The following is a discussion of Everest Re Group, Ltd. and its subsidiaries' (the "Company") results of operations and financial condition. This discussion and analysis should be read in conjunction with the consolidated financial statements and the notes thereto presented under ITEM 8.
RESTRUCTURING On February 24, 2000, a corporate restructuring was completed and Everest Re Group, Ltd. ("Group") became the new parent holding company of Everest Reinsurance Holdings, Inc. ("Holdings"), which remains the holding company for Group's U.S. based operations. The "Company" means Group and its subsidiaries, except when referring to periods prior to February 24, 2000, when it means Holdings and its subsidiaries.
In connection with the Mt. McKinley acquisition, Prupac also provided excess of loss reinsurance for 100% of the first $8.5 million of loss with respect to certain of Mt. McKinley's retrocessions and potentially uncollectible reinsurance coverage. There were $2.5 million and $3.6 million of cessions under this reinsurance during the periods ending December 31, 2000 and 2001, respectively, reducing the limit available under the contract to $2.4 million.
During 2000, the Company completed two additional acquisitions, Everest Security Insurance Company ("Everest Security"), formerly known as Southeastern Security Insurance Company, a United States property and casualty company whose primary
RESULTS OF OPERATIONS UNUSUAL LOSS EVENTS. As a result of the terrorist attacks at the World Trade Center, the Pentagon and on various airlines on September 11, 2001 (collectively the "September 11 attacks"), the Company incurred pre-tax losses, based on an estimate of ultimate exposure developed through a review of its coverages, which totaled $213.2 million gross of reinsurance and $55.0 million net of reinsurance. Associated with this reinsurance were $60.0 million of pre-tax charges, predominantly from adjustment premiums, resulting in a total pre-tax loss from the September 11 attacks of $115.0 million. After tax recoveries relating specifically to this unusual loss event, the net loss from the September 11 attacks totaled $75.0 million. Over 90% of the losses ceded were to treaties, where the reinsurers' obligations are secured, which the Company believes eliminates material reinsurance collection risk.
SEGMENT INFORMATION 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 United States. The U.S. Insurance operation writes property and casualty insurance primarily through general agent relationships and surplus lines brokers within the United States. The Specialty Underwriting operation writes accident and health ("A&H"), marine, aviation and
surety business within the United States and worldwide through brokers and directly with ceding companies. The International operation writes property and casualty reinsurance through the Company's branches in Belgium, London, Canada, and Singapore, in addition to foreign "home-office" business. The Bermuda operation writes property, casualty, life and annuity business through brokers and directly with ceding companies.
EXPENSES. Incurred loss and loss adjustment expenses ("LAE") increased by 36.7% to $1,209.5 million in 2001 from $884.6 million in 2000. The increase in incurred losses and LAE was principally attributable to an increase in business volume as reflected by the increase in net premiums earned, the impact of incurred losses relating to the September 11 attacks and the Enron bankruptcy and modest reserve strengthening in select areas, together with the impact of changes in the Company's mix of business. The Enron bankruptcy contributed $34.0 million of unusual losses in 2001 before cessions under the corporate retrocessional program. Incurred losses and LAE include catastrophe losses, which reflect the impact of both current period events and favorable and unfavorable development on prior period events and are net of reinsurance. A catastrophe is an event that causes a pre-tax loss on property exposures of at least $5.0 million and has an event date of January 1, 1988 or later. Catastrophe losses, net of contract specific cessions but before cessions under the corporate retrocessional program in 2001, were $222.6 million, relating principally to the September 11 attacks, tropical storm Alison, the Petrobras Oil Rig loss and the El Salvador earthquake loss, compared to $13.9 million in 2000. Incurred losses and LAE in 2001 reflected ceded losses and LAE of $486.3 million compared to ceded losses and LAE in 2000 of $161.6 million, with the increase principally attributable to cessions relating to the September 11 attack losses and the Enron bankruptcy, together with the increased cessions under specific reinsurance arrangements in the U.S. Insurance operation. The ceded losses and LAE for 2001 reflect $164.0 million of losses ceded under the 2001 accident year aggregate excess of loss component of the Company's corporate retrocessional program. The ceded losses and LAE for 2001 and 2000 reflect $105.0 million and $70.0 million, respectively, of losses ceded under the 1999 accident year aggregate excess of loss component of the Company's corporate retrocessional program with the amounts in both periods reflecting reserve strengthening in select lines, including with respect to 1999 accident year catastrophes.
During 2000 and 2001, the Company added to its product portfolio a small number of credit default swaps, which it no longer offers, and specialized equity put options. 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 transactions in 2001 was $12.2 million.
INCOME TAXES. The Company generated income tax benefits of $8.7 million in 2001 compared to income tax expense of $45.4 million in 2000. This tax benefit primarily resulted from the impact of losses relating to the September 11 attacks, the Enron bankruptcy and realized capital losses recognized in 2001, which reduced taxable income, partially offset by taxable income relating to the non-recurring receipt of shares in connection with a former client's demutualization.
The Company's combined ratio, which is the sum of the loss and expense ratios, decreased by 0.6 percentage points to 102.9% in 2000 compared to 103.5% in 1999. The following table shows the combined ratios for each of the Company's operating segments for 2000 and 1999. The combined ratios for all operations were impacted by the loss and expense ratio variability noted above.
INCOME TAXES. The Company recognized income tax expense of $45.4 million in 2000 compared to $38.5 million in 1999, with the increase mainly attributable to decreased realized capital losses.
NET INCOME. Net income was $186.4 million in 2000 compared to $158.1 million in 1999. This increase generally reflects the decreases in net realized capital losses, together with the improved underwriting and investment results, partially offset by increased interest and income tax expense.
CRITICAL ACCOUNTING POLICY The Company's most critical accounting policy is the determination of its loss and LAE reserves. The Company maintains reserves to cover its estimated ultimate liability for losses and LAE with respect to reported and unreported claims. Because reserves are estimates of ultimate losses and LAE, management monitors reserve adequacy over time, evaluating new information as it becomes known and adjusting reserves, as necessary. Management considers many factors when setting reserves, including: (1) current legal interpretations of coverage and liability; (2) economic conditions; (3) internal actuarial methodologies which analyze the Company's experience with similar cases, information from ceding companies and historical trends, such as reserving patterns, loss payments, pending levels of unpaid claims and product mix; and (4) the uncertainties discussed below regarding reserve requirements for asbestos and environmental claims. Based on these considerations, management believes that adequate provision has been made for the Company's loss and LAE reserves. Actual losses and LAE ultimately paid may deviate, perhaps substantially, from such reserves, impacting income in the period in which the change is made. See also Footnote 1 to Notes to the Consolidated Financial Statements.
environmental claim to involve many insurance providers over many policy periods; (6) long reporting delays, both from insureds to insurance companies and ceding companies to reinsurers; (7) historical data concerning asbestos and environmental losses, which is more limited than historical information on other types of casualty claims; (8) questions concerning interpretation and application of insurance and reinsurance coverage; and (9) uncertainty regarding the number and identity of insureds with potential asbestos or environmental exposure. Management believes that these factors continue to render reserves for asbestos and environmental losses significantly less subject to traditional actuarial methods than are reserves on 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 company. Due to the uncertainties discussed above, the ultimate losses may vary materially from current loss reserves and could have a material adverse effect on the Company's future financial condition, results of operations and cash flows.
The gross and net IBNR reserves for asbestos and environmental exposures increased in 2000. The increase was mainly attributable to Holdings' acquisition of Mt. McKinley in September of 2000. The gross and net IBNR reserves for asbestos and environmental exposures decreased in 2001 and 1999. The decrease resulted primarily from management's belief that there had been not been a material change in the ultimate asbestos and environmental loss exposures. As a result, the reported incurred losses in 2001 were partly offset with corresponding reductions in IBNR reserves and in 1999 were fully offset with corresponding reductions in IBNR reserves.
SHAREHOLDERS' EQUITY. The Company's shareholders' equity increased to $1,720.5 million as of December 31, 2001 from $1,583.4 million as of December 31, 2000 principally reflecting an increase of $86.1 million in retained earnings, an increase of $44.8 million in net unrealized appreciation of investments and $10.0 million in common shares issued during the year in connection with the exercise of stock options. Shareholders' equity increased to $1,583.4 as of
LIQUIDITY AND CAPITAL RESOURCES CAPITAL. The Company's business operations are in part dependent on the Company's financial strength, and the market's perception thereof, as measured by shareholders' equity, which was $1,720.5 million and $1,583.4 million at December 31, 2001 and 2000, respectively. The Company has flexibility with respect to capitalization as the result of its access to the debt and equity markets. The Company continuously monitors its capital and financial position, as well as investment and security market conditions, in general and with respect to the Company's securities, and responds accordingly. On November 7, 2001, the Company filed a shelf registration statement on Form S-3 with the Securities and Exchange Commission, which provided for the issuance of up to $575 million of common equity. On February 27, 2002, pursuant to this registration statement, the Company completed an offering of 5,000,000 of its common shares at a price of $69.25 per share, which resulted in $346.3 million of proceeds before expenses of approximately $0.5 million related to the offering. The Company will use the net proceeds for working capital and general corporate purposes.
LIQUIDITY. The Company's current investment strategy seeks to maximize after-tax income through a high quality, diversified, taxable bond 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 tax position. Additionally, the Company invests in equity securities, which it believes will enhance the risk-adjusted total return of the investment portfolio.
(1) Recoveries under the Company's Stop Loss Agreement with Mt. McKinley prior to the acquisition of Mt. McKinley. (2) The reduction in net tax payments for 2001 generally reflects the tax impact of losses arising from the September 11 attacks, partially offset by a $35.0 million payment in connection with the Company's 1997 tax year liabilities. The $35.0 million payment had no impact on the Company's current year results of operations. (3) Non-recurring receipt of shares in a demutualized insurer.
Proceeds from sales, calls and maturities and investment asset acquisitions were $1,492.2 million and $1,767.4 million, respectively, in 2001 compared to $1,006.5 million and $2,024.6 million, respectively, in 2000 and $941.1 million and $1,068.4 million, respectively, in 1999. Additionally, the cash flow activity in 2000 included $340.1 million of new cash resulting from the acquisitions of Mt. McKinley and Everest International and $450.0 million in proceeds from Holdings' offering of senior notes.
EXPOSURE TO CATASTROPHES. As with other reinsurers, the Company's operating results and financial condition can be adversely affected by volatile and unpredictable natural and other disasters, such as hurricanes, windstorms, earthquakes, floods, fires, explosions and terrorist events. Any such catastrophic event could generate insured losses in one or many of the Company's treaties or lines of business, including property and/or casualty exposures. Although the Company attempts to limit its exposure to acceptable levels, including through the purchase of reinsurance when considered to be cost effective, it is possible that an actual catastrophic event or multiple catastrophic events could have a material adverse effect on the financial condition, results of operations and cash flows of the Company.
experience losses from one or more catastrophic events that exceed, perhaps by a substantial amount, its estimated PML, particularly if such events also give rise to casualty exposures. Nor can there be assurance that the Company's reinsurance program will not change or that it will respond predictably to any given event.
liquidity ratio requirements as determined in accordance with the relevant statutory accounting practices.
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 March 15, 2005. During 2000, the net proceeds of these offerings and additional funds were distributed by Holdings to Group. Interest expense incurred in connection with these senior notes was $38.9 million and $30.9 million at December 31, 2001 and 2000, respectively.
The Credit Facility requires the Company to maintain a debt to capital ratio of not greater than 0.35 to 1, Holdings to maintain a minimum interest coverage ratio of 2.5 to 1 and Everest Re to maintain its statutory surplus at $850.0 million plus 25% of future aggregate net income and 25% of future aggregate capital contributions. The Company was in compliance with these requirements at December 31, 2001.
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 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 credit default swaps and specialized equity options, the market sensitivity of which is believed to be immaterial.
Interest rate risk is the potential change in value of the fixed maturity portfolio due to change in market interest rates. Further, it includes prepayment risk in a declining interest rate environment on the $728.6 million of the $5.6 billion fixed maturity portfolio, which consists of mortgage-backed securities. Prepayment risk results from potential accelerated principal payments that shorten the average life and thus, the expected yield of the security.
The tables below display the potential impact of market value fluctuations and after-tax unrealized appreciation on the fixed maturity portfolio as of December 31, 2001 and 2000 based on parallel 200 basis point shifts in interest rates up
Foreign currency rate risk is the potential change in value, income and cash flow arising from adverse changes in foreign currency exchange rates. The Company's foreign operations each maintain 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 foreign 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 are the Canadian Dollar, the British Pound Sterling and the Euro for these foreign operations. 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 Financial Accounting Standards Board Statement No. 52, 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 primary functional foreign currency exposures are the Canadian Dollar, the Belgian Franc and the British Pound Sterling for these foreign operations.
The tables below display the potential impact of a parallel 20% increase and decrease in foreign exchange rates on the valuation of invested assets subject to foreign currency exposure in 10% increments as of December 31, 2001 and 2000. This analysis includes the after-tax impact of translation from transactional currency to functional currency as well as the after-tax impact of translation from functional currency to the U.S. dollar reporting currency. All amounts are in U.S. dollars and are presented in millions.
RISK FACTORS The following risk factors, in addition to the other information provided in this report, should be considered when evaluating the Company. The risks and uncertainties described below are not the only ones the Company faces. There may be additional risks and uncertainties. If any of the following risks actually occur, the Company's business, financial condition or results of operations could be materially and adversely affected and the trading price of the Company's common shares could decline significantly.
o rising levels of actual costs that are not known by companies at the time they price their products;
o changes in reserves resulting from different types of claims that may arise and the development of judicial interpretations relating to the scope of insurers' liability; and
The Company's success is dependent on its ability to assess accurately the risks associated with the businesses on which the risk is retained. If the Company fails to assess accurately the risks it retains, the Company may fail to establish appropriate premium rates and the Company's reserves may be inadequate to cover its losses, requiring augmentation of the Company's reserves, which in turn, could reduce the Company's net income.
The Company's insurance company subsidiaries, other than Mt. McKinley, currently hold an A+ ("Superior") financial strength rating from A.M. Best Company, an AA- ("Very Strong") financial strength rating from Standard & Poor's Ratings Services and an Aa3 ("Excellent") financial strength rating from Moody's Investors Service, Inc. Financial strength ratings are used by insurers and reinsurance and insurance intermediaries as an important means of assessing the financial strength and quality of reinsurers. In addition, the rating of a company purchasing reinsurance may be adversely affected by an unfavorable rating or the lack of a rating of its reinsurer. A downgrade or withdrawal of any of these ratings might adversely affect the Company's ability to market its insurance products and would have a significant and adverse effect on its future prospects for growth and profitability.
IF THE COMPANY IS UNABLE TO PURCHASE REINSURANCE AND TRANSFER RISK TO REINSURERS, ITS NET INCOME COULD BE REDUCED OR THE COMPANY COULD INCUR A LOSS.
The Company's success has been, and will continue to be, dependent on its ability to retain the services of its existing key executive officers and to attract and retain additional qualified personnel in the future. The loss of the services of any of its key executive officers or the inability to hire and retain other highly qualified personnel in the future could adversely affect the Company's ability to conduct its business. This dependency is particularly important for the Company's Bermuda operations where, under Bermuda law, non-Bermudians, other than spouses of Bermudians, are not permitted to engage in any gainful occupation in Bermuda without a work permit issued by the Bermuda government. A work permit is only granted or extended if the employer can show that, after proper public advertisement, no Bermudian or spouse of a Bermudian, is available who meets the minimum standards for the position. The Bermuda government recently announced a new policy that places a six-year term limit on individuals with work permits, subject to specified exemptions for persons deemed to be key employees.
A significant portion of the Company's investment portfolio consists of fixed income securities and a smaller portion consists of equity securities. Both the fair market value of these assets and the investment income from these assets fluctuate depending on general economic and market conditions. For example, the fair market value of the Company's fixed income securities generally increases or decreases in an inverse relationship with fluctuations in interest rates. The fair market value of the Company's fixed income securities can also decrease as a result of any downturn in the business cycle that causes the credit quality of those securities to deteriorate. The net investment income that the Company realizes from future investments in fixed income securities will generally increase or decrease with interest rates. Interest rate fluctuations can also cause net investment income from investments that carry prepayment risk, such as mortgage-backed and other asset-backed securities, to differ from the income anticipated from those securities at the time the Company bought them. Because all of the Company's securities are classified as available for sale, changes in the market value of the Company's securities are reflected in its financial statements. Similar treatment is not available for liabilities. As a result, a decline in the value of the securities in the Company's portfolio could reduce its net income or cause the Company to incur a loss.
The Company cannot assure that it has or can maintain all required licenses and approvals or that its business fully complies with the wide variety of applicable laws and regulations or the relevant authority's interpretation of the laws and regulations. In addition, some regulatory authorities have relatively broad discretion to grant, renew or revoke licenses and approvals. If the Company does not have the requisite licenses and approvals or do not comply with applicable regulatory requirements, the insurance regulatory authorities could preclude or temporarily suspend the Company from carrying on some or all of its activities or monetarily penalize the Company. These types of actions could have a material adverse effect on the Company's business.
Group is a holding company whose most significant assets consist of the stock of its operating subsidiaries. Thus, the Company's ability to pay dividends on its common shares in the future may be dependent on the earnings and cash flows of the Company's subsidiaries and the ability of the subsidiaries to pay dividends or to advance or repay funds to Group. This ability is subject to general
GROUP AND/OR BERMUDA RE MAY BE SUBJECT TO U.S. CORPORATE INCOME TAX, WHICH WOULD REDUCE THE COMPANY'S NET INCOME.
The income of Bermuda Re is a significant portion of the Company's worldwide income from operations. The Company has established guidelines for the conduct of its Bermuda operations that are designed to ensure that Bermuda Re is not engaged in the conduct of a trade or business in the United States. Based on its compliance with those guidelines, the Company believes that Bermuda Re should not be required to pay U.S. corporate income tax, other than withholding tax on U.S. source dividend income. However, if the IRS successfully contended that
U.S. holders of the Company's common shares generally will not be subject to any U.S. tax until they receive a distribution from Group or dispose of their common shares. However, special provisions of the U.S. Internal Revenue Code of 1986, which the Company refers to in this document as the Code, may apply to U.S. taxpayers who directly, indirectly or by attribution own 10% or more of the total combined voting power of all classes of share capital of Group and/or Bermuda Re. Under these provisions, those taxpayers generally will be required to include in their income their pro rata share of the income of Group and/or Bermuda Re as earned, even if not distributed. The Company has attempted to avoid having its shareholders become subject to these provisions by including in the Company's bye-laws provisions that limit the ownership of the common shares to levels that will not subject U.S. shareholders to U.S. tax on undistributed income under these provisions. Based on these bye-laws, the Company believes that its shareholders should not be subject to U.S. tax on undistributed income. In addition, special provisions of the Code apply to U.S. persons who are
shareholders of a foreign insurance company and have related person insurance income allocated to them. Related person insurance income, often called RPII, is investment income and premium income derived from the direct or indirect insurance or reinsurance of the risk of:
The RPII provisions of the Code could apply to U.S. taxpayers who directly, indirectly or by attribution own any shares of Bermuda Re if:
o 25% or more of the value or voting power of the share capital of Bermuda Re is owned directly, indirectly or by attribution by U.S. taxpayers;
The Company currently believes that less than 20% of the value or voting power of the share capital of Bermuda Re is owned directly, indirectly or by attribution by U.S. taxpayers insured or reinsured by it or persons related to those taxpayers, and/or that less than 20% of the gross insurance income of Bermuda Re for any taxable year will constitute RPII. However, if neither of these conditions is satisfied, since the Company's U.S. shareholders are treated by the Code as indirectly owning shares of Bermuda Re, they will be required to include in their income their pro rata share of Bermuda Re's RPII as earned, even if not distributed.
its being considered a tax haven. In January 2002, the government of Barbados announced a similar agreement with the OECD.
Bermuda Re is subject to an excise tax on reinsurance and insurance premiums it collects with respect to risks located in the United States. In addition, Bermuda Re may be subject to withholding tax on dividend income from United States sources. These taxes could increase and other taxes could be imposed in the future on Bermuda re's business, which could reduce the Company's net income.
Bermuda Re does not intend to be licensed or admitted as an insurer or reinsurer in any U.S. jurisdiction. Under current law, Bermuda Re generally will be permitted to reinsure U.S. risks from its office in Bermuda without obtaining those licenses. However, the insurance and reinsurance regulatory framework has become subject to increased scrutiny. In the past, there have been congressional and other initiatives in the United States regarding increased supervision and regulation of the insurance industry, including proposals to supervise and
regulate reinsurers domiciled outside the United States. If Bermuda Re were to become subject to any insurance laws of the United States or any U.S. state at any time in the future, it might be required to post deposits or maintain minimum surplus levels and might be prohibited from engaging in lines of business or from writing types of policies. Complying with those laws could have a material adverse effect on the Company's ability to conduct business in the Bermuda market.
As Bermuda Re's business develops, it will monitor the need to obtain licenses in jurisdictions other than Bermuda in order to comply with applicable law or to be able to engage in additional insurance-related activities. In addition, Bermuda Re may be at a competitive disadvantage in jurisdictions where it is not licensed or does not enjoy an exemption from licensing relative to competitors that are so licensed or exempt from licensing. Bermuda Re may not be able to obtain any additional licenses that it determines are necessary or desirable. Furthermore, the process of obtaining those licenses is often costly and may take a long time.
Many jurisdictions do not permit insurance companies to take credit for reinsurance obtained from unlicensed or non-admitted insurers on their statutory financial statements without appropriate security. Bermuda Re's reinsurance clients typically require it to post a letter of credit or enter into other security arrangements. If Bermuda Re is unable to obtain or maintain a letter of credit facility on commercially acceptable terms or unable to arrange for other types of security, its ability to operate its business may be severely limited. If Bermuda Re defaults on any letter of credit that it obtains, it may be required to prematurely liquidate a substantial portion of its investment portfolio and other assets pledged as collateral.
SECURITY HOLDERS MAY NOT BE ABLE TO RECOVER DAMAGES FROM THE COMPANY AND SOME OF ITS DIRECTORS, OFFICERS AND EXPERTS NAMED IN THIS REPORT.