(2) The loss and loss expense ratio is calculated by dividing the losses and loss expenses by net premiums earned excluding life reinsurance premiums. Net premiums earned for life reinsurance were $183,953, $158,277 and $406,280 for the years ended December 31, 2003, 2002 and 2001, respectively.
(5) The net loss reserves to capital and surplus ratio is calculated by dividing the sum of the net unpaid losses and loss expenses and net future policy benefits for life and annuity contracts by shareholders’ equity.
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, 2003. This discussion should be read in conjunction with our Consolidated Financial Statements and related notes presented on pages to of this Form 10-K.
ACE Limited (ACE) is the Bermuda-based holding company of the ACE Group of Companies incorporated with limited liability under the Cayman Islands Companies Law. We created our business office in Bermuda in 1985 when we initially incorporated the Company and we continue to maintain our business office in Bermuda. Through our various operating subsidiaries, we provide a broad range of insurance and reinsurance products to insureds worldwide through operations in the U.S. and almost 50 other countries. Our long-term business strategy focuses on achieving underwriting income and providing value to our clients and shareholders through the utilization of our substantial capital base in the insurance and reinsurance markets.
As an insurance and reinsurance company, we generate gross revenues from two principal sources, premiums which are usually paid in advance of loss payments, and dividends and interest income earned on invested assets. Cash flow is generated from premiums collected and investment income received less paid losses and loss expenses. Generally when an insurance company writing long-tail business grows, as ACE has in 2003, its cash flows tend to be positive. ACE generated approximately $4.2 billion in positive operating cash flow in 2003 while cash and invested assets over this period increased by $5.3 billion.
Invested assets are generally held in liquid, investment grade fixed income securities of relatively short duration. We also invest a small portion of our assets in less liquid or higher risk assets in an attempt to achieve higher returns. Claims payments in any short-term period are highly unpredictable due to the random nature of loss events and the timing of claims awards or settlements. The value of investments held to pay future claims is subject to market forces such as the level of interest rates, stock market volatility and credit events such as corporate defaults. The actual cost of claims is also volatile based on loss trends, inflation rates, court awards and catastrophic events. We believe that our cash balances, our highly liquid investments, credit facilities and reinsurance protection provide sufficient liquidity to meet any unforeseen claim demands that might occur in the year ahead.
In this competitive environment, ACE has maintained its strong financial rating and global infrastructure permitting it to write a considerable volume of new and renewable insurance business at favorable rates.
We are closely following developments on possible legislation to move all U.S. asbestos bodily injury claims to a federal trust for compensation in accordance with an established set of medical criteria and claim values. The trust would be funded by asbestos defendants and their insurers. As currently proposed, ACE would be one of the insurer participants. We believe that if the proposed legislation is enacted, our ultimate funding obligation under the trust would be less than we would be required to pay under the current tort system because the trust would likely avoid payments to unimpaired victims and obviate the need for extensive legal costs. However, we cannot predict if any such proposed legislation will be modified or adopted.
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 Claims, Reinsurance, Investments and Cash, Net Realized Gains (Losses) and Other Income and Expense Items.
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. Within our general insurance business, long-tail casualty business has been increasing and for the year ended December 31, 2003 comprises approximately 43 percent of net premiums earned. There are many factors contributing to the uncertainty and volatility of long-tail business. Among these are:
• Given the recent expansion of this business, 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; and
At December 31, 2003, approximately 83 percent of our reserves (78 percent excluding asbestos and environmental reserves) relate to long-tail business. 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 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.
In establishing A&E reserves for periods prior to the fourth quarter of 2002, we assumed that significant additional state judicial or legislative reform would substantially eliminate payments to future claimants who are not physically impaired. In January 2003, we announced additions to our fourth quarter 2002 A&E reserves based on the more conservative assumption that there will be no future state or federal asbestos reform. Therefore, our A&E reserves do not reflect any anticipated changes in the legal, social or economic environment, or any benefit from future legislative reforms. The vast majority of our reserve increase in the fourth quarter of 2002 is due to the strengthening of the IBNR provision for peripheral defendants and future increases in severity.
Based on the policies, the facts, the law and a careful analysis of the impact that these risk factors will likely have on any given account, we estimate the potential liability for indemnity, policyholder defense costs and coverage litigation expense. There are many complex variables that we consider when estimating the reserves for our inventory of asbestos accounts. The variables involved may directly impact the predicted outcome. Sometimes, the outcomes change significantly based on a small change in one risk factor related to just one account.
• for recoverable balances that are both unrated by a major rating agency and for which management is unable to determine a credible rating equivalent based on a parent, affiliate, peer company, or internal analysis, additional judgment is required to determine a reasonable default factor. Based on certain industry benchmarks, management generally uses a default factor approximating 24 percent for such balances; and
We record all investments in our portfolio at fair value, being the quoted market price of these securities provided by either independent pricing services, or when such prices are not available, by reference to broker or underwriter bid indications. We regularly review our investments for possible impairment. If there is a decline in a security’s net realizable value, we must determine whether that decline is temporary or “other than temporary”. If we believe a decline in the value of a particular investment is temporary, we record the decline as an unrealized loss in our shareholders’ equity. If we believe the decline is “other than temporary”, we write down the carrying value of the investment and record a realized loss in our consolidated statement of operations. The determination as to whether or not the decline is “other than temporary” principally requires the following critical judgments: i) the circumstances that require management to
Because our investment portfolio is the largest component of consolidated assets and a multiple of shareholders’ equity, adverse changes in economic conditions subsequent to the balance sheet date could result in other than temporary impairments that are material to the financial condition and operating results of the Company. Such economic changes could arise from overall changes in the financial markets or specific changes to industries, companies, or foreign governments in which the Company maintains relatively large investment holdings. More information regarding our process for reviewing our portfolio for possible impairments can be found in the section entitled “Net Realized Gains (Losses)”.
We adopted Statement of Financial Accounting Standards (FAS) No. 133, “Accounting for Derivative Instruments and Hedging Activities” (FAS 133), as of January 1, 2001. FAS 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. FAS 133 requires that all derivatives be recognized as either assets or liabilities on the balance sheet and be measured at fair value. We maintain investments in derivative instruments such as futures, options, interest rate swaps and foreign currency forward contracts primarily to manage duration and foreign currency ex -
posure, enhance our portfolio yield or obtain an exposure to a particular financial market. 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. The net fair value related to these instruments at December 31, 2003, was $21 million and is included in accounts payable, accrued expenses and other liabilities.
Certain products (principally credit protection oriented) issued by the Financial Services segment have been determined to meet the definition of a derivative under FAS 133. These products consist primarily of credit default swaps, index-based instruments and certain financial guaranty coverages. We view these products, for which we sell credit protection to others, as an extension of our financial guaranty business but which do not qualify for the financial guaranty insurance scope exception under FAS 133 and therefore are reported at fair value, with changes in fair value included in our earnings. We believe that the most meaningful presentation of these derivatives is to reflect revenue as net premiums earned, and to record estimates of losses and loss expenses on specific credit events as incurred losses. When we determine that a loss on a derivative contract is probable, we establish reserves for the loss. Other changes in fair value are included in realized gains and losses on derivative financial instruments. We generally hold derivative contracts to maturity. Where we hold a derivative to maturity, the cumulative unrealized gains and losses will net to zero if we incur no credit losses on that contract. (See Note 2(o) of the Consolidated Financial Statements for more information).
The fair value of these instruments depends on a number of factors including credit spreads, changes in interest rates, recovery rates and the credit ratings of referenced entities. Where available, we use quoted market prices to determine the fair value of these insured credit derivatives. If the quoted prices are not available, particularly for senior layer CDOs and equity layer credit protection, the fair value is estimated using valuation models for each type of credit protection. These models may be developed by third parties, such as rating agencies, or internally based on market conventions for similar transactions, depending on the circumstances. These models and the related assumptions are continuously reevaluated by management and enhanced, as appropriate, based upon improvements in modeling techniques and availability of more timely market information. The majority of our single name credit derivatives are valued using third-party market quotes. However, in the event that we terminate a derivative contract prior to maturity, as a result of a decision to exit a line of business or for risk management purposes, the unrealized gain or loss will be realized through premiums earned and losses incurred. Our exposures to CDOs are typically valued using a combination of rating agency models and internally developed models.
Valuation models include the use of management estimates and current market information. Management is also required to make assumptions on how the fair value of derivative instruments is affected by current market conditions. Management considers factors such as current prices charged for similar agreements, performance of underlying assets, and our ability to obtain reinsurance for our insured obligations. 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.
Fair value adjustments attributed to derivative transactions, principally credit derivatives, are included in our net realized gains (losses). We recorded a gain of $163 million and losses of $77 million in 2003 and 2002, respectively. The change in fair value is due to many factors but primarily due to a change in credit spreads. For example, the 2003 gain corresponds to an approximately 60-65 percent tightening in investment grade corporate spreads and the 2002 loss corresponds to an approximate 20-25 percent widening. Depending on our ultimate percentage holding of Assured Guaranty after the planned IPO and changes in Assured Guaranty’s credit derivatives business after the IPO, the relationship between changes in corporate credit spreads and changes in the fair value of credit derivatives affecting our net income is apt to differ from historical results. Given these variables, the sensitivity of our future net income to changes in credit spreads is difficult to quantify at this time; however, we anticipate that after the completion of the planned IPO such sensitivity will be reduced relative to 2003.
The discussions that follow include tables, which show both our consolidated and segment operating results for the years ended December 31, 2003, 2002 and 2001. In presenting our operating results, we have discussed our performance with reference to underwriting results and with reference to income excluding net realized gains (losses) and the related income tax, which are both non-GAAP measures. Our consolidated and segment operating results below provide a reconciliation of underwriting results and income excluding net realized gains (losses) to net income, which we consider to be the most directly comparable GAAP financial measure. We consider these measures, which may be defined differently by other companies, to be important to an understanding of our overall results of operations. Underwriting results are calculated by subtracting losses and loss expenses, life and annuity benefits, policy acquisition costs and administrative expenses from net premiums earned. We use underwriting results and operating ratios to monitor the results of our operations without the impact of certain factors, including investment income, other income and expenses, interest and income tax expense and net realized gains (losses). We exclude net realized gains (losses), including the tax effect, when analyzing our operations because the amount of these gains (losses) is heavily influenced by, and fluctuates in part according to, the availability of market opportunities, and are generally driven by economic factors that are not necessarily consistent with key drivers of underwriting performance. We believe the use of these measures enhances the understanding of our results of operations by highlighting the underlying profitability of our insurance business. Underwriting results and income excluding net realized gains (losses) should not be viewed as a substitute for measures determined in accordance with GAAP.
Gross premiums written increased 14 percent in 2003 compared with 2002. Gross premiums written reflect the premiums paid by our customers to secure insurance or reinsurance protection from us. In 2003, gross premiums written in our P&C businesses increased 21 percent (approximately four percent of this increase is due to the appreciation of foreign currencies relative to the U.S. dollar) and gross premiums written in our Financial Services business decreased 32 percent, compared with 2002. Throughout 2003, we continued to experience rate increases and improved terms and conditions on P&C business, especially casualty policies. The decline in the Financial Services business was primarily due to the reduction of premiums for credit default swaps that cover the equity (first-loss portion) of a synthetic collateralized debt obligation (CDO). As discussed later in this report, production in the Financial Services segment can fluctuate dramatically from period to period. Gross premiums written increased 26 percent in 2002 compared with 2001 and net premiums written increased 27 percent.
operating costs. Administrative expenses increased in 2003 and 2002 to support the growth in our business and partially due to the depreciation of the U.S. dollar, which had the effect of increasing administrative expenses for Insurance - Overseas General. The administrative expense ratio improved in 2003 and 2002 due to the significant increase in net premiums earned.
The Insurance - North American segment comprises our P&C insurance operations in the U.S., Bermuda and Canada. This segment writes a variety of insurance products including property, liability (general liability and workers’ compensation), professional lines (directors and officers (D&O) and errors and omissions coverages (E&O)), marine, program business, accident and health (A&H) - principally being personal accident, aerospace, consumer-oriented products and other specialty lines.
Insurance - North American increased gross premiums written 13 percent in 2003 compared with 2002. This segment continues to benefit from a robust market for casualty lines of business, which represent a growing portion of its gross premiums written. Despite strong casualty premium production in 2003, the growth in gross premiums written has been moderate compared with the 35 percent growth reported in 2002 over 2001. This reflects the stabilization of property rates and our decision to exit certain heavily reinsured program business in late 2002 so that we could deploy our capital in areas with the greatest opportunity for underwriting income.
Renewal rates for property business in the U.S. were down slightly in 2003 compared with the significant renewal rate increases experienced in 2002. Overall, property rates are generally at pricing levels that adequately compensate for the exposure being underwritten. For casualty lines, renewal rates on certain of the longer tail lines, such as workers’ compensation, continued to rise, but at a lower pace than in 2002. However, other casualty lines, such as D&O and umbrella excess business, continue to experience solid rate increases in 2003. Insurance - North American significantly increased gross premiums written in 2002 compared with 2001. This increase was due to higher renewal rates as a result of reduced industry capacity, and also due to new products introduced in this segment beginning in 2002, including A&H, excess casualty and medical risk.
Net premiums written increased 38 percent in 2003, compared with 2002. The primary factor contributing to the greater growth rate for net premiums written compared with gross premiums written is Insurance - North American’s decision to retain more of its gross premiums written. Insurance - North American increased its retention in order to take advantage of improved market conditions for rates and terms. A shift in business mix has also contributed to the growth in net premiums written in 2003. ACE Risk Management (ARM) has shifted its business mix away from the heavily reinsured program business and has increased retention of national account business. As a result, the retention ratio for Insurance - North American increased to 58 percent for 2003, compared with 48 percent for 2002.
The loss and loss expense ratio decreased to 69.0 percent in 2003, compared with 88.9 percent in 2002. Losses and loss expenses for 2002 included $516 million related to the A&E reserve strengthening, which added 20.9 percentage points to the 2002 loss and loss expense ratio. The 2003 loss and loss expense ratio for Insurance - North American reflects the effect of a greater proportion of net premiums earned relating to casualty business, which has a longer claim-payout duration and typically produces higher loss and loss expense ratios than property business. The shift to more casualty business in 2003 more than offset the benefit of rate increases on both property and casualty lines of business in 2002. Additionally, Insurance - North American incurred adverse prior period development of $91 million in 2003, compared with adverse development of $79 million in 2002. The 2003 adverse development related primarily to casualty lines and principally emerged from medical inflation in workers’ compensation and large loss activity in commercial multi-peril. Additional minor development was experienced in professional liability, reinsurance of long-term disability and run-off business offset by positive development on property, excess liability and marine lines of business because case reserves developed better than expected. The 2002 development was primarily from run-off business with the remainder being attributed to several lines of business including workers’ compensation, commercial automobile, health care asset management run-off, warranty and financial institutions business. Losses and loss expenses for 2001 included $119 million related to the September 11 tragedy.
The Insurance - Overseas General segment comprises ACE International, our network of indigenous insurance operations, and the insurance operations of ACE Global Markets. The Insurance - Overseas General segment writes a variety of insurance products including property, casualty, professional lines (D&O and E&O), marine, energy, aviation, political risk, consumer-oriented products and A&H - principally being supplemental accident.
ACE International’s P&C operations are organized geographically along product lines. Property insurance products include traditional commercial fire coverage as well as energy industry-related coverages. Principal casualty products are commercial general liability and liability coverage for multinational organizations. Through our professional lines, we provide D&O and professional indemnity coverages for medium to large clients. The A&H insurance operations provide coverage to individuals and groups outside of U.S. insurance markets. ACE International’s gross premiums written increased 36 percent to $3.6 billion in 2003 compared with $2.7 billion in 2002. The increases are due to higher rates and new business across most regions and also due to the weakening of the U.S. dollar against the pound sterling, euro and yen during the period. The depreciation of the U.S. dollar against the major currencies accounted for approximately 12 percent of the increase in gross premiums written in 2003. ACE Europe, which accounts for more than half of ACE International’s gross premiums written, continues to experience rising rates and growth in new policies for casualty business. Additionally, ACE Europe’s A&H lines have contributed positive growth due to strong volume increases. ACE Europe’s P&C growth was driven by rate increases and new business, specifically professional lines, while its A&H growth was driven by continued success in direct marketing campaigns. Asia Pacific reported production growth for P&C lines due to increases in new business and strong Australian growth while A&H lines increased due to favorable results from direct marketing channels. ACE Latin America reported strong demand for A&H products in Mexico and Brazil, and growth in new P&C policies. ACE Far East production declined due primarily to the adverse effect of the SARS epidemic on travel accident insurance and our decision to selectively renew the auto portfolio. ACE International’s gross premiums written increased 26 percent in 2002 compared with 2001, due to higher renewal rates and increased new business across most regions.
ACE Global Markets primarily underwrites P&C insurance through Lloyd’s Syndicate 2488 and ACE INA UK Limited. The main lines of business include aviation, property, energy, professional lines, marine, political risk and A&H. ACE Global Markets’ gross premiums written increased nine percent to $1.6 billion in 2003, compared with 2002. The increase is primarily due to the depreciation of the U.S.
dollar against the major currencies which accounted for approximately three-quarters of the increase in gross premiums written. ACE Global Markets has been able to build upon favorable market conditions, reporting overall average rate increases of 10 percent in 2003. This is a significant achievement, given that this is in addition to average renewal rate increases that were in excess of 40 percent in 2002. Production in 2003 was subdued by lower rates on certain classes of aviation business and the impact of falling airline passenger movement due to the Iraq conflict and SARS. While rates for certain lines of business have stabilized, there are a number of business classes, most notably professional lines, where rates continue to rise. ACE Global Market’s gross premiums written increased by 23 percent to $1.5 billion in 2002 compared with $1.2 billion in 2001. This increase was due to rate increases across most lines and growth in new business. The retention ratio at ACE Global Markets has increased to 70 percent in 2003, compared with 54 percent in 2002 and 60 percent in 2001. The retention ratio was lower in 2002 due to the reinsurance premiums we incurred associated with reinsurance arrangements put into place following a revision of our underwriting strategy and the rebuilding of our reinsurance cover following the September 11 tragedy. Historically, the purchase of reinsurance protection by ACE Global Markets was principally on a whole account basis, and while this approach could have been continued, it was becoming increasingly difficult to acquire economically viable reinsurance protection on this basis. The current reinsurance program is of a more traditional, product line-specific nature. This has resulted in number of advantages, including greater access to participating reinsurance markets, achieving more competitive pricing, greater flexibility and the ability to build capacity and coverage of certain lines.
The table below shows net premiums earned by each of the Insurance - Overseas General segment’s key components for the years ended December 31, 2003, 2002 and 2001.
ACE International’s increase in net premiums earned in 2003 and 2002 is attributed to P&C and A&H lines across all geographical regions, with the exception of ACE Far East, where growth in net premiums written has been minimal. The increase in net premiums earned is principally driven by growth in net premiums written and the appreciation of foreign currencies against the U.S. dollar over the last two years. ACE Global Markets’ increase in net premiums earned in 2003 and 2002 is a result of higher net premiums written across most of its product lines, particularly the professional lines, aviation, and property portfolios. The devalued U.S. dollar increased this segment’s net premiums earned by approximately 11 percentage points.
The policy acquisition cost ratio for Insurance - Overseas General improved in 2003 compared with 2002, primarily due to a change in business mix. The administrative expense ratio for Insurance - Overseas General improved due to the increase in net premiums earned. ACE International’s administrative expenses increased 25 percent in 2003, due mainly to increased costs associated with supporting business growth across all regions of the world. Additionally, the depreciation of the U.S. dollar added $32 million to administrative expenses in 2003. The policy acquisition cost ratio was relatively unchanged in 2002 compared with 2001, while the administrative expense ratio declined due to the increase in net premiums earned outpacing the increase in expenses to support growth in operations.
Net premiums earned increased 62 percent in 2003 compared with 2002. The increase in net premiums earned in all components is primarily due to the increase in traditional non-catastrophe P&C business. In 2003, 65 percent of net premiums earned was from traditional non-catastrophe P&C business, compared with 46 percent in 2002. The increase in 2002 net premiums earned compared with 2001 follows the increase in net premiums written.
The policy acquisition cost ratio for Global Reinsurance increased due to the higher proportion of business generated from ACE Tempest Re USA, relative to ACE Tempest Re Europe and ACE Tempest Re Bermuda. More of ACE Tempest Re USA’s business is written on a treaty-basis which incurs higher acquisition costs due to higher ceding commissions paid. The administrative expense ratio decreased slightly due to increased net premiums earned partially offset by higher staffing costs to support the growth in business. The policy acquisition cost and administrative expense ratios decreased in 2002 due to the shift in business mix and the increase in net premiums earned, respectively.
The Financial Services segment consists of two broad categories: financial guaranty and financial solutions. The financial guaranty operations provide insurance and reinsurance for financial guaranty exposures, including municipal and non-municipal obligations, credit default swaps (CDSs), mortgage guaranty reinsurance, title reinsurance, and trade credit reinsurance. The financial solutions operations provide one-off insurance and reinsurance solutions to clients with unique or complex risks, which are not adequately addressed in the traditional insurance market. Each financial solutions contract is structured to meet the needs of each client. Certain products (principally credit protection oriented) issued by the Financial Services segment have been determined to meet the definition of a derivative under FAS 133. The “Critical Accounting Estimates” section has more information relating to these products.
Gross premiums written decreased 32 percent in 2003 compared with 2002. This decrease is primarily related to the termination of equity layer CDOs during 2003, which resulted in the recording of negative gross premiums written of $79 million. The financial solutions operations have reduced writing equity layer CDOs, and the financial guaranty operations have ceased writing this line completely due to presently unfavorable pricing terms. Gross premiums written in 2002 were slightly higher than in 2001, due to increased writings of equity layer CDOs, and CDSs, which were partially offset by lower LPT volume.
Financial Services reported an increase in income excluding net realized gains (losses) in 2003 compared with 2002. The increase is a result of higher underwriting income and net investment income, and also a reduction in interest expense. Additionally, Financial Services incurred $43 million of adverse prior period development in 2003 principally on the structured finance line of business due to credit deterioration in collateralized debt obligations assumed through reinsurance treaties. In addition, prior year development includes an increase in the case reserve on an auto residual value transaction. Adverse development of $30 million in 2002 was principally from the ACE Financial Solutions International book, which comprises large, unique transactions, including LPTs. The increase in income excluding realized gains (losses) in 2002 compared with 2001, reflects the losses associated with the September 11 tragedy.
Following the closing of the planned IPO, we expect Financial Services’ income excluding net realized gains (losses) for 2004 to decrease 15-20 percent compared with 2003.
Net investment income is influenced by a number of factors, including the amounts and timing of inward and outward cash flows, the level of interest rates, and changes in overall asset allocation. Net investment income increased seven percent in 2003 and two percent in 2002 compared with 2002 and 2001, respectively. The increased net investment income is due to the positive operating cash flows during 2003, 2002 and 2001 that resulted in a higher average invested asset base. This positive impact on investment income was partially offset by a decline in the investment portfolio’s yield, due to the impact of lower interest rates on investment of new cash and reinvestment of maturing securities. The average yield on fixed maturities declined to 4.0 percent at December 31, 2003, compared with 4.4 percent and 5.2 percent at December 31, 2002 and 2001, respectively.
swaps, are marked to fair value or are settled. Changes in unrealized appreciation and depreciation, which result from the revaluation of securities held, are reported as a separate component of accumulated other comprehensive income in shareholders’ equity.
With respect to our credit derivatives’ business, as explained under “Critical Accounting Estimates,” we record a portion of the change in fair value in the losses and loss expense reserves, representing our best estimate of loss payouts, and a portion in net realized gains (losses), representing other changes in fair value. The fair value adjustment included in net realized gains (losses) in 2003 was a net realized gain of $163 million, compared with net realized losses of $77 million and $17 million in 2002 and 2001, respectively. The change in fair value is related to many factors but primarily due to changes in credit spreads. The gain or loss created by the estimated fair value adjustment will rise or fall each period based on estimated market pricing and may not be an indication of ultimate claims. Fair value is defined as the amount at which an asset or liability could be bought or sold in a current transaction between willing parties. We generally plan to hold derivative financial instruments to maturity. Where we hold derivative financial instruments to maturity, these fair value adjustments would generally be expected to reverse resulting in no gain or loss over the entire term of the contract. However, in the event that we terminate a derivative contract prior to maturity, as a result of a decision to exit a line of business or for risk management purposes, the unrealized gain or loss will be realized through premiums earned and losses incurred.
We recorded net realized gains on financial futures and option contracts and interest rate swaps of $34 million in 2003, compared with net realized losses of $188 million and $11 million in 2002 and 2001, respectively. We recorded net realized losses of $6 million on interest rate swaps in 2003, compared with net realized losses of $81 million in 2002. The interest rate swaps are designed to reduce the negative impact of increases in interest rates on our fixed maturity portfolio. We recorded gains of $40 million on our Standard and Poor’s (S&P) equity index futures contracts as the S&P 500 equity index increased 26 percent in 2003. We use foreign currency forward contracts to minimize the effect of fluctuating foreign currencies on certain non-U.S. dollar holdings in our portfolio that are not specifically matching foreign currency liabilities. These contracts are not designated as specific hedges and, in accordance with FAS 133, we record all realized and unrealized gains and losses on these contracts as net realized gains (losses) in the period in which the currency values change.
We regularly review our investment portfolio for possible impairment based on criteria including economic conditions, credit loss experience and issuer-specific developments. If there is a decline in a security’s net realizable value, we must determine whether that decline is temporary or “other than temporary”. If we believe a decline in the value of a particular investment is temporary, we record it as an unrealized loss in our shareholders’ equity. If we believe the decline is “other than temporary”, we write down the carrying value of
the investment and record a net realized loss in our statement of operations. The decision to recognize a decline in the value of a security carried at fair value as “other than temporary” rather than temporary has no impact on our book value. Once a security is identified as having a potential “other than temporary” impairment, we determine whether or not cost will ultimately be recovered and whether we have the intent and ability to hold the security until an expected recovery period, absent a significant change in facts that is expected to have a material adverse financial effect on the issuer.
Our net realized gains (losses) in 2003 included write-downs of $29 million related to fixed maturity investments, $63 million related to equity securities and $29 million related to other investments, as a result of conditions which caused us to conclude the decline in fair value of the investment was “other than temporary”. This compares with write-downs of $101 million related to fixed maturity investments, $153 million related to equity securities and $14 million related to other investments in 2002. Excluding the impairment charges, we recorded $155 million of net gains primarily from the sale of fixed maturities.
The process of determining whether a decline in value is temporary or “other than temporary” requires considerable judgment and differs depending on whether or not the security is traded on a public market as well as by type of security. As a result of our periodic review process, we have determined that there currently is no need to sell any of these securities to fund anticipated payments. We have described below, by type of security, our process for reviewing our investments for possible impairment.
• securities that have been in a loss position for the previous twelve months;
For those securities identified as having a potential “other than temporary” impairment based on the above criteria, we estimate a reasonable period of time in which market value is expected to recover to a level in excess of cost, if at all. For fixed maturity securities, factors considered include:
• current financial strength or debt rating, analysis and guidance provided by rating agencies and analysts.
• whether the decline appears to be related to general market or industry conditions or is issuer-specific; and
• the financial condition and near-term prospects of the issuer, including specific events that may influence the issuer’s operations.
• the issuer has reported losses for two consecutive fiscal years;
• recent issuer-specific news that is expected to adversely affect operating results; and
For those securities identified as having a possible impairment, we determine a reasonable period of time in which market value is expected to recover to a level in excess of cost, if at all. Factors considered include:
These securities will be assessed to have an “other than temporary” impairment if cost is not expected to be recovered or it is concluded that we do not have the ability and specific intent to hold the security until its expected recovery.
The following table summarizes for all securities in an unrealized loss position at December 31, 2003 (including securities on loan), the aggregate fair value and gross unrealized loss by length of time the amounts have continuously been in an unrealized loss position.
The other expense for 2003 includes $9 million of charges related to the commutation of a reinsurance contract and $12 million in goodwill and software impairments. Other expense for 2002 includes $25 million in debt prepayment expense on the ACE INA Subordinated Notes due in 2009. This cost was primarily attributable to a decline in interest rates since the note was originally issued.
We also gain exposure to equity markets through the use of derivative instruments. The combined equity exposure through both our equity portfolio and derivative instruments was valued at $662 million and $603 million at December 31, 2003 and December 31, 2002, respectively. The increase of $5.3 billion in total investments and cash is due to positive cash flows from operations as a result of strong premium volume, increased unrealized gains, increased securities lending collateral and the issuance of preferred shares. Offsetting these increases were dividends paid of $231 million in 2003.
In accordance with the ACE investment process, we invest in below-investment grade securities through dedicated investment portfolios managed by external investments managers that have investment professionals specifically dedicated to this asset class. At December 31, 2003, our fixed income investment portfolio included below-investment grade securities and non-rated securities which, in total, comprised approximately eight percent of our fixed income portfolio. We define a security as being below-investment grade if it has an S&P credit rating of BB or less. Our below investment-grade and non-rated portfolio includes approximately 500 names, with the top ten holdings making up approximately 11 percent of the $1.8 billion balance at December 31, 2003. The highest single exposure in this portfolio of securities is $26 million. Below-investment grade securities have different characteristics than investment grade corporate debt securities. Risk of loss from default by the borrower is greater with below-investment grade securities. Below-investment grade securities are generally unsecured and are often subordinated to other creditors of the issuer. Also, issuers of below-investment grade securities usually have higher levels of debt and are more sensitive to adverse economic conditions such as recession or increasing interest rates, than are investment grade issuers. We reduce the overall risk in the below-investment grade portfolio, as in all investments, through careful credit analysis, strict investment policy guidelines, and diversification by issuer and/or guarantor as well as by industry.
Off-Balance Sheet Arrangements - Variable Interests Related to Equity Investments in CDOs
The value of restricted assets increased $728 million to $5.1 billion at December 31, 2003. The higher value of restricted assets is a result of increased use of our secured credit facility and the higher use of trust funds in place of LOCs.
We have exposure to catastrophic event risk from global (re)insurance writings of property, workers’ compensation and other lines of business. This potential loss accumulation, caused by either man-made or natural events, is addressed within using several different approaches. First, we have established a series of Product Boards to ensure that geographic, product and client exposures are appropriate and meet limit guidelines adopted by the Boards. Second, we have adopted since 1999 a standardized catastrophe exposure modeling approach across each of its underwriting operations which allows the aggregation of risk within and across business units. This aggregation is performed and monitored on a quarterly basis to provide a level assessment of risk. Third, where the risk/return economics are effective, reinsurance is purchased at the business unit level to protect from accumulations arising either within product, business unit or across a combination thereof such that the overall risk from a catastrophic loss is appropriate to our capital structure.
ACE Global Re’s book of business consists of a significant amount of property catastrophe exposure. For this line of business, we develop initial loss estimates for large individual catastrophes based on market share information of potential exposures. Market share analysis uses cedant and industry information at geographic level (e.g. country) and line of business. A range of industry losses is then passed through the relevant market shares to provide a range of losses for the company’s exposures, allowing for program attachment points and the appropriate shares of the indemnity limits involved. When actual case reserves from the ceding companies are received, the initial loss estimates are progressively modified to reflect the actual emerging loss experience. Since the subject business is short tail, most of our historical losses are now reserved on this basis. For the casualty lines of business, similar actuarial techniques are utilized as described above for the Insurance - North American and Insurance - Overseas General segments. However, due to the
immaturity of this book of business, more weight is given to the BF method of projections. There is considerable uncertainty around the expected projections for these lines and any favorable trends that may be seen in the development could easily be reversed.
We also record portfolio reserves for our financial guaranty and mortgage guaranty businesses. Portfolio reserves are established with respect to the portion of our business for which case reserves have not been established. Portfolio reserves are established in an amount equal to the portion of actuarially estimated ultimate losses related to premiums earned to date as a percentage of total expected premiums for that in-force business. Portfolio reserves are developed considering the net par outstanding of each insured obligation, taking account of the probability of future default, the expected timing of the default and the expected recovery following default. These factors vary by type of issue (for example municiple, structured finance corporate), current credit rating and remaining term of the underlying obligation and are principally based on historical data obtained from rating agencies. Actuarially estimated ultimate losses on mortgage guaranty reinsurance are principally determined based on the historical industry loss experience, net of recoveries. During an accounting period, portfolio reserves principally increase or decrease based on changes in aggregate net amount at risk and the probability of default resulting from changes in credit quality of insured obligations, if any.
With respect to our financial solutions business, each contract we write is relatively large and unique, so each contract is reviewed and assessed individually. Most contracts are multi-year in nature. As with our financial guaranty business, traditional actuarial methods such as analyzing and extrapolating historical loss experience are not considered appropriate for financial solutions business because of the relatively small number of large contracts. Our loss estimates are based on contract terms (such as a requirement to pay profit commissions) original pricing information, analysis and comparison with external data and experience to date on the contract.
Following is a breakdown of our reinsurance recoverable on paid losses at December 31, 2003 and 2002:
The following tables provide a listing of our largest reinsurers with the first category representing the top ten reinsurers and the second category representing the remaining reinsurers with balances greater than $20 million. The third category includes amounts due from over 2,500 companies, each having balances of less than $20 million. Our bad debt reserve in the three categories is principally based on an analysis of the credit quality of the reinsurer and collateral balances. The next category, mandatory pools and government agencies, includes amounts backed by certain state and federal agencies. In certain states, insurance companies are required by law to participate in these pools. The fifth category, structured settlements, includes annuities purchased from life insurance companies to settle claims. Since we retain the ultimate liability in the event that the life company fails to pay the claimant, we reflect the amount as a liability and as a recoverable for GAAP purposes. These amounts are not subject to dispute and we establish our bad debt reserve based on the application of historical collection experience. The next category, captives, includes companies established and owned by our insurance clients to assume a significant portion of their direct insurance risk from us, i.e., they are structured to allow clients to self-insure a portion of their insurance risk. It is generally our policy to obtain collateral equal to expected losses; where appropriate, exceptions are granted, but only with review and sign-off at a senior officer level. Our final category, other, includes amounts recoverable that are in dispute or are from companies that are in supervision, rehabilitation or liquidation. We establish our bad debt reserve for these categories based on a case by case analysis of individual situations, including credit and collateral analysis and consideration of our collection experience in similar situations.
Our exposure to asbestos principally arises out of liabilities acquired when we purchased Westchester Specialty in 1998 and the P&C business of CIGNA in 1999, with the larger exposure contained within the liabilities acquired in the CIGNA transaction. These CIGNA
As part of the acquisition of Westchester Specialty, NICO provided $750 million of reinsurance protection for adverse development on loss and loss adjustment expense reserves. At December 31, 2003, the remaining unused limit in this NICO Westchester Specialty cover was approximately $600 million.
As part of the acquisition of the CIGNA P&C business, NICO provided $2.5 billion of reinsurance protection for adverse development on Brandywine loss and loss adjustment expense reserves and for uncollectible ceded reinsurance. This NICO Brandywine cover was exhausted on an incurred basis with the increase in our A&E reserves in the fourth quarter of 2002.
The active ACE INA companies retain two primary funding obligations associated with the run-off Brandywine operations: a dividend retention fund obligation and required reinsurance coverage provided under an aggregate excess of loss reinsurance agreement. In addition, certain active ACE INA companies remain residually liable for pre-1987 general liability business ceded by those companies to the primary Brandywine subsidiary, Century Indemnity Company (“Century”).
In accordance with the Brandywine restructuring order, INA Financial Corporation established and funded a dividend retention fund consisting of $50 million plus investment earnings. Pursuant to terms of the restructuring, the full balance of this dividend retention fund was contributed to Century as of December 31, 2002. To the extent in the future that dividends are paid by INA Holdings Corporation to its parent, INA Financial Corporation, and to the extent that INA Financial Corporation then pays such dividends to INA Corporation, a portion of those dividends must be withheld to replenish the principal of the dividend retention fund to $50 million within five years. In 2003, no such dividends were paid, and therefore no replenishment of the dividend retention fund occurred. This dividend fund obligation, to maintain and to replenish the fund as necessary and to the extent dividends are paid, is ongoing until ACE INA receives prior written approval from the Pennsylvania Commissioner of Insurance to terminate the fund.
In addition, the ACE INA insurance subsidiaries are obligated to provide insurance coverage to Century in the amount of $800 million under an aggregate excess of loss reinsurance agreement if the statutory capital and surplus of Century falls below $25 million or if Century lacks liquid assets with which to pay claims as they become due, after giving effect to contribution of any dividend retention fund balance. Coverage under the aggregate excess of loss reinsurance agreement was triggered as of December 31, 2002 following contribution of the dividend retention fund balance. Approximately $468 million in undiscounted losses were ceded to the aggregate excess of loss reinsurance agreement at December 31, 2003.
Congress has been working on possible legislation to move all U.S. asbestos bodily-injury claims to a federal trust for compensation in accordance with an established set of medical criteria and claim values. The trust would be funded by asbestos defendants and their insurers. As currently proposed, ACE would be one of the insurer participants. We believe that if the proposed legislation is enacted, our ultimate funding obligation under the trust would be less than we would be required to pay under the current tort system because the trust would avoid payments to unimpaired victims and obviate the need for extensive legal costs. However, we cannot predict if any such proposed legislation will be modified or adopted.
The table below presents selected loss reserve data for A&E exposures at December 31, 2003 and 2002.
Paid losses for the year ended December 31, 2003 for asbestos claims were $293 million on gross reserves and $169 million on net reserves. Environmental and other latent exposure claim payments were $204 million on gross reserves and $153 million on net reserves in 2003.
We assess which subsidiaries to draw dividends from based on a number of factors. Considerations such as regulatory and legal restrictions as well as the subsidiary’s financial condition are paramount to the dividend decision. The legal restrictions on the payment of dividends from retained earnings by our Bermuda subsidiaries are currently satisfied by the share capital and additional paid-in capital of each of the Bermuda subsidiaries. During 2003, ACE Bermuda declared and paid dividends of $478 million, compared with $345 million and $234 million in 2002 and 2001, respectively. We received dividends of $25 million from ACE Cap Re International Ltd. during 2003. ACE Tempest Life Re declared and paid dividends of $140 million and $105 million in 2002 and 2001, respectively. We expect that a majority of our cash inflows for 2004 will be from our Bermuda subsidiaries.
issued debt to provide partial financing for the ACE INA acquisition and for other operating needs. This debt is serviced by dividends paid by ACE INA’s insurance subsidiaries to ACE INA as well as other group resources. ACE Financial Services’ U.S. insurance subsidiaries are limited in their dividend paying abilities due to their need to maintain their AA and AAA financial strength ratings.
Financial strength ratings represent the opinions of the rating agencies on the financial strength of a company and its capacity to meet the obligations of insurance policies. Independent ratings are one of the important factors that establish our competitive position in the insurance markets. The rating agencies consider many factors in determining the financial strength rating of an insurance company, including the relative level of statutory surplus necessary to support the business operations of the company. These ratings are based upon factors relevant to policyholders, agents and intermediaries and are not directed toward the protection of investors. Such ratings are not recommendations to buy, sell or hold securities.
Debt ratings apply to short- and long-term debt as well as preferred stock. These ratings are assessments of the likelihood that we will make timely payments of principal and interest and preferred stock dividends.
Capital resources consist of funds deployed or available to be deployed to support our business operations. The following table summarizes the components of our capital resources at December 31, 2003 and 2002.
In 2000, we publicly offered and issued 6,221,000 FELINE PRIDES for aggregate net proceeds of $311 million. Each FELINE PRIDE initially consisted of a unit referred to as an Income PRIDE. Each Income PRIDE consisted of (i) one 8.25 percent Cumulative Redeemable Preferred Share, Series A, liquidation preference $50 per share, and (ii) a purchase contract pursuant to which the holder of the Income PRIDE agreed to purchase from us, on May 16, 2003, $311 million of ordinary shares at the applicable settlement rate. On May 16, 2003, we issued approximately 11.8 million ordinary shares, in satisfaction of the purchase contracts underlying our FELINE PRIDES. In consideration, on June 16, 2003, we redeemed all of our 8.25 percent Cumulative Redeemable Preferred Shares, Series A, at a rate representing an issuance of 1.8991 ordinary shares per preferred share.
The following table analyzes the movements in our shareholders’ equity for the years ended December 31, 2003, 2002, and 2001.
On January 10, 2003 and April 14, 2003, we paid dividends of 17 cents per ordinary share to shareholders of record on December 27, 2002 and March 31, 2003, respectively. On July 14, 2003 and October 14, 2003 and January 14, 2004 we paid dividends of 19 cents per ordinary share to shareholders of record on June 30, 2003, September 30, 2003 and December 31, 2003 respectively. We have paid dividends each quarter since we became a public company in 1993. However, the declaration, payment and value of future dividends on ordinary shares is at the discretion of our Board of Directors and will be dependent upon our profits, financial requirements and other factors, including legal restrictions on the payment of dividends and such other factors as our Board of Directors deems relevant.
The table below shows our contractual obligations and commitments including our payments due by period:
The above table excludes estimated future cash flows for losses and loss expenses as there is typically no minimum contractual commitment associated with insurance and reinsurance contracts and also the amount and timing of the cash outflows are uncertain. Further, the above table excludes pension obligations. While we expect to contribute approximately $10 million to our defined benefit plans during 2004, minimum funding requirements are minimal over the next year. Subsequent funding commitments are apt to vary for many factors and are difficult to estimate at this time.
Deposit liabilities of $212 million include contract holder deposit funds of $94 million and reinsurance deposit liabilities of $118 million. Contract holder deposit funds represent a liability for investment contracts sold that do not meet the definition of an insurance contract under FAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and Realized Gains and Losses from the Sale of Investments”. The investment contracts are sold with a guaranteed rate of return. The proceeds are then invested with the intent of realizing a greater return than is called for in the investment contracts. The above table does not include estimated cash flows for deposit liabilities as the amount and timing of cash flows is uncertain.
We lease office space in most countries in which we operate under operating leases that expire at various dates through January 2018. We renew and enter into new leases in the ordinary course of business as required.
Our total long-term debt of $1.3 billion is described in Note 8 of our Consolidated Financial Statements.
(i) $400 million company-obligated mandatorily redeemable preferred shares ($100 million and $300 million) issued by two business trusts wholly owned by us; and
(ii) $75 million of monthly income preferred securities issued by one of our subsidiary limited liability companies.
The following table shows our credit facilities by credit line, usage, expiry date and purpose at December 31, 2003.
3 Unsecured letters of credit are placed with Lloyd’s as capital on behalf of ACE’s corporate capital vehicles
(ii) maintenance of a maximum debt to total capitalization ratio of not greater than 0.35 to 1. Under this covenant, debt does not include trust preferred securities or mezzanine equity, except where the ratio of the sum of trust preferred securities and mezzanine equity to total capitalization is greater than 15 percent. In this circumstance, the amount greater than 15 percent would be included in the debt to total capitalization ratio.
Certain facilities are guaranteed by either operating subsidiaries or ACE Limited.
Our failure to comply with the covenants under any credit facility would, subject to grace periods in the case of certain covenants, result in an event of default. This could require us to repay any outstanding borrowings or to cash collateralize letters of credit under such facility. An event of default under one or more credit facilities with outstanding credit extensions of $25 million or more would result in an event of default under all of the facilities described above.
As our Bermuda subsidiaries are not admitted insurers and reinsurers in the U.S., the terms of certain insurance and reinsurance contracts require them to provide LOCs to clients. In addition, ACE Global Markets is required to satisfy certain U.S. regulatory trust fund requirements which can be met by the issuance of LOCs.