The following is a discussion of the results of operations of Everest Reinsurance Holdings, Inc. and its subsidiaries (the "Company"). This discussion and analysis should be read in conjunction with the consolidated financial statements and the notes thereto presented under ITEM 8.
RESTRUCTURING On February 24, 2000, a corporate restructuring was completed and Everest Re Group, Ltd. ("Group") became the new parent holding company of the Company, which remains the holding company for Group's U.S. based operations. Holders of the Company's common stock automatically became holders of the same number of Group common shares. See ITEM 1 - "Business - The Company" for a further discussion.
ACQUISITIONS On September 19, 2000, the Company completed the acquisition of all of the issued and outstanding capital stock of Gibraltar Casualty Company ("Gibraltar") from The Prudential Insurance Company of America ("The Prudential") for $51.8 million, which approximated book value. As a result of the acquisition, Gibraltar became a wholly owned subsidiary of the Company and, immediately following the acquisition, its name was changed to Mt. McKinley Insurance Company ("Mt. McKinley"). In connection with the acquisition of Mt. McKinley, which has significant exposure to asbestos and environmental claims, Prudential Property and Casualty Insurance Company ("Prupac"), a subsidiary of The Prudential, provided reinsurance to Mt. McKinley covering 80% ($160.0 million) of the first $200.0 million of any adverse development of Mt. McKinley's reserves as of September 19, 2000. In addition, The Prudential guaranteed Prupac's obligation to Mt. McKinley. There were $78.9 million of cessions under this reinsurance at December 31, 2002, reducing the limit available under this contract to $81.1 million.
Mt. McKinley, a run-off property and casualty insurer in the United States, has had a long relationship with Holdings and its principal operating company, Everest Reinsurance Company ("Everest Re"). Mt. McKinley was formed in 1978 by Everest Re and wrote insurance until 1985, when it was placed in run-off. In 1991, Mt. McKinley became a subsidiary of The Prudential. Mt. McKinley is also a reinsurer of Everest Re. Under a series of transactions dating to 1986, Mt. McKinley reinsured several components of Everest Re's business. In particular, Mt. McKinley provided stop-loss reinsurance protection, in connection with the Company's October 5, 1995 initial public offering, for any adverse loss development on Everest Re's June 30, 1995 (December 31, 1994 for catastrophe losses) reserves, with $375.0 million in limits, of which $103.9 million remains available (the "Stop Loss Agreement"). The Stop Loss Agreement and other reinsurance contracts between Mt. McKinley and Everest Re remain in effect following the acquisition. However, these contracts became transactions with affiliates effective on the date of the Mt. McKinley acquisition, and their financial impact is thereafter eliminated in consolidation. Effective September 19, 2000, Mt. McKinley and Everest Reinsurance (Bermuda), Ltd. ("Bermuda Re")
entered into a loss portfolio transfer reinsurance agreement, whereby Mt. McKinley transferred, for what management believes to be arm's-length consideration, all of its net insurance exposures and reserves to Bermuda Re.
SEGMENT INFORMATION The Company, through its subsidiaries, operates in four segments: U.S. Reinsurance, U.S. Insurance, Specialty Underwriting and International. The U.S. Reinsurance operation writes property and casualty reinsurance on both a treaty and facultative basis through reinsurance brokers as well as directly with ceding companies within the United States. The U.S. Insurance operation writes property and casualty insurance primarily through general agent relationships and surplus lines brokers within the United States. The Specialty Underwriting operation writes accident and health ("A&H"), marine, aviation and surety business within the United States and worldwide through brokers and directly with ceding companies. The International operation writes property and casualty reinsurance through the Company's branches in London, Canada, and Singapore, in addition to foreign business written through the Company's New Jersey headquarters and Miami office.
PREMIUMS. Gross premiums written increased 49.0% to $2,755.4 million in 2002 from $1,849.8 million in 2001, as the Company took advantage of selected growth opportunities and improving pricing in many classes of business, while continuing to maintain a disciplined underwriting approach. Premium growth areas included a 70.5% ($227.9 million) increase in the International operation, mainly attributable to growth in the London, Canadian and Latin American markets, a 63.5% ($319.1 million) increase in the U.S. Insurance operation, principally attributable to growth in worker's compensation insurance, a 46.5% ($284.1 million) increase in the U.S. Reinsurance operation, primarily reflecting growth across property and casualty lines, and an 18.0% ($74.6 million) increase in the Specialty Underwriting operation, mainly attributable to growth in marine, aviation and surety business. The Company continued to decline business that did not meet its objectives regarding underwriting profitability.
Net premiums written increased by 54.5% to $2,189.5 million in 2002 from $1,416.9 million in 2001. This increase was a result of the increase in gross premiums written and ceded premiums.
EXPENSES. Incurred loss and loss adjustment expenses ("LAE") increased by 29.6% to $1,399.0 million in 2002 from $1,079.2 million in 2001. The increase in incurred losses and LAE was principally attributable to the increase in net premiums earned and modest reserve strengthening in select areas, most notably in directors and officers liability, surety and workers' compensation lines and with respect to asbestos exposures, partially offset by lower catastrophe losses and improvements in rates, terms and conditions in many classes of business, as well as the impact of changes in the Company's mix of business. Incurred losses and LAE include catastrophe losses, which reflect the impact both of current period events and favorable and unfavorable development on prior period events and are net of reinsurance. A catastrophe is an event that causes a pre-tax loss on property exposures of at least $5.0 million and has an event date of January 1, 1988 or later. Catastrophe losses, net of contract specific cessions but before cessions under the corporate retrocessional program, were $30.2 million in 2002, principally relating to European flood losses and Hurricanes Isidore and Kenna, compared to net catastrophe losses of $222.6 million in 2001, which was principally related to the September 11 attacks. Incurred losses and LAE in 2002 reflected ceded losses and LAE of $486.1 million compared to ceded losses and LAE in 2001 of $619.4 million. Ceded losses and LAE in 2002 include $178.6 million of ceded losses relating to the reinsurance transactions noted earlier between the Company and Bermuda Re. The ceded losses and LAE in 2002 included $11.0 million and $90.0 million of losses ceded under the 2001 and 2000 accident year aggregate excess of loss components of the Company's corporate retrocessional program, respectively. The ceded losses and LAE in 2001 included $164.0 million and $105.0 million of losses ceded under the 2001 and 1999
Contributing to the increase in incurred losses and LAE in 2002 from 2001 were a 198.4% ($173.4 million) increase in the International operation, a 63.4% ($134.0 million) increase in the U.S. Insurance operation, principally reflecting increased premium volume coupled with changes in this segment's specific reinsurance programs and an 11.4% ($51.4 million) increase in the U.S. Reinsurance operation, principally due to increased premium volume, partially offset by decreased catastrophe losses. These increases were partially offset by an 11.8% ($39.1 million) decrease in the Specialty Underwriting operation, principally attributable to decreased catastrophe losses. Incurred losses and LAE for each operation were also impacted by variability relating to changes in the level of premium volume and mix of business by class and type.
The Company's loss and LAE ratio ("loss ratio"), which is calculated by dividing incurred losses and LAE by premiums earned, decreased by 9.4 percentage points to 71.5% in 2002 from 80.9% in 2001, reflecting the earned premiums and incurred losses and LAE discussed above. The following table shows the loss ratios for each of the Company's operating segments for 2002 and 2001. The loss ratios for all operations were impacted by the expense factors noted above as well as by the impact on ceded premiums of the adjustment premiums under the Company's corporate retrocessional program.
INVESTMENTS. Net investment income decreased by 3.0% to $257.9 million in 2002 from $265.9 million in 2001, principally reflecting the lower interest rate enviroment, partially offset by the effect of investing the $425.2 million of cash flow from operations in 2002 and $203.4 million of net proceeds from Everest Re Capital Trust's ("Capital Trust") issuance of trust preferred securities in November 2002. The following table shows a comparison of various investment yields as of December 31, 2002 and 2001, respectively, and for the periods then ended.
Net realized capital losses were $53.1 million in 2002, reflecting realized capital losses on the Company's investments of $108.9 million, which includes $79.7 million relating to write-downs in the value of securities deemed to be impaired on an other than temporary basis, of which $25.7 million were for WorldCom, partially offset by $55.8 million of realized capital gains, compared to net realized capital losses of $15.7 million in 2001. The net realized capital losses in 2001 reflected realized capital losses of $45.5 million, which included $16.7 million relating to write-downs in the value of securities deemed to be impaired on an other than temporary basis, which were partially offset by $29.8 million of realized capital gains.
Other expense was $21.8 million in 2002 compared to other income of $26.6 million in 2001. Significant contributors to other expense in 2002 were deferred gains principally on the Mt. McKinley reinsurance transaction with Bermuda Re, which is retroactive in nature, foreign exchange losses, normal provision for uncollectible audit premium in the U.S. Insurance operation and the amortization of deferred expenses relating to the Company's issuance of senior notes and Capital Trust's issuance of trust preferred securities in November 2002, partially offset by fee income. Other income for 2001 includes $25.9 million arising from a non-recurring receipt of shares in connection with the demutualization of a former insurance company client that had issued annuities to the Company in connection with certain claim settlement transactions. In
addition, other income for 2001 includes foreign exchange gains as well as fee income, offset by the amortization of deferred expenses relating to the Company's issuance of senior notes.
PREMIUMS. Gross premiums written increased 34.6% to $1,849.8 million in 2001 from $1,374.0 million in 2000, as the Company took advantage of selected growth opportunities, while continuing to maintain a disciplined underwriting approach. Premium growth areas included a 100.6% ($251.9 million) increase in the U.S. Insurance operation, principally attributable to growth in worker's compensation insurance, a 30.1% ($95.7 million) increase in the Specialty Underwriting operation, mainly attributable to growth in A&H medical stop loss writings and a 26.7% ($128.8 million) increase in the U.S. Reinsurance operation, primarily reflecting improved market conditions. These increases were partially offset by a 0.2% ($0.8 million) decrease in the International operation. The Company continued to decline business that did not meet its objectives regarding underwriting profitability.
Net premiums written increased by 17.4% to $1,416.9 million in 2001 from $1,207.3 million in 2000. This increase was as a result of the increase in gross premiums written and the increase in ceded premiums.
PREMIUM REVENUES. Net premiums earned increased by 14.7% to $1,333.5 million in 2001 from $1,162.6 million in 2000. Contributing to this increase were a 189.7% ($192.6 million) increase in the U.S. Insurance operation, a 22.9% ($69.2 million) increase in the Specialty Underwriting operation and a 5.5% ($26.0 million) increase in the U.S. Reinsurance operation. These increases were partially offset by a 40.8% ($116.9 million) decrease in the International operation, principally attributable to $122.3 million relating to the reinsurance transaction between the Company and Bermuda Re noted earlier. All of these changes reflect period to period variability in gross written and ceded premiums, and business mix, together with normal variability in earnings patterns. Business mix changes occur not only as the Company shifts emphasis between products, lines of business, distribution channels and markets but also as individual contracts renew or non-renew, almost always with changes in coverage, structure, prices and/or terms, and as new contracts are accepted with coverages, structures, prices and/or terms different from those of expiring contracts. As premium reporting and earnings and loss and commission characteristics derive from the provisions of individual contracts, the continuous turnover of individual contracts, arising from both strategic shifts and day to day underwriting, can and does introduce appreciable background variability in various underwriting line items.
Contributing to the increase in incurred losses and LAE in 2001 from 2000 were a 200.7% ($141.0 million) increase in the U.S. Insurance operation, principally reflecting increased premium volume, a 41.5% ($131.9 million) increase in the U.S. Reinsurance operation, principally reflecting losses in connection with the September 11 attacks and tropical storm Alison and a 30.1% ($76.5 million) increase in the Specialty Underwriting operation, principally attributable to increased premium volume in A&H medical stop loss business together with marine, aviation and surety losses relating to the September 11 attacks, the Enron bankruptcy and the Petrobras Oil Rig loss. These increases were partially offset by a 62.9% ($148.5 million) decrease in the International operation, principally
attributable to $119.4 million relating to the reinsurance transaction between the Company and Bermuda Re noted earlier, and to more favorable loss experience. Incurred losses and LAE for each operation were also impacted by variability relating to changes in the level of premium volume and mix of business by class and type.
Other income was $26.6 million in 2001 compared to $3.3 million in 2000. Other income for 2001 includes $25.9 million arising from a non-recurring receipt of shares in connection with the demutualization of a former insurance company client that had issued annuities to the Company in connection with certain claim settlement transactions. In addition, other income for 2001 includes foreign exchange gains as well as financing fees from Everest Security, offset by the amortization of deferred expenses relating to the Company's issuance of senior notes. Significant contributors to other income for 2000 were foreign exchange gains as well as financing fees from Everest Security, partially offset by net derivative expense and the amortization of deferred expenses relating to the Company's issuance of senior notes. The foreign exchange gains and losses are attributable to fluctuations in foreign currency exchange rates.
SAFE HARBOR DISCLOSURE This report contains forward-looking statements within the meaning of the U.S. federal securities laws. The Company intends these forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in the federal securities laws. In some cases, these statements can be identified by the use of forward-looking words such as "may", "will", "should", "could", "anticipate", "estimate", "expect", "plan", "believe", "predict", "potential" and "intend". Forward-looking statements only reflect the Company's expectations and are not guarantees of performance. These statements involve risks, uncertainties and assumptions. Actual events or results may differ materially from the Company's expectations. Important factors that could cause actual events or results to be materially different from the Company's expectations include those discussed below under the caption "Risk Factors". The Company undertakes no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise.
The results of companies in the insurance and reinsurance industry historically have been subject to significant fluctuations and uncertainties. Factors that affect the industry in general could also cause the Company's results to fluctuate. The industry's profitability can be affected significantly by:
- - fluctuations in interest rates, inflationary pressures and other changes in the investment environment, which affect returns on invested capital and may impact the ultimate payout of loss amounts;
- - the overall level of economic activity and the competitive environment in the industry.
DECREASES IN RATES FOR PROPERTY AND CASUALTY REINSURANCE AND INSURANCE COULD REDUCE THE COMPANY'S NET INCOME.
The Company is subject to credit risk with respect to its reinsurers because the transfer of risk to a reinsurer does not relieve the Company of its liability to the insured. In addition, reinsurers may be unwilling to pay the Company even though they are able to do so. The failure of one or more of the Company's reinsurers to honor their obligations in a timely fashion would impact the Company's cash flow and reduce its net income and could cause the Company to incur a significant loss.
The Company's industry is highly competitive and has experienced signifiacant price competition. The Company competes in the United States and international markets with domestic and international insurance companies. Some of these competitors have greater financial resources than the Company, have been operating for longer than the Company and have established long-term and continuing business relationships throughout the industry, which can be a significant competitive advantage. In addition, the Company expects to face further competition in the future. The Company may not be able to compete successfully in the future.
The Company's success has been, and will continue to be, dependent on its ability to retain the services of its existing key executive officers and to attract and retain additional qualified personnel in the future. The loss of the
services of any of its key executive officers or the inability to hire and retain other highly qualified personnel in the future could adversely affect the Company's ability to conduct its business.