Everest Re’s corporate offices are located in approximately 115,000 square feet of leased office space in Liberty Corner, New Jersey. Bermuda Re’s corporate offices are located in approximately 3,600 total square feet of leased office space in Hamilton, Bermuda. The Company’s other twelve locations occupy a total of approximately 59,000 square feet, all of which are leased. Management believes that the above-described office space is adequate for its current and anticipated needs.
Gross premiums written $ 4,573 .8 $ 2,846 .5 $ 1,874 .6 $ 1,385 .6 $ 1,141 .8
Net premiums written 4,315 .4 2,637 .6 1,560 .1 1,218 .9 1,095 .6
Net premiums earned 3,737 .9 2,273 .7 1,467 .5 1,174 .2 1,071 .5
Net income (2) $ 426 .0 $ 231 .3 $ 99 .0 $ 186 .4 $ 158 .1
Net income per basic share (3) $ 7 .89 $ 4 .60 $ 2 .14 $ 4 .06 $ 3 .26
Loss and LAE ratio 69.6 % 71.7 % 82.4 % 75.3 % 72.0 %
Combined ratio (2) 95.2 % 99.0 % 113.5 % 102.9 % 103.5 %
Total assets 12,683 .0 9,864 .6 7,796 .2 7,013 .1 5,704 .3
(1) Catastrophe losses are net of reinsurance. A catastrophe is defined, for purposes of the Selected Consolidated Financial Data, as an event that causes a pre-tax loss on property exposures before reinsurance of at least $5.0 million and has an event date of January 1, 1988 or later
(4) Based on weighted average diluted shares outstanding of 55.0 million, 51.1 million, 47.1 million, 46.4 million and 48.7 million for 2003, 2002, 2001, 2000 and 1999, respectively.
(6) Based on 55.7 million, 50.9 million, 46.3 million, 46.0 million and 46.5 million shares outstanding for December 31, 2003, 2002, 2001, 2000 and 1999, respectively.
On September 19, 2000, Holdings completed the acquisition of all of the issued and outstanding capital stock of Gibraltar from The Prudential for $51.8 million, which approximated book value. As a result of the acquisition, Gibraltar became a wholly owned subsidiary of Holdings and, immediately following the acquisition, its name was changed to Mt. McKinley. In connection with the acquisition of Mt. McKinley, which has significant exposure to A&E claims, Prupac, a subsidiary of The Prudential, provided reinsurance to Mt. McKinley covering 80% ($160.0 million) of the first $200.0 million of any adverse development of Mt. McKinley’s reserves as of September 19, 2000. In addition, The Prudential guaranteed Prupac’s obligation to Mt. McKinley. There were $81.1 million, $56.7 million and $22.2 million of cessions under this reinsurance for years ended December 31, 2003, 2002 and 2001, respectively, exhausting the limit available under this contract.
In connection with the Mt. McKinley acquisition, Prupac also provided excess of loss reinsurance for 100% of the first $8.5 million of loss with respect to certain of Mt. McKinley’s retrocessions and potentially uncollectible reinsurance coverage. There were no cessions under this reinsurance for the years ended December 31, 2003 and 2002, maintaining the limit available under the contract at $2.4 million. There was $3.6 million of cessions under this reinsurance for the year ended December 31, 2001.
Mt. McKinley, a run-off property and casualty insurer in the U.S., had a long relationship with Holdings and its principal operating company, Everest Re. Mt. McKinley was formed in 1978 by Everest Re and wrote insurance until 1985, when it was placed in run-off. In 1991, Mt. McKinley became a subsidiary of The Prudential. Mt. McKinley is also a reinsurer of Everest Re. Under a series of transactions dating to 1986, Mt. McKinley reinsured several components of Everest Re’s business. In particular, Mt. McKinley provided stop loss reinsurance protection, in connection with the Company’s October 5, 1995 initial public offering, for any adverse loss development on Everest Re’s June 30, 1995 (December 31, 1994 for catastrophe losses) reserves, with $375.0 million in limits, of which $103.9 million remains available (the “Stop Loss Agreement”). The Stop Loss Agreement and other reinsurance contracts between Mt. McKinley and Everest Re remain in effect following the acquisition. However, these contracts became transactions with affiliates effective on the date of the Mt. McKinley acquisition, and their financial impact is thereafter eliminated in consolidation. Effective September 19, 2000, Mt. McKinley and Bermuda Re entered into a loss portfolio transfer reinsurance agreement, whereby Mt. McKinley transferred, for what management believes to be arm’s-length consideration, all of its net insurance exposures and reserves to Bermuda Re.
These current trends reflect a clear reversal of the general trend from 1987 through 1999, which were characterized by 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 operate and may take on additional importance as the result of the firming market conditions that have emerged.
The Company is generally encouraged by recent industry developments, which have operated to its advantage, and more broadly, by continued favorable current market conditions. However, the Company cannot predict with any reasonable certainty whether and to what extent these conditions will persist.
The Company generated an income tax expense of $65.2 million and $30.7 million for the years ended December 31, 2003 and 2002, respectively, generally reflecting improved underwriting and investment income results. The income tax benefit of $8.7 million for the year ended December 31, 2001 primarily reflected a tax benefit from various unusual loss events in 2001, in particular the September 11 attacks and Enron, which were partially offset by taxable income on a former client’s demutualization.
The increase in net income to $426.0 million and $231.3 million for the years ended December 31, 2003 and 2002, respectively, generally reflects improved underwriting and investment results partially offset by increased income taxes. The net income of $99.0 million for the year ended December 31, 2001 reflects the impact of the unusual loss events in 2001. As a result of the September 11 attacks, the Company incurred pre-tax losses in 2001, based on an estimate of ultimate exposure developed through a review of its coverages, of $213.2 million gross of reinsurance and $55.0 million net of reinsurance. Associated with this reinsurance was $60.0 million of pre-tax charges, predominantly from adjustment premiums, which resulted 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 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, the Company incurred losses in 2001, amounting to $25.0 million after-tax and net of reinsurance. This unusual loss reflected all of the Company’s exposures to this event, including underwriting, credit and investment. The above-mentioned unusual 2001 events were partially offset by the income received from a former client’s demutualization.
Premiums. Gross written premiums increased 60.7% to $4,573.8 million in 2003 from $2,846.5 million in 2002, as the Company took advantage of the general firming of rates, terms and conditions and selected growth opportunities, while continuing to maintain a disciplined underwriting approach. Premium growth areas included a 95.9% ($857.7 million) increase in the U.S. Reinsurance operation, principally related to a $519.4 million increase in treaty casualty business, a $253.9 million increase in treaty property business and a $62.8 million increase in facultative business. The International operation increased 78.3% ($423.4 million), primarily due to a $256.9 million increase in premiums from the London branch, a $79.6 million increase in international business written through the Miami and New Jersey offices representing primarily Latin American business and a $67.4 million increase to Canadian business. The U.S. Insurance operation grew 30.2% ($248.1 million), principally as a result of an $89.5 million increase in workers’ compensation and a $73.2 million increase in excess and surplus lines insurance. The Bermuda operation increased $183.8 million, reflecting a shift toward more traditional business resulting from the rollout of treaty, facultative and individual risk capabilities. The Specialty Underwriting operation increased 2.9% ($14.3 million), resulting primarily from a $38.0 million increase in A&H business and a $19.0 million decrease in marine and aviation.
The U.S. Insurance segment reflected $58.7 million and $14.0 million of net prior period reserve adjustments for years ended December 31, 2003 and 2002, respectively, principally due to California workers’ compensation insurance. This is a relatively new book of business being written in a challenging political and economical environment. While management believes the cumulative results through 2003 remain positive, there has been some deterioration in claim frequency and severity related to accident years 2001 and 2002.
The International segment had net prior period reserve adjustments of $44.6 million and $6.3 million for the years ended December 31, 2003 and 2002, respectively. These reserve adjustments relate primarily to general casualty business written in the U.S., U.K. and Canada on both a quota share and excess basis for accident years 1996 through 2002, with the larger development on the 1998 through 2000 years. For accident year 2002, the adverse general casualty experience was partially offset by favorable property experience.
The Specialty Underwriting segment had net prior period reserve adjustments of $23.9 million and $0.4 million for the years ended December 31, 2003 and 2002, respectively. The favorable adjustments, particularly for 2003, related primarily to A&H business and cessions under the corporate retrocessional program and related principally to the 2000 through 2002 accident years.
In all cases, the prior period development reflects management’s judgment as to the implications of losses and claim information reported during the period on the Company’s reserve balances.
Incurred losses and LAE in 2003 reflected ceded losses and LAE of $278.4 million compared to ceded losses and LAE in 2002 of $287.7 million. The ceded losses and LAE in 2003 included $85.0 million of losses ceded under the 2000 accident year aggregate excess of loss component of the Company’s corporate retrocessional program and $81.1 million under the Prupac/Mt. McKinley reinsurance agreement. The ceded losses and LAE in 2002 included $11.0 million and $90.0 million of losses ceded under the 2001 and 2000 accident year aggregate excess of loss components of the Company’s corporate retrocessional program, respectively, and $56.7 million under the Prupac/Mt. McKinley reinsurance agreement.
The Company’s loss and LAE ratio (“loss ratio”), which is calculated by dividing incurred losses and LAE by net premiums earned, decreased by 2.1 percentage points to 69.6% in 2003 from 71.7% in 2002, reflecting the premiums earned and incurred losses and LAE discussed above, as well as the general firming of rates, terms and conditions and changes in business mix.
Segment underwriting expenses increased by 54.0% to $952.6 million in 2003 from $618.5 million in 2002. Commission, brokerage, taxes and fees increased by $312.2 million, principally reflecting increases in premium volume and changes in the mix of business, together with the Company’s emphasis on acquisition cost control. Segment other underwriting expenses increased by $21.9 million as the Company expanded operations to support its increased business volume. Contributing to these underwriting expense increases were an 84.8% ($170.9 million) increase in the U.S. Reinsurance operation, a 76.0% ($93.8 million) increase in the International operation, a 24.7% ($36.7 million) increase in the U.S. Insurance operation, a $29.6 million increase in the Bermuda operation and a 2.3% ($3.1 million) increase in the Specialty Underwriting 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, changes in the use of specific reinsurance as well as the underwriting performance of the underlying business. The Company’s expense ratio, which is calculated by dividing underwriting expenses by net premiums earned, was 25.6% in 2003 compared to 27.3% in 2002.
Investments. Net investment income increased 14.7% to $402.1 million in 2003 from $350.6 million in 2002, principally reflecting the effects of investing $1,653.8 million of cash flow from operations for the twelve months ended December 31, 2003, $203.4 million of net proceeds from Capital Trust’s issuance of trust preferred securities in November 2002 and $316.8 million of net proceeds from the issuance of Group’s common shares in April 2003, all partially offset by the effects of the lower interest rate environment.
Net realized capital losses were $38.0 million in 2003, reflecting realized capital losses on the Company’s investments of $88.7 million, which included $25.7 million relating to write-downs in the value of securities deemed to be impaired on an other than temporary basis, and $46.2 million related to the impairment on interest only strips in accordance with Emerging Issues Task Force No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Beneficial Interests in Securitized Financial Assets” (“EITF 99-20”), partially offset by $50.7 million of realized capital gains, which included $16.8 million of realized capital gains on sales of the interest only strips, compared to net realized capital losses of $50.0 million in 2002. The net realized capital losses in 2002 reflected realized capital losses on the Company’s investments of $142.8 million, which included $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 was for WorldCom, Inc., partially offset by $92.8 million of realized capital gains. The Company owned no interest only strips during 2002.
Interest expense in 2003 was $40.3 million compared to $42.4 million in 2002. Interest expense in 2003 reflected $38.9 million relating to the senior notes and $1.4 million relating to borrowings under the revolving credit facility. Interest expense in 2002 reflected $38.9 million relating to the issuance of the senior notes and $3.5 million relating to borrowings under the revolving credit facility.
Premium Revenues. Net earned premiums increased by 54.9% to $2,273.7 million in 2002 from $1,467.5 million in 2001. Contributing to this increase were an 154.4% ($25.3 million) increase in the Bermuda operation, a 94.8% ($278.8 million) increase in the U.S. Insurance operation, a 64.4% ($185.1 million) increase in the International operation, a 46.0% ($228.8 million) increase in the U.S. Reinsurance operation and a 23.7% ($88.2 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.
Expenses. Incurred loss and LAE increased by 34.7% to $1,629.4 million in 2002 from $1,209.5 million in 2001. The increase in incurred losses and LAE was principally attributable to the increase in net premiums earned and modest net prior period reserve adjustments in select areas, most notably in D&O liability, surety and workers’ compensation lines, and with respect to asbestos exposures, partially offset by lower catastrophe losses and improvements in rates, terms and conditions in many classes of business, as well as the impact of changes in the Company’s mix of business.
Incurred losses and LAE include catastrophe losses, which reflect the impact both of 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, were $30.2 million in 2002, principally relating to European flood losses and Hurricanes Isidore and Kenna, compared to net catastrophe losses of $222.6 million in 2001, which was principally related to the September 11 attacks.
Incurred losses and LAE in 2002 reflected ceded losses and LAE of $287.7 million compared to ceded losses and LAE in 2001 of $486.3 million. The ceded losses and LAE in 2002 included $11.0 million and $90.0 million of losses ceded under the 2001 and 2000 accident year aggregate excess of loss components of the Company’s corporate retrocessional program, respectively. The ceded losses and LAE in 2001 included $164.0 million and $105.0 million of losses ceded under the 2001 and 1999 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.
Contributing to the increase in incurred losses and LAE in 2002 from 2001 were a 242.3% ($36.7 million) increase in the Bermuda operation, principally reflecting reserve strengthening with respect to Mt. McKinley asbestos exposures and increased premium volume, a 104.9% ($221.6 million) increase in the U.S. Insurance operation, principally reflecting increased premium volume coupled with changes in this segment’s specific reinsurance programs, a 45.8% ($92.8 million) increase in the International operation, principally reflecting increased premium volume and a 19.2% ($86.3 million) increase in the U.S. Reinsurance operation, principally due to increased premium volume, partially offset by decreased catastrophe losses. These increases were partially offset by a 5.3% ($17.5 million) decrease in the Specialty Underwriting operation, principally attributable to decreased catastrophe losses. Incurred losses and LAE for each operation were also impacted by variability relating to changes in the level of premium volume and mix of business by class and type.
The Company because of its income orientation considers total return, the combination of income yield and capital appreciation/depreciation, to be less relevant as a measure of performance than may be the case for investment portfolios managed with alternate strategies. The following table provides a comparison of the Company’s total return by asset class to broadly accepted industry benchmarks for 2002 and 2001.
The Company has a small number of credit default swaps, which it no longer writes, and specialized equity put options in its product portfolio. These products meet the definition of a derivative under FAS 133. Net derivative expense from these derivative transactions in 2002, essentially reflecting changes in fair value, was $14.5 million, principally relating to the specialized equity put options, compared to $12.2 million in 2001, principally relating to the credit default swaps. Net after tax exposure remaining on the credit default agreements is $3.1 million. See also Note 2 of Notes to the Consolidated Financial Statements.
Other expense was $2.1 million in 2002 compared to other income of $28.2 million in 2001. Significant contributors to other expense in 2002 were foreign exchange losses, normal provision for uncollectible audit premium in the U.S. Insurance operation and the amortization of deferred expenses relating to Holdings’ issuance of senior notes and Capital Trust’s issuance of trust preferred securities, partially offset by fee income. Other income for 2001 includes $25.9 million arising from a non-recurring receipt of shares in connection with the demutualization of a former insurance company client that had issued annuities to the Company in connection with certain claim settlement transactions. In addition, other income for 2001 includes foreign exchange gains as well as fee income, offset by the amortization of deferred expenses relating to the issuance of senior notes.
Corporate underwriting expenses not allocated to segments were $3.2 million for 2002 compared with $3.4 million for 2001.
Management believes that these factors continue to render reserves for A&E losses significantly less subject to traditional actuarial methods than reserves for other types of losses. Given these uncertainties, management believes that no meaningful range for such ultimate losses can be established. The Company establishes reserves to the extent that, in the judgment of management, the facts and prevailing law reflect an exposure for the Company or its ceding companies.
In connection with the acquisition of Mt. McKinley, which has significant exposure to A&E claims, Prupac, a subsidiary of The Prudential, provided reinsurance to Mt. McKinley covering 80% ($160.0 million) of the first $200.0 million of any adverse development of Mt. McKinley’s reserves as of September 19, 2000. In addition, The Prudential guaranteed Prupac’s obligations to Mt. McKinley. Through December 31, 2003, cessions under this reinsurance agreement have exhausted the available remaining limits. Due to the uncertainties discussed above, the ultimate losses may vary materially from current loss reserves and, depending on coverage under the Company’s various reinsurance arrangements, could have a material adverse effect on the Company’s future financial condition, results of operations and cash flows. See also Note 1 and 3 of Notes to the Consolidated Financial Statements.
Premiums Written and Earned. Premiums written by the Company are earned ratably over the periods of the related insurance and reinsurance contracts or policies. Unearned premium reserves are established to cover the remainder of the unexpired contract period. Such reserves are established based upon reports received from ceding companies or computed using pro rata methods based on statistical data. Written and premiums earned, and the related costs, which have not yet been reported to the Company are estimated and accrued. Because earned premium generally correlates with the Company’s estimate of its exposure base, variations in premium earnings are to a large degree offset by related variability in incurred losses and commission expense. See also Note 1 of Notes to the Consolidated Financial Statements.
Investment Valuation. The Company’s investment portfolio consists of investments available for sale and accordingly these securities are marked to market on a quarterly basis. Most securities are traded on national exchanges where market values are readily available. The Company holds some privately placed securities that are either valued by an investment advisor or by the Company using cash flow projections. In addition, the Company owns interest only strips that are accounted for in accordance with EITF 99-20, which sets forth the rules for determining when these securities must be written down to fair value due to impairment. Unrealized gains and losses from market fluctuations are reflected as comprehensive income, while market value declines that are considered other than temporary impairments are reflected in the income statement as realized capital losses. The Company considers many factors when determining whether a market value decline is other than temporary, including: (1) the length of time the market value has been below book value, (2) the credit strength of the issuer, (3) the issuer’s market sector, (4) the length of time to maturity and (5) for interest only strips, increases in mortgage prepayments. If management assessments change in the future, the Company may ultimately record a realized loss after management originally concluded that the decline in value was temporary. See also Note 1 of Notes to the Consolidated Financial Statements.
Cash and Invested Assets. Aggregate invested assets, including cash and short-term investments, were $9,314.8 million at December 31, 2003, $7,259.1 million at December 31, 2002 and $5,783.5 million at December 31, 2001. The increase in cash and invested assets in 2003 from 2002 resulted primarily from $1,653.8 million in cash flows from operations generated during 2003, $316.8 million of net proceeds from the offering of common shares in April 2003 and $68.1 million in net unrealized appreciation of the Company’s investments. The increase in cash and invested assets in 2002 from 2001 resulted primarily from $736.1 million in cash flows from operations generated in 2002, $346.3 million of net proceeds from the offering of Group’s common shares in February 2002, $203.4 million of net proceeds from Capital Trust’s issuance of trust preferred securities in November 2002 and $135.9 million in net unrealized appreciation of the Company’s investments. These increases were partially offset by $35.0 million in net payments on the credit facility and $22.9 million in share repurchases.
The increases by segment generally reflect the increases in earned premium, changes in business mix and the impact of reserve recalculations together with the claim settlement activity. The increases for A&E reflect the impact of reserve re-evaluations and claim settlement activity.
The Company re-evaluates its loss and LAE reserves on an ongoing basis, including re-estimates of prior period reserves, taking into consideration all available information and in particular newly reported loss and claim experience. The effect of such re-evaluations impacts incurred losses for the current period. While there can be no assurance that reserves for, and losses from, claim obligations will not increase in the future, management believes that the Company’s existing reserves and reserving methodologies lessen the probability that any such increase would have a material adverse effect on the Company’s financial condition, results of operations or cash flows. In this context, the Company notes that over the past 10 years, its past calendar year operations have been affected variably by effects from prior period reserve re-estimates with such effects ranging from a favorable $35.4 million, representing 1.2% of the net prior period reserves for the year in which the adjustment was made to an unfavorable ($256.9) million, representing 6.7% of the net prior period reserves for the year in which the adjustment was made.
The following table represents the reserve levels and ranges as of December 31, 2003 for each of the Company’s business segments.
(3) Given the uncertainties surrounding the settlement of A&E losses, management is unable to establish a range for these obligations. As a result, which relate principally to the U.S. Reinsurance and Bermuda segments, have been segregated from reserves for which a range has been determined.
The Company has included ranges for loss reserve estimates determined by the Company’s actuaries, which are derived through a combination of objective and subjective criteria. Depending on the specific segment, the range derived for the loss reserves, excluding reserves for A&E exposures, ranges from minus 4.9% to minus 8.1% for the low range and from plus 6.5% to plus 13.7% for the high range. The higher range is associated with the International segment, and the lower range is associated with the Bermuda segment. Within each range, management’s best estimate of loss reserves is based on the point estimate derived by the Company’s actuaries in detailed reserve studies. Such ranges are necessarily subjective due to the lack of generally accepted actuarial standards with respect to their development. In particular, the Company notes that the width of the range is dependent on the level of confidence associated with the outcome. For the above presentation, management has assumed what it believes is a reasonable confidence level but notes that there can be no assurance that the Company’s claim obligations will not vary within and potentially outside of these ranges requiring incurred loss adjustments in the period the variability is recognized. The Company is not able to establish a meaningful range for A&E reserves.
Mt. McKinley began writing small amounts of A&E exposed insurance in 1975 and increased the volume of its writings in 1977. These writings ceased in 1984, giving Mt. McKinley an approximate 10-year window of potential A&E exposure, which is appreciably shorter than is the case for many companies with significant A&E exposure. Additionally, due to changes in and standardization of policy forms, it is rare for policies in the 1970s and 1980s to have been issued without aggregate limits on at least the product liability coverage offered; policies issued in earlier decades are generally more at risk of not having aggregate limits.
Beginning of period reserves $ 667 .9 $ 644 .4 $ 693 .7
End of period reserves $ 765 .3 $ 667 .9 $ 644 .4
Beginning of period reserves $ 527 .5 $ 568 .6 $ 628 .5
Industry analysts have developed a measurement, known as the survival ratio, to compare the A&E reserves among companies with such liabilities. The survival ratio is typically calculated by dividing a company’s current net reserves by the three year average of paid losses, and therefore measures the number of years that it would take to exhaust the current reserves based on historical payment patterns. Using this measurement, the Company’s net three year A&E survival ratio was 8.3 years at December 31, 2003. Adjusting these ratios to exclude the effect of the reinsurance ceded under the reinsurance agreement with Prupac, the measures rise to the equivalent of 10.8 years at December 31, 2003. The cession of $160.0 million to the stop loss reinsurance provided by Prupac in connection with the acquisition of Mt. McKinley proceeds are not reflected in past net payments and effectively extend the funding available for future net payments. Because the survival ratio was developed as a comparative measure of reserve strength and not of absolute reserve adequacy, the Company considers, but does not rely on, the survival ratio when evaluating its reserves.
Developments in 2003 and 2002 affecting asbestos exposures in general and the Company’s asbestos exposures in particular, together with enhancements in the Company’s claim management and analytical processes, resulted in the reserve strengthening noted earlier. These developments and actions have increased the emphasis on asbestos exposures as a separate component of the Company’s A&E exposures. Despite the Company’s approach of handling A&E exposures on a combined basis, management believes additional disclosure of the asbestos element of its A&E exposures is appropriate.
The following tables summarize reserve and claim activity for asbestos claims, on both a gross and net of ceded reinsurance basis, for the periods indicated with particular emphasis on the differentiation of insured categories within the Mt. McKinley operation, which the Company believes reflects the most volatile element of its asbestos exposures.
(2) Under CIP agreements, payments depend upon the insured’s actual claims experience and may be subject to annual caps or other controls on the rate of payment. During 2003, one claim and corresponding reserves were transferred from high profiled insureds to CIP.
CIP settlements (2) $ 65 .4 $ 39 .4 $ 28 .2
Total end of period reserves (4) (5) .9 $ 403 .4 $ 389 .4
(2) Under CIP agreements, payments depend upon the insured's actual claims experience and may be subject to annual caps or other controls on the rate of payment. During 2003, one claim and corresponding reserves were transferred from high profiled insureds to CIP.
(4) Net liabilities represent Everest Re's inception-to-date losses and Mt. McKinley's losses since its acquisition in 2000.
(5) Includes $232.0 million ceded to and collected from The Prudential as part of the Company's stop loss protection resulting from the initial public offering in 1995.
3 Year Survival Ratio excluding CIP, actively managed & stop loss .8
Shareholders’ Equity. The Company’s shareholders’ equity increased to $3,164.9 million as of December 31, 2003 from $2,368.6 million as of December 31, 2002, principally reflecting $426.0 million of net income in 2003, $316.8 million in net proceeds from Group’s offering of 4.5 million common shares in April 2003, an increase of $36.4 million in net unrealized appreciation of investments, and a $22.2 million increase in foreign currency translation, partially offset by $19.6 million in shareholder dividends. The Company’s shareholders’ equity increased to $2,368.6 million as of December 31, 2002 from $1,720.5 million as of December 31, 2001, principally reflecting $346.3 million in net proceeds from Group’s offering of 5.0 million common shares in February 2002, $231.3 million of net income in 2002 and an increase of $104.2 million in net unrealized appreciation of investments, partially offset by $22.9 million in repurchases of 450,000 shares and $16.3 million in shareholder dividends. Dividends of $19.6 million, $16.3 million and $12.9 million were declared and paid by the Company in 2003, 2002 and 2001, respectively. At December 31, 2003, 1.73 million shares remained under the existing repurchase authorization.
On April 23, 2003, the Company expanded the size of the remaining shelf registration to $318 million by filing a Post-Effective Amendment under Rule 462(b) of the Securities Act of 1933, as amended, and General Instruction IV of Form S-3 promulgated there under. On the same date, the Company issued 4,480,135 of its common shares at a price of $70.75 per share, which resulted in $317.0 million in proceeds, before expenses of approximately $0.2 million. This transaction effectively exhausted the September 26, 2002 shelf registration.
Distributions on the trust preferred securities are cumulative and are paid quarterly in arrears. Distributions relating to the trust preferred securities for the years ended December 31, 2003 and 2002 were $16.5 million and $2.1 million, respectively.
On November 7, 2001, the Company filed a shelf registration statement on Form S-3 with the SEC, providing for the issuance of up to $575.0 million of common equity. On February 27, 2002, the Company completed an offering of 5,000,000 of its common shares at a price of $69.25 per share, which resulted in $346.3 million of proceeds before expenses of approximately $0.5 million related to the offering. The Company has used the net proceeds for working capital and general corporate purposes. On October 2, 2002, the Company filed a Post-Effective Amendment to this registration statement that removed the remaining securities from registration.
Management believes that net cash flows from operating activities are generally consistent with expectations given the Company’s large increase in premium volume and investment portfolio. Premiums are generally collected over the policy period, which is typically one year. However, claims related to the policies will be paid out over numerous years. This is particularly true for casualty business. The Company is not able to predict how long this favorable premium volume trend will be sustained.
The Company’s cash flow activity in 2003 included $317.0 million of new investable cash resulting from Group’s offering of common shares in April. The cash flow activity in 2002 included $346.3 million of new investable cash resulting from Group’s offering of common shares in February and $210.0 million of new investable cash from Capital Trust’s issuance of trust preferred securities in November.
The Company employs various techniques, including licensed software modeling, to assess its accumulated exposure. Such techniques are inherently more difficult to apply to non-property exposures. Accumulated exposures with respect to catastrophe losses are generally summarized in terms of the probable maximum loss (“PML”). The Company defines PML as its anticipated maximum loss, taking into account contract limits, caused by a single catastrophe affecting a broad contiguous geographic area, such as that caused by a hurricane or earthquake of such a magnitude that it is expected to occur once in every 100 years.
The Company employs a retrocessional approach under which the Company may purchase reinsurance to cover specific business written or exposure accumulations or as a corporate level retrocessional program covering the potential accumulation or aggregation of exposures across some or all of the Company’s operations. All reinsurance purchasing decisions consider both the potential coverage and market conditions with respect to the pricing, terms, conditions and availability of such coverage, with the aim of securing cost effective protection. The level of reinsurance coverage varies over time, reflecting the underwriter’s and/or Company’s view of the changing dynamics of both the underlying exposure and the reinsurance markets.
For 2002, 2003 and thus far in 2004, the Company has chosen not to purchase corporate retrocessional protection and to generally de-emphasize the purchase of specific reinsurance by its underwriters reflecting the Company’s view that its exposures in the context of its capital and financial position do not warrant reinsurance purchases at current price levels. For 1999, 2000 and 2001, the Company purchased accident year aggregate excess of loss retrocession coverage, which provided up to $175.0 million of recoveries per accident year if Everest Re’s consolidated statutory basis accident year loss ratio exceeded a loss ratio attachment point provided in the contract for the respective accident years. Each arrangement provided for an adjustment premium, which reduces the net benefit by approximately 50%, in the event that the coverage is used. There are no remaining limits available under these coverages. See ITEM 1, “Business - Risk Management and Retrocession Arrangements” for further details.
Contractual Obligations. The following table shows the Company's contractual obligations for the year ended December 31, 2003:
Total $ 766 .9 $ 75 .5 $ 266 .0 $ 9 .3 $ 416 .1
The majority of these contractual obligations are the responsibility of Holdings. While the Company has sufficient cash flow, liquidity, investments and access to capital markets to settle these obligations, Holdings is dependent upon dividends from Everest Re, its operating insurance subsidiary, capital contributions from Group or access to the capital markets for funding. Management is of the opinion that financial resources are or will be readily available to settle these obligations.
During 2003, 2002 and 2001, the Company declared and paid shareholder dividends of $19.6 million, $16.3 million and $12.9 million, respectively. As an insurance holding company, the Company is partially dependent on dividends and other permitted payments from its subsidiaries to pay cash dividends to its shareholders. The payment of dividends to Group by Holdings and to Holdings by Everest Re is subject to Delaware regulatory restrictions and the payment of dividends to Group by Bermuda Re is subject to Bermuda insurance regulatory restrictions. Management expects that, absent significant catastrophe losses, such restrictions should not affect Everest Re’s ability to declare and pay dividends sufficient to support Holdings’ general corporate needs and Holdings’ and Bermuda Re’s ability to declare and pay dividends sufficient to support Group’s general corporate needs. For the years ended December 31, 2003, 2002 and 2001, Everest Re paid dividends to Holdings of $45 million, $85 million and $115 million, respectively to Holdings. See ITEM 1, “Business - Regulatory Matters - Dividends” and Note 14A of Notes to Consolidated Financial Statements.
The SEC’s Financial Reporting Release #48 requires registrants to clarify and expand upon the existing financial statement disclosure requirements for derivative financial instruments, derivative commodity instruments, and other financial instruments (collectively, “market sensitive instruments”). The Company does not enter into market sensitive instruments for trading purposes.
The Company’s current investment strategy 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 the Company’s tax position. The fixed maturities in the investment portfolio are comprised of non-trading available for sale securities. Additionally, the Company invests in equity securities, which it believes will enhance the risk-adjusted total return of the investment portfolio. The Company has also engaged in a small number of credit default swaps and specialized equity options.
Interest rate risk is the potential change in value of the fixed maturity portfolio, including short-term investments, due to change in market interest rates. In a declining interest rate environment, it includes prepayment risk on the $1,383.3 million of mortgage-backed securities in the $8,726.9 million fixed maturity portfolio. Prepayment risk results from potential accelerated principal payments that shorten the average life and thus the expected yield of the security.
The tables below display the potential impact of a parallel 20% increase and decrease in foreign exchange rates on the valuation of invested assets subject to foreign currency exposure in 10% increments as of December 31, 2003 and 2002. This analysis includes the after-tax impact of translation from transactional currency to functional currency as well as the after-tax impact of translation from functional currency to the U.S. dollar reporting currency. The growth in exposure between 2003 and 2002 principally arises from increases in the level of foreign currency investments, which are generally commensurate with changes in the Company’s mix of business. All amounts are in U.S. dollars and are presented in millions.
Market Value of the Equity Portfolio $ 118 .3 $ 133 .1 $ 147 .9 $ 162 .7 $ 177 .5
Although not considered material in the context of the Company’s aggregate exposure to market sensitive instruments, the Company has issued five specialized equity put options based on the Standard & Poor’s 500 (“S&P 500”) index that are market sensitive and sufficiently unique to warrant supplemental disclosure.
During 2001, the Company sold five specialized equity put options based on the S&P 500 index for total consideration, net of commission, of $16.9 million. These contracts each have a single exercise date, with maturities ranging from 18 to 30 years and strike prices ranging from $1,141.21 to $1,540.63. No amounts will be payable under these contracts if the S&P 500 index is at or above the strike price on the exercise dates. If the S&P 500 index is lower than the strike price on the applicable exercise date, the amount due will vary proportionately with the percentage the index is below the strike price. Based on historical index volatilities and trends and the December 31, 2003 index value, the Company estimates the probability for each contract of the S&P 500 index being below the strike price on the exercise date is less than 4.4%. The theoretical maximum payouts under the contracts would occur if on each of the exercise dates the S&P 500 index value were zero.
As there is no active market for these instruments, the determination of their fair value is based on an industry accepted option-pricing model, which requires estimates and assumptions, including those regarding volatility and expected rates of return.
Market Value Change from Base (%) (40 .1)% (18 .0)% .0% .7% .9%
Market Value Change from Base (%) (118 .7)% (49 .2)% .0% .1% .3%
Market Value Change from Base (%) (45 .3)% (20 .0)% .0% .1% .1%
The Company’s success depends on its ability to accurately assess the risks associated with the businesses on which the risk is retained. If the Company fails to accurately assess the risks it retains, it may fail to establish adequate premium rates to cover its losses and LAE. This could reduce the Company’s net income and even result in an operating loss. Losses may arise from events or exposures that are not anticipated when the coverage is priced. An example of an unanticipated event is the September 11 attacks. The Company’s loss from those attacks, after reinsurance and taxes, was $75 million. Neither the magnitude of loss on a single line of business nor the combined impact on several lines of business from an act of terrorism on such a large scale was contemplated when the Company priced its coverages. In addition to unanticipated events, the Company also faces the unanticipated expansion of its exposures, particularly in long-tail liability lines. An example of this is the ongoing expansion of the scope of insurers’ legal liability for A&E exposures discussed above.
The Company is subject to extensive regulation under U.S., state and foreign insurance laws. These laws limit the amount of dividends that can be paid to the Company by its operating subsidiaries, impose restrictions on the amount and type of investments that the Company can hold, prescribe solvency standards that must be met and maintained and require the Company to maintain reserves. These laws also require disclosure of material intercompany transactions and require prior approval of “extraordinary” transactions. These “extraordinary” transactions include declaring dividends from operating subsidiaries that exceed statutory thresholds. These laws also generally require approval of changes of control of insurance companies. The application of these laws could affect the Company’s liquidity and ability to pay dividends, interest and other payments on securities, as applicable, and could restrict the ability to expand business operations through acquisitions of new insurance subsidiaries. In addition, the Company cannot assure that it will have or can maintain all required licenses and approvals or that its business fully complies with the wide variety of applicable laws and regulations or the relevant authority’s interpretation of the laws and regulations. If the Company does not have the requisite licenses and approvals or does not comply with applicable regulatory requirements, the insurance regulatory authorities could preclude or temporarily suspend the Company from carrying on some or all activities or monetarily penalize the Company. These types of actions could have a material adverse effect on the Company’s business. To date, no material fine, penalty or restriction has been imposed on the Company for failure to comply with any insurance law or regulation.
Regulatory challenges in the U.S. could adversely affect the ability of Bermuda Re to conduct business.
Bermuda Re may need to be licensed or admitted in additional jurisdictions to develop its business.
The Company and Holdings are holding companies, each of whose most significant assets consists of the stock of their operating subsidiaries. As a result, each of the Company’s and Holdings’ ability to pay dividends, interest or other payments on its securities in the future will depend on the earnings and cash flows of the operating subsidiaries and the ability of the subsidiaries to pay dividends or to advance or repay funds to it. This ability is subject to general economic, financial, competitive, regulatory and other factors beyond the Company’s control. Payment of dividends and advances and repayments from some of the operating subsidiaries are regulated by U.S., state and foreign insurance laws and regulatory restrictions, including minimum solvency and liquidity thresholds. Accordingly, the operating subsidiaries may not be able to pay dividends or advance or repay funds to the Company and Holdings in the future, which could prevent it from paying dividends, interest or other payments on its securities.
For example, the Company’s bye-laws contain the following provisions that could have an anti-takeover effect:
the total voting power of any shareholder owning more than 9.9% of the common shares will be reduced to 9.9% of the total voting power of the common shares;
the board of directors may decline to register any transfer of common shares if it has reason to believe that the transfer would result in:
any person holding controlled shares in excess of 9.9% of any class of the issued and outstanding share capital of the Company, or
any adverse tax, regulatory or legal consequences to the Company, any of its subsidiaries or any of its shareholders;
the Company also has the option to redeem or purchase all or part of a shareholder’s common shares to the extent the board of directors determines it is necessary or advisable to avoid or cure any adverse or potential adverse consequences if:
any person holds controlled shares in excess of 9.9% of any class of the issued and outstanding share capital of the Company, or
share ownership by any person may result in adverse tax, regulatory or legal consequences to the Company, any of its subsidiaries or any other shareholder.
Alternate Directors. The Company’s bye-laws provide, as permitted by Bermuda law, that each director may appoint an alternate director, who shall have the power to attend and vote at any meeting of the board of directors or committee at which that director is not personally present and to sign written consents in place of that director. Delaware law does not provide for alternate directors.
Interested Directors. Bermuda law and the Company’s bye-laws provide that if a director has a personal interest in a transaction to which the company is also a party and if the director discloses the nature of this personal interest at the first opportunity, either at a meeting of directors or in writing to the directors, then the company will not be able to declare the transaction void solely due to the existence of that personal interest and the director will not be liable to the Company for any profit realized from the transaction. In addition, after a director has made the declaration of interest referred to above, he or she is allowed to be counted for purposes of determining whether a quorum is present and to vote on a transaction in which he or she has an interest, unless disqualified from doing so by the chairman of the relevant board meeting. Under Delaware law, a corporation may be able to declare a transaction with an interested director to be void unless one of the following conditions is fulfilled:
the material facts as to the interested director’s relationship or interests are disclosed or are known to the board of directors and the board in good faith authorizes the transaction by the affirmative vote of a majority of the disinterested directors,
the material facts are disclosed or are known to the shareholders entitled to vote on the transaction and the transaction is specifically approved in good faith by the holders of a majority of the voting shares or
the transaction is fair to the corporation as of the time it is authorized, approved or ratified.
Indemnification of Directors and Officers. the Company’s bye-laws provide that the Company shall indemnify its directors or officers to the full extent permitted by law against all actions, costs, charges, liabilities, loss, damage or expense incurred or suffered by them by reason of any act done, concurred in or omitted in the conduct of the Company’s business or in the discharge of their duties. Under Bermuda law, this indemnification may not extend to any matter involving fraud or dishonesty of which a director or officer may be guilty in relation to the company, as determined in a final judgment or decree not subject to appeal. Under Delaware law, a corporation may indemnify a director or officer who becomes a party to an action, suit or proceeding because of his position as a director or officer if (1) the director or officer acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the corporation and (2) if the action or proceeding involves a criminal offense, the director or officer had no reasonable cause to believe his or her conduct was unlawful.
Enforcement of Civil Liabilities. The Company is organized under the laws of Bermuda. Some of its directors and officers may reside outside the U.S. A substantial portion of the Company’s assets are or may be located in jurisdictions outside the U.S. A person may not be able to effect service of process within the U.S. on directors and officers of the Company and those experts who reside outside the U.S. A person also may not be able to recover against them or the Company on judgments of U.S. courts or to obtain original judgments against them or the Company in Bermuda courts, including judgments predicated upon civil liability provisions of the U.S. federal securities laws.
In the last few years, some members of Congress have expressed concern about U.S. corporations that move their place of incorporation to low-tax jurisdictions. Also, some members of Congress have expressed concern over a competitive advantage that foreign-controlled insurers and reinsurers may have over U.S. controlled insurers and reinsurers due to the purchase of reinsurance by U.S. insurers from affiliates operating in some foreign jurisdictions, including Bermuda. Legislation has recently been proposed in Congress that would increase the U.S. tax burden on so-called “inverting” companies and increase the U.S. tax burden on related-party reinsurance transactions. The Company does not know whether this legislation or any similar legislation will ever be enacted into law. If it were enacted, the U.S. tax burden on the Company’s Bermuda operations, or on some business ceded from its licensed U.S. insurance subsidiaries to some offshore reinsurers, could be increased. This could reduce the Company’s net income.
If Bermuda Re became subject to U.S. income tax on its income or if it became subject to U.S. income tax on more than immaterial amounts of income, its income could also be subject to the U.S. branch profits tax. In that event, the Company and Bermuda Re would be subject to taxation at a higher combined effective rate than if they were organized as U.S. corporations. The combined effect of the 35% U.S. corporate income tax rate and the 30% branch profits tax rate is a net tax rate of 54.5%. The imposition of these taxes would reduce the Company’s net income.
The Organization for Economic Cooperation and Development and the European Union are considering measures that might increase the Company’s taxes and reduce our net income.
The Company and/or Bermuda Re may become subject to Bermuda tax, which would reduce the Company’s net income.
The Company may become subject to Barbados tax, which would reduce the Company’s net income.