The following is a discussion and analysis of the Company’s results of operations for the year ended December 31, 2002 compared to the year ended December 31, 2001, and for the year ended December 31, 2001 compared to the year ended December 31, 2000 and also a discussion of the Company’s financial condition as of December 31, 2002. Certain results for the year ended December 31, 2002 discussed herein differ from those reported in the Company’s earnings release dated February 3, 2003 due to additional information pertaining to 2002 that was received subsequent to the earnings release date. The Company does not believe that these results materially differ from those reported in the earnings release. This discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes that are included in this Annual Report.
The Company is a Bermuda-based provider of reinsurance and insurance products for both the property and casualty and the life and annuity, including disability, markets. The property and casualty market has been presenting more opportunities to the Company than the life and annuity market since the September 11, 2001 tragedy, which has increased demand for property and casualty products. Further, a weak global economy and corrections in the global capital markets over the last several years have resulted in a widening pricing gap between buyers and sellers for the type of life and annuity reinsurance products that the Company offers. The Company anticipates continuing greater demand for its property and casualty products than for its life and annuity products for the foreseeable future.
The Company’s principal operating subsidiary is Max Re. At December 31, 2002, Max Re had $701.4 million of shareholders’ equity. The Company conducts its European activities through Max Re Europe. The Company also provides reinsurance underwriting and administrative services on a fee basis through Max Re Managers. The Company holds all of its alternative investments in Max Re Diversified other than reinsurance private equity investments that are held by Max Re.
Expenses consist primarily of three types-losses, benefits and experience refunds, acquisition costs, and general and administrative expenses. Losses, benefits and experience refunds are based on the amount and type of reinsurance and insurance contracts written by the Company during the current reporting period and information received during the current reporting period from ceding companies pertaining to contracts written in prior years. The Company records losses, benefits and experience refunds based on an actuarial analysis of an estimate of the expected losses, benefits and experience refunds to be incurred on each contract written. The ultimate losses, benefits and experience refunds depend on the actual costs to settle claims. The Company increases or decreases losses, benefits and experience refund estimates as actual claim reports are received. The Company’s ability to estimate losses, benefits and experience refunds accurately at the time of pricing its contracts is a critical factor in determining profitability.
General and administrative expenses are principally employee salaries and related personnel costs, rent and other operating costs. These costs are primarily fixed in nature and do not vary with the amount of premiums written.
The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”), which require management to make estimates and assumptions. The Company believes that the following accounting policies affect the more significant judgments and estimates used in the preparation of its consolidated financial statements.
for Reinsurance of Short-Duration and Long-Duration Contracts,” in determining the accounting for its reinsurance and insurance products. Assessing whether or not the contracts it writes meets the conditions for risk transfer requires judgment. The determination of risk transfer is fundamental to the Company’s determination of gross premiums written and is based, in part, on the use of actuarial and pricing models and assumptions.
Reinstatement and additional premiums are recognized and earned at the time losses are reported to the Company. Reinstatement premiums are the premiums charged for the restoration of the reinsurance limit of a contract to its full amount after payment by the reinsurer of losses as a result of an occurrence. Additional premiums are premiums charged based on loss experience during the policy term or coverage period.
Under GAAP, the Company is not permitted to establish loss reserves until the occurrence of an event that may give rise to a loss. Once such an event occurs, the Company establishes reserves based upon estimates of total losses incurred by the ceding client as a result of the event and the Company’s estimate of the portion of such loss it has reinsured. As a result, only loss reserves applicable to losses incurred up to the reporting date may be recorded, with no allowance for the provision of a contingency reserve to account for expected future losses.
The Company’s investments are carried at fair value or amounts that approximate fair value. Fair value for the Company’s investments in fixed maturities is based generally on quoted market prices, dealer quotes or pricing models. At December 31, 2002, the valuation of approximately 95% of the Company’s fixed maturities portfolio was based on quoted market prices. Fair value for the Company’s alternative investments is generally based on the net asset value reported by the respective investment fund managers or, for its reinsurance equity investments, based on the carried amount under the equity method of accounting. The investment fund managers generally carry their trading positions and investments at fair value. The Company relies principally on the financial reports from these entities for recording the net gains on alternative investments in its statement of income. For its equity investments, the Company initially records the investments at cost and periodically adjusts the carrying values to recognize its proportionate share of income or loss from these investments. Future adverse changes in general market, global and economic conditions, changes to the interest and currency rate environment or poor operating results by the Company’s investments carried under the equity method of accounting could result in losses.
See Note 2 to the audited consolidated financial statements of the Company included herein for the Company’s significant accounting policies.
Premiums ceded. Premiums ceded for the year ended December 31, 2002 were $54.7 million compared to $116.4 million for the year ended December 31, 2001. The premiums ceded were principally related to the Company’s quota-share retrocessional agreement with Grand Central Re. The decline in premiums ceded by 53.0% in the year is a result of the decline in the volume of life and annuity business written by the Company and the change in the mix of property and casualty business written.
Net premiums written. Net premiums written for the year ended December 31, 2002 were $592.7 million compared to $594.2 million for the year ended December 31, 2001. Net premiums written for property and casualty products for the year ended December 31, 2002 were $580.2 million compared to $412.6 million for the year ended December 31, 2001. Net premiums written for life and annuity products for the year ended December 31, 2002 were $12.5 million compared to $181.6 million for the year ended December 31, 2001.
Net premiums earned. Net premiums earned for the year ended December 31, 2002 were $388.0 million compared to $500.9 million for the year ended December 31, 2001, a decline of 22.5%. Property and casualty net premiums earned were $375.5 million, after the deduction of $44.4 million of earned premiums ceded, for the year ended December 31, 2002 compared to $319.3 million, after the deduction of $66.6 million of earned premiums ceded, for the year ended December 31, 2001. Life and annuity net premiums earned were $12.5 million, after the deduction of $2.2 million of earned premiums ceded, for the year ended December 31, 2002 compared to $181.6 million, after the deduction of $32.4 million of earned premiums ceded, for the year ended December 31, 2001. The difference between net premiums written and net premiums earned for the years ended December 31, 2002 and 2001 reflects the fact that most of the Company’s property and casualty reinsurance contracts are written on a prospective basis, with the premium earned over the period reinsurance protection is provided, whereas each of the Company’s life and annuity contracts assumes the existing risk of the reinsured, and, accordingly, the related premium is earned at the time the Company enters into the contract.
Net investment income. Net investment income, excluding realized and unrealized gains and losses, for the year ended December 31, 2002 increased $20.5 million to $64.4 million compared to $43.9 million for the year ended December 31, 2001. The increase was primarily attributable to the growth in the fixed maturities portfolio from $884.1 million to $1,279.6 million resulting from cash received from the collection of premiums written since December 31, 2001 and $6.4 million of additional investment income earned from premiums and deposits withheld by clients during the year ended December 31, 2002 compared to calendar year 2001. The average investment yield on the fixed maturities portfolio for the year ended December 31, 2002 was 5.19% compared to an average yield of 6.15% for the year ended December 31, 2001.
Losses, benefits and experience refunds. Losses, benefits and experience refunds were $379.3 million for the year ended December 31, 2002 compared to $524.4 million for the year ended December 31, 2001. Property and casualty losses and experience refunds were $328.0 million for the year ended December 31, 2002 compared to $322.0 million for the year ended December 31, 2001. The increase in property and casualty losses and experience refunds was smaller than the increase in property and casualty net premiums written and net premiums earned as the Company’s business mix changed during the year 2002. During the year ended December 31, 2002, incurred losses related to prior years contracts amounted to $49.9 million, and includes amortization of deferred charges on retrospective property and casualty reinsurance contracts of $6.3 million. The Company recognized additional premiums and interest on those premiums, net of acquisition costs, of $37.8 million, substantially mitigating the losses incurred on prior years contracts. One contract written during calendar year 2000 accounted for $41.2
million of the prior year incurred losses amount. The contract was a whole account stop loss cover, with worker’s compensation as the principal underlying risk, providing reinsurance for calendar year 1999, where losses incurred and settled through December 31, 2002 by the underlying reinsured exceeded the Company’s estimates and consequently resulted in additional losses being recorded by the Company. Life and annuity benefits and experience refunds were $51.2 million for the year ended December 31, 2002 compared to $202.4 million for the year ended December 31, 2001. The decrease was principally attributable to the lower volume of life and annuity premiums written and earned in 2002 compared to 2001. The Company recorded net adverse mortality and morbidity expense of $7.0 million during the year ended December 31, 2002 resulting principally from worse than expected claims experience on a coinsurance transaction involving group long term disability written during calendar year 2000.
Acquisition costs. Acquisition costs were $97.7 million for the year ended December 31, 2002 compared to $30.9 million for the year ended December 31, 2001. The increase in acquisition costs was a result of the Company’s increase in property and casualty reinsurance volume and a change in the mix and ceding commission rates of contracts written in 2002 compared to 2001. Acquisition costs during each of the years ended December 31, 2002 and 2001 consisted primarily of amortization of deferred policy acquisition costs incurred in connection with writing property and casualty business. Acquisition costs are customarily associated with the type of premium written by the Company. Generally, acquisition costs fluctuate with business volume and changes in product mix. The largest component of deferred policy acquisition costs are ceding commissions paid to the buyer of the Company’s reinsurance products.
General and administrative expenses. General and administrative expenses were $21.3 million for the year ended December 31, 2002 compared to $21.0 million for the year ended December 31, 2001. The increase reflects the costs associated with growing the Company’s operations and principally relates to staff additions, offset by decreased bonuses paid to management and employees in 2002 compared to 2001. The general and administrative expense ratio was 5.5% for the year ended December 31, 2002 compared to 4.2% for the year ended December 31, 2001.
related to the Company’s quota-share retrocessional agreement with Grand Central Re, which incepted January 1, 2001.
Losses, benefits and experience refunds. Losses, benefits and experience refunds were $524.4 million for the year ended December 31, 2001 compared to $408.2 million for the year ended December 31, 2000. Property and casualty losses and experience refunds were $322.0 million for the year ended December 31, 2001 compared to $109.3 million for the year ended December 31, 2000. The increase in property and casualty losses and experience refunds was directly related to the increase in property and casualty premiums written and earned and loss reserve adjustments on premiums written in prior years. In the aggregate, the Company took a gross charge of $5.0 million for estimated claims related the September 11, 2001 terrorist attacks on the World Trade Center. After consideration of reinsurance recoveries and additional premiums on contracts incurring losses from these attacks, the Company’s net provision was $3.0 million. Life and annuity benefits and experience refunds were $202.4 million for the year ended December 31, 2001 compared to $298.9 million for the year ended December 31, 2000. The decrease was attributable to the lower volume of life and annuity premiums written and earned in 2001 compared to 2000.
Acquisition costs. Acquisition costs were $30.9 million for the year ended December 31, 2001 compared to $15.4 million for the year ended December 31, 2000. The increase in acquisition costs was a
Net income. Net income for the year ended December 31, 2001 was $2.5 million compared to net income of $8.7 million for the year ended December 31, 2000.
Cash and invested assets. Aggregate invested assets, comprising cash, fixed maturities and alternative investments were $2,024.8 million at December 31, 2002 compared to $1,610.2 million at December 31, 2001. The increase in cash and invested assets from 2001 to 2002 resulted principally from $225.4 million in cash flows from operations generated in 2002, a $100 million bank loan, $36.1 million in net amounts received under deposit liability contracts and $35.6 million in net unrealized appreciation of the Company’s fixed maturities portfolio.
Central Re. The Company believes that the terms of this letter of credit facility are comparable to the terms that the Company would expect to negotiate at arms’ length with an unrelated party. At December 31, 2002, letters of credit totaling $58.5 million were issued by HVB under this facility. All letters of credit issued under these facilities are collateralized by a portion of the Company’s invested assets. The Company was in compliance with all the covenants of its letter of credit facilities at December 31, 2002.
In connection with the lease of an office building currently under construction in Hamilton, Bermuda, the Company has contractual commitments of approximately $4.4 million for leasehold improvements as of December 31, 2002. The Company anticipates taking occupancy of the building, which will become its corporate headquarters, by May 2003.
In January 2003, the FAS Interpretation No. 46-Consolidation of Variable Interest Entities was issued. This interpretation of Accounting Research Bulletin No. 51-Consolidated Financial Statements addresses consolidation by business enterprises of variable interest entities that have certain characteristics. This interpretation applies to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies from June 15, 2003 to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. The adoption of this interpretation is not expected to have a significant impact on the Company’s financial reporting.
Proposed Statement of Position-Accounting for Certain Nontraditional Long-Duration Contracts and for Separate Accounts