The following discussion highlights material factors affecting Trenwick America Corporation's ("Trenwick America") results of operations for the years ended December 31, 2002 and 2001. This discussion and analysis should be read in conjunction with the consolidated financial statements and notes thereto of Trenwick America for the years ended December 31, 2002, 2001 and 2000, contained in this Annual Report on Form 10-K. Trenwick America meets the conditions set forth in General Instruction I (1)(a) and (b) of Form 10-K and is therefore omitting certain information otherwise required by Item 7.
Trenwick America discloses operating and non-operating income to enable the reader to understand how management evaluates Trenwick America's results of operations. These disclosures are not defined under accounting principles generally accepted in the United States of America; accordingly the use of these disclosures may not be comparable to other registrants.
Trenwick America is a Delaware holding company headquartered in Stamford, Connecticut whose principal treaty reinsurance business provides, through an underwriting facility with Chubb Re, Inc. and its affiliate Federal Insurance Company (together "Chubb"), treaty reinsurance to insurers of property and casualty risks.
During 2002 and the first quarter of 2003, a number of developments have occurred that have significantly and negatively affected Trenwick America's operations, capital structure and the financial resources required to conduct its businesses. Set forth below are brief descriptions of a number of these developments as well as certain material transactions entered into by Trenwick America to enable it to continue to conduct business operations despite the adverse developments. Investors are cautioned that Trenwick America has had a number of significant adverse events which could make it extremely difficult to continue in its current businesses, if at all, and they should carefully review the "Risk Factors" and "Forward-Looking Statements" sections, as well as other sections, of this Report.
Concurrently with the business combination involving LaSalle Re Holdings and Trenwick Group Inc. in September of 2000, Trenwick America and Trenwick Holdings Limited ("Trenwick Holdings"), Trenwick's United Kingdom holding company, entered into an amended and restated $490 million credit agreement with
On October 18, 2002, A.M. Best Company lowered the financial strength ratings of Trenwick's, Trenwick America's and Trenwick Holdings' operating subsidiaries below "A-." The lowered A.M. Best Company ratings constituted an event of default under the credit agreement. In addition, increases in Trenwick's, Trenwick America's and Trenwick Holdings' reserves for unpaid claims and claims expenses and the establishment of a Trenwick America deferred tax asset valuation allowance in the third quarter of 2002 resulted in violations of the financial covenants in the credit agreement requiring Trenwick, Trenwick America and Trenwick Holdings to maintain a minimum tangible net worth and minimum risk-based capital. On November 13, 2002, Trenwick, Trenwick America, Trenwick Holdings and the Banks executed a forbearance agreement with respect to the events of default arising from the lowered A.M. Best Company ratings and financial covenant violations.
Subsequently, an amendment and waiver of default under the credit agreement and amendments to the guaranty agreement have been entered into on December 24, 2002 (the "December Amendments"). The December Amendments extended the letter of credit facility through December 31, 2003 to support Trenwick's underwriting operations at Lloyd's for the 2003 year of account. To those Banks extending their letters of credit, Trenwick, Trenwick America and Trenwick Holdings agreed to pay a 5% per annum cash letter of credit fee, issue pay-in-kind notes bearing interest at LIBOR plus 2.5% per annum to evidence an additional 3.16% per annum letter of credit fee, issue warrants equal to 10% of Trenwick's fully diluted equity capital, and pay 15% of the profits earned by Trenwick and its subsidiaries for the 2002 and 2003 Lloyd's years of account. Trenwick, Trenwick America and Trenwick Holdings agreed to provide the Banks a security interest in all of their respective equity interests in, and the assets and property of, their direct and indirect subsidiaries as additional collateral for the Banks, and to cause the subsidiaries to provide a guaranty to the Banks subject to applicable laws and regulations and certain existing contractual rights of holders of other indebtedness.
Pursuant to the December Amendments, Trenwick is required to collateralize with cash, cash equivalents and marketable securities 60% of the outstanding letters of credit by August 1, 2003. If it is unable to do so, Trenwick's insurance company subsidiaries, including those of Trenwick America, will be prohibited from underwriting any insurance or reinsurance business without the Banks' prior approval. In addition, Trenwick is required to use its best efforts to terminate the letters of credit by December 31, 2003. In order to do so, the letters of credit would need to be replaced with other letters of credit or collateral acceptable to Lloyd's. In the event Trenwick has not terminated the letters of credit by December 31, 2003, it is required on such date to collateralize with cash, cash equivalents and marketable securities the full amount of the outstanding letters of credit. At this time, Trenwick does not have sufficient available liquidity to collateralize the letters of credit as required by the December Amendments. Additionally, Trenwick does not believe that it will be able to replace the letters of credit with other letters of credit or collateral acceptable to Lloyd's. See Item 7 - "Management's Discussion and Analysis of Financial Condition and Results of Operation - Liquidity and Capital Resources."
Included in Trenwick America's indebtedness at December 31, 2002 are 6.7% senior notes with an aggregate principal amount of $75 million, which were initially due on April 1, 2003 and pursuant to an amendment have been extended to August 1, 2003 (the "Senior Notes"). Trenwick America is engaged in continuing discussions with holders of the Senior Notes with respect to a possible restructuring of these Senior Notes. The agreements entered into in connection with the renewal of Trenwick, Trenwick America and Trenwick Holdings' letter of credit facility in December 2002, and as further amended, provide that Trenwick America will replace, refinance or restructure these senior notes by July 15, 2003. At this time, Trenwick America does not have sufficient available liquidity to pay the amount due on August 1, 2003 and is uncertain whether it will be able to complete the restructuring by July 15, 2003. If Trenwick America is unable to restructure these Senior Notes and either the banks under the credit facility or the holders of the Senior Notes decide to exercise the rights available to them or take other action with respect to the assets of Trenwick America, Trenwick America and/or one or more of its subsidiaries may be forced to seek protection from creditors. In
Trenwick America's independent accountants, PricewaterhouseCoopers LLP, have stated in their audit report dated March 31, 2003 except for Note 7 to the financial statements as to which the date is April 9, 2003, with respect to Trenwick America's financial statements as of and for the twelve months ended December 31, 2002, that substantial doubt exists as to Trenwick America's ability to continue as a going concern.
Standard and Poor's Ratings Services announced on April 2, 2003 that it had lowered the counterparty credit ratings on Trenwick and Trenwick America to "D" following the announced non-payment of principal and interest on the senior notes. Standard & Poor's also stated that despite the agreement in principal to extend the maturity of the senior notes, it believes that the prospect for significant recoveries to the senior note holders is very low. Standard & Poor's also announced on March 4, 2003 that it placed its "CCC" counterparty credit and financial strength ratings on Trenwick America's subsidiaries, Trenwick America Reinsurance Corporation ("Trenwick America Re"), Dakota Specialty Insurance Company ("Dakota") and The Insurance Corporation of New York ("INSCORP") on CreditWatch negative. In addition, Standard and Poor's withdrew its "CCC" counterparty credit and financial strength ratings on Chartwell Insurance Company due to its merger with Trenwick America Re.
On April 2, 2003, A.M. Best Company announced that it had withdrawn the financial strength rating of "C" (Weak) and assigned a "NR-4" rating (Rating Withdrawn at Company's Request) to Trenwick America Re. Concurrently, A.M. Best downgraded the debt rating of Trenwick America to "D" from "C" relating to its Senior Notes. These rating actions followed the announced non-payment of principal and interest on the Senior Notes. The financial strength rating of Trenwick America Re had previously been downgraded to "C" (Weak) from "B-" (Fair) on February 3, 2003. At that time, the ratings for all of Trenwick America Re's subsidiaries were withdrawn, and Trenwick America's debt ratings were downgraded to "C".
On April 3, 2003, Fitch Ratings announced that it had lowered its long term and senior debt rating on Trenwick America to "D" from "C". In addition, Fitch lowered its long term ratings on Trenwick and LaSalle Re Holdings to "D" from "C". Fitch's "C" ratings on LaSalle Re Holdings' preferred shares and the capital securities of Trenwick Capital Trust I were unchanged. Fitch's rating action also followed the announced non-payment of principal and interest on the Senior Notes. Fitch's "D" rating indicates that they believe that Trenwick America's senior note holders' recovery value is unlikely to exceed fifty percent.
On December 3, 2002, Trenwick America Re entered into a "letter of understanding" with the state of Connecticut Insurance Department pursuant to which Trenwick America Re agreed that it would not take certain actions without the prior written approval of the Connecticut Insurance Commissioner or her designee, including conducting business, disposing of any assets, settling any intercompany balances or paying any dividends. For further discussion of the Connecticut letter of understanding, see "Regulation ."
Trenwick America Re's reported Risk-Based Capital ("RBC") was at the "Regulatory Action Level Event" at December 31, 2002. At this level, Trenwick America Re was required to submit a Comprehensive Plan of Action to the Connecticut Insurance Department. Such a plan was submitted to the Connecticut Insurance Department on January 23, 2003. In addition, in connection with the Regulatory Action Level Event the Connecticut Insurance Department, at its discretion, is authorized to take any action deemed necessary under the circumstances.
Trenwick America has been notified by the NYID that, in the NYID's view, approximately $26 million in loans made to Trenwick America by INSCORP in 2002 were in contravention of New York regulatory requirements. As a result, INSCORP and Trenwick America may be the subject of regulatory action brought by the NYID.
For a description of the RBC requirements applicable to Trenwick America's United States insurance company subsidiaries, see "--Regulation - Risk Based Capital."
During the fourth quarter of 2002, Trenwick America Re entered into an underwriting facility with Chubb which permits Trenwick America Re to underwrite up to $400 million of treaty reinsurance business on behalf of Chubb through the end of January 2004. The underwriting portion of the facility is subject to cancellation prospectively by either party at anytime. Given the current financial condition of Trenwick America, the ratings of its operating insurance company subsidiaries and the related impact on its ability to continue underwriting, Trenwick America Re periodically reviews the viability of maintaining this underwriting facility and may, at any time in order to reduce costs, discontinue underwriting through the facility. Trenwick America Re is entitled to receive two-thirds of any profits generated by the business, with the initial profit distribution from Chubb to Trenwick America Re scheduled to begin in 2006. See "-- Segment Information - Treaty Reinsurance Segment - Chubb Underwriting Facility."
On October 30, 2002, Trenwick America announced that it had ceased underwriting substantially all new insurance policies in its United States specialty program business, which operated under the name Canterbury and through Trenwick America Re's subsidiaries INSCORP, Dakota and Chartwell Insurance Company (merged with and into Trenwick America Re effective December 31, 2002). Trenwick America's subsidiaries will continue to administer and pay claims in connection with the insurance policies previously underwritten through Canterbury.
Trenwick America's reinsurance segment includes treaty reinsurance on United States property and casualty risks. Treaty reinsurance is written principally through Trenwick America Re, which is located in Stamford, Connecticut and includes the runoff of reinsurance business formerly written by Chartwell Insurance Company (merged with and into Trenwick America Re effective December 31, 2002) and INSCORP. In addition, Trenwick America Re entered into the Chubb underwriting facility which permits Trenwick America Re to underwrite up to $400 million of treaty reinsurance business on behalf of Chubb through the end of January 2004. Chubb retains final underwriting and claims authority with respect to all business generated through the underwriting facility and retains the premium in an experience account for the benefit of both Chubb and Trenwick America Re. Chubb will receive one-third and Trenwick America Re will receive two-thirds of any profits generated by the business with initial profit distribution from Chubb scheduled to begin in 2006. In addition, Trenwick America Re will reinsure Chubb for 100% of the claims, claims expenses and underwriting expenses incurred under the underwriting facility in excess of the premiums collected and investment income earned in the underwriting facility. To collateralize its reinsurance obligations to Chubb, Trenwick America Re posted a $50 million security deposit with Chubb. To date, Trenwick America Re has underwritten approximately $127 million of premiums through the underwriting facility.
Trenwick America's Specialty program insurance segment was written principally through its subsidiary, Canterbury Financial Group, Inc. and its operating subsidiaries, INSCORP, Dakota Specialty Insurance Company and Chartwell Insurance Company (merged with and into Trenwick America Re effective December 31, 2002). Trenwick America ceased underwriting United States specialty program insurance effective October 30, 2002. Therefore this segment will be substantially limited to run off activities in 2003.
1983. Trenwick America Re participated in the ECRA pool during pool years 1978 to 1982 while INSCORP participated during pool years 1950 to 1956.
The operating loss of $231.4 million in 2002 represented a $213.1 million greater loss than the operating loss of $18.3 million in 2001. The operating losses in 2002 and 2001 include an aggregate of $229.4 million and $22.4 million of loss reserve increases, respectively, as a result of adverse development of prior years' losses. The establishment of deferred tax valuation allowances contributed $54.5 million to the operating loss in 2002. The $276.0 million net loss in 2002 compared to the $19.5 million net loss in 2001 was the result of the net operating losses combined with (i) an extraordinary item, the writedown of goodwill resulting from the Trenwick/LaSalle business combination, recorded as a cumulative effect of a change in accounting principles and (ii) reorganization expenses recorded in 2002. These items were offset in part by realized investment gains. The non-operating items are discussed in further detail under the caption "Non-Operating Income and Expenses."
Gross premiums written for 2002 were $810.7 million compared to $641.6 million for 2001, an increase of $169.1 million or 26.4%. Details of gross premiums written are provided below.
2002 2001 Change -------- -------- -------- Treaty reinsurance $409,172 $350,134 $ 59,038 Specialty program insurance 401,491 291,433 110,058 -------- -------- -------- Total $810,663 $641,567 $169,096 ======== ======== ========
Treaty reinsurance and specialty program insurance gross premiums written increased from $350.1 million and $291.4 million, respectively, for 2001, to $409.2 million, and $401.5 million, respectively, for 2002. The increase in gross premiums written for treaty reinsurance was due primarily to increasing rates on renewal treaties. The increase in gross premiums written for specialty program insurance was due to increased volume on two of its larger programs combined with the addition of ten new programs in 2002. Effective October 30, 2002, Trenwick America ceased underwriting substantially all new specialty program insurance.
2002 2001 Change --------- --------- --------- Gross premiums written $ 810,663 $ 641,567 $ 169,096 Change in gross unearned premiums (87,890) (69,638) (18,252) --------- --------- --------- Gross premiums earned 722,773 571,929 150,844 --------- --------- ---------
Gross premiums ceded (249,314) (210,160) (39,154) Change in gross unearned premiums ceded 16,212 18,519 (2,307) --------- --------- --------- Ceded premiums earned (233,102) (191,641) (41,461) --------- --------- --------- Net premiums earned $ 489,671 $ 380,288 $ 109,383 ========= ========= =========
As a result of deterioration in loss reserve indications during the first nine months of 2002, Trenwick America engaged external actuarial consultants during the fourth quarter to assist management in reviewing reserves for December 31, 2002. Based on the results of Trenwick's external and internal actuarial studies, significant reserve adjustments of $100.4 million were made during the fourth quarter of 2002.
Trenwick America's unpaid claims and claims expense liability at December 31, 2002 and 2001 includes an estimate of Trenwick's ultimate liability for asbestos and environmental claims of $112.0 million and $91.0 million, respectively, comprising gross liabilities for unpaid claims and claims expenses of $145.0 million and $118.7 million, respectively, net of reinsurance recoverable on unpaid claims and claims expenses of $33.0 million and $27.6 million.
Interest expense and subsidiary preferred share dividends were $22.6 million for 2002, a decrease of $8.8 million from 2001. The decrease resulted from the repayment of Trenwick America's term loan facility during the second quarter of 2002.
in 2002 relative to 2001, coupled with an increase in the United States dollar to British pounds exchange rate from 2001 to 2002. The intercompany stop loss treaty was commuted effective December 31, 2002.
Net realized gains on investments, net of applicable income taxes, were $16.1 million during 2002, compared to $1.2 million of net realized losses for 2001. The gains in 2002 were a result of actions taken to reposition the investment portfolio into higher quality, shorter duration fixed income securities.
The foregoing data is presented based upon the stated maturities of the securities. Actual maturities may differ for some securities because borrowers may have the right to call or prepay obligations with or without prepayment penalties.
During the first quarter of 2001, Trenwick America sold almost all of its equity securities and reinvested the proceeds in debt securities to increase operating earnings and decrease the volatility of unrealized investment gains and losses. Trenwick America also liquidated the remainder of its tax advantaged municipal government portfolio in early 2001 to increase its taxable yield. Both of these actions were taken to maximize Trenwick America's taxable income.
Trenwick America has not invested in derivative financial instruments such as futures, forward contracts, swaps, options or other financial instruments with similar characteristics such as interest rate caps or floors or fixed-rate loan commitments. Trenwick America's portfolio includes market sensitive instruments, such as mortgage-backed and asset-backed securities, which amounted to approximately $165.9 million at December 31, 2002 or 15.1% of cash and invested assets. There are various categories of mortgage-backed and asset-backed securities that are subject to different degrees of risk from changes in interest rates and, for those mortgage-backed and asset-backed securities that are not agency-backed, defaults. Approximately 53% of Trenwick America's mortgage-backed securities holdings were backed by government agencies, such as GNMA, FNMA and FHLMC, at December 31, 2002 and approximately 97% of asset-backed securities holdings were AAA- rated at December 31, 2002. The principal risks inherent in holding mortgage-backed and asset-backed securities are prepayment and extension risks related to significant decreases and increases in interest rates, resulting in the repayment of principal from the underlying mortgages either earlier or later than originally anticipated.
Trenwick America and its insurance and reinsurance company subsidiaries are subject to regulatory oversight under the insurance statutes and regulations of the jurisdictions in which they conduct business, including all states of the United States. These regulations vary from jurisdiction to jurisdiction and are generally designed to protect ceding insurance companies and policyholders by regulating Trenwick America's financial integrity and solvency in its business transactions and operations. Many of the insurance statutes and regulations applicable to Trenwick America's subsidiaries relate to reporting and enable regulators to closely monitor Trenwick America's performance. Typical required reports include information concerning Trenwick America's capital structure, ownership, financial condition, and general business operations.
Cash used for Trenwick America's operating activities in 2002 was $47.9 million compared to $29.9 million in 2001 and $98.2 million in 2000. The increase in cash used for operations can be mainly attributed to a decrease in net investment income received, a result of the decrease in market yields in 2002 combined with a decrease in invested assets.
Trenwick America's financing obligations generally include debt and lease payment obligations. At December 31, 2002, annual principal payments required by Trenwick America through 2007 and thereafter relating to these financing obligations are as follows (monetary amounts in tables expressed in thousands):
Trenwick America does not have any material off-balance sheet arrangements, trading activities involving non-exchange traded contracts accounted for at fair value or relationships with persons or entities that derive benefits from a non-independent relationship with Trenwick America or its related parties.
Concurrently with the business combination involving LaSalle Re Holdings and Trenwick Group Inc. in September of 2000, Trenwick America and Trenwick Holdings Limited ("Trenwick Holdings"), Trenwick's United States and United Kingdom holding companies, entered into an amended and restated $490 million credit agreement with various lending institutions ("the Banks"), which was guaranteed by LaSalle Re Holdings. The credit agreement consisted of both a $260 million revolving credit facility and a $230 million letter of credit facility. The revolving credit facility was subsequently converted into a four-year term loan and repaid in full on June 17, 2002. Additionally, on December 24, 2002, the credit agreement was amended to reduce the letter of credit facility, which is utilized by Trenwick to support its underwriting operations at Lloyd's, to the currently outstanding $182.5 million. The letter of credit facility is scheduled to terminate on December 31, 2003, although the letters of credit issued pursuant to the facility will not expire until December 31, 2006.
Subsequently, an amendment and waiver of default under the credit agreement and amendments to the guaranty agreement were entered into on December 24, 2002 (the "December Amendments"). The December Amendments extended the letter of credit facility through December 31, 2003 to support Trenwick's underwriting operation at Lloyd's for the 2003 year of account. To those Banks extending their letters of credit, Trenwick, Trenwick America and Trenwick Holdings agreed to pay a 5% per annum cash letter of credit fee, issue pay-in-kind notes bearing interest at LIBOR plus 2.5% per annum to evidence an additional 3.16% per annum letter of credit fee, issue warrants equal to 10% of Trenwick's fully diluted equity capital, and pay 15% of the profits earned by Trenwick and its subsidiaries for the 2002 and 2003 Lloyd's years of account. In addition, Trenwick, Trenwick America and Trenwick Holdings agreed to provide the Banks a security interest in all of their respective equity interests in, and the assets and property of, their direct and indirect subsidiaries as additional collateral for the Banks, and to cause the subsidiaries to provide a guaranty to the Banks subject to applicable laws and regulations and certain existing contractual rights of holders of other indebtedness.
The December Amendments also prohibit Trenwick, Trenwick America and Trenwick Holdings' and their respective subsidiaries from declaring or paying any dividends (including on Trenwick's common shares, the Series A preferred shares of LaSalle Re Holdings and the capital securities of Trenwick Capital Trust I). The December Amendments and the other amendments and waivers entered into in the first quarter of 2003 waive certain other defaults, add covenants further restricting the operation of Trenwick's, Trenwick America's and Trenwick Holdings' business, prohibit Trenwick, Trenwick America and Trenwick Holdings and their respective subsidiaries from making certain payments without the Banks' approval, prohibit Trenwick, Trenwick America and Trenwick Holdings and their respective subsidiaries from selling or otherwise disposing of any assets or property, require Trenwick to regularly report certain financial information to the Banks, and adjust downward certain of the financial covenants.
In connection with the Trenwick/LaSalle business combination, Trenwick America assumed, effective September 27, 2000, Trenwick Group Inc.'s obligations with respect to $75 million aggregate principal amount of 6.70% senior notes (the "Senior Notes"), which were initially due on April 1, 2003 and pursuant to an amendment have been extended to August 1, 2003. They are unsecured obligations and rank senior in right of payment to all existing and future subordinated indebtedness of Trenwick America. Interest on the Senior Notes is payable semi-annually at a rate of 6.7%. In connection with the amendment that extended the maturity date of the Senior Notes from April 1, 2003 to August 1, 2003, interest payable through April 1, 2003, in the aggregate amount of $2.5 million, was paid. Trenwick America anticipates that it will be unable to make payment of principal and interest on the Senior Notes on August 1, 2003 and has continued discussions with the Senior Note holders concerning a proposed restructuring or an additional amendment of the Senior Notes to extend the maturity thereof. There can be no assurance that an agreement relating to this restructuring will be reached by August 1, 2003. If such agreement cannot be reached, Trenwick America will be in default under the terms of the Senior Notes. Additionally, even if the Senior Notes are restructured, Trenwick America expects that, in order to repay the principal amounts of the Senior Notes it will be required to seek additional financing, engage in asset sales, subsidiary dividends or similar transactions. There can be no assurance that Trenwick will be successful in such efforts.
During the years ended December 31, 2002 and 2001, Trenwick America recorded $18.3 million and $9.9 million, respectively, of adverse development related to the subject business, and as a result, the carrying value of the contingent interest notes at December 31, 2002 has been reduced to the minimum principal value of $1 million plus accrued interest, which is the present value of the amount expected to be paid at maturity. The contingent interest notes will continue to accrue interest at a rate of 8% per year. The contingent interest
Trenwick America Re and its subsidiaries remain liable with respect to insurance and reinsurance ceded in the event that the reinsurer or retrocessionaire is unable to meet its obligations. All reinsurers and retrocessionaires must be formally approved by the operating company's security committee. The evaluation process involves financial analysis of current audited financial data and comparative analysis of such data in accordance with guidelines established by Trenwick America. Business is not conducted with reinsurers or retrocessionaires who are not currently approved by the security committee.
The accounting policies described below are those Trenwick America considers critical in preparing its consolidated financial statements. These policies include significant estimates made by management using information available at the time the estimates are made. However, as described below, these estimates could change materially if different information or assumptions were used. The descriptions below are summarized and have been simplified for clarity. A more detailed description of the significant accounting policies used by Trenwick America in preparing its financial statements is included in the Notes to the Consolidated Financial Statements and the note references are included below.
Claims and claims expenses are recorded as incurred, at management's best estimate, in order to match claims and claims expense costs with premiums over the contract periods. The amount provided for unpaid claims and claims expenses consists of any unpaid reported claims and claims expenses and estimates for incurred but not reported claims and claims expenses, net of salvage and subrogation. The estimates for claims and
claims expenses incurred but not reported were developed based on historical claims and claims expense experience and an actuarial evaluation of expected claims and claims expense experience. Workers' compensation indemnity liabilities that are considered fixed and determinable are discounted using an interest rate of 3.5%. Reserves for unpaid claims and claims expenses, by their very nature, do not represent an exact calculation of the liability and, while Trenwick America has established reserves equal to the current best estimate of ultimate losses, there remains a high likelihood that further changes in such claim estimates, either upward or downward, will occur in the future. Adjustments to previously reported reserves for unpaid claims and claims expenses are considered changes in estimates for accounting purposes and are reflected in the income statement in the period in which the adjustment becomes known.
Unpaid claims and claims expenses are recorded based on actuarial estimates of losses inherent in that period's claims, including losses for which claims have not yet been reported. Estimates of unpaid claims and claims expenses rely on actuarial observations of ultimate loss experience for similar historical events. Historical insurance industry experience indicates that a high degree of inherent variability exists in assessing the ultimate amount of losses under short-duration property and casualty contracts. This inherent variability is particularly significant for liability-related exposures, including latent claims issues (such as asbestos and environmental related coverage disputes), because of the extended period of time, often many years, that transpires between when a given claim event occurs and the ultimate full settlement of such claim. This situation is then further exacerbated for reinsurance entities (as opposed to primary insurers) due to coverage often being provided on an "excess-of-loss" basis and the resulting lags in receiving current claims data. Additionally, the uncertainty is increased as a result of the diversity of development patterns among different types of reinsurance and the necessary reliance on ceding companies for information regarding reported claims and differing reserving practices among ceding companies. Other items that have been considered in determining year-end reserves but may develop differently than currently estimated include:
o Claims liabilities also include provisions for latent injury or toxic tort claims that cannot be estimated with traditional reserving techniques. Due to inconsistent court decisions in federal and state jurisdictions and the wide variation among insureds with respect to underlying facts and coverage, uncertainty exists with respect to these claims as to liabilities of ceding companies and, consequently, reinsurance coverage; and
o Reinsurance collectibility - Trenwick America reviews and monitors its reinsurance recoverables from its reinsurers and makes provision for uncollectible reinsurance as appropriate. However, given the magnitude of reinsurance recoverables, $641.2 million at year-end 2002, Trenwick America has a significant exposure to collectibility issues.
Trenwick America's management continually evaluates the potential for changes in unpaid claims and claims expenses to adjust recorded reserves and to proactively modify underwriting criteria and product offerings. In recent periods and continuing throughout 2002, the level of reported claims activity related to prior year loss events, particularly for liability-related exposures underwritten in 1997 through 2001, has been significantly higher than anticipated. Full consideration of these trends was incorporated into a comprehensive reserve study completed in the fourth quarter of 2002. Insurance reserves, by their very nature, do not represent an exact calculation of liability and, while Trenwick America has established reserves equal to the current best
Trenwick America seeks to match the maturities of invested assets with the payment of expected liabilities. By doing this, Trenwick America attempts to make cash available as payments become due. If a significant mismatch of the maturities of assets and liabilities were to occur and Trenwick America had to liquidate investments prior to their maturity, it may incur realized losses and, the effect on Trenwick America's results of operations could be significant. Also see Note 6 of Notes to the Consolidated Financial Statements.
Deferred income tax assets and liabilities are computed based on temporary differences between financial statement and income tax bases of assets and liabilities using enacted income tax rates in effect for the year in which the differences are expected to reverse. FASB Statement No. 109 requires a valuation allowance to be
recorded when it is more likely than not that some or all of the deferred tax assets will not be realized. Due to Trenwick America's cumulative losses generated in recent years and uncertainties as to the amount of taxable income to be generated in future years, as of December 31, 2002, Trenwick America management could not support the future realizability of its net deferred tax asset. The effects of this determination on Trenwick America's results from operations are significant. As of December 31, 2002, Trenwick America had increased its valuation allowance by $118.9 million, so as to record a full valuation allowance for the full amount of its net deferred tax asset. Also see Note 8 of Notes to be Consolidated Financial Statements.
The following sections address the significant market risks associated with Trenwick America's business activities as of December 31, 2002 and 2001. Trenwick America's primary market risk exposures are:
o interest rate risk on fixed and variable rate United States dollar and British pound sterling denominated short and long-term instruments; and
With respect to Trenwick America's investment portfolio, the risk management strategy is to place its investments with high credit quality issuers and to limit the amount of credit exposure with respect to particular ratings categories and any one issuer. Trenwick America selects investments with characteristics such as duration, yield, currency and liquidity to reflect the underlying characteristics of related estimated claim liabilities.
The borrowings of Trenwick America are summarized in Note 7 to the financial statements, and under the caption "Financings, Financing Capacity and Capitalization" in this Management's Discussion and Analysis of Financial Condition and Results of Operations.
Trenwick America's reinsurance operations have exposures to movements in various currencies, particularly the Canadian dollar and the British pound sterling, as some of its business is denominated in those currencies. Therefore, changes in currency exchange rates affect Trenwick America's balance sheet, statement of operations and statement of cash flows. This exposure is somewhat mitigated by the fact that premiums received are invested in the same currency portfolios, to partially offset related unpaid claims and claims expense liabilities denominated in the same currency.
10% shift in foreign currency exchange rates would have resulted in a potential loss in fair value of the foreign denominated net liabilities of approximately $1 million.
Trenwick America's fixed maturity investments and indebtedness are subject to interest rate risk. Increases and decreases in prevailing interest rates generally translate into decreases and increases in the fair value of fixed maturity investments and the interest payable on Trenwick America's outstanding variable rate debt. Additionally, the fair value of interest rate sensitive instruments may be affected by the creditworthiness of the issuer, a prepayment option, relative values of alternative investments, liquidity of the investment and other general market conditions.
A 100 basis point increase in market interest rates would have resulted in an estimated pre-tax loss in the fair value of these instruments of $14 million and $34.0 million at December 31, 2002 and 2001, respectively. Similarly, a 100 basis point decrease in market interest rates would have resulted in an estimated pre-tax gain in the fair value of these instruments of $12 million and $30 million at December 31, 2002 and 2001, respectively.
events, but rather, to illustrate the potential impact of such events.
The potential exists, after a catastrophe loss, for the development of inflationary pressures in a local economy. The effects of inflation are considered in pricing and in estimating reserves for unpaid claims and claim expenses. The actual effects of inflation on Trenwick America's results cannot be accurately known until claims are ultimately settled.
In January 2003, the FASB issued Interpretation No. ("FIN") 46, Consolidation of Variable Interest Entities, which Trenwick America intends to adopt on July 1, 2003. FIN 46's consolidation criteria are based on analysis of risks and rewards, not control, and represent a significant and complex modification of previous accounting principles. FIN 46 represents an accounting change, not a change in the underlying economics of asset sales. Under its provisions, certain assets previously sold to special purpose entities (SPE's) could be consolidated and, if consolidated, any assets and liabilities now on the books related to those SPE's would be removed. Because Trenwick America has not traditionally engaged in the types of securitization vehicles within the scope of FIN 46, management does not believe adoption of the interpretation will impact future results.
The result of the foregoing is that the future operations of Trenwick America, at least in the next several years, are likely to consist substantially of the sale or management in runoff of some or all of its existing insurance and reinsurance businesses including administration of claims, regulatory reporting, settlement of reinsurance agreements (including commutations thereof where appropriate), cash and investment management and related matters. The costs involved in such operations are likely to differ significantly from those of prior years, where a significant portion of the operating costs related to underwriting, marketing and securing reinsurance for new business. The reimbursement of costs as they relate directly to the insurance entities themselves will be subject to review by regulatory authorities which may challenge these costs or impose other restrictions with respect to the runoff including the provision of an acceptable runoff plan. Adverse loss developments or weakness in reinsurance recoveries, among other factors, could significantly and negatively impact the success of any runoff. It is unlikely that any amounts will be available to the creditors or equity holders of the direct and indirect parent companies of any regulated insurance subsidiary of Trenwick until such time as the regulator having jurisdiction over such subsidiary has been assured of the solvency of such entity, which may require several years if achievable at all. It is possible that one or more of Trenwick America's insurance company subsidiaries may be placed under the control of the regulatory body with jurisdiction over such entity, voluntarily or involuntarily, through rehabilitation, liquidation or other proceedings.
You should carefully consider the risks described below regarding us and our securities. The risks and uncertainties described below are not the only ones we face. There may be additional risks and uncertainties. If any of the following risks actually occur or continue to occur, our business, financial condition or results of operations could be materially and adversely affected and the trading price of our securities could decline further.
If potential events of default under our credit facility are not cured or waived by our lenders, there is substantial doubt as to our ability to continue as a going concern.
We currently have outstanding $182.5 million of letters of credit issued by the banks under our credit facility. We are obligated to reimburse the banks for any amounts drawn on these letters of credit, and for related fees and expenses. No amounts have been drawn on the letters of credit to date. The banks have provided us with several waivers of potential defaults and extensions of deadlines under the credit facility, but we presently do not have the liquidity necessary to satisfy the banks by the deadlines that have been imposed. If the potential events of default occur and are not waived, there is substantial doubt as to our ability to continue as a going concern. In addition, we have entered into many covenants in the senior credit facility and related agreements that limit our ability to take certain actions without the consent of the banks, including our ability to borrow money, to make particular types of investments or other restricted payments (including dividend payments), to sell our assets, or to merge or consolidate. These restrictions significantly limit our financial and operational flexibility.
We are unable to repay $75 million in senior notes outstanding which are due August 1, 2003, and are required to replace, refinance or restructure these notes by that date.
We are a holding company with no material assets other than the stock of our operating subsidiaries. Our ability to meet our debt and securities obligations and our ability to pay dividends to our shareholders will be dependent on the earnings and cash flows of our subsidiaries and the ability of the subsidiaries to pay dividends or to advance or repay funds to us. Payment of dividends and advances and repayments from our operating insurance company subsidiaries are regulated by state and foreign insurance laws and regulatory restrictions, including minimum solvency and liquidity thresholds. We are required to maintain specified minimum levels of capital and surplus and risk-based capital at our insurance subsidiaries, which could restrict their ability to pay us dividends, even if the dividends were permitted by relevant insurance laws and regulations. We do not expect the majority of our operating subsidiaries will be able to pay dividends or advance or repay any funds to us in the foreseeable future, which would prevent us from making payments on our debt or securities obligations.
We are in discussions with insurance regulators concerning capital impairment and other issues relating to our insurance company subsidiaries, and these regulators may institute supervision, rehabilitation, conservation or liquidation proceedings with respect to these subsidiaries.
We have been engaged in discussions with the insurance regulators of the jurisdictions in which our insurance company subsidiaries are domiciled. We have been required to restrict our Connecticut insurance company subsidiary from taking certain actions such as paying dividends or disposing of assets, and we have been required to submit a plan of action to eliminate the statutory capital impairment at our New York insurance company subsidiary. The New York Insurance Department ("NYID") has indicated that the NYID would expect to impose restrictions on our New York insurance company subsidiary that are at a minimum similar to those imposed by the Connecticut Insurance Department on our Connecticut subsidiary. Trenwick America has also been notified by the NYID that, in the NYID's view, approximately $26 million in loans made to Trenwick America by INSCORP in 2002 were in contravention of New York regulatory requirements. As a result, INSCORP and Trenwick America may be the subject of regulatory action brought by the NYID. Each of these regulators, as well as the State of North Dakota, may act independently of one another with respect to the insurance company domiciled in its jurisdiction. Any action by an insurance regulator, such as the commencement of voluntary or involuntary supervision, rehabilitation, conservation or liquidation proceedings with respect to one of these companies, could precipitate additional actions by the other insurance regulators. In the event of any such proceedings, it is unlikely that the assets of the insurance companies will be available to satisfy each others' liabilities, or the liabilities of Trenwick America.
We have placed our Specialty program insurance segment, which provided approximately 50% of our gross premiums written in 2002, into runoff, therefore little or no new business is being written and, in addition, in order to reduce operating costs we may be required to put all of our operations in runoff in the future. Our objective is to maximize the economic value of the runoff through effective claims settlement, commutation of assumed obligations where appropriate, collection of reinsurance recoverables and effective cash management. While it is possible that some positive economic value may result over time from the runoff of this operation, we do not expect them to contribute significantly to our revenue or results of operations and there are significant uncertainties that could if realized adversely affect our ability to continue a solvent runoff of this operation. Trenwick has historically not operated in runoff and may not have internal expertise, or may not be able to retain external support such as experienced consultants, to do so effectively.
Our business model relied to a large extent on reinsurance to reduce our underwriting risk. As of December 31, 2002, our reinsurance recoverable balance was approximately $641.2 million. Our subsidiaries are subject to credit risk with respect to their reinsurers because the transfer of risk to a reinsurer does not relieve the insurers of their liability to the insureds. In addition, reinsurers may be unwilling to pay our insurance company subsidiaries even though they have the financial resources and are contractually obligated to do so. Unfavorable arbitration decisions or the failure of one or more of the reinsurers to honor their obligations or make timely payments would impact our subsidiaries' cash flow and could cause us to incur significant losses. In the event of the rehabilitation, supervision, conservation or liquidation of any of our insurance company subsidiaries, we may not be able to influence the outcome of the collectibility of reinsurance recoverables, in that it will be the responsibility of the regulators supervising such proceedings.
If actual claims exceed our loss reserves, our financial results could be significantly adversely affected.
In the fourth quarter of 2002 we increased our loss reserves for unpaid claims and claims expenses by $100 million, which followed other reserve increases earlier in 2002. The reserve increases reflect a reassessment of our reserves in light of recent reported loss activity trends across our major business groups. Our results of operations and financial condition depend upon our ability to assess accurately the potential losses associated with the risks that we insure and reinsure. To the extent actual claims continue to exceed our expectations, we will be required to immediately recognize the less favorable experience. This could cause a material increase in our liabilities and a reduction in our profitability, including an operating loss and reduction of capital.
The supply of insurance and reinsurance coverage has decreased due to withdrawal of capacity and substantial reductions in capital resulting from, among other things, the terrorist attacks of September 11, 2001. This tightening of supply may result in governmental intervention in the insurance and reinsurance markets, both in the United States and worldwide. For example, on November 26, 2002, the Terrorism Risk Insurance Act was enacted to ensure the availability of insurance coverage for terrorist acts in the United States. This law requires insurers writing certain lines of property and casualty insurance to offer coverage against certain acts of terrorism causing damage within the United States or to U.S. flagged vessels or aircraft. In return, the law requires the federal government to indemnify such insurers for 90% of insured losses resulting from covered acts of terrorism, subject to a premium-based deductible. The law expires automatically at the end of 2005. Currently there is a great deal of uncertainty as to what effect the law will have on the insurance industry. We are currently unable to predict the extent to which the foregoing and other new initiatives may affect the demand for our products or the risks which may be available for us to consider underwriting. At the same time, threats of further terrorist attacks and the military initiatives and political unrest in the Middle East and Asia have adversely affected general economic, market and political conditions, increasing many of the risks associated with the insurance markets worldwide.
Before a person can acquire control of a U.S. insurance company, prior written approval must be obtained from the insurance commissioner of the state where the domestic insurer is domiciled. Prior to granting approval of an application to acquire control of a domestic insurer, the state insurance commissioner will consider such factors as the financial strength of the applicant, the integrity and management of the applicant's board of directors and executive officers, the acquiror's plans for the management of the applicant's board of directors and executive officers, the acquiror's plans for the future operations of the domestic insurer and any anti-competitive results that may arise from the consummation of the acquisition of control. Generally, state statutes provide that control over a domestic insurer is presumed to exist if any person, directly or indirectly, owns, controls, holds with the power to vote, or holds proxies representing, 10% or more of the voting securities of the domestic insurer. Because a person acquiring 10% or more of our common shares would indirectly control the same percentage of the stock of our U.S. insurance company, the insurance change of control laws of Connecticut, New York and North Dakota would likely apply to such a transaction.