PREMIUMS. Gross premiums written decreased 2.7% to $1,045.9 million in 1998 from $1,075.0 million in 1997 as the Company maintained a disciplined underwriting approach in the face of increasingly competitive market conditions. Premium growth areas included a 10.8% ($35.2 million) increase in U.S. broker treaty premiums, largely attributable to growth in non-standard auto, accident and health and workers compensation lines where the Company's relatively recent entry to these lines has provided growth opportunities and a 6.8% ($10.8 million) increase in U.S. direct treaty reinsurance and insurance due mainly to portfolio reinsurance transactions. These increases were offset by a 25.5% ($41.2 million) decrease in marine, aviation, and surety premiums, a 13.2% ($10.9 million) decrease in facultative premiums and a 6.6% ($23.0 million) decrease in international premiums reflecting highly competitive current market conditions. The Company continued to decline business that did not meet the Company's objectives regarding underwriting profitability.
REVENUES. Net premiums earned increased by 1.7% to $1,068.0 million in 1998 from $1,049.8 million in 1997, with the increase attributable to premium earnings patterns coupled with the decrease in premiums written.
Pre-tax investment income increased 7.2% to $244.9 million in 1998 from $228.5 million in 1997, principally reflecting the effect of investing the $183.3 million of cash flow from operating activities in 1998. The Company's pre-tax yield on average cash and invested assets decreased to 5.8% in 1998 from 5.9% in 1997 reflecting an increase in tax preferenced investments and a lower interest rate environment. After-tax investment income increased 9.9% to $190.8 million in 1998 from $173.5 million in 1997 reflecting growth in the Company's tax preferenced investment holdings. The Company's after-tax yield on average cash and invested assets was 4.5% in 1998, the same yield as in 1997.
The ceded losses and LAE for 1998 principally reflect a $214.9 million increase in gross reserves with respect to asbestos exposures which the Company judged to be necessary based on continuing reported and paid loss emergence, particularly with respect to secondary defendants, internal and third party statistical analysis, and its assessment of potential ultimate liabilities, $25.7 million of non-asbestos related losses ceded under the Stop Loss Agreement and $23.1 million ceded under various catastrophe retrocessions. The 1998 ceded losses and LAE compares to ceded losses and LAE of $109.6 million in 1997, including $45.0 million ceded under the Stop Loss Agreement. See "Financial Condition" below for a further discussion.
Net realized capital gains increased 179.5% to $15.9 million in 1997 from $5.7 million in 1996, with the gains in both periods mainly arising from activity in the Company's portfolio of equity securities, including, in 1997, a $14.0 million gain on the sale of the Company's remaining investment in the common stock of Corporacion MAPFRE, a publicly traded Spanish insurer.
LOSS AND LAE RESERVES GENERAL. Gross loss and LAE reserves totaled $3,800.0 million at December 31, 1998, $3,437.8 million at December 31, 1997 and $3,246.9 million at December 31, 1996. The increases were mainly due to reserve increases on pre-1986 accident years for asbestos and environmental exposures, most of which were ceded under various retrocessional arrangements resulting in offsetting increases to reinsurance receivables, together with continued growth in the Company's book of business. Reinsurance receivables totaled $982.0 million at December 31, 1998, $692.5 million at December 31, 1997 and $749.1 million at December 31, 1996. At December 31, 1998, $563.3 million or 57.4% of the total was receivable from Gibraltar including $142.0 million which is contractually due in the first quarter of 1999, subject to resolution of the dispute noted above (See - "Year Ended December 31, 1998 Compared to Year Ended December 31, 1997" above), $154.8 million which is collateralized by funds held by the Company or offsetting liabilities and $266.5 million which is subject to the terms and conditions of The Prudential's guarantee of Gibraltar's payment obligations to the Company. Additionally, $150.0 million or $15.3% is receivable from Continental Insurance Company which is secured by a funds held arrangement wherein the Company has retained the premium payments due the retrocessionaire, recognized a liability for such amounts and reduces such liability as payments are due from the retrocessionaire. No other retrocessionaire accounted for more than $25.0 million of the Company's receivable.
Everest Re maintains reserves to cover its estimated ultimate liability for losses and LAE with respect to reported and unreported claims. Because reserves are estimates of ultimate losses and LAE, management monitors reserve adequacy over time, evaluating new information as it becomes known and adjusting reserves, as necessary. Management considers many factors when setting reserves, including: (i) current legal interpretations of coverage and liability; (ii) economic conditions; (iii) internal actuarial methodologies which analyze Everest Re's experience with similar cases, information from ceding companies and historical trends, such as reserving patterns, loss payments, pending levels of unpaid claims
and product mix; and (iv) the uncertainties discussed below regarding reserve requirements for asbestos and environmental claims. Based on these considerations, management believes that adequate provision has been made for Everest Re's loss and LAE reserves. Actual losses and LAE ultimately paid may deviate, perhaps substantially, from such reserves.
ASBESTOS AND ENVIRONMENTAL EXPOSURES. Everest Re's asbestos claims typically involve liability or potential liability for bodily injury from exposure to asbestos or liability for property damage resulting from asbestos or asbestos containing materials. Everest Re's environmental claims typically involve potential liability for the mitigation or remediation of environmental contamination or bodily injury or property damages caused by the release of hazardous substances into the land, air or water. In addition to the previously described general uncertainties inherent in estimating reserves, there are significant additional uncertainties in estimating the amount of Everest Re's potential losses from asbestos and environmental claims. Among the complications impacting the estimation of such losses are: (i) potentially long waiting periods between exposure and manifestation of any bodily injury or property damage; (ii) difficulty in identifying sources of asbestos or environmental contamination; (iii) difficulty in properly allocating responsibility and/or liability for asbestos or environmental damage; (iv) changes in underlying laws and judicial interpretation of those laws; (v) potential for an asbestos or environmental claim to involve many insurance providers over many policy periods; (vi) long reporting delays, both from insureds to insurance companies and ceding companies to reinsurers; (vii) historical data concerning asbestos and environmental losses, which is more limited than historical information on other types of casualty claims; (viii) questions concerning interpretation and application of insurance and reinsurance coverage; and (ix) uncertainty regarding the number and identity of insureds with potential asbestos or environmental exposure. Although these complications have become less severe in recent years, management believes that these factors continue to render reserves for asbestos and environmental losses significantly less subject to traditional actuarial methods than are reserves on other types of losses. Given these uncertainties, management believes that no meaningful range for such ultimate losses can be established. Everest Re establishes reserves to the extent that, in the judgment of management, the facts and prevailing law reflect an exposure for Everest Re or its ceding company. Due to the uncertainties discussed above, the ultimate losses may vary materially from current loss reserves and, if coverage under the Stop Loss Agreement were exhausted, could have a material adverse effect on the Company's future financial condition, results of operations and cash flows.
STOCKHOLDERS' EQUITY. Holdings' stockholders' equity increased to $1,479.2 million as of December 31, 1998 from $1,307.5 million as of December 31, 1997 principally reflecting a $155.1 million increase in retained earnings for the year and an increase of $37.2 million in unrealized appreciation of investments. Stockholders' equity as of December 31, 1997 increased to $1,307.5 million from $1,086.0 million as of December 31, 1996 principally reflecting an increase of $146.9 million in retained earnings and an increase of $82.6 million in unrealized appreciation of investments. Dividends of $10.1 million, $8.1 million and $6.1 million were declared and paid by Holdings in 1998, 1997 and 1996, respectively.
Holdings' stockholders' equity of $1,479.2 million exceeded Everest Re's statutory-basis surplus of $1,059.4 million by $419.8 million at December 31, 1998. The primary differences between GAAP and SAP as they relate to the Company are: (i) the deferral of acquisition costs under GAAP, which are immediately expensed under SAP; (ii) the provision for deferred taxes on temporary tax differences under GAAP, which are excluded under SAP; and (iii) the carrying at market value of fixed maturities available for sale under GAAP, as compared to at amortized cost under SAP.
LIQUIDITY AND CAPITAL RESOURCES EVEREST RE. Everest Re's liquidity requirements are met on both a short-term and long-term basis by funds provided by premiums collected, investment income and collected reinsurance receivables balances, and from the sale and maturity of investments. Everest Re's net cash flows from operating activities were $183.3 million, $376.4 million and $414.0 million, in 1998, 1997 and 1996, respectively. The decreases from 1997 and 1996 in cash provided by operating activities were principally a result of increases in net paid losses, reflecting maturation of the Company's loss reserves, combined with the changes in the Company's mix of business and modest, if any, growth in gross written premium, all of which may affect growth in cash flow from operations in subsequent periods, offset by improved profitability. Recoveries under the Company's Stop Loss Agreement with Gibraltar contributed $31.9 million, $99.8 million and $53.4 million of such net cash flows in 1998, 1997 and 1996 respectively.
Proceeds and applications from sales and acquisitions of investment assets were $634.2 million and $755.3 million, respectively, in 1998 principally reflecting reduced portfolio turnover as the result of the tax implications of capital gain realization, compared to $1,077.0 million and $1,482.8 million, respectively, in 1997 and $1,632.9 million and $2,014.9 million, respectively, in 1996. Everest Re's current investment strategy seeks to maximize after-tax income through a high quality, diversified, duration sensitive, taxable bond and tax-exempt municipal bond portfolio, while maintaining an adequate level of liquidity.
If a single catastrophe were to occur in the United States that resulted in $170.0 million of gross losses and allocated loss adjustment expenses ("ALAE") in 1999 (an amount equivalent to Everest Re's PML), management estimates that the effect (including additional premiums and retained losses and ALAE) on the Company's income before taxes would be $93.0 million. This pre-tax net loss estimate assumes that Everest Re's aggregate losses and ALAE for 1999 would exceed the threshold loss ratio requirement in the aggregate excess of loss cover by $170.0 million.
On March 21, 1996 the Holdings' Board of Directors approved a stock repurchase plan authorizing the repurchase of an aggregate amount of 2.5 million shares of common stock from time to time in open market transactions. During 1998, the first year in which purchases were made under this authorization, 516,900 shares were repurchased at an average price of $33.68 per share.
In September 1998, Holdings adopted a shareholder rights plan ("Plan"). To implement the Plan, the Company declared a dividend of one preferred share purchase right ("Right") for each outstanding share of common stock. Pursuant to the Plan, the Rights can only be exercised in certain situations involving a potential change in control of the Company. For more information see Exhibit 4.1.
The overall 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.
Interest rate risk is the potential change in value of the fixed maturity portfolio due to change in market interest rates. Further, it includes prepayment risk in a declining interest rate environment on the $408.9 million of the $4.1 billion fixed maturity portfolio, which consists of mortgage-backed securities. Prepayment risk results from accelerated principal payments that shorten the average life and thus, the expected yield of the security.
Foreign currency rate risk is the potential change in value, income, and cash flow arising from adverse changes in foreign currency exchange rates. The Company's foreign operations each maintain capital in the currency of the country of its geographic location consistent with local regulatory guidance. Generally, the Company prefers to maintain the capital of its foreign operations in US dollar assets although this varies by regulatory jurisdiction in accordance with market needs. Each foreign operation may conduct business in its local currency as well as the currency of other countries in which it operates. The primary foreign currency exposures are the Canadian Dollar, the Belgian Franc, the British Pound Sterling, the German Deutschmark, and the French Franc for these foreign operations. The Company mitigates foreign exchange exposure by a general matching of the currency and duration of its assets to its corresponding operating liabilities. In accordance with FAS 52, the Company translates the assets, liabilities, and income of non-US dollar functional currency legal entities to the US dollar. This translation amount is reported as a component of other comprehensive income. The primary functional foreign currency exposures are the Canadian Dollar, the British Pound Sterling and the Belgian Franc for these foreign operations.
The table below displays the impact on market value and after-tax unrealized appreciation of a 20% change in equity prices up and down in 10% increments as of December 31, 1998. All amounts are in millions of US$.
READINESS. The Company has been actively engaged in a project to mitigate the potential effects of the year 2000 issue. For each segment of its internal computer processing environment (mainframe, midrange and personal computer equipment), the Company has a multi-phase plan that involves (a) the identification and assessment of year 2000 compliance, (b) the design and development of remedies (including the replacement of non-compliant systems if needed), (c) testing of year 2000 readiness and (d) the implementation of fully integrated year 2000-compliant processing. The assessment phase is complete, and many of the Company's systems are already year 2000-compliant. For those that are not yet compliant, steps are being taken to upgrade or replace them. With the exception of one non-critical application, which will be replaced in the third quarter of 1999, all processing/reporting systems are currently planned to be compliant by June 30, 1999. Testing has indicated that virtually all mission-critical mainframe hardware and software is compliant, and that the few software applications that are non-compliant can be made compliant by June 30, 1999; additional testing of remaining systems will continue as those remaining systems are brought into compliance.
The Company's plan also addresses potential year 2000 issues related to the processing of transactions with its external business contacts, including business partners (e.g., ceding companies) and service providers (e.g., banks). The Company has actively surveyed its significant business partners and service providers concerning their compliance status. The information received to date has not identified any significant barriers to year 2000 compliance, and the Company believes that these entities will be sufficiently compliant that the year 2000 issue will not cause material disruption to the Company's business.
RISKS. The Company does not rely on computer-dependent transactions to the same extent as many other businesses. However, in the event that the Company's internal processing environment could not be made year 2000-compliant, or in the event that significant business partners or service providers or other business entities experienced serious year 2000 problems, the Company could experience disruption in its business. Such disruption could conceivably take several forms: (a) having to compile information and process transactions manually, (b) if compliance problems persisted, impairing the Company's ability to receive premiums from and make claim payments to its ceding companies, (c) impairing the Company's ability to obtain information about its investments or (d) impairing the value of the Company's bond and equity investments, if the entities underlying those investments themselves have substantial year 2000 costs, liabilities or disruptions. Any or all of the types of possible disruptions in such a "worst case scenario" could materially increase the cost of doing business, could impair the Company's ability to make required regulatory filings and could materially affect the Company's results of operations, liquidity or financial condition. However, based upon current information, the Company does not expect such scenarios to occur and does not expect material disruption to its business.
CONTINGENCY PLANS. Although it has considered various scenarios concerning the possible effects of the year 2000 issue, the Company does not yet have formal contingency plans relating to either its internal processing environment or its external business contacts. As it completes the upgrading and testing of non-compliant systems and continues to monitor the status of its important external contacts throughout 1999, the Company will develop contingency plans as necessary for mission-critical systems and relationships.
EURO CONVERSION. On January 1, 1999 eleven of the fifteen member countries of the European Union (the "participating countries") established fixed conversion rates between their existing sovereign currencies (the "legacy currencies") and the Euro. The participating countries have agreed to adopt the Euro as their common legal currency, to issue sovereign debt exclusively in the Euro and to redenominate outstanding sovereign debt. Between January 1, 1999 and January 1, 2002 (the "transition period") the legacy currencies are scheduled to remain legal tender in the participating countries. During the transition period, public and private parties may pay for goods and services using either the Euro or the participating country's legacy currency. European Union regulations, among other matters, specify how legacy currencies convert to Euros. Beginning January 1, 2002, new Euro-denominated bills and coins will be issued and by July 1, 2002, the participating countries' legacy currencies will no longer be legal tender for any transactions. The Company has operations in Belgium and the United Kingdom, both members of the European Union; Belgium became a participating country on January 1, 1999.
SAFE HARBOR DISCLOSURE In connection with the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995 (the "Act"), the Company sets forth below cautionary statements identifying important factors, among others, that in some cases have affected and that could cause its actual results to differ materially from those which might be projected, forecasted, or estimated in its forward-looking statements, as defined in the Act, made by or on behalf of the Company in press releases, written statements or documents filed with the Securities and Exchange Commission, or in its communications and discussions with investors and analysts in the normal course of business through meetings, phone calls and conference calls. These cautionary statements supplement other factors contained in this report which could cause the Company's actual results to differ materially from those which might be projected, forecasted or estimated in its forward-looking statements.
12) Decline in the value of the Company's common equity investments;
18) Adverse results in litigation matters, including, but not limited to, litigation related to environmental, asbestos and other potential mass tort claims;