Selected consolidated income statement data and ending balance sheet data for each of the five years ended December 31, 2003, follows:
(a) Includes the acquisition of OneBeacon on June 1, 2001 and its results of operations from that date through December 31, 2001. In connection with the OneBeacon Acquisition, White Mountains issued $1,085 million in debt. White Mountains also issued preferred stock of subsidiaries, warrants to acquire Common Shares and Convertible Preference Shares for total proceeds of $758 million.
(e) Deferred credits added during 2001 resulted from the purchase of OneBeacon. See Note 2.
(i) Book value per share plus unamortized deferred credits less goodwill per Common and equivalent Common Share. The 2002 fully converted tangible book value per share assumes outstanding convertible preference shares to be equivalent Common Shares.
(k) In accordance with its adoption of Statement of Financial Accounting Standard No. 141, the Company recognized all of its outstanding deferred credits on January 1, 2002. See Note 1.
(l) In accordance with its adoption of the presentation provisions of Statement of Financial Accounting Standard No. 150, on July 1, 2003, the Company reclassified its outstanding mandatorily redeemable preferred stock from mezzanine equity to liabilities on its balance sheet and, beginning in the third quarter of 2003, White Mountains began presenting all accretion and dividends on its mandatorily redeemable preferred stock as interest expense. See Note 1.
A tabular summary of White Mountains’ consolidated financial results for the years ended December 31, 2003, 2002 and 2001 follows:
White Mountains’ total revenues decreased by 10% in 2003 compared to 2002, as an increase in earned reinsurance premiums at Folksamerica was more than offset by a decrease in earned insurance premiums at OneBeacon as a result of the business transferred to Liberty Mutual under the Liberty Agreement. The residual effects of the Liberty Agreement will continue to decrease OneBeacon’s earned insurance premiums in 2004. However, this decrease is expected to be more than offset by new premiums generated as a result of the Atlantic Mutual Transaction. Total revenues in 2003 were also impacted by decreased net investment income due to the runoff of loss reserves from OneBeacon’s non-core business as well as the reduced interest rate environment. The decline in total revenues in 2003 was partially offset by an increase in other revenues, primarily as a result of $50 million in gains recorded during 2003 related to the sale of several real estate properties previously written-off under purchase accounting for OneBeacon and a $30 million increase in 2003 over 2002 in fees and commissions for business placed by WMU. The large increase in total revenues from 2001 to 2002 resulted primarily from the OneBeacon Acquisition, which contributed $2,870.9 million in earned premiums for the year ended December 31, 2002 and $2,208.2 million for the seven months ended December 31, 2001.
White Mountains conducts its operations through three segments: (i) “OneBeacon” (consisting solely of the operations of OneBeacon), (ii) “Reinsurance” (consisting of Folksamerica, WMU, Fund American Re and White Mountains’ investment in Montpelier) and (iii) “Other Operations” (consisting of the International American Group and the operations of the holding companies). White Mountains manages all of its investments through its wholly owned subsidiary, White Mountains Advisors LLC (“WM Advisors”), therefore, a discussion of White Mountains’ consolidated investment operations is included after the discussion of operations by segment. White Mountains’ segment information is presented in Note 13 to the Consolidated Financial Statements.
The following tables provide GAAP ratios, net written premiums and earned insurance premiums for OneBeacon’s core underwriting units and in total for the years ended December 31, 2003, 2002, and 2001:
(1) A key measure of relative performance for an insurance company is the combined ratio. A GAAP combined ratio is calculated by adding (i) the ratio of incurred loss and LAE to earned premiums (the “loss and LAE ratio”) and (ii) the ratio of acquisition and other underwriting expenses to earned premiums (the “expense ratio”).
OneBeacon Results - Year Ended December 31, 2003 versus Year Ended December 31, 2002
OneBeacon’s core personal lines written premium volume for 2003 decreased 14% from 2002, primarily due to re-underwriting efforts such as actions to reduce exposure to windstorms on total insured property values located in coastal areas. Also contributing to the decrease were declines in written premium relating to the transfer of OneBeacon’s private passenger automobile business in New Jersey to New Jersey Skylands Insurance Association in 2002 and lower premiums at AutoOne Insurance, offset partially by increased writings from Esurance. AutoOne Insurance’s written premium volume was lower in 2003 primarily as a result of lower assignments from the NYAIP, partially offset by the sale of takeout credits under the NYAIP’s credit programs.
Commercial Lines. Commercial lines results improved during 2003 due to the positive impact of underwriting and pricing initiatives. Re-underwriting the commercial book has resulted in average price increases of 11% for business written during 2003. Commercial lines results were also improved by changes in business mix away from historically less profitable business lines such as workers compensation. Additionally, OneBeacon continued to shift away from certain classes of risks within its business lines that have historically been less profitable, such as contractors, transportation and non-durable wholesalers, to more profitable industry segments, such as service providers, retailers and light manufacturers. The improvement was mitigated by adverse development on prior year reserves of $13.1 million in connection with the run-off of old workers compensation and contractor business, which added 3 points to the commercial lines combined ratio for 2003.
OneBeacon’s core commercial lines written premium volume for 2003 decreased 6% from 2002, primarily due to the continued effects of actions taken to reduce the concentration of risks subject to terrorism, such as reducing total insured values in 11 major cities, and reductions in workers compensation writings.
Management has been pleased with the changes that it has implemented in OneBeacon’s commercial lines business since the OneBeacon Acquisition and is now beginning to shift its focus from shrinking the business to profitable growth. Consequentially, on December 4, 2003, OneBeacon entered into an agreement in principle to acquire the Atlantic Specialty Insurance Company, a subsidiary of Atlantic Mutual, and the renewal rights to Atlantic Mutual’s commercial insurance business. Upon consummation of the acquisition of this segmented middle-market business, OneBeacon will start underwriting commercial business throughout the United States, bringing the best of Atlantic Mutual’s and OneBeacon’s commercial products, services and people to the market.
Specialty Lines. Overall results for specialty businesses continue to be good. During 2003, OneBeacon wrote specialty lines premiums of $499.9 million, representing an 11% increase as compared to $449.7 million written during 2002. Written premiums for 2003 included $125.7 million from IMU, representing an increase of 15% over 2002. Written premiums from Agri declined to $84.0 million in 2003, a decrease of 18% as compared to 2002, resulting from an exit from several states. Specialty lines written premium also included $169.0 million from NFU in 2003, representing an increase of 2% compared to 2002. Written premiums for 2003 included $68.7 million from OBPP, which were primarily for excess errors and omissions liability coverages for mid-size hospitals and managed care companies and excess directors and officers liability coverages for middle market public companies. Written premiums from other specialty products were relatively flat in 2003 as compared to 2002.
Pursuant to the Liberty Agreement, Liberty Mutual assumed control of OneBeacon’s claims offices in the regions subject to the Liberty Agreement and was responsible for servicing claims from the OneBeacon policies written prior to November 1, 2001, as well as policies which renewed in those regions since that date. As previously discussed, effective July 11, 2003, the servicing agreement with Liberty Mutual was amended and OneBeacon took back substantially all remaining outstanding claims related to policies written prior to the Liberty Agreement. During the second quarter of 2003, OneBeacon claims and actuarial personnel noticed an unusual spike in case reserves related to the policies taken back from Liberty Mutual. As a result, OneBeacon claims and actuarial personnel undertook a study to determine the cause of the increase. This study, which was completed in the third quarter of 2003, indicated that most of the increase in activity was due to differences in case reserving philosophies between
OneBeacon Results - Year Ended December 31, 2002 versus Seven Months Ended December 31, 2001
OneBeacon’s pre-tax income for 2002 was $200.3 million, compared to pre-tax loss of $265.8 million for the seven months ended December 31, 2001. OneBeacon’s results for the year ended December 31, 2002 improved from those for the seven months after the date of the OneBeacon Acquisition, mainly due to improved pricing and other market conditions, mild weather and actions taken post-acquisition to improve the business. The results for the seven months ended December 31, 2001 included $75.0 million in losses from the Attacks. Total revenues and total expenses for 2002 increased by 26% and 8% over 2001, primarily as a result of the inclusion of a full year of OneBeacon’s results in 2002, versus the seven months in 2001 after the OneBeacon Acquisition. A full year over year comparison of OneBeacon’s total revenues and total expenses showed a 33% and 36% decrease in 2002 from all of 2001, which is principally due to the decrease in business volume resulting from the Liberty Agreement.
OneBeacon’s total GAAP combined ratio, including non-core business, was 107% for the year ended December 31, 2002 compared to 123% for all of 2001 (which included approximately 3 points as a result of the Attacks). Net written premiums and earned premiums on OneBeacon’s total business were down to $2.5 billion and $2.9 billion, respectively, in 2002 from $3.5 billion and $3.9 billion, respectively, for all of 2001, as premiums from non-core operations continued to run-off.
OneBeacon’s GAAP combined ratio for core operations improved to 97% for 2002, compared to 117% for all of 2001. Net written premiums and earned premiums for core operations were both $2.0 billion for the year ended 2002 and $1.9 billion and $2.0 billion, respectively, for all of 2001, as price increases were offset by reductions in volume necessary to re-underwrite the book and reduce exposure to catastrophe claims.
Specialty Lines. Overall results for specialty businesses in 2002 were excellent as compared to 2001, as written premiums grew due to rate increases, favorable weather conditions, high renewal retentions and new business. During 2002, OneBeacon wrote Specialty lines premiums of $449.7 million, a 15% increase as compared to $390.6 million written during all of 2001. The 2002 written premium included $109.0 million from IMU and $103.0 million from Agri, representing 18% and 11% increases in written premium, respectively, as compared to all of 2001. 2002 written premium also included $165.5 million from NFU, representing a 2% decrease in written premium compared to all of 2001. Specialty lines written premium also included $28.7 million of new written premiums during 2002 from OBPP, which commenced operations in February 2002.
Results for OneBeacon’s non-core businesses during 2002 were worse than expected. Written premiums decreased to $526.4 million in 2002, from $1.6 billion for all of 2001. For 2002, written premiums on business subject to the Liberty Agreement decreased to $496.7 million from $1.4 billion for all of 2001. In 2002, OneBeacon also recognized a $22.8 million pretax write-off of deferred acquisition costs associated with its business subject to the Liberty Agreement.
(1) The Montpelier Warrants were contributed to Fund American Re by one of the Company’s intermediate holding companies on October 1, 2003. During the fourth quarter of 2003, Fund American Re recognized a $27.4 million realized gain on the Montpelier Warrants, which for purposes of this presentation has been excluded from its results and presented in the Montpelier Warrants column. Fund American Re’s actual reported pretax income, including the Montpelier Warrants, was $34.8 million for the year ended December 31, 2003.
Folksamerica Results - Year Ended December 31, 2003 versus Year Ended December 31, 2002
Folksamerica Results - Year Ended December 31, 2002 versus Year Ended December 31, 2001
Folksamerica’s 2002 losses and LAE include $6.6 million, net of reinstatement premiums, related to European Floods during the third quarter of 2002 as well as $9.7 million of additional losses related to the Attacks. These catastrophe losses accounted for 3 points of Folksamerica’s GAAP combined ratio of 100% for 2002. Folksamerica’s losses and LAE for 2002 included $17.0 million related to prior accident years. This prior year development consisted primarily of (i) additional losses of $9.7 million relating to the Attacks, (ii) additional losses of $7.3 million from aviation insurance coverage, in relation to the Risk Capital business, (iii) reserve additions relating to asbestos and environmental losses of $11.4 million, (iv) $3.5 million of adverse development relating to the remaining business from the USF Re acquisition, offset by (v) $17.0 million of net income recorded during the first quarter from the reversal of an allowance for doubtful reinsurance recoveries related to PCA. These losses, with exception of the those relating to the Attacks, were covered under the Imagine Cover, and were partially offset by amortization of the deferred gain related to retroactive reinsurance (see below).
During 2001, Folksamerica recorded gross losses from the Attacks of approximately $104.0 million, or approximately $25.0 million net of reinsurance recoverables and reinstatement costs. This loss represented approximately six points of its 2001 GAAP combined ratio. Folksamerica also established a reserve of $5.0 million for Enron-related surety exposures in 2001.
WMU. WMU receives advisory fees on reinsurance placements referred to Olympus and is entitled to a profit commission on net profits on referred business. WMU placed $173.6 million of written premiums and recorded $20.8 million of advisory fees during 2003, as compared to $120.2 million and $14.4 million, respectively, in 2002. WMU also recorded $45.2 million of profit commissions during 2003, as compared to $21.3 million for 2002.
WMU also receives management fees and a profit commission on business placed with Folksamerica. However, the revenues earned by WMU on business underwritten by Folksamerica has been eliminated from WMU’s results provided above, as have the offsetting commission expenses been eliminated from Folksamerica’s results. Such intercompany revenue at WMU totaled $14.2 million for 2003 and $7.9 million for 2002.
Fund American Re. Fund American Re reported pretax earnings of $7.4 million for 2003, versus pretax losses of $2.3 million and $.1 million in 2002 and 2001, respectively. The improved results in 2003 were mainly due to income from a termination fee related to Fund American Re’s management of the remaining business of Folksam International (the company from which Fund American Re purchased its international reinsurance business in 2001). Fund American Re also experienced improved underwriting results in 2003 as its GAAP combined ratio improved to 95%, compared to 113% in 2002.
Montpelier. As of December 31, 2003, White Mountains’ investment in Montpelier consists of common shares, which are accounted for under the equity method, and warrants to acquire additional common shares at a fixed price, which are accounted for in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). Through its holdings of common shares and warrants, White Mountains owned approximately 21% of Montpelier on a fully-converted basis as of December 31, 2003.
(1) After-tax equity in earnings/(losses) from Montpelier common shares were $45.2 million, $19.9 million and $(2.0) million for the years ended December 31, 2003, 2002 and 2001, respectively.
(2) The Montpelier Warrants were contributed to Fund American Re by one of the Company’s intermediate holding companies on October 1, 2003. $27.4 million of the $32.5 million realized gain in 2003 was recorded by Fund American Re during the fourth quarter. However, for purposes of this presentation, this realized gain is not included in Fund American Re’s pretax earnings, but is included in this consolidated presentation of White Mountains’ investment in Montpelier.
General and administrative expenses at the Holding Companies consist primarily of compensation expenses of holding company employees, including share-based expense related to outstanding performance shares, Options and Restricted Shares (See Note 9). Compensation expense at the Holding Companies increased to $116.7 million in 2003, from $43.4 million in 2002 and $(.7) million in 2001. The majority of this increase is due to $89.1 million of performance share expense recognized at the Holding Companies in 2003, as compared to $17.8 million in 2002 and $(16.2) million in 2001. The increase in performance share expense in 2003 was due to many factors, including (i) the increase in the per share market value of Common Shares ($459.95 at December 31, 2003, compared to $323.00 and $348.00 at December 31, 2002 and 2001), (ii) the exceptional performance of the Company and its operating subsidiaries in relation to performance targets in 2003, (iii) the inclusion of the expenses of WM Advisors in the Holding Companies in 2003 (previously White Mountains’ investment advisory services had been performed through OneBeacon) and (iv) the accelerated recognition of expense related to the early termination of performance shares previously issued to certain non-management directors in light of the proposed independence standards for directors.
The $23.5 million decrease in interest expense at the Holding Companies from 2002 to 2003 resulted primarily from the absence in 2003 of the $260.0 million Seller Note, which was fully repaid by White Mountains in November 2002, as well as a reduced level of bank debt outstanding (and at a reduced rate) as a result of issuing the Senior Notes to repay the Old Bank Facility. Through the issuance of the Senior Notes, White Mountains reduced the interest rate on the majority of its outstanding debt to 5.9% from approximately 7.0% on the Old Bank Facility (after giving effect to interest rate swaps). During 2003, White Mountains recorded $25.8 million of interest expense on the Senior Notes. Interest expense on the Old Bank Facility was $20.3 million in 2003, versus $57.1 million and $32.4 million for 2002 and 2001. Interest expense from the Seller Note increased from $10.3 million in 2001 to $12.3 million in 2002 as declining interest rates partially offset the effect of four additional months of interest in 2002.
In connection with purchase accounting for the OneBeacon Acquisition, White Mountains was required to adjust to fair value OneBeacon’s loss and LAE reserves and the related reinsurance recoverables by $646.9 million and $346.9 million, respectively, on OneBeacon’s balance sheet at June 1, 2001. This net reduction to loss and LAE reserves of $300.0 million is being accreted through an income statement charge ratably with and over the period that the claims are expected to be settled. As a result, White Mountains recognized $48.6 million, $79.8 million and $56.0 million of accretion to loss and LAE reserves during 2003, 2002 and 2001, respectively. White Mountains will accrete the remaining $115.6 million over the future periods in which the claims are settled, which is expected to be seven or eight years from the OneBeacon Acquisition.
Positive results generated by White Mountains equity portfolios in 2003 reflected the strong stock market. Convertible securities, which are part of the equity portfolios, also provided good returns although considerably below the common equities. As often happens when equity markets soar, convertibles are retired. White Mountains’ portfolio lost a number of large positions this way in 2003, although replacements are currently being sought.
White Mountains’ corporate bond portfolio posted strong results in 2003, reflecting successful credit work and portfolio management. This portfolio’s duration was reduced from 4.8 to 4.2 years during 2003, while total fixed-income portfolio duration went from 3.5 to 2.8 years. While shrinking both the corporate bond portfolio’s size and duration, WM Advisors sought to upgrade the potential return of holdings relative to their default and downgrade risk.
White Mountains’ net investment income is comprised primarily of interest income associated with its substantial portfolio of fixed maturity investments and dividend income from its equity investments. The decrease in investment income in 2003 from 2002 was due primarily to lower interest rates throughout the financial markets and lower average net invested assets in OneBeacon’s investment portfolio as it gradually shrunk with the run-off of OneBeacon’s non-core book. The significant increase in investment income from 2001 to 2002 was due primarily to the inclusion of a full year of investment income generated by OneBeacon’s assets in the 2002 results as compared to the seven months of OneBeacon’s post-acquisition investment activity included in the 2001 results.
During 2003, White Mountains’ net increase in after-tax unrealized investment gains was principally the result of significant gains in the equity market. During 2002, White Mountains’ net increase in after-tax unrealized investment gains was principally the result of significant decreases in market interest rates. During 2001, the net decrease in after-tax net unrealized gains for investments resulted principally from the realization of gains as a result of White Mountains’s sale of a large portion of its fixed maturity investment portfolio.
White Mountains’ methodology of assessing other-than-temporary impairments is based on security-specific facts and circumstances as of the balance sheet date. As a result, subsequent adverse changes in an issuers’ credit quality or subsequent weakening of market conditions that differ from expectations could result in additional other-than-temporary impairments. In addition, the sale of a fixed maturity security with a previously recorded unrealized loss would result in a realized loss. Either of these situations would adversely impact net income and earnings per common share but would not impact comprehensive net income, shareholders’ equity or tangible book value.
The following table presents an analysis of the continuous periods during which White Mountains has held investment positions which were carried at an unrealized loss as of December 31, 2003 (excluding short-term investments):
During the year ended December 31, 2003, White Mountains experienced $20.4 million in pre-tax, other-than-temporary impairment charges, comprised of $13.9 million taken on equity securities, $1.7 million on preferred stocks and $4.8 million on several limited partnership investments included in other long term investments. Of the charge taken on equity securities, $8.1 million was related to White Mountains’ investment in the common stock of Octel Corp (“Octel”) and the remaining $5.8 million related to three other equity positions, none of which were individually significant. White Mountains recorded the other-than-temporary impairments primarily due to the fact that the unrealized loss position on these securities was greater than 20% of White Mountains’ cost over the previous six-month period and also that certain factors have been reported by those companies which affect the likelihood that White Mountains will recover the original cost of its investment. During 2002, White Mountains experienced $9.6 million in pretax other-than-temporary impairment charges. Of the charge recorded in 2002, $4.9 million related to White Mountains’ investment in Insurance Partners and $3.5 million was related to its investment in the Conning Connecticut Insurance Fund. Both of these investments are limited partnerships that are carried in other investments in White Mountains’ consolidated balance sheet. White Mountains did not experience any other material impairment charges relating to any other individual investment security during the three years ended December 31, 2003.
White Mountains believes that the gross unrealized losses relating to its fixed maturity investments at December 31, 2003 resulted primarily from increases in market interest rates from the dates that certain investments within that portfolio were acquired as opposed to fundamental changes in the credit quality of the issuers of such securities. Therefore, these decreases in value are viewed as being temporary because White Mountains has the intent and ability to retain such investments for a period of time sufficient to allow for any anticipated recovery in market value. White Mountains also believes that the gross unrealized losses recorded on its common equity securities and its other investments at December 31, 2003 resulted primarily from decreases in quoted market values from the dates that certain investments securities within that portfolio were acquired as opposed to fundamental changes in the issuer’s financial performance and near-term financial prospects. Therefore, these decreases are also viewed as being temporary. However, due to the inherent risk involved in investing in the equity markets, it is possible that the
decrease in market value of these investments may ultimately prove to be other than temporary. As of December 31, 2003, White Mountains’ investment portfolio did not include any investment securities with an after-tax unrealized loss of more than $3.0 million.
Set forth below is a reconciliation of White Mountains’ fully converted tangible book value per common and equivalent share, supporting the references to fully converted tangible book value per share on page 35:
The primary sources of cash inflows for the Company and certain of its intermediate holding companies are dividends and tax sharing payments received from the operating subsidiaries. Under the insurance laws of the states and jurisdictions under which White Mountains’ domestic insurance subsidiaries are domiciled, an insurer is restricted with respect to the timing or the amount of dividends it may pay without prior approval by regulatory authorities. Accordingly, there can be no assurance regarding the amount of such dividends that may be paid by such subsidiaries in the future. In 2004, OneBeacon’s first tier insurance subsidiaries have the ability to pay dividends of approximately $330.0 million to Fund American without approval of regulatory authorities.
As a result of the Liberty Agreement, premium collections and claim payments at OneBeacon have been declining steadily over the past two years as OneBeacon assumed approximately two-thirds of the operating results from renewals through October 31, 2002 and approximately one-third of the operating results from renewals from November 1, 2002 to October 31, 2003. OneBeacon will continue to run-off the claims on business transferred to Liberty Mutual but will no longer participate in future policy renewals. Therefore, OneBeacon will need to periodically liquidate invested assets to fund the payment of these claims and will manage its short-term liquidity needs accordingly.
Both internal and external forces influence White Mountains’ 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 White Mountains and the settlement of the liability for that loss. Management believes that White Mountains’ cash balances, cash flows from operations, routine sales of investments and the liquidity provided by the New Bank Facility are adequate to meet expected cash requirements for the foreseeable future.
Insurance float is an important dynamic of White Mountains’ operations that must be managed effectively. Float is money that an insurance company holds for a limited time. In an insurance operation, float arises because premiums are collected before losses are paid. This interval can extend over many years. During that time, the insurer invests the money. When the premiums that an insurer collects do not cover the losses and expenses it eventually must pay the result is an underwriting loss, which is considered to be the cost of float. The amount and cost of float for White Mountains is affected by underlying market conditions, as well as acquisitions or dispositions of insurance and reinsurance businesses. Although insurance float can be calculated using numbers determined under GAAP, insurance float is not a GAAP concept and therefore there is no comparable GAAP measure.
For each of the years in the three-year period ending December 31, 2003, the Company has had negative cash flows from operations but has generated significant float from its insurance and reinsurance operations. The Company’s cash flow from operations does not include float generated by the acquisition of insurance and reinsurance businesses in recent years. Post-acquisition, such companies are often placed into partial or complete run-off, thereby resulting in negative cash flows from operations as the investment portfolios acquired are liquidated over time to pay claims. White Mountains expects that it will continue to have negative cash flows from operations for the foreseeable future but expects float to increase, particularly in light of the pending Sirius Insurance Group and Sierra Group acquisitions.
The following table summarizes White Mountains’ capital structure as of December 31, 2003 and 2002:
Below is a schedule of White Mountains’ material contractual obligations and commitments as of December 31, 2003:
White Mountains also has future binding commitments to fund certain limited partnership investments. These commitments, which total approximately $18.6 million, do not have fixed funding dates and are therefore excluded from the table above.
Fund American’s Senior Notes are currently rated “Baa2” (Adequate, the 9th highest of 21 ratings) by Moody’s Investor Services (“Moody’s”) and BBB- (Adequate, the 10th highest of 24 ratings) by S&P. Both Moody’s and S&P affirmed their senior debt ratings for Fund American following the Company’s announcement of its plans to acquire the Sirius Insurance Group and both agencies reported that the outlook for their ratings remain stable. It is possible that, in the future, one or more of the rating agencies may reduce White Mountains’ existing ratings. If one or more of its ratings were downgraded, White Mountains could incur higher borrowing costs and its ability to access the capital markets could be impacted. In addition, White Mountains’ insurance and reinsurance operations could be adversely impacted by a downgrade in its financial strength ratings, including a possible reduction in demand for its products in certain markets.
The Senior Notes were issued under an indenture which contains restrictive covenants that, among other things, limit the ability of the Company, Fund American and their respective subsidiaries to create liens and enter into sale and leaseback transactions and substantially limits the ability of Fund American and its respective subsidiaries to consolidate, merge or transfer its properties and assets. The indenture does not contain any financial ratios or specified levels of net worth or liquidity to which the Company or Fund American must adhere.
In September 2003, Fund American terminated the Old Bank Facility, which then consisted solely of an undrawn $175.0 million revolving credit line, and replaced it with a new $300.0 million revolving credit facility, which matures in September 2006 and under which both Fund American and the Company are permitted borrowers. Under the New Credit Facility, the Company guarantees all obligations of Fund American, and Fund American guarantees all borrowings of the Company subject to certain limitations imposed by the terms of the Berkshire Preferred Stock. As of December 31, 2003, the New Bank Facility was undrawn.
The New Bank Facility contains various affirmative, negative and financial covenants which White Mountains considers to be customary for such borrowings and include maintaining certain minimum net worth and maximum debt to capitalization standards for White Mountains. Failure to meet one or more of these covenants could result in an event of default, which ultimately could result in acceleration of principal repayment. At December 31, 2003, White Mountains was in compliance with all of the covenants under the New Bank Facility, and anticipates it will continue to remain in compliance with these covenants for the foreseeable future.
On December 8, 2003, White Mountains entered into a definitive agreement with ABB to acquire the Sirius Insurance Group at a purchase price of SEK3.22 billion (approximately US$445 million), subject to a kronor-for-kronor adjustment to the extent that the total tangible shareholders’ equity value of the acquired companies as of December 31, 2003 is greater or less than SEK3.566 billion (approximately US$490 million). White Mountains has the existing capital to finance this acquisition through either cash on hand or availability under the New Credit Facility. Because the ultimate purchase price is payable in Swedish kronor, White Mountains purchased SEK2.2 billion for USD$300 million on December 10, 2003 (subsequently invested in short-term Swedish Treasury Bills) to ensure that it held enough Swedish currency in the proper holding company to close the transaction, which White Mountains expects to occur in the second quarter of 2004.
Detailed information concerning White Mountains’ liquidity and capital resource activities during 2003, 2002 and 2001 follows:
On May 19, 2003, Fund American issued the Senior Notes for net proceeds of $693.4 million. Using proceeds from the Senior Notes, Fund American repaid the entire $614.9 million of term loans outstanding under the Old Bank Facility. In addition, on May 27, 2003, using the remaining $78.5 million in proceeds from the Senior Notes and cash on hand, Fund American repaid the entire $125.0 million of revolving loans outstanding under the Old Bank Facility. In connection with the repayment of the Old Bank Facility, on May 20, 2003, Fund American paid an aggregate $56.4 million to unwind all of its existing interest rate swap agreements.
In March 2003, the Company declared and paid an annual dividend of $8.3 million to its common shareholders.
During the fourth quarter of 2003, OneBeacon sold one of its subsidiaries, NFU Standard, to Quanta U.S. Holdings, Inc., an indirect subsidiary of Quanta Capital Holdings Ltd, for $22.4 million.
On December 31, 2002, September 30, 2002, June 28, 2002 and March 29, 2002, White Mountains made scheduled principal amortization payments of $1.4 million, $14.2 million, $14.1 million and $49.0 million, respectively, on the Old Bank Facility. During 2002, White Mountains paid a total of $55.3 million in interest under the Old Bank Facility, including $18.0 million paid under related interest rate swap agreements.
During 2002, OneBeacon declared and paid a total of $172.6 million in cash dividends to Fund American, its immediate parent company.
During 2002, White Mountains paid a total of 31,300 performance shares (relating to the 1999-2001 performance period) at a 200% value, amounting to $20.7 million, to its participants in cash, Common Shares or by deferral into certain non-qualified compensation plans of the Company or its subsidiaries.
In December 2001, White Mountains filed a “shelf” registration statement with the SEC for offerings of up to $1.0 billion of various types of debt and preferred equity securities. In May 2003, White Mountains issued $700.0 million face value of 10-year, fixed-rate Senior Notes under this shelf registration - See “Financing” above for a detailed discussion.
In December 2001, OneBeacon contributed $400.0 million in cash to Folksamerica.
In connection with the OneBeacon Acquisition, White Mountains issued two separate classes of subsidiary preferred stock. Berkshire purchased $300.0 million in face value of cumulative non-voting subsidiary preferred stock for $225.0 million in cash. The Berkshire Preferred Stock is entitled to a dividend of no less than 2.35% per quarter and is mandatorily redeemable after seven years. Zenith purchased $20.0 million in cumulative non-voting subsidiary preferred stock. The Zenith Preferred Stock is entitled to a dividend of no less than 2.5% per quarter through June 30, 2007 and a dividend of no less than 3.5% thereafter and is mandatorily redeemable after ten years.
In connection with the OneBeacon Acquisition, White Mountains borrowed $825.0 million under the Old Bank Facility. The Old Bank Facility, which was comprised of two term loan facilities and a revolving credit facility, was terminated during 2003 - See “Financing” above for a detailed discussion.
In connection with the OneBeacon Acquisition, White Mountains issued the Seller Note to Aviva. The Seller Note had an eighteen-month term and bore interest at a rate equal to 50 basis points over the rate on White Mountains’ revolving loan facility described above. The Seller Note was repaid in full on November 29, 2002.
In January 2001, the Company completed the sale of Waterford Insurance Company (“Waterford”) to a third party for consideration of $23.6 million in cash, net of transaction related expenses.
During 2001, White Mountains paid a total of $18.4 million in dividends to holders of the Convertible Preference Shares, the Berkshire Preferred Stock and the Zenith Preferred Stock. During 2001, White Mountains paid a total of $29.2 million in interest under the Old Bank Facility including $2.9 million paid under related interest rate swap agreements.
NICO and GRC, which have provided the NICO Cover and the GRC Cover to subsidiaries of White Mountains, are wholly-owned subsidiaries of Berkshire (see “Reinsurance Protection” within the “ONEBEACON” section of Item 1 of this report). Through the Warrants, at December 31, 2003, Berkshire has the right to acquire 1,724,200 Common Shares at an exercise price of $173.99 per Common Share, which represented approximately 16.0% of the total outstanding Common Shares on a fully-converted basis. Reinsurance recoverable from, and preferred stock of White Mountains’ subsidiaries owned by, Berkshire are shown as separate line items in White Mountains’ consolidated balance sheet.
As of December 31, 2003, White Mountains’ investment in Montpelier consisted of 10,800,000 common shares and warrants to acquire 4,781,572 common shares at $16.67 per share that are exercisable until December 6, 2011. Through its holdings of common shares and warrants, White Mountains owns approximately 21% of Montpelier on a fully-converted basis.
Four of White Mountains’ directors serve on Montpelier’s eleven member board of directors. Raymond Barrette serves as Montpelier’s Lead Director and John J. Byrne, John Gillespie and K. Thomas Kemp serve as Directors of Montpelier. In addition, Mr. Kemp is the Chief Financial Officer of Montpelier. Certain directors, officers and affiliates of White Mountains own approximately 3% of the common shares of Montpelier.
White Mountains’ insurance subsidiaries establish loss and LAE that are estimates of amounts needed to pay claims and related expenses in the future for insured events that have already occurred. Reinsurance is an arrangement in which a reinsurance company (a “reinsurer”) contractually agrees to indemnify an insurance company for all or a portion of the insurance risks underwritten by the insurance company. White Mountains establishes estimates of amounts recoverable from its reinsurers in a manner consistent with the claim liability covered by the reinsurance contracts, net of an allowance for uncollectible amounts. Net insurance loss reserves represent loss and LAE reserves reduced by reinsurance recoverable on unpaid losses.
In a broad sense, loss and LAE reserves have two components: (i) case reserves, which are reserves established within the claims function for claims that have been reported to White Mountains and (ii) IBNR. Case reserves are estimated based on the experience and knowledge of claims staff regarding the nature and potential cost of each claim. White Mountains’ claims staff periodically adjusts case reserves as additional information becomes known or payments are made. Generally accepted actuarial methods are used to project estimates of IBNR. Actuaries use a variety of statistical and analytical methods to determine estimates of IBNR, which are based, in part, on historical claim reporting and payment patterns. In estimating IBNR, actuaries consider all available information, including historical experience, changes in business mix, coverage limits, changes in claims handling practices, pricing, reinsurance protections, inflation and the effects of legal, social and legislative trends on future claim payments. Management exercises judgment based upon its knowledge of its business, review of the outcome of actuarial studies, historical experience and other factors to record an estimate it believes reflects White Mountains’ expected ultimate unpaid loss and LAE and related reinsurance recoverables.
Regardless of the techniques used, estimation is inherent in the process of establishing unpaid loss reserves and related reinsurance recoverables as of any given date. Uncertainties in projecting ultimate claim amounts are magnified by the time lag between when a claim actually occurs and when it becomes reported and settled. This time lag is sometimes referred to as the “claim-tail”. The claim-tail for most property coverages is typically short. The claim-tail for liability coverages, such as general and product liability, directors and officers liability, medical malpractice and workers’ compensation, can be especially long as claims are often reported or settled years after the related occurrences. During the claims reporting and settlement period, additional facts regarding claims and trends become known which may cause White Mountains to adjust its estimate of its ultimate net loss and LAE liability.
• Expected loss ratio methods: These methods are based on the assumption that ultimate losses vary proportionately with premiums. Expected loss ratios are typically developed based upon the information used in pricing, and are multiplied by the total amount of premiums written to calculate ultimate losses. Expected loss ratio methods are particularly useful for estimating ultimate losses in the early years of long-tailed lines of business, when little or no paid or incurred loss information is available.
Management believes that the recorded reserves represent its best estimate of unpaid loss and LAE by line of business. In its selection of recorded reserves, management has generally given greater weight to adjusted paid loss development methods, which are not dependent on the consistency of case reserving practices, rather than methods that rely on incurred losses, because of the increased adequacy of case reserving by OneBeacon’s claim staff in the recent past. In particular, for multiple peril and general liability, this resulted in OneBeacon recording reserves at or near the low end of the range. For some types of claims, such as workers compensation and construction defect, management also considered special purpose forecasting models that its claims and actuarial staff have created that consider the unique loss development characteristics of these types of claims.
OneBeacon estimates that on an incurred basis it has exhausted approximately $1.7 billion of the coverage provided by NICO at December 31, 2003. Due to the inherent difficulties in estimating ultimate A&E exposures, OneBeacon does not estimate a range for these incurred losses. Approximately $586 million of the estimated $1.7 billion of incurred losses have been paid by NICO through December 31, 2003, with $167 million paid in 2003. The estimate of incurred losses represents management’s best estimate, based on information currently available, of its ultimate liabilities that it is entitled to recover under the NICO Cover. Accordingly, OneBeacon believes the NICO Cover will be adequate to cover all of its A&E obligations. However, as case law expands, medical and clean-up costs increase and industry settlement practices change, OneBeacon may be subject to asbestos and environmental losses beyond currently estimated amounts. Therefore, OneBeacon cannot guarantee that its remaining coverage under the NICO Cover will be sufficient to cover additional liability arising from any such unfavorable developments.
OneBeacon’s liabilities for A&E losses from business underwritten in the recent past are substantially limited by the application of exclusionary clauses in the policy language that eliminated coverage of such claims. After 1987 for pollution and 1992 for asbestos, most liability policies contained industry-standard absolute exclusions of such claims. In earlier years, various exclusions were also applied, but the wording of those exclusions was less strict and subsequent court rulings have reduced their effectiveness.
For purposes of determining available Third Party Recoverables, product liability asbestos claims typically are aggregated as a single loss within each policy period. As a result, losses often exceed the threshold level under the reinsurance agreement and reinsurance recoveries are obtained. However, for claims being asserted under premises and operations coverage, the losses are generally not aggregated for purposes of determining reinsurance recoveries, so OneBeacon expects that in the future a smaller percentage of these losses will be covered as Third Party Recoverables than has been true historically of products liability asbestos losses.
Reinsurance loss and LAE reserve estimates reflect the judgment of both the ceding companies and White Mountains, based on the experience and knowledge of their respective claims personnel, regarding the nature and value of the claims. The ceding companies may periodically adjust the amount of the case reserves as additional information becomes known or partial payments are made. Upon notification of a loss from a ceding company, White Mountains establishes case reserves, including LAE reserves, based upon White Mountains’ share of the amount of reserves established by the ceding company and White Mountains’ independent evaluation of the loss. In cases where available information indicates that reserves established by the ceding company are inadequate, White Mountains establishes reserves in excess of its share of the reserves established by the ceding company.
White Mountains’ net loss and LAE reserves for its Reinsurance segment by class of business at December 31, 2003 and 2002 were as follows:
Once a point estimate is established, in the case of Folksamerica, actuaries estimate loss reserve ranges to measure the sensitivity of the actuarial assumptions used to set the point estimates. These ranges are calculated using similar methods to the point estimate calculation, but with different expected loss ratio and loss reporting pattern assumptions. For the low estimate, more optimistic loss ratios and faster reporting patterns are assumed, while the high estimate uses more conservative loss ratios and slower reporting patterns. These variable assumptions are derived from historic variations in loss ratios and reporting patterns by class and type of business. Due to the inherent difficulties in estimating ultimate A&E exposures, Folksamerica does not estimate ranges of these reserves. In addition, Fund American Re does not estimate a range for its reserves.
Folksamerica has a specialized unit that handles claims emanating from A&E exposures. The issues presented by these types of claims require specialization, expertise and an awareness of the various trends and jurisdictional developments.
Approximately $25.0 million of Folksamerica’s 2003 loss development for asbestos exposures was a bulk increase in IBNR resulting from the completion of a detailed A&E market share study. This study compared Folksamerica’s share of industry paid losses to estimated industry carried reserves.
The costs associated with administering the underlying A&E claims by Folksamerica’s clients tend to be higher than non-A&E claims due to generally higher legal costs incurred by ceding companies in connection with A&E claims that are passed on to Folksamerica under the reinsurance contracts.
Management believes that Fund American Re does not have exposure to A&E claims.
White Mountains’ insurance and reinsurance subsidiaries enter into ceded reinsurance contracts from time to time to protect their businesses from losses due to exposure aggregation, to manage their operating leverage ratios and to limit ultimate losses arising from catastrophic events. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. Amounts related to reinsurance contracts are recorded in accordance with SFAS No. 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts” (“SFAS 113”).
The projected benefit obligation as of a particular date represents the actuarial present value of all benefits attributed by the plan’s benefit formula to employee service rendered prior to that date. Therefore, future cash payments from pension and retiree medical plans are discounted using a discount rate based on published investment grade, long-term corporate bond yields. Many of the factors which are used to determine a plan’s projected benefit obligation as of a particular date and the cost of pension/retiree medical benefits for a particular period are dependent upon future events, such as how long the employee and any survivors live, how many years of service the employee is expected to render and the employee’s compensation in the years immediately before retirement or termination. Accordingly, the effects of such future factors are estimated. Further, since the projected benefit obligation and the periodic cost of pension/retiree medical benefits are based on actuarial present values, they are also sensitive to changes in the discount rate used to determine such amounts.
Additionally, the rate of return that is assumed on plan assets affects OneBeacon’s pension expense during a particular period. Since the retiree medical plan is unfunded, it is not affected by changes in the rate of return assumption. OneBeacon performed an analysis of expected long-term rates of return based on the allocation of its pension plan assets as of both December 31, 2002 and December 31, 2003 to develop expected rates of return for each significant asset class or economic indicator. A range of returns was developed based both on forecasts and on broad-market historical benchmarks for expected return, correlation, and volatility for each asset class. Although the expected investment return assumption is long-term in nature, the range of reasonable returns has dropped over the past few years as a consequence of lower inflation and lower bond yields. As a result of the most recent review, for 2004 OneBeacon elected to keep the expected return on its pension assets at 7.0%, as was used in 2003. At December 31, 2003, 38% of plan assets were invested in fixed maturity securities, 45% in equities and the remainder in cash, cash equivalents and convertible securities. A hypothetical 1% increase or decrease in the assumed rate of return would result in a pretax change in OneBeacon’s pension expense (or income as the case may be) for 2004 of approximately $4.3 million.
The health care cost trend rate was adjusted at December 31, 2003 to 10% from 9% to reflect current market conditions. The rate will decrease 0.50% each year over ten years to an ultimate rate of 5%. Assumed health care cost trend rates typically have a significant effect on the amounts reported for the health care plans. However, a hypothetical one-percentage-point change in assumed health care cost trend rates has a minimal impact on the projected benefit obligation and no impact on the expense. This is due to the significant changes in plan design related to cost-sharing arrangements between OneBeacon and the retirees. Since more cost has shifted to the retirees, the health care cost trend rate has less of an impact on White Mountains’ financial statements.
All acquisitions occurring subsequent to July 1, 2001 were accounted for under the purchase method of accounting in accordance with SFAS No. 141, “Business Combinations” (“SFAS 141”). Under this newly-issued accounting standard, White Mountains recognized a $16.6 million extraordinary gain during 2001 relating to two acquisitions and fully recognized its existing unamortized deferred credit balance of $682.5 million on January 1, 2002 as a change in accounting principle.
• projections of revenues, income (or loss), earnings (or loss) per share, dividends, market share or other financial forecasts;
The financial statements and supplementary data have been filed as a part of this Annual Report on Form 10-K as indicated in the Index to Financial Statements and Financial Statement Schedules appearing on page 89 of this report.