The Company has generally been disappointed by industry developments in 2005 and 2004, which have operated to modestly weaken pricing in most business classes and lines. However, 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. The Company cannot predict with any reasonable certainty whether and to what extent these trends or conditions will persist. In particular, the extent to which the cumulative effect of a weakening pricing environment will impact Company operations is unclear. Additionally, the continued growth of reinsurance capacity, particularly in Bermuda, changes in the Lloyd’s market, and the potential reemergence of a market share orientation among some industry participants, combined with improving and in some cases strong financial results, continue to contribute to uncertainty about the prospective level of competitive pressures.
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:
As indicated in the preceding “Industry Conditions” section, the reinsurance and insurance industry generally experienced favorable market conditions from 2001 through 2003. These favorable market conditions coupled with the Company’s financial strength, strategic positioning and market and underwriting expertise, enabled the Company to increase its volume of business significantly over this period. With the change in trend established in 2004 and continuing in
2005, the Company continued to adapt its operations to slow its rate of 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 underwritten insurance and reinsurance, medical stop loss reinsurance, UK motor business reinsurance and select U.S. casualty reinsurance classes.
Accordingly, gross written premiums for the three months ended March 31, 2005 were $1.0 billion, a decrease of 14.5% compared with $1.2 billion for the three months ended March 31, 2004, which had increased 22.3% compared with the three months ended March 31, 2003.
Due to the nature of its businesses, the Company is unable to precisely differentiate between the effects of price changes as compared to the effects of changes in exposure. Similarly, because individual reinsurance arrangements often reflect revised coverages, structuring, pricing, terms and/or conditions from period to period, the Company is unable to differentiate between the premium volumes attributable to new business as compared to renewal business. Management believes, however, that the Company’s gross written premium decline has been primarily due to a reduction in exposures underwritten, along with slight pricing declines. Management believes further that market conditions, although changing, remain generally more favorable for casualty business classes than for property business classes; however, management notes that it continues to see business opportunities in a variety of product classes and markets. The Company continues to decline business that does not meet its objectives regarding underwriting profitability.
Net written premiums, comprised of gross written premiums less ceded premiums, were $1.0 billion for the three months ended March 31, 2005, a decrease of 14.1% compared with $1.2 billion for the three months ended March 31, 2004, which had increased 23.7% compared with the three months ended March 31, 2003. These reflect premiums ceded of $35.9 million (3.4% of gross written premiums) and $46.9 million (3.8% of gross written premiums) for the three months ended March 31, 2005 and 2004, respectively. Ceded premiums relate primarily to specific reinsurance purchased by the U.S. Insurance operation.
Premiums earned were $1.0 billion for the three months ended March 31, 2005, a decrease of 4.7% compared with $1.1 billion for the three months ended March 31, 2004, which had increased 41.6% compared with the three months ended March 31, 2003. These movements reflect period to period changes in net written premiums and business mix together with normal variability in earning 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. Changes in estimates related to unreported reinsurance activity also affect premiums earned.
Incurred losses and LAE were $668.3 million for the three months ended March 31, 2005, a decrease of 6.1% compared with $711.5 million for the three months ended March 31, 2004, which had increased 38.6% compared with the three months ended March 31, 2003. The $43.3 million decrease in incurred losses and LAE was principally related to a decrease in net adverse prior period reserve adjustments to $22.2 million from $52.2 million for the three months ended March 31, 2005 as compared to the three months ended March 31, 2004, respectively. Other factors, including the level of incurred losses and LAE, related to changes in volume as measured
22
by earned premium; changes in rates and terms, as well as the effect of changes in prior period loss reserve estimates, also contributed.
Commission, brokerage and tax expense were $222.3 million and $222.8 million for the three months ended March 31, 2005 and 2004, respectively, decreasing slightly as a result of premium volume changes offset by the impact of changes in the Company’s business mix and an increase in premium based taxes.
Net investment income was $132.9 million for the three months ended March 31, 2005, an increase of 31.7% compared with $100.9 million for the three months ended March 31, 2004, which had increased 7.9% compared to the three months ended March 31, 2003. The increase was primarily due to the increase in investable assets, up $1.3 billion, or 12.6% at March 31, 2005 as compared to March 31, 2004 as well as $9.3 million of additional income from other asset investments.
Premiums are generally collected over the first 12 to 15 months of the Company’s reinsurance and insurance contracts, while related losses are typically paid out over numerous years. This tends to generate cash flow from operations along with investment income. The Company’s cash flow from operations was $325.2 million for the three months ended March 31, 2005, a decrease of 18.6% compared with $399.6 million for the three months ended March 31, 2004, which had increased 22.0% compared with the three months ended March 31, 2003. Cash flow from operations in the first quarter of 2005 was negatively impacted by an additional $84 million of catastrophe loss payments and $17 million of income tax payments period over period.
Net realized capital gains were $2.5 million for the three months ended March 31, 2005 reflecting normal portfolio management activities, compared to net realized capital losses of $34.9 million for the three months ended March 31, 2004. The realized losses for the three months ended March 31, 2004 were primarily the result of $65.3 million of write-downs in the value of securities deemed to be impaired on an other than temporary basis, partially offset by $30.4 million of realized gains.
The Company’s income tax expense is primarily a function of the statutory tax rates and corresponding net income in the jurisdictions where the Company operates, coupled with the impact from tax-preferenced investment income. Variations generally reflect changes in the relative levels of pre-tax income between jurisdictions with different tax rates. The Company incurred income tax expense of $26.5 million and $20.3 million for the three months ended March 31, 2005 and 2004, respectively. The increase in tax expense for the three months ended March 31, 2005 as compared to the three months ended March 31, 2004 primarily reflected the impact of taxable realized capital gains, increased investment income and deferred tax asset adjustments, partially offset by the decrease in 2005 underwriting results.
The increase in net income to $167.1 million from $126.1 million for the three months ended March 31, 2005 and 2004, respectively, generally reflected increased investment results and realized capital gains, offset by the modest decrease in underwriting results.
The Company’s shareholders’ equity increased to $3,755.7 million as of March 31, 2005 from $3,712.5 million as of December 31, 2004. The increase was primarily due to net income for the period, partially offset by a decrease of unrealized appreciation on the Company’s fixed maturity portfolio.
23
Segment Information
The Company, through its subsidiaries, operates in five segments: U.S. Reinsurance, U.S. Insurance, Specialty Underwriting, International and Bermuda. The U.S. Reinsurance operation writes property and casualty reinsurance, on both a treaty and facultative basis, through reinsurance brokers, as well as directly with ceding companies within the U.S. The U.S. Insurance operation writes property and casualty insurance primarily through general agent relationships and surplus lines brokers within the U.S. The Specialty Underwriting operation writes accident and health (“A&H”), marine, aviation and surety business within the U.S. and worldwide through brokers and directly with ceding companies. The International operation writes property and casualty reinsurance through Everest Re’s branches in Canada and Singapore, in addition to foreign business written through Everest Re’s Miami and New Jersey offices. The Bermuda operation provides reinsurance and insurance to worldwide property and casualty markets and reinsurance to life insurers through brokers and directly with ceding companies from its Bermuda office and property and casualty reinsurance to the United Kingdom and European markets through its UK branch.
These segments are managed in a carefully coordinated fashion with strong elements of central control, including with respect to capital, investments and support operations. As a result, management generally monitors and evaluates the financial performance of these operating segments based upon their underwriting gain (loss) or 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 ratios, which, respectively, divide incurred losses, commissions and brokerage and other underwriting expenses by earned premium. The Company utilizes inter-affiliate reinsurance but such reinsurance generally does not impact segment results, as business is generally reported within the segment in which the business was first produced.
The following tables present the relevant underwriting results for the operating segments for the periods indicated:
| U.S. Reinsurance | |
| Three Months Ended
March 31, |
(Dollars in thousands) | 2005 | | 2004 | |
|
|
|
| Gross written premiums | | | $ | 349,800 | | $ | 367,932 | |
| Net written premiums | | | | 349,493 | | | 357,885 | |
Premiums earned | | | $ | 340,109 | | $ | 362,387 | |
| Incurred losses and loss adjustment expenses | | | | 229,252 | | | 250,217 | |
| Commission and brokerage | | | | 79,492 | | | 97,908 | |
| Other underwriting expenses | | | | 5,713 | | | 5,727 | |
|
|
|
| Underwriting gain | | | $ | 25,652 | | $ | 8,535 | |
|
|
|
24
| U.S. Insurance | |
| Three Months Ended
March 31, |
(Dollars in thousands) | 2005 | | 2004 | |
|
|
|
| Gross written premiums | | | $ | 274,328 | | $ | 353,705 | |
| Net written premiums | | | | 243,720 | | | 317,745 | |
Premiums earned | | | $ | 223,781 | | $ | 218,599 | |
| Incurred losses and loss adjustment expenses | | | | 153,275 | | | 159,440 | |
| Commission and brokerage | | | | 38,749 | | | 22,403 | |
| Other underwriting expenses | | | | 12,100 | | | 11,125 | |
|
|
|
| Underwriting gain | | | $ | 19,657 | | $ | 25,631 | |
|
|
|
| Specialty Underwriting | |
| Three Months Ended
March 31, |
(Dollars in thousands) | 2005 | | 2004 | |
|
|
|
| Gross written premiums | | | $ | 102,991 | | $ | 122,057 | |
| Net written premiums | | | | 98,128 | | | 119,989 | |
Premiums earned | | | $ | 95,997 | | $ | 118,102 | |
| Incurred losses and loss adjustment expenses | | | | 63,776 | | | 73,998 | |
| Commission and brokerage | | | | 25,457 | | | 34,268 | |
| Other underwriting expenses | | | | 1,639 | | | 1,699 | |
|
|
|
| Underwriting gain | | | $ | 5,125 | | $ | 8,137 | |
|
|
|
| International | |
| Three Months Ended
March 31, |
(Dollars in thousands) | 2005 | | 2004 | |
|
|
|
| Gross written premiums | | | $ | 152,365 | | $ | 148,472 | |
| Net written premiums | | | | 151,924 | | | 147,918 | |
Premiums earned | | | $ | 152,445 | | $ | 142,541 | |
| Incurred losses and loss adjustment expenses | | | | 91,145 | | | 72,189 | |
| Commission and brokerage | | | | 34,436 | | | 29,663 | |
| Other underwriting expenses | | | | 2,987 | | | 2,718 | |
|
|
|
| Underwriting gain | | | $ | 23,877 | | $ | 37,971 | |
|
|
|
25
| Bermuda | |
| Three Months Ended
March 31, |
(Dollars in thousands) | 2005 | | 2004 | |
|
|
|
| Gross written premiums | | | $ | 168,088 | | $ | 232,727 | |
| Net written premiums | | | | 168,440 | | | 234,413 | |
Premiums earned | | | $ | 193,583 | | $ | 213,436 | |
| Incurred losses and loss adjustment expenses | | | | 130,806 | | | 155,684 | |
| Commission and brokerage | | | | 44,188 | | | 38,537 | |
| Other underwriting expenses | | | | 3,709 | | | 2,614 | |
|
|
|
| Underwriting gain | | | $ | 14,880 | | $ | 16,601 | |
|
|
|
The following table reconciles the underwriting results for the operating segments to income before tax as reported in the consolidated statements of operations and comprehensive income for the periods indicated:
| | Three Months Ended
March 31, |
| (Dollars in thousands) | 2005 | | 2004 | |
|
|
|
| Underwriting gain | | | $ | 89,191 | | $ | 96,875 | |
| Net investment income | | | | 132,886 | | | 100,897 | |
| Realized gain (loss) | | | | 2,477 | | | (34,908 | ) |
| Net derivative expense | | | | (1,221 | ) | | (3,752 | ) |
| Corporate (expenses) income | | | | (2,608 | ) | | 285 | |
| Interest expense | | | | (21,707 | ) | | (14,479 | ) |
| Other (expense) income | | | | (5,390 | ) | | 1,460 | |
|
|
|
| Income before taxes | | | $ | 193,628 | | $ | 146,378 | |
|
|
|
Three Months Ended March 31, 2005 compared to Three Months Ended March 31, 2004
Premiums. Gross written premiums decreased 14.5% to $1,047.6 million in the three months ended March 31, 2005 from $1,224.9 million in the three months ended March 31, 2004, reflecting increased competitive pressures on pricing. Premium decline areas included a 27.8% ($64.6 million) decrease in the Bermuda operation reflecting declines in individual risk underwritten insurance and reinsurance in Bermuda and in UK motor business reinsurance. The U.S. Insurance operation decreased 22.4% ($79.4 million), principally as a result of a $113.6 million decrease in workers’ compensation business, primarily resulting from the 2004 termination of a contract with American All-Risk Insurance Services, Inc. partially offset by a $34.2 million increase in program business outside of the workers’ compensation class. The Specialty Underwriting operation decreased 15.6% ($19.1 million), resulting primarily from a $21.5 million decrease in A&H business and a $4.1 million decrease in surety business, partially offset by a $6.5 million increase in marine and aviation business. The U.S. Reinsurance operation decreased 4.9% ($18.1 million), principally reflecting a $74.9 million decrease in treaty casualty business and a $7.3 million decrease in facultative business, partially offset by a $71.8 million increase in treaty property business. The International operation saw a 2.6% ($3.9 million) increase, primarily due to a $20.4 million increase in Asian business, partially offset by an $11.6 million decrease in international business written through the Miami and New Jersey
26
offices, representing primarily Latin American business and a $4.8 million decrease in business written in Canada.
Ceded premiums decreased to $35.9 million for the three months ended March 31, 2005 from $46.9 million for the three months ended March 31, 2004. Ceded premiums generally relate to specific reinsurance purchased by the U.S. Insurance operation and fluctuate based upon the level of premiums written in the applicable programs.
Net written premiums decreased by 14.1% to $1,011.7 million for the three months ended March 31, 2005, from $1,178.0 million for the three months ended March 31, 2004, reflecting a decrease in gross written premiums, partially offset by a decrease in ceded premiums.
Premium Revenues. Net premiums earned decreased by 4.7% to $1,005.9 million in the three months ended March 31, 2005 from $1,055.1 million in the three months ended March 31, 2004. Contributing to this decrease was an 18.7% ($22.1 million) decrease in the Specialty Underwriting operation, a 9.3% ($19.9 million) decrease in the Bermuda operation, and a 6.1% ($22.3 million) decrease in the U.S. Reinsurance operation, partially offset by a 6.9% ($9.9 million) increase in the International operation and a 2.4% ($5.2 million) increase in the U.S. Insurance operation. All of these changes reflect period to period changes in net written premiums and business mix, together with normal variability in earning 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 also affect premiums earned.
Expenses. Incurred losses and LAE decreased by 6.1% to $668.3 million in the three months ended March 31, 2005 from $711.5 million in the three months ended March 31, 2004. The decrease in incurred losses and LAE was principally attributable to the decrease in reserve adjustments for prior period losses, the decrease in net premiums earned and the impact of changes in the Company’s mix of business.
The Company’s loss and LAE reserves reflect estimates of ultimate claim liability. Such estimates are re-evaluated on an ongoing basis, including re-estimates of prior period reserves, taking into consideration all available information and, in particular, newly reported loss and claim experience. The effect of such re-evaluations impacts incurred losses for the current period. The Company notes that its analytical methods and processes operate at multiple levels, including individual contracts, groupings of like contracts, classes and lines of business, internal business units, segments, legal entities, and in the aggregate. The complexities of the Company’s business and operations require analyses and adjustments, both qualitative and quantitative, at these various levels. Additionally, the attribution of reserves, changes in reserves and incurred losses between accident year and underwriting year requires adjustments and allocations, both qualitative and quantitative, at these various levels. All of these processes, methods and practices appropriately balance actuarial science, business expertise and management judgment in a manner intended to assure the accuracy, precision and consistency of the Company’s reserving practices, which are fundamental to the Company’s operation. The Company notes,
27
however, that the underlying reserves remain estimates, which are subject to variation, and that the relative degree of variability is generally least when reserves are considered in the aggregate and generally increases as the focus shifts to more granular data levels.
Incurred losses and LAE for the three months ended March 31, 2005 reflected ceded losses and LAE of $37.8 million compared to ceded losses and LAE for the three months ended March 31, 2004 of $40.5 million. The decrease in ceded losses was primarily the result of fluctuations in losses ceded under the specific reinsurance coverages purchased by the U.S. Insurance operation, which generally fluctuate with the change in ceded earned premiums.
Incurred losses and LAE include catastrophe losses, which include the impact of both current period events and favorable and adverse 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”) 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. Catastrophe losses, net of contract specific cessions, were $26.7 million for the three months ended March 31, 2005, relating principally to aggregate estimated additional losses of $32.0 million from hurricanes Charley and Ivan, typhoon Songda, Edmonton hailstorms, Suncor Refinery and Mittal Steel, which were partially offset by $5.3 million of net reserve takedowns related to pre-2004 catastrophes. Catastrophe losses, net of contract specific cessions, were $13.3 million in the three months ended March 31, 2004, relating principally to two industrial risk losses experienced by the Bermuda operation.
The following table shows the net catastrophe losses for each of the Company’s operating segments for the three months ended March 31, 2005 and 2004:
| (Dollars in thousands) Segment Net Catastrophe Losses |
|
|
|
| Segment | 2005 | | 2004 |
|
|
|
| U.S. Reinsurance | | | $ | 6 | .7 | | $ | 0 | .1 |
| U.S. Insurance | | | | | - | | | | - |
| Specialty Underwriting | | | | 1 | .9 | | | 0 | .1 |
| International | | | | 11 | .6 | | | 2 | .1 |
| Bermuda | | | | 6 | .5 | | | 11 | .0 |
|
|
|
|
| Total | | | $ | 26 | .7 | | $ | 13 | .3 |
|
|
|
|
Net adverse prior period reserve adjustments, which includes catastrophe development, for the three months ended March 31, 2005 were $22.2 million compared to $52.2 million for the three months ended March 31, 2004. For the three months ended March 31, 2005, the net adverse reserve adjustments included net adverse asbestos and environmental (“A&E”) adjustments of $18.0 million and net catastrophe development of $13.7 million partially offset by pre-1995 non-A&E favorable development. The reserve adjustments for the three months ended March 31, 2004 included A&E adjustments of $63.2 million, which were partially offset by $9.0 million of favorable loss adjustments. It is important to note that adverse non-A&E accident year reserve development arises from the re-evaluation of accident year results and that such re-evaluations may also impact premiums and commissions attributed by accident year, generally mitigating, in part, the impact of loss development, and that such impacts are recorded as part of the overall reserve evaluation.
28
The U.S. Reinsurance segment accounted for $11.3 million of net adverse prior period reserve adjustments for the three months ended March 31, 2005, which included $10.6 million of unfavorable non-A&E prior period reserve adjustments as compared to net adverse prior period reserve adjustments of $13.2 million for the three months ended March 31, 2004. Asbestos exposures accounted for $0.7 million and $4.2 million of adverse reserve adjustments for the three months ended March 31, 2005 and 2004, respectively.
The U.S. Insurance segment reflected $3.6 million of net favorable prior period reserve adjustments for the three months ended March 31, 2005 and $11.6 million of net adverse prior period reserve adjustment for the three months ended March 31, 2004. The March 31, 2004 prior period reserve adjustments were principally due to non-workers’ compensation programs and related to accident years 2000 through 2002.
The Specialty Underwriting segment had $1.9 million of net adverse prior period reserve adjustments for the three months ended March 31, 2005 and $0.1 million net period reserve adjustments for the three months ended March 31, 2004. The March 31, 2005 net adverse prior period reserve adjustments related principally to catastrophe loss development on the marine and aviation classes of business.
The International segment had $9.3 million and $0.1 million of net adverse prior period reserve adjustments for the three months ended March 31, 2005 and 2004, respectively. The March 31, 2005 net adverse prior period reserve adjustments related primarily to property catastrophe loss development on the Asian, International and Canadian business.
The Bermuda segment reflected $3.3 million and $27.3 million of net adverse prior period reserve adjustments for the three months ended March 31, 2005 and 2004, respectively. The adverse development in the three months ended March 31, 2005 was primarily due to $17.3 million of A&E reserve development, with most of this development related to exposures assumed through the September 19, 2000 loss portfolio transfer from Mt. McKinley Insurance Company (“Mt. McKinley”). Non-asbestos reserves assumed through this portfolio transfer experienced favorable development of $13.5 million. The development in the first quarter of 2004 was the result of $59.0 million of asbestos reserve development, partially offset by $37.7 million of favorable development on other pre-1995 exposures.
The following table shows net prior period reserve adjustments for each of the Company’s operating segments for the three months ended March 31, 2005 and 2004:
| (Dollars in thousands) Segment Net Prior Period Reserve Adjustments |
|
|
|
|
| Segment | 2005 | | 2004 |
|
|
|
|
| U.S. Reinsurance | | | $ | 11 | .3 | | $ | 13 | .1 |
| U.S. Insurance | | | | (3 | .6 | ) | | 11 | .6 |
| Specialty Underwriting | | | | 1 | .9 | | | 0 | .1 | |
| International | | | | 9 | .3 | | | 0 | .1 |
| Bermuda | | | | 3 | .3 | | | 27 | .3 |
|
|
|
|
|
| Total | | | $ | 22 | .2 | | $ | 52 | .2 |
|
|
|
|
|
The segment components of the decrease in incurred losses and LAE for the three months ended March 31, 2005 over the three months ended March 31, 2004 were a 16.0% ($24.9 million)
29
decrease in the Bermuda operation, a 13.8% ($10.2 million) decrease in the Specialty Underwriting operation, a 8.4% ($21.0 million) decrease in the U.S. Reinsurance operation and a 3.9% ($6.2 million) decrease in the U.S. Insurance operation, partially offset by a 26.3% ($19.0 million) increase in the International 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 above. 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, which in general reflected a more favorable mix.
The Company’s loss ratio, which is calculated by dividing incurred losses and LAE by net premiums earned, decreased by 1.0 percentage point to 66.4% in the three months ended March 31, 2005 from 67.4% in the three months ended March 31, 2004, reflecting the impact of the changes in premiums earned and incurred losses and LAE discussed above, as well as changes in the underlying business mix and aggregate rates, terms and conditions.
The following table shows the loss ratios for each of the Company’s operating segments for the three months ended March 31, 2005 and 2004. The loss ratios for all operations were impacted by the factors noted above.
| Segment Loss Ratios |
|
|
|
|
| Segment | 2005 | | 2004 |
|
|
|
|
| U.S. Reinsurance | | | | 67 | .4% | | | 69 | .0% |
| U.S. Insurance | | | | 68 | .5% | | | 72 | .9% |
| Specialty Underwriting | | | | 66 | .4% | | | 62 | .7% | |
| International | | | | 59 | .8% | | | 50 | .6% |
| Bermuda | | | | 67 | .6% | | | 72 | .9% |
Segment underwriting expenses increased by 0.7% to $248.5 million in the three months ended March 31, 2005 from $246.7 million in the three months ended March 31, 2004. Commission, brokerage, taxes and fees decreased by $0.5 million, principally reflecting decreases in premium volume, changes in the mix of business and increases in premium based taxes. Segment other underwriting expenses increased by $2.3 million, as the Company continued to expand operations to support its increased business volume. Contributing to the segment underwriting expense increases were a 51.7% ($17.3 million) increase in the U.S. Insurance operation, a 16.4% ($6.7 million) increase in the Bermuda operation and a 15.6% ($5.0 million) increase in the International operation, which were partially offset by a 24.7% ($8.9 million) decrease in the Specialty Underwriting operation and a 17.8% ($18.4 million) decrease in the U.S. Reinsurance 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 expense ratio, which is calculated by dividing underwriting expenses by net premiums earned, was 25.0% for the three months ended March 31, 2005 compared to 23.4% for the three months ended March 31, 2004.
30
The following table shows the expense ratios for each of the Company’s operating segments for the three months ended March 31, 2005 and 2004.
| Segment Expense Ratios |
|
|
|
|
| Segment | 2005 | | 2004 |
|
|
|
|
| U.S. Reinsurance | | | | 25 | .1% | | | 28 | .6% |
| U.S. Insurance | | | | 22 | .7% | | | 15 | .4% |
| Specialty Underwriting | | | | 28 | .3% | | | 30 | .4% | |
| International | | | | 24 | .5% | | | 22 | .8% |
| Bermuda | | | | 24 | .7% | | | 19 | .3% |
The Company’s combined ratio, which is the sum of the loss and expense ratios, increased by 0.6 percentage points to 91.4% in the three months ended March 31, 2005 compared to 90.8% in the three months ended March 31, 2004.
The following table shows the combined ratios for each of the Company’s operating segments for the three months ended March 31, 2005 and 2004. The combined ratios for all operations were impacted by the loss and expense ratio variability noted above.
| Segment Combined Ratios |
|
|
|
|
| Segment | 2005 | | 2004 |
|
|
|
|
| U.S. Reinsurance | | | | 92 | .5% | | | 97 | .6% |
| U.S. Insurance | | | | 91 | .2% | | | 88 | .3% |
| Specialty Underwriting | | | | 94 | .7% | | | 93 | .1% | |
| International | | | | 84 | .3% | | | 73 | .4% |
| Bermuda | | | | 92 | .3% | | | 92 | .2% |
Investment Results.Net investment income increased 31.7% to $132.9 million for the three months ended March 31, 2005 from $100.9 million for the three months ended March 31, 2004, principally reflecting the effects of the increase of investable assets of $11.5 billion at March 31, 2005 as compared to $10.2 billion at March 31, 2004 as well as $9.3 million of additional income from other asset investments.
The following table shows a comparison of various investment yields for the periods indicated:
| |
| | 2005 | | 2004 |
|
|
|
|
Imbedded pre-tax yield of cash and invested assets at
March 31, 2005 and December 31, 2004 | | | | 4 | .6% | | | 4 | .7% |
Imbedded after-tax yield of cash and invested assets at
March 31, 2005 and December 31, 2004 | | | | 4 | .0% | | | 4 | .1% |
Annualized pre-tax yield on average cash and invested
assets for the three months ended March 31, 2005 and 2004 | | | | 4 | .8% | | | 4 | .3% | |
Annualized after-tax yield on average cash and invested
assets for the three months ended March 31, 2005 and 2004 | | | | 4 | .0% | | | 3 | .8% |
Net realized capital gains were $2.5 million for the three months ended March 31, 2005, which reflected realized capital gains on the Company’s investments of $6.1 million, partially offset by $3.6 million of realized capital losses. Net realized capital losses of $34.9 million for the three months ended March 31, 2004 reflected realized capital losses on the Company’s investments of
31
$65.4 million, which included $65.0 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 Emerging Issues Task Force Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets”(“EITF 99-20”), partially offset by $30.4 million of realized capital gains.
The Company has outstanding one credit default swap and five specialized equity put options in its product portfolio. These products meet the definition of a derivative under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”). Net derivative expense from these derivative transactions for the three months ended March 31, 2005 and 2004 was $1.2 million and $3.8 million, respectively, with both periods principally reflecting changes in fair value for the specialized equity put options.
Other expense for the three months ended March 31, 2005 was $5.4 million compared to other income of $1.5 million for the three months ended March 31, 2004. The change in other expense for the three months ended March 31, 2005 was primarily due to variability in the impact of foreign currency exchange.
Corporate underwriting expenses not allocated to segments increased to $2.6 million for the three months ended March 31, 2005 compared with corporate underwriting income of $0.3 million for the three months ended March 31, 2004.
Interest expense and fees for the three months ended March 31, 2005 and 2004 was $21.7 million and $14.5 million, respectively. Interest expense and fees for the three months ended March 31, 2005 included $12.2 million relating to the senior notes, $9.4 million relating to the junior subordinated debt securities and $0.1 million relating to the credit line under the Company’s revolving credit facility. Interest expense and fees for the three months ended March 31, 2004 included $9.7 million relating to the senior notes, $4.4 million relating to the junior subordinated debt securities and $0.3 million relating to borrowings under the Company’s revolving credit facility. The change in interest expense on the senior notes to $12.2 million for the three months ended March 31, 2005 from $9.7 million for the three months ended March 31, 2004 is due to the issuance on new senior notes on October 12, 2004 partially offset by the retirement of the senior notes due March 15, 2005.
Income Taxes. The Company’s income tax expense is primarily a function of the statutory tax rates and corresponding net income in the jurisdictions where the Company operates, coupled with the impact from tax preferenced investment income. Variations generally reflect changes in the relative levels of pre-tax income between jurisdictions with different tax rates. The Company recognized an income tax expense of $26.5 million in the three months ended March 31, 2005 compared to $20.3 million in the three months ended March 31, 2004.
Net Income. Net income was $167.1 million for the three months ended March 31, 2005 compared to net income of $126.1 million for the three months ended March 31, 2004, reflecting improved investment income and realized capital gains, partially offset by decreased underwriting results.
FINANCIAL CONDITION
Cash and Invested Assets.Aggregate invested assets, including cash and short-term investments, were $11,465.9 million at March 31, 2005 and $11,530.2 million at December 31,
32
2004. This slight decrease in cash and invested assets resulted primarily from the $250.0 million repayment of senior notes due March 15, 2005, $163.9 million in net pre-tax unrealized depreciation of the Company’s investments, which were primarily due to the changes in interest rates, partially offset by cash flow from operations of $325.2 million and $2.5 million of realized capital gains. Gross pre-tax unrealized appreciation and depreciation across the Company’s investment portfolio were $346.1 million and $92.2 million, respectively, at March 31, 2005 compared to gross pre-tax unrealized appreciation and depreciation at December 31, 2004 of $449.1 million and $31.3 million, respectively.
The Company’s current investment strategy generally seeks to maximize after-tax income through a high quality, diversified, taxable and tax-preferenced fixed maturity portfolio, while maintaining an adequate level of liquidity. The Company actively considers total return performance, in particular as respects the potential for variability in the unrealized appreciation/depreciation component of its shareholders equity account as investment conditions shift. The Company’s mix of taxable and tax-preferenced investments is adjusted continuously, consistent with the Company’s current and projected operating results, market conditions and the Company’s tax position. The fixed maturities in the investment portfolio are comprised of available for sale securities. Additionally, the Company continues to expand its investments in equity securities, principally public equity index securities, which it believes will enhance the risk-adjusted total return of the investment portfolio. Such investments account for 21.3% of the Company’s shareholders’ equity at March 31, 2005 as compared to 17.5% at December 31, 2004.
Commencing with the second quarter of 2003 and through the second quarter of 2004, the Company had investments in interest only strips. These investments were aimed at mitigating potential decreases in unrealized appreciation on the Company’s fixed income portfolio during a period where management judged that there was extraordinary potential for an increase in general interest rates. The Company liquidated its interest only strip investment portfolio in the second quarter of 2004, at which point management concluded the extraordinary potential for increases in general interest rates had subsided to a more normal level.
The tables below summarize the composition and characteristics of the Company’s investment portfolio for the periods indicated:
| As of
March 31, 2005 | As of
December 31, 2004 |
|
|
|
| Fixed maturities | | | | 86 | .5% | | 86 | .3% |
| Equity securities | | | | 7 | .0% | | 5 | .6% |
| Short-term investments | | | | 3 | .7% | | 5 | .1% |
| Other invested assets | | | | 1 | .5% | | 1 | .4% |
| Cash | | | | 1 | .3% | | 1 | .6% |
|
|
|
| Total investments and cash | | | | 100 | .0% | | 100 | .0% |
|
|
|
|
As of
March 31, 2005 | As of
December 31, 2004 |
|
|
|
| Fixed income portfolio duration | | | 5.2 years | 5.2 years |
| Fixed income composite credit quality | | | | A | a2 | | A | a2 |
| Imbedded end of period yield, pre-tax | | | | 4 | .6% | | 4 | .7% |
| Imbedded end of period yield, after-tax | | | | 4 | .0% | | 4 | .1% |
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The decrease in short-term investments is partially due to repayment of the $250 million senior notes due in March 2005. The increase in equity securities reflects a modest and continuing reweighting of the Company’s target investment mix.
The Company, because of its historical income orientation, has generally considered total return, the combination of income yield and capital appreciation/depreciation, to be relatively less important as a measure of performance than its overall income yield. The following table provides a comparison of the Company’s total return by asset class to broadly accepted industry benchmarks for the periods indicated:
| |
| | As of
March 31, 2005 | | As of
December 31, 2004 |
|
|
|
| Fixed income portfolio total return | | | | -0 | .3% | | | 6 | .5% |
| Lehman bond aggregate | | | | -0 | .5% | | | 4 | .3% |
| Common equity portfolio total return | | | | -2 | .8% | | | 21 | .9% |
| S&P 500 | | | | -2 | .2% | | | 10 | .9% |
Reinsurance Receivables. Reinsurance receivables for both paid and unpaid losses totaled $1,197.3 million at March 31, 2005 and $1,210.8 million at December 31, 2004. At March 31, 2005, $365.7 million, or 30.5%, was receivable from subsidiaries of London Reinsurance Group (“London Life”). These receivables are collateralized by a combination of letters of credit and funds held arrangements under which the Company has retained the premium payments due the retrocessionaire, recognized liabilities for such amounts and reduced such liabilities as payments are due from the retrocessionaire. In addition, $162.2 million, or 13.6%, was receivable from Transatlantic Reinsurance Company (“Transatlantic”), $160.0 million, or 13.4%, was receivable from LM Property and Casualty Insurance Company (“LM”) whose obligations are guaranteed by The Prudential Insurance Company of America (“The Prudential”), and $100.0 million, or 8.4%, was receivable from Continental Insurance Company (“Continental”), which is partially collateralized by funds held arrangements. No other retrocessionaire accounted for more than 5% of the Company’s receivables.
Loss and LAE Reserves.Gross loss and LAE reserves totaled $7,972.2 million at March 31, 2005 and $7,836.3 million at December 31, 2004. The increase during the three months ended March 31, 2005 is primarily attributable to increases in the Company’s exposure base, net prior period reserve adjustments in select areas, including catastrophe losses and normal variability in claim settlements.
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The following tables summarize gross outstanding loss and LAE reserves, segregated into case reserves and IBNR reserves, which are managed on a combined basis, for the periods indicated.
| Gross Reserves By Segment | | | | |
| As of March 31, 2005 | | | |
| (Dollars in thousands) | Case
Reserves | IBNR
Reserves | Total
Reserves | % of
Total |
|
|
|
|
|
| U.S. Reinsurance | | | $ | 1,417,183 | | $ | 2,113,530 | | $ | 3,530,713 | | | 44 | .3% |
| U.S. Insurance | | | | 589,430 | | | 887,404 | | | 1,476,834 | | | 18 | .5% |
| Specialty Underwriting | | | | 235,022 | | | 125,247 | | | 360,269 | | | 4 | .5% |
| International | | | | 439,388 | | | 354,416 | | | 793,804 | | | 10 | .0% |
| Bermuda | | | | 445,731 | | | 640,066 | | | 1,085,797 | | | 13 | .6% |
|
|
|
|
|
| Total excluding A&E | | | | 3,126,754 | | | 4,120,663 | | | 7,247,417 | | | 90 | .9% |
| A&E | | | | 604,517 | | | 120,308 | | | 724,825 | | | 9 | .1% |
|
|
|
|
|
| Total including A&E | | | $ | 3,731,271 | | $ | 4,240,971 | | $ | 7,972,242 | | | 100 | .0% |
|
|
|
|
|
|
As of December 31, 2004 | | | |
| (Dollars in thousands) | Case
Reserves | IBNR
Reserves | Total
Reserves | % of
Total |
|
|
|
|
|
| U.S. Reinsurance | | | $ | 1,354,647 | | $ | 2,174,762 | | $ | 3,529,409 | | | 45 | .0% |
| U.S. Insurance | | | | 599,200 | | | 793,451 | | | 1,392,651 | | | 17 | .7% |
| Specialty Underwriting | | | | 215,187 | | | 158,793 | | | 373,980 | | | 4 | .8% |
| International | | | | 421,804 | | | 359,073 | | | 780,877 | | | 10 | .0% |
| Bermuda | | | | 425,273 | | | 605,791 | | | 1,031,064 | | | 13 | .2% |
|
|
|
|
|
| Total excluding A&E | | | | 3,016,111 | | | 4,091,870 | | | 7,107,981 | | | 90 | .7% |
| A&E | | | | 571,939 | | | 156,386 | | | 728,325 | | | 9 | .3% |
|
|
|
|
|
| Total including A&E | | | $ | 3,588,050 | | $ | 4,248,256 | | $ | 7,836,306 | | | 100 | .0% |
|
|
|
|
|
The changes by segment generally reflect changes in earned premium, changes in business mix and the impact of reserve re-estimations together with claim settlement activity. The fluctuations for A&E reflect the impact of reserve re-evaluations and claim settlement activity.
The Company’s loss and LAE reserves reflect estimates of ultimate claim liability. Such estimates are re-evaluated on an ongoing basis, including re-estimates of prior period reserves, taking into consideration all available information and, in particular, newly reported loss and claim experience. The effect of such re-evaluations impacts incurred losses for the current period. The Company notes that its analytical methods and processes operate at multiple levels including individual contracts, groupings of like contracts, classes and lines of business, internal business units, segments, legal entities, and in the aggregate. The complexities of the Company’s business and operations require analyses and adjustments, both qualitative and quantitative, at these various levels. Additionally, the attribution of reserves, change in reserves and incurred losses, between accident year and underwriting year requires adjustments and allocations, both qualitative and quantitative, at these various levels. All of these processes, methods and practices appropriately balance actuarial science, business expertise and management judgment in a manner intended to assure the accuracy, precision and consistency of the Company’s reserving practices, which are fundamental to the Company’s operation. The Company notes however, that the underlying reserves remain estimates, which are subject to variation, and that
35
the relative degree of variability is generally least when reserves are considered in the aggregate and generally increases as the focus shifts to more granular data levels.
There can be no assurance that reserves for, and losses from, claim obligations will not increase in the future. However, management believes that the Company’s existing reserves and reserving methodologies lessen the probability that any such increase would have a material adverse effect on the Company’s financial condition, results of operations or cash flows. In this context, the Company notes that over the past 10 years, its past calendar year operations have been affected variably by effects from prior period reserve re-estimates, with such effects ranging from a favorable $35.4 million, representing 1.2% of the net prior period reserves for the year in which the adjustment was made, to an unfavorable $312.0 million, representing 6.0% of the net prior period reserves for the year in which the adjustment was made. The Company’s Annual Report on Form 10-K for the year ended December 31, 2004 discusses the Company’s past experience more fully in Part I, Item 1, “Changes in Historical Reserves”.
Asbestos and Environmental Reserves.The Company continues to receive claims under expired contracts, both insurance and reinsurance, asserting alleged injuries and/or damages relating to or resulting from environmental pollution and hazardous substances, including asbestos. The Company’s asbestos claims typically involve potential liability for bodily injury from exposure to asbestos or for property damage resulting from asbestos or products containing asbestos. The Company’s environmental claims typically involve potential liability for (a) the mitigation or remediation of environmental contamination or (b) bodily injury or property damages caused by the release of hazardous substances into the land, air or water.
The Company’s reserves include an estimate of the Company’s ultimate liability for A&E claims. This estimate is made based on judgmental assessment of the underlying exposures as the result of (1) long and variable reporting delays, both from insureds to insurance companies and from ceding companies to reinsurers; (2) historical data, which is more limited and variable on A&E losses than historical information on other types of casualty claims; and (3) unique aspects of A&E exposures for which ultimate value cannot be estimated using traditional reserving techniques. There are significant uncertainties in estimating the amount of the Company’s potential losses from A&E claims. Among the uncertainties are: (a) potentially long waiting periods between exposure and manifestation of any bodily injury or property damage; (b) difficulty in identifying sources of asbestos or environmental contamination; (c) difficulty in properly allocating responsibility and/or liability for asbestos or environmental damage; (d) changes in underlying laws and judicial interpretation of those laws; (e) the potential for an asbestos or environmental claim to involve many insurance providers over many policy periods; (f) questions concerning interpretation and application of insurance and reinsurance coverage; and (g) uncertainty regarding the number and identity of insureds with potential asbestos or environmental exposure.
With respect to asbestos claims in particular, several additional factors have emerged in recent years that further compound the difficulty in estimating the Company’s liability. These developments include: (a) continued growth in the number of claims filed, in part reflecting a much more aggressive plaintiff bar and including claims against defendants formerly regarded as “peripheral”; (b) a disproportionate percentage of claims filed by individuals with no functional injury, which should have little to no financial value but that have increasingly been considered in jury verdicts and settlements; (c) the growth in the number and significance of bankruptcy filings by companies as a result of asbestos claims (including, more recently, bankruptcy filings in which companies attempt to resolve their asbestos liabilities in a manner that is prejudicial to
36
insurers and forecloses insurers from the negotiation of bankruptcy plans); (d) the concentration of claims in a small number of states that favor plaintiffs; (e) the growth in the number of claims that might impact the general liability portion of insurance policies rather than the product liability portion; (f) measures adopted by specific courts to ameliorate the worst procedural abuses; (g) an increase in settlement values being paid to asbestos claimants, especially those with cancer or functional impairment; (h) legislation in some states to address asbestos litigation issues; and (i) the potential that other states or the U.S. Congress may adopt legislation on asbestos litigation.
Management believes that these uncertainties and factors continue to render reserves for A&E and particularly asbestos losses significantly less subject to traditional actuarial analysis than reserves for other types of losses. Given these uncertainties, management believes that no meaningful range for such ultimate losses can be established. The Company establishes reserves to the extent that, in the judgment of management, the facts and prevailing law reflect an exposure for the Company or its ceding companies.
In connection with the acquisition of Mt. McKinley, which has significant exposure to A&E claims, LM provided reinsurance to Mt. McKinley covering 80% ($160.0 million) of the first $200.0 million of any adverse development of Mt. McKinley’s reserves as of September 19, 2000 and The Prudential guaranteed LM’s obligations to Mt. McKinley. Cessions under this reinsurance agreement exhausted the limit available under the contract at December 31, 2003. Due to the uncertainties discussed above, the ultimate losses attributable to A&E, and particularly asbestos, may be subject to more variability than are non-A&E reserves and such variation could have a material adverse effect on the Company’s financial condition, results of operations and/or cash flows.
With respect to Mt. McKinley, where the Company has a direct relationship with policyholders, the Company’s aggressive litigation posture and the uncertainties inherent in the asbestos coverage and bankruptcy litigation have provided an opportunity to actively engage in settlement negotiations with a number of those policyholders who have potentially significant asbestos liabilities. Those discussions are oriented towards achieving reasonable negotiated settlements that limit Mt. McKinley’s liability to a given policyholder to a sum certain. In 2004, the Company concluded such settlements or reached agreement in principle with 9 of its high profile policyholders. The Company has currently identified 15 policyholders based on their past claim activity and/or potential future liabilities as “High Profile Policyholders” and its settlement efforts are generally directed at such policyholders, in part because their exposures have developed to the point where both the policyholder and the Company have sufficient information to be motivated to settle. The Company believes that this active approach will ultimately result in a more cost-effective liquidation of Mt. McKinley’s liabilities than a passive approach, although it may also introduce additional variability in Mt. McKinley’s losses and cash flows as reserves are adjusted to reflect the development of negotiations and, ultimately, potentially accelerated settlements.
There is less potential for similar settlements with respect to the Company’s reinsurance asbestos claims. Ceding companies, with their direct obligation to insureds and overall responsibility for claim settlements, are not consistently aggressive in developing claim settlement information and conveying this information to reinsurers, which can introduce significant and perhaps inappropriate delays in the reporting of asbestos claims/exposures to reinsurers. These delays not only extend the timing of reinsurance claim settlements, but also restrict the information available to estimate the reinsurers’ ultimate exposure. At March 31, 2005 the Company had
37
asbestos loss reserves of $630.0 million, of which $304.7 million was for assumed business and $325.3 million was for direct business.
The following table summarizes incurred losses with respect to A&E on both a gross and net of retrocessional basis for the periods indicated:
| | Three Months Ended
March 31, |
| (Dollars in thousands) | 2005 | 2004 |
|
|
|
| Gross basis: | | | | | | | | |
| Beginning of period reserves | | | $ | 728,325 | | $ | 765,257 | |
| Incurred losses | | | | 18,000 | | | 66,000 | |
| Paid losses | | | | (21,500 | ) | | (25,408 | ) |
|
|
|
| End of period reserves | | | $ | 724,825 | | $ | 805,849 | |
|
|
|
| Net basis: | | |
| Beginning of period reserves | | | $ | 506,675 | | $ | 534,369 | |
| Incurred losses | | | | 18,000 | | | 63,197 | |
| Paid losses | | | | (20,084 | ) | | (22,382 | ) |
|
|
|
| End of period reserves | | | $ | 504,591 | | $ | 575,184 | |
|
|
|
At March 31, 2005, the gross reserves for A&E losses were comprised of $138.1 million representing case reserves reported by ceding companies, $147.2 million representing additional case reserves established by the Company on assumed reinsurance claims, $319.2 million representing case reserves established by the Company on direct excess insurance claims, including Mt. McKinley, and $120.3 million representing IBNR reserves.
Industry analysts have developed a measurement, known as the survival ratio, to compare the A&E reserves among companies with such liabilities. The survival ratio is typically calculated by dividing a company’s current net reserves by the three year average of paid losses, and therefore measures the number of years that it would take to exhaust the current reserves based on historical payment patterns. Using this measurement, the Company’s net three year A&E survival ratio was 5.1 years at March 31, 2005. Adjusting for the effect of the reinsurance ceded under the reinsurance agreement with LM, this ratio rises to the equivalent of 6.8 years at March 31, 2005. The cession of $160.0 million to the stop loss reinsurance provided by LM in connection with the acquisition of Mt. McKinley results in unpaid proceeds that are not reflected in past net payments and effectively extend the funding available for future net payments. Because the survival ratio was developed as a comparative measure of reserve strength and not of absolute reserve adequacy, the Company considers, but does not rely on, the survival ratio when evaluating its reserves. In particular, the Company notes that loss payout variability, which can be material, due in part to the Company’s orientation to negotiated settlements, particularly on its Mt. McKinley exposures, significantly impairs the credibility and utility of this measure as an analytical tool.
The Company’s net three year survival ratio on its asbestos exposures only was 4.7 years for the period ended March 31, 2005. This three year survival ratio, when adjusted for the effect of the reinsurance ceded under the stop loss cover from LM, was 6.6 years and, when adjusted for settlements in place and structured settlements, which are either fully funded by reserves or
38
subject to financial terms that substantially limit the potential variability in the liability, and the stop loss protection from LM, was 18.5 years.
Shareholders’ Equity. The Company’s shareholders’ equity increased to $3,755.7 million as of March 31, 2005 from $3,712.5 million as of December 31, 2004, principally reflecting $167.1 million of net income for the three months ended March 31, 2005 and $10.9 million in net proceeds from options exercised, partially offset by a decrease of $126.1 million in net unrealized depreciation of investments and $6.2 million of shareholder dividends.
LIQUIDITY AND CAPITAL RESOURCES
Capital. The Company’s business operations are in part dependent on the Company’s financial strength, and the market’s perception thereof, as measured by shareholders’ equity, which was $3,755.7 million and $3,712.5 million at March 31, 2005 and December 31, 2004, respectively. The Company has flexibility with respect to capitalization as a result of its perceived financial strength, including its financial strength ratings as assigned by independent rating agencies, and its access to the debt and equity markets. The Company continuously monitors its capital and financial position, as well as investment and security market conditions, both in general and with respect to the Company’s securities, and responds accordingly.
From time to time the Company has used open market share repurchases to effectively adjust its capital position. It made no such purchases in 2004 or for the three months ended March 31, 2005. In September 2004, the Company’s authorization to purchase its shares was amended to authorize the repurchase of up to 5 million shares. The Company notes that, outside of its open market repurchase program, it repurchased 4,800 shares in 2004 from employees in connection with restricted share vestings where individual employees chose to discharge withholding tax liabilities on vesting shares by the surrender of a portion of such shares. At March 31, 2005, 5 million shares remained under the existing repurchase authorization.
The Company has a shelf registration statement on Form S-3 on file with the Securities and Exchange Commission (“SEC”), which was declared effective by the SEC on December 22, 2003, that provides for the issuance of up to $975 million of securities. Generally, under this shelf registration statement, Group is authorized to issue common shares, preferred shares, debt securities, warrants and hybrid securities, Holdings is authorized to issue debt securities and Everest Re Capital Trust II (“Capital Trust II”) and Everest Re Capital Trust III (“Capital Trust III”) are authorized to issue trust preferred securities. The following securities have been issued pursuant to that registration statement, which at March 31, 2005 has a remaining balance of $405.0 million.
| | o | On March 29, 2004, Capital Trust II, an unconsolidated affiliate, issued trust preferred securities resulting in a takedown from the shelf registration statement of $320 million. In conjunction with the issuance of Capital Trust II’s trust preferred securities, Holdings issued $329.9 million of 6.20% junior subordinated debt securities due March 29, 2034 to Capital Trust II. Part of the proceeds from the junior subordinated debt securities issuance was used for capital contributions to Holdings’ operating subsidiaries. |
| | o | On October 6, 2004, Holdings completed a public offering of $250.0 million principal amount of 5.40% senior notes due October 15, 2014. The net proceeds were used to retire existing debt at Holdings, which was due and retired on March 15, 2005. |
39
Liquidity. The Company’s current investment strategy generally seeks to maximize after-tax income through a high quality, diversified, taxable bond and tax-preferenced fixed maturity portfolio, while maintaining an adequate level of liquidity. The Company’s mix of taxable and tax-preferenced investments is adjusted continuously, consistent with the Company’s current and projected operating results, market conditions and tax position. With changes the Company perceives in overall investment market conditions, and more specifically the acquisition of $147.9 million of equity securities into the overall investment portfolio in 2005 and $496.5 million of equity securities into the overall investment portfolio in 2004, the Company is reweighting its overall portfolio to modestly increase the emphasis on total return.
The Company’s liquidity requirements are generally met from positive cash flow from operations. Positive cash flow results from reinsurance and insurance premiums being collected prior to disbursements for claims, which disbursements generally take place over an extended period after the collection of premiums, sometimes a period of many years. Collected premiums are generally invested, prior to their use in such disbursements, and investment income provides additional funding for loss payments. The Company’s net cash flows from operating activities were $325.2 million and $399.6 millionfor the three months ended March 31, 2005 and 2004, respectively. Additionally, these cash flows reflected net tax payments of $36.9 million and $19.5 million for the three months ended March 31, 2005 and 2004, respectively; catastrophe loss payments of $89.6 million and $6.0 million for the three months ended March 31, 2005 and 2004, respectively; and asbestos loss payments of $20.2 million and $18.1 million for the three months ended March 31, 2005 and 2004, respectively.
In periods for which disbursements for claims and benefits, policy acquisition costs and other operating expenses exceed premium inflows, cash flow from insurance operations would be negative. The effect on cash flow from operations would be partially offset by cash flow from investment income. Additionally, cash flow from investment maturities and dispositions, both short-term investments and longer term maturities, would further mitigate the impact on total cash flow.
As the exact timing of the payment of claims and benefits cannot be predicted with certainty, the Company maintains portfolios of long-term invested assets with varying maturities, along with short-term investments that are intended to provide adequate cash for payment of claims. At March 31, 2005 and December 31, 2004 the Company held cash and short-term investments of $580.1 million and $770.8 million, respectively. In addition to these cash and short-term investments at March 31, 2005, the Company had $0.3 billion, at fair value, of available for sale fixed maturity securities maturing within one year or less, $1.9 billion maturing within one to five years and $7.7 billion maturing after five years. These securities, in conjunction with the short-term investments and positive cash flow from operations, provide adequate sources of liquidity for the expected payment of losses in the near future. The Company does not anticipate selling securities or using available credit facilities to pay losses and LAE but has the ability to do so. Sales might result in realized capital gains or losses and the Company notes that at March 31, 2005 it has $166.2 million of net unrealized appreciation, net of $87.7 million of taxes, comprised of $346.1 million of pre-tax appreciation and $92.2 million of pre-tax depreciation.
Management expects the trend of positive cash flow from operations, which in general reflects the strength of overall pricing, to persist over the near term. However, in the intermediate and long term, the continuation of that trend will be impacted by the extent to which competitive pressures weaken overall pricing available in the Company’s markets and the extent to which the Company successfully implements its strategy of emphasizing profitability over volume.
40
Effective December 8, 2004, Group, Bermuda Re, and Everest International Reinsurance, Ltd. (“Everest International”) entered into a new three year, $750 million senior credit facility with a syndicate of lenders (the “Group Credit Facility”). Wachovia Bank is the administrative agent for the Group Credit Facility. The Group Credit Facility consists of two tranches. Tranche one provides up to $250 million of revolving credit for liquidity and general corporate purposes, and for the issuance of standby letters of credit. The interest on the revolving loans shall, at the option of each of the borrowers, be either (1) Base Rate Loans (as defined below) or (2) an adjusted London Interbank Offered Rate (“LIBOR”) plus a margin. The Base Rate is the higher of the rate of interest established by Wachovia Bank from time to time as its prime rate or the Federal Funds rate, in each case plus 0.5% per annum. The amount of margin and the fees payable for the Group Credit Facility depend on Group’s senior unsecured debt rating. Tranche two exclusively provides up to $500 million for the issuance of standby letters of credit on a collateralized basis.
The Group Credit Facility requires Group to maintain a debt to capital ratio of not greater than 0.35 to 1 and to maintain a minimum net worth amount. Minimum net worth is an amount equal to the sum of (i) $2,599 million (base amount) plus (ii) (A) 25% of consolidated net income for each of Group’s fiscal quarters and (B) 50% of any increase in consolidated net worth attributable to the issuance of ordinary and preferred shares. The base amount is reset at the end of each fiscal year to be the greater of 70% of Group’s consolidated net worth as of the last day of the fiscal year and the calculated minimum amount of net worth prior to the last day of the fiscal year. As of March 31, 2005, the Company was in compliance with these covenants.
During the three months ended March 31, 2005, there were no borrowings under tranche one of the Group Credit Facility. As of March 31, 2005, the Company had $65.0 million of letters of credit outstanding under tranche two of the Group Credit Facility. In addition, the Company has $284.8 million in letters of credit outstanding at March 31, 2005 under a $300 million bilateral agreement with Citibank. All of these letters of credit are collateralized by the Company’s cash and investments. These letters of credit are generally used to collateralize reinsurance assumed by Bermuda Re from jurisdictions where collateralization is generally required for the ceding company to receive credit for such reinsurance recoverables from its principal regulator. Bermuda Re and Everest International also used trust arrangements to provide collateralization to ceding companies, including affiliates. The Company generally avoids providing collateral except where required for ceding companies to receive credit from their regulators. Additionally, at March 31 2005, $179.7 million of assets were deposited in trust accounts, primarily on behalf of Bermuda Re, as security for reinsurance recoverables of certain non-affiliated ceding companies.
Effective October 10, 2003, Holdings entered into a new three year, $150.0 million senior revolving credit facility with a syndicate of lenders, replacing the December 21, 1999, three year senior revolving credit facility, which expired on December 19, 2003. Both the October 10, 2003 and December 21, 1999 senior revolving credit agreements, which have similar terms, are referred to as the “Holdings Credit Facility”. Wachovia Bank is the administrative agent for the Holdings Credit Facility. The Holdings Credit Facility is used for liquidity and general corporate purposes. The Holdings Credit Facility provides for the borrowing of up to $150.0 million with interest at a rate selected by Holdings equal to either, (1) the Base Rate (as defined below) or (2) an adjusted LIBOR plus a margin. The Base Rate is the higher of the rate of interest established by Wachovia Bank from time to time as its prime rate or the Federal Funds rate, in each case plus 0.5% per annum. The amount of margin and the fees payable for the Holdings Credit Facility depends upon Holdings’ senior unsecured debt rating.
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The Holdings Credit Facility requires Holdings to maintain a debt to capital ratio of not greater than 0.35 to 1, Holdings to maintain a minimum interest coverage ratio of 2.5 to 1 and Everest Re to maintain its statutory surplus at $1.0 billion plus 25% of future aggregate net income and 25% of future aggregate capital contributions. As of March 31, 2005, the Company was in compliance with these covenants.
During the three months ended March 31, 2005 and 2004, there were no payments made and no incremental borrowings under the Holdings Credit Facility. As of March 31, 2005 and 2004, there were outstanding Holdings Credit Facility borrowings of $0.0 million and $70.0 million, respectively. Interest expense and fees incurred in connection with the credit line was $0.1 million for the three months ended March 31, 2005. Interest expense and fees incurred in connection with the borrowings was $0.3 million for the three months ended March 31, 2004.
Market Sensitive Instruments. The SEC’s Financial Reporting Release #48 requires registrants to clarify and expand upon the existing financial statement disclosure requirements for derivative financial instruments, derivative commodity instruments and other financial instruments (collectively, “market sensitive instruments”). The Company does not generally enter into market sensitive instruments for trading purposes.
The Company’s current investment strategy seeks to maximize after-tax income through a high quality, diversified, taxable and tax-preferenced fixed maturity portfolio, while maintaining an adequate level of liquidity. The Company’s mix of taxable and tax-preferenced investments is adjusted continuously, consistent with its current and projected operating results, market conditions and the Company’s tax position. The fixed maturities in the investment portfolio are comprised of non-trading available for sale securities. Additionally, the Company invests in equity securities, which it believes will enhance the risk-adjusted total return of the investment portfolio. The Company has also engaged in a small number of credit default swaps and specialized equity options.
The overall investment 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.
The Company’s $11.5 billion investment portfolio at March 31, 2005 is principally comprised of fixed maturity securities, which are subject to interest rate risk and foreign currency rate risk, and equity securities, which are subject to equity price risk. The impact of the foreign exchange risks on the investment portfolio is generally mitigated by changes in the value of operating assets and liabilities and their associated income statement impact.
Interest rate risk is the potential change in value of the fixed maturity portfolio, including short-term investments, due to change in market interest rates. In a declining interest rate environment, it includes prepayment risk on the $1,438.3 million of mortgage-backed securities in the $9,917.7 million fixed maturity portfolio. Prepayment risk results from potential accelerated principal payments that shorten the average life and thus the expected yield of the security.
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The table below displays the potential impact of market value fluctuations and after-tax unrealized appreciation on the Company’s fixed maturity portfolio as of March 31, 2005 based on parallel 200 basis point shifts in interest rates up and down in 100 basis point increments. For legal entities with a U.S. dollar functional currency, this modeling was performed on each security individually. To generate appropriate price estimates on mortgage-backed securities, changes in prepayment expectations under different interest rate environments were taken into account. For legal entities with a non-U.S. dollar functional currency, the effective duration of the involved portfolio of securities was used as a proxy for the market value change under the various interest rate change scenarios. All amounts are in U.S. dollars and are presented in millions.
As of March 31, 2005
Interest Rate Shift in Basis Points |
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| | -200 | | -100 | | 0 | | 100 | | 200 |
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| Total Market Value | | | $ | 11,521.3 | | $ | 10,939.4 | | $ | 10,346.3 | | $ | 9,735.7 | | $ | 9,146.9 | |
| Market Value Change from Base (%) | | | | 11.4 | % | | 5.7 | % | | 0.0 | % | | -5.9 | % | | -11.6 | % |
| Change in Unrealized Appreciation | | |
| After-tax from Base ($) | | | $ | 876.8 | | $ | 441.3 | | $ | - | | $ | (451.4 | ) | $ | (887.0 | ) |
The Company had $7,972.2 million and $7,836.3 million of reserves for loss and LAE as of March 31, 2005 and December 31, 2004. These amounts are recorded at their nominal or estimated ultimate payment amount, as opposed to fair value, which would reflect a discount adjustment to reflect the time value of money. Since losses are paid out over a period of time, the fair value of the reserves is less than the nominal value. As interest rates rise, the fair value of the reserves decreases and, conversely, if interest rates decline, the fair value will increase. These movements are the opposite of the interest rate impacts on the fair value of investments since reserves are future obligations. While the difference between fair value and nominal value is not reflected in the Company’s financial statements, the Company’s financial results will include investment income over time from the investment portfolio until the claims are paid. The Company’s loss and loss reserve obligations have an expected duration of approximately 4.5 years, which is reasonably consistent with the Company’s fixed income portfolio. If the company were to discount its loss and LAE reserves, net of reinsurance receivable on unpaid losses, the discount would be approximately $1.5 billion resulting in a discounted reserve balance of approximately $5.4 billion, representing approximately 52% of the fixed maturity market value. The existence of such obligations, and the variable differential between ultimate and fair value, which in theory applies equally to invested assets and insurance liabilities, provides substantial mitigation of the economic effects of interest rate variability even though such mitigation is not reflected in the Company’s financial statements.
Equity risk is the potential change in market value of the common stock and preferred stock portfolios arising from changing equity prices. The Company invests in exchange traded and mutual funds, which invest principally in high quality common and preferred stocks that are traded on the major exchanges in the U.S. The primary objective in managing the equity portfolio is to provide long-term capital growth through market appreciation and income.
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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 for the period indicated. The growth in exposure is primarily due to the growth in the equity portfolio. All amounts are in U.S. dollars and are presented in millions.
As of March 31, 2005
Change in Equity Values in Percent |
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| | -20% | | -10% | | 0% | | 10% | | 20% |
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| Market Value of the Equity Portfolio | | | $ | 639.0 | | $ | 718.9 | | $ | 798.8 | | $ | 878.7 | | $ | 958.5 | |
| After-tax Change in Unrealized Appreciation | | | $ | (104.8 | ) | $ | (52.4 | ) | $ | - | | $ | 52.4 | | $ | 104.8 | |
Foreign currency rate risk is the potential change in value, income and cash flow arising from adverse changes in foreign currency exchange rates. Each of the Company’s non-U.S./Bermuda (“foreign”) operations maintains capital in the currency of the country of its geographic location consistent with local regulatory guidelines. Generally, the Company prefers to maintain the capital of its operations in U.S. 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 for these foreign operations are the Canadian Dollar, the British Pound Sterling and the Euro. 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 Financial Accounting Standards Board Statement No. 52, the Company translates the assets, liabilities and income of non-U.S. dollar functional currency legal entities to the U.S. dollar. This translation amount is reported as a component of other comprehensive income. As of March 31, 2005, there has been no material change in exposure to foreign exchange rates as compared to December 31, 2004.
Although not considered material in the context of the Company’s aggregate exposure to market sensitive instruments, the Company has issued five specialized equity put options based on the S&P 500 index that are market sensitive and sufficiently unique to warrant supplemental disclosure.
During 2001, the Company sold five specialized equity put options based on the S&P 500 index for total consideration, net of commissions, of $16.9 million. These contracts each have a single exercise date, with maturities ranging from 18 to 30 years and strike prices ranging from $1,141.21 to $1,540.63. No amounts will be payable under these contracts if the S&P 500 index is at or above the strike price on the exercise dates. If the S&P 500 index is lower than the strike price on the applicable exercise date, the amount due will vary proportionately with the percentage by which the index is below the strike price. Based on historical index volatilities and trends and the March 31, 2005 index value, the Company estimates the probability for each contract of the S&P 500 index being below the strike price on the exercise date to be less than 6.9%. The theoretical maximum payouts under the contracts would occur if on each of the exercise dates the S&P 500 index value were zero.
As these specialized equity put options are derivatives within the framework of FAS 133, the Company reports the fair value of these instruments in its balance sheet and records any changes
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to fair value in its statement of operations. The Company has recorded fair values for its obligations on these specialized equity put options at March 31, 2005 and December 31, 2004 of $22.7 million and $21.5 million, respectively; however, the Company does not believe that the ultimate settlement of these transactions is likely to require a payment that would exceed the initial consideration received or any payment at all.
As there is no active market for these instruments, the determination of their fair value is based on an industry accepted option pricing model, which requires estimates and assumptions, including those regarding volatility and expected rates of return.
The table below estimates the impact of potential movements in interest rates and the S&P 500 index, which are the principal factors affecting fair value of these instruments, looking forward from the fair value at March 31, 2005. These are estimates and there can be no assurance regarding future market performance. The asymmetrical results of the interest rate and S&P 500 index shifts reflect that the liability cannot fall below zero whereas it can increase to its theoretical maximum.
As of March 31, 2005
S&P 500 Index Put Options Obligation - Sensitivity Analysis
(Dollars in millions) |
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| Interest Rate Shift in Basis Points: | -100 | | -50 | | 0 | | 50 | | 100 |
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| Total Market Value | | | $ | 34.7 | | $ | 28.1 | | $ | 22.7 | | $ | 18.2 | | $ | 14.6 | |
| Market Value Change from Base (%) | | | | -53.0 | % | | -23.9 | % | | 0.0 | % | | 19.6 | % | | 35.7 | % |
S&P Index Shift in Points: | -200 | | -100 | | 0 | | 100 | | 200 |
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| Total Market Value | | | $ | 30.0 | | $ | 26.0 | | $ | 22.7 | | $ | 19.9 | | $ | 17.5 | |
| Market Value Change from Base (%) | | | | -32.1 | % | | -14.6 | % | | 0.0 | % | | 12.3 | % | | 22.7 | % |
Combined Interest Rate / S&P Index Shift: | -100 / -200 | | -50 / -100 | | 0 / 0 | | 50 / 100 | | 100 / 200 |
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| Total Market Value | | | $ | 44.6 | | $ | 32.0 | | $ | 22.7 | | $ | 15.9 | | $ | 11.0 | |
| Market Value Change from Base (%) | | | | -96.5 | % | | -41.1 | % | | 0.0 | % | | 30.0 | % | | 51.6 | % |
Safe Harbor Disclosure.This report contains forward-looking statements within the meaning of the U.S. federal securities laws. The Company intends these forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in the federal securities laws. In some cases, these statements can be identified by the use of forward-looking words such as “may”, “will”, “should”, “could”, “anticipate”, “estimate”, “expect”, “plan”, “believe”, “predict”, “potential” and “intend”. Forward-looking statements contained in this report include information regarding the Company’s reserves for losses and LAE, the adequacy of the Company’s provision for uncollectible balances, estimates of the Company’s catastrophe exposure, the effects of catastrophic events on the Company’s financial statements, the ability of Everest Re, Holdings and Bermuda Re to pay dividends and the settlement costs of the Company’s specialized equity put options. Forward-looking statements only reflect the Company’s expectations and are not guarantees of performance. These statements involve risks, uncertainties and assumptions. Actual events or results may differ materially from the Company’s expectations. Important factors that could cause the Company’s actual events or results to be materially different from the Company’s expectations include the uncertainties that surround the estimating of reserves for losses and LAE, those discussed in Note 5 of Notes to
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Consolidated Financial Statements (unaudited) included in this report and the risks described under the caption “Risk Factors” in the Company’s most recent Annual Report on Form 10-K, Part II, Item 7. The Company undertakes no obligation to update or revise publicly any forward looking statements, whether as a result of new information, future events or otherwise.
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Part I — Item 3
EVEREST RE GROUP, LTD.
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
Market Risk Instruments. See "Liquidity and Capital Resources - Market Sensitive Instruments" in Part I - Item 2.
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Part I – Item 4
EVEREST RE GROUP, LTD.
CONTROLS AND PROCEDURES
As of the end of the period covered by this report, the Company’s management carried out an evaluation, with the participation of the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)). Based on their evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission’s rules and forms. The Company’s management, with the participation of the Chief Executive Officer and Chief Financial Officer, also conducted an evaluation of the Company’s internal control over financial reporting to determine whether any changes occurred during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. Based on that evaluation, there has been no such change during the quarter covered by this report.
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EVEREST RE GROUP, LTD.
OTHER INFORMATION
Part II – Item 1. Legal Proceedings
In the ordinary course of business, the Company is involved in lawsuits, arbitrations and other formal and informal dispute resolution procedures, the outcomes of which will determine the Company’s rights and obligations under insurance, reinsurance and other contractual agreements. In some disputes, the Company seeks to enforce its rights under an agreement or to collect funds owing to it. In other matters, the Company is resisting attempts by others to collect funds or enforce alleged rights. Such disputes are resolved through formal and informal means, including litigation and arbitration.
In all such matters, the Company believes that its positions are legally and commercially reasonable. The Company also regularly evaluates those positions and, where appropriate, establishes or adjusts insurance reserves to reflect its evaluation. The Company’s aggregate reserves take into account the possibility that the Company may not ultimately prevail in each and every disputed matter. The Company believes its aggregate reserves reduce the potential that an adverse resolution of one or more of these matters, at any point in time, would have a material impact on the Company’s financial condition or results of operations. However, there can be no assurance that adverse resolutions of such matters in any one period or in the aggregate will not result in a material adverse effect on the Company’s results of operations.
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Part II – Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None.
Part II – Item 3. Defaults Upon Senior Securities
None.
Part II – Item 4. Submission of Matters to a Vote of Security Holders
None.
Part II – Item 5. Other Information
None.
Part II – Item 6. Exhibits
| | 11.1 | Statement regarding computation of per share earnings |
| | 31.1 | Section 302 Certification of Joseph V. Taranto |
| | 31.2 | Section 302 Certification of Stephen L. Limauro |
| | 32.1 | Section 906 Certification of Joseph V. Taranto and
Stephen L. Limauro |
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Everest Re Group, Ltd.
Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| |
|---|
| |
| | Everest Re Group, Ltd. |
| | (Registrant) |
| | |
| | |
| | /s/ STEPHEN L. LIMAURO |
| | |
| | Stephen L. Limauro |
| | Executive Vice President and |
| | Chief Financial Officer |
| | |
| | (Duly Authorized Officer and Principal |
| | Financial Officer) |
Dated: May 4, 2005
