We are a Bermuda-based provider of reinsurance and insurance products for both the property and casualty and the life and annuity markets. In the past three years, the property and casualty market has presented more opportunities to us than the life and annuity market due to a shortage of reinsurance capacity in the property and casualty market, resulting in improvement in premium rates, terms and conditions. However, in 2004, we observed premium rates, terms and conditions stabilizing as competition increased in most property and casualty lines of business. With respect to the types of life and annuity contracts we offer, we are beginning to see more opportunities in the market, but remain cautious about whether these opportunities will result in additional business for us in the near term. However, we did execute two life and annuity reinsurance transactions during the year ended December 31, 2004. Despite the increased property and casualty competition and increased life and annuity opportunities, we anticipate continuing greater demand for our property and casualty products than for our life and annuity products during the year 2005.
Our principal operating subsidiary is Max Re. At December 31, 2004, Max Re had $915.3 million of shareholders’ equity. We conduct our European activities through Max Europe Holdings and its operating subsidiaries, Max Re Europe and Max Insurance Europe. We also provide underwriting and administrative services on a fee basis through Max Re Managers. We hold all of our alternative investments in Max Re Diversified, other than reinsurance private equity investments that are held by Max Re.
Our current emphasis on traditional reinsurance underwriting, coupled with two years of insurance operations, has expanded our professional liability and general liability underwriting volume. We intend to continue to diversify our property and casualty underwriting business by writing business with a greater number of clients and by varying the underlying exposures assumed. As part of this effort, we recently hired an experienced underwriting professional to oversee a newly formed property group within our insurance and reinsurance operations. Consequently, we believe our underwriting portfolio is, and will be for the foreseeable future, more diversified than in previous years.
There is a potential for increased volatility in our underwriting results arising from the increase in our traditional reinsurance and traditional insurance business. However, by carefully selecting line sizes of business assumed, diversifying our underlying exposures, establishing contractual liability caps on our contracts and purchasing reinsurance and retrocessional reinsurance protection, we believe we will be able to manage this risk effectively. In support of our belief, we note that, since we commenced operations in 2000, we have incurred small losses, relative to companies of comparable size, from the World Trade Center disaster, United States corporate scandals and the four third quarter 2004 hurricanes that came ashore in Florida.
Our investments during the year ended December 31, 2004 produced a total return of 5.63% compared to 7.74% for the year ended December 31, 2003. The cash and fixed maturities portfolio produced a total return of 4.22% during the year ended December 31, 2004 compared to 3.26% for the year ended December 31, 2003.
Reinsurance and insurance premiums are a function of the amount and type of contracts written as well as prevailing market prices. Premiums are earned over the terms of the underlying contracts. Each of our reinsurance contracts contains unique pricing, terms and conditions and expected profit margins. Therefore, the amount of premiums is not necessarily an accurate indicator of our anticipated profitability. Premium estimates are based upon information in underlying contracts, data received from clients and from premium audits. Changes in premium estimates are expected and may result in significant adjustments in any period. These estimates change over time as additional information regarding the underlying business volume of our clients is obtained. There is often a delay in the receipt of updated premium information from clients due to the time lag in preparing and reporting the data to us. After review by our underwriters, we increase or decrease premium estimates as updated information from our clients is received.
Our net investment income is a function of the average invested assets and the average yield that we earn on those invested assets. The investment yield on our fixed maturities investments is a function of market interest rates as well as the credit quality and maturity of our fixed maturities portfolio. We recognize the realized capital gains or losses on our fixed maturities investments at the time of sale. The realized capital gains or losses reflect the results of changing market conditions, including changes in market interest rates and changes in the market’s perception of the credit quality of our fixed maturities holdings. Our net gains on alternative investments are a function of the success of the funds in which we are invested, which depends on, among other things, the underlying strategies of the funds, the ability of the fund managers to execute the fund strategies, general economic and investment market conditions and the underlying operating results of our private equity reinsurance investments.
the actual costs to settle these liabilities. We increase or decrease losses, benefits and experience refunds estimates as actual claim reports are received. Our ability to estimate losses, benefits and experience refunds accurately at the time of pricing our contracts is a critical factor in determining profitability.
Acquisition costs consist principally of ceding commissions paid to ceding clients and brokerage expenses, and typically represent a negotiated percentage of the premiums on reinsurance and insurance contracts written. We generally defer and amortize these costs over the period in which the related premiums are earned.
General and administrative expenses are principally employee salaries and related personnel costs, office rent, amortization of leasehold improvements and other operating costs. These costs are primarily fixed in nature and do not vary with the amount of premiums written.
Our reinsurance and insurance reserves are actuarial projections as of the balance sheet date of the ultimate unpaid losses and benefits associated with its reinsurance and insurance contracts. Considerable judgment is required in the evaluation of losses and benefits and the establishment of liabilities for losses and benefits. We employ a variety of actuarial loss reserving techniques and several models to assist in the setting and reviewing of reserves. The actuarial loss reserves techniques and models employed include paid loss development, incurred loss development, paid and incurred Bornhuetter-Ferguson methods and frequency and severity methods. The actuarial loss reserves techniques and models employed are principally based on paid and incurred loss development methods. Further, we retain an independent actuarial firm to review annually the adequacy of the reserves as determined by management. Additional information regarding losses, benefits and experience refund amounts incurred will be revealed over time and the estimates of such amounts may need to be revised, resulting in gains and losses in the periods determined.
Our investments are carried at fair value or amounts that approximate fair value. Fair value for our investments in fixed maturities is generally based on quoted market prices or pricing models. At December 31, 2004, the valuation of approximately 96% of our fixed maturities investments was based on quoted market prices. Fair value for our alternative investments is generally based on the net asset value reported by the respective investment fund managers or, for our reinsurance equity investments, based on the carried amount under the equity method of accounting. The investment fund managers generally carry their trading positions and investments at fair value. We rely on the financial reports from these entities for recording the net gains on alternative investments in our statement of income.
The loss ratio (“loss ratio”) is calculated by dividing losses, benefits and experience refunds (shown as (b)) by net premium earned (shown as (a)).
Losses and experience refunds relating to the traditional reinsurance product line increased 344.3% from $28.2 million for the year ended December 31, 2002 to $125.3 million for the year ended December 31, 2003. The increase is less than the 403.9% increase in earned premiums for the same period and reflects the increase in aviation premium earned and low losses incurred during the year ended December 31, 2003, which resulted in a loss ratio of 63.9% for the year ended December 31, 2003 compared to a loss ratio of 72.4% for 2002. During the year ended December 31, 2003, incurred losses relating to prior year traditional reinsurance contracts increased $1.2 million as a result of increases in estimated premium written on traditional reinsurance contracts written in the prior year.
Gross premiums written. Gross premiums written for alternative risk transfer products for the year ended December 31, 2004 were $248.7 million compared to $419.7 million for the year ended December 31, 2003, a decrease of 40.7%. The decrease is net of $2.3 million of increases in premium estimates relating to contracts written in prior periods and $9.0 million of additional premium received related to loss experience on a contract. The decline in premiums written reflects the non-renewal of one large whole account alternative risk transfer contract that accounted for $110.0 million in gross premium written in the year ended December 31, 2003. In addition, we terminated an accident and health alternative risk transfer contract during its term, which resulted in us writing $50.0 million less premium in the current year compared to the same period in 2003. This termination was consistent with our strategy of allocating our capital towards traditional reinsurance and insurance business, which we currently see as offering more compelling risk/return opportunities. We expect our alternative risk premium volume to decline further in 2005.
year ended December 31, 2004 was 84.5% compared to 79.6% for the year ended December 31, 2003. Loss ratios on the alternative risk transfer products can vary significantly from year to year due to the mix of the underlying risk and the size of the contracts. During the year ended December 31, 2004, incurred losses relating to prior year contracts were increased by $10.3 million, which resulted in $9.0 million in additional premium. Losses and experience refunds relating to the alternative risk transfer product line increased 11.4% from $284.9 million for the year ended December 31, 2002 to $317.4 million for the year ended December 31, 2003. During the year ended December 31, 2003, incurred losses relating to prior year contracts increased $2.7 million as a result of increases in estimated premium written on alternative risk contracts written in the prior year.
Acquisition costs. Acquisition costs were $59.6 million for the year ended December 31, 2004 compared to $103.3 million for the year ended December 31, 2003, a decrease of 42.3%. The decrease in acquisition costs is related to the 38.6% decrease in premiums earned for the year ended December 31, 2004. Acquisition costs during each of the years ended December 31, 2004 and 2003 consisted primarily of amortization of deferred policy acquisition costs incurred in connection with writing alternative risk transfer business. Acquisition costs are customarily associated with the type of premium that we write. A significant component of deferred policy acquisition costs are ceding commissions paid to the buyer of our products. Acquisition costs for the year ended December 31, 2003 were $103.3 million, an increase of 16.5% over the same period in 2002.
General and administrative expenses. General and administrative expenses were $7.1 million for the year ended December 31, 2004 compared to $6.2 million for the year ended December 31, 2003, an increase of 14.5%. The increase resulted principally from an increase in personnel costs for those employees underwriting this product. The general and administrative expense to net premiums earned ratio was 2.3% for the year ended December 31, 2004 compared to 1.6% for the years ended December 31, 2003 and 2002.
Net underwriting income (loss) Net underwriting income (loss) attributable to the alternative risk transfer products for the year ended December 31, 2004 was $(18.8) million compared to $(21.8) million for the year ended December 31, 2003. The results for the year ended December 31, 2004 were principally attributable to the nature of the alternative risk transfer business we wrote.
Gross premiums written. Gross premiums written for traditional insurance products for the year ended December 31, 2004 were $248.1 million compared to $163.2 million for the year ended December 31, 2003, an increase of 52.0%. Typically, insurance business is written on an individual risk excess of loss basis with contractually defined premiums rather than estimates, which results in no material premium adjustments. Our first full year of production for our traditional insurance team was 2004.
Net premiums earned. Net premiums earned on our traditional insurance products increased by 170.2% to $124.0 million for the year ended December 31, 2004. The increase is attributed to our expansion of the traditional insurance product line over the past two years and reflects the earning pattern of an increasingly mature portfolio of insurance contracts.
Losses and experience refunds. Losses and experience refunds relating to the traditional insurance product line were $90.6 million for the year ended December 31, 2004 compared to $34.6 million for the year ended December 31, 2003, an increase of 161.9%, which is consistent with the increase in our premiums earned for this product line. The loss ratio for our traditional reinsurance product line for the year ended December 31, 2004 was 73.0% compared to 75.4% in 2003. As our portfolio of insurance contracts matures and we receive more loss notices, we will continue to refine our estimated reserves. Our present reserves are based on client specific loss data and supplemented with industry loss data. During the year ended December 31, 2004, there were no incurred losses relating to prior year contracts.
Acquisition costs. Acquisition costs were $2.5 million for the year ended December 31, 2004 compared to $3.1 million for the year ended December 31, 2003, a decrease of 19.4%. The acquisition costs are net of ceding commissions associated with premiums ceded to our quota share partners. These ceding commissions are designed to compensate us for the costs of producing the portfolio of risks ceded to our reinsurers. The ratio of premiums ceded to premiums written has increased from the prior year as the reinsurance programs have been in place all of 2004 compared to less than six months in 2003 and as a result, net acquisition costs have decreased in the current year. Acquisition costs during each of the years ended December 31, 2004 and 2003 consisted primarily of amortization of deferred policy acquisition costs incurred in connection with writing property and casualty business.
General and administrative expenses. General and administrative expenses were $6.8 million for the year ended December 31, 2004 compared to $4.9 million for the year ended December 31, 2003, an increase of 38.8%. The increase resulted principally from expenses associated with additional staff, including a property underwriting team. The general and administrative expense to net premiums earned ratio was 5.5% for the year ended December 31, 2004 compared to 10.7% for the year ended December 31, 2003. The decline in the ratio is principally due to the increase in premiums earned.
Gross premiums written. Gross premiums written for life and annuity products for the year ended December 31, 2004 were $212.3 million compared to $108.3 million for the year ended December 31, 2003, an increase of 96.0%. We continue to pursue opportunities selectively to expand in this product line. As a result, we were able to write one large annuity contract as well as a small life transaction in 2004. This compares with two medium-sized life transactions written in 2003. In the year ended December 31, 2002 we wrote one health-related contract. The level of business written in future periods will vary, perhaps materially, based upon market conditions and the opportunities presented to us.
Reinsurance premiums ceded. Reinsurance premiums ceded for life and annuity products for the year ended December 31, 2004 were $0.7 million compared to $21.7 million for the year ended December 31, 2003. The life and annuity premium ceded relates to the quota share with Grand Central Re. Effective January 2004, Grand Central Re stopped accepting new business and, accordingly, there has been a decline in premium ceded in the current year with the $0.7 million relating to additional premiums ceded on contracts written in prior years.
Benefits and experience refunds. Benefits and experience refunds relating to the life and annuity product line were $238.2 million for the year ended December 31, 2004 compared to $114.9 million for the year ended December 31, 2003, an increase of 107.3%. The increase was largely due to the recognition of losses associated with the premiums written and earned in the current year as well as loss accretion on benefit reserves. Benefits and experience refunds relating to the life and annuity product line increased 139.9% to $114.9 million for the year ended December 31, 2003 from $47.9 million for the year ended December 31, 2002. The increase was due to the recognition of losses associated with the premium written in the year ended December 31, 2003.
Acquisition costs. Acquisition costs were $3.5 million for the year ended December 31, 2004 compared to $1.9 million for the year ended December 31, 2003, an increase of 84.2%. The increase in acquisition costs is related to the 144.3% increase in premiums earned for the year ended December 31, 2004. The type of life and annuity transactions written by the Company typically have small acquisition costs.
General and administrative expenses. General and administrative expenses were $4.5 million for the year ended December 31, 2004 compared to $4.5 million for the year ended December 31, 2003. General and administrative expenses have remained constant as a result of stable staffing levels.
Net underwriting income(loss). Net underwriting income (loss) attributable to the life and annuity product for the year ended December 31, 2004 was $(34.7) million compared to $(34.7) million for the year ended December 31, 2003. The results are driven by the accretion of the life and annuity reserves over time. Although we expect to incur underwriting losses in connection with our long term life and annuity contracts, we seek to achieve sufficient investment income from premiums received to allow benefit payments as they occur.
Net gains on the alternative investment portfolio were $124.0 million, including a gain of $12.1 million from our private equity reinsurance investments, for the year ended December 31, 2003 compared to $32.1 million, including $8.4 million from our private equity reinsurance investments, for the year ended December 31, 2002. The net gains were in line with improvements in the overall investment markets. The Standard & Poors
Interest expense. Interest expense was $33.6 million for the year ended December 31, 2004 compared to $28.8 million for the year ended December 31, 2003, an increase of 16.7%. The increase resulted principally from interest expense on additional funds withheld from our reinsurers for the year ended December 31, 2004 compared to the same period in 2003. Interest expense in the year ended December 31, 2003 increased 24.7% over the interest expense in the year ended December 31, 2002. The increase resulted principally from interest expense on additional funds withheld from our reinsures, increased deposit liabilities and increased interest expense on the swap transaction accounted for as a bank loan resulting from a $50.0 million increase in the swap notional value.
$206.5 million of additional investments in alternative assets and the appreciation of the alternative investment portfolio of $81.6 million, partially offset by the decline in accumulated other comprehensive income of $3.6 million and dividends paid of $5.5 million.
Property and casualty losses and experience refunds. Property and casualty losses and experience refunds totaled $1,455.1 million at December 31, 2004 compared to $991.7 million at December 31, 2003, an increase of 46.7%. The increase in property and casualty losses and experience refunds was principally attributable to increased losses associated with risk assumed through increased premiums earned during the year ended December 31, 2004, partially offset by losses paid.
Losses recoverable from reinsurers. Losses recoverable from reinsurers totaled $388.1 million at December 31, 2004 compared to $273.7 million at December 31, 2003, an increase of 41.8%, principally reflecting losses ceded under our reinsurance and retrocessional agreements. Grand Central Re, our largest retrocessionaire, accounted for 51.1% of our losses recoverable at December 31, 2004. In September 2004, Grand Central Re requested that A.M. Best Company withdraw its financial strength rating. Consequently, A.M. Best Company has assigned a financial strength rating of “NR-4” to Grand Central Re. We retain funds from Grand Central Re amounting to approximately 101% of its loss recoverable obligations. In addition, at December 31, 2004, one other retrocessionaire accounted for 21.6% of our losses recoverable from reinsurers. This retrocessionaire has a financial strength rating of “A” by A.M. Best Company. We retain funds amounting to approximately 62% of its loss recoverable obligations. All remaining loss recoverables are from organizations rated “A- (Excellent)” or higher by A.M. Best Company.
Shareholders’ equity. Our shareholders’ equity increased to $937.0 million at December 31, 2004 from $805.2 million at December 31, 2003, an increase of 16.4%, principally reflecting income of $133.7 million for the year ended December 31, 2004. We repurchased 268,600 shares during the year at an average price of $18.05 per share for a total consideration of $4.8 million.
opinion of our financial strength, operating performance and ability to meet obligations. If an independent rating agency downgrades or withdraws any of our ratings, we could be severely limited or prevented from writing any new insurance or reinsurance contracts, which would significantly and negatively affect our business. To date, our ratings have been affirmed by A.M. Best and Fitch on each rating review. Ratings are based upon factors relevant to policyholders and are not directed toward the protection of investors.
The amounts in this table represent our gross estimates of known liabilities as of December 31, 2004 and do not include any allowance for claims for future events within the time period specified. As such, it is highly likely that the total amounts paid out in the time periods shown will be greater than that indicated in the table.