The following selected consolidated GAAP financial data of the Company as of and for the years ended December 31, 1997, 1996, 1995, 1994 and 1993 were derived from the consolidated financial statements of the Company, which were audited by Coopers and Lybrand L.L.P. (1997 and 1996) and Deloitte and Touche LLP (1993 - 1995), independent auditors. 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 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.
INITIAL PUBLIC OFFERING. On October 6, 1995 the Company's former ultimate parent, The Prudential Insurance Company of America, ("The Prudential"), completed an initial public offering ("IPO") of 100% of the outstanding stock of the Company. In connection with the IPO, the Company incurred a non-recurring premium charge of $140.0 million ($91.0 million after-tax) for aggregate excess of loss reinsurance coverage (the "Stop Loss Agreement") provided by Gibraltar Casualty Company ("Gibraltar") an affiliate of the former parent. This coverage protects the Company's consolidated earnings against up to $375.0 million of the first $400.0 million of adverse development, if any, on the Company's consolidated reserves for losses, allocated loss adjustment expenses and uncollectible reinsurance at June 30, 1995 (December 31, 1994 for catastrophe losses). At the same time, The Prudential paid $140.0 million to the Company, of which amount $91.0 million was a contribution to capital and $49.0 million was a payment in respect of the tax benefit of the premium paid for the Stop Loss Agreement. In addition, the Company incurred $13.3 million ($8.7 million after-tax) of non-recurring compensation expense, including $12.5 million in connection with IPO-related stock awards to the Chief Executive Officer. All of these IPO-related transactions had the effect of reducing cash flow for 1995 by $0.8 million and increasing stockholders' equity by $3.8 million. The following table shows the Company's 1995 results of operations as reported in the accompanying statement of operations and as adjusted to exclude these IPO-related charges:
YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996 The following discussion and analysis is focused on a comparison of 1997 results of operations to 1996 results of operations.
Net premiums written increased by 0.1% to $1,031.1 million in 1997 from $1,030.5 million in 1996, reflecting the growth in U.S. broker, U.S. direct treaty reinsurance and insurance, international and marine, aviation and surety gross written premiums offset by the decrease in facultative gross premiums written and the increase in ceded premiums.
YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED DECEMBER 31, 1995
Net realized capital gains decreased 83.1% to $5.7 million in 1996 from $33.8 million in 1995, principally reflecting the sale in 1995 of one half of the Company's investment in the common stock of Corporacion MAPFRE. Realized capital gains on the sale of equity securities totalled $17.4 million in 1996, as generally favorable conditions continued in the U.S. equity securities market, and were partially offset by $11.7 million in realized capital losses on the sale of fixed maturities.
Underwriting expenses, as adjusted, increased by 7.7% to $309.5 million in 1996 from $287.4 million in 1995. Commission, brokerage, taxes and fees increased by $27.2 million attributable primarily to increases in written premium and changes in the Company's business mix. Other underwriting expenses decreased by $5.1 million, as the impact of the significant reduction in employees over the course of 1995 and 1996 and other cost reduction initiatives more than offset the impact of salary and other expense increases that were generally in line with inflation. The Company's expense ratio, as adjusted, decreased by 0.4 points to 31.8% in 1996 from 32.2% in 1995 as the increase of premiums earned more than offset the increases in underwriting expenses.
NET INCOME. Net income was $112.0 million in 1996 compared to $100.4 million, as adjusted, in 1995. This improvement mainly reflects higher premiums earned, higher investment income and a lower combined ratio, offset by lower realized capital gains and higher income taxes.
ASBESTOS AND ENVIRONMENTAL EXPOSURES. Everest Re's asbestos claims typically involve liability or potential liability for bodily injury from exposure to asbestos or liability for property damage resulting from asbestos or asbestos containing materials. Everest Re's environmental claims typically involve potential liability for the mitigation or remediation of environmental contamination or bodily injury or property damages caused by the release of hazardous substances into the land, air or water. In addition to the previously described general uncertainties inherent in estimating reserves, there are significant uncertainties in estimating the amount of Everest Re's potential losses from asbestos and environmental claims. Among the complications are: (i) potentially long waiting periods between exposure and manifestation of any bodily injury or property damage; (ii) difficulty in identifying sources of asbestos or environmental contamination; (iii) difficulty in properly allocating responsibility and/or liability for asbestos or environmental damage;(iv) changes in underlying laws and judicial interpretation of those laws; (v) potential for an asbestos or environmental claim to involve many insurance providers over many policy periods; (vi) long reporting delays, both from insureds to insurance companies and ceding companies to reinsurers; (vii) limited historical data concerning asbestos and environmental losses; (viii) questions concerning interpretation and application of insurance and reinsurance coverage; and (ix) uncertainty regarding the number and identity of insureds with potential asbestos or environmental exposure.
- ---------- (1) Net of $41.2 million in 1997, $24.2 million in 1996 and $16.7 million in 1995 ceded under the incurred loss reimbursement feature of the Stop Loss Agreement. (2) Net of $22.6 million in 1997, $34.5 million in 1996 and $5.0 million in 1995 ceded as paid losses under the Stop Loss Agreement.
The $233.7 million of reinsurance receivables as of December 31, 1997 was attributable principally to two retrocessional arrangements: (i) $135.4 million was due from various insurance and reinsurance companies, including Gibraltar, in connection with their participation in Everest Re's management underwriting facility ("MUF"), a reinsurance arrangement begun in 1977 pursuant to which Everest Re ceded certain reinsurance and direct excess insurance business; and (ii) $91.5 million was due as a result of the Company's former direct excess insurance operations, which ceased writing business in 1985 and which has been 100% ceded to Gibraltar since 1986.
STOCKHOLDERS' EQUITY. Holdings' stockholders' equity increased to $1,307.5 million as of December 31, 1997 from $1,086.0 million as of December 31, 1996 principally reflecting $146.9 million in retained earnings for the year and an increase of $82.6 million in unrealized appreciation of investments. Stockholders' equity as of December 31, 1996
Holdings' stockholders' equity exceeded Everest Re's statutory-basis surplus by $398.7 million at December 31, 1997. The primary differences between GAAP and SAP as they relate to the Company are: (i) the deferral of acquisition costs under GAAP, which are immediately expensed under SAP; (ii) the provision for deferred taxes on temporary tax differences under GAAP, which are excluded under SAP; and (iii) the carrying at market value of fixed maturities available for sale under GAAP, as compared to at amortized cost under SAP.
LIQUIDITY AND CAPITAL RESOURCES EVEREST RE. Everest Re's liquidity requirements are met on both a short- and long-term basis by funds provided by premiums collected, investment income and collected reinsurance receivables balances, and from the sale and maturity of investments. The Company's net cash flows from operating activities were $376.4 million, $414.0 million and $397.9 million, as adjusted, in 1997, 1996 and 1995, respectively. The decreases from 1996 in cash provided by operating activities were principally a result of increases in net paid losses offset by improved profitability. Recoveries under the Company's Stop Loss Agreement with Gibraltar contributed $99.8 million, $53.4 million and $12.0 million of such net cash flows in 1997, 1996 and 1995 respectively.
Proceeds and applications from sales and acquisitions of investment assets were $1,077.0 million and $1,482.8 million, respectively, in 1997, compared to $1,632.9 million and $2,014.9 million, respectively, in 1996 and $1,101.0 million and $1,494.7 million, respectively, in 1995. Everest Re's current investment strategy seeks to maximize after-tax income through a high quality, diversified, duration sensitive, taxable bond and tax-exempt municipal bond portfolio, while maintaining an adequate level of liquidity.
EXPOSURE TO CATASTROPHES. As with other reinsurers, Everest Re's operating results and financial condition can be adversely affected by volatile and unpredictable natural and other disasters, such as hurricanes, windstorms, earthquakes, floods, fires and explosions. Although Everest Re attempts to limit its exposure to acceptable levels, it is possible that an actual catastrophic event or multiple catastrophic events could have a material adverse effect on the financial condition, results of operations and cash flows of the Company.
The Company maintains a corporate-level retrocessional protection program, above and beyond retrocessions purchased with respect to specific assumed coverages, to mitigate the potential impact of catastrophe losses. At December 31, 1997, the attachment point of this program was $25.0 million per catastrophe in the U.S. and $10.0 million per catastrophe outside the U.S. No losses were ceded under the corporate-level retrocession program during 1997 or 1996. All aspects of the retrocession program have been structured to permit the program to be accounted for as reinsurance under SFAS No. 113.
The availability of such cash flow to Holdings could also be influenced by, among other things, changes in the limitations imposed by the Delaware 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 1997, 1996 and 1995 Holdings declared and paid dividends of $8.1 million, $6.1 million and $7.0 million, respectively.
TAX CONSOLIDATION WITH THE PRUDENTIAL The Internal Revenue Service ("IRS") has completed its examinations of The Prudential's tax returns for all years through 1992. As those examinations relate to Everest Re, the IRS has disallowed that portion of the fresh start benefit which relates to 1986 reserve strengthening as defined by the IRS. As a result of conflicting decisions by two U.S. Circuit Courts, the Supreme Court of the United States will consider the issue in reviewing ATLANTIC MUTUAL INSURANCE CO. V. COMMISSIONER to determine whether the Treasury regulation that defines the term "reserve strengthening" is a valid interpretation of the law. The Supreme Court's decision in this case is expected to bring about a uniform resolution of this question. The Company agrees with the petitioner in this case in that the term "reserve strengthening" as used in the statute involves changes in assumptions or methodologies. The Company believes that, because there were no changes in reserving assumptions or methodologies between 1985 and 1986, all increases to reserves in 1986 for which a fresh start benefit was taken are normal reserve additions and, therefore, does not constitute reserve strengthening that is not eligible for the fresh start benefit. If the IRS position prevails, the Company will be required to reimburse The Prudential, thereby incurring an additional charge of approximately $9.4 million, including the after-tax cost of interest through December 31, 1997.
YEAR 2000 ISSUES Many computers and software programs were designed to accommodate only two-digit date fields to represent a given year (E.G., "97" represents 1997). It is possible that such systems will not be able to accurately process data containing information about the year 2000 or later. 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 businesses 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.
1) Changes in the level of competition in the domestic and international reinsurance or primary insurance markets that adversely affect the volume or profitability of the Company's reinsurance or insurance business. These changes include, but are not limited to, the intensification of price and contract terms competition, the entry of new competitors, consolidation in the reinsurance and insurance industry and the development of new products by new and existing competitors;
2) Changes in the demand for reinsurance and insurance products of the type offered by the Company and its ceding insurer customers;
7) Changes in inflation that affect the profitability of the Company's current reinsurance and insurance businesses or the adequacy of its claim and claim expense liabilities;
14) Gains or losses related to changes in foreign currency exchange rates;
16) Impact of Year 2000 computer hardware and software issues on the Company's operations and potential for Year 2000 claims under reinsurance and insurance contracts written by the Company;
17) Adverse results in litigation matters, including, but not limited to, litigation related to environmental, asbestos and other potential mass tort claims;