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, Luxembourg, Dallas, Texas and Windsor, England. Our life reinsurance business operates out of the Bermuda, Charlotte and Windsor offices while our wealth management business operates out of the Grand Cayman, Dallas and Luxembourg offices. The Luxembourg lease expires in 2003 and we are currently seeking new office space. The Bermuda and Dallas leases expire in 2005, the Grand Cayman lease expires in 2006, the Charlotte lease expires in 2012 and the Windsor lease expires in 2023.
Scottish Annuity & Life is a holding company organized under the laws of the Cayman Islands with its principal executive office in Bermuda. We are a reinsurer of life insurance, annuities and annuity-type products. These products are written by life insurance companies and other financial institutions located principally in the United States, as well as around the world. We refer to this portion of our business as Life Reinsurance North America. On December 31, 2001, we completed the purchase of World-Wide Holdings Limited and its subsidiary World-Wide Reassurance Company Limited. World-Wide Reassurance specializes in niche markets in developed countries and broader life insurance markets in the developing world. We refer to this portion of our business as Life Reinsurance International. Life Reinsurance North America and Life Reinsurance International together are a reportable operating segment. To a lesser extent, we directly issue variable life insurance and variable annuities and similar products to high net worth individuals and families for insurance, investment and estate planning purposes. We refer to this portion of our business as Wealth Management, which is another reportable operating segment. Other revenues and expenses not related to Life Reinsurance or Wealth Management are reported in the "Other" segment.
When we issue a life reinsurance contract, we establish reserves for benefits. These reserves are our estimates of what we expect to pay in claims and policy benefits and related expenses under the contract or policy. From time to time, we may change the reserves if our experience leads us to believe that benefit claims and expenses will ultimately be greater than the existing reserve. We report the change in these reserves as an expense during the period when the reserve or additional reserve is established.
- the mix of different types of business that we reinsure, because profits on some kinds of business emerge later than on other types;
- our ability to manage our assets and liabilities to manage investment and liquidity risk;
Financial Accounting Standard 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.
In 2002, we completed the acquisition of an in-force block of business. The determination of the fair value of the assets acquired and the liabilities assumed required management to make estimates and assumptions regarding mortality, lapse and expenses. These estimates were based on historical experience, actuarial studies and information provided by the ceding company. Actual results could differ materially from these estimates.
Our results of operations for each of the years ended December 31, 2001 and 2000 do not include the results of operations of World-Wide Holdings, which we acquired at the close of business on December 31, 2001.
Our net income for the year ended December 31, 2002 increased 93% to $32.5 million from $16.8 million in 2001, which was an increase of 5% from $16.0 million in 1999. The increase in 2002 is attributable to the inclusion of World-Wide Holdings for the first time since its acquisition, continued growth in our Life Reinsurance North America operations, and an increase in investment income primarily due to the increase in average invested assets. The contribution to net income by World-Wide Holdings amounted to $12.7 million for the year ended December 31, 2002. The increase in net income was offset in part by an increase in realized losses on fixed maturity investments and unit-linked securities, and by losses incurred in our Wealth Management and Other segments. Realized losses were $11.2 million for the year ended December 31, 2002, compared to realized losses of $3.9 million in the year ended December 31, 2001. The losses in our Wealth Management operations arose principally from increased commission costs, costs of establishing our Luxembourg office and severance payments. The losses in our Other segment arose because of reductions in investment income as we deployed more capital in the Life Reinsurance North America segment and increased costs in the first full year of our operations in Bermuda.
The increase in earnings in 2001 is primarily due to increased income from Life Reinsurance and Wealth Management operations and an increase in investment income due to the increase in average invested assets, offset in part in 2001 by an increase in realized losses on fixed maturity investments.
Diluted earnings per share for the year ended December 31, 2002 increased 21% to $1.23 from $1.02 in 2001, and increased 2% in 2001 from $1.00 in 2000. Diluted earnings per share increased as a result of the growth in net income described above. This increase has occurred despite the increase in the number of ordinary shares outstanding. The increase in the number of ordinary shares outstanding is a result of shares issued in the acquisition of World-Wide Holdings and the equity offering discussed in Note 15 to the consolidated financial statements. The underlying shares of the convertible debt offering do not increase the number of shares outstanding until the price of our ordinary shares reaches $26.05 during specified trading periods. This did not occur in 2002. The increase in diluted earnings per share in 2001 was due to the increased earnings plus the repurchase of 432,500 shares in
2000 and 100,000 shares in 2001, offset in part by the increase in the dilutive effect of options and warrants.
Net operating earnings for the year ended December 31, 2002 increased 94% to $41.8 million from $21.6 million in the same period in 2001. The increase in net operating earnings is primarily attributable to the inclusion of World-Wide Holdings for the first time since its acquisition, continued growth in our Life Reinsurance North America operations and an increase in investment income primarily due to the increase in average invested assets. The increases have been offset by increased costs in our Wealth Management and Other segments as described above. Net operating earnings increased 34% to $21.6 million in 2001 from $16.2 million in 2000.
Premiums earned during the year ended December 31, 2002 increased 196% to $202.5 million compared with the same period in 2001. Premiums earned in 2002 have increased due to the acquisition of World-Wide Holdings and the growth in the number of clients in our Life Reinsurance North America operations. World-Wide Holdings' premiums earned during the year amounted to $79.7 million. Premiums earned on Life Reinsurance North America operations during the year ended December 31, 2002 increased 80% to $122.8 million from the same period in 2001 and were in respect of 73 treaties. Premiums earned in 2001 increased 84% to $68.3 million and were from 39 treaties. Premiums earned in 2000 of $37.1 million were from 11 life reinsurance clients. Premiums earned in 2001 increased over 2000 due to the increase in the number of clients and the increase in business from those clients in our Life Reinsurance North America operations.
Wealth Management fees are earned from both life and annuity clients. The following table summarizes our client base with the associated segregated assets and policy face amounts.
Net investment income increased by 109% to $108.0 million during the year ended December 31, 2002 compared to $51.7 million in the same period in 2001. The increase is due to the growth in our average invested assets offset in part by decreases in realized yields in the current year. Our total invested assets have increased significantly because of growth in our Life Reinsurance North America operations, assets acquired through the acquisition of World-Wide Holdings, investment of the proceeds of our equity offering in April 2002 and our convertible debt and capital securities offerings in November 2002. Total invested assets have increased from $1.3 billion at December 31, 2001 to $2.3 billion at December 31, 2002. Funds withheld at interest grew from $562.4 million to $1.1 billion during 2002.
During the year ended December 31, 2002, average book yields were lower than in 2001, particularly on floating rate assets and cash. On the $1.1 billion portfolio managed by our external investment managers the yields on fixed rate assets were 5.84% and 7.09% at December 31, 2002 and 2001, respectively. The reduction in yield was due primarily to the much lower market yields at which new cash flows were invested and proceeds of maturities and sales were reinvested. Yields on floating rate assets are indexed to LIBOR. The yield on our floating rate assets decreased to 3.11% from 4.43%, and the yield on our cash and cash equivalents decreased to 1.48% from 2.20%. The volume of
floating rate assets increased in 2002 as a result of our investing the proceeds of a $100 million floating rate funding agreement to earn a spread over the cost of funds.
Net investment income increased by $6.9 million or 15% to $51.7 million in 2001 from $44.8 million in 2000 primarily as a result of an increase in average invested assets. Funds withheld at interest grew from $46.3 million to $562.4 million. Since most of this growth occurred in the second half of 2001, its contribution to income was for only part of 2001. Excluding funds withheld at interest and the World-Wide Holdings portfolio, which was added at December 31, 2001, our general account portfolio declined during 2001. This decline resulted from the recapture by a ceding company of $185.7 million of assets on April 30, 2001, offset in part by the addition of investments funded by new transactions and borrowings. During 2001, as compared to 2000, average book yields were lower, particularly on floating rate assets and cash. Yields on floating rate assets decreased significantly during 2001. On the $581.1 million portfolio managed by external investment managers, the yields on fixed rate assets were 7.09% and 7.12% at December 31, 2001 and 2000, respectively. Between those dates, however, LIBOR decreased to 1.88% from 6.40%, causing the yield on floating-rate assets to decrease to 4.43% from 7.82% and the yield on cash and cash equivalents to decrease to 2.20% from 5.70%. Since the floating-rate assets were funded by floating-rate liabilities, the decrease in yield on floating-rate assets had no material effect on earned margins.
unrealized losses of $0.4 million on certain structured securities in accordance with the requirements of EITF 99-20. See discussion of EITF 99-20 below.
The following tables provide details of the sales proceeds, realized loss, the length of time the security had been in an unrealized loss position and reason for sale for securities sold during 2002 and 2001.
Claims and other policy benefits increased by 177% to $141.9 million in the year ended December 31, 2002 from $51.2 million in the same period of 2001. The increase is a result of the acquisition of World-Wide Holdings, the increased number of clients and the increase in our traditional solutions business from these clients in our Life Reinsurance North America operations. World-Wide Holdings claims and other policy benefits were $50.1 million for the year ended December 31, 2002.
For the year ended December 31, 2002 interest credited to interest sensitive contract liabilities increased by $30.8 million or 176% to $48.4 million from $17.6 million in 2001. Interest credited includes interest in respect of a funding agreement for $100.0 million that we wrote on June 28, 2002. The amount due on this funding agreement is included in interest sensitive contract liabilities on our balance sheet. The increase was due to interest credited on new 2002 reinsurance treaties and the funding agreement and increases in interest credited on treaties which commenced in prior years due to increasing average liability balances. Interest credited to interest sensitive contract liabilities increased by $0.2 million or 1% to $17.6 million in 2001 from $17.4 million in 2000. The movement in 2001 was due to the interest credited on new 2001 reinsurance treaties and increases in interest credited on treaties which commenced in prior years due to increasing average liability balances. These increases were offset by the $8.5 million effect of the recapture of a block of business by one client on April 30, 2001.
During the year ended December 31, 2002 acquisition costs and other insurance expenses increased by $35.8 million or 147% to $60.1 million from $24.3 million in 2001. The increase was a result of the acquisition of World-Wide Holdings and the increased number of reinsurance clients in our Life Reinsurance North America business.
Acquisition costs and other insurance expenses increased by $7.1 million or 42% to $24.3 million in 2001 from $17.2 million in 2000. The increases were the result of the increased number of reinsurance clients in our Life Reinsurance North America business.
Operating expenses increased to $23.8 million in the year ended December 31, 2002 compared to $9.1 million in 2001. The increase is a result of the acquisition of World-Wide Holdings, a smaller portion of costs being allocated to acquisition expenses and increased personnel costs and other operating costs as we continued to grow our business. During the year we continued to set up our principal office in Bermuda and opened an office in Luxembourg. In addition, as a result of our acquisition of World-Wide Holdings on December 31, 2001, we have incurred increased operating expenses and additional travel costs. As we continue to grow our operations we have experienced increased personnel costs in all segments. Total employees in our operations, excluding World-Wide Holdings has grown from 66 employees at December 31, 2001 to 75 at December 31, 2002. Operating expenses in the year ended December 31, 2002 included $1.4 million of non-recurring expenses relating to severance arrangements with certain employees.
Interest expense amounted to $1.4 million in both 2002 and 2001. Interest expense in 2002 includes interest on $115.0 million of convertible debt issued on November 22, 2002, $17.5 million of capital securities issued on December 4, 2002 and borrowings under our credit facilities and reverse repurchase agreement. These borrowings are more fully described under "Liquidity and Capital Resources".
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 under the credit facilities as described in "Liquidity and Capital Resources".
The data in the tables above excludes unit-linked securities, which are discussed more fully in Note 2 to the consolidated financial statements. All the data excludes the assets held by ceding insurers under modified coinsurance agreements.
The composition by category of securities that have an unrealized loss at December 31, 2002 and December 31, 2001 are presented in the tables below.
Unrealized losses on securities that have been in an unrealized loss position for periods greater than two years amounted to $478,000 and $1.5 million at December 31, 2002 and 2001, respectively.
Unrealized losses on non-investment grade securities amounted to $3.8 million and $894,000 at December 31, 2002 and 2001, respectively. Of these amounts non-investment grade securities with unrealized losses of $1.6 million at December 31, 2002 and $229,000 at December 31, 2001 had been in an unrealized loss position for a period greater than one year and $30,000 at December 31, 2002 and $229,000 at December 31, 2001 had been in an unrealized loss position for periods greater than two years.
At December 31, 2002 there were 154 securities with unrealized loss positions. There was one security with a loss greater than $1 million. This is a securitized asset and is tested for impairment under EITF Issue No. 99-20. At December 31, 2002 this security satisfied the impairment tests of EITF 99-20. At December 31, 2001 there were 193 securities with unrealized loss positions. There were two securities with unrealized losses greater than $1 million. These were also securitized assets and were tested for impairment under EITF Issue No. 99-20. At December 31, 2001 these securities satisfied the impairment tests of EITF 99-20.
Funds withheld at interest arise on contracts written under modified coinsurance agreements. In each case, the business reinsured consists of fixed deferred annuities. In substance, these agreements are identical to coinsurance treaties except that the ceding company retains control of and title to the assets. The deposits paid to the ceding company by the underlying policyholders are held in a segregated portfolio and managed by the ceding company or by investment managers appointed by the ceding company. These treaties transfer a quota share of the risks. The funds withheld at interest represent our share of the ceding companies' statutory reserves. The cash flows exchanged with each monthly settlement are netted and include, among other items, our quota share of investment income on our proportionate share of the portfolio, realized losses, realized gains (amortized to reflect the statutory rules relating to interest maintenance reserve), interest credited and expense allowances.
At December 31, 2002, we had four modified coinsurance fixed annuity reinsurance contracts with two ceding companies. We had three contracts with Lincoln National Insurance Company that account for $1.1 billion (98%) of the funds withheld balances. The other contract is with Illinois Mutual Insurance Company. At December 31, 2001, we had three modified coinsurance fixed annuity reinsurance contracts with two ceding companies. We had two contracts with Lincoln National Insurance Company that account for $500.0 million (95%) of the funds withheld balances at December 31, 2001. The other contract is with Illinois Mutual Insurance Company. Lincoln National Insurance Company has financial strength ratings of "A+" from A.M. Best, "AA-" from Standard & Poor's, "Aa3" from Moody's and "AA" from Fitch. In the event of insolvency of the ceding companies on our modified coinsurance arrangements we would need to exert a claim on the assets supporting the contract liabilities. However, the risk of loss is mitigated by our ability to offset amounts owed to the ceding company, which are included in interest sensitive contract liabilities, with the amounts owed to us by the ceding company. Interest sensitive contract liabilities relating to the Lincoln National Insurance Company contracts amounted to $1.1 billion and $540.7 million at December 31, 2002 and 2001, respectively.
At December 31, 2002, funds withheld at interest totaled $1.1 billion with an average rating of "A", an average effective duration of 5.4 years and an average book yield of 6.49% as compared with an average rating of "A-", an average effective duration of 6.0 years and an average book yield of 6.80% at December 31, 2001. These are fixed income investments associated with modified coinsurance transactions; they include marketable securities, commercial mortgages, private placements and cash. The market value of the funds withheld amounted to $1.2 billion at December 31, 2002.
The investment objectives for our modified coinsurance arrangements are included in the agreements. The primary objective is to maximize current income, consistent with the long-term preservation of capital. The overall investment strategy is executed within the context of prudent asset/liability management. The investment guidelines permit investments in fixed maturity securities, and include marketable securities, commercial mortgages, private placements and cash. The maximum
According to data provided by our ceding companies, the following table reflects the market value of assets backing the funds withheld at interest portfolio using the lowest rating assigned by the three major rating agencies.
We used operating cash flow of $9.2 million in 2002 in comparison with operating cash flow generated of $31.3 million in 2001 and $81.8 million in 2000. Operating cash flow includes cash inflows from premiums, fees and investment income, and cash outflows for benefits and expenses paid. In periods of growth of new business our operating cash flow may decrease due to first year commissions paid on new business generated. For income recognition purposes these commissions are deferred and amortized over the life of the business. In addition, operating cash flow includes $26.0 million, $107.4 million, and $79.5 million of funds received in connection with the acquisition of blocks of reinsurance during 2002, 2001 and 2000, which are not reflected in the consolidated statements of income. These acquisitions are explained in more detail in Note 11 to the consolidated financial statements.
The decrease in operating cash flow from 2001 to 2002 was primarily due to increases in benefits and expenses paid greater than increases in premiums, fees, and investment income. In addition there was a decrease in the cash flows from the acquisition of blocks of reinsurance. Reinsurance premiums
The decrease in operating cash flow from 2000 to 2001 was primarily due to increases in benefits and acquisition costs that were greater than the increases in premiums, fees, investment income and the cash flows received from the acquisition of blocks of reinsurance. Reinsurance premiums and fees received increased by $18.0 million due to the increase in the number of clients in our Life Reinsurance North America and Wealth Management segments. Investment income received increased by $7.2 million due to the growth in our invested asset base. The increase in investment income was not as great as in prior years because of a reduction in the asset base due to the recapture by a ceding company of $185.7 million of assets on April 30, 2001. The acquisition of blocks of reinsurance business generated $27.9 million more in cash flows in 2001 compared to 2000. Benefits paid increased by $9.8 million due to the increase in the number of clients in our Life Reinsurance North America segment. Acquisition costs, including commissions, increased by $93.8 million. This increase related principally to new business written in our Life Reinsurance North America segment. These costs include commissions on first year business that are deferred when paid and therefore do not impact net income until later years.
At December 31, 2002 total capitalization was $623.6 million compared to $331.3 million at December 31, 2001. Total capitalization includes long-term debt and is analyzed as follows:
At December 31, 2001, total capitalization was $331.3 million compared to $239.6 million in 2000. The $91.7 million increase in capitalization at December 31, 2001 is a result of net income for the year of $16.8 million less dividends paid of $3.1 million 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.
On December 4, 2002 we privately placed $17.5 million of capital securities which were issued by a trust subsidiary holding a thirty year $17.5 million aggregate principal amount subordinated note of Scottish Holdings, Inc. which is guaranteed by Scottish Annuity & Life Insurance Company (Cayman) Ltd. Net proceeds were $16.9 million. Scottish Holdings, Inc. provided a $15.0 million capital infusion to its direct subsidiary, Scottish Re (U.S.), Inc. and used the remainder of the net proceeds for general corporate purposes.
During 2002 we paid quarterly dividends totaling $5.0 million or $0.20 per share. During 2001, we paid quarterly dividends totaling $3.1 million or $0.20 per share.
During 2002, we arranged two secured credit facilities with U.S. banks totaling $100.0 million. Each of the credit facilities provides for a combination of borrowing and letters of credit of $50.0 million. These facilities expire in September 2003 but are renewable with the agreement of both parties. One of the facilities requires that Scottish Annuity & Life Insurance Company (Cayman) Ltd., which we refer to as SALIC, and World-Wide Reassurance maintain Standard & Poor's ratings of at least "A-" and that SALIC maintains shareholder's equity of at least $210.0 million. At December 31, 2002, SALIC and World-Wide Reassurance each had a Standard & Poor's rating of "A-" and SALIC's shareholder's equity was $464.0 million. The other facility requires that Scottish Annuity & Life maintain consolidated net worth of $375.0 million and a maximum debt to total capitalization ratio of 25%. At December 31, 2002, Scottish Annuity & Life's net worth was $492.1 million and the ratio of debt to total capitalization was 21%. Our failure to comply with the requirements of the credit facilities would, subject to grace periods, result in an event of default, and we could be required to repay any outstanding borrowings. At December 31, 2002, there were no borrowings under the facilities. Outstanding letters of credit under these facilities amounted to $9.1 million.
- when Scottish Re (U.S.), Inc. enters into a reinsurance transaction, it typically incurs a need for additional statutory capital This need can be met by its own capital surplus, an infusion of cash or assets from Scottish Annuity & Life or an affiliate or by ceding a portion of the transaction to another company within the group or an unrelated reinsurance company, in which case that reinsurer must provide reserve credit by contributing assets in a reserve credit trust or a letter of credit;
- Scottish Re (U.S.), Inc. is licensed, accredited, approved or authorized to write reinsurance in 47 states and the District of Columbia. When Scottish Re (U.S.), Inc. enters into a reinsurance transaction with a customer domiciled in a state in which it is not a licensed, accredited, authorized or approved reinsurer, it likewise must provide a reserve credit trust or letter of credit; and
- even when Scottish Re (U.S.), Inc. is licensed, accredited, approved or authorized to write reinsurance in a state, it may agree with a customer to provide a reserve credit trust or letter of credit voluntarily to mitigate the counter-party risk from the customer's perspective, thereby doing transactions that would be otherwise unavailable or would be available only on significantly less attractive terms.
- the risk that our risk analysis and underwriting may be inadequate;
- uncertainties arising from control of our invested assets by third parties;
- the impact of acquisitions, including the ability to successfully integrate acquired businesses, the competing demands for our capital and the risk of undisclosed liabilities;
The information called for by this item is set forth in "Item 15: Exhibits, Financial Statement Schedules and Reports on Form 8-K.