whereby 25% and 20% of Everest Re’s net retained liabilities on all new and renewal policies for underwriting years 2003 and 2002, respectively, were ceded to Bermuda Re. Under this agreement, $980.0 million and $372.9 million were ceded for the years ended December 31, 2003 and 2002, respectively. Ceded premiums also included adjustment premiums related to claims made under the Company’s accident year aggregate excess of loss retrocessional programs. The amount of the adjustment premiums was $49.6 million, $54.5 million and $139.4 million for years ended December 31, 2003, 2002 and 2001, respectively. The larger amount of adjustment premium for 2001 relates primarily to losses ceded in conjunction with the September 11 attacks and the Enron bankruptcy.
Incurred losses and loss adjustment expenses (“LAE”) also increased as a result of the increased premium volume. However, the percentage increase in losses was less than the percentage increase in premium volume since part of the premium increase represented improvement in pricing, terms and conditions, as opposed to an increase in exposures. Partially offsetting the impact of improved pricing was the effect of prior year loss reserve strengthening. The increase in losses relating to prior period reserve strengthening was $229.0 million and $119.2 million for years ended December 31, 2003, and 2002, respectively. There was a $5.2 million decrease to prior period loss provisions for the year ended December 31, 2001. Three active classes of business are the principal contributors to the 2003 and 2002 reserve strengthening: professional liability reinsurance, general casualty reinsurance and workers’ compensation insurance.
In the workers’ compensation insurance class, the majority of which was written in California, the Company has experienced adverse development primarily for accident years 2001 and 2002. As a result of significant growth in this book of business in a challenging business environment, the Company’s writings in this class were relatively more subject to variability than are some of its more established and/or stable lines of business. Although cumulative results through 2003 continue to be profitable for this book of business, there has been some deterioration in claim frequency and severity related to accident years 2001 and 2002, which the Company generally attributes to the growth of this portfolio of business.
Commission, brokerage and tax expense also increased as a result of the increasing premium volume as these generally vary in direct proportion to premium. However, the percentage increase was generally less than the percentage increase in premium volume, reflecting the generally improving market conditions, which tend to provide the Company a relatively greater ability to exert downward pressure on commission and brokerage rates.
Net realized capital losses of $22.9 million, $53.1 million and $15.7 million for the years ended December 31, 2003, 2002 and 2001, respectively, were primarily the result of write-downs in the value of securities deemed to be impaired on an other than temporary basis, partially offset by realized gains.
The increase in net income to $206.5 million and $115.1 million for the years ended December 31, 2003 and 2002, respectively, generally reflects improved underwriting and investment results partially offset by increased income taxes. The net income of $38.3 million for the year ended December 31, 2001 reflects the impact of the unusual loss events in 2001. As a result of the September 11 attacks, the Company incurred pre-tax losses in 2001, based on an estimate of ultimate exposure developed through a review of its coverages, of $213.2 million gross of reinsurance and $55.0 million net of reinsurance. Associated with this reinsurance was $60.0 million of pre-tax charges, predominantly from adjustment premiums, which resulted in a total pre-tax loss from the September 11 attacks of $115.0 million. After tax recoveries relating specifically to this unusual loss event, the net loss from the September 11 attacks totaled $75.0 million. Over 90% of the losses ceded by the Company were pursuant to treaties where the reinsurers’ obligations are secured, which the Company believes eliminates material reinsurance collection risk. As a result of the Enron bankruptcy, the Company incurred losses in 2001, amounting to $18.6 million after-tax and net of reinsurance. This unusual loss reflected all of the Company’s exposures to this event, including underwriting, credit and investment. Impact on net income of the above-mentioned unusual 2001 events was partially offset by non-recurring income in 2001 received from a former client’s demutualization.
The Company has recently announced that one of its subsidiaries, Everest Re, has reached agreement to sell its United Kingdom branch to a related company, Bermuda Re. Business for this branch is currently reported through the International segment; however, upon completion of the transaction, the business will no longer be part of the Company’s operating results. As such, appropriate disclosures will be made in future filings to address the segment financial fluctuations resulting from the transfer.
Premiums. Gross written premiums increased 55.8% to $4,293.6 million in 2003 from $2,755.4 million in 2002, as the Company took advantage of the general firming of rates, terms and conditions and selected growth opportunities, while continuing to maintain a disciplined underwriting approach. Premium growth areas included a 95.9% ($857.7 million) increase in the U.S. Reinsurance operation, principally related to a $519.4 million increase in treaty casualty business, a $253.9 million increase in treaty property business and a $62.8 million increase in facultative business. The International operation increased 75.9% ($418.0 million) primarily due to a $256.9 million increase in premiums from the London branch, a $79.6 million increase in international business written through the home office representing primarily Latin American business and a $67.4 million increase to Canadian business. The U.S. Insurance operation grew 30.2% ($248.1 million) principally as a result of a $73.2 million increase in excess and surplus lines insurance and an $89.5 million increase in workers’ compensation. The Specialty Underwriting operation increased 2.9% ($14.3 million) resulting primarily from a $38.0 million increase in A&H business and a $19.0 million decrease in marine and aviation. Ceded premiums increased to $1,206.0 million in 2003 from $565.9 million in 2002. This increase was principally attributable to $980.0 million of ceded premiums relating to quota share reinsurance agreements between Everest Re and Bermuda Re. Under these agreements Everest Re ceded to Bermuda Re 25% of its net retained liability on all new and renewal policies written for underwriting year 2003, Everest Re ceded to Bermuda Re 20% of its net retained liability on all new and renewal policies written for underwriting year 2002, and Everest Re’s Canadian branch ceded to Bermuda Re 50% of its net retained liability on all new and renewal property policies written for the 2003 underwriting year. In addition, ceded premiums for 2003 included $49.6 million in adjustment premium for the Company’s corporate retrocessional programs, while ceded premiums for 2002 included $5.1 million and $49.4 million in adjustment premium relating to claims made under the 2001 and 2000 accident year aggregate excess of loss elements of the Company’s corporate retrocessional programs, respectively.
Net written premiums increased by 41.0% to $3,087.6 million in 2003 from $2,189.5 million in 2002, reflecting the increase in gross written premiums, combined with the growth in ceded premiums.
Premium Revenues. Net premiums earned increased by 40.9% to $2,757.7 million in 2003 from $1,957.3 million in 2002. Contributing to this increase was a 61.1% ($402.2 million) increase in the U.S. Reinsurance operation, a 46.9% ($218.2 million) increase in the U.S. Insurance operation and a 50.2% ($205.4 million) increase in the International operation, which was partially offset by a 6.0% ($25.5 million) decrease in the Specialty Underwriting operation. All of these changes reflect period to period changes in net written premiums and business mix together with normal variability in earnings patterns. Business mix changes occur not only as the Company shifts emphasis between products, lines of business, distribution channels and markets but also as individual contracts renew or non-renew, almost always with changes in coverage, structure, prices and/or terms, and as new contracts are accepted with coverages, structures, prices and terms different from those of expiring contracts. As premium reporting and earnings and loss and commission characteristics derive from the provisions of individual contracts, the continuous turnover of individual contracts, arising from both strategic shifts and day to day underwriting, can and does introduce appreciable background variability in various underwriting line items.
Net prior period reserve adjustments related to A&E exposures were $16.8 million and $6.2 million for the years ended December 31, 2003 and 2002, respectively. The Company has A&E exposure related to contracts written by the Company prior to 1986 and to claim obligations acquired as part of the Mt. McKinley acquisition in September 2000. The development on business written by the Company, net of reinsurance, was $16.8 million and the net development on the acquired business was $0.0 million. Substantially all of the Company’s A&E exposures relate to insurance and reinsurance contracts with coverage periods prior to 1986.
Segment underwriting expenses increased by 22.9% to $679.1 million in 2003 from $552.7 million in 2002. Commission, brokerage, taxes and fees increased by $107.1 million, principally reflecting an increase of $343.1 million in the expenses due to premium volume which was partially offset by an increase in ceded commissions of $236.0 million. Other underwriting expenses increased by $19.4 million. Contributing to the $126.4 million increase in expenses were a 55.5% ($101.3 million) increase in the U.S. Reinsurance operation, a 37.2% ($39.4 million) increase in the International operation, and a 3.9% ($5.3 million) increase in the U.S. Insurance operation, partially offset by a 15.5% ($19.6 million) decrease in the Specialty Underwriting operation. The changes for each operation’s expenses principally resulted from changes in commission expenses related to changes in premium volume and business mix by class and type and, in some cases, changes in the use of reinsurance, including with Bermuda Re, and the underwriting performance of the underlying business. The Company’s expense ratio, which is calculated by dividing underwriting expenses by net premiums earned, was 24.7% for 2003 compared to 28.3% for 2002.
Interest expense was $40.3 million in 2003 compared to $42.4 million for 2002. Interest expense in 2003 reflected $38.9 million relating to the senior notes and $1.4 million relating to borrowings under the revolving credit facility. Interest expense for 2002 reflected $38.9 million relating to the senior notes and $3.5 million relating to borrowings under the revolving credit facility.
Net Income. Net income was $206.5 million in 2003 compared to a net income of $115.1 million in 2002, reflecting improved underwriting and investment income results partly offset by increased income taxes.
Premiums. Gross written premiums increased 49.0% to $2,755.4 million in 2002 from $1,849.8 million in 2001, as the Company took advantage of selected growth opportunities and improving pricing in many classes of business, while continuing to maintain a disciplined underwriting approach. Premium growth areas included a 70.5% ($227.9 million) increase in the International operation, mainly attributable to growth in the London, Canadian and Latin American markets, a 63.5% ($319.1 million) increase in the U.S. Insurance operation, principally attributable to growth in worker’s compensation insurance, a 46.5% ($284.1 million) increase in the U.S. Reinsurance operation, primarily reflecting growth across property and casualty lines, and an 18.0% ($74.6 million) increase in the Specialty Underwriting operation, mainly attributable to growth in marine, aviation and surety business. The Company continued to decline business that did not meet its objectives regarding underwriting profitability.
Premium Revenues. Net premiums earned increased by 46.8% to $1,957.3 million in 2002 from $1,333.5 million in 2001. Contributing to this increase was an 140.7% ($239.0 million) increase in the International operation, a 58.3% ($171.5 million) increase in the U.S. Insurance operation, a 32.3% ($160.5 million) increase in the U.S. Reinsurance operation and a 14.2% ($52.9 million) increase in the Specialty Underwriting operation. All of these changes reflect period to period variability in gross written and ceded written premiums, and business mix, together with normal variability in earnings patterns. Business mix changes occur not only as the Company shifts emphasis between products, lines of business, distribution channels and markets, but also as individual contracts renew or non-renew, almost always with changes in coverage, structure, prices and/or terms, and as new contracts are accepted with coverages, structures, prices and/or terms different from those of expiring contracts. As premium reporting and earnings and loss and commission characteristics derive from the provisions of individual contracts, the continuous turnover of individual contracts, arising from both strategic shifts and day to day underwriting, can and does introduce appreciable background variability in various underwriting line items.
Expenses. Incurred loss and LAE increased by 29.6% to $1,399.0 million in 2002 from $1,079.2 million in 2001. The increase in incurred losses and LAE was principally attributable to the increase in net premiums earned and modest net prior reserve adjustments in select areas, most notably in D&O liability, surety and workers’ compensation lines and with respect to asbestos exposures, partially offset by lower catastrophe losses and improvements in rates, terms and conditions in many classes of business, as well as the impact of changes in the Company’s mix of business.
Segment underwriting expenses increased by 23.5% to $552.7 million in 2002 from $447.6 million in 2001. Commission, brokerage, taxes and fees increased by $94.8 million, principally reflecting increases in premium volume and changes in the mix of business. Other underwriting expenses increased by $10.3 million as the Company expanded its operations to support its increased business volume. Contributing to the underwriting expense increase were a 66.1% ($54.7 million) increase in the U.S. Insurance operation, a 17.6% ($19.0 million) increase in the Specialty operation, a 13.8% ($12.8 million) increase in the International operation and an 11.4% ($18.7 million) increase in the U.S. Reinsurance operation. The changes for each operation’s expenses principally resulted from changes in commission expenses related to changes in premium volume and business mix by class and type and, in some cases, the underwriting performance of the underlying business. The Company’s expense ratio, which is calculated by dividing underwriting expenses by premiums earned, decreased by 5.4 percentage points to 28.3% in 2002 compared to 33.7% in 2001.
Net realized capital losses were $53.1 million in 2002, reflecting realized capital losses on the Company’s investments of $108.9 million, which includes $79.7 million relating to write-downs in the value of securities deemed to be impaired on an other than temporary basis, of which $25.7 million were for WorldCom, partially offset by $55.8 million of realized capital gains, compared to net realized capital losses of $15.7 million in 2001. The net realized capital losses in 2001 reflected realized capital losses of $45.5 million, which included $16.7 million relating to write-downs in the value of securities deemed to be impaired on an other than temporary basis, which were partially offset by $29.8 million of realized capital gains.
Other expense was $21.8 million in 2002 compared to other income of $26.6 million in 2001. Significant contributors to other expense in 2002 were deferred gains principally on the Mt. McKinley reinsurance transaction with Bermuda Re, which is retroactive in nature, foreign exchange losses, normal provision for uncollectible audit premium in the U.S. Insurance operation and the amortization of deferred expenses relating to the Company’s issuance of senior notes and Capital Trust’s issuance of trust preferred securities in November 2002, partially offset by fee income. Other income for 2001 includes $25.9 million arising from a non-recurring receipt of shares in connection with the demutualization of a former insurance company client that had issued annuities to the Company in connection with certain claim settlement transactions. In addition, other income for 2001 includes foreign exchange gains as well as fee income, offset by the amortization of deferred expenses relating to the Company’s issuance of senior notes.
Interest expense was $42.4 million for 2002 compared to $46.0 million for 2001. Interest expense for 2002 reflects $38.9 million relating to the Company’s senior notes and $3.5 million relating to the Company’s borrowing under its revolving credit facility. Interest expense for 2001 reflects $38.9 million relating to the Company’s senior notes and $7.1 million relating to the Company’s borrowing under its revolving credit facility. In addition, 2002 includes incurred expense of $2.1 million for distributions on Capital Trust’s trust preferred securities.
Income Taxes. The Company generated income tax expense of $24.8 million in 2002 compared to an income tax benefit of $9.2 million in 2001. The tax expense in 2002 was mainly attributable to improved underwriting results. The tax benefit in 2001 primarily resulted from the impact of losses relating to the September 11 attacks, the Enron bankruptcy and realized capital losses recognized in 2001, which reduced taxable income, partially offset by taxable income relating to the non-recurring receipt of shares in connection with a former client’s demutualization.
The following risk factors, in addition to the other information provided in this report, should be considered when evaluating the Company. If the circumstances contemplated by the individual risk factors materialize, the Company’s business, financial condition or results of operations could be materially and adversely affected.
If the Company’s net loss reserves are inadequate to meet its actual losses, net income would be reduced or it could incur a loss.
The Company is required to maintain reserves to cover its estimated ultimate liability of losses and LAE for both reported and unreported claims incurred. These reserves are only estimates of what the Company believes the settlement and administration of claims will cost based on facts and circumstances known to it. In setting reserves for its reinsurance liabilities, the Company relies on claim data supplied by its ceding companies and brokers. This information is not always timely or accurate and can result in inaccurate loss projections. Because of the uncertainties that surround estimating loss reserves and LAE, the Company cannot be certain that ultimate losses will not exceed these estimates of losses and loss adjustment reserves. If the Company’s reserves are insufficient to cover its actual losses and loss adjustment expenses, the Company would have to augment its reserves and incur a charge to its earnings. These charges could be material. By way of illustration, during the past five calendar years, the reserve re-estimation process affected the Company’s net income in the following manner:
The failure to accurately assess underwriting risk could reduce the Company’s net income or increase the Company’s net loss.
The Company’s success depends on its ability to accurately assess the risks associated with the business on which the risk is retained. If the Company fails to accurately assess the risks it retains, it may fail to establish adequate premium rates to cover its losses and LAE. This could reduce the Company’s net income and even result in an operating loss. Losses may arise from events or exposures that are not anticipated when the coverage is priced. An example of an unanticipated event is the September 11 attacks. The Company’s loss from those attacks, after reinsurance and taxes, was $75 million. Neither the magnitude of loss on a single line of business nor the combined impact on several lines of business from an act of terrorism on such a large scale was contemplated when the Company priced its coverages. In addition to unanticipated events, the Company also faces the unanticipated expansion of its exposures, particularly in long-tail liability lines.
The Company’s insurance company subsidiaries, other than Mt. McKinley, currently hold an “A+ (“Superior”)” financial strength rating from A.M. Best. Everest Re and Everest National hold an “AA- (“Very Strong”)” financial strength rating from Standard & Poor’s. Everest Re holds an “Aa3 (“Excellent”)” financial strength rating from Moody’s. Financial strength ratings are used by insurers and reinsurance and insurance intermediaries as an important means of assessing the financial strength and quality of reinsurers. In addition, an unfavorable rating or the lack of a rating of its reinsurers may adversely affect the rating of a company purchasing reinsurance. A downgrade or withdrawal of any of these ratings might adversely affect, the Company’s ability to market its insurance products and could have a material and adverse effect on future prospects for growth and profitability. During the last five years, no active subsidiary of the Company has experienced a credit rating downgrade. However, the Company cannot assure that no credit downgrade will ever occur in the future. Consistent with market practice, roughly 20% to 30% of the Company’s treaty reinsurance business allows the ceding company to terminate the contract or seek collateralization of the Company’s obligations in the event of a rating downgrade below a certain threshold. The termination provision would generally be triggered only if a rating fell below A.M. Best’s A- rating level, which is three levels below Everest Re’s current rating of A+. Everest Re also has more modest exposure to reinsurance contracts that contain provisions for obligatory funding of outstanding liabilities in the event of a rating agency downgrade. That provision would also generally be triggered only if Everest Re’s rating fell below A.M. Best’s A- rating level.
The Company’s industry is highly competitive and has experienced significant price competition over most of the last decade. In addition, a number of new well-capitalized competitors have entered the market recently, and the Company expects to face further competition from new market entrants in the future. The Company competes globally in the U.S. and other international markets. According to the 2003 edition of Standard & Poor’s special report on the global reinsurance industry, there are 240 reinsurance organizations operating worldwide, from 41 countries. Market share is largely concentrated within the top 25 groups, one of which is the Company. The Company considers the 15 groups that have financial strength ratings generally comparable to or above its rating to be its primary competitors. The leaders in this market are Munich Re, Swiss Re, Berkshire Hathaway, Hannover Re and Employers Re. Some of these competitors have greater financial resources than the Company does, have been operating for longer than the Company has and have established long-term and continuing business relationships throughout the industry, any of which can be a significant competitive advantage. In addition, the Company expects to face further competition in the future and may not be able to compete successfully in the future.
The Company’s success has been, and will continue to be, dependent on the ability to retain the services of existing key executive officers and to attract and retain additional qualified personnel in the future. The loss of the services of any key executive officer or the inability to hire and retain other highly qualified personnel in the future could adversely affect the ability of the Company to conduct business. Generally, the Company considers key executive officers to be those individuals who have the greatest influence in setting overall policy and controlling operations: Chairman and Chief Executive Officer, Joseph V. Taranto (age 55), President and Chief Operating Officer, Thomas J. Gallagher (age 55), and Executive Vice President and Chief Financial Officer, Stephen L. Limauro (age 52). Of those three officers, the Company only has an employment contract with Mr. Taranto. That contract has been previously filed with the SEC and was most recently amended on April 18, 2003 to extend Mr. Taranto’s term of employment from March 31, 2004 until March 31, 2006. The Company is not aware that any of the above three officers are planning to leave the company or retire in the near future. The Company does not maintain any key employee insurance on any of its employees.
A significant portion of the Company’s investment portfolio consists of fixed income securities and a smaller portion consists of equity securities. Both the fair market value of these assets and the investment income from these assets fluctuate depending on general economic and market conditions. For example, the fair market value of the Company’s fixed income securities generally increases or decreases in an inverse relationship with fluctuations in interest rates. The fair market value of its fixed income securities can also decrease as a result of any downturn in the business cycle that causes the credit quality of those securities to deteriorate. The net investment income that the Company realizes from future investments in fixed income securities will generally increase or decrease with interest rates. Interest rate fluctuations also can cause net investment income from investments that carry prepayment risk, such as mortgage-backed and other asset-backed securities, to differ from the income anticipated from those securities at the time of purchase. In addition, if issuers of individual investments are unable to meet their obligations, investment income will be reduced and realized capital losses may arise. Because all of the Company’s securities are classified as available for sale, changes in the market value of its securities are reflected in its financial statements. Similar treatment is not available for liabilities. As a result, a decline in the value of the securities in the Company’s portfolio could reduce its net income or cause it to incur a loss. The following table quantifies the portion of the Company’s investment portfolio that consists of fixed income securities, equity securities and investments that carry prepayment risk.
Further discussion of market-sensitive instruments can be found in ITEM 7A, “Quantitative and Qualitative Disclosures About Market Risk”.
The Company’s reporting currency is the U.S. dollar. However, the Company is comprised of entities and branches whose functional currency is other than the U.S. dollar. Maintaining assets and liabilities in currencies other than the functional currency of these entities or branches subjects the Company to foreign exchange exposure. Consequently, exchange rate fluctuations derived from relative movements in currency spot rates of assets and liabilities denominated in currencies other than the functional currency of the entity or branch can have a material impact on the Company’s net income. The Company mitigates foreign exposure by a general matching of the currency and duration of its assets to its corresponding operating liabilities. During the year ended December 31, 2003, the Company wrote approximately 26.5% of its reinsurance coverages in currencies that are subject to foreign exchange exposure. To mitigate this risk, the Company also maintains a portion of its investment portfolio in currencies that are subject to similar foreign exchange exposure. As of December 31, 2003, the Company maintained approximately 4% of its investment portfolio in securities that are subject to foreign exchange exposure. During 2003, 2002, 2001, the impact on the Company’s quarterly pre-tax net income from exchange rate fluctuations ranged from a loss of $4.0 million to a gain of $5.4 million. Further discussion of foreign currency rate risk can be found in ITEM 7A, “Quantitative and Qualitative Disclosures About Market Risk”.