The following table sets forth summary historical consolidated financial and operating data for the five-year period ended December 31, 2002. Such data for the three-year period ended December 31, 2002 should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and our financial statements and the related notes.
(1)Net premiums written for the year ended December 31, 2000 includes the reversal of $92.9 million of premiums recorded in prior periods in connection with the sale of our prior reinsurance operations in May 2000.
(3)Net income per share is based on the basic and diluted weighted average number of common shares and common share equivalents outstanding. Net loss per share is based on the basic weighted average number of common shares outstanding.
(4)Book value per common share at December 31, 2002 and December 31, 2001 was determined by dividing (i) the difference between total shareholders' equity and the aggregate liquidation preference of the preference shares of $815.7 million and $749.4 million, respectively, by (ii) the number of common shares outstanding.
The following discussion and analysis contains forward-looking statements which involve inherent risks and uncertainties. All statements other than statements of historical fact are forward-looking statements. These statements are based on our current assessment of risks and uncertainties. Actual results may differ materially from those expressed or implied in these statements and, therefore, undue reliance should not be placed on them. Important factors that could cause actual events or results to differ materially from those indicated in such statements are discussed in this report, including the sections entitled "Cautionary Note Regarding Forward Looking Statements," and "Our Company-Risk Factors."
In October 2001, we launched an underwriting initiative to meet current and future demand in the global insurance and reinsurance markets that included the recruitment of new insurance and reinsurance management teams and an equity capital infusion of $763.2 million. It is our belief that our existing Bermuda- and U.S.-based underwriting platform, our experienced management team and our strong capital base that is unencumbered by significant exposure to pre-2002 risks have enabled us to establish an immediate presence in an attractive insurance and reinsurance marketplace. In April 2002, we completed an offering of 7,475,000 of our common shares and received net proceeds of $179.2 million and, in September 2002, we received proceeds of $74.3 million from the exercise of class A warrants by our principal shareholders and certain other investors.
Due to the significant changes in our business during the years 2002, 2001 and 2000, we believe the comparisons of our results of operations in such periods are not relevant.
In general, operating conditions continued to improve during 2002 in the insurance and reinsurance marketplace. This improvement reflects losses arising from the events of September 11th, as well as recognition that intense competition in the late 1990s led to inadequate pricing and overly broad terms, conditions and coverages. Such industry developments resulted in impaired financial results and erosion of the industry capital base. Additionally, many established insurers and reinsurers have exited key markets. These developments have provided relatively new insurers and reinsurers, like us, with an opportunity to provide needed underwriting capacity at what we believe to be attractive rates in conjunction with improved terms and conditions.
The preparation of consolidated financial statements requires us to make many estimates and judgments that affect the reported amounts of assets, liabilities (including reserves), revenues and expenses, and related disclosures of contingent liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, insurance and other reserves, reinsurance recoverables, investment valuations, intangible assets, bad debts, income taxes, contingencies and litigation. We base our estimates on historical experience, where possible, and on various other assumptions that we believe to be reasonable under the circumstances, which form the basis for our judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Estimates and judgments for a relatively new insurance and reinsurance company, like our company, are even more difficult to make than those made in a mature company since very limited historical information has been reported to us through December 31, 2002. Actual results will differ from these estimates and such differences may be material. We believe that the following critical accounting policies require our more significant judgments and estimates used in the preparation of our consolidated financial statements.
We are required by applicable insurance laws and regulations and GAAP to establish reserves for losses and loss adjustment expenses that arise from the business we underwrite. These reserves are balance sheet liabilities representing estimates of future amounts required to pay losses and loss adjustment expenses for insured or reinsured claims which have occurred at or before the balance sheet date.
For reinsurance assumed, case reserves are based on reports received from ceding companies, supplemented by our estimates of reserves for which ceding company reports have not been received. For our insurance operations, generally, claims personnel determine whether to establish a case reserve for the estimated amount of the ultimate settlement of individual claims. The estimate reflects the judgment of claims personnel based on general corporate reserving practices and the experience and knowledge of such personnel regarding the nature and value of the specific type of claim and, where appropriate, advice of counsel. Our insurance operations also contract with a number of outside third party administrators in the claims process who, in certain cases, have limited authority to establish case reserves. The work of such administrators is reviewed and monitored by our claims personnel. Reserves are also established to provide for the estimated expense of settling claims, including legal and other fees and the general expenses of administering the claims adjustment process. Periodically, adjustments
to the reported or case reserves may be made as additional information regarding the claims is reported or payments are made. In accordance with industry practice, we also maintain IBNR reserves. Such reserves are established to provide for incurred claims which have not yet been reported to an insurer or reinsurer as well as to actuarially adjust for any projected variance in case reserving.
Even though most insurance policies have policy limits, the nature of property and casualty insurance and reinsurance is such that losses can exceed policy limits for a variety of reasons and could very significantly exceed the premiums received on the underlying policies. We attempt to limit our risk of loss through reinsurance and may also use retrocessional arrangements. The availability and cost of reinsurance and retrocessional protection is subject to market conditions, which are beyond our control. See note 2, "Significant Accounting Policies-Reinsurance Ceded," of the notes accompanying our consolidated financial statements.
Insurance premiums written are recorded at the policy inception and are earned ratably in accordance with the terms of the policies. Unearned premium reserves represent the portion of such premiums written that relates to the unexpired terms of insurance policies in-force.
Reinsurance premiums written include amounts reported by the ceding companies, supplemented by our own estimates of premiums for which ceding company reports have not been received. Premiums on our excess of loss and pro rata reinsurance contracts are estimated when the business is underwritten. For excess of loss contracts, the minimum premium, as defined in the contract, is generally recorded as an estimate of premiums written as of the date of the treaty. Estimates of premiums written under pro rata contracts are recorded in the period in which the underlying risks are expected to incept and are based on information provided by the brokers and the ceding companies. For multi-year reinsurance treaties which are payable in annual installments, only the initial annual installment is included as premiums written at policy inception due to the ability of the reinsured to
commute or cancel coverage during the term of the policy. The remaining annual installments are included as premiums written at each successive anniversary date within the multi-year term.
As actual premiums are reported by the ceding companies, management evaluates the appropriateness of the premium estimates, and any adjustment to these estimates is recorded in the period in which it becomes known. Adjustments to original premium estimates could be material and such adjustments could directly and significantly impact earnings in the period they are determined because the subject premium may be fully or substantially earned. A significant portion of amounts included as premiums receivable, which represent estimated premiums written, net of commissions, is not currently due based on the terms of the underlying contracts.
Certain of our reinsurance contracts include provisions that adjust premiums or acquisition expenses based upon the experience under the contracts. Premiums written and earned, as well as related acquisition expenses under those contracts, are recorded based upon the projected experience under these contracts.
Under GAAP, acquisition expenses and other expenses that vary with, and are directly related to, the acquisition of business in our underwriting operations are deferred and amortized over the period in which the related premiums are earned. Under statutory accounting principles, underwriting expenses are recognized immediately as premiums are written.
Reinsurance recoverables on paid and unpaid losses were $225.6 million at December 31, 2002. If 5% of such recoverable balances were deemed uncollectible, such charge would have reduced our 2002 net income by approximately $11.3 million, pre-tax, or $7.7 million, after-tax, which represents approximately 13% of 2002 net income, or $0.13 per diluted share.
We record a valuation allowance to reduce certain of our deferred tax assets to the amount that is more likely than not to be realized. Our deferred income tax asset of $16.5 million at December 31, 2002 is reflected net of a valuation allowance of $2.1 million. We have considered future taxable income and feasible tax planning strategies in assessing the need for a valuation allowance. In the event we determine that we would not be able to realize all or part of our deferred tax assets in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made. In addition, if we subsequently assessed that the valuation allowance was no longer needed, a benefit would be recorded to income in the period in which such determination was made.
In accordance with SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," we periodically review our investments to determine whether a decline in fair value below the amortized cost basis is other than temporary. If such decline in fair value is judged to be other than temporary, we would write down the investment to fair value as a new cost basis and the amount of the write-down would be charged to income as a realized loss. The new cost basis would not be changed for subsequent recoveries in fair value.
We have adopted the provisions of APB Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations in accounting for employee stock options because the alternative fair value accounting provided for under SFAS No. 123, "Accounting for Stock-Based Compensation," requires the use of option valuation models that we believe were not developed for use in valuing employee stock options. Accordingly, under APB No. 25, compensation expense for stock option grants is recognized only to the extent that the fair value of the underlying stock exceeds the exercise price of the option at the measurement date. In addition, under APB No. 25, we do not recognize compensation expense for stock issued to employees under our stock purchase plan. We suspended the operation of our stock purchase plan in December 2002.
For restricted shares granted, we record deferred compensation equal to the market value of the shares at the measurement date, which is amortized and charged to income as non-cash compensation over the vesting period. These restricted shares are recorded as outstanding upon issuance (regardless of any vesting period). See "-Results of Operations-Non-Cash Compensation."
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." SFAS No. 146 will be applied prospectively to exit or disposal activities initiated after December 31, 2002, and requires companies to recognize costs associated with exit activities when they are incurred, rather than at the date of a commitment to an exit or disposal plan. We are currently evaluating this standard.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure." SFAS No. 148 amends SFAS No. 123, "Accounting for Stock-Based Compensation," to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The provisions of SFAS No. 148 are effective for financial statements for fiscal years and interim periods ending after December 15, 2002. We have adopted the disclosure provisions of SFAS No. 148.
Comparisons of our results of operations for the three years ended December 31, 2002, 2001 and 2000 are not relevant due to the significant changes in our business during this period, including (1) our new insurance and reinsurance underwriting initiatives, (2) the significant amount of capital raised by us from November 2001 through September 2002 and (3) our 2001 acquisition activity. In 2000, we also sold our prior reinsurance operations to Folksamerica Reinsurance Company in an asset sale (see note 13, "Acquisitions of Subsidiaries and Disposition of Prior Reinsurance Operations," of the notes accompanying our consolidated financial statements). In addition, because of these factors, as well as the other factors described in this report, including those noted under the sections entitled "Cautionary Note Regarding Forward-Looking Statements" and "Our Company-Risk Factors," our historical financial results, for 2001 and 2000, do not provide you with a meaningful expectation of our future results.
The following table sets forth net income (loss) and earnings per share data:
Due to the significant number of preference shares outstanding in 2002 and 2001, basic earnings per share data is not meaningful, as discussed below.
Gross premiums written for 2002 were $1.5 billion, of which 61.1% were attributable to our reinsurance operations and 38.9% were attributable to our insurance operations. For 2001, premiums written were generated from insurance subsidiaries which had been acquired by us during 2001. For 2000, premiums written reflect the results of our prior reinsurance operations, which were sold in May 2000.
The combined ratio represents a measure of underwriting profitability, excluding investment income, and is the sum of the loss ratio and underwriting expense ratios. A combined ratio under 100% represents an underwriting profit and a combined ratio over 100% represents an underwriting loss.
(1)The loss ratios for statutory and GAAP are based on earned premiums. The statutory expense ratios are based on net premiums written, while the GAAP expense ratios are based on net premiums earned.
For the year ended December 31, 2002, underwriting income for our insurance and reinsurance segments was $59.2 million, which reflected a 90.9% combined ratio on a GAAP basis. The underwriting results for 2002 benefited from better than expected experience on catastrophe-related business. The loss ratio, which was 64.8% for 2002, was comprised of 11.9 points of paid losses, 13.4 points related to case reserves and 39.5 points related to IBNR reserves, and included 0.6 points related to prior year reserve development in our insurance segment. See "-Segment Information-Insurance Segment" for further discussion. Since most of our business is new, very limited data has been reported to us as of December 31, 2002. As a result, a significant portion of the loss ratio is attributable to the increase in IBNR reserves.
The acquisition expense ratio includes commissions, brokerage, premium taxes and other costs incurred to acquire our insurance and reinsurance business. This ratio is stated net of commission income on business ceded to reinsurers and is also calculated net of certain policy-related fee income. This ratio for 2002 was materially influenced by two factors: (1) the mix of insurance and reinsurance business; and (2) the accrual of profit commissions in our reinsurance segment based on the level of claims activity on certain non-traditional contracts during 2002, which increased acquisition expenses and reduced incurred losses by an equivalent amount. Other operating expenses include costs incurred in the staffing of our insurance and reinsurance operations and the building of related infrastructure. Our operating expense ratio is expected to decline in 2003 due to an expected increase in earned premiums; however, consolidated operating expenses are anticipated to increase in 2003 as we continue to build the infrastructure of our insurance operations.
See "-Segment Information" for a discussion regarding the underwriting results of our insurance and reinsurance segments.
These yields were calculated based on the amortized cost of the portfolio. At December 31, 2002, our investment portfolio primarily consisted of short duration, high quality fixed maturities and short-term investments, and is managed on a total return basis. Yields on future investment income may vary based on economic conditions, investment allocation decisions and other factors. The decline in yields in 2002 is primarily due to a reduction in the level of yields available in the financial markets.
ACGL will be subject to U.S. federal income tax only to the extent that it derives U.S. source income that is subject to U.S. withholding tax or income that is effectively connected with the conduct of a trade or business within the U.S. and is not exempt from U.S. tax under an applicable income tax treaty. ACGL will be subject to a withholding tax on dividends from U.S. investments and interest from certain U.S. taxpayers. ACGL does not consider itself to be engaged in a trade or business within the U.S. and, consequently, does not expect to be subject to direct U.S. income taxation. However, because there is uncertainty as to the activities which constitute being engaged in a trade or business within the United States, there can be no assurances that the U.S. Internal Revenue Service will not contend successfully that ACGL or its non-U.S. subsidiaries are engaged in a trade or business in the United States. If ACGL or any of its non-U.S. subsidiaries were subject to U.S. income tax, ACGL's shareholders' equity and earnings could be materially adversely affected. ACGL's U.S. subsidiaries are subject to U.S. income taxes on their worldwide income. See "Our Company-Risk Factors-Risks Relating to Taxation" and "Our Company-Tax Matters."
Our weighted average statutory tax rate for the years ended December 31, 2002 and 2001 of 4.0% and 38.6%, respectively, has been calculated by using the pre-tax income (loss) in each jurisdiction multiplied by that jurisdiction's applicable statutory tax rate. The 2002 and 2001 income tax provisions resulted in effective tax rates of 12.5% and 44.0%, respectively, excluding the effect of changes in our valuation allowance in the amount of $7.4 million and $8.5 million, respectively. Our effective tax rate fluctuates from year to year consistent with the relative mix of income reported by jurisdictions due primarily to the varying tax rates in each jurisdiction. The 2002 effective tax rate, excluding the effect of
We have net operating loss carryforwards in our U.S. operating subsidiaries totaling $42.5 million at December 31, 2002. Such net operating losses are currently available to offset our future U.S. taxable income and expire between 2011 and 2021. Full utilization of our net operating losses would reduce future taxes payable by $14.9 million. In addition, we have an alternative minimum tax credit carryforward in the amount of $1.0 million, which can be carried forward without expiration. In addition, we have capital loss carryforwards of approximately $0.3 million which expire by 2006. On November 20, 2001, we underwent an ownership change for U.S. federal income tax purposes as a result of the capital raised at that time. As a result of this ownership change, limitations are imposed upon the utilization of our existing net operating losses, capital loss carryforwards and the alternative minimum tax credit carryforward. See note 8, "Income Taxes," of the notes accompanying our consolidated financial statements.
resulting from the restructuring of our investment portfolio in connection with our redomestication to Bermuda on November 8, 2000.
At December 31, 2002, we held six investments in privately held securities. Three of such investments are accounted for under the equity method of accounting. Under the equity method, we record a proportionate share of the investee company's net income or loss based on our ownership percentage, which, for 2002, amounted to $2.2 million on a pre-tax basis and is included in other income. Approximately $0.6 million of such amount was generated from an investment which was sold in April 2002.
As discussed above under the caption "Critical Accounting Policies, Estimates and Recent Accounting Pronouncements-Stock Issued to Employees," we have elected to continue to account for stock-based compensation in accordance with APB No. 25 and have provided the required additional pro forma disclosures. Such pro forma information has been determined as if we had accounted for our employee stock options under the fair value method of SFAS No. 123. The fair value of employee stock options has been estimated at the date of grant using the Black-Scholes option valuation model. See note 2, "Significant Accounting Policies-Stock Options," of the notes accompanying our consolidated financial statements.
For purposes of the required pro forma information, the estimated fair value of employee stock options is amortized to expense over the options' vesting period. The weighted average fair value of options granted during the years ended December 31, 2002, 2001 and 2000 was $13.4 million, $26.0 million and $0.9 million, respectively.
Our net income (loss) per share would have been adjusted to the pro forma amounts indicated below; however, the expensing of stock options would have had no impact on our shareholders' equity.
On November 30, 2002, we acquired PSIC, a non-standard automobile insurer, for $2.5 million. For the year ended December 31, 2002, we recorded an extraordinary gain of $3.9 million, or $0.07 per share, from this acquisition. The extraordinary gain represented the excess of the fair value of acquired net assets of $6.4 million over the purchase price of $2.5 million. PSIC is included in our insurance segment.
We classify our businesses into two underwriting segments, reinsurance and insurance. SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information," requires certain disclosures about operating segments in a manner that is consistent with how management evaluates the performance of the segment. For a description of our underwriting segments, refer to note 3, "Segment Information," of the notes accompanying our consolidated financial statements. Segment performance is evaluated primarily based on underwriting income or loss. Due to the significant changes in our business during the years 2002, 2001 and 2000, we believe that comparisons of the results of operations of our business segments are not relevant.
The following table sets forth our reinsurance segment's underwriting results for the year ended December 31, 2002:
Set forth below is summary information regarding the reinsurance segment's net premiums written and earned by major line of business for the year ended December 31, 2002:
Certain reinsurance contracts included in our non-traditional business are deemed, for financial reporting purposes, not to transfer insurance risk, and are accounted for using the deposit method of accounting. For those contracts that contain an element of underwriting risk, the expected estimated profit margin is deferred and amortized over the contract period and such amount is included in our underwriting results. We recorded $7.1 million on such contracts for the year ended December 31, 2002 in our underwriting results and, on a notional basis, the amount of premiums attaching to such contracts was $175.8 million. For those contracts that do not transfer an element of underwriting risk, the expected profit is reflected in earnings over the estimated settlement period using the interest method and such profit is included in investment income. We did not record any contracts using the interest method for the year ended December 31, 2002.
Underwriting Expenses. For the year ended December 31, 2002, reinsurance segment acquisition expenses were 21.0% of net premiums earned. The acquisition expense ratio for 2002 was influenced by three factors: (1) our mix of excess of loss business compared to pro rata business, which is typically
written at a higher expense ratio and lower loss ratio than excess of loss business; (2) the accrual of profit commissions based on the level of claims activity on certain non-traditional contracts during 2002, which increased acquisition expenses and decreased losses and loss adjustment expenses by an equivalent amount; and (3) the effect of a $2.5 million payment to terminate a non-competition covenant, as described in note 13, "Acquisition of Subsidiaries and Disposition of Prior Reinsurance Operations," of the notes accompanying our consolidated financial statements. For the year ended December 31, 2002, other operating expenses were 3.8% of net premiums earned. Since the staffing and infrastructure building of the reinsurance segment has been substantially completed, the anticipated operating expense ratio for 2003 currently is expected to be stable, given current market conditions, although no assurances can be given to that effect.
(1)The loss ratios for statutory and GAAP are based on net premiums earned. The statutory expense ratios are based on net premiums written, while the GAAP expense ratios are based on net premiums earned.
(2)The acquisition expense ratio reflects acquisition expenses net of policy-related fee income. Underwriting Loss. For the year ended December 31, 2002, the combined ratio on a GAAP basis for the insurance segment was 101.1%, which included 2.6 points related to development of prior year reserves in our non-standard automobile and program business. Our total combined statutory ratio for 2002 was 94.0%. In calculating expenses incurred under GAAP, only a portion of operating expenses are deferred. Accordingly, when premiums are growing rapidly, the GAAP expense ratio will be higher
than the statutory expense ratio. With respect to businesses in a start-up phase, like us, the statutory expense ratio generally provides a more accurate indication of a company's cost of producing business. The components of the insurance segment's underwriting loss are discussed below.
Premiums Written. During 2002, our insurance segment began staffing its specialty operations and established new profit centers in various specialty lines, which significantly contributed to revenues in the latter half of the year. Accordingly, gross premiums written and net premiums written in 2002 increased significantly over 2001 levels to $578.5 million and $378.9 million, respectively. In addition, in our program business, we substantially reduced the amount of premiums ceded to unaffiliated reinsurers and added a significant number of new programs. We currently expect that premiums written in the insurance segment will continue to increase substantially in 2003, although no assurance can be given to that effect.
For information regarding net premiums written produced by geographic location for the insurance segment for the year ended December 31, 2002, refer to note 3, "Segment Information," of the notes accompanying our consolidated financial statements.
Policy-Related Fee Income. Policy-related fee income, such as billing, cancellation and reinstatement fees, is primarily recognized as earned when substantially all of the related services have been provided. Policy-related fee income will vary in the future related to such activity and is earned primarily in our non-standard automobile business.
Pursuant to a shareholders agreement that we entered into in connection with the November 2001 capital infusion, we have agreed not to declare any dividend or make any other distribution on our common shares, and not to repurchase any common shares, until we have repurchased from the Warburg Pincus funds, the Hellman & Friedman funds and the other holders of our preference shares, pro rata, on the basis of the amount of each of these shareholders' investment in us at the time of such repurchase, preference shares having an aggregate value of $250.0 million, at a per share price acceptable to these shareholders.
Cash flow from operating activities on a consolidated basis are provided by premiums collected, fee income, investment income and collected reinsurance recoverables, offset by losses and loss adjustment expense payments, reinsurance premiums payable and operating costs. Consolidated cash provided by (used for) operating activities for the years ended December 31, 2002 and 2001 was approximately $669.1 million and ($5.6) million, respectively.
Our expanded underwriting activities will initially be supported by our capital, and we expect that our other operational needs for the foreseeable future will be met by our balance of cash and short-term investments, as well as by funds generated from underwriting activities and investment income and proceeds on the sale or maturity of our investments. We have an effective shelf registration statement with the Securities and Exchange Commission. It permits us to issue various types of securities, including unsecured debt securities, preference shares and common shares, from time to time, up to an aggregate of $500 million. During April 2002, we issued 7,475,000 of our common shares and received net proceeds of approximately $179 million, net of transaction costs. The net proceeds of the offering were principally used to increase the surplus of our insurance and reinsurance subsidiaries. The unused portion of our shelf registration is approximately $309 million following the offering in April 2002. Any additional issuance of common shares by us could have the effect of diluting our earnings per share and our book value per share.
From August to September 2002, an aggregate of 3,748,946 common shares were issued upon the exercise of all 3,842,450 outstanding class A warrants, which were exercisable for $20.00 per share and were scheduled to expire on September 19, 2002. The proceeds from the exercise of class A warrants on a cash basis increased shareholders' equity by approximately $74.3 million. In October 2002, ACGL contributed such proceeds to Arch Re Bermuda.
We establish reserves for losses and loss adjustment expenses which represent estimates involving actuarial and statistical projections, at a given point in time, of our expectations of the ultimate settlement and administration costs of losses incurred. Estimating loss reserves is inherently difficult, which is exacerbated by the fact that we are a new company with relatively no historical experience upon which to base such estimates. We utilize actuarial models as well as available historical insurance industry loss ratio experience and loss development patterns to assist in the establishment of appropriate loss reserves. Actual losses and loss adjustment expenses paid will deviate, perhaps substantially, from the reserve estimates reflected in our financial statements. See the section above entitled "Critical Accounting Policies, Estimates and Recent Accounting Pronouncements-Reserves for Losses and Loss Adjustment Expenses."
The availability and cost of reinsurance and retrocessional protection is subject to market conditions, which are beyond our control. Currently, the market for these arrangements is experiencing high demand for various products and it is not certain that we will be able to obtain adequate protection at cost effective levels. As a result of such market conditions and other factors, we may not be able to successfully mitigate risk through reinsurance and retrocessional arrangements. Further, we are subject to credit risk with respect to our reinsurers and retrocessionaires because the ceding of risk to reinsurers and retrocessionaires does not relieve us of our liability to the clients or companies we insure or reinsure. Our failure to establish adequate reinsurance or retrocessional arrangements or the failure of our existing reinsurance or retrocessional arrangements to protect us from overly concentrated risk exposure could adversely affect our financial condition and results of operations.
The following table details our reinsurance recoverables at December 31, 2002:
(1)The financial strength ratings are as of March 25, 2003 and were assigned by A.M. Best based on its opinion of the insurer's financial strength as of such date. An explanation of the ratings listed in the table follows: ratings of "A++" and "A+" are designated "Superior"; the "A" and "A-" ratings are designated "Excellent"; the "B++" rating is designated "Very Good"; the "B" rating is designated "Fair"; and the "C" rating is designated "Weak". Additionally, A.M. Best has five classifications within the "Not Rated" or "NR" category. Reasons for an "NR" rating being assigned by A.M. Best include insufficient data, size or operating experience, companies which are in run-off with no active business writings or dormant, companies which disagree with their rating and request that a rating not be published or insurers that request not to be formally evaluated for the purposes of assigning a rating opinion.
We have substantial exposure to unexpected, large losses resulting from future man-made catastrophic events, such as acts of war, acts of terrorism and political instability. These risks are inherently unpredictable and recent events may lead to increased frequency and severity of losses. It is difficult to predict the timing of such events with statistical certainty or estimate the amount of loss any given occurrence will generate. It is not possible to eliminate completely our exposure to unforecasted or unpredictable events and, to the extent that losses from such risks occur, our financial condition and results of operations could be materially adversely affected. Therefore, claims for natural and man-made catastrophic events could expose us to large losses and cause substantial volatility in our results of operations, which could cause the value of our common shares to fluctuate widely.
In certain instances, we specifically insure and reinsure risks resulting from terrorism. Even in cases where we attempt to exclude losses from terrorism and certain other similar risks from some coverages written by us, we may not be successful in doing so. Moreover, irrespective of the clarity and inclusiveness of policy language, there can be no assurance that a result-oriented court or arbitration panel favoring the insured or ceding company will enforce the language as written; such a tribunal may adopt a strained interpretation of the policy language, invoke public policy to limit enforceability of policy language, ignore policy language, make factual findings unwarranted by the evidence or otherwise seek to justify a ruling adverse to us.
For 2003 exposures, our insurance operations have entered into a reinsurance treaty which provides coverage for catastrophe-related losses equal to 95% of the first $70 million in excess of a $50 million retention of such losses. In the future, we may seek to purchase additional catastrophe or other reinsurance protection. The availability and cost of such reinsurance protection is subject to market conditions, which are beyond our control. As a result of market conditions and other factors,
we may not be successful in obtaining such protection. See "-Reinsurance Protection and Recoverables" above.
We operate in a highly competitive environment, and since the September 11, 2001 events, new capital has entered the market. These factors may mitigate the benefits that the financial markets may perceive for the property and casualty insurance industry, and we cannot offer any assurances that we will be able to compete successfully in our industry or that the intensity of competition in our industry will not erode profitability for insurance and reinsurance companies generally, including us. In addition, we can offer no assurances that we will participate at all or to the same extent as more established or other companies in any price increases or increased profitability in our industry. If we do not share in such price increases or increased profitability, our financial condition and results of operations could be materially adversely affected.
All of these leases are for the rental of office space, with expiration terms that range from 2004 to 2012. Rental expense (income), net of income from subleases, was approximately $3.2 million, ($132,000) and $190,000 for the years ended December 31, 2002, 2001 and 2000, respectively.
In April 2002, we established a letter of credit facility for up to $200 million. The principal purpose of this facility is to issue, as required, evergreen standby letters of credit in favor of primary insurance or reinsurance counterparties with which we have entered into reinsurance arrangements. Such letters of credit when issued are secured by a portion of our investment portfolio. In addition, the letter of credit facility also requires the maintenance of certain financial covenants, which we were in compliance with at December 31, 2002. At such date, we had approximately $77.6 million in outstanding letters of credit which were secured by investments totaling $89.2 million. In addition to letters of credit, we have and may establish insurance trust accounts in the U.S. and Canada to secure our reinsurance amounts payable as required.
Our diluted per share book value at December 31, 2002 increased to $21.20 from $18.28 at December 31, 2001, as adjusted on a pro forma basis to give effect to the issuance during 2002 of additional preference shares, as described below. The increase in diluted book value per share was primarily attributable to the effects of (1) operating income for the year ended December 31, 2002, (2) an increase in unrealized appreciation of investments, (3) the issuance of 7,475,000 common shares in the stock offering completed in April 2002 and (4) the issuance of 3,748,946 common shares upon the exercise of 3,842,450 class A warrants in September 2002.
included in the number of common shares outstanding as if such shares were issued on the date of grant.
(3)Includes the net number of common shares that could be issued upon the assumed exercise of class A warrants calculated at December 31, 2001 using the treasury stock method. Class A warrants to purchase an aggregate of 5,401,707 common shares were outstanding as of December 31, 2001. Class A warrants were exercisable at $20 per share and were scheduled to expire on September 19, 2002. During 2002, all 5,401,707 class A Warrants that were outstanding as of December 31, 2001 were exercised, which resulted in the issuance of 4,195,554 common shares and the receipt by us of cash proceeds totaling $74.3 million.
under the Subscription Agreement. For a more detailed description of these adjustment provisions, see "Our Company-Risk Factors-Risks Relating to Our Company-We may be required to issue additional preference shares to the investors in the November 2001 capital infusion as a result of various purchase price adjustments agreed to in connection with it, and the value of our common shares may, therefore, be further diluted."
We are exposed to potential loss from various market risks, including changes in equity prices, interest rates and foreign currency exchange rates.
In accordance with the SEC's Financial Reporting Release No. 48, we performed a sensitivity analysis to determine the effects that market risk exposures could have on the future earnings, fair values or cash flows of our financial instruments as of December 31, 2002. Market risk represents the risk of changes in the fair value of a financial instrument and consists of several components, including liquidity, basis and price risks.
The sensitivity analysis performed as of December 31, 2002 presents hypothetical losses in cash flows, earnings and fair values of market sensitive instruments which were held by us on December 31, 2002 and are sensitive to changes in interest rates and equity security prices. This risk management discussion and the estimated amounts generated from the following sensitivity analysis represent forward-looking statements of market risk assuming certain adverse market conditions occur. Actual results in the future may differ materially from these projected results due to actual developments in the global financial markets. The analysis methods used by us to assess and mitigate risk should not be considered projections of future events of losses.
Foreign currency rate risk is the potential change in value, income, and cash flow arising from adverse changes in foreign currency exchange rates. A 10% depreciation of the U.S. dollar against other currencies under our outstanding contracts at December 31, 2002 would have resulted in approximately $8.7 million of unrealized losses. For further discussion on foreign exchange activity, please refer to "-Results of Operations-Net Foreign Exchange Gains or Losses."
See our consolidated financial statements and notes thereto and required financial statement schedules on pages through and S-1 through S-7 below.