The following selected consolidated GAAP financial data of the Company as of and for the years ended December 31, 2002, 2001, 2000, 1999 and 1998 were derived from the consolidated financial statements of the Company, which were audited by PricewaterhouseCoopers LLP. The following financial data should be read in conjunction with the Consolidated Financial Statements and accompanying notes.
- ------------ (1) Catastrophe losses are net of reinsurance. A catastrophe is defined, for purposes of the Selected Consolidated Financial Data, as an event that causes a pre-tax loss on property exposures before reinsurance of at least $5.0 million and has an event date of January 1, 1988 or later. (2) Some amounts may not reconcile due to rounding. (3) Based on weighted average basic shares outstanding of 50.3 million, 46.2 million, 45.9 million, 48.5 million and 50.4 million for 2002, 2001, 2000, 1999 and 1998, respectively. (4) Based on weighted average diluted shares outstanding of 51.1 million, 47.1 million, 46.4 million, 48.7 million and 50.7 million for 2002, 2001, 2000, 1999 and 1998, respectively. (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. (6) Based on 50.9 million, 46.3 million, 46.0 million, 46.5 million and 50.0 million shares outstanding for December 31, 2002, 2001, 2000, 1999 and 1998, respectively.
During 2002, the reinsurance and insurance markets continued to firm. This firming reflects the losses arising from the September 11 attacks as well as reactions to broad and growing recognition that competition in the late 1990s reached extremes in many classes and markets, which ultimately led to inadequate pricing and overly broad terms, conditions and coverages. The effect of these extremes, which is becoming apparent through excessive loss emergence, varies widely by company depending on product offerings, markets accessed, underwriting and operating practices, competitive strategies and business volumes. Across all market participants however, the aggregate effect has been impaired financial results and erosion of the industry capital base. Coupled with deteriorating investment market conditions and results, and renewed concerns regarding longer-term industry specific issues, including asbestos exposure and sub-par capital returns, these financial impacts have introduced substantial, and in some cases extreme, pressure for the initiation and/or strengthening of corrective action by individual market participants. These pressures have resulted in firming prices, more restrictive terms and conditions and tightened coverage availability across most classes and markets.
These changes reflect a clear reversal of the general trend from 1987 through 1999 toward increasingly competitive global market conditions across most lines of business as reflected by decreasing prices and broadening contract terms. The earlier trend resulted from a number of factors, including the emergence of significant reinsurance capacity in Bermuda, changes in the Lloyd's market, 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 and have taken on additional importance as the result of the firming conditions which have emerged. As a result, although the Company is encouraged by the recent improvements and, more generally, by current market conditions, the Company cannot predict with any reasonable certainty whether and to what extent these improvements will persist.
As a result of the Enron bankruptcy in 2001, the Company incurred losses, after-tax and net of reinsurance, amounting to $25.0 million. This unusual loss reflects all of the Company's exposures to this event, including underwriting, credit and investment.
YEAR ENDED DECEMBER 31, 2002 COMPARED TO YEAR ENDED DECEMBER 31, 2001 Premiums. Gross premiums written increased 51.8% to $2,846.5 million in 2002 from $1,874.6 million in 2001, as the Company took advantage of selected growth opportunities and improving pricing in many classes of business, while continuing to maintain a disciplined underwriting approach. Premium growth areas included a 303.8% ($76.0 million) increase in the Bermuda operation, which continues to expand its product line offerings, a 67.6% ($218.1 million) increase in the International operation, mainly attributable to growth in the London, Canadian and Latin American markets, a 63.5% ($319.1 million) increase in the U.S. Insurance operation, principally attributable to growth in worker's compensation insurance, a 46.5% ($284.1 million) increase in the U.S. Reinsurance operation, primarily reflecting growth across property and casualty lines, and an 18.0% ($74.6 million) increase in the Specialty Underwriting operation, mainly attributable to growth in marine, aviation and surety business. The Company continued to decline business that did not meet its objectives regarding underwriting profitability.
Ceded premiums decreased to $208.9 million in 2002 from $314.5 million in 2001. This decrease was principally attributable to a reduction in cessions made under the Company's corporate retrocessional program and to a decrease in ceded premiums in the U.S. Insurance operation as a result of changes in this segment's specific reinsurance programs. Ceded premiums in 2002 included $5.1 million and $49.4 million in adjustment premiums relating to claims made under the 2001 and 2000 accident year aggregate excess of loss elements of the Company's corporate retrocessional programs, respectively. Ceded premiums in 2001 included $81.3 million and $58.1 million in adjustment premiums relating to claims made under the 2001 and 1999 accident year aggregate excess of loss elements of the Company's corporate retrocessional programs, respectively, with the 2001 accident year cessions principally relating to losses incurred as a result of the September 11 attacks and Enron bankruptcy.
PREMIUM REVENUES. Net premiums earned increased by 54.9% to $2,273.7 million in 2002 from $1,467.5 million in 2001. Contributing to this increase were a 154.4% ($25.3 million) increase in the Bermuda operation, a 94.8% ($278.8 million) increase in the U.S. Insurance operation, a 64.4% ($185.1 million) increase in the International operation, a 46.0% ($228.8 million) increase in the U.S. Reinsurance operation and a 23.7% ($88.2 million) increase in the Specialty Underwriting operation. 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.
EXPENSES. Incurred loss and loss adjustment expenses ("LAE") increased by 34.7% to $1,629.4 million in 2002 from $1,209.5 million in 2001. The increase in incurred losses and LAE was principally attributable to the increase in net premiums earned and modest reserve strengthening in select areas, most notably in directors and officers liability, surety and workers' compensation lines, and with respect to asbestos exposures, partially offset by lower catastrophe losses and improvements in rates, terms and conditions in many classes of business, as well as the impact of changes in the Company's mix of business. Incurred losses and LAE include catastrophe losses, which reflect the impact both of 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, were $30.2 million in 2002, principally relating to European flood losses and Hurricanes Isidore and Kenna, compared to net catastrophe losses of $222.6 million in 2001, which was principally related to the September 11 attacks. Incurred losses and LAE in 2002 reflected ceded losses and LAE of $287.7 million compared to ceded losses and LAE in 2001 of $486.3 million. The ceded losses and LAE in 2002 included $11.0 million and $90.0 million of losses ceded under the 2001 and 2000 accident year aggregate excess of loss components of the Company's corporate retrocessional program, respectively. The ceded losses and LAE in 2001 included $164.0 million and $105.0 million of losses ceded under the 2001 and 1999 accident year aggregate excess of loss components of the Company's corporate
The Company's loss and LAE ratio ("loss ratio"), which is calculated by dividing incurred losses and LAE by premiums earned, decreased by 10.7 percentage points to 71.7% in 2002 from 82.4% in 2001, reflecting the earned premium and incurred losses and LAE discussed above. The following table shows the loss ratios for each of the Company's operating segments for 2002 and 2001. The loss ratios for all operations were impacted by the expense factors noted above as well as by the impact on ceded premiums of the adjustment premiums under the Company's corporate retrocessional program.
The Company's combined ratio, which is the sum of the loss and expense ratios, decreased by 14.5 percentage points to 99.0% in 2002 compared to 113.5% in 2001.
The following table shows the combined ratios for each of the Company's operating segments for 2002 and 2001. The combined ratios for all operations were impacted by the loss and expense ratio variability noted above as well as by the impact on ceded premiums of the adjustment premiums under the Company's corporate retrocessional program.
INVESTMENTS. Net investment income increased by 3.0% to $350.6 million in 2002 from $340.4 million in 2001, principally reflecting the effect of investing the $736.1 million of cash flow from operations in 2002, $346.3 million of net proceeds from the offering of common shares in February 2002 and $203.4 million of net proceeds from Everest Re Capital Trust's ("Capital Trust") issuance of trust preferred securities in November 2002, partially offset by the lower interest rate environment. The following table shows a comparison of various investment yields as of December 31, 2002 and 2001, respectively, and for the periods then ended.
Interest expense was $42.4 million for 2002 compared to $46.0 million for 2001. Interest expense for 2002 reflects $38.9 million relating to Holdings' senior notes and $3.5 million relating to Holdings' borrowing under its revolving credit facility. Interest expense for 2001 reflects $38.9 million relating to Holdings' senior notes and $7.1 million relating to Holdings' borrowing under its revolving credit facility. In addition, 2002 includes incurred expense of $2.1 million for distributions on Capital Trust's trust preferred securities.
operation and the amortization of deferred expenses relating to Holdings' issuance of senior notes and Capital Trust's issuance of trust preferred securities, partially offset by fee income. Other income for 2001 includes $25.9 million arising from a non-recurring receipt of shares in connection with the demutualization of a former insurance company client that had issued annuities to the Company in connection with certain claim settlement transactions. In addition, other income for 2001 includes foreign exchange gains as well as fee income, offset by the amortization of deferred expenses relating to Holdings' issuance of senior notes.
The Company has a small number of credit default swaps, which it no longer writes, and specialized equity put options in its product portfolio. 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 in 2002, essentially reflecting changes in fair value, was $14.5 million, principally relating to the specialized equity put options, compared to $12.2 million in 2001, principally relating to the credit default swaps. Net after tax exposure remaining on the credit default agreements is $3.1 million. See also Footnote 2 to Notes to the Consolidated Financial Statements.
NET INCOME. Net income was $231.3 million in 2002 compared to $99.0 million in 2001. This increase generally reflects the improved underwriting and investment results, partially offset by increased tax expense, realized capital losses, derivative expense and a reduction in other income.
Net premiums written increased by 28.0% to $1,560.1 million in 2001 from $1,218.9 million in 2000. This increase was a result of the increase in gross premiums written and the increase in ceded premiums.
PREMIUM REVENUES. Net premiums earned increased by 25.0% to $1,467.5 million in 2001 from $1,174.2 million in 2000. Contributing to this increase were a 189.7% ($192.6 million) increase in the U.S. Insurance operation, a 41.6% ($4.8 million) increase in the Bermuda operation, a 22.9% ($69.2 million) increase in the Specialty Underwriting operation, a 5.5% ($26.0 million) increase in the U.S. Reinsurance operation and a 0.2% ($0.7 million) increase in the International operation. 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.
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. These increases were partially offset by a 14.1% ($33.3 million) decrease in the International operation, principally due 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 7.1 percentage points to 82.4% in 2001 from 75.3% 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 as well as by the impact on ceded premiums of the adjustment premiums under the Company's corporate retrocessional program.
Underwriting expenses increased by 40.6% to $455.7 million in 2001 from $324.1 million in 2000. Commission, brokerage, taxes and fees increased by $124.4 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 $7.3 million as the Company 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 29.0% ($1.7 million) decrease in the Bermuda operation and a 1.5% ($1.4 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 3.5 percentage points to 31.1% in 2001 compared to 27.6% in 2000.
The Company's combined ratio, which is the sum of the loss and expense ratios, increased by 10.6 percentage points to 113.5% in 2001 compared to 102.9% in 2000. The following table shows the combined ratios for each of the Company's operating segments for 2001 and 2000. The combined ratios for all operations were impacted by the loss and expense ratio variability noted above as well as by the impact on ceded premiums of the adjustment premiums under the Company's corporate retrocessional program.
During 2000 and 2001, the Company added to its product portfolio a small number of credit default swaps, which it no longer writes, and specialized equity put options. These products meet the definition of a derivative under FAS 133. Net derivative expense from these transactions in 2001 was $12.2 million.
NET INCOME. Net income was $99.0 million in 2001 compared to $186.4 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.
CRITICAL ACCOUNTING POLICIES LOSS AND LAE RESERVES. 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) its exposure base, generally its earned premiums; (2) its expected loss ratios on current year writings as determined through extensive interaction between its underwriters and actuaries by product and class categories (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; (4) current legal interpretations of coverage and liability; (5) economic conditions; and (6) 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.
uncertainties in estimating the amount of the Company's potential losses from A&E claims. Among the complications are: (a) potentially long waiting periods between exposure and manifestation of any bodily injury or property damage; (b) difficulty in identifying sources of A&E contamination; (c) difficulty in properly allocating responsibility and/or liability for A&E damage; (d) changes in underlying laws and judicial interpretation of those laws; (e) potential for an A&E claim to involve many insurance providers over many policy periods; (f) long reporting delays, both from insureds to insurance companies and ceding companies to reinsurers; (g) historical data on A&E losses, which is more limited and variable than historical information on other types of casualty claims; (h) questions concerning interpretation and application of insurance and reinsurance coverage; and (i) uncertainty regarding the number and identity of insureds with potential A&E exposure.
REINSURANCE RECEIVABLE. The Company utilizes reinsurance agreements to reduce its exposure to large claims and catastrophic loss occurrences. These agreements provide for recovery from reinsurers of a portion of losses and loss expenses under certain circumstances without relieving the insurer of its obligation to the policyholder. In the event reinsurers were unable to meet their obligations under these reinsurance agreements, the Company would not be able to realize the full value of the reinsurance recoverable balance. In some cases, the Company may hold partial collateral, including letters of credit and funds held arrangements, for these agreements. The Company establishes reserves for uncollectible balances based on management's assessment of the collectibility of the outstanding balances. To minimize exposure from uncollectible reinsurance
much shorter than that of many reinsurance companies that have significant A&E exposures. In the earlier years of its existence, Everest Re was not as heavily involved in casualty business as in property business, which generally is not exposed to asbestos claims. Everest Re generally took smaller lines of exposure per contract than many other reinsurers operating in the casualty reinsurance market and those lines were generally also smaller than the excess limits provided by Mt. McKinley policies. This means that the potential adverse development on Everest Re's reinsurance business would not be subject to the same level of volatility as would be the case for companies having greater exposures per risk. Everest Re reinsured both primary and excess policies. However, its claim experience to date indicates that the majority of its reinsurance supported excess policies. As a result, most of Everest Re's exposure derives from excess policies similar to those written by Mt. McKinley.
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 has, within the bounds of its reinsurance contracts, generally supported 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.
The Company believes that its A&E exposures are unique and differentiated from those insurers and reinsurers with appreciable A&E exposure by the points noted above, but there can be no assurance that such factors will protect the Company from adverse development, perhaps material, or allow it to secure advantages in the settlement of its claims obligations.
The table below summarizes the Company's overall reserves and claim activity for asbestos and environmental claims, on both a gross and net of ceded reinsurance basis, for the periods indicated:
Industry analysts have developed a measurement, known as the survival ratio, to compare the asbestos and environmental reserves among companies with such liabilities. The survival ratio is typically calculated by dividing a company's current 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 asbestos and environmental survival ratio was 9.2 years at December 31, 2002. Adjusting these ratios to include the effect of the remaining limits of reinsurance available under the reinsurance agreement with Prupac, the measures rise to the equivalent of 10.6 years at December 31, 2002. Because the survival ratio was developed as a comparative measure of reserve strength and
The following tables summarize reserves and claim activity for asbestos claims, on both a gross and net of ceded reinsurance basis, for the periods indicated with particular emphasis on the differentiation of insured categories within the Mt. McKinley operation, which the Company believes reflects the most volatile element of its asbestos exposures.
(1) Some totals may not reconcile due to rounding. (2) Under CIP agreements, payments depend upon the insured's actual claims experience and may be subject to annual caps or other controls on the rate of payment. (3) Actively Managed means that Mt. McKinley is managing the defense of claims against the insured. (4) Includes ($215.1) million of paid loss impact arising from the Mt. McKinley acquisition in 2000. (5) Net liabilities represent Everest Re's inception-to-date losses and Mt. McKinley's losses since its acquisition in 2000. (6) Includes $203.8 million ceded to and collected from The Prudential as part of the Company's Stop Loss protection resulting from the initial public offering in 1995.
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 $2,368.6 million and $1,720.5 million at December 31, 2002 and 2001, respectively. The Company has flexibility with
respect to capitalization as the result of its perceived financial strength, including its financial strength ratings as assigned by independent rating agencies, and 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, both in general and with respect to the Company's securities, and responds accordingly.
Distributions on the trust preferred securities are cumulative and are paid quarterly in arrears. Disbributions relating to the trust preferred securities for the year ended December 31, 2002 were $2.1 million.
On November 7, 2001, the Company filed a shelf registration statement on Form S-3 with the Securities and Exchange Commission, providing for the issuance of up to $575.0 million of common equity. On February 27, 2002, 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 has used the net proceeds for working capital and general corporate purposes. On October 2, 2002, the Company filed a Post- Effective Amendment to this registration statement that removed the remaining securities from registration.
activities were $736.1 million, $406.0 million and $90.0 million for the years ended December 31, 2002, 2001 and 2000, respectively. The following table shows cash flows from operating activities, as well as the impact of select transactions on those cash flows, for the years ended December 31, 2002, 2001 and 2000.
The growth in net cash flows from operating activities reflects improvements in product pricing, together with growth in the Company's invested asset base, and is generally consistent with expectations, given the Company's investment strategies and mix of business and the normal variability of premium collections and the payout of loss reserves.
On December 21, 1999, Holdings entered into a three-year senior revolving credit facility with a syndicate of lenders (the "Credit Facility"). On November 21, 2002, the maturity date of the Credit Facility was extended to December 19, 2003. Wachovia Bank, National Association (formerly First Union National Bank) is the administrative agent for the Credit Facility. The Credit Facility is used for liquidity and general corporate purposes. The 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 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 plus 0.5% per annum. On December 18, 2000, the Credit Facility was amended to extend the borrowing limit to $235.0 million for a period of 120 days. This 120-day period expired during the three months ended March 31, 2001 and the limit reverted to $150.0 million. The amount of margin and the fees payable for the Credit Facility depend upon Holding's senior unsecured debt rating. Group has guaranteed Holdings' obligations under the Credit Facility.
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. As of December 31, 2002, the Company was in compliance with these requirements.
The Company has arrangements available for the issue of letters of credit, which letters are generally collateralized by the Company's cash or investments. At December 31, 2002, $156.5 million of letters of credit were issued and outstanding under these arrangements.
The Company employs a retrocessional approach under which the Company may purchase reinsurance to cover specific business written or exposure accumulations or as a corporate level retrocessional program covering the potential accumulation or aggregation of exposures across some or all of the Company's operations. All reinsurance purchasing decisions consider both the potential coverage and market conditions with respect to the pricing, terms, conditions and availability of such coverage, with the aim of securing cost- effective protection. The level of reinsurance coverage varies over time, reflecting the underwriter's and/or Company's view of the changing dynamics of both the underlying exposure and the reinsurance markets.
If a single catastrophe were to occur in the United States that resulted in $338 million of gross losses and allocated loss adjustment expenses ("ALAE") in 2003 (an amount equivalent to the Company's PML including its property and workers' compensation exposures), management estimates that the effect on the Company's income before and after taxes would be approximately $338 million and $264 million, respectively. Such impact represents approximately 11.1% of the Company's beginning of year capital.
MARKET SENSITIVE INSTRUMENTS The Securities and Exchange Commission Financial Reporting Release #48 requires registrants to clarify and expand upon the existing financial statement disclosure requirements for derivative financial instruments, derivative commodity instruments, and other financial instruments (collectively, "market sensitive instruments"). The Company does not enter into market sensitive instruments for trading purposes.
The Company's current investment strategy seeks to maximize after-tax income through a high quality, diversified, taxable and tax-preferenced fixed maturity
The overall investment strategy considers the scope of the Company's present and anticipated 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 year, with no material change in the underlying risk characteristics.
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, 2002 and 2001 based on parallel 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 are 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 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, 2002 and 2001. All amounts are in U.S. dollars and are presented in millions.
The duration and nature of these specialized instruments are such that no active trading market exists. This was recognized at the time the transactions were entered into and was the principal rationale for the Company's use of a
probability weighted cash flow model for its analysis of the economics of these transactions, an approach quite similar to analytical models used throughout the Company's reinsurance business.
As these specialized equity put options are derivatives within the framework of FAS No.133, the Company is required to report the fair value of these instruments in its balance sheet and record 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, 2002 and December 31, 2001 of $22.4 million and $13.0 million, respectively; however, the Company does not believe that the ultimate settlement of these transactions is likely to require a payment that would exceed the initial consideration received or any payment at all.
AS OF DECEMBER 31, 2002 S & P 500 INDEX PUT OPTIONS OBLIGATION - SENSITIVITY ANALYSIS (Dollar amounts in millions)
AS OF DECEMBER 31, 2001 S & P 500 INDEX PUT OPTIONS OBLIGATION - SENSITIVITY ANALYSIS (Dollar amounts in millions)
SAFE HARBOR DISCLOSURE 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 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 actual events or results to be materially different from the Company's expectations include those discussed below under the caption "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.
The results of companies in the insurance and reinsurance industry historically have been subject to significant fluctuations and uncertainties. Factors that
o events like the September 11, 2001 attacks, which affect the insurance and reinsurance markets generally;
IF THE COMPANY'S LOSS RESERVES ARE INADEQUATE TO MEET ITS ACTUAL LOSSES, THE COMPANY'S NET INCOME WOULD BE REDUCED OR IT COULD INCUR A LOSS.
The Company is required to maintain reserves to cover its estimated ultimate liability of losses and loss adjustment expenses for both reported and unreported claims incurred. These reserves are only estimates of what the Company thinks the settlement and administration of claims will cost based on facts and circumstances known to the Company. Because of the uncertainties that surround estimating loss reserves and loss adjustment expenses, the Company cannot be certain that ultimate losses will not exceed these estimates of losses and loss adjustment reserves. If the Company's reserves are insufficient to cover its actual losses and loss adjustment expenses, the Company would have to augment its reserves and incur a charge to its earnings. These charges could be material. The difficulty in estimating the Company's reserves is increased because the Company's loss reserves include reserves for potential asbestos and environmental liabilities. Asbestos and environmental liabilities are especially hard to estimate for many reasons, including the long waiting periods between exposure and manifestation of any bodily injury or property damage, difficulty in identifying the source of the asbestos or environmental contamination, long reporting delays and difficulty in properly allocating liability for the asbestos or environmental damage.
The Company primarily writes property and casualty reinsurance and insurance. The property and casualty industry historically has been highly cyclical. Rates for property and casualty reinsurance and insurance are influenced primarily by factors that are outside of the Company's control. Any significant decrease in the rates for property and casualty insurance or reinsurance could reduce the Company's net income.
The Company's insurance company subsidiaries, other than Mt. McKinley and Everest International, currently hold an A+ ("Superior") financial strength rating from A.M. Best Company. Everest Re, Bermuda Re and Everest National hold an AA- ("Positve") financial strength rating from Standard & Poor's Ratings Services. Everest Re and Bermuda Re hold 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.
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 has announced a policy that places a six-year term limit on individuals with work permits, subject to specified exemptions for persons deemed to be key employees. These restrictions make it difficult to hire and retain highly qualified personnel in Bermuda. If work permits are not obtained or renewed for the Company's key employees in Bermuda, the Company could lose their services, which could adversely affect the Company's ability to conduct its business.
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. In addition, if issuers of individual investments are unable to meet their obligations, investment income will be reduced and realized capital losses may arise. 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.
fines and penalties and restrict it from conducting business. The application of these laws could affect the Company's liquidity and ability to pay dividends on its common shares and could restrict the Company's ability to expand its business operations through acquisitions involving the Company's insurance subsidiaries.
The Company may not have all required licenses and approvals or may not comply with the wide variety of applicable laws and regulations or the relevant authorities' interpretation of the laws and regulations. If the Company does not have the requisite licenses and approvals or does 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.
THE COMPANY'S HOLDING COMPANY STRUCTURE COULD PREVENT IT FROM PAYING DIVIDENDS ON ITS COMMON SHARES.
Group is a holding company whose most significant assets consist of the stock of its operating subsidiaries. Thus, Group's ability to pay dividends on its common shares in the future may be dependent on the earnings and cash flows of its subsidiaries and the ability of the subsidiaries to pay dividends or to advance or repay funds to Group. This ability is subject to general economic, financial, competitive, regulatory and other factors beyond the Company's control. Payment of dividends and advances and repayments from some of Group's operating subsidiaries are regulated by U.S., state and foreign insurance laws and regulatory restrictions, including minimum solvency and liquidity thresholds. Accordingly, Group's operating subsidiaries may not be able to pay dividends or advance or repay funds to Group in the future, which could prevent the Company from paying dividends or making other payments or distributions on its securities.
The Company's functional currency is the United States dollar. However, the Company writes a portion of its business and receives a portion of its premiums in currencies other than United States dollars. The Company also maintains a portion of its investment portfolio in investments denominated in currencies other than United States dollars. Consequently, the Company may experience exchange losses if its foreign currency exposure is not properly managed or otherwise hedged. If the Company seeks to hedge its foreign currency exposure by using forward foreign currency exchange contracts or currency swaps, the Company will be subject to the risk that the counter parties to those arrangements will fail to perform, or that those arrangements will not precisely offset the Company's exposure.
In the last few years, some members of Congress have expressed concern about U.S. corporations that move their place of incorporation to low-tax jurisdictions. Also, some members of Congress have expressed concern over a competitive advantage that foreign-controlled insurers and reinsurers may have over U.S. controlled insurers and reinsurers due to the purchase of reinsurance by U.S. insurers from affiliates operating in some foreign jurisdictions, including Bermuda. Legislation has recently been proposed in Congress that would increase the U.S. tax burden on so-called "inverting" companies and increase the
U.S. tax burden on related-party reinsurance transactions. The Company does not know whether this legislation or any similar legislation will ever be enacted into law. If it were enacted, the U.S. tax burden on the Company's Bermuda operations, or on some business ceded from its licensed U.S. subsidiaries to some offshore reinsurers, could be increased. This could 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 Bermuda Re was engaged in a trade or business in the United States, Bermuda Re would be required to pay U.S. corporate income tax on any income that is subject to the taxing jurisdiction of the United States, and possibly the U.S. branch profits tax. Even if the IRS successfully contended that Bermuda Re was engaged in a U.S. trade or business, the U.S.-Bermuda tax treaty would preclude the IRS from taxing Bermuda Re's income except to the extent that its income were attributable to a permanent establishment maintained by that subsidiary. The Company does not believe that Bermuda Re has a permanent establishment in the United States. If the IRS successfully contended that Bermuda Re did have income attributable to a permanent establishment in the United States, it would be subject to U.S. tax on that income.
The Company believes it qualifies for benefits under the U.S.-Barbados tax treaty. Based on the Company's compliance with guidelines designed to ensure that it generates only immaterial amounts, if any, of income that is subject to the taxing jurisdiction of the United States, the Company believes that it should be required to pay only immaterial amounts, if any, of U.S. corporate income tax, other than withholding tax on U.S. source dividend income. However, if the IRS successfully contended that the Company had material amounts of income that is subject to the taxing jurisdiction of the United States, the Company would be required to pay U.S. corporate income tax on that income, and possibly the U.S. branch profits tax. Even if the IRS successfully contended that the Company had material amounts of income that is subject to the taxing jurisdiction of the United States, the U.S.-Barbados tax treaty would preclude the IRS from taxing the Company's income, except to the extent that its income were attributable to a permanent establishment maintained in the United States. The Company does not believe that it has material amounts of income attributable to a permanent establishment in the United States. If the IRS successfully contended, however, that the Company did have income attributable to a permanent establishment in the United States, the Company would be subject to U.S. tax on that income. If Bermuda Re became subject to U.S. income tax on its income or if the Company became subject to U.S. income tax on more than immaterial amounts of income, the Company's income could also be subject to the U.S. branch profits tax. In that event, Group and Bermuda Re would be subject to taxation at a higher combined effective rate than if they were organized as U.S. corporations. The combined effect of the 35% U.S. corporate income tax rate and the 30% branch profits tax rate is a net tax rate of 54.5%. The imposition of these taxes would reduce the Company's net 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:
o any person related to a U.S. taxpayer meeting the above definition.
GAINS RESULTING FROM THE SALE OF THE COMPANY'S COMMON SHARES BY U.S. SHAREHOLDERS COULD BE TAXED IN THE U.S. AS DIVIDENDS.
Generally, a U.S. shareholder will realize capital gain or loss on the sale or exchange of the common shares. However, the IRS could contend that special provisions of the Code apply and that the amount of any gain equal to the
THE ORGANIZATION FOR ECONOMIC COOPERATION AND DEVELOPMENT AND THE EUROPEAN UNION ARE CONSIDERING MEASURES THAT MIGHT INCREASE THE COMPANY'S TAXES AND REDUCE ITS NET INCOME.
Group has obtained an international business company license under the Barbados International Business Companies Act, 1991-24. Based on this license, Group is entitled to special tax benefits, including a preferred rate of tax on profits and gains and an exemption from withholding tax in respect of any dividends, interest, royalties, fees or management fees deemed to be paid to another international business company or to a person not resident in Barbados. Group has also obtained from the Ministry of Economic Development a fifteen year
THE COMPANY'S NET INCOME WILL BE REDUCED IF U.S. EXCISE AND WITHHOLDING TAXES ARE INCREASED.
REGULATORY CHALLENGES IN THE UNITED STATES COULD ADVERSELY AFFECT THE ABILITY OF BERMUDA RE TO CONDUCT BUSINESS.
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 is 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.
The Company is organized under the laws of Bermuda. Some of its directors and officers, as well as some of the experts named in this report, may reside outside the United States. A substantial portion of the Company's and their assets are or may be located in jurisdictions outside the United States. Security holders may not be able to effect service of process within the United States on directors and officers of the Company and those experts who reside outside the United States. Security holders also may not be able to recover against them or the Company on judgments of U.S. courts or to obtain original judgments against them or the Company in Bermuda courts, including judgments predicated upon civil liability provisions of the U.S. federal securities laws.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements and schedules listed in the accompanying Index to Financial Statements and Schedules on page are filed as part of this report.