Everest Re's corporate offices are located in Liberty Corner, New Jersey, and occupy approximately 112,000 square feet of office space under a sublease with The Prudential that expires on November 29, 2003. In January, 1999, Everest Re entered into an agreement to sub-sublease, for the remaining term of Everest Re's sub-lease, approximately 27,000 square feet of space in Everest Re's corporate headquarters. Everest Re's other ten office locations occupy a total of approximately 56,600 square feet, all of which are leased. Management believes that the above described office space is adequate for its current and anticipated needs.
The following selected consolidated GAAP financial data of the Company as of and for the years ended December 31, 1998, 1997, 1996, 1995 and 1994 were derived from the consolidated financial statements of the Company, which were audited by PricewaterhouseCoopers LLP (1998, 1997 and 1996) and by other independent auditors (1995 - 1994). The statutory data have been derived from statutory financial statements of Everest Re filed with the Delaware Insurance Department. Such statutory financial statements are prepared in accordance with Statutory Accounting Principals ("SAP"), which differ from GAAP. The statutory financial statements are unconsolidated and reflect the net assets of Everest Re's subsidiaries, Everest Ltd., Everest National, Everest Canada and Everest Indemnity on the equity method. The following financial data should be read in conjunction with the Consolidated Financial Statements and accompanying notes. The supplemental information for 1995 excludes the effects of an IPO-related premium charge of $140.0 million ($91.0 million after taxes) for the Stop Loss Agreement and an IPO-related compensation expense charge of $13.3 million ($8.7 million after taxes) principally for stock awards to the Company's Chief Executive Officer. Such supplemental information is presented to facilitate an understanding of the impact on the Company's results of operations of these non-recurring charges, but should not, however, be considered as an alternative to the respective amounts determined in accordance with GAAP as an indicator of the Company's operating performance.
- ------------ (1) After-tax operating income (loss), before after-tax net realized capital gains or losses, was $165.7 million (or $3.29 per basic share and $3.27 per diluted share), $144.6 million (or $2.86 per basic and $2.85 per diluted share), $108.3 million (or $2.14 per basic and diluted share), ($21.2) million (or ($0.42) per basic and diluted share) and $17.5 million (or $0.35 per basic and diluted share) for the years ended December 31, 1998, 1997, 1996, 1995 and 1994, respectively. Supplemental after-tax operating income, before net realized gains and excluding IPO-related charges was, $78.4 million (or $1.56 per basic and diluted share) for the year ended December 31, 1995. (2) Catastrophe losses are net of reinsurance. A catastrophe is defined, for purposes of the Selected Consolidated Financial Data, as an event that causes a pre-tax loss before reinsurance of at least $5.0 million and has an event date of January 1, 1988 or later. (3) Some amounts may not reconcile due to rounding. (4) Based on weighted average basic shares outstanding of 50.4 million, 50.5 million, 50.6 million, 50.2 million and 50.0 million for 1998, 1997, 1996, 1995 and 1994, respectively. (5) Based on weighted average diluted shares outstanding of 50.7 million, 50.8 million, 50.7 million, 50.2 million and 50.0 million for 1998, 1997, 1996, 1995 and 1994, respectively. (6) GAAP losses and LAE incurred as a percentage of GAAP net premiums earned. (7) GAAP underwriting expenses as a percentage of GAAP net premiums earned. Including restructuring and early retirement costs, incurred in the fourth quarter of 1994, the Company's GAAP underwriting expense ratio in 1994 was 32.1%. (8) Statutory results are on a Everest Re legal entity basis; consequently, investments in subsidiary operations are accounted for on an equity basis. Effective January 1, 1997, the reinsurance operations of Everest Re Ltd. were transferred to Everest Re on a portfolio basis. Excluding the impact of the portfolio transaction, the 1997 ratio of net written premiums to surplus, the 1997 loss and LAE ratio, the 1997 underwriting expense ratio and the 1997 combined ratio were 1.1 x, 70.5%, 32.2% and 102.7%, respectively. (9) Statutory net premiums written as a percentage of period-end surplus. (10) Statutory losses and LAE incurred as a percentage of SAP net premiums earned. (11) Statutory underwriting expenses as a percentage of SAP net premiums written. (12) Excluding net unrealized appreciation (depreciation) of investments, stockholders' equity was $1,281.6 million, $1,147.1 million, $1,008.3 million, $899.9 million and $799.1 million as of December 31, 1998, 1997, 1996, 1995 and 1994, respectively. (13) Based on 50.0 million shares outstanding for December 31, 1998, 50.5 million shares outstanding for December 31, 1997 and 1996, 50.8 million shares outstanding for December 31, 1995, and 50.0 million shares outstanding for December 31, 1994.
RESULTS OF OPERATIONS INDUSTRY CONDITIONS. Since 1987, a number of factors, including the emergence of significant reinsurance capacity from the Bermuda and rejuvenated Lloyds' markets, higher retentions by primary insurance companies and consolidation and increased capital levels in the insurance industry, have caused increasingly competitive global market conditions across most lines of business and have influenced the softening of prices and contract terms in the current market place. The Company cannot predict with any reasonable certainty, if, when or to what extent market conditions as a whole will change. See "Business-Competition" for a further discussion.
SEGMENT INFORMATION The Company, through its subsidiaries, operates as a single segment focusing on the coverage of property and casualty risks using an approach which emphasizes central control and coordination of critical business elements.
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997 The following discussion and analysis is focused on a comparison of 1998 results of operations to 1997 results of operations.
Incurred losses and LAE for 1998 reflected ceded losses and LAE of $357.4 million. Ceded losses and LAE included $153.9 million net ceded under the Stop Loss Agreement, $33.5 million net ceded to Gibraltar pursuant to a 1986 quota share reinsurance ("Direct Excess Retrocession") through which Gibraltar assumed 100% of the liabilities related to Everest Re's former direct excess insurance operations which ceased writing business in 1985, and $102.4 million ceded under the Company's management underwriting facility ("MUF"), a reinsurance arrangement begun in 1977 pursuant to which Everest Re ceded certain business written prior to 1992 to a number of insurance and reinsurance companies which, as the result of commutations, also includes Gibraltar.
Gibraltar has disputed $63.0 million ceded under the Stop Loss Agreement in 1998 and pursuant to the terms of the Stop Loss Agreement, Gibraltar has secured the disputed amount. Gibraltar has also disputed Everest Re's level of reserves previously ceded to and paid by Gibraltar under the Stop Loss Agreement and claims a refund of $91.7 million. Should Everest Re and Gibraltar not resolve these disputes, pursuant to the terms of the Stop Loss Agreement, each will appoint an independent examiner to review the disputed amounts and to determine the appropriate amount of cessions to Gibraltar, and Everest Re will secure the $91.7 million amount. If the examination process does not resolve the disputes, the Stop Loss Agreement provides for resolution through arbitration. In the event the cessions to Gibraltar were determined to be excessive, Everest Re would reduce the cession to Gibraltar by such excess, refund previous payments made by Gibraltar, if applicable, and the unused portion of the limits of the Stop Loss Agreement would be restored. Also, Everest Re would consider the independent examiners' findings in its ongoing determination of appropriate reserve levels, which may lead to a corresponding reduction in Everest Re's gross reserves, and net reserves to the extent of the coinsurance under the Stop Loss Agreement. In the event the cessions are not determined to be excessive, Gibraltar would be obligated to pay the disputed amount. Accordingly, if the disputes are resolved in Gibraltar's favor, any adverse effect on the Company's financial condition and results of operations would likely be limited to a reduction in cash flows from operations with a corresponding impact on investment income.
Underwriting expenses decreased by 0.7% to $324.1 million in 1998 from $326.5 million in 1997. Commission, brokerage, taxes and fees decreased by $0.2 million attributable to decreases in written premium and changes in the Company's business mix. Other underwriting expenses decreased by $2.1 million, as the Company's cost reduction initiatives continued to provide benefits over the course of 1998 and 1997. The benefits more than offset the impact of salary and other expense increases that were generally in line with inflation. The Company's expense ratio decreased by 0.8 percentage points to 30.3% in 1998 from 31.1% in 1997 as a result of the increase in premiums earned and the decrease in underwriting expenses.
INCOME TAXES. The Company had income tax expense of $47.5 million in 1998 compared to $52.3 million in 1997, with the decrease resulting from the relationship of tax exempt income to pre-tax income as the Company increased the tax preferenced element of investment income at a rate greater than the increase in pre-tax income as a result of growth in the Company's tax preferenced investment holdings.
Ceded premiums increased by 224.7% to $43.8 million in 1997 from $13.5 million in 1996, principally as a result of a return premium in 1996 under the Company's catastrophe retrocessional protection, coupled with increased retrocessional protections for international catastrophe exposures and increases in the Company's contract specific retrocessions in 1997.
REVENUES. Net premiums earned increased by 7.8% to $1,049.8 million in 1997 from $973.6 million in 1996, with the increase attributable to premium earnings patterns coupled with a decrease in the rate of written premium growth.
The Company's combined ratio decreased by 1.3 points to 104.0% in 1997 from 105.3% in 1996, reflecting the lower loss ratio and increased premiums.
FINANCIAL CONDITION CASH AND INVESTED ASSETS. Aggregate invested assets, including cash and short-term investments, were $4,325.8 million at December 31, 1998, $4,163.3 million at December 31, 1997 and $3,624.6 million at December 31, 1996. The change in invested assets resulted primarily from cash flows from operations generated during the period together with net realized and unrealized gains and losses on investments.
- ---------- (1) Net of $138.5 million in 1998, $41.2 million in 1997 and $24.2 million in 1996 ceded under the incurred loss reimbursement feature of the Stop Loss Agreement.
The $397.3 million of reinsurance receivables with respect to asbestos and environmental reserves as of December 31, 1998 was attributable principally to three retrocessional arrangements: (i) $168.6 million was ceded to various insurance and reinsurance companies, including Gibraltar, in connection with their participation in MUF; (ii) $118.8 million was ceded to Gibraltar under the Company's Stop Loss Agreement which is contractually due to the Company in the first quarter of 1999, subject to resolution of the dispute noted above; and (iii) $96.5 million resulting from the Company's former direct excess insurance operations, which ceased writing business in 1985 and which has been 100% ceded to Gibraltar since 1986, a portion of which is subject to resolution of the dispute noted above. See - "Year Ended December 31, 1998 Compared to Year Ended December 31, 1997" above.
STOP LOSS AGREEMENT AND PRUDENTIAL GUARANTEES. To the extent reserves as of June 30, 1995 (December 31, 1994 for catastrophe losses) for losses, allocated LAE and uncollectible reinsurance experience adverse development ("Adverse Development"), Everest Re is entitled, at the time reserves are increased, to payments under the Stop Loss Agreement, subject to the limit and other terms thereof. Gibraltar's obligations to make payments to Everest Re under the Stop Loss Agreement are guaranteed by The Prudential. Management expects that the general effect of the Stop Loss Agreement will be to protect the Company's consolidated earnings against up to $375.0 million of the first $400.0 million of Adverse Development. There can be no assurance, however, that the Company's net liability for such Adverse Development will be limited to $25.0 million. With respect to liquidity, the incurred loss reimbursement features of these agreements provide the Company with cash on or prior to the time it is required to make payment on account of such Adverse Development. Through December 31, 1998, Adverse Development ceded under the Stop Loss Agreement have aggregated $339.2 million with remaining limits available of $35.8 million (net of coinsurance) as respects the next $39.8 million of Adverse Development. See - "Year Ended December 31, 1998 Compared to Year Ended December 31, 1997" - above.
The Prudential has guaranteed all of Gibraltar's payment obligations under the Stop Loss Agreement and up to $400.0 million of Gibraltar's net obligations under all other reinsurance agreements between Gibraltar and Everest Re, $128.3 million of which has been discharged by loss payments made to the Company subsequent to June 30, 1995. At December 31, 1998, Gibraltar's net obligations under such other reinsurance agreements consisted of the following balances:
The Company maintains a corporate-level retrocessional protection program, above and beyond retrocessions purchased with respect to specific assumed coverage, to mitigate the potential impact of catastrophe losses. Prior to the December 31, 1998 cancellation of significant elements of this program, the attachment point of this program was $25.0 million per catastrophe in the United States and $10.0 million per catastrophe outside the United States. During 1998, $23.1 million was ceded under the corporate level retrocession program as a result of catastrophes occurring outside the United States. Effective January 1, 1999 the Company has purchased an accident year aggregate excess of loss protection which provides up to $175.0 million of coverage if Everest Re's statutory basis accident year loss ratio exceeds a certain threshold and responds on an aggregate basis with respect to both property and casualty losses, including those arising from catastrophes. The attachment point is net of inuring retrocessions and includes adjustable premium provisions which effectively cause the Company to offset, on a pre-tax income basis, up to 52.5% of such ceded losses, depending upon the character of the underlying losses, through additional premiums. The maximum recovery is $175.0 million before giving effect to a maximum adjustable premium of $86.3 million. Retrocessions inuring to the benefit of this program, for the period from May 15, 1998 through May 15, 1999, include a catastrophe retrocession which provides coverage of 70.0% of $20.0 million per occurrence in excess of $10.0 million in losses incurred by the Company outside of the United States, and for the period from May 23, 1998 through May 23, 1999, include a catastrophe retrocession which provides coverage of 87.5% of $20.0 million per occurrence in excess of $30.0 million in losses incurred by the Company outside of the United States. All aspects of the retrocession program have been structured to permit the program to be accounted for as reinsurance under SFAS No. 113.
In May 1998, the Company renewed its 364 day revolving line of credit with First Union National Bank originally entered into in June 1997. This credit facility, which will be used for liquidity and general corporate purposes, provides for the borrowing of up to $50 million. There have been no borrowings under this facility in 1998 or 1997. The credit facility agreement continues to require that Everest Re maintains statutory surplus of not less than $575 million and that the Company not allow its ratio of certain debt to capital to be greater than a specified amount. The Company may
choose an interest rate on borrowings equal to either (i) the Base Rate (as defined below), (ii) an adjusted London InterBank Offered Rate ("LIBOR") plus a margin (the "Margin") or (iii) a Money Market Rate, which is a daily uncommitted advised rate. The Base Rate is the higher of the rate of interest established by the bank from time to time as its reference rate in making loans or the Federal Funds rate plus 0.5% per annum. The amount of the Margin and the commitment fee payable to the bank for the credit facility depend upon the insurance strength or claims paying ability ratings of Everest Re.
The payment of dividends to Holdings by Everest Re is subject to limitations imposed by the Delaware Insurance Code. Based upon these restrictions, the maximum amount that will be available for payment of dividends to Holdings by Everest Re in 1999 without the prior approval of regulatory authorities is $179.2 million. Everest Re's future cash flow available to Holdings may be influenced by a variety of factors, including changes in the property and casualty reinsurance market, Everest Re's financial results, insurance regulatory changes and changes in general economic conditions. The availability of such cash flow to Holdings could also be influenced by, among other things, changes in the limitations imposed by the Delaware Insurance Code on the payment of dividends by Everest Re. Holdings expects that, absent significant catastrophe losses, such restrictions should not affect Everest Re's ability to declare and pay dividends sufficient to support Holdings' current dividend policy.
During 1998, 1997 and 1996 Holdings declared and paid dividends of $10.1 million, $8.1 million and $6.1 million, respectively.
INCOME TAXES On April 21, 1998, the Supreme Court issued its decision in Atlantic Mutual Insurance Company v. Commissioner, upholding the Internal Revenue Service's position regarding the computation of the fresh start benefit relating to 1986 reserve strengthening. Pursuant to a separation agreement entered into with The Prudential, its former parent at the time of the Company's initial public offering in 1995, the Company paid The Prudential $10.4 million representing tax and interest in resolution of the matter. The Company had adequate provisions for this tax contingency and, as a result, this item has not materially impacted the Company's financial position.
MARKET SENSITIVE INSTRUMENTS The Securities and Exchange Commission Financial Reporting Release #48 requires registrants to clarify and expand upon the existing financial statement disclosure requirements for derivative financial instruments, derivative commodity instruments, and other financial instruments (collectively, "market sensitive instruments").
Everest Re's current investment strategy does not provide for investments in derivative financial instruments or derivative commodity instruments. The Company's current investment strategy seeks to maximize after-tax income through a high quality, diversified, taxable and tax-exempt fixed maturity portfolio, while maintaining an adequate level of liquidity. Everest Re's mix of taxable and tax-preferenced investments are adjusted continuously, consistent with Everest Re's current and projected operating results, market conditions, and tax position. The fixed maturities in the investment portfolio are comprised of non-trading available for sale securities. Additionally, Everest Re invests in marketable equity securities, which it believes will enhance the risk-adjusted total return of the investment portfolio.
The $4.3 billion investment portfolio is comprised of fixed maturity securities that are subject to interest rate risk and foreign currency rate risk, and equity securities that are subject to equity price risk. The impact of these risks in the investment portfolio is generally mitigated by changes in the value of operating assets and liabilities and their associated income statement impact.
The table below displays the potential impact of market value fluctuations and after-tax unrealized appreciation on the fixed maturity portfolio as of December 31, 1998 based on parallel 200 basis point shifts in interest rates up and down in 100 basis point increments. For legal entities with a US dollar functional currency, this modeling was performed on each security individually. To generate appropriate price estimates on mortgage-backed securities, changes in prepayment expectations under different interest rate environments are taken into account. For legal entities with a non-US dollar functional currency, the effective duration of the involved portfolio of securities was used as a proxy for the market value change under the various interest rate change scenarios. All amounts are in millions of US$.
The table below displays the potential impact of a parallel 20% increase and decrease in foreign exchange rates on the valuation of invested assets subject to foreign currency exposure in 10% increments as of December 31, 1998. This analysis includes the after-tax impact of translation from transactional currency to functional currency as well as the after-tax impact of translation from functional currency to the US dollar reporting currency. All amounts are in millions of US$.
Equity risk is the potential change in market value of the common stock and preferred stock portfolios arising from changing equity prices. The Company invests in predominately high quality preferred and common stocks that are traded on the major exchanges in the United States. The primary objective in managing the $146.3 million equity portfolio is to provide long-term capital growth through market appreciation and income.
YEAR 2000 READINESS DISCLOSURES Many computers, software programs and microprocessors embedded in certain equipment (collectively, "systems") were designed to accommodate only two-digit date fields to represent a given year (e.g., "98" represents 1998). It is possible that such systems will not be able to accurately process data containing information relating to dates before, during or after the year 2000. It is also possible that such systems could fail entirely, although in many instances the consequences of a system not being "year 2000 compliant" are unknown. The "year 2000 issue" has the potential to affect the Company through (i) the disruption of the processing of business and general corporate transactions, both at the Company and between the Company and other business entities with which it interacts, and (ii) claims which may be brought asserting that costs associated with the issue may be covered under insurance or reinsurance contracts in which the Company participates.
Although the Company has devoted significant efforts to assessing and upgrading its systems, most of the Company's computerized systems have been developed and maintained by third-party vendors, and the Company is thus dependent in large part on the efforts of those vendors. In many cases the involved systems have already been made compliant. In other cases the Company continues to communicate with the vendors regarding their plans for making the involved systems compliant. On the basis of those communications, the Company believes that those vendors have a critical business need to make their products compliant and are exercising their best efforts to make their products fully compliant.
In addition to addressing hardware/software information technology ("IT"), the Company has also been assessing year 2000 issues with respect to non-IT systems such as telephones and various building services which may rely on embedded microprocessors. Although failure of non-IT systems such as telephone service could disrupt the Company's business, the Company's inquiries of the relevant vendors have not identified any material year 2000 problems.
POTENTIAL CLAIMS EXPOSURE. It appears probable that individuals or entities which experience business disruption, increased costs or other problems associated with the year 2000 issue may assert claims against their own insurance carrier to recover such costs or against other entities for damages, which entities may in turn assert that such potential damages are covered by insurance. While it appears probable that some such claims will be made against insurers, it is not yet possible to determine whether such claims will be held to have merit or whether any such claims may be made against insurance or reinsurance contracts in which the Company participates. With respect to prospective business, the Company works with brokers and ceding companies to attempt to determine whether prospective or existing business written carries potential year 2000 exposures. If the ceding company, in the Company's opinion, is adequately underwriting the exposures, the Company may not exclude such exposures from its contracts. If the ceding company is not adequately addressing the issue, the Company will attempt to exclude those exposures from its contracts or non-renew those contracts. There can be no assurance, however, that such business will be completely free of potential exposure to claims related to the year 2000 issue.
The nature of the Company's reinsurance business and its investments is such that the Company does not expect the impact of the Euro conversion to be material to the Company's business, operations or financial condition. Although systems which support the Company's United Kingdom and Belgian operations require modifications to enable conversion of legacy currency historical data and accommodate conversions in accordance with European Union requirements, which modifications the system vendor is investigating, a failure of the vendor to modify the system is not expected to be material to the Company's business, operations or financial condition. The Company has not yet determined when it will convert the functional currency for its Belgian operation to the Euro.
17) Impact of the Euro on the Company's operations or financial condition;
21) The impact of current and future regulatory environments, generally, and on the ability of the Company's subsidiaries to enter and exit reinsurance or insurance markets; and
22) Changes in the commission or brokerage levels that competitors are willing to offer to ceding companies, brokers or agents.
The financial statements and schedules listed in the accompanying Index to Financial Statements and Schedules on page are filed as part of this report.