To manage reinsurance and insurance liability exposure, allocate investable assets and assess overall enterprise risk, the Company models its underwriting and investment activities on an integrated basis. The Company’s integrated risk management as well as features of its structured and alternative risk transfer reinsurance products provide flexibility in making decisions regarding investments. The Company’s investments are currently comprised of a high grade fixed maturities portfolio, an alternative investment portfolio that is currently employing ten strategies designed to provide diversification and to generate positive returns while attempting to reduce the frequency and severity of loss outcomes and is currently invested in approximately 40 underlying trading entities and two strategic reinsurance private equity investments. Based on fair value at December 31, 2002, the allocation of invested assets was approximately 68% in cash and fixed maturities and 32% in alternative investments.
conditions and expected profit margins. Therefore, the amount of premiums is not necessarily an accurate indicator of the Company’s anticipated profitability.
The Company’s net investment income is a function of the average invested assets and the average yield that the Company earns on those invested assets. The investment yield on the Company’s fixed maturities portfolio is a function of market interest rates as well as the credit quality and maturity of its fixed maturities holdings. In addition, the Company realizes capital gains or losses on its fixed maturities investment portfolio as a result of changing market conditions, including, but not limited to, changes in market interest rates and changes in the market’s perception of the credit quality of the Company’s fixed maturities holdings. The Company’s net gains on alternative investments is a function of the success of the funds in which such portfolio is invested, which depends on, among other things, the underlying strategies of the funds, the ability of the fund managers to execute the fund strategies and general economic conditions and the underlying operating results of the private equity reinsurance investments. The Company earns investment income primarily on invested assets, but it also earns investment income from premium and loss deposits withheld by its clients.
Acquisition costs consist principally of ceding commissions paid to ceding companies and brokerage expenses, and typically represent a percentage of the premiums on reinsurance and insurance contracts written. These costs are generally deferred and amortized over the period in which the related premiums are earned.
The Company’s premiums are recorded at the inception of each contract, principally based upon contract terms and information received from ceding clients and their brokers. For excess of loss contracts, the amount of premium is usually contractually documented at inception, and no management judgment is necessary in accounting for this. Premiums are earned on a pro rata basis over the coverage period. For quota share or proportional contracts, gross premiums written are normally estimated at inception by the ceding client. The Company accounts for such premiums using the initial estimates, and then adjusts them as advised by its clients. The Company also accrues for reinstatement and additional premiums resulting from losses. Such accruals are based upon actual contractual terms, and the only element of management judgment involved is with respect to the amount of losses, benefits and experience refunds, as described below.
Setting appropriate reserves for losses, benefits and experience refunds is an inherently uncertain process. Losses, benefits and experience refunds reserves represent estimates, at a given point in time, of the ultimate settlement costs of losses incurred (including IBNR losses, which are losses that have been incurred but not yet reported to the insurer). The Company regularly reviews and updates these estimates using the most current information available and employing actuarial methods. Consequently, the ultimate liability for a loss is likely to differ from the original estimate. Whenever the Company determines that any existing reserves for losses, benefits and experience refunds are inappropriate or inadequate, it is required to record a change in estimate, increasing or decreasing reserves with a corresponding reduction or increase, which could be material, in its operating results in the period in which the deficiency or redundancy is identified. Adjustments resulting from changes in the Company’s estimates are recorded in the period such adjustments are determined. The establishment of new reserves, or the adjustment of reserves for reported claims, could result in significant upward or downward changes to the Company’s financial condition or results of its underwriting activities in the period such amounts are reported.
Gross premiums written. Gross premiums written for the year ended December 31, 2002 were $647.4 million compared to $710.6 million for the year ended December 31, 2001, a decrease of 8.9%. Gross premiums written for property and casualty were $632.7 million for the year ended December 31, 2002 compared to $496.5 million for the year ended December 31, 2001. Gross premiums written for property and casualty increased principally due to increased demand for, and improved pricing of, the Company’s products and the expansion of the product offering to include traditional property and casualty reinsurance risks during 2002. Gross premiums written for life and annuity were $14.7 million for the year ended December 31, 2002 compared to $214.1 million for the year ended December 31, 2001. The Company believes that the lack of life and annuity underwriting production during the year ended December 31, 2002 is attributable to the current low interest rate environment and weak global economy. The demand for the type of life and annuity reinsurance that the Company offers is typically weak during periods when interest rates are low.
Net gains on alternative investments. Net gains on the alternative investment portfolio were $32.1 million, including $8.4 million from the Company’s private equity reinsurance investments, for the year ended December 31, 2002 compared to $29.8 million, net of $0.3 million loss from the Company’s private equity reinsurance investments for the year ended December 31, 2001. The alternative investment portfolio returned a 5.24% gain during the year ended December 31, 2002 compared to a 6.69% gain during the year ended December 31, 2001. The increase of $2.3 million results from the return from the Company’s private equity reinsurance investments, the larger size of the alternative investment portfolio, offset by the lower return earned on these investments in 2002 compared to 2001.
Gross premiums written. Gross premiums written for the year ended December 31, 2001 were $710.6 million compared to $409.7 million for the year ended December 31, 2000, an increase of 73.4%. Gross premiums written for property and casualty were $496.5 million for the year ended December 31, 2001 compared to $126.4 million for the year ended December 31, 2000. Gross premiums written for property and casualty increased principally due to the flexibility of the Company’s alternative risk transfer products, which, in a firm price environment for traditional property and casualty reinsurance products, made them more appealing than traditional risk transfer reinsurance products. Gross premiums written for life and annuity were $214.1 million for the year ended December 31, 2001 compared to $283.3 million for the year ended December 31, 2000. The low interest rate environment adversely impacted the Company’s life and annuity production.
Net premiums written. Net premiums written for the year ended December 31, 2001 were $594.2 million compared to $401.8 million for the year ended December 31, 2000. Net premiums written for property and casualty products for the year ended December 31, 2001 were $412.6 million compared to $118.5 million for the year ended December 31, 2000. Net premiums written for life and annuity products for the year ended December 31, 2001 were $181.6 million compared to $283.3 million for the year ended December 31, 2000.
Net investment income. Net investment income was $43.9 million for the year ended December 31, 2001 compared to $38.9 million for the year ended December 31, 2000. The increase was primarily attributable to the increase in the fixed maturities investment portfolio resulting from cash received from the collection of premiums written since December 31, 2000, as well as proceeds contributed from the Company’s initial public offering. Declining interest rates contributed to a total return of 8.55% for the fixed maturities investment portfolio for the year ended December 31, 2001 compared to a total return of 9.61% for the year ended December 31, 2000.
Net gains on alternative investments. Net gains on the alternative investment portfolio were $29.8 million for the year ended December 31, 2001 compared to $9.6 million for the year ended December 31, 2000. The increase was attributable to both an increase in the size of the alternative investment portfolio resulting from cash provided from operating activities in 2001, proceeds contributed from the Company’s initial public offering and an increase in return on the alternative investment portfolio. The alternative investment portfolio returned 6.69% during the year ended December 31, 2001 compared to a 4.22% gain during the year ended December 31, 2000.
Life and annuity benefits and experience refunds. Gross life and annuity benefits and experience refunds totaled $405.0 million at December 31, 2002 compared to $423.8 million at December 31, 2001. The decrease in 2002 was primarily attributable to claims and benefit payments on existing contracts in force, partially offset by the benefit reserves required on business written during the current and prior years.
Property and casualty losses and experience refunds. Gross property and casualty losses and experience refunds totaled $778.1 million at December 31, 2002 compared to $596.4 million at December 31, 2001. The increase in 2002 was primarily attributable to increased premiums earned and normal variability in claim settlements. An analysis of the changes in property and casualty losses and experience refunds can be found in Note 4 to the audited consolidated financial statements of the Company included herein.
Losses recoverable from reinsurers. Losses recoverable from reinsurers totaled $212.2 million at December 31, 2002 compared to $173.7 million at December 31, 2001, principally reflecting the increase in losses ceded under the Company’s retrocessional agreements. At December 31, 2002, two retrocessionaires account for 60.9% and 36.5% of the Company’s losses recoverable from reinsurers. Both retrocessionaires have a financial strength rating of “A” by A.M. Best Company.
Bank Loans. In March 2002, Max Re completed a $100.0 million sale of shares of Max Re Diversified to a third party financial institution. Simultaneous with the sale, Max Re entered into a total return swap with the purchaser of these shares whereby Max Re receives the return earned on the Max Re Diversified shares in exchange for a variable rate of interest based on LIBOR plus a spread. Additional Max Re Diversified shares owned by Max Re with a fair value of $67.9 million at December 31, 2002 were pledged as collateral. Under GAAP, these transactions are viewed on a combined basis and accounted for as a financing transaction, which results in the recording of a $100.0 million bank loan. On February 18, 2003, the Company and the third party financial institution mutually terminated the swap transaction described above and, immediately following the termination, the Company completed a
Liquidity and capital resources. As a holding company, Max Re Capital’s principal assets are its investments in the voting common shares of its principal subsidiary, Max Re, and the common shares of its other subsidiaries. The Company’s principal source of funds is from interest income on cash balances and cash dividends from its subsidiaries, including Max Re. The payment of dividends is limited under Bermuda insurance laws. In particular, Max Re may not declare or pay any dividends if it is in breach of its minimum solvency or liquidity levels under Bermuda law or if the declaration or payment of the dividends would cause it to fail to meet the minimum solvency or liquidity levels under Bermuda laws. At December 31, 2002, Max Re, which is required to have $290.4 million in statutory capital and surplus in order to pay dividends, had $618.3 million in actual statutory capital and surplus.
Capital resources. The Company’s capital structure currently consists of equity and minority interest. At December 31, 2002, total capitalization after deducting loans to management and including retained earnings and accumulated other comprehensive income amounted to $710.7 million as compared with $699.7 million at December 31, 2001. The Company has flexibility with respect to capitalization as the result of its access to the debt and equity markets. The Company regularly reviews its capital adequacy and believes this level of capital is sufficient to support the Company’s reinsurance and insurance operations in 2003. The Company will consider issuing debt, raising additional equity or entering into retrocessional reinsurance contracts if it were to conclude that additional capital resources are necessary to continue growing its business.
In the ordinary course of business, the Company is required to provide letters of credit or other regulatorily approved security to certain of its ceding reinsurance companies to meet contractual and regulatory requirements.
On each of February 8, 2002, May 3, 2002, July 26, 2002 and November 1, 2002, Max Re Capital’s Board of Directors declared quarterly shareholder dividends of $0.02 per share payable to shareholders of record on February 22, 2002, May 17, 2002, August 12, 2002 and November 15, 2002, respectively. The dividends declared on July 26, 2002 and November 1, 2002 were deemed distributions to shareholders since the Company had a retained deficit on the payment date. Continuation of cash dividends in the future will be at the discretion of the Board of Directors and will be dependent upon the Company’s results of operations and cash flows, and its financial position and capital requirements, general business conditions, legal, tax, regulatory and any contractual restrictions on the payment of dividends and other factors the Board of Directors deems relevant. On January 31, 2003, the Board of Directors declared a dividend of $0.02 per share to be paid on March 3, 2003 to shareholders of record on February 17, 2003.
The Company has been assigned an insurer financial strength rating of “A- (Excellent)” by A.M. Best Company, Inc. and an insurer financial strength rating of “A (Strong)” by Fitch, Inc. The ratings assigned by rating agencies to reinsurance companies are an important means of assessing the financial strength and quality of reinsurers. If an independent rating agency downgrades or withdraws any of the Company’s ratings, the Company could be severely limited or prevented from writing any new reinsurance contracts, which would significantly and negatively affect its business. To date, the Company’s ratings have been affirmed by A.M. Best and Fitch on each rating review. Ratings are based upon factors relevant to policyholders and are not directed toward the protection of investors.
FAS Interpretation No. 45-Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others
In November 2002, FAS Interpretation No. 45-Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others was issued. This interpretation elaborates on the disclosures required by a guarantor in its financial statements about its obligations under certain guarantees that it has issued. It also requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of the obligations it has undertaken in issuing the guarantee. The initial recognition and measurement provisions of the interpretation are applicable for all guarantees issued or modified after December 31, 2002 and the disclosure requirements are effective for fiscal years ending after December 15, 2002. The adoption of this interpretation is not expected to have a significant impact on the Company’s financial reporting.
The Accounting Standards Executive Committee, a committee of the American Institute of Certified Public Accountants, has issued a proposed Statement of Position that could set a new standard for accounting for Certain Nontraditional Long-Duration Contracts and for Separate Accounts. This proposed statement applies to certain variable annuity contracts containing minimum interest and/or minimum death benefit guarantees. As at December 31, 2002, the Company had no contracts that would be affected if this proposed statement were adopted.
See Factors Affecting Future Financial Results, filed as Exhibit 99.1 to this report, incorporated by reference herein.