(2) The loss and loss expense ratio is calculated by dividing the losses and loss expenses by net premiums earned excluding life reinsurance premiums. Net premiums earned for life reinsurance were $220,068, $183,953, and $158,277 for the years ended December 31, 2004, 2003 and 2002, respectively.
As an insurance and reinsurance company, we generate gross revenues from two principal sources, premiums which are usually paid in advance of loss payments, and dividends and interest income earned on invested assets. Cash flow is generated from premiums collected and investment income received less paid losses and loss expenses. Generally, when an insurance company writing long-tail business grows, as ACE has over the last two years, its cash flows tend to be positive. ACE generated approximately $5 billion in positive operating cash flow in 2004 while invested assets over this period also increased by $5 billion.
Invested assets are generally held in liquid, investment grade fixed income securities of relatively short duration. We also invest a small portion of our assets in less liquid or higher risk assets in an attempt to achieve higher risk-adjusted returns. Claims payments in any short-term period are highly unpredictable due to the random nature of loss events and the timing of claims awards or settlements. The value of investments held to pay future claims is subject to market forces such as the level of interest rates, stock market volatility and credit events such as corporate defaults. The actual cost of claims is also volatile based on loss trends, inflation rates, court awards and catastrophes. We believe that our cash balances, our highly liquid investments, credit facilities and reinsurance protection provide sufficient liquidity to meet any unforeseen claim demands that might occur in the year ahead.
The insurance industry is highly competitive with many companies offering similar coverage. Until recently, the insurance market had been characterized by sharply rising rates on new and renewal business, combined with restrictive terms and conditions. In 2004, we observed rate reductions across several classes and although we have continued to report growth in net premiums written, the rate of growth declined in 2004, compared with 2003 and 2002. This is a reflection of our underwriting discipline in the face of a weakening market, partially offset by our increased market and product presence both in the U.S. and throughout the world. We believe the market overall remains stable and rates, terms and conditions overall are reasonable despite the downward pressure on rates which has continued into the first quarter of 2005.
2004 was a record year for property catastrophe losses for the insurance industry. We incurred net losses of $499 million in 2004, primarily relating to hurricanes which struck the Caribbean and the U.S. and, to a lesser extent, typhoons which impacted Asia. The tsunami disaster had no material impact on our operating results and financial condition.
and claim values. The trust would be funded by asbestos defendants and their insurers. As currently proposed, ACE would be one of the insurer participants. However, we cannot predict if any such proposed legislation will be modified or adopted.
On October 14, 2004, the NYAG filed a civil suit against Marsh & McLennan Companies Inc. (Marsh), alleging that certain Marsh business practices were fraudulent and violated antitrust and securities laws. ACE was not named as a defendant in the suit, although ACE was named as one of four insurance companies whose employees participated in the practices in question. There can be no assurance that ACE will not be named in future actions brought by the NYAG or any other state attorneys general. In addition, an underwriter, who is no longer employed by ACE, in an ACE insurance subsidiary has pleaded guilty to a misdemeanor based on these practices. ACE is cooperating and will continue to cooperate with the AG Investigations.
ACE, ACE INA Holdings, Inc. and ACE USA have been named in the following ten federal putative nationwide class actions brought by insurance policyholders. Bayou Steel Corporation v. ACE INA Holdings, et al. (Case No. 04 CV 5391 E.D. Pa) (filed November 18, 2004); Eagle Creek, Inc. v. ACE INA Holdings, et al. (Case No. 04 CV 5255; E.D. Pa.) (filed November 10, 2004); Stephen Lewis vs. Marsh & McLennan Companies, Inc., et al. (Case No. 04 CV 7847; N.D. Ill.) (filed December 6, 2004); Opticare Health Systems, Inc. v. Marsh & McLennan Companies, Inc., et al. (Case No. 04 CV 06954; S.D.N.Y.) (filed October 19, 2004); Diane Preuss v. March & McLennan Companies, et al. (Case No. 04 CV 78553; N.D. Ill.) (filed December 6, 2004); Redwood Oil Company v. Marsh & McLennan Companies, Inc. (Case No. 05 C 0390; N.D. Ill.) (filed January 21, 2005); Shell Vacations LLC v. Marsh & McLennan Companies, Inc., et al. (Case No. 05 C 0270; N.D. Ill.) (filed January 14, 2005); Edward Macuish v. Marsh & McLennan Companies, Inc., et al. (Case No. 2005 CV 00440; N.D. Ill.) (filed January 25, 2005); David Boros v. Marsh & McLennan Companies, Inc., et al. (Case No. C050543EDL; N.D. Calf.) (filed February 4, 2005), and Robert Mulcahy v. Arthur J. Gallagher & Co., et al. (Case No. 2005 CV 01064; D. N.J.) (filed February 23, 2005). In each of these cases, the plaintiff has sued a number of other insurance entities in addition to the ACE entities.
to the allegations in the federal class actions identified above. Plaintiffs allege causes of action under every state’s consumer statute and state common law (breach of fiduciary duty and unjust enrichment). The complaint states that “neither the Plaintiff nor any member of the Class has suffered damages exceeding $74,999.00 each, even when trebled. In no event will Plaintiff or any member of the Class accept damages in excess of $74,999.00 for each class member.”
ACE understands that it has been named as a defendant in a derivative suit filed in Delaware Chancery Court by shareholders of Marsh. The derivative suit seeks to recover damages for Marsh and its subsidiary, Marsh, Inc., against officers and directors of Marsh, American International Group Inc. (AIG), AIG’s chief executive officer, and ACE. The suit alleges that the defendants damaged Marsh and Marsh, Inc. by participating in a bid rigging scheme and obtaining “kickbacks” in the form of contingent commissions. The suit alleges that ACE knowingly participated in the officers’ and directors’ breaches of fiduciary duty to Marsh, Inc. and Marsh. The plaintiff has sought unspecified compensatory damages and reimbursement of expenses, including legal fees. ACE has not been served in this action, though no assurance can be given that it will not be served.
On April 28, 2004, we completed the sale of 65.3 percent of our financial and mortgage guaranty reinsurance and insurance businesses (transferred business) through the initial public offering (IPO) of 49 million common shares of Assured Guaranty Ltd. (Assured Guaranty) at $18.00 per share. Assured Guaranty was incorporated in Bermuda in August 2003 for the sole purpose of becoming a holding company for our transferred business.
Subsequent to the IPO, we beneficially own 26 million common shares, or 34.7 percent of Assured Guaranty’s outstanding common shares and accordingly, no longer consolidate our interest in the Assured Guaranty companies. Beginning April 29, 2004, we account for the retained interest under the equity method of accounting with the carrying value of our investment reflected in “Investments in partially-owned insurance companies” within the consolidated balance sheet and our proportionate share of earnings reflected in “Other (income) expense” within the consolidated statement of operations. For segment reporting purposes, our proportionate share of earnings is reflected in our Financial Services segment.
We believe our accounting policies for these items are of critical importance to our Consolidated Financial Statements. The following discussion provides more information regarding the estimates and assumptions required to arrive at
these amounts and should be read in conjunction with the sections entitled: Unpaid Losses and Loss Expenses, Asbestos and Environmental Claims, Reinsurance, Investments, Net Realized Gains (Losses) and Other Income and Expense Items.
We do not calculate a range of loss reserve estimates for our individual loss reserve studies. Actuarial ranges are not a true reflection of the potential volatility between loss reserves estimated at the balance sheet date and the ultimate settlement of losses. This is due to the fact that an actuarial range is developed based on known events as of the valuation date whereas actual volatility or prior period development has historically been reported in subsequent Consolidated Financial Statements, in part from events and circumstances that were unknown as of the original valuation date. We do
Short-tail business describes lines of business for which losses are usually known and paid shortly after the loss actually occurs. This would include, for example, most property, personal accident, aviation hull and automobile physical damage policies that are written. Typically, there is less variability in reserve estimates for these lines of business.
Although the contractual obligation of individual reinsurers to pay their reinsurance obligations is based on specific contract provisions, the collectibility of such amounts requires significant estimation by management. The majority of the balance we have accrued as recoverable will not be due for collection until sometime in the future (in some cases several decades from now). Over this period of time, economic conditions and operational performance of a particular reinsurer may impact their ability to meet these obligations and while they may continue to acknowledge their contractual obligation to do so, they may not have the financial resources or willingness to fully meet their obligation to us.
• historical industry default statistics for the reinsurer’s current ratings class, the actual collection experience of the reinsurer, collateral triggers or other contractual provisions that may mitigate default exposure, and the dates the balances will likely become due (duration). For recoverable balances considered representative of the larger population (i.e., default probabilities are consistent with similarly rated reinsurers and payment durations conform to averages), management generally applies industry default factors consistent with the reinsurer’s particular rating class. Such factors have been developed by a major ratings agency;
At December 31, 2004, the use of different assumptions within the model could have a material effect on the bad debt provision reflected in our Consolidated Financial Statements. To the extent the creditworthiness of our reinsurers were to deteriorate due to an adverse event affecting the reinsurance industry, such as a large number of major catastrophes, actual uncollectible amounts could be significantly greater than our bad debt provision. Such an event could have a material adverse effect on our financial condition, results of operations, and our liquidity. Given the various considerations used to develop default factors, we cannot precisely quantify the effect a specific industry event may have on the bad debt provision. However, based on the composition (particularly the average credit quality) of the reinsurance recoverable balance at December 31, 2004, we estimate that a ratings downgrade of all rated reinsurers could increase our bad debt provision by as much as 15 percent, assuming no other changes relevant to the calculation. While a rating downgrade would result in an increase in our provision for bad debt and a charge to earnings in that period, a downgrade in and of itself does not imply that we will not ultimately collect all of the ceded reinsurance recoverable from the reinsurers in question.
With respect to securities where the decline in value is determined to be temporary and the security’s value is not written down, a subsequent decision may be made to sell that security and realize a loss. Subsequent decisions on security sales could be made based on changes in liquidity needs (i.e., arising from a large insured loss such as a catastrophe), internal risk management considerations, the financial condition of the issuer or its industry, market conditions, and new investment opportunities. Day to day management of the majority of our investment portfolio is outsourced to third party investment managers. While these investment managers may, at a given point in time, believe that the preferred course of action is to hold securities with unrealized losses until such losses are recovered, the dynamic nature of portfolio management may result in a subsequent decision to sell the security and realize the loss based upon new circumstances such as those related to the changes described above. We believe that subsequent decisions to sell such securities are consistent with the classification of our portfolio as available for sale. The gross unrealized loss at December 31, 2004, for all securities in a loss position was $71 million.
Many of our insurance businesses operate in income tax paying jurisdictions. We provide for income taxes in accordance with the provisions of FAS No. 109, “Accounting for Income Taxes” (FAS 109). Our deferred tax assets and liabilities primarily result from temporary differences between the amounts recorded in our Consolidated Financial Statements and the tax basis of our assets and liabilities. We determine deferred tax assets and liabilities separately for each tax-paying component (an individual entity or group of entities that is consolidated for tax purposes) in each tax jurisdiction.
Certain products we sell have been determined to meet the definition of a derivative under FAS 133. These products are accounted for at fair value and consist of GMIB reinsurance in our life operation and credit default swaps principally through our ownership interest in Assured Guaranty. We believe that the most meaningful presentation of these derivatives is to reflect revenue as net premiums earned, and to record estimates of losses and loss expenses on specific credit events as incurred losses. When we determine that a loss on a derivative contract is probable, we establish reserves for the loss. Changes in fair value on all derivatives are included in net realized gains (losses). We generally hold these derivative contracts to maturity. Where we hold a derivative to maturity, the cumulative unrealized gains and losses will net to zero if we incur no credit losses on that contract. (See Note 2(o) of the Consolidated Financial Statements for more information)
The fair value of these instruments depends on a number of factors including changes in interest rates, changes in equity markets, changes in credit markets and for GMIB reinsurance, changes in the allocation of investments underlying annuitant account value. Where available, we use quoted market prices to determine the fair value of these instruments. If the quoted prices are not available, the fair value is estimated using valuation models for each type of instrument. These models may be developed by third parties, such as rating agencies, or internally based on market conventions for similar transactions, depending on the circumstances. These models and related assumptions are continuously reevaluated by management and enhanced, as appropriate, based upon improvements in modeling techniques and availability of more timely market information, such as market conditions and demographics of in-force annuities. Refer to