We operate in over 50 countries around the world including the U.S., Bermuda, the U.K., and Japan. Most of the office facilities that we occupy are leased. We are not dependent on our facilities to conduct business.
The following is a discussion of our results of operations, financial condition, and liquidity and capital resources as of and for the year ended December 31, 2005. This discussion should be read in conjunction with our Consolidated Financial Statements and related notes presented on pages to of this Form 10-K.
The insurance industry is highly competitive, with many companies including several new entrants, offering similar coverage. The rates, terms and conditions related to the products we offer have historically changed depending on the timing of the insurance cycle. During periods of excess underwriting capacity, as defined by availability of capital, competition can result in lower pricing and less favorable terms and conditions. During periods of reduced underwriting capacity, pricing and terms and conditions are generally more favorable.
32.91 million Ordinary Shares, including an over-allotment option of 4.29 million Ordinary Shares (the public offering), at a price per share of $45.58, for net proceeds of approximately $1.5 billion.
Information on the insurance industry investigations and related matters is set forth in Note 7 e) of our Consolidated Financial Statements.
These amounts were based on ground-up reviews of a substantial majority of our in-force direct policies and internal modeling of our in-force reinsurance policies we believe to be affected, together with information from our insureds and cedents which is still being received and evaluated. Actual losses may vary materially from these amounts as a result of, among other things, the receipt of additional information from insureds or brokers, the attribution of losses to coverages that, for the purpose of our calculations, we assumed would not be exposed and inflation in repair costs due to the limited availability of labor and materials. In addition, our Hurricane Katrina and Hurricane Rita losses are subject to a high level of uncertainty due to extremely complex and unique causation and coverage issues
associated with the events, including the attribution of losses to wind or flood damage or other perils, potential legal and regulatory developments related to potential losses, as well as inflation in repair costs due to the limited availability of labor and materials due in part to the size and proximity in time and distance of the two hurricanes. We expect that these issues may become subject to litigation by state attorneys general and private parties and will not be resolved for a considerable period of time. As a result, although we believe our reserves for these events are adequate, both industry wide insured losses and our losses from Hurricanes Katrina and Rita may ultimately be materially greater or lower than our initial reported losses and any additional losses could have a further material adverse impact on our financial results.
The following tables show the impact of catastrophe charges on each of our operating segments in 2005 and 2004. This information is based on currently available information derived from modeling techniques, industry assessments of exposure and claims information obtained from our clients and brokers. Actual losses from these events may vary materially from our estimates due to the inherent uncertainties in making such determinations resulting from several factors, including the potential inaccuracies and inadequacies in the data provided by clients and brokers, the modeling techniques and the application of such techniques, as well as the high frequency of recent catastrophic events and the effects of any resultant demand surge on claims activity.
We believe our accounting policies for these items are of critical importance to our Consolidated Financial Statements. The following discussion provides more information regarding the estimates and assumptions required to arrive at these amounts and should be read in conjunction with the sections entitled: Unpaid Losses and Loss Expenses, Asbestos and Environmental and Other Run-off Liabilities, Reinsurance, Investments, Net Realized Gains (Losses) and Other Income and Expense Items.
As an insurance and reinsurance company, we are required, by applicable laws and regulations and U.S. GAAP, to establish loss and loss expense reserves for the estimated unpaid portion of the ultimate liability for losses and loss expenses under the terms of our policies and agreements with our insured and reinsured customers. The estimate of the unpaid liabilities includes provision for claims that have been reported but unpaid at the balance sheet date (case reserves) and for future obligations from claims that have been incurred but not reported (IBNR) at the balance sheet date. The loss reserve also includes an estimate of expenses associated with processing and settling these unpaid claims (loss expenses). At December 31 2005, our unpaid losses and loss expense reserve was $35 billion. With the exception of certain structured settlements, for which the timing and amount of future claim payments are reliably determinable, our loss reserves are not discounted for time value. In connection with such structured settlements, we carry reserves of $121 million.
The process of establishing loss reserves for property and casualty claims can be complex and is subject to considerable variability as it requires the use of informed estimates and judgments based on circumstances known at the date of accrual. These estimates and judgments are based on numerous factors, and may be revised as additional experience and other data become available and are reviewed, as new or improved methodologies are developed or as current laws change. Hence, ultimate loss payments will differ from the estimate of the ultimate liability made at the balance sheet date. Changes to our previous estimates of prior year loss reserves can impact the reported calendar year underwriting results by reducing our reported results if the prior year reserves prove to be deficient or improving our reported results if the prior year reserves prove to be redundant. The potential for variation in loss reserves is impacted by numerous factors, which we explain below.
We establish loss and loss expense reserves for all of the insurance and reinsurance business that we write and have actuarial staff within each of our operating segments who analyze insurance reserves and regularly evaluate the levels of loss reserves, taking into consideration factors that may impact the ultimate value of the losses. When we establish loss reserves at each balance sheet date, we must make an estimate of IBNR for which there is limited information. As a result, historical experience and other statistical information are used to project the ultimate claims cost. To determine the reserves for a particular line of business, we may perform one or more reserving methods to estimate ultimate losses and loss expenses and select from these a single point estimate. These methods may include, but are not necessarily limited to, extrapolation of our reported and paid losses based on previous experience, application of industry loss development patterns to our reported or paid losses, or expected loss ratios developed by management based on prior company and industry experience. The underlying judgments and assumptions that may be incorporated into these actuarial projection models include, but are not necessarily limited to, adjustments of the historical data to exclude the potential distorting effect on the loss projections arising from catastrophe claims or other major claims with unusual features, the derivation and selection of factors used to project claims from known to ultimate cost using data with limited or volatile historical loss experience, adjustments to actuarial models and related data for known business changes, such as changes in coverage provided by insurance contracts or business mix, and the potential impact of recent or pending litigation on future claim settlements.
Our reserves are established as management’s best estimate of the provision for future unpaid claims. Each product line has an actuarial reserve review performed and a best estimate established at the review’s conclusion following the evaluation of one or more estimates developed during the review. The process to select the best estimate, when more than one estimate is available, may differ across lines of business. However, the objective of such a process is to determine a single best estimate that we believe represents a better estimate than any other. Such an estimate is viewed to support the most likely outcome of ultimate loss settlements and is determined based on several factors, including but not limited to, the segmentation of data to provide sufficient homogeneity and credibility for loss projection methods to apply, the extent of historical data and reliance on such data or industry data within the underlying reserve methodology, the historical variability of loss estimates compared with actual loss experience for the product line or comparable product lines, and nature and extent of underlying assumptions. Depending on the facts and circumstances of each product line, the determination of a single best estimate may be accomplished by selecting a single point estimate when one estimate is determined to reflect a “better” estimate than the other point estimates or using a probability weighted average approach when more than one estimate is viewed to be reasonable. For example, an actuary may select loss reserves developed using an incurred loss development approach instead of a paid loss development approach as the best estimate when reported losses are viewed to be a more credible indication of the ultimate loss compared with paid losses. The actuaries’ evaluation process to determine a best estimate involves collaboration with underwriting, claims, legal and finance departments and culminates with the input of reserve
committees. Each business unit reserve committee includes the participation of the relevant parties from actuarial, finance, claims and executive management and has the responsibility for finalizing and approving the point estimate to be used as our best estimate. Reserves are further reviewed by ACE’s Chief Actuary and senior management.
We do not calculate a range of loss reserve estimates for our individual loss reserve studies. Actuarial ranges are not a true reflection of the potential volatility between loss reserves estimated at the balance sheet date and the ultimate settlement of losses. This is due to the fact that an actuarial range is developed based on known events as of the valuation date whereas actual volatility or prior period development has historically been reported in subsequent Consolidated Financial Statements, in part from events and circumstances that were unknown as of the original valuation date. We do believe, however, that while our recorded reserves are reasonable and represent management’s best estimate for each individual study, based on known events, our total recorded loss reserves at December 31, 2005, are unlikely to vary by more than ten percent of the recorded amounts, either positively or negatively, based on actual claims emergence over the last several years, excluding A&E development. Historically, including A&E reserve charges, our reserves have developed in excess of ten percent of recorded amounts. Refer to “Analysis of Losses and Loss Expense Development”, under Item 1 for a summary of historical volatility between estimated loss reserves and ultimate loss settlements.
The following is a discussion of specific reserving considerations by type of claim:
Long-tail business describes lines of business for which specific losses may not be known for some period and losses take much longer to emerge. This includes most casualty lines such as general liability, directors and officers liability (D&O) and workers’ compensation. There are many factors contributing to the uncertainty and volatility of long-tail business. Among these are:
• Given the recent expansion of this business, our historical experience is often too immature to place reliance upon for reserving purposes. Instead, particularly for newer lines of business, reserve methods are based on industry loss ratios or development patterns that reflect the nature and coverage of the underwritten business and its future development. For new or growing lines of business, actual loss experience is apt to differ from industry loss statistics that are based on averages as well as loss experience of previous underwriting years;
• The possibility of future litigation, legislative or judicial change that might impact future loss experience relative to prior loss experience relied upon in loss reserve analyses;
The estimation of unpaid losses and loss expense reserves can also be affected by the layer at which a particular contract or set of contracts is written. In the case of direct insurance, where the insurer is taking on risk in the lower value end of the particular contract, the experience will tend to be more frequency driven. These lines of business allow for more traditional actuarial methods to be used in determining loss reserve levels, as it is customary to have more historical experience to rely upon. In the case of excess of loss contracts, the experience will tend to be more of a severity nature, as only a significant loss will enter the layer. For structured or unique contracts, most common to the financial solutions business and to a lesser extent our reinsurance business, traditional actuarial methods for setting loss reserves (such as loss development triangles), have to be tempered with an analysis of each contract’s terms,
original pricing information, subsequent internal and external analyses of the ongoing contracts, market exposures and history, and qualitative input from claims managers.
Included in our liabilities for losses and loss expenses are liabilities for asbestos and environmental claims and expenses (A&E). These claims are principally related to claims arising from remediation costs associated with hazardous
Our A&E reserves, and our range of estimates are not discounted and do not reflect any anticipated changes in the legal, social or economic environment, or any benefit from future legislative reforms. Accordingly, our A&E reserves make no allowance for future state or federal asbestos reforms, such as those currently being contemplated. The majority of our reserve increase in the fourth quarter of 2004 arose with the strengthening of a core group of major accounts impacted by changes in the asbestos industry landscape. In particular, our estimates of future liability were impacted by the continued negative effect of bankruptcies and an increase in defense costs to litigate cases.
The results in asbestos cases announced by other carriers may well have little or no relevance to us because coverage exposures are highly dependent upon the specific facts of individual coverage and resolution status of disputes among carrier, policyholder and claimants.
Generally, we use a default analysis to estimate uncollectible reinsurance. The primary components of the default analysis are reinsurance recoverable balances by reinsurer, net of collateral, and default factors used to estimate the probability that the reinsurer may be unable to meet its future obligations in full. The definition of collateral for this purpose requires some judgment and is generally limited to assets held in an ACE only beneficiary trust, letters of credit, and liabilities held by us with the same legal entity for which we believe there is a right of offset. We do not currently include multi-beneficiary trusts. However we have several reinsurers that have established multi-beneficiary trusts for which certain ACE companies are beneficiaries. The determination of the default factor is principally based on the financial strength rating of the reinsurer and a default factor applicable to the financial strength rating. Default factors require considerable judgment and are determined using the current financial strength rating, or rating equivalent, of each reinsurer as well as other key considerations and assumptions. The more significant considerations and assumptions include, but are not necessarily limited to, the following:
• For reinsurers that maintain a financial strength rating from a major ratings agency, and for which recoverable balances are considered representative of the larger population (i.e., default probabilities are consistent with similarly rated reinsurers and payment durations conform to averages), the judgment exercised by management to determine the provision for uncollectible reinsurance of each reinsurer is typically limited because the financial rating is based on a published source and the default factor we apply is based on a default factor of a major ratings agency applicable to the particular rating class. Default factors applied for financial ratings of AAA, AA, A, BBB, BB, B, CCC, are 0.5 percent, 1.2 percent, 1.9 percent, 4.7 percent, 9.6 percent, 23.8 percent, and 49.7 percent, respectively. Because the model we use is predicated on the default factors of a major ratings agency, we do not generally consider alternative factors. However, when a recoverable is expected to be paid in a brief period of time by a highly rated reinsurer, such as certain property catastrophe claims, a default factor may not be applied.
• For other recoverables management determines the provision for uncollectible reinsurance based on the specific facts and circumstances of that dispute.
The following table summarizes reinsurance recoverables and the provision for uncollectible reinsurance for each type of recoverable balance at December 31, 2005.
At December 31, 2005, the use of different assumptions within the model could have a material effect on the provision for uncollectible reinsurance reflected in our Consolidated Financial Statements. To the extent the creditworthiness of our reinsurers were to deteriorate due to an adverse event affecting the reinsurance industry, such as a large number of major catastrophes, actual uncollectible amounts could be significantly greater than our provision for uncollectible reinsurance. Such an event could have a material adverse effect on our financial condition, results of operations, and our liquidity. Given the various considerations used to estimate our uncollectible provision, we cannot precisely quantify the effect a specific industry event may have on the provision for uncollectible reinsurance. However, based on the composition (particularly the average credit quality) of the reinsurance recoverable balance at December 31, 2005, we estimate that a ratings downgrade of one notch for all rated reinsurers (e.g. from A to A- or A- to BBB+) could increase our provision for uncollectible reinsurance by approximately $200 million, assuming no other changes relevant to the calculation. While a rating downgrade would result in an increase in our provision for uncollectible reinsurance and a charge to earnings in that period, a downgrade in and of itself does not imply that we will not ultimately collect all of the ceded reinsurance recoverable from the reinsurers in question. Refer to “Reinsurance” for more information.
With respect to securities where the decline in value is determined to be temporary and the security’s value is not written down, a subsequent decision may be made to sell that security and realize a loss. Subsequent decisions on security sales could be made based on changes in liquidity needs (i.e., arising from a large insured loss such as a catastrophe), internal risk management considerations, the financial condition of the issuer or its industry, market conditions, and new investment opportunities. Day to day management of the majority of our investment portfolio is
At December 31, 2005, our net deferred tax asset was $1.3 billion. (See Note 15 of the Consolidated Financial Statements for more information). At each balance sheet date, management assesses the need to establish a valuation allowance that reduces deferred tax assets when it is more likely than not that all, or some portion, of the deferred tax assets will not be realized. The valuation allowance is based on all available information including projections of future taxable income from each tax-paying component in each tax jurisdiction, principally derived from business plans and available tax planning strategies. Projections of future taxable income incorporate several assumptions of future business and operations that are apt to differ from actual experience. If, in the future, our assumptions and estimates that resulted in our forecast of future taxable income for each tax-paying component proves to be incorrect, an additional valuation allowance could become necessary. This could have a material adverse effect on our financial condition, results of operations and liquidity. At December 31, 2005, the valuation allowance of $87 million (including $29 million with respect to foreign tax credits) reflects management’s assessment that it is more likely than not that a portion of the deferred tax asset will not be realized due to the inability of certain foreign subsidiaries to generate sufficient taxable income or the inability to utilize foreign tax credits.
ii) To mitigate our own financial risks, principally arising from our investment holdings, products sold, or assets and liabilities held in foreign currencies. For these instruments, changes in assets or liabilities measured at fair value are recorded as net realized gains or losses in the consolidated income statement. Derivative instruments used for this purpose include interest rate futures, equity futures based on the Standard & Poor’s (S&P) Index, options, interest rate swaps and foreign currency forward contracts primarily to manage duration and foreign currency exposure, enhance our portfolio yield or obtain an exposure to a particular financial market. In addition, as part of our investing activities, we purchase “to be announced mortgage backed securities” (TBAs), which are derivatives. Open derivatives as of the balance sheet date are reported at fair value based on market quotes or valuations provided to us by third party investment managers using market data. During 2005, 2004 and 2003, we did not designate any such derivatives as accounting hedges.
The fair value of derivative instruments depends on a number of factors including changes in interest rates, changes in equity markets, changes in credit markets and for GMIB reinsurance, changes in the allocation of investments underlying annuitant account value. Where available, we use quoted market prices to determine the fair value of these instruments. If the quoted prices are not available, the fair value is estimated using valuation models for each type of instrument. Internal valuation models include the use of management estimates and current market information. These models may be developed by third parties or internally based on market conventions for similar transactions, depending on the circumstances. These models and related assumptions are continuously reevaluated by management and enhanced, as appropriate, based upon improvements in modeling techniques and availability of more timely market information, such as market conditions and demographics of in-force annuities. Due to the inherent uncertainties of the assumptions used in the valuation models to determine the fair value of these derivative products, actual experience may differ from the estimates reflected in the Consolidated Financial Statements, and the differences may be material. Refer to