Everest Re’s corporate offices are located in approximately 129,700 square feet of leased office space in Liberty Corner, New Jersey. Bermuda Re’s corporate offices are located in approximately 3,600 total square feet of leased office space in Hamilton, Bermuda. The Company’s other twelve locations occupy a total of approximately 74,500 square feet, all of which are leased. Management believes that the above-described office space is adequate for its current and anticipated needs.
Loss and LAE ratio 94.0 % 74.4 % 69.6 % 71.7 % 82.4 %
Combined ratio (2) 120.2 % 98.8 % 95.2 % 99.0 % 113.5 %
(5) Loss ratio is the GAAP losses and LAE incurred as a percentage of GAAP net premiums earned. Underwriting expense ratio is the GAAP commissions, brokerage, taxes, fees and general expenses as a percentage of GAAP net premiums earned. Combined ratio is the sum of the loss ratio and underwriting expense ratio.
The Company competes in the U.S., Bermuda and international reinsurance and insurance markets with numerous global competitors. The Company’s competitors include independent reinsurance and insurance companies, subsidiaries or affiliates of established worldwide insurance companies, reinsurance departments of certain insurance companies and domestic and international underwriting operations, including underwriting syndicates at Lloyd’s. Some of these competitors have greater financial resources than the Company and have established long-term and continuing business relationships throughout the industry, which can be a significant competitive advantage. In addition, the lack of strong barriers to entry into the reinsurance business and the potential for securitization of reinsurance and insurance risks through capital markets provide additional sources of potential reinsurance and insurance capacity and competition.
In 2004 and 2005, market conditions weakened following hard market conditions that had developed from 2000 through 2003. Pricing for most property and casualty classes declined modestly. Competition increased modestly as well, in part due to the relative profitability achieved by many reinsurers from 2002 through 2004, the attendant buildup of capital by these participants and growing pressures to effectively redeploy this capital. However, this profitability and capital buildup varied significantly by market participant, reflecting the fact that the industry was impacted by significant catastrophe losses in the second half of 2004, generally weak investment market conditions and ongoing adverse loss development. All of these factors depressed the industry’s aggregate financial performance and perceptions of individual insurer’s financial strength during the period.
Catastrophe risk is a fundamental risk element to which the Company is exposed. Its risk management framework considers such exposures carefully. As a consequence of the 2005 catastrophe experience, the
Net written premiums and net earned premiums declined 12.3% and 10.4%, respectively, to $4.0 billion in 2005 compared to 2004, consistent with the decrease in gross written premiums.
Net investment income was $522.8 million in 2005, an increase of 5.4% compared with 2004 reflecting growth in invested assets, partially offset by lower investment portfolio yields from the Company’s fixed maturities and lower returns from the Company’s equity investments in limited partnerships. The Company’s invested asset base at year-end 2005 was $13.0 billion, up $1.4 billion over prior year mainly driven by $1.1 billion of cash flow from operations and $758.3 million of common equity offering net proceeds, partially offset by $250.0 million of senior debt repayment during the period. Cash flows, which have been trending down over the past two years due to increased catastrophe losses and reduced premiums written, remain strong and are reflective of strong operating fundamentals. The embedded investment portfolio yields in 2005 were 4.5% pre-tax and 3.9% after-tax, down from 4.7% and 4.1%, respectively, in 2004, reflective of the Company’s elevated short-term investment holdings, which had the effect of reducing the Company’s asset duration and lessening the fixed income portfolio susceptibility to rising interest rates in the future.
events and A&E development of $81.4 million, mostly related to settlement activity with respect to asbestos exposures.
Commission, brokerage and tax expenses for 2005 were $914.8 million, a decrease of $60.3 million compared to 2004, principally reflecting decreases in premium volume and changes in business mix. However, the Company’s commission expense ratio increased by 1.1 points primarily due to an increase in contingent commissions and premium based taxes. Other underwriting expenses for 2005 were $123.5 million, a $16.3 million increase principally reflective of the continued build-out of the U.S. Insurance platform.
The Company, through its subsidiaries, operates in five segments: U.S. Reinsurance, U.S. Insurance, Specialty Underwriting, International and Bermuda. The U.S. Reinsurance operation writes property and casualty reinsurance, on both a treaty and facultative basis, through reinsurance brokers, as well as directly with ceding companies within the U.S. The U.S. Insurance operation writes property and casualty insurance primarily through general agent relationships and surplus lines brokers within the U.S. The Specialty Underwriting operation writes A&H, marine, aviation and surety business within the U.S. and worldwide through brokers and directly with ceding companies. The International operation writes property and casualty reinsurance through Everest Re’s branches in Canada and Singapore, in addition to foreign business written through Everest Re’s Miami and New Jersey offices. The Bermuda operation provides reinsurance and insurance to worldwide property and casualty markets and reinsurance to life insurers through brokers and directly with ceding companies from its Bermuda office and property and casualty reinsurance to the United Kingdom and European markets through its UK branch.
These segments are managed in a carefully coordinated fashion with strong elements of central control, with respect to pricing, risk management, monitoring aggregate exposures to catastrophic events, capital, investments and support operations. Management generally monitors and evaluates the financial performance of these operating segments based upon their underwriting results. Underwriting results include earned premium less losses and LAE incurred, commission and brokerage expenses and other underwriting expenses and are analyzed using ratios, in particular loss, commission and brokerage and other underwriting expense ratios, which, respectively, divide incurred losses, commissions and brokerage and other underwriting expenses by earned premium. The Company utilizes inter-affiliate reinsurance but such reinsurance generally does not impact segment results, as business is generally reported within the segment in which the business was first produced. For selected financial information regarding these segments, see Note 18 of Notes to Consolidated Financial Statements.
The following tables present the relevant underwriting results for the operating segments for the three years ended December 31, 2005, 2004 and 2003:
Underwriting loss $ (465,509 ) $ (91,989 ) $ (7,557 )
Premiums Written. Gross written premiums decreased 12.7% to $4,108.6 million in 2005 from $4,704.1 million in 2004 reflecting a disciplined underwriting response to modest reinsurance market softening that affected all segments, resulting in an overall premium decline. Premiums declined 35.4% ($172.4 million) in the Specialty Underwriting operation, primarily due to a $145.4 million decrease in A&H business and a $47.9 million decrease in surety business, partially offset by a $20.9 million increase in marine and aviation business. The U.S. Insurance operation decreased 20.2% ($235.3 million), principally as a result of a $242.6 million decrease in workers’ compensation, resulting primarily from changes in the California workers’ compensation market. The Bermuda operation decreased 13.0% ($114.7 million) reflecting declines in individual risk underwritten insurance and reinsurance in Bermuda and in motor business reinsurance in the U.K. The U.S.
Net written premiums decreased by 12.3% to $3,972.0 million in 2005 from $4,531.5 million in 2004, consistent with the decrease in gross written premiums, combined with the decrease in ceded premiums.
Incurred Losses and LAE. Incurred loss and LAE increased by 13.2% to $3,724.3 million in 2005 from $3,291.1 million in 2004. The increase in incurred losses and LAE was principally attributable to the increase in estimated losses due to property catastrophes, partially offset by favorable non-catastrophe prior period reserve development and a lower level of earned premiums. Incurred losses and LAE in 2005 reflected ceded losses and LAE of $95.2 million compared to ceded losses and LAE in 2004 of $141.0 million. The decrease in ceded losses was primarily the result of fluctuations in losses ceded under the specific reinsurance coverages purchased by the U.S. Insurance operation and less ceded premium period over period.
The following table shows the loss ratios for each of the Company’s operating segments for 2005 and 2004. The loss ratios for all operations were impacted by the factors noted above.
The segment components of the increase in incurred losses and LAE in 2005 from 2004 were a 37.1% ($155.6 million) increase in the International operation, a 26.6% ($311.0 million) increase in the U.S. Reinsurance operation, a 10.6% ($78.7 million) increase in the Bermuda operation, partially offset by a 19.4% ($128.0 million) decrease in the U.S. Insurance operation and a 5.3% ($15.9 million) decrease in the Specialty Underwriting operation. These changes reflect variability in premiums earned and changes in the loss expectation assumptions for business written, as well as the net prior period reserve development and catastrophe losses discussed above. Incurred losses and LAE for each operation were also impacted by changes in the pricing of the underlying business, as well as variability relating to changes in the mix of business by class and type.
The following table shows the net catastrophe losses for each of the Company’s operating segments for 2005 and 2004.
Incurred losses and LAE include catastrophe losses, which include the impact of both current period events and favorable and unfavorable development on prior period events and are net of reinsurance. Individual catastrophe losses are reported net of specific reinsurance, but before recoveries under corporate level reinsurance and potential incurred but not reported (“IBNR”) loss reserve offsets. The Company defines a catastrophe as a property event with expected reported losses of at least $5.0 million before corporate level reinsurance and taxes. Effective for the third quarter 2005, industrial risk losses have been excluded from catastrophe losses with prior periods adjusted for comparison purposes. Catastrophe losses, net of contract specific cessions, were $1,485.7 million in 2005, related principally to aggregate estimated losses driven by Hurricanes Katrina, Rita and Wilma with catastrophe losses of $765.9 million, $151.0 million and $381.6 million, respectively, but also reflected catastrophe losses related to hurricanes Emily ($19.8 million) and Dennis ($7.0 million), floods in India ($13.2 million), Calgary ($9.6 million) and Europe ($6.2 million) and storms in Ontario ($12.9 million). The 2005 results also reflect net unfavorable reserve development on 2004 and prior catastrophes of $118.5 million. Catastrophe losses, net of contract specific cessions, were $390.0 million in 2004, related principally to aggregate estimated losses of $428.8 million from Hurricanes Charley, Frances, Ivan and Jeanne, Pacific typhoons, Edmonton hailstorms and the Asian tsunami, which were partially offset by $33.4 million of reserve reductions related to the 2001 World Trade Center losses.
The following table shows net prior period reserve adjustments for each of the Company’s operating segments for 2005 and 2004.
Net favorable prior period reserve adjustments for the year ended December 31, 2005 were $26.4 million compared to net unfavorable prior period reserve adjustments of $249.4 million in 2004. For the year ended December 31, 2005, the favorable reserve adjustments included net favorable non-A&E, non-catastrophe reserve adjustments of $226.3 million related primarily to property business classes, partially offset by net unfavorable prior period catastrophe adjustments of $118.5 million related primarily to the 2004 hurricanes and net unfavorable A&E adjustments of $81.4 million. For the year ended December 31, 2004, the unfavorable prior period reserve adjustments included net unfavorable A&E adjustments of $159.4 million and net unfavorable non-A&E, non-catastrophe adjustments of approximately $128.7 million relating primarily to casualty reinsurance. Partially offsetting the 2004 unfavorable development was $38.7 million of favorable catastrophe development principally related to the reduction of reserves for the World Trade Center events. It is important to note that non-A&E accident year reserve development arises from the re-evaluation of accident year results and that such re-evaluations may also impact premiums and commissions attributed by accident year, generally mitigating, in part, the impact of loss development and that such impacts are recorded as part of the overall reserve evaluation process.
The Bermuda segment reflected $37.7 million of net unfavorable prior period reserve adjustments for the year ended December 31, 2005 and $138.4 million of net unfavorable prior period reserve adjustments for the year ended December 31, 2004. The development in the year ended December 31, 2005 was primarily the result of $69.9 million of unfavorable A&E prior period reserve development and $12.2 million unfavorable catastrophe development, partially offset by $44.4 million favorable non-A&E, non-catastrophe prior period reserve adjustments primarily from the UK branch produced business. The development in the year ended December 31, 2004 was primarily the result of $149.1 million of A&E reserve development. All of the development related to asbestos exposures that were assumed through the September 19, 2000 loss portfolio transfer from Mt. McKinley.
The Company, because of its historical income orientation, has generally considered total return, the combination of income yield and capital appreciation/depreciation, to be relatively less important as a measure of performance than its overall income yield. However, in 2005, with changes the Company perceived in overall investment market conditions, the Company continued to reweight its view of total return and added $440.0 million in 2005 of equity securities into the overall investment portfolio. The Company also added $125.5 million of other invested assets, principally limited partnerships. The following table provides a comparison of the Company’s total return by asset class relative to broadly accepted industry benchmarks for 2005 and 2004.
The Company’s net realized capital gains were $90.3 million in 2005, which reflected realized capital gains on the Company’s investments of $106.2 million, including $41.3 million on the sale of interest only strips investments, partially offset by $15.9 million of realized capital losses, which included $7.0 million related to the write-downs in the value of interest only strips deemed to be impaired on an other than temporary basis in accordance with EITF 99-20. Net realized capital gains were $89.6 million in 2004, which reflected realized capital gains on the Company’s investments of $164.3 million, including $118.2 million on the sale of interest only strip investments, partially offset by $74.7 million of realized capital losses, which included $65.0 million related to the write-downs in the value of interest only strips deemed to be impaired on an other than temporary basis in accordance with EITF 99-20.
The Company has outstanding seven specialized equity put options in its product portfolio at December 31, 2005. These products meet the definition of a derivative under Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”). Net derivative expense from these derivative transactions was $2.6 million and $2.7 million in 2005 and 2004, respectively, reflecting changes in fair value for the specialized equity put options. See also Note 2 of Notes to the Consolidated Financial Statements.
Other Expenses. Other expense in 2005 was $18.5 million compared to other income of $0.7 million in 2004. The change in net other expense for 2005 from net other income in 2004 was primarily due to variability in the impact of foreign exchange and share option expense under Financial Accounting Standards No. 123 “Accounting for Stock-Based Compensation” (“FAS 123”).
Income Taxes. The Company’s income tax expense is primarily a function of the statutory tax rates and corresponding net income in the jurisdictions where the Company operates, coupled with the impact from tax preferenced investment income. Variations generally reflect changes in the relative levels of pre-tax income between jurisdictions with different tax rates, and specifically for 2005, also reflected the significant increase in incurred losses relating to catastrophes resulting, ultimately, in a pre-tax loss for the year. The Company recognized income tax benefits of $62.3 million in 2005 compared to income tax expense of $64.9 million in 2004. The 2004 tax expense was impacted by various issues, including the transfer of the Company’s UK branch to Bermuda Re, giving rise to a net tax expense.
Ceded premiums decreased to $172.6 million in 2004 from $258.4 million in 2003, principally resulting from the inclusion in 2003 of $49.6 million in adjustment premiums relating to claims made under the 2000 accident year aggregate excess of loss element of the Company’s corporate retrocessional programs, compared with no such adjustment premiums in 2004. Aside from the corporate retrocessional programs, ceded premiums generally relate to specific reinsurance purchased by the U.S. Insurance operation and fluctuate based upon the level of premiums written in the applicable programs.
Net written premiums increased by 5.0% to $4,531.5 million in 2004 from $4,315.4 million in 2003, reflecting the increase in gross written premiums, combined with the decrease in ceded premiums.
2.1% ($9.6 million) decrease in the Specialty Underwriting operation. All of these changes reflect period to period changes in net written premiums and business mix, together with normal variability in earnings patterns. Business mix changes occur not only as the Company shifts emphasis between products, lines of business, distribution channels and markets, but also as individual contracts renew or non-renew, almost always with changes in coverage, structure, prices and/or terms, and as new contracts are accepted with coverages, structures, prices and/or terms different from those of expiring contracts. As premium reporting, earnings, loss and commission characteristics derive from the provisions of individual contracts, the continuous turnover of individual contracts, arising from both strategic shifts and day to day underwriting, can and does introduce appreciable background variability in various underwriting line items. Changes in estimates related to the reporting patterns of companies also affect premiums earned.
The segment components of the increase in incurred losses and LAE in 2004 from 2003 were a 99.4% ($370.3 million) increase in the Bermuda operation, a 56.6% ($151.4 million) increase in the International operation, a 10.3% ($109.5 million) increase in the U.S. Reinsurance operation, an 8.8% ($53.2 million) increase in the U.S. Insurance operation and a 2.2% ($6.6 million) increase in the Specialty Underwriting operation. These changes reflect variability in premiums earned and changes in the loss expectation assumptions for business written, as well as the net prior period reserve development and catastrophe losses discussed above. Incurred losses and LAE for each operation were also impacted by generally improved pricing of the underlying business, as well as variability relating to changes in the mix of business by class and type, which in general reflected a more favorable mix.
The following table shows the net catastrophe losses for each of the Company’s operating segments for 2004 and 2003.
Incurred losses and LAE include catastrophe losses, which include the impact of both current period events and favorable and unfavorable development on prior period events and are net of reinsurance. Individual catastrophe losses are reported net of specific reinsurance, but before recoveries under corporate level reinsurance and potential IBNR reserve offsets. The Company defines a catastrophe as a property event with expected reported losses of at least $5.0 million before corporate level reinsurance and taxes. Effective in 2005, industrial risk losses were excluded from catastrophe losses. As such, prior periods were adjusted for comparison reasons. Catastrophe losses, net of contract specific cessions, were $390.0 million in 2004, relating principally to aggregate estimated losses of $428.8 million from Hurricanes Charley, Frances, Ivan and Jeanne, Pacific typhoons, Edmonton hailstorms and the Asian tsunami, which were partially offset by $33.4 million of reserve reductions related to the 2001 World Trade Center losses. Catastrophe losses, net of contract specific cessions, were $35.0 million in 2003, relating principally to the May 2003 tornado and hailstorm events and Hurricanes Fabian and Isabel.
The following table shows net prior period reserve adjustments for each of the Company’s operating segments for 2004 and 2003.
The U.S. Reinsurance segment accounted for $77.7 million of net unfavorable prior period reserve adjustments for the year ended December 31, 2004, which included $34.8 million of favorable development due to the reserve reduction principally related to the catastrophe losses from the World Trade Center events, as compared to net unfavorable prior period reserve adjustments of $150.9 million for the year ended December 31, 2003. Asbestos exposures accounted for $10.3 million and $16.8 million of unfavorable reserve adjustments for the years ended December 31, 2004 and 2003, respectively, with the remainder principally attributable to professional liability and casualty business classes. During the late 1990s and early 2000s, there had been a proliferation of claims relating to bankruptcies and other financial management improprieties. This increased number of claims, combined with larger claims, has significantly increased incurred losses on the professional liability policies. In the general casualty area, the Company continues to experience losses greater than historical trends for accident years 1998 through 2001. These losses are being driven by adverse trends in litigation and economic variability. In both the professional liability and general casualty reinsurance areas, the Company relies upon loss reports from ceding companies. Although the Company may record reserves at higher levels than those reported by ceding companies, actual reported results have exceeded the initial loss indications.
The U.S. Insurance segment reflected $43.3 million and $58.7 million of net unfavorable prior period reserve adjustments for the years ended December 31, 2004 and 2003, respectively. The unfavorable prior period reserve adjustments were principally due to accident years 2000 through 2002, where the Company strengthened its reserves for California workers’ compensation insurance. This was a relatively new book of business and was written in a challenging political and economic environment. While management believes the cumulative results through 2004 remain quite positive, there has been some deterioration in claim frequency and severity related to accident years 2001 and 2002.
Underwriting Expenses. The Company’s expense ratio, which is calculated by dividing underwriting expenses by net premiums earned, was 24.4% in 2004 compared to 25.6% in 2003.
The following table shows the expense ratios for each of the Company’s operating segments for 2004 and 2003.
Segment underwriting expenses increased by 12.9% to $1,075.8 million in 2004 from $952.6 million in 2003. Commission, brokerage, taxes and fees increased by $111.2 million, principally reflecting increases in premium volume and changes in the mix of business. Segment other underwriting expenses increased by $11.9 million as the Company continues to expand operations to support its increased business volume. Contributing to the segment underwriting expense increases were a 47.5% ($62.8 million) increase in the Bermuda operation, a 40.4% ($49.6 million) increase in the International operation and a 6.6% ($24.7 million) increase in the U.S. Reinsurance operation, which were partially offset by a 5.5% ($10.1 million) decrease in the U.S. Insurance operation and a 2.7% ($3.7 million) decrease in the Specialty Underwriting operation. The changes for each operation’s expenses principally resulted from changes in commission expenses related to changes in premium volume and business mix by class and type and, in some cases, changes in the use of specific reinsurance, as well as the underwriting performance of the underlying business.
Annualized pre-tax yield on average cash and invested assets 5.0 % 5.1 %
Company's other invested asset portfolio total return 43.2 % 26.2 %
The Company’s net realized capital gains were $89.6 million in 2004, which reflected realized capital gains on the Company’s investments of $164.3 million, including $118.2 million on the sale of interest only strip investments, partially offset by $74.7 million of realized capital losses, which included $65.0 million related to the write-downs in the value of interest only strips deemed to be impaired on an other than temporary basis in accordance with EITF 99-20, prior to liquidation of the interest only strips portfolio during the second quarter of 2004. Net realized capital losses of $38.0 million in 2003 reflected realized capital losses on the Company’s investments of $88.7 million, which included $25.7 million relating to write-downs in the value of securities deemed to be impaired on an other than temporary basis and $46.2 million related to the impairment on interest only strips, partially offset by $50.7 million of realized capital gains, which included $16.8 million of realized capital gains on sales of the interest only strips.
The Company had one credit default swap, which it no longer writes, and five specialized equity put options in its product portfolio. These products meet the definition of a derivative under FAS 133. Net derivative expense from these derivative transactions in 2004 was $2.7 million and net derivative income from these derivative transactions in 2003 was $5.9 million, with both periods principally reflecting changes in fair value for the specialized equity put options. See also Note 2 of Notes to the Consolidated Financial Statements.
Corporate underwriting expenses not allocated to segments increased to $6.5 million for 2004 compared with $6.0 million for 2003 as the Company expanded its infrastructure to support increased business volume.
The Company acknowledges that there is more uncertainty in establishing loss reserves on assumed business as compared to direct business. At December 31, 2005 the Company had direct business reserves of $2,059.1
ASBESTOS AND ENVIRONMENTAL EXPOSURES. The Company continues to receive claims under expired contracts, both insurance and reinsurance, asserting alleged injuries and/or damages relating to or resulting from environmental pollution and hazardous substances, including asbestos. The Company’s environmental claims typically involve potential liability for (a) the mitigation or remediation of environmental contamination or (b) bodily injury or property damages caused by the release of hazardous substances into the land, air or water. The Company’s asbestos claims typically involve potential liability for bodily injury from exposure to asbestos or for property damage resulting from asbestos or products containing asbestos.
Management believes that these uncertainties and factors continue to render reserves for A&E, and particularly asbestos losses, significantly less subject to traditional actuarial analysis than reserves for other types of losses. Given these uncertainties, management believes that no meaningful range for such ultimate losses can be established. The Company establishes reserves to the extent that, in the judgment of management, the facts and prevailing law reflect an exposure for the Company or its ceding companies. The Company’s A&E liabilities stem from Mt. McKinley’s direct insurance business and Everest Re’s assumed reinsurance business.
Due to the uncertainties discussed above, the ultimate losses attributable to A&E, and particularly asbestos, may be subject to more variability than are non-A&E reserves and such variation could have a material adverse effect on the Company’s financial condition, results of operations and/or cash flows. See also Notes 1 and 3 of Notes to the Consolidated Financial Statements.
With respect to Mt. McKinley, where the Company has a direct relationship with policyholders, the Company’s aggressive litigation posture and the uncertainties inherent in the asbestos coverage and bankruptcy litigation have provided an opportunity to actively engage in settlement negotiations with a number of those policyholders who have potentially significant asbestos liabilities. Those discussions are oriented towards achieving reasonable negotiated settlements that limit Mt. McKinley’s liability to a given policyholder to a sum certain. In 2004 and 2005, the Company concluded such settlements or reached agreement in principle with 13 of its high profile policyholders. The Company currently has identified 10 policyholders based on their past claim activity and/or potential future liabilities as “High Profile Policyholders” and its settlement efforts are generally directed at such policyholders, in part because their exposures have developed to the point where both the policyholder and the Company have sufficient information to be motivated to settle. The Company believes that this active approach will ultimately result in a more cost-effective liquidation of Mt. McKinley’s liabilities than a passive approach, although it may also introduce additional variability in Mt. McKinley’s losses and cash flows as reserves are adjusted to reflect the development of negotiations and, ultimately, potentially accelerated settlements.
also restrict the information available to estimate the reinsurers’ ultimate exposure. See the discussion below under the heading “Financial Condition - Loss and LAE Reserves”.
The following table displays the estimated components of earned premiums at December 31 for the periods indicated:
CASH AND INVESTED ASSETS. Aggregate invested assets, including cash and short-term investments, were $12,970.8 million at December 31, 2005, $11,530.2 million at December 31, 2004 and $9,321.3 million at December 31, 2003. The increase in cash and invested assets in 2005 from 2004 resulted primarily from $1,065.7 million in cash flows from operations generated during 2005 and $758.3 million from net proceeds of issuance of common shares, partially offset by the $250.0 million repayment of senior notes due March 15, 2005 and $77.8 million in net pre-tax unrealized depreciation of the Company’s investments. The $2.2 billion increase in cash and invested assets in 2004 from 2003 resulted primarily from $1,487.6 million in cash flows from operations generated during 2004, $320.0 million from net proceeds of the issuance of junior subordinated debt securities, $250.0 million from net proceeds of the issuance of senior notes and $40.1 million in net pre-tax unrealized appreciation of the Company’s investments, partially offset by a $70.0 million repayment on the revolving credit agreement.
The Company’s current investment strategy generally seeks to maximize after-tax income through a high quality, diversified, taxable and tax-preferenced fixed maturity portfolio, while maintaining an adequate level of liquidity. The Company’s mix of taxable and tax-preferenced investments is adjusted continuously, consistent with the Company’s current and projected operating results, market conditions and the Company’s tax position. The fixed maturities in the investment portfolio are comprised of available for sale securities. With changes the Company perceives in overall investment market conditions, the Company is reweighting its overall portfolio to modestly increase the emphasis on total return. Additionally, the Company has invested in equity securities, principally public equity index securities, which it believes will enhance the risk-adjusted total return of the investment portfolio. Equity investments accounted for 26.4%, 17.5% and 4.9% of the Company’s shareholders’ equity at December 31, 2005, 2004 and 2003, respectively.
movements are generally counter to the impact of interest rate movements on the Company’s other fixed income investments. Although the Company invested in interest only strips during 2005, 2004 and 2003, the Company had liquidated its positions in interest only strips and held no such securities at December 31, 2005 and 2004.
The tables below summarize the composition and characteristics of the Company’s investment portfolio at December 31:
Imbedded end of period yield, after-tax 3.9 % 4.1 % 4.1 %
The increase in short-term investments is due principally to maintaining liquidity to pay catastrophe losses as well as to the issuance of common shares during the fourth quarter of 2005. The increase in equity securities reflects a modest and continuing reweighting of the Company’s target investment mix.
The Company, because of its historical income orientation, has generally considered total return, the combination of income yield and capital appreciation/depreciation, to be relatively less important as a measure of performance than its overall income yield. However, in 2005, with changes the Company perceived in overall investment market conditions, the Company continued to reweight its view of total return and added $440.0 million in 2005 of equity securities into the overall investment portfolio. The following table provides a comparison of the Company’s total return by asset class relative to broadly accepted industry benchmarks for the periods indicated:
REINSURANCE RECEIVABLES. Reinsurance receivables for both paid and unpaid losses totaled $1,048.7 million at December 31, 2005, $1,210.8 million at December 31, 2004, and $1,284.1 million at December 31, 2003. At December 31, 2005, $239.8 million, or 22.9%, was receivable from subsidiaries of London Life. These receivables are collateralized by a combination of letters of credit and funds held arrangements under which the Company has retained the premium payments due the retrocessionaire, recognized liabilities for such amounts and reduced such liabilities as payments are due from the retrocessionaire. In addition, $171.5 million, or 16.4%, was receivable from Transatlantic, $160.0 million, or 15.3%, was receivable from LM, whose obligations are guaranteed by The Prudential and $100.0 million, or 9.5%, was receivable from Continental,
Effective January 1, 2004, Everest Re sold its United Kingdom branch to Bermuda Re. Business for this branch was previously included in the International segment and is now included in the Bermuda segment. Due to the sale and in accordance with FAS 131, the Company restated the International and Bermuda segments for the years ended December 31, 2003 to conform to December 31, 2005 and 2004 segment reporting.
The following tables summarize gross outstanding loss and LAE reserves by segment, segregated into case reserves and IBNR reserves, which are managed on a combined basis, for the periods indicated:
The Company’s loss and LAE reserves reflect estimates of ultimate claim liability. Such estimates are re-evaluated on an ongoing basis, including re-estimates of prior period reserves, taking into consideration all available information and, in particular, newly reported loss and claim experience. The effect of such re-evaluations impacts incurred losses for the current period. The Company notes that its analytical methods and processes operate at multiple levels including individual contracts, groupings of like contracts, classes and lines of business, internal business units, segments, legal entities, and in the aggregate. The complexities of the Company’s business and operations require analyses and adjustments, both qualitative and quantitative, at these various levels. Additionally, the attribution of reserves, change in reserves and incurred losses between accident year and underwriting year requires adjustments and allocations, both qualitative and quantitative, at these various levels. All of these processes, methods and practices appropriately balance actuarial science, business expertise and management judgment in a manner intended to assure the accuracy, precision and consistency of the Company’s reserving practices, which are fundamental to the Company’s operation. The Company notes however, that the underlying reserves remain estimates, which are subject to variation, and that the relative degree of variability is generally least when reserves are considered in the aggregate and generally increases as the focus shifts to more granular data levels.
There can be no assurance that reserves for, and losses from, claim obligations will not increase in the future. However, management believes that the Company’s existing reserves and reserving methodologies lessen the probability that any such increase would have a material adverse effect on the Company’s financial condition, results of operations or cash flows. In this context, the Company notes that over the past 10 years, its past calendar year operations have been affected variably by effects from prior period reserve re-estimates, with such effects ranging from a favorable $62.1 million in 1997, representing 2.2% of the net prior period reserves for the year in which the adjustment was made, to an unfavorable $249.4 million in 2004, representing 3.7% of the net prior period reserves for the year in which the adjustment was made. The Company has noted that variability had increased for years 1999 to 2003 and has taken actions to attempt to reduce this year to year variability prospectively.
The following table represents the reserve levels and ranges as of December 31, 2005 for each of the Company’s business segments.
A&E (All Segments) (3) (4) 649,460 N A 649,460 N A 649,460
(2) Although totals are displayed for both the low range and high range amounts, it should be noted that statistically the range of the total is not equal to the sum of the ranges of the segments.
The Company has included ranges for loss reserve estimates determined by the Company’s actuaries, which are derived through a combination of objective and subjective criteria. The Company notes that its presentation of this information is not directly comparable to similar presentations of other companies as there are no consistently applied actuarial or accounting standards governing such presentations. The Company further notes that its recorded reserves reflect the Company’s best point estimate of its liabilities and that its actuarial methodologies focus on such point estimates around which ranges are subsequently developed.
Additional losses, including those relating to latent injuries, and other exposures, which are as yet unrecognized, the type or magnitude of which cannot be foreseen by the Company or the reinsurance and insurance industry generally, may emerge in the future. Such future emergence, to the extent not covered by existing retrocessional contracts, could have material adverse effects on the Company’s future financial condition, results of operations and cash flows.
The Company generally has exposure to A&E losses through its Mt. McKinley operation with respect to insurance policies and through Everest Re with respect to reinsurance contracts. In each case, the Company’s management and analysis of its exposures takes into account a number of features of its business that differentiate the Company’s exposures from many other insurers and reinsurers that have significant A&E exposures.
The vast majority of Mt. McKinley’s A&E exposed insurance policies are excess casualty policies, with aggregate coverage limits, which by definition also have protection afforded by underlying coverage. Mt. McKinley’s attachment points vary but usually are protected by millions, often tens of millions, of dollars of underlying coverage. The excess nature of most of Mt. McKinley’s policies also offers protection against “non-product” claims (for example, claims arising under general liability coverage). Although under some circumstances an excess policy could be exposed to non-product claims, such claims generally pose more of a risk to primary policies because non-product claims are generally less likely to aggregate. In addition, environmental claims arise under general liability coverage, and generally do not aggregate. Thus, these claims tend to create exposure for primary policies to a greater extent than excess policies.
With respect to both the Mt. McKinley and Everest Re operations, the Company was not a member of the Asbestos Claims Facility (“Wellington”) or the Center for Claims Resolution (“CCR”) claim settlement facilities. Insurers supporting those facilities made broad commitments concerning the application of insurance coverage to asbestos claims. With respect to its direct insurance exposures, the fact that the Company has not made those commitments may allow it to resolve insurance exposure to Wellington/CCR insureds more economically than if it had joined these facilities. With respect to its reinsurance exposures, although the Company was not a signatory to the Wellington or CCR facilities, it issued reinsurance contracts to ceding companies that were signatories. Because the insurers supporting these facilities have generally paid their exposures more quickly than non-signatory insurers, the Company believes that this has generally meant that it has paid its reinsurance exposure more quickly than it likely would have if it had not been subject to Wellington/CCR payments.
At December 31, 2005, the gross reserves for A&E losses were comprised of $125.2 million representing case reserves reported by ceding companies, $157.6 million representing additional case reserves established by the Company on assumed reinsurance claims, $243.5 million representing case reserves established by the Company on direct insurance claims, including Mt. McKinley, and $123.2 million representing IBNR reserves.
Industry analysts have developed a measurement, known as the survival ratio, to compare the A&E reserves among companies with such liabilities. The survival ratio is typically calculated by dividing a company’s current net reserves by the three year average of paid losses, and therefore measures the number of years that it would take to exhaust the current reserves based on historical payment patterns. Using this measurement, the Company’s net three year A&E survival ratio was 3.7 years at December 31, 2005. Adjusting for the effect of the reinsurance ceded under the reinsurance agreement with LM, this ratio rises to the equivalent of 5.0 years at December 31, 2005. The cession of $160.0 million to the stop loss reinsurance provided by LM in connection with the acquisition of Mt. McKinley results in unpaid proceeds that are not reflected in past net payments and effectively extend the funding available for future net payments.
Because the survival ratio was developed as a comparative measure of reserve strength and not of absolute reserve adequacy, the Company considers, but does not rely on, the survival ratio when evaluating its reserves. In particular, the Company notes that loss payout variability, which can be material, due in part to the Company’s orientation to negotiated settlements, particularly on its Mt. McKinley exposures, significantly impairs the credibility and utility of this measure as an analytical tool. During 2005, the Company made asbestos net claim payments of $68.0 million on Mt McKinley high profile claimants where the claim was either closed or a settlement was reached. Such payments, which are non-repetitive, do for 2005, and will for 2006 and 2007, distort the Company’s three year survival ratio. Adjusting for such settlements, recognizing total settlements are generally considered fully reserved to an agreed settlement, the Company considers that its adjusted A&E survival ratio for net unsettled claims is 10.7 years, which is closer to prevailing industry norms.
3 Year Survival Ratio excluding SIP, actively managed & stop loss 12.3
SHAREHOLDERS’ EQUITY. The Company’s shareholders’ equity increased to $4,139.7 million as of December 31, 2005 from $3,712.5 million as of December 31, 2004, principally reflecting $758.3 million in net proceeds from the issuance of common shares, partially offset by $218.7 million net loss for the year ended December 31, 2005, a decrease of $77.8 million in net unrealized appreciation of investments, a $27.0 million decrease in foreign currency translation, $25.4 million in shareholder dividends and an increase of $2.9 million in the minimum pension liability. The Company’s shareholders’ equity increased to $3,712.5 million as of December 31, 2004 from $3,164.9 million as of December 31, 2003, principally reflecting $494.9 million of net income for the year ended December 31, 2004, $26.5 million in net proceeds from options exercised, an increase of $25.7 million in net unrealized appreciation of investments and a $22.9 million increase in foreign currency translation, partially offset by $22.4 million in shareholder dividends. Dividends of $25.4 million, $22.4 million and $19.6 million were declared and paid by the Company in 2005, 2004 and 2003, respectively.
On December 1, 2005 under the new registration and offering revisions to the Securities Act of 1933, the Company filed a shelf registration statement on Form S-3 with the SEC, as a Well Known Seasoned Issuer. Generally, under this shelf registration statement, Group is authorized to issue common shares, preferred shares, debt securities, warrants and hybrid securities, Holdings is authorized to issue debt securities and Everest Re Capital Trust III (“Capital Trust III”) is authorized to issue trust preferred securities.
On December 1, 2005, the Company issued 2,238,000 of its common shares at a price of $102.89 per share, which resulted in $236.4 million of proceeds before expenses of approximately $0.3 million and Holdings sold Group shares it acquired in 2002 at a price of $102.89 per share, which resulted in $46.5 million of proceeds, before expenses of approximately $0.2 million.
preferred securities. This shelf registration statement became effective on December 22, 2003 and was exhausted with the October 6, 2005 transaction described below. The following securities were pursuant to that registration statement.
On March 29, 2004, Capital Trust II, an unconsolidated affiliate, issued trust preferred securities resulting in a takedown from the shelf registration statement of $320 million. In conjunction with the issuance of Capital Trust II’s trust preferred securities, Holdings issued $329.9 million of 6.20% junior subordinated debt securities due March 29, 2034 to Capital Trust II. Part of the proceeds from the junior subordinated debt securities issuance was used for capital contributions to Holdings’ operating subsidiaries.
On November 14, 2002, pursuant to a trust agreement between Holdings and JPMorgan Chase Bank, the property trustee, and Chase Manhattan Bank USA, the Delaware trustee, Capital Trust, an unconsolidated affiliate, completed a public offering of $210.0 million of 7.85% trust preferred securities, resulting in net proceeds of $203.4 million. The proceeds of the issuance were used to purchase $210 million of 7.85% junior subordinated debt securities of Holdings that will be held in trust by the property trustee for the benefit of the holders of the trust preferred securities. In conjunction with the issuance of Capital Trust’s trust preferred securities, Holdings issued $216.5 million of 7.85% junior subordinated debt securities due November 15, 2032 to Capital Trust. The proceeds from the junior subordinated debt securities issuance were primarily used for capital contributions to Holdings’ operating subsidiaries.
On April 23, 2003, the Company expanded the size of the remaining shelf registration to $318 million by filing a post-effective amendment under Rule 462(b) of the Securities Act of 1933, as amended, and General Instruction IV of Form S-3 promulgated thereunder. On the same date, the Company issued 4,480,135 of its common shares at a price of $70.75 per share, which resulted in $317.0 million in proceeds, before expenses of approximately $0.2 million. This transaction effectively exhausted the September 26, 2002 shelf registration.
On March 14, 2000, Holdings completed public offerings of $200.0 million principal amount of 8.75% senior notes due March 15, 2010 and $250.0 million principal amount of 8.5% senior notes due and retired March 15, 2005. During 2000, the net proceeds of these offerings and additional funds were distributed by Holdings to Group.
The Company’s liquidity requirements are generally met from positive cash flow from operations. Positive cash flow results from reinsurance and insurance premiums being collected prior to disbursements for claims, which disbursements generally take place over an extended period after the collection of premiums, sometimes a period of many years. Collected premiums are generally invested, prior to their use in such disbursements, and investment income provides additional funding for loss payments. The Company’s net cash flows from operating activities were $1,065.7 million, $1,487.6 million and $1,653.8 million for the years ended December 31, 2005, 2004 and 2003, respectively. Additionally, these cash flows reflected net tax payments of $110.9 million, $100.0 million and $52.6 million for the years ended December 31, 2005, 2004 and 2003, respectively; net catastrophe loss payments of $459.7 million, $200.9 million and $96.0 million for the years ended December 31, 2005, 2004 and 2003, respectively; and net A&E settlements of $137.7 million, $187.1 million and $43.3 million for the years ended December 31, 2005, 2004 and 2003, respectively. The decrease in net cash flows from operations in 2005 compared with 2004 was primarily due to higher claim payments on catastrophes combined with lower premium volume. The decrease in cash flow in 2004 compared with 2003 was primarily due to higher claim payments on catastrophes and increased A&E settlements.
In periods for which disbursements for claims and benefits, policy acquisition costs and other operating expenses exceed premium inflows, cash flow from insurance operations would be negative. The effect on cash flow from operations would be partially offset by cash flow from investment income. Additionally, cash flow from investment maturities and dispositions, both short term investments and longer term maturities, would further mitigate the impact on total cash flow.
Management expects the trend of positive cash flow from operations, which in general reflects the strength of overall pricing, to persist over the near term; however, this continuing underlying trend will be negatively impacted by future catastrophe payments. In the intermediate and long term, the trend will be impacted by the extent to which competitive pressures change overall pricing available in the Company’s markets and the extent to which the Company successfully maintains its strategy of emphasizing profitability over volume.
Effective December 8, 2004, Group, Bermuda Re, and Everest International entered into a three year, $750 million senior credit facility with a syndicate of lenders (the “Group Credit Facility”). Wachovia Bank is the administrative agent for the Group Credit Facility. The Group Credit Facility consists of two tranches. Tranche one provides up to $250 million of revolving credit for liquidity and general corporate purposes, and for the issuance of standby letters of credit. The interest on the revolving loans shall, at the option of each of the borrowers, be either (1) Base Rate (as defined below) or (2) an adjusted London Interbank Offered Rate (“LIBOR”) plus a margin. The Base Rate is the higher of the rate of interest established by Wachovia Bank from time to time as its prime rate or the Federal Funds rate, in each case plus 0.5% per annum. The amount of margin and the fees payable for the Group Credit Facility depend on Group’s senior unsecured debt rating. Tranche two exclusively provides up to $500 million for the issuance of standby letters of credit on a collateralized basis.
During the year ended December 31, 2005, there were no borrowings under tranche one of the Group Credit Facility. As of December 31, 2005, the Company had $122.2 million of letters of credit outstanding under tranche two of the Group Credit Facility. In addition, the Company had $228.3 million in letters of credit outstanding at December 31, 2005 under a $350 million bilateral agreement with Citibank. All of these letters of credit are collateralized by the Company’s cash and investments. These letters of credit are generally used to collateralize reinsurance assumed by Bermuda Re from jurisdictions where collateralization is generally required for the ceding company to receive credit for such reinsurance recoverables from its principal regulator. Bermuda Re and Everest International also used trust arrangements to provide collateralization to ceding companies, including affiliates. The Company generally avoids providing collateral except where required for ceding companies to receive credit from their regulators. Additionally, at December 31, 2005, $164.4 million of assets were deposited in trust accounts, primarily on behalf of Bermuda Re, as security for assumed losses payable to certain non-affiliated ceding companies.
Effective October 10, 2003, Holdings entered into a three year, $150.0 million senior revolving credit facility with a syndicate of lenders, replacing the December 21, 1999 three year senior revolving credit facility, which expired on December 19, 2003. Both the October 10, 2003 and December 21, 1999 senior revolving credit agreements, which have similar terms, are referred to as the “Holdings Credit Facility”. Wachovia Bank is the administrative agent for the Holdings Credit Facility. The Holdings Credit Facility is used for liquidity and general corporate purposes. The Holdings Credit Facility provides for the borrowing of up to $150.0 million with interest at a rate selected by Holdings equal to either, (1) the Base Rate (as defined below) or (2) an adjusted LIBOR plus a margin. The Base Rate is the higher of the rate of interest established by Wachovia Bank from time to time as its prime rate or the Federal Funds rate, in each case plus 0.5% per annum. The amount of margin and the fees payable for the Holdings Credit Facility depends upon Holdings’ senior unsecured debt rating.
Nevertheless, when combined with traditional risk management and sound underwriting judgment, catastrophe models continue to be a useful tool for underwriters to price cat-exposed risks and for providing management with quantitative analysis with regard to monitoring and managing its catastrophe risk exposure by zone and risk hazard.
The Company’s catastrophe loss projections, segmented by risk zones, are updated quarterly and reviewed as part of a formal risk management review process.
If such a single catastrophe loss were to occur, management estimates that the effect on the Company’s income before and after taxes would be approximately $532 million and $415 million, respectively. Such impact represents approximately 10.0% of the Company’s beginning of year capital. Such estimates involve multiple variables, including which Everest entity would experience the loss, and as a result there can be no assurance that this amount would not be exceeded.
(1) Loss and LAE reserves represent the Company’s best estimate of losses from claim and related settlement costs. Both the amounts and timing of such payments are estimates, and the inherent variability of resolving claims as well as changes in market conditions make the timing of cash outflows uncertain. Therefore, the ultimate amount and timing of loss and LAE payments could differ from the Company’s estimates.
In January 2003, the Financial Accounting Standards Board (“FASB”) issued Financial Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”). FIN 46 addresses whether certain types of entities, referred to as variable interest entities (“VIEs”), should be consolidated or deconsolidated in a company’s financial statements. During December 2003, the FASB issued FIN 46R, replacing FIN 46. FIN 46R became
In December 2004, the FASB issued FASB Statement 123(R) “Share-Based Payment” (“FAS 123(R)”). FAS 123(R) requires all share-based compensation awards granted, modified or settled after December 15, 1994 to be accounted for using the fair value method of accounting. Under the modified prospective application, compensation cost is recognized for the outstanding, non-vested awards based on the grant date fair value of those awards as calculated under FAS 123. As the Company implemented FAS 123 prospectively for grants issued on or after January 1, 2002, the Company does not expect the adoption of the statement to have a material impact on the Company’s financial condition or results of operation. The application of FAS 123(R) will become effective for fiscal years starting after June 15, 2005. The Company will adopt FAS 123(R) effective January 1, 2006.
The Company’s current investment strategy seeks to maximize after-tax income through a high quality, diversified, taxable and tax-preferenced fixed maturity portfolio, while maintaining an adequate level of liquidity. The Company’s mix of taxable and tax-preferenced investments is adjusted continuously, consistent with its current and projected operating results, market conditions and the Company’s tax position. The fixed maturities in the investment portfolio are comprised of non-trading available for sale securities. Additionally, the Company invests in equity securities, which it believes will enhance the risk-adjusted total return of the investment portfolio. The Company has also engaged in a small number of specialized equity put options.
The overall investment strategy considers the scope of present and anticipated Company operations. In particular, estimates of the financial impact resulting from non-investment asset and liability transactions, together with the Company’s capital structure and other factors, are used to develop a net liability analysis. This analysis includes estimated payout characteristics for which the investments of the Company provide liquidity. This analysis is considered in the development of specific investment strategies for asset allocation, duration and credit quality. The change in overall market sensitive risk exposure principally reflects the asset changes that took place during the period, including a reduction of the duration of the fixed maturity portfolio that in turn reduced the impact of interest rate shift on the entire portfolio.
The Company’s $13.0 billion investment portfolio at December 31, 2005 is principally comprised of fixed maturity securities, which are subject to interest rate risk and foreign currency rate risk, and equity securities, which are subject to equity price risk. The impact of the foreign exchange risks on the investment portfolio is generally mitigated by changes in the value of operating assets and liabilities and their associated income statement impact.
The tables below display the potential impact of market value fluctuations and after-tax unrealized appreciation on the Company’s fixed maturity portfolio (including $1.4 billion of short-term investments) as of December 31, 2005 and 2004 based on parallel and immediate 200 basis point shifts in interest rates up and down in 100 basis point increments. For legal entities with a U.S. dollar functional currency, this modeling was performed on each security individually. To generate appropriate price estimates on mortgage-backed securities, changes in prepayment expectations under different interest rate environments were taken into account. For legal entities with a non-U.S. dollar functional currency, the effective duration of the involved portfolio of securities was used as a proxy for the market value change under the various interest rate change scenarios. All amounts are in U.S. dollars and are presented in millions.
The Company had $9,126.7 million and $7,836.3 million of reserves for losses and LAE as of December 31, 2005 and December 31, 2004. These amounts are recorded at their nominal or estimated ultimate payment amount, as opposed to fair value, which would reflect a discount adjustment to reflect the time value of money. Since losses are paid out over a period of time, the fair value of the reserves is less than the nominal value. As interest rates rise, the fair value of the reserves decreases and, conversely, if interest rates decline, the fair value will increase. These movements are the opposite of the interest rate impacts on the fair value of investments since reserves are future obligations. While the difference between fair value and nominal value is not reflected in the Company’s financial statements, the Company’ financial results will include investment income over time from the investment portfolio until the claims are paid. The Company’s loss and loss reserve obligations have an expected duration of approximately 3.9 years, which is reasonably consistent with the Company’s fixed income portfolio. If the company were to discount its loss and LAE reserves, net of $1.0 billion of reinsurance receivables on unpaid losses, the discount would be approximately $1.5 billion resulting in a discounted reserve balance of approximately $6.6 billion, representing approximately 57% of the fixed maturity market value. The existence of such obligations, and the variable differential between ultimate and fair value, which in theory applies equally to invested assets and insurance liabilities, provides substantial mitigation of the economic effects of interest rate variability even though such mitigation is not reflected in the Company’s financial statements.
Equity risk is the potential change in market value of the common stock and preferred stock portfolios arising from changing equity prices. The Company’s equity investments are mainly exchange traded and mutual funds, which invest principally in high quality common and preferred stocks that are traded on the major exchanges in the U.S. The primary objective in managing the equity portfolio is to provide long-term capital growth through market appreciation and income.
The tables below display the impact on market value and after-tax unrealized appreciation of a 20% change in equity prices up and down in 10% increments as of December 31, 2005 and 2004. The growth in exposure is primarily due to the growth in the equity portfolio. All amounts are in U.S. dollars and are presented in millions.
After-tax Change in Unrealized Appreciation $ (84.6 ) $ (42.3 ) $ -
Foreign currency rate risk is the potential change in value, income and cash flow arising from adverse changes in foreign currency exchange rates. Each of the Company’s non-U.S./Bermuda (“foreign”) operations maintains capital in the currency of the country of its geographic location consistent with local regulatory guidelines. Generally, the Company prefers to maintain the capital of its operations in U.S. dollar assets, although this varies by regulatory jurisdiction in accordance with market needs. Each foreign operation may conduct business in its local currency, as well as the currency of other countries in which it operates. The primary foreign currency exposures for these foreign operations are the Canadian Dollar, the British Pound Sterling and the Euro. The Company mitigates foreign exchange exposure by a general matching of the currency and duration of its assets to its corresponding operating liabilities. In accordance with Statement of Financial Accounting Standards No. 52 “Foreign Currency Translation”, the Company translates the assets, liabilities and income of non-U.S. dollar functional currency legal entities to the U.S. dollar. This translation amount is reported as a component of other comprehensive income.
The company has sold one specialized equity put option based on the FTSE 100 index for total consideration, net of commissions, of $6.7 million. This contract has an exercise date of July 2020 and a strike price of £5,989.75. No amount will be payable under this contract if the FTSE 100 index is at or above the strike price on the exercise date. If the FTSE 100 index is lower than the strike price on the applicable exercise date, the amount due will vary proportionately with the percentage by which the index is below the strike price. Based on historical index volatilities and trends and the December 31, 2005 index value, the Company estimates the probability for this FTSE 100 index contract being below the strike price on the exercise date to be less than 8.4%. The theoretical maximum payout under the contract would occur if on the exercise date the FTSE 100 index value was zero. The present value of the theoretical maximum payout using a 6.0% discount factor and current exchange rate is $24.2 million.
As these specialized equity put options are derivatives within the framework of FAS 133, the Company reports the fair value of these instruments in its balance sheet and records any changes to fair value in its statement of operations. The Company has recorded fair values for its obligations on these specialized equity put options at December 31, 2005 and 2004 of $36.3 million and $21.5 million, respectively; however, the Company does not
The tables below estimate the impact of potential movements in interest rates and the equity indices, which are the principal factors affecting fair value of these instruments, looking forward from the fair value at December 31, 2005 and 2004. These are estimates and there can be no assurance regarding future market performance. The asymmetrical results of the interest rate and S&P 500 and FTSE 100 indices shift reflect that the liability cannot fall below zero whereas it can increase to its theoretical maximum.
Market Value Change from Base (%) -44.8 % -20.5 % 0.0 % 17.2 % 31.7 %
Market Value Change from Base (%) -24.9 % -11.4 % 0.0 % 9.8 % 18.3 %
Market Value Change from Base (%) -77.4 % -33.7 % 0.0 % 25.7 % 45.0 %
This report contains forward-looking statements within the meaning of the U.S. federal securities laws. The Company intends these forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in the federal securities laws. In some cases, these statements can be identified by the use of forward-looking words such as “may”, “will”, “should”, “could”, “anticipate”, “estimate”, “expect”, “plan”, “believe”, “predict”, “potential” and “intend”. Forward-looking statements contained in this report include information regarding the Company’s reserves for losses and LAE, the adequacy of the Company’s provision for uncollectible balances, estimates of the Company’s catastrophe exposure, the effects of catastrophic events, including the most recent hurricanes, on the Company’s financial statements, the ability of Everest Re, Holdings and Bermuda Re to pay dividends and the settlement costs of the Company’s specialized equity put options. Forward-looking statements only reflect the Company’s expectations and are not guarantees of performance. These statements involve risks, uncertainties and assumptions. Actual events or results may differ materially from the Company’s expectations. Important factors that could cause the Company’s actual events or results to be materially different from the Company’s expectations include those discussed below under the caption Item 1A. “Risk Factors”. The Company undertakes no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.