Only continuing operations are presented. Balance sheet data are as of December 31st. The 1996 North American property/casualty operations include the balance sheet of National Re as of December 31, 1996 and income statement amounts since the October 3, 1996 acquisition. International property/casualty and life/health operations are reported on a one-quarter lag. The international property/casualty operations include Cologne Re's balance sheet beginning at December 31, 1994 and its income statement beginning in 1995. Only nine months of Cologne Re's 1995 results are included in General Re's 1995 results due to the one-quarter reporting lag. Loss ratios, expense ratios and combined ratios shown in the table are computed in relation to net premiums earned (referred to as a "GAAP" combined ratio).
(2) Excludes cumulative effect of accounting changes. The balance sheet data in the table on pages 8 and 9 reflect the adoption of Statement of Financial Accounting Standards ("SFAS") No. 115, Accounting For Certain Investments in Debt and Equity Securities in 1994. In 1993, General Re adopted the accounting prescribed by the Emerging Issues Task Force for multiple-year, retrospectively rated reinsurance contracts. The cumulative effect from prior years recorded in 1993 increased net income by $14 million, or $.17 per share. In 1992, General Re adopted SFAS No. 109, Accounting for Income Taxes. The cumulative effect from prior years recorded in 1992 increased net income by $61 million, or $.71 per share.
Net income of General Re Corporation and its subsidiaries ("General Re") was $968 million, or $12.04 per basic share, in 1997, an increase of 9.5 percent over the $11.00 per basic share earned in 1996. These results include after- tax realized gains of $.04 per basic share in 1997 and $.21 per basic share in 1996. Net income for 1997 on a diluted basis was $11.76 per share, an increase of 9.1 percent over $10.78 per share in 1996. The increase in 1997 earnings was primarily attributable to growth in investment income in the North American property/casualty operations, increased profitability in the global life/health operations, and higher trading revenues in the financial services operations. The North American property/casualty operations included the earnings from National Re Corporation and its subsidiaries ("National Re") for a full year in 1997, while General Re's 1996 operating results included the earnings of National Re only since its acquisition on October 3, 1996.
General Re's consolidated underwriting combined ratio was 100.6 percent in 1997, compared with 100.5 percent in 1996. Neither year was significantly affected by catastrophes.
Consolidated net premiums written in 1997 were $6,545 million, a decrease of $116 million, or 1.7 percent, from $6,661 million in 1996. Adjusted for the effects of foreign exchange, 1997 consolidated net premiums written increased 2.8 percent over 1996. North American property/casualty premium volume was $3,058 million in 1997, compared with $3,081 million in 1996, a decrease of 0.7 percent. Adjusted for the timing of the National Re acquisition, North American property/casualty net premiums written decreased approximately 5.3 percent during 1997. Net premiums written in the international property/casualty reinsurance operations were $2,268 million in 1997, compared to $2,505 million in 1996. Adjusted for the effects of foreign exchange, international property/casualty premiums written decreased approximately 1.0 percent for the year. Net premiums written for the global life/health segment were $1,219 million for 1997, compared to $1,075 million in 1996.
Consolidated net premiums written in 1996 were $6,661 million, an increase of $559 million, or 9.2 percent, from $6,102 million in 1995. North American property/casualty premium volume was $3,081 million in 1996, compared with $2,964 million in 1995, an increase of 3.9 percent. North American property/casualty net premiums written in 1996 included approximately $89 million from National Re. Net premiums written in the international property/casualty reinsurance operations were $2,505 million in 1996, compared to $2,429 million in 1995. Net premiums written for the life/health operations were $1,075 million for 1996, as compared to $709 million in 1995.
Pretax income discussed in each of the segment sections that follow is before minority interest deductions and goodwill amortization, both of which are deemed corporate expenses that have not been allocated to the segments.
The Genesis operations provide direct excess insurance and reinsurance to companies with self-insurance programs. Net premiums written for Genesis decreased during the year by 2.2 percent from 1996 levels, principally due to a decline in specialty liability business.
PIE CHART Germany 46% US$ Foreign 13% Other 12% United Kingdom 9% Australia 6% France 6% Japan 3% Hong Kong 3% Spain 2%
The financial service operations include General Re's derivative products, insurance brokerage and management, investment management, reinsurance brokerage and real estate management operations. Pretax income for the financial service operations was $105 million and $100 million in 1997 and 1996, respectively. The 4.8 percent growth in pretax income was due to higher 1997 income in General Re's derivative products operations, General Re Financial Products Corporation and affiliates ("GRFP").
GRFP is a dealer in derivative products and offers a full line of interest rate, currency, credit and equity swaps, options and other derivative products. GRFP's gross trading revenue was $175 million in 1997, compared to $144 million in 1996 and $142 million in 1995. The growth in 1997 revenues was principally attributable to growth in GRFP's European fixed income and foreign exchange options business.
GRFP closely controls its derivatives operations and actively manages its open positions to limit its risk exposures. GRFP hedges its exposure to market risk (which includes foreign exchange, interest rate, credit spread, equity, swap spread, volatility, correlation, and yield curve risks) in connection with its dealer activities by purchasing or selling futures contracts, entering into forward foreign exchange contracts, purchasing or selling U.S. and foreign government securities or entering into offsetting derivative transactions.
At December 31, 1997, total assets were $41,459 million, compared with $40,161 million at December 31, 1996. The $1,298 million growth in assets was attributable to an increase of $893 million in the total assets of the North American property/casualty operations and $755 million in the financial services segment, offset by a $350 million decrease in the international reinsurance operations due to foreign exchange.
At December 31, 1997, total insurance invested assets were $24,576 million, compared with $23,168 million at December 31, 1996, an increase of 6.1 percent. The $1,408 million increase in insurance invested assets was the result of an increase of $1,116 million in the North American property/casualty segment and an increase of $291 million in the international reinsurance operations. This increase was primarily the result of unrealized appreciation in the fixed income and common equity portfolios and operating cash flow, partly offset by common stock repurchases and dividend payments. The financial service operations had $2,780 million of invested assets at December 31, 1997, a decrease of $613 million compared to December 31, 1996. The $613 million decrease in financial services invested assets results from changes in the hedging needs and activities of GRFP.
Included in General Re's invested assets was $2,460 million and $1,625 million of unrealized appreciation, after deferred income taxes, at December 31, 1997 and December 31, 1996, respectively. The increase was due to the appreciation of equities and bonds held in the North American and the international operations.
General Re's North American property/casualty investment portfolios are managed for both after-tax total return and after-tax investment income. These investment objectives recognize that a significant portion of the fixed income portfolio supports the claim and claim expense liabilities, and therefore, is subject to appropriate liquidity, duration, currency, quality and other constraints. At December 31, 1997, total invested assets of the North American property/casualty operations were $15,995 million, a 7.5 percent increase over 1996 invested assets.
The composition of the North American property/casualty invested assets as a percentage of the total North American property/casualty portfolio at December 31, 1997 is shown in the pie chart below.
As in 1996, almost all newly generated cash flow in 1997 was used to pay dividends to shareowners and repurchase General Re's common stock. Within the portfolio, General Re continued to shift assets from taxable to tax-advantaged securities as part of its tax planning strategies. As new cash flow becomes available for investment, General Re anticipates it will be allocated to share repurchases and to those areas with the highest after-tax returns or income.
PIE CHART U.S. Tax-exempt bonds 48% Common equities 23% Corporate bonds 7% Preferred Stock 7% Mortgage and asset-backed 7% U.S. Government bonds 3% Foreign bonds 2% Other 3%
To minimize its exposure to shifts in interest rates, General Re balances, within a range, the duration of the fixed maturity investments (present-value weighted measure of average life) to match the duration of the property/casualty claim liabilities.
At December 31, 1997, the effective average maturity of the fixed-maturity portfolio was 11.5 years, compared to an estimated average life of 9.2 years for General Re's property/casualty claim liabilities. The duration of property/casualty assets was 4.8 years, compared with 4.5 years for the property/casualty claim liabilities. This compares with 1996 durations of 5.1 years and 4.5 years, respectively.
Included in fixed-maturity investments were mortgage-backed securities of $952 million (3.9 percent of consolidated insurance investments) and other asset- backed securities of $84 million (0.3 percent of consolidated insurance investments) at December 31, 1997. These securities have interest and principal repayment patterns that differ from typical fixed maturities, since their duration and ultimate yield are exposed to the effect of prepayments. Mortgage-backed securities are generally issued by quasi-federal agencies or federally supported institutions, which results in relatively low credit risk. Most of the mortgage-backed and other asset-backed securities are publicly traded and market values were obtained from an external pricing service.
At December 31, 1997, common equity investments in the North American portfolio totaled $3,695 million, representing 23.1 percent of the North American property/casualty investment portfolio. The North American common equity portfolio is well diversified and primarily consists of holdings in companies with large market capitalizations, which collectively have a calculated volatility approximating the Standard & Poor's 500 index. General Re has purchased futures contracts to hedge approximately 10 percent of the common equity portfolio as a means to achieve target asset allocations within the North American portfolio. To the extent that General Re's portfolio held the same securities as the futures contracts, related gains and losses on the futures contracts were treated as basis adjustments to those securities held. Otherwise, gains and losses on the futures contracts were not deemed to qualify for such hedge accounting treatment. Included in realized gains and losses for 1997 and 1996, respectively, were $57 million and $72 million of losses from these futures contracts, while $64 million and $53 million, respectively, of losses were recorded as basis adjustments for hedged equities and, accordingly, reduced shareowners' equity.
The North American investment portfolio includes nontraditional, private investments. These alternative investments, included in the balance sheet caption, "Other invested assets," were $558 million (2.3 percent of consolidated insurance investments) and $435 million (1.9 percent of consolidated insurance investments) at December 31, 1997 and 1996, respectively. Most of these investments are interests in limited partnerships managed by outside professional managers. Over time, these investments are expected to provide a higher return than the overall North American property/casualty investment portfolio. This segment, however, also may entail a greater amount of risk, both in terms of limited liquidity and greater uncertainty of returns, compared to the rest of General Re's portfolio. General Re evaluates the fair value of these alternative investments on a quarterly basis by reviewing available financial information of the investee and performing other financial analyses in consultation with external advisors.
Credit considerations are an BAR CHART important part of General Re's fixed-maturity investment Nonrated 3.9% strategy. The overall fixed- Below BBB 1.0% maturity portfolio continued to BBB 2.6% have an average credit rating of A 17.9% AA at December 31, 1997. The AA 30.0% distribution of General Re's North AAA 44.6% American property/casualty fixed- maturity portfolio by credit quality is presented in the chart on the left. Management estimates that the credit quality of nonrated securities is equivalent of A.
Pretax total return for North American investments was 12.6 percent in 1997, compared with 7.1 percent in 1996 and 18.9 percent in 1995. Almost all investment sectors recorded higher returns in 1997 than in 1996, primarily due to lower interest rates and higher common equity values in 1997. The total pretax returns on the North American investment portfolio by major asset class were as follows:
The total after-tax return for the North American investment portfolio was 12.1 percent in 1997 and 6.0 percent in 1996.
General Re's international property/casualty and life/health reinsurance operations held invested assets of $8,581 million at December 31, 1997, an increase of $291 million from December 31, 1996. These portfolios include $6,851 million of Cologne Re's investments, $1,334 million in wholly owned international operations' investments and $396 million of GR-CK investments. Most of the international invested assets are managed internally.
General Re's international investment portfolios are managed for both after-tax total return and after-tax investment income, taking into consideration the duration and currency structure of the operations' reinsurance liabilities. The investment objectives of each individual subsidiary within the segment are determined by specific investment guidelines which consider the different legal and tax requirements in their respective jurisdictions.
To minimize its exposure to shifts in interest rates, General Re's international operations balance, within a range, the duration of the fixed maturity investments to match the duration of their claim liabilities. The international operations write a greater portion of their business in property lines of business than General Re's North American operations and, accordingly, invest in shorter duration securities as part of their program to match asset and liability durations. The sharing of investment income under certain reinsurance agreements also lowers the duration of the international operations' liabilities. At December 31, 1997, the average duration of the fixed income portfolio including short-term securities was 3.5 years.
BAR CHART Nonrated 2.8% Below BBB 0.6% BBB 1.5% A 5.4% AA 31.8% AAA 57.9%
The currency structure of the international investment portfolio is globally diversified according to the currency of the underlying reinsurance liabilities. General Re hedges its currency risk by seeking to match its assets and liabilities by currency. The composition of the international operation's invested assets by currency is presented in the chart to the left. PIE CHART German Mark 35% U.S. Dollar 31% U.K. Sterling 15% Australian Dollar 6% French Franc 3% Japanese Yen 1% Other 9%
reported ("IBNR"), are evaluated continuously by management, annually by General Re's independent accountants in conjunction with their audit and periodically by independent consulting actuaries at the discretion of the Board of Directors. Any resulting adjustments are included in the current period's income.
Consolidated net claims and claim expenses for 1996 and prior accident years experienced favorable development of $168 million in 1997. Net claims and claim expenses for 1996 and prior accident years for the North American operations experienced favorable development of $178 million in 1997. The net favorable loss development was due to favorable development on casualty lines of business, partially offset by losses related to environmental, asbestos and other mass tort claims. Net claims and claim expenses for 1996 and prior accident years for the international operations, adjusted for the effects of foreign exchange, had adverse development of $10 million in 1997. The net adverse loss development for the international operations was primarily related to strengthening of reserves for certain casualty business. Due to customary lags in underwriting activity reports from European ceding companies, there may be correlated development of premium and losses in the international property/casualty operations. These premiums may not be included in the reserve development discussed above.
General Re continuously estimates its liabilities and related reinsurance recoverable for environmental and latent injury claims and claim expenses. While most of its liabilities for such claims arise from exposures in North America, General Re has also provided for international environmental and latent injury exposures. Environmental and latent injury exposures do not lend themselves to traditional methods of loss development determination and therefore reserves related to these exposures may be considered less reliable than reserves for standard lines of business (e.g., automobile). The estimate for environmental and latent injury losses is composed of four parts: known claims, development on known claims, IBNR and direct excess coverage litigation expenses. General Re's estimate for IBNR is based on fitted curves of estimated future claim emergence; this estimate is less reliable than the estimated liability for reported claims. The effect of joint and several liability on the severity of claims and a provision for future claims inflation have been included in the loss development estimate.
Comprehensive environmental laws have been enacted in many foreign countries, generally imposing sanctions in the form of cleanup costs, civil damage awards, fines and/or imprisonment. Changes in environmental regulations and environmental verdicts may affect future claim development.
Catastrophe losses may have a significant effect on the insurance and reinsurance industry. General Re has exposure to windstorm, hail, earthquake and other catastrophic events, all of which are managed through several measures, including underwriting controls, occurrence caps on certain property treaties, modeling and monitoring its accumulations and imposing zonal limits. In addition, General Re uses its retrocessional programs to limit its net losses from catastrophes.
As a global reinsurance and financial services company, General Re is subject to market risk arising from the potential change in the value of its various financial instruments. These changes may be due to fluctuations in
interest and foreign exchange rates, and changes in credit spreads and in equity prices. The level of market risk is influenced by many factors, such as volatility, correlation and liquidity. Potential gains or losses from changes in market conditions can be estimated through statistical models that attempt to predict within a specified confidence level the "value at risk" based on historical price and volatility movements. For example, if historical probabilities indicate that the change in the value of a fixed income security would not be expected to exceed $1 million with a 95 percent probability within a given time period, then the security's value at risk at a 95 percent confidence level for that period is $1 million.
GRFP evaluates and records a fair-value adjustment against trading revenue to recognize counterparty credit exposure and future costs associated with administering each contract. The expected credit exposure for each trade is initially established on the trade date and is determined through the use of a proprietary credit exposure model that is based on historical default probabilities, market volatilities and, if applicable, the legal right of setoff. These exposures are continually monitored and adjusted due to changes in the credit quality of the counterparty, changes in interest and currency rates or changes in other factors affecting credit exposure. The fair value allowance for counterparty credit exposures and future administrative costs on existing contracts was $93 million and $77 million at December 31, 1997 and 1996, respectively. Since inception, GRFP has not experienced any credit losses
Companies with automated systems generally are facing the problem that certain computer programs may experience software malfunctions with the advent of the Year 2000. Since many business software programs use only two digits to specify the year, rather than four, such programs would likely treat "00" associated with the Year 2000 as the year 1900.
In addition to its own computer systems and third-party relationships, General Re may also have exposure in its property/casualty operations to claims asserted under certain insurance policies for damages caused by companies' failure to address their Year 2000 computer problem. General Re has made significant investments in understanding and evaluating the potential insurance exposures arising from Year 2000 problems. A quantification of the insurance industry's or General Re's potential exposure to Year 2000 losses is not yet possible, as policy wordings vary and legal interpretations of possible insurance coverage for losses is likely to differ from jurisdiction to jurisdiction.
Common shareowners' equity at December 31, 1997 was $8,161 million, or $105.40 per basic share, an increase of 17.3 percent over $89.82 per basic share at December 31, 1996. The increase was primarily due to net income of $968 million, an increase in after-tax unrealized investment gains of $835 million, a decrease in unrealized foreign currency translation losses of $11 million and the reissuance of common stock of $48 million under employee compensation and benefit plans, partially offset by common share repurchases of $864 million and common and preferred stock dividends of $184 million. Common shareowners' equity at December 31, 1996 increased 11.2 percent over the $6,587 million at year-end 1995.
Cash flow from operations was $1,468 million in 1997, compared with $1,678 million in 1996, and $1,774 million in 1995. The decline was principally due to claim commutation activity, foreign exchange and generally lower underwriting cash flow. North American property/casualty financing cash flows include General Re's share repurchases and dividends to shareowners. During 1996, General Re utilized $313 million in cash for the acquisition of National Re.
the common stock of General Re. This represents an increase of 7.3 percent over the $.55 per share dividend paid in prior quarters during 1997 and the 22nd consecutive year in which General Re has increased its dividend.
At December 31, 1997, General Re had $275 million of senior debt outstanding of which $150 million was issued by General Re Corporation and is rated AAA by Standard & Poor's and Aa1 by Moody's, and $125 million was issued by National Re and is rated AA by Standard and Poor's and Aa2 by Moody's. General Re Corporation issues commercial paper to provide additional financial flexibility for its operations. Commercial paper offered by General Re Corporation has been rated A1+ by Standard & Poor's and Prime 1 by Moody's. At December 31, 1997, $689 million of commercial paper was outstanding, all of which was used by the financial service operations for various funding needs.
General Re has $1.8 billion of available lines of credit, which provide financial flexibility and support its commercial paper program. The credit lines consist of a 364-day facility of $800 million and a five-year credit facility for the remaining $1 billion. The credit agreements with the banks require General Re to maintain a minimum consolidated tangible net worth, as defined, of $2.7 billion. All available lines of credit were unused at December 31, 1997 and 1996.
See Note 2 to the consolidated financial statements on page 41 for a discussion of new accounting standards.
In connection with the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995 (the "Act"), General Re sets forth below cautionary statements identifying important factors that could cause its actual results to differ materially from those that might be projected, forecasted or estimated in its forward-looking statements, as defined in the Act, made by or on behalf of General Re in press releases, written statements or documents filed with the Securities and Exchange Commission, or in its communications and discussions with investors and analysts in the normal course of business through meetings, phone calls and conference calls. Such statements may include, but are not limited to, projections of premium revenue, investment income, other revenue, losses, expenses, earnings (including earnings per share), cash flows, plans for future operations, common shareowners' equity (including book value per share), investments, financing needs, capital plans, dividends, plans relating to products or services of General Re and estimates concerning the effects of litigation or other disputes, as well as assumptions for any of the foregoing and are generally expressed with words such as "believes," "estimates," "expects," "anticipates," "plans," "projects," "forecasts," "goals," "could have," "may have" and similar expressions. General Re, as a matter of policy, does not make
any specific projections as to future earnings nor does it endorse any projections regarding future performance that may be made by others.
Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause General Re's results to differ materially from such forward-looking statements and include, but are not limited to, the following:
1) Changes in the level of competition in the North American and international reinsurance or primary insurance markets that affect the volume or profitability of General Re's property/casualty or life/health businesses. These changes include, but are not limited to changes in the intensity of price competition, the entry of new competitors, existing competitors exiting the market, and the development of new products by new and existing competitors;
5) Adverse development on property/casualty claim and claim expense liabilities related to business written in prior years, including, but not limited to, evolving case law and its effect on environmental and other latent injury claims, changing government regulations, newly identified toxins, newly reported claims, new theories of liability, such as possible Year 2000 computer-related losses, or new insurance and reinsurance contract interpretations;
6) Changes in inflation that affect the profitability of General Re's current property/casualty and life/health businesses or the adequacy of its property/casualty claim and claim expense liabilities and life/health policy benefit liabilities related to prior years' business;
8) Lower than estimated retrocessional or reinsurance recoveries on unpaid losses, including, but not limited to, losses due to a decline in the creditworthiness of General Re's retrocessionaires or reinsurers;
9) Increases in interest rates, which cause a reduction in the market value of General Re's fixed income investment portfolio, and its common shareowners' equity;
The consolidated financial statements include estimated liabilities for unpaid claims and claim expenses of General Re's North American and international property/casualty reinsurance subsidiaries. The provision for reported but unpaid claims and claim expenses is based on client reports and individual case estimates, including anticipated salvage and subrogation recoverable. A provision is included for incurred but not reported ("IBNR") claims and claim expenses on the basis of past experience. Historic premium, claim and claim expense data are organized in actuarial formats, analyzed for credibility, and processed through actuarial formulae. Using actuarial judgment, forecasts of IBNR claims and claim expenses are determined and tested for validity. General Re strives for accuracy in its reserving structure and closely monitors its estimates against actual claims and claim expense emergence. The methods of making such estimates and for establishing the resulting liabilities are continually reviewed and updated. All adjustments to the reserve structure (which encompasses claims from up to 50 years ago) are included in current operating results.
Social and economic inflation have a leveraged effect on liabilities for claims and claim expenses. Implicit within the reserve structure is an increase in both the frequency and severity of claims between years. In recent years, some of General Re's clients have increased the amount of their retained risk, which partially offsets the effect of social and economic inflation.
ANALYSIS OF NORTH AMERICAN GROSS CLAIMS AND CLAIM EXPENSE DEVELOPMENT (IN MILLIONS)
RECONCILIATION OF DISCOUNTING NET LIABILITY FOR CLAIMS AND CLAIM EXPENSES (IN MILLIONS)
To the Board of Directors and Shareowners of General Re Corporation Stamford, Connecticut
General Re Corporation and its subsidiaries ("General Re") have global reinsurance and financial service operations in 61 cities in 31 countries on six continents and provide reinsurance coverage in approximately 150 countries. General Re operates four principal businesses: North American property/casualty reinsurance, international property/casualty reinsurance, global life/health reinsurance and financial services. General Re's principal reinsurance operations are based in North America and Germany, with other major operations in Asia, Australia, Europe and South America. General Re's principal financial service operations are located in the United States, the United Kingdom, Japan, Hong Kong and Canada. General Re is the largest North American professional property/casualty reinsurer, and is among the three largest reinsurers in the world based on net premiums written and capital.
General Re's North American property/casualty operations produced revenues of $3,967 million, or 48 percent, of consolidated revenues in 1997. The principal business of these subsidiaries is treaty and facultative reinsurance underwritten on a direct basis throughout North America. General Re predominately writes excess reinsurance across various lines of business.
General Re's international property/casualty operations produced revenues of $2,706 million, or 33 percent, of consolidated revenues in 1997. The international property/casualty operations write proportional and excess reinsurance for both property and casualty risks throughout the world.
General Re's global life/health reinsurance operations produced revenues of $1,277 million, or 15 percent, of consolidated revenues in 1997. These operations include the North American and international life/health reinsurance operations of Cologne Re.
INVESTMENTS: Fixed maturity securities that General Re may sell prior to maturity in response to changes in market interest rates, changes in liquidity needs, or other factors and equity securities are classified as available-for- sale and carried at fair value, with unrealized gains and losses, net of deferred income taxes, excluded from income and reported in a separate component of common shareowners' equity. Fixed maturity securities that are held for resale are classified as trading and carried at fair value, with unrealized gains and losses included in income.
Realized gains or losses on sales of investments are primarily determined on the basis of identified cost and include adjustments to the net realizable value of investments for declines in value that are considered to be other than temporary. Realized gains or losses include gains and losses arising from the translation into U.S. dollars of
investments held by the North American operations and denominated in foreign currencies. General Re periodically uses derivatives to hedge certain risks in its investment portfolio. To the extent the derivatives are considered hedges for accounting purposes, these derivatives must be designated as a hedge of specific securities at their inception and must remain a hedge throughout the hedge period. Related gains or losses are treated as basis adjustments of the hedged securities and are included net of taxes in shareowners' equity. Gains and losses on derivatives not qualifying for hedge accounting treatment are included in income in the current period.
Investment income is recognized as earned and includes the accretion of bond discount and amortization of bond premium. Included in other invested assets are investments in reinsurance joint ventures, limited partnerships and real estate. Reinsurance ventures reported under the equity method are carried at initial cost with adjustment after acquisition for General Re's proportionate share of the venture's earnings. The amount of the adjustment is included in "Other revenues". Limited partnership investments are carried at estimated fair value. Real estate is valued at cost and depreciated over its estimated useful life.
PREMIUMS EARNED: Premiums are recognized in income over the contract period in proportion to the amount of insurance or reinsurance provided. Unearned premium liabilities are established to cover the unexpired portion of premiums written. Such liabilities are computed by pro rata methods based on statistical data and reports received from ceding companies. In the absence of ceding company reports, premiums are estimated using historical information and management judgment. Premium adjustments on contracts and audit premiums are accrued on an estimated basis throughout the contract term. Premiums are reported net of retrocessions.
assumptions include a margin for adverse deviation and vary with the characteristics of the reinsurance contract's date of issuance, policy duration and country of risk. The interest rate assumptions used vary by country ranging principally from 3.0 percent to 7.0 percent. Accrued profit-sharing commissions to ceding companies have been provided based on contractual terms for experience through the balance sheet date.
PRESENT VALUE OF FUTURE PROFITS: The present value of future profits ("PVP") is the actuarially determined present value of the projected profits from the continuation of in-force reinsurance on existing insurance policies on the date Cologne Re was acquired. The calculation of the estimated profits includes anticipated future premiums, death and benefit payments, reserve changes, profit sharing amounts, expenses and related investment income. PVP was determined using risk-adjusted discount rates ranging primarily from 10.0 percent through 16.0 percent. The interest rates selected for the valuation were determined based on the applicable interest rates in the country of risk and the risk inherent in the realization of the estimated future profits. PVP of $100 million and $112 million at December 31, 1997 and 1996, respectively, is included in "Other assets" and is being amortized over the duration of the related life business, based upon the assumed underlying profits of the business acquired using a 7.0 percent interest rate.
GOODWILL: General Re amortizes goodwill arising from its business combinations on a straight-line basis predominantly over 40 years. The amount of goodwill associated with Cologne Re fluctuates based on changes in the value of the German mark relative to the U.S. dollar during the period.
FINANCIAL SERVICES: GRFP's derivative contracts are carried at estimated fair value based on financial models which incorporate current interest rates, currency rates, and security values. Securities owned, securities sold but
not yet purchased and futures contracts are carried at fair value. Realized and unrealized gains or losses from selling or valuing securities and contractual commitments at fair value are included in "Other revenues." Included in trading account assets and liabilities are the unrealized gains and losses on interest rate and currency swaps, forward currency commitments and option products. These estimated unrealized gains and losses, which have been included in income, represent the fair value of estimated future cash flows for these transactions. Purchases of securities under agreements to resell and sales of securities under agreements to repurchase are accounted for as collateralized investing and financing transactions and are recorded at their contractual resale or repurchase amounts, plus accrued interest.
STOCK-BASED COMPENSATION: General Re's expense from stock-based compensation plans is measured based on accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. General Re discloses the pro forma effects on net income and earnings per share of the fair-value based method under Statement of Financial Standard No. 123.
In June 1997, the Financial Accounting Standards Board issued Statement No. 130, Reporting Comprehensive Income, which establishes standards for the reporting and display of comprehensive income and its components in the consolidated financial statements. After-tax unrealized appreciation of investments and currency translation adjustments are among the principal items that will be added to net income to arrive at comprehensive income. The statement is effective in 1998 and will change the presentation of certain information in General Re's financial statements but will not have any effect on financial position, results from operations or cash flows.
Also in June 1997, the Financial Accounting Standards Board issued Statement No. 131, Disclosure about Segments of an Enterprise and Related Information. This statement requires that companies report certain information about their operating segments in the interim and annual financial statements, including information about the products and services from which revenues are derived, the geographic areas of operation, and information about major customers. The statement defines operating segments based on internal management reporting and management's method of allocating resources and assessing performance. The statement is effective for year end 1998 and is not expected to change the four segments now reported by General Re.
On October 3, 1996, General Re acquired all of the outstanding shares of National Re, a North American property/casualty reinsurance group, in exchange for 4,023,901 shares of General Re's common stock and $313 million in cash for a total cost of $900 million. The acquisition of National Re has been accounted for as a purchase. The results of operations subsequent to the date of acquisition are included in General Re's consolidated operating results. At December 31, 1996, National Re's assets and liabilities at acquisition were included in General Re's consolidated balance sheet. Pro forma figures showing the effect of this acquisition on General Re's 1995 and 1996 net income and shareowners' equity have not been presented due to immateriality.
On December 28, 1994, General Re and Colonia Konzern AG formed a new company that acquired 75 percent of the ordinary shares and approximately 30 percent of the preference shares of Cologne Re, which collectively represents a 66.3 percent economic interest in Cologne Re. In exchange for its Cologne Re shares, Colonia Konzern AG, for itself and as trustee for Nordstern Allgemeine Versicherungs AG (collectively, "CKAG"), received 100 percent of the Class A shares of the new company, General Re-CKAG Reinsurance and Investment S.a r.1. ("GR-CK"). General Re initially contributed $884 million (DM 1,377 million) to GR-CK in exchange for 100 percent of the Class B shares of GR-CK. On December 30, 1994, GR-CK paid $302 million (DM 475 million) to General Re in exchange for notes in the principal amount of DM 475 million. The notes pay interest of 8.0 percent annually to GR-CK and are due on December 30, 2004. The intercompany notes have been eliminated in consolidation. The funds invested in GR-CK are subject to certain restrictions according to the joint venture agreement.
The acquisition of the shares of Cologne Re through GR-CK has been accounted for as a purchase. General Re has consolidated GR-CK and Cologne Re in its financial statements and recorded as minority interests the share of CKAG in GR-CK and of the other shareowners in Cologne Re.
General Re's North American reinsurance and insurance subsidiaries file financial statements prepared in accordance with statutory accounting practices prescribed or permitted by insurance regulators. Statutory accounting differs from generally accepted accounting principles in the reporting of certain reinsurance contracts, investments, subsidiaries, acquisition expenses, fixed assets, deferred income taxes and certain other items. Combined statutory surplus of General Re's North American property/casualty operations at December 31, 1997 and 1996 was $6,309 million and $5,326 million, respectively. Combined statutory net income of these operations for 1997, 1996 and 1995 was $968 million, $777 million and $621 million, respectively.
During 1997, GRC paid $850 million in dividends to General Re Corporation. The proceeds from these dividends were primarily used by General Re Corporation for the payment of common dividends and the repurchase of its common stock. This dividend amount was approved by the domiciliary insurance department and exceeded GRC's 1997 ordinary dividend capacity of $607 million. During 1998, GRC's ordinary dividend capacity will be $755 million. As a result of the extraordinary dividend payments in 1997, dividend payments by GRC to General Re Corporation prior to May 1, 1998 will be considered extraordinary and will require regulatory approval prior to payment. The statutory standard for such approval requires that GRC's statutory surplus must be reasonable in relation to its outstanding liabilities and adequate relative to its financial needs following
payment of the dividend. Dividends subsequent to May 1, 1998 will be considered ordinary to the extent they do not exceed the rolling ordinary dividend capacity of $755 million.
The cost, fair value and gross unrealized appreciation and depreciation of investments were as follows:
/1Cost/is amortized cost for short-term investments and fixed maturities and original cost for equity securities and other invested assets. - --------
The contractual maturities of available-for-sale fixed maturity investments for both reinsurance and financial services segments are shown in the following table. Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay certain obligations.
Securities with a market value of approximately $984 million at December 31, 1997 were on deposit with various state or governmental departments to comply with insurance laws.
The gross liability for environmental and latent injury claims and claim expenses and the related reinsurance recoverable were $2,047 million and $611 million, respectively, at December 31, 1997. The liability for environmental and latent injury claims and claim expenses is management's best estimate of future claim and claim expense payments and recoveries which are expected to develop over the next several decades. General Re continuously monitors evolving case law and its effect on environmental and latent injury claims. Changing government regulations, newly identified toxins, newly reported claims, new theories of liability, new contract interpretations and other factors could significantly affect future claim development. While General Re has recorded its current best estimate of its liabilities for unpaid claims and claim expenses, it is reasonably possible that these estimated liabilities, net of estimated reinsurance recoveries, may increase in the future and that the increase may be material to General Re's results from operations, cash flows and financial position. It is not possible to estimate reliably the amount of additional net loss, or the range of net loss, that is reasonably possible.
General Re utilizes reinsurance to reduce its exposure to large claims. These agreements provide for recovery of a portion of certain claims and claim expenses from reinsurers. If the reinsurers are unable to meet their obligations under the agreements, General Re would be liable for such defaulted amounts. General Re holds partial collateral under these agreements and has never suffered a significant loss because of defaults. General Re utilizes various North American and international reinsurers as part of its retrocessional program. Prior to being included in General Re's retrocessional program, reinsurers are reviewed for their anticipated long-term creditworthiness by General Re's Retrocessional Market Committee.
As part of its retrocessional program, General Re has placed a portion of its reinsurance with various Lloyd's of London syndicates. The syndicates act as managing agents for individual Names who bear the risks and rewards of the syndicates' underwriting results. At December 31, 1997, General Re's reinsurance recoverables on paid and unpaid claims and claim expenses from all Lloyd's syndicates aggregated to approximately $270 million.
General Re has $1.8 billion of available lines of credit which provide financial flexibility and support its commercial paper program. The credit lines consist of a 364-day facility of $800 million and a five-year credit facility for the remaining $1.0 billion. The credit agreements with the banks require General Re to maintain a minimum consolidated tangible net worth, as defined, of $2.7 billion. All available lines of credit were unused at December 31, 1997.
Notes and commercial paper of the financial service operations were as follows:
The financial service operations issue notes payable and commercial paper to meet their funding and liquidity needs. Notes issued by General Re Funding Corporation ("GRFC") and the structured finance notes are supported by GRFC's match-funded investments. The 8.375% senior accreting note issued by GRFC matures on July 30, 2037 but is redeemable semiannually beginning July 30, 2004.
GRFC and its affiliates also had outstanding $666 million of structured finance notes at December 31, 1997 with interest rates ranging from 5.9 to 6.3 percent and maturities from one to three years. GRFC has entered into swap transactions that convert the associated fixed interest expense into floating rates. GRFC's debt obligations are guaranteed by General Re Corporation.
Principal maturities on the outstanding notes and mortgage payable of the financial service operations at December 31, 1997 were as follows:
General Re Corporation has issued commercial paper on behalf of GRFP and GRFC to fund short-term liquidity needs. A summary of the commercial paper borrowings for these companies was as follows:
On December 18, 1997, General Re Corporation and GRFC established a $1 billion European Medium Term Note Program. Notes issued under the program by GRFC will be guaranteed by General Re Corporation and will be primarily used for match- funded investment transactions. The program allows for issuance of debt with maturities up to 30 years and denominated in a number of major currencies. With certain exceptions, the instruments may not be offered, sold, or delivered in the United States or to U.S. persons. There were no notes outstanding under the Program at December 31, 1997.
General Re has noncontributory pension plans covering substantially all employees. Plans for U.S. employees provide pension benefits that are generally computed on the basis of the average earnings during the three consecutive years of highest earnings during the employee's service. General Re's funding policy is to contribute sufficient amounts to meet the minimum annual funding required by applicable regulations, plus such additional amounts as it may determine to be appropriate from time to time. Through unfunded plans, General Re provides pension benefits for certain employees above amounts allowed under tax qualified plans. Pension plan assets are principally invested in investment-grade fixed maturities and equities. Cologne Re provides unfunded pension benefits to its employees based on years of service and age at retirement.
Substantially all of General Re's employees in the United States will become eligible for certain health care and group life insurance benefits upon retirement from General Re. General Re has funded the benefit cost of current retirees, with the retiree paying a portion of the costs. The retiree's portion of the costs varies depending upon the individual's length of service with General Re upon retirement. Through a trust, General Re funded $3 million for postretirement health care benefits for current retirees at December 31, 1997 and 1996, and had an accrued liability of $32 million and $30 million, respectively, for current employees.
General Re makes contributions to the ESSOP which, together with the dividend on shares of the preferred stock, are sufficient to make loan interest and principal repayments back to General Re. As interest and principal are repaid, a portion of the preferred stock is released for allocation to participating employees. Annual compensation
General Re has a Long-Term Compensation Plan (the "Plan") which provides for the granting of incentive and nonqualified stock options to officers and members of the Board of Directors. The Plan provides that the exercise price of the options granted may not be less than the fair market value of General Re's common stock on the date the options are granted. The options are exercisable cumulatively, 20 percent each year commencing one year from the date of grant and expire ten years from the grant date. In certain circumstances, replacement options may be granted upon exercise of an original option, with the exercise price equal to the current market price and with a term extending to the expiration date of the original option.
The expected term of replacement options is equal to the time remaining to maturity with a maximum of 6 years. In addition, the risk free interest rate on the date of grant is used, with the maturity equal to the expected term.
General Re has elected to continue accounting for stock-based compensation in accordance with Accounting Principles Board Opinion No. 25 for all of its compensatory plans. Accordingly, no compensation expense has been recognized for its nonqualified stock option plan. Had compensation expense for General Re's nonqualified stock option plan been recognized in accordance with FASB Statement No. 123, General Re's net income and basic earnings per share would have been $952 million, or $11.84 per basic share in 1997, $882 million, or $10.86 per basic share in 1996, and $823 million, or $9.90 per basic share in 1995.
The Plan also provides for bonus awards to be made in cash, common stock, share units or restricted stock options ("RSOs"). RSOs restrictions lapse five years after the grant date and RSOs expire ten years after the grant date. RSOs are included in the tables above. Share units are paid in shares of common stock at a future date designated in advance of the bonus award period.
Interest rate, currency and equity options grant the purchaser the right, but not the obligation, to either purchase from or sell to the writer a specified financial instrument under agreed terms. Interest rate caps and floors require the writer to pay the purchaser at specified future dates the amount, if any, by which the option's underlying market interest rate exceeds the fixed cap or falls below the fixed floor, applied to a notional amount.
Futures contracts are commitments to either purchase or sell a financial instrument at a future date for a specified price and are generally settled in cash. Forward-rate agreements are financial instruments that settle in cash at a specified future date based on the differential between agreed interest rates applied to a notional amount. Foreign exchange contracts generally involve the exchange of two currencies at agreed rates on a specified date; spot contracts usually require the exchange to occur within two business days of the contract date.
Market risk is the potential change in value of the portfolio caused by movements in foreign exchange, interest rate and equity markets. The level of market risk is influenced by factors such as volatility, correlation and liquidity. GRFP controls market risk exposures by taking offsetting positions in either cash instruments or other derivatives to reduce its overall exposure due to movements in these variables. For securities sold, but not yet purchased, GRFP may incur a loss if the market value of the security increases prior to the purchase of the instruments. GRFP manages its exposures on a portfolio basis. GRFP monitors its market risk on a daily basis across all products by calculating the effect on operating results of potential changes in market variables over a one week period. Based on historical market volatility, correlation data and informed judgment, GRFP sets market risk limits for each trading book based on a 95 percent probability that movements in market rates will not affect the results from operations in excess of the limit over a one week holding period. GRFP also monitors its consolidated market risk across all broad risk types on a weekly basis. It has established limits, and measures market risk against them primarily using Monte Carlo simulations to a 99 percent confidence level. When a risk limit is exceeded, appropriate action is taken, dependent upon the amount and duration of the excess, to monitor, control, and reduce the excess within approved levels. The weekly market risk limit across all trading books increased from $10 million to $15 million from April 1997 onward, consistent with the growth in GRFP's business .
Since inception, GRFP has not experienced a weekly position change in excess of the aggregate weekly market risk limit. In addition to these daily and weekly assessments of risk, GRFP prepares periodic stress tests to assess its exposure to movements in various market risk factors such as volatilities, shifts in yield curves and foreign currency exchange rates.
Credit risk arises from the possible inability of counterparties to meet the terms of their contracts. GRFP evaluates and records a fair value adjustment against trading revenue to recognize counterparty credit exposure and future costs associated with administering each contract. The expected credit exposure for each trade is initially established on the trade date and is determined through the use of a proprietary credit exposure model that is based on historical default probabilities, market volatilities and, if applicable, the legal right of setoff. These exposures are continuously monitored, and the fair value adjustment is adjusted to reflect the changes in the credit quality of the counterparty, changes in interest and currency rates or changes in other factors affecting credit exposures. The fair value adjustment for counterparty credit exposures and future administrative costs on existing contracts was $93 million at December 31, 1997. GRFP has not experienced any write-offs on such contracts. In the event counterparties are unable to fulfill their contractual obligations, future losses due to defaults may exceed amounts currently recognized in the balance sheet.
Legal risk arises from the uncertainty of the enforceability, through legal or judicial processes, of the obligations of GRFP's counterparties, including contractual provisions intended to reduce credit exposure by providing for
GRFP is subject to liquidity risk in funding its portfolio of open transactions. Movements in underlying market variables affect both future cash flows related to the transactions and collateral required to cover the value of open positions. General Re has taken action to ensure GRFP has sufficient resources to cover its potential liquidity needs through its access to General Re's internal sources of liquidity, commercial paper program, lines of credit and medium-term program.
Investments--Fair values for fixed maturities and equity securities were generally based on quoted market prices or dealer quotes. The fair value of investments in limited partnerships, which were included in other invested assets on the balance sheet, was determined by reviewing available financial information of the investee and by performing other financial analyses in consultation with external advisors. Fair values for investments in real estate were determined using discounted cash flow analyses for each property. Fair values for reinsurance ventures were based on General Re's proportionate share in the entity's shareowners' equity, since the cost of determining fair value exceeds the benefits derived. The carrying amounts for short-term investments approximate their fair values.
Securities sold but not yet purchased--The fair value for securities sold but not yet purchased was based on quoted market prices.
On July 1, 1996, U.S. Aviation Underwriters, Inc. ("USAU"), a subsidiary of General Re, and the former chief executive officer of USAU, were convicted of mail fraud in connection with the allocation of liability between two policyholders arising from the settlement of claims for a December 7, 1987 airline crash. USAU's sentence included a $20.5 million fine, payable in installments over a five year probation period and restitution in accordance with previously paid civil settlements. These amounts were accrued in prior periods. USAU is appealing both its conviction and sentence. Payment of the fine by USAU is stayed pending the determination of the appeal.
General Re also has the authority to issue 20 million shares of preferred stock, of which 1,700,231 are issued and outstanding and held by the ESSOP, and 1 million (Series A Junior Participating Preferred) are reserved for the Stockholders' Rights Plan. Under the Stockholders' Rights Plan, one Right attaches to each outstanding share of common stock. In the event a person or group acquires or commences a tender or exchange offer for 20 percent or more of General Re's common stock, each Right entitles common shareowners to purchase Series A Junior Participating Stock, which is convertible to common stock having a value equal to two times the rights exercise price.
The effect of stock options on the denominator in the diluted earnings per share calculation was calculated using the treasury stock method. The treasury stock method assumes all potentially dilutive options are exercised as of the beginning of the period and the cash proceeds from assumed exercise are used to purchase common stock at the average market price for the period. The incremental difference between the number of shares assumed to be issued and the number of shares assumed to be purchased are included in the denominator of the diluted earnings per share calculation.
The additional expense due to conversion of preferred stock to common stock relates to the compensation expense recorded for the ESSOP as discussed in Note 11. Subject to certain thresholds, General Re's ESSOP compensation expense equals principal and interest payments made by the ESSOP to General Re less preferred dividends received from General Re. The preferred stock had an annual per share dividend of $6.20 for the years included in the table above compared with a common dividend per share of $2.20, $2.04 and $1.96 in 1997, 1996 and 1995, respectively. When the preferred stock is assumed to be converted for the diluted earnings per share calculation, the after-tax difference between the preferred stock dividend and the common stock dividend increases ESSOP compensation expense, and thus lowers income available to common shareowners.
The following table is a summary of General Re's business by geographic area. Allocations to geographic area have been made on the basis of subsidiary location.