We conduct business from various facilities, most of which are leased. In addition, we own our administrative offices in Overland Park, Kansas and Fort Wayne, Indiana.
Net premiums written and net premiums earned increased $500 million (7%) and $602 million (8%), respectively, in 2002. Substantially all of the growth in premiums earned is attributable to price increases achieved in direct property and casualty insurance. Assumed reinsurance premiums earned grew only slightly ($81 million or 1%) during 2002 as the positive impacts of higher premium pricing stemming from the recent hardening price environment within the overall property and casualty insurance/reinsurance industry were largely negated by our actions initiated in 2001 and 2002 to exit certain reinsurance product lines, policies, contracts and specific customers for which, given the risk, acceptable future levels of profit did not seem achievable. Ceded reinsurance premiums earned also grew only slightly ($40 million or 1%) during 2002 due to the unusually high level of 2001 ceded premium activity driven by the events of September 11, 2001 being offset by similarly elevated 2002 ceded premium levels. The high 2002 ceded premiums resulted from the combination of increasing contingent premium cost estimates (including reinstatement premiums) related to prior year loss events and higher general retrocession costs.
There is a high degree of uncertainty inherent in the estimates of ultimate losses underlying the liability for unpaid claims and claim expenses. This inherent uncertainty is particularly significant for liability-related exposures, including latent claim issues (such as asbestos and environmental related coverage disputes) due to the extended period, often many years, that transpires between a loss event, receipt of related claims data from policyholders and/or primary insurers and ultimate settlement of the claim. This situation is then further exacerbated for reinsurance entities (as opposed to primary insurers) due to lags in receiving current claims data. Because reinsurance protection is often provided on an "excess-of-loss" basis whereby the reinsurer is only obligated to pay losses in excess of pre-established limits, notification is only required to be provided to the reinsurer when the claim is assessed as having a reasonable possibility of exceeding the primary insurer's retention thresholds. This notification can often be years after the loss event was initially reported to the primary insurer.
The liability for claims and claim expenses includes two components: case reserves for reported claims and IBNR reserves (incurred but not reported) for unreported claims that are estimated to have occurred prior to the end of the respective accounting period. Case reserves are established by experienced professionals from our claims teams based on case-specific facts and circumstances and are updated continually as further information becomes available. Determining required IBNR reserves is a more complex and often more subjective process involving qualified actuaries familiar with the underlying exposures in the portfolio.
The reserving actuaries select loss development factors based on prior year claim experience. The selected loss development factors are used to extrapolate future loss development in order to generate ultimate loss estimates driven by actual loss experience. While the LDF methods are statistically based, they also incorporate subjective interpretations of the underlying claim trends.
Higher than anticipated levels of reported claims activity, particularly for liability-related exposures underwritten in 1997 through 2001, combined with updated pricing and underwriting metrics, caused us to both (1) accelerate the migration from an ELR to an LDF based reserving approach for certain liability-related reserving segments and (2) update ELRs assigned to the more recent accident/underwriting years in response to the reported claims activity. As a result of these changes, we concluded that our best estimate of ultimate losses was higher in the range of reasonably possible loss scenarios than previously estimated. Accordingly, we recognized a fourth quarter pre-tax charge of approximately $2.5 billion to increase recorded reserves to reflect the revised indications of remaining liability. The significant components of this adverse development included hospital medical malpractice ($300 million), product liability ($300 million), professional liability ($250 million), umbrella liability ($200 million), workers compensation ($200 million), individual liability ($150 million) and asbestos-related exposures ($150 million). With amounts recognized in previous quarters of 2002, our overall 2002 pre-tax charge for adverse development amounted to approximately $3.7 billion. Insurance loss provisions are based on the best available estimates at a given time. As described on page 29 under the caption "Insurance Liabilities and Reserves," these estimates will be adjusted in the future as required.
In addition to the underwriting results discussed above, 2002 reported operating results as compared to 2001 were also impacted by (1) the January 1, 2002 implementation of SFAS 142, Goodwill and Other Intangible Assets, which resulted in goodwill no longer being amortized (2001 amortization totaled $86 million, $70 million after-tax) and (2) a general increase in other operating costs and expenses. In addition, income tax benefits partially offset the significant pre-tax operating loss generated in 2002. Such recorded tax benefits include the impact of us holding a significant portion of our overall investment portfolio in securities that are substantially exempt from U.S taxation.
Net premiums written and net premiums earned decreased $799 million (or 10%) and $816 million (also 10%), respectively, in 2001. The majority of this decrease is attributable to the $698 million of premiums ceded in connection with the events of September 11, 2001 as discussed below. The remaining decrease in premiums is attributable to (1) the decision to exit certain lines of business and customer relationships as part of a reunderwriting initiative undertaken in 2001 and (2) additional ceded premiums resulting from claims made on prior year retrocession coverages in place as a result of the adverse development on prior year losses recognized in 2001, somewhat offset by general growth in premiums due to the combination of recent hardening of pricing within the overall property and casualty insurance/reinsurance industry and a focus on growth within certain niche markets.
(1) Represents data for the applicable periods calculated in accordance with GAAP. Claims and claim expense ratio represents incurred claims and claim expenses as a percentage of net premiums earned. Underwriting expense ratio represents acquisition costs and other underwriting expenses (excluding amortization of intangibles, interest expense and minority interest in net earnings of consolidated businesses) as a percentage of net premiums earned. The combined ratio represents the sum of the claims and claim expense ratio and the underwriting expense ratio.
only modestly ($129 million or 10%) during 2002 due to the unusually high level of 2001 ceded premium activity driven by the events of September 11, 2001 being largely offset by similarly escalated 2002 ceded premium levels. The high 2002 ceded premiums written resulted from the combination of increasing contingent premium cost estimates (including reinstatement premiums) related to prior loss events and higher general retrocession costs. Net premiums written decreased $114 million or 3% in 2001, primarily attributable to (1) higher levels of ceded losses under aggregate excess-of-loss retrocession programs (both current year principally as a result of the events of September 11, 2001 and prior years due to continued adverse claim development) and (2) the decision to exit certain lines of business and customer relationships as part of a reunderwriting initiative undertaken in 2001, somewhat offset by general growth in premiums due to the combination of recent hardening of pricing within the overall property and casualty insurance/reinsurance industry and a focus on growth within certain niche markets.
The significant increase in the combined ratio in 2002 is primarily attributable to the recognition of adverse development related to prior year loss events, including a significant charge recognized during the fourth quarter. Due to the impacts of existing retrocession coverages previously purchased, the recording of this adverse development both increased incurred claims and claim expenses and, to a lesser extent, decreased premium revenues (principally because of higher levels of contingent ceded premiums following these reserve adjustments). The escalated combined ratio for 2001 is partially attributable to higher levels of ceded premiums and incurred losses resulting from the events of September 11, 2001. Excluding this impact, the 2001 combined ratio would have been 126.6%. The relatively high combined ratios in 2001 (excluding the impact of the events of September 11, 2001) and, to a lesser extent, in 2000 primarily reflect the effects of continued insufficient pricing within the overall property and casualty insurance/reinsurance industry in recent years and adverse development on prior year recorded losses. The majority of the adverse development in 2001 related to higher projected ultimate losses for liability coverages, especially in the hospital liability, nonstandard automobile (automobile insurance extended to higher-risk drivers) and commercial general liability lines of business.
The reduction in net investment income of $72 million (14%) in 2002 and $76 million (13%) in 2001 is primarily due to the declining interest rate environment experienced in both 2002 and 2001. The decrease in net realized gains on investments in 2002 is attributable to reduced opportunity for gains within the overall investment portfolio combined with higher levels of other-than-temporary impairment charges recognized. The decrease in total investment-related revenues is consistent with experience of the insurance industry as a whole.
Earnings (loss) before income taxes and cumulative effect of change in accounting principle, excluding net realized gains on investments, decreased $1.4 billion in 2002, primarily attributable to the factors driving the significant increase in the combined ratio discussed above and, to a lesser extent, a decrease in investment-related income. Earnings (loss) before income taxes and cumulative effect of change in accounting principle, excluding net realized gains on investments, decreased $976 million in 2001, primarily attributable to the increase in the combined ratio (including the significant impact of the events of September 11, 2001) and the decrease in net investment income.
Net premiums written increased only $16 million or 1% in 2002. This modest increase was primarily attributable to the positive impacts of higher premium pricing stemming from the recent hardening price environment within the overall property and casualty insurance/reinsurance industry being largely negated by actions initiated in 2001 and 2002 to exit certain product lines, policies, contracts and specific customers for which, given the risk, acceptable future levels of profit did not seem achievable. Ceded reinsurance premiums written grew somewhat during 2002 ($406 million or 36%) due to the unusually high 2001 ceded premium activity driven by the events of September 11, 2001 being more than matched by elevated 2002 ceded premium levels. The high 2002 ceded premiums written resulted from the combination of increasing contingent premium cost estimates (including reinstatement premiums) related to prior loss events and higher general retrocession costs. Net premiums written decreased $890 million or 32% in 2001, primarily attributable to (1) higher levels of ceded losses under the aggregate excess-of-loss retrocession program principally as a result of the events of September 11, 2001 and (2) the decision to exit certain lines of business and customer relationships as part of a reunderwriting initiative undertaken in 2001, somewhat offset by general growth in premiums due to the recent hardening of pricing within the overall property and casualty insurance/reinsurance industry.
Consistent with experience in the domestic property and casualty business, the significant increase in the combined ratio in 2002 is primarily attributable to the recognition of adverse development related to prior year loss events, including a significant charge recognized during the fourth quarter. Due to the impacts of existing retrocession coverages previously purchased, the recording of this adverse development both increased incurred claims and claim expenses and, to a lesser extent, decreased premium revenues (principally because of higher levels of contingent ceded premiums following these reserve adjustments). The elevated combined ratio for 2001 is partially attributable to higher levels of ceded premiums and incurred losses resulting from the events of September 11, 2001. Excluding this impact, the 2001 combined ratio would have been 114.8%. The relatively high combined ratios in 2001 (excluding the impact of the events of September 11, 2001) and, to a lesser extent in 2000, primarily reflect the effects of continued insufficient pricing within the overall property and casualty insurance/reinsurance industry in recent years and adverse development on prior year recorded losses. The increase in the combined ratio in 2000 also includes the impact of significant adverse development relating to certain European windstorms occurring late in 1999.
Earnings before income taxes and cumulative effect of change in accounting principle decreased $162 million or 62% in 2002, including a $49 million decrease in net realized gains on investments. Excluding net realized gains on investments, earnings before income taxes and cumulative effect of change in accounting principle decreased $113 million or 55% in 2002, primarily attributable to increased claim activity in 2002 as compared to 2001with respect to mortality and certain health-related products. Earnings before income taxes and cumulative effect of change in accounting principle increased $22 million or 9% in 2001, including a $41 million decrease in net realized gains on investments. Excluding net realized gains on investments, earnings before income taxes and cumulative effect of change in accounting principle increased $63 million or 45% in 2001, primarily attributable to the increase in revenues discussed above and more favorable claim experience as compared to 2000 (particularly in the international individual disability line of business).
Cash flows from investing activities decreased $2.1 billion in 2002, primarily attributable to growth in net purchases of investment securities as a result of the increased operating cash flows discussed above. Cash flows from investing activities decreased $1.3 billion in 2001, primarily attributable to a net increase in the purchase of investment securities as a result of the cash inflows from higher volumes of contract deposits within the life reinsurance operations and the capital contributions discussed below under cash flows from financing activities.
2002 ($1.8 billion) as compared to 2001 ($400 million), partially offset by a decrease in the level of contract deposits within the life reinsurance business segment and a decrease in the level of short-term borrowings (including those involving a related party credit facility). The $1.8 billion capital contribution received in 2002 was made to replenish capital sufficient to cover the after-tax impact of the $2.5 billion charge taken in the fourth quarter to strengthen prior year claim reserves. Cash flows from financing activities increased $944 million in 2001, primarily attributable to an increase in contract deposit liabilities resulting from growth within the life reinsurance business segment and capital contributions received to replenish capital sufficient to cover losses associated with the events of September 11, 2001, somewhat offset by a decrease in short-term borrowings.
In connection with the 2002 $1.8 billion capital contribution and other transactions, we transferred our international property and casualty businesses from ERC Life to GE Investments, Inc. ("GEII"), and following those transactions, we own all the outstanding shares of Class C common stock of GEII. The Class C stock is intended to reflect the value and the financial performance of the transferred businesses. Because GE has delegated control of the transferred businesses to us, we continue to consolidate the financial results of those businesses with our results. Our Class C shares represent less than 20% of the outstanding common stock of GEII. The following table providees summary balance sheet information of the transferred businesses as of December 31, 2002:
We have not utilized forms of off-balance sheet arrangements, such as asset securitizations, involving special purpose entities to facilitate improved share owner returns and securities transactions, transfer selected credit risk, or engage in speculative activities and have not provided financial support to special purpose entities under any liquidity or credit support agreements.
Domestic Investment Operations. A substantial portion of our domestic property and casualty investment portfolios are invested in tax-exempt state and municipal bonds, which we believe provide the most attractive after-tax yield. Our domestic life investment portfolios are largely invested in taxable debt securities.
Our emphasis on investment quality is evidenced by the preceding table, which indicates that the bonds in our investment portfolios are principally invested in either U.S. government and government agency securities or issues rated "Baa" or above. The Canadian securities held are similar in quality to the other securities held in our domestic portfolio. Fixed maturity securities held in our domestic life portfolios include mortgage-backed and other asset-backed securities that are matched to the liability profile of specific life reinsurance contracts. Investments in mortgage-backed and other asset-backed securities are limited to lower risk tranches and do not include any interest only or principal only securities. Mortgage-backed and other asset-backed securities in our investment portfolio were principally issued by Federal
Interest rate and currency risk management is important in our normal business activities. We use derivative financial instruments to mitigate or eliminate certain financial and market risks, including those related to changes in interest rates and currency exchange rates. As a matter of policy, we do not engage in derivatives trading, derivatives market-making or other speculative activities. More detailed information regarding these financial instruments, as well as strategies and policies for their use, is contained in notes 2 and 14 to the consolidated financial statements.
Our geographic distribution of operations is diverse. One means of assessing exposure to changes in currency exchange rates is to model effects on reported earnings using a sensitivity analysis. We analyzed year-end 2002 consolidated currency exposures, including financial instruments designated and effective as hedges, to identify assets and liabilities denominated in other than their relevant functional currencies. Net unhedged exposures in each currency were then remeasured generally assuming a 10 percent decrease (substantially greater decreases for hyperinflationary currencies) in currency exchange rates compared with the U.S. dollar. Under this model, we estimated at year-end 2002 that such a decrease would have an insignificant effect on 2003 earnings.
Accounting policies discussed in this section are those that we consider to be critical to an understanding of our financial statements because their application places the most significant demands on our ability to judge the effect of inherently uncertain matters on our financial results. For all of these policies, we caution that future events rarely develop exactly as forecast, and the best estimates routinely require adjustment.
assumptions about mortality, lapse rates and future yield on related investments. Historical insurance industry experience indicates that a greater degree of inherent variability exists in assessing the ultimate amount of losses under short-duration property and casualty contracts than exists for long-duration mortality exposures. This inherent variability is particularly significant for liability-related exposures, including latent claims issues (such as asbestos and environmental related coverage disputes), because of the extended period of time--often many years--that transpires between when a given claim event occurs and the ultimate full settlement of such claim. This situation is then further exacerbated for reinsurance entities (as opposed to primary insurers) due to coverage often being provided on an "excess-of-loss" basis and the resulting lags in receiving current claims data. Benefit-related insurance liabilities totaled $31.8 billion at year-end 2002. Of that total, approximately $25.2 billion ($16.1 billion net of reinsurance recoverables) related to unpaid claims and claims adjustment expenses under short-duration insurance contracts.
We continually evaluate the potential for changes in loss estimates with the support of qualified reserving actuaries and use the results of these evaluations both to adjust recorded reserves and to proactively modify underwriting criteria and product offerings. For actuarial analysis purposes, reported and paid claims activity is segregated into more than 300 reserving segments, each having differing historical settlement trends. A variety of actuarial methodologies are then applied to the underlying data for each of these reserving segments in arriving at an estimated range of "reasonably possible" loss scenarios. Factors such as line of business, length of historical settlement pattern, recent changes in underwriting standards and unusual trends in reported claims activity will generally affect which actuarial methodologies are given more weight for purposes of determining the "best estimate" of ultimate losses in a particular reserving segment.
future impairment actions will depend to a large degree on future economic conditions (including the impact of future claims experience and, to a lesser extent, investment yields), we do not anticipate significant impairment charges in 2003. The reinsurance-specific requirements necessitating projections of future cash flows include "risk transfer" testing for both assumed and ceded business at contract inception and, for certain ceded contracts containing retrocessionaire limits expressed in terms of an "economic loss," throughout the life of the underlying contract. At year-end 2002, approximately $1.3 billion of reinsurance recoverables related to contracts containing economic loss limits. As part of our continuing updates of recorded liabilities for claims and claim expenses, we also periodically reassess the expected pay-out patterns and resulting cash flow projections and make indicated adjustments to the recorded reinsurance recoverables. We do not anticipate significant adjustments during 2003.
Other loss contingencies are recorded as liabilities when it is probable that a liability has been incurred and the amount of the loss is reasonably estimable. Disclosure is required when there is a reasonable possibility that the ultimate loss will exceed the recorded provision. Contingent liabilities are often resolved over long time periods. Estimating probable losses requires analysis of multiple forecasts that often depend on judgments about potential actions by third parties such as regulators.
The Financial Accounting Standards Board's ("FASB") Statement of Financial Accounting Standards ("SFAS") 142, Goodwill and Other Intangible Assets, generally became effective for us on January 1, 2002. Under SFAS 142, goodwill is no longer amortized but is tested for impairment using a fair value methodology. We stopped amortizing goodwill effective January 1, 2002. The result of our applying the new rules as of January 1, 2002, resulted in no impairment charge.