The following selected consolidated GAAP financial data of the Company as of and for the years ended December 31, 2005, 2004, 2003, 2002 and 2001 were derived from the consolidated financial statements of the Company, which were audited by PricewaterhouseCoopers LLP. The following financial data should be read in conjunction with the Consolidated Financial Statements and accompanying notes.
Net (loss) income per basic share (3) $ (3.79 ) $ 8.85
Underwriting expense ratio 26.2 % 24.4 % 25.6 % 27.3 % 31.1 %
(1) Catastrophe losses are presented net of reinsurance and reinstatement premiums. A catastrophe is defined, for purposes of the Selected Consolidated Financial Data, as an event that causes a pre-tax loss on property exposures before reinsurance of at least $5.0 million before corporate level reinsurance and taxes. Effective in 2005, industrial risk losses have been excluded from catastrophe losses with prior periods adjusted for comparison purposes. Catastrophe reinsurance provides coverage for one event. When limits are exhausted, some contractual arrangements provide for the availability of additional coverage upon the payment of additional premium. This additional premium is referred to as reinstatement premium.
(3) Based on weighted average basic shares outstanding of 57.6 million, 55.9 million, 54.0 million, 50.3 million and 46.2 million for 2005, 2004, 2003, 2002 and 2001, respectively.
(4) Based on weighted average diluted shares outstanding of 57.6 million, 56.8 million, 55.0 million, 51.1 million and 47.1 million for 2005, 2004, 2003, 2002 and 2001, respectively.
The worldwide reinsurance and insurance businesses are highly competitive, yet cyclical by product and market. Competition in the types of reinsurance and insurance business that the Company underwrites is based on many factors, including the perceived overall financial strength of the reinsurer or insurer, ratings of the reinsurer or insurer by A.M. Best and/or S&P, underwriting expertise, the jurisdictions where the reinsurer or insurer is licensed or otherwise authorized, capacity and coverages offered, premiums charged, other terms and conditions of the reinsurance and insurance business offered, services offered, speed of claims payment and reputation and experience in lines written. These factors operate at the individual market participant level to varying degrees, as applicable to the specific participant’s circumstances. They also operate in aggregate across the reinsurance industry more generally, contributing, in combination with background economic conditions and variations in the reinsurance buying practices of insurance companies (by participant and in the aggregate), to cyclical movements in reinsurance rates, terms and conditions and ultimately reinsurance industry aggregate financial results.
For the insurance industry, 2005 was a year of unprecedented catastrophe losses in terms of both frequency and severity, which negatively impacted the financial results of a broad number of (re)insurance market participants. The Company believes that the scope and scale of industry losses have helped to stabilize the weakening that was taking place in many sectors and will lead to generally improving market conditions during 2006 that are likely to vary by product and market. For the property catastrophe and retrocession lines, the Company expects
that demand and pricing will increase the most as companies reassess their risk management approach and rating agencies raise the required capital levels for many industry participants. The Company believes that price increases for these two lines will be most pronounced in peak catastrophe zones, such as the southeastern U.S. For remaining property lines, there will likely be modest rate increases, while the casualty markets have generally steadied and are expected to stabilize at adequate pricing levels in 2006 for both insurance and reinsurance.
The Company notes that it continues to see opportunities for profitable writings in a variety of classes and lines owing mainly to the general adequacy of underlying pricing. However, the Company continues to examine its view of price adequacy for property lines in light of 2005‘s unprecedented catastrophe experience from both a frequency and severity perspective. This reexamination is focused on several key factors including the magnitude and character of catastrophe exposures, the level of required capital to support the Company’s businesses from both the Company’s and rating agencies’ perspectives and the actual and potential volatility and variability of results, by product, business class and business unit, including with respect to the reliability of underlying statistical and modeling techniques.
The Company’s management monitors and evaluates overall Company performance based upon financial results. The following table displays a summary of the consolidated net (loss) income, ratios and shareholders’ equity for the periods indicated:
Overall, the Company was disappointed with its 2005 results. The Company generated a net loss of $218.7 million in 2005, which was $713.5 million less than 2004‘s net income of $494.9 million. This $713.5 million deterioration was principally driven by $1.1 billion of higher pre-tax catastrophe losses tempered somewhat by improved non-catastrophe prior year reserve development, which improved by $275.8 million to a total net favorable development of $26.4 million. The Company incurred $1.5 billion of pre-tax catastrophe losses in 2005 driven extensively by Hurricanes Katrina, Rita and Wilma. These three devastating events resulted in the worst catastrophe loss year in history for both the insurance industry and the Company.
Meanwhile, the Company is extremely well positioned to respond to generally improving market conditions in 2006 in the aftermath of unprecedented catastrophe losses in late 2005. First, the Company’s non-catastrophe operating fundamentals remain very strong. Second, the Company’s capital base is as strong as it has ever been having been recently bolstered by proceeds from secondary offerings. Third, the Company’s broad, diversified global franchise and low-cost operating platform provide a wide spectrum of business opportunities in a variety of product classes and markets. Lastly, the discipline with which the Company approaches its business remains intact causing it to look opportunistically at improving market conditions while providing its underwriters with the flexibility to decline business that does not meet its objectives regarding underwriting profitability.
Revenues. Gross written premiums decreased 12.7% to $4.1 billion in 2005 from $4.7 billion in 2004 reflecting the Company’s disciplined response to modest market softening in most sectors, particularly earlier in the year. The Company adapted its operations to slow its growth and even decrease writings for some classes of business and reemphasize its focus on profitability as opposed to volume. The classes most affected by these actions were workers’ compensation insurance, individual risk (re)insurance, medical stop loss reinsurance, UK motor business reinsurance and select U.S. casualty reinsurance classes. As a result, the U.S. Insurance segment decreased 20.2% due to declines in its predominant workers’ compensation book, while the reinsurance segments declined 10.2% in the aggregate.
Net realized capital gains were $90.3 million in 2005 driven by gains on the sale of the Company’s interest only strips investment portfolio and other portfolio management activities in response to interest rate and credit market movements. Other expenses increased by $19.2 million in 2005 driven primarily by foreign exchange losses.
Expenses. Incurred losses and LAE for 2005 were $3.7 billion, an increase of $0.4 billion over 2004, principally related to $1.1 billion higher level of catastrophe losses, partially offset by a $0.4 billion decrease in non-catastrophe prior period reserve adjustments and lower earned premiums. The Company’s non-catastrophe incurred losses were down 10.5% in 2005, which is broadly in line with the 10.4% decline in net earned premiums, reflective of generally stable business trends. The Company’s 2005 incurred losses benefited from $26.4 million of favorable prior period reserve adjustments in 2005 comprised of $226.3 million of favorable reserve development on non-catastrophe, non-A&E reserves principally related to property business classes, partially offset by catastrophe reserve development of $118.5 million, mostly from 2004 Florida hurricane
The Company generated an income tax benefit of $62.3 million in 2005 equating to an effective tax rate of 22.2% applied to its pre-tax loss of $280.9 million for the year. This elevated effective tax rate reflected the impact of the year’s catastrophe losses on U.S. operations, producing a significant tax loss, partly mitigated by continued profitable operations in the United Kingdom.
The Company generated a net loss of $218.7 million in 2005 compared to net income of $494.8 million in 2004. This $713.5 million deterioration in 2005 was principally driven by $1.1 billion of higher catastrophe losses tempered somewhat by improved non-catastrophe prior year reserve development of $0.4 billion.
The Company’s shareholders’ equity increased by $0.4 billion to $4.1 billion at year-end 2005 driven by $758.7 million of equity offering proceeds, partially offset by the $218.7 million net loss for the period and a $77.8 million reduction in net unrealized appreciation on investments, principally related to fixed-income securities affected by modestly rising interest rates.
Effective January 1, 2004, Everest Re sold its United Kingdom branch to Bermuda Re. 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 and Bermuda segments for the year ended December 31, 2003 to conform to December 31, 2005 and 2004 segment reporting.
Underwriting (loss) gain $ (255,959 ) $ (38,603 ) $ 55,357
Reinsurance operation decreased 6.2% ($92.0 million), principally relating to a $173.1 million decrease in treaty casualty business and a $29.3 million decrease in facultative business, partially offset by a $118.9 million increase in treaty property business. The International operation increased 2.8% ($18.9 million), resulting primarily from a $75.0 million increase in Asian business, partially offset by a $43.6 million decrease in international business written through the Miami and New Jersey offices, representing primarily Latin American business and an $11.3 million decrease in Canadian business.
The Company’s loss ratio, which is calculated by dividing incurred losses and LAE by net premiums earned, increased by 19.6 percentage points to 94.0% in 2005 from 74.4% in 2004. This 19.6 point year over year loss ratio deterioration was primarily the result of a 29.5 point increase due to catastrophe losses, partially offset by a 10.2 point improvement in non-catastrophe prior year reserve development.
The U.S. Insurance segment reflected $19.5 million of net favorable prior period reserve adjustments for the year ended December 31, 2005 and $43.3 million of net unfavorable prior period reserve adjustments for the year ended December 31, 2004. The 2005 favorable prior period reserve adjustments related principally to California workers’ compensation for the 2004 accident year as the results of benefit reform have become clearer and the 2004 unfavorable prior period reserve adjustments related principally to the casualty classes related to accident years 2000 through 2002, where the Company strengthened its reserves for California workers’ compensation insurance. While management believes the cumulative results through 2005 remain
quite positive, there was some deterioration in claim frequency and severity related to accident years 2001 and 2002.
The Specialty Underwriting segment had $16.1 million of net favorable prior period reserve adjustments for the year ended December 31, 2005 and $5.1 million of net unfavorable prior period reserve adjustments for the year ended December 31, 2004. In 2005, net favorable prior period reserve adjustments reflected $33.0 million of non-A&E, non-catastrophe favorable development on the marine, aviation, surety and A&H classes of business, partially offset by unfavorable catastrophe development of $16.9 million. In 2004, net unfavorable prior period reserve adjustments related to the surety and A&H classes of business, partially offset by favorable development in the marine and aviation business lines.
The International segment had $49.2 million of favorable net prior period reserve adjustments for the year ended December 31, 2005 and $15.1 million of net favorable prior period reserve adjustments for the year ended December 31, 2004. The favorable development in 2005 related primarily to favorable non-asbestos, non-catastrophe reserve development on the Canadian, Asian, and international business of $66.1 million, partially offset by unfavorable property catastrophe loss development of $16.9 million on the same business. The favorable development in 2004 related primarily to 2003 Canadian property catastrophe, international and Asian business.
Aggregate reserve development related to A&E exposures was $81.4 million and $159.4 million for the years ended December 31, 2005 and 2004, 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 $11.5 million and the net strengthening on the acquired Mt. McKinley business was $69.9 million in 2005. 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.
Underwriting Expenses. The Company’s expense ratio, which is calculated by dividing underwriting expenses by net premiums earned, was 26.2% in 2005 compared to 24.4% in 2004.
The Company’s combined ratio, which is the sum of the loss and expense ratios, increased by 21.4 percentage points to 120.2% in 2005 as compared to 98.8% in 2004, with the increase principally resulting from elevated catastrophe losses, partially offset by improved prior year development.
Investment Results. Net investment income increased 5.4% to $522.8 million in 2005 from $495.9 million in 2004 reflecting growth in invested assets tempered by lower investment yields and lower returns from limited partnership investments. Investable assets increased by $1.4 billion to $13.0 billion in 2005, principally reflecting the effects of investing $1,065.7 million cash flow from operations during the year and $758.3 million net proceeds from issuance of common shares, partially offset by $250.0 million in debt repayment. The lower investment yield reflects the Company’s elevated short-term investments following its common share capital raising in the fourth quarter, which also reduced the investment income portfolio duration. Investment income for the limited partnerships for the year ended December 31, 2005 and 2004 was $12.0 million and $42.0 million, respectively.
Corporate underwriting expenses not allocated to segments were $13.5 million for 2005 as compared to $6.5 million for 2004 as the Company expanded its infrastructure to support operations.
Interest expense and fees in 2005 were $73.4 million compared to $75.5 million in 2004. Interest expense and fees in 2005 included $35.5 million relating to the senior notes, $37.4 million relating to the junior subordinated debt securities and $0.4 million relating to the credit line under the Company’s revolving credit facilities. Interest expense and fees in 2004 included $42.0 million relating to the senior notes, $32.4 million relating to the junior subordinated debt securities and $1.2 million relating to borrowings under the Company’s revolving credit facilities. The lower interest expense on the senior notes was due to the retirement of the 8.5% senior notes due March 15, 2005, partially offset by the issuance of new 5.4 % senior notes on October 12, 2004.
Premium Revenues. Net premiums earned increased by 18.4% to $4,425.1 million in 2004 from $3,737.9 million in 2003. Contributing to this increase was a 60.6% ($339.1 million) increase in the Bermuda operation, a 42.0% ($194.1 million) increase in the International operation, a 13.8% ($114.0 million) increase in the U.S. Insurance operation and a 3.5% ($49.7 million) increase in the U.S. Reinsurance operation, partially offset by a
Incurred Losses and LAE. Incurred loss and LAE increased by 26.6% to $3,291.1 million in 2004 from $2,600.2 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, Pacific typhoons, the Asian tsunami and reserve adjustments for prior period losses, together with the mitigating effects of the increase in net premiums earned and the impact of favorable changes in the Company’s underlying business mix and aggregate rates, terms and conditions. Incurred losses and LAE in 2004 reflected ceded losses and LAE of $141.0 million compared to ceded losses and LAE in 2003 of $278.4 million. The decrease in ceded losses is primarily the result of the absence in 2004 of cessions under the corporate level aggregate reinsurance covers. The ceded losses and LAE in 2003 included $85.0 million of losses ceded under the 2000 accident year aggregate excess of loss component of the Company’s corporate retrocessional program and $81.1 million under the LM/Mt. McKinley reinsurance agreement.
Net unfavorable prior period reserve adjustments for the year ended December 31, 2004 were $249.4 million compared to $196.8 million in 2003. For the year ended December 31, 2004, the unfavorable reserve adjustments included net unfavorable A&E adjustments of $159.4 million and net unfavorable non-A&E, non-catastrophe adjustments of approximately $128.7 million relating primarily to casualty reinsurance and workers’ compensation insurance. Partially offsetting the unfavorable development was favorable catastrophe development of $38.7 million principally related to the reduction of reserves for the World Trade Center events. For the year ended December 31, 2003, net unfavorable prior period reserve adjustments for A&E exposures were $50.2 million and net unfavorable non-A&E adjustments were $146.6 million, which were net of a cession of $85 million under the 2000 accident year aggregate excess of loss component of the Company’s corporate
The Specialty Underwriting segment had $5.1 million of net unfavorable prior period reserve adjustments for the year ended December 31, 2004, principally related to net unfavorable prior period reserve adjustments in the surety and A&H business lines, partially offset by favorable development from marine and aviation. The net favorable prior period reserve adjustments for the year ended December 31, 2003 were $23.9 million, primarily related to A&H business.
The Bermuda segment reflected $138.4 million of net unfavorable prior period reserve adjustments for the year ended December 31, 2004 and $1.8 million of net unfavorable prior reserve adjustments for the year ended December 31, 2003. The development in the year ended December 31, 2004 was primarily the result of $149.1 million of A&E reserve development. For the year ended December 31, 2003, reserve adjustments included $33.4 million unfavorable prior period reserve adjustments related to A&E exposures, partially offset by $31.6 million favorable non-A&E adjustments. All of the development related to asbestos exposures were assumed through the September 19, 2000 loss portfolio transfer from Mt. McKinley.
Investments. Net investment income increased 23.2% to $495.9 million in 2004 from $402.6 million in 2003, principally reflecting the effects of investing $1,487.6 million of cash flow from operations for the twelve months ended December 31, 2004, as well as $320.0 million of net proceeds from the issuance of junior subordinated debt securities in March 2004 and $250.0 million of net proceeds from the issuance of senior notes in October 2004. The increase also reflected $32.7 million representing an atypical increase in the carrying value of a limited partnership investment.
Annualized after-tax yield on average cash and invested assets 4.2 % 4.4 %
The Company, because of its historical income orientation, has generally considered total return, the combination of income yield and capital appreciation/depreciation, to be relatively less important as a measure of performance than its overall income yield. However, in 2004, with changes the Company perceived in overall investment market conditions, the Company continued to reweight its view of total return and added $496.5 million of equity securities in 2004 into the overall investment portfolio. The following table provides a comparison of the Company’s total return by asset class relative to broadly accepted industry benchmarks for 2004 and 2003.
Other Expenses. Other income in 2004 was $0.7 million compared to other expense of $1.0 million in 2003. The decrease in net expense for 2004 was primarily due to variability in the impact of foreign exchange, partially offset by other miscellaneous expenses.
Net Income. Net income was $494.9 million in 2004 compared to net income of $426.0 million in 2003, which reflected improved investment income and realized capital gains, partially offset by reduced underwriting profitability due to catastrophe losses.
LOSS AND LAE RESERVES. The Company’s most critical accounting policy is the determination of its loss and LAE reserves. The Company maintains reserves to cover its estimated ultimate liability for losses and LAE with respect to reported and unreported claims relating to both its insurance and reinsurance businesses. Because reserves are estimates of ultimate losses and LAE, management, using a variety of statistical and actuarial techniques, monitors reserve adequacy over time, evaluating new information as it becomes known and adjusting reserves as necessary. Management considers many factors when setting reserves, including: (1) the Company’s exposure base, generally its premiums earned; (2) its expected loss ratios on current year writings as determined through extensive interaction between its underwriters and actuaries by product and class categories; (3) internal actuarial methodologies which analyze the Company’s loss reporting and payment experience with similar cases, information from ceding companies and historical trends, such as reserving patterns, loss payments and product mix; (4) current legal interpretations of coverage and liability; (5) economic conditions; and (6) the uncertainties discussed below regarding reserve requirements for A&E claims. Based on these considerations, management believes that adequate provision has been made for the Company’s insurance and reinsurance loss and LAE reserves. Actual losses and LAE ultimately paid may deviate, perhaps substantially, from such reserves, impacting income in the period in which the change in reserves is made. See also Note 1 of Notes to the Consolidated Financial Statements.
million and assumed business loss reserves of $7,067.6 million, of which $255.5 million and $313.4 million, respectively, were loss reserves on asbestos business.
Reserving for assumed reinsurance requires evaluating loss information received from ceding companies. Depending on the type of contract and the contractual reporting requirements, ceding companies report losses to the Company in many forms. Generally, proportional/quota share contracts require the submission of a monthly/quarterly account, which includes premium and loss settlement activity for the period with corresponding reserves as established by the ceding company. This information is recorded into the Company’s records. For certain proportional contracts, there is also an individual loss reporting clause, which requires a detailed loss report on claims that exceed a certain dollar threshold or relate to a particular type of loss. Excess of loss and facultative contracts generally require individual loss reporting with precautionary notices generally sent when losses reach a significant percentage of the attachment point of the contract. All individual loss reports and supporting claim information are managed by the Company’s experienced claims staff. Based on the evaluation of the claim, the Company may choose to establish additional case reserves greater than those reported by the ceding company. The Underwriting, Claim, Reinsurance Accounting and Internal Audit departments of the Company perform various reviews of the ceding carriers, particularly larger ceding carriers, to ensure that underwriting and claims procedures meet required standards. The claim information received from the ceding companies is compiled into loss development triangles. Accepted actuarial methodologies, supplemented by judgment where appropriate, are then used to develop the appropriate IBNR for the Company. Included in the determination of IBNR, is a factor for reporting lags of the ceded carriers. Each quarter, the Company compares its actual reported losses for the quarter and cumulatively since the most recently completed reserve study to the expected reported losses for the respective period, which may result in additional reserving actions. This is done by aggregate class and/or type of business. This information is used as a tool in the judgmental process by which management assesses the overall adequacy of loss and LAE reserves.
The Company’s reserves include an estimate of the Company’s ultimate liability for A&E claims. This estimate is made based on judgmental assessment of the underlying exposures as the result of: (1) long and variable reporting delays, both from insureds to insurance companies and from ceding companies to reinsurers; (2) historical data, which is more limited and variable on A&E losses than historical information on other types of casualty claims; and (3) unique aspects of A&E exposures for which ultimate value cannot be estimated using traditional reserving techniques. There are significant uncertainties in estimating the amount of the Company’s potential losses from A&E claims. Among the uncertainties are: (a) potentially long waiting periods between exposure and manifestation of any bodily injury or property damage; (b) difficulty in identifying sources of asbestos or environmental contamination; (c) difficulty in properly allocating responsibility and/or liability for asbestos or environmental damage; (d) changes in underlying laws and judicial interpretation of those laws; (e) the potential for an asbestos or environmental claim to involve many insurance providers over many policy periods; (f) questions concerning interpretation and application of insurance and reinsurance coverage; and (g) uncertainty regarding the number and identity of insureds with potential asbestos or environmental exposure.
There is less potential for similar settlements with respect to the Company’s reinsurance asbestos claims. Ceding companies, with their direct obligation to insureds and overall responsibility for claim settlements, are not consistently aggressive in developing claim settlement information and conveying this information to reinsurers, which can introduce significant and perhaps inappropriate delays in the reporting of asbestos claims/exposures to reinsurers. These delays not only extend the timing of reinsurance claim settlements, but
PREMIUMS WRITTEN AND EARNED. Premiums written by the Company are earned ratably over the periods of the related insurance and reinsurance contracts or policies. Unearned premium reserves are established to cover the remainder of the unexpired contract period. Such reserves are established based upon reports received from ceding companies or computed using pro rata methods based on statistical data. Premiums earned, and the related costs, which have not yet been reported to the Company, are estimated and accrued. Standard accepted actuarial methodologies are used to estimate earned but not reported premium at each financial reporting date. These earned but not reported premiums are combined with reported earned premiums to comprise the exposure base for determining the Company’s incurred losses and loss and LAE reserves. Commission expense and incurred losses related to the change in earned but not reported premium are not differentiated from current period reported premium and the effects of both are included in current period company and segment financial results. See also Note 1 of Notes to the Consolidated Financial Statements.
INVESTMENT VALUATION. The Company’s investment portfolio consists of investments available for sale and equity securities. Accordingly, these securities are marked to market on a quarterly basis. Most securities are
traded on national exchanges where market values are readily available. The Company holds some privately placed securities that are either valued by an investment advisor or by the Company using cash flow projections. In 2005 and 2004, the Company owned interest only strips that were accounted for in accordance with EITF 99-20, which sets forth the rules for determining when these securities must be written down to fair value due to impairment. Unrealized gains and losses from market fluctuations are reflected as comprehensive income, while market value declines that are considered other than temporary impairments are reflected in the income statement as realized capital losses. As of December 31, 2005 and 2004, the Company had unrealized gains net of tax of $214.6 million and $292.3 million, respectively. The Company considers many factors when determining whether a market value decline is other than temporary, including: (1) the length of time the market value has been below book value, (2) the credit strength of the issuer, (3) the issuer’s market sector, (4) the length of time to maturity and (5) for asset backed securities, increases in prepayments. If management assessments change in the future, the Company may ultimately record a realized loss after management originally concluded that the decline in value was temporary. See also Note 1 of Notes to the Consolidated Financial Statements.
The Company from time to time invests in interest only strips. The Company strategically invests in interest only strips in response to movement in, and levels of, capital market interest rates. These investments are aimed at mitigating potential decreases in unrealized appreciation on the Company’s fixed income portfolio during a period where management judges that there is very high potential for an increase in general interest rates. These fixed maturity securities give the holder the right to receive interest payments at a stated coupon rate on an underlying pool of mortgages. The interest payments on the outstanding mortgages are guaranteed by entities generally rated AAA. The ultimate cash flow from these investments is primarily dependent upon the average life of the mortgage pool. Generally, as market interest rates and, more specifically, market mortgage rates decline, mortgagors tend to refinance which will decrease the average life of a mortgage pool and decrease expected cash flows. Conversely, as market interest rates and, more specifically, market mortgage rates rise, repayments will slow and the ultimate cash flows will tend to rise. Accordingly, the market value of these investments tends to increase as general interest rates rise and decline as general interest rates fall. These
Fixed income portfolio duration 4.3 yea rs 5.2 yea rs 4.2 yea rs
Fixed income composite credit quality A a1 A a2 A a2
LOSS AND LAE RESERVES. Gross loss and LAE reserves totaled $9,126.7 million at December 31, 2005, $7,836.3 million at December 31, 2004 and $6,361.2 million at December 31, 2003. The increase in 2005 is primarily attributable to increased catastrophe losses, partially offset by favorable net prior period reserve adjustments and reduced premiums earned. The increase in 2004 and 2003 is primarily attributable to increased premiums earned, increase in catastrophe losses and net prior period reserve adjustments in select areas. Normal variability in claim settlements also affected both periods.
Total Gross Reserves (4) $ 9,126,702 N A $ 8,447,438 N A $ 9,805,966
(1) There can be no assurance that reserves will not ultimately exceed the indicated ranges, requiring additional income statement expense.
Depending on the specific segment, the range derived for the loss reserves, excluding reserves for A&E exposures, ranges from minus 8.0% to minus 14.0% for the low range and from plus 8.0% to plus 14.0% for the high range. Both the higher and lower ranges are associated with the U.S. Insurance segment. Within each range, management’s best estimate of loss reserves is based on the point estimate derived by the Company’s actuaries in detailed reserve studies. Such ranges are necessarily subjective due to the lack of generally accepted actuarial standards with respect to their development. In particular, the Company notes that the width of the range is dependent on the level of confidence associated with the outcome. For the above presentation, management has assumed what it believes is a reasonable confidence level but notes that there can be no assurance that the Company’s claim obligations will not vary within and potentially outside of these ranges, requiring incurred loss adjustments in the period the variability is recognized. The Company is not able to establish a meaningful range for A&E reserves.
Everest Re was formed in 1973 but was not fully engaged in underwriting casualty business, under which A&E exposures generally arise, until 1974, and it effectively eliminated A&E exposures through contract exclusions effected in 1984. Therefore, Everest Re has an approximate 11-year window of A&E exposure, much shorter than that of many reinsurance companies that have significant A&E exposures. In the earlier years of its existence, Everest Re was not as heavily involved in casualty business as in property business, which generally is not exposed to asbestos claims. Everest Re generally took smaller lines of exposure per contract than many other reinsurers operating in the casualty reinsurance market and those lines were generally also smaller than the excess limits provided by Mt. McKinley policies. This means that the potential adverse development on Everest Re’s reinsurance business would not be subject to the same level of volatility as would be the case for companies having greater exposures per risk. Everest Re reinsured both primary and excess policies. However, its claim experience to date indicates that the majority of its reinsurance supported excess policies. As a result, most of Everest Re’s exposure derives from excess policies similar to those written by Mt. McKinley.
The Company believes that its A&E exposures are unique and differentiated, by the points noted above, from those insurers and reinsurers with appreciable A&E exposure but there can be no assurance that such factors will protect the Company from adverse development, perhaps material, or allow it to secure advantages in the settlement of its claims obligations.
The following table summarizes incurred losses with respect to A&E on both a gross and net of retrocessions basis for the periods indicated:
The gross incurred losses for A&E exposures increased by $77.1 million and $171.7 million for the years ended December 31, 2005 and 2004, respectively. These increases are the result of re-evaluations by management reflecting additional information received from insureds and ceding companies, ongoing litigation, additional claims received and settlement activity. Management closely monitors this additional information and adjusts reserves accordingly. The net incurred losses primarily reflect the impact of the reinsurance agreement between Mt. McKinley and LM.
Developments in 2005 and 2004 affecting asbestos exposures in general and the Company’s asbestos exposures in particular, together with enhancements in the Company’s claim management and analytical processes, resulted in the reserve strengthening noted earlier. These developments and actions have increased the emphasis on asbestos exposures as a separate component of the Company’s A&E exposures. Despite the Company’s approach of handling A&E exposures on a combined basis, management believes additional disclosure of the asbestos element of its A&E exposures is appropriate.
The following tables summarize reserve and claim activity for asbestos claims, on both a gross and net of ceded reinsurance basis, for the periods indicated with particular emphasis on the differentiation of insured categories within the Mt. McKinley operation, which the Company believes reflects the most volatile element of its asbestos exposures for the years ended December 31:
(4) Includes $232.0 million ceded to and collected from The Prudential as part of the Company's stop loss protection resulting from the
The Company’s net three year survival ratio on its asbestos exposures only was 3.3 years for the period ended December 31, 2005. This three year survival ratio, when adjusted for the effect of the reinsurance ceded under the stop loss cover from LM, was 4.8 years and, when adjusted for settlements in place and structured settlements, which are either fully funded by reserves or subject to financial terms that substantially limit the potential variability in the liability, and the stop loss protection from LM, was 12.3 years.
From time to time, the Company has used open market share repurchases to effectively adjust its capital position. It made no such purchases in 2005 or in 2004. In September 2004, the Company’s authorization to purchase its shares was amended to authorize the repurchase of up to 5 million shares. The Company notes that, outside of its open market repurchase program, it repurchased 10,430 shares in 2005 and 4,800 shares in 2004 from employees in connection with restricted share vestings where individual employees chose to discharge withholding tax liabilities on vesting shares by the surrender of a portion of such shares and 328 shares in 2005 from a non-employee in connection with payment of the option exercise price. At December 31, 2005, 5 million shares remained under the existing repurchase authorization.
On June 27, 2003, the Company filed a shelf registration statement on Form S-3 with the SEC, providing for the issuance of up to $975 million of securities. Generally, under this shelf registration statement, Group was authorized to issue common shares, preferred shares, debt securities, warrants and hybrid securities, Holdings was authorized to issue debt securities and Capital Trust II and Capital Trust III were authorized to issue trust
On October 6, 2004, Holdings completed a public offering of $250.0 million principal amount of 5.40% senior notes due October 15, 2014. The net proceeds were used to retire existing debt at Holdings, which was due and retired on March 15, 2005.
Capital Trust will redeem all of the outstanding trust preferred securities when the junior subordinated debt securities are paid at maturity on November 15, 2032. Holdings may elect to redeem the junior subordinated debt securities, in whole or in part, at any time after November 14, 2007. If such an early redemption occurs, the outstanding trust preferred securities would also be proportionately redeemed.
LIQUIDITY. The Company’s current investment strategy generally seeks to maximize after-tax income through a high quality, diversified, taxable bond and tax-preferenced fixed maturity portfolio, while maintaining an adequate level of liquidity. The Company’s mix of taxable and tax-preferenced investments is adjusted continuously, consistent with the Company’s current and projected operating results, market conditions and tax position. With changes the Company perceives in overall investment market conditions, the Company continues to reweight its view of total return and added $440.0 million in 2005 and $496.5 million in 2004 of equity securities into the overall investment portfolio.
The Group Credit Facility requires Group to maintain a debt to capital ratio of not greater than 0.35 to 1 and to maintain a minimum net worth amount. Minimum net worth is an amount equal to the sum of (i) $2,599 million (base amount) plus (ii) (A) 25% of consolidated net income for each of Group’s fiscal quarters and (B) 50% of any increase in consolidated net worth attributable to the issuance of ordinary and preferred shares. The base amount is reset at the end of each fiscal year to be the greater of 70% of Group’s consolidated net worth as of the last day of the fiscal year and the calculated minimum amount of net worth prior to the last day of the fiscal year. As of December 31, 2005, the Company was in compliance with these covenants.
The Holdings Credit Facility requires Holdings to maintain a debt to capital ratio of not greater than 0.35 to 1, Holdings to maintain a minimum interest coverage ratio of 2.5 to 1 and Everest Re to maintain its statutory surplus at $1.0 billion plus 25% of future aggregate net income and 25% of future aggregate capital contributions after December 31, 2002. As of December 31, 2005, the Company was in compliance with these covenants.
During the year ended December 31, 2005, there were no payments made and no incremental borrowings under the Holdings Credit Facility. During the year ended December 31, 2004, there were payments made of $70.0 million and there were no incremental borrowings made under Holdings Credit Facility. During the year ended December 31, 2003, there were no payments made and no incremental borrowings made under Holdings Credit Facility. As of December 31, 2005, 2004 and 2003, there were outstanding Holdings Credit Facility borrowings of $0.0 million, $0.0 million and $70.0 million, respectively.
Interest expense and fees incurred in connection with the Group Credit Facility and the Holdings Credit Facility were $0.4 million for the year ended December 31, 2005. Interest expense and fees incurred in connection with the Holdings Credit Facility were $1.2 million and $1.4 million for the years ended December 31, 2004 and 2003, respectively.
The Company’s 2005 total cash flow, as distinguished from its cash flow from operations, activity in 2005 included $758.3 million of new investable cash from Group’s issuance of common shares and Holdings’ sale of Group’s shares. The total cash flow activity in 2004 included $320.0 million of new investable cash from Holdings’ issuance of junior subordinated debt securities in March and $246.7 million of new investable cash from Holdings’ issuance of senior notes securities in October. The total cash flow activity in 2003 included $316.8 million of new investable cash resulting from Group’s offering of common shares in April of that year.
EXPOSURE TO CATASTROPHES. Like other insurance and reinsurance companies, the Company is exposed to multiple insured losses arising out of a single occurrence, whether a natural event, such as a hurricane or an earthquake, or other catastrophe, such as an explosion at a major factory. Any such catastrophic event could generate insured losses in one or more of the Company’s reinsurance treaties, facultative certificates, or across lines of business, including property and/or casualty.
The Company focuses on potential losses that can be generated by any single event as part of its evaluation and monitoring of its aggregate exposures to catastrophic events. Accordingly, the Company employs various techniques to estimate the amount of loss it could sustain from any single catastrophic event in various geographic areas. These techniques range from non-modeled deterministic approaches-such as tracking aggregate limits exposed in catastrophe-prone zones and applying historic damage factors-to modeled approaches that scientifically measure catastrophe risks using sophisticated Monte Carlo simulation techniques that provide insights into the frequency and severity of expected losses on a probabilistic basis.
To date, there is not one universal model capable of projecting the amount and probability of loss in all global geographical regions that the Company conducts business. In addition, the form, quality, and granularity of underwriting exposure data furnished by ceding companies is not always fully aligned with the data requirements for the Company’s licensed model(s) creating potential imprecision in the potential loss projections. Further, the results from multiple models and analytical methods must be combined and interpolated to estimate potential losses by and across business units. Such combination techniques are inherently difficult to apply and may affect the precision of the Company’s estimates. Also, most models have not been accurate in forecasting losses from the unprecedented series of hurricanes that impacted the insurance industry in 2004 and 2005. In particular, many models did not fully consider some of the perils and factors, which have been major contributors to the scale of events like the Katrina loss, such as flood, storm surge, and potential demand surge. Finally, uncertainties with respect to future climate patterns and cycles introduce significant uncertainty with respect to the accuracy of loss projections from models using historic long-term frequency and severity data.
Projected losses with respect to catastrophe events are generally summarized in terms of the probable maximum loss or PML. The Company defines PML as its anticipated loss, taking into account contract terms and limits, caused by a single catastrophe affecting a broad contiguous geographic area, such as that caused by a hurricane or earthquake. The expected PML will vary with the severity of modeled simulated losses and vary with the in-force book of business. The projected severity levels are described in terms of “return periods”, such as “100-year events” and “250-year events”. Simply speaking, a 100-year PML corresponds to a 1% probability that losses from an event could exceed the indicated PML; alternatively, it corresponds to a 99% probability that the loss distribution for an event falls below the indicated PML.
From a risk management perspective, the Company continues to manage its catastrophe risk such that its largest individual 100-year event, on an after-tax basis, generally does not exceed approximately one-half of projected net income. Management also monitors its largest PMLs at multiple points along the loss distribution curve, such as loss amounts at the 20, 50, 100, 250, 500, and 1,000 year return periods. This monitoring procedure enables management to identify discrete risk zone and risk hazard exposure accumulations for integration into risk, underwriting and capital management processes.
The Company believes that the greatest 1 in 100 year catastrophe exposure world wide from any single event is to a hurricane affecting the U.S. southeast coast where the Company estimates it has a pre-tax PML exposure of $532 million. See also table under “Risk Management and Retrocession Arrangements”.
The Company employs a retrocessional approach under which the Company may purchase reinsurance to cover specific business written or as a corporate level retrocessional program covering the potential accumulation or aggregation of exposures across some or all of the Company’s operations. All reinsurance purchasing decisions consider both the potential coverage and market conditions with respect to the pricing, terms, conditions and availability of such coverage, with the aim of securing cost effective protection. The level of reinsurance coverage varies over time, reflecting the underwriter’s and/or Company’s view of the changing dynamics of both the underlying exposure and the reinsurance markets.
For 2004, 2005 and thus far in 2006, the Company has chosen not to purchase corporate retrocessional protection and to generally de-emphasize the purchase of specific reinsurance by its underwriters, reflecting the Company’s view that its exposures, in the context of its capital and financial position and current market pricing, do not warrant reinsurance purchases at currently unattractive retrocessional price levels. For 1999, 2000 and 2001, the Company purchased accident year aggregate excess of loss retrocession coverage, which provided up to $175.0 million of recoveries per accident year if Everest Re’s consolidated statutory basis accident year loss ratio exceeded a loss ratio attachment point provided in the contract for the respective accident years. Each arrangement provided for an adjustment premium, which reduces the net benefit by approximately 50%, in the event that the coverage is used. There are no remaining limits available under these
coverages. See ITEM 1, “Business - Risk Management of Underwriting and Retrocession Arrangements” for further details.
The senior notes and junior subordinated debt contractual obligations are the responsibility of Holdings. While the Company has sufficient cash flow, liquidity, investments and access to capital markets to satisfy these obligations, Holdings generally depends for its funding upon dividends from Everest Re, its operating insurance subsidiary, capital contributions from Group or access to the capital markets. The Company’s various operating insurance and reinsurance subsidiaries have sufficient cash flow, liquidity and investments to settle outstanding reserves for losses and LAE. Management believes that the Company, and each of its entities, have sufficient financial resources, or ready access thereto, to meet all obligations.
During 2005, 2004 and 2003, the Company declared and paid shareholder dividends of $25.4 million, $22.4 million and $19.6 million, respectively. As an insurance holding company, the Company is partially dependent on dividends and other permitted payments from its subsidiaries to pay cash dividends to its shareholders. The payment of dividends to Group by Holdings and to Holdings by Everest Re is subject to Delaware regulatory restrictions and the payment of dividends to Group by Bermuda Re is subject to Bermuda insurance regulatory restrictions. Management expects that, absent extraordinary catastrophe losses, such restrictions should not affect Everest Re’s ability to declare and pay dividends sufficient to support Holdings’ general corporate needs and Holdings’ and Bermuda Re’s ability to declare and pay dividends sufficient to support Group’s general corporate needs. For the years ended December 31, 2005, 2004 and 2003, Everest Re paid dividends to Holdings of $75 million, $70 million and $45 million, respectively. For the years ended December 31, 2005 and 2004 Bermuda Re paid dividends to Group of $45 million and $15 million, respectively. See ITEM 1, “Business - Regulatory Matters - Dividends” and Note 14A of Notes to Consolidated Financial Statements.
effective, for entities that had not adopted FIN 46 as of December 24, 2003. The Company adopted FIN 46R in the first quarter of 2004, resulting in the deconsolidation of Capital Trust and Capital Trust II. For 2003, where applicable, the financial statements have been restated to reflect the deconsolidation.
In November 2005, the FASB issued the FASB Staff Position (“FSP”) FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“FAS 115-1”). FAS 115-1 would be applied prospectively and the effective date would be reporting periods beginning after December 15, 2005. The Company continues to apply Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“FAS 115”), and the SEC’s Staff Accounting Bulletin Topic 5:M, “Other Than Temporary Impairment Of Certain Investments In Debt And Equity Securities” and believes that unrealized losses in its investment portfolio are temporary in nature.
Interest rate risk is the potential change in value of the fixed maturity portfolio, including short-term investments, due to change in market interest rates. In a declining interest rate environment, it includes prepayment risk on the $1,527.2 million of mortgage-backed securities in the $10,042.1 million fixed maturity portfolio. Prepayment risk results from potential accelerated principal payments that shorten the average life and thus the expected yield of the security.
Market Value Change from Base (%) 9.0 % 4.5 % 0.0 % -4.8
Market Value Change from Base (%) 12.0 % 6.1 % 0.0 % -6.2
The tables below display the potential impact of a parallel and immediate 20% increase and decrease in foreign exchange rates on the valuation of invested assets subject to foreign currency exposure in 10% increments as of December 31, 2005 and 2004. This analysis includes the after-tax impact of translation from transactional currency to functional currency as well as the after-tax impact of translation from functional currency to the U.S. dollar reporting currency. The reduction in exposure between 2005 and 2004 principally arises from the strengthening of the U.S. dollar in relation to the British Pound Sterling and the Euro throughout the year. All amounts are in U.S. dollars and are presented in millions.
Although not considered material in the context of the Company’s aggregate exposure to market sensitive instruments, the Company has issued six specialized equity put options based on the S&P 500 index and one specialized equity put option based on the FTSE 100 index, that are market sensitive and sufficiently unique to warrant supplemental disclosure.
The Company has sold six specialized equity put options based on the S&P 500 index for total consideration, net of commissions, of $22.5 million. These contracts each have a single exercise date, with original maturities ranging from 12 to 30 years and strike prices ranging from $1,141.21 to $1,540.63. No amounts will be payable under these contracts if the S&P 500 index is at or above the strike price on the exercise dates, which currently fall between June 2017 and March 2031. If the S&P 500 index is lower than the strike price on the applicable exercise date, the amount due will vary proportionately with the percentage by which the index is below the strike price. Based on historical index volatilities and trends and the December 31, 2005 index value, the Company estimates the probability for each contract of the S&P 500 index being below the strike price on the exercise date to be less than 4.8%. The theoretical maximum payouts under the contracts would occur if on each of the exercise dates the S&P 500 index value were zero. The present value of these theoretical maximum payouts using a 6.0% discount factor is $201.2 million.
believe that the ultimate settlement of these transactions is likely to require a payment that would exceed the initial consideration received or any payment at all.