PROPERTIES Everest Re's corporate offices are located in approximately 115,000 square feet of leased office space in Liberty Corner, New Jersey. The Company's other eleven locations occupy a total of approximately 56,000 square feet, all of which are leased. Management believes that the above-described office space is adequate for its current and anticipated needs.
During 2002, the reinsurance and insurance markets continued to firm. This firming reflects the losses arising from the September 11 attacks as well as reactions to broad and growing recognition that competition in the late 1990's reached extremes in many classes and markets, which ultimately led to inadequate pricing and overly broad terms, conditions and coverages. The effect of these extremes, which is becoming apparent through excessive loss emergence, varies widely by company depending on product offerings, markets accessed, underwriting and operating practices, competitive strategies and business volumes. Across all market participants, however, the aggregate effect has been impaired financial results and erosion of the industry capital base. Coupled with deteriorating investment market conditions and results, and renewed concerns regarding longer-term industry specific issues, including asbestos exposure and sub-par capital returns, these financial impacts have introduced substantial, and in some cases extreme, pressure for the initiation and/or strengthening of corrective action by individual market participants. These pressures have resulted in firming prices, more restrictive terms and conditions and tightened coverage availability across most classes and markets.
These changes reflect a clear reversal of the general trend from 1987 through 1999 toward increasingly competitive global market conditions across most lines of business as reflected by decreasing prices and broadening contract terms. The earlier trend 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, as well as the emergence of new reinsurance and financial products addressing traditional exposures in alternative fashions. Many of these factors continue to exist and have taken on additional importance as the result of the firming conditions which have emerged. As a result, although the Company is encouraged by the recent improvements, and more generally, by current market conditions, the Company cannot predict with any reasonable certainty whether and to what extent these improvements will persist.
RESULTS OF OPERATIONS Unusual Loss Events in 2001. As a result of the September 11 attacks, the Company incurred pre-tax losses, based on an estimate of ultimate exposure developed through a review of its coverages, which totaled $213.2 million gross of reinsurance and $55.0 million net of reinsurance. Associated with this reinsurance were $60.0 million of pre-tax charges, predominantly from adjustment premiums, resulting in a total pre-tax loss from the September 11 attacks of $115.0 million. After tax recoveries relating specifically to this unusual loss event, the net loss from the September 11 attacks totaled $75.0 million. Over 90% of the losses ceded by the Company were pursuant to treaties, where the reinsurers' obligations are secured, which the Company believes eliminates material reinsurance collection risk.
As a result of the Enron bankruptcy in 2001, the Company incurred losses, after-tax and net of reinsurance, amounting to $18.6 million. This unusual loss reflects all of the Company's exposures to this event, including underwriting, credit and investment.
Security and Bermuda Re, whereby Bermuda Re assumes liability for primary insurance workers' compensation losses exceeding $100,000 per occurrence, with its liability not to exceed $150,000 per occurrence. 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 program, 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 program, respectively, with the 2001 accident year cessions principally relating to losses incurred as a result of the September 11 attacks and the Enron bankruptcy.
PREMIUM REVENUES. Net premiums earned increased by 46.8% to $1,957.3 million in 2002 from $1,333.5 million in 2001. Contributing to this increase were a 140.7% ($239.0 million) increase in the International operation, a 58.3% ($171.5 million) increase in the U.S. Insurance operation, a 32.3% ($160.5 million) increase in the U.S. Reinsurance operation and a 14.2% ($52.9 million) increase in the Specialty Underwriting operation. All of these changes reflect period to period variability in gross written and ceded 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.
accident year aggregate excess of loss components of the Company's corporate retrocessional program, respectively, with the 2001 accident year cessions relating principally to losses incurred as the result of the September 11 attacks.
Underwriting expenses increased by 23.3% to $553.5 million in 2002 from $448.9 million in 2001. Commission, brokerage, taxes and fees increased by $94.8 million, principally reflecting increases in premium volume and changes in the mix of business. Other underwriting expenses increased by $9.8 million as the Company expanded its operations to support its increased business volume. Contributing to the underwriting expense increase were a 66.1% ($54.7 million) increase in the U.S. Insurance operation, a 17.6% ($19.0 million) increase in the Specialty operation, a 13.8% ($12.8 million) increase in the International operation and an 11.4% ($18.7 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 5.4 percentage points to 28.3% in 2002 compared to 33.7% in 2001.
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 Company's senior notes and $3.5 million relating to the Company's borrowing under its revolving credit facility. Interest expense for 2001 reflects $38.9 million relating to the Company's senior notes and $7.1 million relating to the Company's borrowing under its revolving credit facility. In addition, 2002 includes incurred expense of $2.1 million for distributions on Capital Trust's trust preferred securities.
The Company has in its product portfolio a credit default swap, which it no longer writes. This product meets the definition of a derivative under Financial Accounting Standard No. 133 "Accounting for Derivative Instruments and Hedging Activities" ("FAS 133"). Net derivative expense, essentially reflecting changes in fair value from this credit default transaction in 2002, was $3.5 million, compared to $7.0 million in 2001. See also Footnote 2 to Notes to the Consolidated Financial Statements.
INCOME TAXES. The Company generated income tax expense of $24.8 million in 2002 compared to an income tax benefit of $9.2 million in 2001. The tax expense in 2002 was mainly attributable to improved underwriting 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 $115.1 million in 2002 compared to $38.3 million in 2001. This increase generally reflects the improved underwriting results, partially offset by increased tax expense, realized capital losses and a decrease in other income.
Ceded premiums increased to $432.9 million in 2001 from $166.7 million in 2000. This increase was principally attributable to $123.2 million of ceded premiums in 2001 relating to an arm's-length loss portfolio reinsurance transaction, whereby the Company transferred the net exposures and reserves of its Belgium branch to Bermuda Re. In addition, ceded premiums in 2001 also reflect $81.3 million of adjustment premiums incurred under the 2001 accident year aggregate excess of loss element of the Company's corporate retrocessional program relating to losses incurred as a result of the September 11 attacks and the Enron bankruptcy. In addition, ceded premiums for 2001 and 2000 also include adjustment premiums of $58.1 million and $35.2 million, respectively, relating to claims made under the 1999 accident year aggregate excess of loss elements of the Company's corporate retrocessional program. The increase in ceded premiums in 2001 also reflects the impact on the U.S. Insurance operation's specific reinsurance protections resulting from this unit's volume increase.
EXPENSES. Incurred loss and LAE increased by 22.9% to $1,079.2 million in 2001 from $878.2 million in 2000. The increase in incurred losses and LAE was principally attributable to an increase in business volume as reflected by the increase in net premiums earned, the impact of incurred losses relating to the September 11 attacks and the Enron bankruptcy and modest reserve strengthening in select areas, together with the impact of changes in the Company's mix of business. The Enron bankruptcy contributed $34.0 million of unusual losses in 2001, before cessions under the corporate retrocessional program. Incurred losses and LAE include catastrophe losses, which reflect 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 but before cessions under the corporate retrocessional program in 2001, were $222.6 million, relating principally to the September 11 attacks, tropical storm Alison, the Petrobras Oil Rig loss and the El Salvador earthquake, compared to $13.9 million in 2000. Incurred losses and LAE in 2001 reflected ceded losses and LAE of $619.4 million compared to ceded losses and LAE in 2000 of $176.4 million, with the increase principally attributable to cessions relating to the September 11 attack losses and the Enron bankruptcy, together with increased cessions under specific reinsurance arrangements in the U.S. Insurance operation. The ceded losses and LAE for 2001 reflect $164.0 million of losses ceded under the 2001 accident year aggregate excess of loss component of the Company's corporate retrocessional program. The ceded losses and LAE for 2001 and 2000 reflect $105.0 million and $70.0 million, respectively, of losses ceded under the 1999 accident year aggregate excess of loss component of the Company's corporate retrocessional program, with the amounts in both periods reflecting reserve strengthening in select lines. In addition, ceded losses and LAE in 2001 reflects $119.4 million relating to the reinsurance transaction between the Company and Bermuda Re noted earlier.
Underwriting expenses increased by 41.3% to $448.9 million in 2001 from $317.7 million in 2000. Commission, brokerage, taxes and fees increased by $126.2 million, principally reflecting increases in premium volume and changes in the mix of business. In addition, in 2000, the Company's reassessment of the expected losses on a multi-year reinsurance treaty led to a $33.8 million decrease in contingent commissions with a corresponding increase to losses. Other underwriting expenses increased by $5.0 million as the Company expanded its business volume and operations. Contributing to the underwriting expense increase were a 122.7% ($45.6 million) increase in the U.S. Insurance operation, mainly relating to the increased premium volume, a 70.8% ($68.0 million) increase in the U.S. Reinsurance operation, which included the impact of the contingent commission adjustment noted above and a 22.5% ($19.8 million) increase in the Specialty operation. These increases were partially offset by a 0.2% ($1.9 million) decrease in the International operation. Except as noted, 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, increased by 6.4 percentage points to 33.7% in 2001 compared to 27.3% in 2000.
The Company's combined ratio, which is the sum of the loss and expense ratios, increased by 11.8 percentage points to 114.6% in 2001 compared to 102.8% in 2000. The following table shows the combined ratios for each of the Company's operating segments for 2001 and 2000. 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 adjustment premiums under the Company's corporate retrocessional program and, for the International operation, the effect on the expense ratio related to the ceded premium associated with the reinsurance transaction between the Company and Bermuda Re noted earlier.
Interest expense was $46.0 million for 2001 compared to $39.4 million in 2000. Interest expense for 2001 reflects $38.9 million relating to the Company's senior notes and $7.1 million relating to the Company's borrowing under its revolving credit facility. Interest expense for 2000 reflects $30.9 million relating to the Company's senior notes and $8.5 million relating to the Company's borrowing under its revolving credit facility.
RISK FACTORS The following risk factors, in addition to the other information provided in this report, should be considered when evaluating the Company. If any of the following risks actually occur, the Company's business, financial condition or results of operations could be materially and adversely affected.
- - volatile and unpredictable developments, including weather-related and other natural catastrophes;
- - events like the September 11, 2001 attacks, which affect the insurance and reinsurance markets generally;
The Company's insurance company subsidiaries, other than Mt. McKinley, currently hold an A+ ("Superior") financial strength rating from A.M. Best. Everest Re and Everest National hold an AA- ("Positive") financial strength rating from Standard & Poor's. Everest Re holds 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, the rating of a company purchasing reinsurance may be adversely affected by an unfavorable rating or the lack of a rating of its reinsurer. A downgrade or withdrawal of any of these ratings might adversely affect the Company's ability to market its insurance products and would have a significant and adverse effect on its future prospects for growth and profitability.
THE COMPANY MAY EXPERIENCE EXCHANGE LOSSES IF IT DOES NOT MANAGE ITS FOREIGN CURRENCY EXPOSURE PROPERLY.