The following is a discussion and analysis of our results of operations for the years ended December 31, 2003 and 2002 and financial condition as at December 31, 2003. This discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes thereto included in this filing.
This discussion contains forward-looking statements that are not historical facts, including statements about the Company’s beliefs and expectations. These statements are based upon current plans, estimates and projections. Our actual results may differ materially from those projected in these forward-looking statements as a result of various factors. See “Note on Forward Looking Statements” and “Risk Factors” contained in Item 1 “Business” of this filing.
We derive our revenues primarily from premiums from our reinsurance and insurance contracts and, to a lesser extent, income from our investment portfolio. Premiums are a function of the number and type of contracts we write, as well as prevailing market prices. Renewal dates for reinsurance business tends to be concentrated at the beginning of quarters, and the timing of premium written varies by line of business. Most property catastrophe business is written in the January 1, April 1, June 1 and July 1 renewal periods, while the property specialty and other specialty lines are written throughout the year. Written premiums are generally lower during the fourth quarter of the year as compared to prior quarters. Gross premiums written for pro-rata contracts, including QQS programs, are initially booked as estimated and are adjusted as actual results are reported by the cedents during the period. Earned premiums do not necessarily follow the written premium pattern as certain written premiums are earned ratably over the contract term, which ordinarily is twelve months, although many pro-rata contracts are written on a risks attaching basis and are generally earned over a 24 month period. Earned premiums are affected by our growing book of business; as written premium levels increase, earned premium levels will correspondingly increase over the earning period. Premiums are generally due in installments.
To a lesser extent, we also write retrocessional coverage contracts, which provide reinsurance protection to other reinsurers, also called retrocedents. Coverage generally provides catastrophe protection for the property portfolios of other reinsurers. Retrocessional contracts typically carry a higher degree of volatility than reinsurance contracts as they protect against concentrations of exposures written by retrocedents, which in turn may experience an aggregation of losses from a single catastrophic event.
Since the classes of business we underwrite have large aggregate exposures to natural and man-made disasters, we expect that our claims experience will predominantly be the result of relatively few events of significant severity. The occurrence of claims from catastrophic events is likely to result in substantial volatility in, and could have a material adverse effect on, our financial condition and results of operations and our ability to write new business. This volatility will affect our results in the period that the loss occurs because U.S. GAAP does not permit reinsurers to reserve for such catastrophic events until they occur. Catastrophic events of significant magnitude have historically been relatively infrequent, although we believe the property catastrophe reinsurance market has experienced a high level of worldwide catastrophic losses in terms of both frequency and severity from 1987 to the present as compared to prior years. We also expect that increases in the values and concentrations of insured property will increase the severity of such occurrences in the future. We seek to reflect these trends as we price our reinsurance.
Our fixed maturity investments are classified as available for sale under U.S. GAAP and are carried at fair value based on quoted market prices. Unrealized gains and losses on these investments are included in accumulated other comprehensive income as a separate component of shareholders’ equity. If management has determined that an investment has sustained an impairment in value that is determined to be other than temporary, the unrealized loss will be charged to income in the period it is determined.
We hold a modest portfolio of equity investments which are classified as available for sale under U.S. GAAP and are carried at fair value based on quoted market prices. We classify our investment in Aspen as an other investment. Aspen completed an initial public offering in December 2003. However, as an original shareholder in Aspen, significant restrictions exist on the sale of our shares, which contribute to the illiquidity of our investment. As a result of this illiquidity, a portion of the total investment is considered restricted and is discounted. Unrealized gains and losses on all investments are included in accumulated other comprehensive income.
Other significant accounting policies that we use to prepare our consolidated financial statements are included in Note 2 to the December 31, 2003 Consolidated Financial Statements included in this filing.
Performance Unit Plan (the “PUP”). The PUP is the Company’s primary executive long-term incentive scheme. Pursuant to the terms of the PUP, at the discretion of the Compensation Committee of the Board of the Directors (the “Committee”), performance units may be granted to executive officers and certain other key employees. Performance units entitle the recipient to receive, without payment to the Company, all, double, or a part of the value of the units granted, depending on the achievement of specific financial or operating goals. Performance units vest at the end of a three-year performance cycle, and are payable in cash, common shares or a combination thereof at the discretion of the Committee.
A total of 936,000 performance units are authorized under the PUP at December 31, 2003 and 2002 (or up to 1,872,000 common shares should the maximum harvest of 200% of units apply). On January 8, 2002, the Committee approved the grant of up to 312,000 performance units for the three year performance period covering financial years 2002, 2003 and 2004 and granted 264,390 performance units related to this performance period. On February 27, 2003, the Committee approved the grant of up 312,000 performance units for the three year performance period covering financial years 2003, 2004 and 2005, granted 288,000 performance units, and granted the remaining 47,610 performance units from the prior performance period. On November 20, 2003, the Committee approved the grant of the remaining 336,000 performance units authorized under the PUP for the three year performance period covering financial years 2004, 2005 and 2006.
We accrue the projected value of these units and expense the value in the income statement over the course of each three-year performance period. The accrual is based on the number of units granted, the share price at the end of the respective fiscal period end, and an assumption of a 100% harvest ratio, unless otherwise adjusted as discussed above. At the end of the sixth quarter, and every subsequent quarter, we reassess the projected results for each three year performance period and adjust the accrued PUP liability as necessary. We recalculate the liability under the PUP as our financial results evolve and the share price changes, and reflect such adjustments in the income statement in the period in which they are determined. This may result in an adjustment to the harvest rate used in the liability calculation which may increase or decrease the amount of liability and expense recorded during the period. Assuming the share price at December 31, 2003 remained constant, if the harvest ratio for the 2002-2004 performance period had been 100% or 150% at December 31, 2003, respectively, the PUP expense would have decreased or increased by approximately $2.4 million or $0.8 million, respectively. Assuming the share price at December 31, 2003 remained constant, if the harvest ratio for the 2003-2005 performance period had been 75% or 137.5% at December 31, 2003, respectively, the PUP expense would have decreased or increased by approximately $1.1 million or $1.7 million, respectively.
In general, in 2003 we experienced premium rate levels which were less volatile than in 2002, but at comparable overall levels with 2002, for the “short-tail” reinsurance and insurance products that we write. We expect both of these trends to continue into 2004. Although we still believe that certain areas are starting to see some competitive forces, overall rates remain healthy and we do not expect as much pressure on rates in 2004 as originally anticipated at the beginning of 2003. Even though there have not been as many large catastrophes during the year as in prior years, we believe that rate levels will continue to remain stable for the “short-tail” insurance and reinsurance products we write due to: (1) increasing modeling risk scenarios which is creating additional demand for catastrophe reinsurance coverage in target zones; (2) the continued significant reserve strengthening in other insurance and reinsurance companies mainly related to asbestos and environmental legacy issues but also now on the casualty underwriting conducted between 1997 and 2000; and (3) rating agency downgrades of competitors.
In market loss terms, 2003 was an active year for catastrophes, especially in North America where there was a significant frequency of tornado, hurricane, and brushfire events in the market loss range of $1 billion to $2.5 billion. However, since our portfolio of business generally attaches in the middle and higher layers of programmes, our largest loss from such events in the year was $10 million and we have benefited from a low level of large catastrophe activity during 2003. We anticipate that we may be impacted in future periods on average by a higher frequency of large natural catastrophic events than those experienced in 2003. Such events could have a material adverse impact on our financial condition and results of operations. In addition, while we believe that overall price levels are currently favorable for reinsurers and better than they have been in many years, capital provided by newly-formed reinsurers or additional capital raised by existing reinsurers may increase the supply of reinsurance which could impact negatively the prices that we receive for the products we write.
• An increase in penetration of existing accounts as we replace capacity of exiting reinsurers;
• An increase in written lines on existing business, and less sign-downs on many classes;
• Planned growth in our casualty account mainly in the areas of medical malpractice and errors and omissions coverage as terms and conditions continue to tighten. Casualty business is expected to represent approximately 10% of gross premiums written in 2004;
• Increasing modeling scenarios leading to cedants purchasing larger limits on programs; and
As expected, our mix of business has changed in 2003 with less QQS premiums written and an increase in direct insurance and facultative and specialty reinsurance business, as a result of expected improved market conditions. As always envisaged, we have not written any QQS contracts for 2004. The development of ultimate loss ratios for the 2002 and 2003 underwriting years on contracts we did write however, continue to improve. For the three syndicates we did reinsure in 2002 and 2003, we have negotiated substantial other reinsurance contracts for 2004 to partly replace the non-renewed QQS premium income.
• The existence of a substantial capital base and a very strong capital to premium ratio;
(1) Total return to shareholders is a non-GAAP measure. It is the percentage increase in fully converted book value per share (described above) excluding the impact of dividends accrued. It is calculated as the December 31, 2003 fully converted book value per share of $24.92 plus the accrued dividend of $0.34, less the fully converted book value per share at December 31, 2002 of $19.39, with the result then being divided by $19.39. The Company believes that this measure most accurately reflects the return made by its shareholders as it takes into account the effect of all dilutive securities and the effect of dividends.
Management believes that fully converted book value per share and total return to shareholders are measurements which are important to investors and other interested parties, and that these persons benefit from having a consistent basis for comparison with other companies within the industry. However, these measures may not be comparable to similarly titled measures used by companies outside of the insurance industry.
The following table summarizes the Company’s consolidated financial results for the years indicated ($ in millions):
The Property Catastrophe and Property Specialty categories have seen a substantial increase in gross premiums written in 2003 as compared to 2002 due to improved signings on renewals as well as increased access to more original programs than in 2002. Our reputation, combined with our strong capital base and additional ratings has also contributed to the increase in gross premiums written. We expect that there will be growth in these areas in 2004 but expect it to be less than the growth from 2002 to 2003.
account for approximately 10% of our gross premiums written in 2004. In 2004, casualty is expected to include professional indemnity casualty reinsurance, predominantly medical malpractice, specialized errors and omissions business, UK Employer’s Liability and catastrophe and/or clash layers for general liability and retrocessional accounts, on an excess of loss basis. The Other Specialty category is expected to experience the most percentage growth during 2004, primarily from an increase in casualty writings, although this growth is expected to be less than the growth seen from 2002 to 2003.
As expected, QQS gross premiums written accounted for less gross premiums written than in 2002. Part of the reduction relates to reduced premiums for the 2002 and 2003 underwriting years as during the year the receipt of new information indicated that the expected premiums for the QQS business for both these underwriting years was going to be lower than previous forecasts. The QQS results for both the 2002 and 2003 underwriting years are estimated on the basis of projections for the respective years supplied by the underlying syndicates, adjusted for actual reported results from the underlying syndicates. Estimated annual premiums can change, based on revised projections supplied by the underlying syndicates. The resulting changes in accrued premium are recorded in the period in which they are determined.
For the years ended December 31, 2003 and 2002, $74.3 million and $nil, respectively was recorded in gross premiums written under our reinsurance arrangements with Aspen Re, in which we have approximately a 5.8% interest on an undiluted basis. These arrangements cover mainly property and casualty risks.
We recorded an insignificant amount of reinstatement premiums during the years ended December 31, 2003 and 2002. The lack of reinstatement premiums continues to be due to the minimal amount of reported losses during these years. In 2004, we would expect to record greater levels of reinstatement premiums as additional losses are notified, consistent with our loss estimates discussed below.
We will continue our limited reinsurance purchase policy protecting ourselves against large risk losses on our direct and facultative book and small to medium-size catastrophes on our overall property writings. For 2004 we expect that reinsurance premiums ceded may rise modestly but is expected to be less than 5% of gross premiums written.
Gross premiums written are earning as expected based on the timing of the gross premiums written which has resulted in an earned premium to written premium ratio of 87.1% for the year ended December 31, 2003, compared to 54.3% for 2002. In addition, we continue to write a minority of our business, including some underlying business contained in the QQS contracts, on a risks attaching basis, for which premiums are earned over a longer period, generally 24 months. We would expect the earned premium to written premium ratio in 2004 to rise modestly from 2003 as the growth rate of gross premiums written slows.
For comparative purposes, our combined ratio and components thereof are set out below for the periods indicated:
(1) The overall gross loss ratio for the year ended December 31, 2003 was 21.3%.
All of these factors combined have resulted in the overall net loss ratio of 23.3% for the year ended December 31, 2003, compared to the overall net loss ratio for the year ended December 31, 2002 of 40.4%.
• Due to the potential variability in ultimate premiums and the limited availability of underlying loss information with the QQS business, our actuaries selected an expected loss ratio based on a review of the information supplied by cedents and applied it to projected premiums. During the year ended December 31, 2003, we reduced our expected gross loss ratio based on information provided by ceding companies, which resulted in a reduction of $15.8 million in gross loss and loss adjustment expense reserves. Some of this was due to reductions in the loss ratio projections provided by the syndicates. Much of the decrease in projected ultimate losses was also due to revised ultimate premium estimates that were considerably lower than those at December 2002. After taking into account the effect of reinsurance purchased by the QQS syndicates with respect to the contracts in which we participate, net loss and loss adjustment expense reserves decreased by $3.8 million for the year ended December 31, 2003.
At December 31, 2003, we estimated our gross and net reserves for loss and loss adjustment expenses using the methodology as outlined in our Critical Accounting Policy earlier in this section.
Gross loss and loss adjustment expense reserves at December 31, 2003
Profit commission expensed was $19.6 million and $1.5 million for the years ended December 31, 2003 and 2002, respectively. The accrual for profit commission increased as a result of favorable loss experience. The expense ratio for the year ended December 31, 2003 and 2002 would have been 24.2% and 26.6%, respectively excluding the effect of profit commission.
For the year ended December 31, 2003 and 2002, acquisition costs incurred were $140.4 million and $62.9 million, respectively, which were principally due to brokerage commissions on our insurance and reinsurance contracts of $82.2 million and $29.6 million respectively, as well as commissions paid to ceding insurers and other costs of $58.2 million and $31.8 million, respectively.
The performance unit plan expense for the year ended December 31, 2003 was higher than the same period in 2002 as the 2003 period includes an accrual for both the 2002-2004 performance period and the 2003-2005 performance period. The share price at December 31, 2002 was used in estimating the 2002 year expense at December 31, 2002 and was significantly less than the share price used at December 31,2003 to calculate the 2003 expense for both performance periods. In addition, during 2003 we increased the harvest ratio used in calculating the expense for the 2002-2004 performance period which also contributed to the increase in expense for the year. In 2004 we expect the performance unit plan expense to increase over 2003 as there will be an additional accrual for the 2004-2006 performance period. In addition, as our results evolve, we may need to increase or decrease our harvest ratio used in the expense calculation which could either reduce or increase the PUP expense. The fluctuation of our share price also affects the calculation of the expense.
Other factors could also affect the expense ratio, including the mix of business written and the amount of acquisition costs incurred.
Net investment income for the years ended December 31, 2003 and 2002 was $50.1 million and $39.7 million, respectively. Net investment income was primarily composed of interest on coupon-paying bonds and bank interest, partially offset by accretion of premium on bonds of $14.6 million and $3.8 million, respectively, and investment management and custodian fees of $3.2 million and $2.3 million, respectively, for the years ended December 31, 2003 and 2002. The investment management fees were paid to White Mountains Advisors LLC, a wholly-owned indirect subsidiary of White Mountains Insurance Group, one of our major shareholders. Management believes that the fees charged were consistent with those that would have been charged by a non-related party.
Based on the weighted average monthly investments held, and including net unrealized gains of $18.1 million and $33.6 million for the years ended December 31, 2003 and 2002, respectively, the total investment return was 4.0% and 7.0%, respectively. Net unrealized gains at December 31, 2003 included $20.7 million related to our investment in Aspen. In 2003 as expected, our total investment income increased as a result of our larger capital base but percentage returns have fallen as a result of lower interest rates. If interest rates remain stable, we expect investment income to increase in 2004 as average investment assets increase.
The performance results of our fixed maturity portfolio, with a comparison to the Lehman Brothers Government/Credit 1-5 Year Index combined with the 1-3 month Treasury Bill rate, for the year ended December 31, 2003 was as follows:
(1) Total return is calculated by dividing total net investment income on fixed maturity investments by the monthly average of the sum of such investments at amortized cost in 2003.
We did not experience any other-than-temporary impairment charges relating to our portfolio of investments for the years ended December 31, 2003 or 2002.
On August 4, 2003, the Company issued $250.0 aggregate principal amount of senior unsecured debt (the “Senior Notes”) at an issue price of $99.517. The Senior Notes bear interest at a rate of 6.125%, payable semi-annually in arrears on February 15 and August 15 of each year, beginning on February 15, 2004. Interest expensed during the year represents interest from the date of issuance until December 31, 2003. We expect interest expense to be higher in 2004 than in 2003 as we will incur interest expense on the Senior Notes for the full year.
We paid interest expense for the year ended December 31, 2003 and 2002 of $2.8 million and $3.5 million, respectively which related to the term loan facility and revolving loan facility only. The term loan facility and revolving credit facility were repaid and terminated during 2003.
Comprehensive income for the years ended December 31, 2003 and 2002 was $ 425.3 million and $185.7 million respectively, which includes the $407.2 million and $152.0 million of net income described above, $18.2 million and $33.7 million, respectively, of net change in unrealized gains on investments and currency translation adjustments.
The Company’s shareholders’ equity at December 31, 2003 was $1,657.7 million, of which $473.6 million was retained earnings. The Company’s capital base has grown since December 31, 2002 primarily as a result of
an increase in net premiums earned, the low level of losses incurred and the increase in capital resulting from the net proceeds from the issuance of $250.0 million in Senior Notes as described below.
We previously maintained two senior credit facilities with a syndicate of commercial banks. The credit facilities consisted of a 364-day revolving credit facility with a $50.0 million borrowing limit and a three-year term loan facility with a $150.0 million aggregate borrowing limit. The $50.0 million revolving credit facility was set to renew in December, 2003. On August 4, 2003, using the proceeds from the issuance of $250.0 million in Senior Notes (see below), we repaid the $150.0 million outstanding under this facility and cancelled the revolving credit facility. These credit facilities contained various restrictions and covenants, which were all met during the time that the facilities were in place. In order to hedge the interest rate risk of the loan, we had entered into an interest rate swap contract, which became effective April 22, 2003 and was scheduled to expire on December 12, 2004, the maturity date of the term loan facility. The swap contract was cancelled simultaneously with the repayment of the term loan facility, resulting in a realized loss on termination of $1.0 million which is included in realized gains (losses) on investments.
In the normal course of business, the Company provides security to reinsureds as required under contract provisions. Such security takes the form of a letter of credit. Letters of credit are issued by a bank at the request of the Company. In order for Montpelier Re to write Lloyd’s Qualifying Quota Share business, it must provide a letter of credit in favor of The Society and Council of Lloyd’s (“Lloyd’s”) in accordance with Lloyd’s rules. Previously Montpelier Re had arrangements with Fleet National Bank for the provision of a standby letter of credit in a form acceptable to Lloyd’s in an amount of up to $250.0 million which was superseded by the Letter of Credit Reimbursement and Pledge Agreement discussed below. Letters of credit outstanding under this Fleet facility at December 31, 2002 were approximately $99.9 million and were secured by investments of approximately $107.5 million.
The Company made arrangements with Barclay’s Bank PLC for the provision of an additional letter of credit facility in favor of certain U.S. ceding companies in an amount of up to $50.0 million. Letters of credit outstanding at December 31, 2003 and 2002 under the Barclay’s facility were approximately $1.4 million and $19.9 million and were secured by cash and investments of approximately $1.5 million and $20.3 million, respectively. This facility was cancelled on January 31, 2004.
Bermuda law limits the maximum amount of annual dividends or distributions payable by Montpelier Re to us and in certain cases requires the prior notification to, or the approval of, the Bermuda Monetary Authority.
Because a significant portion of our contracts provide short-tail reinsurance coverage for damages resulting mainly from natural and man-made catastrophes, it is possible that we could become liable for a significant amount of losses on short notice. Accordingly, we have structured our investment portfolio to preserve capital and provide us with a high level of liquidity, which means that the large majority of our investment portfolio contains shorter term fixed maturity investments, such as U.S. government and agency bonds, corporate debt securities and mortgage-backed and asset-backed securities.
The market value of our portfolio of fixed maturity investments comprises U.S. government and agency bonds (71%), investment grade corporate debt securities (21%) and mortgage-backed and asset-backed securities (8%). All of the fixed maturity investments currently held by us were publicly traded at December 31, 2003. Based on the weighted average monthly investments held, and including unrealized gains, our total return for the year ended December 31, 2003 was 4.0%. This return was principally due to the unrealized gain on our investment in Aspen at December 31, 2003 of $20.7 million. The average duration of our invested asset portfolio was 2.1 years and the average rating of the portfolio was AA+ at December 31, 2003. If the right conditions arise in 2004, we may deploy a further limited amount of capital to strategic investments or investment classes other than fixed income.
Significant assumptions are required to be made when establishing loss reserves. For additional information concerning loss and loss adjustment expenses see the Summary of Critical Accounting Policies section earlier in Item 7.
Our liquidity depends on operating, investing and financing cash flows as described below.
We have written certain business that has loss experience generally characterized as having low frequency and high severity. This may result in volatility in both the Company’s results and operational cash flows. The potential for a large claim under one of our insurance or reinsurance contracts means that substantial and unpredictable payments may need to be made within relatively short periods of time. As a result, cash flows from operating activities may fluctuate, perhaps significantly, between individual quarters and years.
We intend to manage these risks by structuring our investments in an effort to anticipate the payout patterns of our liabilities under insurance or reinsurance policies. No assurance can be given, however, that we will successfully match the structure of Montpelier Re’s investments with its liabilities under insurance or reinsurance contracts. If our calculations with respect to these reinsurance liabilities are incorrect, or if we improperly structure our investments to match such liabilities, we could be forced to liquidate investments prior to maturity, potentially at a significant loss.
The estimated fair value of fixed maturity, equity, other investments and our cash and cash equivalents balance was $2,237.7 million as of December 31, 2003, compared to $1,581.5 million at December 31, 2002. The primary cause of this increase was the receipt of $643.0 million in premiums net of acquisition costs, the receipt of net cash of $98.8 million from the issuance of the Senior Notes and the repayment of our term-loan facility, net investment income of $50.0 million and the increase in net unrealized gains on investments of $18.2 million during the year.
In the third quarter of 2003, we leased additional office space in Bermuda. Approximately $0.5 million in related costs were incurred for the year ended December 31, 2003, the majority of which were capitalized.
For the period from inception until December 31, 2003, we have had sufficient cash flow from operations to meet our liquidity requirements. We have generated cash flows from operations in 2003 and 2002 significantly in