We own the property in which our offices are located in Dublin, Ireland. We lease office space in the other countries in which we operate under operating leases that expire at various dates. We renew and enter into new leases in the ordinary course of business as required. See note 11 to the Consolidated Financial Statements included in Item 8 of this report for a discussion of our lease commitments for real property. We believe that our office space is sufficient for us to conduct our operations for the foreseeable future.
The selected income statement data for the years ended December 31, 2004, 2003 and 2002 and the period ended December 31, 2001 and the selected balance sheet data as of December 31, 2004, 2003, 2002 and 2001 are derived from our audited Consolidated Financial Statements. Consolidated Financial Statements and Notes are presented under Item 8 of this report. These have been prepared
in accordance with U.S. GAAP and have been audited by Deloitte & Touche, our independent registered public accounting firm.
(2)The net loss and loss expense ratio is calculated by dividing net losses and loss expenses by net premiums earned.
(5)The combined ratio is the sum of the net loss and loss expense ratio, the acquisition cost ratio and the general and administrative expense ratio.
On July 7, 2003, we completed an initial public offering of 15.4 million newly issued common shares and 9.3 million common shares offered by selling shareholders. Net proceeds to the Company from the offering were $316.0 million and were credited to shareholders' equity. In April 2004, we completed a secondary offering of 23.0 million common shares offered by selling shareholders. We did not sell any common shares in connection with this offering and did not receive any proceeds.
On December 9, 2004, we announced that our Board had authorized the repurchase of up to $350.0 million of our common shares. On February 16, 2005, we repurchased 12,783,094 common shares owned by initial investors at our formation pursuant to the repurchase program. The average purchase price was $27.38 per common share and the aggregate purchase price was $350.0 million, which exhausted the repurchase program.
in response to the relatively tight reinsurance terms. We believe that this factor may impact the market opportunity for our casualty reinsurance lines.
Our premium income is supplemented by the income we generate from our investment portfolio. Our investment portfolio consists primarily of fixed income investments that are held as available for sale. Under U.S. GAAP, these investments are carried at fair market value and unrealized gains and losses on the investments are not included in our statement of operations. Rather, these unrealized gains and losses are included on our balance sheet in accumulated other comprehensive gain (loss) as a separate component of shareholders' equity. Our investment strategy seeks to preserve principal and maintain liquidity while trying to maximize investment return through a high-quality, diversified portfolio. The volatility of claims and the interest rate environment can affect the returns we generate on our investment portfolio.
Acquisition costs relate to the fees, commissions and taxes paid to obtain business. We offset commissions received on ceded premiums against acquisition costs. Typically, acquisition costs are based on a percentage of the premium written and will vary by each line of business that we underwrite. Our commissions include amounts accrued under incentive commission arrangements. These type of arrangements are under scrutiny following an industry-wide investigation by the Attorney General of the State of New York. We have accrued our best estimate of the amount due under these arrangements; however, given the uncertainties that exist surrounding the calculation and payment of these incentive commissions, this estimate is subject to change.
to support our worldwide insurance and reinsurance operations and costs associated with operating as a publicly-traded company. Prior periods have not been restated to reflect the full allocation of general and administrative costs as our business segments were not fully operational throughout 2003 and 2002. We do not allocate our assets by segment as we evaluate the underwriting results of each segment separately from the results of our investment portfolio.
Our ultimate objective as an insurance and reinsurance company is to generate superior returns on capital that appropriately reward us for the risks we assume and to grow revenue only when we deem the returns meet or exceed our requirements. To achieve this objective, we must be able to accurately assess the potential losses associated with the risks that we insure and reinsure, to manage our investment portfolio risk appropriately and to control acquisition costs and infrastructure throughout the organization. Three financial measures that are meaningful in analyzing our performance are return on equity, combined ratio and underwriting income. Our return on equity calculation is based on the level of net income generated from the average of the opening and closing shareholders' equity during the period. The combined ratio is a formula used by insurance and reinsurance companies to relate net premiums earned during a period to net losses and loss expenses, acquisition costs and general and administrative expenses during a period. A combined ratio above 100% indicates that a company is incurring more in net losses and loss expenses, acquisition costs and general and administrative expenses than it is earning in net premiums. We consider the combined ratio an appropriate indicator of our underwriting performance, particularly given the short tail orientation of our overall portfolio of risks. Underwriting income is a measure of profitability that takes into account net premiums earned and other insurance related income as revenue and net losses and loss expenses, acquisition costs and underwriting related general and administrative expenses as expenses. Underwriting income is the difference between these revenue and expense items. The following table details our key performance indicators:
Because we have a limited operating history and are exposed to volatility in our results of operations, period to period comparisons of our results of operations may not be meaningful. In addition, the amount of premiums written with respect to any particular segment or line of business may vary from year to year as a result of changes in market conditions.
For reported losses, we establish case reserves within the parameters of the coverage provided in the insurance or reinsurance contracts. With respect to our insurance operations, we are notified of insured losses and record a case reserve for the estimated amount of the ultimate expected liability arising from the claim. The estimate reflects the judgment of claims personnel based on general reserving practices, the experience and knowledge of such personnel regarding the nature of the specific claim and, where appropriate, advice of counsel. Reserves are also established to provide for
Loss reserving for catastrophe events is an inherently uncertain process. When a catastrophe occurs, we review our exposures to determine which exposures will be impacted by the event. We contact brokers and clients to determine their estimate of involvement and the extent to which their programs are affected. In addition, we may also use computer modeling to estimate loss exposures under the actual event scenario. We currently use Risklink version 4.5 licensed by RMS, Classic/2 and CATRADER licensed by AIR and WORLDCAT Enterprise licensed by Eqecat. As part of the underwriting process, we obtain exposure data from our clients, so that when an event occurs we can run our models to produce an estimate of the losses incurred by clients on programs that we insure or reinsure. Typically, we derive our estimate for the losses from a catastrophic event by blending all of the sources of loss information available to us. This estimate is derived by the claims team and is known as "case IBNR". Generally, for catastrophic events there is considerable uncertainty underlying the assumptions and associated estimated reserves for losses and loss expenses. Reserves are reviewed quarterly and as experience develops and additional information is known, the reserves are adjusted as necessary. Such adjustments are reflected in the period in which they become known.
Reinsurance operations by their nature add further complications to the reserving process, particularly for casualty business written, in that there is an inherent lag in the timing and reporting of a loss event from an insured or ceding company to the reinsurer. This reporting lag creates an even longer period of time between the policy inception and when a claim is finally settled. As a result, more prudence is required to establish reserves for ultimate claims in our reinsurance operations.
Our IBNR is estimated by independent actuaries using actuarial methods. Our estimate of IBNR is initially derived using the Bornhuetter-Ferguson method although the initial expected loss ratio and chain ladder ("loss emergence") methods are also utilized for some lines of business. The Bornhuetter-Ferguson method is typically used by companies with limited loss experience. This method takes as a starting point an assumed ultimate loss and loss expense ratio and blends in the loss and loss expense ratio implied by the experience to date.
For our global insurance and U.S. insurance segments, the assumed ultimate loss and loss expense ratios are based on benchmarks derived from the independent actuary's wider market experience together with our limited historical data. These benchmarks are then adjusted for rating increases and changes in terms and conditions that have been observed in the market and by us. For our global reinsurance segment, the assumed ultimate loss and loss expense ratios are based on contract-by-contract initial expected loss ratios derived during pricing together with benchmarks derived from the independent actuary's wider market experience. For our U.S. reinsurance segment, the assumed ultimate loss and loss expense ratios are based on a review carried out by the independent actuaries of the pricing loss ratios on a contract-by-contract basis together with benchmarks derived from the independent actuary's wider market experience. Under U.S. GAAP, we are not permitted to establish loss reserves with respect to our catastrophe reinsurance until an event that gives rise to a loss occurs. Within our catastrophe line of business, on some contracts that respond to highly visible, major catastrophes, we are not holding any general IBNR (although in certain cases we are holding case IBNR where potential exposure has been identified).
In assessing the adequacy of these reserves it must be noted that the actual final costs of settling claims outstanding is uncertain as it depends upon future events. There is necessarily a range of possible outcomes and the eventual outcome will almost certainly differ from the projections currently made. This uncertainty is heightened by the short time in which we have operated, thereby providing limited claims loss emergence patterns specifically for the Company. This has necessitated the use of benchmarks in deriving IBNR which, despite management's and the independent actuary's care in selecting them, could differ materially from actual experience.
For the majority of our insurance business, we receive a flat premium which is identified in the policy and which is recorded as unearned premium on the inception date of the contract. This premium will only adjust if the underlying insured values adjust. We actively monitor underlying insured values and record adjustment premiums in the period in which amounts are reasonably determinable.
years ended December 31, 2004, 2003 and 2002, proportional premiums accounted for 10%, 7% and 8%, respectively, of total gross premiums written.
Premiums ceded for the year ended December 31, 2004 were $588.6 million compared with $365.3 million for the year ended December 31, 2003, an increase of $223.3 million. We purchase reinsurance to reduce our exposure to risk of loss on some lines of business written primarily within our global insurance and U.S. insurance segments. The increase in ceded premiums was generated primarily within these segments.
Net premiums earned for the year ended December 31, 2004 were $2.0 billion compared with $1.4 billion for the year ended December 31, 2003, an increase of $0.6 billion. Premiums are earned over the term of the policies in proportion to the risks to which they relate. As the level of net premiums written increases, the level of net premiums earned also increases. As we experienced an increase in net premiums written in all of our segments for the year ended December 31, 2004 compared to the year ended December 31, 2003, our net premiums earned increased.
$78.1 million. This increase was due to a combination of higher investment balances and higher investment yields. The 2003 amount also included an additional charge for the amortization expense on our mortgage-backed securities portfolio. Net investment income consisted primarily of interest on fixed income securities that was partially offset by net investment expenses of $7.0 million for the year ended December 31, 2004 compared with $5.8 million for the year ended December 31, 2003. The higher expenses were a result of an increase in our assets managed by external portfolio managers offset by securities lending income.
The annualized effective yield (calculated by dividing the net investment income generated from invested assets by average balance of the assets managed by our portfolio managers) for the year ended December 31, 2004 was 3.4% compared with 2.6% for the year ended December 31, 2003. The increase in the effective yield was primarily due to higher U.S. interest rates at the short end of the yield curve. The 2003 yield also was reduced by the additional charge for the amortization expense on our mortgage-backed securities portfolio. The yield may vary significantly from period to period due primarily to the timing of cash flows, changes in interest rates and changes in asset allocation.
Net Realized Gains. Net realized gains for the year ended December 31, 2004 were $13.6 million compared with $22.6 million for the year ended December 31, 2003, a decrease of $9.0 million. We invest our portfolios to produce a total return. In assessing returns under this approach, we include investment income, realized gains and losses and unrealized gains and losses generated by the investment portfolios. As a result, there can be significant changes in the levels of our net realized gains (losses) from quarter to quarter. Some of our mortgage-backed securities are required to be classified as derivatives; included within net realized gains was $0.3 million in realized gains associated with these securities.
Other Insurance Related Income. Other insurance related income for the year ended December 31, 2004 was $11.3 million compared with income of $25.0 million for the year ended December 31, 2003, a decrease of $13.7 million. This income related to the movement in the fair value of our insurance and reinsurance contracts that met the definition of a derivative.
General and Administrative Expenses. General and administrative expenses for the year ended December 31, 2004 were $187.3 million compared to $136.5 million for the year ended December 31, 2003, an increase of $50.8 million. This increase was primarily driven by the establishment and expansion of operations in Europe and the U.S. In addition, we incurred $3.8 million of fees in connection with our preparation for compliance with section 404 of the Sarbanes-Oxley Act of 2002. Following the adoption of Financial Accounting Standard No. 148, we began to expense stock options and stock awards over the vesting period using the fair value method. For the year ended December 31, 2004, we expensed $17.3 million compared to $8.5 million for the year ended December 31, 2003. The general and administrative expense ratio for the year ended December 31, 2004 was 9.2% compared to 9.5% for the year ended December 31, 2003. The decrease in the ratio was caused by an increase in the volume of net premiums earned.
Foreign Exchange. Our functional currency is the U.S. dollar; however, some of our business is written in other currencies. For the year ended December 31, 2004, we experienced a gain of $14.5 million compared to a gain of $32.2 million for the year ended December 31, 2003, a decrease of $17.7 million. While the Euro and Sterling appreciated by 7.6% and 7.4%, respectively, in 2004, these increases were less than the appreciation experienced by these currencies in 2003 and, therefore, our gains were less than in 2003.
Net Income. Net income for the year ended December 31, 2004 was $495.0 million compared to $532.3 million, a decrease of $37.3 million. Net income for the year ended December 31, 2004 consisted of net underwriting income of $364.6 million, net investment income and net realized gains of $165.7 million, corporate expenses of $39.1 million, foreign exchange gains of $14.5 million, interest expense of $5.3 million and tax expense of $5.4 million. Net income for the year ended December 31, 2003 consisted of net underwriting income of $497.5 million, net investment income and net realized gains of $96.5 million, corporate expenses of $93.1 million, foreign exchange gains of $32.2 million, interest expense of $1.5 million and an income tax recovery of $0.7 million.
Comprehensive Income. Comprehensive income for the year ended December 31, 2004 was $482.7 million compared to $532.0 million for the year ended December 31, 2003, a decrease of $49.3 million. Comprehensive income represents net income adjusted for changes in the unrealized position in our investment portfolio. For the year ended December 31, 2004, we experienced a decrease of $12.2 million in the unrealized position in our investment portfolio compared to a negligible decrease during the year ended December 31, 2003.
Net premiums earned for the year ended December 31, 2003 were $1.4 billion compared with $536.9 million for the year ended December 31, 2002, an increase of $899.3 million. This increase was caused by two factors. Firstly, we increased the volume of premiums written during the year ended December 31, 2003 over 2002. Secondly, as the year ended December 31, 2002 was our first full underwriting year, premiums were earned only on contracts written following the commencement of operations in November of 2001 through the end of December 2001. For the year ended December 31, 2003, we earned premiums on contracts written in both 2003 and 2002.
Net Investment Income and Net Realized Gains (Losses). Net investment income, including realized gains, for the year ended December 31, 2003 was $96.5 million compared with $97.4 million for the year ended December 31, 2002, a decrease of $0.9 million.
Other Insurance Related Income (Loss). Other insurance related income for the year ended December 31, 2003 was $25.0 million compared with a loss of $0.6 million for the year ended December 31, 2002, an increase of $25.6 million. This income related to the movement in the fair value of our insurance and reinsurance contracts that met the definition of a derivative.
Foreign Exchange Gains. Our functional currency is the U.S. dollar; however, some of our business is written in other currencies. For the year ended December 31, 2003, we experienced a gain
Interest Expense. Interest Expense for the year ended December 31, 2003 was $1.5 million compared to $1.4 million for the year ended December 31, 2002, an increase of $0.1 million. Interest expense related to fees incurred with respect to our credit facility.
Net Income. Net income for the year ended December 31, 2003 was $532.3 million compared to $265.1 million for the year ended December 31, 2002, an increase of $267.2 million. Net income for the year ended December 31, 2003 consisted of net underwriting income of $497.5 million, net investment income and net realized gains of $96.5 million, corporate expenses of $93.1 million, foreign exchange gains of $32.2 million, interest expense of $1.5 million and tax recovery of $0.7 million. Net income for the year ended December 31, 2002 consisted of net underwriting income of $203.2 million, net investment income and net realized gains of $97.4 million, corporate expenses of $45.1 million, foreign exchange gains of $9.6 million, interest expense of $1.4 million and an overall tax benefit of $1.4 million.
Comprehensive Income. Comprehensive income for the year ended December 31, 2003 was $532.0 million compared to $291.1 million for the year ended December 31, 2002, an increase of $240.9 million. Comprehensive income represents net income adjusted for changes in the unrealized position in our investment portfolio. For the year ended December 31, 2003, we experienced a negligible net decrease in the unrealized position in our investment portfolio compared to an increase of $25.9 million during the year ended December 31, 2002.
Our business consists of four underwriting segments: global insurance, global reinsurance, U.S. insurance and U.S. reinsurance.
We evaluate the performance of each underwriting segment based on underwriting results. With effect from January 1, 2004, we included the personnel expenses of our underwriters in general and administrative expenses; prior to that date, they were included in acquisition costs. Disclosures relating to prior periods have been restated to reflect this change. In addition, with effect from January 1, 2004, we allocated all of our general and administrative costs, except for corporate expenses, to our underwriting segments. Our corporate costs include holding company costs necessary to support our worldwide insurance and reinsurance operations and costs associated with operating as a publicly-traded company. We have not restated prior periods to reflect the full allocation of general and administrative costs as our business segments were not fully operational throughout 2003. We do not allocate our assets by segment as we evaluate the underwriting results of each segment separately from the results of our investment portfolio.
in the second half of 2003. Our political risk gross premiums written increased by $35.1 million due to an increase in the level of direct foreign investment and an increased targeting of this business.
increase of $63.7 million. The following table shows the components of net losses and loss expenses incurred:
The net loss and loss expense ratio for the year ended December 31, 2004 was 56.7% compared to 50.8% for the year ended December 31, 2003. During the year ended December 31, 2004, we experienced significant net losses and loss expenses of $50.3 million, or 6.3 percentage points, from Hurricanes Charley, Frances, Ivan and Jeanne in our property, energy and marine books of business. These losses primarily accounted for the increase in the level of reported case reserves. Our estimates for the losses incurred from these hurricanes were derived from formal loss advices, the output of industry models, a review of in-force contracts and preliminary indications from clients. Consequently, actual losses from these hurricanes may vary materially from estimated losses. The increase in our reinsurance recoveries was primarily driven by recoveries of $33.9 million from losses caused by Hurricanes Frances and Ivan.
December 31, 2004 was 4.4% compared with 2.1% for the year ended December 31, 2003. As we did not allocate any of our general and administrative expenses, except for the personnel expenses of our underwriters, prior to January 1, 2004, these amounts and ratios are not comparable.
The following table summarizes the underwriting results and ratios for the years ended December 31, 2003 and December 31, 2002:
Our marine book generated an increase in gross premiums written of $30.8 million. This was primarily derived from the marine liability business where we experienced an increase in the number of contracts and improvements in rates. Gross premiums written in our onshore and offshore energy book
increased by $51.0 million. This was partially generated by the expiration of multi-year deals with other carriers, which allowed us to participate on new contracts in 2003. Our aviation and aerospace book experienced an increase in gross premiums written of $63.7 million. This was generated from our core aviation risks, which include hull and liability risks for passenger and cargo airlines and privately owned aircraft, and two large product liability accounts. Rates within the airline market stabilized at a good level in the last quarter of 2003 driven by a withdrawal of capacity from the market. Gross premium written within our property line of business increased by $19.2 million partially due to greater penetration, which resulted in the addition of several new property accounts. Our specialty risks book generated an increase of $22.2 million in gross premiums written primarily due to an increase in the level of political risk business following a rise in the level of direct foreign investment and an increase in the level of aviation war business due to greater penetration on our aviation hull and liability books. This increase offset the reduction in our terrorism book caused by the effects of TRIA and heightened competition for the business outside of TRIA.
Premiums ceded for the year ended December 31, 2003 were $40.8 million compared to $89.7 million for the year ended December 31, 2002, a decrease of $48.9 million. The decrease was due to timing, with a significant reinsurance policy that incepted in the third quarter of 2002 having a sixteen month coverage period and, therefore, not renewing until the first quarter of 2004.
Ceded premiums are amortized over the contract term. Consequently, the level of amortized ceded premium increased in 2003 as premiums ceded in 2002 continued to be amortized in 2003.
Net Losses and Loss Expenses. Net losses and loss expenses were $388.0 million for the year ended December 31, 2003 compared to $137.8 million for the year ended December 31, 2002, an
increase of $250.2 million. The following table shows the breakdown of net losses and loss expenses incurred:
General and Administrative Expenses. General and administrative expenses for the year ended December 31, 2003 were $15.9 million compared to $6.0 million for the year ended December 31, 2002, an increase of $9.9 million. The general and administrative expenses ratio was 2.1% for the year ended December 31, 2003 and 1.9% for the year ended December 31, 2002. These expenses related to the personnel expenses of our underwriters.
During the year ended December 31, 2004, our gross premiums written increased by 65.5% compared to the year ended December 31, 2003. This was primarily due to our expansion into continental Europe and an increase in catastrophe business. Our catastrophe book of business generated an increase in gross premiums written of $84.1 million. This was driven by a trend toward
counterparty diversification in our target markets, which enabled us to participate on a greater number of programs than in the prior year; this offset some moderate rate reductions and instances where we declined to renew contracts because terms and conditions became unacceptable. The increase in our property pro rata and property per risk gross premiums written of $63.1 million and $28.5 million, respectively, was primarily due to an increase in the number of contracts written. Credit and bond and motor and general liability were new lines of business in 2004 following the opening of a reinsurance branch in Zurich.
Premiums ceded for the year ended December 31, 2004 were $28.1 million compared to $9.4 million for the year ended December 31, 2003, an increase of $18.7 million. For the year ended December 31, 2004, $6.1 million, or 21.7%, related to reinstatement premiums on coverages exhausted by losses from Hurricanes Charley, Frances, Ivan and Jeanne. Our global reinsurance segment purchases reinsurance to protect against a large industry loss or series of losses.
General and Administrative Expenses. General and administrative expenses for the year ended December 31, 2004 were $29.7 million compared to $5.3 million for the year ended December 31, 2003, an increase of $24.4 million. The general and administrative expenses ratio for the year ended December 31, 2004 was 4.6% compared with 1.3% for the year ended December 31, 2003. As we did not allocate any of our general and administrative expenses, except for the personnel expenses of our underwriters, prior to January 1, 2004, these amounts and ratios are not comparable.
Premiums ceded for the year ended December 31, 2003 were $9.4 million. Prior to 2003, we had not purchased reinsurance for this segment. Due to the increase in our catastrophe exposures, we bought some coverages during 2003 aimed at providing reinsurance protection in the event of a large industry loss.
Gross premiums are earned over the period of the insured risk. Consequently, the level of earned premiums increased in 2003 as premiums written throughout 2002 continued to be earned in 2003.
Acquisition Costs. Acquisition costs for the year ended December 31, 2003 were $65.8 million compared to $40.5 million for the year ended December 31, 2002, an increase of $25.3 million. The acquisition cost ratio for the year ended December 31, 2003 was 15.7% compared with 18.3% for the year ended December 31, 2002. This decrease was primarily due to a change in the mix of business, with a lower proportion of property pro rata business written.
General and Administrative Expenses. General and administrative expenses for the year ended December 31, 2003 were $5.3 million compared to $6.5 million for the year ended December 31, 2002. The decrease of $1.2 million was due to a change in the allocation of personnel expenses between segments. The general and administrative expenses ratio for the year ended December 31, 2003 was 1.3% compared with 2.9% for the year ended December 31, 2002.
Our U.S. Insurance segment primarily consists of specialty lines business sourced in the U.S. and covers exposures predominantly in the U.S. The U.S. insurance segment includes the following risk classifications: property, liability and professional lines.
Our property book generated gross premiums written of $313.3 million during the year ended December 31, 2004, an increase of 38.9% over the year ended December 31, 2003. This was primarily due to four reasons: first, we introduced a new product line in mid-2003; second, we increased our maximum line sizes, which enabled our underwriters to access more business; third, we increased the number of states in which we were able to write business on a non-admitted basis; and fourth, we increased our market penetration.
Premiums ceded for the year ended December 31, 2004 were $394.1 million compared to $311.8 million for the year ended December 31, 2003, an increase of $82.3 million. Our U.S. insurance segment purchases significant proportional and excess of loss reinsurance on both a treaty and facultative basis that is designed to reduce the volatility in our severity driven classes of business. As a result, as the total of our gross premiums written increases so does the total of our premiums ceded. The ratio of premiums ceded to gross premiums written decreased to 47.8% for the year ended December 31, 2004 from 49.8% for the year ended December 31, 2003. This reduction was principally driven by our decision to maintain a higher net retention on our professional lines book of business.
Ceded premiums are amortized over the contract term. Consequently, the level of ceded premiums amortized increased in 2004 as premiums ceded in 2003 continued to be amortized in 2004. We expect the level of ceded premiums amortized to continue to increase in 2005.
Net Losses and Loss Expenses. Net losses and loss expenses were $234.7 million for the year ended December 31, 2004 compared to $108.5 million for the year ended December 31, 2003, an increase of $126.2 million. This segment purchases significant reinsurance coverage, therefore, we have recorded reinsurance recoveries in our incurred but not reported loss reserves. The following table shows the components of net losses and loss expenses incurred:
Acquisition Costs. Acquisition costs for the year ended December 31, 2004 were $10.8 million compared to $2.6 million for the year ended December 31, 2003, an increase of $8.2 million. The acquisition cost ratio for the year ended December 31, 2004 was 3.1% compared to 1.6% for the year ended December 31, 2003. As a percentage of gross premiums earned, the acquisition cost ratio was 1.6% for the year ended December 31, 2004 compared to 0.7% for the year ended December 31, 2003. The increase was primarily driven by a reduction in the level of commissions received on ceded premiums, which are offset against acquisition costs. Excluding the impact of commissions received on ceded premiums, the acquisition cost ratio as a percentage of gross premiums earned was consistent at 14.1% for the year ended December 31, 2004 and 14.7% for the year ended December 31, 2003.
Net Losses and Loss Expenses. Net losses and loss expenses were $209.5 million for the year ended December 31, 2004 compared to $63.2 million for the year ended December 31, 2003, an
to maintain minimum solvency requirements and limit the amount of dividends that these subsidiaries can pay to us, which in turn may limit our ability to pay dividends and make other payments.
At December 31, 2004, total investments at fair market value, accrued interest receivable and cash net of unsettled investment trades were $6.0 billion, compared to $4.0 billion at December 31, 2003. Our investment portfolio consisted primarily of fixed income securities at December 31, 2004 and was managed by several external investment management firms. At December 31, 2004, all of these fixed income securities were investment grade, with 83.9% rated Aa3 or AA- or better by an internationally recognized rating agency. The weighted-average rating of our fixed income portfolio was AA+ based on ratings assigned by Standard & Poor's. The net payable for investments purchased at December 31, 2004 was $49.9 million compared to a net receivable of $3.4 million at December 31, 2003. Net receivables/payables are a result of timing differences only, as investments are accounted for on a trade date basis.
At December 31, 2004, we had $2.4 billion of reserves for loss and loss expenses compared to $1.0 billion at December 31, 2003, an increase of $1.4 billion. Of this balance, $1.8 billion, or 75.6%, was incurred but not reported reserves.
Our cash flows from operations generally represent the difference between: (1) premiums collected, reinsurance recoveries and investment earnings realized and (2) losses and loss expenses
In the year ended December 31, 2004, we generated a net operating cash inflow of $1.6 billion, primarily relating to premiums received and investment income. During the same period we paid gross losses of $338.7 million and received reinsurance recoveries of $35.1million. We invested a net cash amount of $1,991.0 million during the period, and at December 31, 2004 had a cash balance of $632.3 million. During the year ended December 31, 2004, net cash of $416.5 million was generated from financing activities. We paid dividends of $78.3 million, and raised $495.7 million from a senior note offering.
We declared four quarterly dividends of $0.125 per common share. The dividends were payable on April 14, 2004, July 14, 2004, October 14, 2004 and January 12, 2005. During 2003, we declared two quarterly dividends of $0.07 per common share. The dividends were payable on October 14, 2003 and January 14, 2004.
On April 21, 2004, we completed a secondary public offering of 20,000,000 common shares held by some of our founding shareholders at a price of $27.91 per share. On April 27, 2004, we completed a secondary public offering of 3,000,000 common shares to cover over-allotments. We did not sell any common shares in connection with the registration and did not receive any proceeds from the offering.
On an ongoing basis, our sources of funds primarily consist of premiums written, reinsurance recoveries, investment income and proceeds from sales and redemptions of investments. Cash is used primarily to pay losses and loss expenses, reinsurance premiums, acquisition costs and general and administrative expenses, to purchase new investments and to fund dividend and interest payments.
On November 15, 2004, we completed a public offering of $500 million of senior notes. The notes bear interest at 5.75%, payable semi-annually and, unless previously redeemed, will mature on December 1, 2014.
We did not make any significant capital expenditures during the year ended December 31, 2004. We currently expect capital expenditures for 2005 to be less than $50 million.
The following table provides an analysis of our contractual obligations at December 31, 2004:
Our reserves for losses and loss expense consist of case reserves, ACR and IBNR. In assessing the adequacy of these reserves, it must be noted that the actual costs of settling claims is uncertain as it depends upon future events. Many of these events will be out of our control and could potentially affect the ultimate liability and timing of any potential payment. There is necessarily a range of possible outcomes and the eventual outcome will certainly differ from the projections currently made. This uncertainty is heightened by the short time in which we have operated, thereby providing limited Company-specific claims loss emergence patterns. Consequently, we must use industry benchmarks, on a line by line basis, in deriving IBNR which, despite management's and our independent actuary's care in selecting them, will differ from actual experience.
Similarly, we have limited loss payout pattern information specific to our experience, therefore we have used industry data, on a line by line basis, to estimate our expected payments. Consequently, despite management's and our independent actuary's care in selecting them, the actual payment of our reserve for losses and loss expenses will differ from estimated payouts.
On November 4, 2004 we signed a letter of intent for a proposed acquisition of all of the outstanding common stock of a Wisconsin domiciled insurance company. The purchase price will be based on market value of the statutory capital and surplus at the date of acquisition and a sum equating to the value of the number of insurance licenses acquired. The acquisition is subject to the completion of a definitive agreement and necessary regulatory approvals.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of AXIS Capital Holdings Limited and subsidiaries at December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company's internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 25, 2005 expressed an unqualified opinion on management's assessment of the effectiveness of the Company's internal control over financial reporting and an unqualified opinion on the effectiveness of the Company's internal control over financial reporting.
AXIS Specialty Holdings Ireland Limited, a wholly owned subsidiary of AXIS Capital, was incorporated in Ireland on January 28, 2002 and acts as a holding company for AXIS Specialty Europe Limited and AXIS Re Limited. AXIS Specialty Europe Limited became licensed as an Irish insurer in May 2002. AXIS Re Limited also became entitled to carry on reinsurance business from Ireland in May 2002. AXIS Specialty London was established in June 2003 as a UK branch of AXIS Specialty Europe Limited. The branch commenced underwriting facultative business in London during September 2003. AXIS Re Europe was established in August 2003 as a Swiss branch of AXIS Re Limited. The branch commenced underwriting reinsurance business in Zurich during November 2003.
These consolidated financial statements include the accounts of AXIS Capital and all of its subsidiaries (together, the "Company") and have been prepared in accordance with accounting principles generally accepted in the United States ("U.S. GAAP"). All significant inter-company accounts and transactions have been eliminated. Certain amounts in 2003 and 2002 have been reclassified to conform to current year presentation. The preparation of these consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period.
Actual results could differ significantly from those estimates. The major estimates reflected in the Company's consolidated financial statements include the reserves for losses and loss expenses, premium estimates for business written on a line slip or proportional basis, the estimation of accruals for amounts due under incentive commission agreements and the estimation of fair values for derivative contracts. The terms "FAS" and "FASB" used in these notes refer to Statements of Financial Accounting Standards issued by the United States Financial Accounting Standards Board.
Investments that are considered to be "available for sale" under the definition included in FAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities" are reported at fair market value. The fair market value of investments is based upon quoted market values. The net unrealized gain or loss on investments, net of tax, is included as accumulated other comprehensive gain (loss) in shareholders' equity.
Purchases and sales of investments are recorded on a trade date basis. Realized gains or losses on sales of investments are determined based on the specific identification method. Net investment income includes interest and dividend income together with amortization of market premiums and discounts and is net of investment fees. For mortgage-backed securities and any other holdings for which there is a prepayment risk, prepayment assumptions are evaluated and revised as necessary. Any adjustments required due to the change in effective yields and maturities are recognized on a prospective basis through yield adjustments.
Premiums written are recorded in accordance with the terms of the underlying policies. Reinsurance premiums assumed are estimated based upon information received from ceding companies and any subsequent differences arising on such estimates are recorded in the period they are determined. Premiums are generally contractually stated except for business written on a line slip or proportional basis. Under FAS 60 "Accounting and Reporting by Insurance Enterprises" a company is permitted to book premium as long as it is reasonably estimable. For line slip premiums, the Company receives an initial estimate of expected premium from the client via the broker. In the case of proportional contracts, the Company receives an estimate of the expected premium to be ceded from its client. The Company actively monitors the emergence of actual premium data on line slip policies and proportional reinsurance contracts and adjusts its estimates of written premiums to reflect reported premiums on a periodic basis as reliable information becomes available.
Applying these loss and loss expense ratios to earned premium derives the estimated baseline ultimate costs of the losses from which paid losses and reported case reserves are deducted to generate baseline IBNR. The actuarial methodologies used to derive the baseline estimate can not fully allow for all uncertainties within the Company's business. To account for some of these uncertainties, the independent actuaries have performed, in conjunction with management, an analysis of additional factors to be considered when establishing IBNR. These uncertainties may vary over time, but generally contemplate matters such as the timing and emergence of claims or short term market trends that might alter our otherwise consistent, baseline approach. A combination of the baseline estimate of IBNR and the reserves for the additional uncertainties constitutes management's and the actuaries' best estimate of IBNR.
The Company accounts for stock compensation in accordance with FAS No. 123, "Accounting for Stock-Based Compensation." Compensation expense for stock options and for restricted stock awards granted to employees is recorded over the vesting period using the fair value method.
The Company adopted FAS No. 123 effective January 1, 2003 by applying the prospective method permitted under FAS No. 148 "Accounting for Stock-Based Compensation-Transition and Disclosure." Prior to 2003, the Company followed Accounting Principles Board Opinion No. 25 "Accounting for Stock Issued to Employees" and related interpretations in accounting for its employee stock compensation. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FAS 123 to all of its stock-based compensation prior to January 1, 2003.
The Company accounts for intangible assets in accordance with FAS No. 142 "Goodwill and Other Intangible Assets." The Company does not amortize goodwill or identifiable intangible assets with indefinite lives, but rather re-evaluates on a yearly basis, or whenever changes in circumstances warrant, the recoverability of the assets. If it is determined that an impairment exists, the Company adjusts the carrying value of the assets to the fair value. In respect of intangible assets with definite lives, the Company will amortize the value over the assets over their useful lives.
A valuation allowance against deferred tax assets is recorded when management's assessment indicates that it is more likely than not that a portion of the deferred tax asset will not be realized in the foreseeable future.
The Company consists of four underwriting segments-global insurance, global reinsurance, U.S. insurance and U.S. reinsurance. In addition, there is a corporate segment that includes the investment and financing operations of the Company. The Company evaluates the performance of each underwriting segment based on underwriting results. With effect from January 1, 2004, the Company
The Company's global insurance segment principally consists of specialty lines business sourced outside of the U.S. but covering exposures throughout the world. In this segment, the Company offers clients tailored solutions in order to respond to their distinctive risk characteristics. Since most of the lines in this segment are for physical damage and related perils and not for liability coverage, the segment is principally short to medium tail business. This means that claims are generally made and settled earlier than in long tail business.
The Company's U.S. reinsurance segment principally consists of treaty reinsurance business sourced in the U.S. and focuses almost exclusively on exposures in the U.S. The underlying property and casualty business classes covered by the treaties the Company writes in the U.S. reinsurance segment include professional lines, liability, property, marine and aviation. The following is an analysis of the underwriting results, ratios and the reserves for losses and loss expenses for the four underwriting segments:
and subsequently renamed it AXIS Surplus Insurance Company ("AXIS Surplus"). The Company paid a purchase price of $34.7 million. The results of AXIS Surplus' operations have been included in the consolidated financial statements from the effective purchase date of January 1, 2003. The purchase of AXIS Surplus was made to expand the Company's ability to write insurance on a non-admitted basis within the U.S.
These purchases have been accounted for under the purchase method of accounting. The assets of the two companies (fixed income securities $23.0 million, cash $3.4 million and licenses $14.1 million) were recorded at their fair values on the date of completion of the acquisitions. The process of determining the fair value of the acquired assets, as required under purchase accounting, included
independent valuations. The purchase prices have been fully allocated against the fair values of the assets; consequently, no goodwill was recorded. At the dates that AXIS Insurance and AXIS Reinsurance were acquired, the pre-acquisition liabilities had been assumed by the sellers or their affiliates. The respective sellers further agreed to indemnify the acquired companies and our U.S. holding company from and against any and all such liabilities. Some of the underlying liabilities have been reinsured with third parties. Other liabilities are being collateralized by the pledge of securities. In the event that the reinsurance and collaterization are insufficient to pay all covered insurance claims, and the sellers do not fulfill their obligations under the indemnification, the Company would have liability for such claims. Given the remote possibility of this event, the Company did not record any of the claim liabilities.
The following represents an analysis of gross realized gains (losses) and the change in unrealized gains on investments included within Accumulated other comprehensive gain:
The unrealized losses on fixed maturity securities were split as follows:
with a fair market value of $88.6 million (2003: $5.9 million). As of December 31, 2004, none (2003: none) of these securities were considered to be other than temporarily impaired. The unrealized losses from these securities were not a result of credit, collateral or structural issues.
The following table sets forth certain information regarding the credit ratings of the Company's fixed maturity portfolio:
At December 31, 2004, $23.7 million (2003: $24.4 million) of securities were on deposit with various state or government insurance departments in order to comply with relevant insurance regulations.
As the Company writes business with loss experience generally characterized as low frequency and high severity in nature, this will result in volatility in its financial results. The Company incurred net losses and loss expenses of $266.3 million relating to Hurricanes Charley, Frances, Ivan and Jeanne. Our estimates for the losses incurred from these hurricanes were derived from formal loss advises, the output of industry models, a review of in-force contracts and preliminary indications from clients. Consequently, actual losses from these hurricanes may vary materially from estimated losses.
During the years ended December 31, 2004 and 2003, the Company has experienced favorable loss development on prior year losses. We primarily use the Bornhuetter-Ferguson method to estimate the ultimate cost of losses; it takes as a starting point an assumed ultimate loss and loss expense ratio and blends in the loss and loss expense ratio implied by experience to date. During the years ended December 31, 2004 and December 31, 2003, actual claims were less than expected, which resulted in favorable development.
Gross premiums written, ceded and net amounts of premiums written and premiums earned for the years ended December 31, 2004, 2003 and 2002 are as follows:
As at December 31, 2004, a net asset of $8.3 million (2003: $5.5 million) was included in insurance and reinsurance premiums receivable. The notional value of such contracts at December 31, 2004 was $315.0 million (2003: $343.4 million: 2002: $315 million).
The Company produces its business through brokers and direct relationships with insurance companies. During the year ended December 31, 2004, three brokers accounted for approximately 58.9% (2003: 64.5%; 2002: 69.2%) of the total gross premiums written by the Company. One broker accounted for approximately 30.2% (2003: 33.7%; 2002: 37.9%), the second for approximately 19.3% (2003: 19.3%; 2002: 20.7%) and the third for approximately 9.4% (2003: 11.5%; 2002: 10.6%). Each of these brokers is a large, well established company. No other broker and no one insured or reinsured accounted for more than 10% of gross premiums written in the years ended December 31, 2004, 2003 and 2002.
Future minimum lease payments under the leases are expected to be as follows:
The Company has invested in senior preferred shares of a CLO with a carrying value of $17.5 million. In connection with this investment, the Company has commitments that may require additional funding of up to $7.5 million through February 2006.
Effective January 1, 2004, the Company implemented supplemental retirement plans ("SERPs") for two executives. The SERP for Mr. Charman requires the Company to make annual payments to Mr. Charman upon his retirement for a period of 20 years. The benefits vest over a period of two years commencing in 2006. Commencing at age 56, Mr. Charman is entitled to an annual payment of $750,000 compounded by 3% annually for each year commencing from inception. The SERP for Mr. Butt requires the Company to make annual payments to Mr. Butt upon his retirement for a period of 10 years. The benefits vest over a period of two years commencing in 2006. Commencing at age 66, Mr. Butt is entitled to an annual payment of $250,000 compounded by 3% annually for each year commencing from inception. If either Mr. Charman or Mr. Butt dies, is permanently disabled or a change of control of the Company occurs, the remaining benefits under his plan are payable by the Company in a lump sum. The benefits received under the SERPs will be reduced by the benefits received by the executives under the Company's Bermuda retirement plan.
Effective January 1, 2003, the Company adopted, prospectively, the fair value recognition provisions of FAS No. 123 "Accounting for Stock-Based Compensation ("SFAS No. 123") for all stock options granted after January 1, 2003. During the year ended December 31, 2004, the Company expensed $2,955 (2003: $425; 2002: $18) related to the grant of options. The weighted average fair value of options granted during 2004 was $7,331 (2003: $1,099; 2002: $7,676). The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants in 2004: risk free interest rates of 4.4% (2003: 4.0%; 2002: 3.8%), expected life of 7 years (2003 and 2002: 7 years), a dividend yield of 1.9% (2003: 1.0%; 2002: nil) and an expected volatility of 23% (2003: 22%).
During the year ended December 31, 2004, 550,500 (2003: 79,800; 2002: 1,652,000) restricted common shares with a fair value of $16.3 million (2003: $1.6 million; 2002: $25.5 million) were awarded to employees of the Company and its subsidiaries and 9,600 restricted common shares were cancelled (2003: 36,000; 2002: 2,000) bringing the total issued to date to 2,674,420 (2003: 2,112,320; 2002: 254,500). Of the total issued to date, 200,000 shares were awarded outside of the plan to an employee of the Company and vested immediately upon issuance. The other restricted shares generally vest three years after the date of grant or upon the employee's earlier retirement, death, permanent disability or a change in control of the Company. Restricted shares are entitled to vote and to receive dividends but may not be transferred during the period of restriction and are forfeited if the employee's employment terminates prior to vesting. Compensation equivalent to the estimated fair market value at the date of grant is amortized over a three-year vesting period. During the year ended December 31, 2004, the Company expensed $14,091 (2003: $8,185; 2002: $6,215) in respect of stock.
The Company has an unfunded nonqualified deferred compensation plan that allows participating directors to elect (i) the amount, if any, of cash or stock as fees for services to be deferred and (ii) the form in which payment is to be made. Directors who choose to defer fees otherwise payable in shares are credited a number of phantom stock units equal in amount to the number of shares of stock deferred. In the event a cash dividend is declared on the stock, the portion of the participant's deferral account denominated in phantom share units is credited with additional phantom share units (or portions thereof). Directors who choose to defer fees otherwise payable in cash are credited with interest on their cash deferral at a rate for the year of deferral that is 100 basis points above the 12-month LIBOR rate for deposits of U.S. dollars. Amounts deferred are 100% vested at all times. Generally, benefits are paid upon termination of service as a director. As at December 31, 2004, 27,708 (2003: 17,620) phantom share units had been issued under the plan.
AXIS Specialty entered into an advisory agreement in November 2001 with MMC Capital, Inc. ("MMC Capital"). Under this agreement, MMC Capital from time to time provides advice and assistance to the Company in connection with transactions and other matters as may be agreed by MMC Capital and the Company. The agreement has a five year term during which AXIS Specialty pays an annual fee of $1.0 million. During the year ended December 31, 2004, AXIS Specialty incurred $1.0 million (2003: $1.0 million; 2002: $1.0 million) of fees and expenses to MMC Capital pursuant to this agreement of which $250 (2003: $250) was included in accounts payable and accrued expenses.
During the year ended December 31, 2004, JPMorgan Chase Bank acted as administrative agent and lender for the Company's $750 million revolving credit facility. In addition, certain subsidiaries of the Company hold several bank accounts with JPMorgan Chase Bank. During the year ended December 31, 2004, the Company incurred fees in relation to these transactions of $678 (2003: $678; 2002: $658), of which $37 (2003: $210) was included in accounts payable and accrued expenses.
During the year ended December 31, 2004, HSBC Bank USA acted as a lender for our syndicated credit facility. Some of our subsidiaries also hold several bank accounts with the Bank of Bermuda. During the year ended December 31, 2004, we incurred fees in connection with these transactions of $134 (2003: $18; 2002: $20), of which $30 (2003: $nil) was included in accounts payable and accrued expenses.
In connection with its initial public offering, the Company used the investment banking services of JP Morgan Securities and Credit Suisse First Boston LLC. For these services, they received fees of $1.9 million and $2.4 million, respectively. During the year ended December 31, 2004, J.P. Morgan Securities, Inc., and Credit Suisse First Boston LLC acted as underwriters in the Company's secondary offering for which they received fees of $1.8 million and $1.2 million, respectively. In addition, in connection with the issuance of Senior Notes, the Company used the investment banking services of JP Morgan Securities for which they received fees of $1.1 million.
During the year ended December 31, 2004, the Company invested in several collateralized loan obligations. The collateral manager of one of these investments was Blackstone Debt Advisors L.P., who as collateral manager is entitled to management fees payable by the collateralized obligations in the ordinary course of business. An underwriter for some of these investments was an affiliate of Credit Suisse Boston LLC, who is entitled to underwriting fees in the ordinary course of business.
During the year ended December 31, 2004, the Company invested in a hedge fund that is managed by Blackstone Alternative Asset Management, LP, who is entitled to management fees in the ordinary course of business. This investment was made on December 31, 2004 and as such we did not incur any fees during 2004 in connection with this investment.
In addition, the Company provides insurance in the ordinary course of business to various entities that are affiliated with some of its directors and with some of its principal shareholders. These transactions are negotiated on an arm's length basis.
The Company has operating subsidiaries and branch operations in Ireland, the United Kingdom and Switzerland and is subject to the relevant taxes in those jurisdictions.
Income tax (expense) recovery for the years ended December 31, 2004, 2003 and 2002 was as follows:
In Management's judgement, the gross deferred tax asset will more likely than not be realized as reductions of future taxes paid. The net deferred tax asset is included in other assets in the consolidated balance sheet.
Reconciliation of the difference between the provision for income taxes and the expected tax provision at the weighted average tax rate for the years December 31, 2004 and 2003 is provided below:
The Company's insurance and reinsurance operations are subject to insurance laws and regulations in the jurisdictions in which they operate, including Bermuda, Ireland and the United States. Statutory capital and surplus as reported to the relevant regulatory authorities for the principal operating subsidiaries of the Company as of December 31, 2004 and 2003 was as follows:
The difference between statutory financial statements and statements prepared in accordance with U.S. GAAP vary by jurisdiction; however, the primary difference is that statutory financial statements do not reflect deferred policy acquisition costs, certain net deferred tax assets, intangible assets, unrealized appreciation on debt securities or certain unauthorized reinsurance recoverables. The Company's U.S. operations required statutory capital and surplus is determined using risk based capital tests, which is the threshold that constitutes the authorized control level. If a Company falls below the control level, the commissioner is authorized to take whatever regulatory actions considered necessary to protect policyholders and creditors.
total statutory capital and surplus. At December 31, 2004, the maximum dividend that the Company's U.S. insurance operations could pay without regulatory approval was approximately $9.6 million.
On February 16, 2005, the Company repurchased 12,783,094 common shares owned by initial investors at the formation of the Company, at an average price of $27.38 per common share. These repurchases were made pursuant to the Company's share repurchase program.