We currently lease office space in Hamilton, Bermuda where our executive and principal offices are located and in Charlotte, North Carolina, George Town, Grand Cayman and Dallas, Texas. Our life reinsurance business operates out of the Charlotte and Bermuda offices while our wealth management business operates out of the Grand Cayman and Dallas offices. The Grand Cayman lease expires in 2006 and the Bermuda, Charlotte and Dallas leases expire in 2005.
World-Wide Holdings maintains premises in Windsor, England. The Windsor lease expired in October 2001 and is currently being renegotiated.
Premiums from reinsurance assumed on life business are included in revenues over the premium paying period of the underlying policies. When we acquire blocks of in-force business, we account for these transactions as purchases, and our results of operations include the net income from these blocks as of their respective dates of acquisition. Reinsurance assumed on annuity business does not generate premium income but generates investment income over time on the assets we receive from the ceding company.
A portion of the costs of acquiring new business, such as commissions, certain internal expenses related to our policy issuance and underwriting departments and some variable selling expenses are capitalized. The resulting deferred acquisition costs asset is amortized over future periods based on our expectations as to the emergence of future gross profits from the underlying contracts. These costs are dependent on the structure, size and type of business written. For certain products, we may retrospectively adjust our amortization when we revise our estimate of current or future gross profits to be realized. The effects of this adjustment are reflected in earnings in the period in which we revise our estimate.
We seek to generate profits from three principal sources. First, in our life reinsurance business, we seek to receive reinsurance premiums and financial reinsurance fees that, together with income from the assets in which those premiums are invested, exceed the amounts we ultimately pay as claims and policy benefits, acquisition costs and ceding commissions. Second, in our wealth management business, we seek to generate fee income that will exceed the expenses of maintaining and administering our variable life insurance and variable annuity products. Third, within our investment guidelines, we seek to maximize the return on our unallocated capital.
- our ability to assess and price adequately for the risks we assume;
Net operating earnings increased 34% to $21.6 million in 2001 from $16.2 million in 2000, which was a 41% increase from $11.5 million in 1999.
Revenues increased by $35.5 million or 42% to $119.5 million in 2001 and by $61.5 million or 274% to $83.9 million in 2000 from $22.5 million in 1999. The increases are primarily due to growth in our life reinsurance operations and an increase in investment income due to the increase in our invested assets resulting from new business.
We earn life reinsurance fees on our financial reinsurance treaties that do not qualify under risk transfer rules for reinsurance accounting.
(1) Investment performance for the period is determined using actual asset valuations where available and estimates where actual data is not available.
Claims and other policy benefits increased by 117% to $51.2 million in 2001 from $23.6 million in 2000 and from $1.7 million in 1999 as a result of the increased number of clients and the increase in business from these clients, together with active management of existing treaties. In 2001, we recorded net claims totaling $750,000 in relation to the World Trade Center and Pentagon attacks on September 11, 2001. Gross claims in relation to these attacks were $816,000 of which $66,000 is recoverable under our catastrophe insurance coverage.
Operating expenses decreased to $9.3 million in 2001 from $9.9 million in 2000 due to the inclusion in 2000 of $0.9 million of non-recurring employee expenses relating to four employees including severance, recruiting and relocation expenses, and more costs being allocated in 2001 to acquisition expenses as they relate to marketing, underwriting and policy and treaty issuance. Expenses increased to $9.9 million in 2000 from $4.5 million in 1999 as a result of increased reinsurance activity including the acquisition of Scottish Re (U.S.), Inc.
We incurred interest expense for the first time in the year ended December 31, 2001 amounting to $1.4 million, reflecting the use of borrowings in 2001 as described in Note 2 to the consolidated financial statements.
The 2001 income tax expense includes taxes on the earnings of Scottish Re (U.S.), Inc., Scottish Annuity & Life International Insurance Company (Bermuda) Ltd. and Scottish Re (Dublin) Limited, which are offset by a release of capital loss carry-forwards. The tax benefits in 2000 and 1999 are related to the earnings of Scottish Re (U.S.), Inc. only, offset by a release of valuation allowances related to capital loss carry-forwards. An analysis of income taxes and movements in deferred taxes appears in Note 14 to the consolidated financial statements.
We now own 100% of Scottish Annuity & Life Holdings (Bermuda) Limited (formerly Scottish Crown Group (Bermuda) Ltd.). In July 2001, we acquired the remaining 49.99% of Scottish Annuity & Life Holdings (Bermuda) Limited that we did not own, and thereby eliminated the minority interest position and certain intangible assets. Prior to July 2001, our ownership in Scottish Annuity & Life Holdings (Bermuda) Limited was 50.01%. Minority interest income represents the minority owner's share of the loss recorded by Scottish Annuity & Life Holdings (Bermuda) Limited prior to July 2001.
Financial Reporting Release No. 60, which was recently released by the SEC, requires all companies to include a discussion of critical accounting policies or methods used in the preparation of financial statements. Note 2 to the consolidated financial statements includes a summary of the significant accounting policies and methods used in the preparation of our consolidated financial statements.
SFAS 60 applies to traditional life policies with continuing premiums. For these policies, future benefits are estimated using a net level premium method on the basis of actuarial assumptions as to mortality, persistency and interest established at policy issue. Assumptions established at policy issue as to mortality and persistency are based on anticipated experience, which, together with interest and expense assumptions, provide a margin for adverse deviation. Acquisition costs are deferred and recognized as expense in a constant percentage of the gross premiums using these assumptions established at issue. Should the liabilities for future policy benefits plus the present value of expected future gross premiums for a product be insufficient to provide for expected future benefits and expenses for that product, deferred acquisition costs will be written off and thereafter, if required, a premium deficiency reserve will be established by a charge to income. Changes in the assumptions for mortality, persistency and interest could result in material changes to the financial statements.
SFAS 97 applies to investment contracts, limited premium contracts, and universal life-type contracts. For investment and universal life-type contracts, future benefit liabilities are held using the retrospective deposit method, increased for amounts representing unearned revenue or refundable policy charges. Acquisition costs are deferred and recognized as expense as a constant percentage of gross margins using assumptions as to mortality, persistency, and expense established at policy issue without provision for adverse deviation and are revised periodically to reflect emerging actual experience and any material changes in expected future experience. Liabilities and the deferral of acquisition costs are established for limited premium policies under the same practices as used for traditional life policies with the exception that any gross premium in excess of the net premium is deferred and recognized into income as a constant percentage of insurance in force. Should the liabilities for future policy benefits plus the present value of expected future gross premiums for a product be insufficient to provide for expected future benefits and expenses for that product, deferred acquisition costs will be written off and thereafter, if required, a premium deficiency reserve will be established by a charge to income. Changes in the assumptions for mortality, persistency, maintenance expense and interest could result in material changes to the financial statements.
Present value of in-force business is established upon the acquisition of a subsidiary and is amortized over the expected life of the business at the time of acquisition. The amortization each year will be a function of the gross profits or revenues each year in relation to the total gross profits or revenues expected over the life of the business, discounted at the assumed net credit rate. The determination of the initial value and the subsequent amortization require management to make estimates and assumptions regarding future business results that could differ materially from actual results. Estimates and assumptions involved in the present value of in-force business and subsequent amortization are similar to those necessary in the establishment of reserves and amortization of deferred acquisition costs.
Intangible assets consist of goodwill that is established upon the acquisition of a subsidiary. Goodwill is calculated as the difference between the price paid and the value of individual assets and liabilities on the date of acquisition. Goodwill has been amortized on a straight line basis over its estimated useful life and is reviewed periodically for impairment. In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets, effective for fiscal years beginning after December 15, 2001. Under
the new rules, goodwill and intangible assets deemed to have indefinite lives will no longer be amortized but will be subject to annual impairment tests in accordance with the Statements. We will apply the new rules on accounting for goodwill and other intangible assets beginning in the first quarter of fiscal 2002. During fiscal 2002, we will perform the first of the required impairment tests of goodwill and have not yet determined what the effect of these tests will be on our earnings and financial position.
At December 31, 2001, funds withheld at interest totaled $562.4 million with an average rating of "A-," an average duration of 6.0 years and an average book yield of 6.8%. These are fixed income investments associated with modified coinsurance transactions and include traded securities, marketable securities, commercial mortgages and private placements.
We generated operating cash flow of $44.3 million in 2001, compared to $77.0 million in 2000 and $108.7 million in 1999. Operating cash flow includes $107.4 million, $79.5 million and $106.4 million of funds received in connection with the acquisition of blocks of reinsurance during 2001, 2000 and 1999, which are not reflected in the consolidated statements of income. These acquisitions are explained in more detail in Note 9 to the consolidated financial statements. The decrease in operating cash flow from 2000 to 2001 is primarily due to an increase in benefits and expenses paid of $99.8 million, offset in part by an increase in reinsurance premiums and fees received of $31.0 million, an increase in investment income received of $7.2 million and an increase of $27.7 million in the amount received on acquisition of blocks of reinsurance. The decrease in operating cash flow from 1999 to 2000 is primarily due to the decrease of $26.9 million in the amount received on acquisition of blocks of reinsurance and an increase in benefits and expenses paid of $43.0 million, offset in part by an increase in reinsurance premiums and fees received of $19.0 million and an increase in investment income received of $21.0 million. Our cash flow from operations may be positive or negative in any period depending on the amount of new life reinsurance business written, the level of ceding commissions paid in connection with writing that business and the level of renewal premiums earned in the period.
At December 31, 2001, total capitalization was $331.3 million ($239.6 million in 2000 and $218.7 million in 1999). The increase in capitalization at December 31, 2001 is a result of earnings for the year, less dividends paid, plus the issuance of 4,532,380 ordinary shares with a value of $78.0 million in respect of the acquisition of World-Wide Holdings on December 31, 2001, less the repurchase of 100,000 ordinary shares for a total of $1.5 million during the year.
Pursuant to stock repurchase programs approved by our Board of Directors, we repurchased 2,529,700 ordinary shares for $25.0 million in 1999, 432,500 ordinary shares for $3.8 million in 2000 and 100,000 ordinary shares for $1.5 million in 2001. Since our initial public offering in November 1998, we have repurchased a total of 3,062,200 ordinary shares at a cost of $30.3 million.
We have in place a credit facility with a U.S. bank that provides up to $70 million in the form of borrowings or outstanding letters of credit. Under the agreement, we may borrow at a predetermined spread of 40 basis points over LIBOR. The agreement expires in April 2002, at which time the borrowings become due. At December 31, 2001 we have $40 million of borrowings under this agreement and no letters of credit outstanding. The agreement requires that we pledge assets as collateral with a market value not less than 111% of the sum of outstanding borrowings and letters of credit.
We also have borrowed $25.1 million under a reverse repurchase agreement with a major broker/ dealer. Under this agreement, we have sold agency mortgage backed securities with the agreement to repurchase them at a fixed price, providing the dealer with a spread that equates to an effective borrowing cost linked to one-month LIBOR. This agreement is renewable monthly at the discretion of the broker/ dealer.
In addition, Scottish Annuity & Life Insurance Company (Cayman) Ltd. and Scottish Holdings have agreed with World-Wide Reassurance that in the event World-Wide Reassurance is unable to meet its obligations under its insurance or reinsurance agreements, Scottish Annuity & Life Insurance Company (Cayman) Ltd. (or if Scottish Annuity & Life Insurance Company (Cayman) Ltd. cannot fulfill such obligations, then Scottish Holdings) will assume all of World-Wide Reassurance's obligations under such agreements.
While we believe that we have sufficient assets available in the short term to support our letter of credit needs, we may need to raise additional capital and/or find alternative assets or unsecured letters of credit to continue to grow.
We expect that our cash and investments, together with cash generated from our businesses, will provide sufficient sources of liquidity to meet our current needs. However, if our business continues to grow significantly, we will need to raise additional capital.
We have no obligations, assets or liabilities other than those disclosed in the financial statements forming part of this Form 10-K; no trading activities involving non-exchange traded contracts accounted for at fair value; and no relationships and transactions with persons or entities that derive benefits from their non-independent relationship with us or our related parties.
We will apply the new rules on accounting for goodwill and other intangible assets beginning in the first quarter of fiscal 2002. Application of the non-amortization provisions of the Statement is expected to result in an increase in net income of approximately $45,000 for fiscal 2002. During fiscal 2002, we will perform the first of the required impairment tests of goodwill and have not yet determined what the effect of these tests will be on our earnings and financial position.
- risks arising from our investment strategy, including risks related to the market value of our investments, fluctuations in interest rates and our need for liquidity;
- the risk that our retrocessionaires may not honor their obligations to us;
- loss of the services of any of our key employees;
- developments in global financial markets that could affect our investment portfolio and fee income.