As of December 31, 2003, the office space of TRH's New York headquarters and its Toronto office are rented from the AIG Group, which leases it from others. The Chicago, Miami, Buenos Aires, Rio de Janeiro, London, Paris, Zurich, Warsaw, Hong Kong, Shanghai, Tokyo and Sydney offices, are rented from third parties. The lease for the office space occupied by TRH's New York headquarters expires in 2021.
(1) Share and per share data have been retroactively adjusted, as appropriate, to reflect common stock splits.
The following discussion refers to the consolidated financial statements of TRH as of December 31, 2003 and 2002 and for each of the three years in the period ended December 31, 2003, which are presented elsewhere herein. Financial data discussed below have been affected by certain transactions between TRH and American International Group, Inc. and its subsidiaries (the AIG Group). (See Notes 10, 12 and 14 of Notes to Consolidated Financial Statements.)
TRH offers reinsurance through reinsurance brokers and, to a lesser extent, directly to domestic and foreign insurance and reinsurance entities. Although TRC and its wholly owned subsidiary, Putnam, are separate entities, together they would have ranked as the 3rd largest domestic reinsurer, based upon combined statutory net premiums written for the year ended December 31, 2003, based on the Reinsurance Association of America's survey as of that date.
TRH's major sources of revenues are net premiums earned for reinsurance risks undertaken and net investment income earned on investments made. The great majority of TRH's investments are in fixed maturity securities with an average duration of 5.3 years as of December 31, 2003. In general, premiums are received significantly in advance of related claims payments. The following table summarizes TRH's revenues, income (loss) before income taxes and net income for the periods indicated:
Income before income taxes and net income improved in 2003 and 2002, each as compared to the immediately prior year, due primarily to improvements in underwriting profit (loss) in each succeeding year. Underwriting profit (loss) represents net premiums earned less net losses and loss adjustment expenses, net commissions and other underwriting expenses, plus (minus) the increase (decrease) in deferred acquisition costs. Generally, rate improvements and more restrictive contract terms and conditions increasingly benefited results in each of 2003 and 2002 as compared to the immediately prior years. In addition, 2002 benefited from the absence, as compared to 2001, of significant catastrophe loss activity and losses related to Enron reinsurance exposure that impacted the 2001 year. The year 2001 included $215 million ($200 million related to September 11) of pre-tax catastrophe losses, or $139.8 million, net of tax, as well as pre-tax losses of $60 million, or $39 million, net of tax, for reinsurance exposure related to Enron Corporation. 2002 results also included the impact of a fourth quarter increase in loss reserves (totaling $100 million, or $65 million, net of tax) largely caused by an unexpected increase, late in the year, in the frequency and severity of reported losses occurring in 1998 through 2000 in certain casualty lines, reflecting industry wide trends. (See Operational Review.)
Market conditions for reinsurers generally continued to improve throughout 2002 and 2003 as rates increased and terms and conditions generally became more restrictive. Attracted by the improved market conditions, additional capital entered the market in late 2001 and has continued through 2003 through the formation of new companies, principally in Bermuda, and through the addition of capital to certain existing companies. The additional market capacity has spurred additional competition, most significantly in property lines, and will also likely serve to lessen the magnitude of pricing improvements in casualty lines going forward.
Rates, terms and conditions were generally stronger in longer-tail casualty lines, particularly in certain specialty casualty classes such as medical malpractice, other professional liability and directors' and officers' liability lines due, in part, to recent elevated industry-wide loss activity (that also materially affected TRH) experienced in certain of those lines related principally to losses occurring in the late 1990s and 2000. In fact, pricing for certain property lines business has begun to be negatively influenced by the added market capacity discussed above. Nevertheless, TRH believes that market conditions in most classes remain favorable. While TRH believes that conditions will continue to remain favorable in 2004, these conditions will not necessarily translate into ultimate pricing adequacy. TRH cannot predict, with any reasonable certainty, future market conditions.
Premiums are expected to grow and result in positive operating cash flow and increased net investment income in 2004, absent any unusual loss events or other unforeseen developments. However, TRH believes that the percentage increase in net premiums written in 2004 over 2003 may be less than the 33.6% year over year increase in 2003 compared to 2002, due largely to the expected overall tempering of premium rate increases in 2004 as compared to 2003.
Further information related to items discussed in this Executive Overview may be found throughout this Management's Discussion and Analysis of Financial Condition and Results of Operations.
Loss development factors -- These factors are used to project reported losses to an ultimate amount by class of business using historical data. These too need to be modified to allow for current trends in a variety of factors such as those discussed in the paragraph above under loss cost trend factors.
Acquisition costs, consisting primarily of net commissions incurred on business conducted through reinsurance contracts or certificates, are deferred, and then amortized over the period in which the related premiums are earned, generally one year. The evaluation of recoverability of acquisition costs to be deferred considers the expected profitability of the underlying treaties and facultative certificates which may vary materially from actual results.
Of the total increase in net premiums written in 2003 compared to 2002, domestic net premiums written increased by $478.2 million, or 35.1%, to $1,840.8 million, due principally to the above mentioned rate increases and overall improved market conditions, with significant increases in net premiums written recorded in specialty casualty (principally directors' and officers' liability, medical malpractice and other professional liability), property and ocean marine and aviation lines. The increase in net premiums written in property lines is due, in part, to a reduction in property quota share retrocession coverage purchased.
Net premiums written by international offices increased in 2002 by $244.9 million, or 27.4%, over the prior year, to $1,137.6 million. All of the international offices recorded increases in net premiums written, led by London, TRZ and Miami (serving Latin America and the Caribbean). International net premiums written increased significantly in property, auto liability and specialty casualty (principally medical malpractice and other professional liability) lines. International business represented 45.5% of 2002 net premiums written compared to 46.8% in 2001.
dollar compared to certain currencies, particularly from European countries, in which TRH's net investment income is earned, offset, in part, by declining investment yields, principally from the fixed maturity portfolio. For 2003, 2002 and 2001, the pre-tax yields on fixed maturities were 4.6 percent, 5.1 percent and 5.6 percent, respectively. The pre-tax yield on fixed maturities represents pre-tax net investment income from fixed maturities for the periods indicated divided by the average balance sheet carrying value of the fixed maturity portfolio for such periods. (See cash flow discussion under Financial Condition and Liquidity.) (See Note 3 of Notes to Consolidated Financial Statements.)
There were no significant catastrophe losses occurring during 2003. In addition, as a result of net increases in estimates of losses occurring in prior years, net losses and loss adjustment expenses were increased by $322.6 million in 2003. As a result of greater than expected reported loss activity in 2003 indicating that TRH's estimates as of the end of 2002 of the ultimate amounts of losses occurring in 2002 and prior years required a further net increase, significant adverse development was recorded in 2003 on losses occurring between 1998 and 2000 in certain casualty lines, principally in domestic and London branch operations, as further discussed in the paragraph immediately below. Such lines included other liability (a portion of which represents certain specialty casualty classes such as directors' and officers' liability and professional liability other than medical malpractice), medical malpractice and, to a lesser extent, surety and fidelity lines. These increases to incurred losses were offset, in small part, by favorable development on losses occurring in 2001 and 2002 in fire and allied lines and, in 2002 only, in other liability lines.
TRH writes a significant amount of non proportional assumed casualty reinsurance as well as proportional assumed reinsurance of excess casualty business for such volatile classes as medical malpractice and directors' and officers' liability. At the primary level, there are significant risk factors which contribute to the variability and unpredictability of the loss cost trends for this business such as
The increase in deferred acquisition costs for 2003 and 2002 each exceeded the respective prior year amounts. As the increase in unearned premiums in 2003 and 2002 was greater than such increase in the respective prior year, a related, and larger, portion of acquisition costs was deferred in 2003 and 2002, each as compared to the respective prior year amounts. Acquisition costs (consisting primarily of net commissions incurred) are charged to earnings over the period in which the related premiums are earned.
Other deductions, net, generally includes expense charges of $1.1 million for stock-based compensation, in 2003 only, (see Other Matters herein for a discussion of the Change in Accounting Principle and Disclosure of Stock-Based Compensation) related to TRH's voluntary adoption of the recognition provisions of Statement of Financial Accounting Standards (SFAS) No. 123, as well as currency transaction gains and losses and other miscellaneous income and expense items.
Income (loss) before income taxes was $386.7 million in 2003, $188.3 million in 2002 and ($34.1) million in 2001. The increase in income before income taxes in 2003 compared to the prior year resulted primarily from improved underwriting profit (loss) and, to a much lesser extent, increased net investment income in 2003. The increase in income before income taxes in 2002 compared to the prior year resulted, in large part, from improved underwriting profit (loss) in 2002 compared to 2001. In particular, the loss and loss adjustment expense ratios have significantly improved in 2003 and 2002, each as compared to the immediately prior year, as further discussed above.
taxable income or loss those items of income of the non-U.S. subsidiary, TRZ, which are subject to U.S. income tax currently, pursuant to Subpart F income rules of the Internal Revenue Code, and included, as appropriate, in the consolidated federal income tax return.
The effective tax rates, which represent the sum of current and deferred income taxes (benefits) divided by income (loss) before income taxes, were 21.5% in 2003, 10.1% in 2002 and 155.4% in 2001. The major adjustments reconciling the 'expected' tax expense (benefit) to actual tax expense (benefit) in each of the three years under discussion (as detailed in Note 4 of Notes to Consolidated Financial Statements) are similar in terms of their nature and relative size, except that the adjustment for tax-exempt interest has been steadily increasing as the size of the tax-exempt fixed maturity portfolio has grown in 2003 and 2002 over the respective immediately prior year.
Net income and net income per common share on a diluted basis, respectively, were as follows: 2003 -- $303.6 million, $5.75; 2002 -- $169.3 million, $3.21; 2001 -- $18.9 million, $0.36. Reasons for the changes between years are as discussed earlier. Outstanding share amounts used in the 2001 net income per common share calculation have been retroactively adjusted, as appropriate, to reflect the 3-for-2 common stock split paid in July 2001. (See Note 7 of Notes to Consolidated Financial Statements.)
In the years under discussion, the after-tax impacts on net income of certain significant items discussed above in the Operational Review are as follows: 2002 -- fourth quarter increase in net loss and loss adjustment expense reserves -- $65.0 million; 2001 -- catastrophe losses -- $139.8 million (including $130.0 million related to the terrorist attack); losses related to Enron reinsurance exposure -- $39.0 million.
2003 compared to 2002 -- European revenue increased compared to the prior year primarily due to significant increases in net premiums written in each location, with the largest increase occurring in London. These increases generally occurred in property, specialty casualty (principally directors' and officers' liability, other professional liability and medical malpractice) and auto liability lines. Such increases were a result, in part, of the weakening U.S. dollar compared to the currencies in which premiums were written in 2003 as compared to 2002. Income before income taxes for 2003 increased compared to the prior year amounts due principally to improved underwriting profit (loss) that was the result of better loss experience in each location, partially offset by a higher commission rate in London, due to a slight change in the mix of business. Such improved loss experience resulted from improving market conditions in recent years. Both years included significant adverse development from the London branch on losses occurring in 1998 through 2000 in certain more volatile casualty classes as further discussed earlier under Results of Operations. Loss activity in 2002 includes a $30 million fourth quarter pre-tax charge (related to the London branch) to net losses and loss adjustment expenses related to an increase in loss reserves, comprising part of the adverse development as discussed earlier in this paragraph.
2002 compared to 2001 -- European revenues increased compared to the prior year primarily due to increases in net premiums earned in London and Trans Re Zurich. The majority of these increases occurred in property and auto liability lines. Income before income taxes for 2002 far exceeded the prior year amount due to improved underwriting profit (loss) in 2002 resulting principally from reduced loss activity compared to 2001. Loss activity in 2002 includes a $30 million fourth quarter pre-tax charge (related to the London branch) to net losses and loss adjustment expenses related to an increase in loss reserves as discussed earlier in the Operational Review. 2001 loss activity includes $100 million of net pre-tax catastrophe losses related to September 11 incurred primarily through the London market.
2002 compared to 2001 -- Revenues increased in 2002 compared to 2001 due to increases in net premiums earned in each of the offices in this grouping, led by Miami and Toronto. Loss before income taxes in 2002 worsened compared to a year ago, due principally to a deterioration of underwriting profit (loss) caused by increased loss activity. Loss activity in 2002 includes a $15 million fourth quarter pre-tax charge (related to the Miami branch) to net losses and loss adjustment expenses related to an increase in loss reserves as discussed earlier in the Operational Review. The underwriting expense ratio improved in 2002 compared to the prior year.
respectively. Sources of funds for the operating subsidiaries consist primarily of premiums, reinsurance recoverables, investment income, proceeds from sales, redemptions and the maturing of investments and funds received under securities loan agreements. Funds are applied primarily to payments of claims, ceded reinsurance premiums, insurance operating expenses, income taxes and investments in fixed income and equity securities. Premiums are generally received substantially in advance of related claims payments. Cash and cash equivalents are maintained for the payment of claims and expenses as they become due. TRH does not anticipate any material capital expenditures in the foreseeable future.
Activity within the fixed maturities available for sale portfolio for the years under discussion generally represented strategic portfolio realignments to maximize after-tax income. TRH adjusts its mix of taxable and tax-exempt investments, as appropriate, generally as a result of strategic investment and tax planning considerations. In 2003, TRH purchased certain fixed maturities which are classified as held-to-maturity and carried at amortized cost as TRH has the positive intent and ability to hold each of these securities to maturity. The duration of the fixed maturity portfolio was 5.3 years as of December 31, 2003. In addition, TRH engaged in securities lending transactions whereby certain securities (i.e., fixed maturities and common stocks available for sale) from its portfolio were loaned to third parties (see Note 2(b) of Notes to Consolidated Financial Statements). The market values of fixed maturities and common stocks available for sale that are on loan are reflected parenthetically as pledged on the balance sheet and totaled $426.5 million and $48.0 million, respectively, as of December 31, 2003.
Gross unrealized gains and losses on fixed maturities as of December 31, 2003 amounted to $211.1 million and $9.2 million, respectively.
As of December 31, 2003, 93.2% of the fixed maturity portfolio was rated Aaa or Aa, an additional 6.2% was also rated investment grade or better, 0.4% was rated below investment grade and 0.2% was not rated. Also, as of December 31, 2003, TRH had no derivative instruments. (See Note 3 of Notes to Consolidated Financial Statements.)
Management reviews TRH's investments on a continual basis for evidence of other than temporary declines in market value and exercises its judgment in making such a determination and calculating the amount of loss recognition (as a realized net capital loss) resulting from investment write-downs.
o The occurrence of a discrete credit event resulting in (i) the issuer defaulting on a material outstanding obligation; or (ii) the issuer seeking protection from creditors under the bankruptcy laws or any similar laws intended for the court supervised reorganization of insolvent enterprises; or (iii) the issuer proposing a voluntary reorganization pursuant to which creditors are asked to exchange their claims for cash or securities having a fair value substantially lower than par value of their claims; or,
TRH has the ability to hold any security to its stated maturity. Therefore, the decision to sell reflects the judgment of management that the security sold is unlikely to provide, on a relative value basis, as attractive a return in the future as alternative securities entailing comparable risks. With respect to distressed securities, the sale decision reflects management's judgment that the risk-discounted anticipated ultimate recovery is less than the value achievable on sale. (See Operational Review for a discussion of realized net capital losses resulting from write-downs of securities for other than temporary declines in market value.)
The reserving process is inherently difficult and subjective, especially in view of changes in the legal and tort environment which impact the development of loss reserves, and therefore quantitative techniques frequently have to be supplemented by subjective considerations and managerial judgment. Trends that have affected development of liabilities in the past may not necessarily occur or affect development to the same degree in the future. While this process is difficult for ceding companies, the inherent uncertainties of estimating reserves are even greater for the reinsurer, due primarily to the longer term nature of most reinsurance business, the diversity of development patterns among different types of reinsurance treaties or facultative contracts and the necessary reliance on the ceding companies for information regarding reported claims and differing reserving practices among ceding companies, which are subject to change without notice. In addition, loss reserves are estimated using data that include reported losses of more recent accident years of long tail casualty lines that have limited statistical credibility. During the loss settlement period, which can be many years in duration, additional facts regarding individual claims and trends usually become known. As these become apparent, it usually becomes necessary to refine and adjust the reserves upward or downward and even then the ultimate net liability may be materially different from the revised estimates. (See discussion of adverse development on losses occurring in prior years under Results of Operations.)
Additionally, loss and loss adjustment expense reserves, net of related reinsurance recoverables, include amounts resulting from the September 11, 2001 terrorist attack which are principally related to
For 2003, TRH's operating cash flows of $921.1 million exceeded the comparable 2002 amount of $598.0 million. The increase was caused largely by increased net premiums written, net of commissions, partially offset by increased paid losses and loss adjustment expenses and taxes paid.
Of total consolidated operating cash flows, $431.7 million, $229.2 million and $138.6 million, were derived from international operations in 2003, 2002 and 2001, respectively. More than half of such international operations cash flows was derived from London in each of such years.
TRH believes that its balance of cash and cash equivalents of $182.9 million as of December 31, 2003 and its future cash flows will be sufficient to meet TRH's cash requirements through the end of 2004 and thereafter for a period the length of which is difficult to predict, but which TRH believes will be at least one year.
Generally, paid losses have been increasing in more recent years largely as a result of a shift in the mix of business towards lines with shorter payment patterns and an increase in the amount of business TRH has written over the past several years. If paid losses accelerated significantly beyond TRH's ability to fund such paid losses from current operating cash flows, TRH would be compelled to liquidate a portion of its investment portfolio and/or arrange for financing. Such events that may cause such a liquidity strain could be the result of several catastrophic events occurring in a relatively short period of time. Additional strain on liquidity could occur if the investments sold to fund such paid losses were sold in a depressed marketplace and/or reinsurance recoverable on such paid losses became uncollectible.
Measuring potential losses in fair values is a major focus of risk management efforts by many companies. Such measurements are performed through the application of various statistical techniques.
The increase in accumulated other comprehensive income consisted principally of the following: net unrealized appreciation of equities, net of income tax, of $67.5 million, caused principally by improved performance of equity markets worldwide over last year, net unrealized appreciation of fixed maturities available for sale, net of income tax, of $6.3 million, partially offset by net unrealized currency translation loss, net of income tax, of ($13.6) million, caused, in large part, by a weakening U.S. dollar particularly against certain European currencies.
Net unrealized appreciation (depreciation) of investments, net of income taxes, is subject to significant volatility resulting from changes in the market value of fixed maturities and equities available for sale. Market values may fluctuate due to changes in general economic and political conditions, market interest rates, prospects of investee companies and other factors.
In December 2002, the Financial Accounting Standards Board (FASB) issued SFAS No. 148, 'Accounting for Stock-Based Compensation -- Transition and Disclosure, an amendment of SFAS No. 123,' to provide alternative methods (in addition to the prospective method already provided in SFAS No. 123) of transition for a voluntary change to the recognition provisions of SFAS No. 123, as well as to amend certain of its disclosure requirements as reflected in Note 2(i) of Notes to Consolidated Financial Statements.
(b) ADOPTION OF SFAS NO. 133 AND CHANGE IN CLASSIFICATION OF CERTAIN FIXED MATURITIES:
activities. In accordance with the standard, TRH adopted its provisions on January 1, 2001 with no resulting effect on net income or cash flows.
In January 2003, the FASB issued, and in December 2003 revised, Interpretation No. 46 (FIN 46), 'Consolidation of Variable Interest Entities, an interpretation of ARB No. 51.' FIN 46 requires a variable interest entity (VIE) to be consolidated by its primary beneficiary if such VIE has (i) equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, or (ii) equity investors that cannot make significant decisions about the entity's operations, or that do not absorb the expected losses or receive the expected returns of the entity. The primary beneficiary of a VIE is the party that has a majority of the expected losses or a majority of the expected residual returns of the VIE, or both. All other entities are evaluated for consolidation under existing guidance. FIN 46 also requires disclosure of significant VIEs for which a company is not the primary beneficiary.
As originally issued in January 2003, the provisions of FIN 46 were to be applied immediately to VIEs created after January 31, 2003 and to VIEs in which an interest was obtained after that date. However, as revised by the FASB in December 2003, the provisions of FIN 46 currently are to be applied to VIEs commonly referred to as special-purpose entities in the first interim or annual period ending after December 15, 2003 and to all other types of VIEs in the first interim or annual period ending after March 15, 2004. In addition, the provisions of FIN 46 are to continue to be applied to any VIEs to which the provisions of FIN 46 were first applied before the FASB's December 2003 revision of FIN 46.
The application of FIN 46 did not have a material effect on results of operations, financial condition or cash flows in 2003, nor does TRH presently anticipate that its application will have a material effect in 2004.
In 1998, the NAIC adopted the Codification as primary guidance on statutory accounting effective January 1, 2001. The Codification provides guidance for areas where previously statutory accounting had been silent and has also changed current statutory accounting in some areas. The New York Insurance Department (the state of domicile of TRC and Putnam) adopted most of the Codification guidance for implementation on January 1, 2001, but did not adopt certain key provisions including those on deferred income taxes. The cumulative effect of the implementation of Codification guidance (as adopted by the New York Insurance Department) on the statutory surplus of TRC and Putnam as of January 1, 2001 was not material. In addition, the implementation of such Codification guidance did not have a material effect on statutory net income in any of the years subsequent to adoption. In the fourth quarter of 2002, the guidance related to deferred income taxes was adopted. Accordingly, as of year-end 2003, statutory surplus of both TRC and Putnam include the impact of deferred tax assets of $90.1 million and $4.7 million, respectively. As of year-end 2002, statutory surplus of both TRC and Putnam include the impact of deferred tax assets of $88.3 million and $4.4 million, respectively, representing the cumulative benefit of adopting such provision in 2002. Statutory net income was not affected in 2002 or 2003 by the adoption of the guidance related to deferred income taxes.
As one or both of TRC and Putnam is also licensed, accredited or otherwise permitted to serve as a reinsurer in all states and the District of Columbia in the United States, they are required to disclose the differences between implementing Codification guidance on a New York State basis and Codification guidance adopted by the NAIC in a footnote to their statutory filings. As of December 31, 2003, remaining differences between Codification and those Codification provisions adopted by the New York Insurance Department were not material to 2003 statutory surplus and net income of TRC or Putnam and were not expected to be material in the future.
As discussed in Note 2 to the consolidated financial statements, the Company adopted Statement of Financial Accounting Standards No. 133, 'Accounting for Derivative Instruments and Hedging Activities,' in 2001.
Transatlantic Holdings, Inc. (the Company) is a holding company, incorporated in the state of Delaware, which owns all of the common stock of Transatlantic Reinsurance Company (TRC). TRC owns all of the common stock of Trans Re Zurich (TRZ) and Putnam Reinsurance Company (Putnam). As of December 31, 2003, 2002 and 2001, American International Group, Inc. (AIG, and collectively, with its subsidiaries, the AIG Group) beneficially owned approximately 60% of the Company's outstanding shares.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) AIG subsidiary) and are carried as an investment on the balance sheet (at cost, which approximates market value). A liability is recorded in an amount equal to the collateral received to recognize TRH's obligation to return such funds when the related loaned securities are returned. The market value of the loaned securities is monitored on a daily basis with additional collateral obtained or refunded as such value fluctuates. Fees received net of fees paid related to these transactions are recorded in net investment income.
Realized gains or losses on the sale of investments are determined on the basis of specific identification. In addition, where the declines in the market value of securities below cost or amortized cost are considered to be other than temporary, a realized loss is recorded for the difference between cost or amortized cost and estimated market value of such securities. Except where there has been an other than temporary impairment of market value, changes in unrealized appreciation (depreciation) of fixed maturities available for sale, equity investments and other invested assets are charged or credited, net of deferred income taxes, directly to accumulated other comprehensive income (see Note 9), a component of stockholders' equity. Investment income is recorded as earned. Amortization of fixed maturity premium and the accrual of fixed maturity discount are charged or credited, respectively, to net investment income.
(d) DEFERRED ACQUISITION COSTS: Acquisition costs, consisting primarily of net commissions incurred on business conducted through reinsurance contracts or certificates, are deferred, and then amortized over the period in which the related premiums are earned, generally one year. Anticipated losses and loss adjustment expenses and estimated remaining costs of servicing the contracts are considered in the evaluation of recoverability of acquisition costs to be deferred. Anticipated investment income is not considered in such evaluation.
(e) PREMIUM REVENUES: Premiums are earned primarily on a pro rata basis over the term of the related coverages. Unearned premiums and prepaid reinsurance premiums represent the portion of gross premiums assumed and reinsurance ceded, respectively, relating to the unexpired terms of such coverages. Premiums written and earned, along with related costs, for which data has not been reported by the ceding companies, are estimated based on historical patterns and other relevant information. These estimates are subject to change when actual data for such items estimated becomes available. In the Consolidated Statements of Operations, premiums written and earned and the change in unearned premiums are presented net of reinsurance ceded.
Estimation of loss reserves is a difficult process, especially in view of changes in the legal and tort environment which impact the development of loss reserves, and therefore quantitative techniques frequently have to be supplemented by subjective considerations and managerial judgment. In addition, trends that have affected development of liabilities in the past may not necessarily occur or affect liability development to the same degree in the future.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) of reinsurance treaties or facultative contracts, the necessary reliance on the ceding companies for information regarding reported claims and differing reserving practices among ceding companies, which are subject to change without notice. TRH writes a significant amount of non-proportional assumed casualty reinsurance as well as proportional assumed reinsurance of excess casualty business for classes such as medical malpractice and directors' and officers' liability, which classes can exhibit greater volatility over time than most other classes due to their low frequency, high severity nature and loss cost trends that are more difficult to predict.
Unpaid losses and loss adjustment expenses include certain amounts for the reinsurance of risks related to environmental impairment and asbestos-related illnesses. The majority of TRH's environmental and asbestos-related liabilities arise from contracts entered into after 1984. These obligations generally arose from contracts underwritten specifically as environmental or asbestos-related coverages rather than from standard general liability coverages where the environmental or asbestos-related liabilities were neither clearly defined nor specifically excluded. The reserves carried at December 31, 2003 for such claims, including IBNR, are based upon known facts and current law. However, significant uncertainty exists as, among other things, there are inconsistent court resolutions and judicial interpretations with respect to underlying policy intent and coverage and uncertainties as to the allocation of responsibility for resultant damages. Further, there is always the possibility of changes in statutes, laws, regulations and other factors that could have a material effect on these liabilities and, accordingly, future earnings.
Additionally, loss and loss adjustment expense reserves, net of related reinsurance recoverables, include amounts resulting from the September 11, 2001 terrorist attack which are principally related to property (including business interruption), other liability, workers' compensation and aviation coverages. These amounts are subject to significant uncertainty due to a variety of issues such as coverage disputes, the assignment of liability and a potentially long latency period for claims due to respiratory disorders and stress. (See Notes 5 and 8.)
(i) CHANGE IN ACCOUNTING PRINCIPLE AND DISCLOSURE OF STOCK-BASED COMPENSATION: Prior to 2003, TRH had accounted for stock-based compensation based on the intrinsic-value method prescribed in Accounting Principles Board Opinion (APB) No. 25, 'Accounting for Stock Issued to Employees' and related Interpretations, as permitted under SFAS No. 123, 'Accounting for Stock-Based Compensation.'
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) the fair value method to all stock-based compensation awards granted, modified, or settled on or after the date of adoption of the standard. Accordingly, net income for 2003 reflects stock-based compensation expenses primarily related to stock options granted in 2003 only. Such expenses are included in the Statement of Operations as a component of other deductions, net. The impact of adopting the recognition provisions of SFAS No. 123 was not material to net income, financial condition or cash flows in 2003. Pursuant to APB No. 25, no stock-based compensation expenses were recognized in 2002 or 2001. Had compensation cost been charged to earnings in accordance with the fair value based method as prescribed in SFAS No. 123 for all outstanding stock-based compensation awards (occurring both before and after adoption of the recognition provisions of SFAS No. 123), TRH's net income and net income per common share (on a pro forma basis) would have been as follows:
For any VIE that must be consolidated under FIN 46 that was created before December 31, 2003, the assets, liabilities and noncontrolling interest of the VIE would be initially measured at their 'carrying' amounts with any difference between the net amount added to the balance sheet and any previously recognized interest being recognized as the cumulative effect of an accounting change.
(a) STATUTORY DEPOSITS: Investments, the substantial majority of which are fixed maturities and common stocks available for sale, were deposited with governmental authorities as required by law and amounted to approximately $187,000,000 and $142,000,000 at December 31, 2003 and 2002, respectively.
(2) Includes write-downs for other than temporary declines in market value of $6,092,000 and $12,122,000 for 2003 and 2002, respectively. There were no write-downs for other than temporary declines in market value in 2001.
(4) Amounts for 2001 include the change in classification of certain fixed maturities (see Note 2(j)).
3. INVESTMENTS (CONTINUED) (d) FIXED MATURITIES: The amortized cost and market value of fixed maturities at December 31, 2003 and 2002 are summarized as follows:
However, in the first quarter of 2002, a change in the U.S. federal income tax law extended the net operating loss carry back period to five years for net operating losses occurring in 2001 and 2002. As a result, the $19.6 million deferred tax asset, established in 2001, was reclassified in 2002 to a current tax benefit as the tax law permitted TRH to fully utilize its tax net operating loss for 2001. To record the impact of this tax law change in 2002, deferred income tax assets and the domestic deferred income tax benefit were reduced by $19.6 million, and federal income tax recoverable was increased by, and domestic current income tax expense was reduced by $19.6 million.
TRH writes a significant amount of non proportional assumed casualty reinsurance as well as proportional assumed reinsurance of excess casualty business for such volatile classes as medical malpractice and directors' and officers' liability. At the primary level, there are significant risk factors which contribute to the variability and unpredictability of the loss cost trends for this business such as jury awards, social inflation, medical inflation, tort reforms, and court interpretations of coverage. In addition, as a reinsurer, TRH is also highly dependent upon the claims reserving and reporting practices of its cedants, which vary greatly by size, specialization and country of origin and whose practices are subject to change without notice. In particular, an unexpected increase in the frequency and severity of large claims beginning towards the end of 2002 and continuing into 2003, reflecting industry wide trends, resulted in material adverse development in TRH's loss reserves in these years.
There were no significant catastrophe losses occurring during 2002. In addition, as a result of net increases in estimates of losses occurring in prior years, net losses and loss adjustment expenses were increased by $339.1 million in 2002. Of this amount, in the fourth quarter of 2002, TRH recorded an increase to net loss and loss adjustment expense reserves of $100 million, resulting in a $65 million after-
Common stock activity for each of the three years in the period ended December 31, 2003 was as follows:
Net income per common share has been computed in the following table based upon weighted average common shares outstanding. Share and per share amounts have been retroactively adjusted, as
8. IMPACT OF SEPTEMBER 11TH TERRORIST ATTACK ON THE UNITED STATES
The charges made to operations for these plans for 2003, 2002 and 2001 were $4,243,000, $3,011,000, and $2,398,000, respectively.
As of December 31, 2003, 2002 and 2001, AIG beneficially owned approximately 60% of the Company's outstanding shares.
TRH has service and expense agreements and certain other agreements with the AIG Group which provide for the reimbursement to the AIG Group of certain administrative and operating expenses which include, but are not limited to, investment advisory and cash management services, office space and human resource related activities. Under the guidance of TRH's Finance Committee of the Board of Directors and senior management, certain subsidiaries of AIG act as financial advisors and managers of TRH's investment portfolio. In 2003, 2002 and 2001, $9,100,000, $8,200,000 and $7,900,000,
12. RELATED PARTY TRANSACTIONS (CONTINUED) respectively, of operating and investment expenses relate to services and expenses provided by the AIG Group under these agreements.
Approximately $633 million (17%), $395 million (13%) and $232 million (10%) of gross premiums written by TRH in 2003, 2002 and 2001, respectively, were attributable to reinsurance purchased by other subsidiaries of AIG, for the production of which TRH paid ceding commissions to such AIG subsidiaries totaling $167 million, $88 million and $50 million, respectively, in such years. The great majority of such gross premiums written were recorded in auto liability, property, other liability and aircraft lines. Of the premiums assumed from other subsidiaries of AIG, $294 million, $162 million and $69 million in 2003, 2002 and 2001, respectively, represent premiums resulting from certain insurance business written by AIG subsidiaries that, by prearrangement with TRH, is almost entirely reinsured by TRH, for the production of which TRH paid ceding commissions to such AIG subsidiaries totaling approximately $83 million, $31 million and $7 million, respectively, in such years. (See Note 14 for information relating to reinsurance ceded to related parties.)
The payment of dividends by the Company is dependent on the ability of its subsidiaries to pay dividends. The payment of dividends by TRC and its wholly-owned subsidiaries, TRZ and Putnam, is restricted by insurance regulations. Under New York insurance law, TRC and Putnam may pay dividends only out of their statutory earned surplus. Such dividends are limited by statutory formula unless otherwise approved by the New York Insurance Department. The statutory surplus of TRC includes the statutory surplus of Putnam since all the capital stock of Putnam is owned by TRC. At December 31, 2003, TRC had statutory earned surplus of $1,300,980,000, and, in 2004, in accordance with the statutory formula, could pay dividends of approximately $185,119,000 without regulatory approval.
In 1998, the NAIC adopted the Codification of Statutory Accounting Principles (Codification) as primary guidance on statutory accounting effective January 1, 2001. The Codification provides guidance for areas where previously statutory accounting had been silent and has also changed current statutory accounting in some areas. The New York Insurance Department adopted most of the Codification guidance for implementation on January 1, 2001, but did not adopt certain key provisions including those on deferred income taxes. The cumulative effect of the implementation of Codification guidance
13. DIVIDEND RESTRICTION AND STATUTORY FINANCIAL DATA (CONTINUED) (as adopted by the New York Insurance Department) on the statutory surplus of TRC and Putnam as of January 1, 2001 was not material. In addition, the implementation of such Codification guidance did not have a material effect on statutory net income in any of the years subsequent to adoption. In the fourth quarter of 2002, the guidance related to deferred income taxes was adopted. The initial establishment of deferred income taxes upon such adoption and any subsequent increases or decreases were credited or charged, respectively, directly to statutory surplus. Accordingly, as of year-end 2003, statutory surplus of both TRC and Putnam include the impact of deferred tax assets of $90.1 million and $4.7 million, respectively. As of year-end 2002, statutory surplus of both TRC and Putnam include the impact of deferred tax assets of $88.3 million and $4.4 million, respectively, which represented the cumulative benefit of adopting such provision in 2002. Statutory net income was not affected in 2002 or 2003 by the adoption of the guidance related to deferred income taxes.
(1) Premiums written and earned that were ceded to affiliates include amounts which, by prearrangement with TRH, were assumed from an affiliate and then ceded in an equal amount to other affiliates. Ceded premiums written include $79 million, $50 million and $56 million in 2003, 2002 and 2001, respectively, and ceded premiums earned include $71 million, $48 million and $55 million in 2003, 2002 and 2001, respectively, related to such arrangements.
14. REINSURANCE CEDED (CONTINUED) Amounts recoverable from retrocessionnaires are recognized in a manner consistent with the claims liabilities associated with the retrocession and are presented on the balance sheet as reinsurance recoverable on paid and unpaid losses and loss adjustment expenses. Such balances at December 31, 2003 and 2002 are comprised as follows:
TRH conducts its business and assesses performance through segments organized along geographic lines. Financial data from the London and Paris branches and from TRZ are reported in the aggregate as International-Europe and considered as one segment due to operational and regional similarities. Data from branches in the Americas, other than those in the United States which underwrite primarily domestic business, and from branches in the Asia Pacific region are grouped as International-Other and represent the aggregation of non-material segments. In each segment, property and casualty reinsurance is provided to insurers and reinsurers on a treaty and facultative basis, through brokers or directly to ceding companies.
(5) Underwriting expenses represent the sum of net commissions and other underwriting expenses.
(8) Results for 2001 include pre-tax net losses and loss adjustment expenses of $200 million (representing $100 million from Domestic operations and $100 million from International-Europe operations) from the September 11th terrorist attack (see Note 8 of Notes to Consolidated Financial Statements).
(b) COMMERCIAL COMMITMENTS: In the normal course of business, TRH has issued letters of credit to ceding companies amounting to $71,926,000. Where TRH provides a letter of credit, it is generally contractually obligated to continue to provide a letter of credit to the ceding company in the future to secure certain reserves and other balances.
16. COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED) (c) LEASES: As of December 31, 2003, the future minimum lease payments (principally for leased office space) under various long-term operating leases were as follows:
(1) Net loss for the fourth quarter of 2002 includes a charge of $65 million (after-tax), related to the increase in net loss and loss adjustment expense reserves in certain casualty lines (see Note 5).
(2) As the impact of potential shares for the three-month period ended December 31, 2002 is antidilutive (i.e., reduces the loss per common share) because there is a loss from continuing operations, potential shares are not included in the diluted net loss per common share calculation for that period.