The following table sets forth selected consolidated financial data of the Company as of and for the years ended December 31, 2003, 2002, 2001, 2000 and 1999. These selected financial and other data should be read in conjunction with the Consolidated Financial Statements and related notes and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations”. In 1999 the Company, through a U.S. holding company, ACE INA, acquired CIGNA Corporation’s domestic property and casualty insurance operations including its run-off business and also its international property and casualty insurance companies and branches, including most of the accident and health business written through those companies.
(1) Diluted earnings (loss) per share is calculated by dividing net income (loss) available to holders of Ordinary Shares by weighted average shares outstanding - diluted.
(3) The underwriting and administrative expense ratio is calculated by dividing the policy acquisition costs and administrative expenses by net premiums earned excluding life reinsurance premiums.
The insurance industry is highly competitive with many companies offering similar coverage. Following two years of sharply rising prices, property insurance rates have leveled off or have declined slightly. The global property catastrophe reinsurance market has also softened with adequate capacity available for good risks. In other lines with rising loss costs, such as casualty and liability lines, or directors and officers liability insurance, rates have continued to increase and terms and conditions have remained restrictive.
Overall we believe that current rate levels are adequate for most of the risks seeking coverage and that favorable industry conditions should persist through the balance of 2004.
Several industry trends are noteworthy, first, favorable capital markets have facilitated the formation of several important new companies anxious to deploy their capital resources. New companies have become a significant factor in providing adequate insurance and reinsurance capacity and a moderating factor with regard to rising premium rates. Second, older companies with legacy issues such as asbestos or excess liability reserves have experienced adverse development from prior years’ unpaid claims. This has kept rates as well as terms and conditions from weakening. Third, interest rates are at historically low levels requiring companies to look to underwriting profitability as their main source of income. Fourth, the rating agencies have generally operated with a negative bias toward the insurance industry, effectively downgrading nearly all reinsurance industry leaders and reducing ratings on numerous primary insurers. This has put pressure on certain major companies to reduce leverage and risk.
On March 8, 2004, Assured Guaranty, formerly AGC Holdings, filed an amendment to the registration statement filed on December 23, 2003 on Form S-1 for an initial public offering (IPO). Assured Guaranty is a wholly owned subsidiary of ACE Limited. Upon completion of the IPO, Assured Guaranty will be the holding company for the operating units now known as ACE Guaranty Corp. and ACE Capital Re International. These two units form part of the Financial Services segment. We expect to retain as much as 25-35 percent of our interest in Assured Guaranty depending on market conditions. We believe this transaction will allow us to allocate more capital to our P&C business and further strengthen our balance sheet. Our website, under the “Investor Information” tab, has a link to the Form S-1 as filed with the SEC.
As an insurance and reinsurance company, we are required, under GAAP, to establish loss reserves for the estimated unpaid portion of the ultimate liability for losses and loss expenses under the terms of our policies and agreements with our insured and reinsured customers. These reserves include estimates for both claims that have been reported and those that have been incurred but not reported (IBNR), and include estimates of expenses associated with processing and settling these claims. At December 31, 2003, the unpaid losses and loss expense reserve was $27.1 billion. Our P&C loss reserves are not discounted. The process of establishing reserves for property and casualty (P&C) claims can be complex and is subject to considerable variability as it requires the use of informed estimates and judgments. These estimates and judgments are based on numerous factors, and may be revised as additional experience and other data become available and are reviewed, as new or improved methodologies are developed or as current laws change. We have actuarial staff in each of our operating segments who track insurance reserves and regularly evaluate the levels of loss reserves, taking into consideration factors that may impact the ultimate loss reserves. The potential for variation in loss reserves is impacted by numerous factors, which we explain below.
We estimate loss reserves for all insurance and reinsurance business we write. In most cases, we do not have all the necessary information to determine the ultimate settlement value for a claim at the time we are required to accrue for the loss. As a result, historical experience and other statistical information are used to estimate the ultimate cost of the loss, depending on the type of business. To
determine carried reserves for a particular line of business, we may perform one or more reserving methods to estimate ultimate losses and loss expenses and use the results to select a single point estimate. These methods may include, but are not necessarily limited to, extrapolations of our historical reported and paid loss data, application of industry loss development patterns to our reported or paid losses, expected loss ratios developed by management, or historical industry loss ratios. Underlying judgments and assumptions that may be incorporated into these actuarial methods include, but are not necessarily limited to, adjustments to historical data used in models to exclude aberrations in claims data such as catastrophes that are typically analyzed separately, application of tail factors used to project ultimate claims from historical loss experience when there are several data points to use, adjustments to actuarial models and related data for known business changes, such as changes in claims covered under insurance contracts, and the effect of recent or pending litigation on future claim settlements. For each of our lines of business, management, in conjunction with internal actuaries, develop their “best estimate” of ultimate liabilities, which they believe provide a reasonable estimate of the required reserve. We utilize one set of assumptions in determining a single point estimate. We do not calculate a range of loss reserve estimates. Actuarial ranges are not a true reflection of the potential volatility between loss reserves estimated at the balance sheet date and the ultimate settlement of losses. This is due to the fact that an actuarial range is developed based on known events as of the valuation date whereas actual volatility or prior period development has historically occurred in subsequent Consolidated Financial Statements in part from events and circumstances that were unknown as of the original valuation date. Since the ACE INA acquisition in 1999, our consolidated reserve for losses and loss expenses, net of reinsurance, reported at each year-end has developed by as much as ten percent (four percent excluding asbestos and environmental reserve strengthening), although ultimate loss reserve development could be higher. See the “Analysis of Losses and Loss Expense Development” for a summary of historical volatility between estimated loss reserves and ultimate loss settlements. The Unpaid Losses and Loss Expenses section below includes a discussion of our reserve-setting procedures by segment. The following is a discussion of specific reserving considerations by type of claim:
• Loss reserve analyses typically require loss or other data be grouped by common characteristics. If data from two combined lines of business exhibit different characteristics, such as loss payment patterns, the credibility of the reserve estimate could be affected. Because casualty lines of business can have various intricacies in their underlying coverage, there is an inherent risk as to the homogeneity of the underlying data used in performing reserve analyses.
We believe the most significant variables relating to our A&E reserves include assumptions with respect to payments to unimpaired claimants and the liability of peripheral defendants. In establishing our A&E reserves, we consider multiple recoveries by claimants against various defendants; the ability of a claimant to bring a claim in a state in which they have no residency or exposure; the ability of a policyholder to claim the right to non-products coverage; and whether high-level excess policies have the potential to be accessed given the policyholders claim trends and liability situation. The results in asbestos cases announced by other carriers may well have little or no relevance to us because other coverage exposures are highly dependent upon the specific facts of individual coverage and resolution status of disputes among carrier, policyholder and claimants.
Although the contractual obligation of individual reinsurers to pay their reinsurance obligations is based on specific contract provisions, the collectibility of such amounts requires significant estimation by management. The majority of the balance we have accrued as recoverable will not be due for collection until sometime in the future (in some cases several decades from now). Over this period of time, economic conditions and operational performance of a particular reinsurer may impact their ability to meet these obligations and
while they may continue to acknowledge their contractual obligation to do so, they may not have the financial resources or willingness to fully meet their obligation to us.
To estimate the bad debt provision, the reinsurance recoverable must first be allocated to applicable reinsurers. This determination is based on a process rather than an estimate, although an element of judgment must be applied. As part of this process, ceded IBNR is allocated by reinsurer. The allocations are generally based on historical relationships between gross and ceded losses. If actual experience varies materially from historical experience, the allocation of reinsurance recoverable by reinsurer will change. While such change is unlikely to result in a large percentage change in the bad debt provision, it could, nevertheless, have a material effect on our net income in the period recorded.
We use a default analysis and, to a lesser extent, actual collection experience to estimate uncollectible reinsurance. The primary components of the default analysis are reinsurance recoverable balances by reinsurer, net of collateral, and default factors used to determine the portion of a reinsurer’s balance deemed uncollectible. The definition of collateral for this purpose requires some judgment and is generally limited to assets held in trust, letters of credit, and liabilities held by us with the same legal entity for which we believe there is a right of offset. Default factors require considerable judgment and are determined using the current rating, or rating equivalent, of each reinsurer as well as other key considerations and assumptions. The more significant considerations include, but are not necessarily limited to, the following:
At December 31, 2003, the use of different assumptions within the model could have a material effect on the bad debt provision reflected in our Consolidated Financial Statements. To the extent the creditworthiness of our reinsurers was to deteriorate due to an adverse event affecting the reinsurance industry, such as a large number of major catastrophes, actual uncollectible amounts could be significantly greater than our bad debt provision. Such an event could have a material adverse effect on our financial condition, results of operations, and our liquidity. Given the various considerations used to develop default factors, we cannot precisely quantify the effect a specific industry event may have on the bad debt provision. However, based on the composition (particularly the average credit quality) of the reinsurance recoverable balance at December 31, 2003, we estimate that a ratings downgrade of one notch (for example from A to A-) for all rated reinsurers could increase our bad debt provision by as much as 15 percent, assuming no other changes relevant to the calculation. While a rating downgrade would result in an increase in our provision for bad debt and a charge to earnings in that period, a downgrade in and of itself does not imply that we will not ultimately collect all of the ceded reinsurance recoverable from the reinsurers in question.
Additional information on reinsurance recoverable can be found in the section entitled “Reinsurance”.
make a specific assessment as to whether or not the decline is “other than temporary”, such as the time period an investment has been in a loss position and the significance of the decline; and ii) for those securities to be assessed, whether we have the ability and intent to hold the security through an expected recovery period, absent a significant change in facts that is expected to have a material adverse effect on either the financial markets or the financial position of the issuer.
Our exposure to interest rate risk is concentrated in our fixed income portfolio. An increase in interest rates of 50 basis points applied instantly across the yield curve would have resulted in a decrease in the market value of the fixed income portfolio of approximately $347 million at December 31, 2003. An immediate time horizon was used as this presents the worst case scenario.
At December 31, 2003, our net deferred tax asset was $1.1 billion, including $412 million of net operating loss carryforwards, which will expire in the years 2018-2022. (See Note 14 of the Consolidated Financial Statements for more information). At each balance sheet date, management assesses the need to establish a valuation allowance that reduces deferred tax assets when it is more likely than not that all, or some portion, of the deferred tax assets will not be realized. The valuation allowance is based on all available information including projections of future taxable income from each tax-paying component in each tax jurisdiction principally derived from business plans, and available tax planning strategies. Projections of future taxable income incorporate several assumptions of future business and operations that are apt to differ from actual experience. If, in the future, our assumptions and estimates that resulted in our forecast of future taxable income for each tax-paying component proves to be incorrect, an additional valuation allowance could become necessary. This could have a material adverse effect on our financial condition, results of operations and liquidity. At December 31, 2003, the valuation allowance of $135.6 million reflects management’s assessment, that it is more likely than not that a portion of the deferred tax asset will not be realized due to the inability of certain foreign subsidiaries to generate sufficient taxable income.
Net premiums written, which reflect the premiums we retain after purchasing reinsurance protection, increased 27 percent in 2003 compared with 2002. Net premiums written increased 40 percent in our P&C businesses (four percent of this increase is due to appreciation of foreign currencies relative to the U.S. dollar) and decreased 31 percent in our Financial Services business. Our P&C net premiums written are growing more than our P&C gross premiums written because we are retaining more of the business we write. Our retention ratio (the ratio of net premiums written to gross premiums written) increased to 67 percent in 2003 compared with 58 percent in 2002. This reflects a conscious decision on our part to focus on direct lines of business and to shift away from heavily reinsured business. Net premiums earned, which reflect the portion of net premiums written that were recorded as revenues for the period, increased 41 percent in 2003 compared with 2002. Net premiums earned in our P&C businesses increased 50 percent (five percent of this increase is due to the appreciation of foreign currencies relative to the U.S. dollar) while our Financial Services business decreased two percent. The growth in P&C net premiums earned is a result of the growth in P&C net premiums written. Net premiums earned in 2002 increased 15 percent compared with 2001. These increases reflect the improved insurance market conditions that resulted in a combination of price increases on renewal business and growth in new business opportunities.
Underwriting results for our P&C and Financial Services business are discussed by reference to the combined ratio, the loss and loss expense ratio, the policy acquisition cost ratio and the administrative expense ratio. We calculate these ratios by dividing the respective expense amounts of our P&C and Financial Services business by net premiums earned from our P&C and Financial Services business. We do not calculate these ratios for the life reinsurance business, because they are not appropriate measures of the underwriting results for that business. The combined ratio is determined by adding the loss and loss expense ratio, the policy acquisition cost ratio and the administrative expense ratio. A combined ratio under 100 percent indicates underwriting income, and a combined ratio exceeding 100 percent indicates underwriting losses.
Our policy acquisition costs include commissions, premium taxes, underwriting and other costs that vary with, and are primarily related to, the production of premium. The policy acquisition cost ratio was stable in 2003 compared with 2002 and 2001. The positive impact of the increase in net premiums earned was offset by changes in business mix. We have increased the volume of business generated from Global Reinsurance in ACE Tempest Re USA. ACE Tempest Re USA writes a higher proportion of business on a treaty-basis which incurs higher acquisition costs due to higher ceding commission expense. We have also purchased less reinsurance in the Insurance - North American segment, which has resulted in reduced ceding commission income. Administrative expenses include all other
Net investment income increased $59 million in 2003 and $17 million in 2002, due to higher average invested assets, partially offset by a decline in the investment portfolio’s yield due to the impact of lower interest rates. See the section entitled “Net Investment Income” for more information.
Increases in net premiums earned and lower catastrophe losses in 2003 contributed to the higher underwriting income compared with 2002, which was impacted by the A&E reserve strengthening. Our net income increased $1.3 billion in 2003 due to higher underwriting income and the impact of net realized gains of $252 million in 2003 compared with net realized losses of $489 million in 2002. The appreciation of foreign currencies relative to the U.S. dollar added $24 million to our net income in 2003. In 2001, we reported underwriting losses due to the September 11 tragedy and the casualty reserve strengthening.
The performance of our management for the P&C and Financial Services segments are measured based on the results achieved in underwriting income and income excluding net realized gains (losses).
Insurance - North American’s insurance operations are organized into distinct divisions, each offering specialized products and services targeted at specific markets. The following table provides an entity/divisional breakdown of Insurance - North American’s net premiums earned for the years ended December 31, 2003, 2002 and 2001.
ACE Diversified Risk, which writes D&O, E&O and aerospace business, doubled its net premiums earned in 2003, compared to 2002. The increase primarily reflects higher D&O and E&O production, which have been experiencing a favorable rate environment and more restrictive policy terms and conditions. In addition, aerospace net premiums earned increased due to new business from an aviation syndicate that ACE USA participates in. Net premiums earned also benefited from increased retention.
ACE U.S. International (formerly referred to as Specialty P&C) provides worldwide risk protection by offering P&C coverages for U.S.-based multi-national companies. As a result of new business and higher renewal rates, ACE U.S. International’s net premiums earned for 2003 increased 24 percent compared with 2002, due to growth in the casualty and commercial marine lines.
Insurance - North American’s other divisions include ACE Select Markets (formerly referred to as Consumer Solutions group), ACE Casualty Risk, the A&H group, Global Energy, ACE USA Warranty, the run-off operations and our insurance-related service operations. Net premiums earned for these divisions increased $127 million for 2003, compared with 2002. Contributing to this increase was higher premium volume for ACE Casualty Risk and the A&H group. These units commenced operations in 2002 and 2001, respectively, and are experiencing strong demand for their primary product offerings, mainly umbrella excess for ACE Casualty Risk and personal accident coverage for the A&H group. In addition, ACE Select Markets also reported strong increases in net premiums earned primarily in 2003 for recreational marine business.
The policy acquisition cost ratio increased despite the growth in net premiums earned, compared with 2002. This reflects the decision to retain a greater percentage of the gross premiums written and to purchase less reinsurance, which has resulted in reduced ceding commissions for Insurance - North American. The administrative expense ratio declined due to the increase in net premiums earned. Administrative expenses increased mainly due to the increased costs associated with servicing the growth in Insurance - North American’s product lines. The policy acquisition cost and administrative expense ratios both declined in 2002 compared with 2001 due to increased net premiums earned with a higher proportion of lower commission professional lines business.
Income excluding net realized gains (losses) increased $435 million in 2003, compared with 2002, as a result of higher underwriting income. The decrease in 2002 compared with 2001, is primarily due to the asbestos reserve strengthening.
The loss and loss expense ratio for Insurance - Overseas General improved slightly in 2003 compared with 2002. Losses for 2003 included $57 million of adverse prior period development, compared with $104 million of adverse development in 2002. Prior period development for 2003 primarily related to casualty lines for ACE International and was a result of lengthening of the loss development patterns for these lines of business. To a lesser extent, ACE Global Markets experienced 2003 adverse development primarily related to marine liability with lower amounts in professional lines, marine hull and bloodstock lines mitigated by positive development on property, energy, aviation and political risk lines of business. 2002 prior period development related primarily to casualty and D&O lines for ACE International and aerospace business for ACE Global Markets. Additionally, this segment incurred $10 million of catastrophe losses in 2003, principally related to hurricanes, while 2002 included $68 million of catastrophe losses related to the European floods. The reduction in the loss and loss expense ratio in 2003 compared with 2002 reflected lower adverse prior period development and lower catastrophe losses mitigated by higher loss ratios for current accident year losses due to changes in business mix. The loss and loss expense ratio for Insurance - Overseas General declined in 2002 compared with 2001. This improvement is attributed to the lack of catastrophe losses of the magnitude of the September 11 tragedy and the casualty reserve strengthening, which increased 2001 losses by $67 million and $170 million, respectively.
Underwriting income increased in 2003 compared with 2002 primarily due to the increase in net premiums earned and a decrease in catastrophe losses of $58 million. Income excluding net realized gains (losses) increased in 2003 compared with 2002, driven by increased underwriting income and higher net investment income, partially offset by higher income tax expense. The underwriting loss and the loss excluding net realized gains (losses) in 2001 was primarily a result of the September 11 tragedy and the casualty reserve strengthening. Overall, the depreciation of the U.S. dollar accounted for eight percent of Insurance - Overseas General’s net income in 2003.
Gross premiums written for Global Reinsurance increased 48 percent in 2003 compared with 2002. The Global Reinsurance segment has expanded into a multi-line global reinsurer that offers a diversified portfolio of products. This shift has enabled it to take advantage of the improved P&C market. In 2003, significant production gains were recorded at ACE Tempest Re USA and ACE Tempest Re Europe as these units benefited from higher rates and increased volume for P&C lines. Gross premiums written for this segment increased 93 percent in 2002 compared with 2001. This increase was a result of the improved market for P&C lines, some of which were first offered in 2002, and additionally due to higher property catastrophe premium rates.
Global Reinsurance’s net premiums written increased 58 percent in 2003 compared with 2002. The retention ratio for this segment has increased to 93 percent in 2003, compared with 88 percent in 2002. The increase in the retention ratio reflects the decline in reinsurance purchased at ACE Tempest Re Europe and the increasing proportion of ACE Tempest Re USA business, which tends to be written at higher retention ratios than other business in this segment. ACE Tempest Re Europe increased its retention in order to take advantage of improved market conditions. Net premiums written more than doubled in 2002 compared with 2001, primarily as a result of increased production and less reinsurance purchased by ACE Tempest Re Europe.
The loss and loss expense ratio increased in 2003 compared with 2002, due to the shift in mix of business which resulted in growth in non-catastrophe P&C business at ACE Tempest Re USA and ACE Tempest Re Europe. Non-catastrophe P&C business typically has higher loss ratios than property catastrophe business (except in periods with high catastrophe losses). Property catastrophe business is mainly written at ACE Tempest Re Bermuda. As Global Reinsurance increases non-catastrophe P&C writing, we expect its loss and loss expense ratio to continue to increase in line with what would be expected from a traditional multi-line reinsurer. Global Reinsurance incurred $82 million of catastrophe losses in 2003, compared with $88 million in 2002. Global Reinsurance had favorable prior period development of $27 million in 2003 compared with favorable development of $20 million in 2002, primarily due to the property catastrophe line of business and the losses in this line being lower than expected. The loss and loss expense ratio improved in 2002 as the Global Reinsurance segment was heavily impacted by the September 11 tragedy, which added 67.6 percentage points to the 2001 loss and loss expense ratio.
Global Reinsurance’s underwriting income increased 28 percent in 2003 compared with 2002. The increase is primarily a result of higher net premiums earned in 2003. Underwriting income increased by $300 million in 2002 compared with 2001, due to the impact of the September 11 tragedy on the 2001 results and the improved market conditions in 2002. Income excluding net realized gains (losses) for Global Reinsurance increased 18 percent in 2003 compared with 2002. The increase in 2003 is a result of higher underwriting income and net investment income, partially offset by higher income tax expense. Foreign exchange did not have a material impact on Global Reinsurance’s income excluding gains in 2003. The large increase in income excluding net realized gains (losses) in 2002 compared with 2001 is due to the impact of the September 11 tragedy in 2001 and the improved market conditions in 2002.
ACE Life Re principally provides reinsurance coverage to other life insurance companies, focusing on guarantees included in certain fixed and variable annuity products. We do not compete on a traditional basis for pure mortality business. The reinsurance transactions we
undertake typically help clients - ceding companies - to manage mortality, morbidity, and/or lapse risks embedded in their book of business. We price life reinsurance using actuarial and investment models that incorporate a number of factors, including assumptions for mortality, morbidity, expenses, demographics, persistency, investment returns and inflation. We assess the performance of our life reinsurance business based on income excluding net realized gains (losses).
ACE Life Re’s gross premiums written increased 17 percent in 2003 compared with 2002. This increase relates mainly to new variable annuity and mortality business. Gross premiums written in 2002 included $59 million of non-recurring business, $55 million of which was group long-term disability business. Gross premiums written decreased 60 percent in 2002 compared with 2001, which included $334 million from non-recurring deals. Income (loss) excluding net realized gains (losses) improved in 2003 due to lower policy acquisition costs and administrative expenses, and higher investment income compared with 2002. Policy acquisition costs decreased due to the growth in life, health and annuity lines, which have lower acquisition costs than the group long-term disability business. Administrative expenses were lower in 2003 due to reduced staff levels. Investment income is higher due to a higher invested asset base, as a result of increased production in 2003. Income (loss) excluding net realized gains (losses) increased in 2002 compared with 2001, primarily due to higher investment income.
Gross premiums written for the financial guaranty operations increased 30 percent to $510 million in 2003, compared with $391 million in 2002. The municipal line reported strong production growth, benefiting from increased new issue activity, due to low interest rates and also a higher proportion of the new issues are insured. In addition, non-municipal and trade credit lines of business achieved strong production results offset by a decline in mortgage and equity CDO business. The decrease in mortgage gross written premium is partly due to the low interest rate environment that has fueled refinancing activity and resulted in a commensurate reduction in the existing in-force quota share book. Additionally, a non-recurring mortgage transaction was completed in 2002. During the fourth quarter of 2003, we terminated three equity layer CDOs, which resulted in the recording of negative gross premiums written. The policy acquisition cost ratio increased due to a change in business mix whereby a greater portion of the business, specifically municipal, non-municipal and trade credit lines, incurs commission costs. Administrative expenses increased as a result of an increase in staff needed to support the growing direct business and also due to a severance charge associated with the planned IPO. Underwriting income decreased $11
million to $37 million in 2003, compared with $48 million in 2002, due to the higher policy acquisition cost and administrative expense ratios. In 2002, the financial guaranty operations increased underwriting income $16 million due to lower losses and loss expenses.
Gross premiums written for the financial solutions operations decreased to $536 million in 2003 compared with $1.1 billion in 2002. This reduction relates to the decline in LPTs written and the recording of negative premiums due to the termination of an equity CDO. Additionally, 2002 was bolstered by several large, multi-year prospective, structured programs sold. Net premiums earned for the financial solutions operations decreased to $773 million in 2003, compared with $845 million, in 2002. This decline in net premiums earned is the result of a reduction of retrospective premiums from LPTs, which are fully earned when written, offset, to a large degree, by an increase in net premiums earned from prospective contracts, typically finite and structured risk products for which premiums may be earned over a three to five year effective period. The financial solutions operations reported an increase in underwriting income of $22 million to $25 million in 2003, compared with $3 million in 2002. Underwriting income increased due to changes in mix of business as well as the discontinuation of life business, which typically incurs higher commissions than other business. The administrative expense ratio increased as a result of increased staffing costs. Underwriting income for the financial solutions operations increased $117 million in 2002 compared with 2001, which included an underwriting income impact of $147 million due to the September 11 tragedy.
The following table presents our pre-tax net realized gains (losses) for the years ended December 31, 2003, 2002 and 2001.
Given our total return objective for our investment portfolio, we may sell securities at a loss due to changes in the investment environment, our expectation that fair value may deteriorate further, our desire to reduce our exposure to an issuer or an industry, and changes in the credit quality of the security.
We review all of our fixed maturity securities, including securities on loan, and equity securities for potential impairment each quarter. Initially, we identify those securities to be evaluated for a potential impairment. In this process, the following is considered by type of security:
• those securities that have been in a loss position for the previous nine months and market value is less than 80 percent of amortized cost, or cost for equity securities; or
• those securities that are rated below investment grade by at least one major rating agency.
• a significant economic event has occurred that is expected to adversely affect the industry the issuer participates in;
• recent issuer-specific news that is likely to have an adverse affect on operating results and cash flows; or
• a missed or late interest or principal payment related to any debt issuance.
• whether an issuer is current in making principal and interest payments on the debt securities in question;
• the issuer’s financial condition and our assessment (using available market information) of its ability to make future scheduled principal and interest payments on a timely basis; and
With respect to other investments that are not traded in a public market, such as venture capital investments, the portfolio managers, as well as our internal valuation committee, consider a variety of factors in determining whether or not the investment should be evaluated for impairment. Indicators of impairment include:
• a missed interest or principal payment related to any debt issuance.
• the issuer’s progress, and whether it has been substantially less than expected.
The decrease in interest expense is a result of a reduction in average outstanding trust preferred securities in 2003 compared with 2002. This decrease was partly offset due to the impact of the $500 million 6.0 percent notes issued late in the first quarter of 2002. During 2002, we repaid $400 million of trust preferred securities. Interest expense declined in 2002 compared with 2001 due to lower interest rates and a reduction in outstanding debt.
The increase in income tax expense is primarily due to the increase in net income in 2003 compared with 2002. Our net realized gains in 2003 compared with net realized losses in 2002 increased income tax expense by $104 million. In addition, the increased profitability for Insurance - Overseas General added $78 million to income tax expense in 2003. Last year’s A&E reserve strengthening resulted in an income tax benefit of $162 million in 2002. We reported an income tax benefit of $78 million in 2001 primarily due to the underwriting loss generated largely by the September 11 tragedy. Our effective tax rate on income excluding net realized gains (losses) for 2003, was 17 percent. Our effective tax rate is dependent upon the mix of earnings from different jurisdictions with various tax rates; a different geographic mix of actual earnings would change the effective tax rate. For further information on taxation, see Note 14 of the Consolidated Financial Statements.
Our principal investment objective is to ensure that funds are available to meet our insurance and reinsurance obligations. Within this broad liquidity constraint, the purpose of our investment portfolio’s structure is to maximize total return subject to specifically approved guidelines of overall asset classes, credit quality, and liquidity and volatility of expected returns. Our investment portfolio is invested primarily in fixed income securities with an average credit quality of AA, as rated by the independent investment rating service S&P. The portfolio is externally managed by independent, professional, investment managers. The average duration of our fixed income securities, including the effect of interest rate swaps, is 3.4 years at December 31, 2003, compared with 3.1 at December 31, 2002. Our other investments principally comprise direct investments, investments in investment funds and investments in limited partnerships.
The following table identifies our invested assets by type held at fair value and cost/amortized cost at December 31, 2003 and 2002.
The following tables show the market value of our fixed maturities, short-term investments, securities on loan and cash at December 31, 2003. The first table lists elements according to type, and the second according to S&P credit rating.
As a complement to our credit default swap business and with the objective of enhancing investment yield, we invested in the equity tranches of six CDOs from June 2001 through August 2002. Our aggregate maximum exposure under these CDOs is $43.8 million, which approximates the cost of these investments. At December 31, 2003, the underlying assets in these CDOs, which aggregate to $2.6 billion for all six CDOs, are principally invested in asset-backed securities, including investments in the debt tranches of other CDOs. While management considers the related entities to be variable interest entities, as defined by FIN 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51,” our equity investments represent a small portion of the variable interests in each CDO. Accordingly, under FIN 46, we are not required to consolidate any of these entities. At December 31, 2003, our aggregate carrying
value for these investments is $29.1 million, which represents our remaining loss exposure related to these investments as of December 31, 2003. From January 1, 2004 through February 11, 2004, we sold four of these six positions, representing $16.1 million of our year end carrying value and $1.9 billion of the aforementioned $2.6 billion of aggregate assets in all six CDOs.
Note 5 of our Consolidated Financial Statements includes a reconciliation of our beginning and ending net losses and loss adjustment expense reserves for each of the three years ended December 31, 2003, 2002, and 2001. The reserve for unpaid losses and loss expenses increased by $2.8 billion to $27.1 billion at December 31, 2003 compared with $24.3 billion at December 31, 2002. This increase is attributed to the significant growth in business in 2003. The balance at December 31, 2003, includes $13.9 billion of IBNR compared with $11.3 billion at December 31, 2002. Our net incurred losses in 2003 were $6.1 billion, compared with $4.9 billion in 2002. Net losses and loss expenses incurred for 2003 and 2002 include $164 million and $709 million of prior period development, respectively. In 2002, we incurred $516 million of prior period development related to A&E. More information regarding prior period development is included in the Segment Operating Results section.
For each of our lines of business, management, in conjunction with internal actuaries, develop a “best estimate” of ultimate liabilities, which they believe provide a reasonable estimate of the required reserve. The following is a discussion of our reserve- setting procedures by segment:
Our internal actuaries perform standard actuarial methodologies including paid and incurred loss development and the Bornhuetter-Ferguson (BF) incurred and paid loss methods. The BF method is a blend of an expected loss ratio method and utilization of a pattern consistent with that of a loss development technique. For those lines of business where there is enough historical experience, in general, all four methods are utilized and an ultimate indication is estimated based on the outcomes of these techniques as well as any other methods used for the given line of business (e.g. counts and averages approaches). More reliance would be placed on loss development techniques for the older years as these are more mature and would have more consistent trends. For the more recent years, especially for long-tailed lines of business, a BF method would be given more weight as these immature years are highly leveraged and in many cases a development method could significantly understate or overstate liabilities. In all cases, additional diagnostics are performed to help in the determination of the most appropriate estimate. These diagnostics include a review of paid loss to incurred loss ratios, claims disposal rates and implied IBNR to case outstanding ratios. In situations where a new line of business is being written or a new product line being sold, an expected loss ratio method would be more appropriate as our own historical loss development information is limited. In these cases, industry benchmark loss ratios and development patterns are utilized to estimate ultimate indications. Given the high severity, low frequency nature of ACE Bermuda’s book of business, the actuarial techniques utilized in calculating IBNR is more heavily weighted to an expected loss ratio/BF methodology. There is intense monitoring by claim of potential case reserve development in this business and the interaction between the claims department and actuarial function is a crucial element in the success of this operating unit.
One of the ways we manage our loss exposure is through the use of reinsurance. While reinsurance agreements are designed to limit our losses from large exposures and permit recovery of a portion of direct unpaid losses, reinsurance does not relieve us of liability to our insureds. Accordingly, the losses and loss expense reserves on our balance sheet represent our total unpaid gross losses. The reinsurance recoverable represents anticipated recoveries of a portion of those gross unpaid losses as well as amounts recoverable from reinsurers with respect to claims paid. The table below presents our net reinsurance recoverable at December 31, 2003 and 2002.
We evaluate the financial condition of our reinsurers and potential reinsurers on a regular basis and also monitor concentrations of credit risk with reinsurers. The provision for uncollectible reinsurance is required principally due to the failure of reinsurers to indemnify us,
primarily because of disputes under reinsurance contracts and insolvencies. Provisions have been established for amounts estimated to be uncollectible.
The general collections category represents amounts in the process of collection in the normal course of business. These are balances for which we have no indication of dispute or credit-related issues.
The other category includes amounts recoverable that are in dispute, or are from companies in supervision, rehabilitation or liquidation. Our estimation of this reserve considers the credit quality of the reinsurer and whether we have received collateral or other credit protections, such as parental guarantees.
Included in our liabilities for losses and loss expenses are amounts for A&E. These A&E liabilities principally relate to claims arising from remediation costs associated with hazardous waste sites and bodily-injury claims related to asbestos products and environmental hazards. These amounts include provision for both reported and IBNR claims.
In a lawsuit filed in the state of California in December 1999, certain competitors of ACE USA have challenged the restructuring that resulted in the creation of Brandywine. The restructuring was previously upheld by the Pennsylvania Supreme Court in July 1999. The lawsuit alleges that the restructuring does not effectively relieve the insurance subsidiary that issued the policies prior to the restructuring (Insurance Company of North America) from liabilities for claims on those policies by California policyholders. The California trial court has held in response to a pre-trial motion that a California statute does prohibit the transfer of California policies to a subsequent legal entity without the consent of the policyholders and noted that consent was not received in the context of the Brandywine restructuring. ACE intends to appeal this decision. In addition, the liabilities that are the subject of this California lawsuit are included within our A&E reserves for Brandywine.
Survival ratios attempt to measure the adequacy of A&E loss reserves by taking the current ending loss reserve and dividing by the average annual claim payments for the prior three years. We believe this to be a simplistic measure of a very complicated issue. However, we understand this ratio is used as a means to compare companies with A&E exposures. Thus, if we average our last three years of gross A&E claim payments and expect payments to continue at the same pace, our gross survival ratio is 10.3 years. Using the 2003 calendar year payments, our net survival ratio is 9.9 years. The current year survival ratios are adversely affected by the timing of certain previously agreed upon settlements. These settlements were anticipated in our 2002 asbestos study.
Liquidity is a measure of a company’s ability to generate cash flows sufficient to meet short-term and long-term cash requirements of its business operations. As a holding company, ACE possesses assets that consist primarily of the stock of its subsidiaries, and of other investments. In addition to net investment income, our cash flows currently depend primarily on dividends or other statutorily permissible payments. Historically, these dividends and other payments have come from our Bermuda-based operating subsidiaries, which we refer to as our Bermuda subsidiaries. During the year ended December 31, 2003, we were able to meet all of our obligations, including the payment of dividends declared on our ordinary shares and preferred shares, with our net cash flow and dividends received. Should the need arise, we generally have access to the debt markets and other available credit facilities that are discussed below.
The payments of dividends or other statutorily permissible distributions from our operating companies are subject to the laws and regulations applicable to each jurisdiction, as well as the need to maintain capital levels adequate to support the insurance and reinsurance operations, including financial strength ratings issued by independent rating agencies, which are discussed later.
The payment of any dividends from ACE Global Markets or its subsidiaries would be subject to applicable U.K. insurance laws and regulations including those promulgated by the Society of Lloyd’s. ACE INA’s and ACE Financial Services’ U.S. insurance subsidiaries may pay dividends, without prior regulatory approval, only from earned surplus and subject to certain annual limitations and the maintenance of a minimum capital requirement. ACE INA’s international subsidiaries are also subject to insurance laws and regulations particular to the countries in which the subsidiaries operate. These laws and regulations include restrictions that limit the amount of dividends payable without prior approval of regulatory insurance authorities.
We did not receive any dividends from ACE Global Markets or ACE INA in 2003. Under the Lloyd’s accounting model, syndicates in Lloyd’s operate each year as an annual venture. Each year of account is held open for three years. At the end of three years, the year of account purchases reinsurance from the next open year, which is known as reinsurance to close or RITC, and distributes the remaining funds to the investors in the syndicate. ACE Global Markets has historically retained these funds for operational purposes. ACE INA
Our consolidated sources of funds consist primarily of net premiums written, net investment income and proceeds from sales and maturities of investments. Funds are used primarily to pay claims, operating expenses, dividends and for the purchase of investments. After satisfying our cash requirements, excess cash flows from these underwriting and investing activities are invested.
Our insurance and reinsurance operations provide liquidity in that premiums are received in advance, sometimes substantially in advance, of the time claims are paid. Our consolidated net cash flows from operating activities were $4.2 billion in 2003 compared with $2.4 billion and $1.4 billion in 2002 and 2001, respectively. The positive operating cash flows were generated from an increase in net premiums written of $2.2 billion for the year ended December 31, 2003, and relatively stable net losses and loss expenses paid compared with 2002. The increase in 2002 compared with 2001 was primarily due to the $1.7 billion increase in net premiums written. Generally cash flows are affected by claim payments that, due to the nature of our operations, may comprise large loss payments on a limited number of claims and therefore can fluctuate significantly from year to year. The irregular timing of these loss payments can create significant variations in cash flows from operations between periods. Sources of liquidity include cash from operations, financing arrangements or routine sales of investments. Our consolidated net cash flows used for investing activities increased to $4.7 billion in 2003, compared with $1.9 billion in 2002. This increase primarily reflects our strong consolidated net cash flows from operating activities in 2003. Net cash flows used for investing activities decreased to $1.9 billion in 2002 compared with $2.2 billion in 2001. This decrease is primarily due to our debt repayment activity in 2002, which reduced net cash available for investment. Our consolidated net cash flows from financing activities were $395 million in 2003, compared with usage of $491 million in 2002. The increase is primarily due to the net proceeds from the issuance of preferred shares in 2003, compared with the repayment of trust preferred securities and short-term debt in 2002. We reported consolidated net cash flows from financing activities of $896 million in 2001, primarily due to the net proceeds from the issuance of ordinary shares. Although our ongoing operations continue to generate positive cash flows, our cash flows are currently impacted by a large book of loss reserves from businesses in run-off. The run-off operations generated negative operating cash flows of $645 million in 2003, compared with $525 million and $614 million in 2002 and 2001, respectively, primarily due to claim payments. Both internal and external forces influence our financial condition, results of operations and cash flows. Claim settlements, premium levels and investment returns may be impacted by changing rates of inflation and other economic conditions. In many cases, significant periods of time, ranging up to several years or more, may lapse between the occurrence of an insured loss, the reporting of the loss to us and the settlement of the liability for that loss. We believe that our cash balances, cash flow from operations, routine sales of investments and the liquidity provided by our credit facilities, as discussed below are adequate to meet expected cash requirements.
ACE and its subsidiaries are assigned debt and financial strength (insurance) ratings from internationally recognized rating agencies, including S&P, A.M. Best, Moody’s Investors Service and Fitch IBCA. The ratings issued on our companies by these agencies are announced publicly and are available directly from the agencies. Our website, acelimited.com, also contains some information about our ratings, which you can find under the “Investor Information” tab.
It is possible that, in the future, one or more of the rating agencies may reduce our existing ratings. If one or more of our ratings were downgraded, we could incur higher borrowing costs and our ability to access the capital markets could be impacted. In addition, our insurance and reinsurance operations could be adversely impacted by a downgrade in our financial strength ratings, including a possible reduction in demand for our products in certain markets.
In May 2003, we sold in a public offering 23 million depositary shares, each representing one-tenth of one of our 7.80 percent Cumulative Redeemable Preferred Shares for $25 per depositary share for net proceeds of $557 million. Gross proceeds from the sale of the preferred shares were $575 million and related expenses were $18 million. We used the net proceeds to make additional capital contributions to some of our subsidiaries and for general corporate purposes. This offering was made under our universal shelf registration statement with the SEC, which became effective in February 2003, allowing us to offer a number of different types of debt and equity securities up to a total offering price of $1.5 billion. Dividends on the preferred shares are payable quarterly, when and if declared by our Boards of Directors, in arrears on March 1, June 1, September 1 and December 1 of each year. On September 1, 2003 and December 1, 2003 we paid dividends of $4.9292 and $4.8750 per preferred share to shareholders of record on August 31, 2003 and November 30, 2003, respectively.
Our diluted book value per ordinary share increased to $29.46 at December 31, 2003, compared with $24.16 at December 31, 2002. In calculating our diluted book value per ordinary share, we include in the denominator in-the-money options together with the 11.8 million shares issued upon conversion of the FELINE PRIDES. The expected proceeds from the in-the-money options are included in the numerator. Shareholders’ equity increased by $2.4 billion in 2003, compared with 2002. This increase is due to the issuance of the preferred shares; our net income, conversion of the FELINE PRIDES which increased shareholder’s equity by $311 million, and unrealized gains on our investment portfolio of $208 million. Partially offsetting these increases, were $236 million of dividends declared on mezzanine equity, ordinary and preferred shares in 2003.
Included in short-term debt is ACE INA’s $400 million, 8.2 percent notes which become due on August 15, 2004. We plan to refinance these notes.
In June 1999, we arranged certain commercial paper programs. The programs use revolving credit facilities as back-up facilities and provide for up to $2.8 billion in commercial paper issuance (subject to the availability of back-up facilities, which currently total $750 million) for ACE and for ACE INA. During 2003 and 2002, we substantially reduced our use of commercial paper.
From time to time, we also use securities repurchase agreements as a source of short-term liquidity. Under these repurchase agreements, we agree to sell securities and repurchase them at a future date for a predetermined price, thereby creating liquidity. The covenants of our existing credit facilities limit our borrowing under repurchase agreements to $800 million.
The following instruments have specific collateral triggers. In 1998, ACE US Holdings issued $250 million of unsecured senior notes that mature in October 2008. In December 1999, ACE INA issued $300 million of unsecured subordinated notes that mature in December 2009. We repaid $100 million of this outstanding amount during 2002. We have a $450 million credit default swap in place that has the economic effect of reducing our cost of borrowing associated with these two issuances. The minimum collateral in connection with the credit default swap is $158 million. The actual collateral can be higher depending on the credit quality of securities pledged.
During 1999 and 2000, we issued $800 million of trust preferred securities of which $400 million matured and was repaid in 2002. The funds generated from these issues were used to partially finance the ACE INA acquisition. The securities outstanding consist of:
Each of the three remaining series of trust preferred securities was issued by a special purpose entity that is wholly owned by us; two trusts and a limited liability company. The sole assets of the special purpose entities are debt instruments issued by one or more of our subsidiaries. The special purpose entities look to payments on the debt instruments to make payments on the preferred securities. We have guaranteed the payments on these debt securities. The trustees of the trusts and the managers of the limited liability company include one or more of our officers and at least one independent trustee or manager, such as a bank or trust company. Our officers serving as trustees of the trusts or managers of the limited liability company do not receive any compensation or other remuneration
for their services in such capacity. The full $475 million of outstanding trust preferred stock is shown on our consolidated balance sheet as a liability. Additional information with respect to the trust preferred securities is contained in Note 8 of our Consolidated Financial Statements.
At December 31, 2003, (a) the minimum consolidated net worth requirement under the covenant described in (i) above was $5.2 billion and our actual consolidated net worth as calculated under that covenant was $8.1 billion; and (b) our ratio of debt to total capitalization was 0.17 to 1.
In addition to these covenants, the ACE Global Markets capital facility requires that collateral be posted if the financial strength rating of ACE Limited falls to S&P BBB+ or lower. Prior to November 2003 (the renewal date of the ACE Global Markets unsecured LOC), this requirement related to ACE Bermuda.
See Note 2(p) to the Consolidated Financial Statements for a discussion of recent accounting pronouncements.