The following is a discussion and analysis of the Company’s results of operations for the year ended December 31, 2003 compared to the year ended December 31, 2002, and for the year ended December 31, 2002 compared to the year ended December 31, 2001 and also a discussion of the Company’s financial condition as of December 31, 2003. This discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes that are included in this Annual Report.
The Company is a Bermuda-based provider of reinsurance and insurance products for both the property and casualty and the life and annuity markets. In the past two years, the property and casualty market has presented more opportunities to the Company than the life and annuity market due to a shortage of reinsurance capacity in the property and casualty market, resulting in improvement in premium rates. Further, a weak global economy and corrections in the global capital markets over the last several years have resulted in a wider pricing gap between buyers and sellers for the type of life and annuity reinsurance products that the Company offers. The Company anticipates continuing greater demand for its property and casualty products than for its life and annuity products for the foreseeable future.
The Company’s principal operating subsidiary is Max Re. At December 31, 2003, Max Re had $793.2 million of shareholders’ equity. The Company conducts its European activities through Max Europe Holdings and its operating subsidiaries, Max Re Europe and Max Insurance Europe. The Company also provides reinsurance underwriting and administrative services on a fee basis through Max Re Managers. The Company holds all of its alternative investments in Max Re Diversified, other than reinsurance private equity investments that are held by Max Re.
combination of loss reserving techniques and actuarial methods. Loss expenses and reserves are reviewed regularly to reflect new information received by the Company. The adequacy of the Company’s reserves is reviewed annually by outside actuaries to support management’s estimates. There was no significant adjustment to the Company’s reserves for the year ended December 31, 2003. An analysis of property and casualty loss development may be found in Note 4 to the audited consolidated financial statements, attached hereto.
The Company’s investments during the year ended December 31, 2003 produced a total return of 7.74% compared to 7.37% for the year ended December 31, 2002. The principal contributor to the investment performance during the year ended December 31, 2003, was the 16.57% rate of return generated on the Company’s alternative investments compared to a 5.24% rate of return in 2002. The Company currently invests in eleven strategies within its alternative investment portfolio, with all strategies showing positive rates of return during the year ended December 31, 2003. In 2003, the Company reallocated investments over a broader array of investment managers, to achieve diversification, to protect against concentrated exposure and to benefit from the proven track records of the new investment managers.
The Company’s net investment income is a function of the average invested assets and the average yield that the Company earns on those invested assets. The investment yield on the Company’s fixed maturities investments is a function of market interest rates as well as the credit quality and maturity of its fixed maturities holdings. The Company realizes capital gains or losses on its fixed maturities investments as a result of changing market conditions, including, but not limited to, changes in market interest rates and changes in the market’s perception of the credit quality of the Company’s fixed maturities holdings. The Company’s net gains on alternative investments is a function of the success of the funds in which the Company is invested, which depends on, among other things, the underlying strategies of the funds, the ability of the fund managers to execute the fund strategies and general economic conditions, and the underlying operating results of the private equity reinsurance investments.
The Company’s three principal expenses are losses, benefits and experience refunds, acquisition costs, and general and administrative expenses. Losses, benefits and experience refunds are based on the amount and type of reinsurance and insurance contracts written by the Company during the current reporting period and information received during the current reporting period from ceding clients pertaining to contracts written in prior years. The Company records losses, benefits and experience refunds based on an actuarial estimate of the expected losses, benefits and experience refunds to be incurred on each contract written. The ultimate losses, benefits and experience refunds depend on the actual costs to settle these liabilities. The Company increases or
decreases losses, benefits and experience refunds estimates as actual claim reports are received. The Company’s ability to estimate losses, benefits and experience refunds accurately at the time of pricing its contracts is a critical factor in determining profitability.
The Company’s consolidated financial statements are prepared in accordance with GAAP, which require management to make estimates and assumptions. The Company believes that the following accounting policies affect the more significant judgments and estimates used in the preparation of its consolidated financial statements.
The Company follows FAS No. 60, “Accounting and Reporting by Insurance Enterprises,” FAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and Realized Gains and Losses from the Sale of Investments,” and FAS No. 113, “Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts,” in determining the accounting for its reinsurance and insurance products. Assessing whether or not the contracts it writes meets the conditions for risk transfer requires judgment. The determination of risk transfer is fundamental to the Company’s determination of gross premiums written and is based, in part, on the use of actuarial and pricing models and assumptions.
Setting appropriate reserves for losses, benefits and experience refunds is an inherently uncertain process. Losses, benefits and experience refunds reserves represent estimates, at a given point in time, of the ultimate settlement costs of losses incurred (including IBNR losses, which are losses that have been incurred but not yet reported). The Company regularly reviews and updates these estimates using the most current information available and employing generally accepted actuarial methods. Consequently, the ultimate liability for a loss is likely to differ from the original estimate. Whenever the Company determines that an existing reserve for losses, benefits and experience refunds needs adjustment, it is required to record a change in estimate, increasing or decreasing the reserve with a corresponding reduction or increase, which could be material, in its operating results in the period in which the deficiency or redundancy is identified. Adjustments resulting from changes in the Company’s estimates are recorded in the period such adjustments are determined. The establishment of new reserves, or the adjustment of reserves for reported claims, could result in significant upward or downward changes to the Company’s financial condition or results of its operations in the period such amounts are reported.
The Company’s investments are carried at fair value or amounts that approximate fair value. Fair value for the Company’s investments in fixed maturities is generally based on quoted market prices, dealer quotes or pricing models. At December 31, 2003, the valuation of approximately 98% of the Company’s fixed maturities investments was based on quoted market prices. Fair value for the Company’s alternative investments is generally based on the net asset value reported by the respective investment fund managers or, for its reinsurance equity investments, based on the carried amount under the equity method of accounting. The investment fund managers generally carry their trading positions and investments at fair value. The Company relies principally on the financial reports from these entities for recording the net gains on alternative investments in its statement of income. For its equity investments, the Company initially records the investments at cost and periodically adjusts the carrying values to recognize its proportionate share of income or loss from these investments. Future adverse changes in general market, global and economic conditions, changes to the interest and currency rate environment or poor operating results by the Company’s investments carried under the equity method of accounting could result in losses.
annuity were $108.3 million for the year ended December 31, 2003 compared to $14.7 million for the year ended December 31, 2002. Gross premiums written for life and annuity in the year ended December 31, 2003 resulted from two life insurance contracts written in the fourth quarter.
Net premiums written. Net premiums written for the year ended December 31, 2003 were $855.2 million compared to $592.7 million for the year ended December 31, 2002, an increase of 44.3%. Net premiums written for property and casualty products for the year ended December 31, 2003 were $768.6 million compared to $580.3 million for the year ended December 31, 2002. Net premiums written for life and annuity products for the year ended December 31, 2003 were $86.6 million compared to $12.5 million for the year ended December 31, 2002.
Net premiums earned. Net premiums earned for the year ended December 31, 2003 were $727.2 million compared to $388.0 million for the year ended December 31, 2002, an increase of 87.4%. Property and casualty net premiums earned were $640.6 million, after the deduction of $86.6 million of earned premiums ceded, for the year ended December 31, 2003 compared to $375.6 million, after the deduction of $44.4 million of earned premiums ceded, for same period in 2002. Life and annuity net premiums earned were $86.6 million, after the deduction of $21.7 million of earned premiums ceded, for the year ended December 31, 2003 compared to $12.5 million, after the deduction of $2.2 million of earned premiums ceded, for the same period in 2002. The difference between net premiums written and net premiums earned for the year ended December 31, 2003 compared to 2002 reflects the earning pattern of an increasingly mature book of property and casualty contracts. In addition, the life and annuity business written in the fourth quarter of the year was fully earned in the year ended December 31, 2003.
Net investment income. Net investment income, excluding realized and unrealized gains and losses, for the year ended December 31, 2003 decreased $4.3 million to $60.1 million compared to $64.4 million for the year ended December 31, 2002, a decrease of 6.7%. The decrease was principally attributable to a $13.4 million decline in the investment income earned from premiums and deposits withheld by clients during the year ended December 31, 2003. Funds withheld by clients declined significantly in the year principally due to the commutation of certain contracts. The overall decline in investment income was partially offset by the growth in the fixed maturities portfolio from $1,279.6 million to $1,604.4 million resulting from cash received from the collection of premiums written since December 31, 2002. For the year ended December 31, 2003, yields on the fixed maturity investments remained at historically low levels. The average investment yield on the cash, fixed maturities investments and funds withheld by clients for the year ended December 31, 2003 was 3.8% compared to an average yield of 5.2% for the year ended December 31, 2002. The decline principally relates to the reduction in interest earned on the funds withheld balances, which also decreased.
Net gains on alternative investments. Net gains on the alternative investment portfolio were $124.0 million, including $12.1 million from the Company’s private equity reinsurance investments, for the year ended December 31, 2003 compared to $32.1 million, including $8.4 million from the Company’s private equity reinsurance investments, for the year ended December 31, 2002. The increase was attributable to both a 16.6% rate of return on the alternative investments for the year ended December 31, 2003 compared to a 5.2% rate of return for the year ended December 31, 2002 and an increase in the amount of the alternative investments resulting from cash flows generated from operating activities during 2003. Every alternative investment strategy
The life and annuity benefits were $114.9 million for the year ended December 31, 2003 which related to two transactions written and earned in the fourth quarter of the current year combined with the accretion of liability for future benefits on contracts written in prior years, compared to $47.9 million for the year ended December 31, 2002.
Interest expense. Interest expense was $28.8 million for the year ended December 31, 2003 compared to $23.1 million for the year ended December 31, 2002, an increase of 24.7%. The increase resulted principally from interest expense on additional funds withheld from reinsurers of the Company and on increased deposit liabilities and increased interest expense on the swap transaction, accounted for as a bank loan, resulting from a higher principal balance for the year ended December 31, 2003 compared to the same period in 2002.
General and administrative expenses. General and administrative expenses were $39.8 million for the year ended December 31, 2003 compared to $21.3 million for the year ended December 31, 2002, an increase of 86.9%. The increase resulted principally from expenses associated with establishing the Company’s insurance operations and expanding the Company’s traditional reinsurance capabilities through the hiring of additional staff. The general and administrative expense to net premiums earned ratio remained unchanged at 5.5% for the year ended December 31, 2003 compared to that for the year ended December 31, 2002.
Net income (loss). Net income for the year ended December 31, 2003 was $120.6 million compared to a net loss of $5.8 million for the year ended December 31, 2002. The results for the year ended December 31, 2003 were principally attributable to increased income from the Company’s alternative investments and underwriting income generated from the Company’s property and casualty products compared to the year ended December 31, 2002.
Reinsurance premiums ceded. Premiums ceded for the year ended December 31, 2002 were $54.7 million compared to $116.4 million for the year ended December 31, 2001, a decrease of 53.0%. The reinsurance premiums ceded were principally related to the Company’s quota-share retrocessional agreement with Grand Central Re. The decline in premiums ceded in the year is a result of the decline in the volume of life and annuity business written by the Company and the change in the mix of property and casualty business written.
Net investment income. Net investment income, excluding realized and unrealized gains and losses, for the year ended December 31, 2002 increased $20.5 million to $64.4 million compared to $43.9 million for the year ended December 31, 2001, an increase of 46.7%. The increase was primarily attributable to the growth in the fixed maturities portfolio from $884.1 million to $1,279.6 million resulting from cash received from the collection of premiums written since December 31, 2001 and $6.4 million of additional investment income earned from premiums and deposits withheld by clients during the year ended December 31, 2002 compared to
calendar year 2001. The average investment yield on the fixed maturities portfolio for the year ended December 31, 2002 was 5.19% compared to an average yield of 6.15% for the year ended December 31, 2001.
Acquisition costs. Acquisition costs were $97.7 million for the year ended December 31, 2002 compared to $30.9 million for the year ended December 31, 2001, an increase of 216.2%. The increase in acquisition costs was a result of the Company’s increase in property and casualty reinsurance volume and a change in the mix and ceding commission rates of contracts written in 2002 compared to 2001. Acquisition costs during each of the years ended December 31, 2002 and 2001 consisted primarily of amortization of deferred policy acquisition costs incurred in connection with writing property and casualty business. Acquisition costs are customarily associated with the type of premium written by the Company. Generally, acquisition costs fluctuate with business volume and changes in product mix. The largest component of deferred policy acquisition costs are ceding commissions paid to the buyer of the Company’s reinsurance products.
Interest expense. Interest expense was $23.1 million for the year ended December 31, 2002 compared to $12.1 million for the year ended December 31, 2001, an increase of 90.9%. The increase resulted principally from interest expense on additional funds withheld from reinsurers of the Company and on increased deposit liabilities and increased interest expense on the swap transaction into which the Company entered in March 2002.
General and administrative expenses. General and administrative expenses were $21.3 million for the year ended December 31, 2002 compared to $21.0 million for the year ended December 31, 2001, an increase of
Cash and invested assets. Aggregate invested assets, comprising cash and cash equivalents, fixed maturities and alternative investments were $2,637.3 million at December 31, 2003 compared to $2,024.8 million at December 31, 2002, an increase of 30.2%. The increase in cash and invested assets from 2002 to 2003 resulted principally from $451.8 million in cash flows from operations generated in 2003, appreciation of the alternative investments portfolio of $124.0 million and a $50.0 million increase in the swap transaction accounted for as a bank loan.
Property and casualty losses and experience refunds. Property and casualty losses and experience refunds totaled $991.7 million at December 31, 2003 compared to $778.1 million at December 31, 2002, an increase of 27.5%. The increase in property and casualty losses and experience refunds was principally attributable to increased premiums earned during the year ended December 31, 2003 and expected claim settlements. The increase is partially offset by a decrease in these liabilities, resulting from an amendment, effective January 1, 2003, to the terms of a property and casualty contract written in a prior year. The amendment was a material change to the contract, causing the Company to record the amended contract as a deposit arrangement, thereby reducing the liabilities for property and casualty losses and experience refunds by $160.7 million and increasing the deposit liabilities by a corresponding amount. An analysis of the changes in property and casualty losses and experience refunds can be found in Note 4 to the audited consolidated financial statements of the Company included herein.
Life and annuity benefits and experience refunds. Gross life and annuity benefits and experience refunds totaled $480.1 million at December 31, 2003 compared to $405.0 million at December 31, 2002, an increase of 18.5%. The increase in 2003 was principally attributable to the benefit reserves of $107.2 million required on business written and earned during the current year, partially offset by benefit payments of $32.1 million on existing contracts in force.
Losses recoverable from reinsurers. Losses recoverable from reinsurers totaled $273.7 million at December 31, 2003 compared to $212.2 million at December 31, 2002, an increase of 29.0%, principally reflecting losses ceded under the Company’s retrocessional agreements. At December 31, 2003, two retrocessionaires account for 61.8% and 28.7% of the Company’s losses recoverable from reinsurers. The retrocessionaires have a financial strength ratings of “A-” and “A”, respectively, by A.M. Best Company. The Company retains funds from these two retrocessionaires to secure the obligations.
Bank loans. In March 2002, Max Re completed a $100.0 million sale of shares of Max Re Diversified to a third party financial institution. Simultaneous with the sale, Max Re entered into a total return swap with the purchaser of these shares whereby Max Re received the return earned on the Max Re Diversified shares in exchange for a variable rate of interest based on LIBOR plus a spread. Under GAAP, these transactions were viewed on a combined basis and accounted for as a financing transaction, which resulted in the recording of a $100.0 million bank loan.
On February 18, 2003, the Company and the third party financial institution mutually terminated the swap transaction described above and, immediately following the termination, the Company completed a $150.0
Shareholders’ equity. The Company’s shareholders’ equity increased to $805.2 million at December 31, 2003 from $710.7 million, including minority interest, at December 31, 2002, an increase of 13.3%, principally reflecting income of $120.6 million for the year ended December 31, 2003, partially offset by unrealized holding losses on fixed maturities arising during the period of $21.2 million and dividends paid and minority interest distributions in the amount of $4.1 million.
On July 30, 2003, the holders of non-voting common shares of Max Re and warrants to acquire non-voting common shares of Max Re exchanged such shares and warrants for Common Shares of the Company and warrants to acquire Common Shares of the Company. The effect of this exchange resulted in the elimination of minority interest and an increase in shareholders’ equity of equal amounts as of the date of the exchange. This exchange did not have a dilutive effect on equity.
Liquidity and capital resources. The Company generated $451.8 million from operations during the year ended December 31, 2003 compared to $225.4 million in 2002, an increase of 100.4%, principally reflecting the shift in product mix, which generated increased gross premiums written during the year. The Company generated $53.8 million from financing activities, with the principal contributor being an increase in the bank loan facility of $50.0 million during the year. The cash generated from operating and financing activities was applied to the Company’s investing activities, through the net purchase of $341.6 million in fixed maturities and $54.5 million in alternative investments.
The Company regularly reviews its capital adequacy and believes its current level of capital is sufficient to support the Company’s current reinsurance and insurance operations. The Company is currently evaluating various capital resource alternatives to continue growing its business, and believes that issuing debt is likely in 2004.
In September 2003, the Company entered into a $100.0 million letter of credit facility with an independent commercial bank. At December 31, 2003, there were $nil million letters of credit issued under this letter of credit facility. Fixed maturities and cash equivalents with a fair value of $nil million were pledged as collateral for these letters of credit.
The Company has been assigned an insurer financial strength rating of “A- (Excellent)” by A.M. Best Company, Inc. and an insurer financial strength rating of “A (Strong)” by Fitch, Inc. These ratings reflect each
No off-balance sheet arrangements. The Company does not participate in transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or variable interest entities (“VIEs”), which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. As of December 31, 2003, the Company was not aware of any unconsolidated VIE transactions.