We incurred a loss before cumulative effect of change in accounting principle (see further discussion of this accounting change in note 2 to the accompanying consolidated financial statements) of $1.7 billion in 2002, compared to a loss of $184 million in 2001. The significant 2002 net loss is primarily attributable to the recognition of approximately $3.7 billion ($2.4 billion after-tax) of adverse development related to prior year loss events, including a $2.5 billion ($1.6 billion after-tax) charge recognized during the fourth quarter. Due to the impacts of existing retrocession coverages previously purchased, the recording of this adverse development both increased incurred claims and claim expenses and, to a lesser extent, decreased premium revenues (principally because of higher levels of contingent ceded premiums following these reserve adjustments).
We continually update loss estimates using both quantitative information from our reserving actuaries and qualitative information from other sources. While detailed analysis is performed on a quarterly basis to assess the overall adequacy of recorded claim reserves, a more comprehensive evaluation is undertaken on an annual basis. Consistent with historical practices, this more comprehensive review was completed during the fourth quarter of 2002 using both reported and paid claims activity as of September 30. This more comprehensive review was performed on all major reserve segments, with specific additional emphasis focused on those lines of business in which recent reported claims activity differed significantly from anticipated levels.
The methodology we employ in establishing IBNR reserves for a given reserving segment consists of a combination of the use of expected loss ratios ("ELRs") and loss development factor based methodologies ("LDFs"). The ELRs, when multiplied by earned premiums, generate an expected ultimate loss for a portfolio of business. For the most recent underwriting year, ELRs initially are established jointly by the reserving and underwriting teams. The underwriting teams are comprised of professional underwriters and pricing actuaries. The ELRs reflect recent years' underwriting results, adjusted for known changes in pricing, loss trends, contract terms and conditions and other factors that will likely influence actual underwriting results achieved (using both quantitative and subjective analysis). As new information becomes available regarding loss trends, pricing levels, and other factors that influence underwriting results, ELRs for prior periods are reviewed jointly by underwriting, pricing actuaries, reserving actuaries, and selected business leaders, and revised where appropriate.
The LDF-based approach is generally viewed as preferable once an acceptable base of observable loss activity is available. Accordingly, for more recent/immature experience periods, the ELR-based approach is generally more heavily relied upon due to the lack of historical loss data on which to perform the LDF loss projections. As the experience period matures (i.e., more data becomes available over time), the weights given to the ELRs are generally shifted to the LDF-based loss projections.
We apply the ELR and LDF reserving approaches to over 300 individual reserving segments, each possessing unique actuarial development trends. However, these 300 reserving segments can generally be broadly assigned to property-related exposures or liability-related exposures. For property-related exposures, the insured "loss event" is normally readily apparent (e.g., losses due to fires, windstorms or vehicle accidents) and the related claims are generally received within a relatively short period following such event. Property claims involve relatively infrequent disputes as to coverage or determination of damages but, in such an event, the disputes are normally fully settled within a few years following the underlying event. As a result, the migration within our reserving process from reliance on ELRs to the more claims driven LDF approach happens quite quickly. Compared to property-related exposures, liability-related exposures are often significantly more complicated and routinely involve situations in which claims are identified and submitted many years after the occurrence of the insured "loss event" giving rise to such claims. As would be expected, these types of claims also involve a higher incidence of dispute as to coverage, interpretation of contract wording and fair compensation for damages. Consequently, it generally takes a number of years before a sufficient base of reported claims experience develops in order to support reliable LDF loss projections. Accordingly, we rely on ELRs within the reserving process much longer for liability-related exposures than for property-related exposures.
We have continued our rigorous commitment to improved underwriting initiatives aimed at ensuring consistent and diligent underwriting standards are applied to all risks. Throughout 2002, we have been disciplined in rejecting risks that either fail to meet the established standards of price or terms and conditions, or involve areas for which sufficient historical data does not exist to evaluate the risk adequately. For risks that pass our criteria, we have sought to retain or even judiciously expand our business. On the other hand, we have curtailed or exited business in particular property and casualty channels when expected returns do not appear to justify the risks. Incorporated into these evaluations are realistic expectations of investment returns based on the current investment environment (which are lower than those achieved in recent years) and the understanding that greater levels of underwriting profits will be required in order to meet desired levels of profitability in the foreseeable future.
We incurred a loss before cumulative effect of change in accounting principle (see further discussion of this accounting change in note 2 to the accompanying consolidated financial statements) of $184 million in 2001, as compared to earnings of $581 million in 2000. Operating results for 2001 as compared to 2000 were adversely impacted by approximately $575 million related to the insurance losses arising from the events of September 11, 2001. This amount, which primarily resulted from contingent premium payments contained in certain retrocession agreements, comprises $698 million recorded as a reduction in net premiums earned, and $78 million reflecting additional claims, claim expenses and policy benefits, partially offset by $201 million reflecting a reduction in insurance acquisition costs. The gross losses arising from the events of September 11, 2001 (estimated to be $3.3 billion) relate to underlying insurance policies and reinsurance contracts providing general property, general liability, aviation, business interruption, workers compensation and life and health-related coverages. Historical experience related to large catastrophic events has shown that a broad range of total insurance industry loss estimates often exists following such an event and it is not unusual for there to be significant subsequent revisions in such estimates. Our best estimate of
existing net liability, net of estimated recoveries under retrocession arrangements, has not changed significantly from our initial estimate. Further information regarding potential litigation associated with the events of September 11, 2001 is discussed in note 13 to the consolidated financial statements.
Our retrocession program includes aggregate excess of loss coverages in which accident year losses exceeding a specified loss ratio are ceded to retrocessionaires. These contracts also contain contingent premium provisions whereby we are required to cede additional premiums equal to a specified portion of the covered losses. As described in more detail in the section that follows titled "Aggregate Excess-of-Loss Program," the accident year losses incurred in 2001, primarily as a result of the insurance losses arising from the events of September 11, 2001, exceeded the specified loss ratio and, accordingly, accruals for reinsurance recoverables and ceded premium payables were reflected in the accompanying consolidated financial statements in accordance with the terms of the underlying retrocession contracts. The associated reinsurance recoverables will be collected when the underlying paid losses exceed the specified loss ratios. Substantially all of our retrocessionaires are large, highly rated reinsurance entities or members of similarly rated reinsurance groups. At this time, we do not anticipate that any significant portion of estimated recoveries will be uncollectible.
Operating results in 2001 were also adversely affected by the continued deterioration of underwriting results, reflecting higher property and casualty-related losses (principally as a result of adverse development relating to prior-year loss events) and the continued effects of low premiums in the property and casualty insurance/reinsurance industry in recent years. As our underwriting results in 2001, typical of the global property and casualty industry, were realized, we began underwriting initiatives that increased premium prices for given levels of coverage. These initiatives resulted in us reconsidering and clarifying the product lines, policies, contracts and specific customers for which, given the risk, acceptable future levels of profit seem achievable. For these businesses, we have sought to retain or even expand such business. On the other hand, we have identified particular property and casualty business channels from which returns do not appear to justify the risks. For these channels, new business will be significantly curtailed or exited.
The majority of the adverse development in 2001 related to higher projected ultimate losses for liability coverages, especially in the hospital liability, nonstandard automobile (automobile insurance extended to higher-risk drivers) and commercial general liability lines of business.
During 1999 through 2001, accident year loss ratios exceeded the attachment point specified in our aggregate excess-of-loss reinsurance contracts and, accordingly, we have accrued for the expected recovery on an undiscounted basis (consistent with our establishment of the related undiscounted reserves--a GAAP requirement). Additionally, during each of the years 2002, 2001 and 2000, the recognition of adverse development related to prior year loss events resulted in additional recoveries being accrued under the aggregate contracts. As of December 31, 2002, the coverage under the 1999, 2000 and 2001 aggregate contracts has been substantially exhausted. No claim is currently anticipated with respect to the 2002 aggregate contract as the accident year losses and loss expenses recognized to date are less than the attachment point specified in the 2002 contracts. The impact of these aggregate contracts on our reported operating results for 2002, 2001 and 2000 was as follows:
Our insurance company businesses remain liable to their policyholders if the reinsurers they cede to are unable to meet their contractual obligations under the applicable reinsurance agreements. To minimize our exposure to significant losses from reinsurance insolvencies, we routinely evaluate the financial condition of our reinsurers and monitor concentrations of credit risk arising from similar geographic regions, activities or economic characteristics of the reinsurers. Of the $10.9 billion of consolidated reinsurance recoverables at December 31, 2002, approximately 33% is due from 4 specific retrocessionaires, primarily in connection with our aggregate excess-of- loss retrocession program. All of these retrocessionaires are large, highly rated reinsurance entities or members of similarly rated reinsurance groups. At this time, we do not anticipate that any significant portion of recorded reinsurance recoverables will be uncollectible.
Net premiums written increased $204 million or 6% in 2002, primarily attributable to the positive impacts of higher premium pricing stemming from the recent hardening price environment within the overall property and casualty insurance/reinsurance industry. This growth was partially negated by actions initiated in 2001 and 2002 to exit certain product lines, policies, contracts and specific customers for which, given the risk, acceptable future levels of profit did not seem achievable. Ceded reinsurance premiums written decreased
Typically, the underwriting performance of property and casualty business is measured in terms of a combined ratio. The combined ratio is the sum of the loss ratio and the underwriting expense ratio, with a combined ratio lower than 100% indicating an underwriting profit and a combined ratio greater than 100% indicating an underwriting loss. Although the combined ratio has been greater than 100% for the three years presented above, the operating results of insurance/reinsurance companies include net investment income, which has a positive impact on overall operating profitability.
Revenues, which consist of net premiums earned, net investment income, net realized gains on investments and other revenues--including fees generated from investment-related life reinsurance products and financial reinsurance transactions--increased $176 million or 7% in 2002 and $259 million or 12% in 2001. The revenue growth in 2002 was primarily related to the acquisition during the year of a relatively substantial block of traditional life business in the U.S., somewhat offset by a decrease in net realized gains on investments. The increase in revenues in 2001 was primarily attributable to growth in the international traditional life and health business (principally in Europe and Latin America), somewhat offset by a decrease in net realized gains on investments.
GE Global Insurance's ability to meet its obligations, including debt service and operating expenses, and pay dividends to its shareholder depends primarily upon the receipt of sufficient funds from its insurance businesses. The payment of dividends by ERC, GE Re, Medical Protective and CORE Insurance are subject to restrictions set forth in the insurance laws of Missouri, Illinois, Indiana and Vermont, respectively, as well as other restrictions. Historically, our liquidity requirements have been met by funds provided from operations and from the maturity and sales of investments. In the recent past (such as in 2002 in response to the significant fourth quarter charge taken for adverse development and in 2001 in response to the events of September 11), capital contributions from our ultimate parent--GE Company--have been a liquidity source. However, there are no contractual capital support agreements in place and, accordingly, there can be no assurances as to the level of any future capital contributions.
Cash flows from operating activities, which primarily consists of premiums collected during the period (net of related acquisition costs) and payments made for claims and claim expenses, increased $2.1 billion in 2002. This increase is primarily attributable to the relatively immediate positive cash impact stemming from the recent hardening premium price environment. While reported 2002 GAAP-basis underwriting results were significantly depressed as compared to 2001, the majority of this was attributable to reserve strengthening actions for liability-related exposures underwritten in 1997-2001. The cash impact of these actions will be spread out over a number of future years. Cash flows from operating activities increased $74 million in 2001, primarily attributable to a decrease in claim settlements relative to the collection of premiums, somewhat offset by an increase in reinsurance recoverables under our aggregate excess-of-loss retrocession program.
Cash flows from financing activities increased $596 million in 2002, primarily attributable to an increase in the level of capital contributions received in
We have a one-year $600 million revolving credit agreement with GE Capital Services which enables us to borrow from GE Capital Services at an interest rate per annum equal to GE Capital Services' cost of funds for a one year period. The agreement is automatically extended for successive terms of one year each unless terminated in accordance with terms of the agreement. The total amount outstanding on this credit facility, including accrued interest payable, was $190 million and $109 million as of December 31, 2002 and 2001, respectively.
During 2002, certain external credit rating agencies announced actions with respect to GE Global Insurance and its businesses. Those rating agencies made similar announcements with regard to other property and casualty insurance and reinsurance entities at about the same time. A.M. Best lowered its financial strength group rating for us from A++ (superior) to A+ (superior). Debt ratings for us affect $1.7 billion of outstanding debt. These ratings were also adjusted negatively in 2002, but remained investment grade. We do not believe these actions will materially affect our liquidity or capital resources or the ability to write future business.
General. We follow a conservative investment strategy that emphasizes maintaining a high quality investment portfolio. The primary goals include a growing stream of investment income and improving total investment returns. All investments are administered under guidelines established and approved by our Board of Directors. Our guidelines specify credit quality and concentration limits with respect to both fixed maturity and equity securities.
In structuring our fixed maturity portfolios, we consider the duration of our assets and claims and claim expense reserves. Most fixed maturity portfolios have total return benchmarks against which relative performance is measured. The total return benchmarks include investment income and realized and unrealized gains and losses on investments. Equity portfolios are managed for total return and performance is measured against equity benchmarks.
On a worldwide basis, based on data as of December 31, 2002, we manage 23% of our investments internally. GE Asset Management Incorporated, an affiliate, manages an additional 58% of our investments, and the balance is managed by unaffiliated outside managers.
The increase in net unrealized gains on investment securities, before deferred income taxes in 2002 is primarily due to the effects of a general decrease in interest rates which occurred during the year.
We continue to seek opportunities to enhance investment yield through a conservative, primarily fixed maturity investment strategy. Our current investment strategy does not contemplate material additional investments in non-investment grade debt securities, commercial real estate, commercial mortgages or derivatives.
Our domestic fixed maturity portfolios, categorized by rating based on market values, are summarized as follows:
agencies. The majority of the balance of other securities held in both the domestic property and casualty and domestic life portfolios represent investments in non-rated debt securities. We do not contemplate significant additional investment in non-investment grade securities in either the property and casualty or life portfolios.
International Investment Operations. The investment portfolios of our international operations (other than certain equity portfolios, which are managed by outside managers) are managed by the GE Frankona Re Group's investment personnel based in Munich, within guidelines established by the management of the GE Frankona Re Group and under the overall supervision and review of ERC's investment department. The principal objective of the GE Frankona Re Group's investment policy is to manage the investment portfolios on a total return basis taking into consideration the duration and currency structure of the GE Frankona Re Group's reinsurance liabilities. The GE Frankona Re Group's investment portfolios are geographically diversified with investments principally from the major European markets and the United States.
We manage our exposure to currency principally by matching investment assets with the underlying insurance/reinsurance liabilities. Any remaining significant net asset/liability positions in a given currency are hedged with forward currency purchase or sale contracts to further mitigate currency exposures. We also hedge our currency risk by utilizing cross currency swaps and currency forwards. We manage our exposure to interest rates principally by matching floating rate liabilities with corresponding floating rate assets and by matching fixed rate liabilities with corresponding fixed rate assets. Certain of the products reinsured within the life segment include fixed rate interest rate features that are matched with fixed rate investments of a similar duration.
On a limited basis, and as part of ongoing customer activities, we use equity options to minimize exposure to movements in equity markets that have a direct correlation with certain of its reinsurance products. Additionally, we have entered into a limited number of credit default swaps to lessen exposure on certain financial guarantee reinsurance business.
Substantially all derivative transactions are executed by our Treasury Department, which works closely with GE Capital Treasury personnel to maintain controls on all exposures, adhere to stringent counterparty credit standards and actively monitor marketplace exposures. Although we are exposed to credit risk that the counterparty may not be able to comply with the terms and conditions of the contracts, we use only highly rated institutions as counterparties to derivative transactions.
The U.S. Securities and Exchange Commission requires that registrants provide information about potential effects of changes in interest rates and currency exchange rates. The following discussion is based on so-called "shock tests," which model effects of interest rate and currency shifts on the reporting company. While the following results of shock tests for changes in interest rates and currency exchange rates may have some limited use as benchmarks, they should not be viewed as forecasts.
The property and casualty reinsurance industry has been highly cyclical. Underwriting results of primary property and casualty insurance companies and prevailing general economic and reinsurance premium rates significantly influences demand for reinsurance. The cyclical trends in the industry and the industry's profitability can also be affected significantly by volatile and unpredictable developments, including changes in what we believe to be the propensity of courts to grant large awards, natural disasters and other catastrophic events (such as hurricanes, windstorms, earthquakes, floods, fires and, as experienced in 2001, intentional events such as terrorist acts), fluctuations in interest rates and other changes in the investment environment which affect inflationary pressures that may tend to affect the size of losses experienced by ceding primary insurance companies.
Our ultimate claims and claim expense costs on claims not yet settled is increased by the effects of inflation, and changes in the inflation rate therefore could become a significant factor in determining appropriate claims and claim expense reserves, as well as reinsurance premium rates. Generally, our methods used to estimate claims and claim expense reserves and to calculate reinsurance premium rates take into account the anticipated effects of inflation in estimating the ultimate claims and claim expense costs. We use both insurance industry data and government economic indices in estimating the effects of inflation on claims and claim expense reserves and reinsurance premium rates. However, until claims are ultimately settled, the full effect of inflation on our results cannot be known.
Insurance liabilities and reserves differ for short and long-duration insurance contracts. Short-duration contracts such as property and casualty policies are accounted for based on actuarial estimates of losses inherent in that period's claims, including losses for which claims have not yet been reported. Short-duration contract loss estimates rely on actuarial observations of ultimate loss experience for similar historical events. Measurement of long-duration insurance liabilities (such as term and whole life insurance policies) also is based on approved actuarial techniques that include
As discussed on pages 18-20, in recent periods and continuing throughout 2002, the level of reported claims activity related to prior year loss events, particularly for liability-related exposures underwritten in 1997 through 2001, has been significantly higher than anticipated. Full consideration of these trends was incorporated into a comprehensive reserve study completed in the fourth quarter of 2002. Insurance reserves, by their very nature, do not represent an exact calculation of liability and, while we have established reserves equal to the current best estimate of ultimate losses, there remains a high likelihood that further changes in such loss estimates--either upward or downward--will occur in the future. Further information about insurance liabilities is provided in note 6.
Projections of future cash flows are required in order to both perform impairment testing for certain asset categories and to properly account for reinsurance arrangements. The more significant asset categories requiring routine impairment testing using a cash flow based methodology include deferred insurance acquisition costs, present value of future profits and goodwill. At year-end 2002, these asset categories totaled $3.7 billion. While any required
Other significant accounting policies, not involving the same level of measurement uncertainties as those discussed above, are nevertheless important to an understanding of the financial statements. Policies related to revenue recognition, financial instruments and business combinations require difficult judgments on complex matters that are often subject to multiple sources of authoritative guidance. Certain of these matters are among topics currently under reexamination by accounting standards setters and regulators. Although no specific conclusions reached by these standard setters appear likely to cause a material change in our accounting policies, outcomes cannot be predicted with confidence. Also see note 2, Summary of Significant Accounting Policies, which discusses accounting policies that must be selected when there are acceptable alternatives.
In January 2003, the FASB issued Interpretation No. ("FIN") 46, Consolidation of Variable Interest Entities, which we intend to adopt on July 1, 2003. FIN 46's consolidation criteria are based on analysis of risks and rewards, not control, and represent a significant and complex modification of previous accounting principles. FIN 46 represents an accounting change, not a change in the underlying economics of asset sales. Under its provisions, certain assets previously sold to special purpose entities (SPE's) could be consolidated and, if consolidated, any assets and liabilities now on the books related to those SPE's would be removed. Because we have not traditionally engaged in the types of securitization vehicles within the scope of FIN 46, we do not believe adoption of the interpretation will impact our future results.
The Derivatives Implementation Group ("DIG") of the FASB is currently discussing the accounting treatment under SFAS 133 for modified coinsurance arrangements in which funds are withheld by the ceding insurer. In 2003, the DIG might determine that these types of arrangements include an embedded derivative that must be bifurcated from the host instrument. This issue would also be applicable to other funds withheld arrangements that incorporate credit risk exposures that are unrelated or only partially related to the creditworthiness of the issuer of that instrument. We are currently evaluating the effect that this interpretation may have upon our operations, and at this time, we do not believe it will have a material negative consequence on future operating results.