Everest Re’s corporate offices are located in approximately 129,700 square feet of leased office space in Liberty Corner, New Jersey. Bermuda Re’s corporate offices are located in approximately 3,600 total square feet of leased office space in Hamilton, Bermuda. The Company’s other thirteen locations occupy a total of approximately 75,000 square feet, all of which are leased. Management believes that the above-described office space is adequate for its current and anticipated needs.
The following selected consolidated GAAP financial data of the Company as of and for the years ended December 31, 2006, 2005, 2004, 2003 and 2002 were derived from the consolidated financial statements of the Company, which were audited by PricewaterhouseCoopers LLP. The following financial data should be read in conjunction with the Consolidated Financial Statements and accompanying notes.
(3) Based on weighted average basic shares outstanding of 64.7 million, 57.6 million, 55.9 million, 54.0 million and 50.3 million for 2006, 2005, 2004, 2003 and 2002, respectively.
(4) Based on weighted average diluted shares outstanding of 65.3 million, 57.6 million, 56.8 million, 55.0 million and 51.1 million for 2006, 2005, 2004, 2003 and 2002, respectively.
In 2006, the Company observed strong price increases, and more restricted limits, in those property lines and regions that were most affected by the catastrophe events of 2005, principally Hurricanes Katrina, Rita and Wilma. Reinsurance capacity in these areas was constrained, particularly for catastrophe reinsurance, which includes southeastern U.S. exposures and in the retrocession and energy lines. The record catastrophe losses of 2005 have also generally led to modest strengthening for U.S. property lines that have little or no substantive catastrophe exposure and price stabilization in most casualty insurance and reinsurance markets. However, certain of the Company’s U.S. casualty lines continue to exhibit weaker market conditions led by the medical stop loss and D&O reinsurance classes, as well as the California workers’ compensation insurance line. The Company believes that U.S. casualty reinsurance generally remains adequately priced; however, increased price competition at the insurance company level and cedants’ increased appetite for retaining more profitable business net following several years of hard-market conditions, may result in modestly softer reinsurance pricing. The Company’s U.S. insurance operation is less affected by these standard casualty insurance market conditions given its specialty insurance program orientation. Finally, the Company continues to observe generally stable property reinsurance market conditions in most countries outside of the U.S., except for hardening property market conditions in Mexico following Hurricane Wilma, while casualty rates are softening.
Net investment income increased 20.4% for 2006 compared to 2005, reflecting continued year-over-year growth in invested assets from positive cash flow from operations and a $43.2 million increase in income from limited partnership investments. The average investment portfolio yields for 2006 were 4.6% pre-tax and 4.0% after-tax, slightly higher compared to the prior year.
The Company’s loss ratio improvement of 31 points for 2006 compared to 2005 included a 30 point improvement due to the relative absence of current year catastrophes.
The Company, through its subsidiaries, operates in five segments: U.S. Reinsurance, U.S. Insurance, Specialty Underwriting, International and Bermuda. The U.S. Reinsurance operation writes property and casualty, treaty and facultative reinsurance, through reinsurance brokers, as well as directly with ceding companies within the U.S. The U.S. Insurance operation writes property and casualty insurance primarily through general agents and
surplus lines brokers within the U.S. The Specialty Underwriting operation writes A&H, marine, aviation and surety business within the U.S. and worldwide through brokers and directly with ceding companies. The International operation writes property and casualty reinsurance through Everest Re’s branches in Canada and Singapore, in addition to foreign business written through Everest Re’s Miami and New Jersey offices. The Bermuda operation provides reinsurance and insurance to worldwide property and casualty markets and reinsurance to life insurers through brokers and directly with ceding companies from its Bermuda office and reinsurance to the United Kingdom and European markets through its UK branch.
These segments are managed in a carefully coordinated fashion with strong elements of central control, with respect to pricing, risk management, control of aggregate exposures to catastrophic events, capital, investments and support operations. Management monitors and evaluates the financial performance of these operating segments based upon their underwriting results. Underwriting results include earned premium less losses and LAE incurred, commission and brokerage expenses and other underwriting expenses and are analyzed using ratios, in particular loss, commission and brokerage and other underwriting expense ratios, which, respectively, divide incurred losses, commissions and brokerage and other underwriting expenses by earned premium. The Company utilizes inter-affiliate reinsurance but such reinsurance generally does not impact segment results, as business is generally reported within the segment in which the business was produced. For selected financial information regarding these segments, see Note 18 of Notes to Consolidated Financial Statements.
The following tables present the relevant underwriting results for the operating segments for the three years ended December 31, 2006, 2005 and 2004:
Premiums Written. Gross written premiums decreased 2.6% to $4,000.9 million in 2006 from $4,108.6 million in 2005. The Specialty Underwriting operation decreased 20.2% ($63.4 million), driven by a $53.2 million reduction in A&H premiums, as pricing for this business continues to be difficult and a $23.6 million decrease in marine and aviation premiums, partially offset by a $13.4 million increase in surety premiums. The U.S. Insurance operation decreased 7.1% ($66.2 million), mainly reflecting continued reductions in the California workers’ compensation business and run-off of the credit business. The U.S. Reinsurance operation decreased 3.6% ($49.4 million), principally reflecting a $72.7 million decrease in treaty casualty business, partially offset by a $16.4 million increase in treaty property business and by an $11.6 million increase in facultative business. Partially offsetting these declines was a 6.0% ($46.2 million) increase in the Bermuda operation, reflecting increases in treaty business in the UK, Europe and Bermuda, partially offset by decreased facultative business in Bermuda. The International operation increased 3.6% ($25.2 million), primarily due to a $47.1 million increase in international business written through the Miami and New Jersey offices, representing primarily Latin American business and by a $22.8 million increase in Canadian business, partially offset by a $44.1 million decrease in Asian business. The Company endeavors to write only business that meets its profit criteria; generally, increases and decreases in a line of business or region are the result of changing perceptions of the profit opportunities in the various markets.
Premium Revenues. Net premiums earned decreased by 2.8% to $3,853.2 million in 2006 from $3,963.1 million in 2005. Contributing to this decrease was an 18.9% ($57.0 million) decrease in the Specialty Underwriting operation, an 8.2% ($115.1 million) decrease in the U.S. Reinsurance operation, a 7.5% ($61.3 million) decrease in the U.S. Insurance operation, partially offset by an 11.5% ($87.4 million) increase in the Bermuda operation and a 5.3% ($36.0 million) increase in the International operation. Additional premiums, related to catastrophe business, included in net earned premiums contributed $4.9 million and $81.8 million for 2006 and 2005, respectively. The changes reflect period to period changes in net written premiums and business mix, together with normal variability in earning 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. As premium reporting, earnings, loss and commission characteristics derive from the provisions of individual contracts, the continuous turnover of individual contracts, arising from both strategic shifts and daily underwriting decisions, can and does introduce appreciable variability in various underwriting line items. Changes in estimates of the reporting patterns of ceding companies also affect premiums earned.
The U.S. Reinsurance segment’s incurred losses and LAE decreased 42.5%, or $628.4 million, for 2006 compared to 2005, primarily due to significantly reduced current year catastrophe losses, principally within the treaty property unit and decreased earned premiums. The segment’s loss ratio improved by 39.6 points from 2005 due to a decrease in catastrophe losses, coupled with an improvement in the overall attritional loss ratio. The segment’s attritional loss ratio improvement generally results from more favorable current year pricing, principally on the property business.
The Specialty Underwriting segment’s incurred losses and LAE decreased 48.4%, or $154.0 million, for 2006 as compared to 2005, primarily due to decreased catastrophe losses and a reduction in earned premiums across all classes of business. Correspondingly, the segment’s loss ratio improved by 38.5 points from 2005.
The International segment’s incurred losses and LAE decreased 33.4%, or $191.8 million, for 2006 as compared to 2005, reflecting lower catastrophe losses. The segment’s loss ratio improved by 30.9 points from 2005, primarily due to reduced current year catastrophe losses incurred in Canada, Asia and international.
The following table shows the Bermuda segment components of incurred losses and LAE for 2006 and 2005:
The Bermuda segment’s incurred losses and LAE decreased 37.1%, or $304.8 million, for 2006 as compared to 2005. The segment’s loss ratio improved by 47.2 points from 2005, due to a reduction in catastrophe losses in the current year and an increase in favorable development on prior period attritional reserves, partially offset by A&E reserve strengthening. The net prior year improvement was more than offset by an increase in the current year attritional losses reflecting increased earned premiums and a mix of business shift toward more casualty business.
Underwriting Expenses. The Company’s expense ratio, which is calculated by dividing underwriting expenses by net premiums earned, was 26.5% for 2006 compared to 26.3% for 2005.
Segment underwriting expenses decreased by 3.1% to $994.7 million for 2006 from $1,026.3 million in 2005. Commission, brokerage, taxes and fees decreased by $31.6 million, principally due to decreases in premium volume and changes in the mix and of business. Segment other underwriting expenses were $0.1 million for both 2006 and 2005. Contributing to the segment underwriting expense decreases were a 15.5% ($59.0 million) decrease in the U.S. Reinsurance operation, a 14.0% ($12.1 million) decrease in the Specialty Underwriting operation and a 6.8% ($12.5 million) decrease in the U.S. Insurance operation, partially offset by an 19.3% ($37.3 million) increase in the Bermuda operation and an 8.2% ($14.8 million) increase in the International operation. The changes for each operation’s expenses principally resulted from changes in commission expenses due to changes in premium volume and business mix by class and type and, in some cases, changes in the use of specific reinsurance.
Investment Results. Net investment income increased 20.4% to $629.4 million in 2006 from $522.8 million in 2005, primarily reflecting the growth in invested assets to $14.0 billion in 2006 from $13.0 billion in 2005 and a $43.2 million increase in investment income from limited partnership investments. Investment income from equity investments in limited partnerships fluctuates from year to year depending on the performance of the individual investments made by the partnerships as well as the movement in the equity markets. Period to period changes in investment income are also impacted by changes in the level and mix of invested assets, prevailing interest rates and price movements in the equity markets.
Imbedded after-tax yield of cash and invested assets at December 31 4.0 % 3.9 %
Annualized after-tax yield on average cash and invested assets 4.2 % 3.8 %
Company's other invested asset portfolio total return 19.8 % 7.2 %
Net realized capital gains of $35.1 million in 2006 emanated from realized capital gains on the Company’s investments of $49.0 million, resulting principally from gains on equity securities of $34.1 million and fixed maturities of $14.9 million, partially offset by $13.9 million of realized capital losses, resulting principally from losses on equity securities of $11.9 million and fixed maturities of $2.0 million including $14.0 thousand from other than temporary market declines. Net realized capital gains of $90.3 million in 2005, reflected realized capital gains on the Company’s investments of $106.2 million, including $41.3 million on the sale of interest only strips investments, partially offset by $15.9 million of realized capital losses, which included $7.0 million related to the write-downs in the value of interest only strips deemed to be impaired on an other than temporary basis in accordance with Emerging Issues Task Force Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets” (“EITF 99-20”).
The Company had issued seven equity put options in prior years, which were outstanding at December 31, 2006. These products meet the definition of derivatives under FAS 133. The Company recognized net derivative expense of $0.4 million and $2.6 million in 2006 and 2005, respectively, reflecting changes in the fair value of the equity put options.
Net Income (Loss). Net income was $840.8 million in 2006 compared to a net loss of $218.7 million in 2005, primarily caused by much larger catastrophe losses in 2005 than in 2006.
Premiums Written. Gross written premiums decreased 12.7% to $4,108.6 million in 2005 from $4,704.1 million in 2004 reflecting a disciplined underwriting response to modest reinsurance market softening that affected all segments, resulting in an overall premium decline. Premiums declined 35.4% ($172.4 million) in the Specialty Underwriting operation, primarily due to a $145.4 million decrease in A&H business and a $47.9 million decrease in surety business, partially offset by a $20.9 million increase in marine and aviation business. The U.S. Insurance operation decreased 20.2% ($235.3 million), principally as a result of a $242.6 million decrease in workers’ compensation, resulting primarily from changes in the California workers’ compensation market. The Bermuda operation decreased 13.0% ($114.7 million), reflecting declines in individual risk underwritten insurance and reinsurance in Bermuda and in motor business reinsurance in the U.K. The U.S. Reinsurance operation decreased 6.2% ($92.0 million), principally relating to a $173.1 million decrease in treaty casualty business and a $29.3 million decrease in facultative business, partially offset by a $118.9 million increase in treaty property business. The International operation increased 2.8% ($18.9 million), resulting primarily from a $75.0 million increase in Asian business, partially offset by a $43.6 million decrease in international business written through the Miami and New Jersey offices, representing primarily Latin American business and an $11.3 million decrease in Canadian business.
Ceded premiums decreased to $136.5 million in 2005 from $172.6 million in 2004, principally resulting from the decrease in gross premiums in the U.S. Insurance operations. Ceded premiums generally relate to specific reinsurance purchased by the U.S. Insurance operation and fluctuate based upon the level of premiums written in the individual reinsured programs.
Net written premiums decreased by 12.3% to $3,972.0 million in 2005 from $4,531.5 million in 2004, reflecting the $595.6 million decrease in gross written premiums and the $36.1 million decrease in ceded premiums.
Incurred Losses and LAE. The Company’s loss and LAE reserves reflect estimates of ultimate claim liability. Such estimates are re-evaluated on an ongoing basis, including re-estimates of prior period reserves, taking into consideration all available information and, in particular, newly reported loss and claim experience. The effect of such re-evaluations impacts incurred losses for the current period.
The Company’s loss ratio, which is calculated by dividing incurred losses and LAE by net premiums earned, increased by 19.6 percentage points to 94.0% in 2005 from 74.4% in 2004. This 19.6 point year over year loss ratio increase was primarily the result of a 28.7 point increase due to catastrophe losses, partially offset by a 10.2 point improvement in attritional and A&E prior year reserve development.
Incurred losses and LAE include catastrophe losses, which include the impact of both current period events and favorable and unfavorable development on prior period events and are net of reinsurance. Individual catastrophe losses are reported net of specific reinsurance, but before recoveries under corporate level reinsurance and potential incurred but not reported (“IBNR”) loss reserve offsets. Catastrophe losses, net of contract specific cessions, were $1,485.7 million in 2005, related principally to aggregate estimated losses driven by Hurricanes Katrina, Rita and Wilma with catastrophe losses of $765.9 million, $151.0 million and $381.6 million, respectively, but also reflected catastrophe losses related to hurricanes Emily ($19.8 million) and Dennis ($7.0 million), floods in India ($13.2 million), Calgary ($9.6 million) and Europe ($6.2 million) and storms in Ontario ($12.9 million). The 2005 results also reflect net unfavorable reserve development on 2004 and prior catastrophes of $118.5 million. Catastrophe losses, net of contract specific cessions, were $390.0 million in 2004, related principally to aggregate estimated losses of $428.8 million from Hurricanes Charley, Frances, Ivan and Jeanne, Pacific typhoons, Edmonton hailstorms and the Asian tsunami, which were partially offset by $33.4 million of reserve reductions related to the 2001 World Trade Center losses.
The U.S. Reinsurance segment’s incurred losses and LAE increased 26.6%, or $311.0 million, for 2005 as compared to 2004. The segment’s loss ratio increased by 26.7 points over 2004 due to current year catastrophe losses and unfavorable prior period catastrophe reserve adjustments, partially offset by favorable attritional loss development.
The Bermuda segment’s incurred losses and LAE increased 10.6%, or $78.7 million, for 2005 as compared to 2004. The segment’s loss ratio increased by 25.6 points over 2004, reflecting catastrophe losses in 2005 and prior period catastrophe development, partially offset by favorable prior period attritional reserves, primarily from the UK branch produced business. The A&E reserve development for both 2005 and 2004 primarily related to asbestos exposures that were assumed through the September 19, 2000 loss portfolio transfer from Mt. McKinley.
The following table shows a comparison of various investment yields for the years indicated:
Company's other invested asset portfolio total return 7.2 % 43.2 %
Interest, fees and bond issue cost amortization expense in 2005 and 2004 were $74.4 million and $76.6 million, respectively. Interest, fees and bond issue cost amortization expense in 2005 included $35.5 million related to the senior notes, $37.5 million related to the junior subordinated debt securities, $1.0 million related to the bond issue cost amortization and $0.4 million related to the credit line under the Company’s revolving credit facilities. Interest, fees and bond issue cost amortization expense in 2004 included $41.9 million related to the senior notes, $32.4 million related to the junior subordinated debt securities, $1.1 million related to the bond issue cost amortization and $1.2 million related to the credit line under the Company’s revolving credit facilities. The lower interest expense on the senior notes was due to the retirement of the 8.5% senior notes due March 15, 2005, partially offset by the issuance of new 5.4% senior notes on October 12, 2004.
The Company notes that there generally is more uncertainty in establishing loss reserves for reinsurance liabilities than for insurance liabilities. At December 31, 2006 the Company had reinsurance reserves of $6,720.7 million and insurance loss reserves of $2,119.4 million, of which $260.4 million and $320.5 million, respectively, were loss reserves for A&E liabilities. A detailed discussion of additional considerations related to A&E exposures follows later in this section.
judgment. Due to the inherent uncertainty in estimating such losses, these estimates are subject to variability, the potential for which increases with the severity and complexity of the underlying event.
The Company’s reserves include an estimate of the Company’s ultimate liability for A&E claims. This estimate is made based on judgmental assessment of the underlying exposures as the result of: (1) long and variable reporting delays, both from insureds to insurance companies and from ceding companies to reinsurers; (2) historical data, which is more limited and variable on A&E losses than historical information on other types of casualty claims; and (3) unique aspects of A&E exposures for which ultimate value cannot be estimated using traditional reserving techniques. There are significant uncertainties in estimating the amount of the Company’s
potential losses from A&E claims. Among the uncertainties are: (a) potentially long waiting periods between exposure and manifestation of any bodily injury or property damage; (b) difficulty in identifying sources of asbestos or environmental contamination; (c) difficulty in properly allocating responsibility and/or liability for asbestos or environmental damage; (d) changes in underlying laws and judicial interpretation of those laws; (e) the potential for an asbestos or environmental claim to involve many insurance providers over many policy periods; (f) questions concerning interpretation and application of insurance and reinsurance coverage; and (g) uncertainty regarding the number and identity of insureds with potential asbestos or environmental exposure.
In connection with the acquisition of Mt. McKinley, which has significant exposure to A&E claims, LM 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 and The Prudential guaranteed LM’s obligations to Mt. McKinley. Cessions under this reinsurance agreement exhausted the limit available under the contract at December 31, 2003.
With respect to Mt. McKinley, where the Company has a direct relationship with policyholders, the Company’s aggressive litigation posture and the uncertainties inherent in the asbestos coverage and bankruptcy litigation have provided an opportunity to actively engage in settlement negotiations with a number of those policyholders who have potentially significant asbestos liabilities. Those discussions are oriented towards achieving reasonable negotiated settlements that limit Mt. McKinley’s liability to a given policyholder to a sum certain. Because of uncertainties and risks inherent in litigation, the Company cannot be certain that in every instance
this approach will lead to negotiated settlements in the range expected by the Company. Between 2004 and 2006, the Company concluded such settlements or reached agreement in principle with 14 of its high profile policyholders. The Company currently has identified 8 policyholders based on their past claim activity and/or potential future liabilities as “High Profile Policyholders” and its settlement efforts are generally directed at such policyholders, in part because their exposures have developed to the point where both the policyholder and the Company have sufficient information to be motivated to settle. The Company believes that this active approach will ultimately result in a more cost-effective liquidation of Mt. McKinley’s liabilities than a passive approach, although it may also introduce additional variability in Mt. McKinley’s losses and cash flows as reserves are adjusted to reflect the developments in litigation, negotiations and, ultimately, potential settlements.
REINSURANCE RECEIVABLES. The Company purchases reinsurance to reduce its exposure to large claims and catastrophic loss occurrences. These agreements provide for recovery from reinsurers of a portion of losses and loss expenses under certain circumstances without relieving the insurer of its obligation to the policyholder. In the event reinsurers were unable to meet their obligations under these agreements or were able to successfully challenge losses ceded by the Company under the contracts, the Company would not be able to realize the full value of the reinsurance recoverable balance. In some cases, the Company may hold partial collateral for the receivable, including letters of credit, trust assets and cash. Additionally, creditworthy foreign reinsurers of business written in the U.S. are generally required to secure their obligations. The Company establishes reserves for uncollectible balances based on management’s assessment of the collectibility of the outstanding balances. As of December 31, 2006 and 2005, the reserve for uncollectible balances was $87.0 million and $25.0 million, respectively. To minimize exposure from uncollectible reinsurance receivables, the Company has a reinsurance credit security committee that generally evaluates the financial strength of a reinsurer prior to entering into a reinsurance arrangement. Management believes that adequate provision has been made for the Company’s uncollectible balances. Actual uncollectible amounts may vary, perhaps substantially, from such reserves, impacting income in the period in which the change in reserves is made. See also Note 1 of Notes to the Consolidated Financial Statements and “Financial Condition - Reinsurance Receivables” below.
INVESTMENT VALUATION. The Company’s investment portfolio consists of fixed income investments classified for accounting purposes as available for sale and equity securities. Accordingly, these securities are marked to market on a quarterly basis. Most securities are traded on national exchanges where market values are readily available. The Company holds some privately placed securities, less than 0.5% of the portfolio, that are either valued by an investment advisor or by the Company using cash flow projections. At December 31, 2006, the Company’s investment portfolio included $442.5 million of limited partnership investments whose value are reported pursuant to the equity method of accounting, which management believes approximates market value. In 2005, the Company owned interest only strips that were accounted for in accordance with EITF 99-20, which sets forth the rules for determining when these securities must be written down to fair value due to impairment. Unrealized gains and losses from market fluctuations are reflected as comprehensive income, while market value declines that are considered other than temporary impairments are reflected in the income statement as realized capital losses. As of December 31, 2006 and 2005, the Company had unrealized gains net of tax of $302.9 million and $214.6 million, respectively. The Company considers many factors when determining whether a market value decline is other than temporary, including: (1) the length of time the market value has been below book value, (2) the credit strength of the issuer, (3) the issuer’s market sector, (4) the length of time to maturity and (5) for asset backed securities, increases in prepayments. If management assessments change in the future, the Company may ultimately record a realized loss after management originally concluded that the decline in value was temporary. See also Note 1 of Notes to the Consolidated Financial Statements.
LOSS AND LAE RESERVES. Gross loss and LAE reserves totaled $8,840.1 million at December 31, 2006, $9,126.7 million at December 31, 2005 and $7,836.3 million at December 31, 2004. The decrease in 2006 was primarily attributable to the payout in 2006 of catastrophe loss reserves held at December 31, 2005, partially offset by unfavorable net prior period reserve strengthening. The increases in 2005 and 2004 were primarily attributable to increased catastrophe losses, partially offset by favorable net prior period reserve adjustments and reduced premiums earned.
The following tables summarize gross outstanding loss and LAE reserves by segment, segregated into case reserves and IBNR reserves, which are managed on a combined basis, for the years indicated:
The changes by segment generally reflect changes in earned premium, changes in business mix, the impact of reserve re-estimations and changes in catastrophe loss reserves, together with claim settlement activity. The fluctuations for A&E reflect the impact of reserve re-evaluations and claim settlement activity.
The Company’s loss and LAE reserves are an estimate of the ultimate liability for unpaid claims. Such estimates are re-evaluated on an ongoing basis, including re-estimates of prior period reserves, taking into consideration all available information and, in particular, newly reported loss and claim experience. Such re-evaluations impact incurred losses in the period when the re-evaluation is made. The Company notes that its analytical methods and processes operate at multiple levels including individual contracts, groupings of like contracts, classes and lines of business, internal business units, segments, legal entities, and in the aggregate. The complexities of the Company’s business and operations require analyses and adjustments, both qualitative and quantitative, at these various levels. Additionally, the attribution of reserves, change in reserves and incurred losses between accident year and underwriting year requires adjustments and allocations, both qualitative and quantitative, at these various levels. All of these processes, methods and practices appropriately balance actuarial science, business expertise and management judgment in a manner intended to assure the accuracy, precision and consistency of the Company’s reserving practices, which are fundamental to the Company’s operation. The Company notes however, that the underlying reserves are estimates, which are subject to variation.
There can be no assurance that reserves for, and losses from, claim obligations will not increase in the future, possibly by a material amount. However, management believes that the Company’s existing reserves and reserving methodologies lessen the probability that any such increase would have a material adverse effect on the Company’s financial condition, results of operations or cash flows. In this context, the Company notes that over the past 10 years, its past calendar year operations have been affected variably by effects from prior period reserve re-estimates, with such effects ranging from a favorable $62.1 million in 1997, representing 2.2% of the net prior period reserves for the year in which the adjustment was made, to an unfavorable $249.4 million in 2004, representing 3.7% of the net prior period reserves for the year in which the adjustment was made. The
(3) Given the uncertainties surrounding the settlement of A&E losses, management is unable to establish a range for these obligations. As a result, these reserves which relate principally to the U.S. Reinsurance and Bermuda segments, have been segregated from reserves for which a range has been determined.
Depending on the specific segment, the range derived for the loss reserves, excluding reserves for A&E exposures, ranges from minus 8.8% to minus 14.8% for the low range and from plus 8.8% to plus 14.8% for the high range. Both the higher and lower ranges are associated with the U.S. Insurance segment. The Company notes that the width of the range is dependent on the level of confidence associated with the outcome. Within each range, management’s best estimate of loss reserves is based on the point estimate derived by the Company’s actuaries in detailed reserve studies. Such ranges are necessarily subjective due to the lack of generally accepted actuarial standards with respect to their development. For the above presentation, management has assumed what it believes is a reasonable confidence level but notes that there can be no assurance that the Company’s claim obligations will not vary within and potentially outside of these ranges, requiring incurred loss adjustments in the period the variability is recognized. The Company is not able to establish a meaningful range for A&E reserves.
The following table summarizes incurred losses with respect to A&E on both a gross and net of retrocessions basis for the years indicated:
At December 31, 2006, the gross reserves for A&E losses were comprised of $135.6 million representing case reserves reported by ceding companies, $152.1 million representing additional case reserves established by the Company on assumed reinsurance claims, $213.7 million representing case reserves established by the Company on direct excess insurance claims, including Mt. McKinley, and $148.7 million representing IBNR reserves.
The Company incurred adverse development for A&E exposures of $113.4 million and $77.1 million for the years ended December 31, 2006 and 2005, respectively. These increases are the result of re-evaluations by management of additional information received from insureds and ceding companies, ongoing litigation, additional claims received and settlement activity. Management closely monitors this additional information and adjusts reserves accordingly.
The following tables summarize reserve and claim activity for asbestos claims, gross and net of ceded reinsurance, for the periods indicated with particular emphasis on the differentiation of insured categories within the Mt. McKinley operation, which the Company believes reflects the most volatile element of its asbestos exposures for the years ended December 31:
3 Year Survival Ratio excluding SIP, actively managed & stop loss 7.7
SHAREHOLDERS’ EQUITY. The Company’s shareholders’ equity increased to $5,107.7 million as of December 31, 2006 from $4,139.7 million as of December 31, 2005, principally reflecting $840.8 million of net income for 2006, a $54.1 million increase due to net currency translation, a $38.6 million increase in net share-based compensation activity and a $88.3 million increase in net unrealized appreciation on investments, partially offset by $39.0 million of shareholder dividends and an increase of $15.0 million in accumulated other comprehensive income due to FAS 158 for pensions. The Company’s shareholders’ equity increased to $4,139.7 million as of December 31, 2005 from $3,712.5 million as of December 31, 2004, principally reflecting $758.2 million in net proceeds from the issuance of common shares, partially offset by $218.7 million of net loss for 2005, a $27.0 million decrease in net currency translation, a $77.8 million decrease in net unrealized appreciation on investments, $25.4 million shareholder dividends and an increase of $2.9 million in the minimum pension liability.
CAPITAL. The Company’s business operations are in part dependent on the Company’s financial strength, and the market’s perception thereof, as measured by shareholders’ equity, which was $5,107.7 million and $4,139.7 million at December 31, 2006 and 2005, respectively. The Company possesses significant financial flexibility and access to the debt and equity markets as a result of its perceived financial strength, as evidenced by the financial strength ratings as assigned by independent rating agencies. The Company continuously monitors its capital and financial position, as well as investment and security market conditions and responds accordingly.
From time to time, the Company has used open market share repurchases to effectively adjust its capital position. In September 2004, the Company’s authorization to purchase its shares was amended to authorize the repurchase of up to 5 million shares. It made no such purchases in 2006 or in 2005. The Company notes that, outside of its open market repurchase program, it repurchased 21,384 shares in 2006 and 10,430 shares in 2005 from employees in connection with restricted share vestings where individual employees chose to discharge withholding tax liabilities on vesting shares by the surrender of a portion of such shares. In 2005, 328 shares were surrendered from a non-employee in connection with payment of the option exercise price. At December 31, 2006, there remained 5 million shares under the repurchase authorization.
On December 1, 2005, the Company issued 2,298,000 of its common shares at a price of $102.89 per share, which resulted in $236.4 million of proceeds before expenses and Holdings sold Group shares it acquired in 2002 at a price of $102.89 per share, which resulted in $46.5 million of proceeds before expenses. Expenses incurred for this transaction were approximately $0.3 million.
On June 27, 2003, the Company filed a shelf registration statement on Form S-3 with the SEC, providing for the issuance of up to $975.0 million of securities. Generally, under this shelf registration statement, Group was authorized to issue common shares, preferred shares, debt securities, warrants and hybrid securities, Holdings was authorized to issue debt securities and Capital Trust II and Capital Trust III were authorized to issue trust preferred securities. This shelf registration statement became effective on December 22, 2003 and was
On March 29, 2004, Capital Trust II, an unconsolidated affiliate, issued trust preferred securities resulting in a takedown from the shelf registration statement of $320.0 million. In conjunction with the issuance of Capital Trust II’s trust preferred securities, Holdings issued $329.9 million of 6.20% junior subordinated debt securities due March 29, 2034 to Capital Trust II. Part of the proceeds from the issuance of the junior subordinated debt securities was used for capital contributions to Holdings’ operating subsidiaries.
On October 12, 2004, Holdings completed a public offering of $250.0 million principal amount of 5.40% senior notes due October 15, 2014. The net proceeds were used to retire existing debt at Holdings, which was due and retired on March 15, 2005.
On March 14, 2000, Holdings completed a public offering of $200.0 million principal amount of 8.75% senior notes due March 15, 2010 and $250.0 million principal amount of 8.50% senior notes due and retired March 15, 2005. During 2000, the net proceeds of these offerings and additional funds were distributed by Holdings to Group.
LIQUIDITY. The Company’s principal investment objectives are to ensure funds are available to meet its insurance and reinsurance obligations and to maximize after-tax investment income while maintaining a high quality diversified investment portfolio. Considering these objectives, the Company views its investment portfolio as having two components; 1) the investments needed to satisfy outstanding liabilities and 2) investments funded by the Company’s shareholders’ equity.
Over the past few years, the Company has reallocated its shareholders’ equity investment portfolio to include 1) publicly traded equity securities, primarily exchange traded funds, and 2) private equity limited partnership investments. The objective of this portfolio diversification is to enhance the risk-adjusted total return of the investment portfolio by allocating a prudent portion of the portfolio to higher return asset classes. The Company has limited its allocation to these asset classes because 1) the potential for volatility in their values and 2) the impact of these investments on regulatory and rating agency capital adequacy models. At December 31, 2006, the market value of investments in equity and limited partnership securities approximated 40% of shareholders’ equity.
investment income provides additional funding for loss payments. The Company’s net cash flows from operating activities were $636.3 million, $1,070.6 million and $1,490.9 million for the years ended December 31, 2006, 2005 and 2004, respectively. Additionally, these cash flows reflected net tax payments of $46.6 million, $110.9 million and $100.0 million for the years ended December 31, 2006, 2005 and 2004, respectively; net catastrophe loss payments of $896.5 million, $459.7 million and $200.9 million for the years ended December 31, 2006, 2005 and 2004, respectively; and net A&E settlements of $45.5 million, $137.7 million and $187.1 million for the years ended December 31, 2006, 2005 and 2004, respectively. The decrease in net cash flows from operations in 2006 compared with 2005 was primarily due to higher claim payments on catastrophes. The decrease in net cash flows from operations in 2005 compared with 2004 was primarily due to higher claim payments on catastrophes combined with lower premium volume.
Effective August 23, 2006, Holdings entered into a new five year, $150.0 million senior revolving credit facility with a syndicate of lenders, replacing the October 10, 2003 three year senior revolving credit facility, which expired on October 10, 2006. Both the August 23, 2006 and October 10, 2003 senior revolving credit agreements, which have similar terms, are referred to as the “Holdings Credit Facility”. Citibank N.A. is the administrative agent for the Holdings Credit Facility. The Holdings Credit Facility is used for liquidity and general corporate purposes. The Holdings Credit Facility provides for the borrowing of up to $150.0 million with interest at a rate selected by Holdings equal to either, (1) the Base Rate (as defined below) or (2) a periodic fixed rate equal to the Eurodollar Rate plus an applicable margin. The Base Rate means a fluctuating interest rate per annum in effect from time to time to be equal to the higher of (a) the rate of interest publicly announced by Citibank as its prime rate or 0.5% per annum above the Federal Funds Rate, in each case plus the applicable margin. The amount of margin and the fees payable for the Holdings Credit Facility depends upon Holdings’ senior unsecured debt rating.
EXPOSURE TO CATASTROPHES. Like other insurance and reinsurance companies, the Company is exposed to multiple insured losses arising out of a single occurrence, whether a natural event, such as a hurricane or an earthquake, or other catastrophe, such as an explosion at a major factory. A large catastrophic event can be expected to generate insured losses to multiple reinsurance treaties, facultative certificates and across lines of business.
Projected catastrophe losses are generally summarized in terms of the PML. The Company defines PML as its anticipated loss, taking into account contract terms and limits, caused by a single catastrophe affecting a broad contiguous geographic area, such as that caused by a hurricane or earthquake. The PML will vary depending upon the severity of modeled simulated losses and the make-up of the in force book of business. The projected severity levels are described in terms of “return periods”, such as “100-year events” and “250-year events”. For example, a 100-year PML corresponds to the estimated loss from a single event which has a 1% probability of being exceeded in a twelve month period. Conversely, it corresponds to a 99% probability that the loss from a single event will fall below the indicated PML. It is important to notes that PMLs are estimates. Modeled events are hypothetical events produced by a stochastic model. As a result, there can be no assurance that any actual event will align with the modeled event or that actual losses from events similar to the modeled events will not vary materially from the modeled event PML.
From a risk management perspective, the Company endeavors to manage its catastrophe risk profile such that the projected economic loss from its largest 100-year event does not exceed approximately $500 million. Economic loss is viewed as the gross PML loss reduced by estimated reinstatement premiums to renew coverage and income taxes. The impact of income taxes on the PML depends on the distribution of the losses by corporate entity, which is also affected by inter-affiliate reinsurance. Management also monitors its largest PMLs at multiple points along the loss distribution curve, such as loss amounts at the 20, 50, 100, 250, 500 and 1,000 year return periods. This process enables management to identify exposure accumulations to integrate into enterprise risk, underwriting and capital management processes.
If such a single catastrophe loss were to occur, management estimates that the economic loss to the Company would be approximately $471 million. The impact represents approximately 9% of the Company’s beginning of year capital. The estimate involves multiple variables, including which Everest entity would experience the loss, and as a result there can be no assurance that this amount would not be exceeded.
The Company may purchase reinsurance to cover specific business written or the potential accumulation or aggregation of exposures across some or all of the Company’s operations. Reinsurance purchasing decisions consider both the potential coverage and market conditions including the pricing, terms, conditions and availability of coverage, with the aim of securing cost effective protection. The amount of reinsurance purchased has varied over time, reflecting the Company’s view of its exposures and the cost of reinsurance.
CONTRACTUAL OBLIGATIONS. The following table shows the Company’s contractual obligations for the year ended December 31, 2006:
In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement 123(R) “Share-Based Payment” (“FAS 123(R)”), which is effective for fiscal years beginning after June 15, 2005. The Company adopted FAS 123(R) effective January 1, 2006. FAS 123(R) requires all share-based compensation awards, granted, modified or settled after December 15, 1994 to be accounted for using the fair value method of accounting. Under the modified prospective application, compensation cost is recognized for the outstanding, non-vested awards based on the grant date fair value of those awards as calculated under Statement of Financial Accounting Standards No. 123 “Accounting for Stock-Based Compensation” (“FAS 123”). The Company implemented FAS 123 prospectively for grants issued on or after January 1, 2002. The adoption of FAS 123(R) resulted in $169,037 of additional compensation expense for the year ended December 31, 2006 for options granted prior to FAS 123.
In November 2005, the FASB issued FASB Staff Position (“FSP”) FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“FAS 115-1”), which is effective for reporting periods beginning after December 15, 2005. FAS 115-1 addresses the determination of when an investment is considered impaired, whether the impairment is other than temporary and the measurement of an impairment loss. FAS 115-1 also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses not recognized as other-than-temporary impairments. The Company adopted FAS 115-1 prospectively effective January 1, 2006. The Company believes it has appropriately recorded realized losses for all securities owned that have experienced an other-than-temporary impairment, and all unrealized losses in its investment portfolio are temporary in nature.
In July 2006, the FASB released FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” (“FIN 48”), which is effective for fiscal years beginning after December 15, 2006. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes” (“FAS 109”). FIN 48 prescribes the recognition and measurement criteria for the financial statements for tax positions taken or expected to be taken in a tax return. Further, FIN 48 expands the required disclosures associated with uncertain tax positions. The Company will adopt FIN 48 on January 1, 2007. The Company does not believe the impact of implementing FIN 48 will be material on its consolidated financial statements.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 158 “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (“FAS 158”), which is effective for employers with publicly traded equity securities as of the end of the fiscal year ending after December 15, 2006. FAS 158 requires an employer to (a) recognize in its financial statements an asset for a plan’s over funded status or a liability for a plan’s under funded status, (b) measure a plan’s assets and its obligations that determine its funded status as of the end of the employer’s fiscal year and (c) recognize changes in the funded status of a defined benefit postretirement plan in the year in which the changes occur as other comprehensive income. The Company adopted FAS 158 for the reporting period ended December 31, 2006. The impact on the Company’s consolidated balance sheets at December 31, 2006 was a $23.1 million pre-tax, or $15.0 million after-tax, reduction to accumulated other comprehensive income.
The Company’s current investment strategy seeks to maximize after-tax income through a high quality, diversified, taxable and tax-preferenced fixed maturity portfolio, while maintaining an adequate level of liquidity. The Company’s mix of taxable and tax-preferenced investments is adjusted continuously, consistent with its current and projected operating results, market conditions and the Company’s tax position. The fixed maturities in the investment portfolio are comprised of non-trading available for sale securities. Additionally, the Company invests in equity securities, which it believes will enhance the risk-adjusted total return of the investment portfolio. The Company has also written a small number of equity put options.
The overall investment strategy considers the scope of present and anticipated Company operations. In particular, estimates of the financial impact resulting from non-investment asset and liability transactions, together with the Company’s capital structure and other factors, are used to develop a net liability analysis. This analysis includes estimated payout characteristics for which the investments of the Company provide liquidity. This analysis is considered in the development of specific investment strategies for asset allocation, duration and credit quality. The change in overall market sensitive risk exposure principally reflects the asset changes that took place during the period.
Interest Rate Risk. The Company’s $14.0 billion investment portfolio at December 31, 2006 is principally comprised of fixed maturity securities, which are generally subject to interest rate risk and 17.1%, are subject to foreign currency rate risk, and equity securities, which are subject to price fluctuations. The impact of the foreign exchange risks on the investment portfolio is generally mitigated by changes in the dollar value of foreign currency denominated liabilities and their associated income statement impact.
Interest rate risk is the potential change in value of the fixed maturity portfolio, including short-term investments, from a change in market interest rates. In a declining interest rate environment, it includes prepayment risk on the $1,594.0 million of mortgage-backed securities in the $10,319.9 million fixed maturity portfolio. Prepayment risk results from potential accelerated principal payments that shorten the average life and thus the expected yield of the security.
rates. For legal entities with a U.S. dollar functional currency, this modeling was performed on each security individually. To generate appropriate price estimates on mortgage-backed securities, changes in prepayment expectations under different interest rate environments were taken into account. For legal entities with a non-U.S. dollar functional currency, the effective duration of the involved portfolio of securities was used as a proxy for the market value change under the various interest rate change scenarios. All amounts are in U.S. dollars and are presented in millions.
Market Value Change from Base (%) 9.0 % 4.5 % 0.0 % -4.8%
The Company had $8,840.1 million and $9,126.7 million of reserves for losses and LAE as of December 31, 2006 and December 31, 2005. These amounts are recorded at their nominal value, as opposed to fair value, which would reflect a discount adjustment to reflect the time value of money. Since losses are paid out over a period of time, the fair value of the reserves is less than the nominal value. As interest rates rise, the fair value of the reserves decreases and, conversely, as interest rates decline, the fair value increases. These movements are the opposite of the interest rate impacts on the fair value of investments. While the difference between fair value and nominal value is not reflected in the Company’s financial statements, the Company’s financial results will include investment income over time from the investment portfolio until the claims are paid. The Company’s loss and loss reserve obligations have an expected duration of approximately 3.8 years, which is reasonably consistent with the Company’s fixed income portfolio. If the Company were to discount its loss and LAE reserves, net of $0.8 billion of reinsurance receivables on unpaid losses, the discount would be approximately $1.5 billion resulting in a discounted reserve balance of approximately $6.5 billion, representing approximately 56% of the market value of the fixed maturity investment portfolio funds.
Equity Risk. Equity risk is the potential change in market value of the common stock and preferred stock portfolios arising from changing equity prices. The Company’s equity investments are mainly exchange traded and mutual funds, which invest principally in high quality common and preferred stocks that are traded on the major exchanges in the U.S. The primary objective in managing the equity portfolio is to provide capital growth over time through market appreciation and income.
The tables below display the impact on market value and after-tax unrealized appreciation of a 10% and 20% change in equity prices up and down as of December 31, 2006 and 2005. The growth in exposure is primarily due to the growth in the equity portfolio. All amounts are in U.S. dollars and are presented in millions.
After-tax Change in Unrealized Appreciation $ (146.5 ) $ (73.3 ) $ -
Foreign Currency Risk. Foreign currency risk is the potential change in value, income and cash flow arising from adverse changes in foreign currency exchange rates. Each of the Company’s non-U.S./Bermuda (“foreign”) operations maintains capital in the currency of the country of its geographic location consistent with local regulatory guidelines. Generally, the Company prefers to maintain the capital of its operations in U.S. dollar assets, although this varies by regulatory jurisdiction in accordance with market needs. Each foreign operation may conduct business in its local currency, as well as the currency of other countries in which it operates. The primary foreign currency exposures for these foreign operations are the Canadian Dollar, the British Pound Sterling and the Euro. The Company mitigates foreign exchange exposure by generally matching the currency and duration of its assets to its corresponding operating liabilities. In accordance with Financial Accounting Standards Board Statement No. 52, “Foreign Currency Translation”, the Company translates the assets, liabilities and income of non-U.S. dollar functional currency legal entities to the U.S. dollar. This translation amount is reported as a component of other comprehensive income. As of December 31, 2006 there has been no material change in exposure to foreign exchange rates as compared to December 31, 2005.
Although not considered material in the context of the Company’s aggregate exposure to market sensitive instruments, the Company has issued six equity put options based on the S&P 500 index and one equity put
option based on the FTSE 100 index, that are market sensitive and sufficiently unique to warrant supplemental disclosure.
The Company has sold six equity put options based on the S&P 500 index for total consideration, net of commissions, of $22.5 million. These contracts each have a single exercise date, with original maturities ranging from 12 to 30 years and strike prices ranging from $1,141.21 to $1,540.63. No amounts will be payable under these contracts if the S&P 500 index is at or above the strike price on the exercise dates, which currently fall between June 2017 and March 2031. If the S&P 500 index is lower than the strike price on the applicable exercise date, the amount due will vary proportionately with the percentage by which the index is below the strike price. Based on historical index volatilities and trends and the December 31, 2006 index value, the Company estimates the probability for each contract of the S&P 500 index falling below the strike price on the exercise date to be less than 4.4%. The theoretical maximum payouts under the contracts would occur if on each of the exercise dates the S&P 500 index value were zero. The present value of these theoretical maximum payouts using a 6.0% discount factor is $213.2 million.
Combined Interest Rate / Equity Indices Shift: -100/-200 -50/-100 0/0 50/100 100/200