The Company’s combined ratio, which is the sum of the loss and expense ratios, decreased by 3.7 points to 87.7% for the three months ended June 30, 2006 compared to 91.4% for the three months ended June 30, 2005, with the decrease resulting from decreased attritional losses, partially offset by increased catastrophe loss development as well as decreased expenses due to the change in business mix.
The following table shows the combined ratios for each of the Company’s operating segments for the three months ended June 30, 2006 and 2005. The combined ratios for all operations were impacted by the loss and expense ratio variability noted above.
The following table shows the components of net investment income for the three months ended as indicated:
The following table shows a comparison of various investment yields for the periods indicated:
Net realized capital gains of $2.5 million for the three months ended June 30, 2006 reflected realized capital gains on the Company’s investments of $7.2 million, resulting principally from gains on the sale of fixed maturities of $0.6 million and equities of $6.6 million, partially offset by $4.7 million of realized capital losses.Net realized capital gains of $27.3 million for the three months ended June 30, 2005 reflected $36.0 million of
realized capital gains on the Company’s investments, partially offset by $8.7 million of realized capital losses, which included $7.0 million related to write-downs in the value of interest only strips of mortgage-backed securities (“interest only strips”) deemed to be impaired on an other than temporary basis in accordance with Emerging Issues Task Force No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets (“EITF 99-20”)".
The Company has outstanding seven 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”). The Company recognized net derivative income of $1.3 million for the three months ended June 30, 2006 as compared to net derivative expense of $6.8 million for the three months ended June 30, 2005, reflecting changes in the fair value of the specialized equity put options.
Corporate, Non-allocated Expenses.Corporate underwriting expenses not allocated to segments were $6.8 million for the three months ended June 30, 2006, which were comparable with the $4.6 million for the three months ended June 30, 2005.
Interest, fees and bond issue cost amortization expense for the three months ended June 30, 2006 and 2005 were $17.5 million and $17.4 million, respectively. Interest, fees and bond issue cost amortization expense for the three months ended June 30, 2006 included $7.8 million related to the senior notes, $9.4 million related to the junior subordinated debt securities, $0.2 million related to the bond issue cost amortization and $0.1 million related to the credit line under the Company’s revolving credit facilities. Interest, fees and bond issue cost amortization expense for the three months ended June 30, 2005 included $7.7 million related to the senior notes, $9.4 million related to the junior subordinated debt securities, $0.2 million related to the bond issue cost amortization and $0.1 million related to credit line under the Company’s revolving credit facilities.
Other income for the three months ended June 30, 2006 was $2.3 million compared to other income of $0.5 million for the three months ended June 30, 2005. The change in other income for the three months ended June 30, 2006 was primarily due to variability in the impact of foreign currency exchange gains.
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 income tax expense of $31.2 million for the three months ended June 30, 2006 compared to $40.9 million for the three months ended June 30, 2005. The decrease was primarily attributable to higher income in jurisdictions with lower effective tax rates.
Net Income. Net income was $220.4 million for the three months ended June 30, 2006 compared to $194.2 million for the three months ended June 30, 2005.
Six Months Ended June 30, 2006 compared to Six Months Ended June 30, 2005
Premiums Written.Gross written premiums decreased 8.9% to $1,965.4 million for the six months ended June 30, 2006 from $2,156.9 million for the six months ended June 30, 2005. The decrease in premiums was primarily due to a decrease in the Specialty Underwriting operation of 40.2% ($78.9 million), primarily due to a $48.9 million decrease in A&H business, as pricing for this business continues to be difficult, a $19.3 million decrease in marine and aviation business and a $10.8 million decrease in surety business. The U.S. Insurance operation decreased 24.2% ($131.7 million), mainly reflecting continued retrenchment in the California workers’ compensation and credit business. The U.S. Reinsurance operation decreased 9.6% ($70.0 million),
35
principally reflecting a $77.7 million decrease in treaty casualty business and a $1.5 million decrease in treaty property business, partially offset by a $9.4 million increase in facultative business. The Bermuda operation increased 25.5% ($85.8 million), reflecting increases in treaty business in the UK, Europe and Bermuda. The International operation increased 0.9% ($3.2 million), primarily due to a $12.4 million increase in Canadian business and a $4.8 million increase in international business written through the Miami and New Jersey offices, representing primarily Latin American business, partially offset by a $13.3 million decrease in Asian business.
Ceded premiums decreased to $63.1 million for the six months ended June 30, 2006 from $71.5 million for the six months ended June 30, 2005. 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 individual reinsured programs.
Net written premiums decreased by 8.8% to $1,902.3 million for the six months ended June 30, 2006 from $2,085.4 million for the six months ended June 30, 2005, reflecting the $191.5 million decrease in gross written premiums and the $8.5 million decrease in ceded premiums.
Premium Revenues. Net premiums earned decreased by 8.7% to $1,915.1 million for the six months ended June 30, 2006 from $2,098.4 million for the six months ended June 30, 2005. Contributing to this decrease was a 36.5% ($68.0 million) decrease in the Specialty Underwriting operation, a 16.7% ($127.5 million) decrease in U.S. Reinsurance operation, a 14.0% ($59.6 million) decrease in the U.S. Insurance operation, partially offset by a 16.9% ($63.3 million) increase in the Bermuda operation and a 2.4% ($8.4 million) increase in the International operation. Included in net premiums earned for the six months ended June 30, 2006, was a reduction of $2.2 million of reinstatement premiums. 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 the reporting patterns of ceding companies also affect premiums earned.
Expenses
Incurred Losses and LAE.Incurred losses and LAE represent the Company’s estimates, which are subject to considerable uncertainty due to the timing, complexity and nature of the underlying ceding company exposures. These estimates reflect management’s best judgment based on all available information, but ultimate losses could differ, perhaps materially. The change in incurred losses and LAE, period over period also reflects variability in premiums earned and changes in the loss expectation assumptions for business written, net prior period reserve development, as well as catastrophe losses. Incurred losses and LAE are 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.
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
36
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, 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.
The following table shows the components of the Company’s incurred loss and LAE for the six months ended as indicated:
| June 30, 2006 | | June 30, 2005 |
|---|
| (Dollars in millions) | Current
Year
| Prior
Years
| Total
Incurred
| | Current
Year
| Prior
Years
| Total
Incurred
|
|---|
| All Segments | | | | | | | | | | | | | | | | | | | | | | | |
| Attritional (a) | | | $ | 1,120.9 | | $ | (61.6 | ) | $ | 1,059.3 | | | | | $ | 1,260.4 | | $ | (9.4 | ) | $ | 1,251.0 | |
| Catastrophes | | | | 5.4 | | | 162.8 | | | 168.2 | | | | | | 29.2 | | | 54.0 | | | 83.3 | |
| A&E | | | | - | | | 15.1 | | | 15.1 | | | | | | - | | | 24.6 | | | 24.6 | |
|
|
|
| |
|
|
|
| Total All segments | | | $ | 1,126.3 | | $ | 116.3 | | $ | 1,242.6 | | | | | $ | 1,289.6 | | $ | 69.3 | | $ | 1,358.9 | |
|
|
|
| |
|
|
|
| Loss Ratio | | | | 58.8 | % | | 6.1 | % | | 64.9 | % | | | | | 61.5 | % | | 3.3 | % | | 64.8 | % |
(a) Attritional losses exclude catastrophe and A&E losses.
(Some amounts may not reconcile due to rounding.) | | |
The Company’s incurred losses and LAE decreased 8.6% to $1,242.6 million for the six months ended June 30, 2006 from $1,358.9 million for the six months ended June 30, 2005 reflective of lower earned premiums and more favorable prior year attritional losses, partially offset by increased prior year reserve development on catastrophe losses.
The Company’s loss ratio, which is calculated by dividing incurred losses and LAE by current year net premiums earned, deteriorated by 0.1 point to 64.9% over the comparable 2005 period reflective of increased prior year reserve development on catastrophe losses, partially offset by an improved current year attritional loss ratio, principally due to strong premium rate increases in its property classes of business. Included in the six months ended June 30, 2006 loss ratio was prior year reserve development of 6 points, which was higher than prior period levels. While the Company experienced 9 points of prior year catastrophe reserve development for the six months ended June 30, 2006, principally from the 2005 Hurricanes Katrina, Rita and Wilma, it also recognized 3 points of offsetting prior year favorable attritional reserve development due to favorable claims emergence trends within property and other short-tailed lines of business.
37
The following table shows the U.S. Reinsurance segment components of incurred loss and LAE for the six months ended as indicated:
| June 30, 2006 | | June 30, 2005 |
|---|
| (Dollars in millions) | Current
Year
| Prior
Years
| Total
Incurred
| | Current
Year
| Prior
Years
| Total
Incurred
|
|---|
| U.S. Reinsurance | | | | | | | | | | | | | | | | | | | | | | | |
| Attritional | | | $ | 328.1 | | $ | 4.8 | | $ | 332.9 | | | | | $ | 446.2 | | $ | 9.7 | | $ | 475.9 | |
| Catastrophes | | | | - | | | 109.7 | | | 109.7 | | | | | | 7.7 | | | 24.6 | | | 32.3 | |
| A&E | | | | - | | | 1.2 | | | 1.2 | | | | | | - | | | 5.9 | | | 5.9 | |
|
|
|
| |
|
|
|
| Total segment | | | $ | 328.1 | | $ | 115.7 | | $ | 443.8 | | | | | $ | 473.9 | | $ | 40.2 | | $ | 514.1 | |
|
|
|
| |
|
|
|
| Loss Ratio | | | | 51.4 | % | | 18.1 | % | | 69.5 | % | | | | | 61.9 | % | | 5.2 | % | | 67.1 | % |
(Some amounts may not reconcile due to rounding.) | | |
The U.S. Reinsurance segment’s incurred losses and LAE decreased 13.7%, or $70.3 million, for the six months ended June 30, 2006 as compared to the same period in 2005, mainly reflecting reduced earned premiums principally within the treaty property and treaty casualty units. The segment’s loss ratio deteriorated by 2.4 points over the comparable 2005 period reflective of an increase in catastrophe losses, partially offset by an improvement in the attritional loss ratio. Catastrophe losses increased principally due to reserve strengthening for the 2005 Hurricanes Katrina, Rita, and Wilma. The segment’s attritional loss ratio improvement generally reflects improved current year pricing, principally on the property business.
The following table shows the U.S. Insurance segment components of incurred loss and LAE for the six months ended as indicated:
| June 30, 2006 | | June 30, 2005 |
|---|
| (Dollars in millions) | Current
Year
| Prior
Years
| Total
Incurred
| | Current
Year
| Prior
Years
| Total
Incurred
|
|---|
| U.S. Insurance | | | | | | | | | | | | | | | | | | | | | | | |
| Attritional | | | $ | 270.4 | | $ | (24.5 | ) | $ | 245.9 | | | | | $ | 290.5 | | $ | 2.5 | | $ | 293.0 | |
| Catastrophes | | | | - | | | 0.6 | | | 0.6 | | | | | | - | | | - | | | - | |
|
|
|
| |
|
|
|
| Total segment | | | $ | 270.4 | | $ | (23.9 | ) | $ | 246.5 | | | | | $ | 290.5 | | $ | 2.5 | | $ | 293.0 | |
|
|
|
| |
|
|
|
| Loss Ratio | | | | 74.0 | % | | -6.5 | % | | 67.5 | % | | | | | 68.4 | % | | 0.6 | % | | 69.0 | % |
(Some amounts may not reconcile due to rounding.) | | |
The U.S. Insurance segment’s incurred losses and LAE decreased 15.8%, or $46.4 million, for the six months ended June 30, 2006 as compared to the same period in 2005, mainly reflecting reduced earned premiums, principally related to the retrenchment in the California workers’ compensation and credit program. The segment’s loss ratio improved 1.5 points over the comparable 2005 period due to favorable prior year reserve adjustments mostly for the California workers’ compensation business resulting from benefit reform, partially offset by an increased current year attritional loss ratio reflective of higher loss ratios established for new programs.
38
The following table shows the Specialty Underwriting segment components of incurred loss and LAE for the six months ended as indicated:
| June 30, 2006 | | June 30, 2005 |
|---|
| (Dollars in millions) | Current
Year
| Prior
Years
| Total
Incurred
| | Current
Year
| Prior
Years
| Total
Incurred
|
|---|
| Specialty Underwriting | | | | | | | | | | | | | | | | | | | | | | | |
| Attritional | | | $ | 71.8 | | $ | (23.1 | ) | $ | 48.7 | | | | | $ | 108.4 | | $ | 1.6 | | $ | 110.0 | |
| Catastrophes | | | | - | | | 32.9 | | | 32.9 | | | | | | - | | | 8.3 | | | 8.3 | |
|
|
|
| |
|
|
|
| Total segment | | | $ | 71.8 | | $ | (9.8 | ) | $ | 81.6 | | | | | $ | 108.4 | | $ | 9.9 | | $ | 118.2 | |
|
|
|
| |
|
|
|
| Loss Ratio | | | | 60.8 | % | | 8.3 | % | | 69.1 | % | | | | | 58.2 | % | | 5.3 | % | | 63.6 | % |
(Some amounts may not reconcile due to rounding.) | | |
The Specialty Underwriting segment’s incurred losses and LAE decreased 31.0%, or $36.7 million, for the six months ended June 30, 2006 as compared to the same period in 2005, mainly reflecting a reduction in earned premiums across all classes of business. The segment’s loss ratio deteriorated by 5.5 points over the comparable 2005 period due to increased catastrophe loss development principally for 2005 Hurricane Katrina, partially offset by favorable current and prior year attritional losses.
The following table shows the International segment components of incurred loss and LAE for the six months ended as indicated:
| June 30, 2006 | | June 30, 2005 |
|---|
| (Dollars in millions) | Current
Year
| Prior
Years
| Total
Incurred
| | Current
Year
| Prior
Years
| Total
Incurred
|
|---|
| International | | | | | | | | | | | | | | | | | | | | | | | |
| Attritional | | | $ | 183.6 | | $ | 5.6 | | $ | 189.2 | | | | | $ | 182.1 | | $ | (17.5 | ) | $ | 164.6 | |
| Catastrophes | | | | 5.4 | | | 18.0 | | | 23.4 | | | | | | 10.6 | | | 15.5 | | | 26.0 | |
|
|
|
| |
|
|
|
| Total segment | | | $ | 189.0 | | $ | 23.6 | | $ | 212.6 | | | | | $ | 192.6 | | $ | (2.1 | ) | $ | 190.6 | |
|
|
|
| |
|
|
|
| Loss Ratio | | | | 53.1 | % | | 6.6 | % | | 59.8 | % | | | | | 55.5 | % | | -0.6 | % | | 54.9 | % |
(Some amounts may not reconcile due to rounding.) | | |
The International segment’s incurred losses and LAE increased 11.6%, or $22.1 million, for the six months ended June 30, 2006 as compared to the same period in 2005, mainly reflecting 7.2 points of increased unfavorable prior year reserve adjustments principally due to attritional losses. The segment’s loss ratio deteriorated by 4.9 points over the comparable 2005 period, primarily reflective of less favorable prior year attritional reserve adjustments in Canada and Asia, partially offset by an improved current year attritional loss ratio from price increases in the property classes as well as lower catastrophe losses.
39
The following table shows the Bermuda segment components of incurred loss and LAE for the six months ended as indicated:
| June 30, 2006 | | June 30, 2005 |
|---|
| (Dollars in millions) | Current
Year
| Prior
Years
| Total
Incurred
| | Current
Year
| Prior
Years
| Total
Incurred
|
|---|
| Bermuda | | | | | | | | | | | | | | | | | | | | | | | |
| Attritional | | | $ | 266.9 | | $ | (24.4 | ) | $ | 242.5 | | | | | $ | 213.2 | | $ | (5.7 | ) | $ | 207.6 | |
| Catastrophes | | | | - | | | 1.6 | | | 1.6 | | | | | | 11.0 | | | 5.7 | | | 16.7 | |
| A&E | | | | - | | | 13.9 | | | 13.9 | | | | | | - | | | 18.7 | | | 18.7 | |
|
|
|
| |
|
|
|
| Total segment | | | $ | 266.9 | | $ | (8.9 | ) | $ | 258.0 | | | | | $ | 224.2 | | $ | 18.8 | | $ | 243.0 | |
|
|
|
| |
|
|
|
| Loss Ratio | | | | 61.0 | % | | -2.0 | % | | 59.0 | % | | | | | 59.9 | % | | 5.0 | % | | 64.9 | % |
(Some amounts may not reconcile due to rounding.) | | |
The Bermuda segment’s incurred losses and LAE increased 6.2%, or $15.0 million, for the six months ended June 30, 2006 as compared to the same period in 2005, mainly reflecting increased earned premiums and a mix of business shift toward more casualty business. The segment’s loss ratio improved by 5.9 points over the comparable 2005 period reflective of an improved prior year attritional loss ratio due to a mix of business shift toward more casualty business as well as decreased A&E and catastrophe losses.
Underwriting Expenses.The Company’s expense ratio, which is calculated by dividing underwriting expenses by net premiums earned, was 26.4% for the six months ended June 30, 2006 compared to 26.7% for the six months ended June 30, 2005.
The following table shows the expense ratios for each of the Company’s operating segments for the six months ended June 30, 2006 and 2005.
Segment Expense Ratios
|
|---|
Segment
| 2006
| 2005
|
|---|
| U.S. Reinsurance | | | | 27.4 | % | | 27.1 | % |
| U.S. Insurance | | | | 21.1 | % | | 22.0 | % |
| Specialty Underwriting | | | | 30.8 | % | | 28.0 | % |
| International | | | | 26.2 | % | | 25.9 | % |
| Bermuda | | | | 25.7 | % | | 29.2 | % |
Segment underwriting expenses decreased by 10.6% to $494.0 million for the six months ended June 30, 2006 from $552.3 million for the six months ended June 30, 2005. Commission, brokerage, taxes and fees decreased by $55.0 million, principally reflecting decreases in premium volume and changes in the mix and distribution channel of business. Segment other underwriting expenses decreased by $3.3 million. Contributing to the segment underwriting expense decreases were a 30.3% ($15.8 million) decrease in the Specialty Underwriting operation, a 17.6% ($16.5 million) decrease in the U.S. Insurance operation and a 15.7% ($32.5 million) decrease in the U.S. Reinsurance operation, partially offset by a 3.4% ($3.1 million) increase in the International operation and a 3.1% ($3.4 million) increase in the Bermuda 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.
40
The Company’s combined ratio, which is the sum of the loss and expense ratios, decreased by 0.2 points to 91.3% for the six months ended June 30, 2006 compared to 91.5% for the six months ended June 30, 2005, with the decrease resulting from decreased attritional losses, partially offset by increased catastrophe loss development as well as decreased expenses due to the change in business mix.
The following table shows the combined ratios for each of the Company’s operating segments for the six months ended June 30, 2006 and 2005. The combined ratios for all operations were impacted by the loss and expense ratio variability noted above.
Segment Combined Ratios
|
|---|
Segment
| 2006
| 2005
|
|---|
| U.S. Reinsurance | | | | 96.9 | % | | 94.2 | % |
| U.S. Insurance | | | | 88.6 | % | | 91.0 | % |
| Specialty Underwriting | | | | 99.9 | % | | 91.6 | % |
| International | | | | 86.0 | % | | 80.8 | % |
| Bermuda | | | | 84.7 | % | | 94.1 | % |
Investment Results.Net investment income increased 10.4% to $298.4 million for the six months ended June 30, 2006 from $270.3 million for the six months ended June 30, 2005, primarily reflecting the growth in invested assets to $13.2 billion at June 30, 2006 from $12.0 billion at June 30, 2005.
The following table shows the components of net investment income for the six months ended as indicated:
| (Dollars in thousands) | 2006
| 2005
|
|---|
| Fixed maturities | | | $ | 255,668 | | $ | 254,477 | |
| Equity securities | | | | 6,181 | | | 4,590 | |
| Short-term investments | | | | 24,928 | | | 6,213 | |
| Other income | | | | 22,210 | | | 20,371 | |
|
|
|
| Total gross investment income | | | | 308,987 | | | 285,651 | |
| Interest credited and other expense | | | | (10,628 | ) | | (15,317 | ) |
|
|
|
| Total net investment income | | | $ | 298,359 | | $ | 270,334 | |
|
|
|
The following table shows a comparison of various investment yields for the periods indicated:
| 2006
| 2005
|
|---|
| Imbedded pre-tax yield of cash and invested assets at | | | | | | | | |
| June 30 and December 31 | | | | 4.5 | % | | 4.5 | % |
| Imbedded after-tax yield of cash and invested assets at | | |
| June 30 and December 31 | | | | 3.9 | % | | 3.9 | % |
| Annualized pre-tax yield on average cash and invested | | |
| assets for the six months ended June 30 | | | | 4.6 | % | | 4.8 | % |
| Annualized after-tax yield on average cash and invested | | |
| assets for the six months ended June 30 | | | | 4.0 | % | | 4.1 | % |
Net realized capital gains of $16.1 million for the six months ended June 30, 2006 reflected realized capital gains on the Company’s investments of $21.3 million, resulting principally from gains on the sale of fixed maturities of $9.8 million and equities of $11.5 million, partially offset by $5.2 million of realized capital losses. Net realized capital gains of $29.8 million for the six months ended June 30, 2005 reflected $42.1 million of
41
realized capital gains on the Company’s investments, partially offset by $12.3 million of realized capital losses, which included $7.0 million related to write-downs in the value of interest only strips deemed to be impaired on an other than temporary basis in accordance with EITF 99-20.
The Company has outstanding seven 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”). The Company recognized net derivative income of $5.2 million for the six months ended June 30, 2006 as compared to net derivative expense of $8.0 million for the six months ended June 30, 2005, reflecting changes in the fair value of the specialized equity put options.
Corporate, Non-allocated Expenses.Corporate underwriting expenses not allocated to segments were $12.6 million for the six months ended June 30, 2006, which were comparable with the $8.3 million for the six months ended June 30, 2005.
Interest, fees and bond issue cost amortization expense for the six months ended June 30, 2006 and 2005 were $35.0 million and $39.4 million, respectively. Interest, fees and bond issue cost amortization expense for the six months ended June 30, 2006 included $15.6 million related to the senior notes, $18.7 million related to the junior subordinated debt securities, $0.5 million related to the bond issue cost amortization and $0.2 million related to the credit line under the Company’s revolving credit facilities. Interest, fees and bond issue cost amortization expense for the six months ended June 30, 2005 included $19.9 million related to the senior notes, $18.7 million related to the junior subordinated debt securities, $0.6 million to the bond issue cost amortization and $0.2 million related to the credit line under the Company’s revolving credit facilities. Interest expense on senior notes decreased due to the retirement on March 15, 2005 of the 8.5% senior notes issued on March 14, 2000.
Other expense for the six months ended June 30, 2006 and 2005 was $4.3 million and $2.9 million, respectively. The change in other expense for the six months ended June 30, 2006 was primarily due to variability in the impact of foreign currency exchange losses.
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 income tax expense of $57.5 million for the six months ended June 30, 2006 compared to $67.4 million for the six months ended June 30, 2005. The decrease was primarily attributable to higher income in jurisdictions with lower effective tax rates.
Net Income. Net income was $388.8 million for the six months ended June 30, 2006 compared to $361.3 million for the six months ended June 30, 2005.
FINANCIAL CONDITION
Cash and Invested Assets.Aggregate invested assets, including cash and short-term investments, were $13,187.6 million at June 30, 2006 and $12,970.8 million at December 31, 2005. This increase in cash and invested assets resulted primarily from $313.3 million in cash flows from operations, $106.5 million of foreign translation and $16.1 million of realized capital gains, partially offset by a decrease of $228.1 million in net pre-tax unrealized appreciation of the Company’s investments comprised of a $269.2 million reduction in pre-tax unrealized appreciation on the fixed maturities portfolio; reflecting the impact of increases in interest rates, partially offset by a $41.1 million increase in pre-tax unrealized appreciation on the equity portfolio. Gross pre-tax unrealized appreciation and depreciation across the Company’s investment portfolio were $371.4 million and
42
$259.5 million, respectively, at June 30, 2006 compared to $443.1 million and $103.0 million, respectively, at December 31, 2005.
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’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. The Company continues to reweight its overall portfolio to modestly increase the emphasis on total return. In this context, the Company has invested in equity securities, principally public equity index securities, which it believes will enhance the risk-adjusted total return of the investment portfolio. Equity investments accounted for 32.3% of the Company’s shareholders’ equity at June 30, 2006 as compared to 26.4% at December 31, 2005.
The tables below summarize the composition and characteristics of the Company’s investment portfolio for the periods indicated:
| (Dollars in thousands) | As of
June 30, 2006
| As of
December 31, 2005
|
|---|
| Fixed maturities | | | $ | 10,177.1 | | | 77.2% | | $ | 10,042.1 | | | 77.4 | % |
| Equity securities | | | | 1,415.7 | | | 10.7% | | | 1,090.8 | | | 8.4 | % |
| Short-term investments | | | | 1,097.1 | | | 8.3% | | | 1,443.8 | | | 11.1 | % |
| Other invested assets | | | | 322.3 | | | 2.4% | | | 286.8 | | | 2.2 | % |
| Cash | | | | 175.4 | | | 1.3% | | | 107.3 | | | 0.8 | % |
|
|
|
|
|
| Total investments and cash | | | $ | 13,187.6 | | | 100.0% | | $ | 12,970.8 | | | 100.0 | % |
|
|
|
|
|
|
As of
June 30, 2006
| As of
December 31, 2005
|
|---|
| Fixed income portfolio duration | | | | 4.5 y | ears | | 4.3 y | ears |
| Fixed income composite credit quality | | | | Aa | 1 | | Aa | 1 |
| Imbedded end of period yield, pre-tax | | | | 4.5 | % | | 4.5 | % |
| Imbedded end of period yield, after-tax | | | | 3.9 | % | | 3.9 | % |
The decrease in short-term investments was due principally to a reallocation to fixed maturities and equities.
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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. However, with changes the Company perceives in overall investment market conditions, the Company continues to reweight its view of total return and added $283.9 million of equity securities into the overall investment portfolio in 2006. The following table provides a comparison of the Company’s total return by asset class to broadly accepted industry benchmarks for the periods indicated:
| Six Months Ended
June 30, 2006
| Twelve Months Ended
December 31, 2005
|
|---|
| Company's fixed income portfolio total return | | | | 0.2 | % | | 3.2 | % |
| Lehman bond aggregate | | | | -0.7 | % | | 2.4 | % |
Company's common equity portfolio total return | | | | 5.0 | % | | 13.8 | % |
| S & P 500 | | | | 2.7 | % | | 4.9 | % |
Company's other invested asset portfolio total return | | | | 8.4 | % | | 7.2 | % |
Reinsurance Receivables. Reinsurance receivables for both paid and unpaid losses were $963.9 million at June 30, 2006, an 8.1% decrease from the $1,048.7 million at December 31, 2005. At June 30, 2006, $158.1 million, or 16.4%, 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, $181.5 million, or 18.8%, was receivable from Transatlantic Reinsurance Company (“Transatlantic”), $142.3 million, or 14.8%, 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 10.4%, 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 $9,041.7 million at June 30, 2006 and $9,126.7 million at December 31, 2005. The decrease during the six months ended June 30, 2006 is primarily attributable to the payout of catastrophe losses and the Company’s lower earned premiums. Net prior period reserve adjustments, including additional catastrophe loss reserves and normal variability in claim settlements also impacted the period over period change.
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The following tables summarize gross outstanding loss and LAE reserves by segment except for the Company wide aggregation of A&E reserves; segregated into case reserves and incurred but not reported loss (“IBNR”) reserves, which are all managed on a combined basis, for the periods indicated.
| Gross Reserves By Segment |
|---|
| As of June 30, 2006 |
|---|
| (Dollars in thousands) | Case
Reserves
| IBNR
Reserves
| Total
Reserves
| % of
Total
|
|---|
| U.S. Reinsurance | | | $ | 1,821,489 | | $ | 2,084,554 | | $ | 3,906,043 | | | 43.2 | % |
| U.S. Insurance | | | | 581,992 | | | 966,114 | | | 1,548,106 | | | 17.1 | % |
| Specialty Underwriting | | | | 351,733 | | | 140,067 | | | 491,800 | | | 5.4 | % |
| International | | | | 580,786 | | | 397,852 | | | 978,638 | | | 10.8 | % |
| Bermuda | | | | 809,923 | | | 687,315 | | | 1,497,238 | | | 16.6 | % |
|
|
|
|
|
| Total excluding A&E | | | | 4,145,923 | | | 4,275,902 | | | 8,421,825 | | | 93.1 | % |
| A&E | | | | 516,451 | | | 103,427 | | | 619,878 | | | 6.9 | % |
|
|
|
|
|
| Total including A&E | | | $ | 4,662,374 | | $ | 4,379,329 | | $ | 9,041,703 | | | 100.0 | % |
|
|
|
|
|
|
As of December 31, 2005 |
|---|
| (Dollars in thousands) | Case
Reserves
| IBNR
Reserves
| Total
Reserves
| % of
Total
|
|---|
| U.S. Reinsurance | | | $ | 1,654,597 | | $ | 2,423,192 | | $ | 4,077,789 | | | 44.7 | % |
| U.S. Insurance | | | | 583,729 | | | 948,288 | | | 1,532,017 | | | 16.8 | % |
| Specialty Underwriting | | | | 273,369 | | | 184,719 | | | 458,088 | | | 5.0 | % |
| International | | | | 577,276 | | | 434,541 | | | 1,011,817 | | | 11.1 | % |
| Bermuda | | | | 618,066 | | | 779,465 | | | 1,397,531 | | | 15.3 | % |
|
|
|
|
|
| Total excluding A&E | | | | 3,707,037 | | | 4,770,205 | | | 8,477,242 | | | 92.9 | % |
| A&E | | | | 526,210 | | | 123,250 | | | 649,460 | | | 7.1 | % |
|
|
|
|
|
| Total including A&E | | | $ | 4,233,247 | | $ | 4,893,455 | | $ | 9,126,702 | | | 100.0 | % |
|
|
|
|
|
The changes by segment generally reflect changes in earned premium, changes in business mix, the impact of reserve re-estimations and changes in catastrophe loss reserves, 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 operations. The Company notes 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.
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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 $62.1 million in 1997, representing 2.2% of the net prior period reserves for the year in which the adjustment was made, to an unfavorable $249.4 million in 2004, representing 3.7% 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, 2005 discusses the Company’s past experience more fully in Part I, Item 1, “Changes in Historical Reserves”.
Asbestos and Environmental Exposures.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 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 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 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 who may only have a “peripheral” connection to asbestos; (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 insurers and forecloses insurers from participating in the negotiation of asbestos related bankruptcy reorganization 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.
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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. The Company’s A&E liabilities stem from Mt. McKinley’s direct insurance business and Everest Re’s assumed reinsurance business.
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 and 2005 and thusfar in 2006, the Company concluded such settlements or reached agreement in principle with 14 of its high profile policyholders. The Company has currently identified 8 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 June 30, 2006 the Company had gross asbestos loss reserves of $542.5 million, of which $303.9 million was for assumed business and $238.6 million was for direct business.
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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
June 30, | Six Months Ended
June 30, |
|---|
| (Dollars in thousands) | 2006
| 2005
| 2006
| 2005
|
|---|
| Gross basis: | | | | | | | | | | | | | | |
| Beginning of period reserves | | | $ | 639,635 | | $ | 724,825 | | $ | 649,460 | | $ | 728,325 | |
| Incurred losses | | | | 6,400 | | | - | | | 16,400 | | | 18,000 | |
| Paid losses | | | | (26,156 | ) | | (23,069 | ) | | (45,981 | ) | | (44,569 | ) |
|
|
|
|
|
| End of period reserves | | | $ | 619,879 | | $ | 701,756 | | $ | 619,879 | | $ | 701,756 | |
|
|
|
|
|
| Net basis: | | |
| Beginning of period reserves | | | $ | 461,235 | | $ | 504,591 | | $ | 450,350 | | $ | 506,675 | |
| Incurred losses | | | | 6,400 | | | 6,603 | | | 15.125 | | | 24,603 | |
| Paid losses | | | | (27,620 | ) | | (20,990 | ) | | (25,460 | ) | | (41,074 | ) |
|
|
|
|
|
| End of period reserves | | | $ | 440,015 | | $ | 490,204 | | $ | 440,015 | | $ | 490,204 | |
|
|
|
|
|
At June 30, 2006, the gross reserves for A&E losses were comprised of $137.8 million representing case reserves reported by ceding companies, $157.3 million representing additional case reserves established by the Company on assumed reinsurance claims, $221.4 million representing case reserves established by the Company on direct excess insurance claims, including Mt. McKinley, and $103.4 million representing IBNR reserves.
The gross incurred losses for A&E exposures increased by $6.4 million and $0.0 million for the three months ended June 30, 2006 and 2005, respectively, and $16.4 million and $18.0 million for the six months ended June 30, 2006 and 2005, respectively. These increases are the result of re-evaluations by management reflecting additional information received from insureds and ceding companies, ongoing litigation, additional claims received and settlement activity. Management closely monitors this additional information and adjusts reserves accordingly. The net incurred losses primarily reflect the impact of the reinsurance agreement between Mt. McKinley.
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 3.7 years at June 30, 2006. Adjusting for the effect of the reinsurance ceded under the reinsurance agreement with LM, this ratio rises to the equivalent of 4.9 years at June 30, 2006. The cession of $142.3 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 was 3.3 years for the period ended June 30, 2006. This three year survival ratio, when adjusted for the effect of the reinsurance ceded under the stop
48
loss cover from LM, was 4.6 years and, when adjusted for settlements in place and structured settlements, which are either fully funded by reserves or subject to financial terms that substantially limit the potential variability in the liability, and the stop loss protection from LM, was 10.6 years.
Shareholders’ Equity. The Company’s shareholders’ equity increased to $4,379.1 million as of June 30, 2006 from $4,139.7 million as of December 31, 2005, principally reflecting $388.8 million of net income for the six months ended June 30, 2006, $29.4 million increase due to net currency translation and $24.8 million in net share compensation activity, partially offset by a decrease of $188.0 million in net unrealized appreciation on investments and $15.6 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. The Company has flexibility with respect to capitalization as a result of its perceived financial strength, in part measured by the Company’s shareholders’ equity noted above, 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 for the six months ended June 30, 2006 or in 2005. At June 30, 2006, 5 million shares remained under the existing repurchase authorization.
On December 1, 2005 under the new registration and offering revisions to the Securities Act of 1933, the Company filed a shelf registration statement on Form S-3 with the Securities and Exchange Commission (“SEC”), as a Well Known Seasoned Issuer. 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 III (“Capital Trust III”) is authorized to issue trust preferred securities.
| | | • | | On December 1, 2005, the Company issued 2,298,000 of its common shares at a price of $102.89 per share, which resulted in $236.4 million of proceeds before expenses of approximately $0.3 million and Holdings sold Group shares it acquired in 2002 at a price of $102.89 per share, which resulted in $46.5 million of proceeds, before expenses of approximately $0.3 million. |
On June 27, 2003, the Company filed a shelf registration statement on Form S-3 with the SEC, providing for the issuance of up to $975 million of securities. Generally, under this shelf registration statement, Group was authorized to issue common shares, preferred shares, debt securities, warrants and hybrid securities, Holdings was authorized to issue debt securities and Everest Re Capital Trust II (“Capital Trust II”) and Everest Re Capital Trust III were authorized to issue trust preferred securities. This shelf registration statement became effective on December 22, 2003 and was exhausted with the October 6, 2005 transaction described below. The following securities were issued pursuant to that registration statement.
| | | • | | On March 29, 2004, Capital Trust II, an unconsolidated affiliate, issued trust preferred securities resulting in a takedown from the shelf registration statement of $320.0 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. |
49
| | | • | | 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 March 15, 2005. |
| | | • | | On October 6, 2005, the Company expanded the size of the remaining shelf registration to $486.0 million by filing under Rule 462(b) of the Securities Act of 1933, as amended, and General Instruction IV of Form S-3 promulgated there under. On the same date, the Company entered into an agreement to issue 5,200,000 of its common shares at a price of $91.50 per share, which resulted in $475.8 million in proceeds received on October 12, 2005, before expenses of approximately $0.3 million. This transaction effectively exhausted the December 22, 2003 shelf registration. |
On March 14, 2000, the Company completed a public offering of $200 million principal amount of 8.75% senior notes due March 15, 2010 and $250 million principal amount of 8.50% senior notes due and retired March 15, 2005. During 2000, the net proceeds of these offerings and additional funds were distributed by Holdings to Group.
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, the Company continues to reweight its view of total return and added $283.9 million for the six months ended June 30, 2006 and $350.4 million in 2005 of equity securities in the overall portfolio.
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 $313.3 million and $618.5 millionfor the six months ended June 30, 2006 and 2005, respectively. Additionally, these cash flows reflected a net tax refund of $25.1 million and a net tax payment of $107.5 million for the six months ended June 30, 2006 and 2005, respectively; net catastrophe loss payments of $506.0 million and $157.8 million for the six months ended June 30, 2006 and 2005, respectively; and asbestos loss payments of $25.5 million and $41.1 million for the six months ended June 30, 2006 and 2005, 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.
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, this continuing underlying trend is negatively impacted by the payout of catastrophe loss reserves. In the intermediate and long term, the trend will be impacted by the extent to which competitive pressures change overall pricing available in the Company’s markets and the extent to which the Company successfully maintains its strategy of emphasizing profitability over volume.
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
50
are intended to provide adequate cash for payment of claims. At June 30, 2006 and December 31, 2005 the Company held cash and short-term investments of $1,272.5 million and $1,551.0 million, respectively. In addition to these cash and short-term investments at June 30, 2006, the Company had $525.2 million, at fair value, of available for sale fixed maturity securities maturing within one year or less, $2,369.6 million maturing within one to five years and $7,282.3 million maturing after five years. These fixed maturity and equity 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 may result in realized capital gains or losses and the Company notes that at June 30, 2006 it had $26.6 million of net unrealized appreciation, net of $85.3 million of taxes, comprised of $371.4 million of pre-tax appreciation and $259.5 million of pre-tax depreciation.
Effective December 8, 2004, Group, Bermuda Re, and Everest International Reinsurance, Ltd. (“Everest International”) entered into a 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) the Base Rate (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) $2,898 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 June 30, 2006, the Company was in compliance with these covenants.
For the six months ended June 30, 2006 and 2005, there were no outstanding borrowings under tranche one of the Group Credit Facility. At June 30, 2006, there was $121.8 million used of the $500 million available for tranche two of standby letters of credit. In addition, the Company had $262.7 million in letters of credit outstanding at June 30, 2006 under a $350 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 June 30, 2006, $144.2 million of assets were deposited in trust accounts, primarily on behalf of Bermuda Re, as security for assumed losses payable to certain non-affiliated ceding companies.
Effective October 10, 2003, Holdings entered into a 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
51
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.
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 after December 31, 2002. As of June 30, 2006, Holdings was in compliance with these covenants.
For the six months ended June 30, 2006 and 2005, there were no outstanding borrowings under the Holdings Credit Facility.
Interest expense and fees incurred in connection with the Group Credit Facility and the Holdings Credit Facility were $0.1 million for the three months ended June 30, 2006 and 2005 and $0.2 million for the six months ended June 30, 2006 and 2005.
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 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 change in overall market sensitive risk exposure principally reflects the asset changes that took place during the period.
The Company’s $13.2 billion investment portfolio at June 30, 2006 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 $1,649.6 million of mortgage-backed securities in the $10,177.1 million fixed maturity
52
portfolio. Prepayment risk results from potential accelerated principal payments that shorten the average life and thus the expected yield of the security.
The table below displays the potential impact of market value fluctuations and after-tax unrealized appreciation on the Company’s fixed maturity portfolio (including $1,097.1 million of short-term investments) as of June 30, 2006 based on parallel and immediate 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 June 30, 2006
Interest Rate Shift in Basis Points
|
|---|
| -200
| -100
| 0
| 100
| 200
|
|---|
| Total Market Value | | | $ | 12,335.7 | | $ | 11,812.7 | | $ | 11,274.2 | | $ | 10,702.5 | | $ | 10,133.3 | |
| Market Value Change from Base (%) | | | | 9.4 | % | | 4.8 | % | | 0.0 | % | | -5.1 | % | | -10.1 | % |
| Change in Unrealized Appreciation | | |
| After-tax from Base ($) | | | $ | 797.6 | | $ | 404.0 | | $ | - | | $ | (424.9 | ) | $ | (846.7 | ) |
The Company had $9,041.7 million and $9,126.7 million of reserves for losses and LAE as of June 30, 2006 and December 31, 2005, respectively. 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 3.8 years, which is reasonably consistent with the duration of the Company’s fixed maturities portfolio. If the Company were to discount its loss and LAE reserves, net of $0.9 billion of reinsurance receivables on unpaid losses, the discount would be approximately $1.5 billion, resulting in a discounted reserve balance of approximately $6.6 billion, representing approximately 59% of the fixed maturities 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’s equity investments are mainly 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 June 30, 2006
Change in Equity Values in Percent
|
|---|
| -20%
| -10%
| 0%
| 10%
| 20%
|
|---|
| Market Value of the Equity Portfolio | | | $ | 1,132.5 | | $ | 1,274.1 | | $ | 1,415.7 | | $ | 1,557.3 | | $ | 1,698.8 | |
| After-tax Change in Unrealized | | |
| Appreciation | | | $ | (195.0 | ) | $ | (97.5 | ) | $ | - | | $ | 97.5 | | $ | 195.0 | |
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 June 30, 2006, there has been no material change in exposure to foreign exchange rates as compared to December 31, 2005.
Although not considered material in the context of the Company’s aggregate exposure to market sensitive instruments, the Company has issued six specialized equity put options based on the S&P 500 index and one specialized equity put option based on the FTSE 100 index, that are market sensitive and sufficiently unique to warrant supplemental disclosure.
The Company has sold six specialized equity put options based on the S&P 500 index for total consideration, net of commissions, of $22.5 million. These contracts each have a single exercise date, with original maturities ranging from 12 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, which currently fall between June 2017 and March 2031. 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 June 30, 2006 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 6.5%. The theoretical maximum payouts under the contracts would occur if on each of the exercise dates the S&P 500 index value were zero. The present value of these theoretical maximum payouts using a 6% discount factor is $207.1 million.
The company has sold one specialized equity put option based on the FTSE 100 index for total consideration, net of commissions, of $6.7 million. This contract has an exercise date of July 2020 and a strike price of £5,989.75. No amount will be payable under this contract if the FTSE 100 index is at or above the strike price on the exercise date. If the FTSE 100 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 June 30, 2006 index value, the Company estimates the probability
54
for this FTSE 100 index contract being below the strike price on the exercise date to be less than 9.5%. The theoretical maximum payout under the contract would occur if on the exercise date the FTSE 100 index value was zero. The present value of the theoretical maximum payout using a 6.0% discount factor is $26.8 million.
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 to fair value in its consolidated statements of operations and comprehensive income. The Company has recorded fair values for its obligations on these specialized equity put options at June 30, 2006 and December 31, 2005 of $31.6 million and $36.3 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 Equity Indices, which are the principal factors affecting fair value of these instruments, looking forward from the fair value at June 30, 2006. These are estimates and there can be no assurance regarding future market performance. The asymmetrical results of the interest rate and S&P 500 and FTSE 100 indices shifts reflect that the liability cannot fall below zero whereas it can increase to its theoretical maximum.
As of June 30, 2006
S & P 500 Index Put Options Obligation – Sensitivity Analysis
(Dollars in millions)
|
|---|
Interest Rate Shift in Basis Points:
| -100
| -50
| 0
| 50
| 100
|
|---|
| Total Market Value | | | $ | 45.2 | | $ | 37.8 | | $ | 31.6 | | $ | 26.3 | | $ | 21.8 | |
| Market Value Change from Base (%) | | | | -43.1 | % | | -19.8 | % | | 0.0 | % | | 16.7 | % | | 30.8 | % |
|
|
|
|
|
|
S & P Index Shift in Points:
| -200
| -100
| 0
| 100
| 200
|
|---|
| Total Market Value | | | $ | 39.3 | | $ | 35.1 | | $ | 31.6 | | $ | 28.5 | | $ | 25.9 | |
| Market Value Change from Base (%) | | | | -24.5 | % | | -11.3 | % | | 0.0 | % | | 9.6 | % | | 18.0 | % |
|
|
|
|
|
|
Combined Interest Rate / S & P Index Shift:
| -100/-200
| -50/-100
| 0/0
| 50/100
| 100/200
|
|---|
| Total Market Value | | | $ | 55.2 | | $ | 41.9 | | $ | 31.6 | | $ | 23.6 | | $ | 17.6 | |
| Market Value Change from Base (%) | | | | -75.1 | % | | -32.7 | % | | 0.0 | % | | 25.0 | % | | 44.1 | % |
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, including the most recent hurricanes, 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
55
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 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 I, Item 1A. 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. These disputes arise from time to time and as they arise are addressed, and ultimately resolved, through both informal and formal means, including negotiated resolution, arbitration and litigation. In all such matters, the Company believes that its positions are legally and commercially reasonable. While the final outcome of these matters cannot be predicted with certainty, the Company does not believe that any of these matters, when finally resolved, will have a material adverse effect on the Company’s financial position or liquidity. However, an adverse resolution of one or more of these items in any one quarter or fiscal year could have a material adverse effect on the Company’s results of operations in that period.
In May 2005, Holdings received and responded to a subpoena from the SEC seeking information regarding certain loss mitigation insurance products. The Company has stated that Holdings will fully cooperate with this and any future inquiries and that Holdings does not believe that it has engaged in any improper business practices with respect to loss mitigation insurance products.
The Company’s insurance subsidiaries have also received and have responded to broadly distributed information requests by state regulators including among others, from Delaware and Georgia.
PART II – Item 1A. Risk Factors
No material changes.
PART II - Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
None.
PART II – Item 3. Defaults Upon Senior Securities
None.
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Part II – Item 4. Submission of Matters to a Vote of Security Holders
(a) The Annual General Meeting of Shareholders of Everest Re Group, Ltd. was held on May 23, 2006.
(b) All director nominees were elected.
(c) Each matter voted upon at the meeting and the votes cast with respect to each such matter are as follows:
| Votes Cast | | | |
|
| | | |
|
50,343,445 | | | |
|
For | Against or
Withheld | Abstain | Broker
Non-votes |
|
|
|
|
|
| Approval of the appointment | | | | | | | | | | | | | | |
| of an independent registered | | | | | | | | | | | | | | |
| public accounting firm for the | | | | | | | | | | | | | | |
| 2006 audit | | | | 50,333,462 | | | 3,809 | | | 6,174 | | | - | |
Approval of the amendment | | |
| to the 2002 | | |
| Everest Re Group, Ltd, | | |
| Stock Option Plan | | | | 38,700,452 | | | 8,339,710 | | | 55,867 | | | 3,247,416 | |
Election of directors for a term | | |
| expiring 2009: | | |
Martin Abrahams | | | | 49,707,030 | | | 636,415 | | | N/A | | | - | |
John R. Dunne | | | | 50,153,315 | | | 190,130 | | | N/A | | | - | |
John A. Weber | | | | 50,151,400 | | | 192,045 | | | N/A | | | - | |
PART II – Item 5. Other Information
None.
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Part II – Item 6. Exhibits
| | 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: August 9, 2006
