Combined ratio (2) 89.7 % 120.3 % 99.0 % 95.3 % 99.1 %
(1) Catastrophe losses are presented net of reinsurance and reinstatement premiums. A catastrophe is defined, for purposes of the Selected Consolidated Financial Data, as an event that caused a pre-tax loss on property exposures before reinsurance of at least $5.0 million before corporate level reinsurance and taxes. Effective in 2005, industrial risk losses have been excluded from catastrophe losses with prior periods adjusted for comparison purposes. Catastrophe reinsurance provides coverage for one event. When limits are exhausted, some contractual arrangements provide for the availability of additional coverage upon the payment of additional premium. This additional premium is referred to as reinstatement premium.
(6) Based on 65.0 million, 64.6 million, 56.2 million, 55.7 million and 50.9 million shares outstanding for December 31, 2006, 2005, 2004, 2003 and 2002, respectively.
The worldwide reinsurance and insurance businesses are highly competitive, as well as cyclical by product and market. Competition in the types of reinsurance and insurance business that the Company underwrites is based on many factors, including the perceived overall financial strength of the reinsurer or insurer, ratings of the reinsurer or insurer by A.M. Best and/or S&P, underwriting expertise, the jurisdictions where the reinsurer or insurer is licensed or otherwise authorized, capacity and coverages offered, premiums charged, other terms and conditions of the reinsurance and insurance business offered, services offered, speed of claims payment and reputation and experience in lines written. These factors operate at the individual market participant level to varying degrees, as applicable to the specific participant’s circumstances. They also operate in aggregate across the reinsurance industry more generally, contributing, in combination with economic conditions and variations in the reinsurance buying practices of insurance companies (by participant and in the aggregate), to cyclical movements in reinsurance rates, terms and conditions and ultimately reinsurance industry aggregate financial results.
The Company competes in the U.S., Bermuda and international reinsurance and insurance markets with numerous global competitors. The Company’s competitors include independent reinsurance and insurance companies, subsidiaries or affiliates of established worldwide insurance companies, reinsurance departments of certain insurance companies and domestic and international underwriting operations, including underwriting syndicates at Lloyd’s. Some of these competitors have greater financial resources than the Company and have established long-term and continuing business relationships, which can be a significant competitive advantage. In addition, the lack of strong barriers to entry into the reinsurance business and the potential for securitization of reinsurance and insurance risks through capital markets provide additional sources of potential reinsurance and insurance capacity and competition.
reduce catastrophe limit purchases. In turn, insurance companies continue to adjust limits and coverages and increase the premium rates they charge their customers. Together, these trends have generally resulted in insurance companies retaining more property risk exposure and being more prone to potential future earnings volatility than in past years. This trend reflects an imbalance between reinsurance supply and demand. As a result of this imbalance and higher rates, additional competition is entering the market in the form of new companies and alternative risk transfer mechanisms. In January 2007, the Florida legislature enacted insurance reform that increases insurer’s access to the Florida Hurricane Catastrophe Fund, thus potentially reducing the amount of reinsurance purchased from the private reinsurance market. The Company is unable to predict the impact on future market conditions from the increased competition and legislative reform. In addition to these market forces, reinsurers continue to reassess their risk appetites and rebalance their property portfolios to reflect improved price to exposure metrics against the backdrop of: (i) recent revisions to the industry’s catastrophe loss projection models, which are indicating significantly higher loss potentials and consequently higher pricing requirements and (ii) elevated rating agency scrutiny and capital requirements for many catastrophe exposed companies.
The Company’s management monitors and evaluates overall Company performance based upon financial results. The following table displays a summary of the consolidated net income (loss), ratios and shareholders’ equity for the years indicated:
The Company’s 2006 results were very strong with net income of $840.8 million compared to a net loss of $218.7 million for 2005. This significant earnings improvement reflects the favorable effect of a benign U.S. hurricane season relative to unprecedented Company and industry hurricane losses experienced in 2005, as well as favorable underlying underwriting fundamentals.
Gross written premiums declined for 2006 compared to 2005 as the Company continued its disciplined underwriting and risk management practices. In particular, the Company repositioned its U.S. property reinsurance portfolio resulting in improved pricing, but lower premium volume. The premium volume decline also reflects much lower premiums due to the run-off insurance credit program business and a cut back in treaty casualty writings in response to market softening in many U.S. casualty reinsurance classes.
The Company’s shareholders’ equity increased by $1.0 billion to $5.1 billion in 2006, principally attributable to the record net income generated during the year. This compares to an increase of $0.4 billion to $4.1 billion in 2005.
Revenues. Gross and net written premiums declined 2.6% and 2.4%, respectively, for 2006 compared to 2005, while net premiums earned declined 2.8% in 2006 compared to 2005. The decrease in full year net premiums earned was primarily due to a decline in the U.S. insurance segment of 7.5%, reflective of: i) a reduction in credit business from an auto loan insurance program which is in run-off; and ii) continued reductions in the California workers’ compensation writings due to competitive market conditions. In addition, net premiums earned for the worldwide reinsurance segments in the aggregate decreased by 1.5% for 2006, reflecting multiple segment level factors, including a significant return premium for a Florida property quota share contract cancelled in 2006, the absence of sizable reinstatement premiums triggered in 2005 from severe catastrophic events, as well as the exercise of continued underwriting disciplines which emphasizes potential profitability over volume.
Expenses. The Company’s incurred losses and loss adjustment expenses (“LAE”) decreased 34.6% in 2006 compared to 2005, primarily due to the relative absence of current year catastrophe losses.
Commission, brokerage, and tax expenses decreased by 3.5% in 2006 from 2005. The 2.8% decline in earned premiums in 2006 compared to 2005 was the principal driver of the decrease in this directly variable expense. Other underwriting expenses for 2006 increased by 6.3% compared to 2005, all due to growth in corporate non-allocated expenses.
The Company’s effective income tax rate for 2006 was 15.2% compared with the effective tax rate for 2005 of 22.2%, which was impacted by the large catastrophe losses.
The following table reconciles the underwriting results for the operating segments to income before tax as reported in the consolidated statements of operations and comprehensive income for the three years ended December 31:
Interest, fee and bond issue cost amortization expense (69,899 ) (74,413 ) (76,610 )
Ceded premiums decreased to $125.2 million in 2006 from $136.5 million in 2005. Ceded premiums generally relate to specific reinsurance purchased by the U.S. Insurance operation and fluctuate based upon the level of premiums written in the individual reinsured programs.
Net written premiums decreased by 2.4% to $3,875.7 million in 2006 from $3,972.0 million in 2005, reflecting the $107.7 million decrease in gross written premiums and the $11.4 million decrease in ceded premiums.
Incurred Losses and LAE. The Company’s loss and LAE reserves reflect estimates of ultimate claim liability. Such estimates are re-evaluated on an ongoing basis, including re-estimates of prior period reserves, taking into consideration all available information and, in particular, recently reported loss and claim experience related to prior periods. The effect of such re-evaluations is recorded in incurred losses for the current period.
The Company’s loss ratio, which is calculated by dividing incurred losses and LAE by current year net premiums earned, improved by 30.8 points to 63.2% over the comparable 2005 period, principally due to a 34.1 point improvement of current year catastrophe losses, partially offset by 4.2 points related to an increase in prior years reserve strengthening.
The U.S. Insurance segment’s incurred losses and LAE decreased 2.0%, or $10.9 million, for 2006 as compared to 2005, primarily due to reduced earned premiums, which related to the continued reduction in the California workers’ compensation business and run-off of a credit program. The segment’s loss ratio increased 3.8 points from 2005, primarily due to higher losses on the credit program.
The Company’s combined ratio, which is the sum of the loss and expense ratios, decreased by 30.6 points to 89.7% in 2006 compared to 120.3% in 2005, as a result of lower catastrophe and attritional losses.
The following table shows the combined ratios for each of the Company’s operating segments in 2006 and 2005. The combined ratios for all operations were impacted by the loss and expense ratio variations noted above.
The following table shows a comparison of various investment yields for the year indicated:
The Company, because of its historical income orientation, had generally managed its investments to maximize reportable income. Starting in 2004, the Company began investing a portion of its assets in equity securities, principally in response to perceived changes in the relative attractiveness of the debt and equity markets. In 2006, the Company added $330.5 million of equity securities into the overall investment portfolio. The Company also added $180.4 million of other invested assets, principally limited partnerships. The following table provides a comparison of the Company’s total return by asset class relative to broadly accepted industry benchmarks for 2006 and 2005.
Corporate, Non-allocated Expenses. Corporate underwriting expenses not allocated to segments were $26.5 million in 2006, compared to $18.4 million in 2005, primarily due to increase in share-based compensation expense.
Interest, fees and bond issue cost amortization expense in 2006 and 2005 were $69.9 million and $74.4 million, respectively. Interest, fees and bond issue cost amortization expense in 2006 included $31.1 million related to the senior notes, $37.5 million related to the junior subordinated debt securities, $0.9 million related to the bond issue cost amortization and $0.4 million related to the credit line under the Company’s revolving credit facilities. Interest, fees and bond issue cost amortization expense in 2005 included $35.5 million related to the senior notes, $37.5 million related to the junior subordinated debt securities, $1.0 million to the bond issue cost amortization and $0.4 million related to the credit line under the Company’s revolving credit facilities. Interest expense on senior notes decreased due to the retirement on March 15, 2005 of the 8.5% senior notes issued on March 14, 2000.
Other income in 2006 was $0.1 million and other expense in 2005 was $11.1 million. The change was primarily due to the fluctuation in foreign currency exchange.
Income Taxes. The Company’s income tax expense is primarily a function of the statutory tax rates and corresponding net income in the jurisdictions where the Company operates, coupled with the impact from tax preferenced investment income. Variations in the effective tax rate generally result from changes in the relative levels of pre-tax income among jurisdictions with different tax rates. The Company recorded income tax expense of $150.9 million in 2006 compared to an income tax benefit of $62.3 million in 2005. The increase was primarily due to the significant change in pre-tax income in 2006 compared to the pre-tax loss in 2005.
Premium Revenues. Net premiums earned decreased by 10.4% to $3,963.1 million in 2005 from $4,425.1 million in 2004. Contributing to this decrease was a 34.4% ($157.8 million) decrease in the Specialty Underwriting operation, a 15.6% ($139.9 million) decrease in the Bermuda operation, a 12.2% ($114.6 million) decrease in the U.S. Insurance operation and a 5.3% ($77.4 million) decrease in the U.S. Reinsurance operation, partially offset by a 4.2% ($27.7 million) increase in the International operation. Partially tempering the decline in net premiums earned in 2005 were $81.8 million of reinstatement premiums of which $64.4 million were due to Hurricanes Katrina and Wilma. Generally, catastrophe reinsurance provides coverage for one event; however, when limits are exhausted, some contractual arrangements provide for the availability of additional coverage upon the payment of additional premium. This additional premium is referred to as reinstatement premium. There were no such reinstatement premiums for 2004. All of these changes reflect period to period changes in net written 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, earnings, 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. Changes in estimates related to the reporting patterns of ceding companies also affect premiums earned.
Net favorable prior period reserve adjustments for the year ended December 31, 2005 were $26.4 million compared to net unfavorable prior period reserve adjustments of $249.4 million in 2004. For the year ended December 31, 2005, the favorable reserve adjustments included net favorable attritional reserve adjustments of $226.3 million related primarily to property business classes, partially offset by net unfavorable prior period catastrophe adjustments of $118.5 million related primarily to the 2004 hurricanes and net unfavorable A&E adjustments of $81.4 million. For the year ended December 31, 2004, the unfavorable prior period reserve adjustments included net unfavorable A&E adjustments of $159.4 million and net unfavorable attritional development of approximately $128.7 million relating primarily to casualty reinsurance. Partially offsetting the 2004 unfavorable development was $38.7 million of favorable catastrophe development principally related to the reduction of reserves for the World Trade Center events. It is important to note that attritional reserve development arises from the re-evaluation of accident year results and that such re-evaluations may also impact premiums and commissions attributed by accident year, generally mitigating, in part, the impact of loss developments and that such impacts are recorded as part of the overall reserve evaluation process.
The Specialty Underwriting segment’s incurred losses and LAE increased 5.3%, or $15.9 million, for 2005 as compared to 2004, due to the significant catastrophe losses in 2005 and development of catastrophes from prior years. The segment’s loss ratio increased by 39.7 points over 2004, primarily due to increased catastrophe losses, however was partially offset by favorable attritional loss development on the marine, aviation, surety and A&H classes of business.
The International segment’s incurred losses and LAE increased 37.1%, or $155.6 million, for 2005 as compared to 2004. The segment’s loss ratio increased by 20.2 points over 2004, primarily reflective of the significant property catastrophe losses in 2005 and development on prior years’ catastrophes, partially offset by an improvement in attritional prior year reserves on the Canadian, Asian and international business.
The following table shows the Bermuda segment components of incurred losses and LAE for 2005 and 2004:
Underwriting Expenses. The Company’s expense ratio, which is calculated by dividing underwriting expenses by net premiums earned, was 26.3% for 2005 compared to 24.6% for 2004.
The Company’s combined ratio, which is the sum of the loss and expense ratios, increased by 21.3 percentage points to 120.3% in 2005 as compared to 99.0% in 2004, with the increase principally resulting from elevated catastrophe losses, partially offset by improved prior year development.
The following table shows the combined ratios for each of the Company’s operating segments in 2005 and 2004. The combined ratios for all operations were impacted by the loss and expense ratio variability noted above.
Imbedded after-tax yield of cash and invested assets at December 31 3.9 % 4.1 %
Annualized after-tax yield on average cash and invested assets 3.8 % 4.2 %
The Company, because of its historical income orientation, has generally considered total return, the combination of income yield and capital appreciation/depreciation, to be relatively less important as a measure of performance than its overall income yield. However, in 2005, with changes the Company perceived in overall investment market conditions, the Company continued to reweight its view of total return and added $350.4 million in 2005 of equity securities into the overall investment portfolio. The Company also added $125.2 million of other invested assets, principally limited partnerships. The following table provides a comparison of the Company’s total return by asset class relative to broadly accepted industry benchmarks for 2005 and 2004.
The Company has issued seven equity put options in its product portfolio at December 31, 2005, which were outstanding. These products meet the definition of a derivative under Financial Accounting Standards No. 133. The Company recognized net derivative expense of $2.6 million and $2.7 million in 2005 and 2004,
Corporate, Non-allocated Expenses. Corporate underwriting expenses not allocated to segments were $18.4 million for 2005 as compared to $9.8 million for 2004 as the Company expanded its infrastructure to support operations.
Other expense in 2005 was $11.1 million compared to other income of $9.6 million in 2004. The change in net other expense for 2005 from net other income in 2004 was primarily due to variability in the impact of foreign exchange.
Net (Loss) Income. Net loss was $218.7 million in 2005 compared to net income of $494.9 million in 2004, with the change primarily reflecting reduced underwriting profitability due to catastrophe losses, partially offset by favorable prior period reserve development, related tax benefits and improved investment income.
LOSS AND LAE RESERVES. The Company’s most critical accounting policy is the determination of its loss and LAE reserves. The Company maintains reserves equal to its estimated ultimate liability for losses and LAE with respect to reported and unreported claims relating to both its insurance and reinsurance businesses. Because reserves are based on estimates of ultimate losses and LAE by underwriting or accident year, management, uses a variety of statistical and actuarial techniques to monitor reserve adequacy over time and evaluates new information as it becomes known and adjusts reserves whenever an adjustment appears warranted. Management considers many factors when setting reserves, including: (1) the Company’s exposure base, generally its projected ultimate premiums earned; (2) its expected loss ratios by product and class categories as determined through extensive interaction between its underwriters and actuaries; (3) actuarial methodologies which analyze the Company’s loss reporting and payment experience, information from ceding companies and historical trends, such as reserving patterns, loss payments 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 (A&E) claims. Based on these considerations, management believes that adequate provision has been made for the Company’s insurance and reinsurance 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 in estimated ultimate loss projections is recorded. See also Note 1 of Notes to the Consolidated Financial Statements.
Both reinsurance and insurance reserves are categorized into exposure groupings for actuarial analysis. The exposure groupings are selected in such that the underlying exposures have reasonably homogeneous loss development characteristics but are large enough to make the estimation of ultimate losses credible. The selection of exposure groupings is reviewed periodically and may change over time as the Company’s business changes. The Company currently uses over 200 exposure groupings to develop its reserve estimates. One of the key selection characteristics for the exposure groupings is the length of time it historically takes to report and settle claims. Claims that are reported and settled relatively quickly are commonly referred to as short tail lines and principally derive from property coverages. Casualty claims on the other hand tend to take longer to be reported and settled and are generally referred to as long tail lines. Shorter tail lines are generally subject to less volatility in the ultimate loss estimation and re-estimation process than longer tail lines.
The same accepted actuarial methodologies, such as Borhuetter-Ferguson, expected loss ratio and chain ladder reserving methods, supplemented by judgment where appropriate, are used to develop an estimate of ultimate losses and LAE for each exposure group. Although the same actuarial methodologies are used for both short tail and long tail lines, the faster reporting of experience for the short tail lines allows for earlier reliance on the estimates derived from the reported loss experience based methods than is possible for the long tail lines, for which, consequently, reliance must be placed on the exposure based estimates. For both short and long tail lines, these general approaches are supplemented by judgment in determining the ultimate losses and LAE for each exposure group. Projected losses from widespread catastrophic events, such as hurricanes, generally cannot be estimated using traditional actuarial models. The loss estimates for these types of events are judgmentally established based on available information derived from the Company’s quantitative and qualitative exposure analyses, reports and communications from ceding companies and management’s
There are no explicit provisions for reserve uncertainty imbedded in the key actuarial assumptions or added to the actuarially determined reserves. In situations where historical results have been volatile or the class of business is new and immature, the Company actuaries’ ultimate reserve selections may implicitly include a provision for uncertainty, but this is not significant in relation to the entire reserve balance and is not separately captured on a quantitative basis.
The amount of carried reserves at the end of each reporting period is the amount of projected ultimate losses and LAE, reduced by the cumulative amount paid. Similarly, IBNR reserves are determined by subtracting case reserves and ACRs from total loss reserves. Detailed reserve studies for each exposure group are completed once a year for reinsurance and quarterly for insurance. The completed annual reinsurance reserve studies are rolled forward for each accounting period until the subsequent reserve study is completed. The roll forward analysis includes a comparison of actual reported losses to actuarially expected losses. Any significant variance between actual and expected losses is investigated and appropriate adjustments recorded. For the years presented, there were no significant changes in the key actuarial methodologies and procedures used to project ultimate losses and therefore, loss reserve changes principally result from changes in managements’ estimates of ultimate losses from amounts reported in prior periods.
With respect to asbestos claims in particular, several additional factors have emerged in recent years that further compound the difficulty in estimating the Company’s liability. These developments include: (a) the significant growth over a short period of time in the number of claims filed, in part reflecting a much more aggressive plaintiff bar and including claims against defendants who may only have a “peripheral” connection to asbestos; (b) a disproportionate percentage of claims filed by individuals with no functional injury, which should have little to no financial value but that have increasingly been considered in jury verdicts and settlements; (c) the growth in the number and significance of bankruptcy filings by companies as a result of asbestos claims (including, more recently, bankruptcy filings in which companies attempt to resolve their asbestos liabilities in a manner that is prejudicial to insurers and forecloses insurers from participating in the negotiation of asbestos related bankruptcy reorganization plans); (d) the concentration of claims in a small number of states that favor plaintiffs; (e) the growth in the number of claims that might impact the general liability portion of insurance policies rather than the product liability portion; (f) measures adopted by specific courts to ameliorate the worst procedural abuses; (g) an increase in settlement values being paid to asbestos claimants, especially those with cancer or functional impairment; (h) legislation in some states to address asbestos litigation issues; and (i) the potential that other states or the U.S. Congress may adopt legislation on asbestos litigation. Anecdotal evidence suggests that new claims filing rates have decreased, that new filings of asbestos-driven bankruptcies have decreased and that various procedural and legislative reforms are beginning to diminish the potential ultimate liability for asbestos losses.
Management believes that these uncertainties and factors continue to render reserves for A&E and particularly asbestos losses significantly less subject to traditional actuarial analysis than reserves for other types of losses. Given these uncertainties, management believes that no meaningful range for such ultimate losses can be established. The Company establishes reserves to the extent that, in the judgment of management, the facts and prevailing law reflect an exposure for the Company or its ceding companies. The Company’s A&E liabilities stem from Mt. McKinley’s direct insurance business and Everest Re’s assumed reinsurance business.
There is less potential for similar settlements with respect to the Company’s reinsurance asbestos claims. Ceding companies, with their direct obligation to insureds and overall responsibility for claim settlements, are not consistently aggressive in developing claim settlement information and conveying this information to reinsurers, which can introduce significant and perhaps inappropriate delays in the reporting of asbestos claims/exposures to reinsurers. These delays not only extend the timing of reinsurance claim settlements, but also restrict the information available to estimate the reinsurers’ ultimate exposure. See the discussion below under the heading “Financial Condition - Loss and LAE Reserves”.
PREMIUMS WRITTEN AND EARNED. Premiums written by the Company are earned ratably over the coverage periods of the related insurance and reinsurance contracts or policies. Unearned premium reserves are established to cover the remainder of the unexpired contract period. Such reserves are established based upon reports received from ceding companies or computed using pro rata methods based on statistical data. Premiums earned, and the related costs, which have not yet been reported to the Company, are estimated and accrued. Because of the inherent lag in the reporting of written and earned premiums by the Company’s ceding companies, standard accepted actuarial methodologies are used to estimate earned but not reported premium at each financial reporting date. These earned but not reported premiums are combined with reported earned premiums to comprise the exposure base for determining the Company’s incurred losses and loss and LAE reserves. Commission expense and incurred losses related to the change in earned but not reported premium are included in current period company and segment financial results. See also Note 1 of Notes to the Consolidated Financial Statements.
CASH AND INVESTED ASSETS. Aggregate invested assets, including cash and short-term investments, were $13,957.1 million at December 31, 2006 and $12,970.8 million at December 31, 2005. This increase in cash and invested assets resulted primarily from $636.3 million in cash flows from operations, $176.4 million of foreign currency translation gains, $35.1 million of net realized capital gains and a $131.7 million increase in net pre-tax unrealized appreciation of the Company’s investments comprised of a $191.9 million increase in pre-tax unrealized appreciation on the equity securities portfolio, partially offset by a $60.2 million decrease in pre-tax unrealized appreciation in fixed maturities portfolio. Cumulative gross pre-tax unrealized appreciation and depreciation across the Company’s investment portfolio were $594.5 million and $122.8 million, respectively, at December 31, 2006 compared to $443.1 million and $103.1 million, respectively, at December 31, 2005.
For outstanding liabilities, the Company invests in taxable and tax-preferenced fixed income securities with an average credit quality of Aa, as rated by the independent investment rating service of Moody’s. The Company’s mix of taxable and tax-preferenced investments is adjusted continuously, consistent with the Company’s current and projected operating results, market conditions and the Company’s tax position. This fixed maturity portfolio is externally managed by an independent, professional investment manager using portfolio guidelines approved by the Company.
The increase in equity securities and other invested assets reflects a modest and continuing reweighting of the Company’s target investment mix.
The following table provides a comparison of the Company’s total return by asset class relative to broadly accepted industry benchmarks for the years indicated:
REINSURANCE RECEIVABLES. Reinsurance receivables for both paid and unpaid losses totaled $772.8 million at December 31, 2006, $1,048.7 million at December 31, 2005, and $1,210.8 million at December 31, 2004. At December 31, 2006, $169.4 million, or 21.9%, was receivable from Transatlantic, $100.9 million, or 13.1%, was receivable from LM, whose obligations are guaranteed by The Prudential, $100.2 million, or 13.0%, was receivable from Founders, $100.0 million, or 12.9%, was receivable from Continental, which is partially collaterized by funds held arrangements, $52.5 million, or 6.8%, was receivable from subsidiaries of London Life, which is fully collateralized by letters of credit, and $42.7 million, or 5.5%, was receivable from Munich Re. Continental is collateralized by a funds held arrangements under which the Company has retained the premium payments due the retrocessionaire, recognized liabilities for such amounts and reduced such liabilities as payments are due from the retrocessionaire. No other retrocessionaire accounted for more than 5% of the Company’s receivables.
Company has noted that variability had increased for years 1999 to 2003 and has taken actions to attempt to reduce year to year variability prospectively.
The Company has included ranges for loss reserve estimates determined by the Company’s actuaries, which are derived through a combination of objective and subjective criteria. The Company notes that its presentation of this information is not directly comparable to similar presentations of other companies as there are no consistently applied actuarial or accounting standards governing such presentations. The Company further notes that its recorded reserves reflect the Company’s best point estimate of its liabilities. The Company’s actuarial methodologies develop point estimates and the ranges are developed subsequently.
The following table below represents the reserve levels and ranges as of December 31, 2006 for each of the Company’s business segments.
contracts, could have material adverse effects on the Company’s future financial condition, results of operations and cash flows.
The vast majority of Mt. McKinley’s A&E exposed insurance policies are excess casualty policies, with aggregate coverage limits, which by definition also have protection afforded by underlying coverage. Mt. McKinley’s attachment points vary but generally are excess of millions, often tens of millions, of dollars of underlying coverage. The excess nature of most of Mt. McKinley’s policies also offers insulation against “non-product” claims (for example, claims arising under general liability coverage). Although under some circumstances an excess policy could be exposed to non-product claims, such claims generally pose more of a risk to primary policies because non-product claims are generally less likely to aggregate. In addition, environmental claims arise under general liability coverage, and generally do not aggregate. Thus, these claims tend to create exposure for primary policies to a greater extent than excess policies.
Everest Re was formed in 1973 but was not fully engaged in underwriting casualty business, under which A&E exposures generally arise, until 1974, and it effectively eliminated A&E exposures through contract exclusions effected in 1984. Therefore, Everest Re has an approximate 11-year window of A&E exposure, 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 is likely to be smaller than 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 was on 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 issued reinsurance contracts to 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.
years that it would take to exhaust the current reserves based on historical payment levels. Using this measurement, the Company’s net three year A&E survival ratio was 4.1 years at December 31, 2006. Adjusting for the effect of the reinsurance ceded under the reinsurance agreement with LM, this ratio rises to the equivalent of 5.0 years at December 31, 2006. The cession of $100.9 million to the stop loss reinsurance provided by LM in connection with the acquisition of Mt. McKinley results in unpaid proceeds that are not reflected in past net payments and effectively extends the funding available for future net payments.
Because the survival ratio was developed as a comparative measure of reserve strength and not of absolute reserve adequacy, the Company considers, but does not rely on, the survival ratio when evaluating its reserves. In particular, the Company notes that year to year loss payment variability can be material. This is due in part, to the Company’s orientation to negotiated settlements, particularly on its Mt. McKinley exposures, which significantly impairs the credibility and utility of this measure as an analytical tool. During 2006, the Company made asbestos net claim payments of $16.6 million to Mt McKinley high profile claimants where the claim was either closed or a settlement was reached. Such payments, which are non-repetitive, distort the Company’s three year survival ratio for 2006 and will continue to do so for 2007 and 2008. Adjusting for such settlements, recognizing total settlements are generally considered fully reserved to an agreed settlement, the Company considers that its adjusted A&E survival ratio for net unsettled claims is 7.7 years, which is closer to prevailing industry norms.
Developments in 2006 and 2005 affecting asbestos exposures in general and the Company’s asbestos exposures in particular, together with enhancements in the Company’s claim management and analytical processes, resulted in the reserve strengthening noted earlier. These developments and actions have increased the emphasis on asbestos exposures as a separate component of the Company’s A&E exposures. Despite the Company’s approach of handling A&E exposures on a combined basis, management believes additional disclosure of the asbestos element of its A&E exposures is appropriate.
On December 1, 2005, the Company filed a shelf registration statement on Form S-3 with the SEC, as a Well Known Seasoned Issuer under the new registration and offering revisions to the Securities Act of 1933. Generally, under this shelf registration statement, Group is authorized to issue common shares, preferred shares, debt securities, warrants and hybrid securities, Holdings is authorized to issue debt securities and Everest Re Capital Trust III (“Capital Trust III”) is authorized to issue trust preferred securities.
exhausted with the October 6, 2005 transaction described below. The following securities were issued issued pursuant to that registration statement.
Management expects the trend of positive cash flow from operations, which in general reflects the strength of overall pricing, to persist over the near term; however, cashflow from operations will continue to be negatively impacted by the payout of catastrophe loss reserves. In the intermediate and long term, the trend will be impacted by the extent to which competitive pressures affect overall pricing in the Company’s markets and the extent to which the Company successfully maintains its strategy of emphasizing underwriting profitability.
Effective December 8, 2004, Group, Bermuda Re, and Everest International entered into a three year, $750.0 million senior credit facility with a syndicate of lenders (the “Group Credit Facility”). Wachovia Bank is the administrative agent for the Group Credit Facility. The Group Credit Facility consists of two tranches. Tranche one provides up to $250.0 million of revolving credit for liquidity and general corporate purposes, and for the issuance of standby letters of credit. The interest on the revolving loans shall, at the option of each of the borrowers, be 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, in each case plus 0.5% per annum. The amount of margin and the fees payable for the Group Credit Facility depend on Group’s senior unsecured debt rating. Tranche two exclusively provides up to $500.0 million for the issuance of collateralized standby letters of credit.
The Group Credit Facility requires Group to maintain a debt to capital ratio of not greater than 0.35 to 1 and to maintain a minimum net worth. Minimum net worth is an amount equal to the sum of (i) $2,898.0 million (base
amount) plus (ii) (A) 25% of consolidated net income for each of Group’s fiscal quarters and (B) 50% of any increase in consolidated net worth attributable to the issuance of ordinary and preferred shares. The base amount is reset at the end of each fiscal year to be the greater of 70% of Group’s consolidated net worth as of the last day of the fiscal year and the calculated minimum amount of net worth prior to the last day of the fiscal year. As of December 31, 2006, the Company was in compliance with these covenants.
During the year ended December 31, 2006, there were no outstanding borrowings under tranche one of the Group Credit Facility. As of December 31, 2006, $185.4 million of the $500.0 million available for tranche two of standby letters of credit was used. In addition, the Company had $274.6 million in letters of credit outstanding at December 31, 2006 under a $350.0 million bilateral agreement with Citibank. All of these letters of credit are collateralized by the Company’s cash and investments. These letters of credit are generally used to collateralize reinsurance assumed by Bermuda Re from jurisdictions where collateralization is generally required for the ceding company to receive financial statement credit for such reinsurance recoverables from its principal regulator. Bermuda Re and Everest International also used trust arrangements to provide collateralization to ceding companies, including affiliates. The Company generally avoids providing collateral except where required for ceding companies to receive credit from their regulators. Additionally, at December 31, 2006, $135.7 million of assets were deposited in trust accounts, primarily on behalf of Bermuda Re, as security for assumed losses payable to certain non-affiliated ceding companies.
The Holdings Credit Facility requires Holdings to maintain a debt to capital ratio of not greater than 0.35 to 1 and Everest Re to maintain its statutory surplus at $1.5 billion plus 25% of future aggregate net income and 25% of future aggregate capital contributions after December 31, 2005. As of December 31, 2006, Holdings was in compliance with these covenants.
As of December 31, 2006 and 2005, there were no outstanding Holdings Credit Facility borrowings.
Interest expense and fees incurred in connection with the Group Credit Facility and the Holdings Credit Facility were $0.4 million for the years ended December 31, 2006 and 2005. Interest expense and fees incurred in connection with the Holdings Credit Facility was $1.2 million for the year ended December 31, 2004.
The Company focuses on potential losses that could result from any single event, or series of events as part of its evaluation and monitoring of its aggregate exposures to catastrophic events. Accordingly, the Company employs
various techniques to estimate the amount of loss it could sustain from any single catastrophic event in various geographic areas. These techniques range from non-modeled deterministic approaches-such as tracking aggregate limits exposed in catastrophe-prone zones and applying historic damage factors-to modeled approaches that scientifically measure catastrophe risks using sophisticated Monte Carlo simulation techniques that forecast frequency and severity of expected losses on a probabilistic basis.
No single universal model is currenty capable of projecting the amount and probability of loss in all global geographic regions in which the Company conducts business. In addition, the form, quality and granularity of underwriting exposure data furnished by ceding companies is not uniformly compatible with the data requirements for the Company’s licensed models, which adds to the inherent imprecision in the potential loss projections. Further, the results from multiple models and analytical methods must be combined and interpolated to estimate potential losses by and across business units. The combination of techniques potentially adds to the imprecision of the Company’s estimates. Also, while most models have been updated in 2006 to better incorporate factors that contributed to unprecedented industry storm losses in 2004 and 2005, such as flood, storm surge and demand surge, catastrophe model projections are inherently imprecise. In addition, uncertainties with respect to future climatic patterns and cycles add to the already significant uncertainty of loss projections from models using historic long-term frequency and severity data.
The Company believes that its greatest worldwide 1 in 100 year exposure to a single catastrophic event is to a hurricane affecting the U.S. southeast coast where the Company estimates it has a gross PML exposure of $777 million. See also table under “Risk Management and Retrocession Arrangements”.
For 2004, 2005 and thus far in 2006, the Company has not purchased corporate retrocessional protection and has generally de-emphasized the purchase of specific reinsurance by its underwriters, reflecting the Company’s view that its exposures, in the context of its capital, financial position and current market pricing, do not warrant reinsurance purchases at current price levels. For 1999, 2000 and 2001, the Company purchased accident year aggregate excess of loss retrocession coverage, which provided up to $175.0 million of recoveries per accident year if Everest Re’s consolidated statutory basis accident year loss ratio exceeded a loss ratio attachment point provided in the contract for the respective accident years. Each arrangement provided for an adjustment premium, which reduced the net benefit by approximately 50%, in the event that the coverage was used. The limit has been fully utilized and there are no remaining limits available under these agreements. See ITEM 1, “Business - Risk Management of Underwriting and Retrocession Arrangements” for further details.
The contractual obligations for senior notes and junior subordinated debt are the responsibility of Holdings. The Company has sufficient cash flow, liquidity, investments and access to capital markets to satisfy these obligations, Holdings generally depends for its funding upon dividends from Everest Re, its operating insurance subsidiary, capital contributions from Group or access to the capital markets. The Company’s various operating insurance and reinsurance subsidiaries have sufficient cash flow, liquidity and investments to settle outstanding reserves for losses and LAE. Management believes that the Company, and each of its entities, have sufficient financial resources, or ready access thereto, to meet all obligations.
During 2006, 2005 and 2004, the Company declared and paid shareholder dividends of $39.0 million, $25.4 million and $22.4 million, respectively. As an insurance holding company, the Company is partially dependent on dividends and other permitted payments from its subsidiaries to pay cash dividends to its shareholders. The payment of dividends to Group by Holdings and to Holdings by Everest Re is subject to Delaware regulatory restrictions and the payment of dividends to Group by Bermuda Re is subject to Bermuda insurance regulatory restrictions. Management expects that, absent extraordinary catastrophe losses, such restrictions should not affect Everest Re’s ability to declare and pay dividends sufficient to support Holdings’ general corporate needs and that Holdings and Bermuda Re will have the ability to declare and pay dividends sufficient to support Group’s general corporate needs. For the years ended December 31, 2006, 2005 and 2004, Everest Re paid dividends to Holdings of $100.0 million, $75.0 million and $70.0 million, respectively. For the years ended December 31, 2006, 2005 and 2004, Bermuda Re paid dividends to Group of $60.0 million, $45.0 million and $15.0 million, respectively. See ITEM 1, “Business - Regulatory Matters - Dividends” and Note 14A of Notes to Consolidated Financial Statements.
157 on January 1, 2008. The Company does not believe the impact of implementing FAS 157 will be material on its consolidated financial statements.
The tables below display the potential impact of market value fluctuations and after-tax unrealized appreciation on the Company’s fixed maturity portfolio (including $1.3 billion of short-term investments) as of December 31, 2006 and 2005 based on upward and downward parallel and immediate 100 and 200 basis point shifts in interest
The tables below display the potential impact of a parallel and immediate 10% and 20% increase and decrease in foreign exchange rates on the valuation of invested assets subject to foreign currency exposure as of December 31, 2006 and 2005. This analysis includes the after-tax impact of translation from transactional currency to functional currency as well as the after-tax impact of translation from functional currency to the U.S. dollar reporting currency. All amounts are in U.S. dollars and are presented in millions.
The Company has sold one equity put option based on the FTSE 100 index for total consideration, net of commissions, of $6.7 million. This contract has an exercise date of July 2020 and a strike price of £5,989.75. No amount will be payable under this contract if the FTSE 100 index is at or above the strike price on the exercise date. If the FTSE 100 index is lower than the strike price on the applicable exercise date, the amount due will vary proportionately with the percentage by which the index is below the strike price. Based on historical index volatilities and trends and the December 31, 2006 index value, the Company estimates the probability that FTSE 100 index contract will be below the strike price on the exercise date to be less than 7.0%. The theoretical maximum payout under the contract would occur if on the exercise date the FTSE 100 index value was zero. The present value of the theoretical maximum payout using a 6.0% discount factor is $29.2 million.
Because the equity put options are derivatives within the framework of FAS 133, the Company reports the fair value of these instruments in its balance sheet and records any changes to fair value in its statement of operations. The Company has recorded fair values for its obligations on these equity put options at December 31, 2006 and 2005 of $37.5 million and $36.3 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.
The tables below estimate the impact of potential movements in interest rates and the equity indices, which are the principal factors affecting fair value of these instruments, looking forward from the fair value at December 31, 2006 and 2005. These are estimates and there can be no assurance regarding future market performance. The asymmetrical results of the interest rate and S&P 500 and FTSE 100 indices shift reflect that the liability cannot fall below zero whereas it can increase to its theoretical maximum.
Market Value Change from Base (%) -40.7 % -18.8 % 0.0 % 16.0 % 29.5 %
Market Value Change from Base (%) -20.2 % -9.4 % 0.0 % 8.2 % 15.4 %
Market Value Change from Base (%) -66.9 % -29.5 % 0.0 % 23.1 % 41.0 %