Why did ACE's 2002 earnings fall so sharply despite strong premium growth?

The main driver was a fourth-quarter 2002 increase of $516 million pre-tax ($354 million after-tax) to A&E reserves, following an internal review that assumed no future asbestos reform. Realized investment losses of $489 million pre-tax also weighed on results. Excluding realized losses and debt prepayment costs, net operating income was $511 million, which is a substantial recovery from 2001.

How strong is the balance sheet, and does ACE have enough capital to absorb further reserve charges?

Shareholders' equity was $6.39 billion at year-end 2002, and the consolidated net worth covenant was met with $5.9 billion against a $3.8 billion minimum. The debt-to-total-capitalization ratio was 20.9%. Management believes liquidity is adequate, and it planned to issue $300-500 million of new debt or trust preferred securities to add capital to its U.S. operating subsidiaries after the A&E charge. Management also noted that reserves are at the high end of its internal range, but further adverse development remains possible.

What are the main risks to the reserve estimates?

The filing identifies asbestos and environmental claims as the primary uncertainty. Key variables include payments to unimpaired claimants, the liability of peripheral defendants (over 6,000 defendants have been sued per a 2002 RAND report), and the outcome of federal or state asbestos reform. The Brandywine exposure is the largest concern, and its NICO reinsurance cover is exhausted. Management states that adverse developments could require further reserve increases that would materially affect results.

Is the pricing cycle favorable for ACE going forward?

Management described a hard market in which casualty rates (over 75% at ACE USA, and 97% for D&O) were still accelerating into 2003, while property rates were stabilizing. Global Reinsurance expected catastrophe rates to be flat to slightly down in 2003. Management also acknowledged that current pricing levels will not be sustainable indefinitely and that it expects the market to soften at some point.

What did ACE's rating agencies do after the January 2003 announcement?

Following the January 27, 2003 announcement, S&P placed ratings on watch with negative implications, then on March 21, 2003, affirmed the financial strength ratings of ongoing operating subsidiaries, lowered the Century Indemnity (Brandywine) rating, and lowered senior debt ratings to standard notching. Moody's placed its debt ratings on watch negative, and Fitch placed ACE INA Holdings and its subsidiaries on ratings watch negative and downgraded Brandywine. Lower ratings could raise borrowing costs and reduce demand for ACE's products.

CB 10-K FY2002 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed March 27, 2003. Cited figures are marked; the original filing is the authoritative source.

ACE Limited (NYSE: ACE, Cayman Islands holding company with business office in Bermuda) closed 2002 with total assets of $43.5 billion^a and shareholders' equity of $6.39 billion (diluted book value per share of $24.16, up from $23.59).

Reported net income collapsed to $76.5 million^b ($0.19 diluted EPS) from a $146.4 million loss in 2001, driven by a $516 million pre-tax (~$354 million after-tax) strengthening of asbestos and environmental (A&E) reserves recorded in Q4 2002, plus $489 million of pre-tax net realized investment losses including $268 million of other-than-temporary write-downs. Excluding realized losses and debt prepayment costs, net operating income was $511 million, versus $(69) million in 2001, which had absorbed $650 million of September 11 losses. The combined ratio improved to 101.7% from 111.6%, and the underlying (ex-A&E) loss ratio improved meaningfully, though the reported A&E charge pushed the Insurance-North American segment to an 111.4% combined ratio.

Top-line growth was strong: gross premiums written rose 26% to $12.8 billion^c, led by Insurance-North American (+35%) and Global Reinsurance P&C (+93%), reflecting a hard market with rate increases of over 75% in casualty and 97% in D&O at ACE USA. Management expects casualty pricing to keep accelerating into 2003 while property rates stabilize. Operating cash flow was $2.4 billion.

The company also flagged risks it considers material: A&E exposures tied to the CIGNA P&C acquisition (Brandywine run-off, now with NICO cover exhausted), asbestos reserve adequacy in the face of potential future legal reform, September 11 development, and rating agency actions, including S&P, Moody's and Fitch placing ratings on negative watch after the January 2003 charge. Liquidity remains adequate, with a debt-to-capitalization ratio of 20.9% and planned new debt or trust preferred issuance of $300^d-500 million to recapitalize U.S. subsidiaries. For investors, the central question is whether the A&E reserve increase fully resolves the legacy exposure.

Management states its reserves now represent the high end of its internal task force's range, but the filing also notes that adverse development could require further increases and that large unidentified peripheral defendants remain a risk. The stock traded near $30 at the time of filing, and the dividend was $0.17 per quarter.

02—Key points

Key Highlights

Q4 2002 A&E reserve strengthening of $516 million pre-tax ($354 million after-tax) drove the full-year net income of only $76.5 million, or $0.19 per diluted share, versus a 2001 net loss of $146.4 million.
Gross premiums written grew 26% to $12.8 billion, with Insurance-North American up 35%, Global Reinsurance P&C up 93%, and casualty rate increases above 75% at ACE USA, reflecting a strong hard market.
Underlying profitability improved: the combined ratio fell to 101.7% from 111.6%, and net operating income excluding realized losses was $511 million versus a $69 million loss in 2001 that included September 11 losses of $650 million.
Net realized investment losses of $489 million included $268 million of other-than-temporary write-downs and $188 million of derivative and futures losses, largely from equity and interest rate hedging.
Total assets were $43.5 billion and shareholders' equity was $6.4 billion, with diluted book value per share up to $24.16 from $23.59 and a debt-to-capitalization ratio of 20.9%.
Ratings pressure: after the January 2003 A&E announcement, S&P, Moody's and Fitch placed ratings on watch with negative implications, and S&P lowered the Century Indemnity (Brandywine) financial strength rating, with a planned $300-500 million debt or trust preferred raise to recapitalize U.S. subsidiaries.
Ongoing asbestos and environmental exposure is concentrated in the Brandywine run-off (acquired with CIGNA P&C in 1999), where NICO reinsurance cover is exhausted and the company assumes no future state or federal asbestos reform.

03—Questions

Frequently Asked Questions

Why did ACE's 2002 earnings fall so sharply despite strong premium growth?
The main driver was a fourth-quarter 2002 increase of $516 million pre-tax ($354 million after-tax) to A&E reserves, following an internal review that assumed no future asbestos reform. Realized investment losses of $489 million pre-tax also weighed on results. Excluding realized losses and debt prepayment costs, net operating income was $511 million, which is a substantial recovery from 2001.
How strong is the balance sheet, and does ACE have enough capital to absorb further reserve charges?
Shareholders' equity was $6.39 billion at year-end 2002, and the consolidated net worth covenant was met with $5.9 billion against a $3.8 billion minimum. The debt-to-total-capitalization ratio was 20.9%. Management believes liquidity is adequate, and it planned to issue $300-500 million of new debt or trust preferred securities to add capital to its U.S. operating subsidiaries after the A&E charge. Management also noted that reserves are at the high end of its internal range, but further adverse development remains possible.
What are the main risks to the reserve estimates?
The filing identifies asbestos and environmental claims as the primary uncertainty. Key variables include payments to unimpaired claimants, the liability of peripheral defendants (over 6,000 defendants have been sued per a 2002 RAND report), and the outcome of federal or state asbestos reform. The Brandywine exposure is the largest concern, and its NICO reinsurance cover is exhausted. Management states that adverse developments could require further reserve increases that would materially affect results.
Is the pricing cycle favorable for ACE going forward?
Management described a hard market in which casualty rates (over 75% at ACE USA, and 97% for D&O) were still accelerating into 2003, while property rates were stabilizing. Global Reinsurance expected catastrophe rates to be flat to slightly down in 2003. Management also acknowledged that current pricing levels will not be sustainable indefinitely and that it expects the market to soften at some point.
What did ACE's rating agencies do after the January 2003 announcement?
Following the January 27, 2003 announcement, S&P placed ratings on watch with negative implications, then on March 21, 2003, affirmed the financial strength ratings of ongoing operating subsidiaries, lowered the Century Indemnity (Brandywine) rating, and lowered senior debt ratings to standard notching. Moody's placed its debt ratings on watch negative, and Fitch placed ACE INA Holdings and its subsidiaries on ratings watch negative and downgraded Brandywine. Lower ratings could raise borrowing costs and reduce demand for ACE's products.

04—Continue

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