The following selected consolidated GAAP financial data of the Company as of and for the years ended December 31, 2003, 2002, 2001, 2000 and 1999 were derived from the consolidated financial statements of the Company, which were audited by PricewaterhouseCoopers LLP. The following financial data should be read in conjunction with the Consolidated Financial Statements and accompanying notes.
Net realized capital (losses) gains (38 .0) (50 .0) (22 .3) .8 (16 .8)
Net income per diluted share (4) $ 7 .74 $ 4 .52 $ 2 .10 $ 4 .02 $ 3 .25
Dividends paid per share $ 0 .36 $ 0 .32 $ 0 .28 $ 0 .24 $ 0 .24
Total investments and cash $ 9,314 .8 $ 7,259 .1 $ 5,783 .5 $ 5,493 .0 $ 4,139 .2
Total liabilities 9,518 .1 7,496 .0 6,075 .6 5,429 .7 4,376 .8
Shareholders' equity 3,164 .9 2,368 .6 1,720 .5 1,583 .4 1,327 .5
(3) Based on weighted average basic shares outstanding of 54.0 million, 50.3 million, 46.2 million, 45.9 million and 48.5 million for 2003, 2002, 2001, 2000 and 1999, respectively. for 2003, 2002, 2001, 2000 and 1999, respectively.
The worldwide reinsurance and insurance businesses are highly competitive yet cyclical by product and market. Competition with respect to the types of reinsurance and insurance business in which the Company is engaged is based on many factors, including the perceived overall financial strength of the reinsurer or insurer, A.M. Best’s and/or Standard & Poor’s rating of the reinsurer or insurer, underwriting expertise, the jurisdictions where the reinsurer or insurer is licensed or otherwise authorized, capacity and coverages offered, premiums charged, other terms and conditions of the reinsurance and insurance business offered, services offered, speed of claims payment and reputation and experience in lines written. The Company competes in the U.S., Bermuda and international reinsurance and insurance markets with numerous international and domestic reinsurance and insurance companies. The Company’s competitors include independent reinsurance and insurance companies, subsidiaries or affiliates of established worldwide insurance companies, reinsurance departments of certain insurance companies and domestic and international underwriting operations, including underwriting syndicates at Lloyd’s. Some of these competitors have greater financial resources than the Company and have established long-term and continuing business relationships throughout the industry, which can be a significant competitive advantage. In addition, the potential for securitization of reinsurance and insurance risks through capital markets provides an additional source of potential reinsurance and insurance capacity and competition.
In 2003, the improving market trends established in 2000 and 2001 have continued generally sustaining upward pressure on pricing, continued constriction of terms, conditions and coverages and constrained capacity. There are signs that pressures for incremental firming have abated for property classes, but these are partially offset by signs that pressures for incremental firming continue for casualty classes in general. More broadly, the industry remains exposed to fundamental issues that negatively impacted its aggregate capacity in 2002, including weak investment market conditions and adverse loss emergence, both of which have continued to depress the industry’s aggregate financial performance and affect perceptions of the financial strength of industry participants. These factors suggest that the current favorable market conditions are likely to persist until further corrective actions, possibly combined with improving investment market conditions, restore more normal competitive conditions.
The September 11 attacks solidified and amplified the trend reversal that began in 2000. These attacks resulted in losses which reduced industry capacity and were of sufficient magnitude to cause most companies to reassess their capital position, tolerance for risk, exposure control mechanisms and the pricing terms and conditions at which they are willing to take on risk. The gradual and variable improving trend that had been apparent through 2000 and earlier in 2001 firmed significantly after the September 11 attacks. This firming generally took the form of immediate and significant upward pressure on prices, more restrictive terms and conditions and a reduction of coverage limits and capacity availability. Such pressures were widespread with variability depending on the product and markets involved, but mainly depending on the characteristics of the underlying risk exposures. The magnitude of the changes was sufficient to create temporary disequilibrium in some markets as individual buyers and sellers adapted to changes in both their internal and market dynamics.
The Company’s management monitors and evaluates overall Company performance based principally upon underwriting and financial results. The following is a three year summary of consolidated underwriting results and net income:
As indicated in the preceding Industry Conditions section, the reinsurance and insurance industry has experienced very favorable market conditions over the past three years. The favorable market conditions coupled with the Company’s financial strength, strategic positioning and market and underwriting expertise enabled it to significantly increase its volume of business. As a result, gross written premiums for the year ended December 31, 2003 increased by 60.7% compared with the year ended December 31, 2002, which had increased 51.8% compared with the year ended December 31, 2001. Gross written premiums for the year ended December 31, 2001 had increased by 35.3% compared with the year ended December 31, 2000. Due to the nature of its businesses, the Company is unable to precisely differentiate the effects of price changes as compared to changes in exposure. Similarly, because individual reinsurance arrangements often reflect revised coverages, structuring, pricing, terms and/or conditions from period to period, the Company is unable to differentiate between the premium volumes attributable to new business as compared to renewal business. Management believes however, that on balance, during the past three years, the more significant component of growth related to growth in exposures underwritten with a lesser but still significant component relating to increased pricing and/or improved terms and conditions. Management believes further that market conditions are generally more favorable for casualty business classes than for property business classes; however, management notes that it continues to see business opportunities in virtually all operating classes and markets. Although premium volumes have increased significantly, the Company continues to decline business that does not meet its objectives regarding underwriting profitability.
The other components of underwriting gain (loss) are highly correlated to the level of premium volume. The amount of net written premiums reflects gross written premiums less ceded premiums. Premiums ceded were $258.4 million (5.6% of gross written premiums), $208.9 million (7.3% of gross written premiums) and $314.5 million (16.8% of gross written premiums) for the years ended December 31, 2003, 2002 and 2001, respectively. The fluctuation in ceded premiums was primarily due to adjustment premiums relating to claims made under the Company’s accident year aggregate excess of loss retrocessional programs. The amount of the adjustment premiums was $49.6 million, $54.5 million and $139.4 million for years ended December 31, 2003, 2002 and 2001, respectively. The larger amount of adjustment premium for 2001 relates primarily to losses ceded in conjunction with the September 11 attacks and the Enron bankruptcy. The increase in ceded premiums for 2003 and 2002 relates in part to specific reinsurance programs in the U.S. Insurance segment, which totaled $146.4 million and $116.1 million, respectively, for the years ended December 31, 2003 and 2002.
Incurred losses and LAE also increased as a result of the increased premium volume. However, the percentage increase in losses was less than the percentage increase in premium volume since part of the premium increase represented improvement in pricing, terms and conditions, as opposed to an increase in exposures. Partially offsetting the impact of improved pricing was the effect of prior year loss reserve strengthening. The increase in losses relating to prior period reserve strengthening was $256.9 million, $140.1 million and $0.0 million for years ended December 31, 2003, 2002 and 2001, respectively. See ITEM 1, “Business - Changes in Historical Reserves” for additional details and explanation.
The increase in net investment income to $402.1 million, $350.6 million and $340.4 million for the years ended December 31, 2003, 2002 and 2001, respectively, is also correlated to the increased premium volume. Premiums are generally collected over the first 12 to 15 months of the reinsurance contract while related losses are typically paid out over numerous years, resulting in an increase in cash flow when premiums are increasing. The Company’s cash flow from operations was $1,653.8 million, $736.1 million and $406.0 million for the years ended December 31, 2003, 2002 and 2001, respectively. Coupled with common stock offerings and the issuance of trust preferred securities, this facilitated the growth in the Company’s total investments and cash to $9,314.8 million, $7,259.1 million and $5,783.5 million as of December 31, 2003, 2002 and 2001, respectively. The impact on net investment income resulting from the growth in the investment portfolio was partially offset by an overall decline in interest rates during this same time period.
The Company’s shareholders’ equity increased to $3,164.9 million, $2,368.6 million and $1,720.5 million as of December 31, 2003, 2002 and 2001, respectively. This increase is due to increased net income, common stock offerings and increased unrealized appreciation on the Company’s investments. Management believes that the Company generally has sufficient capital and resources to meet its known obligations.
These segments are managed in a carefully coordinated fashion with strong elements of central control, including with respect to capital, investments and support operations. As a result, management monitors and evaluates the financial performance of these operating segments principally based upon their underwriting results. The Company utilizes inter-affiliate reinsurance but such reinsurance does not impact segment results, as business is generally reported within the segment in which the business was first produced.
Underwriting loss $ (7,557 ) $ (11,032 ) $ (116,053 )
The Company has recently announced that one of its subsidiaries, Everest Re, has reached agreement, subject to regulatory approval, to sell its United Kingdom branch to another of the Company’s subsidiaries, Bermuda Re. Business for this branch is currently reported through the International segment. Upon completion of the transaction, the business of this branch will be included in the Bermuda segment. Appropriate disclosures will be made in future filings to address the segment financial result fluctuations caused by the transfer.
Ceded premiums increased to $258.4 million in 2003 from $208.9 million in 2002, principally reflecting growth in specific reinsurance of the Company’s primary insurance business, which increased from $116.1 million to $146.4 million. In addition, ceded premiums for 2003 included $49.6 million in adjustment premiums relating to claims made under the 2000 accident year aggregate excess of loss element of the Company’s corporate retrocessional programs, while ceded premiums for 2002 included $5.1 million and $49.4 million in adjustment premium relating to claims made under the 2001 and 2000 accident year aggregate excess of loss elements of the Company’s corporate retrocessional programs, respectively.
Premium Revenues. Net premiums earned increased by 64.4% to $3,737.9 million in 2003 from $2,273.7 million in 2002. Contributing to this increase was a 96.0% ($697.5 million) increase in the U.S. Reinsurance operation, a 79.9% ($377.4 million) increase in the International operation, a 43.7% ($250.5 million) increase in the U.S. Insurance operation, a $129.8 million increase in the Bermuda operation and an 1.9% ($9.0 million) increase in the Specialty Underwriting operation. All of these changes reflect period-to-period changes in net written premiums and business mix together with normal variability in earnings patterns. Business mix changes occur not only as the Company shifts emphasis between products, lines of business, distribution channels and markets but also as individual contracts renew or non-renew, almost always with changes in coverage, structure, prices and/or terms, and as new contracts are accepted with coverages, structures, prices and/or terms different from those of expiring contracts. As premium reporting and earnings and loss and commission characteristics derive from the provisions of individual contracts, the continuous turnover of individual contracts, arising from both strategic shifts and day to day underwriting, can and does introduce appreciable background variability in various underwriting line items.
The U.S. Reinsurance segment accounted for $134.2 million and $96.7 million of the net prior period reserve adjustments for the years ended December 31, 2003 and 2002, respectively. The two principal underwriting areas responsible for these deficiencies are professional liability and general casualty. During the late 1990s and early 2000s, there had been a proliferation of claims relating to bankruptcies and other financial management improprieties. This increased number of claims combined with larger claims has significantly increased incurred losses on the professional liability policies. In the general casualty area, the Company continues to experience losses greater than historical trends for accident years 1998 through 2003. These losses are being driven by unfavorable trends in litigation and economic variability. In both the professional liability and general casualty reinsurance areas, the Company relies upon loss reports from ceding companies. Although the Company generally records reserves at higher levels than those reported by ceding companies, actual reported results have exceeded the initial loss indications. The reserve adjustments in these areas were partially offset by favorable reserve development relating to property reinsurance for the 2002 accident year.
The Bermuda segment reflected $6.9 million of favorable net prior period reserve adjustments for the year ended December 31, 2003 and no development for the year ended December 31,2002.
Incurred losses and LAE include catastrophe losses, which include the impact of both current period events and favorable and unfavorable development on prior period events, and are net of reinsurance. A catastrophe is an event that causes a pre-tax loss on property exposures of at least $5.0 million and has an event date of January 1, 1988 or later. Catastrophe losses, net of contract specific cessions, were $36.8 million in 2003, relating principally to the May 2003 tornado and hailstorm events and hurricanes Fabian and Isabel, compared to $30.2 million in 2002.
The segment components of the increase in incurred losses and LAE in 2003 from 2002 were a 97.6% ($523.1 million) increase in the U.S. Reinsurance operation, an 80.8% ($238.6 million) increase in the International operation, a 39.9% ($172.7 million) increase in the U.S Insurance operation, a $54.4 million increase in the Bermuda operation, partially offset by a 5.7% ($18.0 million) decrease in the Specialty Underwriting operation. These changes generally reflect increases in premiums earned, changes in the current year loss expectation assumptions for business written generally reflecting continued improvement in market conditions and pricing, increase in catastrophe losses and the net prior period reserve development discussed above. Incurred losses and LAE for each operation were also impacted by variability relating to changes in the level of premium volume and the mix of business by class and type.
The Company’s combined ratio, which is the sum of the loss and expense ratios, decreased by 3.8 percentage points to 95.2% in 2003 compared to 99.0% in 2002.
The following table shows the combined ratios for each of the Company’s operating segments in 2003 and 2002. The combined ratios for all operations were impacted by the loss and expense ratio variability noted above.
Distributions on the trust preferred securities are cumulative and pay quarterly in arrears. Distributions relating to the trust preferred securities were $16.5 million in 2003 compared to $2.1 million in 2002. These securities were issued in November 2002.
Premiums. Gross written premiums increased 51.8% to $2,846.5 million in 2002 from $1,874.6 million in 2001, as the Company took advantage of selected growth opportunities and improving pricing in many classes of business, while continuing to maintain a disciplined underwriting approach. Premium growth areas included a 303.8% ($76.0 million) increase in the Bermuda operation, which continues to expand its product line offerings, a 67.6% ($218.1 million) increase in the International operation, mainly attributable to growth in the London, Canadian and Latin American markets, a 63.5% ($319.1 million) increase in the U.S. Insurance operation, principally attributable to growth in worker’s compensation insurance, a 46.5% ($284.1 million) increase in the U.S. Reinsurance operation, primarily reflecting growth across property and casualty lines, and an 18.0% ($74.6 million) increase in the Specialty Underwriting operation, mainly attributable to growth in marine, aviation and surety business. The Company continued to decline business that did not meet its objectives regarding underwriting profitability.
Ceded premiums decreased to $208.9 million in 2002 from $314.5 million in 2001. This decrease was principally attributable to a reduction in cessions made under the Company’s corporate retrocessional program and to a decrease in ceded premiums in the U.S. Insurance operation as a result of changes in this segment’s specific reinsurance programs. Ceded premiums in 2002 included $5.1 million and $49.4 million in adjustment premiums relating to claims made under the 2001 and 2000 accident year aggregate excess of loss elements of the Company’s corporate retrocessional programs, respectively. Ceded premiums in 2001 included $81.3 million and $58.1 million in adjustment premiums relating to claims made under the 2001 and 1999 accident year aggregate excess of loss elements of the Company’s corporate retrocessional programs, respectively, with the 2001 accident year cessions principally relating to losses incurred as a result of the September 11 attacks and Enron bankruptcy.
Net written premiums increased by 69.1% to $2,637.6 million in 2002 from $1,560.1 million in 2001. This increase was a result of the increase in gross written premiums and the decrease in ceded premiums.
Segment underwriting expenses increased by 36.8% to $618.5 million in 2002 from $452.2 million in 2001. Commission, brokerage, taxes and fees increased by $155.0 million, principally reflecting increases in premium volume and changes in the mix of business. Other underwriting expenses increased by $11.3 million as the Company expanded its operations to support its increased business volume. Contributing to the underwriting expense increase were a 95.6% ($4.0 million) increase in the Bermuda operation, a 79.7% ($65.9 million) increase in the U.S. Insurance operation, a 31.9% ($29.8 million) increase in the International operation, a 27.0% ($29.1 million) increase in the Specialty operation and a 22.8% ($37.4 million) increase in the U.S. Reinsurance operation. The changes for each operation’s expenses principally resulted from changes in commission expenses related to changes in premium volume and business mix by class and type and, in some cases, the underwriting performance of the underlying business. The Company’s expense ratio, which is calculated by dividing underwriting expenses by premiums earned, decreased by 3.8 percentage points to 27.3% in 2002 compared to 31.1% in 2001.
The Company’s combined ratio, which is the sum of the loss and expense ratios, decreased by 14.5 percentage points to 99.0% in 2002 compared to 113.5% in 2001. The following table shows the combined ratios for each of the Company’s operating segments for 2002 and 2001. The combined ratios for all operations were impacted by the loss and expense ratio variability noted above as well as by the impact on ceded premiums of the adjustment premiums under the Company’s corporate retrocessional program.
Investments. Net investment income increased by 3.0% to $350.6 million in 2002 from $340.4 million in 2001, principally reflecting the effect of investing the $736.1 million of cash flow from operations in 2002, $346.3 million of net proceeds from the offering of Group’s common shares in February 2002 and $203.4 million of net proceeds from Capital Trust’s issuance of trust preferred securities in November 2002, partially offset by the lower interest rate environment. The following table shows a comparison of various investment yields as of December 31, 2002 and 2001, respectively, and for the periods then ended.
Net realized capital losses were $50.0 million in 2002, reflecting realized capital losses on the Company’s investments of $142.8 million, which includes $101.3 million relating to write-downs in the value of securities deemed to be impaired on an other than temporary basis, of which $33.0 million were for WorldCom, partially offset by $92.8 million of realized capital gains, compared to net realized capital losses of $22.3 million in 2001. The net realized capital losses in 2001 reflected realized capital losses of $55.1 million, which included $22.6 million relating to write-downs in the value of securities deemed to be impaired on an other than temporary basis, which were partially offset by $32.8 million of realized capital gains.
Interest expense was $42.4 million for 2002 compared to $46.0 million for 2001. Interest expense for 2002 reflects $38.9 million relating to the senior notes and $3.5 million relating to borrowings under the revolving credit facility. Interest expense for 2001 reflects $38.9 million relating to the senior notes and $7.1 million relating to borrowings under the revolving credit facility. In addition, 2002 includes incurred expense of $2.1 million for distributions on Capital Trust’s trust preferred securities.
Income Taxes. The Company generated income tax expense of $30.7 million in 2002 compared to income tax benefits of $8.7 million in 2001. The tax expense in 2002 was mainly attributable to improved underwriting and investment results. The tax benefit in 2001 primarily resulted from the impact of losses relating to the September 11 attacks, the Enron bankruptcy and realized capital losses recognized in 2001, which reduced taxable income, partially offset by taxable income relating to the non-recurring receipt of shares in connection with a former client’s demutualization.
Net Income. Net income was $231.3 million in 2002 compared to $99.0 million in 2001. This increase generally reflects the improved underwriting and investment results, partially offset by increased tax expense, realized capital losses, derivative expense and a reduction in other income.
Loss and LAE Reserves. The Company’s most critical accounting policy is the determination of its loss and LAE reserves. The Company maintains reserves to cover its estimated ultimate liability for losses and LAE with respect to reported and unreported claims. Because reserves are estimates of ultimate losses and LAE, management, using a variety of statistical and actuarial techniques, monitors reserve adequacy over time, evaluating new information, as it becomes known and adjusting reserves as necessary. Management considers many factors when setting reserves, including: (1) its exposure base, generally its premiums earned; (2) its expected loss ratios on current year writings as determined through extensive interaction between its underwriters and actuaries by product and class categories; (3) internal actuarial methodologies which analyze the Company’s experience with similar cases, information from ceding companies and historical trends, such as reserving patterns, loss payments and product mix; (4) current legal interpretations of coverage and liability; (5) economic conditions; and (6) the uncertainties discussed below regarding reserve requirements for A&E claims. Based on these considerations, management believes that adequate provision has been made for the Company’s loss and LAE reserves. Actual losses and LAE ultimately paid may deviate, perhaps substantially, from such reserves, impacting income in the period in which the change is made. See also Note 1 of Notes of the Consolidated Financial Statements.
Asbestos and Environmental Exposures. The Company continues to receive claims under expired contracts, asserting alleged injuries and/or damages relating to or resulting from environmental pollution and hazardous substances, including asbestos. The Company’s asbestos claims typically involve potential liability for bodily injury from exposure to asbestos or for property damage resulting from asbestos or products containing asbestos. The Company’s environmental claims typically involve potential liability for (a) the mitigation or remediation of environmental contamination or (b) bodily injury or property damage caused by the release of hazardous substances into the land, air or water.
The Company’s reserves include an estimate of the Company’s ultimate liability for A&E claims for which ultimate value cannot be estimated using traditional reserving techniques. There are significant uncertainties in estimating the amount of the Company’s potential losses from A&E claims. Among the uncertainties are: (a) potentially long waiting periods between exposure and manifestation of any bodily injury or property damage; (b) difficulty in identifying sources of A&E contamination; (c) difficulty in properly allocating responsibility and/or liability for A&E damage; (d) changes in underlying laws and judicial interpretation of those laws; (e) potential for an A&E claim to involve many insurance providers over many policy periods; (f) long reporting delays, both from insureds to insurance companies and from ceding companies to reinsurers; (g) historical data on A&E losses, which is more limited and variable than historical information on other types of casualty claims; (h) questions concerning interpretation and application of insurance and reinsurance coverage; and (i) uncertainty regarding the number and identity of insureds with potential A&E exposure.
Reinsurance Receivable. The Company utilizes reinsurance agreements to reduce its exposure to large claims and catastrophic loss occurrences. These agreements provide for recovery from reinsurers of a portion of losses and loss expenses under certain circumstances without relieving the insurer of its obligation to the policyholder. In the event reinsurers were unable to meet their obligations under these reinsurance agreements or successfully challenge losses ceded by the Company under the reinsurance contracts, the Company would not be able to realize the full value of the reinsurance recoverable balance. In some cases, the Company may hold partial collateral, including letters of credit and funds held arrangements, for these agreements. The Company establishes reserves for uncollectible balances based on management’s assessment of the collectibility of the outstanding balances. To minimize exposure from uncollectible reinsurance receivables, the Company has a reinsurance credit security committee that generally evaluates the financial strength of a reinsurer prior to entering into a reinsurance arrangement. Additionally, creditworthy foreign reinsurers of business written in the U.S. are generally required to secure their obligations. Management believes that adequate provision has been made for the Company’s uncollectible balances. Actual uncollectible amounts may vary, perhaps substantially, from such reserves, impacting income in the period in which the change is made. See also Note 1 of Notes to the Consolidated Financial Statements.
The Company’s current investment strategy generally seeks to maximize after-tax income through a high quality, diversified, taxable and tax-preferenced fixed maturity portfolio, while maintaining an adequate level of liquidity. The Company’s mix of taxable and tax-preferenced investments is adjusted continuously, consistent with its current and projected operating results, market conditions and tax position. The fixed maturities in the investment portfolio are comprised of non-trading available for sale securities. Commencing with the second quarter of 2003, the Company invested in interest only strips of mortgage-backed securities. These fixed maturity securities give the holder the right to receive interest payments at a stated coupon rate on an underlying pool of mortgages. The interest payments on the outstanding mortgages are guaranteed by entities generally rated AAA. The ultimate cash flow from these investments is primarily dependent upon the average life of the mortgage pool. Generally, as market interest rates and more specifically market mortgage rates decline, mortgagees tend to refinance which will decrease the average life of a mortgage pool and decrease expected cash flows. Conversely, as market interest rates and more specifically market mortgage rates rise, repayments will slow and the ultimate cash flows will tend to rise. Accordingly, the market value of these investments tends to increase as general interest rates rise and decline as general interest rates fall. These movements are generally counter to the impact of interest rate movements on the Company’s other fixed income investments. The market value of the interest only strips was $310.2 million at December 31, 2003. Additionally, the Company invests in equity securities, which it believes will enhance the risk-adjusted total return of the investment portfolio.
The tables below briefly summarize the characteristics of the investment portfolio at December 31, 2003, 2002 and 2001.
Loss and LAE Reserves. Gross loss and LAE reserves totaled $6,361.2 million at December 31, 2003, $4,905.6 million at December 31, 2002, and $4,278.3 million at December 31, 2001. The increase in 2003 is primarily attributable to increased premiums earned, net prior period reserve adjustments in select areas and normal variability in claim settlements. The increase in 2002 was primarily attributable to increased premiums earned, modest reserve strengthening in select areas and normal variability in claim settlements. Reinsurance receivables totaled $1,284.1 million at December 31, 2003, $1,116.4 million at December 31, 2002, and $895.1 million at December 31, 2001, with the changes in 2003 consisting of the increase in reinsurance receivables reflecting an additional $85.0 million cession under the 2000 accident year aggregate excess of loss element of the Company’s corporate retrocessional program and $81.1 million losses ceded as part of a reinsurance agreement between Mt. McKinley and Prupac. At December 31, 2003, $494.5 million, or 38.5%, was receivable from subsidiaries of London Reinsurance Group. These receivables are effectively secured by a combination of letters of credit and funds held arrangements under which the Company has retained the premium payments due the retrocessionaire, recognized liabilities for such amounts and reduced such liabilities as payments are due from the retrocessionaire. In addition, $160.0 million or 12.5%, was receivable from Prupac, whose obligations are guaranteed by The Prudential, $145.0 million, or 11.3%, was receivable from Continental Insurance Company and $96.7 million, or 7.5% was receivable from Tranatlantic Reinsurance Company, which is partially secured by funds held arrangements. No other retrocessionaire accounted for more than 5% of the Company’s receivables.
Loss and LAE reserves net of reinsurance recoverables (“net loss and LAE reserves”) totaled $5,100.1 million at December 31, 2003, $3,817.0 million at December 31, 2002 and $3,394.8 million at December 31, 2001. The following table summarizes net outstanding loss and LAE reserves by segment and A&E reserves, which are managed on a combined basis, at December 31, 2003, 2002 and 2001.
U.S. Reinsurance $ 2,250 .1 $ 1,742 .9 $ 1,621 .9
Total Net Reserves $ 5,100 .1 $ 3,817 .0 $ 3,394 .8
(1) There can be no assurances that reserves will not ultimately exceed the indicated ranges requiring additional incomestatement expense.
The vast majority of Mt. McKinley’s A&E exposed insurance policies are excess casualty policies, with aggregate coverage limits, which by definition also have protection afforded by underlying coverage. Mt. McKinley’s attachment points vary but usually are protected by millions, often tens of millions, of dollars of underlying coverage. The excess nature of most of Mt. McKinley’s policies also offers protection against non-product claims (for example, claims arising under general liability coverage). Although under some circumstances an excess policy could be exposed to non-product claims, such claims generally pose more of a risk to primary policies because non-product claims are generally less likely to aggregate. In addition, environmental claims arise under general liability coverage, and generally do not aggregate. Thus, these claims tend to create exposure for primary policies to a greater extent than excess policies.
With respect to both the Mt. McKinley and Everest Re operations, the Company was not a member of the Asbestos Claims Facility (“Wellington”) or the Center for Claims Resolution (“CCR”) claim settlement facilities. Insurers supporting those facilities made broad commitments concerning the application of insurance coverage to asbestos claims. With respect to its direct insurance exposures, the fact that the Company has not made those commitments may allow it to resolve insurance exposure to Wellington/CCR insureds more economically than if it had joined these facilities. With respect to its reinsurance exposures, although the Company was not a signatory to the Wellington or CCR facilities, it has, within the bounds of its reinsurance contracts, generally supported ceding companies that were signatories. Because the insurers supporting these facilities have generally paid their exposures more quickly than non-signatory insurers, the Company believes that this has generally meant that it has paid its reinsurance exposure more quickly than it likely would have if it had not been subject to Wellington/CCR payments.
The following table shows the development of prior year A&E reserves on both a gross and net of retrocessional basis for the years ended December 31, 2003, 2002 and 2001:
End of period reserves $ 534 .4 $ 527 .5 $ 568 .6
The gross incurred losses for A&E exposures increased by $172.6 million and $95.0 million for the years ended December 31, 2003 and 2002, respectively. These increases are the result of re-evaluations by management reflecting additional information received from insureds and ceding companies, ongoing litigation, additional claims received and settlement activity. Management closely monitors this additional information and adjusts reserves accordingly. The net incurred losses primarily reflect the impact of the reinsurance agreement between Mt. McKinley and Prupac.
Coverage in place ("CIP") settlements (2) $ 72 .1 $ 43 .5 $ 32 .1
Total end of period reserves $ 652 .7 $ 541 .4 $ 457 .7
(3) Actively Managed means that Mt. McKinley is managing the defense of claims against the insured.
The Company’s net three year survival ratio on its asbestos exposures was 9.8 years for the period ended December 31, 2003. This three year survival ratio when adjusted to exclude the effect of the reinsurance ceded under the stop loss cover from Prupac was 13.6 years, and when adjusted to exclude the CIP, actively managed reserves, and the stop loss cession to Prupac was 23.8 years.
Capital. The Company’s business operations are in part dependent on the Company’s financial strength, and the market’s perception thereof, as measured by shareholders’ equity, which was $3,164.9 million and $2,368.6 million at December 31, 2003 and 2002, respectively. The Company has flexibility with respect to capitalization as the result of its perceived financial strength, including its financial strength ratings as assigned by independent rating agencies, and its access to the debt and equity markets. The Company continuously monitors its capital and financial position, as well as investment and security market conditions, both in general and with respect to the Company’s securities, and responds accordingly.
The Company filed a shelf registration statement on Form S-3 with the SEC that provides for the issuance of up to $975 million of securities. Generally, under this shelf registration statement, Group is authorized to issue common shares, preferred shares, debt securities, warrants and hybrid securities, Holdings is authorized to issue debt securities and Everest Re Capital Trust II and III are authorized to issue trust preferred securities. The registration statement was declared effective by the SEC on December 22, 2003.
On July 30, 2002, the Company filed a shelf registration statement on Form S-3 with the SEC, providing for the issuance of up to $475.0 million of securities. Generally, under this shelf registration statement, Group was authorized to issue common shares, preferred shares, debt securities, warrants and hybrid securities, Holdings was authorized to issue debt securities and Capital Trust was authorized to issue trust preferred securities. This shelf registration statement became effective on September 26, 2002. The following securities were issued pursuant to that registration statement.
On March 14, 2000, Holdings completed public offerings of $200.0 million principal amount of 8.75% senior notes due March 15, 2010 and $250.0 million principal amount of 8.5% senior notes due March 15, 2005. During 2000, the net proceeds of these offerings and additional funds were distributed by Holdings to Group. Interest expense incurred in connection with these senior notes was $38.9 million for the years ended December 31, 2003, 2002 and 2001.
Liquidity. The Company’s current investment strategy generally seeks to maximize after-tax income through a high quality, diversified, taxable bond and tax-preferenced fixed maturity portfolio, while maintaining an adequate level of liquidity. The Company’s mix of taxable and tax-preferenced investments is adjusted continuously, consistent with the Company’s current and projected operating results, market conditions and tax position. Additionally, the Company invests in equity securities, which it believes will enhance the risk-adjusted total return of the investment portfolio.
The Company’s liquidity requirements are met on both a short and long-term basis by funds provided by premiums collected, investment income, collected reinsurance receivable balances and the sale and maturity of investments, together with the availability of funds under the Company’s revolving credit facility. The Company’s net cash flows from operating activities were $1,653.8 million at December 31, 2003, $736.1 million for December 31, 2002 and $406.0 million for December 31, 2001. The increase in net cash flows from operations for 2003 compared with 2002 was primarily due to the growth in business coupled with favorable underwriting results. Additionally, these cash flows included net tax payments of $52.6 million, $10.0 million and $24.9 million for December 31, 2003, 2002 and 2001, respectively; catastrophe loss payments of $96.0 million, $62.0 million and $32.5 million for December 31, 2003, 2002 and 2001, respectively, and net derivative settlement payments of $3.9 million, $39.5 million and $1.5 million for December 31, 2003, 2002 and 2001, respectively. The increase in net cash flows from operations from 2002 to 2003 was primarily due to the growth in business coupled with favorable underwriting results.
In addition to its net cash flows from operating activities, the Company’s investment portfolio, through normal portfolio activities, provides substantial additional liquidity. Proceeds from sales, calls and maturities and cost of investment asset acquisitions were $2,127.2 million and $4,144.2 million, respectively, for December 31, 2003, compared to $2,822.1 million and $3,929.7 million, respectively, for December 31, 2002 and $1,492.2 million and $1,767.4 million, respectively, for December 31, 2001.
Effective October 10, 2003, Holdings entered into a new three year, $150.0 million senior revolving credit facility with a syndicate of lenders, replacing the December 21, 1999, three year senior revolving credit facility, which expired on December 19, 2003. Both the October 10, 2003 and December 21, 1999 senior revolving credit agreements, which have similar terms, are referred to as the “Credit Facility”. Wachovia Bank is the administrative agent for the Credit Facility. The Credit Facility is used for liquidity and general corporate purposes. The Credit Facility provides for the borrowing of up to $150.0 million with interest at a rate selected by Holdings equal to either (1) the Base Rate (as defined below) or (2) an adjusted London InterBank Offered Rate (“LIBOR”) plus a margin. The Base Rate is the higher of the rate of interest established by Wachovia Bank from time to time as its prime rate or the Federal Funds rate plus 0.5% per annum. The amount of margin and the fees payable for the Credit Facility depend upon Holdings’ senior unsecured debt rating.
The Credit Facility requires Holdings to maintain a debt to capital ratio of not greater than 0.35 to 1, Holdings to maintain a minimum interest coverage ratio of 2.5 to 1 and Everest Re to maintain its statutory surplus at $1.0 billion plus 25% of future aggregate net income and 25% of future aggregate capital contributions. As of December 31, 2003, the Company was in compliance with these covenants.
During the year ended December 31, 2003, Holdings made no payments on and had no borrowings under the Credit Facility. During the years ended December 31, 2002 and 2001, Holdings made payments on the Credit Facility of $80.0 million and $152.0 million, respectively. During the years ended December 31, 2002 and 2001, Holdings had new Credit Facility borrowings of $45.0 million and $22.0 million, respectively. As of December 31, 2003 and 2002, Holdings had outstanding Credit Facility borrowings of $70.0 million. Interest expense incurred in connection with these borrowings was $1.4 million, $3.5 million and $7.1 million for the years ended December 31, 2003, 2002 and 2001, respectively.
The Company has arrangements available for the issue of letters of credit, which letters are generally collateralized by the Company’s cash or investments and which are generally used to collateralize reinsurance assumed by Bermuda Re from jurisdictions where collateralization is generally required for the ceding company to receive credit for such reinsurance recoverables from its principal regulator. Bermuda Re and Everest International also used trust arrangements to provide collateralization to ceding companies including affiliates. The Company generally avoids providing collateral except where required for ceding companies to receive credit from their regulators. At December 31, 2003, $246.2 million of letters of credit were issued and outstanding under these arrangements and substantially all were related to Bermuda Re and Everest Re’s U.K. branch. Additionally, at December 31, 2003, $254.0 million of assets were deposited in trust accounts.
Management believes that the Company’s greatest catastrophe exposure world wide from any single event is to a European windstorm where the Company estimates it has a pre-tax PML exposure of $430 million. The Company further estimates that its greatest pre-tax U.S. PML exposure, which relates to an earthquake affecting the west coast, including workers’ compensation exposure is $404 million. The second largest U.S. exposure relates to a hurricane affecting the east coast with a PML of $302 million. There can be no assurance that the Company will not experience losses from one or more catastrophic events that exceed, perhaps by a substantial amount, its estimated PML.
If a single catastrophe were to occur that resulted in $430 million of gross losses and ALAE in 2004 (an amount equivalent to the Company’s PML including its property and workers’ compensation exposures), management estimates that the effect on the Company’s income before and after taxes would be approximately $430 million and $335 million, respectively. Such impact represents approximately 10.6% of the Company’s beginning of year capital.
The overall investment strategy considers the scope of present and anticipated Company operations. In particular, estimates of the financial impact resulting from non-investment asset and liability transactions, together with the Company’s capital structure and other factors, are used to develop a net liability analysis. This analysis includes estimated payout characteristics for which the investments of the Company provide liquidity. This analysis is considered in the development of specific investment strategies for asset allocation, duration and credit quality. The change in overall market sensitive risk exposure principally reflects the asset changes that took place during the year, including the acquisition of interest only strips in which market value increases as interest rates rise and decreases as interest rates fall. The addition of these securities to the portfolio has reduced the impact of interest rate shift on the entire portfolio.
The Company’s $9,314.8 million investment portfolio is principally comprised of fixed maturity securities that are subject to interest rate risk and foreign currency rate risk, and equity securities that are subject to equity price risk. The impact of these risks on the investment portfolio is generally mitigated by changes in the value of operating assets and liabilities and their associated income statement impact.
The tables below display the potential impact of market value fluctuations and after-tax unrealized appreciation on the fixed maturity portfolio as of December 31, 2003 and 2002 based on parallel 200 basis point shifts in interest rates up and down in 100 basis point increments. For legal entities with a U.S. dollar functional currency, this modeling was performed on each security individually. To generate appropriate price estimates on mortgage-backed securities, changes in prepayment expectations under different interest rate environments are taken into account. For legal entities with a non-U.S. dollar functional currency, the effective duration of the involved portfolio of securities was used as a proxy for the market value change under the various interest rate change scenarios. All amounts are in U.S. dollars and are presented in millions. In general, the reduced volatility is attributable to the Company’s investments in interest only strips, the effect of which was to reduce overall portfolio duration and therefore sensitivity to interest rate moves.
Total Market Value $ 9,858 .7 $ 9,353 .9 $ 8,878 .7 $ 8,483 .5 $ 8,004 .1
Total Market Value $ 7,985 .3 $ 7,480 .3 $ 6,949 .0 $ 6,541 .4 $ 6,116 .2
Foreign currency rate risk is the potential change in value, income and cash flow arising from adverse changes in foreign currency exchange rates. Each of the Company’s foreign operations maintains capital in the currency of the country of its geographic location consistent with local regulatory guidelines. Generally, the Company prefers to maintain the capital of its foreign operations in U.S. dollar assets, although this varies by regulatory jurisdiction in accordance with market needs. Each foreign operation may conduct business in its local currency as well as the currency of other countries in which it operates. The primary foreign currency exposures for these foreign operations are the Canadian Dollar, the British Pound Sterling and the Euro. The Company mitigates foreign exchange exposure by a general matching of the currency and duration of its assets to its corresponding operating liabilities. In accordance with Financial Accounting Standards Board Statement No. 52, the Company translates the assets, liabilities and income of non-U.S. dollar functional currency legal entities to the U.S. dollar. This translation amount is reported as a component of other comprehensive income. The primary functional foreign currency exposures for these foreign operations are the Canadian Dollar, the Euro and the British Pound Sterling.
Equity risk is the potential change in market value of the common stock and preferred stock portfolios arising from changing equity prices. The Company invests in high quality common and preferred stocks that are traded on the major exchanges in the U.S. and funds investing in such securities. The primary objective in managing the equity portfolio is to provide long-term capital growth through market appreciation and income.
The tables below display the impact on market value and after-tax unrealized appreciation of a 20% change in equity prices up and down in 10% increments as of December 31, 2003 and 2002. The growth in exposure is primarily due to the growth in the equity portfolio. All amounts are in U.S. dollars and are presented in millions.
As these specialized equity put options are derivatives within the framework of FAS 133, the Company is required to report the fair value of these instruments on its balance sheet and record any changes to fair value in its statement of operations. The Company has recorded fair values for its obligations on these specialized equity put options at December 31, 2003 and December 31, 2002 of $16.5 million and $22.4 million, respectively; however, the Company does not believe that the ultimate settlement of these transactions is likely to require a payment that would exceed the initial consideration received or any payment at all.
S & P 500 Index Put Options Obligation - Sensitivity Analysis
Market Value Change from Base (%) (61 .8)% (27 .6)% .0% .1% .7%
Total Market Value $ 23 .2 $ 19 .5 $ 16 .5 $ 14 .1 $ 12 .1
Total Market Value $ 36 .2 $ 24 .7 $ 16 .5 $ 10 .9 $ 7 .1
Market Value Change from Base (%) (59 .0)% (26 .5)% .0% .4% .6%
Total Market Value $ 49 .5 $ 33 .7 $ 22 .4 $ 14 .6 $ 9 .4
Market Value Change from Base (%) (121 .1)% (50 .2)% .0% .7% .2%
This report contains forward-looking statements within the meaning of the U.S. federal securities laws. The Company intends these forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in the federal securities laws. In some cases, these statements can be identified by the use of forward-looking words such as “may”, “will”, “should”, “could”, “anticipate”, “estimate”, “expect”, “plan”, “believe”, “predict”, “potential” and “intend”. Forward-looking statements contained in this report include information regarding the Company’s reserves for losses and LAE, the adequacy of the Company’s provision for uncollectible balances, estimates of the Company’s catastrophe exposure, the effects of catastrophic events on the Company’s financial statements, the ability of Everest Re, Holdings and Bermuda Re to pay dividends and the settlement costs of the Company’s specialized equity put options. Forward-looking statements only reflect the Company’s expectations and are not guarantees of performance. These statements involve risks, uncertainties and assumptions. Actual events or results may differ materially from the Company’s expectations. Important factors that could cause actual events or results to be materially different from the Company’s expectations include those discussed below under the caption “Risk Factors”. The Company undertakes no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.
The Company writes primarily property and casualty reinsurance and insurance. The worldwide reinsurance and insurance businesses are highly competitive, yet cyclical by product and market. These cycles, as well as other business, economic and societal trends that influence aggregate supply and demand for property and casualty insurance and reinsurance products, are outside of the Company’s control. The phase of the industry cycle that prevailed from 1987 through 1999 was characterized by increasingly competitive global market conditions across most lines of business, leading to decreasing prices and broadening contract terms, which in turn had a negative impact on insurers’ financial results and eroded the industry capital base. These trends resulted from a number of factors, including the emergence of significant reinsurance capacity in Bermuda, changes in the Lloyd’s market, consolidation and increased capital levels in the insurance and reinsurance industries and the emergence of new reinsurance and financial products addressing traditional exposures in alternative fashions. This industry cycle began to reverse in 2000, when the industry entered a period of firming prices, more restrictive terms and conditions and tightened coverage availability across most classes and markets. These new trends were intensified and accelerated by losses from the September 11 attacks, which reduced industry capacity and were of sufficient magnitude to cause most insurers to reassess their capital position, tolerance for risk, exposure control mechanisms and the pricing terms and conditions at which they are willing to take on risk. Additional contributing factors included deteriorating investment market conditions and results and renewed concerns regarding longer-term industry-specific issues, such as A&E exposures. Although the industry is currently in a favorable phase of the pricing cycle, the Company cannot assure that this favorable phase will continue. Many of the factors that contributed to decreasing prices during the prior phase of the cycle continue to exist and new and unanticipated factors could emerge. Any significant decrease in pricing for property and casualty insurance or reinsurance could reduce the Company’s ability to write business profitably and reduce its net income. Further discussion of competition issues can be found in ITEM 1, “Business - Competition”.
The Company’s insurance company subsidiaries, other than Mt. McKinley and Everest International, currently hold an “A+ (“Superior”)” financial strength rating from A.M. Best. Everest Re, Bermuda Re and Everest National hold an “AA- (“Very Strong”)” financial strength rating from Standard & Poor’s. Everest Re and Bermuda Re hold an “Aa3 (“Excellent”)” financial strength rating from Moody’s Financial strength ratings are used by insurers and reinsurance and insurance intermediaries as an important means of assessing the financial strength and quality of reinsurers. In addition, an unfavorable rating or the lack of a rating of its reinsurers may adversely affect the rating of a company purchasing reinsurance. A downgrade or withdrawal of any of these ratings might adversely affect, the Company’s ability to market its insurance products and could have a material and adverse effect on future prospects for growth and profitability. During the last five years, no active subsidiary of the Company has experienced a credit rating downgrade. However, the Company cannot assure that no credit downgrade will ever occur in the future. Consistent with market practice, roughly 20% to 30% of the Company’s treaty reinsurance business allows the ceding company to terminate the contract or seek collateralization of the Company’s obligations in the event of a rating downgrade below a certain threshold. The termination provision would generally be triggered only if a rating fell below A.M. Best’s A- rating level, which is three levels below Everest Re’s current rating of A+. Everest Re also has more modest exposure to reinsurance contracts that contain provisions for obligatory funding of outstanding liabilities in the event of a rating agency downgrade. That provision would also generally be triggered only if Everest Re’s rating fell below A.M. Best’s A- rating level.
The Company’s industry is highly competitive and it may not be able to compete successfully in the future.
The Company’s industry is highly competitive and has experienced significant price competition over most of the last decade. In addition, a number of new well-capitalized competitors have entered the market recently, and the Company expects to face further competition from new market entrants in the future. The Company competes globally in the U.S., Bermuda and other international markets. According to the 2003 edition of Standard & Poor’s special report on the global reinsurance industry, there are 240 reinsurance organizations operating worldwide, from 41 countries. Market share is largely concentrated within the top 25 groups, one of which is the Company. The Company considers the 15 groups that have financial strength ratings generally comparable to or above it’s rating to be its primary competitors. The leaders in this market are Munich Re, Swiss Re, Berkshire Hathaway, Hannover Re and Employers Re. Some of these competitors have greater financial resources than the Company does, have been operating for longer than the Company has and have established long-term and continuing business relationships throughout the industry, any of which can be a significant competitive advantage. In addition, the Company expects to face further competition in the future and may not be able to compete successfully in the future.
Special considerations apply to the Company’s Bermuda operations. Under Bermuda law, non-Bermudians, other than spouses of Bermudians and individuals holding permanent resident certificates, are not permitted to engage in any gainful occupation in Bermuda without a work permit issued by the Bermuda government. A work permit is only granted or extended if the employer can show that, after a proper public advertisement, no Bermudian, spouse of a Bermudian or individual holding a permanent resident certificate is available who meets the minimum standards for the position. The Bermuda government has announced a policy that places a six-year term limit on individuals with work permits, subject to specified exemptions for persons deemed to be key employees. Currently, all four of the Company’s Bermuda-based professional employees who require work permits have been granted permits by the Bermuda government that expire at various times between July 2004 and May 2006. This includes Peter J. Bennett, the chief executive officer of the Company’s Bermuda reinsurance operation. In the event his work permit were not renewed, the Company could lose his services, thereby adversely affecting its ability to conduct its business in Bermuda until it was able to replace him with an individual in Bermuda who did not require a work permit or who was granted the permit.
The Company’s functional currency is the U.S. dollar. However, the Company writes a portion of its business in currencies other than U.S. dollars. During the year ended December 31, 2003, the Company wrote approximately 26.1% of its reinsurance coverages in currencies other than U.S. dollars. The Company also maintains a portion of its investment portfolio in investments denominated in currencies other than U.S. dollars. As of December 31, 2003, the Company maintained approximately 11% of its investment portfolio in investments denominated in currencies other than U.S. dollars. Consequently, quarterly exchange rate fluctuations may have a material impact on the Company’s quarterly net income. During 2003, 2002, 2001, the impact on the Company’s quarterly pre-tax net income from exchange rate fluctuations ranged from a loss of $3.6 million to a gain of $7.8 million. Further discussion of foreign currency rate risk can be found in ITEM 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Market Sensitive Instruments”.
Insurance laws and regulations restrict the Company’s ability to operate and any failure to comply with those laws and regulations could have a material adverse effect on its business.
Bermuda Re does not intend to be licensed or admitted as an insurer or reinsurer in any U.S. jurisdiction. Under current law, Bermuda Re generally will be permitted to reinsure U.S. risks from its office in Bermuda without obtaining those licenses. However, the insurance and reinsurance regulatory framework has become subject to increased scrutiny. In the past, there have been congressional and other initiatives in the U.S. regarding increased supervision and regulation of the insurance industry, including proposals to supervise and regulate reinsurers domiciled outside the U.S. If Bermuda Re were to become subject to any insurance laws of the U.S. or any U.S. state at any time in the future, it might be required to post deposits or maintain minimum surplus levels and might be prohibited from engaging in lines of business or from writing types of policies. Complying with those laws could have a material adverse effect on the Company’s ability to conduct business in the Bermuda market.
As Bermuda Re’s business develops, it will monitor the need to obtain licenses in jurisdictions other than Bermuda in order to comply with applicable law or to be able to engage in additional insurance-related activities. In addition, Bermuda Re may be at a competitive disadvantage in jurisdictions where it is not licensed or does not enjoy an exemption from licensing relative to competitors that are so licensed or exempt from licensing. Bermuda Re may not be able to obtain any additional licenses that it determines are necessary or desirable. Furthermore, the process of obtaining those licenses is often costly and may take a long time.
Provisions in the Company’s bye-laws could have an anti-takeover effect, which could diminish the value of its common shares.
election of directors is staggered, meaning that the members of only one of three classes of directors are selected each year;
any person that is not an investment company beneficially owning more than 5.0% of any class of the issued and outstanding share capital of the Company,
any person that is not an investment company beneficially owns more than 5.0% of any class of the issued and outstanding share capital of the Company,
Investors in the Company may have more difficulty in protecting their interests than investors in a U.S. corporation.
Under Delaware law, an interested director could be held liable for a transaction in which that director derived an improper personal benefit.
Limitation of Liability of Directors and Officers. the Company’s bye-laws provide that the Company and its shareholders waive all claims or rights of action that they might have, individually or in the right of the Company, against any director or officer for any act or failure to act in the performance of that director’s or officer’s duties. However, this waiver does not apply to claims or rights of action that arise out of fraud or dishonesty. This waiver may have the effect of barring claims arising under U.S. federal securities laws. Under Delaware law, a corporation may include in its certificate of incorporation provisions limiting the personal liability of its directors to the corporation or its stockholders for monetary damages for many types of breach of fiduciary duty. However, these provisions may not limit liability for any breach of the duty of loyalty, acts or omissions not in good faith or that involve intentional misconduct or a knowing violation of law, the authorization of unlawful dividends, stock repurchases or stock redemptions, or any transaction from which a director derived an improper personal benefit. Moreover, these provisions would not be likely to bar claims arising under U.S. federal securities laws.
Dividends. Bermuda law does not allow a company to declare or pay a dividend, or make a distribution out of contributed surplus, if there are reasonable grounds for believing that the company, after the payment is made, would be unable to pay its liabilities as they become due, or that the realizable value of the company’s assets would be less, as a result of the payment, than the aggregate of its liabilities and its issued share capital and share premium accounts. The share capital account represents the aggregate par value of the company’s issued shares, and the share premium account represents the aggregate amount paid for issued shares over and above their par value. Under Delaware law, subject to any restrictions contained in the company’s certificate of incorporation, a company may pay dividends out of the surplus or, if there is no surplus, out of net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year. Surplus is the amount by which the net assets of a corporation exceed its stated capital. Delaware law also provides that dividends may not be paid out of net profits at any time when stated capital is less than the capital represented by the outstanding stock of all classes having a preference upon the distribution of assets.
The income of Bermuda Re is a significant portion of the Company’s worldwide income from operations. The Company has established guidelines for the conduct of its Bermuda operations that are designed to ensure that Bermuda Re is not engaged in the conduct of a trade or business in the U.S. Based on its compliance with those guidelines, the Company believes that Bermuda Re should not be required to pay U.S. corporate income tax, other than withholding tax on U.S. source dividend income. However, if the Internal Revenue Service (“IRS”) successfully contended that Bermuda Re was engaged in a trade or business in the U.S., Bermuda Re would be required to pay U.S. corporate income tax on any income that is subject to the taxing jurisdiction of the U.S., and possibly the U.S. branch profits tax. Even if the IRS successfully contended that Bermuda Re was engaged in a U.S. trade or business, the U.S.-Bermuda tax treaty would preclude the IRS from taxing Bermuda Re’s income except to the extent that its income were attributable to a permanent establishment maintained by that subsidiary. The Company does not believe that Bermuda Re has a permanent establishment in the U.S. If the IRS successfully contended that Bermuda Re did have income attributable to a permanent establishment in the U.S., it would be subject to U.S. tax on that income.
The Company conducts its Barbados operations in a manner designed to minimize its U.S. tax exposure. Based on its compliance with guidelines designed to ensure that it generates only immaterial amounts, if any, of income that is subject to the taxing jurisdiction of the U.S., the Company believes that it should be required to pay only immaterial amounts, if any, of U.S. corporate income tax, other than withholding tax on U.S. source dividend income. However, if the IRS successfully contended that the Company had material amounts of income that is subject to the taxing jurisdiction of the U.S., it would be required to pay U.S. corporate income tax on that income, and possibly the U.S. branch profits tax. Even if the IRS successfully contended that the Company had material amounts of income that is subject to the taxing jurisdiction of the U.S., the U.S.-Barbados tax treaty would preclude the IRS from taxing its income, except to the extent that its income was attributable to a permanent establishment maintained by it in the U.S. The Company does not believe that it has material amounts of income attributable to a permanent establishment in the U.S. If the IRS successfully contended, however, that the Company did have income attributable to a permanent establishment in the U.S., it would be subject to U.S. tax on that income.
A number of multinational organizations, including the Organization for Economic Cooperation and Development (the “OECD”), the European Union, the Financial Action Task Force and the Financial Stability Forum (the “FSF”), have all recently identified some countries as not participating in adequate information exchange, engaging in harmful tax practices or not maintaining adequate controls to prevent corruption, such as money laundering activities. The OECD has threatened non-member jurisdictions that do not agree to cooperate with the OECD with punitive sanctions by OECD member countries, though specific sanctions have yet to be adopted by OECD member countries. It is as yet unclear as to what these sanctions will be, who will adopt them and when or if they will be imposed. On April 18, 2002, the OECD published a list of “uncooperative tax havens,” which are those jurisdictions from whom the OECD has not received commitments to the OECD’s principles of regulatory and tax transparency and effective exchange of information. The governments of both Bermuda and Barbados have made these commitments. As a result, neither Bermuda nor Barbados is currently listed as an uncooperative tax haven. However, it is possible that the OECD could change its view in the future and decide to list Bermuda or Barbados as an uncooperative tax haven, or that one of the other multinational organizations could take a different view from the OECD and decide to recommend sanctions against Bermuda or Barbados. Any sanctions imposed on Bermuda or Barbados could increase the Company’s taxes and reduce its net income. In addition, the Company is not able to predict what changes will arise from the commitments given to the OECD by the governments of Bermuda and Barbados or whether those changes will subject it to additional taxes.
The Company and Bermuda Re currently are not subject to income or capital gains taxes in Bermuda. Both companies have received an assurance from the Bermuda Minister of Finance under The Exempted Undertakings Tax Protection Act 1966 of Bermuda to the effect that if any legislation is enacted in Bermuda that imposes any tax computed on profits or income, or computed on any capital asset, gain or appreciation, or any tax in the nature of estate duty or inheritance tax, then that tax will not apply to them or to any of the Company’s operations or its shares, debentures or other obligations until March 28, 2016. This assurance does not prevent the application of any of those taxes to persons ordinarily resident in Bermuda and does not prevent the imposition of any tax payable in accordance with the provisions of The Land Tax Act 1967 of Bermuda or otherwise payable in relation to any land leased to the Company or Bermuda Re. There are currently no procedures for extending these assurances. As a result, the Company and Bermuda Re could be subject to taxes in Bermuda after March 28, 2016, which could reduce the Company’s net income.
The Company has obtained an international business company license under the Barbados International Business Companies Act, 1991-24. Based on this license, the Company is entitled to special tax benefits, including a preferred rate of tax on profits and gains and an exemption from withholding tax in respect of any dividends, interest, royalties, fees or management fees deemed to be paid to another international business company or to a person not resident in Barbados. the Company also has obtained from the Ministry of Economic Development a fifteen year guarantee in accordance with Section 27 of the International Business Companies Act with regards to its continued eligibility for this preferred status. This guarantee is applicable until 2014 and is subject to negative resolution, which means that this guarantee can be revoked at any time. In addition, there are currently no procedures for extending this guarantee. As a result, the Company could be ineligible for these benefits after that period or earlier if the guarantee is revoked, which could reduce the Company’s net income.