In 2004 and 2005, market conditions weakened following hard market conditions that had developed from 2000 through 2003. Pricing for most property and casualty classes declined modestly. Competition increased modestly as well, in part due to the relative profitability achieved by many reinsurers from 2002 through 2004, the attendant buildup of capital by these participants and growing pressures to effectively redeploy this capital. However, this profitability and capital buildup varied significantly by market participant, reflecting the fact that the industry was impacted by significant catastrophe losses in the second halves of both 2005 and 2004, generally weak investment market conditions and ongoing adverse loss development. All of these factors depressed the industry’s aggregate financial performance and perceptions of individual insurer’s financial strength during the period.
The Company notes that it continues to see opportunities for profitable writings in a variety of classes and lines owing mainly to the general adequacy of underlying pricing. However, the Company continues to examine its view of price adequacy for property lines in light of 2005‘s unprecedented catastrophe experience from both a frequency and severity perspective. This reexamination is focused on several key factors including the
The Company’s management monitors and evaluates overall Company performance based upon financial results. The following table displays a summary of the consolidated net income for the periods indicated:
Overall the Company was disappointed with its 2005 results. The Company generated income of $4.7 million, which was $170.8 million less than 2004‘s net income of $175.5 million. This $170.8 million decrease was principally driven by $576.7 million of higher pre-tax catastrophe losses, which were partially offset by $353.6 million of improved non-catastrophe prior year reserve development year over year. The Company incurred $833.0 million of pre-tax catastrophe losses in 2005 driven extensively by Hurricanes Katrina, Rita and Wilma. These three devastating events resulted in the worst catastrophe loss year in history for both the insurance industry and the Company.
Catastrophe risk is a fundamental risk element to which the Company is exposed. The Company’s risk management framework considers such exposures carefully. As a consequence of the 2005 catastrophe
Meanwhile, the Company is well positioned to respond to generally improving market conditions in 2006 in the aftermath of unprecedented catastrophe losses in late 2005. First, the Company’s non-catastrophe operating fundamentals remain very strong. Second, the Company’s broad and diversified business and low-cost operating platform provide a wide spectrum of opportunities in a variety of product classes and markets. Lastly, the discipline with which the Company approaches its business remains intact, causing it to look opportunistically at improving market conditions while providing its underwriters with the flexibility to decline business that does not meet its objectives regarding underwriting profitability.
Additionally, in order to provide comparability of the financial results between the years, the 2004 results were adjusted to exclude the non-recurring impact associated with the UK Branch Sale. As a result of that adjustment, net written premiums would decrease by $139.8 million and premiums earned, incurred losses and LAE and underwriting expenses would decrease by $118.8 million, $118.6 million and $30.9 million, respectively. This adjusts the operating results for the year ended December 31, 2004 to exclude the one-time effects related to the sale.
The following table reflects the reconciliation from reported to proforma for the period indicated:
Revenues. Gross written premiums decreased 12.6% to $3.3 billion in 2005 from $3.8 billion in 2004, reflecting the Company’s disciplined response to modest market softening in most sectors, particularly earlier in the year. The Company adapted its operations to slow its growth and even decrease writings for some classes of business and reemphasize its focus on profitability as opposed to volume. The classes most affected by these actions were workers’ compensation insurance, individual risk (re)insurance, medical stop loss reinsurance and select U.S. casualty reinsurance classes. As a result, the U.S. Insurance segment decreased 20.2% due to declines in its predominant workers’ compensation book, while the reinsurance segments declined 9.3% in the aggregate.
Net written premiums declined 14.2% to $2.4 billion in 2005 as compared to $2.8 billion in 2004, which was consistent with the decrease in gross written premiums. Net earned premiums declined 10.5% to $2.4 billion in 2005 as compared to $2.7 billion in 2004.
Net investment income was $325.2 million in 2005, a decrease of 1.2% compared with 2004, primarily due to lower returns from the Company’s equity investments in limited partnerships. The Company’s invested asset base at year-end 2005 was $7.9 billion, up $0.4 billion over the prior year, which was mainly driven by cash flow from operations, partially offset by $250.0 million of senior debt repayment in 2005. Cash flows, which have been trending down over the past two years due to increased catastrophe losses and reduced premiums written, remain strong and are reflective of strong operating fundamentals.
Other expenses decreased by $81.4 million in 2005, primarily as a result of decreased deferrals on the retroactive reinsurance agreements with affiliates.
Expenses. Incurred losses and LAE for 2005 were $2.2 billion, an increase of $0.1 billion over 2004, principally related to $0.6 billion higher level of catastrophe losses, partially offset by a $0.4 billion decrease in non-catastrophe prior period reserve adjustments and lower earned premiums. The Company’s non-catastrophe incurred losses were down 23.8% in 2005. The Company’s 2005 incurred losses benefited from $67.3 million of favorable prior period reserve adjustments in 2005, comprised of $156.3 million of favorable reserve development on non-catastrophe, non-A&E reserves, principally related to property business classes, partially offset by catastrophe reserve development of $77.6 million, mostly from 2004 Florida hurricane events and A&E development of $11.5 million.
Commission, brokerage and tax expenses for 2005 were $513.4 million, a decrease of $33.1 million compared to 2004, principally reflecting decreases in premium volume and changes in business mix. However, the Company’s commission expense ratio increased by 1.0 point, primarily due to an increase in contingent commissions and premium based taxes. Other underwriting expenses for 2005 were $100.1 million, a $15.5 million increase, principally reflective of the continued build-out of the U.S. Insurance platform.
The Company generated net income of $4.7 million in 2005 compared to net income of $175.5 million in 2004. This $170.8 million deterioration in 2005 was principally driven by $576.7 million of higher pre-tax catastrophe losses, tempered somewhat by improved non-catastrophe prior year reserve development of $353.6 million.
These segments are managed in a carefully coordinated fashion with strong elements of central control, with respect to pricing, risk management, monitoring aggregate exposures to catastrophic events, capital, investments and support operations. Management generally 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
The following table reflects the reconciliation from reported to proforma for the International segment for the period indicated:
Underwriting (loss) gain $ (355,705 ) $ (89,910 ) $ 11,533
Premiums Written. Gross written premiums decreased 12.6% to $3,339.9 million in 2005 from $3,820.7 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 U.S. Reinsurance operation decreased 6.2% ($92.0 million), principally related 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.
Net written premiums decreased by 14.2% to $2,395.7 million in 2005 from $2,793.0 million in 2004, reflecting the decrease in gross written premiums, combined with a slightly smaller decrease in ceded premiums.
Premium Revenues. Net premiums earned decreased by 10.5% to $2,426.1 million in 2005 from $2,710.3 million in 2004. Contributing to this decrease was a 37.0% ($132.1 million) decrease in the Specialty Underwriting operation, a 12.3% ($89.9 million) decrease in the U.S. Insurance operation and 6.5% ($74.9 million) decrease in the U.S. Reinsurance operation, partially offset by a 2.6% ($12.4 million) increase in the International operation. Partially tempering the decline in net premiums earned in 2005 were $52.5 million of reinstatement premiums of which $40.5 million were due to Hurricanes Katrina and Wilma. Generally, catastrophe reinsurance provides coverage for one event; however, when limits are exhausted, some contractual arrangements provide for the availability of additional coverage upon the payment of additional premium. This additional premium is referred to as reinstatement premium. There were no such reinstatement premiums for 2004. These net premiums earned reflect period to period changes in net written premiums and business mix, together with normal variability in earnings patterns. Business mix changes occur not only as the Company shifts emphasis between products, lines of business, distribution channels and markets, but also as individual contracts renew or non-renew, almost always with changes in coverage, structure, prices and/or terms, and as new contracts are accepted with coverages, structures, prices and/or terms different from those of expiring contracts. As premium reporting, earnings, loss and commission characteristics derive from the provisions of individual contracts, the continuous turnover of individual contracts, arising from both strategic shifts and day to day underwriting, can and does introduce appreciable background variability in various underwriting line items. Changes in estimates related to unreported reinsurance activity may also affect premiums earned.
The following table shows the loss ratios for each of the Company’s operating segments for the years ended December 31, 2005 and 2004. The loss ratios for all operations were impacted by the factors noted above.
The segment components of the increase in incurred losses and LAE in 2005 from 2004 were a 29.3% ($92.8 million) increase in the International operation and a 21.8% ($205.0 million) increase in the U.S. Reinsurance operation, partially offset by a 23.2% ($125.4 million) decrease in the U.S. Insurance operation and a 9.4% ($23.3 million) decrease in the Specialty Underwriting operation. These changes reflect variability in premiums earned and changes in the loss expectation assumptions for business written, as well as the net prior period reserve development and catastrophe losses discussed below. Incurred losses and LAE for each operation were
also impacted by changes in the pricing of the underlying business, as well as variability relating to changes in the mix of business by class and type.
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. The Company defines a catastrophe as a property event with expected reported losses of at least $5.0 million before corporate level reinsurance and taxes. Effective for the third quarter 2005, industrial risk losses have been excluded from catastrophe losses with prior periods adjusted for comparison purposes. Catastrophe losses, net of contract specific cessions, were $833.0 million in 2005, related principally to aggregate estimated losses driven by Hurricanes Katrina, Rita and Wilma with catastrophe losses of $406.7 million, $74.4 million and $236.0 million, respectively, but also reflected catastrophe losses related to Hurricanes Emily ($14.9 million) and Dennis ($5.3 million), floods in India ($9.9 million) and Calgary ($3.6 million) and storms in Ontario ($4.9 million). The 2005 results also reflect net unfavorable reserve development on 2004 and prior catastrophes of $77.6 million. Catastrophe losses, net of contract specific cessions, were $256.3 million in 2004, related principally to aggregate estimated losses of $290.9 million from Hurricanes Charley, Frances, Ivan and Jeanne, Pacific typhoons, Edmonton hailstorms and the Asian tsunami, which were partially offset by $32.7 million of reserve reductions related to the 2001 World Trade Center losses.
Net favorable prior period reserve adjustments for the year ended December 31, 2005 were $67.3 million compared to net unfavorable prior period reserve adjustments of $174.2 million in 2004. For the year ended December 31, 2005, the favorable reserve adjustments included net favorable non-A&E, non-catastrophe reserve adjustments of $156.3 million related primarily to property business classes, partially offset by net unfavorable prior period catastrophe adjustments of $77.6 million related primarily to the 2004 hurricanes and
The U.S. Reinsurance segment accounted for $24.7 million of net unfavorable prior period reserve adjustments for the year ended December 31, 2005, which included $54.3 million of unfavorable catastrophe prior period reserve adjustments, partially offset by favorable net non-A&E, non-catastrophe reserve adjustments of $41.0 million. Net unfavorable prior period reserve adjustments were $103.4 million for the year ended December 31, 2004, which included $127.9 million of unfavorable non-A&E, non-catastrophe prior period reserve adjustments, partially offset by $34.8 million of favorable development primarily due to reserve reduction related to catastrophe losses from the 2001 World Trade Center losses. Asbestos exposures accounted for $11.5 million and $10.3 million of unfavorable reserve adjustments for the years ended December 31, 2005 and 2004, respectively. The non-A&E unfavorable development is primarily the result of a proliferation of claims related to bankruptcies and other financial management improprieties during the late 1990s and early 2000s. This increased number of claims, combined with larger claims, has significantly increased incurred losses on the professional liability policies. In the general casualty area, the Company continues to experience losses greater than historical trends for accident years 1998 through 2001. These losses are being driven by adverse trends in litigation and economic variability.
In all cases, the prior period reserve development, sometimes referred to as reserve strengthening, reflects management’s judgment as to the implications of losses and claim information reported during the period on the Company’s reserve balances.
Underwriting Expenses.The Company’s expense ratio, which is calculated by dividing underwriting expenses by net premiums earned, was 25.3% in 2005 compared to 23.3% in 2004.
Segment underwriting expenses decreased by 4.1% to $607.2 million in 2005 from $633.1 million in 2004. Commission, brokerage, taxes and fees decreased by $33.1 million, principally reflecting decreases in premium volume and changes in the mix of business. Segment other underwriting expenses increased by $7.2 million as the Company continued to expand operations. Contributing to the segment underwriting expense decreases were a 38.8% ($39.4 million) decrease in the Specialty Underwriting operation, a 4.7% ($14.0 million) decrease in the U.S. Reinsurance operation and a 0.7% ($0.8 million) decrease in the International operation, partially offset by a 24.5% ($28.4 million) increase in the U.S. Insurance operation. The changes for each operation’s expenses principally resulted from changes in commission expenses related to changes in premium volume and business mix by class and type and, in some cases, changes in the use of specific reinsurance, as well as the underwriting performance of the underlying business.
The Company’s combined ratio, which is the sum of the loss and expense ratios, increased by 17.0 percentage points to 116.1% in 2005 as compared to 99.1% in 2004, with the increase principally resulting from elevated catastrophe losses, partially offset by improved prior year development.
Income Taxes. The Company’s income tax expense is primarily a function of the U.S. statutory tax rate and the impact from tax preferenced investment income. The Company recognized income tax benefits of $70.2 million in 2005, primarily due to the significant incurred losses relating to catastrophes resulting, ultimately, in a pre-tax loss for the year. The Company recognized an income tax expense of $56.1 million in 2004, reflecting pre-tax income of $231.6 million and the impact of various tax issues giving rise to net tax expenses in conjunction with the transfer of the Company’s UK branch to Bermuda Re.
Net Income. Net income was $4.7 million in 2005 compared to net income of $175.5 million in 2004, with the change primarily reflecting reduced underwriting profitability due to catastrophe losses, partially offset by favorable prior period reserve development and related tax benefits.
Premiums Written. Gross written premiums decreased 0.8% to $3,820.7 million in 2004 from $3,850.1 million in 2003, reflecting increased competitive pressures on pricing, particularly on U.S. Reinsurance property and casualty classes of business. Adjusting to these market conditions, the U.S. Reinsurance operation decreased 15.6% ($274.1 million), principally relating to a $142.5 million decrease in treaty casualty business, a $74.9 million decrease in facultative business, a $32.6 million decrease in treaty property business and a $19.8 million decrease in treaty non-property business. The Specialty Underwriting operation decreased 3.1% ($15.8 million), resulting primarily from a $70.4 million decrease in A&H business, partially offset by an increase in surety business of $29.6 million and an increase in marine and aviation business of $25.0 million. Partially offsetting these decreases were areas where the company continued to grow. The International operation saw a 30.9% ($162.2 million) increase, primarily due to a $97.7 million increase in international business written through the Miami and New Jersey offices, representing primarily Latin American business, and a $67.2 million increase in Asian business. The U.S. Insurance operation grew 9.2% ($98.3 million), principally as a result of a $193.8 million increase in program business other than workers’ compensation, partially offset by a $95.5 million decrease in workers’ compensation business.
Incurred Losses and LAE. Incurred loss and LAE increased by 14.3% to $2,053.8 million in 2004 from $1,796.9 million in 2003. The increase in incurred losses and LAE was principally attributable to the provision for estimated catastrophe losses from Hurricanes Charley, Frances, Ivan and Jeanne, the Pacific typhoons, the Asian tsunami and the net reserve adjustments for prior period losses, together with the mitigating effects of the impact of favorable changes in the Company’s underlying business mix and aggregate rates, terms and conditions. Incurred losses and LAE in 2004 reflected ceded losses and LAE of $789.6 million compared to ceded losses and LAE in 2003 of $688.8 million. Ceded losses and LAE in 2004 included $480.2 of ceded losses relating to the quota share reinsurance transactions noted earlier between Everest Re and Bermuda Re and Everest International as compared with ceded losses of $422.9 million for 2003. The ceded losses and LAE for 2003 included $85.0 million of losses ceded under the 2000 accident year aggregate excess of loss component of the Company’s corporate retrocessional program and $81.1 million under an aggregate excess of loss reinsurance agreement provided by LM Property and Casualty Insurance Company (“LM”). The Prudential continues to guarantee LM’s obligation under this agreement. Cessions under this reinsurance agreement exhausted the limit available under the contract at December 31, 2003.
The segment components of the increase in incurred losses and LAE in 2004 from 2003 were a 42.2% ($94.0 million) increase in the International operation, a 23.9% ($182.7 million) increase in the U.S. Reinsurance operation and a 3.9% ($20.4 million) increase in the U.S. Insurance operation. These increases were partially offset by a 13.9% ($40.2 million) decrease in the Specialty Underwriting operation. These changes reflect variability in premiums earned and changes in the loss expectation assumptions for business written, as well as the net prior period reserve development and catastrophe losses discussed below. Incurred losses and LAE for each operation were also impacted by generally improved pricing of the underlying business, as well as variability relating to changes in the mix of business by class and type, which in general reflected a more favorable mix.
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 IBNR reserve offsets. The Company defines a catastrophe as a property event with expected reported losses of at least $5.0 million before corporate level reinsurance and taxes. Effective in 2005, industrial risk losses were excluded from catastrophe losses. As such, prior periods were adjusted for comparison reasons. Catastrophe losses, net of contract specific cessions and the inter-affiliate quota share reinsurance described above, were $256.3 million in 2004, related principally to aggregate estimated losses of $290.9 million from Hurricanes Charley, Frances, Ivan and Jeanne, Pacific typhoons, Edmonton hailstorms and the Asian tsunami, which were partially offset by $32.7 million of reserve reductions related to the 2001 World Trade Center events. Catastrophe losses, net of contract specific cessions and the inter-affiliate quota share reinsurance described above, were $20.1 million in 2003, relating principally to the May 2003 tornado and hailstorm events and Hurricanes Fabian and Isabel.
The U.S. Reinsurance segment accounted for $103.4 million of net unfavorable prior period reserve adjustments for the year ended December 31, 2004, which included $34.2 million of favorable development due to the reserve reduction related to the catastrophe losses from the 2001 World Trade Center events, as compared to net unfavorable prior period reserve adjustments of $150.9 million for the year ended December 31, 2003. Asbestos exposures accounted for $10.3 million and $16.8 million of unfavorable reserve adjustments for the years ended December 31, 2004 and 2003, respectively, with the remainder principally attributable to professional liability and casualty business classes. During the late 1990s and early 2000s, there had been a proliferation of claims relating to bankruptcies and other financial management improprieties. This increased number of claims, combined with larger claims, has significantly increased incurred losses on the professional liability policies. In the general casualty area, the Company continues to experience losses greater than historical trends for accident years 1998 through 2001. These losses are being driven by adverse trends in litigation and economic variability. In both the professional liability and general casualty reinsurance areas, the Company relies upon loss reports from ceding companies. Although the Company may record reserves at higher levels than those reported by ceding companies, actual reported results have exceeded the initial loss indications.
The U.S. Insurance segment reflected $54.0 million and $58.7 million of net unfavorable prior period reserve adjustments for the years ended December 31, 2004 and 2003, respectively. The unfavorable prior period reserve adjustments were principally due to accident years 2000 through 2002, where the Company strengthened its reserves for California workers’ compensation insurance. This was a relatively new book of business and was written in a challenging political and economic environment. While management believes that cumulative results through 2004 remained quite positive, there had been some deterioration in claim frequency and severity related to accident years 2001 and 2002.
Segment underwriting expenses increased by 3.7% to $633.1 million in 2004 from $610.8 million in 2003. Commission, brokerage, taxes and fees increased by $12.2 million, principally reflecting increases in premium volume and changes in the mix of business. Segment other underwriting expenses increased by $10.1 million as the Company continues to expand operations to support its increased business. Contributing to the segment underwriting expense increases were a 53.4% ($41.0 million) increase in the International operation and a 4.8% ($13.7 million) increase in the U.S. Reinsurance operation, which were all partially offset by a 18.9% ($27.0 million) decrease in the U.S. Insurance operation and a 5.1% ($5.4 million) decrease in the Specialty Underwriting operation. The changes for each operation’s expenses principally resulted from changes in commission expenses related to changes in premium volume and business mix by class and type and, in some cases, changes in the use of specific reinsurance, as well as the underwriting performance of the underlying business.
Net realized capital gains were $56.7 million in 2004, reflecting realized capital gains on the Company’s investments of $107.4 million, including $77.6 million on the sale of interest only strip investments. This was partially offset by $50.7 million of realized capital losses, which included $43.9 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 EITF 99-20. Net realized capital losses of $22.9 million in 2003 reflected realized capital losses on the Company’s investments of $51.5 million, which included $16.4 million relating to write-downs in the value of securities deemed to be impaired on an other than temporary basis and $25.2 million related to the impairment on interest only strips, partially offset by $28.6 million of realized capital gains, which included $12.5 million of realized capital gains on sales of the interest only strips.
Other Expense. Other expense was $73.4 million and $14.0 million in 2004 and 2003, respectively. This change was primarily due to increased deferrals on the retroactive reinsurance agreements with affiliates for asbestos reserve strengthening.
Interest expense in 2004 was $75.5 million compared to $57.3 million in 2003. Interest expense in 2004 included $42.0 million related to the senior notes, $32.4 million related to the junior subordinated debt securities and $1.2 million related to borrowings under the Company’s revolving credit facility. Interest expense in 2003 reflected $38.9 million related to the issuance of the senior notes, $17.0 million related to the junior subordinated debt securities and $1.4 million related to borrowings under the Company’s revolving credit facility. The increase in interest expense in 2004 was due to the additional issuance of $320 million of junior subordinated debt securities in March 2004 and the issuance of $250 million of senior notes in October 2004.