(1) Excludes $20.8 million and $22.2 million of premium assumed from the Individual Risk segment in the years ended December 31, 2003 and 2002, respectively.
The following is a discussion and analysis of our results of operations for the year ended December 31, 2003 compared with the years ended December 31, 2002 and December 31, 2001. The following also includes a discussion of our financial condition at December 31, 2003. This discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes included in this filing. This filing contains forward-looking statements that involve risks and uncertainties. Actual results may differ materially from the results described or implied by these forward-looking statements (see "Note on Forward-Looking Statements").
RenaissanceRe was established in 1993 to write property catastrophe reinsurance. By pioneering the use of sophisticated computer models to construct our portfolio, we have become one of the world's largest and most successful catastrophe reinsurers. We are seeking to leverage our expertise to establish leading franchises in additional selected areas of insurance and reinsurance.
In reserving for our specialty reinsurance and Individual Risk coverages we do not have the benefit of a significant amount of our own historical experience in these lines, and therefore we estimate our IBNR for our specialty reinsurance and Individual Risk coverages by utilizing an actuarial method known as the Bornhuetter-Ferguson technique, a widely used method for lines of business in which a company may have limited historical loss experience. The utilization of the Bornhuetter-Ferguson technique requires a company to estimate an ultimate claims and claim expense ratio and select an estimated loss reporting pattern for each line of business that it offers. The expected loss ratio is modified to the extent that reported losses to date differ from what would be expected based on the selected loss reporting pattern. This method gives more weight to the actual reported loss experience as the underwriting period matures. We select our estimates of the ultimate claims and claim expense ratios and estimated loss reporting patterns by reviewing industry standards and adjusting these standards based upon the coverages and terms of the coverages we offer.
All of our estimates are reviewed annually with an independent actuarial firm. We also review our assumptions and our methodologies on a quarterly basis. If we determine that an adjustment to an earlier estimate is appropriate, such adjustments are recorded in the quarter in which they are identified. Although we believe we are cautious in our assumptions, and in the application of our methodologies, we cannot be certain that our ultimate payments will not vary, perhaps materially, from the estimates we have made.
At December 31, 2003, our total gross reserves for claims and claim expenses was $977.9 million and our estimated IBNR reserves were $596.6 million. A 5% change in such IBNR reserves would equate to a $29.8 million adjustment to claims and claim expenses incurred, which would represent 4.9% of our 2003 net income and 1.3% of shareholders' equity at December 31, 2003.
We recognize premiums as income over the terms of the related contracts and policies. Our written premiums are based on policy and contract terms and include estimates based on information received from both insureds and ceding companies. We record adjustment premiums in the period in which they occur.
The minimum and deposit premium on excess policies are usually determined by the contract wording. In the absence of defined amounts in the contract, management estimates written premium on these contracts based on historical experience and judgment. Actual amounts are determined in subsequent periods based on actual exposures and any adjustments are recorded in the period in which they occur.
We record ceded premiums on the same basis as assumed premiums. Reinstatement premiums are estimated by management, based on the contract terms, at the time of the loss occurrence giving rise to the reinstatement.
With our increase in premiums written, we generally have also experienced related increases in: 1) claims and claim expenses incurred; 2) acquisition expenses; 3) operational expenses; and 4) net income. However, during 2003, we produced a claims and claim expense ratio of 33.0%, which was aided by reductions of prior years estimated ultimate claims reserves of $95 million, and by an estimate of approximately $40 million of reduced losses due to a reduced level of catastrophe loss events occurring in 2003.
During 2003 we increased the amount of investments allocated to other investments. These investments are carried at fair value, with interest, dividend income, realized gains (losses) and unrealized gains (losses) included in investment income. During 2003, we recorded $25.9 million of net investment income from these other investments (2002 - $0.4 million loss), which were largely responsible for the increase in net investment income during 2003 (see Investments). The increase in our net investment income in 2002 as compared with 2001 was due to the significant increase in our invested assets from $2.2 billion at December 31, 2001 to $3.1 billion at December 31, 2002, which was generated primarily from strong cash flows from operations of $778 million. Also, in the latter
Corporate expenses include expenses related to legal and certain consulting expenses, costs for research and development, and other miscellaneous costs associated with operating as a publicly traded company. The increase in corporate expenses during 2003 primarily related to an increase in the cost for directors' and officers' insurance and increases in fees to comply with recently adopted regulations of the Securities and Exchange Commission, including those related to complying with the Sarbanes-Oxley Act of 2002. The majority of the increase in corporate expenses in 2002 primarily related to $1.9 million increase in legal costs and $1.2 million of costs related to accelerated vesting of equity compensation.
Our interest payments and preferred dividends increased during 2003, primarily as a result of the issuance of $100 million 5.875% Senior Notes and the issuance of $100 million 7.3% Series B Preference Shares. This capital was raised to support the growth in our insurance and reinsurance operations.
Our interest payments and preferred dividends increased during 2002, primarily as a result of the timing of our capital raising activities, which occurred in the latter half of 2001. Accordingly, during 2002, the balance of the 7.0% Senior Notes and the 8.1% Series A - Preference Shares were outstanding for the entire year, and we incurred a full year of charges related to these securities during 2002 as compared to a partial year of charges during 2001.
During 2001, we also had little or no net income in the U.S., however, at December 31, 2001 we had accumulated a $26.9 million deferred tax asset. As a result of the limited number of attractive opportunities in the U.S. primary insurance market at that time, we decided to increase our valuation allowance by $14.0 million. At December 31, 2003, the gross and net balance of the deferred tax asset was $33.3 million and $4.0 million, respectively.
We conduct our business through two reportable segments, Reinsurance and Individual Risk. Our Reinsurance segment provides reinsurance through our catastrophe reinsurance and specialty reinsurance business units and through Renaissance Underwriting Managers. Our Individual Risk segment provides primary insurance and quota share reinsurance.
Property catastrophe - During 2003 our consolidated property catastrophe premiums remained relatively flat, primarily due to increased competition and due to some softening of prices in the market, where we accordingly chose not to renew certain policies.
The increase in our property catastrophe premiums during 2002 was primarily due to an improving market following 1) the World Trade Center disaster in 2001 and 2) insured losses from nine significant worldwide catastrophic events in 1999. Because of these events, as with many large losses, two changes occurred in 2002: 1) many reinsurers recorded significant losses and were forced to, or chose to, withdraw their underwriting capacity from these regions; and 2) these losses raised the awareness of the severity of the losses which could impact these geographic locations. As a result of these factors, prices for reinsurance coverages in these and other geographic locations increased, in some cases significantly. Accordingly, our 2002 reinsurance premiums also increased, firstly from the increased prices on renewing policies and secondly by enabling us to write new business which was previously priced at an uneconomical rate of return.
The following is a summary of our reinsurance premiums by geographic region.
(2) The category specialty reinsurance consists of contracts that are predominantly exposed to U.S. risks, with a small portion of the risks being Worldwide.
(3) Excludes $20.8 million and $22.2 million of total premium assumed by the Reinsurance segment from the Individual Risk segment in 2003 and 2002, respectively.
Because of the potential volatility of the property catastrophe reinsurance business, we purchase reinsurance to reduce our exposure to large losses. We use our REMS(C) modeling system to evaluate how each purchase interacts with our portfolio of reinsurance contracts we write, and with the other ceded reinsurance contracts we purchase, to determine the appropriateness of the pricing of each contract. During 2003, we reduced the level of reinsurance purchased because of the reduction in the availability of appropriately priced opportunities.
During 2002, the majority of the increase in our ceded reinsurance premiums was from placements of quota share reinsurance agreements for participations in our property catastrophe book of business. In accordance with these
agreements we retain fees and have the right to receive profit commissions associated with these cessions. The fees and profit commissions are reflected as a reduction to operating expenses and acquisition expenses, respectively.
To the extent that appropriately priced coverage is available, we anticipate continued use of reinsurance to reduce the potential volatility of our results.
Losses from our property catastrophe reinsurance and specialty reinsurance policies can be infrequent, but severe; however during periods with benign property catastrophe loss activity, such as 2003 and 2002, we have the potential to produce a low level of losses and a related increase in underwriting income. Although this occurred during 2003 and 2002, there can be no guarantee that this reduced level of losses will occur in 2004 or beyond.
Recently, we have entered into joint ventures and specialized quota share cessions of our book of business. In accordance with the joint venture and quota share agreements, we are entitled to certain fee income and profit commissions. We record these fees and profit commissions as a reduction in acquisition expenses or operating expenses and accordingly these fees have also contributed to the reduction in our expense ratio.
The following table summarizes the underwriting results and ratios for the Individual Risk segment for the years ended December 31, 2003, 2002, and 2001:
The increase in our premiums from our Individual Risk operations was as a result of an improving market environment due primarily to: 1) the increase in demand for insurance and reinsurance protection, and the withdrawal of supply, as a result of the substantial losses stemming from the World Trade Center disaster in 2001; 2) the ongoing increase to prior year reserves for many companies with asbestos and environmental liabilities; and 3) the continuing increases to prior year reserves for companies who participated in the casualty market of the late 1990's. As a result of these items, many insurance companies in the U.S. have withdrawn from the U.S. insurance market, and many insurance companies have had their credit ratings substantially reduced. In response to these dislocations, we received numerous opportunities to partner with program managers who were looking for high quality, stable companies with which to do business. Also, because of our financial strength and our strong credit ratings, we received increasing opportunities to work with existing insurance companies on a quota share basis.
We purchase reinsurance to reduce our exposure to large losses. With the continued growth in the gross written premiums of our Individual Risk segment, we continued to look for and were able to find opportunities to purchase appropriately priced reinsurance coverage. To the extent that appropriately priced coverage is available, we anticipate continued use of reinsurance to reduce the potential volatility of our results.
The increases in the 2003 and 2002 net underwriting income of our Individual Risk segment were primarily due to the growth in net earned premiums by $213.4 million and $85.1 million, respectively (as discussed above). In the future, the combined ratio in our Individual Risk segment could fluctuate due to catastrophe losses, adverse development or losses from other coverages that we write. During 2003 we began issuing insurance policies for certain commercial liability coverages, including general, automobile and professional liability risks. The claim reporting and claim development periods of these risks are longer than the reporting and development periods for our property risks, and accordingly there is normally greater uncertainty in the estimation of the reserves associated with these policies.
Our U.S. insurance subsidiary, Stonington, is also required to maintain certain measures of solvency and liquidity. These are calculated using risk based capital tests, which tests determine the threshold that constitutes the authorized control level. If Stonington's statutory capital and surplus falls below the authorized control level, the commissioner is authorized to take whatever regulatory actions are considered necessary to protect policyholders and creditors. At December 31, 2003, the statutory capital and surplus of Stonington was $28.8 million and the maximum dividend we can pay in 2004 without prior approval is $2.6 million.
Our operating subsidiaries have historically produced sufficient cash flows to meet their own expected claims payments and operational expenses and to provide dividend payments to us. Our subsidiaries also maintain a concentration of investments in high quality liquid securities, which management believes will provide additional liquidity for extraordinary claims payments should the need arise. Additionally, we maintain a $400 million credit facility to meet additional liquidity and capital requirements, if necessary.
We have generated cash flows from operations in 2003, 2002 and 2001 significantly in excess of our operating commitments. Because a large portion of the coverages we provide typically can produce losses of high severity and low frequency, it is not possible to accurately predict our future cash flows from operating activities. As a consequence, cash flows from operating activities may fluctuate, perhaps significantly, between individual quarters and years.
During 2002 and 2003 we increased our specialty reinsurance and Individual Risk gross written premiums (see "Premiums"). The addition of these lines of business adds complexity to our claims reserving process and therefore adds uncertainty to our claims reserve estimates as the reporting of information, the setting of initial reserves and the loss settlement process for these lines of business vary from our traditional property catastrophe line of business.
For our Reinsurance and Individual Risk operations, our estimates of claims reserves include case reserves reported to us as well as our estimate of IBNR losses to us. Our case reserve and our estimates for IBNR reserves are based on 1) claims reports from insureds and program managers, 2) our underwriters' experience in setting claims reserves; 3) the use of computer models where applicable; and 4) historical industry claims experience. For some classes of business we also use statistical and actuarial methods to estimate ultimate expected claims and claim expenses. We review our claims reserves on a regular basis. (Also see "Summary of Critical Accounting Policies and Estimates".)
November 19, 2006, respectively; however we have no current intentions to redeem the shares. Dividends on the Series B and Series A preference shares are cumulative from the date of original issuance and are payable quarterly in arrears at 7.3% and 8.1%, respectively, when, if, and as declared by the Board of Directors. If we submit a proposal to our shareholders concerning an amalgamation or submit any proposal that, as a result of any changes to Bermuda law, requires approval of the holders of our preference shares to vote as a single class, we may redeem the Series B and Series A preference shares prior to February 4, 2008 and November 19, 2006, respectively, at $26 per share. The preference shares have no stated maturity and are not convertible into any other of our securities.
On April 19, 2002, DaVinciRe entered into a credit agreement providing for a $100 million committed revolving credit facility. On May 10, 2002, DaVinciRe borrowed the full $100 million available under this facility to repay $100 million of bridge financing provided by RenaissanceRe. Neither RenaissanceRe nor Renaissance Reinsurance is a guarantor of this facility and the lenders have no recourse against us or our subsidiaries other than DaVinciRe and its subsidiary under the DaVinciRe facility. Pursuant to the terms of the $400 million facility maintained by RenaissanceRe, a default by DaVinciRe in its obligations will not result in a default under the RenaissanceRe facility. At December 31, 2003, the full amount was outstanding under this facility. Interest rates on the facility are based on a spread above LIBOR, and averaged approximately 2.09% during 2003 (2002 - 2.63%). The credit agreement contains certain covenants requiring DaVinciRe to maintain a debt to capital ratio of 30% or below and a minimum net worth of $230 million. At December 31, 2003, DaVinciRe was in compliance with the covenants of this agreement.
Our subsidiary, Glencoe U.S., had a $10.0 million term loan and $15.0 million revolving loan facility with a syndicate of commercial banks. The term loan and revolving credit facility were repaid in full in June 2003 in accordance with the mandatory repayment provisions and the facility was terminated.
From time to time, we have returned capital to our shareholders through share repurchases. In August 2003, the Board authorized a share repurchase program of $150 million. This authorization includes the remaining amounts available under prior authorizations. No shares were repurchased during 2003 or 2002. In the future, we may purchase shares under our current authorization, or increase the size of our repurchase program. Any such determination will be subject to market conditions and numerous other factors.
At December 31, 2003, we held investments and cash totaling $4.2 billion, compared to $3.1 billion in 2002.
Included in other investments are investments in hedge funds of $170.1 million (2002 - $61.4 million), a fund that invests in senior secured bank loans of $77.2 million (2002 - $20.4 million), a European high yield credit fund of $38.3 million (2002 - $nil) and private equity partnerships of $24.2 million (2002 - $14.6 million) (collectively "Investment Funds"). Also included in other investments are investments in a medium term note, representing an interest in a pool of European fixed income securities, of $30.0 million (2002 - $nil), catastrophe bonds of $26.3 million (2002 - $33.5 million) and miscellaneous investments of $4.2 million (2002 - $nil).
Fair values of Investment Funds noted above are generally established on the basis of the net valuation criteria established by the managers of the Investment Funds. These net valuations are determined based upon the valuation criteria established by the governing documents of such Investment Funds. Due to a lag in the valuations reported by the fund managers the majority of our Investment Funds are reported on a one month or one quarter lag. Such valuations may differ significantly from the values that would have been used had ready markets existed for the shares, partnership interests or notes of the Investment Funds. Many of the Investment Funds are subject to restrictions on redemptions which are determined by the governing documents and limit the Company's ability to liquidate these investments in the short term. Interest income, income distributions and realized and unrealized gains and losses on other investments, including Investment Funds, are included in net investment income and totaled $25.9 million (2002 - loss of $0.4 million) of which $21.2 million (2002 - loss of $1.4 million) was related to net unrealized gains (losses).
The hedge funds are engaged in various investment strategies, including event driven, diversified arbitrage, distressed, US long/short, global long/short and sector long/short with original capital contributed by us, generally in the range of $5 million to $15 million per fund. The loan fund primarily invests in senior secured floating rate loans. The medium term note is issued by an investment company which invests predominantly in investment-grade European fixed income securities and passes through a variable U.S. dollar return on the note based on the performance of the underlying securities. The European high yield credit fund is denominated in Euros and primarily invests in unlisted and listed fixed and floating rate debt securities issued by entities that are domiciled in or have a substantial portion of their total assets or operations in a European country. The private equity funds are primarily engaged in U.S. private equity, real estate, distressed securities and secondary investment strategies with initial capital commitments ranging from $1.5 million to $15 million. Catastrophe bonds generally include variable rate notes where the return is contingent upon climatical or geological events.
Effective January 1, 2002, we adopted SFAS 142, "Goodwill and Other Intangible Assets." (see Cumulative Effect of a Change in Accounting Principle - Goodwill.)
and related interpretations in accounting for its employee stock compensation. Effective January 1, 2003, we adopted, prospectively, the fair value recognition provisions of SFAS 123 for all stock-based employee compensation granted, modified or settled after January 1, 2003. Under the fair value recognition provisions of SFAS 123, we estimate the fair value of employee stock options and other stock-based compensation on the date of grant and amortize this value as an expense over the vesting period.
We expect that our property catastrophe reinsurance premium will decline because a declining price environment will result in fewer transactions that meet our hurdle rate. We expect that specialty reinsurance premium will continue to increase both as a function of increasing prices and additions to our specialty underwriting staff. In addition, we believe that our position in the reinsurance market is increasingly strong as a result of our reputation for service, prompt claims payments, proprietary analytic tools and financial strength.