PROPERTIES Everest Re's corporate offices are located in approximately 112,000 square feet of leased office space in Liberty Corner, New Jersey. The Company's other thirteen locations occupy a total of approximately 67,000 square feet, all of which are leased. Management believes that the above-described office space is adequate for its current and anticipated needs.
The following is a discussion of the results of operations and financial condition of Everest Reinsurance Holdings, Inc. and its subsidiaries (the "Company"). This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and the Notes thereto presented under ITEM 8.
ACQUISITIONS On September 19, 2000, the Company completed the acquisition of all of the issued and outstanding capital stock of Gibraltar Casualty Company ("Gibraltar") from The Prudential Insurance Company of America ("The Prudential") for $51.8 million, which approximated book value. As a result of the acquisition, Gibraltar became a wholly owned subsidiary of the Company and, immediately following the acquisition, its name was changed to Mt. McKinley Insurance Company ("Mt. McKinley"). In connection with the acquisition of Mt. McKinley, which has significant exposure to asbestos and environmental claims, Prudential Property and Casualty Insurance Company ("Prupac"), a subsidiary of The Prudential, provided reinsurance to Mt. McKinley covering 80% ($160.0 million) of the first $200.0 million of any adverse development of Mt. McKinley's reserves as of September 19, 2000 and The Prudential guaranteed Prupac's obligation to Mt. McKinley. There were $22.2 million of cessions under this reinsurance at December 31, 2001, reducing the limit available under this contract to $137.8 million.
Mt. McKinley, a run-off property and casualty insurer in the United States, has had a long relationship with the Company and its principal operating company, Everest Reinsurance Company ("Everest Re"). Mt. McKinley was formed in 1978 by Everest Re and wrote insurance until 1985, when it was placed in run-off. In 1991, Mt. McKinley became a subsidiary of The Prudential. Mt. McKinley is also a reinsurer of Everest Re. Under a series of transactions dating to 1986, Mt.
consolidation and increased capital levels in the insurance and reinsurance industries, as well as the emergence of new reinsurance and financial products addressing traditional exposures in alternative fashions. Many of these factors continue to exist. As a result, although the Company is encouraged by the recent improvements, and more generally, current market conditions, the Company cannot predict with any reasonable certainty whether and to what extent these improvements will persist.
Ceded premiums increased to $432.9 million in 2001 from $166.7 million in 2000. This increase was principally attributable to $123.2 million of ceded premiums in 2001 relating to an arm's-length loss portfolio reinsurance transaction, whereby the Company transferred the net exposures and reserves of its Belgium branch to Bermuda Re. In addition, ceded premiums in 2001 also reflect $81.3 million of adjustment premiums incurred under the 2001 accident year aggregate excess of loss element of the Company's corporate retrocessional program relating to losses incurred as a result of the September 11 attacks and the Enron bankruptcy. In addition, ceded premiums for 2001 and 2000 also include adjustment premiums of $58.1 million and $35.2 million, respectively, relating to claims made under the 1999 accident year aggregate excess of loss element of the Company's corporate retrocessional program. The increase in ceded premiums in 2001 also reflects the impact on the U.S. Insurance operation's specific reinsurance protections resulting from this unit's volume increase.
PREMIUM REVENUES. Net premiums earned increased by 14.7% to $1,333.5 million in 2001 from $1,162.6 million in 2000. Contributing to this increase were a 189.7% ($192.6 million) increase in the U.S. Insurance operation, a 22.9% ($69.2 million) increase in the Specialty Underwriting operation and a 5.5% ($26.0 million) increase in the U.S. Reinsurance operation. These increases were partially offset by a 40.8% ($116.9 million) decrease in the International operation principally attributable to $122.3 million relating to the reinsurance transaction between the Company and Bermuda Re noted earlier. All of these changes reflect period to period variability in gross written and ceded 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 and earnings and 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.
Contributing to the increase in incurred losses and LAE in 2001 from 2000 were a 200.7% ($141.0 million) increase in the U.S. Insurance operation principally reflecting increased premium volume, a 41.5% ($131.9 million) increase in the U.S. Reinsurance operation, principally reflecting losses in connection with the September 11 attacks and tropical storm Alison and a 30.1% ($76.5 million) increase in the Specialty Underwriting operation principally attributable to increased premium volume in A&H medical stop loss business together with marine,
aviation and surety losses relating to the September 11 attacks, the Enron bankruptcy and the Petrobras Oil Rig loss event. These increases were partially offset by a 62.9% ($148.5 million) decrease in the International operation principally attributable to $119.4 million relating to the reinsurance transaction between the Company and Bermuda Re noted earlier, and to more favorable loss experience. Incurred losses and LAE for each operation were also impacted by variability relating to changes in the level of premium volume and mix of business by class and type.
The Company's loss and LAE ratio ("loss ratio"), which is calculated by dividing incurred losses and LAE by premiums earned, increased by 5.4 percentage points to 80.9% in 2001 from 75.5% in 2000 reflecting the incurred losses and LAE discussed above. The following table shows the loss ratios for each of the Company's operating segments for 2001 and 2000. The loss ratios for all operations were impacted by the expense factors noted above, the impact on ceded premiums of adjustment premiums under the Company's corporate retrocessional program.
Underwriting expenses increased by 41.3% to $448.9 million in 2001 from $317.7 million in 2000. Commission, brokerage, taxes and fees increased by $126.2 million, principally reflecting increases in premium volume and changes in the mix of business. In addition, in 2000, the Company's reassessment of the expected losses on a multi-year reinsurance treaty led to a $33.8 million decrease in contingent commissions with a corresponding increase to losses. Other underwriting expenses increased by $5.0 million as the Company has expanded its business volume and operations. Contributing to the underwriting expense increase were a 122.7% ($45.6 million) increase in the U.S. Insurance operation, mainly relating to the increased premium volume, a 70.8% ($68.0 million) increase in the U.S. Reinsurance operation, which included the impact of the contingent commission adjustment noted above and a 22.5% ($19.8 million) increase in the Specialty operation. These increases were partially offset by a 0.2% ($1.9 million) decrease in the International operation. Except as noted, 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, the underwriting performance of the underlying business. The Company's expense ratio, which is calculated by dividing underwriting expenses by premiums earned, increased by 6.4 percentage points to 33.7% in 2001 compared to 27.3% in 2000.
INVESTMENTS. Net investment income decreased by 0.2% to $265.9 million in 2001 from $271.4 million in 2000, principally reflecting the effect of investing the $303.8 million of cash flow from operations in 2001, offset by the lower interest rate environment and increased interest expense on funds held relating to the utilization of the 1999 and 2001 accident year aggregate excess of loss elements of the corporate retrocessional program. The following table shows a comparison of various investment yields as of December 31, 2001 and 2000, respectively, and for the periods then ended.
Interest expense was $46.0 million for 2001 compared to $39.4 million in 2000. Interest expense for 2001 reflects $38.9 million relating to the Company's senior notes issued on March 14, 2000 and $7.1 million relating to the company's borrowing under its revolving credit facility. Interest expense for 2000 reflects $30.9 million relating to the Company's issuance of senior notes and $8.5 million relating to the Company's borrowing under its revolving credit facility.
NET INCOME. Net income was $38.3 million in 2001 compared to $158.5 million in 2000. This decrease generally reflects the losses attributable to the September 11 attacks and the Enron bankruptcy, partially offset by improved investment results and the non-recurring receipt of shares in connection with a former client's demutualization.
THE COMPANY'S INABILITY TO ASSESS UNDERWRITING RISK ACCURATELY COULD REDUCE ITS NET INCOME.
The Company's industry is highly competitive and has experienced severe price competition over the last several years. The Company competes in the United States and international markets with domestic and international insurance companies. Some of these competitors have greater financial resources than the Company, have been operating for longer 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 Company expects to face further competition in the future. The Company may not be able to compete successfully in the future.
THE VALUE OF THE COMPANY'S INVESTMENT PORTFOLIO AND THE INVESTMENT INCOME IT RECEIVES FROM THAT PORTFOLIO COULD DECLINE AS A RESULT OF MARKET FLUCTUATIONS AND ECONOMIC CONDITIONS.