Scottish Holdings is a holding company organized under the laws of the Cayman Islands with its principal executive office in Bermuda. We are a reinsurer of life insurance, annuities and annuity-type products. These products are written by life insurance companies and other financial institutions located principally in the United States, as well as around the world. We refer to this portion of our business as life reinsurance. To a lesser extent, we directly issue variable life insurance and variable annuities and similar products to high net worth individuals and families for insurance, investment and estate planning purposes. We refer to this portion of our business as wealth management.
In our wealth management business, when we sell a variable life insurance policy or a variable annuity contract, we charge mortality, expense and distribution risk fees that are based on total assets in each policyholder's separate account. In the case of variable life insurance policies, we also charge a cost of insurance fee based on the amount necessary to cover the death benefit under the policy. We also earn fees in our financial reinsurance transactions with U.S. insurance company clients. Because some of these transactions do not satisfy the risk transfer rules for reinsurance accounting, the premiums and benefits are not reported in the consolidated statements of income.
Realized gains and losses include gains and losses on investment securities that we sell during a period and write downs of securities deemed to be other than temporarily impaired.
When we issue a life reinsurance contract, we establish reserves for benefits. These reserves are our estimates of what we expect to pay in claims and policy benefits and related expenses under the contract or policy. From time to time we may also add to reserves if our experience leads us to believe that benefit claims and expenses will ultimately be greater than the existing reserve. We report the provision for these reserves as an expense during the period when the reserve or additional reserve is established.
Our results of operations for each of the years ended December 31, 2001, 2000 and 1999 do not include the results of operations of World-Wide Holdings, which we acquired at the close of business on December 31, 2001.
Our net income for the year ended December 31, 2001 increased 5% to $16.8 million from $16.0 million in 2000, which was an increase of 80% from $8.9 million in 1999. The increases in earnings in 2001 and 2000 are primarily due to increased income from life reinsurance and wealth management operations and an increase in investment income due to the increase in average invested assets, offset in part in 2001 by an increase in realized losses on fixed maturity investments.
Net operating earnings excludes the effect of net realized capital gains and losses, net of deferred acquisitions costs, and non-recurring events and transactions. We determine net operating earnings by adjusting GAAP net income for net realized capital gains and losses, as adjusted for the related effects upon the amortization of deferred acquisition costs, and non-recurring items that we believe are not indicative of overall operating trends. While these items may be significant components in understanding and assessing our consolidated financial performance, we believe the presentation of net operating earnings enhances the understanding of our results of operations by highlighting earnings attributable to the normal, recurring operations of our business. However, net operating earnings are not a substitute for net income determined in accordance with GAAP.
Wealth management fees increased in 2001 by 43% to $3.1 million from $2.2 million in 2000 which was a 115% increase from $1.0 million in 1999. The growth has been primarily due to increases in variable account balances on which we earn fees and the increase in the number of clients.
Wealth management fees are earned from both life and annuity clients. The following table summarizes our client base with the associated segregated assets and policy face amounts.
Net investment income increased by $6.9 million or 15% to $51.7 million in 2001 from $44.8 million in 2000 primarily as a result of an increase in average invested assets. Funds withheld at interest grew from $46.3 million to $562.4 million; since most of this growth occurred in the second half of the year, its contribution to income was for only part of the year. Excluding funds withheld at interest and the World-Wide Holdings portfolio, which was added at year end, our general account portfolio declined during the year. This decline was the net result of the recapture by a ceding company of $185.7 million of assets on April 30, 2001, offset in part by the addition of investments funded by new transactions and borrowings. During 2001, as compared to 2000, average book yields were lower, particularly on floating rate assets and cash. Yields on floating rate assets generally move with LIBOR, which decreased
significantly during 2001. On the $581.1 million portfolio managed by NEAM, the yields on fixed rate assets were 7.09% and 7.12% at December 31, 2001 and 2000, respectively. Between those dates, however, LIBOR decreased to 1.88% from 6.40%, causing the yield on floating-rate assets to decrease to 4.43% from 7.82% and the yield on cash and cash equivalents to decrease to 2.20% from 5.70%. Since the floating-rate assets were funded by floating-rate liabilities, the decrease in yield on floating-rate assets had no material effect on earned margins.
Net investment income increased by $20.7 million or 86% from $24.1 million in 1999 to $44.8 million in 2000 as a result of growth in invested assets plus an increase in our average book yield from 6.75% in 1999 to 7.24% in 2000.
For the year ended December 31, 2001, realized losses on investments were $5.4 million as compared to $0.2 million in 2000 and $2.6 million in 1999. The realization of losses in 2001 was due to the sale and write down of carrying values of securities, predominately securities issued by Enron and its affiliate, Osprey. These losses were offset in part by gains realized primarily for tax purposes on bonds in the portfolio of Scottish Re (U.S.), Inc. and gains of $529,000 on assets sold to fund part of the recapture of a block of business by one client on April 30, 2001.
Interest credited to interest sensitive contract liabilities increased by $0.2 million or 1% to $17.6 million in 2001 from $17.4 million in 2000, which was an increase of $11.8 million from $5.5 million in 1999. The movement in 2001 was the net effect of interest credited on new 2001 reinsurance treaties and increases in interest credited to treaties which commenced in 2000 and 1999 due to increasing average liability balances, which was offset by the $8.5 million effect of the recapture of a block of business by one client on April 30, 2001. The increase from 1999 to 2000 was due to increases in the number of treaties and the increase in average liability balances.
Acquisition costs and other insurance expenses increased by $5.6 million or 33% to $22.8 million in 2001 from $17.2 million in 2000, which was an increase of $15.2 million from $2.0 million in 1999. The increases from 1999 were the result of the increased number of reinsurance clients in our life reinsurance business and the increase in premiums earned over the last two years.
Commissions and excise taxes vary with premiums earned. Other insurance expenses include direct and indirect expenses of those departments involved in the marketing, underwriting and issuing of reinsurance treaties. Of these total expenses a portion is deferred and amortized over the life of the reinsurance treaty or in relation to the estimated gross profit in respect of our interest sensitive contracts.
Other operating expenses include executive salaries, head office expenses, legal and professional fees and other expenses not related to either our life reinsurance or wealth management lines of business. Other operating expenses increased significantly in 2001 due to the cost of setting up our principal executive office in Bermuda, an increase in the number of executive staff including a full year of the salaries of those staff who joined us in 2000 and increases in legal and professional expenses.
There are two Statements of Financial Accounting Standards ("SFAS") that apply to our insurance business and the related reserves and deferred acquisition costs:
Fixed maturity investments are evaluated for other than temporary impairments in accordance with SFAS 115 and EITF 99-20 as described in Note 2 to the consolidated financial statements. Under these pronouncements, realized losses are recognized on securities if the securities are determined to be other than temporarily impaired. Factors involved in the determination of potential impairment include fair value as compared to cost, length of time to maturity, length of time the value has been below cost, creditworthiness of the issuer, forecasted financial performance of the issuer, and interest rates. Changes in these factors could result in additional writedowns being necessary. At December 31, 2001 investments were written down by $4.0 million to their estimated realizable values.
The below table illustrates the fixed income investment portfolio (market value) credit exposure by category as assigned by Standard & Poor's.
The below table illustrates the fixed income investment portfolio (market value) sector exposure.
The December 31, 2001 data in the tables above includes the World-Wide Holdings investment portfolio and excludes unit-linked securities, which are discussed more fully in Note 2 to the consolidated financial statements. All the data excludes the assets held by ceding insurers under modified coinsurance agreements.
During 2001, we paid quarterly dividends totaling $3.1 million or $0.20 per share ($3.2 million or $0.20 per share in 2000 and $2.7 million or $0.15 per share in 1999).
- when Scottish Annuity & Life Insurance Company (Cayman) Ltd. enters into a reinsurance treaty with a U.S. customer, it must pledge assets into a reserve credit trust with a U.S. bank in order that the ceding company may obtain reserve credit for the reinsurance transaction; in some cases, a letter of credit may be substituted for all or a portion of a reserve credit trust;
- when Scottish Re (U.S.), Inc. enters into a reinsurance transaction, it typically incurs a need for additional statutory capital; this need can be met by its own capital surplus, an infusion of cash or assets from Scottish Annuity & Life Insurance Company (Cayman) Ltd. or by ceding a portion of the transaction to another company within the group or an unrelated reinsurance company, in which case that reinsurer must provide reserve credit by pledging assets in a reserve credit trust or pledging assets to a bank to support a letter of credit;
- Scottish Re (U.S.), Inc. is licensed, accredited, approved or authorized to write reinsurance in 46 states and the District of Columbia. When Scottish Re (U.S.), Inc. enters into a reinsurance transaction with a customer domiciled in a state in which it is not a licensed, accredited, authorized or approved reinsurer, it likewise must provide a reserve credit trust or letter of credit; and
- even when Scottish Re (U.S.), Inc. is licensed, accredited, approved or authorized to write reinsurance in the state, it may agree with a customer to provide a reserve credit trust or letter of credit voluntarily to mitigate the counter-party risk from the customer's perspective, thereby doing transactions that would be otherwise unavailable or would be available only on significantly less attractive terms; such a requirement most often arises in connection with interest-sensitive liabilities.
Scottish Holdings and Scottish Annuity & Life Insurance Company (Cayman) Ltd. may, from time to time, execute additional agreements guaranteeing the performance and/or obligations of their subsidiaries.
- uncertainties relating to government and regulatory policies (such as subjecting us to insurance regulation or taxation in additional jurisdictions);
- changes in the rate of policyholder withdrawals or recapture of reinsurance treaties;
- the competitive environment in which we operate and associated pricing pressures; and
The effects of these factors are difficult to predict. New factors emerge from time to time and we cannot assess the potential impact of any such factor on the business or the extent to which any factor, or combination of factors, may cause results to differ materially from those contained in any forward-looking statement. Any forward-looking statement speaks only as of the date of this report and we do not undertake any obligation to update any forward-looking statement to reflect events or circumstances after the date of such statement or to reflect the occurrence of unanticipated events.