Everest Re’s corporate offices are located in approximately 115,000 square feet of leased office space in Liberty Corner, New Jersey. The Company’s other eleven locations occupy a total of approximately 71,000 square feet, all of which are leased. Management believes that the above-described office space is adequate for its current and anticipated needs.
The following is a discussion of the results of operations and financial condition of the Company. This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and accompanying notes thereto presented under ITEM 8, “Financial Statements and Supplementary Data”.
The Company competes in the U.S. and international reinsurance and insurance markets with numerous international and domestic reinsurance and insurance companies. The Company’s competitors include independent reinsurance and insurance companies, subsidiaries or affiliates of established worldwide insurance companies, reinsurance departments of certain insurance companies and domestic and international underwriting operations, including underwriting syndicates at Lloyd’s. Some of these competitors have greater financial resources than the Company and have established long-term and continuing business relationships throughout the industry, which can be a significant competitive advantage. In addition, the potential for securitization of reinsurance and insurance risks through capital markets provides an additional source of potential reinsurance and insurance capacity and competition.
In 2004, the favorable market conditions, which had developed during 2000 through 2003, generally began to weaken. There were signs that pricing for most property classes declined modestly and that pricing for most casualty classes softened. Competition increased, in part due to the relative profitability achieved by many reinsurers over 2002 and 2003 and the attendant buildup of capital in these participants. However, this profitability and capital buildup varied significantly by market participant, reflecting the fact that the industry generally still remained exposed to fundamental issues that had negatively impacted its aggregate capacity in 2002 and 2003, including weak investment market conditions and adverse loss emergence. Both of these had tended to depress the industry’s aggregate financial performance and perceptions of financial strength of industry participants over this period albeit with significant variation by individual market participant. The industry experienced a record level of catastrophe losses during 2004, particularly in the second half of the year, and it remains unclear whether the aggregate catastrophe losses experienced by the industry will reverse, stop or even moderate the trends toward market softening, particularly as respects property classes.
operating practices, competitive strategies and business volumes. Across all market participants, however, the aggregate general effect was depressed financial results and erosion of the industry capital base. Coupled with deteriorating investment market conditions and results, and renewed concerns regarding longer-term industry specific issues, including asbestos exposure and sub-par capital returns, these financial impacts introduced substantial, and in some cases extreme, pressure for the initiation and/or strengthening of corrective action by individual market participants. These pressures, aggregating across industry participants, reinforced the trend established in 2000 through 2003 toward firming prices, more restrictive terms and conditions, tightened coverage availability across most classes and markets and increasing concern with respect to the financial security of insurance and reinsurance providers, impacts which set the stage for the 2004 trends discussed above.
Effective January 1, 2004, Everest Re sold its UK branch to Bermuda Re and in conjunction with the sale, Everest Re provided a reserve indemnity agreement for adverse development on loss and loss adjustment expenses (“LAE”) reserve balances as of December 31, 2002, as well as made sale related adjustments for the 2003 and 2002 quota share cessions. In order to provide comparability of the financial results between the years, the 2003 and 2002 results need to be adjusted to exclude the UK branch activity. For the year ended December 31, 2003, gross written premiums, net written premiums, premiums earned, incurred losses and LAE and other operating expenses would decrease by $443.5 million, $325.9 million, $290.3 million, $202.7 million and $68.3 million, respectively. For the year ended December 31, 2002, gross written premiums, net written premiums, premiums earned, incurred losses and LAE and underwriting expenses would decrease by $186.5 million, $155.8 million, $133.6 million, $97.4 million and $28.3 million, respectively. Effectively, these adjustments remove the UK branch from the operating results for the years ended December 31, 2003 and 2002.
Additionally, in order to provide comparability of the financial results between the years, the 2004 results need to be adjusted to exclude the one-time effects associated with the branch sale. As a result of that adjustment, net written premiums would decrease by $139.8 million and premiums earned, incurred losses and LAE and underwriting expenses would decrease by $118.8 million, $118.6 million and $30.9 million, respectively. This adjusts the operating results for the year ended December 31, 2004 to exclude the one-time effects related to the sale.
Due to the nature of its businesses, the Company is unable to precisely differentiate between the effects of price changes as compared to the effects of changes in exposure. Similarly, because individual reinsurance arrangements often reflect revised coverages, structuring, pricing, terms and/or conditions from period to period, the Company is unable to differentiate between the premium volumes attributable to new business as compared to renewal business. Management believes, however, that on balance, the Company’s growth has been reasonably balanced between growth in exposures underwritten and increased pricing and/or improved terms and conditions. Management believes further that market conditions, although changing, remain generally more favorable for casualty business classes than for property business classes; however, management notes that it continues to see business opportunities in most product classes and markets. Although premium volumes on a year to date basis have decreased only slightly, the Company continues to decline business that does not meet its objectives regarding underwriting profitability, a discipline which became more apparent over the second half of 2004 with quarterly volumes for the third and fourth quarters which reflected year over year declines in gross premiums written.
In June 2004, the Company received notification of termination with respect to its contract with American All-Risk Insurance Services, LLC, its single largest producer of California workers’ compensation insurance. In 2004, American All-Risk Insurance Services, LLC accounted for approximately 9.6% of the Company's total gross written premiums. Under the terms of the contract, the agency continued to produce business exclusively for the Company through October 15, 2004. The business produced under this relationship will continue in force through the policy expiration dates or cancellation. The Company does not believe that the termination of this contract will have a material adverse effect on future Company operations and believes the termination was not entirely inconsistent with its plan to moderate its writings in this market.
Incurred losses and LAE for the year ended December 31, 2004 were $2.1 billion, an increase of 14.3% compared with $1.8 billion for the year ended December 31, 2003, which had increased 38.1% compared with the year ended December 31, 2002. Incurred losses and LAE for the year ended December 31, 2002 were $1.3 billion, an increase of 32.6% compared with the year ended December 31, 2001. The major contributing factor for the increases in 2004 was the increase in incurred losses and LAE due to property catastrophe net event losses of $257.5 million, arising principally from hurricanes Charley, Frances, Ivan and Jeanne, Pacific typhoons, Edmonton hailstorms and the Asian tsunami. Other factors, including the level of incurred losses and LAE related to changes in volume as measured by earned premium, changes in rates, and terms and the effect of changes in prior period loss reserve estimates, also contributed. The increase in incurred losses and LAE
In the workers’ compensation insurance class, the majority of which was written in California, the Company has experienced adverse development primarily for accident years 2001 and 2002. As a result of significant growth in this book of business in a challenging business environment, the Company’s writings in this class were relatively more subject to variability than are some of its more established and/or stable lines of business. Although cumulative results through 2003 continue to be profitable for this book of business, there has been some deterioration in claim frequency and severity related to accident years 2001 and 2002, which the Company generally attributes to the growth of this portfolio of business
Net investment income was $329.2 million for the year ended December 31, 2004, an increase of 15.6% compared with $284.8 million for the year ended December 31, 2003, which had increased 10.4% compared with the year ended December 31, 2002. Net investment income for the year ended December 31, 2002 was $258.0 million, a decrease of 3.0% compared with the year ended December 31, 2001. The year ended December 31, 2004 included a $32.7 million increase arising from an atypical increase in the value of one of the Company’s limited partnership investments. Excluding this increase, the net investment income increase generally reflected growth in the Company’s cash and invested assets. Premiums are generally collected over the first 12 to 15 months of the Company’s reinsurance and insurance contract, while related losses are typically paid out over several years. This tends to increase cash flow from operations when premiums are increasing. The Company’s cash flow from operations was $921.6 million, $1,051.0 million and $431.8 million for the years ended December 31, 2004, 2003 and 2002, respectively. Cash flow from operations was impacted in particular by increased loss payments relating to catastrophe losses and net asbestos claim settlements in 2004. Coupled with the issuance of junior subordinated debt securities, this contributed to the growth in the Company’s total investments and cash to $7,496.3 million.
The Company’s income tax expense is primarily a function of the U.S. statutory tax rate and the impact from tax preferenced investment income. Additionally, in conjunction with the transfer of the Company’s UK Branch to Bermuda Re, there were various tax issues giving rise to incremental net tax expenses in 2004. The Company incurred income tax expenses of $56.1 million, $61.0 million and $24.8 million for the years ended December 31, 2004, 2003 and 2002, respectively. The slight decrease in tax expense primarily reflected the impact of the catastrophe losses on 2004 operating results, which were partially offset by additional taxable net investment income, taxable realized capital gains and the expense associated with the transfer of the UK branch.
Effective January 1, 2004, Everest Re sold its United Kingdom branch to Bermuda Re, a Bermuda insurance company and a direct subsidiary of Group. Business for this branch was previously included in the International segment and is now included in the Bermuda segment. Due to the sale and in accordance with FAS 131, the Company restated the International segment for the years ended December 31, 2003 and 2002 to conform to December 31, 2004 segment reporting. For the year ended December 31, 2003 the International segment was adjusted to exclude the UK branch activity. As a result of that adjustment, gross written premiums, net written premiums, premiums earned, incurred losses and LAE and other expenses decreased by
The following tables reflect reconciliations from reported to proforma for the International segment for the periods indicated:
Premiums. Gross written premiums decreased 0.8% to $3,820.7 million in 2004 from $3,850.1 million in 2003, reflecting increased competitive pressures on pricing, particularly on U.S. Reinsurance property and casualty classes of business. Adjusting to these market conditions, the U.S. Reinsurance operation decreased 15.6% ($274.1 million), principally relating to a $142.5 million decrease in treaty casualty business, a $74.9 million decrease in facultative business, a $32.6 million decrease in treaty property business and a $19.8 million decrease in treaty non-property business. The Specialty Underwriting operation decreased 3.1% ($15.8 million), resulting primarily from a $70.4 million decrease in A&H business, partially offset by an increase in surety business of $29.6 million and an increase in marine and aviation business of $25.0 million. Partially offsetting these decreases were areas where the company continued to grow. The International operation saw a 30.9% ($162.2 million) increase, primarily due to a $97.7 million increase in international business written through the Miami and New Jersey offices, representing primarily Latin American business, and a $67.2 million increase in Asian business. The U.S. Insurance operation grew 9.2% ($98.3 million), principally as a result of a
Ceded premiums decreased to $1,027.7 million in 2004 from $1,088.4 million in 2003, principally resulting from the inclusion in 2003 of $49.6 million in adjustment premiums relating to claims made under the 2000 accident year aggregate excess of loss element of the Company’s corporate retrocessional programs, compared with no such adjustment premiums in 2004. Ceded premiums relate primarily to quota share reinsurance agreements between Everest Re and Bermuda Re and Everest International. Under these agreements Everest Re ceded to Bermuda Re 22.5% and to Everest International 2.5% of its net retained liability on all new and renewal policies written for underwriting year 2004, Everest Re ceded to Bermuda Re 25% of its net retained liability on all new and renewal policies written for underwriting year 2003, Everest Re ceded to Bermuda Re 20% of its net retained liability on all new and renewal polices written for underwriting year 2002, and Everest Re’s Canadian branch ceded to Bermuda Re 50% of its net retained liability on all new and renewal property polices written for the 2004 and 2003 underwriting years.
Net written premiums increased by 1.1% to $2,793.0 million in 2004 from $2,761.7 million in 2003, reflecting the decrease in gross written premiums, combined with a slightly larger decrease in ceded premiums.
Premium Revenues. Net premiums earned increased by 9.8% to $2,710.3 million in 2004 from $2,467.4 million in 2003. Contributing to this increase was a 45.7% ($148.1 million) increase in the International operation, a 9.0% ($95.0 million) increase in the U.S. Reinsurance operation and a 6.2% ($42.4 million) increase in the U.S. Insurance operation, partially offset by a 10.6% ($42.5 million) decrease in the Specialty Underwriting operation. All of these changes reflect period to period changes in net written 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, earnings, 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. Changes in estimates related to unreported reinsurance activity may also affect premiums earned.
Expenses. Incurred loss and LAE increased by 14.3% to $2,053.8 million in 2004 from $1,796.9 million in 2003. The increase in incurred losses and LAE was principally attributable to the provision for estimated catastrophe losses from hurricanes Charley, Frances, Ivan and Jeanne, the Pacific typhoons, the Asian tsunami and the net reserve adjustments for prior period losses, together with the mitigating effects of the impact of favorable changes in the Company’s underlying business mix and aggregate rates, terms and conditions.
The Company’s loss and LAE reserves reflect estimates of ultimate claim liability. Such estimates are reevaluated 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 reevaluations impacts incurred losses for the current period. The Company notes that its analytical methods and processes operate at multiple levels, including individual contracts, groupings of like contracts, classes and lines of business, internal business units, segments, legal entities, and in the aggregate. The complexities of the Company’s business and operations require analyses and adjustments, both qualitative and quantitative, at these various levels. Additionally, the attribution of reserves, changes in reserves and incurred losses between accident year and underwriting year requires adjustments and allocations, both qualitative and quantitative, at these various levels. All of these processes, methods and practices appropriately balance actuarial science, business expertise and management judgment in a manner intended to assure the accuracy, precision and consistency of the Company’s reserving practices, which are fundamental to the Company’s operation. The
Company notes, however, that the underlying reserves remain estimates, which are subject to variation, and that the relative degree of variability is generally least when reserves are considered in the aggregate and generally increases as the focus shifts to more granular data levels.
Incurred losses and LAE include catastrophe losses, which include the impact of both current period events and favorable and adverse development on prior period events and are net of reinsurance. Individual catastrophe losses are reported net of specific reinsurance, but before recoveries under corporate level reinsurance and potential incurred by not reported (“IBNR”) reserve offsets. The Company defines a catastrophe as a property event with expected reported losses of at least $5.0 million before corporate level reinsurance and taxes. Catastrophe losses, net of contract specific cessions and the inter-affiliate quota share reinsurance described above, were $257.5 million in 2004, relating principally to aggregate estimated losses of $290.9 million from hurricanes Charley, Frances, Ivan and Jeanne, Pacific typhoons, Edmonton hailstorms and the Asian tsunami, which were partially offset by $32.7 million of reserve reductions related to the World Trade Center events. Catastrophe losses, net of contract specific cessions and the inter-affiliate quota share reinsurance described above, were $22.3 million in 2003, relating principally to the May 2003 tornado and hailstorm events and hurricanes Fabian and Isabel.
The U.S. Reinsurance segment accounted for $103.4 million of net adverse prior period reserve adjustments for the year ended December 31, 2004, which included $34.2 million of favorable development due to the reserve reduction related to the catastrophe losses from the World Trade Center events, as compared to net adverse prior period reserve adjustments of $150.9 million for the year ended December 31, 2003. Asbestos exposures accounted for $10.3 million and $16.8 million of adverse reserve adjustments for the years ended December 31, 2004 and 2003, respectively, with the remainder principally attributable to professional liability and casualty business classes. During the late 1990s and early 2000s, there had been a proliferation of claims relating to bankruptcies and other financial management improprieties. This increased number of claims, combined with larger claims, has significantly increased incurred losses on the professional liability policies. In the general casualty area, the Company continues to experience losses greater than historical trends for accident years 1998 through 2001. These losses are being driven by adverse trends in litigation and economic variability. In both the professional liability and general casualty reinsurance areas, the Company relies upon loss reports from ceding companies. Although the Company may record reserves at higher levels than those reported by ceding companies, actual reported results have exceeded the initial loss indications.
Aggregate reserve development related to A&E exposures was $10.3 million and $16.8 million for the years ended December 31, 2004 and 2003, respectively. The Company has A&E exposure related to contracts written by the Company prior to 1986 and to claim obligations acquired as part of the Mt. McKinley acquisition in September 2000. The reserve strengthening on business written by the Company, net of reinsurance, was $10.3 million in 2004. Substantially all of the Company’s A&E exposures relate to insurance and reinsurance contracts with coverage periods prior to 1986. Given the uncertainties surrounding the settlement of A&E losses, management is unable to establish a meaningful range for these obligations.
Segment underwriting expenses increased by 3.7% to $633.1 million in 2004 from $610.8 million in 2003. Commission, brokerage, taxes and fees increased by $12.2 million, principally reflecting increases in premium volume and changes in the mix of business. Segment other underwriting expenses increased by $10.1 million as the Company continues to expand operations to support its increased business volume. Contributing to the segment underwriting expense increases were a 53.4% ($41.0 million) increase in the International operation and a 4.8% ($13.7 million) increase in the U.S. Reinsurance operation, which were all partially offset by a 18.9% ($27.0 million) decrease in the U.S. Insurance operation and a 5.1% ($5.4 million) decrease 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
with EITF 99-20. Net realized capital losses of $22.9 million in 2003 reflected realized capital losses on the Company’s investments of $51.5 million, which included $16.4 million relating to write-downs in the value of securities deemed to be impaired on an other than temporary basis and $25.2 million related to the impairment on interest only strips, partially offset by $28.6 million of realized capital gains, which included $12.5 million of realized capital gains on sales of the interest only strips.
The Company has one credit default swap, a type of contract which it no longer writes. This contract meets the definition of a derivative under Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”). There was no net derivative expense from this credit default transaction in 2004 and 2003.
YEAR ENDED DECEMBER 31, 2003 COMPARED TO YEAR ENDED DECEMBER 31, 2002
Ceded premiums increased to $1,088.4 million in 2003 from $535.2 million in 2002. This increase was principally attributable to $867.4 million of ceded premiums relating to quota share reinsurance agreements between Everest Re and Bermuda Re. Under these agreements Everest Re ceded to Bermuda Re 25% of its net
retained liability on all new and renewal policies written for underwriting year 2003, Everest Re ceded to Bermuda Re 20% of its net retained liability on all new and renewal policies written for underwriting year 2002, and Everest Re’s Canadian branch ceded to Bermuda Re 50% of its net retained liability on all new and renewal property policies written for the 2003 underwriting year. In addition, ceded premiums for 2003 included $49.6 million in adjustment premiums for the Company’s corporate retrocessional programs, while ceded premiums for 2002 included $5.1 million and $49.4 million in adjustment premium relating to claims made under the 2001 and 2000 accident year aggregate excess of loss elements of the Company’s corporate retrocessional programs, respectively.
Net written premiums increased by 35.8% to $2,761.7 million in 2003 from $2,033.7 million in 2002, reflecting the increase in gross written premiums, combined with the growth in ceded premiums.
Premium Revenues. Net premiums earned increased by 35.3% to $2,467.4 million in 2003 from $1,823.8 million in 2002. Contributing to this increase was a 61.1% ($402.2 million) increase in the U.S. Reinsurance operation, a 46.9% ($218.2 million) increase in the U.S. Insurance operation and a 17.7% ($48.7 million) increase in the International operation, which was partially offset by a 6.0% ($25.5 million) decrease in the Specialty Underwriting operation. All of these changes reflect period to period changes in net written 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 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.
The following table shows the net catastrophe losses for each of the Company’s operating segments for 2003 and 2002.
Net adverse prior period reserve adjustments related to A&E exposures were $16.8 million and $6.2 million for the years ended December 31, 2003 and 2002, respectively. The Company has A&E exposure related to contracts written by the Company prior to 1986 and to claim obligations acquired as part of the Mt. McKinley acquisition in September 2000. The adverse development on business written by the Company, net of reinsurance, was $16.8 million and the net adverse development on the acquired business was $0.0 million. Substantially all of the Company’s A&E exposures relate to insurance and reinsurance contracts with coverage periods prior to 1986.
Segment underwriting expenses increased by 16.5% to $610.8 million in 2003 from $524.4 million in 2002. Commission, brokerage, taxes and fees increased by $70.2 million principally reflecting increases in premium volume and changes in the mix of business. Other underwriting expenses increased by $16.2 million. Contributing to the $86.4 million increase in expenses were a 55.5% ($101.3 million) increase in the U.S. Reinsurance operation and a 3.9% ($5.3 million) increase in the U.S. Insurance operation, partially offset by a 15.5% ($19.6 million) decrease in the Specialty Underwriting operation and a 0.9% ($1.0 million) decrease in the International 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 reinsurance, including with Bermuda Re, and the underwriting performance of the underlying business. The Company’s expense ratio, which is calculated by dividing underwriting expenses by net premiums earned, was 24.8% for 2003 compared to 28.8% for 2002.
The Company’s combined ratio, which is the sum of the loss and expense ratios, decreased by 2.5 percentage points to 97.7% in 2003 compared to 100.2% in 2002. The following table shows the combined ratios for each of the Company’s operating segments for 2003 and 2002. The combined ratios for all operations were impacted by the loss and expense ratio variability noted above.
Imbedded after-tax yield of cash and invested assets at December 31, 2003 and 2002 .8%
Annualized pre-tax yield on average cash and invested assets for the twelve months
The Company has in its product portfolio a credit default swap contract, a type of contract which it no longer writes. This contract meets the definition of a derivative under FAS 133. There was no net derivative expense from this credit default transaction in 2003, compared to the $3.5 million derivative expense for 2002.
Income Taxes. The Company recognized income tax expense of $61.0 million in 2003 compared to an income tax expense of $24.8 million in 2002. The increase in taxes generally reflects the improved underwriting and investment income results.
This report contains forward-looking statements within the meaning of the U.S. federal securities laws. The Company intends these forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in the federal securities laws. In some cases, these statements can be identified by the use of forward-looking words such as “may”, “will”, “should”, “could”, “anticipate”, “estimate”, “expect”, “plan”, “believe”, “predict”, “potential” and “intend”. Forward-looking statements contained in this report include information regarding the Company’s reserves for losses and LAE, the adequacy of the Company’s provision for uncollectible balances, estimates of the Company’s catastrophe exposure, the effects of catastrophic events on the Company’s financial statements, the ability of Everest Re, Holdings and Bermuda Re to pay dividends and the settlement costs of the Company’s specialized equity put options. Forward-looking statements only reflect the Company’s expectations and are not guarantees of performance. These statements involve risks, uncertainties and assumptions. Actual events or results may differ materially from the Company’s expectations. Important factors that could cause the Company’s actual events or results to be materially different from the Company’s expectations include those discussed below under the caption “Risk Factors”. The Company undertakes no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.
circumstances known to it. In setting reserves for its reinsurance liabilities, the Company relies on claim data supplied by its ceding companies and brokers. This information is not always timely or accurate and can result in inaccurate loss projections. Because of the uncertainties that surround estimating loss reserves and LAE, the Company cannot be certain that ultimate losses will not exceed these estimates of losses and loss adjustment reserves. If the Company’s reserves are insufficient to cover its actual losses and loss adjustment expenses, the Company would have to augment its reserves and incur a charge to its earnings. These charges could be material. By way of illustration, during the past five calendar years, the reserve re-estimation process affected the Company’s net income in the following manner:
The difficulty in estimating the Company’s reserves is increased because loss reserves include reserves for potential A&E liabilities. A&E liabilities are especially hard to estimate for many reasons, including the long waiting periods between exposure and manifestation of any bodily injury or property damage, difficulty in identifying the source of the asbestos or environmental contamination, long reporting delays and difficulty in properly allocating liability for the asbestos or environmental damage. Legal tactics and judicial and legislative developments affecting the scope of insurers’ liability, which can be difficult to predict, also contribute to uncertainties in estimating reserves for A&E liabilities.
The failure to accurately assess underwriting risk could reduce the Company’s net income or generate a net loss.
The Company writes primarily property and casualty reinsurance and insurance. The worldwide reinsurance and insurance businesses are highly competitive, yet cyclical by product and market. These cycles, as well as other business, economic and societal trends that influence aggregate supply and demand for property and casualty insurance and reinsurance products, are outside of the Company’s control.
reinsurers over 2002 and 2003 and the attendant buildup of capital in these market participants. However, this profitability and capital buildup varied significantly by participant reflecting the fact that the industry generally still remained exposed to fundamental issues that had negatively impacted its aggregate capacity in 2002 and 2003, including weak investment market conditions and adverse loss emergence. Both of these had tended to depress the industry’s aggregate financial performance and perceptions of financial strength of industry participants over this period albeit with significant variation by individual market participant. The industry experienced a record level of catastrophe losses during 2004, particularly in the second half of the year, and it remains unclear whether the aggregate catastrophe losses experienced by the industry will reverse, stop or even moderate the trends toward market softening, particularly as respects property classes. Further discussion of competitive issues can be found in ITEM 1, “Business - Competition”.
The Company is generally less reliant on the purchase of third party reinsurance than many of its competitors, in part because of its strategic emphasis on underwriting discipline and management of the cycles inherent in its business. The Company tries to separate its risk taking process from its risk mitigation process in order to avoid developing too great a reliance on reinsurance. Thus, the Company generally evaluates, underwrites, selects and prices its products prior to consideration of reinsurance. However, the Company’s underwriters generally consider purchasing reinsurance with respect to specific insurance contracts or programs, and its senior management generally considers purchasing reinsurance with respect to its overall operations, where
reinsurance is deemed prudent from a risk mitigation perspective or is expected to have a positive cost/benefit relationship. Since the Company generally purchases reinsurance only when it expects a net benefit, the percentage of business that it reinsures, as indicated in the chart below, varies considerably from year to year, depending on its view of the relationship between cost and expected benefit for the contract period.
The Company’s functional currency is the U.S. dollar. However, the Company writes a portion of its business in currencies other than U.S. dollars. During the year ended December 31, 2004, the Company wrote approximately 13.5% of its reinsurance coverages in currencies other than U.S. dollars. The Company also maintains a portion of its investment portfolio in investments denominated in currencies other than U.S. dollars. As of December 31, 2004, the Company maintained approximately 6.4% of its investment portfolio in investments denominated in currencies other than U.S. dollars. Consequently, quarterly exchange rate fluctuations may have a material impact on the Company’s quarterly net income. During 2004, 2003, 2002, the impact on the Company’s quarterly pre-tax net income from exchange rate fluctuations ranged from a loss of
$4.3 million to a gain of $5.4 million. Further discussion of foreign currency rate risk can be found in ITEM 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Market Sensitive Instruments”.