Cash dividends per ordinary share for 1999 have not been adjusted for the pooling effect of NAC.
The property and casualty insurance and reinsurance markets have historically been cyclical meaning that based on market conditions, there have been periods where premium rates are high and policy terms and conditions are more favorable (a “hard market”) to the Company and then there have been periods where premium rates decline and policy terms and conditions are less favorable (a “soft market”) to the Company. This has been driven primarily by competition in the marketplace, the supply of capital in the industry, investment yields and the frequency and severity of loss events. Management’s goal is to build long-term shareholder value by capitalizing on current opportunities and managing through any potential downward cycles by reducing property and casualty premiums written and exposures if and when rates deteriorate to unprofitable levels for the Company. As part of its strategy, the Company also looks to its financial products and services segment to provide a diversified stream of earnings that are not directly tied to the property and casualty cycle. In this regard, the Company’s financial guarantee insurance and reinsurance operations have substantially achieved relative trading parity with its peers.
The Company also generates revenue from investment activities through returns on its investment portfolio. The Company’s current investment strategy seeks to maximize investment returns balancing market and credit risk relative to the Company’s business objective of stable earnings growth and growth in long-term book value. In addition, at this stage of the interest cycle, the Company has reduced its duration of the general account portfolio from 3. 5 years as at December 31, 2002 to 3.3 years as at December 31, 2003. For the three years ended December 31, 2003, there have been declines in interest rates that have negatively impacted the Company’s investment interest income. Investment interest income was under continued pressure in 2003 and continues to be under pressure due to the low interest rate environment. In 2003, the Company generated net realized gains from both its equity and fixed income portfolios reflecting the overall improvement in capital markets and narrowing of credit spreads. The Company incurred net realized losses on its investments in 2002 resulting primarily from a high level of corporate defaults. The Company expects investment interest income to rise moderately in 2004 supported by positive cash flow from operations.
Management continues to focus heavily on the Company’s financial strength and claims paying ratings because the Company’s ability to write business is dependent on the quality of these ratings. Management seeks to maintain a strong financial strength and claims paying ratings, relative to its competitors. As noted above, the Company’s results were significantly impacted in the second half of 2003 by prior period adverse development mainly from its North American casualty reinsurance business written in the 1997 through 2001 underwriting years and, accordingly, some of the Company’s ratings have been downgraded. The Company currently anticipates it will raise additional capital of approximately $750 million in the first half of 2004 in the form of mandatory convertible securities. The Company currently anticipates that it will be able to successfully raise this capital, however, if the Company does not achieve this, it is likely that the Company’s ratings could be lowered further which could trigger downgrade provisions contained in the Company’s various capital and credit facility documents as well as impact the ability of the Company to write new business.
As noted above, in the three years ended December 31, 2003 the Company has experienced pricing increases and improved terms and conditions across most of the lines of business it writes, notably in casualty and aviation lines. This is discussed further within the segments below.
As at December 31, 2003 and 2002, the Company’s reported claims for its high layer excess casualty business were 32 and 31 shock losses, 57 and 51 non-shock losses and 84 and 63 professional liability losses, respectively.
The Company enters into credit derivatives in connection with its financial guaranty business and the Company intends to hold these contracts to maturity. In determining fair value, management differentiates between investment and non-investment grade exposures and models them separately.
The loss ratio was lower in the year ended December 31, 2002 as compared to 2001 due primarily to a relatively lower level of current year loss activity in 2002 and the positive effect of pricing increases across most lines written. Current year loss activity in 2001 included $442.1 million of net losses incurred relating to the September 11 event.
The Company believes it has made reasonable provision for its asbestos and environmental exposures and is unaware of any specific issues that would significantly affect its estimate for loss and loss expenses.
In 2002, acquisition costs as a percentage of net premiums earned increased as compared to 2001, due to an increase in ceding commissions paid, lower reinsurance commissions received and increased amortization of deferred underwriting expenses.
Gross and net premiums written and earned in 2003 and 2002 related to certain blocks of U.S based term life mortality reinsurance business written that were novated to the Company from an insurance affiliate in December 2002. Claims and policy benefits from this book of business are in line with the management’s expectations.
Premiums are earned on a pro-rata basis over the period the coverage is provided. Financial guaranty insurance premiums are earned over the life of the exposure. Unearned premiums represent the portion of premiums written applicable to the unexpired terms of policies in force. Net premiums earned are presented after deductions for reinsurance ceded, as applicable.
Cash equivalents include fixed interest deposits placed with a maturity of under 90 days when purchased.
Reinsurance general business written includes treaty and facultative reinsurance to primary insurers of casualty and property risks, principally: general liability; professional liability; accident and health; automobile and workers compensation; commercial and personal property risks; specialty risks including fidelity and surety and ocean marine; property catastrophe; property excess of loss; property pro-rata; marine and energy; aviation and satellite; and various other reinsurance to insurers on a worldwide basis. The Company’s reinsurance life business is primarily European term assurance, group life, critical illness cover, immediate annuities in payment and disability income business.
Financial products and services businesses include insurance, reinsurance and derivative solutions for complex financial risks. These include financial guaranty insurance and reinsurance, credit enhancement swaps, other collateralized transactions, weather and energy risk management products and institutional life insurance products. While each of these is unique and is tailored for the specific needs of the insured or user, they are often multi-year contracts. Due to the nature of these types of contracts, premium volume as well as underwriting results can vary significantly from period to period. The financial products and services life business written includes funding agreements, municipal guaranteed reinvestment contracts and highly structured life co/reinsurance transactions.
The Company’s significant financial affiliate investments at December 31, 2003 included Primus Guaranty, Ltd. and FSA International with ownership in those entities of 43.0% and 20.0% respectively.
In June 2003, the Company renewed its principal revolving credit and letter of credit facility. The facility was increased from $2.0 billion to $2.5 billion of which up to $675 million is available as revolving credit and up to $2.3 billion is available in the form of letters of credit, with the combined total not to exceed $2.5 billion. As at December 31, 2003 approximately $1.6 billion of this facility was in use in the form of letters of credit.
Credit derivatives where the Company participates in the higher quality rated tranches are considered, in substance, financial guaranty transactions as the Company intends to hold them to maturity. The rated tranches are fair valued using changes in credit spreads to reflect current market conditions. The Company will also consider the characteristics and credit ratings of the underlying portfolio. The change in fair value recorded for the rated tranches was a gain of $2.8 million, a loss of $29.9 million, and a loss of $27.5 million for the years ended December 31, 2003, 2002 and 2001 respectively.
(2) Includes 14,818 options outstanding and exercisable, with an average exercise price of $37.49 that have no expiration date. These options are not included in the calculation of the average remaining contractual life.
In the second quarter of 2002, the Company recorded net losses and loss expenses incurred of approximately $200.0 million related to the September 11 event. The Company also recorded net realized losses on investments of $110.0 million.